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

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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

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.

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Table of Contents

AMERICAN FINANCIAL GROUP, INC. 10-Q

TABLE OF CONTENTS




	Page
Part I — Financial Information
Item 1 — Financial Statements:
Consolidated Balance Sheet	2
Consolidated Statement of Earnings	3
Consolidated Statement of Comprehensive Income	4
Consolidated Statement of Changes in Equity	5
Consolidated Statement of Cash Flows	6
Notes to Consolidated Financial Statements	7
Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations	30
Item 3 — Quantitative and Qualitative Disclosure about Market Risk	60
Item 4 — Controls and Procedures	61

Part II — Other Information
Item 1A — Risk Factors	61
Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds	62
Item 5 — Other Information	62
Item 6 — Exhibits	63
Signature	63

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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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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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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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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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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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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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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 2016 — 2.1 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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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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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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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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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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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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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.

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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.

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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
	Amortized Cost		Gains		Losses			Net Unrealized			Fair Value		Amortized Cost		Gains		Losses			Net Unrealized			Fair Value
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.

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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.

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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.

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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

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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.

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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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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