AFG-2013.3.31 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 March 31, 2013
 
Commission File No. 1-13653 


 

AMERICAN FINANCIAL GROUP, INC.
Incorporated under the Laws of Ohio
 
IRS Employer I.D. No. 31-1544320
301 East Fourth Street, Cincinnati, Ohio 45202
(513) 579-2121
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ    No  ¨
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).    Yes  þ    No  ¨
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company:
     Large Accelerated Filer  þ Accelerated Filer  ¨ Non-Accelerated Filer  ¨ Smaller Reporting Company  ¨
Indicate by check mark whether the Registrant is a shell company.    Yes  ¨    No  þ
As of May 1, 2013, there were 89,913,011 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)
 
March 31,
2013
 
December 31,
2012
Assets:
 
 
 
Cash and cash equivalents
$
1,529

 
$
1,705

Investments:
 
 
 
Fixed maturities, available for sale at fair value (amortized cost — $22,755 and $22,083)
24,775

 
24,118

Fixed maturities, trading at fair value
307

 
321

Equity securities, at fair value (cost — $837 and $778)
1,065

 
939

Mortgage loans
584

 
607

Policy loans
224

 
228

Real estate and other investments
600

 
531

Total cash and investments
29,084

 
28,449

Recoverables from reinsurers
3,083

 
3,750

Prepaid reinsurance premiums
466

 
471

Agents’ balances and premiums receivable
649

 
636

Deferred policy acquisition costs
565

 
550

Assets of managed investment entities
3,285

 
3,225

Other receivables
384

 
539

Variable annuity assets (separate accounts)
614

 
580

Other assets
824

 
786

Goodwill
185

 
185

Total assets
$
39,139

 
$
39,171

 
 
 
 
Liabilities and Equity:
 
 
 
Unpaid losses and loss adjustment expenses
$
6,238

 
$
6,845

Unearned premiums
1,697

 
1,651

Annuity benefits accumulated
18,075

 
17,609

Life, accident and health reserves
2,021

 
2,059

Payable to reinsurers
250

 
475

Liabilities of managed investment entities
2,880

 
2,892

Long-term debt
950

 
953

Variable annuity liabilities (separate accounts)
614

 
580

Other liabilities
1,506

 
1,359

Total liabilities
34,231

 
34,423

Shareholders’ equity:
 
 
 
Common Stock, no par value
       — 200,000,000 shares authorized
       — 89,883,222 and 88,979,303 shares outstanding
90

 
89

Capital surplus
1,090

 
1,063

Retained earnings:
 
 
 
Appropriated — managed investment entities
64

 
75

Unappropriated
2,620

 
2,520

Accumulated other comprehensive income, net of tax
869

 
831

Total shareholders’ equity
4,733

 
4,578

Noncontrolling interests
175

 
170

Total equity
4,908

 
4,748

Total liabilities and equity
$
39,139

 
$
39,171


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 March 31,
 
2013
 
2012
Revenues:
 
 
 
Property and casualty insurance net earned premiums
$
687

 
$
603

Life, accident and health net earned premiums
30

 
105

Net investment income
326

 
317

Realized gains on securities (*)
57

 
44

Income (loss) of managed investment entities:
 
 
 
Investment income
34

 
29

Loss on change in fair value of assets/liabilities
(8
)
 
(29
)
Other income
22

 
18

Total revenues
1,148

 
1,087

 
 
 
 
Costs and Expenses:
 
 
 
Property and casualty insurance:
 
 
 
Losses and loss adjustment expenses
393

 
344

Commissions and other underwriting expenses
251

 
211

Annuity benefits
134

 
130

Life, accident and health benefits
40

 
90

Annuity and supplemental insurance acquisition expenses
36

 
45

Interest charges on borrowed money
18

 
19

Expenses of managed investment entities
22

 
19

Other expenses
79

 
83

Total costs and expenses
973

 
941

Earnings before income taxes
175

 
146

Provision for income taxes
62

 
58

Net earnings, including noncontrolling interests
113

 
88

Less: Net earnings (loss) attributable to noncontrolling interests
(7
)
 
(25
)
Net Earnings Attributable to Shareholders
$
120

 
$
113

 
 
 
 
Earnings Attributable to Shareholders per Common Share:
 
 
 
Basic
$
1.34

 
$
1.16

Diluted
$
1.32

 
$
1.14

Average number of Common Shares:
 
 
 
Basic
89.4

 
97.7

Diluted
91.0

 
99.4

 
 
 
 
Cash dividends per Common Share
$
0.195

 
$
0.175

________________________________________
 
 
 
(*) Consists of the following:
 
 
 
Realized gains before impairments
$
57

 
$
48

 
 
 
 
Losses on securities with impairment
—

 
(5
)
Non-credit portion recognized in other comprehensive income (loss)
—

 
1

Impairment charges recognized in earnings
—

 
(4
)
Total realized gains on securities
$
57

 
$
44


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 March 31,
 
2013
 
2012
Net earnings, including noncontrolling interests
$
113

 
$
88

Other comprehensive income (loss), net of tax:
 
 
 
Net unrealized gains on securities:
 
 
 
Unrealized holding gains on securities arising during the period
79

 
158

Reclassification adjustment for realized gains included in net earnings
(36
)
 
(28
)
Total net unrealized gains on securities
43

 
130

Foreign currency translation adjustments
(4
)
 
7

Pension and other postretirement plans adjustments
—

 
1

Other comprehensive income (loss), net of tax
39

 
138

Total comprehensive income, net of tax
152

 
226

Less: Comprehensive income (loss) attributable to noncontrolling interests
(6
)
 
(21
)
Comprehensive income attributable to shareholders
$
158

 
$
247



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, 2012
88,979,303

 
$
1,152

 
$
75

 
$
2,520

 
$
831

 
$
4,578

 
$
170

 
$
4,748

Net earnings
—

 
—

 
—

 
120

 
—

 
120

 
(7
)
 
113

Other comprehensive income
—

 
—

 
—

 
—

 
38

 
38

 
1

 
39

Allocation of losses of managed investment entities
—

 
—

 
(11
)
 
—

 
—

 
(11
)
 
11

 
—

Dividends on Common Stock
—

 
—

 
—

 
(17
)
 
—

 
(17
)
 
—

 
(17
)
Shares issued:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Exercise of stock options
646,136

 
21

 
—

 
—

 
—

 
21

 
—

 
21

Other benefit plans
344,736

 
4

 
—

 
—

 
—

 
4

 
—

 
4

Dividend reinvestment plan
3,986

 
—

 
—

 
—

 
—

 
—

 
—

 
—

Stock-based compensation expense
—

 
4

 
—

 
—

 
—

 
4

 
—

 
4

Shares acquired and retired
(61,586
)
 
(1
)
 
—

 
(2
)
 
—

 
(3
)
 
—

 
(3
)
Shares exchanged — benefit plans
(29,353
)
 
—

 
—

 
(1
)
 
—

 
(1
)
 
—

 
(1
)
Balance at March 31, 2013
89,883,222

 
$
1,180

 
$
64

 
$
2,620

 
$
869

 
$
4,733

 
$
175

 
$
4,908

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2011
97,846,402

 
$
1,219

 
$
173

 
$
2,439

 
$
580

 
$
4,411

 
$
146

 
$
4,557

Net earnings
—

 
—

 
—

 
113

 
—

 
113

 
(25
)
 
88

Other comprehensive income
—

 
—

 
—

 
—

 
134

 
134

 
4

 
138

Allocation of losses of managed investment entities
—

 
—

 
(28
)
 
—

 
—

 
(28
)
 
28

 
—

Dividends on Common Stock
—

 
—

 
—

 
(17
)
 
—

 
(17
)
 
—

 
(17
)
Shares issued:
 
 
 
 
 
 
 
 
 
 

 
 
 

Exercise of stock options
551,219

 
14

 
—

 
—

 
—

 
14

 
—

 
14

Other benefit plans
250,072

 
5

 
—

 
—

 
—

 
5

 
—

 
5

Dividend reinvestment plan
3,916

 
—

 
—

 
—

 
—

 
—

 
—

 
—

Stock-based compensation expense
—

 
4

 
—

 
—

 
—

 
4

 
—

 
4

Shares acquired and retired
(1,473,789
)
 
(19
)
 
—

 
(37
)
 
—

 
(56
)
 
—

 
(56
)
Other
—

 
—

 
—

 
—

 
—

 
—

 
(1
)
 
(1
)
Balance at March 31, 2012
97,177,820

 
$
1,223

 
$
145

 
$
2,498

 
$
714

 
$
4,580

 
$
152

 
$
4,732


5
Table of Contents

AMERICAN FINANCIAL GROUP, INC. 10-Q
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Millions)
  
Three months ended March 31,
 
2013
 
2012
Operating Activities:
 
 
 
Net earnings, including noncontrolling interests
$
113

 
$
88

Adjustments:
 
 
 
Depreciation and amortization
35

 
46

Annuity benefits
134

 
130

Realized gains on investing activities
(58
)
 
(44
)
Net (purchases) sales of trading securities
10

 
(13
)
Deferred annuity and life policy acquisition costs
(34
)
 
(60
)
Change in:
 
 
 
Reinsurance and other receivables
807

 
535

Other assets
(25
)
 
(30
)
Insurance claims and reserves
(597
)
 
(373
)
Payable to reinsurers
(225
)
 
(183
)
Other liabilities
85

 
(3
)
Managed investment entities’ assets/liabilities
(193
)
 
(86
)
Other operating activities, net
7

 
3

Net cash provided by operating activities
59

 
10

 
 
 
 
Investing Activities:
 
 
 
Purchases of:
 
 
 
Fixed maturities
(1,370
)
 
(951
)
Equity securities
(71
)
 
(59
)
Mortgage loans
—

 
(39
)
Real estate, property and equipment
(28
)
 
(44
)
Proceeds from:
 
 
 
Maturities and redemptions of fixed maturities
675

 
514

Repayments of mortgage loans
23

 
2

Sales of fixed maturities
91

 
131

Sales of equity securities
58

 
65

Managed investment entities:
 
 
 
Purchases of investments
(440
)
 
(566
)
Proceeds from sales and redemptions of investments
578

 
774

Other investing activities, net
14

 
(10
)
Net cash used in investing activities
(470
)
 
(183
)
 
 
 
 
Financing Activities:
 
 
 
Annuity receipts
624

 
803

Annuity surrenders, benefits and withdrawals
(372
)
 
(348
)
Net transfers from variable annuity assets
3

 
8

Reductions of long-term debt
(3
)
 
(3
)
Issuances of managed investment entities’ liabilities
233

 
359

Retirement of managed investment entities’ liabilities
(251
)
 
(489
)
Issuances of Common Stock
21

 
14

Repurchases of Common Stock
(3
)
 
(56
)
Cash dividends paid on Common Stock
(17
)
 
(17
)
Net cash provided by financing activities
235

 
271

Net Change in Cash and Cash Equivalents
(176
)
 
98

Cash and cash equivalents at beginning of period
1,705

 
1,324

Cash and cash equivalents at end of period
$
1,529

 
$
1,422


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.
Sale 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
 
 
 
 
 
 
 
 
 
 

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, primarily the reclassification of investment expenses and real estate income and expenses to net investment income. 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, 2013, 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 2013   Effective January 1, 2013, AFG prospectively adopted Accounting Standards Update (“ASU”) 2013-02, which requires companies to disclose, in a single location within the financial statements or footnotes, reclassifications out of accumulated other comprehensive income (“AOCI”) separately for each component of other comprehensive income. For significant reclassifications, the disclosure is required to include the respective line items in net earnings affected by the reclassification. Disclosures required by the guidance are included in Note K — “Shareholders’ Equity.” This new disclosure requirement had no impact on 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 quarter of 2013 or 2012.
 
Investments   Fixed maturity and equity 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 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.
 

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


Gains or losses on securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other-than-temporary at the balance sheet date, a provision for impairment is charged to earnings (included in realized gains (losses) on securities) and the cost basis of that investment is reduced. If management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will have to sell the security 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.
 
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 (a) the estimated reinsurance recoverable on paid and unpaid losses, including an estimate for losses incurred but not reported, and (b) 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.
 
A 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

8
Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


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 Note A, “Accounting Policies — Life, Accident and Health Reserves” for details on the impact of loss recognition on the accounting for traditional life and health insurance contracts.

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

DPAC and certain other balance sheet amounts related to annuity, long-term care and life businesses are also adjusted, net of tax, for the change in expense that would have been recorded if the unrealized gains (losses) from securities had actually been realized. These adjustments are included in unrealized gains (losses) on marketable securities, a component of AOCI in AFG’s Balance Sheet.
 
Managed Investment Entities   A company is considered the primary beneficiary of, and therefore must consolidate, a variable interest entity (“VIE”) based primarily on its ability to direct the activities of the VIE that most significantly impact that entity’s economic performance and the obligation to absorb losses of, or receive benefits from, the entity that could potentially be significant to the VIE.
 
AFG manages, and has investments in, collateralized loan obligations (“CLOs”) that are VIEs (see Note H — “Managed Investment Entities”). 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 (at fair value). 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 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 2023), 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 March 31, 2013 and December 31, 2012, assets and liabilities of managed investment entities include $370 million and $107 million in assets and $316 million and $87 million in liabilities, respectively, 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 securities in April 2013.
 
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

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


coverage litigation. Establishing reserves for asbestos, environmental and other mass tort claims involves considerably more judgment than other types of claims due to, among other things, inconsistent court decisions, an increase in bankruptcy filings as a result of asbestos-related liabilities, novel theories of coverage, and judicial interpretations that often expand theories of recovery and broaden the scope of coverage.
 
Loss reserve liabilities are subject to the impact of changes in claim amounts and frequency and other factors. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the Statement of Earnings in the period in which determined. Despite the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
 
Annuity Benefits Accumulated   Annuity receipts and benefit payments are recorded as increases or decreases in annuity benefits accumulated rather than as revenue and expense. Increases in this liability for interest credited are charged to expense and decreases for policy charges are credited to other income.
 
For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses, guaranteed withdrawals and excess benefits expected to be paid on future deaths and annuitizations (“EDAR”). The 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 estimated future investment margin, surrender, mortality, and other life and annuity policy charges, and unearned revenues once they are recognized as income.
 
Annuity benefits accumulated also includes amounts advanced from the Federal Home Loan Bank of Cincinnati.
 
Unearned Revenue   Certain upfront policy charges on annuities are deferred as unearned revenue (included in other liabilities) and recognized in net earnings using the same assumptions and estimated gross profits used to amortize DPAC.

Life, Accident and Health Reserves   Liabilities for future policy benefits under traditional life, accident and health policies are computed using the net level premium method. Computations are based on the original projections of investment yields, mortality, morbidity and surrenders and include provisions for unfavorable deviations unless a loss recognition event (premium deficiency) occurs. Claim reserves and liabilities established for accident and health claims are modified as necessary to reflect actual experience and developing trends.
 
For long-duration contracts (such as traditional life and long-term care policies), loss recognition occurs when, based on current expectations as of the measurement date, existing contract liabilities plus the present value of future premiums (including reasonably expected rate increases) are not expected to cover the present value of future claims payments and related settlement and maintenance costs (excluding overhead) as well as unamortized acquisition costs. If a block of business is determined to be in loss recognition, a charge is recorded in earnings in an amount equal to the excess of the present value of expected future claims costs and unamortized acquisition costs over existing reserves plus the present value of expected future premiums (with no provision for adverse deviation). The charge is recorded first to reduce unamortized acquisition costs and then as an additional reserve (if unamortized acquisition costs have been reduced to zero).

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

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.

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


On reinsurance assumed from other insurance companies or written through various underwriting organizations, unearned premiums are based on information received from such companies and organizations. For traditional life, accident and health products, premiums are recognized as revenue when legally collectible from policyholders. For interest-sensitive life and universal life products, premiums are recorded in a policyholder account, which is reflected as a liability. Revenue is recognized as amounts are assessed against the policyholder account for mortality coverage and contract expenses.

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

Income Taxes   Deferred income taxes are calculated using the liability method. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases and are measured using enacted tax rates. A valuation allowance is established to reduce total deferred tax assets to an amount that will more likely than not be realized.

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

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

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 of 1.6 million for the first three months of 2013 and 1.7 million for the first three months of 2012 related to stock-based compensation plans.
 
AFG’s weighted average diluted shares outstanding excludes 1.5 million for the first three months of 2013 and 2012 in anti-dilutive potential common shares related to stock compensation plans. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were nominal in the 2013 and 2012 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.


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


B.     Sale of Subsidiaries

Medicare Supplement and Critical Illness Segment   In August 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 $326 million in cash resulting in a pretax gain of $170 million (including post-closing adjustments). Since the transaction includes the ongoing cessions of certain business to Cigna, the operations sold are not reported as discontinued operations. Summarized Statement of Earnings information for the Medicare supplement and critical illness segment for the first quarter of 2012 is shown below (in millions):
Total revenues
 
$
80

Total costs and expenses
 
74

Earnings before income taxes
 
$
6


C.    Segments of Operations

AFG manages its business as five segments: (i) Property and casualty insurance, (ii) Annuity, (iii) Run-off long-term care and life, (iv) Medicare supplement and critical illness (sold in August 2012) and (v) Other, which includes holding company costs, and the 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, 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 leasing and financing 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 retail, financial institutions and education markets. AFG’s reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.


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


The following tables (in millions) show AFG’s revenues and earnings before income taxes by significant business segment and sub-segment.
 
Three months ended March 31,
 
2013
 
2012
Revenues
 
 
 
Property and casualty insurance:
 
 
 
Premiums earned:
 
 
 
Specialty
 
 
 
Property and transportation
$
293

 
$
263

Specialty casualty
259

 
220

Specialty financial
116

 
103

Other specialty
19

 
17

Total premiums earned
687

 
603

Net investment income
66

 
70

Other income
3

 
3

Total property and casualty insurance
756

 
676

Annuity:
 
 
 
Net investment income
248

 
228

Other income
14

 
13

        Total annuity
262

 
241

Run-off long-term care and life
50

 
47

Medicare supplement and critical illness (a)
—

 
80

Other
23

 
(1
)
Total revenues before realized gains
1,091

 
1,043

Realized gains on securities
57

 
44

Total revenues
$
1,148

 
$
1,087

Earnings Before Income Taxes
 
 
 
Property and casualty insurance:
 
 
 
Underwriting:
 
 
 
Specialty
 
 
 
Property and transportation
$
10

 
$
27

Specialty casualty
19

 
4

Specialty financial
13

 
16

Other specialty
6

 
1

Other lines, primarily A&E charges
(5
)
 
—

Total underwriting
43

 
48

Investment and other income, net
56

 
55

Total property and casualty insurance
99

 
103

Annuity
76

 
60

Run-off long-term care and life
(1
)
 
1

Medicare supplement and critical illness (a)
—

 
6

Other (b)
(56
)
 
(68
)
Total earnings before realized gains and income taxes
118

 
102

Realized gains on securities
57

 
44

Total earnings before income taxes
$
175

 
$
146


(a)
Sold in August 2012.
(b)
Includes holding company expenses and $11 million and $28 million in losses of managed investment entities attributable to noncontrolling interests for the first quarter of 2013 and 2012, respectively.

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


D.    Fair Value Measurements

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

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

Level 3 — Valuations derived from market valuation techniques generally consistent with those used to estimate the fair values of Level 2 financial instruments in which one or more significant inputs are unobservable or when the market for a security exhibits significantly less liquidity relative to markets supporting Level 2 fair value measurements. The unobservable inputs may include management’s own assumptions about the assumptions market participants would use based on the best information available in the circumstances. AFG’s Level 3 is comprised of financial instruments, 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 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 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
March 31, 2013
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
Available for sale (“AFS”) fixed maturities:
 
 
 
 
 
 
 
U.S. Government and government agencies
$
170

 
$
152

 
$
20

 
$
342

States, municipalities and political subdivisions
—

 
4,590

 
54

 
4,644

Foreign government
—

 
254

 
—

 
254

Residential MBS
—

 
3,908

 
354

 
4,262

Commercial MBS
—

 
2,829

 
30

 
2,859

Asset-backed securities (“ABS”)
—

 
1,769

 
245

 
2,014

Corporate and other
5

 
10,151

 
244

 
10,400

Total AFS fixed maturities
175

 
23,653

 
947

 
24,775

Trading fixed maturities
—

 
307

 
—

 
307

Equity securities
881

 
135

 
49

 
1,065

Assets of managed investment entities (“MIE”)
354

 
2,901

 
30

 
3,285

Variable annuity assets (separate accounts) (a)
—

 
614

 
—

 
614

Other investments
—

 
195

 
—

 
195

Total assets accounted for at fair value
$
1,410

 
$
27,805

 
$
1,026

 
$
30,241

Liabilities:
 
 
 
 
 
 
 
Liabilities of managed investment entities
$
379

 
$
—

 
$
2,501

 
$
2,880

Derivatives in annuity benefits accumulated
—

 
—

 
555

 
555

Other liabilities — derivatives
—

 
16

 
—

 
16

Total liabilities accounted for at fair value
$
379

 
$
16

 
$
3,056

 
$
3,451

 
 
 
 
 
 
 
 
December 31, 2012
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
Available for sale fixed maturities:
 
 
 
 
 
 
 
U.S. Government and government agencies
$
227

 
$
141

 
$
20

 
$
388

States, municipalities and political subdivisions
—

 
4,410

 
58

 
4,468

Foreign government
—

 
260

 
—

 
260

Residential MBS
—

 
3,833

 
371

 
4,204

Commercial MBS
—

 
2,896

 
22

 
2,918

Asset-backed securities
—

 
1,387

 
253

 
1,640

Corporate and other
5

 
9,999

 
236

 
10,240

Total AFS fixed maturities
232

 
22,926

 
960

 
24,118

Trading fixed maturities
—

 
321

 
—

 
321

Equity securities
781

 
121

 
37

 
939

Assets of managed investment entities
256

 
2,929

 
40

 
3,225

Variable annuity assets (separate accounts) (a)
—

 
580

 
—

 
580

Other investments
—

 
133

 
—

 
133

Total assets accounted for at fair value
$
1,269

 
$
27,010

 
$
1,037

 
$
29,316

Liabilities:
 
 
 
 
 
 
 
Liabilities of managed investment entities
$
147

 
$
—

 
$
2,745

 
$
2,892

Derivatives in annuity benefits accumulated
—

 
—

 
465

 
465

Other liabilities — derivatives
—

 
17

 
—

 
17

Total liabilities accounted for at fair value
$
147

 
$
17

 
$
3,210

 
$
3,374

 
(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


At March 31, 2012, six preferred stocks with an aggregate fair value of $35 million were transferred from Level 1 to Level 2 due to decreases in trade frequency, resulting in lack of available trade data sufficient to warrant classification in Level 1. During the first quarter of 2013 and 2012, there were no transfers from Level 2 to Level 1. Approximately 3% of the total assets carried at fair value on March 31, 2013, were Level 3 assets. Approximately 95% 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 $555 million at March 31, 2013. 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
  
0.30% – 2.00% over the risk free rate
Risk margin for uncertainty in cash flows
  
0.4% reduction in the discount rate
Surrenders
  
4% – 20% of indexed account value
Partial surrenders
  
2% – 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

The range of adjustments for insurance subsidiary’s credit risk reflects credit spread variations across the yield curve. The range of projected surrender rates reflects the specific surrender charges and other features of AFG’s individual fixed-indexed annuity products with an expected range of 5% to 12% in the majority of future calendar years (4% — 20% over all periods). Increasing the budgeted option cost or risk margin for uncertainty in cash flows assumptions in the table above would increase the fair value of the fixed-indexed annuity embedded derivatives, while increasing any of the other unobservable inputs in the table above would decrease the fair value of the embedded derivatives.


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


Changes in balances of Level 3 financial assets and liabilities carried at fair value during the first quarter of 2013 and 2012 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, 2012
 
Net
income
 
Other
comprehensive
income (loss)
 
Purchases
and
issuances
 
Sales and
settlements
 
Transfer
into
Level 3
 
Transfer
out of
Level 3
 
Balance at March 31, 2013
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government
$
20

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
20

State and municipal
58

 
—

 
—

 
—

 
—

 
—

 
(4
)
 
54

Residential MBS
371

 
2

 
6

 
6

 
(12
)
 
16

 
(35
)
 
354

Commercial MBS
22

 
1

 
—

 
—

 
—

 
7

 
—

 
30

Asset-backed securities
253

 
1

 
—

 
12

 
(6
)
 
—

 
(15
)
 
245

Corporate and other
236

 
—

 
—

 
10

 
(2
)
 
—

 
—

 
244

Equity securities
37

 
—

 
3

 
9

 
—

 
—

 
—

 
49

Assets of MIE
40

 
(4
)
 
—

 
—

 
—

 
—

 
(6
)
 
30

Liabilities of MIE (*)
(2,745
)
 
(25
)
 
—

 
—

 
250

 
—

 
19

 
(2,501
)
Embedded derivatives
(465
)
 
(80
)
 
—

 
(17
)
 
7

 
—

 
—

 
(555
)

(*)
Total realized/unrealized loss included in net income includes losses of $18 million related to liabilities outstanding as of March 31, 2013. See Note H — “Managed Investment Entities.”
 
  
 
 
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 March 31, 2012
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
State and municipal
$
83

 
$
—

 
$
—

 
$
10

 
$
—

 
$
—

 
$
(21
)
 
$
72

Residential MBS
361

 
1

 
—

 
8

 
(10
)
 
60

 
(106
)
 
314

Commercial MBS
19

 
—

 
1

 
—

 
—

 
—

 
—

 
20

Asset-backed securities
220

 
1

 
5

 
8

 
(5
)
 
10

 
—

 
239

Corporate and other
299

 
1

 
(2
)
 
18

 
(11
)
 
11

 
(40
)
 
276

Trading fixed maturities
1

 
—

 
—

 
—

 
—

 
—

 
—

 
1

Equity securities
11

 
—

 
—

 
9

 
—

 
4

 
—

 
24

Assets of MIE
44

 
—

 
—

 
12

 
(3
)
 
14

 
(3
)
 
64

Liabilities of MIE (*)
(2,593
)
 
(84
)
 
—

 
(366
)
 
489

 
—

 
—

 
(2,554
)
Embedded derivatives
(361
)
 
(60
)
 
—

 
(21
)
 
5

 
—

 
—

 
(437
)

(*)
Total realized/unrealized loss included in net income includes losses of $39 million related to liabilities outstanding as of March 31, 2012. See Note H — “Managed Investment Entities.”

17
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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
Value
 
Fair
Value
 
Level 1
 
Level 2
 
Level 3
March 31, 2013
 
 
 
 
 
 
 
 
 
Financial assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
1,529

 
$
1,529

 
$
1,529

 
$
—

 
$
—

Mortgage loans
584

 
590

 
—

 
—

 
590

Policy loans
224

 
224

 
—

 
—

 
224

Total financial assets not accounted for at fair value
$
2,337

 
$
2,343

 
$
1,529

 
$
—

 
$
814

Financial liabilities:
 
 
 
 
 
 
 
 
 
Annuity benefits accumulated (*)
$
17,872

 
$
17,700

 
$
—

 
$
—

 
$
17,700

Long-term debt
950

 
1,107

 
—

 
1,014

 
93

Total financial liabilities not accounted for at fair value
$
18,822

 
$
18,807

 
$
—

 
$
1,014

 
$
17,793

 
 
 
 
 
 
 
 
 
 
December 31, 2012
 
 
 
 
 
 
 
 
 
Financial assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
1,705

 
$
1,705

 
$
1,705

 
$
—

 
$
—

Mortgage loans
607

 
613

 
—

 
—

 
613

Policy loans
228

 
228

 
—

 
—

 
228

Total financial assets not accounted for at fair value
$
2,540

 
$
2,546

 
$
1,705

 
$
—

 
$
841

Financial liabilities:
 
 
 
 
 
 
 
 
 
Annuity benefits accumulated (*)
$
17,405

 
$
17,422

 
$
—

 
$
—

 
$
17,422

Long-term debt
953

 
1,086

 
—

 
990

 
96

Total financial liabilities not accounted for at fair value
$
18,358

 
$
18,508

 
$
—

 
$
990

 
$
17,518


(*)    Excludes life contingent annuities in the payout phase.

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

E.    Investments

Available for sale fixed maturities and equity securities at March 31, 2013, and December 31, 2012, consisted of the following (in millions): 

March 31, 2013
 
December 31, 2012
Amortized
Cost
 
Fair
Value
 
Gross Unrealized
 
Amortized
Cost
 
Fair
Value
 
Gross Unrealized
Gains
 
Losses
 
Gains
 
Losses
Fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Government and government agencies
$
327

 
$
342

 
$
15

 
$
—

 
$
373

 
$
388

 
$
15

 
$
—

States, municipalities and political subdivisions
4,334

 
4,644

 
316

 
(6
)
 
4,144

 
4,468

 
329

 
(5
)
Foreign government
238

 
254

 
16

 
—

 
242

 
260

 
18

 
—

Residential MBS
3,922

 
4,262

 
378

 
(38
)
 
3,921

 
4,204

 
337

 
(54
)
Commercial MBS
2,556

 
2,859

 
303

 
—

 
2,583

 
2,918

 
335

 
—

Asset-backed securities
1,954

 
2,014

 
62

 
(2
)
 
1,590

 
1,640

 
52

 
(2
)
Corporate and other
9,424

 
10,400

 
982

 
(6
)
 
9,230

 
10,240

 
1,015

 
(5
)
Total fixed maturities
$
22,755

 
$
24,775

 
$
2,072

 
$
(52
)
 
$
22,083

 
$
24,118

 
$
2,101

 
$
(66
)
Common stocks
$
655

 
$
867

 
$
215

 
$
(3
)
 
$
600

 
$
749

 
$
157

 
$
(8
)
Perpetual preferred stocks
$
182

 
$
198

 
$
17

 
$
(1
)
 
$
178

 
$
190

 
$
13

 
$
(1
)

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


The non-credit related portion of other-than-temporary impairment charges is included in other comprehensive income. Cumulative non-credit charges taken for securities still owned at March 31, 2013 and December 31, 2012 were $227 million and related to residential MBS.

The following tables show gross unrealized losses (in millions) on fixed maturities and equity securities by investment category and length of time that individual securities have been in a continuous unrealized loss position at March 31, 2013 and December 31, 2012. 
  
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, 2013
 
 
 
 
 
 
 
 
 
 
 
Fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
U.S. Government and government agencies
$
—

 
$
11

 
100
%
 
$
—

 
$
—

 
—
%
States, municipalities and political subdivisions
(5
)
 
368

 
99
%
 
(1
)
 
49

 
98
%
Foreign government
—

 
—

 
—
%
 
—

 
—

 
—
%
Residential MBS
(3
)
 
184

 
98
%
 
(35
)
 
333

 
90
%
Commercial MBS
—

 
7

 
100
%
 
—

 
—

 
—
%
Asset-backed securities
(1
)
 
299

 
100
%
 
(1
)
 
42

 
98
%
Corporate and other
(5
)
 
327

 
98
%
 
(1
)
 
43

 
98
%
Total fixed maturities
$
(14
)
 
$
1,196

 
99
%
 
$
(38
)
 
$
467

 
92
%
Common stocks
$
(3
)
 
$
61

 
95
%
 
$
—

 
$
—

 
—
%
Perpetual preferred stocks
$
—

 
$
17

 
100
%
 
$
(1
)
 
$
26

 
96
%
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2012
 
 
 
 
 
 
 
 
 
 
 
Fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
U.S. Government and government agencies
$
—

 
$
22

 
100
%
 
$
—

 
$
—

 
—
%
States, municipalities and political subdivisions
(5
)
 
285

 
98
%
 
—

 
24

 
100
%
Foreign government
—

 
—

 
—
%
 
—

 
—

 
—
%
Residential MBS
(3
)
 
146

 
98
%
 
(51
)
 
411

 
89
%
Commercial MBS
—

 
16

 
100
%
 
—

 
—

 
—
%
Asset-backed securities
—

 
146