AFG-2012.9.30 10Q


________________________________________________________
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, 2012
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  x    No  ¨
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).    Yes  x    No  ¨
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company:
      Large Accelerated Filer  x Accelerated Filer  ¨ Non-Accelerated Filer  ¨ Smaller Accelerated Filer  ¨

Indicate by check mark whether the Registrant is a shell company.    Yes  ¨    No  x
As of November 1, 2012, there were 90,234,106 shares of the Registrant’s Common Stock outstanding, excluding 14.9 million shares owned by subsidiaries.

________________________________________________________

Table of Contents

AMERICAN FINANCIAL GROUP, INC.
TABLE OF CONTENTS
 
 
 
  
Page
 
 
 
 
 


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,
2012
 
December 31, 2011
(as adjusted)
Assets:
 
 
 
Cash and cash equivalents
$
1,626

 
$
1,324

Investments:
 
 
 
Fixed maturities, available for sale at fair value (amortized cost – $21,760 and $20,562)
23,746

 
21,807

Fixed maturities, trading at fair value
309

 
440

Equity securities, at fair value (cost – $825 and $744)
1,031

 
928

Mortgage loans
566

 
401

Policy loans
229

 
252

Real estate and other investments
530

 
425

Total cash and investments
28,037

 
25,577

Recoverables from reinsurers
3,865

 
2,942

Prepaid reinsurance premiums
587

 
409

Agents’ balances and premiums receivable
750

 
565

Deferred policy acquisition costs
621

 
901

Assets of managed investment entities
3,102

 
3,058

Other receivables
1,168

 
895

Variable annuity assets (separate accounts)
577

 
548

Other assets
741

 
757

Goodwill
185

 
186

Total assets
$
39,633

 
$
35,838

Liabilities and Equity:
 
 
 
Unpaid losses and loss adjustment expenses
$
7,277

 
$
6,520

Unearned premiums
1,821

 
1,484

Annuity benefits accumulated
17,245

 
15,420

Life, accident and health reserves
1,699

 
1,727

Payable to reinsurers
656

 
475

Liabilities of managed investment entities
2,753

 
2,787

Long-term debt
966

 
934

Variable annuity liabilities (separate accounts)
577

 
548

Other liabilities
1,675

 
1,386

Total liabilities
34,669

 
31,281

Shareholders’ equity:
 
 
 
Common Stock, no par value
- 200,000,000 shares authorized
- 90,846,962 and 97,846,402 shares outstanding
91

 
98

Capital surplus
1,071

 
1,121

Retained earnings:
 
 
 
Appropriated — managed investment entities
109

 
173

Unappropriated
2,577

 
2,439

Accumulated other comprehensive income, net of tax
931

 
580

Total shareholders’ equity
4,779

 
4,411

Noncontrolling interests
185

 
146

Total equity
4,964

 
4,557

Total liabilities and equity
$
39,633

 
$
35,838


2
Table of Contents

AMERICAN FINANCIAL GROUP, INC. 10-Q
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF EARNINGS (UNAUDITED)
(In Millions, Except Per Share Data)
 
 
Three months ended
 
Nine months ended
  
September 30,
 
September 30,
 
2012
 
2011
(as adjusted)
 
2012
 
2011
(as adjusted)
Revenues:
 
 
 
 
 
 
 
Property and casualty insurance premiums
$
848

 
$
835

 
$
2,091

 
$
2,043

Life, accident and health premiums
80

 
107

 
290

 
324

Investment income
327

 
310

 
981

 
916

Realized gains (losses) on:
 
 
 
 
 
 
 
Securities (*)
85

 
8

 
145

 
27

Subsidiaries
156

 
—

 
155

 
(3
)
Income (loss) of managed investment entities:
 
 
 
 
 
 
 
Investment income
31

 
27

 
92

 
78

Gain (loss) on change in fair value of assets/liabilities
(13
)
 
1

 
(63
)
 
(54
)
Other income
49

 
47

 
135

 
136

Total revenues
1,563

 
1,335

 
3,826

 
3,467

Costs and Expenses:
 
 
 
 
 
 
 
Property and casualty insurance:
 
 
 
 
 
 
 
Losses and loss adjustment expenses
610

 
549

 
1,317

 
1,303

Commissions and other underwriting expenses
254

 
228

 
697

 
648

Annuity benefits
140

 
142

 
417

 
383

Life, accident and health benefits
68

 
90

 
244

 
275

Annuity and supplemental insurance acquisition expenses
47

 
46

 
142

 
145

Interest charges on borrowed money
22

 
21

 
64

 
63

Expenses of managed investment entities
19

 
17

 
58

 
53

Other operating and general expenses
118

 
86

 
320

 
279

Total costs and expenses
1,278

 
1,179

 
3,259

 
3,149

Operating earnings before income taxes
285

 
156

 
567

 
318

Provision for income taxes
74

 
48

 
184

 
126

Net earnings, including noncontrolling interests
211

 
108

 
383

 
192

Less: Net earnings (loss) attributable to noncontrolling interests
(15
)
 
11

 
(55
)
 
(41
)
Net Earnings Attributable to Shareholders
$
226

 
$
97

 
$
438

 
$
233

 
 
 
 
 
 
 
 
Earnings Attributable to Shareholders per Common Share:
 
 
 
 
 
 
 
Basic
$
2.43

 
$
0.97

 
$
4.58

 
$
2.27

Diluted
$
2.39

 
$
0.95

 
$
4.50

 
$
2.23

Average number of Common Shares:
 
 
 
 
 
 
 
Basic
92.9

 
99.7

 
95.7

 
102.3

Diluted
94.6

 
101.3

 
97.4

 
104.1

 
 
 
 
 
 
 
 
Cash dividends per Common Share
$
0.175

 
$
0.1625

 
$
0.525

 
$
0.4875

________________________________________
 
 
 
 
 
 
 
(*) Consists of the following:
 
 
 
 
 
 
 
Realized gains before impairments
$
93

 
$
18

 
$
164

 
$
68

 
 
 
 
 
 
 
 
Losses on securities with impairment
(8
)
 
(6
)
 
(20
)
 
(23
)
Non-credit portion recognized in other comprehensive income (loss)
—

 
(4
)
 
1

 
(18
)
Impairment charges recognized in earnings
(8
)
 
(10
)
 
(19
)
 
(41
)
Total realized gains on securities
$
85

 
$
8

 
$
145

 
$
27


3
Table of Contents

AMERICAN FINANCIAL GROUP, INC. 10-Q
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (UNAUDITED)
(In Millions)
 
 
Three months ended
 
Nine months ended
  
September 30,
 
September 30,
2012
 
2011
 
2012
 
2011
Net earnings, including noncontrolling interests
$
211

 
$
108

 
$
383

 
$
192

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Net unrealized gains (losses) on securities:
 
 
 
 
 
 
 
Unrealized holding gains (losses) on securities arising during the period
228

 
(1
)
 
464

 
135

Reclassification adjustment for realized gains included in net earnings
(56
)
 
(14
)
 
(96
)
 
(34
)
Reclassification adjustment for unrealized gains of subsidiaries sold
(18
)
 
—

 
(18
)
 
—

Total net unrealized gains (losses) on securities
154

 
(15
)
 
350

 
101

Foreign currency translation adjustments
10

 
(14
)
 
9

 
(9
)
Pension and other postretirement plans adjustments
—

 
—

 
1

 
1

Other comprehensive income (loss), net of tax
164

 
(29
)
 
360

 
93

Total comprehensive income, net of tax
375

 
79

 
743

 
285

Less: Comprehensive income (loss) attributable to noncontrolling interests
(10
)
 
12

 
(47
)
 
(38
)
Comprehensive income attributable to shareholders
$
385

 
$
67

 
$
790

 
$
323



4
Table of Contents

AMERICAN FINANCIAL GROUP, INC. 10-Q
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY (UNAUDITED)
(Dollars in Millions)
 
  
 
 
Shareholders’ Equity
 
 
 
 
Common
 
Common Stock
and Capital
 
Retained Earnings
 
Accumulated
Other Comp
 
 
 
Noncon-
trolling
 
Total
Shares
 
Surplus
 
Approp.
 
Unapprop.
 
Inc. (Loss)
 
Total
 
Interests
 
Equity
Balance at December 31, 2011,
as adjusted
97,846,402

 
$
1,219

 
$
173

 
$
2,439

 
$
580

 
$
4,411

 
$
146

 
$
4,557

Net earnings
—

 
—

 
—

 
438

 
—

 
438

 
(55
)
 
383

Other comprehensive income
—

 
—

 
—

 
—

 
352

 
352

 
8

 
360

Allocation of losses of managed investment entities
—

 
—

 
(64
)
 
—

 
—

 
(64
)
 
64

 
—

Dividends on Common Stock
—

 
—

 
—

 
(50
)
 
—

 
(50
)
 
—

 
(50
)
Shares issued:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Exercise of stock options
1,009,714

 
27

 
—

 
—

 
—

 
27

 
—

 
27

Other benefit plans
291,610

 
6

 
—

 
—

 
—

 
6

 
—

 
6

Dividend reinvestment plan
11,697

 
—

 
—

 
—

 
—

 
—

 
—

 
—

Stock-based compensation expense
—

 
15

 
—

 
—

 
—

 
15

 
—

 
15

Shares exchanged - benefit plans
(23,685
)
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Shares acquired and retired
(8,288,776
)
 
(105
)
 
—

 
(210
)
 
—

 
(315
)
 
—

 
(315
)
Other
—

 
—

 
—

 
(40
)
 
(1
)
 
(41
)
 
22

 
(19
)
Balance at September 30, 2012
90,846,962

 
$
1,162

 
$
109

 
$
2,577

 
$
931

 
$
4,779

 
$
185

 
$
4,964

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2010
105,168,366

 
$
1,271

 
$
197

 
$
2,523

 
$
479

 
$
4,470

 
$
150

 
$
4,620

Cumulative effect of accounting change
—

 
—

 
—

 
(155
)
 
16

 
(139
)
 
—

 
(139
)
Balance at December 31, 2010,
as adjusted
105,168,366

 
1,271

 
197

 
2,368

 
495

 
4,331

 
150

 
4,481

Net earnings
—

 
—

 
—

 
233

 
—

 
233

 
(41
)
 
192

Other comprehensive income
—

 
—

 
—

 
—

 
90

 
90

 
3

 
93

Allocation of losses of managed investment entities
—

 
—

 
(47
)
 
—

 
—

 
(47
)
 
47

 
—

Dividends on Common Stock
—

 
—

 
—

 
(50
)
 
—

 
(50
)
 
—

 
(50
)
Shares issued:
 
 
 
 
 
 
 
 
 
 

 
 
 

Exercise of stock options
758,075

 
19

 
—

 
—

 
—

 
19

 
—

 
19

Other benefit plans
371,392

 
8

 
—

 
—

 
—

 
8

 
—

 
8

Dividend reinvestment plan
11,686

 
—

 
—

 
—

 
—

 
—

 
—

 
—

Stock-based compensation expense
—

 
10

 
—

 
—

 
—

 
10

 
—

 
10

Shares acquired and retired
(7,803,286
)
 
(95
)
 
—

 
(168
)
 
—

 
(263
)
 
—

 
(263
)
Other
—

 
—

 
—

 
—

 
—

 
—

 
(4
)
 
(4
)
Balance at September 30, 2011
98,506,233

 
$
1,213

 
$
150

 
$
2,383

 
$
585

 
$
4,331

 
$
155

 
$
4,486


5
Table of Contents

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,
 
2012
 
2011
(as adjusted)
Operating Activities:
 
 
 
Net earnings, including noncontrolling interests
$
383

 
$
192

Adjustments:
 
 
 
Depreciation and amortization
118

 
131

Annuity benefits
417

 
383

Realized gains on investing activities
(299
)
 
(23
)
Net (purchases) sales of trading securities
27

 
(44
)
Deferred annuity and life policy acquisition costs
(177
)
 
(187
)
Change in:
 
 
 
Reinsurance and other receivables
(1,387
)
 
(519
)
Other assets
6

 
(99
)
Insurance claims and reserves
1,275

 
347

Payable to reinsurers
181

 
331

Other liabilities
(56
)
 
153

Managed investment entities’ assets/liabilities
(13
)
 
(22
)
Other operating activities, net
12

 
18

Net cash provided by operating activities
487

 
661

Investing Activities:
 
 
 
Purchases of:
 
 
 
Fixed maturities
(3,240
)
 
(4,062
)
Equity securities
(231
)
 
(365
)
Mortgage loans
(178
)
 
(132
)
Real estate, property and equipment
(61
)
 
(82
)
Proceeds from:
 
 
 
Maturities and redemptions of fixed maturities
1,617

 
1,455

Repayments of mortgage loans
10

 
227

Sales of fixed maturities
495

 
865

Sales of equity securities
235

 
88

Sales of real estate, property and equipment
4

 
4

Sales of subsidiaries
302

 
—

Cash and cash equivalents of businesses sold
(34
)
 
—

Managed investment entities:
 
 
 
Purchases of investments
(1,246
)
 
(1,085
)
Proceeds from sales and redemptions of investments
1,429

 
1,170

Other investing activities, net
(40
)
 
(14
)
Net cash used in investing activities
(938
)
 
(1,931
)
Financing Activities:
 
 
 
Annuity receipts
2,433

 
2,468

Annuity surrenders, benefits and withdrawals
(1,127
)
 
(971
)
Additional long-term borrowings
344

 
2

Reductions of long-term debt
(323
)
 
(17
)
Issuances of managed investment entities’ liabilities
456

 
—

Retirement of managed investment entities’ liabilities
(704
)
 
(60
)
Issuances of Common Stock
27

 
19

Repurchases of Common Stock
(315
)
 
(263
)
Cash dividends paid on Common Stock
(50
)
 
(50
)
Other financing activities, net
12

 
34

Net cash provided by financing activities
753

 
1,162

Net Change in Cash and Cash Equivalents
302

 
(108
)
Cash and cash equivalents at beginning of period
1,324

 
1,099

Cash and cash equivalents at end of period
$
1,626

 
$
991


6
Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 


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

A.     Accounting Policies

Basis of Presentation   The accompanying consolidated financial statements for American Financial Group, Inc. (“AFG”) and its subsidiaries 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.
 
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, 2012, and prior to the filing date 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.
 
Accounting Standards Adopted in 2012   Effective January 1, 2012, AFG retrospectively adopted Accounting Standards Update (“ASU”) 2010-26 that addresses which costs related to issuing or renewing insurance contracts qualify for deferral. To qualify for deferral, the guidance specifies that a cost must be directly related to the successful acquisition of an insurance contract. The financial statements for prior periods have been adjusted to reflect the adoption of the new standard.
 
The impact of adoption on amounts previously reported is shown in the table below (in millions, except per share data):
  
December 31,
2011
Deferred policy acquisition costs
 
As previously reported
$
1,105

As adjusted
901

 
 
Net deferred tax liability (included in other liabilities)
 
As previously reported
$
203

As adjusted
133

 
 
Shareholders’ equity
 
As previously reported
$
4,545

As adjusted
4,411


7
Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


  
2011
  
1st
Quarter
 
2nd
Quarter
 
3rd
Quarter
 
4th
Quarter
 
Total
Year
Net earnings attributable to shareholders
 
 
 
 
 
 
 
 
 
As previously reported
$
83

 
$
55

 
$
96

 
$
109

 
$
343

As adjusted
88

 
48

 
97

 
109

 
342

 
 
 
 
 
 
 
 
 
 
Diluted earnings per Common Share
 
 
 
 
 
 
 
 
 
As previously reported
$
0.79

 
$
0.52

 
$
0.94

 
$
1.10

 
$
3.33

As adjusted
0.83

 
0.46

 
0.95

 
1.09

 
3.32

 
Effective January 1, 2012, AFG retrospectively adopted ASU 2011-05, which eliminates the option to report other comprehensive income in the Statement of Changes in Equity. As permitted by the standard, comprehensive income is presented herein in a separate statement immediately following the Statement of Earnings. This new presentation does not change the measurement of net earnings, other comprehensive income or earnings per share, and accordingly, had no impact on AFG’s results of operations or financial position.
 
Effective January 1, 2012, AFG adopted ASU 2011-04, which clarifies the application of existing fair value measurement and amends certain disclosure requirements. Disclosures required by the guidance are included in Note D. The impact of adoption was not material to AFG’s results of operations or financial position.
 
Fair Value Measurements   Accounting standards define fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The standards establish a hierarchy of valuation techniques based on whether the assumptions that market participants would use in pricing the asset or liability (“inputs”) are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect AFG’s assumptions about the assumptions market participants would use in pricing the asset or liability. AFG did not have any significant nonrecurring fair value measurements of nonfinancial assets and liabilities in the first nine months of 2012 or 2011.
 
Investments   Fixed maturity and equity securities classified as “available for sale” are reported at fair value with unrealized gains and losses included in accumulated other comprehensive income in AFG’s Balance Sheet. Fixed maturity and equity securities classified as “trading” are reported at fair value with changes in unrealized holding gains or losses during the period included in 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 interest method; mortgage-backed securities (“MBS”) are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations.
 
Gains or losses on securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other-than-temporary at the balance sheet date, a provision for impairment is charged to earnings (included in realized gains (losses)) 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: 1) the amount related to credit losses (recorded in earnings) and 2) 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 and consist primarily of (i) components of certain fixed maturity securities (primarily interest-only MBS) and (ii) the equity-based component of certain annuity products (included in annuity benefits accumulated) and related call options (included in other investments) designed to be consistent with the characteristics of the liabilities and used to mitigate the risk embedded in those annuity products. Changes in the fair value of derivatives are included in earnings.
 

8
Table of Contents
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. Under guidance adopted in 2011, an entity is only required to complete the quantitative annual goodwill impairment test on a reporting unit if the entity determines (through qualitative analysis) that it is more likely than not that the reporting unit’s fair value is less than 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 (a) the estimated reinsurance recoverable on paid and unpaid losses, including an estimate for losses incurred but not reported, and (b) amounts paid to reinsurers applicable to the unexpired terms of policies in force. Payable to reinsurers includes ceded premiums 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.
 
Certain annuity and supplemental insurance subsidiaries cede life insurance policies to a third party on a funds withheld basis whereby the subsidiaries retain the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. These reinsurance contracts are considered to contain embedded derivatives (that must be adjusted to fair value) because the yield on the payables is based on specific blocks of the ceding companies’ assets, rather than the overall creditworthiness of the ceding company. AFG determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. The securities related to these transactions are classified as “trading.” The adjustment to fair value on the embedded derivatives offsets the investment income recorded on the adjustment to fair value of the related trading portfolios.
 
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. As discussed previously under “Accounting Standards Adopted in 2012,” AFG’s accounting for DPAC changed effective January 1, 2012, and amounts previously reported have been adjusted retrospectively.
 
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 variable annuity policy charges, less death and annuitization 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).

DPAC related to annuities is also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in unrealized gains (losses) on marketable securities, a component of accumulated other comprehensive income in AFG’s Balance Sheet.

DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues.

DPAC includes the present value of future profits on business in force of annuity and supplemental 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.
 

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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”). Both the management fees (payment of which is subordinate to other obligations of the CLOs) and the investments in the CLOs are considered variable interests. AFG has determined that it is the primary beneficiary of the CLOs because (i) its role as asset manager gives it the power to direct the activities that most significantly impact the economic performance of the CLOs and (ii) it has exposure to CLO losses (through its investments in the CLO debt tranches) and the right to receive benefits (through its subordinated management fees and returns on its investments), both of which 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 excess of fair value of the CLOs’ assets over the fair value of the liabilities is recorded in AFG’s Balance Sheet as appropriated retained earnings — managed investment entities, representing amounts that ultimately will inure to the benefit of the CLO debt holders.
 
The net gain or loss from accounting for the CLO assets and liabilities at fair value is separately presented in AFG’s Statement of Earnings. CLO earnings attributable to AFG’s shareholders represent the change in fair value of AFG’s investments in the CLOs (including distributions) and management fees earned. All other CLO earnings (losses) are not attributable to AFG’s shareholders and will ultimately inure to the benefit of the other CLO debt holders. As a result, such CLO earnings (losses) are included in net earnings (loss) attributable to noncontrolling interests in AFG’s Statement of Earnings and in appropriated retained earnings — managed investment entities in the Balance Sheet. As the CLOs approach maturity (2016 to 2022), it is expected that losses attributable to noncontrolling interests will reduce appropriated retained earnings towards zero as the fair values of the assets and liabilities converge and the CLO assets are used to pay the CLO debt.

At September 30, 2012, assets and liabilities of managed investment entities include $308 million in assets and $267 million in liabilities of a temporary warehousing entity that was established in connection with the formation of a new CLO. All warehoused assets were transferred to the new CLO and the liabilities were repaid when the CLO formation was completed and the CLO issued its securities in October 2012.
 
Unpaid Losses and Loss Adjustment Expenses   The net liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based upon (a) the accumulation of case estimates for losses reported prior to the close of the accounting period on direct business written; (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of unreported losses (including possible development on known claims) based on past experience; (d) estimates based on experience of expenses for investigating and adjusting claims; and (e) the current state of the law and coverage litigation. Establishing reserves for asbestos, environmental and other mass tort claims involves considerably more judgment than other types of claims due to, among other things, inconsistent court decisions, an increase in bankruptcy filings as a result of asbestos-related liabilities, novel theories of coverage, and judicial interpretations that often expand theories of recovery and broaden the scope of coverage.
 
Loss reserve liabilities are subject to the impact of changes in claim amounts and frequency and other factors. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the Statement of Earnings in the period in which determined. Despite the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
 
Annuity Benefits Accumulated   Annuity receipts and benefit payments are recorded as increases or decreases in annuity benefits accumulated rather than as revenue and expense. Increases in this liability for interest credited are charged to expense and decreases for surrender charges are credited to other income.
 
For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses and excess benefits expected to be paid on future deaths and annuitizations (“EDAR”). The liability for EDAR is 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

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


estimated future investment margin, surrender, mortality, and other life and variable 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.
 
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. Claim reserves and liabilities established for accident and health claims are modified as necessary to reflect actual experience and developing trends.
 
Variable Annuity Assets and Liabilities   Separate accounts related to variable annuities represent the fair value of deposits invested in underlying investment funds on which AFG earns a fee. Investment funds are selected and may be changed only by the policyholder, who retains all investment risk.
 
AFG’s variable annuity contracts contain a guaranteed minimum death benefit (“GMDB”) to be paid if the policyholder dies before the annuity payout period commences. In periods of declining equity markets, the GMDB may exceed the value of the policyholder’s account. A GMDB liability is established for future excess death benefits using assumptions together with a range of reasonably possible scenarios for investment fund performance that are consistent with DPAC capitalization and amortization assumptions.
 
Premium Recognition   Property and casualty premiums are earned generally over the terms of the policies on a pro rata basis. Unearned premiums represent that portion of premiums written which is applicable to the unexpired terms of policies in force. On reinsurance assumed from other insurance companies or written through various underwriting organizations, unearned premiums are based on information received from such companies and organizations. For traditional life, accident and health products, premiums are recognized as revenue when legally collectible from policyholders. For interest-sensitive life and universal life products, premiums are recorded in a policyholder account, which is reflected as a liability. Revenue is recognized as amounts are assessed against the policyholder account for mortality coverage and contract expenses.
 
Noncontrolling Interests   For Balance Sheet purposes, noncontrolling interests represents the interests of shareholders other than AFG in consolidated entities. In the Statement of Earnings, net earnings and losses attributable to noncontrolling interests represents such shareholders’ interest in the earnings and losses of those entities.
 
Income Taxes   Deferred income taxes are calculated using the liability method. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases and are measured using enacted tax rates. A valuation allowance is established to reduce total deferred tax assets to an amount that will more likely than not be realized.
 
AFG records a liability for the inherent uncertainty in quantifying its income tax provisions. Related interest and penalties are recognized as a component of tax expense.
 
Stock-Based Compensation   All share-based grants are recognized as compensation expense on a straight-line basis over their vesting periods based on their calculated fair value at the date of grant. AFG uses the Black-Scholes pricing model to measure the fair value of employee stock options. See Note K - “Shareholders’ Equity” for further information.
 
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   Basic earnings per share is calculated using the weighted average number of shares of common stock outstanding during the period. The calculation of diluted earnings per share includes adjustments to weighted average common shares related to stock-based compensation plans: third quarter 2012 and 2011 – 1.7 million and 1.6 million; first nine months of 2012 and 2011 – 1.7 million and 1.8 million, respectively.
 

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


AFG’s weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: third quarter 2012 and 2011 – 1.9 million and 2.6 million; first nine months of 2012 and 2011 – 1.8 million and 2.3 million, respectively. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were nominal in the 2012 and 2011 periods.
 
Statement of Cash Flows   For cash flow purposes, “investing activities” are defined as making and collecting loans and acquiring and disposing of debt or equity instruments and property and equipment. “Financing activities” include obtaining resources from owners and providing them with a return on their investments, borrowing money and repaying amounts borrowed. Annuity receipts, benefits and withdrawals are also reflected as financing activities. All other activities are considered “operating.” Short-term investments having original maturities of three months or less when purchased are considered to be cash equivalents for purposes of the financial statements.

B.     Acquisitions and Sales of Subsidiaries 

On August 31, 2012, AFG completed the sale of its Medicare supplement and critical illness businesses, which included Loyal American Life Insurance Company and four other insurance companies, to Cigna Corporation for $307 million in cash. AFG realized a gain of $155 million on the sale (subject to post-closing adjustments). Since the transaction includes the ongoing cessions of certain business to Cigna, the operations being sold are not reported as discontinued operations. Following the sale, AFG’s supplemental insurance operations consist solely of its run-off long-term care business.
 
The impact of the August 2012 sale of the Medicare supplement and critical illness businesses on AFG’s financial statements is shown below (in millions):
Sale proceeds
$
307

Expenses
(12
)
Net proceeds
$
295

 
 
Assets of businesses sold:
 
Cash and investments
$
217

Deferred policy acquisition costs
108

Other assets
31

Total assets
356

Liabilities of businesses sold:
 
Life, accident and health reserves
209

Other liabilities
7

Total liabilities
216

Net assets of businesses sold
$
140

 
 
Gain on sale of subsidiaries
$
155


Summarized Statement of Earnings information for the Medicare supplement and critical illness businesses through the sale date is shown below (in millions): 
  
Three months ended
 
Nine months ended
 
September 30,
 
September 30,
 
     2012 (*)
 
2011
 
     2012 (*)
 
2011
Total revenues
$
53

 
$
80

 
$
212

 
$
244

Total costs and expenses
43

 
69

 
184

 
223

Operating earnings before income taxes
$
10

 
$
11

 
$
28

 
$
21


(*) Reflects revenues and expenses through the end of August 2012.


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


During the third quarter of 2012, AFG acquired the outstanding 28% of Marketform, its London-based Lloyd’s property and casualty insurance operation, that it did not already own for $17 million and sold an additional small annuity and supplemental insurance company for $7 million.
C.    Segments of Operations

AFG manages its business as three segments: (i) property and casualty insurance, (ii) annuity and supplemental insurance and (iii) other, which includes holding company costs and amounts 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, trucks and recreational vehicles, inland and ocean marine, agricultural-related products and other property coverages, (ii) Specialty casualty, which includes primarily excess and surplus, general liability, executive liability, umbrella and excess liability, customized programs for small to mid-sized businesses and workers’ compensation, and (iii) Specialty financial, which includes risk management insurance programs for lending and leasing institutions (including collateral and mortgage protection insurance), surety and fidelity products and trade credit insurance. AFG’s annuity business markets traditional fixed and fixed-indexed annuities in the education, bank and individual markets. Following the sale of its Medicare supplement and critical illness businesses in August 2012 (see Note B — “Acquisitions and Sales of Subsidiaries”), AFG’s remaining supplemental insurance operations consist solely of its run-off blocks of long-term care and life insurance business.

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 operating earnings before income taxes by significant business segment and sub-segment.
  
Three months ended
 
Nine months ended
September 30,
 
September 30,
2012
 
2011
 
2012
 
2011
Revenues
 
 
 
 
 
 
 
Property and casualty insurance:
 
 
 
 
 
 
 
Premiums earned:
 
 
 
 
 
 
 
Specialty
 
 
 
 
 
 
 
Property and transportation
$
487

 
$
500

 
$
1,040

 
$
1,029

Specialty casualty
243

 
216

 
699

 
651

Specialty financial
100

 
101

 
301

 
313

Other
18

 
18

 
51

 
50

Total premiums earned
848

 
835

 
2,091

 
2,043

Investment income
69

 
73

 
210

 
223

Realized gains
44

 
15

 
88

 
47

Other income
16

 
20

 
47

 
55

Total property and casualty insurance
977

 
943

 
2,436

 
2,368

Annuity and supplemental insurance:
 
 
 
 
 
 
 
Investment income
270

 
236

 
789

 
694

Life, accident and health premiums
80

 
107

 
290

 
324

Realized gains (losses) on securities
41

 
(8
)
 
57

 
(22
)
Realized gains (losses) on subsidiaries
156

 
—

 
155

 
(2
)
Other income
30

 
27

 
84

 
79

Total annuity and supplemental insurance
577

 
362

 
1,375

 
1,073

Other
9

 
30

 
15

 
26

Total revenues
$
1,563

 
$
1,335

 
$
3,826

 
$
3,467



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


  
Three months ended
 
Nine months ended
September 30,
 
September 30,
2012
 
2011
 
2012
 
2011
Operating Earnings (Losses) Before Income Taxes
 
 
 
 
 
 
 
Property and casualty insurance:
 
 
 
 
 
 
 
Underwriting:
 
 
 
 
 
 
 
Specialty
 
 
 
 
 
 
 
Property and transportation
$
—

 
$
5

 
$
33

 
$
38

Specialty casualty
8

 
20

 
45

 
38

Specialty financial
1

 
24

 
28

 
52

Other
7

 
9

 
10

 
14

Other lines (a)
(32
)
 
—

 
(39
)
 
(50
)
Total underwriting
(16
)
 
58

 
77

 
92

Investment and other income, net
58

 
65

 
174

 
205

Realized gains
44

 
15

 
88

 
47

Total property and casualty insurance
86

 
138

 
339

 
344

Annuity and supplemental insurance:
 
 
 
 
 
 
 
Operations (b)
81

 
47

 
224

 
157

Realized gains (losses) on securities
41

 
(8
)
 
57

 
(22
)
Realized gains (losses) on subsidiaries
156

 
—

 
155

 
(2
)
Total annuity and supplemental insurance
278

 
39

 
436

 
133

Other (c)
(79
)
 
(21
)
 
(208
)
 
(159
)
Total operating earnings before income taxes
$
285

 
$
156

 
$
567

 
$
318


(a)
Includes third quarter 2012 and second quarter 2011 special charges of $31 million and $50 million, respectively, to increase asbestos and environmental reserves.
(b)
Includes earnings from the Medicare supplement and critical illness operations, which were sold in August 2012, of $10 million and $11 million for the third quarter and $28 million and $21 million for the first nine months of 2012 and 2011, respectively.
(c)
Includes holding company expenses and earnings (losses) of managed investment entities attributable to noncontrolling interests of ($18) million and $8 million for the third quarter and ($64) million and ($47) million for the first nine months of 2012 and 2011, respectively. Holding company expenses for the third quarter of 2012 include an $8 million loss on retirement of debt and a $15 million charge for a labor matter related to AFG’s former railroad operations.

D.    Fair Value Measurements

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

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

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


broker/dealer quotes, issuer spreads and benchmark securities. When non-binding broker quotes can be corroborated by comparison to similar securities priced using observable inputs, they are classified as Level 2.

Level 3 — Valuations derived from market valuation techniques generally consistent with those used to estimate the fair values of Level 2 financial instruments in which one or more significant inputs are unobservable or when the market for a security exhibits significantly less liquidity relative to markets supporting Level 2 fair value measurements. The unobservable inputs may include management’s own assumptions about the assumptions market participants would use based on the best information available in the circumstances. AFG’s Level 3 is comprised of financial instruments, including liabilities of managed investment entities, 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.

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 the 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 service regarding the methods and assumptions used in pricing, including verifying, on a test basis, the inputs used by the service to value specific securities.
 

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


Assets and liabilities measured and carried at fair value in the financial statements are summarized below (in millions): 
 
Level 1
 
Level 2
 
Level 3
 
Total
September 30, 2012
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
Available for sale (“AFS”) fixed maturities:
 
 
 
 
 
 
 
U.S. Government and government agencies
$
198

 
$
143

 
$
20

 
$
361

States, municipalities and political subdivisions
—

 
4,268

 
58

 
4,326

Foreign government
—

 
264

 
—

 
264

Residential MBS
—

 
3,953

 
367

 
4,320

Commercial MBS
—

 
2,924

 
21

 
2,945

All other corporate
4

 
11,031

 
495

 
11,530

Total AFS fixed maturities
202

 
22,583

 
961

 
23,746

Trading fixed maturities
—

 
308

 
1

 
309

Equity securities
883

 
112

 
36

 
1,031

Assets of managed investment entities (“MIE”)
221

 
2,846

 
35

 
3,102

Variable annuity assets (separate accounts) (a)
—

 
577

 
—

 
577

Other investments
—

 
153

 
—

 
153

Total assets accounted for at fair value
$
1,306

 
$
26,579

 
$
1,033

 
$
28,918

Liabilities:
 
 
 
 
 
 
 
Liabilities of managed investment entities
$
247

 
$
—

 
$
2,506

 
$
2,753

Derivatives in annuity benefits accumulated
—

 
—

 
497

 
497

Other liabilities — derivatives
—

 
18

 
—

 
18

Total liabilities accounted for at fair value
$
247

 
$
18

 
$
3,003

 
$
3,268

December 31, 2011
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
Available for sale (“AFS”) fixed maturities:
 
 
 
 
 
 
 
U.S. Government and government agencies
$
248

 
$
134

 
$
—

 
$
382

States, municipalities and political subdivisions
—

 
3,794

 
83

 
3,877

Foreign government
—

 
254

 
—

 
254

Residential MBS
—

 
3,487

 
361

 
3,848

Commercial MBS
—

 
2,821

 
19

 
2,840

All other corporate
9

 
10,078

 
519

 
10,606

Total AFS fixed maturities
257

 
20,568

 
982

 
21,807

Trading fixed maturities
—

 
439

 
1

 
440

Equity securities
888

 
29

 
11

 
928

Assets of managed investment entities (“MIE”)
290

 
2,724

 
44

 
3,058

Variable annuity assets (separate accounts) (a)
—

 
548

 
—

 
548

Other investments
—

 
71

 
—

 
71

Total assets accounted for at fair value
$
1,435

 
$
24,379

 
$
1,038

 
$
26,852

Liabilities:
 
 
 
 
 
 
 
Liabilities of managed investment entities
$
194

 
$
—

 
$
2,593

 
$
2,787

Derivatives in annuity benefits accumulated
—

 
—

 
361

 
361

Other liabilities — derivatives
—

 
23

 
—

 
23

Total liabilities accounted for at fair value
$
194

 
$
23

 
$
2,954

 
$
3,171

 
 
 
 
 
 
 
 
 (a)   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 first nine months of 2012, six preferred stocks with an aggregate fair value of $35 million were transferred from Level 1 to Level 2. All of these transfers occurred in the first quarter. The transfers were due to decreases in trade frequency, resulting in lack of available trade data sufficient to warrant classification in Level 1. Approximately 4% of the total assets accounted for at fair value on September 30, 2012, were Level 3 assets. Approximately 90% ($907 million) of the Level 3 assets were priced using non-binding broker quotes, for which there is a lack of transparency as to the inputs used to determine fair value. Details as to the quantitative inputs are neither provided by the brokers nor otherwise reasonably obtainable by AFG. Since internally developed Level 3 asset fair values represent less than one-half of 1% of the total assets measured at fair value and less than 3% of AFG’s shareholders’ equity, changes in unobservable inputs used to determine internally developed fair values would not have a material impact on AFG’s financial position.

The fair values of the liabilities of managed investment entities were determined using primarily non-binding broker quotes, which were reviewed by AFG’s investment professionals. AFG’s investment professionals are familiar with the cash flow models used by the brokers to determine the fair value of these liabilities and review the broker quotes based on their knowledge of the CLO market and the market for the underlying assets. Their review includes consideration of expected reinvestment, default and recovery rates on the assets supporting the CLO liabilities, as well as surveying general CLO liability fair values and analysis provided by third parties.

The only significant Level 3 assets or liabilities carried at fair value in the financial statements that were not measured using broker quotes are the derivatives embedded in AFG’s fixed-indexed annuity liabilities, which are measured using a discounted cash flow approach and had a fair value of $497 million at September 30, 2012. The following table presents information about the unobservable inputs used by management in determining fair value of these embedded derivatives. See Note F — “Derivatives.”

Unobservable Input
  
Range
Adjustment for insurance subsidiary’s credit risk
  
0.5% – 2.05% over the risk free rate
Risk margin for uncertainty in cash flows
  
0.3% reduction in the discount rate
Surrenders
  
4% – 25% of indexed account value
Partial surrenders
  
3% – 5% of indexed account value
Annuitizations
  
1% – 2% of indexed account value
Deaths
  
1% – 2.5% of indexed account value
Budgeted option costs
  
2.5% – 4.0% of indexed account value

Increasing the budgeted option cost or risk margin for uncertainty in cash flows assumptions in the table above would increase the fair value of the fixed-indexed annuity embedded derivatives, while increasing any of the other unobservable inputs in the table above would decrease the fair value of the embedded derivatives.


17
Table of Contents
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 2012 and 2011 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 June 30, 2012
 
Net
income
 
Other
comprehensive
income (loss)
 
Purchases
and
issuances
 
Sales and
Settlements
 
Transfer
into
Level 3
 
Transfer
out of
Level 3
 
Balance at September 30, 2012
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government
$
20

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
20

State and municipal
86

 
—

 
2

 
—

 
(6
)
 
4

 
(28
)
 
58

Residential MBS
320

 
3

 
7

 
15

 
(11
)
 
86

 
(53
)
 
367

Commercial MBS
20

 
1

 
—

 
—

 
—

 
—

 
—

 
21

All other corporate
537

 
2

 
6

 
67

 
(19
)
 
1

 
(99
)
 
495

Trading fixed maturities
1

 
—

 
—

 
—

 
—

 
—

 
—

 
1

Equity securities
41

 
—

 
—

 
4

 
—

 
9

 
(18
)
 
36

Assets of MIE
54

 
—

 
—

 
—

 
(1
)
 
—

 
(18
)
 
35

Liabilities of MIE (*)
(2,429
)
 
(52
)
 
—

 
(97
)
 
72

 
—

 
—

 
(2,506
)
Embedded derivatives
(444
)
 
(41
)
 
—

 
(19
)
 
7

 
—

 
—

 
(497
)

(*)
Total realized/unrealized loss included in net income includes losses of $49 million related to liabilities outstanding as of September 30, 2012. See Note H — “Managed Investment Entities.”
 
  
 
 
Total
realized/unrealized
gains (losses)
included in
 
 
 
 
 
 
 
 
 
 
Balance at June 30, 2011
 
Net
income
 
Other
comprehensive
income (loss)
 
Purchases
and
Issuances
 
Sales and
Settlements
 
Transfer
into
Level 3
 
Transfer
out of
Level 3
 
Balance at September 30, 2011
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
State and municipal
$
84

 
$
—

 
$
4

 
$
—

 
$
(3
)
 
$
—

 
$
(13
)
 
$
72

Residential MBS
255

 
1

 
(5
)
 
25

 
(9
)
 
24

 
(7
)
 
284

Commercial MBS
10

 
—

 
—

 
9

 
—

 
9

 
—

 
28

All other corporate
382

 
2

 
12

 
32

 
(14
)
 
46

 
(24
)
 
436

Trading fixed maturities
1

 
—

 
—

 
—

 
—

 
—

 
—

 
1

Equity securities
21

 
—

 
(1
)
 
2

 
—

 
2

 
—

 
24

Assets of MIE
53

 
(6
)
 
—

 
5

 
(7
)
 
—

 
(5
)
 
40

Liabilities of MIE (*)
(2,322
)
 
89

 
—

 
—

 
51

 
—

 
—

 
(2,182
)
Embedded derivatives
(279
)
 
32

 
—

 
(62
)
 
4

 
—

 
—

 
(305
)

(*)
Total realized/unrealized loss included in net income includes losses of $89 million related to liabilities outstanding as of September 30, 2011. See Note H — “Managed Investment Entities.”
 

18
Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


  
 
 
Total
realized/unrealized
gains (losses)
included in
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2011
 
Net
income
 
Other
comprehensive
income (loss)
 
Purchases
and
Issuances
 
Sales and
Settlements
 
Transfer
into
Level 3
 
Transfer
out of
Level 3
 
Balance at September 30, 2012
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government
$
—

 
$
—

 
$
—

 
$
20

 
$
—

 
$
—

 
$
—

 
$
20

State and municipal
83

 
—

 
4

 
19

 
(7
)
 
9

 
(50
)
 
58

Residential MBS
361

 
5

 
11

 
86

 
(29
)