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 September 30, 2017
 
 
 
Commission File No. 1-13653 

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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. Yes þ No ¨
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer  þ                        Accelerated filer  ¨                        Non-accelerated filer  ¨
Smaller reporting company  ¨                        Emerging growth company  ¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ
As of November 1, 2017, there were 88,112,753 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)
 
September 30,
2017
 
December 31,
2016
Assets:
 
 
 
Cash and cash equivalents
$
2,349

 
$
2,107

Investments:
 
 
 
Fixed maturities, available for sale at fair value (amortized cost — $36,412 and $33,735)
37,818

 
34,544

Fixed maturities, trading at fair value
350

 
359

Equity securities, available for sale at fair value (cost — $1,312 and $1,351)
1,579

 
1,502

Equity securities, trading at fair value
60

 
56

Mortgage loans
1,043

 
1,147

Policy loans
186

 
192

Equity index call options
629

 
492

Real estate and other investments
1,239

 
1,034

Total cash and investments
45,253

 
41,433

Recoverables from reinsurers
3,262

 
2,737

Prepaid reinsurance premiums
691

 
539

Agents’ balances and premiums receivable
1,173

 
997

Deferred policy acquisition costs
1,119

 
1,239

Assets of managed investment entities
4,767

 
4,765

Other receivables
1,545

 
908

Variable annuity assets (separate accounts)
628

 
600

Other assets
1,526

 
1,655

Goodwill
199

 
199

Total assets
$
60,163

 
$
55,072

 
 
 
 
Liabilities and Equity:
 
 
 
Unpaid losses and loss adjustment expenses
$
9,563

 
$
8,563

Unearned premiums
2,567

 
2,171

Annuity benefits accumulated
32,671

 
29,907

Life, accident and health reserves
667

 
691

Payable to reinsurers
906

 
634

Liabilities of managed investment entities
4,506

 
4,549

Long-term debt
1,284

 
1,283

Variable annuity liabilities (separate accounts)
628

 
600

Other liabilities
1,992

 
1,755

Total liabilities
54,784

 
50,153

Shareholders’ equity:
 
 
 
Common Stock, no par value
       — 200,000,000 shares authorized
       — 88,092,794 and 86,924,399 shares outstanding
88

 
87

Capital surplus
1,167

 
1,111

Retained earnings
3,435

 
3,343

Accumulated other comprehensive income, net of tax
689

 
375

Total shareholders’ equity
5,379

 
4,916

Noncontrolling interests
—

 
3

Total equity
5,379

 
4,919

Total liabilities and equity
$
60,163

 
$
55,072


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 September 30,
 
Nine months ended September 30,
 
2017
 
2016
 
2017
 
2016
Revenues:
 
 
 
 
 
 
 
Property and casualty insurance net earned premiums
$
1,267

 
$
1,159

 
$
3,354

 
$
3,184

Life, accident and health net earned premiums
6

 
6

 
17

 
18

Net investment income
471

 
433

 
1,366

 
1,267

Realized gains (losses) on:
 
 
 
 
 
 
 
Securities (*)
(12
)
 
2

 
(1
)
 
(32
)
Subsidiaries
—

 
—

 
—

 
2

Income of managed investment entities:
 
 
 
 
 
 
 
Investment income
54

 
48

 
155

 
141

Gain on change in fair value of assets/liabilities
1

 
11

 
12

 
9

Other income
48

 
46

 
154

 
172

Total revenues
1,835

 
1,705

 
5,057

 
4,761

 
 
 
 
 
 
 
 
Costs and Expenses:
 
 
 
 
 
 
 
Property and casualty insurance:
 
 
 
 
 
 
 
Losses and loss adjustment expenses
995

 
765

 
2,239

 
2,033

Commissions and other underwriting expenses
357

 
356

 
1,062

 
1,038

Annuity benefits
215

 
189

 
635

 
640

Life, accident and health benefits
6

 
8

 
21

 
26

Annuity and supplemental insurance acquisition expenses
55

 
54

 
156

 
131

Interest charges on borrowed money
21

 
19

 
65

 
56

Expenses of managed investment entities
45

 
38

 
137

 
109

Other expenses
112

 
98

 
285

 
258

Total costs and expenses
1,806

 
1,527

 
4,600

 
4,291

Earnings before income taxes
29

 
178

 
457

 
470

Provision for income taxes
18

 
65

 
146

 
190

Net earnings, including noncontrolling interests
11

 
113

 
311

 
280

Less: Net earnings attributable to noncontrolling interests
—

 
4

 
2

 
16

Net Earnings Attributable to Shareholders
$
11

 
$
109

 
$
309

 
$
264

 
 
 
 
 
 
 
 
Earnings Attributable to Shareholders per Common Share:
 
 
 
 
 
 
 
Basic
$
0.13

 
$
1.25

 
$
3.52

 
$
3.04

Diluted
$
0.13

 
$
1.23

 
$
3.44

 
$
2.98

Average number of Common Shares:
 
 
 
 
 
 
 
Basic
88.1

 
86.9

 
87.7

 
86.8

Diluted
90.0

 
88.5

 
89.7

 
88.4

 
 
 
 
 
 
 
 
Cash dividends per Common Share
$
0.3125

 
$
0.28

 
$
2.4375

 
$
0.84

________________________________________
 
 
 
 
 
 
 
(*) Consists of the following:
 
 
 
 
 
 
 
Realized gains before impairments
$
26

 
$
18

 
$
52

 
$
75

 
 
 
 
 
 
 
 
Losses on securities with impairment
(38
)
 
(16
)
 
(54
)
 
(106
)
Non-credit portion recognized in other comprehensive income (loss)
—

 
—

 
1

 
(1
)
Impairment charges recognized in earnings
(38
)
 
(16
)
 
(53
)
 
(107
)
Total realized gains (losses) on securities
$
(12
)
 
$
2

 
$
(1
)
 
$
(32
)

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 September 30,
 
Nine months ended September 30,
 
2017
 
2016
 
2017
 
2016
Net earnings, including noncontrolling interests
$
11

 
$
113

 
$
311

 
$
280

Other comprehensive income, net of tax:
 
 
 
 
 
 
 
Net unrealized gains on securities:
 
 
 
 
 
 
 
Unrealized holding gains on securities arising during the period
59

 
89

 
299

 
427

Reclassification adjustment for realized (gains) losses included in net earnings
8

 
(1
)
 
3

 
20

Total net unrealized gains on securities
67

 
88

 
302

 
447

Net unrealized gains on cash flow hedges
—

 
—

 
1

 
4

Foreign currency translation adjustments
7

 
(3
)
 
11

 
4

Pension and other postretirement plans adjustments
—

 
—

 
—

 
1

Other comprehensive income, net of tax
74

 
85

 
314

 
456

Total comprehensive income, net of tax
85

 
198

 
625

 
736

Less: Comprehensive income attributable to noncontrolling interests
—

 
5

 
2

 
23

Comprehensive income attributable to shareholders
$
85

 
$
193

 
$
623

 
$
713



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
Shares
 
 
Common
Stock and
Capital
Surplus
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income
 
Total
 
Noncontrolling
Interests
 
Total
Equity
Balance at December 31, 2016
86,924,399

 
 
$
1,198

 
$
3,343

 
$
375

 
$
4,916

 
$
3

 
$
4,919

Net earnings
—

 
 
—

 
309

 
—

 
309

 
2

 
311

Other comprehensive income
—

 
 
—

 
—

 
314

 
314

 
—

 
314

Dividends on Common Stock
—

 
 
—

 
(214
)
 
—

 
(214
)
 
—

 
(214
)
Shares issued:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Exercise of stock options
870,022

 
 
29

 
—

 
—

 
29

 
—

 
29

Restricted stock awards
232,250

 
 
—

 
—

 
—

 
—

 
—

 
—

Other benefit plans
85,190

 
 
8

 
—

 
—

 
8

 
—

 
8

Dividend reinvestment plan
22,243

 
 
2

 
—

 
—

 
2

 
—

 
2

Stock-based compensation expense
—

 
 
18

 
—

 
—

 
18

 
—

 
18

Shares exchanged — benefit plans
(34,922
)
 
 
—

 
(3
)
 
—

 
(3
)
 
—

 
(3
)
Forfeitures of restricted stock
(6,388
)
 
 
—

 
—

 
—

 
—

 
—

 
—

Other
—

 
 
—

 
—

 
—

 
—

 
(5
)
 
(5
)
Balance at September 30, 2017
88,092,794

 
 
$
1,255

 
$
3,435

 
$
689

 
$
5,379

 
$
—

 
$
5,379

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2015
87,474,452

 
 
$
1,301

 
$
2,987

 
$
304

 
$
4,592

 
$
178

 
$
4,770

Net earnings
—

 
 
—

 
264

 
—

 
264

 
16

 
280

Other comprehensive income
—

 
 
—

 
—

 
449

 
449

 
7

 
456

Dividends on Common Stock
—

 
 
—

 
(73
)
 
—

 
(73
)
 
—

 
(73
)
Shares issued:
 
 
 
 
 
 
 
 
 

 
 
 

Exercise of stock options
753,095

 
 
26

 
—

 
—

 
26

 
—

 
26

Restricted stock awards
318,940

 
 
—

 
—

 
—

 
—

 
—

 
—

Other benefit plans
82,087

 
 
6

 
—

 
—

 
6

 
—

 
6

Dividend reinvestment plan
10,930

 
 
1

 
—

 
—

 
1

 
—

 
1

Stock-based compensation expense
—

 
 
22

 
—

 
—

 
22

 
—

 
22

Shares acquired and retired
(1,796,009
)
 
 
(27
)
 
(97
)
 
—

 
(124
)
 
—

 
(124
)
Shares exchanged — benefit plans
(28,059
)
 
 
—

 
(2
)
 
—

 
(2
)
 
—

 
(2
)
Forfeitures of restricted stock
(2,785
)
 
 
—

 
—

 
—

 
—

 
—

 
—

Other
—

 
 
—

 
—

 
—

 
—

 
(4
)
 
(4
)
Balance at September 30, 2016
86,812,651

 
 
$
1,329

 
$
3,079

 
$
753

 
$
5,161

 
$
197

 
$
5,358


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

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Millions)
 
Nine months ended September 30,
 
2017
 
2016
Operating Activities:
 
 
 
Net earnings, including noncontrolling interests
$
311

 
$
280

Adjustments:
 
 
 
Depreciation and amortization
105

 
91

Annuity benefits
635

 
640

Realized gains on investing activities
(18
)
 
(6
)
Net sales of trading securities
5

 
73

Deferred annuity and life policy acquisition costs
(177
)
 
(172
)
Change in:
 
 
 
Reinsurance and other receivables
(1,467
)
 
(972
)
Other assets
(59
)
 
(193
)
Insurance claims and reserves
1,372

 
796

Payable to reinsurers
272

 
244

Other liabilities
—

 
230

Managed investment entities’ assets/liabilities
14

 
(235
)
Other operating activities, net
—

 
(30
)
Net cash provided by operating activities
993

 
746

 
 
 
 
Investing Activities:
 
 
 
Purchases of:
 
 
 
Fixed maturities
(7,163
)
 
(5,604
)
Equity securities
(73
)
 
(143
)
Mortgage loans
(149
)
 
(310
)
Equity index call options and other investments
(594
)
 
(490
)
Real estate, property and equipment
(46
)
 
(37
)
Proceeds from:
 
 
 
Maturities and redemptions of fixed maturities
4,690

 
3,111

Repayments of mortgage loans
191

 
197

Sales of fixed maturities
179

 
496

Sales of equity securities
97

 
193

Sales and settlements of equity index call options and other investments
565

 
138

Sales of real estate, property and equipment
54

 
45

Managed investment entities:
 
 
 
Purchases of investments
(2,330
)
 
(1,405
)
Proceeds from sales and redemptions of investments
2,343

 
1,381

Other investing activities, net
6

 
(91
)
Net cash used in investing activities
(2,230
)
 
(2,519
)
 
 
 
 
Financing Activities:
 
 
 
Annuity receipts
3,432

 
3,474

Annuity surrenders, benefits and withdrawals
(1,725
)
 
(1,726
)
Net transfers from variable annuity assets
43

 
29

Additional long-term borrowings
345

 
302

Reductions of long-term debt
(355
)
 
—

Issuances of managed investment entities’ liabilities
1,926

 
1,028

Retirements of managed investment entities’ liabilities
(1,998
)
 
(747
)
Issuances of Common Stock
30

 
34

Repurchases of Common Stock
—

 
(124
)
Cash dividends paid on Common Stock
(212
)
 
(72
)
Other financing activities, net
(7
)
 
(6
)
Net cash provided by financing activities
1,479

 
2,192

Net Change in Cash and Cash Equivalents
242

 
419

Cash and cash equivalents at beginning of period
2,107

 
1,220

Cash and cash equivalents at end of period
$
2,349

 
$
1,639


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


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

A.     Accounting Policies

Basis of Presentation   The accompanying consolidated financial statements for American Financial Group, Inc. and its subsidiaries (“AFG”) are unaudited; however, management believes that all adjustments (consisting only of normal recurring accruals unless otherwise disclosed herein) necessary for fair presentation have been made. The results of operations for interim periods are not necessarily indicative of results to be expected for the year. The financial statements have been prepared in accordance with the instructions to Form 10-Q and, therefore, do not include all information and footnotes necessary to be in conformity with U.S. generally accepted accounting principles (“GAAP”).
 
Certain reclassifications have been made to prior periods to conform to the current year’s presentation. All significant intercompany balances and transactions have been eliminated. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. Events or transactions occurring subsequent to September 30, 2017, 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 nine months of 2017.

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. At the date of adoption, the net unrealized gain on equity securities included in AOCI will be reclassified to retained earnings in the Balance Sheet as the cumulative effect of an accounting change.

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

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


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

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

Changes in the fair value of derivatives that are designated and qualify as highly effective cash flow hedges are recorded in AOCI and are reclassified into earnings when the variability of the cash flows from the hedged items impacts earnings. 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.
 

8
Table of Contents
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.

Because AFG has no right to use the CLO assets and no obligation to pay the CLO liabilities, the assets and liabilities of the CLOs are shown separately in AFG’s Balance Sheet. AFG has elected the fair value option for reporting on the CLO assets and liabilities to improve the transparency of financial reporting related to the CLOs. The net gain or loss from accounting for the CLO assets and liabilities at fair value is presented separately in AFG’s Statement of Earnings.

The fair values of a CLO’s assets may differ from the separately measured fair values of its liabilities even though the CLO liabilities only have recourse to the CLO assets. AFG has set the carrying value of the CLO liabilities equal to the fair value of the CLO assets (which have more observable fair values) as an alternative to reporting those liabilities at a separately measured fair value. CLO earnings attributable to AFG’s shareholders are measured by the change in the fair value of AFG’s investments in the CLOs and management fees earned.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED



At September 30, 2017, assets and liabilities of managed investment entities included $383 million in assets and $316 million in liabilities of a temporary warehousing entity that was established in connection with the formation of a new CLO that closed in October 2017. At closing, all warehoused assets were transferred to the new CLO and the liabilities were repaid.

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.

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.


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


Debt Issuance Costs   Debt issuance costs related to AFG’s outstanding debt are presented in its Balance Sheet as a direct reduction in the carrying value of long-term debt and are amortized over the life of the related debt using the effective interest method as a component of interest expense. Debt issuance costs related to AFG’s revolving credit facilities are included in other assets in AFG’s Balance Sheet.

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

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

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. See Note K — “Shareholders’ Equity” for further information.

In the fourth quarter of 2016, AFG adopted ASU 2016-09, which, among other things, requires excess tax benefits or deficiencies for share-based payments to be recorded through income tax expense in the statement of earnings instead of directly to capital surplus (as required under the previous guidance). In addition, under the new guidance, AFG elected to account for forfeitures of awards when they occur rather than accruing expense based on an estimate of expected forfeitures (as required under the previous guidance). The resulting cumulative effect of accounting change of less than $1 million was recorded directly to retained earnings on January 1, 2016.

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


stock-based compensation plans: third quarter of 2017 and 2016 — 1.9 million and 1.6 million; first nine months of 2017 and 2016 — 2.0 million and 1.6 million, respectively.
 
AFG’s weighted average diluted shares outstanding for the third quarter and first nine months of 2016 excludes 0.2 million and 0.6 million anti-dilutive potential common shares related to stock compensation plans, respectively. There were no anti-dilutive potential common shares in the third quarter or first nine months of 2017.
 
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.

Effective October 1, 2016, AFG early adopted (on a retrospective basis) ASU 2016-15, which addresses the diversity in practice in how certain cash receipts and cash payments are presented in the statement of cash flows. Among other things, this guidance requires proceeds received from the settlement of corporate-owned life insurance policies to be classified as cash inflows from investing activities and allows premiums paid for policies to be reported as cash outflows either from investing activities or operating activities. AFG has elected to show all corporate-owned life insurance activity in investing activities. Prior to adoption of this guidance, AFG accounted for these transactions as operating activities. In addition, ASU 2016-15 clarifies when distributions received from investees accounted under the equity method should be accounted for as a cash inflow from operating activities or as a cash inflow from investing activities. AFG had previously accounted for all distributions from investments accounted for under the equity method as investing activities. The new guidance solely related to the presentation of certain transactions in the statement of cash flows. Accordingly, adoption of this guidance did not impact AFG’s results of operations or financial position.

Revenue Recognition Guidance Effective in 2018 In May 2014, the FASB issued ASU 2014-09, which requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Revenue is recognized when (or as) the entity satisfies a performance obligation under the contract. The new guidance also updates the accounting for certain costs associated with obtaining and fulfilling contracts with customers and requires disclosures regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. Revenue recognition for insurance contracts and financial instruments, which are AFG’s primary sources of revenue, is excluded from the scope of the new guidance. AFG will adopt the new guidance effective January 1, 2018. Because the new guidance does not apply to the vast majority of AFG’s business, management does not expect the adoption of this guidance to have a material impact on AFG’s results of operations or financial position. Based on implementation efforts to date, management believes that the new standard would only have applied to 2% of AFG’s 2016 consolidated revenues.

B.     Acquisition of Business

Acquisition of Noncontrolling Interest in National Interstate Corporation   In November 2016, AFG acquired the 49% of National Interstate Corporation (“NATL”) not previously owned by AFG’s wholly-owned subsidiary, Great American Insurance Company, for $315 million ($32.00 per share) in a merger transaction. In addition, NATL paid a one-time special cash dividend of $0.50 per share to its shareholders immediately prior to the merger closing. Because NATL was already a consolidated subsidiary of AFG prior to the merger, the acquisition was accounted for as an equity transaction.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


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.

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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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 September 30,
 
Nine months ended September 30,
 
2017
 
2016
 
2017
 
2016
Revenues
 
 
 
 
 
 
 
Property and casualty insurance:
 
 
 
 
 
 
 
Premiums earned:
 
 
 
 
 
 
 
Specialty
 
 
 
 
 
 
 
Property and transportation
$
527

 
$
493

 
$
1,226

 
$
1,197

Specialty casualty
568

 
497

 
1,613

 
1,496

Specialty financial
142

 
145

 
435

 
416

Other specialty
30

 
24

 
80

 
75

Total premiums earned
1,267

 
1,159

 
3,354

 
3,184

Net investment income
94

 
93

 
276

 
265

Other income (a)
1

 
3

 
21

 
46

Total property and casualty insurance
1,362

 
1,255

 
3,651

 
3,495

Annuity:
 
 
 
 
 
 
 
Net investment income
375

 
351

 
1,082

 
1,010

Other income
26

 
26

 
79

 
76

Total annuity
401

 
377

 
1,161

 
1,086

Run-off long-term care and life
12

 
13

 
35

 
37

Other
72

 
58

 
211

 
173

Total revenues before realized gains (losses)
1,847

 
1,703

 
5,058

 
4,791

Realized gains (losses) on securities
(12
)
 
2

 
(1
)
 
(32
)
Realized gains on subsidiaries
—

 
—

 
—

 
2

Total revenues
$
1,835

 
$
1,705

 
$
5,057

 
$
4,761

Earnings Before Income Taxes
 
 
 
 
 
 
 
Property and casualty insurance:
 
 
 
 
 
 
 
Underwriting:
 
 
 
 
 
 
 
Specialty
 
 
 
 
 
 
 
Property and transportation
$
6

 
$
44

 
$
70

 
$
91

Specialty casualty
2

 
13

 
46

 
65

Specialty financial
(3
)
 
19

 
42

 
64

Other specialty
4

 
2

 
3

 
7

Other lines (b)
(90
)
 
(36
)
 
(92
)
 
(101
)
Total underwriting
(81
)
 
42

 
69

 
126

Investment and other income, net (a)
87

 
79

 
271

 
269

Total property and casualty insurance
6

 
121

 
340

 
395

Annuity
102

 
107

 
283

 
236

Run-off long-term care and life
2

 
1

 
4

 
—

Other (c)
(69
)
 
(53
)
 
(169
)
 
(131
)
Total earnings before realized gains (losses) and income taxes
41

 
176

 
458

 
500

Realized gains (losses) on securities
(12
)
 
2

 
(1
)
 
(32
)
Realized gains on subsidiaries
—

 
—

 
—

 
2

Total earnings before income taxes
$
29

 
$
178

 
$
457

 
$
470

(a)
Includes pretax income of $13 million (before noncontrolling interest) from the sale of a hotel in the first quarter of 2017 and pretax income of $32 million (before noncontrolling interest) from the sale of an apartment property in the second quarter of 2016.
(b)
Includes special charges of $89 million and $36 million in the third quarter of 2017 and 2016, respectively, to increase asbestos and environmental (“A&E”) reserves and a $65 million special charge related to the exit of certain lines of business with AFG’s Lloyd’s-based insurer, Neon, in the second quarter of 2016.
(c)
Includes holding company interest and expenses, including losses on retirement of debt of $4 million in the third quarter of 2017 and $7 million in the second quarter of 2017, and special charges of $24 million and $5 million in the third quarter of 2017 and 2016, respectively, to increase A&E reserves related to AFG’s former railroad and manufacturing operations.

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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, highly liquid government bonds for which quoted market prices in active markets are available and short-term investments of managed investment entities.

Level 2 — Quoted prices for similar instruments in active markets; quoted prices for identical or similar assets or liabilities in inactive markets (markets in which there are few transactions, the prices are not current, price quotations vary substantially over time or among market makers, or in which little information is released publicly); and valuations based on other significant inputs that are observable in active markets. AFG’s Level 2 financial instruments include separate account assets, corporate and municipal fixed maturity securities, asset-backed securities, 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 at the valuation date. 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.

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

AFG’s management is responsible for the valuation process and uses data from outside sources (including nationally recognized pricing services and broker/dealers) in establishing fair value. AFG’s internal investment professionals are a group of approximately 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 services regarding the methods and assumptions used in pricing, including verifying, on a test basis, the inputs used by the service to value specific securities.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


Assets and liabilities measured and carried at fair value in the financial statements are summarized below (in millions): 
 
Level 1
 
Level 2
 
Level 3
 
Total
September 30, 2017
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
Available for sale (“AFS”) fixed maturities:
 
 
 
 
 
 
 
U.S. Government and government agencies
$
120

 
$
129

 
$
8

 
$
257

States, municipalities and political subdivisions
—

 
6,845

 
152

 
6,997

Foreign government
—

 
144

 
—

 
144

Residential MBS
—

 
3,252

 
144

 
3,396

Commercial MBS
—

 
974

 
36

 
1,010

Asset-backed securities (“ABS”)
—

 
6,860

 
536

 
7,396

Corporate and other
30

 
17,538

 
1,050

 
18,618

Total AFS fixed maturities
150

 
35,742

 
1,926

 
37,818

Trading fixed maturities
48

 
302

 
—

 
350

Equity securities — AFS and trading
1,397

 
79

 
163

 
1,639

Assets of managed investment entities (“MIE”)
368

 
4,378

 
21

 
4,767

Variable annuity assets (separate accounts) (*)
—

 
628

 
—

 
628

Equity index call options
—

 
629

 
—

 
629

Other assets — derivatives
—

 
1

 
—

 
1

Total assets accounted for at fair value
$
1,963

 
$
41,759

 
$
2,110

 
$
45,832

Liabilities:
 
 
 
 
 
 
 
Liabilities of managed investment entities
$
348

 
$
4,138

 
$
20

 
$
4,506

Derivatives in annuity benefits accumulated
—

 
—

 
2,293

 
2,293

Derivatives in long-term debt
—

 
—

 
—

 
—

Other liabilities — derivatives
—

 
31

 
—

 
31

Total liabilities accounted for at fair value
$
348

 
$
4,169

 
$
2,313

 
$
6,830

 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
Available for sale fixed maturities:
 
 
 
 
 
 
 
U.S. Government and government agencies
$
133

 
$
174

 
$
8

 
$
315

States, municipalities and political subdivisions
—

 
6,641

 
140

 
6,781

Foreign government
—

 
136

 
—

 
136

Residential MBS
—

 
3,445

 
190

 
3,635

Commercial MBS
—

 
1,468

 
25

 
1,493

Asset-backed securities
—

 
5,475

 
484

 
5,959

Corporate and other
29

 
15,484

 
712

 
16,225

Total AFS fixed maturities
162

 
32,823

 
1,559

 
34,544

Trading fixed maturities
30

 
329

 
—

 
359

Equity securities — AFS and trading
1,305

 
79

 
174

 
1,558

Assets of managed investment entities
380

 
4,356

 
29

 
4,765

Variable annuity assets (separate accounts) (*)
—

 
600

 
—

 
600

Equity index call options
—

 
492

 
—

 
492

Other assets — derivatives
—

 
1

 
—

 
1

Total assets accounted for at fair value
$
1,877

 
$
38,680

 
$
1,762

 
$
42,319

Liabilities:
 
 
 
 
 
 
 
Liabilities of managed investment entities
$
363

 
$
4,158

 
$
28

 
$
4,549

Derivatives in annuity benefits accumulated
—

 
—

 
1,759

 
1,759

Derivatives in long-term debt
—

 
(1
)
 
—

 
(1
)
Other liabilities — derivatives
—

 
30

 
—

 
30

Total liabilities accounted for at fair value
$
363

 
$
4,187

 
$
1,787

 
$
6,337

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

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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 third quarter of 2017, there was one perpetual preferred stock with an aggregate fair value of $1 million that transferred between Level 2 and Level 1. During the first nine months of 2017, there were three preferred stocks with an aggregate fair value of $17 million that transferred from Level 2 to Level 1. During the third quarter of 2016, there was one common stock with a fair value of less than $1 million that transferred from Level 1 to Level 2. During the first nine 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 and one common stock with aggregate fair values of $12 million and less than $1 million, respectively, that transferred from Level 1 to Level 2.

Approximately 5% of the total assets carried at fair value at September 30, 2017, were Level 3 assets. Approximately 76% ($1.61 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 $2.29 billion at September 30, 2017. 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
 
0.2% – 2.4% over the risk free rate
 
 
Risk margin for uncertainty in cash flows
 
0.68% reduction in the discount rate
 
 
Surrenders
 
3% – 23% of indexed account value
 
 
Partial surrenders
 
2% – 10% of indexed account value
 
 
Annuitizations
 
0.1% – 1% of indexed account value
 
 
Deaths
 
1.5% – 8.0% of indexed account value
 
 
Budgeted option costs
 
2.4% – 3.7% 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 6% to 10% in the majority of future calendar years (3% to 23% 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 third quarter and first nine months of 2017 and 2016 are presented below (in millions). The transfers into and out of Level 3 were due to changes in the availability of market observable inputs. All transfers are reflected in the table at fair value as of the end of the reporting period.

 
 
 
Total realized/unrealized
gains (losses) included in
 
 
 
 
 
 
 
 
 
 
 
Balance at June 30, 2017
 
Net
income
 
Other
comprehensive
income (loss)
 
Purchases
and
issuances
 
Sales and
settlements
 
Transfer
into
Level 3
 
Transfer
out of
Level 3
 
Balance at September 30, 2017
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agency
$
8

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
8

State and municipal
143

 
—

 
—

 
—

 
(1
)
 
10

 
—

 
152

Residential MBS
153

 
2

 
1

 
—

 
(6
)
 
15

 
(21
)
 
144

Commercial MBS
45

 
1

 
—

 
—

 
(10
)
 
—

 
—

 
36

Asset-backed securities
498

 
(2
)
 
1

 
13

 
(26
)
 
163

 
(111
)
 
536

Corporate and other
953

 
(9
)
 
—

 
172

 
(59
)
 
—

 
(7
)
 
1,050

Total AFG fixed maturities
1,800

 
(8
)
 
2

 
185

 
(102
)
 
188

 
(139
)
 
1,926

Equity securities
168

 
(3
)
 
(4
)
 
2

 
—

 
—

 
—

 
163

Assets of MIE
23

 
(4
)
 
—

 
2

 
—

 
—

 
—

 
21

Total Level 3 assets
$
1,991

 
$
(15
)
 
$
(2
)
 
$
189

 
$
(102
)
 
$
188

 
$
(139
)
 
$
2,110

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Embedded derivatives
$
(2,129
)
 
$
(127
)
 
$
—

 
$
(65
)
 
$
28

 
$
—

 
$
—

 
$
(2,293
)
Total Level 3 liabilities (*)
$
(2,129
)
 
$
(127
)
 
$
—

 
$
(65
)
 
$
28

 
$
—

 
$
—

 
$
(2,293
)


 
 
 
Total realized/unrealized
gains (losses) included in
 
 
 
 
 
 
 
 
 
 
Balance at June 30, 2016
 
Net
income
 
Other
comprehensive
income (loss)
 
Purchases
and
issuances
 
Sales and
settlements
 
Transfer
into
Level 3
 
Transfer
out of
Level 3
 
Balance at September 30, 2016
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agency
$
8

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
8

State and municipal
91

 
—

 
1

 
—

 
(1
)
 
—

 
—

 
91

Residential MBS
231

 
(2
)
 
—

 
—

 
(8
)
 
—

 
(2
)
 
219

Commercial MBS
36

 
—

 
—

 
—

 
(2
)
 
—

 
—

 
34

Asset-backed securities
478

 
(1
)
 
4

 
—

 
(5
)
 
—

 
(9
)
 
467

Corporate and other
689

 
—

 
(3
)
 
37

 
(14
)
 
—

 
—

 
709

Total AFS fixed maturities
1,533

 
(3
)
 
2

 
37

 
(30
)
 
—

 
(11
)
 
1,528

Equity securities
166

 
5

 
5

 
10

 
(21
)
 
—

 
—

 
165

Assets of MIE
26

 
(2
)
 
—

 
—

 
—

 
—

 
—

 
24

Total Level 3 assets
$
1,725

 
$
—

 
$
7

 
$
47

 
$
(51
)
 
$
—

 
$
(11
)
 
$
1,717

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Embedded derivatives
$
(1,557
)
 
$
(109
)
 
$
—

 
$
(53
)
 
$
31

 
$
—

 
$
—

 
$
(1,688
)
Total Level 3 liabilities (*)
$
(1,557
)
 
$
(109
)
 
$
—

 
$
(53
)
 
$
31

 
$
—

 
$
—

 
$
(1,688
)

(*)
As discussed previously, these tables exclude the portion of MIE liabilities allocated to Level 3, which are derived from the fair value of the MIE assets.

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



 
 
 
Total realized/unrealized
gains (losses) included in
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2016
 
Net
income
 
Other
comprehensive
income (loss)
 
Purchases
and
issuances
 
Sales and
settlements
 
Transfer
into
Level 3
 
Transfer
out of
Level 3
 
Balance at September 30, 2017
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agency
$
8

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
8

State and municipal
140

 
—

 
4

 
—