_____________________________________________________________________________________________________

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 September 30, 2019

or

☐ Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from            to           

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 ☑ No ☐

Indicate by check mark whether the Registrant has submitted electronically, every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months. Yes ☑ No ☐

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a 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  ☑                        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 ☑

Securities Registered Pursuant to Section 12(b) of the Act:
	Title of Each Class		Trading Symbol(s)		Name of Each Exchange on Which Registered
	Common Stock		AFG		New York Stock Exchange
	6-1/4% Subordinated Debentures due September 30, 2054		AFGE		New York Stock Exchange
	6% Subordinated Debentures due November 15, 2055		AFGH		New York Stock Exchange
	5.875% Subordinated Debentures due March 30, 2059		AFGB		New York Stock Exchange

As of November 1, 2019, there were 90,176,219 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	7
Notes to Consolidated Financial Statements	8
Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations	38
Item 3 — Quantitative and Qualitative Disclosure about Market Risk	100
Item 4 — Controls and Procedures	100
Part II — Other Information
Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds	100
Item 6 — Exhibits	100
Signature	101

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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)

	September 30, 2019				December 31, 2018
Assets:
Cash and cash equivalents	$	2,693			$	1,515
Investments:
Fixed maturities, available for sale at fair value (amortized cost — $43,334 and $41,837)	45,503				41,997
Fixed maturities, trading at fair value	108				105
Equity securities, at fair value	2,004				1,814
Investments accounted for using the equity method	1,535				1,374
Mortgage loans	1,174				1,068
Policy loans	166				174
Equity index call options	750				184
Real estate and other investments	274				267
Total cash and investments	54,207				48,498
Recoverables from reinsurers	3,261				3,349
Prepaid reinsurance premiums	781				610
Agents’ balances and premiums receivable	1,403				1,234
Deferred policy acquisition costs	964				1,682
Assets of managed investment entities	4,702				4,700
Other receivables	1,187				1,090
Variable annuity assets (separate accounts)	601				557
Other assets	1,754				1,529
Goodwill	207				207
Total assets	$	69,067			$	63,456
Liabilities and Equity:
Unpaid losses and loss adjustment expenses	$	9,847			$	9,741
Unearned premiums	2,986				2,595
Annuity benefits accumulated	39,651				36,616
Life, accident and health reserves	613				635
Payable to reinsurers	867				752
Liabilities of managed investment entities	4,523				4,512
Long-term debt	1,423				1,302
Variable annuity liabilities (separate accounts)	601				557
Other liabilities	2,235				1,774
Total liabilities	62,746				58,484
Redeemable noncontrolling interests	—				—
Shareholders’ equity:
Common Stock, no par value        — 200,000,000 shares authorized        — 90,127,423 and 89,291,724 shares outstanding	90				89
Capital surplus	1,292				1,245
Retained earnings	4,022				3,588
Accumulated other comprehensive income, net of tax	917				48
Total shareholders’ equity	6,321				4,970
Noncontrolling interests	—				2
Total equity	6,321				4,972
Total liabilities and equity	$	69,067			$	63,456

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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 September 30,								Nine months ended September 30,
	2019				2018				2019				2018
Revenues:
Property and casualty insurance net earned premiums	$	1,442			$	1,327			$	3,815			$	3,595
Life, accident and health net earned premiums	6				6				17				18
Net investment income	588				527				1,710				1,552
Realized gains (losses) on securities (*)	(18		)		34				222				(28		)
Income (loss) of managed investment entities:
Investment income	67				65				206				187
Gain (loss) on change in fair value of assets/liabilities	(14		)		(5		)		(16		)		(10		)
Other income	52				54				153				146
Total revenues	2,123				2,008				6,107				5,460
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses	944				872				2,359				2,206
Commissions and other underwriting expenses	450				424				1,275				1,205
Annuity benefits	250				222				900				664
Life, accident and health benefits	9				10				26				32
Annuity and supplemental insurance acquisition expenses	120				71				181				203
Interest charges on borrowed money	17				15				50				46
Expenses of managed investment entities	54				52				168				154
Other expenses	102				98				299				272
Total costs and expenses	1,946				1,764				5,258				4,782
Earnings before income taxes	177				244				849				678
Provision for income taxes	34				41				171				126
Net earnings, including noncontrolling interests	143				203				678				552
Less: Net earnings (losses) attributable to noncontrolling interests	(4		)		(1		)		(8		)		(7		)
Net Earnings Attributable to Shareholders	$	147			$	204			$	686			$	559
Earnings Attributable to Shareholders per Common Share:
Basic	$	1.64			$	2.30			$	7.65			$	6.29
Diluted	$	1.62			$	2.26			$	7.55			$	6.17
Average number of Common Shares:
Basic	90.0				89.1				89.7				88.9
Diluted	91.1				90.7				90.9				90.6
________________________________________
(*) Consists of the following:
Realized gains (losses) before impairments	$	(9	)		$	36			$	235			$	(25	)
Losses on securities with impairment	(9		)		(2		)		(13		)		(3		)
Non-credit portion recognized in other comprehensive income (loss)	—				—				—				—
Impairment charges recognized in earnings	(9		)		(2		)		(13		)		(3		)
Total realized gains (losses) on securities	$	(18	)		$	34			$	222			$	(28	)

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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 September 30,								Nine months ended September 30,
	2019				2018				2019				2018
Net earnings, including noncontrolling interests	$	143			$	203			$	678			$	552
Other comprehensive income (loss), net of tax:
Net unrealized gains (losses) on securities:
Unrealized holding gains (losses) on securities arising during the period	107				(96		)		847				(523		)
Reclassification adjustment for realized (gains) losses included in net earnings	1				(2		)		(10		)		(3		)
Total net unrealized gains (losses) on securities	108				(98		)		837				(526		)
Net unrealized gains (losses) on cash flow hedges	7				(5		)		36				(19		)
Foreign currency translation adjustments	(7		)		—				(3		)		(3		)
Pension and other postretirement plans adjustments	1				—				1				—
Other comprehensive income (loss), net of tax	109				(103		)		871				(548		)
Total comprehensive income, net of tax	252				100				1,549				4
Less: Comprehensive income (loss) attributable to noncontrolling interests	(3		)		(1		)		(6		)		(7		)
Comprehensive income attributable to shareholders	$	255			$	101			$	1,555			$	11

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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																								Redeemable
	Common Shares				Common Stock and Capital Surplus				Retained Earnings				Accumulated Other Comp. Income (Loss)				Total				Noncon- trolling Interests				Total Equity				Noncon- trolling Interests
Balance at June 30, 2019	89,917,601				$	1,367			$	3,914			$	809			$	6,090			$	—			$	6,090			$	—
Net earnings (losses)	—				—				147				—				147				—				147				(4		)
Other comprehensive income (loss)	—				—				—				108				108				—				108				1
Dividends ($0.40 per share)	—				—				(36		)		—				(36		)		—				(36		)		—
Shares issued:
Exercise of stock options	191,227				8				—				—				8				—				8				—
Restricted stock awards	70				—				—				—				—				—				—				—
Other benefit plans	17,345				2				—				—				2				—				2				—
Dividend reinvestment plan	1,570				—				—				—				—				—				—				—
Stock-based compensation expense	—				5				—				—				5				—				5				—
Shares exchanged — benefit plans	(80	)			—				—				—				—				—				—				—
Forfeitures of restricted stock	(310	)			—				—				—				—				—				—				—
Other	—				—				(3		)		—				(3		)		—				(3		)		3
Balance at September 30, 2019	90,127,423				$	1,382			$	4,022			$	917			$	6,321			$	—			$	6,321			$	—
Balance at June 30, 2018	89,072,114				$	1,309			$	3,628			$	147			$	5,084			$	—			$	5,084			$	—
Net earnings (losses)	—				—				204				—				204				—				204				(1		)
Other comprehensive loss	—				—				—				(103		)		(103		)		—				(103		)		—
Dividends ($0.35 per share)	—				—				(31		)		—				(31		)		—				(31		)		—
Shares issued:
Exercise of stock options	103,638				4				—				—				4				—				4				—
Restricted stock awards	—				—				—				—				—				—				—				—
Other benefit plans	12,553				2				—				—				2				—				2				—
Dividend reinvestment plan	3,066				—				—				—				—				—				—				—
Stock-based compensation expense	—				6				—				—				6				—				6				—
Shares exchanged — benefit plans	(2,210	)			(1		)		—				—				(1		)		—				(1		)		—
Forfeitures of restricted stock	(453	)			—				—				—				—				—				—				—
Other	—				—				(1		)		—				(1		)		—				(1		)		1
Balance at September 30, 2018	89,188,708				$	1,320			$	3,800			$	44			$	5,164			$	—			$	5,164			$	—

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AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CHANGES IN EQUITY (UNAUDITED) — CONTINUED

(Dollars in Millions)

 

					Shareholders’ Equity																								Redeemable
	Common Shares				Common Stock and Capital Surplus				Retained Earnings				Accumulated Other Comp. Income (Loss)				Total				Noncon- trolling Interests				Total Equity				Noncon- trolling Interests
Balance at December 31, 2018	89,291,724				$	1,334			$	3,588			$	48			$	4,970			$	2			$	4,972			$	—
Net earnings (losses)	—				—				686				—				686				—				686				(8		)
Other comprehensive income	—				—				—				869				869				—				869				2
Dividends ($2.70 per share)	—				—				(242		)		—				(242		)		—				(242		)		—
Shares issued:
Exercise of stock options	591,233				25				—				—				25				—				25				—
Restricted stock awards	232,635				—				—				—				—				—				—				—
Other benefit plans	58,488				6				—				—				6				—				6				—
Dividend reinvestment plan	11,059				1				—				—				1				—				1				—
Stock-based compensation expense	—				17				—				—				17				—				17				—
Shares exchanged — benefit plans	(47,069	)			(1		)		(4		)		—				(5		)		—				(5		)		—
Forfeitures of restricted stock	(10,647	)			—				—				—				—				—				—				—
Other	—				—				(6		)		—				(6		)		(2		)		(8		)		6
Balance at September 30, 2019	90,127,423				$	1,382			$	4,022			$	917			$	6,321			$	—			$	6,321			$	—
Balance at December 31, 2017	88,275,460				$	1,269			$	3,248			$	813			$	5,330			$	1			$	5,331			$	3
Cumulative effect of accounting change	—				—				225				(221		)		4				—				4				—
Net earnings (losses)	—				—				559				—				559				(1		)		558				(6		)
Other comprehensive loss	—				—				—				(548		)		(548		)		—				(548		)		—
Dividends ($2.55 per share)	—				—				(227		)		—				(227		)		—				(227		)		—
Shares issued:
Exercise of stock options	635,364				23				—				—				23				—				23				—
Restricted stock awards	200,625				—				—				—				—				—				—				—
Other benefit plans	86,229				10				—				—				10				—				10				—
Dividend reinvestment plan	21,072				2				—				—				2				—				2				—
Stock-based compensation expense	—				17				—				—				17				—				17				—
Shares exchanged — benefit plans	(26,520	)			(1		)		(2		)		—				(3		)		—				(3		)		—
Forfeitures of restricted stock	(3,522	)			—				—				—				—				—				—				—
Other	—				—				(3		)		—				(3		)		—				(3		)		3
Balance at September 30, 2018	89,188,708				$	1,320			$	3,800			$	44			$	5,164			$	—			$	5,164			$	—

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AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)

(In Millions)

	Nine months ended September 30,
	2019				2018
Operating Activities:
Net earnings, including noncontrolling interests	$	678			$	552
Adjustments:
Depreciation and amortization	195				163
Annuity benefits	900				664
Realized (gains) losses on investing activities	(223		)		28
Net (purchases) sales of trading securities	(2		)		116
Deferred annuity and life policy acquisition costs	(163		)		(192		)
Change in:
Reinsurance and other receivables	(330		)		(868		)
Other assets	(281		)		(257		)
Insurance claims and reserves	475				507
Payable to reinsurers	115				189
Other liabilities	417				346
Managed investment entities’ assets/liabilities	(2		)		104
Other operating activities, net	(88		)		(75		)
Net cash provided by operating activities	1,691				1,277
Investing Activities:
Purchases of:
Fixed maturities	(5,533		)		(6,700		)
Equity securities	(161		)		(342		)
Mortgage loans	(181		)		(112		)
Equity index options and other investments	(658		)		(695		)
Real estate, property and equipment	(33		)		(60		)
Proceeds from:
Maturities and redemptions of fixed maturities	3,411				3,516
Repayments of mortgage loans	76				87
Sales of fixed maturities	569				275
Sales of equity securities	223				150
Sales and settlements of equity index options and other investments	486				688
Sales of real estate, property and equipment	3				3
Managed investment entities:
Purchases of investments	(1,062		)		(1,674		)
Proceeds from sales and redemptions of investments	1,081				1,485
Other investing activities, net	1				4
Net cash used in investing activities	(1,778		)		(3,375		)
Financing Activities:
Annuity receipts	3,821				3,925
Annuity surrenders, benefits and withdrawals	(2,502		)		(2,101		)
Net transfers from variable annuity assets	45				35
Additional long-term borrowings	121				—
Issuances of managed investment entities’ liabilities	—				1,572
Retirements of managed investment entities’ liabilities	(8		)		(1,463		)
Issuances of Common Stock	29				26
Cash dividends paid on Common Stock	(241		)		(225		)
Net cash provided by financing activities	1,265				1,769
Net Change in Cash and Cash Equivalents	1,178				(329		)
Cash and cash equivalents at beginning of period	1,515				2,338
Cash and cash equivalents at end of period	$	2,693			$	2,009

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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.	Leases
D.	Fair Value Measurements		L.	Shareholders’ Equity
E.	Investments		M.	Income Taxes
F.	Derivatives		N.	Contingencies
G.	Deferred Policy Acquisition Costs		O.	Insurance
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 September 30, 2019, 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 material nonrecurring fair value measurements in the first nine months of 2019.

Investments On January 1, 2018, AFG adopted Accounting Standards Update (“ASU”) 2016-01, which requires all equity securities other than those accounted for under the equity method to be reported at fair value with holding gains and losses recognized in net earnings. At December 31, 2017, AFG had $1.60 billion in equity securities classified as “available for sale” under the prior guidance with holding gains and losses included in accumulated other comprehensive income (“AOCI”) instead of net earnings. At the date of adoption, the $221 million net unrealized gain on equity securities included in AOCI was reclassified to retained earnings as the cumulative effect of an accounting change. The cumulative effect of the accounting change also includes the net unrealized gain on AFG’s small number of limited partnerships and similar investments carried at cost under the prior guidance that are carried at fair value through net earnings under the new guidance ($4 million net of tax at the date of adoption).

Holding gains and losses on equity securities carried at fair value are generally recorded in realized gains (losses) on securities. However, AFG records holding gains and losses on securities classified as “trading” under previous guidance, its small portfolio of limited partnerships and similar investments carried at fair value and certain other securities classified at purchase as “fair value through net investment income” in net investment income.

Fixed maturity securities classified as “available for sale” are reported at fair value with unrealized gains and losses included in AOCI in AFG’s Balance Sheet. Fixed maturity 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.

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AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Premiums and discounts on fixed maturity securities are amortized using the effective 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.

Limited partnerships and similar investments are generally accounted for using the equity method of accounting. Under the equity method, AFG records its share of the earnings or losses of the investee based on when they are reported by the investee in its financial statements rather than in the period in which the investee declares a dividend. AFG’s share of the earnings or losses from equity method investments is generally recorded on a quarter lag due to the timing of the receipt of the investee’s financial statements. AFG’s equity in the earnings (losses) of limited partnerships and similar investments is included in net investment income.

Gains or losses on fixed maturity 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 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 and principal-only MBS) and (ii) the equity-based component of certain annuity products (included in annuity benefits accumulated) and related equity index 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. 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.

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

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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.

 

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 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 these 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.

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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.

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 annuity benefits expense and decreases for annuity policy charges are recorded in other income. For traditional fixed annuities, the liability for annuity benefits accumulated represents the account value that had accrued to the benefit of the policyholder as of the balance sheet date. For fixed-indexed annuities (“FIAs”), the liability for annuity benefits accumulated includes an embedded derivative that represents the estimated fair value of the index participation with the remaining component representing the discounted value of the guaranteed minimum contract benefits.

 

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).

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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 (losses) 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.

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.

Leases   On January 1, 2019, AFG adopted ASU 2016-02, which requires entities that lease assets for terms longer than one year to recognize assets and liabilities for the rights and obligations created by those leases on the balance sheet based on the present value of contractual cash flows. As permitted under the ASU, AFG adopted the guidance on a modified retrospective basis (comparative periods were not adjusted) and elected the following accounting policies and practical expedients:

•	exclude leases with a term of 12 months or less from the calculation of lease assets and liabilities,

•	not separate lease and non-lease components except for buildings (office space and storage facilities),

•	for contracts existing at the date of adoption – not reassess whether a contract is a lease or contains a lease, how initial direct costs were accounted for or whether the lease is an operating or finance lease, and

•	use hindsight to determine the lease term for leases existing at the date of adoption.

Adoption of the new guidance resulted in AFG recognizing a lease liability of $198 million (included in other liabilities) and a corresponding right-of-use asset of $174 million (which is presented net of $24 million in deferred rent and lease incentives) on January 1, 2019. Deferred rent and lease incentives were recognized as liabilities under the previous guidance and result from the straight-line expensing of operating leases. The adoption of the new guidance did not have a material effect on the AFG’s results of operations or liquidity. See Note K — “Leases” for additional disclosures.

Noncontrolling Interests   For balance sheet purposes, noncontrolling interests represent 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. Noncontrolling interests that are redeemable at the option of the holder are presented separately in the mezzanine section of the balance sheet (between liabilities and equity).

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.

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. The effect of a change in tax rates on deferred tax assets and liabilities is recorded in net earnings in the period that includes the enactment date.

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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 L — “Shareholders’ Equity” for further information.

AFG records excess tax benefits or deficiencies for share-based payments through income tax expense in the statement of earnings. In addition, AFG accounts for forfeitures of awards when they occur.

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: third quarter 2019 and 2018 — 1.1 million and 1.6 million; first nine months of 2019 and 2018 — 1.2 million and 1.7 million, respectively.

 

There were no anti-dilutive potential common shares in the third quarter or first nine months of 2019 or 2018.

 

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, property and equipment and businesses. “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.

B.     Acquisition of Business

Effective June 10, 2019, National Interstate, a property and casualty insurance subsidiary of AFG, entered into an agreement with Atlas Financial Holdings, Inc. (“AFH”) to become the exclusive underwriter of AFH’s paratransit book of business. National Interstate estimates that the majority of AFH’s $110 million paratransit business will be eligible for quotation under this arrangement over the first 12 months following inception of the agreement. Under the terms of the agreement, AFH will act as an underwriting manager for National Interstate for at least 12 months, after which time National Interstate is entitled to acquire the renewal rights for the business from AFH for a purchase price equal to 15% of the in force gross written premiums at that date. The majority of the purchase price ultimately paid for the renewal rights will be recorded as an intangible renewal rights asset and will be amortized over the estimated life of the business acquired. In connection with the transaction, AFG was granted a five-year warrant to acquire approximately 2.4 million shares of AFH. The estimated fair value of the warrant was approximately $1 million at the date it was received.

C.    Segments of Operations

AFG manages its business as three segments: (i) Property and casualty insurance, (ii) Annuity and (iii) Other, which includes holding company costs, revenues and costs of AFG’s limited insurance operations outside of property and casualty insurance and annuity segments, and operations attributable to the noncontrolling interests of the managed investment entities.

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 and trucks, inland and ocean marine, agricultural-related products and other commercial property coverages, (ii) Specialty casualty, which includes primarily excess and surplus, executive and professional liability, general liability, umbrella and excess liability, specialty coverages in targeted markets, customized programs for small to mid-sized businesses and workers’ compensation insurance, and (iii) Specialty

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financial, which includes risk management insurance programs for lending and leasing institutions (including equipment leasing and collateral and lender-placed mortgage property insurance), fidelity and surety 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 sells traditional fixed, fixed-indexed and variable-indexed annuities in the retail, financial institutions, broker-dealer and registered investment advisor markets. AFG’s reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.

The following tables (in millions) show AFG’s revenues and earnings before income taxes by segment and sub-segment.

	Three months ended September 30,								Nine months ended September 30,
	2019				2018				2019				2018
Revenues
Property and casualty insurance:
Premiums earned:
Specialty
Property and transportation	$	583			$	526			$	1,323			$	1,250
Specialty casualty	658				616				1,921				1,790
Specialty financial	161				149				458				457
Other specialty	40				36				113				98
Total premiums earned	1,442				1,327				3,815				3,595
Net investment income	124				108				352				323
Other income	5				4				10				8
Total property and casualty insurance	1,571				1,439				4,177				3,926
Annuity:
Net investment income	448				413				1,334				1,219
Other income	28				27				82				80
Total annuity	476				440				1,416				1,299
Other	94				95				292				263
Total revenues before realized gains (losses)	2,141				1,974				5,885				5,488
Realized gains (losses) on securities	(18		)		34				222				(28		)
Total revenues	$	2,123			$	2,008			$	6,107			$	5,460

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	Three months ended September 30,								Nine months ended September 30,
	2019				2018				2019				2018
Earnings Before Income Taxes
Property and casualty insurance:
Underwriting:
Specialty
Property and transportation	$	38			$	—			$	81			$	56
Specialty casualty	23				49				106				119
Specialty financial	26				9				60				46
Other specialty	1				(3		)		(11		)		(1		)
Other lines (a)	(34		)		(17		)		(36		)		(19		)
Total underwriting	54				38				200				201
Investment and other income, net	118				101				328				300
Total property and casualty insurance	172				139				528				501
Annuity	73				117				234				341
Other (b)	(50		)		(46		)		(135		)		(136		)
Total earnings before realized gains (losses) and income taxes	195				210				627				706
Realized gains (losses) on securities	(18		)		34				222				(28		)
Total earnings before income taxes	$	177			$	244			$	849			$	678

(a)	Includes special charges of $18 million in both the third quarter of 2019 and 2018, respectively, to increase asbestos and environmental (“A&E”) reserves.

(b)	Includes holding company interest and expenses, including special charges of $11 million and $9 million in the third quarter of 2019 and 2018, respectively, to increase A&E reserves related to AFG’s former railroad and manufacturing operations.

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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, 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, asset-backed securities (“ABS”), mortgage-backed securities (“MBS”), non-affiliated common stocks, equity index options 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 at the valuation date. 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 are classified as Level 3.

As discussed in Note A — “Accounting Policies — Managed Investment Entities,” AFG has set the carrying value of its 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 separately measured fair values. 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 20 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
September 30, 2019
Assets:
Available for sale (“AFS”) fixed maturities:
U.S. Government and government agencies	$	151			$	70			$	8			$	229
States, municipalities and political subdivisions	—				6,862				102				6,964
Foreign government	—				164				—				164
Residential MBS	—				2,406				156				2,562
Commercial MBS	—				911				55				966
Collateralized loan obligations	—				4,257				57				4,314
Other asset-backed securities	—				5,317				414				5,731
Corporate and other	29				22,258				2,286				24,573
Total AFS fixed maturities	180				42,245				3,078				45,503
Trading fixed maturities	2				106				—				108
Equity securities	1,518				66				420				2,004
Equity index call options	—				750				—				750
Assets of managed investment entities (“MIE”)	228				4,456				18				4,702
Variable annuity assets (separate accounts) (*)	—				601				—				601
Other assets — derivatives	—				69				—				69
Total assets accounted for at fair value	$	1,928			$	48,293			$	3,516			$	53,737
Liabilities:
Liabilities of managed investment entities	$	219			$	4,287			$	17			$	4,523
Derivatives in annuity benefits accumulated	—				—				3,469				3,469
Other liabilities — derivatives	—				6				—				6
Total liabilities accounted for at fair value	$	219			$	4,293			$	3,486			$	7,998
December 31, 2018
Assets:
Available for sale fixed maturities:
U.S. Government and government agencies	$	141			$	83			$	9			$	233
States, municipalities and political subdivisions	—				6,880				59				6,939
Foreign government	—				142				—				142
Residential MBS	—				2,547				197				2,744
Commercial MBS	—				864				56				920
Collateralized loan obligations	—				4,162				116				4,278
Other asset-backed securities	—				4,802				731				5,533
Corporate and other	28				19,184				1,996				21,208
Total AFS fixed maturities	169				38,664				3,164				41,997
Trading fixed maturities	9				96				—				105
Equity securities	1,410				68				336				1,814
Equity index call options	—				184				—				184
Assets of managed investment entities	203				4,476				21				4,700
Variable annuity assets (separate accounts) (*)	—				557				—				557
Other assets — derivatives	—				16				—				16
Total assets accounted for at fair value	$	1,791			$	44,061			$	3,521			$	49,373
Liabilities:
Liabilities of managed investment entities	$	195			$	4,297			$	20			$	4,512
Derivatives in annuity benefits accumulated	—				—				2,720				2,720
Other liabilities — derivatives	—				49				—				49
Total liabilities accounted for at fair value	$	195			$	4,346			$	2,740			$	7,281

(*)	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

During the third quarter and first nine months of 2019, there were two preferred stocks with an aggregate fair value of $11 million that transferred from Level 2 to Level 1. During the first nine months of 2019, there was one preferred stock with an aggregate fair value of $6 million that transferred from Level 1 to Level 2. During the third quarter of 2018, there were no transfers between Level 1 and Level 2. During the first nine months of 2018, there were two preferred stocks with an aggregate fair value of $6 million that transferred from Level 1 to Level 2.

Approximately 7% of the total assets carried at fair value at September 30, 2019, were Level 3 assets. Approximately 49% ($1.72 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.

Internally developed Level 3 asset fair values represent approximately $1.48 billion at September 30, 2019. Of this amount, approximately $998 million relates to fixed maturity securities that were priced using management’s best estimate of an appropriate credit spread over the treasury yield (of a similar duration) to discount future expected cash flows using a third-party model. The credit spread applied by management is the significant unobservable input. For this group of approximately 175 securities, the average spread used was 568 basis points over the reference treasury yield and the spreads ranged from 100 basis points to 2,966 basis points (approximately 80% of the spreads were between 400 and 700 basis points). Had management used higher spreads, the fair value of this group of securities would have been lower. Conversely, if the spreads used were lower, the fair values would have been higher. For the remainder of the internally developed prices, any justifiable changes in unobservable inputs used to determine fair value would not have resulted in a material change in AFG’s financial position.

The derivatives embedded in AFG’s fixed-indexed and variable-indexed annuity liabilities are measured using a discounted cash flow approach and had a fair value of $3.47 billion at September 30, 2019. The following table presents information about the unobservable inputs used by management in determining fair value of these Level 3 liabilities. See Note F — “Derivatives.”

	Unobservable Input		Range
	Adjustment for insurance subsidiary’s credit risk		0.2% – 2.6% over the risk-free rate
	Risk margin for uncertainty in cash flows		0.80% reduction in the discount rate
	Surrenders		3% – 22% of indexed account value
	Partial surrenders		2% – 9% of indexed account value
	Annuitizations		0.1% – 1% of indexed account value
	Deaths		1.7% – 10.6% of indexed account value
	Budgeted option costs		2.3% – 3.3% of indexed account value

The range of adjustments for insurance subsidiary’s credit risk is based on the Moody’s corporate A2 bond index and 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 and variable-indexed annuity products with an expected range of 7% to 10% in the majority of future calendar years (3% to 22% over all periods). Increasing the budgeted option cost or risk margin for uncertainty in cash flow assumptions in the table above would increase the fair value of the fixed-indexed and variable-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 third quarter and first nine months of 2019 and 2018 are presented below (in millions). The transfers into and out of Level 3 were due to changes in the availability of market observable inputs and $29 million of equity securities transferred into Level 3 in the first quarter of 2018 related to a small number of limited partnerships and similar investments carried at cost under the prior guidance that are carried at fair value through net earnings under new guidance adopted on January 1, 2018, as discussed in Note A — “Accounting Policies — Investments.” 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 June 30, 2019				Net earnings				Other comprehensive income (loss)				Purchases and issuances				Sales and settlements				Transfer into Level 3				Transfer out of Level 3				Balance at September 30, 2019
AFS fixed maturities:
U.S. government agency	$	8			$	—			$	—			$	—			$	—			$	—			$	—			$	8
State and municipal	82				—				2				—				—				18				—				102
Residential MBS	139				1				(1		)		—				(4		)		22				(1		)		156
Commercial MBS	50				1				—				—				—				4				—				55
Collateralized loan obligations	50				(2		)		1				8				—				—				—				57
Other asset-backed securities	367				—				1				49				(3		)		—				—				414
Corporate and other	2,014				—				20				324				(81		)		10				(1		)		2,286
Total AFS fixed maturities	2,710				—				23				381				(88		)		54				(2		)		3,078
Equity securities	377				(7		)		—				18				(2		)		34				—				420
Assets of MIE	19				(1		)		—				—				—				—				—				18
Total Level 3 assets	$	3,106			$	(8	)		$	23			$	399			$	(90	)		$	88			$	(2	)		$	3,516
Embedded derivatives (a)	$	(3,541	)		$	70			$	—			$	(63	)		$	65			$	—			$	—			$	(3,469	)
Total Level 3 liabilities (b)	$	(3,541	)		$	70			$	—			$	(63	)		$	65			$	—			$	—			$	(3,469	)

					Total realized/unrealized gains (losses) included in
	Balance at June 30, 2018				Net earnings				Other comprehensive income (loss)				Purchases and issuances				Sales and settlements				Transfer into Level 3				Transfer out of Level 3				Balance at September 30, 2018
AFS fixed maturities:
U.S. government agency	$	8			$	—			$	—			$	—			$	—			$	—			$	—			$	8
State and municipal	61				—				—				—				(1		)		—				—				60
Residential MBS	147				(2		)		(2		)		—				(6		)		13				(5		)		145
Commercial MBS	56				2				—				(1		)		—				—				—				57
Collateralized loan obligations	212				—				(2		)		—				—				—				—				210
Other asset-backed securities	792				—				(1		)		13				(23		)		—				—				781
Corporate and other	1,408				—				(3		)		312				(59		)		—				(12		)		1,646
Total AFS fixed maturities	2,684				—				(8		)		324				(89		)		13				(17		)		2,907
Equity securities	230				(5		)		—				81				—				—				(17		)		289
Assets of MIE	23				(1		)		—				—				—				—				—				22
Total Level 3 assets	$	2,937			$	(6	)		$	(8	)		$	405			$	(89	)		$	13			$	(34	)		$	3,218
Embedded derivatives	$	(2,776	)		$	(223	)		$	—			$	(151	)		$	45			$	—			$	—			$	(3,105	)
Total Level 3 liabilities (b)	$	(2,776	)		$	(223	)		$	—			$	(151	)		$	45			$	—			$	—			$	(3,105	)

(a)	Total realized/unrealized gains (losses) included in net earnings for the embedded derivatives reflects a favorable adjustment related to the unlocking of actuarial assumptions of $181 million in the third quarter of 2019.

(b)	As previously discussed, 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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AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

					Total realized/unrealized gains (losses) included in
	Balance at December 31, 2018				Net earnings				Other comprehensive income (loss)				Purchases and issuances				Sales and settlements				Transfer into Level 3				Transfer out of Level 3				Balance at September 30, 2019
AFS fixed maturities:
U.S. government agency	$	9			$	—			$	—			$	—			$	(1	)		$	—			$	—			$	8
State and municipal	59				—				9				—				(2		)		36				—				102
Residential MBS	197				10				(6		)		—				(14		)		24				(55		)		156
Commercial MBS	56				3				—				—				(3		)		4				(5		)		55
Collateralized loan obligations	116				(5		)		7				8				—				13				(82		)		57
Other asset-backed securities	731				—				6				141				(135		)		—				(329		)		414
Corporate and other	1,996				2				71				985				(330		)		12				(450		)		2,286
Total AFS fixed maturities	3,164				10				87				1,134				(485		)		89				(921		)		3,078
Equity securities	336				(7		)		—				38				(3		)		56				—				420
Assets of MIE	21				(3		)		—				—				—				—				—				18
Total Level 3 assets	$	3,521			$	—			$	87			$	1,172			$	(488	)		$	145			$	(921	)		$	3,516
Embedded derivatives (a)	$	(2,720	)		$	(643	)		$	—			$	(276	)		$	170			$	—			$	—			$	(3,469	)
Total Level 3 liabilities (b)	$	(2,720	)		$	(643	)		$	—			$	(276	)		$	170			$	—			$	—			$	(3,469	)

					Total realized/unrealized gains (losses) included in
	Balance at December 31, 2017				Net earnings				Other comprehensive income (loss)				Purchases and issuances				Sales and settlements				Transfer into Level 3				Transfer out of Level 3				Balance at September 30, 2018
AFS fixed maturities:
U.S. government agency	$	8			$	—			$	—			$	—			$	—			$	—			$	—			$	8
State and municipal	148				—				(2		)		—				(2		)		—				(84		)		60
Residential MBS	122				(9		)		(2		)		—				(17		)		70				(19		)		145
Commercial MBS	36				1				—				20				—				—				—				57
Collateralized loan obligations	180				(2		)		(3		)		35				—				—				—				210
Other asset-backed securities	564				—				(3		)		318				(80		)		—				(18		)		781
Corporate and other	1,044				2				(21		)		784				(138		)		—				(25		)		1,646
Total AFS fixed maturities	2,102				(8		)		(31		)		1,157				(237		)		70				(146		)		2,907
Equity securities	165				9				—				106				(4		)		30				(17		)		289
Assets of MIE	23				(6		)		—				5				—				—				—				22
Total Level 3 assets	$	2,290			$	(5	)		$	(31	)		$	1,268			$	(241	)		$	100			$	(163	)		$	3,218
Embedded derivatives (a)	$	(2,542	)		$	(286	)		$	—			$	(395	)		$	118			$	—			$	—			$	(3,105	)
Total Level 3 liabilities (b)	$	(2,542	)		$	(286	)		$	—			$	(395	)		$	118			$	—			$	—			$	(3,105	)

(a)	Total realized/unrealized gains (losses) included in net earnings for the embedded derivatives reflects a favorable adjustment related to the unlocking of actuarial assumptions of $181 million in the first nine months of 2019 compared to a loss of $44 million in the first nine months of 2018.

(b)	As previously discussed, 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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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
September 30, 2019
Financial assets:
Cash and cash equivalents	$	2,693			$	2,693			$	2,693			$	—			$	—
Mortgage loans	1,174				1,195				—				—				1,195
Policy loans	166				166				—				—				166
Total financial assets not accounted for at fair value	$	4,033			$	4,054			$	2,693			$	—			$	1,361
Financial liabilities:
Annuity benefits accumulated (*)	$	39,401			$	39,468			$	—			$	—			$	39,468
Long-term debt	1,423				1,521				—				1,518				3
Total financial liabilities not accounted for at fair value	$	40,824			$	40,989			$	—			$	1,518			$	39,471