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AMERICAN FINANCIAL GROUP INC - Quarter Report: 2017 March (Form 10-Q)

______________________________________________________________________________________________________
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the Quarterly Period Ended March 31, 2017
 
 
 
Commission File No. 1-13653 

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AMERICAN FINANCIAL GROUP, INC.
Incorporated under the Laws of Ohio
 
IRS Employer I.D. No. 31-1544320
301 East Fourth Street, Cincinnati, Ohio 45202
(513) 579-2121
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 þ No ¨
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes þ No ¨
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer  þ                        Accelerated filer  ¨                        Non-accelerated filer  ¨
Smaller reporting company  ¨                        Emerging growth company  ¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ
As of May 1, 2017, there were 87,636,894 shares of the Registrant’s Common Stock outstanding, excluding 14.9 million shares owned by subsidiaries.
______________________________________________________________________________________________________


Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q

TABLE OF CONTENTS
 
 
 
 
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Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q

PART I
ITEM I — FINANCIAL STATEMENTS
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET (UNAUDITED)
(Dollars in Millions)
 
March 31,
2017
 
December 31,
2016
Assets:
 
 
 
Cash and cash equivalents
$
1,890

 
$
2,107

Investments:
 
 
 
Fixed maturities, available for sale at fair value (amortized cost — $35,445 and $33,735)
36,456

 
34,544

Fixed maturities, trading at fair value
359

 
359

Equity securities, available for sale at fair value (cost — $1,356 and $1,351)
1,579

 
1,502

Equity securities, trading at fair value
58

 
56

Mortgage loans
1,159

 
1,147

Policy loans
190

 
192

Equity index call options
573

 
492

Real estate and other investments
1,086

 
1,034

Total cash and investments
43,350

 
41,433

Recoverables from reinsurers
2,735

 
2,737

Prepaid reinsurance premiums
533

 
539

Agents’ balances and premiums receivable
989

 
997

Deferred policy acquisition costs
1,205

 
1,239

Assets of managed investment entities
5,331

 
4,765

Other receivables
875

 
908

Variable annuity assets (separate accounts)
614

 
600

Other assets
1,633

 
1,655

Goodwill
199

 
199

Total assets
$
57,464

 
$
55,072

 
 
 
 
Liabilities and Equity:
 
 
 
Unpaid losses and loss adjustment expenses
$
8,621

 
$
8,563

Unearned premiums
2,174

 
2,171

Annuity benefits accumulated
31,002

 
29,907

Life, accident and health reserves
687

 
691

Payable to reinsurers
621

 
634

Liabilities of managed investment entities
5,101

 
4,549

Long-term debt
1,283

 
1,283

Variable annuity liabilities (separate accounts)
614

 
600

Other liabilities
2,166

 
1,755

Total liabilities
52,269

 
50,153

Shareholders’ equity:
 
 
 
Common Stock, no par value
       — 200,000,000 shares authorized
       — 87,591,671 and 86,924,399 shares outstanding
88

 
87

Capital surplus
1,138

 
1,111

Retained earnings
3,466

 
3,343

Accumulated other comprehensive income, net of tax
499

 
375

Total shareholders’ equity
5,191

 
4,916

Noncontrolling interests
4

 
3

Total equity
5,195

 
4,919

Total liabilities and equity
$
57,464

 
$
55,072


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Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF EARNINGS (UNAUDITED)
(In Millions, Except Per Share Data)
 
Three months ended March 31,
 
2017
 
2016
Revenues:
 
 
 
Property and casualty insurance net earned premiums
$
1,022

 
$
998

Life, accident and health net earned premiums
6

 
6

Net investment income
435

 
411

Realized gains (losses) on securities (*)
3

 
(18
)
Income (loss) of managed investment entities:
 
 
 
Investment income
51

 
45

Gain (loss) on change in fair value of assets/liabilities

 
(13
)
Other income
59

 
46

Total revenues
1,576

 
1,475

 
 
 
 
Costs and Expenses:
 
 
 
Property and casualty insurance:
 
 
 
Losses and loss adjustment expenses
609

 
581

Commissions and other underwriting expenses
339

 
334

Annuity benefits
196

 
228

Life, accident and health benefits
9

 
9

Annuity and supplemental insurance acquisition expenses
53

 
35

Interest charges on borrowed money
21

 
18

Expenses of managed investment entities
41

 
35

Other expenses
85

 
79

Total costs and expenses
1,353

 
1,319

Earnings before income taxes
223

 
156

Provision for income taxes
68

 
52

Net earnings, including noncontrolling interests
155

 
104

Less: Net earnings attributable to noncontrolling interests
2

 
3

Net Earnings Attributable to Shareholders
$
153

 
$
101

 
 
 
 
Earnings Attributable to Shareholders per Common Share:
 
 
 
Basic
$
1.76

 
$
1.16

Diluted
$
1.72

 
$
1.14

Average number of Common Shares:
 
 
 
Basic
87.2

 
86.9

Diluted
89.3

 
88.5

 
 
 
 
Cash dividends per Common Share
$
0.3125

 
$
0.28

________________________________________
 
 
 
(*) Consists of the following:
 
 
 
Realized gains before impairments
$
9

 
$
34

 
 
 
 
Losses on securities with impairment
(6
)
 
(51
)
Non-credit portion recognized in other comprehensive income (loss)

 
(1
)
Impairment charges recognized in earnings
(6
)
 
(52
)
Total realized gains (losses) on securities
$
3

 
$
(18
)

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AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (UNAUDITED)
(In Millions)
 
 
Three months ended March 31,
 
2017
 
2016
Net earnings, including noncontrolling interests
$
155

 
$
104

Other comprehensive income, net of tax:
 
 
 
Net unrealized gains on securities:
 
 
 
Unrealized holding gains on securities arising during the period
125

 
125

Reclassification adjustment for realized (gains) losses included in net earnings

 
11

Total net unrealized gains on securities
125

 
136

Net unrealized gains (losses) on cash flow hedges
(1
)
 
3

Foreign currency translation adjustments

 
6

Pension and other postretirement plans adjustments

 
1

Other comprehensive income, net of tax
124

 
146

Total comprehensive income, net of tax
279

 
250

Less: Comprehensive income attributable to noncontrolling interests
2

 
5

Comprehensive income attributable to shareholders
$
277

 
$
245



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Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY (UNAUDITED)
(Dollars in Millions)
 
 
 
 
 
Shareholders’ Equity
 
 
 
 
Common
Shares
 
 
Common
Stock and
Capital
Surplus
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income
 
Total
 
Noncontrolling
Interests
 
Total
Equity
Balance at December 31, 2016
86,924,399

 
 
$
1,198

 
$
3,343

 
$
375

 
$
4,916

 
$
3

 
$
4,919

Net earnings

 
 

 
153

 

 
153

 
2

 
155

Other comprehensive income

 
 

 

 
124

 
124

 

 
124

Dividends on Common Stock

 
 

 
(27
)
 

 
(27
)
 

 
(27
)
Shares issued:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Exercise of stock options
411,167

 
 
15

 

 

 
15

 

 
15

Restricted stock awards
232,250

 
 

 

 

 

 

 

Other benefit plans
54,453

 
 
5

 

 

 
5

 

 
5

Dividend reinvestment plan
3,277

 
 

 

 

 

 

 

Stock-based compensation expense

 
 
8

 

 

 
8

 

 
8

Shares exchanged — benefit plans
(32,176
)
 
 

 
(3
)
 

 
(3
)
 

 
(3
)
Forfeitures of restricted stock
(1,699
)
 
 

 

 

 

 

 

Other

 
 

 

 

 

 
(1
)
 
(1
)
Balance at March 31, 2017
87,591,671

 
 
$
1,226

 
$
3,466

 
$
499

 
$
5,191

 
$
4

 
$
5,195

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2015
87,474,452

 
 
$
1,301

 
$
2,987

 
$
304

 
$
4,592

 
$
178

 
$
4,770

Net earnings

 
 

 
101

 

 
101

 
3

 
104

Other comprehensive income

 
 

 

 
144

 
144

 
2

 
146

Dividends on Common Stock

 
 

 
(24
)
 

 
(24
)
 

 
(24
)
Shares issued:
 
 
 
 
 
 
 
 
 

 
 
 

Exercise of stock options
279,165

 
 
10

 

 

 
10

 

 
10

Restricted stock awards
317,230

 
 

 

 

 

 

 

Other benefit plans
47,566

 
 
3

 

 

 
3

 

 
3

Dividend reinvestment plan
3,736

 
 

 

 

 

 

 

Stock-based compensation expense

 
 
7

 

 

 
7

 

 
7

Shares acquired and retired
(1,128,128
)
 
 
(16
)
 
(60
)
 

 
(76
)
 

 
(76
)
Shares exchanged — benefit plans
(27,551
)
 
 

 
(2
)
 

 
(2
)
 

 
(2
)
Forfeitures of restricted stock
(180
)
 
 

 

 

 

 

 

Other

 
 

 

 

 

 
(1
)
 
(1
)
Balance at March 31, 2016
86,966,290

 
 
$
1,305

 
$
3,002

 
$
448

 
$
4,755

 
$
182

 
$
4,937


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Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Millions)
 
Three months ended March 31,
 
2017
 
2016
Operating Activities:
 
 
 
Net earnings, including noncontrolling interests
$
155

 
$
104

Adjustments:
 
 
 
Depreciation and amortization
38

 
28

Annuity benefits
196

 
228

Realized (gains) losses on investing activities
(17
)
 
15

Net sales of trading securities
3

 
71

Deferred annuity and life policy acquisition costs
(67
)
 
(68
)
Change in:
 
 
 
Reinsurance and other receivables
63

 
197

Other assets
(58
)
 
2

Insurance claims and reserves
57

 
(26
)
Payable to reinsurers
(13
)
 
(90
)
Other liabilities
45

 
15

Managed investment entities’ assets/liabilities
(487
)
 
(55
)
Other operating activities, net
9

 
(13
)
Net cash provided by (used in) operating activities
(76
)
 
408

 
 
 
 
Investing Activities:
 
 
 
Purchases of:
 
 
 
Fixed maturities
(2,879
)
 
(2,125
)
Equity securities
(22
)
 
(74
)
Mortgage loans
(23
)
 
(131
)
Equity index call options and other investments
(181
)
 
(139
)
Real estate, property and equipment
(11
)
 
(18
)
Proceeds from:
 
 
 
Maturities and redemptions of fixed maturities
1,511

 
840

Repayments of mortgage loans
12

 
101

Sales of fixed maturities
38

 
225

Sales of equity securities
14

 
55

Sales and settlements of equity index call options and other investments
174

 
4

Sales of real estate, property and equipment
24

 
5

Managed investment entities:
 
 
 
Purchases of investments
(910
)
 
(239
)
Proceeds from sales and redemptions of investments
1,058

 
290

Other investing activities, net
1

 
(63
)
Net cash used in investing activities
(1,194
)
 
(1,269
)
 
 
 
 
Financing Activities:
 
 
 
Annuity receipts
1,290

 
1,435

Annuity surrenders, benefits and withdrawals
(567
)
 
(503
)
Net transfers from variable annuity assets
17

 
9

Issuances of managed investment entities’ liabilities
537

 
31

Retirements of managed investment entities’ liabilities
(212
)
 
(11
)
Issuances of Common Stock
15

 
13

Repurchases of Common Stock

 
(76
)
Cash dividends paid on Common Stock
(27
)
 
(24
)
Other financing activities, net

 
(2
)
Net cash provided by financing activities
1,053

 
872

Net Change in Cash and Cash Equivalents
(217
)
 
11

Cash and cash equivalents at beginning of period
2,107

 
1,220

Cash and cash equivalents at end of period
$
1,890

 
$
1,231


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Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 


INDEX TO NOTES
 
 
 
 
 
 
A.
Accounting Policies
 
I.
Goodwill and Other Intangibles
 
B.
Acquisition of Business
 
J.
Long-Term Debt
 
C.
Segments of Operations
 
K.
Shareholders’ Equity
 
D.
Fair Value Measurements
 
L.
Income Taxes
 
E.
Investments
 
M.
Contingencies
 
F.
Derivatives
 
N.
Insurance
 
G.
Deferred Policy Acquisition Costs
 
O.
Subsequent Event
 
H.
Managed Investment Entities
 
 
 
 
 
 
 
 
 
 

A.     Accounting Policies

Basis of Presentation   The accompanying consolidated financial statements for American Financial Group, Inc. and its subsidiaries (“AFG”) are unaudited; however, management believes that all adjustments (consisting only of normal recurring accruals unless otherwise disclosed herein) necessary for fair presentation have been made. The results of operations for interim periods are not necessarily indicative of results to be expected for the year. The financial statements have been prepared in accordance with the instructions to Form 10-Q and, therefore, do not include all information and footnotes necessary to be in conformity with U.S. generally accepted accounting principles (“GAAP”).
 
Certain reclassifications have been made to prior periods to conform to the current year’s presentation. All significant intercompany balances and transactions have been eliminated. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. Events or transactions occurring subsequent to March 31, 2017, and prior to the filing of this Form 10-Q, have been evaluated for potential recognition or disclosure herein.
 
The preparation of the financial statements 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.

Fair Value Measurements   Accounting standards define fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The standards establish a hierarchy of valuation techniques based on whether the assumptions that market participants would use in pricing the asset or liability (“inputs”) are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect AFG’s assumptions about the assumptions market participants would use in pricing the asset or liability. AFG did not have any significant nonrecurring fair value measurements in the first three months of 2017.

Investments   Fixed maturity and equity securities classified as “available for sale” are reported at fair value with unrealized gains and losses included in accumulated other comprehensive income (“AOCI”) in AFG’s Balance Sheet. Fixed maturity and equity securities classified as “trading” are reported at fair value with changes in unrealized holding gains or losses during the period included in net investment income. Mortgage and policy loans are carried primarily at the aggregate unpaid balance.

In January 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-01, which, among other things, will require all equity securities currently classified as “available for sale” to be reported at fair value, with holding gains and losses recognized in net income, instead of AOCI. AFG will be required to adopt this guidance effective January 1, 2018.

Premiums and discounts on fixed maturity securities are amortized using the interest method. Mortgage-backed securities (“MBS”) 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.
 
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 at the balance sheet date, a provision for impairment is charged to earnings (included in realized gains (losses) on securities) and the cost basis of that investment is reduced. If management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will have to sell the security

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Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


before recovery of its amortized cost basis, then the other-than-temporary impairment is separated into two components: (i) the amount related to credit losses (recorded in earnings) and (ii) the amount related to all other factors (recorded in other comprehensive income). The credit-related portion of an other-than-temporary impairment is measured by comparing a security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. Both components are shown in the statement of earnings. If management intends to sell an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge to earnings is recorded to reduce the amortized cost of that security to fair value.
 
Derivatives   Derivatives included in AFG’s Balance Sheet are recorded at fair value. Changes in fair value of derivatives are included in earnings, unless the derivatives are designated and qualify as highly effective cash flow hedges. Derivatives that do not qualify for hedge accounting under GAAP consist primarily of (i) components of certain fixed maturity securities (primarily interest-only MBS) and (ii) the equity-based component of certain annuity products (included in annuity benefits accumulated) and related equity index call options designed to be consistent with the characteristics of the liabilities and used to mitigate the risk embedded in those annuity products.

To qualify for hedge accounting, at the inception of a derivative contract, AFG formally documents the relationship between the terms of the hedge and the hedged items and its risk management objective. This documentation includes defining how hedge effectiveness and ineffectiveness will be measured on a retrospective and prospective basis.

Changes in the fair value of derivatives that are designated and qualify as highly effective cash flow hedges are recorded in AOCI and are reclassified into earnings when the variability of the cash flows from the hedged items impacts earnings. Any hedge ineffectiveness is immediately recorded in current period earnings. When the change in the fair value of a qualifying cash flow hedge is included in earnings, it is included in the same line item in the statement of earnings as the cash flows from the hedged item. AFG uses interest rate swaps that are designated and qualify as highly effective cash flow hedges to mitigate interest rate risk related to certain floating-rate securities included in AFG’s portfolio of fixed maturity securities.

For derivatives that are designated and qualify as highly effective fair value hedges, changes in the fair value of the derivative, along with changes in the fair value of the hedged item attributable to the hedged risk, are recognized in current period earnings. AFG has entered into an interest rate swap that qualifies as a highly effective fair value hedge to mitigate the interest rate risk associated with fixed-rate long-term debt by economically converting certain fixed-rate debt obligations to floating-rate obligations. Since the terms of the swap match the terms of the hedged debt, changes in the fair value of the swap are offset by changes in the fair value of the hedged debt attributable to changes in interest rates. Accordingly, the net impact on AFG’s current period earnings is that the interest expense associated with the hedged debt is effectively recorded at the floating rate.

Goodwill   Goodwill represents the excess of cost of subsidiaries over AFG’s equity in their underlying net assets. Goodwill is not amortized, but is subject to an impairment test at least annually. An entity is not required to complete the quantitative annual goodwill impairment test on a reporting unit if the entity elects to perform a qualitative analysis and determines that it is more likely than not that the reporting unit’s fair value exceeds its carrying amount.
 
Reinsurance   Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. AFG’s property and casualty insurance subsidiaries report as assets (i) the estimated reinsurance recoverable on paid and unpaid losses, including an estimate for losses incurred but not reported, and (ii) amounts paid or due to reinsurers applicable to the unexpired terms of policies in force. Payable to reinsurers includes ceded premiums due to reinsurers, as well as ceded premiums retained by AFG’s property and casualty insurance subsidiaries under contracts to fund ceded losses as they become due. AFG’s insurance subsidiaries also assume reinsurance from other companies. Earnings on reinsurance assumed is recognized based on information received from ceding companies.
 
An AFG subsidiary cedes life insurance policies to a third party on a funds withheld basis whereby the subsidiary retains the assets (securities) associated with the reinsurance contract. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. This reinsurance contract is considered to contain an embedded derivative (that must be adjusted to fair value) because the yield on the payable is based on a specific block of the ceding company’s assets, rather than the overall creditworthiness of the ceding company. AFG determined that changes in the fair value of the underlying portfolio of fixed maturity securities is an appropriate measure of the value of the embedded derivative. The securities related to this contract are classified as “trading.” The adjustment to fair value on the embedded derivative offsets the investment income recorded on the adjustment to fair value of the related trading portfolio.
 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


Deferred Policy Acquisition Costs (“DPAC”)   Policy acquisition costs (principally commissions, premium taxes and certain underwriting and policy issuance costs) directly related to the successful acquisition or renewal of an insurance contract are deferred. DPAC also includes capitalized costs associated with sales inducements offered to fixed annuity policyholders such as enhanced interest rates and premium and persistency bonuses.
 
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. A premium deficiency is recognized if the sum of expected claims costs, claims adjustment expenses and unamortized acquisition costs exceed the related unearned premiums. A premium deficiency is first recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency is greater than unamortized acquisition costs, a liability is accrued for the excess deficiency and reported with unpaid losses and loss adjustment expenses.

DPAC related to annuities is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of actual and expected gross profits on the policies. Expected gross profits consist principally of estimated future investment margin (estimated future net investment income less interest credited on policyholder funds) and surrender, mortality, and other life and annuity policy charges, less death, annuitization and guaranteed withdrawal benefits in excess of account balances and estimated future policy administration expenses. 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 (losses) on securities.

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. See Life, Accident and Health Reserves below for details on the impact of loss recognition on the accounting for traditional life and health insurance contracts.

DPAC includes the present value of future profits on business in force of annuity and life, accident and health insurance companies acquired (“PVFP”). PVFP represents the portion of the costs to acquire companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. PVFP is amortized with interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.

DPAC and certain other balance sheet amounts related to annuity, long-term care and life businesses are also adjusted, net of tax, for the change in expense that would have been recorded if the unrealized gains (losses) from securities had actually been realized. These adjustments are included in unrealized gains (losses) on marketable securities, a component of AOCI in AFG’s Balance Sheet.
 
Managed Investment Entities   A company is considered the primary beneficiary of, and therefore must consolidate, a variable interest entity (“VIE”) based primarily on its ability to direct the activities of the VIE that most significantly impact that entity’s economic performance and the obligation to absorb losses of, or receive benefits from, the entity that could potentially be significant to the VIE.
 
AFG manages, and has investments in, collateralized loan obligations (“CLOs”) that are VIEs (see Note H — “Managed Investment Entities). AFG has determined that it is the primary beneficiary of the CLOs because (i) its role as asset manager gives it the power to direct the activities that most significantly impact the economic performance of the CLOs and (ii) through its investment in the CLO debt tranches, it has exposure to CLO losses (limited to the amount AFG invested) and the right to receive CLO benefits that could potentially be significant to the CLOs.

Because AFG has no right to use the CLO assets and no obligation to pay the CLO liabilities, the assets and liabilities of the CLOs are shown separately in AFG’s Balance Sheet. AFG has elected the fair value option for reporting on the CLO assets and liabilities to improve the transparency of financial reporting related to the CLOs. The net gain or loss from accounting for the CLO assets and liabilities at fair value is presented separately in AFG’s Statement of Earnings.

The fair values of a CLO’s assets may differ from the separately measured fair values of its liabilities even though the CLO liabilities only have recourse to the CLO assets. AFG has set the carrying value of the CLO liabilities equal to the fair value of the CLO assets (which have more observable fair values) as an alternative to reporting those liabilities at a separately measured fair value. CLO earnings attributable to AFG’s shareholders are measured by the change in the fair value of AFG’s investments in the CLOs and management fees earned.

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AMERICAN FINANCIAL GROUP, INC. 10-Q
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 represent management’s best estimate and are based upon (i) the accumulation of case estimates for losses reported prior to the close of the accounting period on direct business written; (ii) estimates received from ceding reinsurers and insurance pools and associations; (iii) estimates of unreported losses (including possible development on known claims) based on past experience; (iv) estimates based on experience of expenses for investigating and adjusting claims; and (v) the current state of the law and coverage litigation. Establishing reserves for asbestos, environmental and other mass tort 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 earnings in the period in which determined. Despite 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 policy charges are credited to other income.
 
For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses, guaranteed withdrawals and excess benefits expected to be paid on future deaths and annuitizations (“EDAR”). The liabilities for EDAR and guaranteed withdrawals are accrued for and modified using assumptions consistent with those used in determining DPAC and DPAC amortization, except that amounts are determined in relation to the present value of total expected assessments. Total expected assessments consist principally of estimated future investment margin, surrender, mortality, and other life and annuity policy charges, and unearned revenues once they are recognized as income.
 
Annuity benefits accumulated also includes amounts advanced from the Federal Home Loan Bank of Cincinnati.
 
Unearned Revenue   Certain upfront policy charges on annuities are deferred as unearned revenue (included in other liabilities) and recognized in net earnings (included in other income) using the same assumptions and estimated gross profits used to amortize DPAC.

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 unless a loss recognition event (premium deficiency) occurs. Claim reserves and liabilities established for accident and health claims are modified as necessary to reflect actual experience and developing trends.

For long-duration contracts (such as traditional life and long-term care policies), loss recognition occurs when, based on current expectations as of the measurement date, existing contract liabilities plus the present value of future premiums (including reasonably expected rate increases) are not expected to cover the present value of future claims payments and related settlement and maintenance costs (excluding overhead) as well as unamortized acquisition costs. If a block of business is determined to be in loss recognition, a charge is recorded in earnings in an amount equal to the excess of the present value of expected future claims costs and unamortized acquisition costs over existing reserves plus the present value of expected future premiums (with no provision for adverse deviation). The charge is recorded first to reduce unamortized acquisition costs and then as an additional reserve (if unamortized acquisition costs have been reduced to zero).

In addition, reserves for traditional life and long-term care policies are subject to adjustment for loss recognition charges that would have been recorded if the unrealized gains from securities had actually been realized. This adjustment is included in unrealized gains (losses) on marketable securities, a component of AOCI in AFG’s Balance Sheet.

Debt Issuance Costs   Debt issuance costs related to AFG’s outstanding debt are presented in its Balance Sheet as a direct reduction in the carrying value of long-term debt and are amortized over the life of the related debt using the effective interest method as a component of interest expense. Debt issuance costs related to AFG’s revolving credit facilities are included in other assets in AFG’s Balance Sheet.


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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


Variable Annuity Assets and Liabilities   Separate accounts related to variable annuities represent the fair value of deposits invested in underlying investment funds on which AFG earns a fee. Investment funds are selected and may be changed only by the policyholder, who retains all investment risk.

AFG’s variable annuity contracts contain a guaranteed minimum death benefit (“GMDB”) to be paid if the policyholder dies before the annuity payout period commences. In periods of declining equity markets, the GMDB may exceed the value of the policyholder’s account. A GMDB liability is established for future excess death benefits using assumptions together with a range of reasonably possible scenarios for investment fund performance that are consistent with DPAC capitalization and amortization assumptions.

Premium Recognition   Property and casualty premiums are earned generally 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 information 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.

Noncontrolling Interests   For balance sheet purposes, noncontrolling interests represents the interests of shareholders other than AFG in consolidated entities. In the statement of earnings, net earnings and losses attributable to noncontrolling interests represents such shareholders’ interest in the earnings and losses of those entities.

Income Taxes   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. A valuation allowance is established to reduce total deferred tax assets to an amount that will more likely than not be realized.

AFG recognizes the tax benefits of uncertain tax positions only when the position is more likely than not to be sustained under examination by the appropriate taxing authority. Interest and penalties on AFG’s reserve for uncertain tax positions are recognized as a component of tax expense.

Stock-Based Compensation   All share-based grants are recognized as compensation expense on a straight-line basis over their vesting periods based on their calculated fair value at the date of grant. AFG uses the Black Scholes pricing model to measure the fair value of employee stock options. See Note K — “Shareholders’ Equity for further information.

In the fourth quarter of 2016, AFG adopted ASU 2016-09, which, among other things, requires excess tax benefits or deficiencies for share-based payments to be recorded through income tax expense in the statement of earnings instead of directly to capital surplus (as required under the previous guidance). In addition, under the new guidance, AFG elected to account for forfeitures of awards when they occur rather than accruing expense based on an estimate of expected forfeitures (as required under the previous guidance). The resulting cumulative effect of accounting change of less than $1 million was recorded directly to retained earnings on January 1, 2016.

Benefit Plans   AFG provides retirement benefits to qualified employees of participating companies through the AFG 401(k) Retirement and Savings Plan, a defined contribution plan. AFG makes all contributions to the retirement fund portion of the plan and matches a percentage of employee contributions to the savings fund. Company contributions are expensed in the year for which they are declared. AFG and many of its subsidiaries provide health care and life insurance benefits to eligible retirees. AFG also provides postemployment benefits to former or inactive employees (primarily those on disability) who were not deemed retired under other company plans. The projected future cost of providing these benefits is expensed over the period employees earn such benefits.

Earnings Per Share   Although basic earnings per share only considers shares of common stock outstanding during the period, the calculation of diluted earnings per share includes the following adjustments to weighted average common shares related to stock-based compensation plans: first three months of 2017 and 20162.1 million and 1.6 million, respectively.
 
AFG’s weighted average diluted shares outstanding for the first three months of 2016 excludes 0.8 million anti-dilutive potential common shares related to stock compensation plans. There were no anti-dilutive potential common shares for the first three months of 2017.

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


 
Statement of Cash Flows   For cash flow purposes, “investing activities” are defined as making and collecting loans and acquiring and disposing of debt or equity instruments and property and equipment. “Financing activities” include obtaining resources from owners and providing them with a return on their investments, borrowing money and repaying amounts borrowed. Annuity receipts, surrenders, 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.

Effective October 1, 2016, AFG early adopted (on a retrospective basis) ASU 2016-15, which addresses the diversity in practice in how certain cash receipts and cash payments are presented in the statement of cash flows. Among other things, this guidance requires proceeds received from the settlement of corporate-owned life insurance policies to be classified as cash inflows from investing activities and allows premiums paid for policies to be reported as cash outflows either from investing activities or operating activities. AFG has elected to show all corporate-owned life insurance activity in investing activities. Prior to adoption of this guidance, AFG accounted for these transactions as operating activities. In addition, ASU 2016-15 clarifies when distributions received from investees accounted under the equity method should be accounted for as a cash inflow from operating activities or as a cash inflow from investing activities. AFG had previously accounted for all distributions from investments accounted for under the equity method as investing activities. The new guidance solely related to the presentation of certain transactions in the statement of cash flows. Accordingly, adoption of this guidance did not impact AFG’s results of operations or financial position.

Revenue Recognition Guidance Effective in 2018 In May 2014, the FASB issued ASU 2014-09, which requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Revenue is recognized when (or as) the entity satisfies a performance obligation under the contract. The new guidance also updates the accounting for certain costs associated with obtaining and fulfilling contracts with customers and requires disclosures regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. Revenue recognition for insurance contracts and financial instruments, which are AFG’s primary sources of revenue, is excluded from the scope of the new guidance. AFG will adopt the new guidance effective January 1, 2018. Because the new guidance does not apply to the vast majority of AFG’s business, management does not expect the adoption of this guidance to have a material impact on AFG’s results of operations or financial position. Based on implementation efforts to date, management believes that the new standard would only have applied to 2% of AFG’s 2016 consolidated revenues.

B.     Acquisition of Business

Acquisition of Noncontrolling Interest in National Interstate Corporation   In November 2016, AFG acquired the 49% of National Interstate Corporation (“NATL”) not previously owned by AFG’s wholly-owned subsidiary, Great American Insurance Company, for $315 million ($32.00 per share) in a merger transaction. In addition, NATL paid a one-time special cash dividend of $0.50 per share to its shareholders immediately prior to the merger closing. Because NATL was already a consolidated subsidiary of AFG prior to the merger, the acquisition was accounted for as an equity transaction.

C.    Segments of Operations

AFG manages its business as four segments: (i) Property and casualty insurance, (ii) Annuity, (iii) Run-off long-term care and life and (iv) Other, which includes holding company costs.

AFG reports its property and casualty insurance business in the following Specialty sub-segments: (i) Property and transportation, which includes physical damage and liability coverage for buses, trucks and recreational vehicles, inland and ocean marine, agricultural-related products and other property coverages, (ii) Specialty casualty, which includes primarily excess and surplus, general liability, executive liability, professional liability, umbrella and excess liability, specialty coverage in targeted markets, customized programs for small to mid-sized businesses and workers’ compensation insurance, and (iii) Specialty financial, which includes risk management insurance programs for leasing and financing institutions (including collateral and lender-placed mortgage property insurance), surety and fidelity products and trade credit insurance. Premiums and underwriting profit included under Other specialty represent business assumed by AFG’s internal reinsurance program from the operations that make up AFG’s other Specialty sub-segments and amortization of deferred gains on retroactive reinsurance transactions related to the sales of businesses in prior years. AFG’s annuity business markets traditional fixed and fixed-indexed annuities in the retail, financial institutions and education markets. AFG’s reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED



The following tables (in millions) show AFG’s revenues and earnings before income taxes by segment and sub-segment.
 
Three months ended March 31,
 
2017
 
2016
Revenues
 
 
 
Property and casualty insurance:
 
 
 
Premiums earned:
 
 
 
Specialty
 
 
 
Property and transportation
$
342

 
$
339

Specialty casualty
508

 
502

Specialty financial
147

 
132

Other specialty
25

 
25

Total premiums earned
1,022

 
998

Net investment income
86

 
83

Other income (a)
16

 
3

Total property and casualty insurance
1,124

 
1,084

Annuity:
 
 
 
Net investment income
347

 
315

Other income
27

 
26

Total annuity
374

 
341

Run-off long-term care and life
12

 
12

Other
63

 
56

Total revenues before realized gains (losses)
1,573

 
1,493

Realized gains (losses) on securities
3

 
(18
)
Total revenues
$
1,576

 
$
1,475

Earnings Before Income Taxes
 
 
 
Property and casualty insurance:
 
 
 
Underwriting:
 
 
 
Specialty
 
 
 
Property and transportation
$
43

 
$
32

Specialty casualty
15

 
29

Specialty financial
22

 
23

Other specialty
(1
)
 
2

Other lines
(1
)
 
1

Total underwriting
78

 
87

Investment and other income, net (a)
93

 
75

Total property and casualty insurance
171

 
162

Annuity
96

 
53

Run-off long-term care and life

 
(1
)
Other (b)
(47
)
 
(40
)
Total earnings before realized gains (losses) and income taxes
220

 
174

Realized gains (losses) on securities
3

 
(18
)
Total earnings before income taxes
$
223

 
$
156

(a)
Includes pretax income of $13 million (before noncontrolling interest) from the sale of a hotel in the first quarter of 2017.
(b)
Includes holding company interest and expenses.

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


D.    Fair Value Measurements

Accounting standards for measuring fair value are based on inputs used in estimating fair value. The three levels of the hierarchy are as follows:
 
Level 1 — Quoted prices for identical assets or liabilities in active markets (markets in which transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis). AFG’s Level 1 financial instruments consist primarily of publicly traded equity securities and highly liquid government bonds for which quoted market prices in active markets are available and short-term investments of managed investment entities.

Level 2 — Quoted prices for similar instruments in active markets; quoted prices for identical or similar assets or liabilities in inactive markets (markets in which there are few transactions, the prices are not current, price quotations vary substantially over time or among market makers, or in which little information is released publicly); and valuations based on other significant inputs that are observable in active markets. AFG’s Level 2 financial instruments include separate account assets, corporate and municipal fixed maturity securities, mortgage-backed securities (“MBS”) and investments of managed investment entities priced using observable inputs. Level 2 inputs include benchmark yields, reported trades, corroborated broker/dealer quotes, issuer spreads and benchmark securities. When non-binding broker quotes can be corroborated by comparison to similar securities priced using observable inputs, they are classified as Level 2.

Level 3 — Valuations derived from market valuation techniques generally consistent with those used to estimate the fair values of Level 2 financial instruments in which one or more significant inputs are unobservable or when the market for a security exhibits significantly less liquidity relative to markets supporting Level 2 fair value measurements. The unobservable inputs may include management’s own assumptions about the assumptions market participants would use based on the best information available in the circumstances. AFG’s Level 3 is comprised of financial instruments whose fair value is estimated based on non-binding broker quotes or internally developed using significant inputs not based on, or corroborated by, observable market information.

As discussed in Note A — Accounting Policies — Managed Investment Entities,” AFG has set the carrying value of the CLO liabilities equal to the fair value of the CLO assets (which have more observable fair values) as an alternative to reporting those liabilities at a separately measured fair value. As a result, the CLO liabilities are categorized within the fair value hierarchy on the same basis (proportionally) as the related CLO assets. Since the portion of the CLO liabilities allocated to Level 3 is derived from the fair value of the CLO assets, these amounts are excluded from the progression of Level 3 financial instruments.

AFG’s management is responsible for the valuation process and uses data from outside sources (including nationally recognized pricing services and broker/dealers) in establishing fair value. AFG’s internal investment professionals are a group of approximately 25 analysts whose primary responsibility is to manage AFG’s investment portfolio. These professionals monitor individual investments as well as overall industries and are active in the financial markets on a daily basis. The group is led by AFG’s chief investment officer, who reports directly to one of AFG’s Co-CEOs. Valuation techniques utilized by pricing services and prices obtained from external sources are reviewed by AFG’s internal investment professionals who are familiar with the securities being priced and the markets in which they trade to ensure the fair value determination is representative of an exit price. To validate the appropriateness of the prices obtained, these investment managers consider widely published indices (as benchmarks), recent trades, changes in interest rates, general economic conditions and the credit quality of the specific issuers. In addition, the Company communicates directly with the pricing services regarding the methods and assumptions used in pricing, including verifying, on a test basis, the inputs used by the service to value specific securities.

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


Assets and liabilities measured and carried at fair value in the financial statements are summarized below (in millions): 
 
Level 1
 
Level 2
 
Level 3
 
Total
March 31, 2017
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
Available for sale (“AFS”) fixed maturities:
 
 
 
 
 
 
 
U.S. Government and government agencies
$
122

 
$
158

 
$
8

 
$
288

States, municipalities and political subdivisions

 
6,758

 
143

 
6,901

Foreign government

 
138

 

 
138

Residential MBS

 
3,541

 
175

 
3,716

Commercial MBS

 
1,224

 
29

 
1,253

Asset-backed securities (“ABS”)

 
5,998

 
594

 
6,592

Corporate and other
30

 
16,710

 
828

 
17,568

Total AFS fixed maturities
152

 
34,527

 
1,777

 
36,456

Trading fixed maturities
26

 
333

 

 
359

Equity securities — AFS and trading
1,383

 
81

 
173

 
1,637

Assets of managed investment entities (“MIE”)
896

 
4,409

 
26

 
5,331

Variable annuity assets (separate accounts) (*)

 
614

 

 
614

Equity index call options

 
573

 

 
573

Other assets — derivatives

 

 

 

Total assets accounted for at fair value
$
2,457

 
$
40,537

 
$
1,976

 
$
44,970

Liabilities:
 
 
 
 
 
 
 
Liabilities of managed investment entities
$
857

 
$
4,219

 
$
25

 
$
5,101

Derivatives in annuity benefits accumulated

 

 
1,963

 
1,963

Derivatives in long-term debt

 

 

 

Other liabilities — derivatives

 
32

 

 
32

Total liabilities accounted for at fair value
$
857

 
$
4,251

 
$
1,988

 
$
7,096

 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
Available for sale fixed maturities:
 
 
 
 
 
 
 
U.S. Government and government agencies
$
133

 
$
174

 
$
8

 
$
315

States, municipalities and political subdivisions

 
6,641

 
140

 
6,781

Foreign government

 
136

 

 
136

Residential MBS

 
3,445

 
190

 
3,635

Commercial MBS

 
1,468

 
25

 
1,493

Asset-backed securities

 
5,475

 
484

 
5,959

Corporate and other
29

 
15,484

 
712

 
16,225

Total AFS fixed maturities
162

 
32,823

 
1,559

 
34,544

Trading fixed maturities
30

 
329

 

 
359

Equity securities — AFS and trading
1,305

 
79

 
174

 
1,558

Assets of managed investment entities
380

 
4,356

 
29

 
4,765

Variable annuity assets (separate accounts) (*)

 
600

 

 
600

Equity index call options

 
492

 

 
492

Other assets — derivatives

 
1

 

 
1

Total assets accounted for at fair value
$
1,877

 
$
38,680

 
$
1,762

 
$
42,319

Liabilities:
 
 
 
 
 
 
 
Liabilities of managed investment entities
$
363

 
$
4,158

 
$
28

 
$
4,549

Derivatives in annuity benefits accumulated

 

 
1,759

 
1,759

Derivatives in long-term debt

 
(1
)
 

 
(1
)
Other liabilities — derivatives

 
30

 

 
30

Total liabilities accounted for at fair value
$
363

 
$
4,187

 
$
1,787

 
$
6,337

(*)
Variable annuity liabilities equal the fair value of variable annuity assets.

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED



Transfers between Level 1 and Level 2 for all periods presented were a result of increases or decreases in observable trade activity.

During the first three months of 2017, there were no transfers between Level 1 and Level 2. During the first three months of 2016, there was one perpetual preferred stock with a fair value of $8 million transferred from Level 2 to Level 1 and three perpetual preferred stocks with an aggregate fair value of $6 million transferred from Level 1 to Level 2.

Approximately 4% of the total assets carried at fair value on March 31, 2017, were Level 3 assets. Approximately 75% ($1.49 billion) of the Level 3 assets were priced using non-binding broker quotes, for which there is a lack of transparency as to the inputs used to determine fair value. Details as to the quantitative inputs are neither provided by the brokers nor otherwise reasonably obtainable by AFG. Since internally developed Level 3 asset fair values represent less than 10% of AFG’s Shareholders’ Equity, any justifiable changes in unobservable inputs used to determine internally developed fair values would not have a material impact on AFG’s financial position.

The only significant Level 3 assets or liabilities carried at fair value in the financial statements that were not measured using broker quotes are the derivatives embedded in AFG’s fixed-indexed annuity liabilities, which are measured using a discounted cash flow approach and had a fair value of $1.96 billion at March 31, 2017. The following table presents information about the unobservable inputs used by management in determining fair value of these embedded derivatives. See Note F — “Derivatives.”

 
Unobservable Input
 
Range
 
 
Adjustment for insurance subsidiary’s credit risk
 
0.2% – 2.8% over the risk free rate
 
 
Risk margin for uncertainty in cash flows
 
0.68% reduction in the discount rate
 
 
Surrenders
 
3% – 21% of indexed account value
 
 
Partial surrenders
 
2% – 10% of indexed account value
 
 
Annuitizations
 
0.1% – 1% of indexed account value
 
 
Deaths
 
1.5% – 8.0% of indexed account value
 
 
Budgeted option costs
 
2.4% – 3.6% of indexed account value
 

The range of adjustments for insurance subsidiary’s credit risk reflects credit spread variations across the yield curve. The range of projected surrender rates reflects the specific surrender charges and other features of AFG’s individual fixed-indexed annuity products with an expected range of 6% to 10% in the majority of future calendar years (3% to 21% over all periods). Increasing the budgeted option cost or risk margin for uncertainty in cash flows assumptions in the table above would increase the fair value of the fixed-indexed annuity embedded derivatives, while increasing any of the other unobservable inputs in the table above would decrease the fair value of the embedded derivatives.


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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


Changes in balances of Level 3 financial assets and liabilities carried at fair value during the first three months of 2017 and 2016 are presented below (in millions). The transfers into and out of Level 3 were due to changes in the availability of market observable inputs. All transfers are reflected in the table at fair value as of the end of the reporting period.

 
 
 
Total realized/unrealized
gains (losses) included in
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2016
 
Net
income
 
Other
comprehensive
income (loss)
 
Purchases
and
issuances
 
Sales and
settlements
 
Transfer
into
Level 3
 
Transfer
out of
Level 3
 
Balance at March 31, 2017
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agency
$
8

 
$

 
$

 
$

 
$

 
$

 
$

 
$
8

State and municipal
140

 

 
3

 

 

 

 

 
143

Residential MBS
190

 
1

 

 
1

 
(8
)
 
7

 
(16
)
 
175

Commercial MBS
25

 

 

 

 

 
4

 

 
29

Asset-backed securities
484

 

 

 
104

 
(11
)
 
17

 

 
594

Corporate and other
712

 
1

 
4

 
120

 
(38
)
 
29

 

 
828

Total AFS fixed maturities
1,559

 
2

 
7

 
225

 
(57
)
 
57

 
(16
)
 
1,777

Equity securities
174

 
(6
)
 
7

 
12

 

 

 
(14
)
 
173

Assets of MIE
29

 
(1
)
 

 
2

 

 

 
(4
)
 
26

Total Level 3 assets
$
1,762

 
$
(5
)
 
$
14

 
$
239

 
$
(57
)
 
$
57

 
$
(34
)
 
$
1,976

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Embedded derivatives
$
(1,759
)
 
$
(147
)
 
$

 
$
(79
)
 
$
22

 
$

 
$

 
$
(1,963
)
Total Level 3 liabilities (*)
$
(1,759
)
 
$
(147
)
 
$

 
$
(79
)
 
$
22

 
$

 
$

 
$
(1,963
)


 
 
 
Total realized/unrealized
gains (losses) included in
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2015
 
Net
income
 
Other
comprehensive
income (loss)
 
Purchases
and
issuances
 
Sales and
settlements
 
Transfer
into
Level 3
 
Transfer
out of
Level 3
 
Balance at March 31, 2016
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agency
$
15

 
$

 
$

 
$

 
$

 
$

 
$

 
$
15

State and municipal
89

 

 
3

 

 

 

 

 
92

Residential MBS
224

 
1

 

 

 
(7
)
 
11

 
(16
)
 
213

Commercial MBS
39

 

 

 

 
(1
)
 

 

 
38

Asset-backed securities
470

 

 
(6
)
 
4

 
(8
)
 
41

 

 
501

Corporate and other
633

 
(2
)
 
15

 
86

 
(7
)
 
5

 

 
730

Total AFS fixed maturities
1,470

 
(1
)
 
12

 
90

 
(23
)
 
57

 
(16
)
 
1,589

Equity securities
140

 
(17
)
 
8

 
12

 

 
15

 

 
158

Assets of MIE
26

 
(2
)
 

 

 

 

 

 
24

Total Level 3 assets
$
1,636

 
$
(20
)
 
$
20

 
$
102

 
$
(23
)
 
$
72

 
$
(16
)
 
$
1,771

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Embedded derivatives
$
(1,369
)
 
$
(17
)
 
$

 
$
(82
)
 
$
18

 
$

 
$

 
$
(1,450
)
Total Level 3 liabilities (*)
$
(1,369
)
 
$
(17
)
 
$

 
$
(82
)
 
$
18

 
$

 
$

 
$
(1,450
)

(*)
As discussed previously, these tables exclude the portion of MIE liabilities allocated to Level 3, which are derived from the fair value of the MIE assets.


17

Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


Fair Value of Financial Instruments   The carrying value and fair value of financial instruments that are not carried at fair value in the financial statements are summarized below (in millions): 
 
Carrying
 
Fair Value
 
Value
 
Total
 
Level 1
 
Level 2
 
Level 3
March 31, 2017
 
 
 
 
 
 
 
 
 
Financial assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
1,890

 
$
1,890

 
$
1,890

 
$

 
$

Mortgage loans
1,159

 
1,158

 

 

 
1,158

Policy loans
190

 
190

 

 

 
190

Total financial assets not accounted for at fair value
$
3,239

 
$
3,238

 
$
1,890

 
$

 
$
1,348

Financial liabilities:
 
 
 
 
 
 
 
 
 
Annuity benefits accumulated (*)
$
30,799

 
$
29,997

 
$

 
$

 
$
29,997

Long-term debt
1,283

 
1,382

 

 
1,379

 
3

Total financial liabilities not accounted for at fair value
$
32,082

 
$
31,379

 
$

 
$
1,379

 
$
30,000

 
 
 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
 
 
Financial assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
2,107

 
$
2,107

 
$
2,107

 
$

 
$

Mortgage loans
1,147

 
1,146

 

 

 
1,146

Policy loans
192

 
192

 

 

 
192

Total financial assets not accounted for at fair value
$
3,446

 
$
3,445

 
$
2,107

 
$

 
$
1,338

Financial liabilities:
 
 
 
 
 
 
 
 
 
Annuity benefits accumulated (*)
$
29,703

 
$
28,932

 
$

 
$

 
$
28,932

Long-term debt
1,284

 
1,356

 

 
1,353

 
3

Total financial liabilities not accounted for at fair value
$
30,987

 
$
30,288

 
$

 
$
1,353

 
$
28,935


(*)
Excludes $203 million and $204 million of life contingent annuities in the payout phase at March 31, 2017 and December 31, 2016, respectively.

The carrying amount of cash and cash equivalents approximates fair value. Fair values for mortgage loans are estimated by discounting the future contractual cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings. The fair value of policy loans is estimated to approximate carrying value; policy loans have no defined maturity dates and are inseparable from insurance contracts. The fair value of annuity benefits was estimated based on expected cash flows discounted using forward interest rates adjusted for the Company’s credit risk and includes the impact of maintenance expenses and capital costs. Fair values of long-term debt are based primarily on quoted market prices.


18

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


E.    Investments

Available for sale fixed maturities and equity securities at March 31, 2017 and December 31, 2016, consisted of the following (in millions): 
 
March 31, 2017
 
December 31, 2016
Amortized
Cost
 
Gross Unrealized
 
Net
Unrealized
 
Fair
Value
 
Amortized
Cost
 
Gross Unrealized
 
Net
Unrealized
 
Fair
Value
Gains
 
Losses
 
Gains
 
Losses
Fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Government and government agencies
$
289

 
$
2

 
$
(3
)
 
$
(1
)
 
$
288

 
$
315

 
$
3

 
$
(3
)
 
$

 
$
315

States, municipalities and political subdivisions
6,736

 
213

 
(48
)
 
165

 
6,901

 
6,650

 
200

 
(69
)
 
131

 
6,781

Foreign government
133

 
5

 

 
5

 
138

 
131

 
5

 

 
5

 
136

Residential MBS
3,432

 
295

 
(11
)
 
284

 
3,716

 
3,367

 
281

 
(13
)
 
268

 
3,635

Commercial MBS
1,211

 
43

 
(1
)
 
42

 
1,253

 
1,446

 
49

 
(2
)
 
47

 
1,493

Asset-backed securities
6,548

 
74

 
(30
)
 
44

 
6,592

 
5,962

 
43

 
(46
)
 
(3
)
 
5,959

Corporate and other
17,096

 
544

 
(72
)
 
472

 
17,568

 
15,864

 
473

 
(112
)
 
361

 
16,225

Total fixed maturities
$
35,445

 
$
1,176

 
$
(165
)
 
$
1,011

 
$
36,456

 
$
33,735

 
$
1,054

 
$
(245
)
 
$
809

 
$
34,544

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Equity Securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Common stocks
$
884

 
$
216

 
$
(21
)
 
$
195

 
$
1,079

 
$
879

 
$
160

 
$
(23
)
 
$
137

 
$
1,016

Perpetual preferred stocks
472

 
31

 
(3
)
 
28

 
500

 
472

 
21

 
(7
)
 
14

 
486

Total equity securities
$
1,356

 
$
247

 
$
(24
)
 
$
223

 
$
1,579

 
$
1,351

 
$
181

 
$
(30
)
 
$
151

 
$
1,502


The non-credit related portion of other-than-temporary impairment charges is included in other comprehensive income. Cumulative non-credit charges taken for securities still owned at March 31, 2017 and December 31, 2016, respectively, were $170 million and $189 million. Gross unrealized gains on such securities at March 31, 2017 and December 31, 2016 were $128 million and $130 million, respectively. Gross unrealized losses on such securities at March 31, 2017 and December 31, 2016 were $2 million and $3 million, respectively. These amounts represent the non-credit other-than-temporary impairment charges recorded in AOCI adjusted for subsequent changes in fair values and relate to residential MBS.

19

Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


The following tables show gross unrealized losses (dollars in millions) on fixed maturities and equity securities by investment category and length of time that individual securities have been in a continuous unrealized loss position at March 31, 2017 and December 31, 2016. 
  
Less Than Twelve Months
 
Twelve Months or More
Unrealized
Loss
 
Fair
Value
 
Fair Value as
% of Cost
 
Unrealized
Loss
 
Fair
Value
 
Fair Value as
% of Cost
March 31, 2017
 
 
 
 
 
 
 
 
 
 
 
Fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
U.S. Government and government agencies
$
(1
)
 
$
152

 
99
%
 
$
(2
)
 
$
8

 
80
%
States, municipalities and political subdivisions
(44
)
 
1,925

 
98
%
 
(4
)
 
37

 
90
%
Foreign government

 
4

 
100
%
 

 

 
%
Residential MBS
(6
)
 
455

 
99
%
 
(5
)
 
188

 
97
%
Commercial MBS
(1
)
 
71

 
99
%
 

 

 
%
Asset-backed securities
(14
)
 
1,313

 
99
%
 
(16
)
 
512

 
97
%
Corporate and other
(57
)
 
2,799

 
98
%
 
(15
)
 
298

 
95
%
Total fixed maturities
$
(123
)
 
$
6,719

 
98
%
 
$
(42
)
 
$
1,043

 
96
%
 
 
 
 
 
 
 
 
 
 
 
 
Equity securities:
 
 
 
 
 
 
 
 
 
 
 
Common stocks
$
(21
)
 
$
138

 
87
%
 
$

 
$

 
%
Perpetual preferred stocks
(2
)
 
85

 
98
%
 
(1
)
 
6

 
86
%
Total equity securities
$
(23
)
 
$
223

 
91
%
 
$
(1
)
 
$
6

 
86
%
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
 
 
 
 
Fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
U.S. Government and government agencies
$
(1
)
 
$
153

 
99
%
 
$
(2
)
 
$
8

 
80
%
States, municipalities and political subdivisions
(64
)
 
2,289

 
97
%
 
(5
)
 
44

 
90
%
Residential MBS
(7
)
 
502

 
99
%
 
(6
)
 
162

 
96
%
Commercial MBS
(2
)
 
121

 
98
%
 

 

 
%
Asset-backed securities
(29
)
 
1,737

 
98
%
 
(17
)
 
634

 
97
%
Corporate and other
(93
)
 
3,849

 
98
%
 
(19
)
 
312

 
94
%
Total fixed maturities
$
(196
)
 
$
8,651

 
98
%
 
$
(49
)
 
$
1,160

 
96
%
 
 
 
 
 
 
 
 
 
 
 
 
Equity securities:
 
 
 
 
 
 
 
 
 
 
 
Common stocks
$
(23
)
 
$
215

 
90
%
 
$

 
$

 
%
Perpetual preferred stocks
(6
)
 
135

 
96
%
 
(1
)
 
6

 
86
%
Total equity securities
$
(29
)
 
$
350

 
92
%
 
$
(1
)
 
$
6

 
86
%

At March 31, 2017, the gross unrealized losses on fixed maturities of $165 million relate to 1,048 securities. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 84% of the gross unrealized loss and 89% of the fair value.

AFG analyzes its MBS securities for other-than-temporary impairment each quarter based upon expected future cash flows. Management estimates expected future cash flows based upon its knowledge of the MBS market, cash flow projections (which reflect loan to collateral values, subordination, vintage and geographic concentration) received from independent sources, implied cash flows inherent in security ratings and analysis of historical payment data. In the first three months of 2017, AFG recorded less than $1 million in other-than-temporary impairment charges related to its residential MBS.

In the first three months of 2017, AFG recorded less than $1 million in other-than-temporary impairment charges related to corporate bonds and other fixed maturities.

AFG recorded $3 million in other-than-temporary impairment charges on common stocks in the first three months of 2017. At March 31, 2017, the gross unrealized losses on common stocks of $21 million relate to 17 securities, none of which has been in an unrealized loss position for more than 12 months.

20

Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED



AFG recorded $6 million in other-than-temporary impairment charges on preferred stocks in the first three months of 2017. At March 31, 2017, the gross unrealized losses on preferred stocks of $3 million relate to 13 securities. The one preferred stock that has been in an unrealized loss position for 12 months or more is rated investment grade.

Management believes AFG will recover its cost basis in the securities with unrealized losses and that AFG has the ability to hold the securities until they recover in value and had no intent to sell them at March 31, 2017.

A progression of the credit portion of other-than-temporary impairments on fixed maturity securities for which the non-credit portion of an impairment has been recognized in other comprehensive income is shown below (in millions):

 
2017
 
2016
Balance at January 1
$
153

 
$
160

Additional credit impairments on:
 
 
 
Previously impaired securities

 
2

Securities without prior impairments

 

Reductions due to sales or redemptions
(7
)
 
(2
)
Balance at March 31
$
146

 
$
160


The table below sets forth the scheduled maturities of available for sale fixed maturities as of March 31, 2017 (dollars in millions). 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.
  
Amortized
 
Fair Value
Cost
 
Amount
 
%
Maturity
 
 
 
 
 
One year or less
$
1,038

 
$
1,051

 
3
%
After one year through five years
6,034

 
6,300

 
17
%
After five years through ten years
12,717

 
12,990

 
36
%
After ten years
4,465

 
4,554

 
12
%
 
24,254

 
24,895

 
68
%
ABS (average life of approximately 5 years)
6,548

 
6,592

 
18
%
MBS (average life of approximately 4-1/2 years)
4,643

 
4,969

 
14
%
Total
$
35,445

 
$
36,456

 
100
%

Certain risks are inherent in 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.
There were no investments in individual issuers that exceeded 10% of shareholders’ equity at March 31, 2017 or December 31, 2016.


21

Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


Net Unrealized Gain on Marketable Securities   In addition to adjusting equity securities and fixed maturity securities classified as “available for sale” to fair value, GAAP requires that deferred policy acquisition costs and certain other balance sheet amounts related to annuity, long-term care and life businesses be adjusted to the extent that unrealized gains and losses from securities would result in adjustments to those balances had the unrealized gains or losses actually been realized. The following table shows (in millions) the components of the net unrealized gain on securities that is included in AOCI in AFG’s Balance Sheet. 
 
Pretax
 
Deferred Tax
 
Net
March 31, 2017
 
 
 
 
 
Net unrealized gain on:
 
 
 
 
 
Fixed maturities — annuity segment (*)
$
800

 
$
(280
)
 
$
520

Fixed maturities — all other
211

 
(74
)
 
137

Total fixed maturities
1,011

 
(354
)
 
657

Equity securities
223

 
(78
)
 
145

Total investments
1,234

 
(432
)
 
802

Deferred policy acquisition costs — annuity segment
(333
)
 
117

 
(216
)
Annuity benefits accumulated
(103
)
 
36

 
(67
)
Unearned revenue
15

 
(5
)
 
10

Total net unrealized gain on marketable securities
$
813

 
$
(284
)
 
$
529

 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
Net unrealized gain on:
 
 
 
 
 
Fixed maturities — annuity segment (*)
$
640

 
$
(224
)
 
$
416

Fixed maturities — all other
169

 
(59
)
 
110

Total fixed maturities
809

 
(283
)
 
526

Equity securities
151

 
(53
)
 
98

Total investments
960

 
(336
)
 
624

Deferred policy acquisition costs — annuity segment
(273
)
 
96

 
(177
)
Annuity benefits accumulated
(78
)
 
27

 
(51
)
Unearned revenue
13

 
(5
)
 
8

Total net unrealized gain on marketable securities
$
622

 
$
(218
)
 
$
404


(*)
Net unrealized gains on fixed maturity investments supporting AFG’s annuity benefits accumulated.

Net Investment Income   The following table shows (in millions) investment income earned and investment expenses incurred.
 
Three months ended March 31,
 
2017
 
2016
Investment income:
 
 
 
Fixed maturities
$
389

 
$
367

Equity securities
21

 
19

Equity in earnings of partnerships and similar investments
10

 
11

Other
20

 
19

Gross investment income
440

 
416

Investment expenses
(5
)
 
(5
)
Net investment income
$
435

 
$
411



22

Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


Realized gains (losses) and changes in unrealized appreciation (depreciation) related to fixed maturity and equity security investments are summarized as follows (in millions): 
 
Three months ended March 31, 2017
 
Three months ended March 31, 2016
 
Realized gains (losses)
 
 
 
Realized gains (losses)
 
 
 
Before Impairments
 
Impairments
 
Total
 
Change in Unrealized
 
Before Impairments
 
Impairments
 
Total
 
Change in Unrealized
Fixed maturities
$
5

 
$

 
$
5

 
$
202

 
$
14

 
$
(16
)
 
$
(2
)
 
$
453

Equity securities
2

 
(9
)
 
(7
)
 
72

 
23

 
(41
)
 
(18
)
 
(23
)
Mortgage loans and other investments
3

 

 
3

 

 

 

 

 

Other (*)
(1
)
 
3

 
2

 
(83
)
 
(3
)
 
5

 
2

 
(220
)
Total pretax
9

 
(6
)
 
3

 
191

 
34

 
(52
)
 
(18
)
 
210

Tax effects
(3
)
 
2

 
(1
)
 
(66
)
 
(12
)
 
19

 
7

 
(74
)
Noncontrolling interests

 

 

 

 

 
1

 
1

 
(2
)
Net of tax and noncontrolling interests
$
6

 
$
(4
)
 
$
2

 
$
125

 
$
22

 
$
(32
)
 
$
(10
)
 
$
134


(*)
Primarily adjustments to deferred policy acquisition costs and reserves related to the annuity business.

Gross realized gains and losses (excluding impairment write-downs and mark-to-market of derivatives) on available for sale fixed maturity and equity security investment transactions included in the statement of cash flows consisted of the following (in millions): 
  
Three months ended March 31,
2017
 
2016
Fixed maturities:
 
 
 
Gross gains
$
5

 
$
14

Gross losses

 
(1
)
Equity securities:
 
 
 
Gross gains
4

 
25

Gross losses
(2
)
 


F.    Derivatives

As discussed under Derivatives in Note A — “Accounting Policies to the financial statements, AFG uses derivatives in certain areas of its operations.

Derivatives That Do Not Qualify for Hedge Accounting   The following derivatives that do not qualify for hedge accounting under GAAP are included in AFG’s Balance Sheet at fair value (in millions):
 
 
 
 
March 31, 2017
 
December 31, 2016
Derivative
 
Balance Sheet Line
 
Asset
 
Liability
 
Asset
 
Liability
MBS with embedded derivatives
 
Fixed maturities
 
$
104

 
$

 
$
107

 
$

Public company warrants
 
Equity securities
 
4

 

 
4

 

Fixed-indexed annuities (embedded derivative)
 
Annuity benefits accumulated
 

 
1,963

 

 
1,759

Equity index call options
 
Equity index call options
 
573

 

 
492

 

Reinsurance contracts (embedded derivative)
 
Other liabilities
 

 
8

 

 
8

 
 
 
 
$
681

 
$
1,971

 
$
603

 
$
1,767


The MBS with embedded derivatives consist primarily of interest-only MBS with interest rates that float inversely with short-term rates. AFG records the entire change in the fair value of these securities in earnings. These investments are part of AFG’s overall investment strategy and represent a small component of AFG’s overall investment portfolio.

Warrants to purchase shares of publicly traded companies, which represent a small component of AFG’s overall investment portfolio, are considered to be derivatives that are required to be carried at fair value through earnings.

23

Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED



AFG’s fixed-indexed annuities provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase of call options on the appropriate index. AFG receives collateral from its counterparties to support its purchased call option assets. This collateral ($387 million at March 31, 2017 and $380 million at December 31, 2016) is included in other assets in AFG’s Balance Sheet with an offsetting liability to return the collateral, which is included in other liabilities. AFG’s strategy is designed so that the change in the fair value of the call option assets will generally offset the economic change in the liabilities from the index participation. Both the index-based component of the annuities and the related call options are considered derivatives. Fluctuations in interest rates and the stock market, among other factors, can cause volatility in the periodic measurement of fair value of the embedded derivative that management believes can be inconsistent with the long-term economics of these products.

As discussed under Reinsurance in Note A to the financial statements, certain reinsurance contracts are considered to contain embedded derivatives.

The following table summarizes the gain (loss) included in AFG’s Statement of Earnings for changes in the fair value of derivatives that do not qualify for hedge accounting for the first three months of 2017 and 2016 (in millions): 
 
 
 
 
Three months ended March 31,
Derivative
 
Statement of Earnings Line
 
2017
 
2016
MBS with embedded derivatives
 
Realized gains on securities
 
$

 
$
1

Public company warrants
 
Realized gains on securities
 

 
(2
)
Fixed-indexed annuities (embedded derivative)
 
Annuity benefits
 
(147
)
 
(17
)
Equity index call options
 
Annuity benefits
 
141

 
(40
)
Reinsurance contracts (embedded derivative)
 
Net investment income
 
(1
)
 
(3
)
 
 
 
 
$
(7
)
 
$
(61
)

Derivatives Designated and Qualifying as Cash Flow Hedges  As of March 31, 2017, AFG has entered into seven interest rate swaps that are designated and qualify as highly effective cash flow hedges to mitigate interest rate risk related to certain floating-rate securities included in AFG’s portfolio of fixed maturity securities. The purpose of each of these swaps is to effectively convert a portion of AFG’s floating-rate fixed maturity securities to fixed rates by offsetting the variability in cash flows attributable to changes in short-term LIBOR.

Under the terms of the swaps, AFG receives fixed-rate interest payments in exchange for variable interest payments based on short-term LIBOR. The notional amounts of the interest rate swaps amortize down over each swap’s respective life (the swaps expire between August 2019 and June 2030) in anticipation of the expected decline in AFG’s portfolio of fixed maturity securities with floating interest rates based on short-term LIBOR. The total outstanding notional amount of AFG’s interest rate swaps was $1.03 billion at March 31, 2017 compared to $1.08 billion at December 31, 2016, reflecting the scheduled amortization discussed above. The fair value of the effective portion of the interest rate swaps in an asset position and included in other assets was less than $1 million at March 31, 2017 and $1 million at December 31, 2016. The fair value of the effective portion of the interest rate swaps in a liability position and included in other liabilities was $24 million at March 31, 2017 and $22 million at December 31, 2016. The net unrealized gain or loss on cash flow hedges is included in AOCI, net of DPAC and deferred taxes. Amounts reclassified from AOCI (before DPAC and taxes) to net investment income were $2 million in both the first three months of 2017 and 2016. There was no ineffectiveness recorded in net earnings during these periods. A collateral receivable supporting these swaps of $60 million at both March 31, 2017 and December 31, 2016 is included in other assets in AFG’s Balance Sheet.

Derivative Designated and Qualifying as a Fair Value Hedge   In June 2015, AFG entered into an interest rate swap to mitigate the interest rate risk associated with its fixed-rate 9-7/8% Senior Notes due June 2019 by effectively converting the interest rate on those notes to a floating rate of three-month LIBOR plus 8.099% (9.2302% at March 31, 2017). Since the terms of the interest rate swap match the terms of the hedged debt, changes in the fair value of the interest rate swap are offset by changes in the fair value of the hedged debt attributable to changes in interest rates. The fair value of the interest rate swap (asset of less than $1 million at March 31, 2017 and $1 million at December 31, 2016) and the offsetting adjustment to the carrying value of the 9-7/8% Senior Notes are both included in long-term debt on AFG’s Balance Sheet. Accordingly, the net impact on AFG’s current period earnings is that the interest expense associated with the hedged debt is effectively recorded at

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Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


the floating rate. The net reduction in interest expense from the swap was $1 million for both the first three months of 2017 and 2016.

G.    Deferred Policy Acquisition Costs

A progression of deferred policy acquisition costs is presented below (in millions):
 
P&C
 
 
Annuity and Run-off Long-term Care and Life
 
 
 
 
Deferred
 
 
Deferred
 
Sales
 
 
 
 
 
 
 
 
 
 
Consolidated
 
Costs
 
 
Costs
 
Inducements
 
PVFP
 
Subtotal
 
Unrealized
 
Total
 
 
Total
Balance at December 31, 2016
$
238

 
 
$
1,110

 
$
110

 
$
46

 
$
1,266

 
$
(265
)
 
$
1,001

 
 
$
1,239

Additions
139

 
 
67

 
1

 

 
68

 

 
68

 
 
207

Amortization:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Periodic amortization
(135
)
 
 
(42
)
 
(6
)
 
(2
)
 
(50
)
 

 
(50
)
 
 
(185
)
Included in realized gains

 
 
2

 

 

 
2

 

 
2

 
 
2

Foreign currency translation
1

 
 

 

 

 

 

 

 
 
1

Change in unrealized

 
 

 

 

 

 
(59
)
 
(59