Edgar Filing: AMERICAN FINANCIAL GROUP INC

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Form 10-Q

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, 2012

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 x 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 x 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:

Indicate by check mark whether the Registrant is a shell company. Yes ¨ No x

As of August 1, 2012, there were 93,867,273 shares of the Registrant’s Common Stock outstanding, excluding 14.9 million shares owned by subsidiaries.

AMERICAN FINANCIAL GROUP, INC.

TABLE OF CONTENTS


	Page
Part I — Financial Information
Item 1 — Financial Statements:
Consolidated Balance Sheet		2
Consolidated Statement of Earnings		3
Consolidated Statement of Comprehensive Income		4
Consolidated Statement of Changes in Equity		5
Consolidated Statement of Cash Flows		6
Notes to Consolidated Financial Statements		7
Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations		30
Item 3 — Quantitative and Qualitative Disclosure of Market Risk		48
Item 4 — Controls and Procedures		48

Part II — Other Information
Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds		49
Item 6 — Exhibits		49
Signatures		50

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,		December 31, 2011
	2012		(as adjusted)
Assets:
Cash and cash equivalents	$	1,523	$	1,324
Investments:
Fixed maturities, available for sale at fair value (amortized cost – $21,373 and $20,562)		22,981		21,807
Fixed maturities, trading at fair value		447		440
Equity securities, at fair value (cost – $897 and $744)		1,121		928
Mortgage loans		488		401
Policy loans		247		252
Real estate and other investments		494		425

Total cash and investments		27,301		25,577

Recoverables from reinsurers		2,740		2,942
Prepaid reinsurance premiums		488		409
Agents’ balances and premiums receivable		702		565
Deferred policy acquisition costs		846		901
Assets of managed investment entities		2,825		3,058
Other receivables		673		895
Variable annuity assets (separate accounts)		574		548
Other assets		717		757
Goodwill		186		186

Total assets	$	37,052	$	35,838

Liabilities and Equity:
Unpaid losses and loss adjustment expenses	$	6,153	$	6,520
Unearned premiums		1,661		1,484
Annuity benefits accumulated		16,758		15,420
Life, accident and health reserves		1,750		1,727
Payable to reinsurers		396		475
Liabilities of managed investment entities		2,502		2,787
Long-term debt		1,158		934
Variable annuity liabilities (separate accounts)		574		548
Other liabilities		1,325		1,386

Total liabilities		32,277		31,281

Shareholders’ equity:
Common Stock, no par value - 200,000,000 shares authorized - 94,959,232 and 97,846,402 shares outstanding		95		98
Capital surplus		1,112		1,121
Retained earnings:
Appropriated — managed investment entities		127		173
Unappropriated		2,515		2,439
Accumulated other comprehensive income, net of tax		773		580

Total shareholders’ equity		4,622		4,411

Noncontrolling interests		153		146

Total equity		4,775		4,557

Total liabilities and equity	$	37,052	$	35,838

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,
	2012			2011 (as adjusted)			2012			2011 (as adjusted)
Revenues:
Property and casualty insurance premiums	$	640		$	609		$	1,243		$	1,208
Life, accident and health premiums		105			107			210			217
Investment income		332			306			654			606
Realized gains (losses) on:
Securities (*)		16			19			60			19
Subsidiaries		(1	)		—			(1	)		(3	)
Income (loss) of managed investment entities:
Investment income		32			26			61			51
Loss on change in fair value of assets/liabilities		(21	)		(22	)		(50	)		(55	)
Other income		47			48			86			89

Total revenues		1,150			1,093			2,263			2,132

Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses		363			413			707			754
Commissions and other underwriting expenses		232			217			443			420
Annuity benefits		147			125			277			241
Life, accident and health benefits		84			89			176			185
Annuity and supplemental insurance acquisition expenses		48			49			95			99
Interest charges on borrowed money		21			21			42			42
Expenses of managed investment entities		20			18			39			36
Other operating and general expenses		99			101			202			193

Total costs and expenses		1,014			1,033			1,981			1,970

Operating earnings before income taxes		136			60			282			162
Provision for income taxes		52			30			110			78

Net earnings, including noncontrolling interests		84			30			172			84
Less: Net earnings (loss) attributable to noncontrolling interests		(15	)		(18	)		(40	)		(52	)

Net Earnings Attributable to Shareholders	$	99		$	48		$	212		$	136

Earnings Attributable to Shareholders per Common Share:
Basic	$	1.02		$	.47		$	2.18		$	1.31

Diluted	$	1.01		$	.46		$	2.15		$	1.29

Average number of Common Shares:
Basic		96.4			102.7			97.0			103.7
Diluted		98.0			104.4			98.7			105.3

Cash dividends per Common Share	$	.175		$	.1625		$	.35		$	.325
(*) Consists of the following:
Realized gains before impairments	$	23		$	40		$	71		$	50

Losses on securities with impairment		(7	)		(10	)		(12	)		(17	)
Non-credit portion recognized in other comprehensive income (loss)		—			(11	)		1			(14	)

Impairment charges recognized in earnings		(7	)		(21	)		(11	)		(31	)

Total realized gains on securities	$	16		$	19		$	60		$	19

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,
	2012			2011			2012			2011
Net earnings, including noncontrolling interests	$	84		$	30		$	172		$	84
Other comprehensive income, net of tax:
Net unrealized gains on securities:
Unrealized holding gains on securities arising during the period		78			115			236			136
Reclassification adjustment for realized gains included in net earnings		(12	)		(17	)		(40	)		(20	)

Total net unrealized gains on securities		66			98			196			116
Foreign currency translation adjustments		(8	)		(2	)		(1	)		5
Pension and other postretirement plans adjustments		—			1			1			1

Other comprehensive income, net of tax		58			97			196			122

Total comprehensive income, net of tax		142			127			368			206

Less: Comprehensive income (loss) attributable to noncontrolling interests		(16	)		(16	)		(37	)		(50	)

Comprehensive income attributable to shareholders	$	158		$	143		$	405		$	256

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						Accum. Other Comp					Noncon- trolling			Total
	Shares			Surplus			Appro.			Unappro.			Inc.(Loss)		Total			Interests			Equity
Balance at December 31, 2011, as adjusted		97,846,402		$	1,219		$	173		$	2,439		$	580	$	4,411		$	146		$	4,557

Net earnings		—			—			—			212			—		212			(40	)		172
Other comprehensive income		—			—			—			—			193		193			3			196
Allocation of losses of managed investment entities		—			—			(46	)		—			—		(46	)		46			—
Dividends on Common Stock		—			—			—			(33	)		—		(33	)		—			(33	)
Shares issued:
Exercise of stock options		814,394			21			—			—			—		21			—			21
Other benefit plans		276,195			5			—			—			—		5			—			5
Dividend reinvestment plan		7,711			—			—			—			—		—			—			—
Stock-based compensation expense		—			12			—			—			—		12			—			12
Shares acquired and retired		(3,985,470	)		(50	)		—			(103	)		—		(153	)		—			(153	)
Other		—			—			—			—			—		—			(2	)		(2	)

Balance at June 30, 2012		94,959,232		$	1,207		$	127		$	2,515		$	773	$	4,622		$	153		$	4,775


Balance at December 31, 2010		105,168,366		$	1,271		$	197		$	2,523		$	479	$	4,470		$	150		$	4,620
Cumulative effect of accounting change		—			—			—			(155	)		16		(139	)		—			(139	)

Balance at December 31, 2010, as adjusted		105,168,366			1,271			197			2,368			495		4,331			150			4,481

Net earnings		—			—			—			136			—		136			(52	)		84
Other comprehensive income		—			—			—			—			120		120			2			122
Allocation of losses of managed investment entities		—			—			(55	)		—			—		(55	)		55			—
Dividends on Common Stock		—			—			—			(34	)		—		(34	)		—			(34	)
Shares issued:
Exercise of stock options		654,799			16			—			—			—		16			—			16
Other benefit plans		357,042			8			—			—			—		8			—			8
Dividend reinvestment plan		7,870			—			—			—			—		—			—			—
Stock-based compensation expense		—			7			—			—			—		7			—			7
Shares acquired and retired		(5,167,842	)		(63	)		—			(115	)		—		(178	)		—			(178	)
Other		—			—			—			—			—		—			(2	)		(2	)

Balance at June 30, 2011		101,020,235		$	1,239		$	142		$	2,355		$	615	$	4,351		$	153		$	4,504

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,
	2012			2011 (as adjusted)
Operating Activities:
Net earnings, including noncontrolling interests	$	172		$	84
Adjustments:
Depreciation and amortization		83			91
Annuity benefits		277			241
Realized gains on investing activities		(57	)		(16	)
Net sales of trading securities		5			6
Deferred annuity and life policy acquisition costs		(129	)		(119	)
Change in:
Reinsurance and other receivables		212			156
Other assets		50			13
Insurance claims and reserves		(167	)		(12	)
Payable to reinsurers		(79	)		(18	)
Other liabilities		(179	)		112
Managed investment entities’ assets/liabilities		40			(12	)
Other operating activities, net		(2	)		8

Net cash provided by operating activities		226			534

Investing Activities:
Purchases of:
Fixed maturities		(1,976	)		(2,302	)
Equity securities		(194	)		(104	)
Mortgage loans		(97	)		(91	)
Real estate, property and equipment		(52	)		(57	)
Proceeds from:
Maturities and redemptions of fixed maturities		993			1,106
Repayments of mortgage loans		6			224
Sales of fixed maturities		239			374
Sales of equity securities		107			41
Sales of real estate, property and equipment		3			1
Managed investment entities:
Purchases of investments		(925	)		(681	)
Proceeds from sales and redemptions of investments		1,106			754
Other investing activities, net		(36	)		(6	)

Net cash used in investing activities		(826	)		(741	)

Financing Activities:
Annuity receipts		1,710			1,578
Annuity surrenders, benefits and withdrawals		(696	)		(636	)
Additional long-term borrowings		223			2
Reductions of long-term debt		(6	)		(14	)
Issuances of managed investment entities’ liabilities		359			—
Retirement of managed investment entities’ liabilities		(633	)		(8	)
Issuances of Common Stock		22			16
Repurchases of Common Stock		(153	)		(178	)
Cash dividends paid on Common Stock		(33	)		(34	)
Other financing activities, net		6			11

Net cash provided by financing activities		799			737

Net Change in Cash and Cash Equivalents		199			530

Cash and cash equivalents at beginning of period		1,324			1,099

Cash and cash equivalents at end of period	$	1,523		$	1,629

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

INDEX TO NOTES


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

A.	Accounting Policies

Basis of Presentation The accompanying consolidated financial statements for American Financial Group, Inc. (“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 June 30, 2012, and prior to the filing date of this Form 10-Q, have been evaluated for potential recognition or disclosure herein.

The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates.

Accounting Standards Adopted in 2012 Effective January 1, 2012, AFG retrospectively adopted Accounting Standards Update (“ASU”) 2010-26 that addresses which costs related to issuing or renewing insurance contracts qualify for deferral. To qualify for deferral, the guidance specifies that a cost must be directly related to the successful acquisition of an insurance contract. The financial statements for prior periods have been adjusted to reflect the adoption of the new standard.

The impact of adoption on amounts previously reported is shown in the table below (in millions, except per share data):


	December 31, 2011
Deferred policy acquisition costs
As previously reported	$	1,105
As adjusted		901

Net deferred tax liability (included in other liabilities)
As previously reported	$	203
As adjusted		133

Shareholders’ equity
As previously reported	$	4,545
As adjusted		4,411

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


	2011
	1st Quarter		2nd Quarter		3rd Quarter		4th Quarter		Total Year
Net earnings attributable to shareholders
As previously reported	$	83	$	55	$	96	$	109	$	343
As adjusted		88		48		97		109		342

Diluted earnings per Common Share
As previously reported	$	.79	$	.52	$	.94	$	1.10	$	3.33
As adjusted		.83		.46		.95		1.09		3.32

Effective January 1, 2012, AFG retrospectively adopted ASU 2011-05, which eliminates the option to report other comprehensive income in the Statement of Changes in Equity. As permitted by the standard, comprehensive income is presented herein in a separate statement immediately following the Statement of Earnings. This new presentation does not change the measurement of net earnings, other comprehensive income or earnings per share, and accordingly, had no impact on AFG’s results of operations or financial position.

Effective January 1, 2012, AFG adopted ASU 2011-04, which clarifies the application of existing fair value measurement and amends certain disclosure requirements. Disclosures required by the guidance are included in Note D. The impact of adoption was not material to AFG’s results of operations or financial position.

Fair Value Measurements Accounting standards define fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The standards establish a hierarchy of valuation techniques based on whether the assumptions that market participants would use in pricing the asset or liability (“inputs”) are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect AFG’s assumptions about the assumptions market participants would use in pricing the asset or liability. AFG did not have any significant nonrecurring fair value measurements of nonfinancial assets and liabilities in the first six months of 2012 or 2011.

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 in AFG’s Balance Sheet. Fixed maturity and equity securities classified as “trading” are reported at fair value with changes in unrealized holding gains or losses during the period included in investment income. Mortgage and policy loans are carried primarily at the aggregate unpaid balance.

Premiums and discounts on fixed maturity securities are amortized using the interest method; mortgage-backed securities (“MBS”) are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Gains or losses on securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other-than-temporary at the balance sheet date, a provision for impairment is charged to earnings (included in realized gains (losses)) and the cost basis of that investment is reduced. If management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will have to sell the security before recovery of its amortized cost basis, then the other-than-temporary impairment is separated into two components: 1) the amount related to credit losses (recorded in earnings) and 2) the amount related to all other factors (recorded in other comprehensive income). The credit-related portion of an other-than-temporary impairment is measured by comparing a security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. Both components are shown in the Statement of Earnings. If management intends to sell an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge to earnings is recorded to reduce the amortized cost of that security to fair value.

Derivatives Derivatives included in AFG’s Balance Sheet are recorded at fair value and consist primarily of (i) components of certain fixed maturity securities (primarily interest-only MBS) and (ii) the equity-based component of certain annuity products (included in annuity benefits accumulated) and related call options (included in other investments) designed to be consistent with the characteristics of the liabilities and used to mitigate the risk embedded in those annuity products. Changes in the fair value of derivatives are included in earnings.

Goodwill Goodwill represents the excess of cost of subsidiaries over AFG’s equity in their underlying net assets. Goodwill is not amortized, but is subject to an impairment test at least annually. Under guidance adopted in 2011, an entity is only required to complete the quantitative annual goodwill impairment test on a reporting unit if the entity determines (through qualitative analysis) that it is more likely than not that the reporting unit’s fair value is less than its carrying amount.

Reinsurance Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. AFG’s property and casualty insurance subsidiaries report as assets (a) the estimated reinsurance recoverable on paid and unpaid losses, including an estimate for losses incurred but not reported, and (b) amounts paid 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.

Certain annuity and supplemental insurance subsidiaries cede life insurance policies to a third party on a funds withheld basis whereby the subsidiaries retain the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. These reinsurance contracts are considered to contain embedded derivatives (that must be adjusted to fair value) because the yield on the payables is based on specific blocks of the ceding companies’ assets, rather than the overall creditworthiness of the ceding company. AFG determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. The securities related to these transactions are classified as “trading.” The adjustment to fair value on the embedded derivatives offsets the investment income recorded on the adjustment to fair value of the related trading portfolios.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Deferred Policy Acquisition Costs (“DPAC”) Policy acquisition costs (principally commissions, premium taxes and certain underwriting and policy issuance costs) directly related to the successful acquisition or renewal of an insurance contract are deferred. DPAC also includes capitalized costs associated with sales inducements offered to fixed annuity policyholders such as enhanced interest rates and premium and persistency bonuses. As discussed above under “Accounting Standards Adopted in 2012,” AFG’s accounting for DPAC changed effective January 1, 2012, and amounts previously reported have been adjusted retrospectively.

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 variable annuity policy charges, less death and annuitization 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).

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.

DPAC related to annuities is also adjusted, net of tax, for the change in amortization 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 accumulated other comprehensive income in AFG’s Balance Sheet.

DPAC includes the present value of future profits on business in force of annuity and supplemental 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.

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.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

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 are 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. 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 other 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 2022), 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.

Unpaid Losses and Loss Adjustment Expenses The net liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based upon (a) the accumulation of case estimates for losses reported prior to the close of the accounting period on direct business written; (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of unreported losses (including possible development on known claims) based on past experience; (d) estimates based on experience of expenses for investigating and adjusting claims; and (e) the current state of the law and 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 surrender charges are credited to other income.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses and excess benefits expected to be paid on future deaths and annuitizations (“EDAR”). The liability for EDAR is accrued for and modified using assumptions consistent with those used in determining DPAC and DPAC amortization, except that amounts are determined in relation to the present value of total expected assessments. Total expected assessments consist principally of estimated future investment margin, surrender, mortality, and other life and variable 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.

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. Claim reserves and liabilities established for accident and health claims are modified as necessary to reflect actual experience and developing trends.

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.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

AFG records a liability for the inherent uncertainty in quantifying its income tax provisions. Related interest and penalties are recognized as a component of tax expense.

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

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

Earnings Per Share Basic earnings per share is calculated using the weighted average number of shares of common stock outstanding during the period. The calculation of diluted earnings per share includes adjustments to weighted average common shares related to stock-based compensation plans: second quarter 2012 and 2011 – 1.6 million and 1.7 million; first six months of 2012 and 2011 – 1.7 million and 1.6 million, respectively.

AFG’s weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: second quarter 2012 and 2011 – 2.1 million and 2.4 million; first six months of 2012 and 2011 – 1.8 million and 2.1 million, respectively. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were nominal in the 2012 and 2011 periods.

Statement of Cash Flows For cash flow purposes, “investing activities” are defined as making and collecting loans and acquiring and disposing of debt or equity instruments and property and equipment. “Financing activities” include obtaining resources from owners and providing them with a return on their investments, borrowing money and repaying amounts borrowed. Annuity receipts, benefits and withdrawals are also reflected as financing activities. All other activities are considered “operating.” Short-term investments having original maturities of three months or less when purchased are considered to be cash equivalents for purposes of the financial statements.

Sale of Operations In May 2012 AFG reached a definitive agreement to sell its Medicare supplement and critical illness business to Cigna Corporation for approximately $295 million in cash. The sale is expected to close in the third quarter of 2012, and result in a pretax gain of approximately $150 – $165 million. Since the transaction will include the ongoing ceding of business to Cigna in a reinsurance transaction, the operations being sold are not reported as discontinued operations. Following the sale, AFG’s supplemental insurance operations will consist solely of its run-off long-term care business. Long-term care insurance is highly sensitive to actuarial assumptions and subject to significant uncertainties.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Summarized financial information for the Medicare supplement and critical illness businesses being sold is shown below (in millions):


	June 30, 2012		December 31, 2011
Assets:
Cash and investments	$	213	$	205
Deferred policy acquisition costs		107		110
Other assets		84		88

Total assets	$	404	$	403

Liabilities:
Accident and health reserves	$	262	$	264
Other liabilities		18		15

Total liabilities	$	280	$	279


	Six months ended June 30,
	2012		2011
Total revenues	$	159	$	164
Total costs and expenses		141		154

Operating earnings before income taxes	$	18	$	10

C.	Segments of Operations

AFG manages its business as three segments: (i) property and casualty insurance, (ii) annuity and supplemental insurance and (iii) other, which includes holding company costs and amounts attributable to the noncontrolling interests of the managed investment entities.

AFG reports its property and casualty insurance business in the following Specialty sub-segments: (i) Property and transportation, which includes physical damage and liability coverage for buses, trucks and recreational vehicles, inland and ocean marine, agricultural-related products and other property coverages, (ii) Specialty casualty, which includes primarily excess and surplus, general liability, executive liability, umbrella and excess liability, customized programs for small to mid-sized businesses and workers’ compensation, and (iii) Specialty financial, which includes risk management insurance programs for lending and leasing institutions (including collateral and mortgage protection insurance), surety and fidelity products and trade credit insurance. AFG’s annuity and supplemental insurance business markets traditional fixed and indexed annuities and a variety of supplemental insurance products such as Medicare supplement. Following the sale of its Medicare supplement and critical illness businesses (see Note B – “Sale of Operations”), AFG’s annuity and supplemental insurance business will market solely traditional fixed and indexed annuities and, to a much lesser extent, variable annuities. In addition, this segment will include run-off blocks of long-term care and life insurance.

AFG’s reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

The following tables (in millions) show AFG’s revenues and operating earnings before income taxes by significant business segment and sub-segment.


	Three months ended June 30,						Six months ended June 30,
	2012			2011			2012			2011
Revenues
Property and casualty insurance:
Premiums earned:
Specialty
Property and transportation	$	290		$	274		$	553		$	529
Specialty casualty		236			219			456			435
Specialty financial		98			100			201			212
Other		16			16			33			32

Total premiums earned		640			609			1,243			1,208
Investment income		70			75			141			150
Realized gains		13			32			44			32
Other income		18			20			31			35

Total property and casualty insurance		741			736			1,459			1,425
Annuity and supplemental insurance:
Investment income		267			230			519			458
Life, accident and health premiums		105			107			210			217
Realized gains (losses)		2			(13	)		15			(16	)
Other income		28			28			54			52

Total annuity and supplemental insurance		402			352			798			711
Other		7			5			6			(4	)

Total revenues	$	1,150		$	1,093		$	2,263		$	2,132

Operating Earnings Before Income Taxes
Property and casualty insurance:
Underwriting:
Specialty
Property and transportation	$	6			($3	)	$	33		$	33
Specialty casualty		33			17			37			18
Specialty financial		11			12			27			28
Other		2			3			3			5
Other lines (a)		(7	)		(50	)		(7	)		(50	)

Total underwriting		45			(21	)		93			34
Investment and other income, net		61			71			116			140
Realized gains		13			32			44			32

Total property and casualty insurance		119			82			253			206
Annuity and supplemental insurance:
Operations		76			56			143			110
Realized gains (losses)		2			(13	)		15			(16	)

Total annuity and supplemental insurance		78			43			158			94
Other (b)		(61	)		(65	)		(129	)		(138	)

Total operating earnings before income taxes	$	136		$	60		$	282		$	162

(a)	Includes a second quarter 2011 special charge of $50 million to increase asbestos and environmental reserves.

(b)	Includes holding company expenses and losses of managed investment entities attributable to noncontrolling interests of $18 million and $20 million for the second quarter and $46 million and $55 million for the first six months of 2012 and 2011, respectively.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

D.	Fair Value Measurements

Accounting standards for measuring fair value are based on inputs used in estimating fair value. The three levels of the hierarchy are as follows:

Level 1 — Quoted prices for identical assets or liabilities in active markets (markets in which transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis). AFG’s Level 1 financial instruments consist primarily of publicly traded equity securities and highly liquid government bonds for which quoted market prices in active markets are available and short-term investments of managed investment entities.

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

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

AFG’s management is responsible for the valuation process and uses data from outside sources (including nationally recognized pricing services and broker/dealers) in establishing fair value. AFG’s internal investment professionals are a group of approximately 20 analysts whose primary responsibility is to manage AFG’s investment portfolio. These professionals monitor individual investments as well as overall industries and are active in the financial markets on a daily basis. The group is led by AFG’s chief investment officer, who reports directly to one of the 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.

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, 2012
Assets:
Available for sale (“AFS”) fixed maturities:
U.S. Government and government agencies	$	234	$	145	$	—	$	379
States, municipalities and political subdivisions		—		3,981		86		4,067
Foreign government		—		256		—		256
Residential MBS		—		3,869		320		4,189
Commercial MBS		—		2,866		20		2,886
All other corporate		5		10,642		557		11,204

Total AFS fixed maturities		239		21,759		983		22,981

Trading fixed maturities		—		446		1		447
Equity securities		991		89		41		1,121
Assets of managed investment entities (“MIE”)		153		2,618		54		2,825
Variable annuity assets (separate accounts) (a)		—		574		—		574
Other investments		—		131		—		131

Total assets accounted for at fair value	$	1,383	$	25,617	$	1,079	$	28,079

Liabilities:
Liabilities of managed investment entities	$	73	$	—	$	2,429	$	2,502
Derivatives in annuity benefits accumulated		—		—		512		512
Other liabilities — derivatives		—		26		—		26

Total liabilities accounted for at fair value	$	73	$	26	$	2,941	$	3,040

December 31, 2011
Assets:
Available for sale (“AFS”) fixed maturities:
U.S. Government and government agencies	$	248	$	134	$	—	$	382
States, municipalities and political subdivisions		—		3,794		83		3,877
Foreign government		—		254		—		254
Residential MBS		—		3,487		361		3,848
Commercial MBS		—		2,821		19		2,840
All other corporate		9		10,078		519		10,606

Total AFS fixed maturities		257		20,568		982		21,807

Trading fixed maturities		—		439		1		440
Equity securities		888		29		11		928
Assets of managed investment entities (“MIE”)		290		2,724		44		3,058
Variable annuity assets (separate accounts) (a)		—		548		—		548
Other investments		—		71		—		71

Total assets accounted for at fair value	$	1,435	$	24,379	$	1,038	$	26,852

Liabilities:
Liabilities of managed investment entities	$	194	$	—	$	2,593	$	2,787
Derivatives in annuity benefits accumulated		—		—		395		395
Other liabilities — derivatives		—		23		—		23

Total liabilities accounted for at fair value	$	194	$	23	$	2,988	$	3,205

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

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

During the first six months of 2012, six preferred stocks with an aggregate fair value of $35 million were transferred from Level 1 to Level 2. The transfers were due to decreases in trade frequency, resulting in lack of available trade data sufficient to warrant classification in Level 1. Approximately 4% of the total assets accounted for at fair value on June 30, 2012, were Level 3 assets. Approximately 89% ($952 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 less than 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 indexed annuity liabilities, which are measured using a discounted cash flow approach and had a fair value of $512 million at June 30, 2012. 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		0.5% – 2.35% over the risk free rate
Risk margin for uncertainty in cash flows		0.3% reduction in the discount rate
Surrenders		4% – 25% of indexed account value
Partial surrenders		3% – 5% of indexed account value
Annuitizations		1% – 2% of indexed account value
Deaths		1% – 2.5% of indexed account value
Budgeted option costs		2.5% – 4.0% of indexed account value

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 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.

Changes in balances of Level 3 financial assets and liabilities carried at fair value during the second quarter and first six months of 2012 and 2011 are presented below (in millions). The transfers into and out of Level 3 were due to changes in the availability of market observable inputs. All transfers are reflected in the table at fair value as of the end of the reporting period.


				Total realized/unrealized gains (losses) included in
	Balance at March 31, 2012			Net income			Other comp. income (loss)		Purchases and issuances			Sales and Settlements			Transfer into Level 3		Transfer out of Level 3			Balance at June 30, 2012
AFS fixed maturities:
State and municipal	$	72		$	—		$	1	$	9		$	—		$	5		($1	)	$	86
Residential MBS		314			1			—		63			(7	)		21		(72	)		320
Commercial MBS		20			—			—		—			—			—		—			20
All other corporate		515			5			8		51			(22	)		7		(7	)		557
Trading fixed maturities		1			—			—		—			—			—		—			1
Equity securities		24			—			—		17			—			—		—			41
Assets of MIE		64			—			—		1			(9	)		—		(2	)		54
Liabilities of MIE (*)		(2,554	)		(19	)		—		—			144			—		—			(2,429	)
Embedded derivatives		(483	)		—			—		(39	)		10			—		—			(512	)

(*)	Total realized/unrealized loss included in net income includes losses of $14 million related to liabilities outstanding as of June 30, 2012. See Note H — “Managed Investment Entities.”

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


				Total realized/unrealized gains (losses) included in
	Balance at March 31, 2011			Net income			Other comp. income (loss)			Purchases and Issuances			Sales and Settlements			Transfer into Level 3		Transfer out of Level 3			Balance at June 30, 2011
AFS fixed maturities:
State and municipal	$	21		$	—		$	—		$	53		$	—		$	10	$	—		$	84
Residential MBS		271			—			(2	)		17			(7	)		—		(24	)		255
Commercial MBS		9			—			—			—			—			1		—			10
All other corporate		424			1			6			46			(26	)		2		(71	)		382
Trading fixed maturities		1			—			—			—			—			—		—			1
Equity securities		21			—			—			—			—			—		—			21
Assets of MIE		54			—			—			9			(2	)		2		(10	)		53
Liabilities of MIE (*)		(2,316	)		(10	)		—			—			4			—		—			(2,322	)
Embedded derivatives		(234	)		(10	)		—			(60	)		5			—		—			(299	)

(*)	Total realized/unrealized loss included in net income includes losses of $10 million related to liabilities outstanding as of June 30, 2011. See Note H — “Managed Investment Entities.”


				Total realized/unrealized gains (losses) included in
	Balance at December 31, 2011			Net income			Other comp. income (loss)		Purchases and Issuances			Sales and Settlements			Transfer into Level 3		Transfer out of Level 3			Balance at June 30, 2012
AFS fixed maturities:
State and municipal	$	83		$	—		$	1	$	19		$	—		$	5		($22	)	$	86
Residential MBS		361			2			—		71			(17	)		81		(178	)		320
Commercial MBS		19			—			1		—			—			—		—			20
All other corporate		519			7			11		77			(38	)		28		(47	)		557
Trading fixed maturities		1			—			—		—			—			—		—			1
Equity securities		11			—			—		26			—			4		—			41
Assets of MIE		44			—			—		13			(12	)		14		(5	)		54
Liabilities of MIE (*)		(2,593	)		(103	)		—		(366	)		633			—		—			(2,429	)
Embedded derivatives		(395	)		(62	)		—		(73	)		18			—		—			(512	)

(*)	Total realized/unrealized loss included in net income includes losses of $51 million related to liabilities outstanding as of June 30, 2012. See Note H — “Managed Investment Entities.”


				Total realized/unrealized gains (losses) included in
	Balance at December 31, 2010			Net income			Other comp. income (loss)			Purchases and Issuances			Sales and Settlements			Transfer into Level 3		Transfer out of Level 3			Balance at June 30, 2011
AFS fixed maturities:
State and municipal	$	20		$	—		$	1		$	53		$	—		$	10	$	—		$	84
Residential MBS		312			1			(2	)		17			(20	)		7		(60	)		255
Commercial MBS		6			—			—			—			—			4		—			10
All other corporate		436			(1	)		6			91			(37	)		24		(137	)		382
Trading fixed maturities		3			—			—			—			—			—		(2	)		1
Equity securities		21			—			2			—			(2	)		—		—			21
Assets of MIE		48			(1	)		—			16			(6	)		8		(12	)		53
Liabilities of MIE (*)		(2,258	)		(72	)		—			—			8			—		—			(2,322	)
Embedded derivatives		(190	)		(29	)		—			(90	)		10			—		—			(299	)

(*)	Total realized/unrealized loss included in net income includes losses of $71 million related to liabilities outstanding as of June 30, 2011. See Note H — “Managed Investment Entities.”

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

The carrying value and fair value of financial instruments that are not carried at fair value in the financial statements are summarized below (in millions):


June 30, 2012	Carrying Value		Fair Value		Level 1		Level 2		Level 3
Financial assets:
Cash and cash equivalents	$	1,523	$	1,523	$	1,523	$	—	$	—
Mortgage loans		488		491		—		—		491
Policy loans		247		247		—		—		247

Total financial assets not accounted for at fair value	$	2,258	$	2,261	$	1,523	$	—	$	738

Financial liabilities:
Annuity benefits accumulated (*)	$	16,559	$	16,773	$	—	$	—	$	16,773
Long-term debt		1,158		1,271		—		1,158		113

Total financial liabilities not accounted for at fair value	$	17,717	$	18,044	$	—	$	1,158	$	16,886

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

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

E.	Investments

Available for sale fixed maturities and equity securities at June 30, 2012, and December 31, 2011, consisted of the following (in millions):


	June 30, 2012									December 31, 2011
	Amortized Cost		Fair Value		Gross Unrealized					Amortized Cost		Fair Value		Gross Unrealized
	Amortized Cost		Fair Value		Gains		Losses			Amortized Cost		Fair Value		Gains		Losses
Fixed maturities:
U.S. Government and government agencies	$	362	$	379	$	17	$	—		$	363	$	382	$	19	$	—
States, municipalities and political subdivisions		3,756		4,067		313		(2	)		3,613		3,877		267		(3	)
Foreign government		238		256		18		—			236		254		18		—
Residential MBS		4,103		4,189		212		(126	)		3,858		3,848		170		(180	)
Commercial MBS		2,636		2,886		250		—			2,628		2,840		218		(6	)
All other corporate		10,278		11,204		949		(23	)		9,864		10,606		802		(60	)

Total fixed maturities	$	21,373	$	22,981	$	1,759		($151	)	$	20,562	$	21,807	$	1,494		($249	)

Common stocks	$	726	$	945	$	236		($17	)	$	610	$	797	$	207		($20	)

Perpetual preferred stocks	$	171	$	176	$	8		($3	)	$	134	$	131	$	5		($8	)

The non-credit related portion of other-than-temporary impairment charges are included in other comprehensive income. Cumulative charges taken for residential MBS still owned at June 30, 2012 and December 31, 2011, respectively were $229 million and $227 million.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

The following tables show gross unrealized losses (in millions) on fixed maturities and equity securities by investment category and length of time that individual securities have been in a continuous unrealized loss position at June 30, 2012 and December 31, 2011.


	Less Than Twelve Months								Twelve Months or More
	Unrealized Loss			Fair Value		Fair Value as % of Cost			Unrealized Loss			Fair Value		Fair Value as % of Cost
	Unrealized Loss			Fair Value		Fair Value as % of Cost			Unrealized Loss			Fair Value		Fair Value as % of Cost
June 30, 2012
Fixed maturities:
U.S. Government and government agencies	$	—		$	26		100	%	$	—		$	—		—	%
States, municipalities and political subdivisions		(1	)		101		99	%		(1	)		16		94	%
Foreign government		—			—		—	%		—			—		—	%
Residential MBS		(22	)		696		97	%		(104	)		602		85	%
Commercial MBS		—			39		99	%		—			—		—	%
All other corporate		(10	)		408		98	%		(13	)		166		93	%

Total fixed maturities		($33	)	$	1,270		97	%		($118	)	$	784		87	%

Common stocks		($16	)	$	146		90	%		($1	)	$	4		80	%

Perpetual preferred stocks		($1	)	$	9		90	%		($2	)	$	22		92	%

December 31, 2011
Fixed maturities:
U.S. Government and government agencies	$	—		$	2		100	%	$	—		$	—		—	%
States, municipalities and political subdivisions		(2	)		120		98	%		(1	)		59		98	%
Foreign government		—			1		100	%		—			—		—	%
Residential MBS		(59	)		1,141		95	%		(121	)		473		80	%
Commercial MBS		(6	)		183		97	%		—			18		100	%
All other corporate		(43	)		940		96	%		(17	)		114		87	%

Total fixed maturities		($110	)	$	2,387		96	%		($139	)	$	664		83	%

Common stocks		($19	)	$	169		90	%		($1	)	$	4		80	%

Perpetual preferred stocks		($1	)	$	23		96	%		($7	)	$	31		82	%

At June 30, 2012, the gross unrealized losses on fixed maturities of $151 million relate to approximately 625 securities. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 21% of the gross unrealized loss and 49% of the fair value.

AFG analyzes its MBS securities for other-than-temporary impairment each quarter based upon expected future cash flows. Management estimates expected future cash flows based upon its knowledge of the MBS market, cash flow projections (which reflect loan to collateral values, subordination, vintage and geographic concentration) received from independent sources, implied cash flows inherent in security ratings and analysis of historical payment data. For the first six months of 2012, AFG recorded in earnings $4 million in other-than-temporary impairment charges related to its residential MBS.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

A progression of the credit portion of other-than-temporary impairments on fixed maturity securities for which the non-credit portion of an impairment has been recognized in other comprehensive income is shown below (in millions).


	2012		2011
Balance at March 31	$	190	$	151
Additional credit impairments on:
Previously impaired securities		1		22
Securities without prior impairments		—		4
Reductions — disposals		—		(6	)

Balance at June 30	$	191	$	171

Balance at January 1	$	187	$	143
Additional credit impairments on:
Previously impaired securities		4		29
Securities without prior impairments		—		5
Reductions — disposals		—		(6	)

Balance at June 30	$	191	$	171

The table below sets forth the scheduled maturities of available for sale fixed maturities as of June 30, 2012 (in millions). Asset-backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers. MBS had an average life of approximately 4 years at June 30, 2012.


	Amortized		Fair Value
	Cost		Amount		%
Maturity
One year or less	$	791	$	806		3	%
After one year through five years		5,374		5,735		25
After five years through ten years		6,399		7,068		31
After ten years		2,070		2,297		10

		14,634		15,906		69
MBS		6,739		7,075		31

Total	$	21,373	$	22,981		100	%

Certain risks are inherent in connection with fixed maturity securities, including loss upon default, price volatility in reaction to changes in interest rates, and general market factors and risks associated with reinvestment of proceeds due to prepayments or redemptions in a period of declining interest rates.

There were no investments in individual issuers that exceeded 10% of Shareholders’ Equity at June 30, 2012 or December 31, 2011.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Net Unrealized Gain on Marketable Securities In addition to adjusting equity securities and fixed maturity securities classified as “available for sale” to fair value, GAAP requires that deferred policy acquisition costs related to annuities and certain other balance sheet amounts be adjusted to the extent that unrealized gains and losses from securities would result in adjustments to those balances had the unrealized gains or losses actually been realized. The following table shows (in millions) the components of the net unrealized gain on securities that is included in Accumulated Other Comprehensive Income in AFG’s Balance Sheet.


	Pre-tax			Deferred Tax and Amounts Attributable to Noncontrolling Interests			Net
June 30, 2012
Unrealized gain on:
Fixed maturities	$	1,608			($573	)	$	1,035
Equity securities		224			(79	)		145
Deferred policy acquisition costs		(642	)		225			(417	)
Annuity benefits and other liabilities		13			(5	)		8

	$	1,203			($432	)	$	771

December 31, 2011
Unrealized gain on:
Fixed maturities	$	1,245			($444	)	$	801
Equity securities		184			(65	)		119
Deferred policy acquisition costs		(537	)		188			(349	)
Annuity benefits and other liabilities		10			(3	)		7

	$	902			($324	)	$	578

Realized gains (losses) and changes in unrealized appreciation (depreciation) related to fixed maturity and equity security investments are summarized as follows (in millions):


	Fixed Maturities			Equity Securities			Mortgage Loans and Other Investments			Other (a)			Tax Effects			Noncon- trolling Interests			Total
Quarter ended June 30, 2012
Realized before impairments	$	6		$	21			($4	)	$	—			($8	)		($1	)	$	14
Realized — impairments		—			(8	)		—			1			3			—			(4	)
Change in unrealized		231			(30	)		—			(100	)		(35	)		—			66

Quarter ended June 30, 2011
Realized before impairments	$	11		$	34			($5	)	$	—			($15	)		($1	)	$	24
Realized — impairments		(26	)		—			(1	)		6			8			—			(13	)
Change in unrealized		208			(15	)		—			(42	)		(53	)		(2	)		96

Six months ended June 30, 2012
Realized before impairments	$	20		$	56			($3	)		($2	)		($25	)		($1	)	$	45
Realized — impairments		(4	)		(10	)		—			3			4			—			(7	)
Change in unrealized		363			40			—			(102	)		(105	)		(3	)		193

Six months ended June 30, 2011
Realized before impairments	$	24		$	35			($7	)		($2	)		($18	)		($1	)	$	31
Realized — impairments		(37	)		—			(4	)		10			11			—			(20	)
Change in unrealized		245			(2	)		—			(64	)		(63	)		(2	)		114

(a)	Primarily adjustments to deferred policy acquisition costs related to annuities.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Realized gains (losses) on securities includes net losses of $1 million in the second quarter and net gains of $3 million in the first six months of 2012 compared to net losses of less than $1 million in the second quarter and $3 million in the first six months of 2011 from the mark-to-market of certain MBS, primarily interest-only securities with interest rates that float inversely with short-term rates. Gross realized gains and losses (excluding impairment writedowns and mark-to-market of derivatives) on available for sale fixed maturity and equity security investment transactions included in the Statement of Cash Flows consisted of the following (in millions):


	Six months ended June 30,
	2012			2011
Fixed maturities:
Gross gains	$	18		$	29
Gross losses		(1	)		(2	)

Equity securities:
Gross gains		57			36
Gross losses		(1	)		—

F.	Derivatives

As discussed under “Derivatives” in Note A, AFG uses derivatives in certain areas of its operations. AFG’s derivatives do not qualify for hedge accounting under GAAP; changes in the fair value of derivatives are included in earnings.

The following derivatives are included in AFG’s Balance Sheet at fair value (in millions):


		June 30, 2012				December 31, 2011
Derivative	Balance Sheet Line	Asset		Liability		Asset		Liability
MBS with embedded derivatives	Fixed maturities	$	97	$	—	$	99	$	—
Interest rate swaptions	Other investments		2		—		5		—
Indexed annuities (embedded derivative)	Annuity benefits accumulated		—		512		—		395
Equity index call options	Other investments		129		—		66		—
Reinsurance contracts (embedded derivative)	Other liabilities		—		26		—		23

		$	228	$	538	$	170	$	418

The MBS with embedded derivatives consist primarily of interest-only MBS with interest rates that float inversely with short-term rates. AFG records the entire change in the fair value of these securities in earnings. These investments are part of AFG’s overall investment strategy and represent a small component of AFG’s overall investment portfolio.

AFG has entered into $1 billion notional amount of pay-fixed interest rate swaptions (options to enter into pay-fixed/receive floating interest rate swaps at future dates expiring between 2012 and 2015) to mitigate interest rate risk in its annuity operations. AFG paid $29 million to purchase these swaptions, which represents its maximum potential economic loss over the life of the contracts.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

AFG’s indexed annuities, which represented approximately one-third of annuity benefits accumulated at June 30, 2012, provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase of call options on the appropriate index. AFG’s strategy is designed so that an increase in the liabilities, due to an increase in the market index, will be generally offset by unrealized and realized gains on the call options purchased by AFG. Both the index-based component of the annuities and the related call options are considered derivatives. As shown in the table below, the embedded derivative remained relatively flat while the call options declined in value during the second quarter of 2012. The decline in fair value of the options reflects the decline in the stock market during the quarter. However, the negative impact of lower interest rates more than offset the positive impact of the stock market performance on the fair value of the indexed annuity embedded derivative.

As discussed under “Reinsurance” in Note A, certain reinsurance contracts in AFG’s annuity and supplemental insurance business are considered to contain embedded derivatives.

The following table summarizes the gain (loss) included in the Statement of Earnings for changes in the fair value of these derivatives for the second quarter and first six months of 2012 and 2011 (in millions):


		Three months ended June 30,						Six months ended June 30,
Derivative	Statement of Earnings Line	2012			2011			2012			2011
MBS with embedded derivatives	Realized gains		($1	)	$	—		$	3			($3	)
Interest rate swaptions	Realized gains		(3	)		(5	)		(3	)		(7	)
Indexed annuities (embedded derivative)	Annuity benefits		—			(10	)		(62	)		(29	)
Equity index call options	Annuity benefits		(20	)		2			37			20
Reinsurance contracts (embedded derivative)	Investment income		(4	)		(4	)		(3	)		(4	)

			($28	)		($17	)		($28	)		($23	)

G.	Deferred Policy Acquisition Costs

Deferred policy acquisition costs consisted of the following (in millions):


	June 30, 2012			December 31, 2011
Property and casualty insurance	$	198		$	189
Annuity and supplemental insurance:
Policy acquisition costs		955			898
Policyholder sales inducements		200			207
Present value of future profits (“PVFP”)		135			144
Impact of unrealized gains and losses on securities		(642	)		(537	)

Total annuity and supplemental		648			712

	$	846		$	901

See Accounting Standards Adopted in 2012 under Note A – “Accounting Policies.”

The PVFP amounts in the table above are net of $204 million and $195 million of accumulated amortization at June 30, 2012 and December 31, 2011, respectively.

Amortization of deferred acquisition costs for the second quarter and first six months of 2012 and 2011 were as follows (in millions):


	Three months ended June 30,				Six months ended June 30,
	2012		2011		2012		2011
Property and casualty insurance	$	111	$	108	$	212	$	208
Annuity and supplemental insurance:
Policy acquisition costs		31		30		59		62
Policyholder sales inducements		8		7		16		14
PVFP		4		5		9		11

Total annuity and supplemental		43		42		84		87

	$	154	$	150	$	296	$	295

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

H.	Managed Investment Entities

AFG is the investment manager and has investments ranging from 7.5% to 51.2% of the most subordinate debt tranche of eight collateralized loan obligation entities or “CLOs,” which are considered variable interest entities. Upon formation between 2004 and 2012, these entities issued securities in various senior and subordinate classes and invested the proceeds primarily in secured bank loans, which serve as collateral for the debt securities issued by each particular CLO. None of the collateral was purchased from AFG. AFG’s investments in the subordinate debt tranches of these entities receive residual income from the CLOs only after the CLOs pay operating expenses (including management fees to AFG), interest on and returns of capital to senior levels of debt securities. There are no contractual requirements for AFG to provide additional funding for these entities. AFG has not provided and does not intend to provide any financial support to these entities.

AFG’s maximum ultimate exposure to economic loss on its CLOs is limited to its investment in the CLOs, which had an aggregate fair value of $196 million at June 30, 2012, and $98 million at December 31, 2011.

In February 2012, one of the AFG CLOs was substantially liquidated at the instruction of the holder of the majority of the most subordinate debt tranche, as permitted by the CLO indentures. In March 2012, AFG formed a new CLO, which issued $410 million face amount of liabilities (including $39 million face amount purchased by subsidiaries of AFG).

The revenues and expenses of the CLOs are separately identified in AFG’s Statement of Earnings, after the elimination of management fees and earnings attributable to shareholders of AFG as measured by the change in the fair value of AFG’s investments in the CLOs. Selected financial information related to the CLOs is shown below (in millions):


	Three months ended June 30,						Six months ended June 30,
	2012			2011			2012			2011
Gains (losses) on change in fair value of assets/liabilities (a):
Assets		($2	)		($12	)	$	53		$	17
Liabilities		(19	)		(10	)		(103	)		(72	)
Management fees paid to AFG		4			5			8			8
CLO earnings (losses) attributable to:
AFG shareholders (b)		5			1			10			7
Noncontrolling interests (b)		(18	)		(20	)		(46	)		(55	)

(a)	Included in AFG’s “Revenues.”

(b)	Included in AFG’s “Operating earnings before income taxes.”

The aggregate unpaid principal balance of the CLOs’ fixed maturity investments exceeded the fair value of the investments by $66 million and $120 million at June 30, 2012 and December 31, 2011. The aggregate unpaid principal balance of the CLOs’ debt exceeded its fair value by $203 million and $306 million at those dates. The CLO assets include $5 million and $2 million in loans (aggregate unpaid principal balance of $12 million and $7 million, respectively) at June 30, 2012 and December 31, 2011, for which the CLOs are not accruing interest because the loans are in default.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

I.	Goodwill and Other Intangibles

There were no changes in the goodwill balance of $186 million during the six months ended June 30, 2012. Included in other assets in AFG’s Balance Sheet is $35 million at June 30, 2012 and $41 million at December 31, 2011, in amortizable intangible assets related to property and casualty insurance acquisitions. These amounts are net of accumulated amortization of $54 million and $47 million, respectively. Amortization of these intangibles was $3 million in each of the second quarters of 2012 and 2011 and $7 million and $6 million in the first six months of 2012 and 2011, respectively. Other assets also include $8 million in non-amortizable intangible assets related to property and casualty insurance acquisitions.

J.	Long-Term Debt

The carrying value of long-term debt consisted of the following (in millions):


	June 30, 2012		December 31, 2011
Direct obligations of AFG:
9-7/8% Senior Notes due June 2019	$	350	$	350
6-3/8% Senior Notes due June 2042		230		—
7% Senior Notes due September 2050		132		132
7-1/8% Senior Debentures due February 2034		115		115
Other		3		3

		830		600

Subsidiaries:
Obligations of AAG Holding (guaranteed by AFG):
7-1/2% Senior Debentures due November 2033(*)		112		112
7-1/4% Senior Debentures due January 2034(*)		86		86
Notes payable secured by real estate due 2012 through 2016		64		64
Secured borrowings ($16 and $17 guaranteed by AFG)		24		30
National Interstate bank credit facility		22		22

		308		314

Payable to Subsidiary Trusts:
AAG Holding Variable Rate Subordinated Debentures due May 2033		20		20

	$	1,158	$	934

(*)	Called for redemption on July 13, 2012 at par value.

Scheduled principal payments on debt for the balance of 2012 and the subsequent five years were as follows: 2012 — $28 million; 2013 — $20 million; 2014 — $2 million; 2015 — $14 million; 2016 — $45 million and 2017 — none.

As shown below (in millions), the majority of AFG’s long-term debt is unsecured obligations of the holding company and its subsidiaries:


	June 30, 2012		December 31, 2011
Unsecured obligations	$	1,070	$	840
Obligations secured by real estate		64		64
Other secured borrowings		24		30

	$	1,158	$	934

AFG can borrow up to $500 million under its revolving credit facility which expires in August 2013. Amounts borrowed under this agreement bear interest at rates ranging from 1.75% to 3.00% (currently 2%) over LIBOR based on AFG’s credit rating. No amounts were borrowed under this facility at June 30, 2012.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

In June 2012, AFG issued $230 million in 6-3/8% Senior Notes due 2042 and used the proceeds to redeem the outstanding AAG Holding Company, Inc. (a subsidiary of AFG) 7-1/2% Senior Debentures due 2033 and 7-1/4% Senior Debentures due 2034 at par value in July 2012.

K.	Shareholders’ Equity

AFG is authorized to issue 12.5 million shares of Voting Preferred Stock and 12.5 million shares of Nonvoting Preferred Stock, each without par value.

Accumulated Other Comprehensive Income, Net of Tax (“AOCI”) Comprehensive income is defined as all changes in Shareholders’ Equity except those arising from transactions with shareholders. Comprehensive income includes net earnings and other comprehensive income (“OCI”), which consists primarily of changes in net unrealized gains or losses on available for sale securities. The progression of the components of accumulated other comprehensive income follows (in millions):


				OCI
	AOCI Beginning Balance			Pre- tax			Tax			Non- controlling interests			Net			AOCI Ending Balance
Quarter ended June 30, 2012
Net unrealized gains on securities	$	705	(a)	$	101			($35	)	$	—		$	66		$	771	(a)
Foreign currency translation adjustments		16			(8	)		—			1			(7	)		9
Pension and other postretirement plans adjustments		(7	)		—			—			—			—			(7	)

Total	$	714		$	93			($35	)	$	1		$	59		$	773

Quarter ended June 30, 2011
Net unrealized gains on securities	$	509		$	151			($53	)		($2	)	$	96		$	605
Foreign currency translation adjustments		19			(2	)		—			—			(2	)		17
Pension and other postretirement plans adjustments		(8	)		1			—			—			1			(7	)

Total	$	520		$	150			($53	)		($2	)	$	95		$	615

Six months ended June 30, 2012
Net unrealized gains on securities	$	578	(a)	$	301			($105	)		($3	)	$	193		$	771	(a)
Foreign currency translation adjustments		10			(1	)		—			—			(1	)		9
Pension and other postretirement plans adjustments		(8	)		1			—			—			1			(7	)

Total	$	580		$	301			($105	)		($3	)	$	193		$	773

Six months ended June 30, 2011
Net unrealized gains on securities	$	491		$	179			($63	)		($2	)	$	114		$	605
Foreign currency translation adjustments		12			5			—			—			5			17
Pension and other postretirement plans adjustments		(8	)		1			—			—			1			(7	)

Total	$	495		$	185			($63	)		($2	)	$	120		$	615

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