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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K/A
Amendment No. 2 to
Annual Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the Fiscal Year Ended Commission File
December 31, 2002 No. 1-7361
AMERICAN FINANCIAL CORPORATION
Incorporated under IRS Employer I.D.
the Laws of Ohio No. 31-0624874
One East Fourth Street, Cincinnati, Ohio 45202
(513) 579-2121
Securities Registered Pursuant to Section 12(b) of the Act:
Name of Each Exchange
Title of Each Class on which Registered
------------------- ---------------------
Series J Voting Cumulative Preferred Stock Archipelago Exchange
Securities Registered Pursuant to Section 12(g) of the Act: None
Other securities for which reports are submitted pursuant to Section 15(d) of
the Act: None
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months, and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and need not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer.
Yes No X
The aggregate market value of the Registrant's Preferred Stock as of the
Registrant's most recently completed second fiscal quarter (June 30, 2002) was
approximately $57.7 million (based upon nonaffiliate holdings of 2,886,161
shares and a market price of $20.00 per share).
As of March 1, 2003, there were 10,593,000 shares of the Registrant's
Common Stock outstanding, all of which were owned by American Financial Group,
Inc. At that date there were 2,886,161 shares of Series J Voting Preferred Stock
outstanding (all of which were owned by non-affiliates).
-------------
Documents Incorporated by Reference: None
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AMERICAN FINANCIAL CORPORATION
INDEX TO ANNUAL REPORT
ON FORM 10-K
Page
----
Part I
Item 1 - Business:
Introduction 1
Property and Casualty Insurance Operations 2
Annuity and Life Operations 15
Other Companies 19
Investment Portfolio 19
Foreign Operations 20
Regulation 20
Item 2 - Properties 21
Item 3 - Legal Proceedings 22
Item 4 - Submission of Matters to a Vote of Security Holders 23
Part II
Item 5 - Market for Registrant's Common Equity and Related
Stockholder Matters 24
Item 6 - Selected Financial Data 25
Item 7 - Management's Discussion and Analysis of Financial
Condition and Results of Operations 26
Item 7A - Quantitative and Qualitative Disclosures About
Market Risk 43
Item 8 - Financial Statements and Supplementary Data 43
Item 9 - Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure (a)
Part III
Item 10 - Directors and Executive Officers of the Registrant 44
Item 11 - Executive Compensation 46
Item 12 - Security Ownership of Certain Beneficial Owners
and Management and Related Stockholder Matters 52
Item 13 - Certain Relationships and Related Transactions 53
Item 14 - Controls and Procedures 53
Part IV
Item 15 - Exhibits, Financial Statement Schedules and
Reports on Form 8-K S-1
(a) The response to this Item is "none".
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EXPLANATORY NOTE
This Amendment to Form 10-K includes the text of the Form 10-K in its
entirety and is being filed to:
(i) add additional disclosure in the last paragraph on page 4 regarding
performance measures in Item 1 - Business,
(ii) disclose the expiration of two reinsurance agreements in the paragraph
following the table on page 12 in Item 1 - Business,
(iii) provide comparative investment performance results under "Investment
Portfolio - General" in Item 1 - Business,
(iv) include submission of matters to a vote of security holders under Item 4,
(v) add additional disclosure under "Uncertainties - Property and Casualty
Insurance Reserves" and delete the reference to "core earnings" under
"Results of Operations - Three Years Ended December 31, 2002 - General"
in Item 7 - Management's Discussion and Analysis of Financial Condition
and Results of Operations, and
(vi) delete the calculation of earnings to fixed charges excluding interest on
annuities in Exhibit 12.
There are no changes to the audited financial statements. This filing amends
only the items specified above and does not otherwise update the disclosures in
the Form 10-K or Amendment No. 1 as originally filed and does not reflect events
occurring after the original filing of the Form 10-K or Amendment No. 1.
AMERICAN FINANCIAL CORPORATION
FORWARD-LOOKING STATEMENTS
This Form 10-K, chiefly in Items 1, 3, 5, 7 and 8, contains certain
forward-looking statements that are subject to numerous assumptions, risks or
uncertainties. The Private Securities Litigation Reform Act of 1995 provides a
safe harbor for forward-looking statements. Some of the forward-looking
statements can be identified by the use of forward-looking words such as
"anticipates", "believes", "expects", "estimates", "intends", "plans", "seeks",
"could", "may", "should", "will" or the negative version of those words or other
comparable terminology. Examples of such forward-looking statements include
statements relating to: expectations concerning market and other conditions and
their effect on future premiums, revenues, earnings and investment activities;
recoverability of asset values; expected losses and the adequacy of reserves for
asbestos, environmental pollution and mass tort claims; rate increases, improved
loss experience and expected expense savings resulting from recent initiatives.
Actual results could differ materially from those contained in or implied by
such forward-looking statements for a variety of factors including:
o changes in economic conditions, including interest rates, performance
of securities markets, and the availability of capital;
o regulatory actions;
o changes in legal environment;
o tax law changes;
o levels of natural catastrophes, terrorist events, incidents of war and
other major losses;
o the ultimate amount of liabilities associated with certain asbestos and
environmental-related claims;
o the unpredictability of possible future litigation if certain
settlements do not become effective;
o adequacy of insurance reserves;
o trends in mortality and morbidity;
o availability of reinsurance and ability of reinsurers to pay their
obligations;
o competitive pressures, including the ability to obtain rate increases; and
o changes in debt and claims paying ratings.
The forward-looking statements herein are made only as of the date of this
report. The Company assumes no obligation to publicly update any forward-looking
statements.
PART I
ITEM 1
BUSINESS
--------
Please refer to "Forward-Looking Statements" following the Index in front of
this Form 10-K.
INTRODUCTION
American Financial Corporation ("AFC") is a holding company which, through
subsidiaries, is engaged primarily in property and casualty insurance, focusing
on specialized commercial products for businesses, and in the sale of retirement
annuities, life, and supplemental health insurance products. AFC was
incorporated as an Ohio corporation in 1955. Its insurance subsidiaries have
been operating as far back as the 1800's. Its address is One East Fourth Street,
Cincinnati, Ohio 45202; its phone number is (513) 579-2121. At December 31,
2002, all of the outstanding Common Stock of AFC was owned by American Financial
Group, Inc. ("AFG").
Over the years, AFC has owned, operated, and invested in businesses in a
variety of industries and geographic areas, culminating in today's group of
insurance companies. Generally, AFC's interests have been in the following
areas: insurance, savings and loan, leasing, banking, real estate,
communications/ entertainment and food distribution. A small number of
opportunistic investments have been made in troubled and other undervalued
assets.
RECENT TRANSACTIONS
Infinity Property and Casualty Corporation ("Infinity") was incorporated
in September 2002 as a wholly-owned subsidiary of AFC. On December 31, 2002, AFC
transferred to Infinity the following subsidiaries: Atlanta Casualty Company,
Infinity Insurance Company, Leader Insurance Company and Windsor Insurance
Company. In exchange, AFC received all of the issued and outstanding shares of
Infinity common stock and a $55 million 10-year promissory note. In addition,
effective January 1, 2003, Great American Insurance Company ("GAI"), an AFC
subsidiary, transferred to Infinity its personal insurance business written
through independent agents. In 2002, 2001 and 2000, these businesses represented
28%, 35% and 46%, respectively, of AFC's property and casualty group's net
written premiums. In a February 2003 public offering, AFC sold 61% (12.5 million
shares) of Infinity for net proceeds of approximately $186 million, realizing a
pretax loss of approximately $40 million. In January 2003, GAI entered into an
agreement to sell its direct-to-consumer auto business.
In March 2001, GAI sold its Japanese property and casualty division to
Mitsui Marine & Fire Insurance Company of America for $22 million in cash. At
the same time, a reinsurance agreement under which GAI ceded a portion of its
pool of insurance to Mitsui was terminated. The Japanese division generated net
written premiums of approximately $60 million per year to GAI while GAI ceded
approximately $45 million per year to Mitsui.
In connection with the sale of the Japanese division, GAI continues to
write certain business for, and fully reinsures it to, Mitsui. When GAI sold its
commercial lines division in 1998, it had a similar arrangement which lasted
through early 2001. Such business does not appear in the net written premiums or
net earned premiums information herein.
In September 2000, AFC sold Stonewall Insurance Company for approximately
$31 million. Stonewall was a non-operating property and casualty subsidiary
engaged primarily in the run-off of approximately $170 million in asbestos and
environmental liabilities associated with policies written through 1991.
The businesses discussed above are included in the tables and financial
statements herein through their respective disposal dates.
1
PROPERTY AND CASUALTY INSURANCE OPERATIONS
AFC's property and casualty group has been engaged primarily in specialty
and private passenger automobile insurance businesses which have been managed as
two major business groups: Specialty and Personal. Each group has reported to an
individual senior executive and is comprised of multiple business units which
operate autonomously but with certain strong central controls and full
accountability. Decentralized control allows each unit the autonomy necessary to
respond to local and specialty market conditions while capitalizing on the
efficiencies of centralized investment and administrative support functions.
Approximately 40% of the 7,100 people employed by AFC's property and casualty
insurance operations at December 31, 2002 work for the businesses transferred to
Infinity.
The property and casualty group operates in a highly competitive industry
that is affected by many factors which can cause significant fluctuations in its
results of operations. The industry has historically been subject to pricing
cycles characterized by periods of intense competition and lower premium rates
(a "downcycle") followed by periods of reduced competition, reduced underwriting
capacity due to lower policyholders' surplus and higher premium rates (an
"upcycle"). After being in an extended downcycle for over a decade, the property
and casualty insurance industry is experiencing significant market firming and
price increases in certain specialty markets and in the private passenger
automobile market.
The primary objective of AFC's property and casualty insurance operations
is to achieve solid underwriting profitability while providing excellent service
to its policyholders. Underwriting profitability is measured by the combined
ratio which is a sum of the ratios of underwriting losses, loss adjustment
expenses ("LAE"), underwriting expenses and policyholder dividends to premiums.
When the combined ratio is under 100%, underwriting results are generally
considered profitable; when the ratio is over 100%, underwriting results are
generally considered unprofitable. The combined ratio does not reflect
investment income, other income or federal income taxes.
While many costs included in underwriting may be readily determined
(commissions, administrative expenses, many of the losses on claims reported),
the process of determining overall underwriting results is also highly dependent
upon the use of estimates in the case of losses incurred or expected but not yet
reported or developed. Actuarial procedures and projections are used to obtain
"best estimates" which are then included in the overall results. While the
process is imprecise and develops amounts which are subject to change over time,
AFC's projections, excluding asbestos and environmental ("A&E") claims, have
been close to the developed ultimate results, as can be seen in the "reserve
development triangles" on page 13.
AFC's property and casualty group, like many others in the industry, has
A&E claims arising in most cases from general liability policies written in
years before 1987. The establishment of reserves for such A&E claims presents
unique and difficult challenges and is subject to uncertainties significantly
greater than those presented by other types of claims.
In February 2003, GAI entered into an agreement for the settlement of
asbestos-related coverage litigation from insurance policies issued in the
1970's and 1980's. Management believes that the $123.5 million settlement (GAI
has the option to pay in cash or over time with 5.25% interest) with parties
related to and known as A.P. Green Industries, Inc. will enhance financial
certainty and provide resolution to litigation that represents AFC's largest
known asbestos-related claim and the only such claim that management believes to
be material. For a discussion of uncertainties related to A&E claims, see
Management's Discussion and Analysis - "Asbestos and Environmental-related
Reserves."
Management's focus on underwriting performance has resulted in a statutory
combined ratio averaging 107.2% for the period 1998 to 2002 (or 104.4% excluding
special charges in 2002, 2001 and 1998 related to asbestos and other
environmental matters), as compared to 109.1% for the property and casualty
industry over the same period (Source: "Best's Review/Preview -
Property/Casualty" - January 2003 Edition). AFC believes that its product line
diversification and underwriting discipline have
2
contributed to the Company's ability to consistently outperform the industry's
underwriting results. Management's philosophy is to refrain from writing
business that is not expected to produce an underwriting profit even if it is
necessary to limit premium growth to do so.
Generally, while financial data is reported on a statutory basis for
insurance regulatory purposes, it is reported in accordance with generally
accepted accounting principles ("GAAP") for shareholder and other investment
purposes. In general, statutory accounting results in lower capital and surplus
and lower net earnings than result from application of GAAP. Major differences
include charging policy acquisition costs to expense as incurred rather than
spreading the costs over the periods covered by the policies; reporting
investment-grade bonds and redeemable preferred stocks at amortized cost;
netting of reinsurance recoverables and prepaid reinsurance premiums against the
corresponding liability; requiring additional loss reserves; and charging to
surplus certain assets, such as furniture and fixtures and agents' balances over
90 days old.
Unless indicated otherwise, the financial information presented for the
property and casualty insurance operations herein is presented based on GAAP.
The following table shows (in millions) certain information of AFC's
property and casualty insurance operations.
2002 2001 2000
---- ---- ----
Statutory Basis
---------------
Premiums Earned $ 2,372 $ 2,566 $2,484
Admitted Assets 7,233 6,736 6,472
Unearned Premiums 1,168 1,158 1,154
Loss and LAE Reserves (net) 3,607 3,539 3,445
Capital and Surplus 1,742 1,669 1,763
GAAP Basis
----------
Premiums Earned $ 2,403 $ 2,594 $2,495
Total Assets 10,927 10,007 9,458
Unearned Premiums 1,848 1,641 1,414
Loss and LAE Reserves (gross)(*) 5,204 4,778 4,516
Shareholder's Equity 3,241 3,288 3,360
(*) GAAP loss and LAE reserves net of reinsurance recoverable were $3.4
billion at December 31, 2002, $3.3 billion at December 31, 2001, and
$3.2 billion at December 31, 2000.
3
The following table shows the segment, independent ratings, and size (in
millions) of AFC's major property and casualty insurance subsidiaries. AFC
continues to focus on growth opportunities in what it believes to be more
profitable specialty businesses.
Net Written Premiums
----------------------------
Company (Ratings - AM Best/S&P) Personal Specialty
--------------------------------------------------- -------- ---------
Great American Pool(a): A A
Written through independent agents $ 80(b) $ 929
Written directly with customers 108(c) -
Mid-Continent A A 19 215
Republic Indemnity A- A 2 219
National Interstate A- - - 92
American Empire Surplus Lines A A - 116
Infinity Property and Casualty:
Infinity A A 233(b) -
Windsor A A 145(b) -
Atlanta Casualty A A 142(b) -
Leader A A 93(b) -
Other 14 6
---- ------
$836 $1,577
==== ======
(a) The Great American Pool represents approximately 15 subsidiaries.
(b) Business transferred to Infinity Property and Casualty Corporation
except for $6 million in assigned risk business retained by GAI. In
February 2003, AFC sold 61% of Infinity in a public offering.
(c) The direct-to-consumer business which GAI agreed to sell in 2003
produced $79 million of the 2002 premiums.
PERFORMANCE MEASURES SUCH AS SEGMENT UNDERWRITING PROFIT OR LOSS AND RELATED
COMBINED RATIOS ARE OFTEN USED BY PROPERTY AND CASUALTY INSURERS TO HELP USERS
OF THEIR FINANCIAL STATEMENTS BETTER UNDERSTAND THE COMPANY'S PERFORMANCE.
SEE NOTE C - "SEGMENT OF OPERATIONS" TO THE FINANCIAL STATEMENTS FOR THE
RECONCILIATION OF AFC'S OPERATING PROFIT BY SIGNIFICANT BUSINESS SEGMENT TO
THE CONSOLIDATED STATEMENT OF OPERATIONS.
4
The following table shows the performance of AFC's property and casualty
insurance operations (dollars in millions):
2002 2001 2000
---- ---- ----
Gross written premiums (a) $3,935 $3,520 $3,231
Ceded reinsurance (a) (1,521) (938) (593)
------ ------ ------
Net written premiums $2,414 $2,582(b) $2,638
====== ====== ======
Net earned premiums $2,403 $2,594 $2,495
Loss and LAE 1,785 1,980 1,962
Asbestos litigation settlement 30 - -
Special A&E charge - 100 -
Underwriting expenses 606 737 732
Policyholder dividends 8 5 3
------ ------ ------
Underwriting loss ($ 26) ($ 228) ($ 202)
====== ====== ======
GAAP ratios:
Loss and LAE ratio 75.5% 80.2% 78.6%
Underwriting expense ratio 25.3 28.4 29.3
Policyholder dividend ratio .3 .2 .1
------ ------ ------
Combined ratio (c) 101.1% 108.8% 108.0%
====== ====== ======
Statutory ratios:
Loss and LAE ratio 76.4% 81.1% 80.1%
Underwriting expense ratio 25.0 28.3 28.4
Policyholder dividend ratio .2 .3 .3
------ ------ ------
Combined ratio (c) 101.6% 109.7% 108.8%
====== ====== ======
Industry statutory combined ratio (d) 105.7% 116.0% 110.1%
(a) Excludes the following premiums that were written on behalf of, and
fully reinsured to, the purchasers of the Commercial lines and
Japanese divisions: 2002 - $173 million; 2001 - $143 million; and
2000 - $213 million.
(b) Before a reduction of $29.7 million for unearned premium transfer
related to the sale of the Japanese division.
(c) The 2002 combined ratios include 1.2 percentage points (GAAP) and
1.3 points (statutory) related to the A.P. Green asbestos
litigation settlement. The 2001 combined ratios include 3.9
percentage points for the third quarter strengthening of insurance
reserves relating to A&E matters and 1 percentage point
attributable to the attack on the World Trade Center. The 2000
combined ratios include 1.4 percentage points for reserve
strengthening in AFC's California workers' compensation business.
(d) Ratios are derived from "Best's Review/Preview - Property/Casualty"
(January 2003 Edition).
As with other property and casualty insurers, AFC's operating results can
be adversely affected by unpredictable catastrophe losses. Certain natural
disasters (hurricanes, tornadoes, floods, forest fires, etc.) and other
incidents of major loss (explosions, civil disorder, fires, etc.) are classified
as catastrophes by industry associations. Losses from these incidents are
usually tracked separately from other business of insurers because of their
sizable effects on overall operations. AFC generally seeks to reduce its
exposure to such events through individual risk selection and the purchase of
reinsurance. Total net losses to AFC's insurance operations from catastrophes
were $7 million in 2002; $42 million in 2001 and $8 million in 2000. These
amounts are included in the tables herein. AFC's catastrophe losses in 2001
included $25 million related to the terrorist attack on the World Trade Center.
The Terrorism Risk Insurance Act of 2002 ("TRIA") is to be in effect until
the end of 2005 and establishes a temporary Terrorism Risk Insurance Program
which requires commercial insurers to offer virtually all policyholders coverage
for certain "acts of terrorism" as defined by TRIA. This federal legislation
provides that coverage may not materially differ from the terms, amounts, and
other coverage limitations applicable to losses arising from occurrences other
than terrorism. The federal government provides some stop loss insurance to
insurers after an act has
5
been certified by the government as an act of terrorism and after an insurer has
paid losses in excess of a deductible. The deductible progresses from 7% to 15%
of direct earned premium in each of the three program years. TRIA supersedes
state insurance law to the extent that such law is inconsistent with its terms.
For 2003, AFC would have to sustain losses in excess of $128 million to be
eligible for the reinsurance under TRIA. AFC believes that it is unlikely that
its losses in the event of a terrorist act would be so significant as to exceed
the deductible necessary to participate in the federal reinsurance. AFC
generally seeks to limit its exposure to catastrophe losses including those
arising from terrorist acts. AFC is complying with the obligations of TRIA to
offer coverage but continues to review its business with consideration of the
price it charges for such coverage, as well as through management of individual
risk selection.
SPECIALTY
GENERAL The Specialty group emphasizes the writing of specialized
insurance coverage where AFC personnel are experts in particular lines of
business or customer groups. The following are examples of such specialty
businesses:
Inland and Ocean Marine Provides coverage primarily for marine cargo,
boat dealers, marina operators/dealers, excursion
vessels, builder's risk, contractor's equipment,
excess property and motor truck cargo.
Workers' Compensation Writes coverage for prescribed benefits
payable to employees (principally in California)
who are injured on the job.
Agricultural-related Provides federally reinsured multi-peril crop
(allied lines) insurance covering most perils
as well as crop hail, equine mortality and
other coverages for full-time operating
farms/ranches and agribusiness operations on a
nationwide basis.
Executive and Professional Markets coverage for attorneys, architects and
Liability engineers, and for directors and officers of
businesses and not-for-profit organizations.
Fidelity and Surety Bonds Provides surety coverage for various types of
contractors and public and private corporations
and fidelity and crime coverage for
government, mercantile and financial institutions.
Collateral Protection Provides coverage for insurance risk management
programs for lending and leasing institutions.
Umbrella and Excess Provides higher layer liability coverage in
Liability excess of primary layers.
Excess and Surplus Specially designed insurance products offered
to those that can't find coverage in standard
markets.
Commercial Automobile Markets customized insurance programs for public
transportation operations (such as busses and
limousines), and a specialized physical damage
product for the trucking industry.
Specialization is the key element to the underwriting success of these
business units. Each unit has independent management with significant operating
autonomy to oversee the important operational functions of its business such as
underwriting, pricing, marketing, policy processing and claims service. These
specialty businesses are opportunistic and their premium volume will vary based
on prevailing market conditions. AFC continually evaluates expansion in existing
markets and opportunities in new specialty markets that meet its profitability
objectives.
6
The U.S. geographic distribution of the Specialty group's statutory direct
written premiums in 2002 (excluding business written on behalf of, and fully
reinsured to, the purchaser of the Japanese division) compared to 1998 is shown
below.
2002 1998 2002 1998
---- ---- ---- ----
California 21.4% 22.1% Pennsylvania 2.7% 2.6%
Texas 9.9 7.1 New Jersey 2.6 3.8
New York 5.7 6.6 Michigan 2.1 2.4
Florida 5.5 4.1 Missouri 2.0 *
Illinois 4.3 3.7 Massachusetts * 4.8
Georgia 3.0 2.2 North Carolina * 3.0
Ohio 2.9 2.3 Connecticut * 2.2
Oklahoma 2.8 3.0 Other 35.1 30.1
----- -----
100.0% 100.0%
===== =====
----------------
(*) less than 2%
The following table sets forth a distribution of statutory net written premiums
for AFC's Specialty group by NAIC annual statement line for 2002 compared to
1998.
2002 1998
---- ----
Other liability 30.1% 19.7%
Workers' compensation 16.2 23.5
Auto liability 8.7 9.0
Commercial multi-peril 8.6 10.7
Inland marine 7.2 10.1
Fidelity and surety 5.8 4.5
Collateral protection 5.3 *
Auto physical damage 4.8 4.5
Ocean marine 3.7 3.2
Product Liability 2.7 *
Allied lines 2.5 4.7
Aircraft * 4.0
Other 4.4 6.1
----- -----
100.0% 100.0%
===== =====
----------------
(*) less than 2%
7
The following table shows the performance of AFC's Specialty group
insurance operations (dollars in millions):
2002 2001 2000
---- ---- ----
Gross written premiums (a) $2,713 $2,236 $1,889
Ceded reinsurance (a) (1,136) (694) (565)
------ ------ ------
Net written premiums $1,577 $1,542(b) $1,324
====== ====== ======
Net earned premiums $1,497 $1,409 $1,223
Loss and LAE 1,009 997 902
Underwriting expenses 455 430 413
Policyholder dividends 8 5 3
------ ------ ------
Underwriting profit (loss) $ 25 ($ 23) ($ 95)
====== ====== ======
GAAP ratios:
Loss and LAE ratio 67.5% 70.7% 73.8%
Underwriting expense ratio 30.4 30.6 33.8
Policyholder dividend ratio .5 .4 .3
------ ------ ------
Combined ratio (c) 98.4% 101.7% 107.9%
====== ====== ======
Statutory ratios:
Loss and LAE ratio 68.7% 73.6% 76.5%
Underwriting expense ratio 31.1 30.5 31.4
Policyholder dividend ratio .3 .5 .5
------ ------ ------
Combined ratio (c) 100.1% 104.6% 108.4%
====== ====== ======
Industry statutory combined ratio (d) 103.4% 117.1% 108.2%
(a) Excludes the following premiums that were written on behalf of, and
fully reinsured to, the purchasers of the Commercial lines and
Japanese divisions: 2002 - $173 million; 2001 - $143 million; and
2000 - $213 million.
(b) Before a reduction of $29.7 million for unearned premium transfer
related to the sale of the Japanese division.
(c) The 2001 combined ratios include 1.8 percentage points attributable
to the attack on the World Trade Center. The 2000 combined ratios
include 2.9 percentage points for reserve strengthening in AFC's
California workers' compensation business. Because the combined
ratio is calculated based on premiums, the impact of these two
items is greater for the Specialty segment alone than it is for the
overall company.
(d) Represents the commercial industry statutory combined ratio derived
from "Best's Review/Preview - Property/Casualty" (January 2003
Edition).
MARKETING The Specialty group operations direct their sales efforts
primarily through independent property and casualty insurance agents and
brokers, although portions are written through employee agents. These businesses
write insurance through several thousand agents and brokers and have
approximately 440,000 policies in force.
COMPETITION These businesses compete with other individual insurers,
state funds and insurance groups of varying sizes, some of which are mutual
insurance companies possessing competitive advantages in that all their profits
inure to their policyholders. They also compete with self-insurance plans,
captive programs and risk retention groups. Because of the specialty nature of
these coverages, competition is based primarily on service to policyholders and
agents, specific characteristics of products offered and reputation for claims
handling. Price, commissions and profit sharing terms are also important
factors. Management believes that sophisticated data analysis for refinement of
risk profiles, extensive specialized knowledge and loss prevention service have
helped AFC's Specialty group compete successfully.
8
PERSONAL
GENERAL The Personal group wrote primarily private passenger automobile
liability and physical damage insurance, and to a lesser extent, homeowners'
insurance. In February 2003, AFC sold 61% of Infinity Property and Casualty
Corporation in a public offering. The businesses sold in the Infinity
transaction represented 82% of the Personal group's 2002 net written premiums.
In January 2003, GAI entered into an agreement to sell its direct-to-consumer
auto business. As a result of these transactions, AFC's future interest in
personal lines insurance will be limited to two subsidiaries that generated less
than $35 million in net written premiums in 2002, certain direct-to-consumer
business in run-off that had approximately $28 million in net written premiums
in 2002 and its 39% continuing interest in Infinity.
Historically, the majority of the Personal group's auto premiums was from
sales in the nonstandard market covering drivers unable to obtain insurance
through standard market carriers due to factors such as age, record of prior
accidents, driving violations, particular occupation or type of vehicle. The
Personal group's approach to its auto business was to develop tailored rates for
its personal automobile customers based on a variety of factors, including the
driving record of the insureds, the number of and type of vehicles covered,
credit history, and other factors. Management believes this approach enabled the
Personal group to rate each risk appropriately and provided a means to serve a
broad spectrum of customers.
The Personal group's approach to homeowners business was to limit exposure
in locations which have significant catastrophic potential (such as windstorms,
earthquakes and hurricanes). Since 1997, the Personal group ceded the majority
of its homeowners' business through reinsurance agreements; in 2002, it ceded
80% of this business.
The Personal group held licenses to write policies in all states and the
District of Columbia. The U.S. geographic distribution of the Personal group's
statutory direct written premiums in 2002 compared to 1998, was as follows:
2002 1998 2002 1998
---- ---- ---- ----
California 28.7% 14.8% New Jersey 2.8% 3.3%
New York 10.0 6.2 Oklahoma 2.2 *
Florida 10.0 9.4 South Carolina 2.0 *
Connecticut 8.3 10.0 North Carolina * 2.8
Pennsylvania 7.2 5.5 Arizona * 2.6
Georgia 6.0 10.1 Missouri * 2.0
Texas 4.0 5.0 Other 18.8 28.3
----- -----
100.0% 100.0%
===== =====
(*) less than 2%
The Personal group's underwriting strategy was to sell its products
through independent agents in the states that management believed offer the
greatest opportunity for profitable growth based on market size and legal and
regulatory environments. Management was focused on obtaining adequate rates to
achieve underwriting profitability and was willing to forego volume to meet its
profit objectives. Since April 1, 2001, the Personal group ceded 90% of the
automobile physical damage business written by certain subsidiaries under
reinsurance agreements.
9
The following table shows the performance of AFC's Personal group
insurance operations (dollars in millions):
2002 2001 2000
---- ---- ----
Gross written premiums $1,221 $1,284 $1,339
Ceded reinsurance (385) (244) (28)
------ ------ ------
Net written premiums $ 836 $1,040 $1,311
====== ====== ======
Net earned premiums $ 905 $1,183 $1,270
Loss and LAE 753 970 1,061
Underwriting expenses (a) 151 306 317
------ ------ ------
Underwriting profit (loss) $ 1 ($ 93) ($ 108)
====== ====== ======
GAAP ratios:
Loss and LAE ratio 83.1% 82.1% 83.6%
Underwriting expense ratio (a) 16.7 25.8 25.0
------ ------ ------
Combined ratio 99.8% 107.9% 108.6%
====== ====== ======
Statutory ratios:
Loss and LAE ratio 83.4% 82.3% 83.9%
Underwriting expense ratio (a) 13.3 25.0 25.2
------ ------ ------
Combined ratio 96.7% 107.3% 109.1%
====== ====== ======
Industry statutory combined ratio (b) 105.6% 111.6% 110.3%
(a) The Personal group recorded commissions of $159 million in 2002 and
$47 million in 2001 on business ceded to reinsurers. Commissions on
ceded business are recorded as a reduction of underwriting
expenses.
(b) Represents the personal lines industry statutory combined ratio
derived from "Best's Review/Preview - Property/Casualty" (January
2003 Edition).
The Personal group had approximately 790,000 auto policies in force at
December 31, 2002, over 75% of which had policy limits of $50,000 or less per
occurrence.
10
REINSURANCE
Consistent with standard practice of most insurance companies, AFC
reinsures a portion of its business with other insurance companies and assumes a
relatively small amount of business from other insurers. Ceding reinsurance
permits diversification of risks and limits the maximum loss arising from large
or unusually hazardous risks or catastrophic events. The availability and cost
of reinsurance are subject to prevailing market conditions which may affect the
volume and profitability of business that is written. AFC is subject to credit
risk with respect to its reinsurers, as the ceding of risk to reinsurers
generally does not relieve AFC of its liability to its insureds until claims are
fully settled.
AFC regularly monitors the financial strength of its reinsurers. This
process periodically results in the transfer of risks to more financially secure
reinsurers. Substantially all reinsurance is ceded to reinsurers having more
than $100 million in capital and A.M. Best ratings of "A-" or better. AFC
further minimizes the credit risk of certain ceding arrangements, including the
90% automobile physical damage quota share, by entering into the contracts on a
"funds withheld" basis. Under "funds withheld" arrangements, AFC retains ceded
premiums, in exchange for a fee, to fund ceded losses as they become due from
the reinsurer. As an alternative method to reduce credit risk, AFC has, on
occasion, required reinsurers to secure financial guarantees or establish lines
of credit to support recoverables under reinsurance agreements. Excluding Mitsui
and Ohio Casualty (discussed below), approximately half of AFC's total
reinsurance recoverable (net of funds withheld) at December 31, 2002, was with
the following companies: American Re-Insurance Company, Swiss Reinsurance
America Corporation, General Reinsurance Corporation, X.L. Reinsurance America,
Inc., Converium Reinsurance North America, Inc., Employers Reinsurance
Corporation, Inter-Ocean Reinsurance (Ireland) Ltd., Continental Casualty
Company, Everest Reinsurance Company, Transatlantic Reinsurance Company,
Hartford Fire Insurance Company, Berkley Insurance Company and Folksamerica
Reinsurance Company. At December 31, 2002, less than 1% of AFC's reinsurance
recoverable balance was with companies affiliated with reinsurer Gerling Global
Re., a European reinsurer which has been the subject of recent news articles.
Reinsurance is provided on one of two bases, facultative or treaty.
Facultative reinsurance is generally provided on a risk by risk basis.
Individual risks are ceded and assumed based on an offer and acceptance of risk
by each party to the transaction. Treaty reinsurance provides for risks meeting
prescribed criteria to be automatically ceded and assumed according to contract
provisions. The following table presents (by type of coverage) the amount of
each loss above the specified retention maximum generally covered by treaty
reinsurance programs (in millions):
Retention Reinsurance
Coverage Maximum Coverage(a)
-------- --------- -----------
California Workers' Compensation $ 1.0 $99.0
Other Workers' Compensation 2.0 48.0
Commercial Umbrella 3.6 46.4
Other Casualty 5.0 25.0
Property - General 2.0 28.0 (b)
Property - Catastrophe 10.0 65.0
(a) Reinsurance covers substantial portions of losses in excess of
retention. However, in general, losses resulting from terrorism are
not covered.
(b) Since 1997, AFC has ceded at least 80% of its homeowners insurance
coverage through reinsurance agreements. Since April 1, 2001, AFC
has ceded 90% of the automobile physical damage business written by
certain subsidiaries. In July 2002, AFC added certain specialty
businesses to the 90% reinsurance agreement.
AFC also purchases facultative reinsurance providing coverage on a risk by
risk basis, both pro rata and excess of loss, depending on the risk and
available reinsurance markets.
11
Included in the balance sheet caption "recoverables from reinsurers and
prepaid reinsurance premiums" were approximately $226 million on paid losses and
LAE and $1.8 billion on unpaid losses and LAE at December 31, 2002. The
collectibility of a reinsurance balance is based upon the financial condition of
a reinsurer as well as individual claim considerations. At December 31, 2002,
AFC's insurance subsidiaries had allowances of approximately $38 million for
doubtful collection of reinsurance recoverables.
Premiums written for reinsurance ceded and assumed are presented in the
following table (in millions):
2002 2001 2000
---- ---- ----
Reinsurance ceded $1,693 $1,114 $803
Reinsurance assumed - including
involuntary pools and associations 80 94 76
In connection with the sales of the Japanese division to Mitsui in 2001 and
the Commercial lines division to Ohio Casualty in 1998, Great American agreed to
issue and renew policies related to the businesses transferred until each
purchaser received the required approvals and licensing to begin writing
business on their own behalf. The Ohio Casualty agreement expired December 1,
2000, and the Mitsui agreement expires December 31, 2003. Under these
agreements, Great American cedes 100% of these premiums to the respective
purchaser. In 2002, 2001, and 2000, premiums of $173 million, $143 million, and
$213 million, respectively, were ceded under these agreements.
LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
The consolidated financial statements include the estimated liability for
unpaid losses and LAE of AFC's insurance subsidiaries. This liability represents
estimates of the ultimate net cost of all unpaid losses and LAE and is
determined by using case-basis evaluations and actuarial projections. These
estimates are subject to the effects of changes in claim amounts and frequency
and are periodically reviewed and adjusted as additional information becomes
known. In accordance with industry practices, such adjustments are reflected in
current year operations.
Generally, reserves for reinsurance and involuntary pools and associations
are reflected in AFC's results at the amounts reported by those entities.
12
The following discussion of insurance reserves includes the reserves of
American Premier's subsidiaries for only those periods following its acquisition
in 1995. See Note N to the Financial Statements for an analysis of changes in
AFC's estimated liability for losses and LAE, net and gross of reinsurance, over
the past three years on a GAAP basis.
The following table presents the development of AFC's liability for losses
and LAE, net of reinsurance, on a GAAP basis for the last ten years, excluding
reserves of American Premier subsidiaries prior to 1995. The top line of the
table shows the estimated liability (in millions) for unpaid losses and LAE
recorded at the balance sheet date for the indicated years. The second line
shows the re-estimated liability as of December 31, 2002. The remainder of the
table presents intervening development as percentages of the initially estimated
liability. The development results from additional information and experience in
subsequent years. The middle line shows a cumulative deficiency (redundancy)
which represents the aggregate percentage increase (decrease) in the liability
initially estimated. The lower portion of the table indicates the cumulative
amounts paid as of successive periods as a percentage of the original loss
reserve liability. For purposes of this table, reserves of businesses sold are
considered paid at the date of sale. For example, the percentage of the December
31, 1997 reserve liability paid in 1998 includes approximately 10 percentage
points for reserves ceded in connection with the sale of the Commercial lines
division.
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ----
Liability for unpaid losses
and loss adjustment expenses:
- ----------------------------
As originally estimated $2,123 $2,113 $2,187 $3,393 $3,404 $3,489 $3,305 $3,224 $3,192 $3,253 $3,400
As re-estimated at
December 31, 2002 2,551 2,464 2,545 3,654 3,667 3,687 3,172 3,194 3,355 3,424 N/A
Liability re-estimated:
- ----------------------
One year later 99.9% 98.1% 95.9% 98.7% 100.9% 104.5% 97.8% 98.1% 105.1% 105.2%
Two years later 98.2% 94.1% 99.3% 98.5% 105.9% 104.6% 96.3% 100.1% 105.1%
Three years later 95.2% 97.4% 99.9% 103.9% 105.2% 102.9% 97.4% 99.0%
Four years later 100.3% 98.9% 109.4% 103.1% 103.6% 105.4% 96.0%
Five years later 102.6% 109.7% 109.0% 102.9% 106.9% 105.7%
Six years later 113.6% 108.8% 108.5% 106.8% 107.7%
Seven years later 112.3% 108.5% 115.3% 107.7%
Eight years later 112.2% 115.5% 116.4%
Nine years later 119.1% 116.6%
Ten years later 120.2%
Cumulative deficiency
(redundancy):
Aggregate 20.2% 16.6% 16.4% 7.7% 7.7% 5.7% ( 4.0%) ( 1.0%) 5.1% 5.2% N/A
==== ==== ==== ==== ==== ==== ==== ==== ==== ==== ===
Excluding the 2002 A.P.
Green settlement charge
and special A&E charges
and reallocations in
1994, 1996, 1998 and 2001 ( 0.9%) ( 3.5%) ( 3.0%) ( 4.8%) ( 2.4%) ( 4.2%) ( 8.0%) ( 5.0%) 1.0% 4.3% N/A
==== ==== ==== ==== ==== ==== ==== ==== ==== ==== ===
Cumulative paid as of:
- ---------------------
One year later 26.7% 25.2% 26.8% 33.1% 33.8% 41.7% 28.3% 34.8% 38.3% 33.6%
Two years later 43.7% 40.6% 42.5% 51.6% 58.0% 56.6% 51.7% 52.7% 52.2%
Three years later 54.2% 50.9% 54.4% 67.2% 66.7% 70.8% 62.4% 60.0%
Four years later 60.8% 59.1% 66.3% 72.0% 77.3% 78.6% 65.6%
Five years later 67.0% 68.0% 69.8% 80.4% 82.8% 81.1%
Six years later 74.0% 70.8% 80.0% 84.7% 84.6%
Seven years later 76.3% 80.6% 84.9% 86.0%
Eight years later 85.9% 85.1% 86.1%
Nine years later 89.5% 86.3%
Ten years later 90.7%
The following is a reconciliation of the net liability to the gross
liability for unpaid losses and LAE.
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
---- ---- ---- ---- ---- ---- ---- ---- ---- ----
As originally estimated:
Net liability shown above $2,113 $2,187 $3,393 $3,404 $3,489 $3,305 $3,224 $3,192 $3,253 $3,400
Add reinsurance recoverables 611 730 704 720 736 1,468 1,571 1,324 1,525 1,804
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Gross liability $2,724 $2,917 $4,097 $4,124 $4,225 $4,773 $4,795 $4,516 $4,778 $5,204
====== ====== ====== ====== ====== ====== ====== ====== ====== ======
As re-estimated at
December 31, 2002:
Net liability shown above $2,464 $2,545 $3,654 $3,667 $3,687 $3,172 $3,194 $3,355 $3,424
Add reinsurance recoverables 956 885 1,126 1,142 1,219 1,841 1,942 1,569 1,681
------ ------ ------ ------ ------ ------ ------ ------ ------
Gross liability $3,420 $3,430 $4,780 $4,809 $4,906 $5,013 $5,136 $4,924 $5,105 N/A
====== ====== ====== ====== ====== ====== ====== ====== ====== ===
Gross cumulative deficiency
(redundancy) 25.5% 17.7% 16.7% 16.6% 16.1% 5.0% 7.1% 9.0% 6.8% N/A
==== ==== ==== ==== ==== ==== ==== ==== ==== ===
13
These tables do not present accident or policy year development data.
Furthermore, in evaluating the re-estimated liability and cumulative deficiency
(redundancy), it should be noted that each percentage includes the effects of
changes in amounts for prior periods. For example, AFC's $100 million special
charge for A&E claims related to losses recorded in 2001, but incurred before
1992, is included in the re-estimated liability and cumulative deficiency
(redundancy) percentage for each of the previous years shown. Conditions and
trends that have affected development of the liability in the past may not
necessarily exist in the future. Accordingly, it may not be appropriate to
extrapolate future redundancies or deficiencies based on this table.
The adverse development in the tables is due primarily to A&E exposures
for which AFC has been held liable under general liability policies written
years ago where such coverage was not intended. Other factors affecting
development included higher than projected inflation on medical,
hospitalization, material, repair and replacement costs. Additionally, changes
in the legal environment have influenced the development patterns over the past
ten years. For example, changes in the California workers' compensation law in
1993 and subsequent court decisions, primarily in late 1996, greatly limited the
ability of insurers to challenge medical assessments and treatments. These
limitations, together with changes in work force characteristics and medical
delivery costs, are contributing to an increase in claims severity.
The differences between the liability for losses and LAE reported in the
annual statements filed with the state insurance departments in accordance with
statutory accounting principles ("SAP") and that reported in the accompanying
consolidated financial statements in accordance with GAAP at December 31, 2002
are as follows (in millions):
Liability reported on a SAP basis, net of $238 million
of retroactive reinsurance $3,368
Additional discounting of GAAP reserves in excess
of the statutory limitation for SAP reserves (13)
Reserves of foreign operations 7
Reinsurance recoverables, net of allowance 1,804
Reclassification of allowance for uncollectible
Reinsurance 38
------
Liability reported on a GAAP basis $5,204
======
ASBESTOS AND ENVIRONMENTAL RESERVES ("A&E") In addressing asbestos and
environmental reserves, the insurance industry typically includes claims
relating to polluted waste sites and asbestos as well as other mass tort claims
such as those relating to breast implants, repetitive stress on keyboards, DES
(a drug used in pregnancies years ago alleged to cause cancer and birth defects)
and other latent injuries.
Establishing reserves for A&E claims is subject to uncertainties that are
significantly greater than those presented by other types of claims. For a
discussion of these uncertainties, see Management's Discussion and Analysis
- -"Uncertainties - Asbestos and Environmental-related Reserves", and "Special A&E
Charge" and Note L - "Commitments and Contingencies" to the Financial
Statements.
The survival ratio, which is an industry measure of A&E claim reserves, is
derived by dividing reserves for A&E exposures by annual paid losses. At
December 31, 2002, AFC's three year survival ratio (after adjusting for the sale
of Stonewall and excluding amounts associated with the A.P. Green settlement) is
approximately 22.4 times paid losses for the remaining asbestos reserves and
11.6 times paid losses for total A&E reserves. In October 2002, A.M. Best
reported its estimate that the property and casualty insurance industry's three
year survival ratio for A&E reserves was approximately 7.2 times paid losses at
December 31, 2001.
14
The following table (in millions) is a progression of A&E reserves.
2002 2001 2000
---- ---- ----
Reserves at beginning of year $446.8 $357.7 $576.7
Incurred losses and LAE (a) 48.6 108.0 (1.9)
Paid losses and LAE (28.7) (28.1) (48.7)
Reserves not classified as A&E prior to 2001:
Reserves - 1.4 -
Allowance for uncollectible reinsurance
applicable to ceded A&E reserves - 7.8 -
Reserves transferred with sale of Stonewall - - (168.4)
------ ------ ------
Reserves at end of year, net of
reinsurance recoverable 466.7 446.8 357.7
Reinsurance recoverable, net of allowance 105.1 101.4 105.7
------ ----- ------
Gross reserves at end of year $571.8 $548.2 $463.4
====== ====== ======
(a) Includes $30 million in 2002 related to the settlement of the A.P.
Green asbestos litigation and a special charge of $100 million in 2001.
ANNUITY AND LIFE OPERATIONS
GENERAL
AFC's annuity and life operations are conducted through Great American
Financial Resources, Inc. ("GAFRI"), a holding company which markets retirement
products, primarily fixed and variable annuities, and various forms of life and
supplemental health insurance through the following subsidiaries which were
acquired in the years shown. GAFRI and its subsidiaries employ approximately
1,600 persons.
Great American Life Insurance Company ("GALIC") - 1992(*)
Annuity Investors Life Insurance Company ("AILIC") - 1994
Loyal American Life Insurance Company ("Loyal") - 1995
Great American Life Assurance Company of Puerto Rico ("GAPR") - 1997
United Teacher Associates Insurance Company ("UTA") - 1999
Manhattan National Life Insurance Company ("MNL") - 2002
(*) Acquired from Great American Insurance.
Acquisitions in recent years have supplemented GAFRI's internal growth as
the assets of the holding company and its operating subsidiaries have increased
from $4.5 billion at the end of 1992 to $9.3 billion at the end of 2002.
Premiums over the last three years were as follows (in millions):
Insurance Product(*) 2002 2001 2000
----------------- ---- ---- ----
Annuities $1,001 $ 751 $ 747
Life and supplemental health 313 310 261
------ ------ ------
$1,314 $1,061 $1,008
====== ====== ======
-----------------
(*) Table does not include premiums of subsidiaries or divisions until
their first full year following acquisition or formation.
ANNUITIES
GAFRI's principal retirement products are Flexible Premium Deferred
Annuities ("FPDAs") and Single Premium Deferred Annuities ("SPDAs"). Annuities
are long-term retirement saving instruments that benefit from income accruing on
a tax-deferred basis. The issuer of the annuity collects premiums, credits
interest or earnings on the policy and pays out a benefit upon death, surrender
or annuitization. FPDAs are characterized by premium payments that are flexible
in both amount and timing as determined by the policyholder. SPDAs are issued in
exchange for a one-time lump-sum premium payment.
15
The following table (in millions) presents combined financial information
of GAFRI's principal annuity operations.
2002 2001 2000
---- ---- ----
GAAP Basis
----------
Total Assets $8,014 $7,456 $7,052
Fixed Annuity Reserves 6,111 5,632 5,365
Variable Annuity Reserves 455 530 534
Stockholder's Equity 1,139 1,023 915
Statutory Basis
---------------
Total Assets $7,319 $6,896 $6,620
Fixed Annuity Reserves 6,192 5,729 5,536
Variable Annuity Reserves 455 530 534
Capital and Surplus 419 388 363
Asset Valuation Reserve (a) 63 79 77
Interest Maintenance Reserve (a) 27 11 3
Annuity Receipts:
Flexible Premium:
First Year $ 60 $ 67 $ 71
Renewal 191 176 157
------ ------ ------
251 243 228
Single Premium 750 508 519
------ ------ ------
Total Annuity Receipts $1,001 $ 751 $ 747
====== ====== ======
-----------------
(a) Allocation of surplus.
Sales of annuities are affected by many factors, including: (i)
competitive annuity products and rates; (ii) the general level of interest
rates; (iii) the favorable tax treatment of annuities; (iv) commissions paid to
agents; (v) services offered; (vi) ratings from independent insurance rating
agencies; (vii) other alternative investments; (viii) performance of the equity
markets and (ix) general economic conditions. At December 31, 2002, GAFRI had
over 300,000 annuity policies in force.
Annuity contracts are generally classified as either fixed rate (including
equity-indexed) or variable. The following table presents premiums by
classification:
2002 2001 2000
---- ---- ----
Premiums
--------
Traditional fixed 77% 68% 50%
Variable 18 27 43
Equity-indexed 5 5 7
--- --- ---
100% 100% 100%
=== === ===
With a traditional fixed rate annuity, the interest crediting rate is
initially set by the issuer and thereafter may be changed from time to time by
the issuer subject to any guaranteed minimum interest crediting rates or any
guaranteed term in the policy.
GAFRI seeks to maintain a desired spread between the yield on its
investment portfolio and the rate it credits to its fixed rate annuities. GAFRI
accomplishes this by: (i) offering crediting rates which it has the option to
change after any initial guarantee period; (ii) designing annuity products that
encourage persistency and (iii) maintaining an appropriate matching of assets
and liabilities. GAFRI designs its products with certain provisions to encourage
policyholders to maintain their funds with GAFRI for at least five to ten years.
Virtually all of GAFRI's traditional fixed rate annuities offer a minimum
interest rate guarantee of 3% or 4% (as determined by applicable law); the
majority permit GAFRI to change the crediting rate at any time (subject to the
minimum guaranteed interest rates). In determining the frequency and extent of
changes in the crediting rate, GAFRI takes into account the economic environment
and the relative competitive position of its products. Historically, management
has been able to react to changes in market interest rates and maintain a
desired interest
16
rate spread. The recent interest rate environment has resulted in a compression
of the spread, which could continue at least through 2003.
Sales of GAFRI's fixed rate annuities have increased over the past three
years, due to the weak stock market environment, as well as the development of
new products.
In addition to traditional fixed rate annuities, GAFRI offers variable and
equity-indexed annuities. Industry sales of such annuities increased
substantially in the 1990s as investors sought to obtain the returns available
in the equity markets while enjoying the tax-deferred status of annuities. With
a variable annuity, the earnings credited to the policy vary based on the
investment results of the underlying investment options chosen by the
policyholder, generally without any guarantee of principal except in the case of
death of the insured annuitant. Premiums directed to the variable options in
policies issued by GAFRI are invested in funds maintained in separate accounts
managed by various independent investment managers. GAFRI earns a fee on amounts
deposited into variable accounts. Policyholders may also choose to direct all or
a portion of their premiums to various fixed rate options, in which case GAFRI
earns a spread on amounts deposited. With the downturn in the stock market
during the past three years, industry wide sales of variable annuities,
including GAFRI's sales, have decreased substantially.
An equity-indexed fixed annuity provides policyholders with a crediting
rate tied, in part, to the performance of an existing stock market index while
protecting them against the related downside risk through a guarantee of
principal. GAFRI purchases call options designed to offset substantially all of
the increase in the liabilities associated with equity-indexed annuities. In
2002, GAFRI chose to suspend new sales of equity-indexed annuities due primarily
to a lack of volume.
No individual state accounted for more than 10% of GAFRI's annuity
premiums in the past three years except as follows:
2002 2001 2000
---- ---- ----
California 16% 17% 24%
Washington 10 - -
Ohio - 13 -
GAFRI's FPDAs are sold primarily to employees of not-for-profit and
commercial organizations who are eligible to save for retirement through
contributions made on a before-tax or after-tax basis. Contributions are made at
the discretion of the participants through payroll deductions or through
tax-free "rollovers" of funds from other qualified investments. Federal income
taxes are not payable on pretax contributions or earnings until amounts are
withdrawn.
GAFRI distributes its fixed rate products primarily through a network of
130 managing general agents ("MGAs") who, in turn, direct more than 1,300
actively producing independent agents. The top 15 MGAs accounted for nearly
two-thirds of GAFRI's fixed annuity premiums in 2002. No one MGA represented
more than 9% of total fixed annuity premiums in 2002. In addition, GAFRI offers
all of its annuity product lines through financial institutions. Sales of
annuities through financial institutions were approximately 6% of total annuity
premiums in 2002.
In 2002, GAFRI exited the highly competitive single premium, non-qualified
segment of the variable annuity market due primarily to insufficient returns and
a lack of critical mass. GAFRI intends to redesign its variable product and
offer it as an ancillary product solely through its fixed annuity sales
channels. Approximately one-third of GAFRI's variable annuity sales in 2002 were
made through a wholly-owned subsidiary, Great American Advisors, Inc. ("GAA").
GAA is a broker/dealer licensed in all 50 states to sell stocks, bonds, options,
mutual funds and variable insurance contracts through independent
representatives and financial institutions. GAA also acts as the principal
underwriter and distributor for GAFRI's variable annuity products.
17
LIFE AND SUPPLEMENTAL INSURANCE
GAFRI offers a variety of life and supplemental health products through
GALIC's life operations, MNL, Loyal, GAPR and UTA. This group produced $313
million of statutory premiums in 2002.
GALIC offers traditional term, universal and whole life insurance products
through national marketing organizations. In 2002, GAFRI issued over $8.0
billion gross ($1.9 billion net) face amount of insurance through its life
operations; at year-end 2002, this operation had approximately 228,000 policies
and $39 billion gross ($12 billion net) face amount of insurance in force.
UTA, provides supplemental health products and annuities through
independent agents. UTA's principal health products include coverage for
Medicare supplement, cancer and long-term care. In 2000, UTA purchased a block
of approximately 50,000 Medicare supplement and cancer policies.
Loyal offers a variety of supplemental health and life products. The
principal products sold by Loyal include cancer, accidental injury, short-term
disability, hospital indemnity, universal life and traditional whole life. In
2001, Loyal reinsured a substantial portion of its life insurance business,
reduced its operating expenses, and redirected its marketing efforts in that
line of business. In 2002, Loyal's operations were consolidated with UTA's
operations.
At year-end 2002, GAFRI's operating units writing supplemental insurance
products had assets of nearly $800 million and approximately 354,000 policies
with annualized health premiums in force of $185 million and gross life
insurance in force of $1.4 billion.
GAPR sells in-home service life and supplemental health products through a
network of company-employed agents. Ordinary life, cancer, credit and group life
products are sold through independent agents.
INDEPENDENT RATINGS
GAFRI's principal insurance subsidiaries are rated by A.M. Best and
Standard & Poor's. In addition, GALIC is rated A+ (strong) by Fitch and A3 (good
financial security) by Moody's. Such ratings are generally based on concerns of
policyholders and agents and are not directed toward the protection of
investors. Following are the ratings as of March 1, 2003:
Standard
A.M. Best & Poor's
------------- ----------
GALIC A (Excellent) A-(Strong)
AILIC A (Excellent) A-(Strong)
Loyal A (Excellent) Not rated
UTA A-(Excellent) Not rated
GAPR A (Excellent) Not rated
GAFRI believes that the ratings assigned by independent insurance rating
agencies are important because potential policyholders often use a company's
rating as an initial screening device in considering annuity products. GAFRI
believes that (i) a rating of "A" by A.M. Best (its third highest rating) is
necessary to successfully market tax-deferred annuities to public education
employees and other not-for-profit groups and (ii) a rating in the "A" category
by at least one rating agency is necessary to successfully compete in other
annuity markets.
GAFRI's insurance ratings were recently affirmed by Fitch (with a stable
outlook), and affirmed by Moody's (with a negative outlook); its ratings were
downgraded by Standard & Poor's (with a negative outlook). GAFRI's operations
could be materially and adversely affected by additional downgrades. In
connection with recent reviews by independent rating agencies, management
indicated that it intends to maintain the capital of its significant insurance
subsidiaries at levels currently indicated by the rating agencies as appropriate
for the current ratings. Items which could adversely affect capital levels
include (i) a sustained decrease in the stock market in 2003 or beyond; (ii) a
significant period of low interest rates and a resulting significant narrowing
of annuity "spread"; (iii) investment impairments; (iv) a change in statutory
reserving requirements for guaranteed
18
minimum death benefits on variable annuities, (v) adverse mortality, and (vi)
higher than planned dividends paid due to liquidity needs by GAFRI's holding
companies.
COMPETITION
GAFRI's insurance companies operate in highly competitive markets. They
compete with other insurers and financial institutions based on many factors,
including: (i) ratings; (ii) financial strength; (iii) reputation; (iv) service
to policyholders and agents; (v) product design (including interest rates
credited and premium rates charged); and (vi) commissions. Since policies are
marketed and distributed primarily through independent agents (except at GAPR),
the insurance companies must also compete for agents.
No single insurer dominates the markets in which GAFRI's insurance
companies compete. Competitors include (i) individual insurers and insurance
groups, (ii) mutual funds and (iii) other financial institutions. In a broader
sense, GAFRI's insurance companies compete for retirement savings with a variety
of financial institutions offering a full range of financial services. Financial
institutions have demonstrated a growing interest in marketing investment and
savings products other than traditional deposit accounts.
OTHER COMPANIES
Through subsidiaries, AFC is engaged in a variety of other operations,
including The Golf Center at Kings Island in the Greater Cincinnati area;
commercial real estate operations in Cincinnati (office buildings and The
Cincinnatian Hotel), New Orleans (Le Pavillon Hotel), Cape Cod (Chatham Bars
Inn), Austin (Driskill Hotel), Chesapeake Bay (Skipjack Cove Yachting Resort),
Charleston (Charleston Harbor Resort and Marina) and apartments in Louisville,
Pittsburgh, St. Paul and Tampa Bay. These operations employ approximately 800
full-time employees.
INVESTMENT PORTFOLIO
GENERAL The following tables present the percentage distribution and
yields of AFC's investment portfolio (excluding investment in equity securities
of investee corporations) as reflected in its financial statements.
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Cash and Short-term Investments 6.4% 4.5% 3.8% 3.5% 2.5%
Fixed Maturities:
U.S. Government and Agencies 9.9 8.3 4.7 4.9 4.4
State and Municipal 4.3 3.4 3.6 2.7 1.2
Public Utilities 7.6 6.4 5.5 5.1 6.0
Mortgage-Backed Securities 22.8 21.8 22.7 22.0 20.8
Corporate and Other 39.6 47.3 51.4 55.3 53.2
Redeemable Preferred Stocks .4 .5 .5 .6 .5
----- ----- ----- ----- -----
84.6 87.7 88.4 90.6 86.1
Net Unrealized Gains (Losses) 3.3 1.3 .1 (2.1) 3.5
----- ----- ----- ----- -----
87.9 89.0 88.5 88.5 89.6
Other Stocks, Options and Warrants 2.2 2.6 3.4 3.7 3.7
Policy Loans 1.6 1.7 1.9 1.9 1.9
Real Estate and Other Investments 1.9 2.2 2.4 2.4 2.3
----- ----- ----- ----- -----
100.0% 100.0% 100.0% 100.0% 100.0%
===== ===== ===== ===== =====
Yield on Fixed Income Securities (a):
Excluding realized gains and losses 7.2% 7.6% 7.7% 7.7% 7.8%
Including realized gains and losses 6.7% 7.5% 7.4% 7.6% 8.0%
Yield on Stocks (a):
Excluding realized gains and losses 5.4% 4.5% 5.0% 5.9% 5.4%
Including realized gains and losses (4.6%) (.3%) 3.9% 20.7% (5.3%)
Yield on Investments (a)(b):
Excluding realized gains and losses 7.2% 7.6% 7.6% 7.7% 7.8%
Including realized gains and losses 6.5% 7.4% 7.4% 7.9% 7.8%
(a) Excludes effects of changes in unrealized gains.
(b) Excludes "Real Estate and Other Investments".
The table below compares total returns on AFC's fixed income and equity
securities to comparable public indices. While there are no directly
comparable indices to AFC's portfolio, the two shown below are widely used
benchmarks in the industry. Both AFC's performance and the indices include
changes in unrealized gains and losses.
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Yield on fixed income securities 9.2% 8.8% 9.8% 1.6% 8.1%
Lehman Universal Bond Index 9.8% 8.1% 10.8% 0.2% 7.3%
Yield on equity securities (5.0%) (46.3%) 18.1% 1.8% (43.4%)
Standard & Poors 500 Index (22.1%) (11.9%) (9.1%) 21.0% 28.6%
19
FIXED MATURITY INVESTMENTS
AFC's bond portfolio is invested primarily in taxable bonds. The NAIC
assigns quality ratings which range from Class 1 (highest quality) to Class 6
(lowest quality). The following table shows AFC's bonds and redeemable preferred
stocks, by NAIC designation (and comparable Standard & Poor's Corporation
rating) as of December 31, 2002 (dollars in millions).
NAIC Amortized Market Value
------------------
Rating Comparable S&P Rating Cost Amount %
- ------ --------------------- --------- --------- ---
1 AAA, AA, A $ 8,335 $ 8,772 73%
2 BBB 2,304 2,395 20
------- ------- ---
Total investment grade 10,639 11,167 93
------- ------- ---
3 BB 495 435 4
4 B 299 292 2
5 CCC, CC, C 76 74 1
6 D 41 39 *
------- ------- ---
Total noninvestment grade 911 840 7
------- ------- ---
Total $11,550 $12,007 100%
======= ======= ===
-----------------
(*) Less than 1%
Risks inherent in connection with fixed income securities include loss
upon default and market price volatility. Factors which can affect the market
price of securities include: creditworthiness, changes in interest rates, the
number of market makers and investors and defaults by major issuers of
securities.
AFC's primary investment objective for fixed maturities is to earn
interest and dividend income rather than to realize capital gains. AFC invests
in bonds and redeemable preferred stocks that have primarily intermediate-term
maturities. This practice allows flexibility in reacting to fluctuations of
interest rates.
EQUITY INVESTMENTS
At December 31, 2002, AFC held $299 million in stocks and warrants;
approximately 63% represents an investment in Provident Financial Group, Inc., a
Cincinnati-based commercial banking and financial services company; another 12%
consists of three investments of more than $8 million each. Such equity
investments, because of their size, may not be as readily marketable as the
typical small investment position. Alternatively, a large equity position may be
attractive to persons seeking to control or influence the policies of a company.
FOREIGN OPERATIONS
AFC sells life and supplemental health products in Puerto Rico and
property and casualty products in Mexico, Canada, Puerto Rico, Europe and Asia.
In addition, GAFRI has an office in India where employees perform computer
programming and certain back office functions. Less than 3% of AFC's revenues
and costs and expenses are derived from sources outside of the United States.
REGULATION
AFC's insurance company subsidiaries are subject to regulation in the
jurisdictions where they do business. In general, the insurance laws of the
various states establish regulatory agencies with broad administrative powers
governing, among other things, premium rates, solvency standards, licensing of
insurers, agents and brokers, trade practices, forms of policies, maintenance of
specified reserves and capital for the protection of policyholders, deposits of
securities for the benefit of policyholders, investment activities and
relationships between insurance subsidiaries and their parents and affiliates.
Material transactions between insurance subsidiaries and their parents and
affiliates generally must be disclosed and prior approval of the applicable
insurance regulatory authorities generally is required for any such transaction
which may be deemed to be material or extraordinary. In addition, while
differing from state to state, these regulations typically restrict the maximum
amount of dividends that may be paid by an insurer to its shareholders in
20
any twelve-month period without advance regulatory approval. Such limitations
are generally based on net earnings or statutory surplus. Under applicable
restrictions, the maximum amount of dividends available to AFC in 2003 from its
insurance subsidiaries without seeking regulatory clearance is approximately $24
million. During 2002, those companies received approval and paid $92 million in
dividends in excess of the applicable limitation.
Changes in state insurance laws and regulations have the potential to
materially affect the revenues and expenses of the insurance operations. For
example, between July 1993 and January 1995, the California Commissioner ordered
reductions in workers' compensation insurance premium rates totaling more than
30% and subsequently replaced the workers' compensation insurance minimum rate
law with an "open rating" policy. The Company is unable to predict whether or
when other state insurance laws or regulations may be adopted or enacted or what
the impact of such developments would be on the future operations and revenues
of its insurance businesses.
Most states have created insurance guaranty associations to provide for
the payment of claims of insurance companies that become insolvent. Annual
assessments for AFC's insurance companies have not been material. In addition,
many states have created "assigned risk" plans or similar arrangements to
provide state mandated minimum levels of automobile liability coverage to
drivers whose driving records or other relevant characteristics make it
difficult for them to obtain insurance otherwise. Automobile insurers in those
states are required to provide such coverage to a proportionate number of those
drivers applying as assigned risks. Premium rates for assigned risk business are
established by the regulators of the particular state plan and are frequently
inadequate in relation to the risks insured, resulting in underwriting losses.
Assigned risks accounted for less than one percent of AFC's net written premiums
in 2002.
The NAIC is an organization which is comprised of the chief insurance
regulator for each of the 50 states and the District of Columbia. The NAIC model
law for Risk Based Capital applies to both life and property and casualty
companies. The risk-based capital formulas determine the amount of capital that
an insurance company needs to ensure that it has an acceptably low expectation
of becoming financially impaired. The model law provides for increasing levels
of regulatory intervention as the ratio of an insurer's total adjusted capital
and surplus decreases relative to its risk-based capital, culminating with
mandatory control of the operations of the insurer by the domiciliary insurance
department at the so-called "mandatory control level". At December 31, 2002, the
capital ratios of all AFC insurance companies substantially exceeded the
risk-based capital requirements.
------------------------------------------------
ITEM 2
PROPERTIES
----------
Subsidiaries of AFC own several buildings in downtown Cincinnati. AFC and
its affiliates occupy about three-fourths of the aggregate 660,000 square feet
of commercial and office space.
AFC's insurance subsidiaries lease the majority of their office and
storage facilities in numerous cities throughout the United States, including
Great American's and GAFRI's home offices in Cincinnati. A GAFRI subsidiary owns
a 40,000 square foot office building in Austin, Texas, most of which is used by
the company for its operations.
AFC subsidiaries own transferable rights to develop approximately 800,000
square feet of floor space in the Grand Central Terminal area in New York City.
The development rights were derived from ownership of the land upon which the
terminal is constructed. Since the beginning of 1999, AFC has sold approximately
420,000 square feet of such air rights for total consideration of $22.2 million.
21
ITEM 3
LEGAL PROCEEDINGS
-----------------
Please refer to "Forward-Looking Statements" following the Index in front of
this Form 10-K.
AFC and its subsidiaries are involved in various litigation, most of which
arose in the ordinary course of business, including litigation alleging bad
faith in dealing with policyholders and challenging certain business practices
of insurance subsidiaries. Except for the following, management believes that
none of the litigation meets the threshold for disclosure under this Item.
AFC's insurance company subsidiaries and American Premier are parties to
litigation and receive claims asserting alleged injuries and damages from
asbestos, environmental and other substances and workplace hazards and have
established loss accruals for such potential liabilities. The ultimate loss for
these claims may vary materially from amounts currently recorded as the
conditions surrounding resolution of these claims continue to change.
American Premier is a party or named as a potentially responsible party in
a number of proceedings and claims by regulatory agencies and private parties
under various environmental protection laws, including the Comprehensive
Environmental Response, Compensation and Liability Act ("CERCLA"), seeking to
impose responsibility on American Premier for hazardous waste remediation costs
at certain railroad sites formerly owned by its predecessor, Penn Central
Transportation Company ("PCTC"), and at certain other sites where hazardous
waste allegedly generated by PCTC's railroad operations and APU's former
manufacturing operations is present. It is difficult to estimate American
Premier's liability for remediation costs at these sites for a number of
reasons, including the number and financial resources of other potentially
responsible parties involved at a given site, the varying availability of
evidence by which to allocate responsibility among such parties, the wide range
of costs for possible remediation alternatives, changing technology and the
period of time over which these matters develop. Nevertheless, American Premier
believes that its accruals for potential environmental liabilities are adequate
to cover the probable amount of such liabilities, based on American Premier's
estimates of remediation costs and related expenses and its estimates of the
portions of such costs that will be borne by other parties. Such estimates are
based on information currently available to American Premier and are subject to
future change as additional information becomes available. American Premier
seeks reimbursement from certain insurers for portions of whatever remediation
costs it incurs.
As previously reported, Great American Insurance Company and certain other
insurers have been parties to asbestos-related coverage litigation under
insurance policies issued during the 1970's and 1980's to Bigelow-Liptak
Corporation and related companies, subsequently known as A.P. Green Industries,
Inc. ("A.P. Green"). These claims (some of which are direct actions against
Great American) allege that the refractory materials manufactured, sold or
installed by A.P. Green contained asbestos and resulted in bodily injury from
exposure to asbestos. A.P. Green has sought to recover defense and indemnity
expenses related to those claims from a number of insurers, including Great
American, and in an effort to maximize coverage has asserted that Great
American's policies are not subject to aggregate limits on liability, and that
each insurer is liable for all sums that A.P. Green becomes legally obliged to
pay.
In February 2002, A.P. Green filed petitions for bankruptcy under Chapter
11 of the Bankruptcy Code in the United States Bankruptcy Court for the Western
District of Pennsylvania (In Re Global Industrial Technologies, Inc., et al,
filed February 14, 2002). Prior to the bankruptcy filing, Great American sought
to have these coverage issues decided as part of the contribution and
declaratory judgment action that it brought several years earlier (Great
American Insurance Company, et al v. The Royal Insurance Company, et al, United
States District Court, Southern District of Ohio, filed January 29, 1998) (the
"District Court Action"). The bankruptcy filing, however, stayed the District
Court action.
In March 2002, Great American and other insurers filed a motion in the
Bankruptcy Court to modify the stay so as to permit the District Court action to
22
proceed. During the same month, A.P. Green filed adversary proceedings in the
Bankruptcy Court to decide the coverage issues. In June of 2002, the Bankruptcy
Court entered orders continuing proceedings on both the stay motion and the
adversary proceeding and referred the insurance coverage dispute to non-binding
mediation. The mediation resulted in the negotiated settlement discussed below.
On February 19, 2003, AFG announced that Great American Insurance
Company has entered into an agreement for the settlement of the A.P. Green
litigation. The settlement is for $123.5 million (Great American has the option
to pay in cash or over time with 5.25% interest), all but $30 million of which
will be covered by reserves established prior to September 30, 2002, and
anticipated reinsurance recoverables. The remaining $30 million has been
recorded as of December 31, 2002. The agreement allows up to 10% of the
settlement to be paid in AFG common stock. The settlement, however, is subject
to a number of contingencies, including approval of the Bankruptcy Court
supervising the reorganization of A.P. Green and subsequent confirmation of a
plan of reorganization that includes an injunction prohibiting the assertion
against Great American of any present or future asbestos personal injury claims
under policies issued to A.P. Green and related companies. This process could
take a year or more and no assurance can be made that all of these consents and
approvals will be obtained; no payments are required until completion of the
process. If not obtained, the outcome of this litigation will again be subject
to the complexities and uncertainties associated with a Chapter 11 proceeding
and asbestos coverage litigation.
UTA was named a defendant in a purported class action lawsuit. (Peggy
Berry, et al. v. United Teacher Associates Insurance Company, Travis County
District Court, Case No. GN100461, filed February 11, 2001). The complaint
sought unspecified damages based on the alleged misleading disclosure of UTA's
interest crediting practices on its fixed rate annuities. UTA has entered into
an agreement to resolve this matter. The settlement is subject to approval of
the trial court. The resolution of this matter is not expected to have a
material impact on UTA.
ITEM 4
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
---------------------------------------------------
AFC's Annual Meeting of Shareholders was held on November 20, 2002; the only
issue voted upon was the election of a Board of Directors. Approximately 93%
of the total voting shares (Common and Preferred) were represented at the
meeting. The votes cast for and those withheld are set forth below:
Name For Against Withheld Abstain
---- --- ------- -------- -------
Theodore H. Emmerich 12,477,946 N/A 24,859 N/A
James E. Evans 12,454,115 N/A 48,690 N/A
Carl H. Lindner 12,452,984 N/A 49,821 N/A
Carl H. Lindner III 12,453,969 N/A 48,436 N/A
Keith E. Lindner 12,454,822 N/A 47,983 N/A
S. Craig Lindner 12,453,969 N/A 48,836 N/A
William R. Martin 12,479,310 N/A 23,495 N/A
William W. Verity 12,478,445 N/A 24,360 N/A
- ----------------------
N/A - Not Applicable
23
PART II
ITEM 5
MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
---------------------------------------------------------------------
Not applicable - Registrant's Common Stock is owned by American Financial Group,
Inc. See Consolidated Financial Statements for information regarding dividends.
24
ITEM 6
SELECTED FINANCIAL DATA
-----------------------
The following table sets forth certain data for the periods indicated
(dollars in millions).
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Earnings Statement Data:
- -----------------------
Total Revenues $3,745 $3,929 $3,820 $3,359 $4,084
Operating Earnings Before Income Taxes 195 70 120 310 269
Earnings (Loss) Before Extraordinary Items
and Accounting Changes 134 13 (23) 153 130
Extraordinary Items - - - (4) (1)
Cumulative Effect of Accounting Changes (a) (40) (10) (9) (4) -
Net Earnings (Loss) 94 3 (32) 145 129
Ratio of Earnings to Fixed Charges (b):
Including Annuity Benefits 1.48 1.14 1.26 1.81 1.69
Excluding Annuity Benefits 3.36 1.56 2.02 4.01 3.44
Ratio of Earnings to Fixed Charges and
Preferred Dividends (b):
Including Annuity Benefits 1.46 1.12 1.23 1.76 1.65
Excluding Annuity Benefits 3.09 1.45 1.87 3.67 3.15
Balance Sheet Data:
- ------------------
Total Assets $19,502 $17,398 $16,407 $16,024 $15,848
Long-term Debt:
Holding Companies 268 228 204 113 315
Subsidiaries 297 271 195 240 177
Minority Interest 494 461 510 490 524
Shareholders' Equity 1,730 1,478 1,454 1,324 1,531
(a) Reflects the implementation in the following years of accounting
changes mandated by recently enacted accounting standards:
2002 - SFAS #142 (Goodwill and Other Intangibles)
2001 - EITF 99-20 (Asset-backed Securities)
2000 - SFAS #133 (Derivatives)
1999 - SOP 98-5 (Start-up Costs)
(b) Fixed charges are computed on a "total enterprise" basis. For purposes of
calculating the ratios, "earnings" have been computed by adding to pretax
earnings the fixed charges and the minority interest in earnings of
subsidiaries having fixed charges and the undistributed equity in losses
of investees. Fixed charges include interest (including or excluding
interest credited to annuity policyholders' accounts as indicated),
amortization of debt premium/discount and expense, preferred dividend and
distribution requirements of subsidiaries and a portion of rental expense
deemed to be representative of the interest factor.
Although the ratio of earnings to fixed charges excluding interest on
annuities is not required or encouraged to be disclosed under Securities
and Exchange Commission rules, some investors and lenders may not consider
interest credited to annuity policyholders' accounts a borrowing cost for
an insurance company, and accordingly, believe this ratio is meaningful.
25
ITEM 7
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
------------------------------------------------
Please refer to "Forward-Looking Statements" following the Index in front of
this Form 10-K.
GENERAL
Following is a discussion and analysis of the financial statements and
other statistical data that management believes will enhance the understanding
of AFC's financial condition and results of operations. This discussion should
be read in conjunction with the financial statements beginning on page F-1.
CRITICAL ACCOUNTING POLICIES
Significant accounting policies are summarized in Note A to the financial
statements. The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that can have a significant effect on amounts reported in the
financial statements. As more information becomes known, these estimates and
assumptions could change and thus impact amounts reported in the future.
Management believes that the establishment of insurance reserves, especially
asbestos and environmental-related reserves, and the determination of "other
than temporary" impairment on investments are the two areas where the degree of
judgment required to determine amounts recorded in the financial statements make
the accounting policies critical. For further discussion of these policies, see
"Liquidity and Capital Resources - Investments" and "Liquidity and Capital
Resources - Uncertainties."
LIQUIDITY AND CAPITAL RESOURCES
RATIOS AFC's debt to total capital ratio at the parent holding company level
(excluding amounts due AFG) was approximately 13% at December 31, 2002 and 2001.
Including amounts due AFG, the ratio was 25% at the end of 2002 and 28% at the
end of 2000. AFC used a portion of the proceeds from the Infinity sale in
February 2003 to repay parent debt. Adjusting to reflect this repayment reduces
the ratio to 6% excluding amounts due AFG and 20% including amounts due AFG at
December 31, 2002.
AFC's ratio of earnings to fixed charges excluding and including preferred
dividends, on a total enterprise basis for the year ended December 31, 2002, was
3.36 and 3.09, respectively. Including annuity benefits as a fixed charge, this
ratio was 1.48 and 1.46 respectively. Although not required to be disclosed, the
ratio excluding interest on annuities is presented because interest credited to
annuity policyholder accounts is not always considered a borrowing cost for an
insurance company.
The National Association of Insurance Commissioners' model law for risk
based capital ("RBC") applies to both life and property and casualty companies.
RBC formulas determine the amount of capital that an insurance company needs to
ensure that it has an acceptable expectation of not becoming financially
impaired. At December 31, 2002, the capital ratios of all AFC insurance
companies substantially exceeded the RBC requirements (the lowest capital ratio
of any AFC subsidiary was 2.3 times its authorized control level RBC; weighted
average of all AFC subsidiaries was 5.0 times).
SOURCES OF FUNDS AFC and American Premier are organized as holding companies
with almost all of their operations being conducted by subsidiaries. These
parent corporations, however, have continuing cash needs for administrative
expenses, the payment of principal and interest on borrowings, shareholder
dividends, and taxes. Funds to meet these obligations come primarily from
dividend and tax payments from their subsidiaries.
Management believes these parent holding companies have sufficient
resources to meet their liquidity requirements. If funds generated from
operations, including dividends and tax payments from subsidiaries, are
insufficient to meet fixed charges in any period, these companies would be
required to generate cash through borrowings, sales of securities or other
assets, or similar transactions.
26
AFC has a reciprocal Master Credit Agreement with various AFG holding
companies under which these companies make funds available to each other for
general corporate purposes.
In November 2002, AFC replaced its $300 million bank credit line with a
new bank credit agreement. Currently, AFC may borrow up to $280 million under
the new agreement; the line may be expanded to $300 million through the end of
2003. The new line consists of two facilities: a 364-day revolving facility,
extendable annually, for one-third of the total line and a three-year revolving
facility for the remaining two-thirds. Amounts borrowed bear interest at rates
ranging from 1.25% to 2.25% over LIBOR based on AFG's credit rating. This credit
agreement provides ample liquidity and can be used to obtain funds for operating
subsidiaries or, if necessary, for the parent companies. At December 31, 2002,
there was $248 million borrowed under the agreement. At March 14, 2003, there
was $95 million borrowed under the line.
In December 2000, AFC borrowed $155 million under its credit agreement
with AFG to make capital contributions to its property and casualty operations.
For statutory accounting purposes, equity securities of non-affiliates are
generally carried at market value. At December 31, 2002, AFC's insurance
companies owned publicly traded equity securities with a market value of $297
million. In addition, Great American owns GAFRI common stock with a market value
of $603 million and a carrying value of $422 million. Since significant amounts
of these are concentrated in a relatively small number of companies, decreases
in the market prices could adversely affect the insurance group's capital,
potentially impacting the amount of dividends available or necessitating a
capital contribution. Conversely, increases in the market prices could have a
favorable impact on the group's dividend-paying capability.
Under tax allocation agreements with AFC, its 80%-owned U.S. subsidiaries
generally compute tax provisions as if filing separate returns based on book
taxable income computed in accordance with generally accepted accounting
principles. The resulting provision (or credit) is currently payable to (or
receivable from) AFC.
INVESTMENTS Approximately two-thirds of AFC's consolidated assets are invested
in marketable securities. AFC's investment portfolio at December 31, 2002,
contained $12 billion in "Fixed maturities" and $299 million in "Other stocks",
all carried at market value with unrealized gains and losses reported as a
separate component of shareholders' equity on an after-tax basis. At December
31, 2002, AFC had pretax net unrealized gains of $457.2 million on fixed
maturities and $125.2 million on other stocks. AFC attempts to optimize
investment income while building the value of its portfolio, placing emphasis
upon long-term performance. AFC's goal is to maximize return on an ongoing basis
rather than focusing on short-term performance.
Fixed income investment funds are generally invested in securities with
intermediate-term maturities with an objective of optimizing total return while
allowing flexibility to react to changes in market conditions. At December 31,
2002, the average life of AFC's fixed maturities was about six years.
Approximately 93% of the fixed maturities held by AFC were rated
"investment grade" (credit rating of AAA to BBB) by nationally recognized rating
agencies at December 31, 2002. Investment grade securities generally bear lower
yields and lower degrees of risk than those that are unrated or noninvestment
grade. Management believes that the high quality investment portfolio should
generate a stable and predictable investment return.
Investments in mortgage backed securities ("MBSs") represented
approximately one-fourth of AFC's fixed maturities at December 31, 2002. MBSs
are subject to significant prepayment risk due to the fact that, in periods of
declining interest rates, mortgages may be repaid more rapidly than scheduled as
borrowers refinance higher rate mortgages to take advantage of lower rates. Due
to the significant decline in the general level of interest rates in 2002, AFC
has experienced an increase in the level of prepayments on its MBSs; these
prepayments have not been reinvested at interest rates comparable to the rates
earned on the prepaid MBSs. Substantially all of AFC's MBSs are investment grade
quality, with over 95% rated "AAA" at December 31, 2002.
27
Summarized information for the unrealized gains and losses recorded in AFC's
balance sheet at December 31, 2002, is shown in the following table (dollars in
millions). Approximately $170 million of "Fixed maturities" and $21 million of
"Other stocks" had no unrealized gains or losses at December 31, 2002.
Securities Securities
With With
Unrealized Unrealized
Gains Losses
---------- ----------
Fixed Maturities
----------------
Market value of securities $10,458 $1,379
Amortized cost of securities $ 9,868 $1,512
Gross unrealized gain (loss) $ 590 ($ 133)
Market value as % of amortized cost 106% 91%
Number of security positions 1,725 328
Number individually exceeding
$2 million gain or loss 23 18
Concentration of gains (losses) by
type or industry (exceeding 5% of
unrealized):
Mortgage-backed securities $ 134.6 ($ 9.1)
Banks and savings institutions 55.2 (1.3)
U.S. government and government agencies 49.5 (1.1)
State and municipal 36.4 (5.6)
Electric services 31.6 (15.2)
Asset-backed securities 14.4 (10.6)
Air transportation (generally collateralized) 5.3 (47.7)
Percentage rated investment grade 97% 65%
Other Stocks
------------
Market value of securities $ 260 $ 18
Cost of securities $ 130 $ 23
Gross unrealized gain (loss) $ 130 ($ 5)
Market value as % of cost 200% 78%
Number individually exceeding
$2 million gain or loss 3 1
AFC's investment in equity securities of Provident Financial Group, a
Cincinnati-based commercial banking and financial services company, represents
$117 million of the $130 million in unrealized gains on other stocks at
December 31, 2002. At March 14, 2003, the unrealized gain on Provident was
approximately $86 million.
The table below sets forth the scheduled maturities of fixed maturity securities
at December 31, 2002, based on their market values. Asset backed securities and
other securities with sinking funds are reported at average maturity. Actual
maturities may differ from contractual maturities because certain securities may
be called or prepaid by the issuers.
Securities Securities
with With
Unrealized Unrealized
Maturity Gains Losses
-------- ---------- ----------
One year or less 6% 5%
After one year through five years 22 27
After five years through ten years 33 39
After ten years 10 17
--- ---
71 88
Mortgage-backed securities 29 12
--- ---
100% 100%
=== ===
28
AFC realized aggregate losses of $11.1 million during 2002 on $72.9 million in
sales of fixed maturity securities (14 issues; 12 issuers) that had individual
unrealized losses greater than $500,000 at December 31, 2001. Market values of
eleven of the securities increased an aggregate of $8 million from year-end 2001
to date of sale. The market value of one of the securities did not change from
year-end 2001 to the date of sale. One of the securities was a Conseco bond that
decreased in value by $5 million from year-end 2001 to the date of sale due to
the continued decline in Conseco's financial condition. The market value of the
remaining security decreased $920,000 from year-end 2001 to the sale date.
Although AFC had the ability to continue holding these investments, its intent
to hold them changed due primarily to deterioration in the issuers'
creditworthiness, decisions to lessen exposure to a particular credit or
industry, or to modify asset allocation within the portfolio.
The table below (dollars in millions) summarizes the length of time securities
have been in an unrealized gain or loss position at December 31, 2002.
Market
Aggregate Aggregate Value as
Market Unrealized % of Cost
Value Gain (Loss) Basis
--------- ----------- ---------
Fixed Maturities
-----------------------------------------------
SECURITIES WITH UNREALIZED GAINS:
Exceeding $500,000 at 12/31/02 and for:
Less than one year (354 issues) $ 4,561 $327 108%
More than one year (64 issues) 762 83 112
Less than $500,000 at 12/31/02 (1,307 issues) 5,135 180 104
------- ----
$10,458 $590 106%
======= ====
SECURITIES WITH UNREALIZED LOSSES:
Exceeding $500,000 at 12/31/02 and for:
Less than one year (50 issues) $ 379 ($ 75) 84%
More than one year (17 issues) 118 (35) 77
Less than $500,000 at 12/31/02 (261 issues) 882 (23) 98
------- ----
$ 1,379 ($133) 91%
======= ====
Other Stocks
------------------------------------------------
SECURITIES WITH UNREALIZED GAINS:
Exceeding $500,000 at 12/31/02 and for:
Less than one year (4 issues) $ 26 $ 6 130%
More than one year (4 issues) 207 121 241
Less than $500,000 at 12/31/02 (66 issues) 27 3 113
------- ----
$ 260 $130 200%
======= ====
SECURITIES WITH UNREALIZED LOSSES:
Exceeding $500,000 at 12/31/02 and for:
Less than one year (1 issue) $ 2 ($ 1) 67%
More than one year (none) - - -
Less than $500,000 at 12/31/02 (75 issues) 16 (4) 80
------- ----
$ 18 ($ 5) 78%
======= ====
29
When a decline in the value of a specific investment is considered to be
"other than temporary," a provision for impairment is charged to earnings
(accounted for as a realized loss) and the cost basis of that investment is
reduced. The determination of whether unrealized losses are "other than
temporary" requires judgment based on subjective as well as objective factors.
Factors considered and resources used by management include:
a) whether the unrealized loss is credit-driven or a result of changes in
market interest rates,
b) the extent to which market value is less than cost basis,
c) historical operating, balance sheet and cash flow data contained in
issuer SEC filings,
d) issuer news releases,
e) near-term prospects for improvement in the issuer and/or its industry,
f) industry research and communications with industry specialists,
g) third party research and credit rating reports,
h) internally generated financial models and forecasts,
i) discussions with issuer management, and
j) ability and intent to hold the investment for a period of time sufficient
to allow for any anticipated recovery in market value.
Based on its analysis of the factors enumerated above, management believes
(i) AFC will recover its cost basis in the securities with unrealized losses and
(ii) that AFC has the ability and intent to hold the securities until they
mature or recover in value. Should either of these beliefs change with regard to
a particular security, a charge for impairment would likely be required. While
it is not possible to accurately predict if or when a specific security will
become impaired, charges for other than temporary impairment could be material
to results of operations in a future period. Management believes it is not
likely that future impairment charges will have a significant effect on AFC's
liquidity.
Net realized gains (losses) on securities sold and charges for "other than
temporary" impairment on securities held were as follows (in millions):
Net Realized
Gains (Losses) Charges for
on Sales Impairment Other(a) Total
-------------- ----------- ----- ------
2002 $112.9 ($179.4) ($12.4) ($78.9)
2001 89.8 (125.5) (b) 11.6 (24.1)
2000 (1.7) (27.5) 2.6 (26.6)
1999 37.4 (19.4) 2.1 20.1
1998 42.6 (34.6) (1.7) 6.3
(a) Includes adjustments to carry derivatives at market and to reflect
the impact of realized gains and losses on the amortization of
deferred policy acquisition costs.
(b) Does not include $16.9 million writedown of certain collateralized
debt obligations which was recorded as the cumulative effect of an
adoption of an accounting change at April 1, 2001.
Increased impairment charges in recent years reflect a rise in corporate
defaults in the marketplace resulting from the weakened economy.
UNCERTAINTIES As more fully explained in the following paragraphs, management
believes that the areas posing the greatest risk of material loss are the
adequacy of its insurance reserves and American Premier's contingencies arising
out of its former operations.
PROPERTY AND CASUALTY INSURANCE RESERVES The liability for unpaid losses
and loss adjustment expenses was as follows (in millions):
December 31,
----------------------
2002 2001
---- ----
Specialty $3,712 $3,295
Personal 838 843
Other lines (including asbestos
and environmental) 654 640
------ ------
$5,204 $4,778
====== ======
30
The liabilities for unpaid claims and for expenses of investigation and
adjustment of unpaid claims are based upon: (a) the accumulation of case
estimates for losses reported prior to the close of the accounting periods on
direct business written; (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 expense for investigating
and adjusting claims; and (e) the current state of law and coverage litigation.
Using these items as well as historical trends adjusted for changes in
underwriting standards, policy provisions, product mix and other factors,
company actuaries determine a single or "point" estimate which management
utilizes in recording its best estimate of the liabilities. Ranges of loss
reserves are not developed by company actuaries.
Estimating the liability for unpaid losses and LAE is inherently
judgmental and is influenced by factors which are subject to significant
variation. Through the use of analytical reserve development techniques,
management utilizes items such as the effect of inflation on medical,
hospitalization, material, repair and replacement costs, general economic trends
and the legal environment. While current factors and reasonably likely changes
in variable factors are considered in estimating the liability for unpaid
losses, there is no method or system which can eliminate the risk of actual
ultimate results differing from such estimates. Reserve development in recent
years is quantified and discussed for major areas of AFC's property and casualty
insurance operations in the pages that follow under "Results of Operations -
Property and Casualty Insurance - Underwriting."
Quarterly reviews of unpaid loss and LAE reserves are prepared using
standard actuarial techniques. These may include: Case Incurred Development
Method; Paid Development Method; Bornhuetter-Ferguson Method; and Incremental
Paid LAE to Paid Loss Methods. Generally, data is segmented by major product or
coverage within product using countrywide data; however, in some situations data
may be reviewed by state for large volume states.
ASBESTOS AND ENVIRONMENTAL-RELATED ("A&E") RESERVES Establishing reserves
for A&E claims relating to policies and participations in reinsurance treaties
and former operations is subject to uncertainties that are significantly greater
than those presented by other types of claims. For this group of claims,
traditional actuarial techniques that rely on historical loss development trends
cannot be used and a meaningful range of loss cannot be estimated. Case reserves
and expense reserves are established by the claims department as specific
policies are identified. In addition to the case reserves established for known
claims, management establishes additional reserves for claims not yet known or
reported and for possible development on known claims. These additional reserves
are management's best estimate based on its review of industry trends and other
industry information about such claims, with due consideration to individual
claim situations like A.P. Green. Estimating ultimate liability for asbestos
claims presents a unique and difficult challenge to the insurance industry due
to, among other things, inconsistent court decisions, an increase in bankruptcy
filings as a result of asbestos-related liabilities, novel theories of coverage,
and judicial interpretations that often expand theories of recovery and broaden
the scope of coverage. The casualty insurance industry is engaged in extensive
litigation over these coverage and liability issues as the volume and severity
of claims against asbestos defendants continue to increase.
While management believes that AFC's reserves for A&E claims are a
reasonable estimate of ultimate liability for such claims, actual results may
vary materially from the amounts currently recorded due to the difficulty in
predicting the number of future claims and the impact of recent bankruptcy
filings, and unresolved issues such as whether coverage exists, whether policies
are subject to aggregate limits on coverage, whether claims are to be allocated
among triggered policies and implicated years, and whether claimants who exhibit
no signs of illness will be successful in pursuing their claims.
In February 2003, Great American Insurance Company entered into an
agreement for the settlement of asbestos related coverage litigation under
insurance polices issued during the 1970's and 1980's to Bigelow-Liptak
Corporation and related companies, subsequently known as A.P. Green Industries,
Inc. ("A.P. Green"). Management believes that this settlement will enhance
financial certainty and provides resolution to litigation that represents AFC's
largest known asbestos-related claim and the only such claim that management
believes to be material.
The settlement is for $123.5 million (Great American has the option to pay
in cash or over time with 5.25% interest), all but $30 million of which will be
covered by reserves established prior to September 30, 2002, and anticipated
reinsurance recoverables for this matter. As a result, AFC recorded a $30
million pretax charge ($19.5 million after tax) in the fourth quarter of 2002.
The agreement allows up to 10% of the settlement to be paid in AFG common stock.
31
The settlement is subject to a number of contingencies, including the
approval of the bankruptcy court supervising the reorganization of A.P. Green
and subsequent confirmation of a plan of reorganization that includes an
injunction prohibiting the assertion against Great American of any present or
future asbestos personal injury claims under policies issued to A.P. Green and
related companies. This process could take a year or more and no assurance can
be made that all of these consents and approvals will be obtained; no payments
are required until completion of the process. If not obtained, the outcome of
this litigation will again be subject to the complexities and uncertainties
associated with a Chapter 11 proceeding and asbestos coverage litigation.
The payments, reserve balances and policy count information for asbestos,
environmental and other mass torts were as follows (dollars in millions):
Net Net
Amounts Reserve Policyholder Counts
Paid in Balance (Direct and Assumed)
-----------------------------------
2002 12/31/02 12/31/01 New Closed 12/31/02
------- -------- -------- --- ------ --------
Asbestos $16.8 $302.3 429 82 39 472
Environmental 9.6 139.4 715 95 152 658
Other Mass Tort 2.3 25.0 109 23 28 104
----- ------ ----- --- --- -----
Total $28.7 $466.7 1,253 200 219 1,234
===== ====== ===== === === =====
Of the open asbestos accounts, approximately 270 are holders of policies
written by AFC subsidiaries and approximately 200 represent assumed reinsurance
business. The direct policyholders with asbestos claims consist of limited
exposures, dominated by small to mid-sized commercial entities that are mostly
regional policyholders with few national target defendants. With respect to
non-products exposures, there are few accounts with potentially significant
exposure, none of which is considered to be material to the Company.
The assumed reinsurance business includes exposures for the periods 1954
to 1983. The asbestos and environmental assumed claims are ceded by various
insurance companies under reinsurance treaties. A majority of the individual
assumed claims have exposures of less than $100,000 to AFC. Asbestos losses
assumed include some of the industry known manufacturers, distributors and
installers. Pollution losses include industry known insured names and sites.
Other mass tort losses include Agent Orange, breast implants, DES, Dalkon
Shield, lead, silicon and various chemical exposures.
EXPOSURE TO MARKET RISK Market risk represents the potential economic loss
arising from adverse changes in the fair value of financial instruments. AFC's
exposures to market risk relate primarily to its investment portfolio and
annuity contracts which are exposed to interest rate risk and, to a lesser
extent, equity price risk. To a much lesser extent, AFC's long-term debt is also
exposed to interest rate risk.
32
FIXED MATURITY PORTFOLIO The fair value of AFC's fixed maturity portfolio
is directly impacted by changes in market interest rates. AFC's fixed maturity
portfolio is comprised of substantially all fixed rate investments with
primarily intermediate-term maturities. This practice allows flexibility in
reacting to fluctuations of interest rates. The portfolios of AFC's insurance
operations are managed with an attempt to achieve an adequate risk-adjusted
return while maintaining sufficient liquidity to meet policyholder obligations.
AFC's life and annuity operations attempt to align the duration of their
invested assets to the projected cash flows of policyholder liabilities.
The following table provides information about AFC's fixed maturity
investments at December 31, 2002 and 2001, that are sensitive to interest rate
risk. The table shows principal cash flows (in millions) and related weighted
average interest rates by expected maturity date for each of the five subsequent
years and for all years thereafter. Callable bonds and notes are included based
on call date or maturity date depending upon which date produces the most
conservative yield. Mortgage-backed securities ("MBSs") and sinking fund issues
are included based on maturity year adjusted for expected payment patterns.
Actual cash flows may differ from those expected.
December 31, 2002 December 31, 2001
--------------------- ---------------------
Principal Principal
Cash Flows Rate Cash Flows Rate
---------- ----- ---------- ----
2003 $ 1,301 10.09% 2002 $ 956 8.62%
2004 848 8.31 2003 1,407 7.84
2005 1,035 7.05 2004 860 8.56
2006 1,135 6.69 2005 1,082 7.50
2007 1,158 6.12 2006 1,110 6.89
Thereafter 5,939 6.13 Thereafter 5,263 7.08
------- -------
Total $11,416 6.88% $10,678 7.46%
======= =======
Fair Value $12,007 $10,749
======= =======
EQUITY PRICE RISK Equity price risk is the potential economic loss from
adverse changes in equity security prices. Although AFC's investment in "Other
stocks" is less than 3% of total investments, two-thirds of "Other stocks" is
invested in Provident Financial Group which exposes AFC to the risk of price
declines in a single position.
Included in "Other stocks" at December 31, 2002 were warrants (valued at
$13.8 million) to purchase common stock of various companies. Under Statement of
Financial Accounting Standards ("SFAS") No. 133, which was adopted as of October
1, 2000, these warrants are generally considered derivatives and marked to
market through current earnings as realized gains and losses.
ANNUITY CONTRACTS Substantially all of GAFRI's fixed rate annuity
contracts permit GAFRI to change crediting rates (subject to minimum interest
rate guarantees of 3% to 4% per annum as determined by applicable law) enabling
management to react to changes in market interest rates and maintain an adequate
spread. Nonetheless, due to the sharp drop in interest rates in 2002, GAFRI's
spreads have narrowed and will likely continue to narrow through at least 2003.
Actuarial assumptions used to estimate DPAC and Annuity Benefits, as well as
GAFRI's ability to maintain spread, could be impacted if the current interest
rate environment continues for an extended period and causes policyholder
behavior to be altered.
Projected payments (in millions) in each of the subsequent five years and
for all years thereafter on GAFRI's fixed annuity liabilities at December 31
were as follows.
Fair
First Second Third Fourth Fifth Thereafter Total Value
----- ------ ----- ------ ----- ---------- ------ ------
2002 $550 $610 $740 $810 $700 $3,044 $6,454 $6,284
2001 750 680 650 630 610 2,512 5,832 5,659
33
Nearly half of GAFRI's fixed annuity liabilities at December 31, 2002,
were two-tier in nature in that policyholders can receive a higher amount if
they annuitize rather than surrender their policy, even if the surrender charge
period has expired. At December 31, 2002, the average crediting rate on GAFRI's
principal fixed annuity products was approximately 4.3% and current stated
crediting rates (excluding bonus interest) on GAFRI's active products generally
range from 3.0% to 3.6%. GAFRI estimates that its effective weighted-average
crediting rate over the next five years will approximate 4.3%. This rate
reflects actuarial assumptions as to (i) expected investment spread, (ii)
deaths, (iii) annuitizations, (iv) surrenders and (v) renewal premiums. Actual
experience and changes in actuarial assumptions may result in different
effective crediting rates than those above.
GAFRI's equity-indexed fixed annuities provide policyholders with a
crediting rate tied, in part, to the performance of an existing stock market
index. GAFRI attempts to mitigate the risk in the equity-based component of
these products through the purchase of call options on the appropriate index.
GAFRI's strategy is designed so that an increase in the liabilities due to an
increase in the market index will be substantially offset by unrealized gains on
the call options. Under SFAS No. 133, both the equity-based component of the
annuities and the related call options are considered derivatives and marked to
market through current earnings as annuity benefits. Adjusting these derivatives
to market value had a net effect of less than 1% of annuity benefits in 2002 and
2001. In 2002, GAFRI chose to suspend new sales of equity-indexed annuities due
primarily to lack of volume.
DEBT AND PREFERRED SECURITIES The following table shows scheduled
principal payments (in millions) on fixed-rate long-term debt of AFC and its
subsidiaries and related weighted average interest rates for each of the
subsequent five years and for all years thereafter.
December 31, 2002 December 31, 2001
---------------------- ---------------------
Scheduled Scheduled
Principal Principal
Payments Rate Payments Rate
--------- ---- --------- ----
2003 * 2002 $ 4.3 7.02%
2004 * 2003 *
2005 $ 10.1 9.09% 2004 *
2006 18.7 6.74 2005 10.1 9.07
2007 * 2006 18.7 6.73
Thereafter 126.5 7.19 Thereafter 126.8 7.17
------ ------
Total $157.4 7.26% $161.6 7.23%
====== ======
Fair Value $148.5 $156.5
====== ======
(*) Less than $2 million.
At December 31, 2002 and 2001, respectively, AFC and its subsidiaries had
$406 million and $337 million in variable-rate debt maturing primarily in 2003
through 2005. The weighted average interest rate on AFC's variable-rate debt was
2.84% at December 31, 2002 compared to 2.67% at December 31, 2001. There were
$143 million of subsidiary trust preferred securities with a weighted average
interest rate of 9.07% outstanding at December 31, 2002 and 2001, none of which
is scheduled for maturity or mandatory redemption during the next five years.
34
RESULTS OF OPERATIONS - THREE YEARS ENDED DECEMBER 31, 2002
GENERAL The following table shows AFC's net earnings as stated in the Statement
of Operations as well as the after-tax effect of other items included in these
GAAP measures that are listed below to assist investors in analyzing their
impact on the trend in operating results (in millions):
2002 2001 2000
---- ---- ----
NET EARNINGS (LOSS) $94.4 $ 2.6 ($32.1)
After tax income (expense) items included in
net earnings:
Asbestos litigation settlement (19.5) - -
Tax resolution benefits 31.0 - -
A&E charge and WTC losses - (81.3) -
Net losses from investee corporations (9.0) (16.5) (91.4)
Realized investment gains (losses) (44.0) (12.6) 2.8
Cumulative effect of accounting changes (40.4) (10.0) (9.1)
In addition to the effects of items shown in the table above, net earnings
increased in 2002 primarily due to significantly improved underwriting results
and income from the sale of real estate, partially offset by reduced earnings in
the annuity and life operations. Net earnings for 2001 and 2000 include goodwill
amortization expense of $13.8 million and $16.5 million, respectively.
Aside from the asbestos charges and losses from the World Trade Center,
underwriting results improved in 2001 but were partially offset by a $15 million
charge to increase reserves for environmental costs related to certain former
operations.
PROPERTY AND CASUALTY INSURANCE - UNDERWRITING AFC's property and casualty
operations have consisted of two major business groups: Specialty and Personal.
See Note P, "Subsequent Events", to the Financial Statements for a discussion of
the sale of nearly all of the Personal group.
The Specialty group includes a highly diversified group of business lines.
Some of the more significant areas are inland and ocean marine, California
workers' compensation, agricultural-related coverages, executive and
professional liability, fidelity and surety bonds, collateral protection, and
umbrella and excess coverages.
The Personal group sells nonstandard and preferred/standard private
passenger auto insurance and, to a lesser extent, homeowners' insurance.
Nonstandard automobile insurance covers risks not typically accepted for
standard automobile coverage because of the applicant's driving record, type of
vehicle, age or other criteria.
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.
35
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 many of the various
specialty businesses listed above), management believes that it is prudent and
appropriate to use conservative assumptions until such time as the data,
experience and projections have more credibility, as evidenced by data volume,
consistency and maturity of the data. While this practice mitigates the risk of
adverse development on this business, it does not eliminate it.
While 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.
Since mid-2000, AFC has been actively realigning its mix of business and
resetting its rate structure with a goal of achieving underwriting profits, even
if it entails sacrificing volume. Management believes these efforts have been
successful and expects further improvement in underwriting profitability in 2003
resulting from these strategic actions.
AFC's combined ratio has been better than the industry average for sixteen
of the last seventeen years and, excluding AFC's special A&E charges, for all
seventeen years. AFC's insurance operations have performed better than the
industry by focusing on growth opportunities in the more profitable areas of its
specialty and nonstandard auto businesses.
Net written premiums and combined ratios for AFC's property and casualty
insurance subsidiaries were as follows (dollars in millions):
2002 2001 2000
---- ---- ----
Gross Written Premiums (GAAP)
-----------------------------
Specialty $2,713 $2,236 $1,889
Personal 1,221 1,284 1,339
Other Lines 1 - 3
------ ------ ------
$3,935 $3,520 $3,231
====== ====== ======
Net Written Premiums (GAAP)
---------------------------
Specialty $1,577 $1,542 $1,324
Personal 836 (a) 1,040 (a) 1,311
Other Lines 1 - 3
------ ------ ------
$2,414 $2,582 $2,638
====== ====== ======
Combined Ratios (GAAP)
----------------------
Specialty 98.4% 101.7%(b) 107.9%
Personal 99.8 107.9 108.6
Aggregate (including discontinued lines) 101.1%(c) 108.8%(c) 108.0%
(a) Reflects the ceding of $375 million and $220 million in premiums in 2002
and 2001, respectively under a reinsurance agreement (effective April 1,
2001).
(b) Includes 1.8% for 2001 relating to the attack on the World Trade Center.
(c) Includes 1.2% for 2002 relating to the A.P. Green asbestos litigation
charge and 4.8% for 2001 relating to the A&E charge and the attack on
the World Trade Center.
36
As shown in Note N under "Insurance Reserves," AFC's property and casualty
operations recorded loss development of $171 million in 2002 and $163 million in
2001 related to prior accident years. Major areas of adverse development were as
follows (in millions):
2002 2001
---- ----
Asbestos $ 49 $108
Executive liability 26 26
Other liability 21 *
Personal lines 15 *
Other discontinued specialty businesses 41 32
Other 19 (3)
---- ----
$171 $163
==== ====
(*) Amounts are immaterial and included in Other
"Asbestos" development was due primarily to charges for settlement of
litigation (2002) and the special $100 million A&E charge (2001), both of which
are discussed below. See "Uncertainties - Asbestos and Environmental-related
Reserves" for additional information about these claims.
"Executive liability" development resulted primarily from claim severity
on policy coverages for 1999 and 2000. Both settlement costs and defense costs
related to shareholder lawsuits have increased beyond estimates.
"Other liability" development was the result of an unexpected shift of the
judicial climate in some previously relatively conservative states. Verdicts,
judgments, and settlements have increased and reserves were adjusted
accordingly.
In the "Personal lines," personal injury and uninsured motorist claims
have experienced increased severity. During 2002, claims remained open longer
and settlement amounts have been higher than in previous years.
Development in the "Other discontinued specialty businesses" related
primarily to excess casualty and homebuilders' product liability. During 2002,
both experienced higher frequency of claims, primarily related to the 1999 and
2000 accident years for the excess casualty line, and 1993 through 2001 for the
homebuilders' liability. Development in 2001, and to a lesser extent in 2002,
was affected by increased severity in excess casualty resulting from a rigorous
claims review of case reserves established by former management.
"Other" development represents an aggregation of all other lines. While
both increases and decreases occurred in these individual lines, none
experienced development greater than the smallest listed in the table above.
Aggregate adverse development in the "Other" lines was approximately $44 million
in 2002, and $25 million in 2001. Aggregate positive development was $25 million
in 2002 and $28 million in 2001.
ASBESTOS LITIGATION SETTLEMENT CHARGE As more fully discussed under
"Uncertainties - Asbestos and Environmental-related Reserves," AFC recorded a
fourth quarter 2002 pretax charge of $30 million related to the settlement of
asbestos-related coverage litigation.
2001 SPECIAL A&E CHARGE During the third quarter of 2001, AFC recorded an
A&E charge of $100 million after experiencing an increase in the number and
severity of asbestos claims and observing the developments of adverse trends in
the property and casualty insurance industry concerning asbestos losses. This
charge, accompanied by a transfer of $36 million from excess reserves for other
environmental claims, resulted in an increase of $136 million in asbestos
reserves. For a discussion of uncertainties relative to asbestos and
environmental claims, see "Uncertainties -Asbestos and Environmental-related
Reserves".
37
SPECIALTY The Specialty group's gross written premiums increased 21% in
2002 compared to 2001, reflecting the effect of rate increases and the volume
growth in certain businesses, partially offset by planned reductions in less
profitable lines of business. Specialty rate increases averaged about 27% during
2002 and are targeted to be 25% or more going into 2003. Net written premiums
increased 2% in 2002 compared to 2001. Strong growth in gross written premiums
was offset by the impact of expanding the Personal group automobile physical
damage reinsurance agreement discussed below to include several Specialty
business lines as well as increased reinsurance coverage in certain other lines.
Excluding the effect of the attack on the World Trade Center, the
Specialty group's combined ratio improved 1.5 points for 2002. The improvement
reflects strategic changes in the mix of specialty businesses and the impact of
rate increases, partially offset by the effects of prior year loss development.
The Specialty group's increase in gross and net written premiums in 2001
reflects the impact of rate increases implemented in 2000 and 2001 and the
realization of growth opportunities in certain commercial markets, partially
offset by the decision to discontinue certain lines of business that were not
achieving adequate returns. Specialty rate increases averaged over 20% in 2001.
The improvement in the combined ratio compared to 2000 reflects the impact of
rate increases and unusually strong results in several businesses. Due primarily
to adverse development in prior year losses, AFC recorded a $35 million pretax
charge in 2000 to strengthen loss reserves in its California workers'
compensation business (a combined ratio effect of 2.9 points). Excluding the
effect of the attack on the World Trade Center, the Specialty group reported an
underwriting profit with a combined ratio of 99.9% for 2001.
PERSONAL The Personal group's gross written premiums for 2002 decreased
about 5% compared to 2001 due primarily to intentional reductions in new
business volume in certain non-core markets and through the direct channel,
partially offset by the effect of continuing rate increases and volume growth in
target markets. Rate increases implemented in 2002 were approximately 10%.
Since April 2001, AFC has reinsured 90% of the automobile physical damage
business written by certain of its insurance subsidiaries. In September 2002,
AFC's use of the existing agreement was expanded to include physical damage
business written through the agency channel of Great American Insurance pool
companies. This agreement enables AFC to reallocate some of its capital to the
more profitable specialty operations. The decline in net written premiums in
2001 and 2002 reflects the impact of this reinsurance agreement.
Due primarily to rate increases and a $12.6 million reduction in marketing
and media cost of the direct business, the Personal group's combined ratio
improved by 8.1 points compared to 2001. More than 80% of the Personal group's
business is written by the insurance operations included in the recent public
offering of Infinity Property and Casualty Corporation. Business written through
these operations achieved an underwriting profit with a combined ratio of 96.1%
for 2002.
The Personal group's gross written premiums declined about 4% in 2001
compared to 2000 as lower business volume was partially offset by the impact of
significant rate increases in 2000 and 2001. The group implemented rate
increases of about 14% in 2001. As a result of rate increases in 2001 and 2000,
the combined ratio improved to 107.9% for 2001.
LIFE, ACCIDENT AND HEALTH PREMIUMS AND BENEFITS Life, accident and health
premiums and benefits increased in 2002 due primarily to the acquisition of
Manhattan National Life ("MNL") in June 2002 and increased in 2001 due primarily
to the acquisition of a block of supplemental health insurance business in
November 2000. In addition to these acquisitions, life, accident and health
benefits for 2002 reflect the effects of adverse mortality in GAFRI's life
insurance operations.
INVESTMENT INCOME Changes in investment income reflect fluctuations in market
rates and changes in average invested assets. Investment income increased in
2002 and 2001 due primarily to higher average investment in fixed maturity
securities, partially offset by lower average yields on those investments.
38
GAINS (LOSSES) ON SECURITIES Realized gains (losses) on sales of securities
include provisions for other than temporary impairment of securities still held
of $179.4 million in 2002, $125.5 million in 2001 and $27.5 million in 2000. The
provision for 2001 includes $8 million for the writedown of AFC's investment in
Chiquita from $1.00 per share to $.67 per share.
Realized gains (losses) on securities include losses of $11.9 million in
2002, and gains of $5.2 million in 2001 and $1.5 million in the fourth quarter
of 2000 to adjust the carrying value of AFC's investment in warrants to market
value under SFAS No. 133.
GAINS ON SALES OF SUBSIDIARIES See Note P, to the financial statements for a
discussion of the anticipated loss in connection with the 2003 public offering
of Infinity.
In 2002, AFC recognized a $10.8 million pretax loss on the disposal of its
New Jersey private passenger auto business.
In 2001, AFC recognized a $7.1 million pretax gain on the sale of a small
insurance subsidiary. In connection with the sale of the Japanese division in
2001, AFC recognized a $6.9 million pretax loss and deferred a gain of
approximately $21 million on ceded insurance which is being recognized over the
estimated settlement period (weighted average of 4 years) of the ceded claims.
In 2000, AFC recognized (i) a $25 million pretax gain representing an
earn-out related to the 1998 sale of its Commercial lines division, (ii) a $10.3
million pretax loss on the sale of Stonewall Insurance Company and (iii) a $10.7
million estimated pretax loss related to the agreement to sell its Japanese
division (completed in 2001).
GAIN ON SALE OF OTHER INVESTMENTS In September 2000, GAFRI realized a $27.2
million pretax gain on the sale of its minority ownership in a company engaged
in the production of ethanol. GAFRI's investment was repurchased by the ethanol
company which, following the purchase, became wholly-owned by AFC's Chairman.
REAL ESTATE OPERATIONS AFC's subsidiaries are engaged in a variety of real
estate operations including hotels, apartments, office buildings and
recreational facilities; they also own several parcels of land. Revenues and
expenses of these operations, including gains and losses on disposal, are
included in AFC's statement of operations as shown below (in millions).
2002 2001 2000
---- ---- ----
Other income $115.0 $102.6 $95.9
Other operating and general expenses 71.7 64.9 65.6
Interest charges on borrowed money 2.6 2.3 2.6
Minority interest expense, net 1.2 3.9 1.9
Other income includes net pretax gains on the sale of real estate assets
of $31.0 million in 2002, $27.2 million in 2001 and $12.4 million in 2000.
OTHER INCOME
2002 COMPARED TO 2001 Other income increased $38.7 million (18%) in 2002
due primarily to higher income from real estate operations (including the effect
of property sales and a hotel acquired in May 2002), increased fees earned by
the Specialty group's new warranty business and higher fee income in certain
other specialty insurance operations.
2001 COMPARED TO 2000 Other income declined in 2001 compared to 2000 due
primarily to the absence of income from the sale of lease rights, lease
residuals and other operating assets.
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 reflect
39
amounts accrued on annuity policyholders' funds accumulated. The rate at which
GAFRI credits interest on most of its annuity policyholders' funds is subject to
change based on management's judgment of market conditions. Historically,
management has been able to react to changes in market interest rates and
maintain a desired interest rate spread. The recent interest rate environment
has resulted in spread compression which could continue at least through 2003.
In 2000, annuity benefits also includes a second quarter charge of $14.2 million
related to the settlement of a policyholder class action lawsuit.
On its deferred annuities (annuities in the accumulation phase), GAFRI
generally credits interest to policyholders' accounts at their current stated
"surrender" interest rates. Furthermore, for "two-tier" deferred annuities
(annuities under which a higher interest amount can be earned if a policy is
annuitized rather than surrendered), GAFRI accrues an additional liability to
provide for expected deaths and annuitizations. Changes in crediting rates,
actual surrender, death and annuitization experience or modifications in
actuarial assumptions can affect this accrual. In 2002, this accrual was reduced
by approximately $2 million due to decreases in crediting rates on certain fixed
annuity products, partially offset by a modification in projected investment
yields. Significant changes in projected investment yields could result in
additional benefits or charges to earnings.
ANNUITY AND LIFE ACQUISITION EXPENSES Annuity and life acquisition expenses
include amortization of annuity and life, accident and health deferred policy
acquisition costs ("DPAC") as well as a portion of commissions on sales of
insurance products. Annuity and life acquisition expenses also include
amortization of the present value of future profits of businesses acquired.
2002 COMPARED TO 2001 The increase in annuity and life acquisition
expenses in 2002 compared to 2001 reflects (i) a writeoff of DPAC; (ii) the
amortization costs associated with GAFRI's purchase of MNL in June 2002 and
(iii) higher commission expense due to GAFRI's growth in premiums. Included in
2002 and 2001 were DPAC writeoffs related to variable annuities of $13.5 million
and $3.0 million, respectively, resulting from the actual performance of the
equity markets and a reduction of assumed future returns. Poor performance in
the equity markets could lead to additional DPAC writeoffs or a charge to
earnings in order to accrue for guaranteed minimum death benefits included in
the variable products. (See "Proposed Accounting Standard"). Included in 2002 is
a DPAC writeoff of $4 million related primarily to adverse mortality in GAFRI's
life operations. Partially offsetting the DPAC writeoffs in 2002 was a reduction
of approximately $7 million in DPAC amortization on fixed annuities relating to
decreases in crediting rates on certain fixed annuity products. Continued
adverse mortality could lead to additional DPAC writeoffs. Significant changes
in projected investment yields could result in additional benefits or charges to
earnings.
2001 COMPARED TO 2000 The increase in annuity and life acquisition
expenses resulted primarily from (i) increased lapses and increased sales of
traditional life insurance and (ii) the effect of the equity markets on variable
annuity DPAC.
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.
2002 COMPARED TO 2001 Interest expense decreased significantly in 2002 as
lower average rates on AFC's variable rate debt (including AFC's payable to AFG)
more than offset the effect of higher average indebtedness and higher average
payable to reinsurers balances.
2001 COMPARED TO 2000 Interest expense decreased in 2001 as lower average
interest rates on AFC's variable rate debt and lower average subsidiary
indebtedness more than offset higher average borrowings under the AFC bank line.
OTHER OPERATING AND GENERAL EXPENSES
2002 COMPARED TO 2001 Other operating and general expenses for 2001
include goodwill amortization of $13.8 million. Under SFAS No. 142, which was
implemented January 1, 2002, goodwill is no longer amortized. Excluding 2001
goodwill
40
amortization, other operating and general expenses increased $36.0 million (10%)
in 2002. Expenses of the Specialty group's new warranty business, higher
expenses in real estate operations (due primarily to the acquisition of a new
hotel in May 2002) and higher expenses related to growth in certain other
Specialty operations were partially offset by lower charges for environmental
reserves related to former operations and lower IT-related expenses.
2001 COMPARED TO 2000 Excluding the 2000 litigation charges discussed
below, other operating and general expenses increased $12.0 million (3%) due
primarily to a $14.8 million increase in environmental reserves related to
former operations.
Other operating and general expenses for 2000 include second quarter
charges of $18.3 million related to an agreement to settle a lawsuit against a
GAFRI subsidiary and $8.8 million for an adverse California Supreme Court ruling
against an AFC property and casualty subsidiary.
INCOME TAXES The 2002 provision for income taxes includes $31 million in tax
benefits for the reduction of previously accrued amounts due to the resolution
of certain tax matters. See Note J to the Financial Statements for an analysis
of items affecting AFC's effective tax rate.
INVESTEE CORPORATIONS
START-UP MANUFACTURING BUSINESSES AFC's pretax operating earnings for 2000
include losses of $6.7 million from two start-up manufacturing businesses
acquired in 2000 from their former owners. AFC sold the equity interests in
these businesses in the fourth quarter of 2000 for a nominal cash consideration
plus warrants to repurchase a significant ownership interest. Due to the absence
of significant financial investment by the buyers relative to the amount of
loans ($61.5 million at December 31, 2000) owed to AFC subsidiaries, AFC
retained the financial risk in these businesses and continued accounting for
their operations under the equity method as investees.
Beginning in the fourth quarter of 2000, AFC's equity in the results of
operations of these businesses is included in investee earnings. In 2002, 2001
and 2000, equity in net losses of investee corporations includes $9.0 million,
$16.6 million and $4.1 million, respectively, in losses of these businesses.
Investee losses in 2001 include litigation judgments of $4.7 million
against one of these companies. In December 2002, this company sold its fixed
assets, ceased operations and transferred approximately $30 million in cash and
other assets to AFC. The amount transferred approximated AFC's carrying value of
loans to this business. Amounts included in equity in net losses of investee
corporations for this business were $5.4 million in 2002, $13.7 million in 2001
and $3.1 million in 2000.
CHIQUITA Equity in net losses of investee corporations for 2000 includes
AFC's proportionate share of the results of Chiquita Brands International.
Chiquita reported net losses attributable to common shareholders of $112 million
in 2000.
Equity in net losses of investees for 2000 includes a $95.7 million pretax
charge to writedown AFC's investment in Chiquita to a market value of
approximately $1 per share. In 2001, AFC suspended accounting for Chiquita under
the equity method due to Chiquita's pending restructuring. In March 2002,
Chiquita completed its reorganization under Chapter 11 of the U.S. Bankruptcy
Code. As a result of the restructuring, AFC's ownership percentage of Chiquita
was reduced to less than one-half of 1%.
CUMULATIVE EFFECT OF ACCOUNTING CHANGES Effective January 1, 2002, AFC
implemented Statement of Financial Accounting Standards ("SFAS") No. 142,
"Goodwill and Other Intangible Assets", under which goodwill is no longer
amortized, but is subject to an impairment test at least annually. The initial
impairment testing resulted in a charge of $40.4 million (net of minority
interest and taxes) for the cumulative effect of a change in accounting
principle.
41
In 2001, the cumulative effect of accounting change represents the
implementation of a new accounting standard (EITF 99-20) which resulted in a
writedown of $10.0 million (net of minority interest and taxes) of the carrying
value of certain collateralized debt obligations as of April 1, 2001.
In October 2000, AFC implemented Statement of Financial Accounting
Standards No. 133, "Accounting for Derivative Instruments and Hedging
Activities", which requires all derivatives to be recognized in the balance
sheet at fair value and that the initial effect of recognizing derivatives at
fair value be reported as a cumulative effect of a change in accounting
principle. Accordingly, AFC recorded a charge of $9.1 million (net of minority
interest and taxes) to record its derivatives at fair value at the beginning of
the fourth quarter of 2000.
RECENT ACCOUNTING STANDARDS The following accounting standards have been or may
be implemented by AFC. The implementation of these standards is discussed under
various subheadings of Note A to the Financial Statements; effects of each are
shown in the relevant Notes.
Accounting
Standard Subject of Standard (Year Implemented) Reference
---------- -------------------------------------- ---------
SFAS #133 Derivatives (2000) "Derivatives"
EITF 99-20 Asset-backed Securities (2001) "Investments"
SFAS #141 Business Combinations (2001) "Business Combinations"
SFAS #142 Goodwill and Other Intangibles (2002) "Goodwill"
Other standards issued in recent years did not apply to AFC or had only
negligible effects on AFC.
In January 2003, the Financial Accounting Standards Board issued
Interpretation No.46, Consolidation of Variable Interest Entities ("FIN 46").
This interpretation will require companies to consolidate entities without
sufficient equity based on ownership of expected gains and losses. FIN 46 is
effective immediately to variable interest entities acquired after January 31,
2003. For entities acquired before that date, the guidance becomes effective for
periods beginning after June 15, 2003.
AFC is currently assessing the application of FIN 46 as it relates to its
investments in two collateralized debt obligations ("CDOs"), for which AFC also
acts as investment manager. Under the CDOs, securities were issued in various
senior and subordinate classes and the proceeds were invested primarily in bank
loans, and to a lesser extent, high yield bonds, all of which serve as
collateral for the securities issued by the CDOs. None of the collateral was
purchased from AFC. The market value of the collateral at December 31, 2002 was
approximately $800 million.
AFC's investments in the two CDOs are subordinate to the senior classes
(approximately 92% of the total securities) issued by the CDOs. To the extent
there are defaults and unrecoverable losses on the underlying collateral
resulting in reduced cash flows, AFC's class would bear losses first. Holders of
the CDO debt securities have no recourse against AFC for the liabilities of the
CDOs; accordingly, AFC's exposure to loss on these investments is limited to its
investment. AFC's investments in the CDOs are carried at estimated market value
of $13.7 million at December 31, 2002 and are included in fixed maturities in
AFC's balance sheet.
PROPOSED ACCOUNTING STANDARD GAFRI's variable annuity contracts contain a
guaranteed minimum death benefit ("GMDB") (which may exceed the value of the
policyholder's account) to be paid if the annuityholder dies before the annuity
payout period commences. At December 31, 2002, the aggregate GMDB values
(assuming every policyholder died on that date) exceeded the market value of the
underlying variable annuities by $233 million. Industry practice varies, but
GAFRI does not establish GAAP reserves for this mortality risk. If a proposed
accounting standard becomes effective, GAFRI would be required to record a
liability for the present value of expected GMDB payments. Initial recognition
of a GAAP liability (estimated to be less than 4% of the difference between the
underlying market value of the variable annuities and GMDB value) would be
accounted for as the cumulative effect of a change in accounting principles.
Death benefits paid in excess of the variable annuity account balance were $1.1
million in 2002.
42
ITEM 7A
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
----------------------------------------------------------
The information required by Item 7A is included in Management's Discussion and
Analysis of Financial Condition and Results of Operations.
ITEM 8
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
-------------------------------------------
Page
Report of Independent Auditors F-1
Consolidated Balance Sheet:
December 31, 2002 and 2001 F-2
Consolidated Statement of Operations:
Years ended December 31, 2002, 2001, and 2000 F-3
Consolidated Statement of Changes in Shareholders' Equity
Years ended December 31, 2002, 2001, and 2000 F-4
Consolidated Statement of Cash Flows:
Years ended December 31, 2002, 2001, and 2000 F-5
Notes to Consolidated Financial Statements F-6
"Selected Quarterly Financial Data" has been included in Note M to the
Consolidated Financial Statements.
Please refer to "Forward-Looking Statements" following the Index in front of
this Form 10-K.
- --------------------------------------------------------------------------------
43
PART III
ITEM 10
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
--------------------------------------------------
The directors and executive officers of American Financial Corporation
("AFC") at April 15, 2003, were as follows:
Director or
Age (a) Position Executive Since
------- ------------------------------------------------- ---------------
Carl H. Lindner 83 Chairman of the Board and Chief Executive Officer 1959
S. Craig Lindner 48 Co-President and a Director 1979
Keith E. Lindner (b) 43 Co-President and a Director 1981
Carl H. Lindner III 49 Co-President and a Director 1980
Michael R. Barrett (c) 52 Director 2003
James E. Evans 57 Senior Vice President and General Counsel
and a Director 1976
Timothy J. Fogarty (c) 45 Director 2003
Joseph P. Tomain (c) 54 Director 2003
Keith A. Jensen 52 Senior Vice President 1999
Thomas E. Mischell 55 Senior Vice President - Taxes 1985
Fred J. Runk 60 Senior Vice President and Treasurer 1978
- ---------------------
(a) As of March 31, 2003.
(b) Keith E. Lindner has informed AFC that he will not stand for reelection
to AFC's Board of Directors in 2003 at the upcoming AFG shareholders'
meeting and that he does not wish to be re-elected as a Co-President.
(c) On April 14, 2003, American Financial Group, Inc. submitted a merger
proposal to AFC, whereby AFC would merge with AFG, and in which each
outstanding share of AFC's Series J Preferred Stock would be converted
into the right to receive $22.00 of value in shares of AFG common stock.
In order to respond to the proposal, the AFC Board elected three new
directors (who are independent of AFG) to act as a special committee of
the Board to consider the proposal. Joining the AFC Board to comprise the
special committee were Joseph P. Tomain, Michael R. Barrett and Timothy
J. Fogarty. Upon their election, Theodore H. Emmerich, William R. Martin
and William W. Verity resigned from the Board.
CARL H. LINDNER Mr. Lindner is the Chairman of the Board and Chief Executive
Officer of American Financial Group, Inc. ("AFG") and AFC. He is Chairman of the
Board of Directors of Great American Financial Resources, Inc., an 83%-owned
subsidiary of AFC that markets tax-deferred annuities principally to employees
of educational institutions and offers life and health insurance products.
KEITH E. LINDNER For more than five years, Mr. Lindner has served as
Co-President and a director of AFC and AFG. From March 1997 until March 2002,
Mr. Lindner was Vice Chairman of the Board of Directors of Chiquita Brands
International, Inc., a worldwide marketer and producer of bananas and other food
products. Mr. Lindner has informed AFC that he will not stand for reelection to
the Board of Directors of AFC and AFG in 2003 and he does not wish to be
re-elected as a Co-President.
CARL H. LINDNER III For more than five years, Mr. Lindner has served as
Co-President and a director of AFC and AFG. For over ten years, Mr. Lindner has
been principally responsible for AFC's property and casualty insurance
operations.
S. CRAIG LINDNER For more than five years, Mr. Lindner has served as
Co-President and a director of AFC and AFG. He is also President and a director
of Great American Financial Resources, Inc. Mr. Lindner is also President of
American Money Management Corporation, a subsidiary that provides investment
services for AFC and its affiliated companies.
44
MICHAEL R. BARRETT Mr. Barrett has been a practicing attorney for over 25 years.
He is currently in private practice, concentrating in general litigation. He
serves on the board of trustees of a number of civic and charitable
organizations.
JAMES E. EVANS For more than five years, Mr. Evans has served as Senior Vice
President and General Counsel of AFC and AFG. Mr. Evans is also a director of
AFG.
TIMOTHY J. FOGARTY Mr. Fogarty has served as co-chief executive officer of West
Chester Holdings, Inc., a private company which distributes protective clothing.
For over five years prior, he was an Executive Vice President and member of the
management committee of Firstar Corporation (now known as US Bancorp), a
regional bank holding company.
JOSEPH P. TOMAIN Mr. Tomain has served as the Dean of the University of
Cincinnati College of Law for nearly fifteen years. He serves on the board of
trustees of a number of civic and charitable organizations.
KEITH A. JENSEN Mr. Jensen was named a Senior Vice President of AFC and AFG in
February 1999. He served as a Senior Vice President of Great American Financial
Resources from February 1997 until he was named Executive Vice President of that
company in May 1999.
THOMAS E. MISCHELL Mr. Mischell has served as Senior Vice President - Taxes of
AFC and AFG for over five years.
FRED J. RUNK Mr. Runk has served as Senior Vice President and Treasurer of AFC
and AFG for more than five years.
Carl H. Lindner is the father of Carl H. Lindner III, S. Craig Lindner
and Keith E. Lindner.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Exchange Act requires AFC's executive officers,
directors and persons who own more than ten percent of AFC's Series J Preferred
Stock to file reports of ownership with the Securities and Exchange Commission
and to furnish AFC with copies of these reports. AFC believes that all filing
requirements were met during 2002.
45
ITEM 11
EXECUTIVE COMPENSATION
----------------------
The following table summarizes the aggregate compensation for 2002, 2001
and 2000 of AFC's Chairman of the Board and Chief Executive Officer and its four
other most highly compensated executive officers during 2002 (the "Named
Executive Officers"). Such compensation includes amounts paid by AFC and its
subsidiaries and certain affiliates during the years indicated.
SUMMARY COMPENSATION TABLE
Long-Term
Annual Compensation Compensation
--------------------------------------- -----------------
Securities
Name Other Annual Underlying All Other
And Compensation Options Granted Compensation
Principal Position Year Salary (a) Bonus (b) (c) (# of Shares) (d) (e)
----------------------------- ---- ---------- --------- ------------ ----------------- ------------
Carl H. Lindner 2002 $990,000 $950,000 $ 39,000 --- $41,000
Chairman of the Board and 2001 950,000 415,600 47,000 --- 48,000
Chief Executive Officer 2000 950,500 0 54,000 --- 44,000
-----------------------------
2002 990,000 950,000 41,000 55,000 30,000
Keith E. Lindner 2001 950,000 415,600 26,000 --- 29,400
Co-President 2000 950,500 0 35,000 110,000 34,000
-----------------------------
2002 990,000 950,000 88,000 55,000 31,000
Carl H. Lindner III 2001 950,000 415,600 74,000 --- 30,400
Co-President 2000 950,500 0 79,000 110,000 29,000
-----------------------------
2002 990,000 950,000 112,000 55,000 31,000
S. Craig Lindner 2001 950,000 415,600 106,000 --- 30,400
Co-President 2000 950,500 0 98,000 110,000 28,000
-----------------------------
James E. Evans 2002 990,000 750,000 200 50,000 34,000
Senior Vice President and 2001 950,000 400,000 4,000 --- 33,400
General Counsel 2000 950,500 290,000 500 100,000 30,000
-----------------------------
(a) This column includes salaries paid by Chiquita to Keith E. Lindner of $8,500
in 2002, $55,000 in 2001, and $47,500 in 2000, and to Carl H. Lindner of
$12,000 in 2002, $70,000 in 2001, and $62,500 in 2000.
(b) Bonuses are for the year shown, regardless of when paid.
46
(c) This column includes amounts for personal homeowners and automobile
insurance coverage, and the use of corporate aircraft and automobile
service as follows.
Aircraft &
Name Year Insurance Automobile
-------------------- ---- --------- ----------
Carl H. Lindner 2002 $19,000 $20,000
2001 24,000 23,000
2000 25,000 29,000
Keith E. Lindner 2002 26,000 15,000
2001 21,000 5,000
2000 21,000 14,000
Carl H. Lindner III 2002 40,000 48,000
2001 37,000 47,000
2000 32,000 47,000
S. Craig Lindner 2002 52,000 60,000
2001 43,000 63,000
2000 44,000 54,000
James E. Evans 2002 -- 200
2001 -- 4,000
2000 -- 500
(d) The number of options shown as granted during 2000 includes the 2001
grant, which was made in late December 2000.
(e) Includes AFC 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 a benefit equalization plan which
generally makes up certain reductions caused by Internal Revenue Code
limitations in contributions to certain retirement plans) and AFC paid
group life insurance as set forth below.
AFG
Auxiliary Retirement
Name Year RASP Plan Savings Plan Term Life
-------------------- ---- --------- ---------- ------------ ---------
Carl H. Lindner 2002 $15,000 $10,000 -- $16,000
2001 16,500 8,500 -- 23,000
2000 16,500 8,500 -- 19,000
Keith E. Lindner 2002 15,000 10,000 $4,000 1,000
2001 16,500 8,500 3,400 1,000
2000 16,500 8,500 8,000 1,000
Carl H. Lindner III 2002 15,000 10,000 4,000 2,000
2001 16,500 8,500 3,400 2,000
2000 16,500 8,500 2,000 2,000
S. Craig Lindner 2002 15,000 10,000 4,000 2,000
2001 16,500 8,500 3,400 2,000
2000 16,500 8,500 2,000 1,000
James E. Evans 2002 15,000 10,000 4,000 5,000
2001 16,500 8,500 3,400 5,000
2000 16,500 8,500 2,000 3,000
47
STOCK OPTIONS
No AFC stock options were granted to, or exercised by, the Named
Executive Officers during 2002. Certain executive officers of AFC also serve as
executive officers of AFG and certain AFC subsidiaries and may be granted
employee stock options by such companies. The tables set forth below disclose
stock options granted to, or exercised by, the Named Executive Officers during
2002, and the number and value of unexercised options held by them at December
31, 2002.
OPTION GRANTS IN 2002
Individual Grants
----------------------------------------------------------------
Potential Realizable
Number of Percent of Exercise Value at Assumed Annual Rates
Securities Total Price per of Stock Price
Underlying Options Options Share Appreciation for Option
Granted to (fair market Term(b)
Granted (a) Employees value at date Expiration ----------------------------
Name (# of shares) in 1999 of grant) Date 5% 10%
- ------------------- ------------------ ---------- ------------- ---------- --------- ----------
Carl H. Lindner - - - - - - -
Keith E. Lindner AFG 55,000 5.2% $25.78 2/25/12 $891,710 $2,259,767
S. Craig Lindner AFG 55,000 5.2% $25.78 2/25/12 $891,710 $2,259,767
Carl H. Lindner III AFG 55,000 5.2% $25.78 2/25/12 $891,710 $2,259,767
James E. Evans AFG 50,000 4.7% $25.78 2/25/12 $810,645 $2,054,334
(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 or disability 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 the options were exercised immediately prior to their expiration in
2012 and assuming that the market price of AFG's common stock had
appreciated in value through the year 2012 at the annual rate of 5% (to
$41.99 per share) or 10% (to $66.87 per share). Such hypothetical
future values have not been discounted to their respective present
values, which are lower.
AGGREGATED OPTION EXERCISES IN 2002 AND 2002 YEAR-END OPTION VALUES
Number of Securities
Shares Underlying Value of Unexercised
Acquired on Unexercised Options In-the-Money Options
Exercise at Year End at Year End (a)
(# of Value ---------------------------- ---------------------------
Name Company Shares) Realized Exercisable Unexercisable Exercisable Unexercisable
- --------------------- ------- ----------- -------- ----------- ------------- ----------- -------------
Carl H. Lindner AFG - $ - - - - -
Carl H. Lindner III AFG - $ - 547,272 149,000 $144,100 $216,150
S. Craig Lindner AFG - $ - 547,272 149,000 $149,017 $216,150
Keith E. Lindner AFG - $ - 547,272 149,000 $144,100 $216,150
James E. Evans AFG - $ - 276,000 135,000 $131,000 $196,500
(a) The value of unexercised in-the-money options is calculated based on
the New York Stock Exchange closing market price of AFG's common stock
at year-end 2002. This price was $23.07 per share.
48
COMPENSATION COMMITTEE REPORT
The Compensation Committee of the Board of Directors consists of three
directors, none of whom is an employee of AFC, 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") and the Co-Presidents. The Compensation Committee has the exclusive
authority to grant stock options under AFG's Stock Option Plan to employees of
AFG and its subsidiaries, including senior executive officers.
COMPENSATION OF EXECUTIVE OFFICERS The Company's compensation policy
for all executive officers of the Company has three principal components: annual
base salary, annual incentive bonuses and stock option grants. Before decisions
were made regarding 2002 compensation for the senior executives, the Committee
had discussions with Company executives to solicit their thoughts regarding
compensation. Based in part on such discussions as well as the Committee's
review of the Company's financial results for the preceding year, the Committee
deliberated, 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 the senior executive officers that were appropriate, in the
Committee's subjective judgment, for their respective positions and levels of
responsibilities. The Committee approved the 2002 salaries of the CEO and the
Co-Presidents, noting that such salaries represented an approximately 4%
increase over the salary that had been in effect in 2001, 2000, 1999, 1998 and
the latter part of 1997.
ANNUAL BONUSES As was the case for the past five years, the Committee,
working with management, developed an annual bonus plan for 2002 for the CEO and
the Co-Presidents 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. Other executive officers of the
Company were included in the annual bonus plan for 2002 by action of the
Executive Committee.
The annual bonus plan for 2002 made 50% of each participant's annual
bonus dependent on AFG attaining certain earnings per share targets. The other
50% is based on the Company's overall performance, as subjectively determined by
the Committee.
Under the 2002 annual bonus plan, the bonus target amount for the CEO
and each of the Co-Presidents was $990,000 with 0% to 175% of $495,000 (50% of
$990,000) to be paid depending on AFG achieving certain 2002 earnings per share
allocable to insurance operations (the "EPS Component") and 0% to 175% of
$495,000 to be paid based on the Company's overall performance, as subjectively
determined by the Committee (the "Company Performance Component").
The earnings per share target which would result in the payment of 100%
of the EPS Component bonus was set by the Committee at $2.35. In recommending
the 2002 annual bonus plan to the Board for adoption, the Committee noted that
no bonus should be paid under the plan if 2002 earnings per share from insurance
operations are less than $1.76 (75% of the 2002 EPS target). The Committee noted
that the annual bonus plan provides that unusual or non-recurring items are not
to be included in determining earnings allocable to insurance operations. Not
including an increase in reserves in connection with asbestos related litigation
and tax resolution benefits, AFG reported earnings per share from insurance
operations of $2.42. The annual bonus plan provided that in the event earnings
per share from insurance operations exceed $2.35, more than 100% of the EPS
Component bonus could be paid, such excess to be subjectively determined. The
Committee considered the factors discussed below to determine if any amount over
100% should be paid under the EPS Component and any amount that may have been
earned under the Company Performance Component. The Committee concurred with the
senior executives that the amount of bonus to be paid
49
under the EPS Component to the CEO and each of the Co-Presidents would be
$495,000, and no amount over 100% of the target of the EPS Component would be
paid.
The Committee considered a number of factors in discussions of the
Company's performance with senior executives. The Committee viewed the following
factors positively: (i) the fact that earnings per share from insurance
operations exceeded published analyst expectations; (ii) the two segments of the
Company's property and casualty insurance operations achieved underwriting
profits and were able to increase rates more than planned; (iii) the Company
raised capital through the sale of common stock of Infinity Property and
Casualty Corporation (the positive view of this consideration was somewhat
offset by the stock offering resulting in a loss to the Company); (iv) the
return on equity of earnings from insurance operations; (v) resolution of
certain tax matters; and (vi) investment portfolio performance including the
sale of an investee. The Committee viewed negatively these factors: (i) the
decline in AFG's stock price from December 31, 2001 to December 31, 2002,
although it noted that the percentage decline in the stock price was less than
that of the Standard & Poors 500 Index, the Dow Jones Industrial Average, the
Standard & Poors 500 Property and Casualty Stock Index, the Standard & Poors
Mid-Cap Insurance Index and the Standard and Poors 500 Life & Health Insurance
Index; (ii) the fact that AFG's and certain subsidiaries' credit and financial
strength ratings were given a negative outlook or, in one instance, due to a
rating agency policy as opposed to AFG performance, a downgrade; and (iii) the
only asbestos-related claim known to be material to the Company was settled for
an amount in excess of existing reserves (the negative view was somewhat offset
by the fact that the settlement enhances financial certainty). The Committee
agreed with management's recommendation that a bonus of $455,000 (approximately
90% of the Company Performance Component) under the Company Performance
Component would be appropriate.
The annual base salary and bonus target amounts of the CEO and the
Co-Presidents are virtually identical because the Committee views them as a
management team whose skills and areas of expertise complement each other.
STOCK OPTION GRANTS Stock options represent an important part of the
Company's performance-based compensation system. The Committee believes that AFG
shareholders' interests are well served by aligning the Company'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 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 the Company's long-term success. Options
for 55,000 shares were granted to each of the Co-Presidents and additional
options were granted to the other senior executives of the Company in February
2002. No options were granted to such persons in 2001. No options were granted
to the CEO in 2001 or 2002.
Members of the Compensation Committee: William R. Martin, Chairman
Theodore H. Emmerich
William W. Verity
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
One of the adult sons of William R. Martin was an employee of the
Registrant's technology group through August 2002. He received compensation of
approximately $65,000 from AFC during 2002.
PERFORMANCE GRAPH
No performance graph is included as AFC's Common Stock is not publicly
traded.
50
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 AFG's Non-Employee Directors' Compensation Plan (the
"Directors' Plan"), 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 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 the director has met certain eligibility requirements, receive upon
retirement (in a lump sum or, if elected, 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 an AFG director or not being nominated
for reelection by shareholders as an AFG director. To be eligible for the
retirement benefit, a person must have served as an AFG director for at least
four years while not an officer or employee of AFG or any of its subsidiaries.
In addition, an AFG 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 an AFG 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.
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 2002, each non-employee director
was granted an option under the foregoing provisions of the Stock Option Plan to
purchase 2,500 shares at an exercise price of $26.86 per share on June 1, 2002,
the exercise price being the fair market value of AFG's Common Stock on the
date of grant.
51
ITEM 12
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
--------------------------------------------------------------
PRINCIPAL SHAREHOLDERS
The following shareholders are the only persons known to own
beneficially 5% or more of AFC's outstanding voting securities as of March 31,
2003.
Name and Address
of Amount and Nature of Percent of
Beneficial Owner Voting Securities Held Voting Securities
- ---------------------------------- ---------------------- -----------------
American Financial Group, Inc. (a)
One East Fourth Street
Cincinnati, Ohio 45202 10,593,000 (b) 79.0% (b)
(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 AFC.
(b) 100% of the shares of Common Stock. Voting securities also include
shares of Series J Preferred Stock.
SECURITIES OWNERSHIP
The voting equity securities of AFC consist of its Common Stock and voting
preferred stock. All of AFC's Common Stock is owned by AFG. At March 31, 2003,
the beneficial ownership of AFC voting preferred stock and the equity securities
of AFC's parent and subsidiaries by each director, nominee for director, the
executive officers named in the Summary Compensation Table and by all directors
and executive officers as a group was as set forth below. Mr. Martin and all
directors and executive officers as a group beneficially own 40,126 (1.4%) and
63,494 (2.1%) shares, respectively, of the voting preferred stock of AFC.
Messrs. Emmerich, Evans, C.H. Lindner, S.C. Lindner, Martin and all directors
and executive officers as a group beneficially own 1,561; 11,138; 6,100;
120,873; 29,275; and 302,851 shares, respectively, of the common stock of Great
American Financial Resources. Beneficial ownership of shares of common stock of
AFG was as follows: Carl H. Lindner - 8,646,204 (12.7%); Carl H. Lindner III -
6,483,956 (9.4%); S. Craig Lindner - 6,483,956 (9.4%); Keith E. Lindner -
6,483,956 (9.4%); Mr. Emmerich - 29,944; Mr. Evans - 431,675; Mr. Martin -
57,096; Mr. Verity - 5,745; and all directors and executive officers as a group
- - 29,477,320 (43.2%).
EQUITY COMPENSATION PLAN INFORMATION
Not Applicable - Registrant's Common Stock is owned by American Financial Group,
Inc.
52
ITEM 13
CERTAIN RELATIONSHIPS AND RELATED TRANSACTION
---------------------------------------------
Various business has been transacted between AFC and certain
affiliates, including rentals, investment management services, insurance and
sales of assets. The financial terms (costs, interest rates, collateral, risks
of collectibility and other) of these transactions are comparable to those
prevailing at the time of consummation which would apply to unrelated parties,
unless noted otherwise.
On April 14, 2003, AFG submitted a merger proposal to AFC, whereby AFC
would merge with AFG. See footnote(c) to the table in Item 10 for a discussion
of the proposal.
AFC has a reciprocal Master Credit Agreement with AFG, AFC Holding
Company ("AFCH") and certain subsidiary holding companies under which these
companies make funds available to each other for general corporate purposes.
Amounts borrowed under the agreement bear interest based on LIBOR. In January
2003, AFC agreed to guarantee the obligations of AFG with respect to $382
million principal amount of AFG publicly-held senior debentures, in
consideration of a payment of approximately $350,000 and an increase of .125% in
the interest rate which AFG pays AFC under the credit agreement. The highest
amount payable to AFCH during 2002 was $334.8 million and the amount due AFCH at
March 1, 2003, was $332.6 million. The highest amount receivable from AFG during
2002 was $181.4 million and the amount receivable at March 1, 2003, was $190.2
million.
An AFC subsidiary owns a 29% interest in an aircraft, the remaining
interests in which are owned by Carl H. Lindner and his two brothers. Each owner
is committed to use and pay for a minimum number of flight hours. Capital costs
and fixed operating costs are allocated generally in proportion to ownership;
variable operating costs are allocated generally in proportion to usage.
Mr. Lindner has assigned his hours to the AFC subsidiary along with the
obligation to pay for operating costs allocated; Mr. Lindner continues to pay
allocated capital costs. Total charges paid by AFC during 2002 were $959,000.
In 1997, Carl H. Lindner and Great American Financial Resources, Inc.
(an 83%-owned subsidiary of AFC) purchased 51% and 49%, respectively, of the
outstanding common stock of a newly incorporated entity formed to acquire the
assets of a company engaged in the production of ethanol. In 2000, the ethanol
company repurchased the 49% interest from GAFRI for amounts which included an
$18.9 million subordinated debenture bearing interest at 12 1/4% with scheduled
repayments through 2005. The highest balance owed on the subordinated debenture
during 2002 was $12.9 million and interest received during the year was
$1.6 million; the balance outstanding on March 1, 2003, was $10.9 million.
Another AFC subsidiary has a working capital credit facility in place under
which the ethanol company may borrow up to $10 million at a rate of prime plus
3%. There were no borrowings outstanding under this facility in 2002. In 1998,
GAFRI made a loan to the ethanol company in the amount of $4 million, bearing
interest at the rate of 14% and maturing in September 2008. Interest received
on this loan during 2002 was $568,000.
An AFC subsidiary had a loan outstanding during part of 2002 to a
Florida-based homebuilder which was 49% owned by AFG and 51% owned by brothers
of Carl H. Lindner. The highest outstanding balance owed to the AFC subsidiary
during 2002 was $8.0 million and interest paid during the year was $693,000. The
loan was repaid and terminated in 2002 when AFG sold its investment to an
unrelated party.
Members of the Lindner Family are the principal owners of Provident
Financial Group, Inc. ("Provident"). Provident leases its main banking and
corporate offices, which are located in the same building as AFC's headquarters,
from AFC. Provident paid AFC rent of $3,778,000 for this office space in 2002.
In 2002, AFC paid Provident $150,000 in connection with an expense sharing
arrangement for a cafeteria operated by Provident for the employees of both
companies. AFC provides security guard and surveillance services at the main
office of Provident for which Provident paid $100,000 in 2002. Provident paid
AFC subsidiaries $612,000 for insurance coverage and $114,000 for record
retention services in 2002.
53
During 2002, AFC paid the Cincinnati Reds $162,000 for tickets to
baseball games. Carl H. Lindner is the Chief Executive Officer of the Reds. In
addition, a subsidiary of AFC, and a company owned by Carl H. Lindner, Carl H.
Lindner III, Keith E. Lindner and S. Craig Lindner, are part owners of the Reds.
In July 2000, AFC's principal insurance company subsidiary, Great
American Insurance Company, entered into a thirty-two-year agreement with the
Reds, pursuant to which the Reds' home stadium was named "Great American Ball
Park". Although no payments were required to be made in 2002, payments to the
Reds average approximately $2.3 million annually over the term of the agreement.
For these payments, Great American also receives approximately $1.3 million
annually of premium seating, marketing credits, and related sponsorship rights.
A brother-in-law of S. Craig Lindner is employed by GAFRI in a sales
and marketing position. During 2002, he was paid approximately $95,000 by GAFRI.
ITEM 14
CONTROLS AND PROCEDURES
-----------------------
AFC's chief executive officer and chief financial officer, with
assistance from management, have evaluated AFC's disclosure controls and
procedures (as defined in Exchange Act Rule 13a-14(c)) as of a date within 90
days prior to filing this report. Based on that evaluation, they concluded that
the controls and procedures are effective. There have been no significant
changes in AFC's internal controls or in other factors that could significantly
affect these controls subsequent to the date of their evaluation.
54
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, 2002 and 2001, and the
related consolidated statements of operations, changes in shareholders' equity
and cash flows for each of the three years in the period ended December 31,
2002. Our audits also included the financial statement schedules listed in the
Index at Item 15(a). These financial statements and schedules are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of American Financial
Corporation and subsidiaries at December 31, 2002 and 2001, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2002, in conformity with accounting principles
generally accepted in the United States. Also, in our opinion, the related
financial statement schedules, when considered in relation to the basic
financial statements taken as a whole, present fairly in all material respects
the information set forth therein.
As discussed in Notes A and E to the consolidated financial statements, in 2002,
the Company implemented Statement of Financial Accounting Standards No. 142,
which required a change in the method of accounting for goodwill.
ERNST & YOUNG LLP
Cincinnati, Ohio
February 19, 2003
F-1
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars In Thousands)
December 31,
---------------------------
2002 2001
---- ----
ASSETS:
Cash and short-term investments $ 870,797 $ 543,644
Investments:
Fixed maturities - at market
(amortized cost - $11,549,710 and $10,593,205) 12,006,910 10,748,605
Other stocks - at market
(cost - $173,933 and $187,810) 299,133 313,710
Policy loans 214,852 211,288
Real estate and other investments 257,731 262,801
----------- -----------
Total investments 12,778,626 11,536,404
Recoverables from reinsurers and prepaid
reinsurance premiums 2,866,780 2,286,509
Agents' balances and premiums receivable 708,327 666,171
Deferred acquisition costs 842,070 818,323
Other receivables 306,904 254,137
Variable annuity assets (separate accounts) 455,142 529,590
Prepaid expenses, deferred charges and other assets 425,127 451,362
Goodwill 248,683 312,134
----------- -----------
$19,502,456 $17,398,274
=========== ===========
LIABILITIES AND CAPITAL:
Unpaid losses and loss adjustment expenses $ 5,203,831 $ 4,777,580
Unearned premiums 1,847,924 1,640,955
Annuity benefits accumulated 6,453,881 5,832,120
Life, accident and health reserves 902,393 638,522
Payable to reinsurers 508,718 296,462
Payable to American Financial Group, Inc. 310,010 356,689
Long-term debt:
Holding companies 267,512 228,252
Subsidiaries 296,771 270,752
Variable annuity liabilities (separate accounts) 455,142 529,590
Accounts payable, accrued expenses and other
liabilities 1,032,079 888,684
----------- -----------
Total liabilities 17,278,261 15,459,606
Minority interest 494,472 460,737
Shareholders' Equity:
Preferred Stock - at liquidation value 72,154 72,154
Common Stock, no par value
- 20,000,000 shares authorized
- 10,593,000 shares outstanding 9,625 9,625
Capital surplus 987,539 984,125
Retained earnings 343,705 255,127
Unrealized gain on marketable securities, net 316,700 156,900
----------- -----------
Total shareholders' equity 1,729,723 1,477,931
----------- -----------
$19,502,456 $17,398,274
=========== ===========
See notes to consolidated financial statements.
F-2
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(In Thousands)
Year ended December 31,
---------------------------------------------
2002 2001 2000
---- ---- ----
INCOME:
Property and casualty insurance premiums $2,402,600 $2,593,938 $2,494,892
Life, accident and health premiums 305,647 280,122 230,441
Investment income 867,618 859,484 837,361
Realized gains (losses) on:
Securities (78,935) (24,140) (26,581)
Subsidiaries (10,769) 170 4,032
Other investments - - 27,230
Other income 258,560 219,891 252,735
---------- ---------- ----------
3,744,721 3,929,465 3,820,110
COSTS AND EXPENSES:
Property and casualty insurance:
Losses and loss adjustment expenses 1,814,699 2,080,057 1,961,538
Commissions and other underwriting expenses 614,225 741,396 735,241
Annuity benefits 300,966 294,654 293,171
Life, accident and health benefits 245,271 213,022 175,174
Annuity and life acquisition expenses 114,507 79,297 62,259
Interest charges on borrowed money 47,459 60,556 67,310
Other operating and general expenses 412,338 390,102 405,158
---------- ---------- ----------
3,549,465 3,859,084 3,699,851
---------- ---------- ----------
Operating earnings before income taxes 195,256 70,381 120,259
Provision for income taxes 23,996 15,287 32,812
---------- ---------- ----------
Net operating earnings 171,260 55,094 87,447
Minority interest expense, net of tax (27,560) (25,954) (18,051)
Equity in net losses of investees, net of tax (8,990) (16,550) (92,449)
---------- ---------- ----------
Earnings (loss) before cumulative effect of
accounting changes 134,710 12,590 (23,053)
Cumulative effect of accounting changes (40,360) (10,040) (9,072)
---------- ---------- ----------
NET EARNINGS (LOSS) $ 94,350 $ 2,550 ($ 32,125)
========== ========== ==========
See notes to consolidated financial statements.
F-3
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(Dollars In Thousands)
Common Stock Unrealized
Preferred And Capital Retained Gain (Loss)
Stock Surplus Earnings on Securities Total
--------- ------------ -------- ------------- ----------
BALANCE AT DECEMBER 31, 1999 $72,154 $970,407 $296,246 ($ 14,700) $1,324,107
Net loss - - ( 32,125) - (32,125)
Change in unrealized - - - 153,900 153,900
----------
Comprehensive income 121,775
Dividends on Preferred Stock - - (5,772) - (5,772)
Capital Contribution from parent - 12,267 - - 12,267
Other - 1,739 - - 1,739
------- -------- -------- -------- ----------
BALANCE AT DECEMBER 31, 2000 $72,154 $984,413 $258,349 $139,200 $1,454,116
======= ======== ======== ======== ==========
Net earnings $ - $ - $ 2,550 $ - $ 2,550
Change in unrealized - - - 17,700 17,700
----------
Comprehensive income 20,250
Dividends on Preferred Stock - - (5,772) - (5,772)
Capital Contribution from parent - 12,267 - - 12,267
Other - (2,930) - - (2,930)
------- -------- -------- -------- ----------
BALANCE AT DECEMBER 31, 2001 $72,154 $993,750 $255,127 $156,900 $1,477,931
======= ======== ======== ======== ==========
Net earnings $ - $ - $ 94,350 $ - $ 94,350
Change in unrealized - - - 159,800 159,800
----------
Comprehensive income (loss) 254,150
Dividends on Preferred Stock - - (5,772) - (5,772)
Capital Contribution from parent - 6,133 - - 6,133
Other - (2,719) - - (2,719)
------- -------- -------- -------- -----------
BALANCE AT DECEMBER 31, 2002 $72,154 $997,164 $343,705 $316,700 $1,729,723
======= ======== ======== ======== ==========
See notes to consolidated financial statements.
F-4
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(In Thousands)
Year ended December 31,
--------------------------------------------
2002 2001 2000
---- ---- ----
OPERATING ACTIVITIES:
Net earnings (loss) $ 94,350 $ 2,550 ($ 32,125)
Adjustments:
Cumulative effect of accounting changes 40,360 10,040 9,072
Equity in net losses of investees 8,990 16,550 92,449
Depreciation and amortization 174,525 125,814 99,867
Annuity benefits 300,966 294,654 293,171
Realized (gains) losses on investing activities 58,202 (2,604) (25,173)
Deferred annuity and life policy acquisition
costs (170,194) (137,724) (146,686)
Decrease (increase) in reinsurance and
other receivables (669,790) (299,802) 74,885
Decrease (increase) in other assets 29,545 (20,136) (70,191)
Increase in insurance claims and reserves 703,244 546,522 189,587
Increase in payable to reinsurers 212,256 154,384 14,270
Increase (decrease) in other liabilities 45,567 8,193 (34,563)
Increase (decrease) in minority interest 16,603 18,491 (445)
Other, net (4,820) 12,904 1,927
---------- ---------- ----------
839,804 729,836 466,045
---------- ---------- ----------
INVESTING ACTIVITIES:
Purchases of and additional investments in:
Fixed maturity investments (6,199,022) (3,827,768) (1,635,578)
Equity securities (16,583) (9,071) (45,800)
Subsidiary (48,447) - -
Real estate, property and equipment (53,639) (90,111) (88,371)
Maturities and redemptions of fixed maturity
investments 1,807,482 902,820 689,691
Sales of:
Fixed maturity investments 3,566,812 2,468,492 810,942
Equity securities 23,669 15,814 84,147
Investees and subsidiaries - 40,395 30,694
Real estate, property and equipment 22,417 71,002 30,150
Cash and short-term investments of acquired
(former) subsidiaries, net 4,684 (134,237) (132,163)
Decrease (increase) in other investments 14,223 (7,827) 5,637
---------- ---------- ----------
(878,404) (570,491) (250,651)
---------- ---------- ----------
FINANCING ACTIVITIES:
Fixed annuity receipts 874,470 616,628 496,742
Annuity surrenders, benefits and withdrawals (549,919) (622,474) (731,856)
Net transfers from (to) variable annuity assets 20,807 (363) (50,475)
Additional long-term borrowings 224,560 242,613 182,462
Reductions of long-term debt (159,926) (143,840) (141,577)
Borrowings from AFG 14,300 17,077 174,500
Payments to AFG (62,100) (100,500) (108,413)
Repurchases of trust preferred securities - (75,000) (1,427)
Capital contributions 9,333 18,667 18,667
Cash dividends paid (5,772) (5,772) (5,772)
---------- ---------- ----------
365,753 (52,964) (167,149)
---------- ---------- ----------
NET INCREASE IN CASH AND SHORT-TERM INVESTMENTS 327,153 106,381 48,245
Cash and short-term investments at beginning of
period 543,644 437,263 389,018
---------- ---------- ----------
Cash and short-term investments at end of period $ 870,797 $ 543,644 $ 437,263
========== ========== ==========
See notes to consolidated financial statements.
F-5
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
-------------------------------------------------------------------------------
INDEX TO NOTES
A. Accounting Policies I. Shareholders' Equity
B. Acquisitions and Sales of J. Income Taxes
Subsidiaries and Investees K. Equity in Losses of Investees
C. Segments of Operations L. Commitments and Contingencies
D. Investments M. Quarterly Operating Results
E. Goodwill and Other Intangibles N. Insurance
F. Payable to American Financial Group O. Additional Information
G. Long-Term Debt P. Subsequent Events
H. Minority Interest
---------------------------------------------------------------------------
A. ACCOUNTING POLICIES
BASIS OF PRESENTATION The consolidated financial statements include the
accounts of American Financial Corporation ("AFC") and its subsidiaries.
Certain reclassifications have been made to prior years to conform to the
current year's presentation. All significant intercompany balances and
transactions have been eliminated. All acquisitions have been treated as
purchases. The results of operations of companies since their formation or
acquisition are included in the consolidated financial statements.
The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements
and accompanying notes. Changes in circumstances could cause actual
results to differ materially from those estimates.
INVESTMENTS All fixed maturity securities are considered "available for
sale" and reported at fair value with unrealized gains and losses reported
as a separate component of shareholders' equity. Short-term investments
are carried at cost; loans receivable are carried primarily at the
aggregate unpaid balance. Premiums and discounts on mortgage-backed
securities are amortized over a period based on estimated future principal
payments, including prepayments. Prepayment assumptions are reviewed
periodically and adjusted to reflect actual prepayments and changes in
expectations. The most significant determinants of prepayments are the
difference between interest rates on the underlying mortgages and current
mortgage loan rates and the structure of the security. Other factors
affecting prepayments include the size, type and age of underlying
mortgages, the geographic location of the mortgaged properties and the
credit worthiness of the borrowers. Variations from anticipated
prepayments will affect the life and yield of these securities.
Gains or losses on securities are determined on the specific
identification basis. When a decline in the value of a specific investment
is considered to be other than temporary, a provision for impairment is
charged to earnings and the cost basis of that investment is reduced.
Emerging Issues Task Force Issue No. 99-20 established a new standard for
recognizing interest income and impairment on certain asset-backed
investments. Interest income on these investments is recorded at a yield
based on projected cash flows. The yield is adjusted prospectively to
reflect actual cash flows and changes in projected amounts. Impairment
losses on these investments must be recognized when (i) the fair value of
the security is less than its cost basis and (ii) there has been an
adverse change in the expected cash flows. The new standard became
effective on April 1, 2001. Impairment losses at initial application of
this rule were recognized as the cumulative effect of an accounting
change. Subsequent impairments are recognized as a component of net
realized gains and losses.
F-6
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
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.
Due to Chiquita's announced intention to pursue a plan to restructure its
public debt, AFC wrote down its investment in Chiquita common stock to
market value at December 31, 2000. In 2001, AFC suspended accounting for
the investment under the equity method due to the expected restructuring,
and reclassified the investment to "Other stocks." In a 2002
reorganization of Chiquita, AFC's ownership was reduced to less than
one-half of 1%.
GOODWILL Goodwill represents the excess of cost of subsidiaries over AFC's
equity in their underlying net assets. Through December 31, 2001, goodwill
was being amortized over periods of 20 to 40 years. Effective January 1,
2002, AFC implemented Statement of Financial Accounting Standards ("SFAS")
No. 142, under which goodwill is no longer amortized but is subject to an
impairment test at least annually. As required under SFAS No. 142, AFC
completed the transitional test for goodwill impairment (as of January 1,
2002) in the fourth quarter of 2002. The resulting write-down was reported
by restating first quarter 2002 results for the cumulative effect of a
change in accounting principle.
INSURANCE As discussed under "Reinsurance" below, unpaid losses and loss
adjustment expenses and unearned premiums have not been reduced for
reinsurance recoverable.
REINSURANCE Amounts recoverable from reinsurers are estimated in a
manner consistent with the claim liability associated with the reinsured
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. Payable to reinsurers
includes ceded premiums retained by AFC's insurance subsidiaries under
contracts to fund ceded losses as they become due. AFC's insurance
subsidiaries also assume reinsurance from other companies. Income on
reinsurance assumed is recognized based on reports received from ceding
companies.
DEFERRED POLICY ACQUISITION COSTS ("DPAC") Policy acquisition costs
(principally commissions, premium taxes and other marketing and
underwriting expenses) related to the production of new business are
deferred. For the property and casualty companies, DPAC is limited based
upon recoverability without any consideration for anticipated investment
income and is charged against income ratably over the terms of the related
policies.
DPAC related to annuities and universal life insurance products is
deferred to the extent deemed recoverable and amortized, with interest, in
relation to the present value of expected gross profits on the policies.
To the extent that realized gains and losses result in adjustments to the
amortization of DPAC related to annuities, such adjustments are reflected
as components of realized gains. DPAC related to annuities is also
adjusted, net of tax, for the change in amortization that would have been
recorded if the unrealized gains (losses) from securities had actually
been realized. This adjustment is included in "Unrealized gains (losses)
on marketable securities, net" in the shareholders' equity section of the
Balance Sheet.
DPAC related to traditional life and health insurance is amortized over
the expected premium paying period of the related policies, in proportion
to the ratio of annual premium revenues to total anticipated premium
revenues.
ANNUITY AND LIFE ACQUISITION EXPENSES Annuity and life acquisition
expenses on the Statement of Operations consists primarily of amortization
of DPAC related to the annuity and life, accident and health businesses.
This line item also includes certain marketing and commission costs that
are expensed as paid.
F-7
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES The net liabilities
stated for unpaid claims and for expenses of investigation and adjustment
of unpaid claims are based upon (a) the accumulation of case estimates for
losses reported prior to the close of the accounting period on direct
business written; (b) estimates received from ceding reinsurers and
insurance pools and associations; (c) estimates of unreported losses based
on past experience; (d) estimates based on experience of expenses for
investigating and adjusting claims and (e) the current state of the law
and coverage litigation. Establishing reserves for asbestos and
environmental claims involves considerably more judgment than other types
of claims due to, among other things, inconsistent court decisions, an
increase in bankruptcy filings as a result of asbestos-related
liabilities, novel theories of coverage, and judicial interpretations that
often expand theories of recovery and broaden the scope of coverage.
Loss reserve liabilities are subject to the impact of changes in claim
amounts and frequency and other factors. Changes in estimates of the
liabilities for losses and loss adjustment expenses are reflected in the
Statement of Operations in the period in which determined. In spite of the
variability inherent in such estimates, management believes that the
liabilities for unpaid losses and loss adjustment expenses are adequate.
ANNUITY BENEFITS ACCUMULATED Annuity receipts and benefit payments
are recorded as increases or decreases in "annuity benefits accumulated"
rather than as revenue and expense. Increases in this liability for
interest credited are charged to expense and decreases for surrender
charges are credited to other income.
LIFE, ACCIDENT AND HEALTH RESERVES Liabilities for future policy
benefits under traditional life, accident and health policies are computed
using the net level premium method. Computations are based on the original
projections of investment yields, mortality, morbidity and surrenders and
include provisions for unfavorable deviations. Reserves established for
accident and health claims are modified as necessary to reflect actual
experience and developing trends.
VARIABLE ANNUITY ASSETS AND LIABILITIES Separate accounts related to
variable annuities represent deposits invested in underlying investment
funds on which Great American Financial Resources, Inc. ("GAFRI"), an
83%-owned subsidiary, earns a fee. Investment funds are selected and may
be changed only by the policyholder, who retains all investment risk.
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.
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. Estimates are accrued during the
period in which premiums are 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.
F-8
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MINORITY INTEREST For balance sheet purposes, minority interest represents
(i) the interests of noncontrolling shareholders in AFC subsidiaries,
including preferred securities issued by trust subsidiaries of GAFRI and
(ii) American Financial Group, Inc.'s ("AFG") direct ownership interest in
American Premier Underwriters, Inc. ("American Premier" or "APU") and
American Financial Enterprises, Inc. 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.
INCOME TAXES AFC files consolidated federal income tax returns which
include all 80%-owned U.S. subsidiaries, except for certain life insurance
subsidiaries and their subsidiaries. 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 the AFG Retirement and Savings Plan, a
defined contribution plan. The Company makes all contributions to the
retirement fund portion of the Plan and matches a percentage of employee
contributions to the savings fund. Employees have been permitted to direct
the investment of their contributions to independently managed investment
funds, while Company contributions have been invested primarily in
securities of AFG and affiliates. Employees may direct the investment of a
portion of their vested retirement fund account balances (increasing from
12.5% in July 2002 to 100% in April 2004) from securities of AFG and its
affiliates to independently managed investment funds. As of December 31,
2002, the Plan owned 12% of AFG's outstanding common stock. Company
contributions are expensed in the year for which they are declared.
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.
DERIVATIVES Effective October 1, 2000, AFC implemented SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities", which
established accounting and reporting standards for derivative instruments
(including derivative instruments that are embedded in other contracts)
and for hedging activities. Prior year financial statements were not
restated. SFAS No. 133 generally requires that derivatives (both assets
and liabilities) be recognized in the balance sheet at fair value with
changes in fair value included in current earnings. The cumulative effect
of implementing SFAS No. 133, which resulted from the initial recognition
of AFC's derivatives at fair value, was a loss of $9.1 million (net of
minority interest and taxes).
Derivatives are included in AFC's Balance Sheet and consist primarily of
investments in common stock warrants (valued at $13.8 million at
December 31, 2002; included in other stocks), the equity-based component
of certain annuity products (included in annuity benefits accumulated)
and related call options (included in other investments) designed to be
consistent with the characteristics of the liabilities and used to
mitigate the risk embedded in those annuity products.
STATEMENT OF CASH FLOWS For cash flow purposes, "investing activities" are
defined as making and collecting loans and acquiring and disposing of debt
or equity instruments and property and equipment. "Financing activities"
include obtaining resources from owners and providing them with a return
on their investments, borrowing money and repaying amounts borrowed.
Annuity receipts, benefits and withdrawals are also reflected as financing
activities. All other activities are considered "operating". Short-term
investments having original maturities of three months or less when
purchased are considered to be cash equivalents for purposes of the
financial statements.
F-9
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
B. ACQUISITIONS AND SALES OF SUBSIDIARIES AND INVESTEES See Note P,
"Subsequent Events" for information on the 2003 sales of Infinity and the
direct-to-consumer auto business.
NEW JERSEY PRIVATE PASSENGER AUTOMOBILE INSURANCE BUSINESS In September
2002, an AFC subsidiary entered into an agreement under which an unrelated
insurer will assume the subsidiary's obligations to renew its private
passenger automobile insurance business written in New Jersey. AFC
recognized a $10.8 million pretax loss on the transaction. As of September
9, 2002, AFC no longer accepts any new private passenger automobile
insurance in that state.
MANHATTAN NATIONAL LIFE INSURANCE On June 28, 2002, GAFRI acquired
Manhattan National Life Insurance Company ("MNL") from Conseco, Inc. for
$48.5 million in cash. At December 31, 2002, MNL reinsured 90% of its in
force business.
SEVEN HILLS INSURANCE COMPANY In July 2001, AFC sold Seven Hills Insurance
Company for $18.4 million, realizing a pretax gain of $7.1 million. AFC
retained all liability for Seven Hills' business related to the period AFC
owned the company.
JAPANESE DIVISION In December 2000, AFC agreed to sell its Japanese
property and casualty division to Mitsui Marine & Fire Insurance Company
of America for $22 million in cash and recorded an estimated $10.7 million
pretax loss. Upon completion of the sale in March 2001, AFC realized an
additional pretax loss of $6.9 million (including post closing
adjustments) and deferred a gain of approximately $21 million on ceded
insurance; the deferred gain is being recognized over the estimated
settlement period (weighted average of 4 years) of the ceded claims. At
the same time, a reinsurance agreement under which Great American
Insurance ceded a portion of its pool of insurance to Mitsui was
terminated. The Japanese division generated net written premiums of
approximately $60 million per year to Great American while Great American
ceded approximately $45 million per year to Mitsui.
STONEWALL INSURANCE COMPANY In September 2000, AFC sold Stonewall
Insurance Company for $31.2 million (net of post closing adjustments),
realizing a pretax loss of $10.3 million. Stonewall was a non-operating
property and casualty subsidiary with approximately $320 million in
assets, engaged primarily in the run-off of approximately $170 million in
asbestos and environmental liabilities associated with policies written
through 1991.
COMMERCIAL LINES DIVISION In 1998, AFC sold its Commercial lines division
to Ohio Casualty Corporation for $300 million cash plus warrants to
purchase shares of Ohio Casualty common stock. AFC received an additional
$25 million (included in gains on sales of subsidiaries) in August 2000
under a provision in the sale agreement related to the retention and
growth of the insurance businesses sold.
START-UP MANUFACTURING BUSINESSES Since 1998, AFC subsidiaries have made
loans to two start-up manufacturing businesses which were previously owned
by unrelated third-parties. During 2000, the former owners chose to
forfeit their equity interests to AFC rather than invest additional
capital. Total loans extended to these businesses prior to forfeiture
amounted to $49.7 million and the accumulated losses of the two businesses
were approximately $29.7 million.
During the fourth quarter of 2000, AFC sold the equity interests to a
group of employees for nominal cash consideration plus warrants to
repurchase a significant ownership interest. Due to the absence of
significant financial investment by the buyers relative to the amount of
loans ($61.5 million at December 31, 2000) owed to AFC subsidiaries, the
sale was not recognized as a divestiture for accounting purposes and AFC
continued accounting for their operations under the equity method as
investees. In December 2002, one of the businesses sold substantially all
of its assets for $29.5 million, which proceeds and approximately $675,000
in receivables and other assets were transferred to AFC. The amount
transferred approximated AFC's carrying value of loans to this
F-10
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
business. At December 31, 2001, $41.6 million in assets of this business
were included in other assets and $9.8 million in liabilities of this
business (after consolidation and elimination of loans from AFC
subsidiaries) were included in other liabilities in AFC's consolidated
balance sheet.
Assets of the remaining start-up business ($15.3 million at December 31,
2002, and $15.5 million at December 31, 2001) are included in other
assets; liabilities of the business ($2.0 million at December 31, 2002 and
2001, after consolidation and elimination of loans from AFC subsidiaries)
are included in other liabilities.
AFC's equity in the losses of these two companies during 2002, 2001 and
the fourth quarter of 2000 was $9.0 million, $16.6 million and $4.1
million, respectively, and is included in investee losses in the Statement
of Operations.
F-11
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
C. SEGMENTS OF OPERATIONS AFC's property and casualty group has been engaged
primarily in specialty commercial insurance and private passenger
automobile insurance business. The Specialty group includes a highly
diversified group of specialty business units. Some of the more
significant areas are inland and ocean marine, California workers'
compensation, agricultural-related coverages, executive and professional
liability, fidelity and surety bonds, collateral protection, and umbrella
and excess coverages. In 2003, AFC sold a substantial portion of its
Personal segment; see Note P - "Subsequent Events." The Personal
group wrote nonstandard and preferred/standard private passenger auto and
other personal insurance coverage. AFC's annuity, life and health
business markets primarily retirement products as well as life and
supplemental health insurance. AFC's businesses operate throughout the
United States. In 2002, 2001, and 2000, AFC derived less than 2% of its
revenues from the sale of life and supplemental health products in Puerto
Rico and less than 1% of its revenues from the sale of property and
casualty insurance in Mexico, Canada, Puerto Rico, Europe and Asia.
The following tables (in thousands) show AFC's assets, revenues and
operating profit (loss) by significant business segment. Operating profit
(loss) represents total revenues less operating expenses.
2002 2001 2000
---- ---- ----
ASSETS
Property and casualty insurance (a) $ 9,960,769 $ 8,796,909 $ 8,200,683
Annuities and life 9,349,280 8,370,904 7,934,851
Other 192,407 230,461 247,942
----------- ----------- -----------
19,502,456 17,398,274 16,383,476
Investment in investees - - 23,996
----------- ----------- -----------
$19,502,456 $17,398,274 $16,407,472
=========== =========== ===========
REVENUES (b)
Property and casualty insurance:
Premiums earned:
Specialty $ 1,497,088 $ 1,409,497 $ 1,223,435
Personal 905,246 1,182,651 1,270,328
Other lines (c) 266 1,790 1,129
----------- ----------- -----------
2,402,600 2,593,938 2,494,892
Investment and other income 410,947 458,410 450,537
----------- ----------- -----------
2,813,547 3,052,348 2,945,429
Annuities and life (d) 897,365 855,733 823,586
Other 33,809 21,384 51,095
----------- ----------- -----------
$ 3,744,721 $ 3,929,465 $ 3,820,110
=========== =========== ===========
OPERATING PROFIT (LOSS)
Property and casualty insurance:
Underwriting:
Specialty $ 24,544 ($ 23,274) ($ 94,857)
Personal 1,339 (93,254) (108,372)
Other lines (c)(e) (52,207) (110,987) 1,342
----------- ----------- -----------
(26,324) (227,515) (201,887)
Investment and other income 211,424 296,725 289,549
----------- ----------- -----------
185,100 69,210 87,662
Annuities and life 61,553 100,864 96,211
Other (f) (51,397) (99,693) (63,614)
----------- ----------- -----------
$ 195,256 $ 70,381 $ 120,259
=========== =========== ===========
(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 development of lines in "run-off"; AFC has ceased
underwriting new business in these operations.
(d) Represents primarily investment income.
(e) Includes a special charge of $100 million in 2001 related to asbestos
and other environmental matters ("A&E").
(f) Includes holding company expenses.
F-12
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
D. INVESTMENTS Fixed maturities and other stocks at December 31 consisted
of the following (in millions):
2002 2001
------------------------------------------- -------------------------------------------
Amortized Market Gross Unrealized Amortized Market Gross Unrealized
----------------- -----------------
Cost Value Gains Losses Cost Value Gains Losses
--------- ----- ----- ------ --------- ------ ------ ------
Fixed Maturities:
United States Government
and government agencies
and authorities $ 1,353.6 $ 1,402.0 $ 49.5 ($ 1.1) $ 1,000.1 $ 1,017.8 $ 21.7 ($ 4.0)
States, municipalities and
political subdivisions 584.4 615.2 36.4 (5.6) 405.6 414.9 16.2 (6.9)
Foreign government 163.3 169.9 6.6 - 105.5 108.8 3.5 (.2)
Public utilities 1,038.9 1,058.3 43.4 (24.0) 772.0 778.8 14.4 (7.6)
Mortgage-backed securities 3,106.6 3,232.1 134.6 (9.1) 2,632.9 2,702.5 89.5 (19.9)
All other corporate 5,241.8 5,462.7 312.0 (91.1) 5,616.6 5,673.5 160.2 (103.3)
Redeemable preferred stocks 61.1 66.7 7.8 (2.2) 60.5 52.3 .8 (9.0)
--------- --------- ------ ------ --------- --------- ------ ------
$11,549.7 $12,006.9 $590.3 ($133.1) $10,593.2 $10,748.6 $306.3 ($150.9)
========= ========= ====== ====== ========= ========= ====== ======
Other stocks $ 173.9 $ 299.1 $129.9 ($ 4.7) $ 187.8 $ 313.7 $135.7 ($ 9.8)
========= ========= ====== ====== ========= ========= ====== ======
The table below sets forth the scheduled maturities of fixed maturities
based on market value as of December 31, 2002. Asset-backed securities and
other securities with sinking funds are reported at average maturity. Data
based on amortized cost is generally the same. Actual maturities may
differ from contractual maturities because certain securities may be
called or prepaid by the issuers. Mortgage-backed securities had an
average life of approximately five years at December 31, 2002.
Maturity
----------------
One year or less 6%
After one year through five years 23
After five years through ten years 33
After ten years 11
---
73
Mortgage-backed securities 27
---
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.
The only investment which exceeds 10% of Shareholders' Equity is an equity
investment in Provident Financial Group, Inc., having a market value of
$189 million and $191 million at December 31, 2002 and 2001, respectively.
Realized gains (losses) and changes in unrealized appreciation
(depreciation) on fixed maturity and equity security investments are
summarized as follows (in thousands):
Fixed Equity Tax
Maturities Securities Effects Total
---------- ---------- --------- ---------
2002
----
Realized ($ 61,081) ($17,854) $ 27,582 ($ 51,353)
Change in Unrealized 301,800 (700) (103,800) 197,300
2001
----
Realized (15,315) (8,825) 8,451 (15,689)
Change in Unrealized 139,000 (84,500) (19,200) 35,300
2000
----
Realized (24,186) (2,395) 9,303 (17,278)
Change in Unrealized 255,200 29,900 (98,200) 186,900
F-13
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
Gross gains and losses on fixed maturity investment transactions included
in the Statement of Cash Flows consisted of the following (in millions):
2002 2001 2000
---- ---- ----
Gross Gains $155.4 $108.9 $15.9
Gross Losses ($216.5) ($124.2) ($40.1)
E. GOODWILL AND OTHER INTANGIBLES Effective January 1, 2002, goodwill is no
longer amortized but is subject to annual impairment testing under a two
step process. Under the first step, an entity's net assets are classified
by reporting units and compared to their fair value. Fair value was
estimated based primarily on the present value of expected future cash
flows. If the carrying amount of a reporting unit exceeds its fair value,
the second step of the goodwill impairment test is performed to measure
the amount of impairment loss, if any. In the second quarter of 2002,
AFC completed the first step of its transitional impairment test and
identified potential impairment of goodwill in its annuities and life
insurance segment and the personal lines segment of its property and
casualty insurance business. The second step of the impairment test,
measuring the amount of impairment loss, was completed in the fourth
quarter with a resulting $40.4 million impairment charge reported by
restating first quarter 2002 results for the cumulative effect of a change
in accounting principle. The impairment charge for the annuities and life
insurance segment was related to a decrease in estimated future earnings
based upon lower forecasted new business sales over the next few years.
The impairment charge for the personal lines segment related primarily to
planned future reductions in new business volume written through the
direct channel.
If the goodwill amortization of $13.8 million and $16.5 million in the
years 2001 and 2000, respectively, had not been expensed, net earnings
(loss) for the periods would have been earnings of $16.3 million and a
loss of $15.6 million.
Changes in the carrying value of goodwill during 2002, by reporting
segment, are presented in the following table (in thousands):
Property and Casualty Annuities
--------------------------
Specialty Personal and Life Total
--------- -------- --------- -----
Balance December 31, 2001 $154,339 $117,391 $40,404 $312,134
Goodwill from acquisitions - - 1,461 1,461
Transitional impairment charge - (39,600) (21,184) (60,784)
Other (4,128) - - (4,128)
-------- -------- ------- --------
Balance December 31, 2002 $150,211 $ 77,791 $20,681 $248,683
======== ======== ======= ========
Included in deferred acquisition costs in AFC's Balance Sheet are $66.8
million and $71.2 million at December 31, 2002 and 2001, respectively,
representing the present value of future profits ("PVFP") related to
acquisitions by AFC's annuity and life business. The PVFP amounts are net
of $57.3 million and $45.5 million of accumulated amortization.
Amortization of the PVFP was $11.8 million in 2002, $9.2 million in 2001
and $10.7 million in 2000. During each of the next five years, the PVFP is
expected to decrease at a rate of approximately 13% of the balance at the
beginning of each respective year.
F. PAYABLE TO AMERICAN FINANCIAL GROUP AFC has a reciprocal Master Credit
Agreement with various AFG holding companies under which these companies
make funds available to each other for general corporate purposes. Amounts
borrowed under the agreement bear interest at 1% over LIBOR.
F-14
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
G. LONG-TERM DEBT Long-term debt consisted of the following at
December 31, (in thousands):
2002 2001
---- ----
HOLDING COMPANIES:
AFC notes payable under bank line $248,000 $203,000
American Premier Underwriters, Inc. ("APU")
10-7/8% Subordinated Notes due May 2011,
including premium of $777 and $836
(imputed rate - 9.6%) 11,498 11,557
Other 8,014 13,695
-------- --------
$267,512 $228,252
======== ========
SUBSIDIARIES:
GAFRI 6-7/8% Senior Notes due June 2008 $100,000 $100,000
GAFRI notes payable under bank line 148,600 121,100
Notes payable secured by real estate 35,610 36,253
Other 12,561 13,399
-------- --------
$296,771 $270,752
======== ========
At December 31, 2002, sinking fund and other scheduled principal payments
on debt for the subsequent five years were as follows (in millions):
Holding
Companies Subsidiaries Total
--------- ------------ ------
2003 $ 78.0 $ 2.1 $ 80.1
2004 - 150.8 150.8
2005 170.0 11.3 181.3
2006 - 19.6 19.6
2007 5.1 .2 5.3
In November 2002, AFC replaced its $300 million bank credit line with a
new bank credit agreement. Currently, AFC may borrow up to $280 million
under the new agreement; the line may be expanded to $300 million through
the end of 2003. The new line consists of two facilities: a 364-day
revolving facility, extendable annually, for one-third of the total line
and a three-year revolving facility for the remaining two-thirds. Amounts
borrowed bear interest at rates ranging from 1.25% to 2.25% over LIBOR
based on AFG's credit rating. In addition, GAFRI has an unsecured credit
agreement under which it can borrow up to $155 million at floating rates
based on prime or Eurodollar rates through December 2004.
Cash interest payments of $32 million, $50 million and $58 million were
made on long-term debt in 2002, 2001 and 2000, respectively. Interest
expense in the Statement of Operations includes interest credited on funds
held by AFC's insurance subsidiaries under reinsurance contracts and other
similar agreements as follows: 2002 - $11.7 million; 2001 - $7.1 million;
and 2000 - $9.5 million.
F-15
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
H. MINORITY INTEREST Minority interest in AFC's balance sheet is
comprised of the following (in thousands):
2002 2001
---- ----
Interest of AFG (parent) and noncontrolling
shareholders in subsidiaries' common stock $351,559 $317,824
Preferred securities issued by
subsidiary trusts 142,913 142,913
-------- --------
$494,472 $460,737
======== ========
SUBSIDIARY PREFERRED SECURITIES Wholly-owned subsidiary trusts of GAFRI
have issued preferred securities and, in turn, purchased a like amount of
subordinated debt which provides interest and principal payments to fund
the respective trusts' obligations. The preferred securities must be
redeemed upon maturity or redemption of the subordinated debt. GAFRI
effectively provides unconditional guarantees of its trusts' obligations.
The preferred securities consisted of the following (in thousands):
Date of Optional
Issuance Issue (Maturity Date) 2002 2001 Redemption Dates
------------- ------------------------ ---- ---- --------------------
November 1996 GAFRI 9-1/4% TOPrS (2026) $72,913 $72,913 Currently redeemable
March 1997 GAFRI 8-7/8% Pfd (2027) 70,000 70,000 On or after 3/1/2007
MINORITY INTEREST EXPENSE Minority interest expense is comprised of (in
thousands):
2002 2001 2000
---- ---- ----
Interest of AFG (parent) and noncontrolling
shareholders in earnings of subsidiaries $19,136 $14,879 $ 6,092
Accrued distributions by subsidiaries
on preferred securities, net of tax 8,424 11,075 11,959
------- ------- -------
$27,560 $25,954 $18,051
======= ======= =======
I. SHAREHOLDERS' EQUITY At December 31, 2002, and 2001, American Financial
Group beneficially owned all of the outstanding shares of AFC's Common
Stock.
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, 2002 and 2001, the outstanding voting 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 AFC's option at $25.75 per
share beginning December 2005 declining to $25.00 at December 2007
and thereafter; 2,886,161 shares (stated value $72.2 million)
outstanding at December 31, 2002 and 2001.
F-16
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
UNREALIZED GAIN (LOSS) ON MARKETABLE SECURITIES, NET The change in
unrealized gain (loss) on marketable securities included the following (in
millions):
Tax Minority
Pretax Effects Interest Net
------ ------- -------- -----
2002
------------------------------------------
Unrealized holding gains on
securities arising during the period $195.2 ($66.4) ($15.5) $113.3
Realized losses included in net income 78.9 (27.7) (4.7) 46.5
------ ----- ----- ------
Change in unrealized gain on marketable
securities, net $274.1 ($94.1) ($20.2) $159.8
====== ===== ===== ======
2001
------------------------------------------
Unrealized holding gains (losses) on
securities arising during the period $ 0.8 ($ 0.3) ($ 5.0) ($ 4.5)
Adoption of EITF 99-20 16.9 (6.0) (0.9) 10.0
Realized losses included in net income and
unrealized gains of subsidiary sold 23.6 (8.3) (3.1) 12.2
------ ----- ----- ------
Change in unrealized gain on marketable
securities, net $ 41.3 ($14.6) ($ 9.0) $ 17.7
====== ===== ===== ======
2000
------------------------------------------
Unrealized holding gains on
securities arising during the period $221.1 ($75.8) ($18.8) $126.5
Adoption of SFAS No. 133 15.0 (5.3) - 9.7
Realized gains included in net income and
unrealized losses of subsidiary sold 31.3 (10.9) (2.7) 17.7
------ ----- ----- ------
Change in unrealized gain on marketable
securities, net $267.4 ($92.0) ($21.5) $153.9
====== ===== ===== ======
J. 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
Operations (in thousands):
2002 2001 2000
---- ---- ----
Earnings (loss) before income taxes:
Operating $195,256 $70,381 $120,259
Minority interest expense (32,096) (31,917) (24,491)
Equity in net losses of investees (13,830) (25,462) (142,230)
Accounting changes (57,716) (15,948) (13,882)
-------- ------- --------
Total $ 91,614 ($ 2,946) ($ 60,344)
======== ======= ========
Income taxes at statutory rate $ 32,065 ($ 1,031) ($ 21,120)
Effect of:
Adjustment to prior year taxes (33,192) (6,317) -
Minority interest 5,602 4,881 2,177
Effect of foreign operations (4,212) (3,421) 951
Amortization and writeoff of intangibles 3,711 4,568 5,537
Losses utilized (3,300) (1,245) (7,000)
Dividends received deduction (2,313) (2,317) (2,378)
Tax exempt interest (1,367) (1,233) (1,571)
Nondeductible meals, etc. 992 1,381 1,300
State income taxes 153 781 298
Tax credits - (1,243) (5,757)
Other (875) (300) (656)
-------- ------- -------
Total Provision (Credit) (2,736) (5,496) (28,219)
Amounts applicable to:
Minority interest expense 4,536 5,963 6,440
Equity in net losses of investees 4,840 8,912 49,781
Accounting changes 17,356 5,908 4,810
-------- ------- --------
Provision for income taxes as shown
on the Statement of Operations $ 23,996 $15,287 $ 32,812
======== ======= ========
F-17
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
Total earnings before income taxes include income subject to tax in
foreign jurisdictions of $17.8 million in 2002, $8.3 million in 2001 and
$10.6 million in 2000.
The total income tax provision (credit) consists of (in thousands):
2002 2001 2000
---- ---- ----
Current taxes:
Federal $17,535 $44,715 $10,324
Foreign 2,293 - 1,106
State 236 1,201 459
Deferred taxes:
Federal (24,492) (50,679) (39,588)
Foreign 1,692 (733) (520)
------- ------- -------
($ 2,736) ($ 5,496) ($28,219)
======= ======= =======
For income tax purposes, certain members of the AFC consolidated tax group
had the following carryforwards available at December 31, 2002 (in
millions):
Expiring Amount
{ 2003 - 2007 $11
Operating Loss { 2008 - 2017 -
{ 2018 - 2020 89
Other - Tax Credits 11
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):
2002 2001
---- ----
Deferred tax assets:
Net operating loss carryforwards $ 35.4 $ 68.3
Insurance claims and reserves 278.6 268.2
Other, net 108.8 96.4
------ ------
422.8 432.9
Valuation allowance for deferred
tax assets (34.9) (40.9)
------ ------
387.9 392.0
Deferred tax liabilities:
Deferred acquisition costs (242.6) (231.5)
Investment securities (188.3) (109.0)
------ ------
(430.9) (340.5)
------ ------
Net deferred tax asset (liability) ($ 43.0) $ 51.5
====== ======
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.
Cash payments for income taxes, net of refunds, were $30.0 million, $10.0
million and $24.4 million for 2002, 2001 and 2000, respectively.
F-18
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
K. EQUITY IN LOSSES OF INVESTEES In addition to the start-up manufacturing
operations discussed in Note B, and prior to Chiquita's March 2002
restructuring, AFC owned 24 million shares (31% as of December 31, 2001)
of Chiquita common stock. Chiquita is a leading international marketer,
producer and distributor of quality fresh fruits and vegetables and
processed foods.
In January 2001, Chiquita announced a restructuring initiative that
included discontinuing all interest and principal payments on its public
debt. Due to the expected restructuring, AFC recorded a fourth quarter
2000 pretax charge of $95.7 million to write down its investment in
Chiquita to quoted market value at December 31, 2000. In 2001, AFC
suspended accounting for the investment under the equity method and
reclassified the investment to "Other stocks". In the third quarter of
2001, AFC wrote down its investment in Chiquita by an additional $8
million (to $.67 per share). In March 2002, the court approved Chiquita's
plan of reorganization under Chapter 11 of the U.S. Bankruptcy Code. Under
the plan, over $700 million in principal and accrued interest related to
Chiquita's public debt was converted into common equity. As a result of
the restructuring, AFC received approximately 171,000 "new" shares (less
than one-half of 1%) in the reorganized company plus warrants expiring in
2009 to purchase an additional 2.9 million shares at $19.23 per share. All
of the shares and approximately 4% of the warrants have been sold.
For the year ended December 31, 2000, Chiquita reported net sales of $2.25
billion, operating income of $27 million, a net loss of $95 million, and a
net loss attributable to common shares of $112 million.
L. COMMITMENTS AND CONTINGENCIES Loss accruals (included in other
liabilities) 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 and certain manufacturing operations disposed of by
American Premier.
At December 31, 2002, American Premier had liabilities for environmental
and personal injury claims aggregating $66.4 million. The environmental
claims consist of a number of proceedings and claims seeking to impose
responsibility for hazardous waste remediation costs related to certain
sites formerly owned or operated by the railroad and manufacturing
operations. Remediation costs are difficult to estimate 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.
The personal injury claims include pending and expected claims, primarily
by former employees of PCTC, for injury or disease allegedly caused by
exposure to excessive noise, asbestos or other substances in the
workplace. In December 2001, American Premier recorded a $12.1 million
charge to increase its environmental reserves due to an increase in
expected ultimate claim costs. At December 31, 2002, American Premier had
$46.4 million of offsetting recovery assets (included in other assets) for
such environmental and personal injury claims based upon estimates of
probable recoveries from insurance carriers.
AFC has accrued approximately $7 million at December 31, 2002, for
environmental costs and certain other matters associated with the sales of
former operations.
AFC's insurance subsidiaries continue to receive claims related to
environmental exposures, asbestos and other mass tort claims. Establishing
reserves for these claims is subject to uncertainties that are
significantly greater than those presented by other types of claims. The
liability for asbestos and environmental reserves at December 31, 2002 and
2001, respectively, was $572 million and $548 million; related
recoverables from reinsurers (net of allowances for doubtful accounts) at
those dates were $105 million and $101 million, respectively.
F-19
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
While management believes AFC has recorded adequate reserves for the items
discussed in this note, the outcome is uncertain and could result in
liabilities exceeding amounts AFC has currently recorded. Additional
amounts could have a material adverse effect on AFC's future results of
operations and financial condition.
M. 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.
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, 2002 (in millions, except per share amounts).
1st 2nd 3rd 4th Total
Quarter Quarter Quarter Quarter Year
------- ------- ------- ------- --------
2002
---------------------------------------
Revenues $925.6 $920.1 $935.4 $963.6 $3,744.7
Earnings before accounting change 46.1 16.4 24.1 48.2 134.8
Cumulative effect of accounting change (40.4) - - - (40.4)
Net earnings 5.7 16.4 24.1 48.2 94.4
2001
----------------------------------------
Revenues $973.5 $995.0 $1,016.4 $944.6 $3,929.5
Earnings (loss) before accounting change 17.0 12.6 (51.9) 34.9 12.6
Cumulative effect of accounting change - (10.0) - - (10.0)
Net earnings (loss) 17.0 2.6 (51.9) 34.9 2.6
Results for 2002 include a $16 million tax benefit in the first quarter
and a $15 million tax benefit in the fourth quarter resulting from the
reduction of previously accrued amounts due to the resolution of certain
tax matters. Fourth quarter 2002 results also include a $30 million charge
related to the settlement of asbestos-related litigation.
The results for 2001 include goodwill amortization of approximately $3.4
million per quarter.
The 2001 third quarter results include a $100 million pretax charge to
strengthen asbestos and environmental insurance reserves and pretax losses
of $25 million resulting from the World Trade Center terrorist attack.
AFC has realized gains (losses) on sales of subsidiaries in recent years
(see Note B). Realized gains (losses) on securities, affiliates and other
investments amounted to (in millions):
1st 2nd 3rd 4th Total
Quarter Quarter Quarter Quarter Year
------- ------- ------- ------- ------
2002 ($17.8) ($47.5) ($33.9) $9.5 ($89.7)
2001 (8.5) (26.4) 7.0 3.9 (24.0)
F-20
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
N. INSURANCE Securities owned by insurance subsidiaries having a carrying
value of just over $1 billion at December 31, 2002, 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 about 8%,
an approximation of long-term investment yields. As a result, the total
liability for losses and loss adjustment expenses at December 31, 2002,
has been reduced by $25 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). Adverse
development recorded in 2002 and 2001 in prior year reserves related
primarily to charges for asbestos and certain Specialty lines in run-off.
2002 2001 2000
---- ---- ----
Balance at beginning of period $3,253 $3,192 $3,224
Provision for losses and LAE occurring
in the current year 1,664 1,950 2,056
Net increase (decrease) in provision for
claims of prior years 171 163 (60)
------ ------ ------
Total losses and LAE incurred (*) 1,835 2,113 1,996
Payments for losses and LAE of:
Current year (594) (831) (905)
Prior years (1,094) (1,036) (936)
------ ------ ------
Total payments (1,688) (1,867) (1,841)
Reserves of businesses sold - (120) (187)
Reclass to unearned premiums - (65) -
------ ------ ------
Balance at end of period $3,400 $3,253 $3,192
====== ====== ======
Add back reinsurance recoverables, net
of allowance 1,804 1,525 1,324
------ ------ ------
Gross unpaid losses and LAE included
in the Balance Sheet $5,204 $4,778 $4,516
====== ====== ======
(*) Before amortization of deferred gains on retroactive reinsurance of
$20 million in 2002, $33 million in 2001 and $34 million in 2000.
NET INVESTMENT INCOME The following table shows (in millions) investment
income earned and investment expenses incurred by AFC's insurance
companies.
2002 2001 2000
---- ---- ----
Insurance group investment income:
Fixed maturities $850.9 $841.0 $815.5
Equity securities 9.6 8.1 10.4
Other .6 1.1 4.3
------ ------ ------
861.1 850.2 830.2
Insurance group investment expenses (*) (40.4) (36.8) (41.4)
------ ------ ------
$820.7 $813.4 $788.8
====== ====== ======
(*) Included primarily in "Other operating and general expenses" in the
Statement of Operations.
F-21
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 (Loss) Surplus
------------------- ----------------
2002 2001 2000 2002 2001
---- ---- ---- ---- ----
Property and casualty companies $116 $34 $10 $1,742 $1,669
Life insurance companies (24) (25) 40 445 414
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 agreements covering
reinsurance ceded, AFC's insurance subsidiaries would remain liable. The
following table shows (in millions) (i) amounts deducted from property and
casualty written and earned premiums in connection with reinsurance ceded,
(ii) written and earned premiums included in income for reinsurance
assumed and (iii) reinsurance recoveries deducted from losses and loss
adjustment expenses.
2002 2001 2000
---- ---- ----
Direct premiums written $4,027 $3,573 $3,365
Reinsurance assumed 80 94 76
Reinsurance ceded (1,693) (1,114) (803)
------ ------ ------
Net written premiums $2,414 $2,553 (*) $2,638
====== ====== ======
Direct premiums earned $3,798 $3,393 $3,306
Reinsurance assumed 91 92 45
Reinsurance ceded (1,486) (891) (856)
------ ------ ------
Net earned premiums $2,403 $2,594 $2,495
====== ====== ======
Reinsurance recoveries $1,142 $ 773 $ 567
====== ====== ======
(*) Net of $29.7 million unearned premium transfer related to the
sale of the Japanese division.
O. ADDITIONAL INFORMATION Total rental expense for various leases of office
space and equipment was $52 million, $53 million and $44 million for 2002,
2001 and 2000, respectively. Sublease rental income related to these
leases totaled $612,000 in 2002, $2.4 million in 2001 and $2.5 million in
2000.
Future minimum rentals, related principally to office space, required
under operating leases having initial or remaining noncancelable lease
terms in excess of one year at December 31, 2002, were as follows: 2003 -
$57 million; 2004 - $50 million; 2005 - $35 million; 2006 - $26 million;
2007 - $17 million and $33 million thereafter. In addition, AFC has
99-year land leases (approximately 94 years remaining) at one of its real
estate properties. Minimum lease payments under these leases are expected
to be approximately $180,000 in 2003 and are adjusted annually for
inflation.
Other operating and general expenses included charges for possible losses
on agents' balances, other receivables and other assets in the following
amounts: 2002 - $2.7 million; 2001 - $3.5 million; and 2000 - $9.7
million. Losses and loss adjustment expenses included charges for possible
losses on reinsurance recoverables of $6.6 million in 2002 and $11 million
in 2001. The aggregate allowance for all such losses amounted to
approximately $72 million and $67 million at December 31, 2002 and 2001,
respectively.
F-22
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
UNREALIZED GAIN (LOSS) ON MARKETABLE SECURITIES, NET In addition to
adjusting equity securities and fixed maturity securities classified as
"available for sale" to fair value, SFAS 115 requires that certain other
balance sheet amounts be adjusted to the extent that unrealized gains and
losses from securities would result in adjustments had those gains or
losses actually been realized. The components of the Consolidated Balance
Sheet caption "Unrealized gain on marketable securities, net" in
shareholders' equity are summarized as follows (in millions):
Unadjusted Adjusted
Asset Effect of Asset
(Liability) SFAS 115 (Liability)
----------- --------- -----------
2002
----
Fixed maturities $11,549.7 $457.2 $12,006.9
Other stocks 173.9 125.2 299.1
Deferred acquisition costs 873.1 (31.0) 842.1
Annuity benefits accumulated (6,444.7) (9.2) (6,453.9)
------
Pretax unrealized 542.2
Deferred taxes 144.3 (187.3) (43.0)
Minority interest (456.3) (38.2) (494.5)
------
Unrealized gain $316.7
======
2001
----
Fixed maturities $10,593.2 $155.4 $10,748.6
Other stocks 187.8 125.9 313.7
Deferred acquisition costs 827.3 (9.0) 818.3
Annuity benefits accumulated (5,827.9) (4.2) (5,832.1)
------
Pretax unrealized 268.1
Deferred taxes 144.7 (93.2) 51.5
Minority interest (442.7) (18.0) (460.7)
------
Unrealized gain $156.9
======
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.
2002 2001
---------------------- ----------------------
Carrying Fair Carrying Fair
Value Value Value Value
-------- ------- -------- -------
ASSETS:
Fixed maturities $12,007 $12,007 $10,749 $10,749
Other stocks 299 299 314 314
LIABILITIES:
Annuity benefits
accumulated $ 6,454 $ 6,284 $ 5,832 $ 5,659
Long-term debt:
Holding companies 268 268 228 229
Subsidiaries 297 287 271 264
MINORITY INTEREST:
Trust preferred securities $ 143 $ 139 $ 143 $ 143
AFC preferred stock 72 54 72 61
When available, fair values are based on prices quoted in the most active
market for each security. If quoted prices are not available, fair value
is estimated based on present values, discounted cash flows, fair value of
comparable securities, or similar methods. The fair value of the liability
for annuities in the payout phase is assumed to be the present value of
the anticipated cash flows, discounted at current interest rates. Fair
value of annuities in the accumulation phase is assumed to be the
policyholders' cash surrender amount.
F-23
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
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 a credit and market risk nature.
These transactions include commitments to fund loans, loan guarantees and
commitments to purchase and sell securities or loans. At December 31,
2002, AFC and its subsidiaries had commitments to fund credit facilities
and contribute limited partnership capital totaling up to $18 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 2003
from its insurance subsidiaries without seeking regulatory clearance is
approximately $24 million. Additional amounts of dividends, loans and
advances require regulatory approval.
BENEFIT PLANS AFC expensed approximately $20 million in 2002, $19 million
in 2001 and $22 million in 2000 for its retirement and employee savings
plans.
TRANSACTIONS WITH AFFILIATES AFG purchased a $3.7 million minority
interest in a residential homebuilding company from an unrelated party in
1995. At that same time, a brother of AFC's chairman purchased a minority
interest in the company for $825,000. In 2000, that brother and another
brother of AFC's chairman acquired the remaining shares from the third
parties. In addition, GAFRI had extended a line of credit to this company
under which the homebuilder could borrow up to $8 million at 13%. At
December 31, 2001, $6.4 million was due under the credit line. In
September 2002, the homebuilding company was sold to an unrelated party
and GAFRI's line of credit was repaid and terminated.
In 2001, an AFC subsidiary purchased a 29% interest in an aircraft for
$1.6 million (fair value as determined by independent third party) from a
company owned by a brother of AFC's chairman. The remaining interests in
the aircraft are owned by AFC's chairman and his two brothers. Costs of
operating the aircraft are being borne proportionately.
In September 2000, GAFRI's minority ownership in a company engaged in the
production of ethanol was repurchased by that company for $7.5 million in
cash and $21.9 million liquidation value of non-voting redeemable
preferred stock. Following the repurchase, AFC's Chairman beneficially
owns 100% of the ethanol company. In December 2000, the ethanol company
retired $3 million of the preferred stock at liquidation value plus
accrued dividends and issued an $18.9 million subordinated note in
exchange for the remaining preferred stock. The subordinated note bears
interest at 12-1/4% with scheduled repayments through 2005. During 2002
and 2001, respectively, $1 million and $6 million of this note was repaid.
The ethanol company also owes GAFRI $4.0 million under a subordinated note
bearing interest at 14%. In addition, Great American has extended a $10
million line of credit to this company; no amounts have been borrowed
under the credit line.
P. SUBSEQUENT EVENTS (UNAUDITED)
INFINITY PROPERTY AND CASUALTY CORPORATION On December 31, 2002, AFC
transferred to Infinity Property and Casualty Corporation ("Infinity", a
newly formed subsidiary) the following subsidiaries involved primarily in
the issuance of nonstandard auto policies: Atlanta Casualty Company,
Infinity Insurance Company, Leader Insurance Company and Windsor Insurance
Company. Effective January 1, 2003, Great American Insurance Company, an
AFC subsidiary, transferred to Infinity its personal insurance business
written through independent agents. In February 2003, AFC sold 61% of
Infinity in a public offering. The businesses transferred generated
aggregate net written premiums
F-24
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
of approximately $690 million, $900 million and $1.2 billion for the years
ended December 31, 2002, 2001, and 2000, respectively. AFC expects to
realize a pretax loss of about $40 million on the sale in the first
quarter of 2003. In addition, a substantial tax benefit related to AFC's
book versus tax basis in Infinity stock may be available.
DIRECT AUTOMOBILE INSURANCE BUSINESS In January 2003, AFC reached an
agreement to sell two of its subsidiaries that market automobile insurance
directly to customers. The transaction will include the transfer of Great
American Insurance's right to renew certain of its personal automobile
insurance business written on a direct basis in selected markets. Premiums
generated by the businesses being sold were approximately $79 million in
2002. AFC does not expect to report a significant gain or loss on the
sale.
F-25
PART IV
ITEM 15
EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
---------------------------------------------------------------
(a) Documents filed as part of this Report:
1. Financial Statements are included in Part II, Item 8.
2. Financial Statement Schedules:
A. Selected Quarterly Financial Data is included in Note M to the
Consolidated Financial Statements.
B. Schedules filed herewith for 2002, 2001 and 2000:
Page
----
I - Condensed Financial Information of Registrant S-2
V - Supplemental Information Concerning
Property-Casualty Insurance Operations S-4
All other schedules for which provisions are made in the
applicable regulation of the Securities and Exchange
Commission have been omitted as they are not applicable, not
required, or the information required thereby is set forth in
the Financial Statements or the notes thereto.
3. Exhibits - see Exhibit Index on page E-1.
(b) Report on Form 8-K: none
S-1
AMERICAN FINANCIAL CORPORATION - PARENT ONLY (*)
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(In Thousands)
- --------------------------------------------------------------------------------
CONDENSED BALANCE SHEET
-----------------------
December 31
----------------------------
2002 2001
---- ----
ASSETS:
Cash and short-term investments $ 5,778 $ 13,636
Investment in securities 1,152 2,502
Receivables from affiliates 11,376 45,565
Investment in subsidiaries 3,446,378 3,005,541
Other assets 94,232 43,742
---------- ----------
$3,558,916 $3,110,986
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY:
Accounts payable, accrued expenses
and other liabilities $ 65,257 $ 100,201
Payables to affiliates 1,507,922 1,316,159
Long-term debt 256,014 216,695
Shareholders' equity 1,729,723 1,477,931
---------- ----------
$3,558,916 $3,110,986
========== ==========
CONDENSED STATEMENT OF OPERATIONS
---------------------------------
Year Ended December 31,
-----------------------------------
2002 2001 2000
---- ---- ----
INCOME:
Dividends from subsidiaries $ 75,722 $ 60,000 $25,000
Equity in undistributed earnings
of subsidiaries 141,686 45,046 37,570
Realized gains (losses) on investments (33) 849 (9)
Investment and other income 5,242 11,288 16,833
-------- -------- --------
222,617 117,183 79,394
COSTS AND EXPENSES:
Interest charges on intercompany borrowings 28,599 44,212 58,283
Interest charges on other borrowings 6,400 11,794 12,415
Other operating and general expenses 38,288 48,175 55,158
-------- -------- --------
73,287 104,181 125,856
-------- -------- --------
Earnings (loss) before income taxes and
accounting changes 149,330 13,002 (46,462)
Provision (credit) for income taxes 14,620 412 (23,409)
-------- --------- --------
Earnings (loss) before accounting changes 134,710 12,590 (23,053)
Cumulative effect of accounting changes (40,360) (10,040) (9,072)
------- -------- --------
NET EARNINGS (LOSS) $94,350 $ 2,550 ($ 32,125)
======= ======== ========
S-2
AMERICAN FINANCIAL CORPORATION - PARENT ONLY
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT - CONTINUED
(In Thousands)
- -------------------------------------------------------------------------------
CONDENSED STATEMENT OF CASH FLOWS
---------------------------------
Year Ended December 31,
--------------------------------
2002 2001 2000
---- ---- ----
OPERATING ACTIVITIES:
Net earnings (loss) $ 94,350 $ 2,550 ($ 32,125)
Adjustments:
Cumulative effect of accounting changes 40,360 10,040 9,072
Equity in earnings of subsidiaries (118,116) (65,126) (47,903)
Depreciation and amortization 3,510 4,249 1,647
Realized losses (gains) on investments 412 (2,432) 9
Change in receivables from and
payables to affiliates 54,404 54,243 41,095
Increase in other assets (75,655) (33,901) (4,744)
Increase (decrease) in payables (32,931) 32,536 (35,548)
Dividends from subsidiaries 48,450 60,000 25,000
Other, net 1,424 83 894
-------- -------- --------
16,208 62,242 (42,603)
-------- -------- --------
INVESTING ACTIVITIES:
Capital contributions to subsidiaries (156,041) (67,514) -
Purchases of property and equipment (1,429) (4,620) (8,940)
Other, net 1,542 1,233 (1,634)
-------- -------- --------
(155,928) (70,901) (10,574)
-------- -------- --------
FINANCING ACTIVITIES:
Additional long-term borrowings 192,060 135,338 165,800
Reductions of long-term debt (153,414) (112,152) (56,485)
Borrowings from affiliates 128,155 104,377 80,388
Repayments of borrowings from affiliates (38,500) (119,000) (149,525)
Capital contributions from parent 9,333 18,667 18,667
Cash dividends paid (5,772) (5,772) (5,772)
-------- -------- --------
131,862 21,458 53,073
-------- -------- --------
NET INCREASE (DECREASE) IN CASH AND SHORT-TERM INVESTMENTS (7,858) 12,799 (104)
Cash and short-term investments at beginning of period 13,636 837 941
-------- -------- --------
Cash and short-term investments at end of period $ 5,778 $ 13,636 $ 837
======== ======== ========
S-3
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE V - SUPPLEMENTAL INFORMATION CONCERNING
PROPERTY-CASUALTY INSURANCE OPERATIONS
THREE YEARS ENDED DECEMBER 31, 2002
(IN MILLIONS)
--------------- ---------------- --------------- ------------- -----------
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E
--------------- ---------------- --------------- ------------- -----------
(a)
RESERVES FOR
DEFERRED UNPAID CLAIMS (b)
AFFILIATION POLICY AND CLAIMS DISCOUNT (c)
WITH ACQUISITION ADJUSTMENT DEDUCTED IN UNEARNED
REGISTRANT COSTS EXPENSES COLUMN C PREMIUMS
--------------- ---------------- --------------- ------------- -----------
CONSOLIDATED PROPERTY-CASUALTY ENTITIES
---------------------------------------
2002 $251 $5,204 $25 $1,848
==== ====== === ======
2001 $262 $4,778 $24 $1,641
==== ====== === ======
2000
---------------- ------------------- ----------------------- --------------- --------------- -----------
COLUMN F COLUMN G COLUMN H COLUMN I COLUMN J COLUMN K
---------------- ------------------- ----------------------- --------------- --------------- -----------
CLAIMS AND CLAIM
ADJUSTMENT EXPENSES AMORTIZATION PAID
INCURRED RELATED TO OF DEFERRED CLAIMS
NET ------------------- POLICY AND CLAIM
EARNED INVESTMENT CURRENT PRIOR ACQUISITION ADJUSTMENT PREMIUMS
PREMIUMS INCOME YEARS YEARS COSTS EXPENSES WRITTEN
---------------- ------------------- ----------- ----------- --------------- --------------- -----------
2002 $2,403 $294 $1,664 $171 $429 $1,688 $2,414
====== ==== ====== ==== ==== ====== ======
2001 $2,594 $309 $1,950 $163 $556 $1,867 $2,553
====== ==== ====== ==== ==== ====== ======
2000 $2,495 $297 $2,056 ($ 60) $560 $1,841 $2,638
====== ==== ====== ==== ==== ====== ======
(a) Grossed up for reinsurance recoverables of $1,804 and $1,525 at
December 31, 2002 and 2001, respectively.
(b) Discounted at approximately 8%.
(c) Grossed up for prepaid reinsurance premiums of $679 and $477 at
December 31, 2002 and 2001, respectively.
S-4
SIGNATURE
----------
Pursuant to the requirements of Section 13 of the Securities Exchange Act
of 1934, American Financial Corporation has duly caused this Report to be signed
on its behalf by the undersigned, duly authorized.
American Financial Corporation
Signed: September 10, 2003 BY:s/FRED J. RUNK
------------------------------------
Fred J. Runk
Senior Vice President and
Treasurer
INDEX TO EXHIBITS
AMERICAN FINANCIAL CORPORATION
Number Exhibit Description
- ------ -------------------
3(a) Amended and Restated Articles of
Incorporation, filed as Exhibit 3(a)
to AFC's Form 10-K for 1997 (*)
3(b) Code of Regulations, filed as
Exhibit 3(b) to AFC's Form 10-K
for 1997. (*)
4 Instruments defining the rights of The rights of holders of
security holders. Registrant's Preferred Stock are
defined in the Articles of
Incorporation. Registrant has
no outstanding debt issues
exceeding 10% of the assets of
Registrant and consolidated
subsidiaries.
Management Contracts:
10(a) Nonqualified Auxiliary RASP, filed as
Exhibit 10(a) to AFC's Form 10-K for 1998. (*)
10(b) 2002 Annual Bonus Plan, filed as Exhibit 10
to AFC's March 31, 2002 Form 10-Q. (*)
10(c) Deferred Compensation Plan, filed as
Exhibit 10 to AFG's Registration Statement
No. 333-91945 on Form S-8 on December 2, 1999. (*)
10(d) Credit Agreement, dated as of November 25, 2002,
among American Financial Group, Inc., as Guarantor,
AFC Holding Company, as Guarantor, American
Financial Corporation, as Borrower, Fleet National
Bank, Bank of America, N.A. and KeyBank National
Association filed as Exhibit 10 to AFG's
Registration Statement No. 333-102556 on Form S-3
on February 4, 2003. (*)
12 Computation of ratios of earnings
to fixed charges.
21 Subsidiaries of the Registrant, filed as Exhibit 21
to AFG's Form 10-K for 2002. (*)
31(a) Sarbanes-Oxley Section 302(a) Certification of Chief
Executive Officer
31(b) Sarbanes-Oxley Section 302(a) Certification of Chief
Financial Officer
32 Sarbanes-Oxley Section 906 Certification of Chief
Executive Officer and Chief Financial Officer
(*) Incorporated herein by reference.
E-1