Document
______________________________________________________________________________________________________
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the Quarterly Period Ended June 30, 2018
 
 
 
Commission File No. 1-13653 

afglogo.jpg


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 August 1, 2018, there were 89,087,663 shares of the Registrant’s Common Stock outstanding, excluding 14.9 million shares owned by subsidiaries.
______________________________________________________________________________________________________

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

TABLE OF CONTENTS
 
 
 
 
Page
 
 
 
 
 


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

PART I
ITEM I — FINANCIAL STATEMENTS
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET (UNAUDITED)
(Dollars in Millions)
 
June 30,
2018
 
December 31,
2017
Assets:
 
 
 
Cash and cash equivalents
$
1,810

 
$
2,338

Investments:
 
 
 
Fixed maturities, available for sale at fair value (amortized cost — $39,244 and $37,038)
39,648

 
38,379

Fixed maturities, trading at fair value
137

 
348

Equity securities, at fair value
1,777

 
1,662

Investments accounted for using the equity method
1,194

 
999

Mortgage loans
1,147

 
1,125

Policy loans
179

 
184

Equity index call options
615

 
701

Real estate and other investments
272

 
312

Total cash and investments
46,779

 
46,048

Recoverables from reinsurers
3,073

 
3,369

Prepaid reinsurance premiums
645

 
600

Agents’ balances and premiums receivable
1,266

 
1,146

Deferred policy acquisition costs
1,582

 
1,216

Assets of managed investment entities
5,032

 
4,902

Other receivables
1,048

 
1,030

Variable annuity assets (separate accounts)
636

 
644

Other assets
1,574

 
1,504

Goodwill
199

 
199

Total assets
$
61,834

 
$
60,658

 
 
 
 
Liabilities and Equity:
 
 
 
Unpaid losses and loss adjustment expenses
$
9,093

 
$
9,678

Unearned premiums
2,539

 
2,410

Annuity benefits accumulated
34,886

 
33,316

Life, accident and health reserves
647

 
658

Payable to reinsurers
721

 
743

Liabilities of managed investment entities
4,840

 
4,687

Long-term debt
1,301

 
1,301

Variable annuity liabilities (separate accounts)
636

 
644

Other liabilities
2,087

 
1,887

Total liabilities
56,750

 
55,324

 
 
 
 
Redeemable noncontrolling interests
—

 
3

 
 
 
 
Shareholders’ equity:
 
 
 
Common Stock, no par value
       — 200,000,000 shares authorized
       — 89,072,114 and 88,275,460 shares outstanding
89

 
88

Capital surplus
1,220

 
1,181

Retained earnings
3,628

 
3,248

Accumulated other comprehensive income, net of tax
147

 
813

Total shareholders’ equity
5,084

 
5,330

Noncontrolling interests
—

 
1

Total equity
5,084

 
5,331

Total liabilities and equity
$
61,834

 
$
60,658


2
Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF EARNINGS (UNAUDITED)
(In Millions, Except Per Share Data)
 
Three months ended June 30,
 
Six months ended June 30,
 
2018
 
2017
 
2018
 
2017
Revenues:
 
 
 
 
 
 
 
Property and casualty insurance net earned premiums
$
1,161

 
$
1,065

 
$
2,268

 
$
2,087

Life, accident and health net earned premiums
6

 
5

 
12

 
11

Net investment income
530

 
460

 
1,025

 
895

Realized gains (losses) on securities (*)
31

 
8

 
(62
)
 
11

Income (loss) of managed investment entities:
 
 
 
 
 
 
 
Investment income
64

 
50

 
122

 
101

Gain (loss) on change in fair value of assets/liabilities
(2
)
 
11

 
(5
)
 
11

Other income
43

 
47

 
92

 
106

Total revenues
1,833

 
1,646

 
3,452

 
3,222

 
 
 
 
 
 
 
 
Costs and Expenses:
 
 
 
 
 
 
 
Property and casualty insurance:
 
 
 
 
 
 
 
Losses and loss adjustment expenses
693

 
635

 
1,334

 
1,244

Commissions and other underwriting expenses
400

 
366

 
781

 
705

Annuity benefits
260

 
224

 
442

 
420

Life, accident and health benefits
11

 
6

 
22

 
15

Annuity and supplemental insurance acquisition expenses
50

 
48

 
132

 
101

Interest charges on borrowed money
16

 
23

 
31

 
44

Expenses of managed investment entities
54

 
51

 
102

 
92

Other expenses
89

 
88

 
174

 
173

Total costs and expenses
1,573

 
1,441

 
3,018

 
2,794

Earnings before income taxes
260

 
205

 
434

 
428

Provision for income taxes
52

 
60

 
85

 
128

Net earnings, including noncontrolling interests
208

 
145

 
349

 
300

Less: Net earnings (losses) attributable to noncontrolling interests
(2
)
 
—

 
(6
)
 
2

Net Earnings Attributable to Shareholders
$
210

 
$
145

 
$
355

 
$
298

 
 
 
 
 
 
 
 
Earnings Attributable to Shareholders per Common Share:
 
 
 
 
 
 
 
Basic
$
2.36

 
$
1.64

 
$
3.99

 
$
3.40

Diluted
$
2.31

 
$
1.61

 
$
3.92

 
$
3.32

Average number of Common Shares:
 
 
 
 
 
 
 
Basic
89.0

 
87.8

 
88.8

 
87.5

Diluted
90.7

 
89.8

 
90.5

 
89.6

 
 
 
 
 
 
 
 
Cash dividends per Common Share
$
1.85

 
$
1.8125

 
$
2.20

 
$
2.125

________________________________________
 
 
 
 
 
 
 
(*) Consists of the following:
 
 
 
 
 
 
 
Realized gains (losses) before impairments
$
31

 
$
17

 
$
(61
)
 
$
26

 
 
 
 
 
 
 
 
Losses on securities with impairment
—

 
(10
)
 
(1
)
 
(16
)
Non-credit portion recognized in other comprehensive income (loss)
—

 
1

 
—

 
1

Impairment charges recognized in earnings
—

 
(9
)
 
(1
)
 
(15
)
Total realized gains (losses) on securities
$
31

 
$
8

 
$
(62
)
 
$
11


3
Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (UNAUDITED)
(In Millions)
 
 
Three months ended June 30,
 
Six months ended June 30,
 
2018
 
2017
 
2018
 
2017
Net earnings, including noncontrolling interests
$
208

 
$
145

 
$
349

 
$
300

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Net unrealized gains (losses) on securities:
 
 
 
 
 
 
 
Unrealized holding gains (losses) on securities arising during the period
(148
)
 
115

 
(427
)
 
240

Reclassification adjustment for realized gains included in net earnings
(3
)
 
(5
)
 
(1
)
 
(5
)
Total net unrealized gains (losses) on securities
(151
)
 
110

 
(428
)
 
235

Net unrealized gains (losses) on cash flow hedges
(3
)
 
2

 
(14
)
 
1

Foreign currency translation adjustments
(4
)
 
4

 
(3
)
 
4

Other comprehensive income (loss), net of tax
(158
)
 
116

 
(445
)
 
240

Total comprehensive income (loss), net of tax
50

 
261

 
(96
)
 
540

Less: Comprehensive income (loss) attributable to noncontrolling interests
(2
)
 
—

 
(6
)
 
2

Comprehensive income (loss) attributable to shareholders
$
52

 
$
261

 
$
(90
)
 
$
538



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
 
 
 
 
 
Redeemable
Common
Shares
 
 
Common Stock
and Capital
Surplus
 
Retained
Earnings
 
Accumulated
Other Comp.
Income (Loss)
 
Total
 
Noncon-
trolling
Interests
 
Total
Equity
 
Noncon-
trolling
Interests
Balance at December 31, 2017
88,275,460

 
 
$
1,269

 
$
3,248

 
$
813

 
$
5,330

 
$
1

 
$
5,331

 
$
3

Cumulative effect of accounting change
—

 
 
—

 
225

 
(221
)
 
4

 
—

 
4

 
—

Net earnings (losses)
—

 
 
—

 
355

 
—

 
355

 
(1
)
 
354

 
(5
)
Other comprehensive loss
—

 
 
—

 
—

 
(445
)
 
(445
)
 
—

 
(445
)
 
—

Dividends on Common Stock
—

 
 
—

 
(196
)
 
—

 
(196
)
 
—

 
(196
)
 
—

Shares issued:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Exercise of stock options
531,726

 
 
19

 
—

 
—

 
19

 
—

 
19

 
—

Restricted stock awards
200,625

 
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Other benefit plans
73,676

 
 
8

 
—

 
—

 
8

 
—

 
8

 
—

Dividend reinvestment plan
18,006

 
 
2

 
—

 
—

 
2

 
—

 
2

 
—

Stock-based compensation expense
—

 
 
11

 
—

 
—

 
11

 
—

 
11

 
—

Shares exchanged — benefit plans
(24,310
)
 
 
—

 
(2
)
 
—

 
(2
)
 
—

 
(2
)
 
—

Forfeitures of restricted stock
(3,069
)
 
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Other
—

 
 
—

 
(2
)
 
—

 
(2
)
 
—

 
(2
)
 
2

Balance at June 30, 2018
89,072,114

 
 
$
1,309

 
$
3,628

 
$
147

 
$
5,084

 
$
—

 
$
5,084

 
$
—

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2016
86,924,399

 
 
$
1,198

 
$
3,343

 
$
375

 
$
4,916

 
$
3

 
$
4,919

 
$
—

Net earnings
—

 
 
—

 
298

 
—

 
298

 
2

 
300

 
—

Other comprehensive income
—

 
 
—

 
—

 
240

 
240

 
—

 
240

 
—

Dividends on Common Stock
—

 
 
—

 
(187
)
 
—

 
(187
)
 
—

 
(187
)
 
—

Shares issued:
 
 
 
 
 
 
 
 
 

 
 
 

 
 
Exercise of stock options
792,288

 
 
26

 
—

 
—

 
26

 
—

 
26

 
—

Restricted stock awards
232,250

 
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Other benefit plans
75,381

 
 
7

 
—

 
—

 
7

 
—

 
7

 
—

Dividend reinvestment plan
19,516

 
 
2

 
—

 
—

 
2

 
—

 
2

 
—

Stock-based compensation expense
—

 
 
13

 
—

 
—

 
13

 
—

 
13

 
—

Shares exchanged — benefit plans
(32,509
)
 
 
—

 
(3
)
 
—

 
(3
)
 
—

 
(3
)
 
—

Forfeitures of restricted stock
(4,073
)
 
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Other
—

 
 
—

 
—

 
—

 
—

 
(5
)
 
(5
)
 
—

Balance at June 30, 2017
88,007,252

 
 
$
1,246

 
$
3,451

 
$
615

 
$
5,312

 
$
—

 
$
5,312

 
$
—


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

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Millions)
 
Six months ended June 30,
 
2018
 
2017
Operating Activities:
 
 
 
Net earnings, including noncontrolling interests
$
349

 
$
300

Adjustments:
 
 
 
Depreciation and amortization
106

 
69

Annuity benefits
442

 
420

Realized (gains) losses on investing activities
64

 
(28
)
Net sales of trading securities
83

 
31

Deferred annuity and life policy acquisition costs
(127
)
 
(133
)
Change in:
 
 
 
Reinsurance and other receivables
72

 
(291
)
Other assets
(16
)
 
(8
)
Insurance claims and reserves
(268
)
 
275

Payable to reinsurers
(22
)
 
47

Other liabilities
55

 
(32
)
Managed investment entities’ assets/liabilities
138

 
(72
)
Other operating activities, net
(53
)
 
(4
)
Net cash provided by operating activities
823

 
574

 
 
 
 
Investing Activities:
 
 
 
Purchases of:
 
 
 
Fixed maturities
(4,549
)
 
(5,387
)
Equity securities
(248
)
 
(44
)
Mortgage loans
(90
)
 
(146
)
Equity index options and other investments
(446
)
 
(360
)
Real estate, property and equipment
(44
)
 
(30
)
Proceeds from:
 
 
 
Maturities and redemptions of fixed maturities
2,283

 
3,285

Repayments of mortgage loans
68

 
110

Sales of fixed maturities
203

 
150

Sales of equity securities
106

 
50

Sales and settlements of equity index options and other investments
446

 
360

Sales of real estate, property and equipment
1

 
53

Managed investment entities:
 
 
 
Purchases of investments
(1,261
)
 
(1,780
)
Proceeds from sales and redemptions of investments
1,035

 
1,738

Other investing activities, net
11

 
7

Net cash used in investing activities
(2,485
)
 
(1,994
)
 
 
 
 
Financing Activities:
 
 
 
Annuity receipts
2,547

 
2,556

Annuity surrenders, benefits and withdrawals
(1,372
)
 
(1,161
)
Net transfers from variable annuity assets
21

 
30

Additional long-term borrowings
—

 
345

Reductions of long-term debt
—

 
(230
)
Issuances of managed investment entities’ liabilities
1,572

 
977

Retirements of managed investment entities’ liabilities
(1,461
)
 
(835
)
Issuances of Common Stock
21

 
27

Cash dividends paid on Common Stock
(194
)
 
(185
)
Other financing activities, net
—

 
(4
)
Net cash provided by financing activities
1,134

 
1,520

Net Change in Cash and Cash Equivalents
(528
)
 
100

Cash and cash equivalents at beginning of period
2,338

 
2,107

Cash and cash equivalents at end of period
$
1,810

 
$
2,207


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


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

A.     Accounting Policies

Basis of Presentation   The accompanying consolidated financial statements for American Financial Group, Inc. and its subsidiaries (“AFG”) are unaudited; however, management believes that all adjustments (consisting only of normal recurring accruals unless otherwise disclosed herein) necessary for fair presentation have been made. The results of operations for interim periods are not necessarily indicative of results to be expected for the year. The financial statements have been prepared in accordance with the instructions to Form 10-Q and, therefore, do not include all information and footnotes necessary to be in conformity with U.S. generally accepted accounting principles (“GAAP”).
 
Certain reclassifications have been made to prior periods to conform to the current year’s presentation. All significant intercompany balances and transactions have been eliminated. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. Events or transactions occurring subsequent to June 30, 2018, and prior to the filing of this Form 10-Q, have been evaluated for potential recognition or disclosure herein.
 
The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates.

Fair Value Measurements   Accounting standards define fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The standards establish a hierarchy of valuation techniques based on whether the assumptions that market participants would use in pricing the asset or liability (“inputs”) are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect AFG’s assumptions about the assumptions market participants would use in pricing the asset or liability. AFG did not have any significant nonrecurring fair value measurements in the first six months of 2018.

Investments On January 1, 2018, AFG adopted Accounting Standards Update (“ASU”) 2016-01, which requires all equity securities other than those accounted for under the equity method to be reported at fair value with holding gains and losses recognized in net earnings. At December 31, 2017, AFG had $1.60 billion in equity securities classified as “available for sale” under the prior guidance with holding gains and losses included in accumulated other comprehensive income (“AOCI”) instead of net earnings. At the date of adoption, the $221 million net unrealized gain on equity securities included in AOCI was reclassified to retained earnings as the cumulative effect of an accounting change. The cumulative effect of the accounting change also includes the net unrealized gain on AFG’s small number of limited partnerships and similar investments carried at cost under the prior guidance that are carried at fair value through net earnings under the new guidance ($4 million net of tax at the date of adoption).

Holding gains and losses on equity securities carried at fair value under ASU 2016-01 are generally recorded in realized gains (losses) on securities. However, prior to the adoption of the new guidance, AFG classified a small portion of its equity securities as “trading” and reported those investments at fair value with holding gains and losses recognized in net investment income. These investments consisted primarily of equity securities held to offset the impact of changes in the stock market on employee benefit plans that are impacted by stock market performance and totaled $62 million at December 31, 2017. Following the adoption of the new guidance, AFG continues to record holding gains and losses on these securities, as well as its small portfolio of limited partnerships and similar investments carried at fair value under the new guidance and certain other securities classified at purchase as “fair value through net investment income” in net investment income.


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


Under the new guidance, AFG recorded holding losses of $57 million on equity securities in net earnings during the first six months of 2018 on securities that were still owned at June 30, 2018. Under the prior guidance, these holding losses would have been recorded in AOCI (with the exception of any impairment charge that may have been recorded). Because almost all of the equity securities impacted by the new guidance were carried at fair value through AOCI under the prior guidance, the adoption of the new guidance did not have a material impact on AFG’s financial position.

Fixed maturity securities classified as “available for sale” are reported at fair value with unrealized gains and losses included in AOCI in AFG’s Balance Sheet. Fixed maturity 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 effective 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.

Limited partnerships and similar investments are generally accounted for using the equity method of accounting. Under the equity method, AFG records its share of the earnings or losses of the investee based on when they are reported by the investee in its financial statements rather than in the period in which the investee declares a dividend. AFG’s share of the earnings or losses from equity method investments is generally recorded on a quarter lag due to the timing of the receipt of the investee’s financial statements. AFG’s equity in the earnings (losses) of limited partnerships and similar investments is included in net investment income.

Gains or losses on fixed maturity 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 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 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.


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


Goodwill   Goodwill represents the excess of cost of subsidiaries over AFG’s equity in their underlying net assets. Goodwill is not amortized, but is subject to an impairment test at least annually. 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.
 
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 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.


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


Managed Investment Entities   A company is considered the primary beneficiary of, and therefore must consolidate, a variable interest entity (“VIE”) based primarily on its ability to direct the activities of the VIE that most significantly impact that entity’s economic performance and the obligation to absorb losses of, or receive benefits from, the entity that could potentially be significant to the VIE.
 
AFG manages, and has investments in, collateralized loan obligations (“CLOs”) that are VIEs (see Note G — “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.

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 annuity policy charges are recorded in 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

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


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 (losses) from securities had actually been realized. This adjustment is included in unrealized gains (losses) on marketable securities, a component of AOCI in AFG’s Balance Sheet.

Debt Issuance Costs   Debt issuance costs related to AFG’s outstanding debt are 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 represent 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. Noncontrolling interests that are redeemable at the option of the holder are presented separately in the mezzanine section of the balance sheet (between liabilities and equity).

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. The effect of a change in tax rates on deferred tax assets and liabilities is recorded in net earnings in the period that includes the enactment date.

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.

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



AFG records excess tax benefits or deficiencies for share-based payments through income tax expense in the statement of earnings. In addition, AFG accounts for forfeitures of awards when they occur.

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

Earnings Per Share   Although basic earnings per share only considers shares of common stock outstanding during the period, the calculation of diluted earnings per share includes the following adjustments to weighted average common shares related to stock-based compensation plans: second quarter of 2018 and 2017 — 1.7 million and 2.0 million; first six months of 2018 and 2017 — 1.7 million and 2.1 million, respectively.
 
There were no anti-dilutive potential common shares in the second quarter or first six months of 2018 or 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.

Revenue Recognition Guidance Effective in 2018 On January 1, 2018, AFG adopted ASU 2014-09, which provides guidance on recognizing revenue when (or as) performance obligations under the contract are satisfied. The new guidance also updates the accounting for certain costs associated with obtaining and fulfilling contracts with customers and requires certain new disclosures. Because revenue recognition for insurance contracts and financial instruments (AFG’s primary sources of revenue) were excluded from the scope of the new guidance, the adoption of ASU 2014-09 did not have a material impact on AFG’s results of operations or financial position.

B.    Segments of Operations

AFG manages its business as three segments: (i) Property and casualty insurance, (ii) Annuity and (iii) Other, which includes holding company costs, revenues and costs of AFG’s limited insurance operations outside of property and casualty insurance and annuities, and operations attributable to the noncontrolling interests of the managed investment entities.

AFG reports its property and casualty insurance business in the following Specialty sub-segments: (i) Property and transportation, which includes physical damage and liability coverage for buses, trucks and recreational vehicles, inland and ocean marine, agricultural-related products and other property coverages, (ii) Specialty casualty, which includes primarily excess and surplus, general liability, executive liability, professional liability, umbrella and excess liability, specialty coverage in targeted markets, customized programs for small to mid-sized businesses and workers’ compensation insurance, and (iii) Specialty financial, which includes risk management insurance programs for leasing and financing institutions (including equipment leasing and 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, fixed-indexed and variable-indexed annuities in the retail, financial institutions, registered investment advisor and education markets. AFG’s reportable segments and their components were determined based primarily upon similar economic characteristics, products and services. Effective January 1, 2018, the results of AFG’s run-off long-term care and life businesses are included in the “Other” segment instead of as a separate reportable segment based on the immaterial size of the remaining operations. Prior period amounts were reclassified for consistent presentation.


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


The following tables (in millions) show AFG’s revenues and earnings before income taxes by segment and sub-segment.
 
Three months ended June 30,
 
Six months ended June 30,
 
2018
 
2017
 
2018
 
2017
Revenues
 
 
 
 
 
 
 
Property and casualty insurance:
 
 
 
 
 
 
 
Premiums earned:
 
 
 
 
 
 
 
Specialty
 
 
 
 
 
 
 
Property and transportation
$
374

 
$
357

 
$
724

 
$
699

Specialty casualty
595

 
537

 
1,174

 
1,045

Specialty financial
159

 
146

 
308

 
293

Other specialty
33

 
25

 
62

 
50

Total premiums earned
1,161

 
1,065

 
2,268

 
2,087

Net investment income
115

 
96

 
215

 
182

Other income (a)
2

 
4

 
4

 
20

Total property and casualty insurance
1,278

 
1,165

 
2,487

 
2,289

Annuity:
 
 
 
 
 
 
 
Net investment income
412

 
360

 
806

 
707

Other income
27

 
26

 
53

 
53

Total annuity
439

 
386

 
859

 
760

Other
85

 
87

 
168

 
162

Total revenues before realized gains (losses)
1,802

 
1,638

 
3,514

 
3,211

Realized gains (losses) on securities
31

 
8

 
(62
)
 
11

Total revenues
$
1,833

 
$
1,646

 
$
3,452

 
$
3,222

Earnings Before Income Taxes
 
 
 
 
 
 
 
Property and casualty insurance:
 
 
 
 
 
 
 
Underwriting:
 
 
 
 
 
 
 
Specialty
 
 
 
 
 
 
 
Property and transportation
$
23

 
$
21

 
$
56

 
$
64

Specialty casualty
29

 
29

 
70

 
44

Specialty financial
22

 
23

 
37

 
45

Other specialty
(1
)
 
—

 
2

 
(1
)
Other lines
(1
)
 
(1
)
 
(2
)
 
(2
)
Total underwriting
72

 
72

 
163

 
150

Investment and other income, net (a)
106

 
91

 
199

 
184

Total property and casualty insurance
178

 
163

 
362

 
334

Annuity
99

 
85

 
224

 
181

Other (b)
(48
)
 
(51
)
 
(90
)
 
(98
)
Total earnings before realized gains (losses) and income taxes
229

 
197

 
496

 
417

Realized gains (losses) on securities
31

 
8

 
(62
)
 
11

Total earnings before income taxes
$
260

 
$
205

 
$
434

 
$
428

(a)
Includes income of $13 million (before noncontrolling interest) from the sale of a hotel in the first quarter of 2017.
(b)
Includes holding company interest and expenses, including a $7 million loss on retirement of debt in the second quarter of 2017.

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


C.    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 (“ABS”), mortgage-backed securities (“MBS”), non-affiliated common stocks, equity index call options 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 its CLO liabilities equal to the fair value of the CLO assets (which have more observable fair values) as an alternative to reporting those liabilities at separately measured fair values. 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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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


Assets and liabilities measured and carried at fair value in the financial statements are summarized below (in millions): 
 
Level 1
 
Level 2
 
Level 3
 
Total
June 30, 2018
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
Available for sale (“AFS”) fixed maturities:
 
 
 
 
 
 
 
U.S. Government and government agencies
$
140

 
$
92

 
$
8

 
$
240

States, municipalities and political subdivisions
—

 
6,852

 
61

 
6,913

Foreign government
—

 
129

 
—

 
129

Residential MBS
—

 
2,739

 
147

 
2,886

Commercial MBS
—

 
878

 
56

 
934

Asset-backed securities
—

 
7,931

 
1,004

 
8,935

Corporate and other
29

 
18,174

 
1,408

 
19,611

Total AFS fixed maturities
169

 
36,795

 
2,684

 
39,648

Trading fixed maturities
38

 
99

 
—

 
137

Equity securities
1,471

 
76

 
230

 
1,777

Equity index call options
—

 
615

 
—

 
615

Assets of managed investment entities (“MIE”)
229

 
4,780

 
23

 
5,032

Variable annuity assets (separate accounts) (*)
—

 
636

 
—

 
636

Total assets accounted for at fair value
$
1,907

 
$
43,001

 
$
2,937

 
$
47,845

Liabilities:
 
 
 
 
 
 
 
Liabilities of managed investment entities
$
220

 
$
4,598

 
$
22

 
$
4,840

Derivatives in annuity benefits accumulated
—

 
—

 
2,776

 
2,776

Other liabilities — derivatives
—

 
72

 
—

 
72

Total liabilities accounted for at fair value
$
220

 
$
4,670

 
$
2,798

 
$
7,688

 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
Available for sale fixed maturities:
 
 
 
 
 
 
 
U.S. Government and government agencies
$
122

 
$
112

 
$
8

 
$
242

States, municipalities and political subdivisions
—

 
6,975

 
148

 
7,123

Foreign government
—

 
127

 
—

 
127

Residential MBS
—

 
3,105

 
122

 
3,227

Commercial MBS
—

 
926

 
36

 
962

Asset-backed securities
—

 
7,218

 
744

 
7,962

Corporate and other
30

 
17,662

 
1,044

 
18,736

Total AFS fixed maturities
152

 
36,125

 
2,102

 
38,379

Trading fixed maturities
44

 
304

 
—

 
348

Equity securities
1,411

 
86

 
165

 
1,662

Equity index call options
—

 
701

 
—

 
701

Assets of managed investment entities
307

 
4,572

 
23

 
4,902

Variable annuity assets (separate accounts) (*)
—

 
644

 
—

 
644

Total assets accounted for at fair value
$
1,914

 
$
42,432

 
$
2,290

 
$
46,636

Liabilities:
 
 
 
 
 
 
 
Liabilities of managed investment entities
$
293

 
$
4,372

 
$
22

 
$
4,687

Derivatives in annuity benefits accumulated
—

 
—

 
2,542

 
2,542

Other liabilities — derivatives
—

 
35

 
—

 
35

Total liabilities accounted for at fair value
$
293

 
$
4,407

 
$
2,564

 
$
7,264

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


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


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

During the second quarter and first six months of 2018, there were two preferred stocks with an aggregate fair value of $6 million that transferred from Level 1 to Level 2. During the second quarter and first six months of 2017, there were two preferred stocks with an aggregate fair value of $16 million that transferred from Level 2 to Level 1.

Approximately 6% of the total assets carried at fair value at June 30, 2018, were Level 3 assets. Approximately 73% ($2.14 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 approximately 14% 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 and variable-indexed annuity liabilities, which are measured using a discounted cash flow approach and had a fair value of $2.78 billion at June 30, 2018. The following table presents information about the unobservable inputs used by management in determining fair value of these embedded derivatives. See Note E — “Derivatives.”

 
Unobservable Input
 
Range
 
 
Adjustment for insurance subsidiary’s credit risk
 
0.4% – 1.7% over the risk free rate
 
 
Risk margin for uncertainty in cash flows
 
0.70% reduction in the discount rate
 
 
Surrenders
 
3% – 23% of indexed account value
 
 
Partial surrenders
 
2% – 9% of indexed account value
 
 
Annuitizations
 
0.1% – 1% of indexed account value
 
 
Deaths
 
1.6% – 8.0% of indexed account value
 
 
Budgeted option costs
 
2.5% – 3.5% of indexed account value
 

The range of adjustments for insurance subsidiary’s credit risk reflects credit spread variations across the yield curve. The range of projected surrender rates reflects the specific surrender charges and other features of AFG’s individual fixed-indexed and variable-indexed annuity products with an expected range of 7% to 11% 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 flow assumptions in the table above would increase the fair value of the fixed-indexed and variable-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.


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


Changes in balances of Level 3 financial assets and liabilities carried at fair value during the second quarter and first six months of 2018 and 2017 are presented below (in millions). The transfers into and out of Level 3 were due to changes in the availability of market observable inputs and $29 million of equity securities transferred into Level 3 in the first quarter of 2018 related to a small number of limited partnerships and similar investments carried at cost under the prior guidance that are carried at fair value through net earnings under new guidance adopted on January 1, 2018, as discussed in Note A — “Accounting Policies — Investments.” All transfers are reflected in the table at fair value as of the end of the reporting period.
 
 
 
Total realized/unrealized
gains (losses) included in
 
 
 
 
 
 
 
 
 
 
Balance at March 31, 2018
 
Net
earnings
 
Other
comprehensive
income (loss)
 
Purchases
and
issuances
 
Sales and
settlements
 
Transfer
into
Level 3
 
Transfer
out of
Level 3
 
Balance at June 30, 2018
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agency
$
8

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
8

State and municipal
62

 
—

 
(1
)
 
—

 
—

 
—

 
—

 
61

Residential MBS
115

 
(3
)
 
—

 
—

 
(5
)
 
50

 
(10
)
 
147

Commercial MBS
47

 
—

 
—

 
9

 
—

 
—

 
—

 
56

Asset-backed securities
912

 
—

 
(6
)
 
136

 
(20
)
 
—

 
(18
)
 
1,004

Corporate and other
1,238

 
1

 
(4
)
 
234

 
(48
)
 
—

 
(13
)
 
1,408

Total AFS fixed maturities
2,382

 
(2
)
 
(11
)
 
379

 
(73
)
 
50

 
(41
)
 
2,684

Equity securities
194

 
19

 
—

 
16

 
—

 
1

 
—

 
230

Assets of MIE
24

 
(3
)
 
—

 
2

 
—

 
—

 
—

 
23

Total Level 3 assets
$
2,600

 
$
14

 
$
(11
)
 
$
397

 
$
(73
)
 
$
51

 
$
(41
)
 
$
2,937

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Embedded derivatives (a)
$
(2,549
)
 
$
(126
)
 
$
—

 
$
(141
)
 
$
40

 
$
—

 
$
—

 
$
(2,776
)
Total Level 3 liabilities (b)
$
(2,549
)
 
$
(126
)
 
$
—

 
$
(141
)
 
$
40

 
$
—

 
$
—

 
$
(2,776
)


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

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
8

State and municipal
143

 
—

 
1

 
—

 
(1
)
 
—

 
—

 
143

Residential MBS
175

 
(3
)
 
2

 
—

 
(23
)
 
13

 
(11
)
 
153

Commercial MBS
29

 
1

 
—

 
15

 
—

 
—

 
—

 
45

Asset-backed securities
594

 
—

 
2

 
—

 
(25
)
 
19

 
(92
)
 
498

Corporate and other
828

 
4

 
4

 
168

 
(27
)
 
—

 
(24
)
 
953

Total AFS fixed maturities
1,777

 
2

 
9

 
183

 
(76
)
 
32

 
(127
)
 
1,800

Equity securities
173

 
(10
)
 
6

 
8

 
(3
)
 
—

 
(6
)
 
168

Assets of MIE
26

 
(5
)
 
—

 
2

 
—

 
—

 
—

 
23

Total Level 3 assets
$
1,976

 
$
(13
)
 
$
15

 
$
193

 
$
(79
)
 
$
32

 
$
(133
)
 
$
1,991

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Embedded derivatives
$
(1,963
)
 
$
(112
)
 
$
—

 
$
(80
)
 
$
26

 
$
—

 
$
—

 
$
(2,129
)
Total Level 3 liabilities (b)
$
(1,963
)
 
$
(112
)
 
$
—

 
$
(80
)
 
$
26

 
$
—

 
$
—

 
$
(2,129
)
(a)
Total realized/unrealized gains (losses) included in net earnings for the embedded derivatives reflects losses related to the unlocking of actuarial assumptions of $44 million in the second quarter of 2018.
(b)
As previously discussed, these tables exclude the portion of MIE liabilities allocated to Level 3, which are derived from the fair value of the MIE assets.

17
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, 2017
 
Net
earnings
 
Other
comprehensive
income (loss)
 
Purchases
and
issuances
 
Sales and
settlements
 
Transfer
into
Level 3
 
Transfer
out of
Level 3
 
Balance at June 30, 2018
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agency
$
8

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
8

State and municipal
148

 
—

 
(2
)
 
—

 
(1
)
 
—

 
(84
)
 
61

Residential MBS
122

 
(7
)
 
—

 
—

 
(11
)
 
57

 
(14
)
 
147

Commercial MBS
36

 
(1
)
 
—

 
21

 
—

 
—

 
—

 
56