Document
______________________________________________________________________________________________________
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 June 30, 2016
 
 
 
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. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
          Large accelerated filer  þ Accelerated filer  ¨ Non-accelerated filer  ¨ Smaller reporting company  ¨
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ
As of August 1, 2016, there were 86,893,457 shares of the Registrant’s Common Stock outstanding, excluding 14.9 million shares owned by subsidiaries.


______________________________________________________________________________________________________

Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q

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)
 
June 30,
2016
 
December 31,
2015
Assets:
 
 
 
Cash and cash equivalents
$
1,548

 
$
1,220

Investments:
 
 
 
Fixed maturities, available for sale at fair value (amortized cost — $32,882 and $31,565)
34,638

 
32,284

Fixed maturities, trading at fair value
271

 
254

Equity securities, available for sale at fair value (cost — $1,400 and $1,469)
1,472

 
1,553

Equity securities, trading at fair value
86

 
166

Mortgage loans
1,159

 
1,067

Policy loans
195

 
201

Real estate and other investments
1,270

 
991

Total cash and investments
40,639

 
37,736

Recoverables from reinsurers
2,576

 
2,636

Prepaid reinsurance premiums
521

 
480

Agents’ balances and premiums receivable
992

 
937

Deferred policy acquisition costs
881

 
1,184

Assets of managed investment entities
4,410

 
4,047

Other receivables
788

 
820

Variable annuity assets (separate accounts)
595

 
608

Other assets
1,132

 
1,190

Goodwill
199

 
199

Total assets
$
52,733

 
$
49,837

 
 
 
 
Liabilities and Equity:
 
 
 
Unpaid losses and loss adjustment expenses
$
8,203

 
$
8,127

Unearned premiums
2,109

 
2,060

Annuity benefits accumulated
28,596

 
26,622

Life, accident and health reserves
702

 
705

Payable to reinsurers
588

 
591

Liabilities of managed investment entities
4,192

 
3,781

Long-term debt
998

 
998

Variable annuity liabilities (separate accounts)
595

 
608

Other liabilities
1,557

 
1,575

Total liabilities
47,540

 
45,067

Shareholders’ equity:
 
 
 
Common Stock, no par value
       — 200,000,000 shares authorized
       — 86,850,459 and 87,474,452 shares outstanding
87

 
87

Capital surplus
1,228

 
1,214

Retained earnings
3,016

 
2,987

Accumulated other comprehensive income, net of tax
669

 
304

Total shareholders’ equity
5,000

 
4,592

Noncontrolling interests
193

 
178

Total equity
5,193

 
4,770

Total liabilities and equity
$
52,733

 
$
49,837


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 June 30,
 
Six months ended June 30,
 
2016
 
2015
 
2016
 
2015
Revenues:
 
 
 
 
 
 
 
Property and casualty insurance net earned premiums
$
1,027

 
$
985

 
$
2,025

 
$
1,931

Life, accident and health net earned premiums
6

 
27

 
12

 
52

Net investment income
423

 
404

 
834

 
792

Realized gains (losses) on:
 
 
 
 
 
 
 
Securities (*)
(16
)
 
(1
)
 
(34
)
 
18

Subsidiaries
2

 
—

 
2

 
(162
)
Income (loss) of managed investment entities:
 
 
 
 
 
 
 
Investment income
48

 
38

 
93

 
72

Gain (loss) on change in fair value of assets/liabilities
11

 
(2
)
 
(2
)
 
(5
)
Other income
80

 
92

 
126

 
142

Total revenues
1,581

 
1,543

 
3,056

 
2,840

 
 
 
 
 
 
 
 
Costs and Expenses:
 
 
 
 
 
 
 
Property and casualty insurance:
 
 
 
 
 
 
 
Losses and loss adjustment expenses
687

 
601

 
1,268

 
1,177

Commissions and other underwriting expenses
348

 
338

 
682

 
651

Annuity benefits
223

 
151

 
451

 
335

Life, accident and health benefits
9

 
33

 
18

 
65

Annuity and supplemental insurance acquisition expenses
42

 
66

 
77

 
107

Interest charges on borrowed money
19

 
20

 
37

 
40

Expenses of managed investment entities
36

 
28

 
71

 
52

Other expenses
81

 
80

 
160

 
157

Total costs and expenses
1,445

 
1,317

 
2,764

 
2,584

Earnings before income taxes
136

 
226

 
292

 
256

Provision for income taxes
73

 
77

 
125

 
82

Net earnings, including noncontrolling interests
63

 
149

 
167

 
174

Less: Net earnings attributable to noncontrolling interests
9

 
8

 
12

 
14

Net Earnings Attributable to Shareholders
$
54

 
$
141

 
$
155

 
$
160

 
 
 
 
 
 
 
 
Earnings Attributable to Shareholders per Common Share:
 
 
 
 
 
 
 
Basic
$
0.63

 
$
1.60

 
$
1.79

 
$
1.82

Diluted
$
0.62

 
$
1.57

 
$
1.76

 
$
1.79

Average number of Common Shares:
 
 
 
 
 
 
 
Basic
86.8

 
87.7

 
86.8

 
87.6

Diluted
88.4

 
89.5

 
88.4

 
89.4

 
 
 
 
 
 
 
 
Cash dividends per Common Share
$
0.28

 
$
0.25

 
$
0.56

 
$
0.50

________________________________________
 
 
 
 
 
 
 
(*) Consists of the following:
 
 
 
 
 
 
 
Realized gains before impairments
$
23

 
$
29

 
$
57

 
$
52

 
 
 
 
 
 
 
 
Losses on securities with impairment
(39
)
 
(30
)
 
(90
)
 
(34
)
Non-credit portion recognized in other comprehensive income (loss)
—

 
—

 
(1
)
 
—

Impairment charges recognized in earnings
(39
)
 
(30
)
 
(91
)
 
(34
)
Total realized gains (losses) on securities
$
(16
)
 
$
(1
)
 
$
(34
)
 
$
18


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 June 30,
 
Six months ended June 30,
 
2016
 
2015
 
2016
 
2015
Net earnings, including noncontrolling interests
$
63

 
$
149

 
$
167

 
$
174

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Net unrealized gains (losses) on securities:
 
 
 
 
 
 
 
Unrealized holding gains (losses) on securities arising during the period
213

 
(214
)
 
338

 
(145
)
Reclassification adjustment for realized (gains) losses included in net earnings
10

 
(1
)
 
21

 
(13
)
Total net unrealized gains (losses) on securities
223

 
(215
)
 
359

 
(158
)
Net unrealized gains (losses) on cash flow hedges
1

 
(1
)
 
4

 
—

Foreign currency translation adjustments
1

 
—

 
7

 
(8
)
Pension and other postretirement plans adjustments
—

 
—

 
1

 
—

Other comprehensive income (loss), net of tax
225

 
(216
)
 
371

 
(166
)
Total comprehensive income (loss), net of tax
288

 
(67
)
 
538

 
8

Less: Comprehensive income attributable to noncontrolling interests
13

 
5

 
18

 
12

Comprehensive income (loss) attributable to shareholders
$
275

 
$
(72
)
 
$
520

 
$
(4
)


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.
 
Income
 
Total
 
Interests
 
Equity
Balance at December 31, 2015
87,474,452

 
 
$
1,301

 
$
—

 
$
2,987

 
$
304

 
$
4,592

 
$
178

 
$
4,770

Net earnings
—

 
 
—

 
—

 
155

 
—

 
155

 
12

 
167

Other comprehensive income
—

 
 
—

 
—

 
—

 
365

 
365

 
6

 
371

Dividends on Common Stock
—

 
 
—

 
—

 
(48
)
 
—

 
(48
)
 
—

 
(48
)
Shares issued:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Restricted stock awards
317,230

 
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Exercise of stock options
448,136

 
 
16

 
—

 
—

 
—

 
16

 
—

 
16

Other benefit plans
72,050

 
 
5

 
—

 
—

 
—

 
5

 
—

 
5

Dividend reinvestment plan
7,427

 
 
1

 
—

 
—

 
—

 
1

 
—

 
1

Stock-based compensation:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Expense
—

 
 
10

 
—

 
—

 
—

 
10

 
—

 
10

Excess tax benefits
—

 
 
4

 
—

 
—

 
—

 
4

 
—

 
4

Shares acquired and retired
(1,438,142
)
 
 
(22
)
 
—

 
(76
)
 
—

 
(98
)
 
—

 
(98
)
Shares exchanged — benefit plans
(28,044
)
 
 
—

 
—

 
(2
)
 
—

 
(2
)
 
—

 
(2
)
Forfeitures of restricted stock
(2,650
)
 
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Other
—

 
 
—

 
—

 
—

 
—

 
—

 
(3
)
 
(3
)
Balance at June 30, 2016
86,850,459

 
 
$
1,315

 
$
—

 
$
3,016

 
$
669

 
$
5,000

 
$
193

 
$
5,193

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2014
87,708,793

 
 
$
1,240

 
$
(2
)
 
$
2,914

 
$
727

 
$
4,879

 
$
175

 
$
5,054

Cumulative effect of accounting change
—

 
 
—

 
2

 
—

 
—

 
2

 
—

 
2

Net earnings
—

 
 
—

 
—

 
160

 
—

 
160

 
14

 
174

Other comprehensive loss
—

 
 
—

 
—

 
—

 
(164
)
 
(164
)
 
(2
)
 
(166
)
Dividends on Common Stock
—

 
 
—

 
—

 
(44
)
 
—

 
(44
)
 
—

 
(44
)
Shares issued:
 
 
 
 
 
 
 
 
 
 
 

 
 
 

Restricted stock awards
171,130

 
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Exercise of stock options
852,691

 
 
28

 
—

 
—

 
—

 
28

 
—

 
28

Other benefit plans
88,181

 
 
5

 
—

 
—

 
—

 
5

 
—

 
5

Dividend reinvestment plan
7,041

 
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Stock-based compensation:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Expense
—

 
 
10

 
—

 
—

 
—

 
10

 
—

 
10

Excess tax benefits
—

 
 
6

 
—

 
—

 
—

 
6

 
—

 
6

Shares acquired and retired
(1,254,791
)
 
 
(18
)
 
—

 
(60
)
 
—

 
(78
)
 
—

 
(78
)
Shares exchanged — benefit plans
(32,633
)
 
 
—

 
—

 
(2
)
 
—

 
(2
)
 
—

 
(2
)
Other
—

 
 
—

 
—

 
—

 
—

 
—

 
(5
)
 
(5
)
Balance at June 30, 2015
87,540,412

 
 
$
1,271

 
$
—

 
$
2,968

 
$
563

 
$
4,802

 
$
182

 
$
4,984


5
Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Millions)
 
Six months ended June 30,
 
2016
 
2015
Operating Activities:
 
 
 
Net earnings, including noncontrolling interests
$
167

 
$
174

Adjustments:
 
 
 
Depreciation and amortization
53

 
84

Annuity benefits
451

 
335

Realized (gains) losses on investing activities
(3
)
 
81

Net (purchases) sales of trading securities
85

 
(5
)
Deferred annuity and life policy acquisition costs
(124
)
 
(90
)
Change in:
 
 
 
Reinsurance and other receivables
42

 
314

Other assets
(150
)
 
(83
)
Insurance claims and reserves
121

 
(64
)
Payable to reinsurers
(3
)
 
(134
)
Other liabilities
12

 
53

Managed investment entities’ assets/liabilities
(199
)
 
(107
)
Other operating activities, net
(26
)
 
18

Net cash provided by operating activities
426

 
576

 
 
 
 
Investing Activities:
 
 
 
Purchases of:
 
 
 
Fixed maturities
(3,776
)
 
(3,728
)
Equity securities
(101
)
 
(152
)
Mortgage loans
(255
)
 
(62
)
Real estate, property and equipment
(26
)
 
(32
)
Proceeds from:
 
 
 
Maturities and redemptions of fixed maturities
2,073

 
1,688

Repayments of mortgage loans
163

 
127

Sales of fixed maturities
373

 
231

Sales of equity securities
139

 
149

Sales of real estate, property and equipment
43

 
92

Managed investment entities:
 
 
 
Purchases of investments
(869
)
 
(808
)
Proceeds from sales and redemptions of investments
771

 
439

Other investing activities, net
(282
)
 
(58
)
Net cash used in investing activities
(1,747
)
 
(2,114
)
 
 
 
 
Financing Activities:
 
 
 
Annuity receipts
2,533

 
2,012

Annuity surrenders, benefits and withdrawals
(1,118
)
 
(937
)
Net transfers from variable annuity assets
17

 
20

Reductions of long-term debt
—

 
(37
)
Issuances of managed investment entities’ liabilities
1,028

 
639

Retirements of managed investment entities’ liabilities
(682
)
 
(192
)
Issuances of Common Stock
20

 
34

Repurchases of Common Stock
(98
)
 
(78
)
Cash dividends paid on Common Stock
(48
)
 
(44
)
Other financing activities, net
(3
)
 
(6
)
Net cash provided by financing activities
1,649

 
1,411

Net Change in Cash and Cash Equivalents
328

 
(127
)
Cash and cash equivalents at beginning of period
1,220

 
1,343

Cash and cash equivalents at end of period
$
1,548

 
$
1,216


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 Business
 
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. and its subsidiaries (“AFG”) are unaudited; however, management believes that all adjustments (consisting only of normal recurring accruals unless otherwise disclosed herein) necessary for fair presentation have been made. The results of operations for interim periods are not necessarily indicative of results to be expected for the year. The financial statements have been prepared in accordance with the instructions to Form 10-Q and, therefore, do not include all information and footnotes necessary to be in conformity with U.S. generally accepted accounting principles (“GAAP”).
 
Certain reclassifications have been made to prior periods to conform to the current year’s presentation. All significant intercompany balances and transactions have been eliminated. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. Events or transactions occurring subsequent to June 30, 2016, and prior to the filing of this Form 10-Q, have been evaluated for potential recognition or disclosure herein.
 
The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates.

Fair Value Measurements   Accounting standards define fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The standards establish a hierarchy of valuation techniques based on whether the assumptions that market participants would use in pricing the asset or liability (“inputs”) are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect AFG’s assumptions about the assumptions market participants would use in pricing the asset or liability. AFG did not have any significant nonrecurring fair value measurements in the first six months of 2016.

Investments   Fixed maturity and equity securities classified as “available for sale” are reported at fair value with unrealized gains and losses included in accumulated other comprehensive income (“AOCI”) in AFG’s Balance Sheet. Fixed maturity and equity securities classified as “trading” are reported at fair value with changes in unrealized holding gains or losses during the period included in net investment income. Mortgage and policy loans are carried primarily at the aggregate unpaid balance.

In January 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-01, which, among other things, will require all equity securities currently classified as “available for sale” to be reported at fair value, with holding gains and losses recognized in net income, instead of AOCI. AFG will be required to adopt this guidance effective January 1, 2018.

Premiums and discounts on fixed maturity securities are amortized using the interest method. Mortgage-backed securities (“MBS”) are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations.
 
Gains or losses on securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other-than-temporary at the balance sheet date, a provision for impairment is charged to earnings (included in realized gains (losses) on securities) and the cost basis of that investment is reduced. If management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will have to sell the security

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


before recovery of its amortized cost basis, then the other-than-temporary impairment is separated into two components: (i) the amount related to credit losses (recorded in earnings) and (ii) the amount related to all other factors (recorded in other comprehensive income). The credit-related portion of an other-than-temporary impairment is measured by comparing a security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. Both components are shown in the statement of earnings. If management intends to sell an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge to earnings is recorded to reduce the amortized cost of that security to fair value.
 
Derivatives   Derivatives included in AFG’s Balance Sheet are recorded at fair value. Changes in fair value of derivatives are included in earnings, unless the derivatives are designated and qualify as highly effective cash flow hedges. Derivatives that do not qualify for hedge accounting under GAAP consist primarily of (i) components of certain fixed maturity securities (primarily interest-only MBS) and (ii) the equity-based component of certain annuity products (included in annuity benefits accumulated) and related 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.

To qualify for hedge accounting, at the inception of a derivative contract, AFG formally documents the relationship between the terms of the hedge and the hedged items and its risk management objective. This documentation includes defining how hedge effectiveness and ineffectiveness will be measured on a retrospective and prospective basis.

Changes in the fair value of derivatives that are designated and qualify as highly effective cash flow hedges are recorded in AOCI and are reclassified into earnings when the variability of the cash flows from the hedged items impacts earnings. Any hedge ineffectiveness is immediately recorded in current period earnings. When the change in the fair value of a qualifying cash flow hedge is included in earnings, it is included in the same line item in the statement of earnings as the cash flows from the hedged item. AFG uses interest rate swaps that are designated and qualify as highly effective cash flow hedges to mitigate interest rate risk related to certain floating-rate securities included in AFG’s portfolio of fixed maturity securities.

For derivatives that are designated and qualify as highly effective fair value hedges, changes in the fair value of the derivative, along with changes in the fair value of the hedged item attributable to the hedged risk, are recognized in current period earnings. AFG has entered into an interest rate swap that qualifies as a highly effective fair value hedge to mitigate the interest rate risk associated with fixed-rate long-term debt by economically converting certain fixed-rate debt obligations to floating-rate obligations. Since the terms of the swap match the terms of the hedged debt, changes in the fair value of the swap are offset by changes in the fair value of the hedged debt attributable to changes in interest rates. Accordingly, the net impact on AFG’s current period earnings is that the interest expense associated with the hedged debt is effectively recorded at the floating rate.

Goodwill   Goodwill represents the excess of cost of subsidiaries over AFG’s equity in their underlying net assets. Goodwill is not amortized, but is subject to an impairment test at least annually. An entity is not required to complete the quantitative annual goodwill impairment test on a reporting unit if the entity elects to perform a qualitative analysis and determines that it is more likely than not that the reporting unit’s fair value exceeds its carrying amount.
 
Reinsurance   Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. AFG’s property and casualty insurance subsidiaries report as assets (i) the estimated reinsurance recoverable on paid and unpaid losses, including an estimate for losses incurred but not reported, and (ii) amounts paid or due to reinsurers applicable to the unexpired terms of policies in force. Payable to reinsurers includes ceded premiums due to reinsurers, as well as ceded premiums retained by AFG’s property and casualty insurance subsidiaries under contracts to fund ceded losses as they become due. AFG’s insurance subsidiaries also assume reinsurance from other companies. Earnings on reinsurance assumed is recognized based on information received from ceding companies.
 
An AFG subsidiary cedes life insurance policies to a third party on a funds withheld basis whereby the subsidiary retains the assets (securities) associated with the reinsurance contract. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. This reinsurance contract is considered to contain an embedded derivative (that must be adjusted to fair value) because the yield on the payable is based on a specific block of the ceding company’s assets, rather than the overall creditworthiness of the ceding company. AFG determined that changes in the fair value of the underlying portfolio of fixed maturity securities is an appropriate measure of the value of the embedded derivative. The securities related to this contract are classified as “trading.” The adjustment to fair value on the embedded derivative offsets the investment income recorded on the adjustment to fair value of the related trading portfolio.
 

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


Deferred Policy Acquisition Costs (“DPAC”)   Policy acquisition costs (principally commissions, premium taxes and certain underwriting and policy issuance costs) directly related to the successful acquisition or renewal of an insurance contract are deferred. DPAC also includes capitalized costs associated with sales inducements offered to fixed annuity policyholders such as enhanced interest rates and premium and persistency bonuses.
 
For the property and casualty companies, DPAC is limited based upon recoverability without any consideration for anticipated investment income and is charged against income ratably over the terms of the related policies. A premium deficiency is recognized if the sum of expected claims costs, claims adjustment expenses and unamortized acquisition costs exceed the related unearned premiums. A premium deficiency is first recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency is greater than unamortized acquisition costs, a liability is accrued for the excess deficiency and reported with unpaid losses and loss adjustment expenses.

DPAC related to annuities is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of actual and expected gross profits on the policies. Expected gross profits consist principally of estimated future investment margin (estimated future net investment income less interest credited on policyholder funds) and surrender, mortality, and other life and annuity policy charges, less death, annuitization and guaranteed withdrawal benefits in excess of account balances and estimated future policy administration expenses. To the extent that realized gains and losses result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains (losses) on securities.

DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues. See “Life, Accident and Health Reserves” below for details on the impact of loss recognition on the accounting for traditional life and health insurance contracts.

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

DPAC and certain other balance sheet amounts related to annuity, long-term care and life businesses are also adjusted, net of tax, for the change in expense that would have been recorded if the unrealized gains (losses) from securities had actually been realized. These adjustments are included in unrealized gains (losses) on marketable securities, a component of AOCI in AFG’s Balance Sheet.
 
Managed Investment Entities   A company is considered the primary beneficiary of, and therefore must consolidate, a variable interest entity (“VIE”) based primarily on its ability to direct the activities of the VIE that most significantly impact that entity’s economic performance and the obligation to absorb losses of, or receive benefits from, the entity that could potentially be significant to the VIE.
 
AFG manages, and has investments in, collateralized loan obligations (“CLOs”) that are VIEs (see Note H — “Managed Investment Entities”). AFG has determined that it is the primary beneficiary of the CLOs because (i) its role as asset manager gives it the power to direct the activities that most significantly impact the economic performance of the CLOs and (ii) through its investment in the CLO debt tranches, it has exposure to CLO losses (limited to the amount AFG invested) and the right to receive CLO benefits that could potentially be significant to the CLOs.

On January 1, 2016, AFG adopted ASU 2015-02, which amended certain consolidation accounting guidance, including the VIE guidance that applies to collateralized financing entities such as CLOs. The new guidance affects how fee arrangements with CLO asset managers impact the determination of the primary beneficiary of those entities. Due to the significance of AFG’s investments in the CLOs that it manages, the new guidance did not impact the consolidation of AFG’s currently outstanding CLOs. The new guidance also impacted the consolidation analysis that applies to limited partnerships and similar entities, but did not result in a change to the accounting for AFG’s existing investments in those entities.

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

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


liabilities to improve the transparency of financial reporting related to the CLOs. The net gain or loss from accounting for the CLO assets and liabilities at fair value is presented separately in AFG’s Statement of Earnings.

Effective January 1, 2015, AFG adopted (on a modified retrospective basis) ASU 2014-13, which addresses the diversity in practice regarding the accounting for assets and liabilities of a consolidated collateralized financing entity (such as a CLO) when an election has been made to account for that entity’s assets and liabilities at fair value. The fair values of a CLO’s assets may differ from the separately measured fair values of its liabilities even though the CLO liabilities only have recourse to the CLO assets. Under the new guidance, AFG elected to set the carrying value of the CLO liabilities equal to the fair value of the CLO assets (which have more observable fair values) as an alternative to reporting those liabilities at a separately measured fair value. CLO earnings attributable to AFG’s shareholders continue to be measured by the change in the fair value of AFG’s investments in the CLOs and management fees earned.

Prior to the adoption of ASU 2014-13, measuring both the CLO assets and CLO liabilities at separately determined fair values resulted in a difference between the carrying value of the CLO assets and the carrying value of the CLO liabilities that was not attributable to AFG’s ownership interest in the CLOs. This difference was recorded as “appropriated retained earnings — managed investment entities” in AFG’s Balance Sheet. In accordance with the guidance adopted in 2015, the amount reported as “appropriated retained earnings — managed investment entities” at December 31, 2014 was reclassified to “liabilities of managed investment entities” on January 1, 2015 as the cumulative effect of an accounting change.

Unpaid Losses and Loss Adjustment Expenses   The net liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims represent management’s best estimate and are based upon (i) the accumulation of case estimates for losses reported prior to the close of the accounting period on direct business written; (ii) estimates received from ceding reinsurers and insurance pools and associations; (iii) estimates of unreported losses (including possible development on known claims) based on past experience; (iv) estimates based on experience of expenses for investigating and adjusting claims; and (v) the current state of the law and coverage litigation. Establishing reserves for asbestos, environmental and other mass tort claims involves considerably more judgment than other types of claims due to, among other things, inconsistent court decisions, an increase in bankruptcy filings as a result of asbestos-related liabilities, novel theories of coverage, and judicial interpretations that often expand theories of recovery and broaden the scope of coverage.
 
Loss reserve liabilities are subject to the impact of changes in claim amounts and frequency and other factors. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the statement of earnings in the period in which determined. Despite the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
 
Annuity Benefits Accumulated   Annuity receipts and benefit payments are recorded as increases or decreases in annuity benefits accumulated rather than as revenue and expense. Increases in this liability for interest credited are charged to expense and decreases for policy charges are credited to other income.
 
For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses, guaranteed withdrawals and excess benefits expected to be paid on future deaths and annuitizations (“EDAR”). The liabilities for EDAR and guaranteed withdrawals are accrued for and modified using assumptions consistent with those used in determining DPAC and DPAC amortization, except that amounts are determined in relation to the present value of total expected assessments. Total expected assessments consist principally of estimated future investment margin, surrender, mortality, and other life and annuity policy charges, and unearned revenues once they are recognized as income.
 
Annuity benefits accumulated also includes amounts advanced from the Federal Home Loan Bank of Cincinnati.
 
Unearned Revenue   Certain upfront policy charges on annuities are deferred as unearned revenue (included in other liabilities) and recognized in net earnings (included in other income) using the same assumptions and estimated gross profits used to amortize DPAC.

Life, Accident and Health Reserves   Liabilities for future policy benefits under traditional life, accident and health policies are computed using the net level premium method. Computations are based on the original projections of investment yields, mortality, morbidity and surrenders and include provisions for unfavorable deviations unless a loss recognition event (premium deficiency) occurs. Claim reserves and liabilities established for accident and health claims are modified as necessary to reflect actual experience and developing trends.


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


For long-duration contracts (such as traditional life and long-term care policies), loss recognition occurs when, based on current expectations as of the measurement date, existing contract liabilities plus the present value of future premiums (including reasonably expected rate increases) are not expected to cover the present value of future claims payments and related settlement and maintenance costs (excluding overhead) as well as unamortized acquisition costs. If a block of business is determined to be in loss recognition, a charge is recorded in earnings in an amount equal to the excess of the present value of expected future claims costs and unamortized acquisition costs over existing reserves plus the present value of expected future premiums (with no provision for adverse deviation). The charge is recorded first to reduce unamortized acquisition costs and then as an additional reserve (if unamortized acquisition costs have been reduced to zero).

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

Debt Issuance Costs   Debt issuance costs related to AFG’s outstanding debt are amortized over the life of the related debt using the effective interest method. Effective January 1, 2016, AFG adopted (on a retrospective basis) ASU 2015-03, which requires debt issuance costs to be presented in the balance sheet as a direct reduction in the carrying value of long-term debt (consistent with the treatment of debt discounts) with the periodic amortization of such costs included in interest expense. Debt issuance costs related to AFG’s revolving credit facilities will continue to be included in other assets in AFG’s Balance Sheet. Prior to AFG’s adoption of ASU 2015-03, AFG reported unamortized debt issuance costs as a deferred charge asset (included in other assets) in AFG’s Balance Sheet and the periodic amortization was included in other expenses in AFG’s Statement of Earnings. The updated guidance did not affect the overall recognition and measurement guidance for debt issuance costs. Accordingly, the guidance did not have an overall impact on AFG’s Shareholders’ Equity or results of operations.

Variable Annuity Assets and Liabilities   Separate accounts related to variable annuities represent the fair value of deposits invested in underlying investment funds on which AFG earns a fee. Investment funds are selected and may be changed only by the policyholder, who retains all investment risk.

AFG’s variable annuity contracts contain a guaranteed minimum death benefit (“GMDB”) to be paid if the policyholder dies before the annuity payout period commences. In periods of declining equity markets, the GMDB may exceed the value of the policyholder’s account. A GMDB liability is established for future excess death benefits using assumptions together with a range of reasonably possible scenarios for investment fund performance that are consistent with DPAC capitalization and amortization assumptions.

Premium Recognition   Property and casualty premiums are earned generally over the terms of the policies on a pro rata basis. Unearned premiums represent that portion of premiums written which is applicable to the unexpired terms of policies in force. On reinsurance assumed from other insurance companies or written through various underwriting organizations, unearned premiums are based on information received from such companies and organizations. For traditional life, accident and health products, premiums are recognized as revenue when legally collectible from policyholders. For interest-sensitive life and universal life products, premiums are recorded in a policyholder account, which is reflected as a liability. Revenue is recognized as amounts are assessed against the policyholder account for mortality coverage and contract expenses.

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

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

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

Stock-Based Compensation   All share-based grants are recognized as compensation expense on a straight-line basis over their vesting periods based on their calculated fair value at the date of grant. AFG uses the Black-Scholes pricing model to measure the fair value of employee stock options.

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



Benefit Plans   AFG provides retirement benefits to qualified employees of participating companies through the AFG 401(k) Retirement and Savings Plan, a defined contribution plan. AFG makes all contributions to the retirement fund portion of the plan and matches a percentage of employee contributions to the savings fund. Company contributions are expensed in the year for which they are declared. AFG and many of its subsidiaries provide health care and life insurance benefits to eligible retirees. AFG also provides postemployment benefits to former or inactive employees (primarily those on disability) who were not deemed retired under other company plans. The projected future cost of providing these benefits is expensed over the period employees earn such benefits.

Earnings Per Share   Although basic earnings per share only considers shares of common stock outstanding during the period, the calculation of diluted earnings per share includes the following adjustments to weighted average common shares related to stock-based compensation plans: second quarter of 2016 and 2015 — 1.6 million and 1.8 million; first six months of 2016 and 2015 — 1.6 million and 1.8 million, respectively.
 
AFG’s weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: second quarter of 2016 and 2015 — 0.7 million and 1.5 million; first six months of 2016 and 2015 — 0.8 million and 1.4 million, respectively. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were nominal in the 2016 and 2015 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, surrenders, benefits and withdrawals are also reflected as financing activities. All other activities are considered “operating.” Short-term investments having original maturities of three months or less when purchased are considered to be cash equivalents for purposes of the financial statements.

B.     Sale of Business

On December 24, 2015, AFG completed the sale of substantially all of its run-off long-term care insurance business (which was included in the run-off long-term care and life segment) to HC2 Holdings, Inc. (“HC2”) for an initial payment of $7 million in cash and HC2 securities with a fair value of $11 million (subject to post-closing adjustments). AFG may also receive up to $13 million of additional proceeds from HC2 in the future contingent upon the release of certain statutory-basis liabilities of the legal entities sold by AFG. In connection with obtaining regulatory approval for the transaction, AFG agreed to provide up to an aggregate of $35 million of capital support for the insurance companies, on an as-needed basis to maintain specified surplus levels, subject to immediate reimbursement by HC2 through a five-year capital maintenance agreement. The legal entities involved in the transaction, United Teacher Associates Insurance Company (“UTA”) and Continental General Insurance Company (“CGIC”), contained substantially all of AFG’s long-term care insurance reserves (96% as measured by net statutory reserves as of November 30, 2015), as well as smaller blocks of annuity and life insurance business. Following the sale of these subsidiaries, AFG has only a small block of long-term care insurance (1,600 policies) with approximately $37 million of reserves at June 30, 2016. AFG had ceased new sales of long-term care insurance in January 2010, but continued to service and accept renewal premiums on its outstanding policies, which are guaranteed renewable.

In addition to the $18 million in cash and securities received at closing and the $13 million of potential additional proceeds in the future from the release of statutory liabilities, AFG received a total of $97 million in tax benefits related to the sale. AFG received substantially all of these tax benefits through reduced estimated tax payments and a tax refund resulting from the carryback of the tax-basis capital loss in the first six months of 2016. The receivables for these tax benefits were reflected in AFG’s financial statements at December 31, 2015.

Based on the status of ongoing negotiations at the end of the first quarter of 2015, management determined that the potential sale of the run-off long-term care insurance business met the GAAP “held for sale” criteria as of March 31, 2015. Accordingly, AFG recorded a $162 million pretax loss ($105 million loss after tax) in the first quarter of 2015 to establish a liability equal to the excess of the net carrying value of the assets and liabilities to be disposed over the estimated net sale proceeds. At the closing date, the loss was adjusted to $166 million ($108 million loss after tax) based on the actual proceeds received and the final carrying value of the net assets disposed. In the second quarter of 2016, AFG received additional proceeds based on the final closing balance sheet and adjusted certain accrued expense estimates associated with the sale, resulting in a $2 million pretax gain. At March 31, 2015 and at the sale date, the carrying value of the assets and liabilities disposed represented approximately 4% of both AFG’s assets and liabilities.

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



Revenues, costs and expenses, and earnings before income taxes for the subsidiaries sold were (in millions):
 
Three months ended June 30, 2015
 
Six months ended June 30, 2015
Life, accident and health net earned premiums:
 
 
 
Long-term care
$
20

 
$
37

Life operations
2

 
5

Net investment income
19

 
37

Realized gains (losses) on securities and other income
—

 
(2
)
Total revenues
41

 
77

Annuity benefits
2

 
4

Life, accident and health benefits:
 
 
 
Long-term care
25

 
46

Life operations
2

 
5

Annuity and supplemental insurance acquisition expenses
3

 
6

Other expenses
5

 
9

Total costs and expenses
37

 
70

Earnings before income taxes
$
4

 
$
7


C.    Segments of Operations

AFG manages its business as four segments: (i) Property and casualty insurance, (ii) Annuity, (iii) Run-off long-term care and life and (iv) Other, which includes holding company costs 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, professional liability, umbrella and excess liability, specialty coverage in targeted markets, customized programs for small to mid-sized businesses and workers’ compensation insurance, and (iii) Specialty financial, which includes risk management insurance programs for leasing and financing institutions (including collateral and lender-placed mortgage property insurance), surety and fidelity products and trade credit insurance. Premiums and underwriting profit included under Other specialty represent business assumed by AFG’s internal reinsurance program from the operations that make up AFG’s other Specialty sub-segments and amortization of deferred gains on retroactive reinsurance transactions related to the sales of businesses in prior years. AFG’s annuity business markets traditional fixed and fixed-indexed annuities in the retail, financial institutions and education markets. AFG’s reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.


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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 segment and sub-segment.
 
Three months ended June 30,
 
Six months ended June 30,
 
2016
 
2015
 
2016
 
2015
Revenues
 
 
 
 
 
 
 
Property and casualty insurance:
 
 
 
 
 
 
 
Premiums earned:
 
 
 
 
 
 
 
Specialty
 
 
 
 
 
 
 
Property and transportation
$
365

 
$
327

 
$
704

 
$
640

Specialty casualty
497

 
503

 
999

 
993

Specialty financial
139

 
129

 
271

 
249

Other specialty
26

 
26

 
51

 
49

Total premiums earned
1,027

 
985

 
2,025

 
1,931

Net investment income
89

 
83

 
172

 
162

Other income (a)
40

 
53

 
43

 
59

Total property and casualty insurance
1,156

 
1,121

 
2,240

 
2,152

Annuity:
 
 
 
 
 
 
 
Net investment income
344

 
306

 
659

 
598

Other income
24

 
24

 
50

 
51

Total annuity
368

 
330

 
709

 
649

Run-off long-term care and life (b)
12

 
49

 
24

 
95

Other
59

 
44

 
115

 
88

Total revenues before realized gains (losses)
1,595

 
1,544

 
3,088

 
2,984

Realized gains (losses) on securities
(16
)
 
(1
)
 
(34
)
 
18

Realized gains (losses) on subsidiaries
2

 
—

 
2

 
(162
)
Total revenues
$
1,581

 
$
1,543

 
$
3,056

 
$
2,840


Earnings Before Income Taxes
 
 
 
 
 
 
 
Property and casualty insurance:
 
 
 
 
 
 
 
Underwriting:
 
 
 
 
 
 
 
Specialty
 
 
 
 
 
 
 
Property and transportation
$
15

 
$
(13
)
 
$
47

 
$
(6
)
Specialty casualty
23

 
37

 
52

 
65

Specialty financial
22

 
24

 
45

 
46

Other specialty
3

 
3

 
5

 
6

Other lines (c)
(66
)
 
(1
)
 
(65
)
 
(1
)
Total underwriting
(3
)
 
50

 
84

 
110

Investment and other income, net (a)
115

 
124

 
190

 
197

Total property and casualty insurance
112

 
174

 
274

 
307

Annuity
76

 
88

 
129

 
163

Run-off long-term care and life (b)
—

 
4

 
(1
)
 
8

Other (d)
(38
)
 
(39
)
 
(78
)
 
(78
)
Total earnings before realized gains (losses) and income taxes
150

 
227

 
324

 
400

Realized gains (losses) on securities
(16
)
 
(1
)
 
(34
)
 
18

Realized gains (losses) on subsidiaries
2

 
—

 
2

 
(162
)
Total earnings before income taxes
$
136

 
$
226

 
$
292

 
$
256

(a)
Includes pretax income of $32 million (before noncontrolling interest) from the sale of an apartment property in the second quarter of 2016 and $51 million (before noncontrolling interest) from the sale of the Le Pavillon Hotel in the second quarter of 2015.
(b)
AFG sold substantially all of its run-off long-term care insurance business in December 2015.
(c)
Includes a $65 million special charge related to the exit of certain lines of business within AFG’s Lloyd’s-based insurer, Neon, in the second quarter of 2016.
(d)
Includes holding company interest and expenses.


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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 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, and prior to 2015 certain liabilities of the CLOs.

Under new guidance adopted in the first quarter of 2015, discussed in Note A — “Accounting Policies — Managed Investment Entities,” AFG has elected to set the carrying value of the CLO liabilities equal to the fair value of the CLO assets (which have more observable fair values) as an alternative to reporting those liabilities at separately measured fair values. Following the adoption of the new guidance, the CLO liabilities are categorized within the fair value hierarchy on the same basis (proportionally) as the related CLO assets. Since the portion of the CLO liabilities allocated to Level 3 is derived from the fair value of the CLO assets, these amounts are excluded from the progression of Level 3 financial instruments.

AFG’s management is responsible for the valuation process and uses data from outside sources (including nationally recognized pricing services and broker/dealers) in establishing fair value. AFG’s internal investment professionals are a group of approximately 25 analysts whose primary responsibility is to manage AFG’s investment portfolio. These professionals monitor individual investments as well as overall industries and are active in the financial markets on a daily basis. The group is led by AFG’s chief investment officer, who reports directly to one of AFG’s Co-CEOs. Valuation techniques utilized by pricing services and prices obtained from external sources are reviewed by AFG’s internal investment professionals who are familiar with the securities being priced and the markets in which they trade to ensure the fair value determination is representative of an exit price. To validate the appropriateness of the prices obtained, these investment managers consider widely published indices (as benchmarks), recent trades, changes in interest rates, general economic conditions and the credit quality of the specific issuers. In addition, the Company communicates directly with the pricing 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.

On December 24, 2015, AFG completed the sale of substantially all of its run-off long-term care insurance business. Based on the status of ongoing negotiations at the end of the first quarter of 2015, management determined that the potential sale of the run-off long-term care insurance business met GAAP “held for sale” criteria as of March 31, 2015. Accordingly, AFG recorded a loss in the first quarter of 2015 to write down the net carrying value of the assets and liabilities to be disposed to the estimated net sale proceeds of $14 million (estimated fair value less costs to sell). The estimate of fair value used to determine that loss was derived using significant unobservable inputs (Level 3).

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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
June 30, 2016
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
Available for sale (“AFS”) fixed maturities:
 
 
 
 
 
 
 
U.S. Government and government agencies
$
103

 
$
227

 
$
8

 
$
338

States, municipalities and political subdivisions
—

 
7,048

 
91

 
7,139

Foreign government
—

 
143

 
—

 
143

Residential MBS
—

 
3,516

 
231

 
3,747

Commercial MBS
—

 
2,006

 
36

 
2,042

Asset-backed securities (“ABS”)
—

 
5,022

 
478

 
5,500

Corporate and other
38

 
15,002

 
689

 
15,729

Total AFS fixed maturities
141

 
32,964

 
1,533

 
34,638

Trading fixed maturities
12

 
259

 
—

 
271

Equity securities — AFS and trading
1,305

 
87

 
166

 
1,558

Assets of managed investment entities (“MIE”)
338

 
4,046

 
26

 
4,410

Variable annuity assets (separate accounts) (*)
—

 
595

 
—

 
595

Other investments — equity index call options
—

 
368

 
—

 
368

Other assets — derivatives
—

 
18

 
—

 
18

Total assets accounted for at fair value
$
1,796

 
$
38,337

 
$
1,725

 
$
41,858

Liabilities:
 
 
 
 
 
 
 
Liabilities of managed investment entities
$
322

 
$
3,846

 
$
24

 
$
4,192

Derivatives in annuity benefits accumulated
—

 
—

 
1,557

 
1,557

Derivatives in long-term debt
—

 
(9
)
 
—

 
(9
)
Other liabilities — derivatives
—

 
13

 
—

 
13

Total liabilities accounted for at fair value
$
322

 
$
3,850

 
$
1,581

 
$
5,753

 
 
 
 
 
 
 
 
December 31, 2015
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
Available for sale fixed maturities:
 
 
 
 
 
 
 
U.S. Government and government agencies
$
100

 
$
192

 
$
15

 
$
307

States, municipalities and political subdivisions
—

 
6,767

 
89

 
6,856

Foreign government
—

 
154

 
—

 
154

Residential MBS
—

 
3,305

 
224

 
3,529

Commercial MBS
—

 
2,148

 
39

 
2,187

Asset-backed securities
—

 
4,464

 
470

 
4,934

Corporate and other
50

 
13,634

 
633

 
14,317

Total AFS fixed maturities
150

 
30,664

 
1,470

 
32,284

Trading fixed maturities
13

 
241

 
—

 
254

Equity securities — AFS and trading
1,362

 
217

 
140

 
1,719

Assets of managed investment entities
309

 
3,712

 
26

 
4,047

Variable annuity assets (separate accounts) (*)
—

 
608

 
—

 
608

Other investments — equity index call options
—

 
241

 
—

 
241

Other assets — derivatives
—

 
2

 
—

 
2

Total assets accounted for at fair value
$
1,834

 
$
35,685

 
$
1,636

 
$
39,155

Liabilities:
 
 
 
 
 
 
 
Liabilities of managed investment entities
$
289

 
$
3,468

 
$
24

 
$
3,781

Derivatives in annuity benefits accumulated
—

 
—

 
1,369

 
1,369

Derivatives in long-term debt
—

 
(2
)
 
—

 
(2
)
Other liabilities — derivatives
—

 
8

 
—

 
8

Total liabilities accounted for at fair value
$
289

 
$
3,474

 
$
1,393

 
$
5,156

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

16
Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


Transfers between Level 1 and Level 2 for all periods presented were a result of increases or decreases in observable trade activity.

During the second quarter of 2016, there were five perpetual preferred stocks with an aggregate fair value of $27 million that transferred from Level 2 to Level 1 and two perpetual preferred stocks with an aggregate fair value of $6 million that transferred from Level 1 to Level 2. During the first six months of 2016, there were six perpetual preferred stocks with a fair value of $35 million that transferred from Level 2 to Level 1 and five perpetual preferred stocks with an aggregate fair value of $12 million that transferred from Level 1 to Level 2. During the second quarter of 2015, there were five common stocks, two perpetual preferred stocks and one mandatory redeemable preferred stock with aggregate fair values of $26 million, $14 million and $10 million, respectively, transferred from Level 2 to Level 1. During the first six months of 2015, there were six common stocks, four perpetual preferred stocks and one mandatory redeemable preferred stock with aggregate fair values of $79 million, $19 million and $10 million, respectively, transferred from Level 2 to Level 1. There were no transfers from Level 1 to Level 2 in the second quarter and first six months of 2015.

Approximately 4% of the total assets carried at fair value on June 30, 2016, were Level 3 assets. Approximately 77% ($1.33 billion) of the Level 3 assets were priced using non-binding broker quotes, for which there is a lack of transparency as to the inputs used to determine fair value. Details as to the quantitative inputs are neither provided by the brokers nor otherwise reasonably obtainable by AFG. Since internally developed Level 3 asset fair values represent less than 10% of AFG’s shareholders’ equity, any justifiable changes in unobservable inputs used to determine internally developed fair values would not have a material impact on AFG’s financial position.

The only significant Level 3 assets or liabilities carried at fair value in the financial statements that were not measured using broker quotes are the derivatives embedded in AFG’s fixed-indexed annuity liabilities, which are measured using a discounted cash flow approach and had a fair value of $1.56 billion at June 30, 2016. 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
 
0.1% – 3.1% over the risk free rate
 
 
Risk margin for uncertainty in cash flows
 
0.58% reduction in the discount rate
 
 
Surrenders
 
3% – 21% of indexed account value
 
 
Partial surrenders
 
2% – 10% of indexed account value
 
 
Annuitizations
 
0.25% – 1% of indexed account value
 
 
Deaths
 
1.5% – 4.0% of indexed account value
 
 
Budgeted option costs
 
1.75% – 3.5% 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 10% in the majority of future calendar years (3% to 21% over all periods). Increasing the budgeted option cost or risk margin for uncertainty in cash flows assumptions in the table above would increase the fair value of the fixed-indexed annuity embedded derivatives, while increasing any of the other unobservable inputs in the table above would decrease the fair value of the embedded derivatives.


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 second quarter and first six months of 2016 and 2015 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 March 31, 2016
 
Net
income
 
Other
comprehensive
income (loss)
 
Purchases
and
issuances
 
Sales and
settlements
 
Transfer
into
Level 3
 
Transfer
out of
Level 3
 
Balance at June 30, 2016
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agency
$
15

 
$
(8
)
 
$
1

 
$
—

 
$
—

 
$
—

 
$
—

 
$
8

State and municipal
92

 
—

 
—

 
—

 
(1
)
 
—

 
—

 
91

Residential MBS
213

 
1

 
1

 
—

 
(6
)
 
22

 
—

 
231

Commercial MBS
38

 
(1
)
 
—

 
—

 
(1
)
 
—

 
—

 
36

Asset-backed securities
501

 
—

 
3

 
11

 
(11
)
 
—

 
(26
)
 
478

Corporate and other
730

 
2

 
12

 
8

 
(68
)
 
10

 
(5
)
 
689

Total AFS fixed maturities
1,589

 
(6
)
 
17

 
19

 
(87
)
 
32

 
(31
)
 
1,533

Equity securities
158

 
—

 
8

 
—

 
—

 
—

 
—

 
166

Assets of MIE
24

 
(2
)
 
—

 
4

 
—

 
—

 
—

 
26

Total Level 3 assets
$
1,771

 
$
(8
)
 
$
25

 
$
23

 
$
(87
)
 
$
32

 
$
(31
)
 
$
1,725

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Embedded derivatives
$
(1,450
)
 
$
(62
)
 
$
—

 
$
(72
)
 
$
27

 
$
—

 
$
—

 
$
(1,557
)
Total Level 3 liabilities (*)
$
(1,450
)
 
$
(62
)
 
$
—

 
$
(72
)
 
$
27

 
$
—

 
$
—

 
$
(1,557
)


 
 
 
Total realized/unrealized
gains (losses) included in
 
 
 
 
 
 
 
 
 
 
Balance at March 31, 2015
 
Net
income
 
Other
comprehensive
income (loss)
 
Purchases
and
issuances
 
Sales and
settlements
 
Transfer
into
Level 3
 
Transfer
out of
Level 3
 
Balance at June 30, 2015
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agency
$
15

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
15

State and municipal
61

 
—

 
(2
)
 
25

 
—

 
—

 
—

 
84

Residential MBS
306

 
(1
)
 
(2
)
 
—

 
(9
)
 
16

 
(14
)
 
296

Commercial MBS
44

 
—

 
—

 
—

 
—

 
4

 
—

 
48

Asset-backed securities
211

 
1

 
—

 
115

 
(7
)
 
12

 
—

 
332

Corporate and other
583

 
(3
)
 
(17
)
 
35

 
(11
)
 
10

 
—

 
597

Total AFS fixed maturities
1,220

 
(3
)
 
(21
)