AMERICAN FINANCIAL GROUP INC - Quarter Report: 2020 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, 2020

☐ 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% Subordinated Debentures due November 15, 2055	AFGH	New York Stock Exchange
	5.875% Subordinated Debentures due March 30, 2059	AFGB	New York Stock Exchange
	5.125% Subordinated Debentures due December 15, 2059	AFGC	New York Stock Exchange

As of May 1, 2020, there were 89,841,655 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	32
Item 3 — Quantitative and Qualitative Disclosure about Market Risk	71
Item 4 — Controls and Procedures	71

Part II — Other Information
Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds	72
Item 6 — Exhibits	73
Signature	73

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AMERICAN FINANCIAL GROUP, INC. 10-Q

PART I

ITEM 1. — FINANCIAL STATEMENTS

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEET (UNAUDITED)

(Dollars in Millions)



	March 31, 2020		December 31, 2019
Assets:
Cash and cash equivalents	$	1,673	$	2,314
Investments:
Fixed maturities, available for sale at fair value (amortized cost — $46,101 and $44,524; allowance for expected credit losses of $61 at March 31, 2020)	46,134		46,505
Fixed maturities, trading at fair value	96		113
Equity securities, at fair value	1,559		1,937
Investments accounted for using the equity method	1,763		1,688
Mortgage loans	1,346		1,329
Policy loans	161		164
Equity index call options	209		924
Real estate and other investments	280		278
Total cash and investments	53,221		55,252
Recoverables from reinsurers	3,387		3,415
Prepaid reinsurance premiums	708		678
Agents’ balances and premiums receivable	1,302		1,335
Deferred policy acquisition costs	1,573		1,037
Assets of managed investment entities	4,026		4,736
Other receivables	981		975
Variable annuity assets (separate accounts)	497		628
Other assets	1,741		1,867
Goodwill	207		207
Total assets	$	67,643	$	70,130

Liabilities and Equity:
Unpaid losses and loss adjustment expenses	$	10,106	$	10,232
Unearned premiums	2,808		2,830
Annuity benefits accumulated	40,463		40,406
Life, accident and health reserves	607		612
Payable to reinsurers	779		814
Liabilities of managed investment entities	3,865		4,571
Long-term debt	1,473		1,473
Variable annuity liabilities (separate accounts)	497		628
Other liabilities	1,998		2,295
Total liabilities	62,596		63,861

Redeemable noncontrolling interests	—		—

Shareholders’ equity:
Common Stock, no par value — 200,000,000 shares authorized — 89,827,336 and 90,303,686 shares outstanding	90		90
Capital surplus	1,309		1,307
Retained earnings	3,616		4,009
Accumulated other comprehensive income, net of tax	32		863
Total shareholders’ equity	5,047		6,269
Noncontrolling interests	—		—
Total equity	5,047		6,269
Total liabilities and equity	$	67,643	$	70,130

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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,
	2020			2019
Revenues:
Property and casualty insurance net earned premiums	$	1,209		$	1,173
Net investment income	544			542
Realized gains (losses) on securities (*)	(551		)	184
Income (loss) of managed investment entities:
Investment income	59			69
Gain (loss) on change in fair value of assets/liabilities	(43		)	—
Other income	57			56
Total revenues	1,275			2,024

Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses	707			692
Commissions and other underwriting expenses	420			399
Annuity benefits	276			311
Annuity and supplemental insurance acquisition expenses	113			28
Interest charges on borrowed money	17			16
Expenses of managed investment entities	48			55
Other expenses	82			110
Total costs and expenses	1,663			1,611
Earnings (loss) before income taxes	(388		)	413
Provision (credit) for income taxes	(84		)	87
Net earnings (loss), including noncontrolling interests	(304		)	326
Less: Net earnings (loss) attributable to noncontrolling interests	(3		)	(3		)
Net Earnings (Loss) Attributable to Shareholders	$	(301	)	$	329

Earnings (Loss) Attributable to Shareholders per Common Share:
Basic	$	(3.34	)	$	3.68
Diluted	$	(3.34	)	$	3.63
Average number of Common Shares:
Basic	90.3			89.4
Diluted	90.3			90.7
________________________________________
(*) Consists of the following:
Realized gains (losses) before impairments	$	(505	)	$	186

Losses on securities with impairment	(69		)	(2		)
Non-credit portion recognized in other comprehensive income (loss)	23			—
Impairment charges recognized in earnings	(46		)	(2		)
Total realized gains (losses) on securities	$	(551	)	$	184

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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,
	2020			2019
Net earnings (loss), including noncontrolling interests	$	(304	)	$	326
Other comprehensive income (loss), net of tax:
Net unrealized gains (losses) on securities:
Unrealized holding gains (losses) on securities arising during the period	(865		)	384
Reclassification adjustment for realized (gains) losses included in net earnings	19			(3		)
Total net unrealized gains (losses) on securities	(846		)	381
Net unrealized gains on cash flow hedges	27			11
Foreign currency translation adjustments	(10		)	4
Other comprehensive income (loss), net of tax	(829		)	396
Total comprehensive income (loss), net of tax	(1,133		)	722
Less: Comprehensive income (loss) attributable to noncontrolling interests	(1		)	(3		)
Comprehensive income (loss) attributable to shareholders	$	(1,132	)	$	725

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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		Common Stock and Capital			Retained			Accumulated Other Comp.						Noncon- trolling			Total			Noncon- trolling
	Shares		Surplus			Earnings			Inc. (Loss)			Total			Interests			Equity			Interests
Balance at December 31, 2019	90,303,686		$	1,397		$	4,009		$	863		$	6,269		$	—		$	6,269		$	—
Cumulative effect of accounting change	—		—			7			—			7			—			7			—
Net earnings (loss)	—		—			(301		)	—			(301		)	—			(301		)	(3		)
Other comprehensive income (loss)	—		—			—			(831		)	(831		)	—			(831		)	2
Dividends ($0.45 per share)	—		—			(40		)	—			(40		)	—			(40		)	—
Shares issued:
Exercise of stock options	204,093		9			—			—			9			—			9			—
Restricted stock awards	227,867		—			—			—			—			—			—			—
Other benefit plans	14,541		1			—			—			1			—			1			—
Dividend reinvestment plan	1,617		—			—			—			—			—			—			—
Stock-based compensation expense	—		6			—			—			6			—			6			—
Shares acquired and retired	(826,283	)	(12		)	(49		)	—			(61		)	—			(61		)	—
Shares exchanged — benefit plans	(95,854	)	(2		)	(9		)	—			(11		)	—			(11		)	—
Forfeitures of restricted stock	(2,331	)	—			—			—			—			—			—			—
Other	—		—			(1		)	—			(1		)	—			(1		)	1
Balance at March 31, 2020	89,827,336		$	1,399		$	3,616		$	32		$	5,047		$	—		$	5,047		$	—

Balance at December 31, 2018	89,291,724		$	1,334		$	3,588		$	48		$	4,970		$	2		$	4,972		$	—
Net earnings (loss)	—		—			329			—			329			—			329			(3		)
Other comprehensive income	—		—			—			396			396			—			396			—
Dividends ($0.40 per share)	—		—			(36		)	—			(36		)	—			(36		)	—
Shares issued:
Exercise of stock options	152,253		6			—			—			6			—			6			—
Restricted stock awards	232,565		—			—			—			—			—			—			—
Other benefit plans	11,062		1			—			—			1			—			1			—
Dividend reinvestment plan	1,893		—			—			—			—			—			—			—
Stock-based compensation expense	—		6			—			—			6			—			6			—
Shares exchanged — benefit plans	(43,470	)	(1		)	(3		)	—			(4		)	—			(4		)	—
Forfeitures of restricted stock	(8,314	)	—			—			—			—			—			—			—
Other	—		—			(3		)	—			(3		)	(2		)	(5		)	3
Balance at March 31, 2019	89,637,713		$	1,346		$	3,875		$	444		$	5,665		$	—		$	5,665		$	—

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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,
	2020			2019
Operating Activities:
Net earnings (loss), including noncontrolling interests	$	(304	)	$	326
Adjustments:
Depreciation and amortization	113			34
Annuity benefits	276			311
Realized (gains) losses on investing activities	550			(184		)
Net sales of trading securities	8			1
Deferred annuity and life policy acquisition costs	(49		)	(64		)
Change in:
Reinsurance and other receivables	161			128
Other assets	410			(271		)
Insurance claims and reserves	(152		)	(112		)
Payable to reinsurers	(35		)	(22		)
Other liabilities	(543		)	304
Managed investment entities’ assets/liabilities	89			16
Other operating activities, net	8			(13		)
Net cash provided by operating activities	532			454

Investing Activities:
Purchases of:
Fixed maturities	(4,140		)	(1,801		)
Equity securities	(232		)	(35		)
Mortgage loans	(21		)	(38		)
Equity index options and other investments	(245		)	(220		)
Real estate, property and equipment	(9		)	(10		)
Proceeds from:
Maturities and redemptions of fixed maturities	1,220			1,032
Repayments of mortgage loans	4			29
Sales of fixed maturities	1,483			201
Sales of equity securities	80			95
Sales and settlements of equity index options and other investments	248			79
Sales of real estate, property and equipment	1			1
Managed investment entities:
Purchases of investments	(414		)	(391		)
Proceeds from sales and redemptions of investments	370			373
Other investing activities, net	2			1
Net cash used in investing activities	(1,653		)	(684		)

Financing Activities:
Annuity receipts	1,410			1,395
Annuity surrenders, benefits and withdrawals	(813		)	(782		)
Net transfers from variable annuity assets	15			13
Additional long-term borrowings	—			121
Retirements of managed investment entities’ liabilities	(41		)	(3		)
Issuances of Common Stock	10			7
Repurchases of Common Stock	(61		)	—
Cash dividends paid on Common Stock	(40		)	(36		)
Net cash provided by financing activities	480			715
Net Change in Cash and Cash Equivalents	(641		)	485
Cash and cash equivalents at beginning of period	2,314			1,515
Cash and cash equivalents at end of period	$	1,673		$	2,000

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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 Events
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, 2020, 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 three months of 2020.

Credit Losses on Financial Instruments On January 1, 2020, AFG adopted Accounting Standards Update (“ASU”) 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments, which provides a new loss model for determining credit-related impairments for financial instruments measured at amortized cost (mortgage loans, premiums receivable and reinsurance recoverables) and requires an entity to estimate the credit losses expected over the life of an exposure or pool of exposures. The estimate of expected credit losses considers historical information, current information, as well as reasonable and supportable forecasts, including estimates of prepayments. Expected credit losses, and subsequent increases or decreases in such expected losses, are recorded immediately through net earnings as an allowance that is deducted from the amortized cost basis of the financial asset, with the net carrying value of the financial asset presented on the balance sheet at the amount expected to be collected. AFG’s portfolio of mortgage loans crosses a wide variety of commercial properties with very strong loan to value ratios and no credit losses in recent years. In addition, the reinsurance used in AFG’s insurance operations is purchased from financially strong (highly rated) reinsurers and the Company has a long history of collecting premiums receivable through various economic cycles. At the date of adoption, the impact of adjusting AFG’s existing allowances for uncollectable mortgage loans, premiums receivable and reinsurance recoverables to the allowances calculated under the new guidance resulted in a reduction in the net allowance, which was recorded as the cumulative effect of an accounting change ($7 million increase in retained earnings at January 1, 2020).

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AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

The updated guidance also amended the current other-than-temporary impairment model for available for sale debt securities by requiring the recognition of impairments relating to credit losses through an allowance and limits the amount of credit loss to the difference between a security’s amortized cost basis and its fair value. Subsequent increases or decreases in expected credit losses will be recorded immediately in net earnings through realized gains (losses).

Investments Equity securities other than those accounted for under the equity method are reported at fair value with holding gains and losses 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.

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.

Realized gains or losses on the disposal of fixed maturity securities are determined on the specific identification basis. When a decline in the value of an available for sale fixed maturity is considered to be other-than-temporary at the balance sheet date, an allowance for credit losses (impairment), including any write-off of accrued interest, is charged to earnings (included in realized gains (losses) on securities). If management can assert that it does not intend to sell the security and it is not more likely than not that it will have to sell it before recovery of its amortized cost basis (net of allowance), then the impairment allowance 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 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 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 is recorded in earnings to reduce the amortized cost (net of allowance) of that security to fair value. See “Credit Losses on Financial Instruments” above for a discussion of new guidance adopted on January 1, 2020.

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.

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AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

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.

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.

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AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

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.

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.

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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 (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. The adoption of the new guidance did not have a material effect on AFG’s results of operations or liquidity.

At March 31, 2020 AFG has a $182 million lease liability included in other liabilities and a lease right-of-use asset of $162 million included in other assets compared to $180 million and $158 million, respectively, at December 31, 2019.

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,

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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.

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.

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: first three months of 2020 and 2019 — none and 1.3 million, respectively.

There were 0.8 million anti-dilutive potential common shares for the first three months of 2020 due to AFG’s net loss and no anti-dilutive potential common shares for the first three months of 2019.

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

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B. Acquisition of Business

Effective in June 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 (19.9% at the acquisition date). 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 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 and 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.

In December 2019, AFG initiated actions to exit the Lloyd’s of London insurance market, which included placing its Lloyd’s subsidiaries including its Lloyd’s Managing Agency, Neon Underwriting Ltd., into run-off. Neon and its predecessor, Marketform, have failed to achieve AFG’s profitability objectives since AFG’s purchase of Marketform in 2008. Beginning prospectively with the first quarter of 2020, the results for AFG’s Specialty casualty sub-segment exclude the run-off operations of Neon (“Neon exited lines”).

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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,
	2020			2019
Revenues
Property and casualty insurance:
Premiums earned:
Specialty
Property and transportation	$	386		$	361
Specialty casualty	556			629
Specialty financial	156			146
Other specialty	40			37
Other lines (a)	71			—
Total premiums earned	1,209			1,173
Net investment income (b)	93			104
Other income	5			3
Total property and casualty insurance	1,307			1,280
Annuity:
Net investment income	422			435
Other income	35			28
Total annuity	457			463
Other	62			97
Total revenues before realized gains (losses)	1,826			1,840
Realized gains (losses) on securities	(551		)	184
Total revenues	$	1,275		$	2,024


(a)	Represents premiums earned in the Neon exited lines during the first three months of 2020. Neon’s $88 million in earned premiums during the first three months of 2019 are included in the Specialty casualty sub-segment.


(b)	Includes a net loss of $6 million in the Neon exited lines, primarily from the change in fair value of equity securities.



	Three months ended March 31,
	2020			2019
Earnings (Loss) Before Income Taxes
Property and casualty insurance:
Underwriting:
Specialty
Property and transportation	$	27		$	39
Specialty casualty	52			36
Specialty financial	17			13
Other specialty	(7		)	—
Other lines (a)	(2		)	(1		)
Total underwriting	87			87
Investment and other income, net (b)	84			95
Total property and casualty insurance	171			182
Annuity	29			90
Other (c)	(37		)	(43		)
Total earnings before realized gains (losses) and income taxes	163			229
Realized gains (losses) on securities	(551		)	184
Total earnings (loss) before income taxes	$	(388	)	$	413


(a)	Includes a $1 million underwriting loss in the first three months of 2020 in the Neon exited lines. Neon’s $10 million underwriting loss in the first three months of 2019 is included in the Specialty casualty sub-segment.


(b)	Includes $9 million in net expenses from the Neon exited lines, before noncontrolling interest.


(c)	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, 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”), certain 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
March 31, 2020
Assets:
Available for sale (“AFS”) fixed maturities:
U.S. Government and government agencies	$	158	$	32	$	15	$	205
States, municipalities and political subdivisions	—		6,801		105		6,906
Foreign government	—		170		—		170
Residential MBS	—		2,968		163		3,131
Commercial MBS	—		875		32		907
Collateralized loan obligations	—		3,970		168		4,138
Other asset-backed securities	—		5,728		1,030		6,758
Corporate and other	25		22,346		1,548		23,919
Total AFS fixed maturities	183		42,890		3,061		46,134
Trading fixed maturities	1		95		—		96
Equity securities	1,056		67		436		1,559
Equity index call options	—		209		—		209
Assets of managed investment entities (“MIE”)	169		3,841		16		4,026
Variable annuity assets (separate accounts) (*)	—		497		—		497
Other assets — derivatives	—		125		—		125
Total assets accounted for at fair value	$	1,409	$	47,724	$	3,513	$	52,646
Liabilities:
Liabilities of managed investment entities	$	162	$	3,688	$	15	$	3,865
Derivatives in annuity benefits accumulated	—		—		3,099		3,099
Other liabilities — derivatives	—		10		—		10
Total liabilities accounted for at fair value	$	162	$	3,698	$	3,114	$	6,974

December 31, 2019
Assets:
Available for sale fixed maturities:
U.S. Government and government agencies	$	151	$	43	$	15	$	209
States, municipalities and political subdivisions	—		6,858		105		6,963
Foreign government	—		172		—		172
Residential MBS	—		2,987		173		3,160
Commercial MBS	—		892		35		927
Collateralized loan obligations	—		4,265		15		4,280
Other asset-backed securities	—		5,842		1,286		7,128
Corporate and other	29		21,879		1,758		23,666
Total AFS fixed maturities	180		42,938		3,387		46,505
Trading fixed maturities	2		111		—		113
Equity securities	1,433		67		437		1,937
Equity index call options	—		924		—		924
Assets of managed investment entities	213		4,506		17		4,736
Variable annuity assets (separate accounts) (*)	—		628		—		628
Other assets — derivatives	—		50		—		50
Total assets accounted for at fair value	$	1,828	$	49,224	$	3,841	$	54,893
Liabilities:
Liabilities of managed investment entities	$	206	$	4,349	$	16	$	4,571
Derivatives in annuity benefits accumulated	—		—		3,730		3,730
Other liabilities — derivatives	—		10		—		10
Total liabilities accounted for at fair value	$	206	$	4,359	$	3,746	$	8,311


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

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Approximately 7% of the total assets carried at fair value at March 31, 2020, were Level 3 assets. Approximately 43% ($1.52 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 $1.63 billion at March 31, 2020. Of this amount, approximately $727 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 37 securities, the average spread used was 414 basis points over the reference treasury yield and the spreads ranged from 53 basis points to 1,253 basis points (approximately 70% of the spreads were between 200 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 $3.10 billion at March 31, 2020. 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		1.9% – 3.6% over the risk-free rate
	Risk margin for uncertainty in cash flows		0.80% reduction in the discount rate
	Surrenders		4% – 21% of indexed account value
	Partial surrenders		2% – 9% of indexed account value
	Annuitizations		0.1% – 1% of indexed account value
	Deaths		1.9% – 10.6% of indexed account value
	Budgeted option costs		2.5% – 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 (4% to 21% 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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Changes in balances of Level 3 financial assets and liabilities carried at fair value during the first three months of 2020 and 2019 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, 2019			Net earnings			Other comprehensive income (loss)			Purchases and issuances			Sales and settlements			Transfer into Level 3		Transfer out of Level 3			Balance at March 31, 2020
AFS fixed maturities:
U.S. government agency	$	15		$	1		$	(1	)	$	—		$	—		$	—	$	—		$	15
State and municipal	105			—			1			—			(1		)	—		—			105
Residential MBS	173			5			(12		)	—			(5		)	2		—			163
Commercial MBS	35			—			—			—			(3		)	—		—			32
Collateralized loan obligations	15			(7		)	2			—			—			158		—			168
Other asset-backed securities	1,286			(14		)	(11		)	77			(178		)	13		(143		)	1,030
Corporate and other	1,758			(3		)	(27		)	119			(36		)	5		(268		)	1,548
Total AFS fixed maturities	3,387			(18		)	(48		)	196			(223		)	178		(411		)	3,061
Equity securities	437			(24		)	—			6			—			17		—			436
Assets of MIE	17			(1		)	—			—			—			—		—			16
Total Level 3 assets	$	3,841		$	(43	)	$	(48	)	$	202		$	(223	)	$	195	$	(411	)	$	3,513

Embedded derivatives	$	(3,730	)	$	647		$	—		$	(78	)	$	62		$	—	$	—		$	(3,099	)
Total Level 3 liabilities (*)	$	(3,730	)	$	647		$	—		$	(78	)	$	62		$	—	$	—		$	(3,099	)



				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 March 31, 2019
AFS fixed maturities:
U.S. government agency	$	9		$	—		$	—		$	—		$	(1	)	$	—	$	—		$	8
State and municipal	59			—			5			—			(1		)	—		—			63
Residential MBS	197			5			(5		)	—			(6		)	—		(22		)	169
Commercial MBS	56			—			—			—			(1		)	—		—			55
Collateralized loan obligations	116			—			—			—			—			—		—			116
Other asset-backed securities	731			(3		)	8			75			(114		)	—		(143		)	554
Corporate and other	1,996			2			31			432			(88		)	—		(27		)	2,346
Total AFS fixed maturities	3,164			4			39			507			(211		)	—		(192		)	3,311
Equity securities	336			1			—			1			—			16		—			354
Assets of MIE	21			(1		)	—			—			—			—		—			20
Total Level 3 assets	$	3,521		$	4		$	39		$	508		$	(211	)	$	16	$	(192	)	$	3,685

Embedded derivatives	$	(2,720	)	$	(462	)	$	—		$	(112	)	$	47		$	—	$	—		$	(3,247	)
Total Level 3 liabilities (*)	$	(2,720	)	$	(462	)	$	—		$	(112	)	$	47		$	—	$	—		$	(3,247	)


(*)	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
March 31, 2020
Financial assets:
Cash and cash equivalents	$	1,673	$	1,673	$	1,673	$	—	$	—
Mortgage loans	1,346		1,350		—		—		1,350
Policy loans	161		161		—		—		161
Total financial assets not accounted for at fair value	$	3,180	$	3,184	$	1,673	$	—	$	1,511
Financial liabilities:
Annuity benefits accumulated (*)	$	40,218	$	39,773	$	—	$	—	$	39,773
Long-term debt	1,473		1,411		—		1,408		3
Total financial liabilities not accounted for at fair value	$	41,691	$	41,184	$	—	$	1,408	$	39,776

December 31, 2019
Financial assets:
Cash and cash equivalents	$	2,314	$	2,314	$	2,314	$	—	$	—
Mortgage loans	1,329		1,346		—		—		1,346
Policy loans	164		164		—		—		164
Total financial assets not accounted for at fair value	$	3,807	$	3,824	$	2,314	$	—	$	1,510
Financial liabilities:
Annuity benefits accumulated (*)	$	40,159	$	40,182	$	—	$	—	$	40,182
Long-term debt	1,473		1,622		—		1,619		3
Total financial liabilities not accounted for at fair value	$	41,632	$	41,804	$	—	$	1,619	$	40,185


(*)	Excludes $245 million and $247 million of life contingent annuities in the payout phase at March 31, 2020 and December 31, 2019, respectively.

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AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

E. Investments

Available for sale fixed maturities at March 31, 2020 and December 31, 2019, consisted of the following (in millions):



	Amortized Cost		Allowance for Expected Credit Losses		Gross Unrealized					Net Unrealized			Fair Value
	Amortized Cost		Allowance for Expected Credit Losses		Gains		Losses			Net Unrealized			Fair Value
March 31, 2020
Fixed maturities:
U.S. Government and government agencies	$	190	$	—	$	15	$	—		$	15		$	205
States, municipalities and political subdivisions	6,526		—		388		(8		)	380			6,906
Foreign government	164		—		6		—			6			170
Residential MBS	3,078		6		133		(74		)	59			3,131
Commercial MBS	892		—		20		(5		)	15			907
Collateralized loan obligations	4,456		17		5		(306		)	(301		)	4,138
Other asset-backed securities	7,069		14		65		(362		)	(297		)	6,758
Corporate and other	23,726		24		786		(569		)	217			23,919
Total fixed maturities	$	46,101	$	61	$	1,418	$	(1,324	)	$	94		$	46,134

December 31, 2019
Fixed maturities:
U.S. Government and government agencies	$	199	$	—	$	10	$	—		$	10		$	209
States, municipalities and political subdivisions	6,604		—		363		(4		)	359			6,963
Foreign government	170		—		3		(1		)	2			172
Residential MBS	2,900		—		265		(5		)	260			3,160
Commercial MBS	896		—		31		—			31			927
Collateralized loan obligations	4,307		—		10		(37		)	(27		)	4,280
Other asset-backed securities	6,992		—		156		(20		)	136			7,128
Corporate and other	22,456		—		1,231		(21		)	1,210			23,666
Total fixed maturities	$	44,524	$	—	$	2,069	$	(88	)	$	1,981		$	46,505

Equity securities, which are reported at fair value with holding gains and losses recognized in net earnings, consisted of the following at March 31, 2020 and December 31, 2019 (in millions):



	March 31, 2020							December 31, 2019
					Fair Value							Fair Value
	Actual Cost				over (under)			Actual Cost				over (under)
	Actual Cost		Fair Value		Cost			Actual Cost		Fair Value		Cost
Common stocks	$	1,315	$	919	$	(396	)	$	1,164	$	1,283	$	119
Perpetual preferred stocks	685		640		(45		)	640		654		14
Total equity securities carried at fair value	$	2,000	$	1,559	$	(441	)	$	1,804	$	1,937	$	133

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AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

The following tables show gross unrealized losses (dollars in millions) on available for sale fixed maturities by investment category and length of time that individual securities have been in a continuous unrealized loss position at the following balance sheet dates.



	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, 2020
Fixed maturities:
U.S. Government and government agencies	$	—		$	—	—	%	$	—		$	1	100	%
States, municipalities and political subdivisions	(8		)	235		97	%	—			26		100	%
Foreign government	—			3		100	%	—			—		—	%
Residential MBS	(70		)	1,562		96	%	(4		)	31		89	%
Commercial MBS	(5		)	117		96	%	—			—		—	%
Collateralized loan obligations	(141		)	2,234		94	%	(165		)	1,691		91	%
Other asset-backed securities	(352		)	4,597		93	%	(10		)	94		90	%
Corporate and other	(554		)	7,738		93	%	(15		)	98		87	%
Total fixed maturities	$	(1,130	)	$	16,486	94	%	$	(194	)	$	1,941	91	%

December 31, 2019
Fixed maturities:
U.S. Government and government agencies	$	—		$	16	100	%	$	—		$	11	100	%
States, municipalities and political subdivisions	(3		)	254		99	%	(1		)	82		99	%
Foreign government	(1		)	70		99	%	—			—		—	%
Residential MBS	(4		)	509		99	%	(1		)	69		99	%
Commercial MBS	—			17		100	%	—			—		—	%
Collateralized loan obligations	(11		)	1,284		99	%	(26		)	1,728		99	%
Other asset-backed securities	(12		)	1,211		99	%	(8		)	123		94	%
Corporate and other	(13		)	1,100		99	%	(8		)	211		96	%
Total fixed maturities	$	(44	)	$	4,461	99	%	$	(44	)	$	2,224	98	%

At March 31, 2020, the gross unrealized losses on fixed maturities of $1.32 billion relate to 1,871 securities. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 83% of the gross unrealized loss and 89% of the fair value.

To evaluate fixed maturities for expected credit losses (impairment), management considers whether the unrealized loss is credit-driven or a result of changes in market interest rates, the extent to which fair value is less than cost basis, historical operating, balance sheet and cash flow data from the issuer, third party research and communications with industry specialists and discussions with issuer management.

AFG analyzes its MBS securities for expected credit losses (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 2020, AFG recorded an allowance for credit losses of $6 million related to its residential MBS.

In the first three months of 2020, AFG recorded an allowance for credit losses of $24 million related to corporate bonds and other fixed maturities, $17 million on third-party collateralized loan obligations and $14 million on other asset-backed securities.

Management believes AFG will recover its cost basis (net of any allowance) 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, 2020.

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AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

See Note A — “Accounting Policies — Credit Losses on Financial Instruments,” for a discussion of new guidance effective January 1, 2020, which impacts the accounting for expected credit losses (impairments) of fixed maturity securities. Under the new guidance, credit losses on available for sale fixed maturities continue to be measured based on the present value of expected future cash flows compared to amortized cost; however, impairment losses are now recognized through an allowance instead of a direct writedown of amortized cost. Under the new guidance, recoveries of previously impaired amounts are recorded as an immediate reversal of all or a portion of the allowance instead of accredited as investment income through a yield adjustment. In addition, the allowance on available for sale fixed maturities cannot cause the amortized cost net of the allowance to be below fair value. Accordingly, future changes in the fair value of an impaired security (when the allowance was limited by the fair value) due to reasons other than issuer credit (e.g. changes in market interest rates) could result in increases or decreases in the allowance, which will be recorded through realized gains (losses) on securities. A progression of the allowance for expected credit losses on fixed maturity securities is shown below (in millions):



	2020
Balance at January 1	$	—
Impact of adoption of new accounting policy	—
Provision for expected credit losses	61
Reductions due to sales or redemptions	—
Balance at March 31	$	61

The table below sets forth the scheduled maturities of available for sale fixed maturities as of March 31, 2020 (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, net (*)		Amount		%
Maturity
One year or less	$	2,018	$	2,027	4	%
After one year through five years	10,563		10,710		23	%
After five years through ten years	14,450		14,722		32	%
After ten years	3,551		3,741		8	%
	30,582		31,200		67	%
Collateralized loan obligations and other ABS (average life of approximately 4-1/2 years)	11,494		10,896		24	%
MBS (average life of approximately 3-1/2 years)	3,964		4,038		9	%
Total	$	46,040	$	46,134	100	%


(*)	Amortized cost, net of allowance for expected credit losses.

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, 2020 or December 31, 2019.

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AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Net Unrealized Gain on Marketable Securities In addition to adjusting 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, 2020
Net unrealized gain on:
Fixed maturities — annuity segment (*)	$	124		$	(26	)	$	98
Fixed maturities — all other	(30		)	7			(23		)
Total fixed maturities	94			(19		)	75
Deferred policy acquisition costs — annuity segment	(57		)	12			(45		)
Annuity benefits accumulated	(18		)	3			(15		)
Unearned revenue	1			—			1
Total net unrealized gain on marketable securities	$	20		$	(4	)	$	16

December 31, 2019
Net unrealized gain on:
Fixed maturities — annuity segment (*)	$	1,611		$	(338	)	$	1,273
Fixed maturities — all other	370			(78		)	292
Total fixed maturities	1,981			(416		)	1,565
Deferred policy acquisition costs — annuity segment	(681		)	143			(538		)
Annuity benefits accumulated	(219		)	46			(173		)
Life, accident and health reserves	(1		)	—			(1		)
Unearned revenue	11			(2		)	9
Total net unrealized gain on marketable securities	$	1,091		$	(229	)	$	862


(*)	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,
	2020			2019
Investment income:
Fixed maturities	$	491		$	469
Equity securities:
Dividends	17			22
Change in fair value (a) (b)	(12		)	11
Equity in earnings of partnerships and similar investments	25			21
Other	28			25
Gross investment income	549			548
Investment expenses	(5		)	(6		)
Net investment income (b)	$	544		$	542

(a)

Although the change in the fair value of the majority of AFG’s equity securities is recorded in realized gains (losses) on securities, AFG records holding gains and losses in net investment income on equity securities classified as “trading” under previous guidance and on a small portfolio of limited partnership and similar investments that do not qualify for the equity method of accounting.


(b)	Net investment income in the first three months of 2020 includes a loss of $6 million on investments held by the companies that comprise the Neon exited lines due primarily to the $7 million loss recorded on equity securities that are carried at fair value through net investment income.

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AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Realized gains (losses) and changes in unrealized appreciation (depreciation) included in AOCI related to fixed maturity and equity security investments are summarized as follows (in millions):



	Three months ended March 31, 2020												Three months ended March 31, 2019
	Realized gains (losses)												Realized gains (losses)
	Before Impairments			Impairment Allowance			Total			Change in Unrealized			Before Impairments			Impairments			Total			Change in Unrealized
Fixed maturities	$	29		$	(61	)	$	(32	)	$	(1,887	)	$	3		$	(3	)	$	—		$	853
Equity securities	(535		)	—			(535		)	—			182			—			182			—
Mortgage loans and other investments	4			—			4			—			—			—			—			—
Other (*)	(3		)	15			12			816			1			1			2			(370		)
Total pretax	(505		)	(46		)	(551		)	(1,071		)	186			(2		)	184			483
Tax effects	106			10			116			225			(39		)	—			(39		)	(102		)
Net of tax	$	(399	)	$	(36	)	$	(435	)	$	(846	)	$	147		$	(2	)	$	145		$	381


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

All equity securities other than those accounted for under the equity method are carried at fair value through net earnings. AFG recorded net holding gains (losses) on equity securities during the first three months of 2020 and 2019 on securities that were still owned at March 31, 2020 and March 31, 2019 as follows (in millions):



	Three months ended March 31,
	2020			2019
Included in realized gains (losses)	$	(540	)	$	163
Included in net investment income	(5		)	11
	$	(545	)	$	174

Gross realized gains and losses (excluding impairment write-downs and mark-to-market of derivatives) on available for sale fixed maturity investment transactions consisted of the following (in millions):



	Three months ended March 31,
	2020			2019
Gross gains	$	29		$	6
Gross losses	(4		)	(9		)

F. Derivatives

As discussed under “Derivatives” in Note A — “Accounting Policies,” 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, 2020				December 31, 2019
Derivative	Balance Sheet Line	Asset		Liability		Asset		Liability
MBS with embedded derivatives	Fixed maturities	$	103	$	—	$	102	$	—
Fixed-indexed and variable-indexed annuities (embedded derivative)	Annuity benefits accumulated	—		3,099		—		3,730
Equity index call options	Equity index call options	209		—		924		—
Equity index put options	Other liabilities	—		8		—		1
Reinsurance contracts (embedded derivative)	Other liabilities	—		2		—		4
		$	312	$	3,109	$	1,026	$	3,735

The MBS with embedded derivatives consist of primarily interest-only and principal-only MBS. 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.

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AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

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.

AFG’s fixed-indexed and variable-indexed annuities provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market or other financial index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase and sale of call and put options on the appropriate index. AFG receives collateral from certain counterparties to support its purchased call option assets (net of collateral required under put option contracts with the same counterparties). This collateral ($76 million at March 31, 2020 and $577 million at December 31, 2019) 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 net change in the fair value of the call option assets and put option liabilities will generally offset the economic change in the net liability from the index participation. Both the index-based component of the annuities (an embedded derivative) and the related call and put options are considered derivatives that must be adjusted for changes in fair value through earnings each period. The fair values of these derivatives are impacted by actual and expected stock market performance and interest rates as well as other factors. Fluctuations in certain of these factors, such as changes in interest rates and the performance of the stock market, are not economic in nature for the current reporting period, but rather impact the timing of reported results.

As discussed under “Reinsurance” in Note A, AFG has a reinsurance contract that is considered to contain an embedded derivative.

The following table summarizes the gains (losses) 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 2020 and 2019 (in millions):



		Three months ended March 31,
Derivative	Statement of Earnings Line	2020			2019
MBS with embedded derivatives	Realized gains (losses) on securities	$	4		$	6
Fixed-indexed and variable-indexed annuities (embedded derivative)	Annuity benefits	647			(462		)
Equity index call options	Annuity benefits	(628		)	366
Equity index put options	Annuity benefits	(6		)	1
Reinsurance contract (embedded derivative)	Net investment income	2			(1		)