AFG-2014.9.30 10Q

______________________________________________________________________________________________________
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the Quarterly Period Ended September 30, 2014
 
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 November 1, 2014, there were 87,870,863 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,
2014
 
December 31,
2013
Assets:
 
 
 
Cash and cash equivalents
$
1,310

 
$
1,639

Investments:
 
 
 
Fixed maturities, available for sale at fair value (amortized cost — $28,409 and $25,366)
29,965

 
26,456

Fixed maturities, trading at fair value
342

 
305

Equity securities, at fair value (cost — $1,279 and $987)
1,474

 
1,179

Mortgage loans
1,064

 
781

Policy loans
230

 
238

Real estate and other investments
766

 
715

Total cash and investments
35,151

 
31,313

Recoverables from reinsurers
3,134

 
3,157

Prepaid reinsurance premiums
587

 
408

Agents’ balances and premiums receivable
901

 
739

Deferred policy acquisition costs
858

 
975

Assets of managed investment entities
2,946

 
2,888

Other receivables
1,140

 
854

Variable annuity assets (separate accounts)
649

 
665

Other assets
985

 
903

Goodwill
201

 
185

Total assets
$
46,552

 
$
42,087

 
 
 
 
Liabilities and Equity:
 
 
 
Unpaid losses and loss adjustment expenses
$
7,645

 
$
6,410

Unearned premiums
2,114

 
1,757

Annuity benefits accumulated
23,044

 
20,944

Life, accident and health reserves
2,098

 
2,008

Payable to reinsurers
673

 
508

Liabilities of managed investment entities
2,625

 
2,567

Long-term debt
1,062

 
913

Variable annuity liabilities (separate accounts)
649

 
665

Other liabilities
1,564

 
1,546

Total liabilities
41,474

 
37,318

Shareholders’ equity:
 
 
 
Common Stock, no par value
       — 200,000,000 shares authorized
       — 88,490,967 and 89,513,386 shares outstanding
88

 
90

Capital surplus
1,150

 
1,123

Retained earnings:
 
 
 
Appropriated — managed investment entities
2

 
49

Unappropriated
2,946

 
2,777

Accumulated other comprehensive income, net of tax
718

 
560

Total shareholders’ equity
4,904

 
4,599

Noncontrolling interests
174

 
170

Total equity
5,078

 
4,769

Total liabilities and equity
$
46,552

 
$
42,087


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,
 
2014
 
2013
 
2014
 
2013
Revenues:
 
 
 
 
 
 
 
Property and casualty insurance net earned premiums
$
1,132

 
$
949

 
$
2,817

 
$
2,345

Life, accident and health net earned premiums
27

 
29

 
82

 
87

Net investment income
377

 
338

 
1,117

 
996

Realized gains on securities (*)
13

 
56

 
44

 
154

Income (loss) of managed investment entities:
 
 
 
 
 
 
 
Investment income
29

 
32

 
84

 
98

Gain (loss) on change in fair value of assets/liabilities
(25
)
 
15

 
(35
)
 
(21
)
Other income
28

 
24

 
75

 
71

Total revenues
1,581

 
1,443

 
4,184

 
3,730

 
 
 
 
 
 
 
 
Costs and Expenses:
 
 
 
 
 
 
 
Property and casualty insurance:
 
 
 
 
 
 
 
Losses and loss adjustment expenses
784

 
680

 
1,815

 
1,503

Commissions and other underwriting expenses
302

 
261

 
869

 
772

Annuity benefits
157

 
140

 
491

 
394

Life, accident and health benefits
37

 
42

 
119

 
120

Annuity and supplemental insurance acquisition expenses
46

 
40

 
122

 
128

Interest charges on borrowed money
18

 
18

 
53

 
54

Expenses of managed investment entities
19

 
22

 
60

 
68

Other expenses
73

 
98

 
219

 
248

Total costs and expenses
1,436

 
1,301

 
3,748

 
3,287

Earnings before income taxes
145

 
142

 
436

 
443

Provision for income taxes
54

 
44

 
155

 
155

Net earnings, including noncontrolling interests
91

 
98

 
281

 
288

Less: Net earnings (loss) attributable to noncontrolling interests
(25
)
 
15

 
(44
)
 
(25
)
Net Earnings Attributable to Shareholders
$
116

 
$
83

 
$
325

 
$
313

 
 
 
 
 
 
 
 
Earnings Attributable to Shareholders per Common Share:
 
 
 
 
 
 
 
Basic
$
1.30

 
$
0.94

 
$
3.64

 
$
3.51

Diluted
$
1.28

 
$
0.92

 
$
3.56

 
$
3.44

Average number of Common Shares:
 
 
 
 
 
 
 
Basic
89.0

 
89.1

 
89.4

 
89.4

Diluted
90.9

 
91.0

 
91.4

 
91.2

 
 
 
 
 
 
 
 
Cash dividends per Common Share
$
0.22

 
$
0.195

 
$
0.66

 
$
0.585

________________________________________
 
 
 
 
 
 
 
(*) Consists of the following:
 
 
 
 
 
 
 
Realized gains before impairments
$
24

 
$
61

 
$
57

 
$
160

 
 
 
 
 
 
 
 
Losses on securities with impairment
(11
)
 
(5
)
 
(13
)
 
(6
)
Non-credit portion recognized in other comprehensive income (loss)
—

 
—

 
—

 
—

Impairment charges recognized in earnings
(11
)
 
(5
)
 
(13
)
 
(6
)
Total realized gains on securities
$
13

 
$
56

 
$
44

 
$
154


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,
 
2014
 
2013
 
2014
 
2013
Net earnings, including noncontrolling interests
$
91

 
$
98

 
$
281

 
$
288

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Net unrealized gains (losses) on securities:
 
 
 
 
 
 
 
Unrealized holding gains (losses) on securities arising during the period
(73
)
 
4

 
194

 
(162
)
Reclassification adjustment for realized gains included in net earnings
(8
)
 
(36
)
 
(28
)
 
(99
)
Total net unrealized gains (losses) on securities
(81
)
 
(32
)
 
166

 
(261
)
Foreign currency translation adjustments
(2
)
 
3

 
(5
)
 
(6
)
Other comprehensive income (loss), net of tax
(83
)
 
(29
)
 
161

 
(267
)
Total comprehensive income, net of tax
8

 
69

 
442

 
21

Less: Comprehensive income (loss) attributable to noncontrolling interests
(27
)
 
15

 
(41
)
 
(31
)
Comprehensive income attributable to shareholders
$
35

 
$
54

 
$
483

 
$
52



4
Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY (UNAUDITED)
(Dollars in Millions)
 
 
 
 
 
Shareholders’ Equity
 
 
 
 
Common
 
 
Common Stock
and Capital
 
Retained Earnings
 
Accumulated
Other Comp
 
 
 
Noncon-
trolling
 
Total
Shares
 
 
Surplus
 
Approp.
 
Unapprop.
 
Inc. (Loss)
 
Total
 
Interests
 
Equity
Balance at December 31, 2013
89,513,386

 
 
$
1,213

 
$
49

 
$
2,777

 
$
560

 
$
4,599

 
$
170

 
$
4,769

Net earnings
—

 
 
—

 
—

 
325

 
—

 
325

 
(44
)
 
281

Other comprehensive income
—

 
 
—

 
—

 
—

 
158

 
158

 
3

 
161

Allocation of losses of managed investment entities
—

 
 
—

 
(47
)
 
—

 
—

 
(47
)
 
47

 
—

Dividends on Common Stock
—

 
 
—

 
—

 
(59
)
 
—

 
(59
)
 
—

 
(59
)
Shares issued:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Exercise of stock options
972,847

 
 
34

 
—

 
—

 
—

 
34

 
—

 
34

Other benefit plans
227,782

 
 
7

 
—

 
—

 
—

 
7

 
—

 
7

Dividend reinvestment plan
9,749

 
 
1

 
—

 
—

 
—

 
1

 
—

 
1

Stock-based compensation expense
—

 
 
14

 
—

 
—

 
—

 
14

 
—

 
14

Shares acquired and retired
(2,209,007
)
 
 
(31
)
 
—

 
(96
)
 
—

 
(127
)
 
—

 
(127
)
Shares exchanged — benefit plans
(23,790
)
 
 
—

 
—

 
(1
)
 
—

 
(1
)
 
—

 
(1
)
Other
—

 
 
—

 
—

 
—

 
—

 
—

 
(2
)
 
(2
)
Balance at September 30, 2014
88,490,967

 
 
$
1,238

 
$
2

 
$
2,946

 
$
718

 
$
4,904

 
$
174

 
$
5,078

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2012
88,979,303

 
 
$
1,152

 
$
75

 
$
2,520

 
$
831

 
$
4,578

 
$
170

 
$
4,748

Net earnings
—

 
 
—

 
—

 
313

 
—

 
313

 
(25
)
 
288

Other comprehensive loss
—

 
 
—

 
—

 
—

 
(261
)
 
(261
)
 
(6
)
 
(267
)
Allocation of losses of managed investment entities
—

 
 
—

 
(30
)
 
—

 
—

 
(30
)
 
30

 
—

Dividends on Common Stock
—

 
 
—

 
—

 
(52
)
 
—

 
(52
)
 
—

 
(52
)
Shares issued:
 
 
 
 
 
 
 
 
 
 
 

 
 
 

Exercise of stock options
1,350,551

 
 
44

 
—

 
—

 
—

 
44

 
—

 
44

Other benefit plans
376,574

 
 
6

 
—

 
—

 
—

 
6

 
—

 
6

Dividend reinvestment plan
10,514

 
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Stock-based compensation expense
—

 
 
15

 
—

 
—

 
—

 
15

 
—

 
15

Shares acquired and retired
(1,448,156
)
 
 
(19
)
 
—

 
(51
)
 
—

 
(70
)
 
—

 
(70
)
Shares exchanged — benefit plans
(45,179
)
 
 
—

 
—

 
(1
)
 
—

 
(1
)
 
—

 
(1
)
Other
—

 
 
—

 
—

 
—

 
—

 
—

 
(1
)
 
(1
)
Balance at September 30, 2013
89,223,607

 
 
$
1,198

 
$
45

 
$
2,729

 
$
570

 
$
4,542

 
$
168

 
$
4,710


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,
 
2014
 
2013
Operating Activities:
 
 
 
Net earnings, including noncontrolling interests
$
281

 
$
288

Adjustments:
 
 
 
Depreciation and amortization
95

 
110

Annuity benefits
491

 
394

Realized gains on investing activities
(48
)
 
(162
)
Net (purchases) sales of trading securities
(39
)
 
20

Deferred annuity and life policy acquisition costs
(144
)
 
(148
)
Change in:
 
 
 
Reinsurance and other receivables
(459
)
 
(288
)
Other assets
(38
)
 
(108
)
Insurance claims and reserves
505

 
(7
)
Payable to reinsurers
162

 
126

Other liabilities
(92
)
 
161

Managed investment entities’ assets/liabilities
(44
)
 
(23
)
Other operating activities, net
4

 
25

Net cash provided by operating activities
674

 
388

 
 
 
 
Investing Activities:
 
 
 
Purchases of:
 
 
 
Fixed maturities
(5,358
)
 
(4,903
)
Equity securities
(356
)
 
(334
)
Mortgage loans
(355
)
 
(100
)
Real estate, property and equipment
(34
)
 
(43
)
Businesses
(267
)
 
—

Proceeds from:
 
 
 
Maturities and redemptions of fixed maturities
2,252

 
2,356

Repayments of mortgage loans
74

 
97

Sales of fixed maturities
262

 
257

Sales of equity securities
97

 
278

Cash and cash equivalents of businesses acquired
1,078

 
—

Managed investment entities:
 
 
 
Purchases of investments
(1,075
)
 
(1,061
)
Proceeds from sales and redemptions of investments
1,153

 
1,515

Other investing activities, net
94

 
25

Net cash used in investing activities
(2,435
)
 
(1,913
)
 
 
 
 
Financing Activities:
 
 
 
Annuity receipts
2,725

 
2,852

Annuity surrenders, benefits and withdrawals
(1,289
)
 
(1,157
)
Net transfers from variable annuity assets
36

 
25

Additional long-term borrowings
145

 
—

Reductions of long-term debt
(1
)
 
(40
)
Issuances of managed investment entities’ liabilities
538

 
747

Retirement of managed investment entities’ liabilities
(571
)
 
(1,196
)
Issuances of Common Stock
35

 
45

Repurchases of Common Stock
(127
)
 
(70
)
Cash dividends paid on Common Stock
(59
)
 
(52
)
Other financing activities, net
—

 
(3
)
Net cash provided by financing activities
1,432

 
1,151

Net Change in Cash and Cash Equivalents
(329
)
 
(374
)
Cash and cash equivalents at beginning of period
1,639

 
1,705

Cash and cash equivalents at end of period
$
1,310

 
$
1,331


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


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

A.     Accounting Policies

Basis of Presentation   The accompanying consolidated financial statements for American Financial Group, Inc. (“AFG”) and its subsidiaries are unaudited; however, management believes that all adjustments (consisting only of normal recurring accruals unless otherwise disclosed herein) necessary for fair presentation have been made. The results of operations for interim periods are not necessarily indicative of results to be expected for the year. The financial statements have been prepared in accordance with the instructions to Form 10-Q and, therefore, do not include all information and footnotes necessary to be in conformity with U.S. generally accepted accounting principles.
 
Certain reclassifications have been made to prior periods to conform to the current year’s presentation. 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, 2014, 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. Other than the recording of the acquisition of Summit Holding Southeast, Inc. and its related companies (see Note B — “Acquisitions”), AFG did not have any significant nonrecurring fair value measurements of nonfinancial assets and liabilities in the first nine months of 2014 or 2013.

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.

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 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

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


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 as 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 impact 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 Consolidated Statement of Earnings as the cash flows from the hedged item. Qualifying highly effective cash flow hedges include interest rate swaps, which are used to mitigate interest rate risk related to certain floating-rate securities included in AFG’s portfolio of fixed maturity securities.

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.
 
A subsidiary cedes life insurance policies to a third party on a funds withheld basis whereby the subsidiary retains the assets (securities) associated with the reinsurance contract. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. This reinsurance contract is considered to contain an embedded derivative (that must be adjusted to fair value) because the yield on the payable is based on a specific block of the ceding company’s assets, rather than the overall creditworthiness of the ceding company. AFG determined that changes in the fair value of the underlying portfolio of fixed maturity securities is an appropriate measure of the value of the embedded derivative. The securities related to this contract are classified as “trading.” The adjustment to fair value on the embedded derivative offsets the investment income recorded on the adjustment to fair value of the related trading portfolio.
 
Deferred Policy Acquisition Costs (“DPAC”)   Policy acquisition costs (principally commissions, premium taxes and certain underwriting and policy issuance costs) directly related to the successful acquisition or renewal of an insurance contract are deferred. DPAC also includes capitalized costs associated with sales inducements offered to fixed annuity policyholders such as enhanced interest rates and premium and persistency bonuses.
 
For the property and casualty companies, DPAC is limited based upon recoverability without any consideration for anticipated investment income and is charged against income ratably over the terms of the related policies. A premium deficiency is recognized if the sum of expected claims costs, claims adjustment expenses and unamortized acquisition costs exceed the related unearned premiums. A premium deficiency is first recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency is greater than unamortized acquisition costs, a liability is accrued for the excess deficiency and reported with unpaid losses and loss adjustment expenses.

DPAC related to annuities is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of actual and expected gross profits on the policies. Expected gross profits consist principally of estimated future

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


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”). Both the management fees (payment of which is subordinate to other obligations of the CLOs) and the investments in the CLOs are considered variable interests. AFG has determined that it is the primary beneficiary of the CLOs because (i) its role as asset manager gives it the power to direct the activities that most significantly impact the economic performance of the CLOs and (ii) it has exposure to CLO losses (through its investments in the CLO debt tranches) and the right to receive benefits (through its subordinated management fees and returns on its investments), both of which could potentially be significant to the CLOs.
 
Because AFG has no right to use the CLO assets and no obligation to pay the CLO liabilities, the assets and liabilities of the CLOs are shown separately in AFG’s Balance Sheet (at fair value). AFG has elected the fair value option for reporting on the CLO assets and liabilities to improve the transparency of financial reporting related to the CLOs. The excess of fair value of the CLOs’ assets over the fair value of the liabilities is recorded in AFG’s Balance Sheet as appropriated retained earnings — managed investment entities, representing amounts that ultimately will inure to the benefit of the CLO debt holders.

The net gain or loss from accounting for the CLO assets and liabilities at fair value is separately presented in AFG’s Statement of Earnings. CLO earnings attributable to AFG’s shareholders represent the change in fair value of AFG’s investments in the CLOs (including distributions) and management fees earned. All other CLO earnings (losses) are not attributable to AFG’s shareholders and will ultimately inure to the benefit of the CLO debt holders. As a result, such CLO earnings (losses) are included in net earnings (loss) attributable to noncontrolling interests in AFG’s Statement of Earnings and in appropriated retained earnings — managed investment entities in the Balance Sheet. As the CLOs approach maturity (2016 to 2026), it is expected that losses attributable to noncontrolling interests will reduce appropriated retained earnings towards zero as the fair values of the assets and liabilities converge and the CLO assets are used to pay the CLO debt.

At September 30, 2014, assets and liabilities of managed investment entities included $153 million in assets and $124 million in liabilities of a temporary warehousing entity that was established in connection with the formation of a new CLO that is expected to close in the fourth quarter of 2014. Upon closing, all warehoused assets are expected to be transferred to the new CLO and the liabilities will be repaid.
 
In August 2014, the FASB issued Accounting Standards Update (“ASU”) 2014-13 to address 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

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been made to account for that entity’s assets and liabilities at fair value. As discussed above, the fair values of a CLO’s assets may differ from the fair values of its liabilities even though the liabilities only have recourse to the assets, which results in “appropriated retained earnings — managed investment entities” in AFG’s Balance Sheet. Under ASU 2014-13, AFG will have the option 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 fair value. Under this alternative, CLO earnings attributable to AFG’s shareholders would continue to be measured by the change in the fair value of AFG’s investments in the CLOs and management fees earned. However, as a result of setting the carrying value of the CLO liabilities equal to the fair value of the CLO assets, there would no longer be any excess carrying value of CLO assets over the carrying value of CLO liabilities to be reported as “appropriated retained earnings — managed investment entities” in AFG’s Balance Sheet or any CLO earnings to be attributed to noncontrolling interests in AFG’s Statement of Earnings. If AFG elects to continue to measure both the CLO assets and liabilities at fair value, ASU 2014-13 will require amounts currently reflected as “appropriated retained earnings — managed investment entities” to be reclassified to unappropriated retained earnings in the Balance Sheet and amounts currently attributed to noncontrolling interests in the Statement of Earnings to be included in earnings attributable to AFG shareholders. AFG will be required to adopt this guidance effective on January 1, 2016, but may elect to early adopt the guidance as of January 1, 2015 (as permitted). AFG expects to elect the alternative measurement guidance, which is not expected to have a material impact on AFG’s net earnings attributable to shareholders. Management is currently evaluating the early adoption provisions, transition guidance and overall impact of the ASU on AFG’s Consolidated Financial Statements.

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 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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


reasonably expected rate increases) are not expected to cover the present value of future claims payments and related settlement and maintenance costs (excluding overhead) as well as unamortized acquisition costs. If a block of business is determined to be in loss recognition, a charge is recorded in earnings in an amount equal to the excess of the present value of expected future claims costs and unamortized acquisition costs over existing reserves plus the present value of expected future premiums (with no provision for adverse deviation). The charge is recorded first to reduce unamortized acquisition costs and then as an additional reserve (if unamortized acquisition costs have been reduced to zero).

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

Variable Annuity Assets and Liabilities   Separate accounts related to variable annuities represent the fair value of deposits invested in underlying investment funds on which AFG earns a fee. Investment funds are selected and may be changed only by the policyholder, who retains all investment risk.
 
AFG’s variable annuity contracts contain a guaranteed minimum death benefit (“GMDB”) to be paid if the policyholder dies before the annuity payout period commences. In periods of declining equity markets, the GMDB may exceed the value of the policyholder’s account. A GMDB liability is established for future excess death benefits using assumptions together with a range of reasonably possible scenarios for investment fund performance that are consistent with DPAC capitalization and amortization assumptions.

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

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

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

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

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

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

Earnings Per Share   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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stock-based compensation plans: third quarter of 2014 and 2013 — 1.9 million and 1.9 million; first nine months of 2014 and 2013 — 2.0 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: third quarter of 2014 and 2013 — 1.2 million and 1.0 million; first nine months of 2014 and 2013 — 1.0 million and 1.3 million, respectively. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were nominal in the 2014 and 2013 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.     Acquisitions

On March 27, 2014, AFG completed a renewal rights agreement with Selective Insurance Company of America to acquire Selective’s pooled public entity book of business for $8 million. At the acquisition date, this book of business had approximately $38 million in in-force gross written premiums.

On April 1, 2014, AFG acquired Summit Holding Southeast, Inc. and its related companies (“Summit”), from Liberty Mutual Insurance for $259 million using cash on hand at the parent company. Immediately following the acquisition, AFG made a capital contribution of $140 million, bringing its total capital investment in the Summit business to $399 million. Summit is based in Lakeland, Florida and is a leading provider of specialty workers’ compensation solutions in the southeastern United States with over $500 million in net written premiums in 2013. Summit continues to operate under the Summit brand as a member of AFG’s Great American Insurance Group. Summit is included in the Specialty casualty sub-segment and generated a total of $268 million in net earned premiums in the second and third quarters of 2014.


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Expenses related to the acquisition were less than $1 million and were expensed as incurred. The purchase price was allocated to the acquired assets and liabilities of Summit based on management’s best estimate of fair value as of the acquisition date. The allocation of the purchase price is shown in the table below (in millions):

Total purchase price


 
$
259

 
 
 
 
Tangible assets acquired:
 
 
 
Cash and cash equivalents
$
1,078

 
 
Fixed maturities, available for sale
92

 
 
Recoverables from reinsurers
116

 
 
Agents’ balances and premiums receivable
41

 
 
Deferred tax assets, net (a)
67

 
 
Other receivables
21

 
 
Other assets
11

 
 
Total tangible assets acquired


 
1,426

 
 
 
 
Liabilities acquired:
 
 
 
Unpaid losses and loss adjustment expenses
1,142

 
 
Unearned premiums
3

 
 
Payable to reinsurers
3

 
 
Other liabilities
66

 
 
Total liabilities acquired


 
1,214

 
 
 
 
Net tangible assets acquired, at fair value

 
212

Excess purchase price over net tangible assets acquired
 
 
$
47

 
 
 
 
Allocation of excess purchase price:
 
 
 
Intangible assets acquired (b)
 
 
$
47

Deferred tax on intangible assets acquired (a)
 
 
(16
)
Goodwill
 
 
16

 
 
 
$
47


(a)
Included with AFG’s net deferred tax liabilities, which are included in Other liabilities in AFG’s Consolidated Balance Sheet.
(b)
Included in Other assets in AFG’s Consolidated Balance Sheet.

AFG believes that the agents’ balances and other acquired receivables are collectible. The intangible assets acquired include $1 million in indefinite lived intangible assets related to state insurance licenses and $46 million in finite lived intangibles, primarily related to agency relationships. The finite lived intangibles will be amortized over an average life of 7 years. The fair value of the acquired liability for unpaid losses and loss adjustment expenses and related recoverables from reinsurers was estimated by discounting actuarial projected future net cash flows using the U.S. Treasury yield curve (with an adjustment for the illiquidity of insurance reserves) and then adding a risk adjustment to reflect the net present value of the profit that a market participant would require in return for the assumption of the risk associated with the reserves. The fair value of Summit’s agency relationship was estimated using a multi-period excess earnings method, which is a form of the income approach. The acquisition resulted in the recognition of $16 million in non-deductible goodwill based on the excess of the purchase price over the fair value of the net assets acquired. The goodwill represents the fair value of acquired intangible assets that do not qualify for separate recognition, including the value of Summit’s assembled workforce.

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

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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. 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,
 
2014
 
2013
 
2014
 
2013
Revenues
 
 
 
 
 
 
 
Property and casualty insurance:
 
 
 
 
 
 
 
Premiums earned:
 
 
 
 
 
 
 
Specialty
 
 
 
 
 
 
 
Property and transportation
$
504

 
$
517

 
$
1,129

 
$
1,111

Specialty casualty
486

 
289

 
1,266

 
825

Specialty financial
115

 
121

 
348

 
350

Other specialty
27

 
22

 
74

 
59

Total premiums earned
1,132

 
949

 
2,817

 
2,345

Net investment income
76

 
65

 
219

 
196

Other income
4

 
1

 
8

 
10

Total property and casualty insurance
1,212

 
1,015

 
3,044

 
2,551

Annuity:
 
 
 
 
 
 
 
Net investment income
287

 
259

 
851

 
764

Other income
20

 
17

 
57

 
46

Total annuity
307

 
276

 
908

 
810

Run-off long-term care and life
48

 
50

 
147

 
147

Other
1

 
46

 
41

 
68

Total revenues before realized gains
1,568

 
1,387

 
4,140

 
3,576

Realized gains on securities
13

 
56

 
44

 
154

Total revenues
$
1,581

 
$
1,443

 
$
4,184

 
$
3,730


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Three months ended September 30,
 
Nine months ended September 30,
 
2014
 
2013
 
2014
 
2013
Earnings Before Income Taxes
 
 
 
 
 
 
 
Property and casualty insurance:
 
 
 
 
 
 
 
Underwriting:
 
 
 
 
 
 
 
Specialty
 
 
 
 
 
 
 
Property and transportation
$
11

 
$
16

 
$
(1
)
 
$
(5
)
Specialty casualty
32

 
19

 
100

 
70

Specialty financial
21

 
22

 
46

 
50

Other specialty
6

 
5

 
13

 
16

Other lines (a)
(24
)
 
(54
)
 
(25
)
 
(61
)
Total underwriting
46

 
8

 
133

 
70

Investment and other income, net
64

 
53

 
180

 
169

Total property and casualty insurance
110

 
61

 
313

 
239

Annuity (b)
86

 
78

 
243

 
231

Run-off long-term care and life
1

 
(4
)
 
(3
)
 
(7
)
Other (c)
(65
)
 
(49
)
 
(161
)
 
(174
)
Total earnings before realized gains and income taxes
132

 
86

 
392

 
289

Realized gains on securities
13

 
56

 
44

 
154

Total earnings before income taxes
$
145

 
$
142

 
$
436

 
$
443


(a)
Includes special charges of $24 million and $54 million in the third quarter of 2014 and 2013, respectively, to increase asbestos and environmental (“A&E”) reserves.
(b)
Includes a $5 million charge in the second quarter of 2013 to cover expected assessments from state guaranty funds related to the insolvency and liquidation of an unaffiliated life insurance company.
(c)
Includes holding company expenses and earnings (losses) of managed investment entities attributable to noncontrolling interest of ($29) million and $12 million for the third quarter and ($47) million and ($30) million for the first nine months of 2014 and 2013, respectively. Holding company expenses includes special charges totaling $6 million in the third quarter of 2014 and $22 million in the third quarter of 2013 to increase A&E reserves related to AFG’s former railroad and manufacturing operations.

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D.    Fair Value Measurements

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

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

Level 3 — Valuations derived from market valuation techniques generally consistent with those used to estimate the fair values of Level 2 financial instruments in which one or more significant inputs are unobservable or when the market for a security exhibits significantly less liquidity relative to markets supporting Level 2 fair value measurements. The unobservable inputs may include management’s own assumptions about the assumptions market participants would use based on the best information available in the circumstances. AFG’s Level 3 is comprised of financial instruments, including liabilities of managed investment entities, whose fair value is estimated based on non-binding broker quotes or internally developed using significant inputs not based on, or corroborated by, observable market information.

AFG’s management is responsible for the valuation process and uses data from outside sources (including nationally recognized pricing services and broker/dealers) in establishing fair value. AFG’s internal investment professionals are a group of approximately 20 analysts whose primary responsibility is to manage AFG’s investment portfolio. These professionals monitor individual investments as well as overall industries and are active in the financial markets on a daily basis. The group is led by AFG’s chief investment officer, who reports directly to one of AFG’s Co-CEOs. Valuation techniques utilized by pricing services and prices obtained from external sources are reviewed by AFG’s internal investment professionals who are familiar with the securities being priced and the markets in which they trade to ensure the fair value determination is representative of an exit price. To validate the appropriateness of the prices obtained, these investment managers consider widely published indices (as benchmarks), recent trades, changes in interest rates, general economic conditions and the credit quality of the specific issuers. In addition, the Company communicates directly with the pricing service regarding the methods and assumptions used in pricing, including verifying, on a test basis, the inputs used by the service to value specific securities.
 

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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, 2014
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
Available for sale (“AFS”) fixed maturities:
 
 
 
 
 
 
 
U.S. Government and government agencies
$
168

 
$
182

 
$
15

 
$
365

States, municipalities and political subdivisions
—

 
6,304

 
66

 
6,370

Foreign government
—

 
204

 
—

 
204

Residential MBS
—

 
4,326

 
263

 
4,589

Commercial MBS
—

 
2,464

 
27

 
2,491

Asset-backed securities (“ABS”)
—

 
3,440

 
179

 
3,619

Corporate and other
30

 
11,855

 
442

 
12,327

Total AFS fixed maturities
198

 
28,775

 
992

 
29,965

Trading fixed maturities
30

 
312

 
—

 
342

Equity securities
1,305

 
88

 
81

 
1,474

Assets of managed investment entities (“MIE”)
281

 
2,636

 
29

 
2,946

Variable annuity assets (separate accounts) (*)
—

 
649

 
—

 
649

Other investments — derivatives
—

 
288

 
—

 
288

Total assets accounted for at fair value
$
1,814

 
$
32,748

 
$
1,102

 
$
35,664

Liabilities:
 
 
 
 
 
 
 
Liabilities of managed investment entities
$
242

 
$
—

 
$
2,383

 
$
2,625

Derivatives in annuity benefits accumulated
—

 
—

 
1,085

 
1,085

Other liabilities — derivatives
—

 
13

 
—

 
13

Total liabilities accounted for at fair value
$
242

 
$
13

 
$
3,468

 
$
3,723

 
 
 
 
 
 
 
 
December 31, 2013
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
Available for sale fixed maturities:
 
 
 
 
 
 
 
U.S. Government and government agencies
$
147

 
$
152

 
$
15

 
$
314

States, municipalities and political subdivisions
—

 
5,311

 
61

 
5,372

Foreign government
—

 
208

 
—

 
208

Residential MBS
—

 
3,994

 
316

 
4,310

Commercial MBS
—

 
2,696

 
28

 
2,724

Asset-backed securities
—

 
2,418

 
75

 
2,493

Corporate and other
28

 
10,672

 
335

 
11,035

Total AFS fixed maturities
175

 
25,451

 
830

 
26,456

Trading fixed maturities
—

 
305

 
—

 
305

Equity securities
1,023

 
125

 
31

 
1,179

Assets of managed investment entities
266

 
2,592

 
30

 
2,888

Variable annuity assets (separate accounts) (*)
—

 
665

 
—

 
665

Other investments — derivatives
—

 
274

 
—

 
274

Total assets accounted for at fair value
$
1,464

 
$
29,412

 
$
891

 
$
31,767

Liabilities:
 
 
 
 
 
 
 
Liabilities of managed investment entities
$
156

 
$
—

 
$
2,411

 
$
2,567

Derivatives in annuity benefits accumulated
—

 
—

 
804

 
804

Other liabilities — derivatives
—

 
10

 
—

 
10

Total liabilities accounted for at fair value
$
156

 
$
10

 
$
3,215

 
$
3,381

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




17
Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


During the third quarter ended September 30, 2014, there were no transfers from Level 1 to Level 2. During the nine months ended September 30, 2014, nine perpetual preferred stocks with an aggregate fair value of $55 million were transferred from Level 1 to Level 2 due to insufficient trade data to warrant classification in Level 1. During the third quarter and nine months ended September 30, 2014, there were fourteen perpetual preferred stocks with an aggregate fair value of $96 million transferred from Level 2 to Level 1 as a result of increases in trade frequency sufficient to warrant classification in Level 1. During the first nine months of 2013 (in the third quarter), there was one perpetual preferred stock with a fair value of $10 million transferred from Level 1 to Level 2 due to a decrease in trade frequency, resulting in lack of available trade data sufficient to warrant classification in Level 1. Transfers from Level 2 to Level 1 for the third quarter and nine months ended September 30, 2013 included six and ten perpetual preferred stocks with an aggregate fair value of $46 million and one common stock with a fair value of $16 million. In addition, for the nine months ended September 30, 2013, one mandatory redeemable preferred stock with a fair value of $11 million was transferred from Level 2 to Level 1. All Level 2 to Level 1 transfers were a result of increases in trade frequency sufficient to warrant classification in Level 1. Approximately 3% of the total assets carried at fair value on September 30, 2014, were Level 3 assets. Approximately 85% ($919 million) of the Level 3 assets were priced using non-binding broker quotes, for which there is a lack of transparency as to the inputs used to determine fair value. Details as to the quantitative inputs are neither provided by the brokers nor otherwise reasonably obtainable by AFG. Since internally developed Level 3 asset fair values represent less than one-half of 1% of the total assets measured at fair value and approximately 2% of AFG’s shareholders’ equity, changes in unobservable inputs used to determine internally developed fair values would not have a material impact on AFG’s financial position.

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

The only significant Level 3 assets or liabilities carried at fair value in the financial statements that were not measured using broker quotes are the derivatives embedded in AFG’s fixed-indexed annuity liabilities, which are measured using a discounted cash flow approach and had a fair value of $1.09 billion at September 30, 2014. The following table presents information about the unobservable inputs used by management in determining fair value of these embedded derivatives. See Note F — “Derivatives.”

Unobservable Input
  
Range
Adjustment for insurance subsidiary’s credit risk
  
0.30% – 1.60% over the risk free rate
Risk margin for uncertainty in cash flows
  
0.3% reduction in the discount rate
Surrenders
  
4% – 16% of indexed account value
Partial surrenders
  
2% – 6% of indexed account value
Annuitizations
  
1% – 2% of indexed account value
Deaths
  
1.5% – 2.5% of indexed account value
Budgeted option costs
  
2.5% – 4.0% of indexed account value

The range of adjustments for insurance subsidiary’s credit risk reflects credit spread variations across the yield curve. The range of projected surrender rates reflects the specific surrender charges and other features of AFG’s individual fixed-indexed annuity products with an expected range of 6% to 12% in the majority of future calendar years (4% to 16% 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.


18
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 2014 and 2013 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, 2014
 
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, 2014
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agency
$
15

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
15

State and municipal
61

 
(1
)
 
(1
)
 
—

 
—

 
7

 
—

 
66

Residential MBS
256

 
—

 
(1
)
 
8

 
(8
)
 
20

 
(12
)
 
263

Commercial MBS
28

 
(1
)
 
—

 
—

 
—

 
—

 
—

 
27

Asset-backed securities
204

 
—

 
(3
)
 
8

 
(7
)
 
—

 
(23
)
 
179

Corporate and other
313

 
(1
)
 
1

 
51

 
(13
)
 
91

 
—

 
442

Equity securities
81

 
—

 
(2
)
 
2

 
—

 
—

 
—

 
81

Assets of MIE
27

 
—

 
—

 
3

 
(1
)
 
—

 
—

 
29

Liabilities of MIE (*)
(2,322
)
 
5

 
—

 
(135
)
 
69

 
—

 
—

 
(2,383
)
Embedded derivatives
(1,026
)
 
(21
)
 
—

 
(51
)
 
13

 
—

 
—

 
(1,085
)

(*)
Total realized/unrealized gains (losses) included in net income includes gains of $6 million related to liabilities outstanding as of September 30, 2014. See Note H — “Managed Investment Entities.”

  
 
 
Total realized/unrealized
gains (losses) included in
 
 
 
 
 
 
 
 
 
 
 
Balance at June 30, 2013
 
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, 2013
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agency
$
20

 
$
—

 
$
(1
)
 
$
—

 
$
—

 
$
—

 
$
—

 
$
19

State and municipal
63

 
—

 
(1
)
 
—

 
—

 
—

 
—

 
62

Residential MBS
329

 
1

 
8

 
—

 
(13
)
 
43

 
(47
)
 
321

Commercial MBS
28

 
1

 
(1
)
 
—

 
—

 
—

 
—

 
28

Asset-backed securities
180

 
—

 
—

 
—

 
(4
)
 
11

 
(1
)
 
186

Corporate and other
295

 
—

 
(4
)
 
6

 
(3
)
 
—

 
(4
)
 
290

Equity securities
78

 
(2
)
 
—

 
—

 
—

 
—

 
(19
)
 
57

Assets of MIE
31

 
—

 
—

 
—

 
—

 
—

 
—

 
31

Liabilities of MIE (*)
(2,482
)
 
17

 
—

 
(95
)
 
236

 
—

 
—

 
(2,324
)
Embedded derivatives
(577
)
 
(33
)
 
—

 
(53
)
 
10

 
—

 
—

 
(653
)

(*)
Total realized/unrealized gains (losses) included in net income includes gains of $20 million related to liabilities outstanding as of September 30, 2013. See Note H — “Managed Investment Entities.”


19
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, 2013
 
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, 2014
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agency
$
15

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
15

State and municipal
61

 
(1
)
 
(1
)
 
—

 
—

 
7

 
—

 
66

Residential MBS
316

 
3

 
5

 
8

 
(23
)
 
58

 
(104
)
 
263

Commercial MBS
28

 
(1
)
 
—

 
—

 
—

 
—

 
—

 
27

Asset-backed securities
75

 
3

 
(2
)
 
68

 
(23
)
 
81

 
(23
)
 
179

Corporate and other
335

 
4

 
4

 
72