SCHEDULE 14A SCHEDULE 14A INFORMATION Proxy Statement Pursuant to Section 14(a) of the Securities Exchange Act of 1934 (Amendment No. ____) Filed by the Registrant [X] Filed by a Party other than the Registrant [ ] Check the appropriate box: [ ] Preliminary Proxy Statement [ ] Confidential, for Use of the Commission Only (as permitted by Rule 14a-6(e)(2)) [x] Definitive Proxy Statement [ ] Definitive Additional Materials [ ] Soliciting Material Pursuant to 240.14a-11(c) or 240.14a- 12 AMERICAN FINANCIAL CORPORATION (Name of Registrant as Specified In Its Charter) (Name of Person(s) Filing Proxy Statement if other than the Registrant) Payment of Filing Fee (Check the appropriate box): [X] No fee required. [ ] Fee computed on table below per Exchange Act Rules 14a- 6(i)(4) and 0-11. Title of each class of securities to which transaction applies: Aggregate number of securities to which transaction applies: Per unit price or other underlying value of transaction computed pursuant to Exchange Act Rule 0-11 (Set forth the amount on which the filing fee is calculated and state how it was determined) Proposed maximum aggregate value of transaction: [ ] Fee paid previously with preliminary materials. [ ] Check box if any part of the fee is offset as provided by Exchange Act Rule 0-11(a)(2) and identity the filing for which the offsetting fee was paid previously. Identify the previous filing by registration statement number, or the Form or Schedule and the date of its filing. (1) Amount Previously Paid: (2) Form, Schedule or Registration Statement No.: (3) Filing Party: (4) Date Filed: AMERICAN FINANCIAL CORPORATION One East Fourth Street Cincinnati, Ohio 45202 NOTICE OF ANNUAL MEETING OF SHAREHOLDERS To be Held on May 28, 1998 To our Shareholders: The Annual Meeting of Shareholders of American Financial Corporation will be held on Thursday, May 28, 1998, at 10:30 a.m., at The Cincinnatian Hotel, 601 Vine Street, Cincinnati, Ohio. The purposes of the meeting are: 1. To elect eight directors; and 2. To transact such other business as may properly come before the meeting or any adjournment thereof. Only holders of record of Common Stock and Series J Preferred Stock of the Company at the close of business on March 31, 1998 are entitled to receive notice of and to vote at the meeting or any adjournment thereof. You are invited to be present at the meeting so that you can vote in person. Whether or not you plan to attend the meeting, please date, sign and return the accompanying proxy form in the enclosed, postage-paid envelope. If you do attend the meeting, you may either vote by proxy or revoke your proxy and vote in person. You may also revoke your proxy at any time before the vote is taken at the meeting by written revocation or by submitting a later-dated proxy form. Sincerely, Carl H. Lindner Chairman of the Board and Chief Executive Officer Cincinnati, Ohio April 21, 1998 AMERICAN FINANCIAL CORPORATION PROXY STATEMENT INTRODUCTION This Proxy Statement is furnished in connection with the solicitation of proxies by the Board of Directors of American Financial Corporation ("AFC" or the "Company") for use at the Annual Meeting of Shareholders (the "Meeting") to be held on Thursday, May 28, 1998, and any adjournment thereof. The Meeting will be held concurrently with the meeting of American Financial Group, Inc. ("AFG"), the Company's parent company. The approximate mailing date of this Proxy Statement and accompanying proxy form is April 21, 1998. At the Meeting, shareholders will be asked to elect eight directors and to transact such other business as may properly come before the Meeting or any adjournment thereof. VOTING AT THE MEETING Record Date; Shares Outstanding As of March 31, 1998, the record date for determining shareholders entitled to notice of and to vote at the Meeting (the "Record Date"), the Company had outstanding two classes of voting securities, its common stock, no par value ("Common Stock") and its Series J Preferred Stock ("Preferred Stock"). At the Record Date, 10,593,000 shares of Common Stock were outstanding, all of which were held by AFG, and 2,886,161 shares of Preferred Stock were outstanding. Each share of outstanding Common Stock and Preferred Stock is entitled to one vote on each matter to be presented at the Meeting. Abstentions and broker non-votes will have no effect on any item voted on at the Meeting. Proxies If a choice is specified on a properly executed proxy form, the shares will be voted accordingly. If a proxy form is signed without a preference indicated, those shares will be voted "FOR" the election of the eight nominees proposed by the Board of Directors. If any other matters properly come before the Meeting or any adjournment thereof, each properly executed proxy form will be voted in the discretion of the proxies named therein. Shareholders may vote in person or by proxy at the Meeting. Proxies given may be revoked at any time by filing with the Company either a written revocation or a duly executed proxy bearing a later date, or shareholders may appear at the Meeting and vote in person. Solicitation of proxies is being made by management at the direction of the Company's Board of Directors, without additional compensation, through the mail, in person, by facsimile or by telephone. The cost will be borne by the Company. In addition, the Company will request brokers and other custodians, nominees and fiduciaries to forward proxy soliciting material to the beneficial owners of shares held of record by such persons, and the Company will reimburse them for their expenses in so doing. Adjournment and Other Matters Approval of a motion for adjournment or other matters brought before the Meeting requires the affirmative vote of a majority of the shares voting at the Meeting. Management knows of no other matters to be presented at the Meeting other than those stated in the Notice. Principal Shareholders The following shareholders are the only persons known by the Company to own beneficially 5% or more of its outstanding voting securities as of March 31, 1998: Name and Address Amount and Nature of of Voting Percent of Beneficial Owner Securities Voting Securities - -------------------- ------------------- ----------------- American Financial Group, Inc. (a) 10,593,000 78.6% One East Fourth Street shares Cincinnati, Ohio 45202 of Common Stock (a) Carl H. Lindner, Carl H. Lindner III, S. Craig Lindner, Keith E. Lindner and trusts for their benefit (collectively the "Lindner Family") are the beneficial owners of approximately 44% of the voting stock of AFG. AFG and the Lindner Family may be deemed to be controlling persons of the Company. 2 PROPOSAL Election of Directors The Board of Directors has nominated eight directors to hold office until the next Annual Meeting of Shareholders and until their successors are elected and qualified. If any of the nominees should become unable to serve as a director, the proxies will be voted for any substitute nominee designated by the Board of Directors but, in any event, no proxy may be voted for more than eight nominees. The eight nominees who receive the greatest number of votes will be elected. The nominees for election to the Board of Directors are CARL H. LINDNER, KEITH E. LINDNER, CARL H. LINDNER III, S. CRAIG LINDNER, THEODORE H. EMMERICH, JAMES E. EVANS, THOMAS M. HUNT and WILLIAM R. MARTIN. All of these nominees were elected directors at the Company's last Annual Meeting of Shareholders held on December 2, 1997. Three directors who were elected at that meeting are not standing for election. William W. Verity resigned as a director in January 1998 and Messrs. Gregory C. Thomas and Alfred W. Martinelli have indicated to management that they did not wish to be nominated to serve past the date of the Meeting. See "Management" below for information concerning the background, securities holdings, remuneration and certain other matters relating to the nominees. The Board of Directors recommends that shareholders vote FOR the election of the eight nominees as directors. 3 MANAGEMENT The directors and executive officers of the Company are: Director or Age* Position Executive Since Carl H. Lindner 78 Chairman of the Board and Chief Executive Officer 1959 S. Craig Lindner 43 Co-President and a Director 1979 Keith E. Lindner 38 Co-President and a Director 1981 Carl H. Lindner III 44 Co-President and a Director 1980 Theodore H. Emmerich 71 Director 1995 James E. Evans 52 Senior Vice President, General Counsel and a Director 1976 Thomas M. Hunt 74 Director 1995 William R. Martin 69 Director 1995 Sandra W. Heimann 55 Vice President 1984 Robert C. Lintz 64 Vice President 1979 Thomas E. Mischell 50 Senior Vice President - Taxes 1985 Fred J. Runk 55 Senior Vice President and Treasurer 1978 *As of March 31, 1998 Carl H. Lindner (Chairman of the Executive Committee) Mr. Lindner is the Chairman of the Board and Chief Executive Officer of the Company. During the past five years, Mr. Lindner has also been Chairman of the Board and Chief Executive Officer of AFG. He is Chairman of the Board of Directors of American Annuity Group, Inc. ("AAG") and Chiquita Brands International, Inc. ("Chiquita"). Mr. Lindner is the father of Keith E. Lindner, Carl H. Lindner III and S. Craig Lindner. S. Craig Lindner (Member of the Executive Committee) Since March 1996, Mr. Lindner has served as Co-President and a director of the Company. For over five years, Mr. Lindner has been President of AAG, an 81%-owned subsidiary of the Company that markets tax-deferred annuities principally to employees of educational institutions. Mr. Lindner is also President of American Money Management Corporation ("AMMC"), a subsidiary of AFC which provides investment services for the Company and its affiliated companies. Mr. Lindner is also a director of AAG and AFG. 4 Keith E. Lindner (Member of the Executive Committee) Since March 1996, Mr. Lindner has served as Co-President and a director of the Company. In March 1997, Mr. Lindner was named Vice Chairman of the Board of Directors of Chiquita, a worldwide marketer and producer of bananas and other food products in which the Company has a 37.5% ownership interest. For more than five years prior to that time, Mr. Lindner had been President and Chief Operating Officer and a director of Chiquita. Mr. Lindner is also a director of AFG. Carl H. Lindner III (Member of the Executive Committee) Mr. Lindner was President of AFG's predecessor from February 1992 until he became Co-President in March 1996. During the last five years, Mr. Lindner has been President of Great American Insurance Company ("Great American"), the principal property and casualty insurance subsidiary of AFC. Mr. Lindner is also a director of AFG. Theodore H. Emmerich (Chairman of the Audit Committee; Member of the Compensation Committee) Until his retirement in 1986, Mr. Emmerich was managing partner of the Cincinnati office of the independent accounting firm of Ernst & Whinney. He is also a director of AFG, Carillon Fund, Inc., Carillon Investment Trust, Gradison Custodial Trust, Gradison-McDonald Municipal Custodial Trust, Gradison-McDonald Cash Reserve Trust and Summit Investment Trust. James E. Evans Since April 1995, Mr. Evans has served as Senior Vice President and General Counsel of the Company. For more than five years prior thereto, he had been Vice President and General Counsel of AFC. Mr. Evans is also a director of AFG. Thomas M. Hunt (Member of the Compensation Committee) During the past five years, Mr. Hunt has been Chairman of the Board of Hunt Petroleum Corporation, an oil and gas production company. He is also a director of AFG. William R. Martin (Chairman of the Compensation Committee; Member of the Audit Committee) During the past five years, Mr. Martin has been Chairman of the Board (since 1993) and President and Chief Executive Officer (until 1993) of MB Computing, Inc., a computer software and services company. Mr. Martin is also a director of AAG and AFG. Thomas E. Mischell Since April 1995, Mr. Mischell has served as Senior Vice President - Taxes of the Company. For more than five years prior thereto, he had served as a Vice President of AFC. 5 Fred J. Runk Since April 1995, Mr. Runk has served as Senior Vice President and Treasurer of the Company. For more than five years prior thereto, he had served as Vice President and Treasurer of AFC. Sandra W. Heimann has served as a Vice President of the Company for more than five years. Robert C. Lintz has served as a Vice President of the Company for more than five years. In December 1993, Great American Communications Company, which subsequently changed its name to Citicasters Inc., completed a comprehensive financial restructuring that included a prepackaged plan of reorganization under Chapter 11 of the Bankruptcy Code. Messrs. Carl H. Lindner, Mischell and Runk had been executive officers of that company within two years before its bankruptcy reorganization. The Company sold its interest in Citicasters in September 1996. Section 16(a) Beneficial Ownership Reporting Compliance Section 16(a) of the Exchange Act requires AFC's officers, directors and persons who own more than ten percent of AFC's voting stock to file reports of ownership with the Securities and Exchange Commission and to furnish AFC with copies of these reports. The Company believes that all filing requirements were met during 1997. Securities Ownership The following table sets forth information, as of March 31, 1998, concerning the beneficial ownership of equity securities of the Company and its subsidiaries by each director, nominee for director, the executive officers named in the Summary Compensation Table (see "Compensation" below) and by all directors and executive officers as a group. Such information is based on data 6 furnished by the persons named. Except as set forth in the following table, no director or executive officer beneficially owned 1% or more of any class of equity security of the Company or any of its subsidiaries outstanding at March 31, 1998. Amount and Nature of Beneficial Ownership (a) --------------------------------------------- Name of Shares of Common Shares of Preferred Beneficial Owner Stock Held Stock Held - ---------------------------------------- -------------------- Carl H. Lindner 10,593,000 (b) --- Carl H. Lindner III 10,593,000 (b) --- S. Craig Lindner 10,593,000 (b) --- Keith E. Lindner 10,593,000 (b) --- Theodore H. Emmerich --- --- James E. Evans --- --- Thomas M. Hunt --- --- William R. Martin --- 40,126 (b) All directors and executive officers as a group (12 persons) 10,593,000 (c) 60,684 (d) (a) Does not include the following ownership interests in AAG common stock: Messrs. Emmerich, Evans, Hunt, S.C. Lindner and Martin, and all directors and executive officers as a group beneficially own 1,561; 19,638; 382; 69,308; 10,632 and 164,273 shares, respectively. Also excludes the following ownership of Chiquita common stock: Messrs. Emmerich, C.H. Lindner and K.E. Lindner, and all directors and executive officers as a group beneficially own 1,000; 44,873; 13,759 and 268,963 shares, respectively. This table also excludes the ownership of shares of common stock of AFG, the Company's parent, as follows: Carl H. Lindner - 6,735,045; Carl H. Lindner III - 4,483,665; S. Craig Lindner - 4,199,244; Keith E. Lindner - 6,392,209; Mr. Emmerich - 18,663, Mr. Evans - 135,301; Mr. Hunt - 17,991; Mr. Martin - 42,044; and all directors and executive officers as a group - 22,845,708. 7 (b) Represents 1.4% of the Preferred Stock outstanding. (c) Represents shares held by AFG. The Lindner Family may be deemed to be the beneficial owners of these shares, which represent 100% of the Common Stock outstanding. (d) Represents 2.1% of the Preferred Stock outstanding. 8 COMPENSATION The following table summarizes the aggregate cash compensation for 1997, 1996 and 1995 of the Company's Chairman of the Board and Chief Executive Officer and its four other most highly compensated executive officers during 1997 (such five executive officers being herein referred to as the "Named Executive Officers"). Such compensation includes amounts paid by AFC and AFG as well as its subsidiaries and certain affiliates during the years indicated. SUMMARY COMPENSATION TABLE --------------------------- Annual Compensation Long-Term Compensation ---------------------------------- ------------------ Securities Under Name Other Annual lying All Other and Salary Bonus Compensation Options Granted Compensation Principal Position Year (a) (b) (c) (# of Shares) (d) - ---------------------------------------------------------------------------- ------------ Carl H. Lindner 1997 $957,000 $370,000 $107,000 --- $75,000 Chairman of the Board 1996 913,000 900,000 156,000 --- 118,400 and Chief Executive 1995 1,364,000 900,000 254,000 --- 169,000 Officer Keith E. Lindner 1997 957,000 370,000 14,000 50,000 31,000 Co-President 1996 917,000 900,000 28,000 --- 31,000 1995 935,000 900,000 --- 400,000 30,000 Carl H. Lindner III 1997 957,000 370,000 117,000 50,000 34,000 Co-President 1996 917,000 900,000 174,000 --- 60,500 1995 1,076,000 900,000 223,000 --- 103,000 S. Craig Lindner 1997 957,000 370,000 132,000 50,000 34,000 Co-President 1996 917,000 900,000 137,000 --- 32,000 1995 1,121,000 900,000 142,000 388,181 83,000 James E. Evans 1997 957,000 350,000 2,000 30,000 260,000 Senior Vice President 1996 917,000 639,000 14,000 --- 49,500 and General Counsel 1995 948,000 850,000 10,000 150,000 58,000 9 (a) This column includes salary paid by Chiquita to Carl H. Lindner of $200,000 in 1997 and 1996 and $269,000 in 1995, and to Keith E. Lindner of $381,000 in 1997, $900,000 in 1996 and $935,000 in 1995. (b) Bonuses are for the year shown, regardless of when paid. Approximately one-fourth of the 1997 and 1996 bonus for each individual was paid in shares of AFG Common Stock. (c) This column includes amounts for personal homeowners and automobile insurance coverage, and the use of corporate aircraft and value of automobiles as follows. Aircraft & Name Year Insurance Automobile - ------------------------ ----- --------- ----------- Carl H. Lindner 1997 $19,000 $88,000 1996 16,000 140,000 1995 18,000 236,000 Keith E. Lindner 1997 6,000 8,000 1996 12,000 16,000 1995 -- -- Carl H. Lindner III 1997 23,000 94,000 1996 19,000 155,000 1995 17,000 206,000 S. Craig Lindner 1997 26,000 106,000 1996 23,000 114,000 1995 20,000 122,000 James E. Evans 1997 -- 2,000 1996 -- 14,000 1995 -- 10,000 10 (d) Represents options to purchase shares of AFG common stock. (e) Includes Company or subsidiary contributions or allocations under the (i) defined contribution retirement plans and (ii) employee savings plan in which the following Named Executive Officers participate (and related accruals for their benefit under the Company's benefit equalization plan which generally makes up certain reductions caused by Internal Revenue Code limitations in the Company's contributions to certain of the Company's retirement plans) and Company paid group life insurance as set forth below. For Mr. Evans only, this column also includes the fair market value of a special 1997 award of 5,000 shares of AFG common stock. AFG Auxiliary Retirement Directors' Savings Term Name Year RASP Plan Fees Plan Life - ------------------------------------------------------------------------- Carl H. Lindner 1997 $30,000 -- $2,000 $15,000 $28,000 1996 21,400 $55,000 4,500 14,500 23,000 1995 30,000 56,000 18,000 25,000 40,000 Keith E. Lindner 1997 30,000 -- -- -- 1,000 1996 30,000 -- -- -- 1,000 1995 30,000 -- -- -- -- Carl H. Lindner III 1997 30,000 -- 2,000 -- 2,000 1996 30,000 28,500 -- -- 2,000 1995 30,000 67,000 -- -- 6,000 S. Craig Lindner 1997 30,000 -- 2,000 -- 2,000 1996 30,000 -- -- -- 2,000 1995 30,000 -- -- 51,000 2,000 James E. Evans 1997 30,000 -- 2,000 -- 5,000 1996 30,000 -- -- 14,500 5,000 1995 30,000 -- -- 25,000 3,000 11 Stock Options The tables set forth below disclose AFG stock options granted to, or exercised by, the Named Executive Officers during 1997, as well as the number and value of unexercised options held by them at December 31, 1997. OPTION GRANTS IN 1997 ----------------------- Individual Grants --------------------------------------------------- Potential Realizable Number of Securities Percent of Exercise Value at Assumed Annual Underlying Options Total Price per Rates of Stock Price Options Share Appreciation for Option Granted to (fair market Term (b) Granted (a) Employees value at date Expiration Name (# of shares) in 1997 of grant Date 5% 10% - -------------------------------------------------------------------------------------------- Carl H. Lindner - - - - - - - Carl H. Lindner III AFG 50,000 6.5% $37.88 3/14/07 $1,191,12 $3,018,548 S. Craig lindner AFG 50,000 6.5% $37.88 3/14/07 $1,191,12 $3,018,548 Keith E. Lindner AFG 50,000 6.5% $37.88 3/14/07 $1,191,12 $3,018,548 James E. Evans AFG 30,000 3.9% $37.88 3/14/07 $714,676 $1,811,129 (a) The options were granted under AFG's Stock Option Plan and cover AFG Common Stock. They vest (become exercisable) to the extent of 20% per year, beginning one year from the respective dates of grant, and become fully exercisable in the event of death, disability or retirement or in the event of involuntary termination of employment without cause within one year after a change of control of AFG. (b) Represents the hypothetical future values that would be realizable if all of the options were exercised immediately prior to their expiration in 2007 and the market price of AFG's Common Stock had appreciated in value through the year 2007 at the annual rate of 5% (to $61.70 per share) or 10% (to $98.25 per share). Such hypothetical future values have not been discounted to their respective present values, which are lower. 12 AGGREGATED OPTION EXERCISES IN 1997 AND 1997 YEAR-END OPTION VALUES Shares Number of Securities Acquir- Underlying Unexer- Value of Unexercised ed on cised Options In-the-Money Options Exer- at Year End at Year End (a) cise -------------------- --------------------- (# of Value Exer- Unexer- Exer- Unexer- Name Company Shares) Realized cisable cisable cisable cisable - ----------------------------------------------------------------------------------------- Carl H. Lindner AFG - - 41,818 10,000 $703,187 $121,225 Carl H. Lindner III AFG - - 400,000 50,000 $6,536,883 $121,625 S. Craig Lindner AFG - - 167,091 282,909 $2,744,976 $3,927,940 Keith E. Lindner AFG - - 160,000 290,000 $2,614,800 $4,043,825 James E. Evans AFG - - 61,000 120,000 $624,083 $995,700 AFEI(b) 115,000 $1,878,750 - - - - (a) The value of unexercised in-the-money options is calculated based on the closing market price on December 31, 1997 for AFG's Common Stock on the New York Stock Exchange of $40.3125 per share. (b) American Financial Enterprises, Inc., formerly an 83%-owned subsidiary of the Company, which became wholly-owned in December 1997. Compensation Committee Report The Compensation Committee of the Board of Directors consists of three directors, none of whom is an employee of the Company, AFG or any of its subsidiaries. This Committee also acts as the Compensation Committee for AFG. The Committee's functions include reviewing and making recommendations to the Board of Directors with respect to the compensation of the Company's senior executive officers, as defined from time to time by the Board. The term senior executive officers currently includes the Chairman of the Board and Chief Executive Officer (the "CEO"), the Co-Presidents and each other executive officer whose annual base salary exceeds $500,000. The Compensation Committee has the exclusive authority to grant stock options under AFG's Stock Option Plan to employees of the Company and its subsidiaries, including senior executive officers. Compensation of Executive Officers. AFG's compensation policy for all executive officers has three principal components: annual base salary, annual incentive bonuses and stock option grants. Before decisions were made regarding 1997 compensation for senior executives, the Committee first had discussions with senior executives to solicit their thoughts regarding compensation. Based in part on such discussions as well as AFG's financial results for the preceding year, the Committee deliberated and formed its recommendations, and presented its determinations regarding salary and bonus to the full Board for its review and approval. The compensation decisions discussed in this report conformed with recommendations made by the Committee, the CEO and the Co-Presidents. Annual Base Salaries. The Committee approved annual base salaries and salary increases for senior executive officers that were appropriate, in the Committee's subjective judgment, for their respective positions and levels of responsibilities. In March 1997, the Committee approved the 1997 salaries of the CEO, the Co-Presidents and the other senior executive officers, noting that such salaries would be about 5% more than in 1996 and 1995. Annual Bonuses. As in 1996, in 1997 the Committee developed an annual bonus plan for the CEO, the Co-Presidents and the senior executive officers that would make a substantial portion of their total compensation dependent on the Company's performance, including achievement of pre-established earnings per share targets. The annual bonus plan for 1997 made 60% of each participant's annual bonus dependent on AFG attaining certain earnings per share targets and 40% on AFG's overall performance, as determined by the Committee. A significant aspect of the 1997 annual bonus plan is that it provided that 25% of any bonuses be paid in AFG Common Stock. As in the grant of stock options discussed below, the Committee believes that payment of a substantial portion of annual bonuses in AFG Common Stock align further the interests of AFG's senior executives with those of its shareholders. The Committee also selected the senior executive officers whose 1997 bonus would be subject to this plan, including the CEO, the Co-Presidents and the Senior Vice Presidents. The Committee recommended to the Board the earnings per share targets that were the measure for the greater part of such bonus payments. 14 Under the 1997 annual bonus plan, the bonus target amount for the CEO and each of the Co-Presidents was $925,000, with 0% to 150% of $555,000 (60% of $925,000) to be paid depending on AFG's earnings per share for 1997 allocable to the Company's insurance operations (as determined pursuant to the Committee's annual bonus plan guidelines) and 0% to 150% of $370,000 (40% of $925,000) to be paid based on AFG's performance, as determined by the Committee. In recommending the 1997 annual bonus plan to the Board for adoption in March 1997, the Committee noted that no bonus should be paid under the plan if 1997 earnings per share from insurance operations are less than 75% of the 1997 goals for such earnings. Such earnings per share were less than 75% of the 1997 goals and as a result, no 1997 bonus allocable to the earnings per share component was paid. The Committee then evaluated AFG's performance during 1997. The Committee considered a number of factors, with no relative weight being given to any specific factor. In determining that each of the CEO and the Co-Presidents should receive $370,000 (100% of the target amount under the company performance component), the Committee concluded that a number of 1997 developments enhanced the value and operations of AFG and its subsidiaries, including maintaining the debt-to-capital ratio in a range desirable for investment grade companies, other favorable operating criteria, successfully completing comprehensive restructurings to simplify AFG's corporate structure, selling a technology subsidiary and the upgrade of the debt ratings of AFG and certain AFG subsidiaries. The Board adopted all of the Committee's recommendations with respect to the determination of amounts paid under the annual bonus plan for 1997. Under the 1997 Plan, 25% of the bonus payment was paid in AFG Common Stock. The annual base salary and bonuses received by the CEO and the Co-Presidents from AFG and its affiliates are virtually identical because the Committee views them as working as a management team whose skills and areas of expertise complement each other. In 1993, Congress enacted a $1 million ceiling on tax- deductible remuneration paid after January 1, 1994 to the five most highly compensated executive officers of a publicly held corporation. The limitation does not apply to remuneration payable solely on account of the attainment of one or more performance goals pursuant to a plan approved by the compensation committee of outside directors. The Company does not anticipate that this limitation will apply to the compensation paid to any of its employees in 1997. 15 Stock Option Grants. Stock options represent an important part of AFG's performance-based compensation plan. The Committee believes that AFG shareholders' interests are well served by aligning AFG's senior executives' interests with those of its shareholders through the grant of stock options in addition to paying a portion of any annual bonus in AFG Common Stock. Options under AFG's Stock Option Plan are granted at exercise prices equal to the fair market value of Common Stock on the date of grant and vest at the rate of 20% per year. The Committee believes that these features provide an optionee with substantial incentive to maximize AFG's long-term success. Options for 50,000 shares were granted to the Co-Presidents and additional options were granted to the other senior executives of AFG in 1997. No options were granted to the CEO in 1997. Other Information. In April 1998, the Committee discussed the 1998 salaries, bonuses and stock option grants of the CEO, the Co-Presidents and certain other senior executives. The Committee approved the 1998 salaries for such persons which are the same as in 1997 for the CEO and each of the Co-Presidents and the same bonus target amounts for them for 1998 as in 1997. Earlier in 1998, the Committee granted each of the Co-Presidents options to purchase 40,000 shares of AFG Common Stock. Members of the Compensation Committee: William R.Martin, Chairman Theodore H. Emmerich Thomas H. Hunt Performance Graph No performance graph is included as the Company's Common Stock is not publicly traded. Certain Transactions AFC and its subsidiaries have had and expect to continue to have transactions with AFC's directors, officers, principal shareholders, their affiliates and members of their families. AFC believes that the financial terms of these transactions are comparable to those that would apply to unrelated parties and are fair to AFC. Members of the Lindner Family are the principal owners of Provident Financial Group, Inc. ("Provident"). AFC provides security guard and surveillance services at the main office of Provident for which Provident paid $92,000 in 1997. Provident leases its main banking and corporate office from AFC for which Provident paid rent of $1,963,000 in 1997. In addition, a former subsidiary of AFG provided Year 2000 programming and consulting services to Provident in 1997 for which Provident paid $164,000. In July 1997, Carl H. Lindner and a subsidiary of AFC purchased 51% and 49%, respectively, of common stock of a newly incorporated entity formed to acquire the assets of a company engaged in the production of ethanol. The AFC subsidiary invested $4.9 million and Mr. Lindner invested $5.1 million; the asset purchase was completed in December 1997. In connection with their investment, the AFC subsidiary and Mr. Lindner entered into a Shareholders' Agreement which provides, among other things, for restrictions on transfer of shares of such company and that Mr. Lindner will have the ability to nominate a majority of such company's directors. Certain AFC subsidiaries have entered into a credit facility under which the ethanol producer may borrow up to $10 million at a rate of prime plus 3%. The highest outstanding balance during 1997 was $1.2 million, all of which was repaid in 1997. In December 1997, AFC purchased $138,000 of ice cream from United Dairy Farmers, Inc. ("UDF"). UDF is owned by one of Carl H. Lindner's brothers and his family. During 1997, AFC and its subsidiaries chartered an aircraft from an entity owned by one of Carl H. Lindner's brothers. The total charges for such aircraft usage was $678,000. 17 Directors' Compensation AFC's Board of Directors receives no annual compensation from AFC. However, they are paid as directors of AFG, as follows: Pursuant to the AFG Non-Employee Directors' Compensation Plan (the "Directors' Plan") implemented in 1996, all directors who are not officers or employees of AFG are paid the following fees: an annual retainer of $40,000; an additional annual retainer of $12,000 for each Board Committee on which the non- employee director serves; and an attendance fee of $1,000 for each Board or Committee meeting attended. Non-employee directors who become directors during the year receive a pro rata portion of these annual retainers. The retainers and fees to be paid under the Directors' Plan are reviewed by the Board of Directors from time to time and are subject to change at its discretion. In order to align further the interests of AFG's non- employee directors with the interests of its shareholders, the Directors' Plan provides that a minimum of 50% of such directors' annual retainers are paid through the issuance of shares of AFG Common Stock. The Board of Directors has a program under which a retiring AFG director (other than an officer or employee of AFG or any of its subsidiaries) will, if he has met certain eligibility requirements, receive upon his retirement (in a lump sum or, at his election, in deferred payments) an amount equal to five times the then current annual director's fee. For purposes of this program, retirement means resignation as a director or not being nominated for reelection by shareholders as a director. To be eligible for the retirement benefit, a person must have served as a director for at least four years while not an officer or employee of AFG or any of its subsidiaries. In addition, a director will not become eligible for the retirement benefit until reaching age 55. A director who receives a retirement benefit must provide consulting services to AFG on request for five years following retirement without further compensation (except reimbursement for expenses). Under the program, a death benefit equal to the retirement benefit will be paid (in lieu of any retirement benefit under the program) to the designated beneficiary or legal representative of any person who dies while serving as a director, whether or not eligible for a retirement benefit at time of death. This death benefit will not be available to a director who at any time during the two years immediately preceding death was an officer or employee of AFG or any of its subsidiaries. 18 In addition to providing for the grant of stock options to key employees, the Stock Option Plan provides for automatic annual grants of options to each non-employee director of AFG. During 1997, each non-employee director was granted an option under the foregoing provisions of the Stock Option Plan to purchase 1,000 shares at an exercise price of $37.75 per share on June 1, 1997, the exercise price being the fair market value of AFG's Common Stock on the date of grant. Committees and Meetings of the Board of Directors The Company's Board of Directors held seven meetings and took action in writing seven times in 1997. The Company's Board of Directors has an Executive Committee, an Audit Committee and a Compensation Committee. There is no Nominating Committee. Executive Committee: The Executive Committee consists of Carl H. Lindner (Chairman), Carl H. Lindner III, S. Craig Lindner and Keith E. Lindner. The Committee's functions include analyzing the future development of the business affairs and operations of the Company, including further expansion of businesses in which the Company is engaged and acquisitions and dispositions of businesses. With certain exceptions, the Executive Committee is generally authorized to exercise the powers of the Board of Directors between meetings of the Board of Directors. The Executive Committee consulted among themselves informally many times throughout the year and took action in writing on twelve occasions in 1997. Audit Committee. The Audit Committee consists of Theodore H. Emmerich (Chairman) and William R. Martin. Neither is an officer or employee of the Company or any of its subsidiaries. The Committee's functions include recommending to the Board of Directors the engagement of independent accounting firms to audit the financial statements of the Company and its subsidiaries and to provide other audit-related services and recommending the terms of such firms' engagements; reviewing the engagement of independent accounting firms to provide non-audit services, including the terms of their engagements; reviewing the adequacy and implementation of the Company's internal audit function; reviewing the policies, procedures and principles of the management of the Company for purposes of conformity to the standards required by the Foreign Corrupt Practices Act; establishing procedures designed to provide and encourage timely access to the Committee by the independent accounting firms 19 engaged by the Company, its internal audit department and its principal financial officers; and conducting such investigations relating to the Company's financial affairs as the Committee or the Board of Directors deems desirable. The Committee's functions also include supervising, reviewing and reporting to the Board of Directors on the performance of management committees of the Company responsible for the administration of the employee benefit plans of the Company and its subsidiaries. The Audit Committee met five times in 1997. Compensation Committee The Compensation Committee consists of William R. Martin (Chairman), Theodore H. Emmerich and Thomas M. Hunt. The functions of the Compensation Committee are discussed under "Compensation - Compensation Committee Report." The Compensation Committee met two times and took action in writing on six occasions in 1997. INDEPENDENT AUDITORS The accounting firm of Ernst & Young LLP served as the Company's independent auditors for the fiscal year ended December 31, 1997. Representatives of that firm will attend the Meeting and will be given the opportunity to comment, if they so desire, and to respond to appropriate questions that may be asked by shareholders. No auditor has yet been selected for the current year because it is generally the practice of the Company not to select independent auditors prior to the annual shareholders meeting. SHAREHOLDER PROPOSALS If a shareholder desires to have a proposal included in the proxy statement for the 1999 annual shareholders meeting, such proposal must be received by the Company's Secretary at his office by December 31, 1998 in order to be considered for inclusion. 20 REQUESTS FOR FORM 10-K The Company will send, upon written request, without charge, a copy of the Company's most current Annual Report on Form 10-K to any shareholder who writes to Fred J. Runk, Senior Vice President and Treasurer, American Financial Corporation, One East Fourth Street, Cincinnati, Ohio 45202. By order of the Board of Directors, James C. Kennedy Vice President and Secretary Cincinnati, Ohio April 21, 1998 Pages F1 though F-35 which follow are taken from AFC's Annual Report on Form 10-K for the year ended December 31, 1997. This information is being included herein in accordance with Rule 14a- 3 promulgated under the Securities Act of 1934. AMERICAN FINANCIAL CORPORATION One East Fourth Street Cincinnati, Ohio 45202 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. 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. 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. F-1 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. F-2 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. F-3 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. F-4 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. F-5 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. F-6 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. F-7 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. F-8 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. F-9 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. F-10 Financial Statements and Supplementary Data Page Report of Independent Auditors F-12 Consolidated Balance Sheet: December 31, 1997 and 1996 F-13 Consolidated Statement of Earnings: Years ended December 31, 1997, 1996 and 1995 F-14 Consolidated Statement of Changes in Shareholders' Equity: Years ended December 31, 1997, 1996 and 1995 F-15 Consolidated Statement of Cash Flows: Years ended December 31, 1997, 1996 and 1995 F-16 Notes to Consolidated Financial Statements F-17 "Selected Quarterly Financial Data" has been included in Note P to the Consolidated Financial Statements. _______________________________________________ F-11 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-12 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-13 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-14 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-15 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-16 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-17 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-18 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-19 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-20 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-21 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-22 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-23 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-24 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-25 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-26 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-27 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-28 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-29 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-30 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-31 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-32 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-33 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-34 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-35