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 March 31, 2019
 
 
 
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, every Interactive Data File required to be submitted 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, a 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
Securities Registered Pursuant to Section 12(b) of the Act:
 
Title of Each Class
 
Trading Symbol(s)
 
Name of Each Exchange on Which Registered
 
Common Stock
 
AFG
 
New York Stock Exchange
 
6-1/4% Subordinated Debentures due September 30, 2054
 
AFGE
 
New York Stock Exchange
 
6% Subordinated Debentures due November 15, 2055
 
AFGH
 
New York Stock Exchange
 
5.875% Subordinated Debentures due March 30, 2059
 
AFGB
 
New York Stock Exchange
As of May 1, 2019, there were 89,687,455 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)
 
March 31,
2019
 
December 31,
2018
Assets:
 
 
 
Cash and cash equivalents
$
2,000

 
$
1,515

Investments:
 
 
 
Fixed maturities, available for sale at fair value (amortized cost — $42,418 and $41,837)
43,431

 
41,997

Fixed maturities, trading at fair value
107

 
105

Equity securities, at fair value
1,930

 
1,814

Investments accounted for using the equity method
1,440

 
1,374

Mortgage loans
1,078

 
1,068

Policy loans
172

 
174

Equity index call options
620

 
184

Real estate and other investments
262

 
267

Total cash and investments
51,040

 
48,498

Recoverables from reinsurers
3,258

 
3,349

Prepaid reinsurance premiums
636

 
610

Agents’ balances and premiums receivable
1,283

 
1,234

Deferred policy acquisition costs
1,447

 
1,682

Assets of managed investment entities
4,786

 
4,700

Other receivables
1,011

 
1,090

Variable annuity assets (separate accounts)
610

 
557

Other assets
1,854

 
1,529

Goodwill
207

 
207

Total assets
$
66,132

 
$
63,456

 
 
 
 
Liabilities and Equity:
 
 
 
Unpaid losses and loss adjustment expenses
$
9,623

 
$
9,741

Unearned premiums
2,605

 
2,595

Annuity benefits accumulated
38,006

 
36,616

Life, accident and health reserves
632

 
635

Payable to reinsurers
730

 
752

Liabilities of managed investment entities
4,593

 
4,512

Long-term debt
1,423

 
1,302

Variable annuity liabilities (separate accounts)
610

 
557

Other liabilities
2,245

 
1,774

Total liabilities
60,467

 
58,484

 
 
 
 
Redeemable noncontrolling interests
—

 
—

 
 
 
 
Shareholders’ equity:
 
 
 
Common Stock, no par value
       — 200,000,000 shares authorized
       — 89,637,713 and 89,291,724 shares outstanding
90

 
89

Capital surplus
1,256

 
1,245

Retained earnings
3,875

 
3,588

Accumulated other comprehensive income, net of tax
444

 
48

Total shareholders’ equity
5,665

 
4,970

Noncontrolling interests
—

 
2

Total equity
5,665

 
4,972

Total liabilities and equity
$
66,132

 
$
63,456


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 March 31,
 
2019
 
2018
Revenues:
 
 
 
Property and casualty insurance net earned premiums
$
1,173

 
$
1,107

Life, accident and health net earned premiums
6

 
6

Net investment income
542

 
495

Realized gains (losses) on securities (*)
184

 
(93
)
Income (loss) of managed investment entities:
 
 
 
Investment income
69

 
58

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

 
(3
)
Other income
50

 
49

Total revenues
2,024

 
1,619

 
 
 
 
Costs and Expenses:
 
 
 
Property and casualty insurance:
 
 
 
Losses and loss adjustment expenses
692

 
641

Commissions and other underwriting expenses
399

 
381

Annuity benefits
311

 
182

Life, accident and health benefits
9

 
11

Annuity and supplemental insurance acquisition expenses
28

 
82

Interest charges on borrowed money
16

 
15

Expenses of managed investment entities
55

 
48

Other expenses
101

 
85

Total costs and expenses
1,611

 
1,445

Earnings before income taxes
413

 
174

Provision for income taxes
87

 
33

Net earnings, including noncontrolling interests
326

 
141

Less: Net earnings (losses) attributable to noncontrolling interests
(3
)
 
(4
)
Net Earnings Attributable to Shareholders
$
329

 
$
145

 
 
 
 
Earnings Attributable to Shareholders per Common Share:
 
 
 
Basic
$
3.68

 
$
1.64

Diluted
$
3.63

 
$
1.60

Average number of Common Shares:
 
 
 
Basic
89.4

 
88.6

Diluted
90.7

 
90.4

________________________________________
 
 
 
(*) Consists of the following:
 
 
 
Realized gains (losses) before impairments
$
186

 
$
(92
)
 
 
 
 
Losses on securities with impairment
(2
)
 
(1
)
Non-credit portion recognized in other comprehensive income (loss)
—

 
—

Impairment charges recognized in earnings
(2
)
 
(1
)
Total realized gains (losses) on securities
$
184

 
$
(93
)

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 March 31,
 
2019
 
2018
Net earnings, including noncontrolling interests
$
326

 
$
141

Other comprehensive income (loss), net of tax:
 
 
 
Net unrealized gains (losses) on securities:
 
 
 
Unrealized holding gains (losses) on securities arising during the period
384

 
(279
)
Reclassification adjustment for realized (gains) losses included in net earnings
(3
)
 
2

Total net unrealized gains (losses) on securities
381

 
(277
)
Net unrealized gains (losses) on cash flow hedges
11

 
(11
)
Foreign currency translation adjustments
4

 
1

Other comprehensive income (loss), net of tax
396

 
(287
)
Total comprehensive income (loss), net of tax
722

 
(146
)
Less: Comprehensive income (loss) attributable to noncontrolling interests
(3
)
 
(4
)
Comprehensive income (loss) attributable to shareholders
$
725

 
$
(142
)


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, 2018
89,291,724

 
 
$
1,334

 
$
3,588

 
$
48

 
$
4,970

 
$
2

 
$
4,972

 
$
—

Net earnings (losses)
—

 
 
—

 
329

 
—

 
329

 
—

 
329

 
(3
)
Other comprehensive income
—

 
 
—

 
—

 
396

 
396

 
—

 
396

 
—

Dividends ($0.40 per share)
—

 
 
—

 
(36
)
 
—

 
(36
)
 
—

 
(36
)
 
—

Shares issued:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Exercise of stock options
152,253

 
 
6

 
—

 
—

 
6

 
—

 
6

 
—

Restricted stock awards
232,565

 
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Other benefit plans
11,062

 
 
1

 
—

 
—

 
1

 
—

 
1

 
—

Dividend reinvestment plan
1,893

 
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Stock-based compensation expense
—

 
 
6

 
—

 
—

 
6

 
—

 
6

 
—

Shares exchanged — benefit plans
(43,470
)
 
 
(1
)
 
(3
)
 
—

 
(4
)
 
—

 
(4
)
 
—

Forfeitures of restricted stock
(8,314
)
 
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Other
—

 
 
—

 
(3
)
 
—

 
(3
)
 
(2
)
 
(5
)
 
3

Balance at March 31, 2019
89,637,713

 
 
$
1,346

 
$
3,875

 
$
444

 
$
5,665

 
$
—

 
$
5,665

 
$
—

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
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)
—

 
 
—

 
145

 
—

 
145

 
(1
)
 
144

 
(3
)
Other comprehensive loss
—

 
 
—

 
—

 
(287
)
 
(287
)
 
—

 
(287
)
 
—

Dividends ($0.35 per share)
—

 
 
—

 
(31
)
 
—

 
(31
)
 
—

 
(31
)
 
—

Shares issued:
 
 
 
 
 
 
 
 
 

 
 
 

 
 
Exercise of stock options
374,314

 
 
14

 
—

 
—

 
14

 
—

 
14

 
—

Restricted stock awards
200,625

 
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Other benefit plans
52,583

 
 
6

 
—

 
—

 
6

 
—

 
6

 
—

Dividend reinvestment plan
2,779

 
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Stock-based compensation expense
—

 
 
5

 
—

 
—

 
5

 
—

 
5

 
—

Shares exchanged — benefit plans
(23,882
)
 
 
—

 
(3
)
 
—

 
(3
)
 
—

 
(3
)
 
—

Forfeitures of restricted stock
(666
)
 
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Other
—

 
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Balance at March 31, 2018
88,881,213

 
 
$
1,294

 
$
3,584

 
$
305

 
$
5,183

 
$
—

 
$
5,183

 
$
—


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

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Millions)
 
Three months ended March 31,
 
2019
 
2018
Operating Activities:
 
 
 
Net earnings, including noncontrolling interests
$
326

 
$
141

Adjustments:
 
 
 
Depreciation and amortization
34

 
71

Annuity benefits
311

 
182

Realized (gains) losses on investing activities
(184
)
 
93

Net sales of trading securities
1

 
61

Deferred annuity and life policy acquisition costs
(64
)
 
(57
)
Change in:
 
 
 
Reinsurance and other receivables
128

 
245

Other assets
(271
)
 
26

Insurance claims and reserves
(112
)
 
(284
)
Payable to reinsurers
(22
)
 
(82
)
Other liabilities
304

 
(16
)
Managed investment entities’ assets/liabilities
16

 
31

Other operating activities, net
(13
)
 
(20
)
Net cash provided by operating activities
454

 
391

 
 
 
 
Investing Activities:
 
 
 
Purchases of:
 
 
 
Fixed maturities
(1,801
)
 
(2,464
)
Equity securities
(35
)
 
(212
)
Mortgage loans
(38
)
 
—

Equity index options and other investments
(220
)
 
(195
)
Real estate, property and equipment
(10
)
 
(23
)
Proceeds from:
 
 
 
Maturities and redemptions of fixed maturities
1,032

 
962

Repayments of mortgage loans
29

 
43

Sales of fixed maturities
201

 
105

Sales of equity securities
95

 
32

Sales and settlements of equity index options and other investments
79

 
208

Sales of real estate, property and equipment
1

 
—

Managed investment entities:
 
 
 
Purchases of investments
(391
)
 
(606
)
Proceeds from sales and redemptions of investments
373

 
478

Other investing activities, net
1

 
16

Net cash used in investing activities
(684
)
 
(1,656
)
 
 
 
 
Financing Activities:
 
 
 
Annuity receipts
1,395

 
1,148

Annuity surrenders, benefits and withdrawals
(782
)
 
(647
)
Net transfers from variable annuity assets
13

 
11

Additional long-term borrowings
121

 
—

Issuances of managed investment entities’ liabilities
—

 
775

Retirements of managed investment entities’ liabilities
(3
)
 
(684
)
Issuances of Common Stock
7

 
14

Cash dividends paid on Common Stock
(36
)
 
(31
)
Net cash provided by financing activities
715

 
586

Net Change in Cash and Cash Equivalents
485

 
(679
)
Cash and cash equivalents at beginning of period
1,515

 
2,338

Cash and cash equivalents at end of period
$
2,000

 
$
1,659


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.
Leases
 
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 March 31, 2019, 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 three months of 2019.

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 are generally recorded in realized gains (losses) on securities. However, AFG records holding gains and losses on securities classified as “trading” under previous guidance, its small portfolio of limited partnerships and similar investments carried at fair value 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


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 and principal-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.

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

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


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.

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.

9
Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED



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 annuity benefits expense and decreases for annuity policy charges are recorded in other income. For traditional fixed annuities, the liability for annuity benefits accumulated represents the account value that had accrued to the benefit of the policyholder as of the balance sheet date. For fixed-indexed annuities, the liability for annuity benefits accumulated includes an embedded derivative that represents the estimated fair value of the index participation with the remaining component representing the discounted value of the guaranteed minimum contract benefits.
 
For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses, guaranteed withdrawals and excess benefits expected to be paid on future deaths and annuitizations (“EDAR”). The liabilities for EDAR and guaranteed withdrawals are accrued for and modified using assumptions consistent with those used in determining DPAC and DPAC amortization, except that amounts are determined in relation to the present value of total expected assessments. Total expected assessments consist principally of estimated future investment margin, surrender, mortality, and other life and annuity policy charges, and unearned revenues once they are recognized as income.
 
Annuity benefits accumulated also includes amounts advanced from the Federal Home Loan Bank of Cincinnati.
 
Unearned Revenue   Certain upfront policy charges on annuities are deferred as unearned revenue (included in other liabilities) and recognized in net earnings (included in other income) using the same assumptions and estimated gross profits used to amortize DPAC.

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

For long-duration contracts (such as traditional life and long-term care policies), loss recognition occurs when, based on current expectations as of the measurement date, existing contract liabilities plus the present value of future premiums (including reasonably expected rate increases) are not expected to cover the present value of future claims payments and related settlement

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


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.

Leases   On January 1, 2019, AFG adopted ASU 2016-02, which requires entities that lease assets for terms longer than one year to recognize assets and liabilities for the rights and obligations created by those leases on the balance sheet based on the present value of contractual cash flows. As permitted under the ASU, AFG adopted the guidance on a modified retrospective basis (comparative periods were not adjusted) and elected the following accounting policies and practical expedients:
•
exclude leases with a term of 12 months or less from the calculation of lease assets and liabilities,
•
not separate lease and non-lease components except for buildings (office space and storage facilities),
•
for contracts existing at the date of adoption – not reassess whether a contract is a lease or contains a lease, how initial direct costs were accounted for or whether the lease is an operating or finance lease, and
•
use hindsight to determine the lease term for leases existing at the date of adoption.

Adoption of the new guidance resulted in AFG recognizing a lease liability of $198 million (included in other liabilities) and a corresponding right-of-use asset of $174 million (which is presented net of $24 million in deferred rent and lease incentives) on January 1, 2019. Deferred rent and lease incentives were recognized as liabilities under the previous guidance and result from the straight-line expensing of operating leases. The adoption of the new guidance did not have a material effect on the AFG’s results of operations or liquidity. See Note J — “Leases” for additional disclosures.

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).

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.

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

11
Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


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.

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: first three months of 2019 and 2018 — 1.3 million and 1.8 million, respectively.
 
There were no anti-dilutive potential common shares for the first three months of 2019 or 2018.
 
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, property and equipment and businesses. “Financing activities” include obtaining resources from owners and providing them with a return on their investments, borrowing money and repaying amounts borrowed. Annuity receipts, surrenders, benefits and withdrawals are also reflected as financing activities. All other activities are considered “operating.” Short-term investments having original maturities of three months or less when purchased are considered to be cash equivalents for purposes of the financial statements.

B.    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 commercial property coverages, (ii) Specialty casualty, which includes primarily excess and surplus, general liability, executive liability, professional liability, umbrella and excess liability, specialty coverages 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 lending and leasing 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 sells traditional fixed, fixed-indexed and variable-indexed annuities in the retail, financial institutions, broker-dealer and registered investment advisor markets. AFG’s reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.


12
Table of Contents
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 March 31,
 
2019
 
2018
Revenues
 
 
 
Property and casualty insurance:
 
 
 
Premiums earned:
 
 
 
Specialty
 
 
 
Property and transportation
$
361

 
$
350

Specialty casualty
629

 
579

Specialty financial
146

 
149

Other specialty
37

 
29

Total premiums earned
1,173

 
1,107

Net investment income
104

 
100

Other income
3

 
2

Total property and casualty insurance
1,280

 
1,209

Annuity:
 
 
 
Net investment income
435

 
394

Other income
27

 
26

Total annuity
462

 
420

Other
98

 
83

Total revenues before realized gains (losses)
1,840

 
1,712

Realized gains (losses) on securities
184

 
(93
)
Total revenues
$
2,024

 
$
1,619

Earnings Before Income Taxes
 
 
 
Property and casualty insurance:
 
 
 
Underwriting:
 
 
 
Specialty
 
 
 
Property and transportation
$
39

 
$
33

Specialty casualty
36

 
41

Specialty financial
13

 
15

Other specialty
—

 
3

Other lines (*)
(1
)
 
(1
)
Total underwriting
87

 
91

Investment and other income, net
95

 
93

Total property and casualty insurance
182

 
184

Annuity
90

 
125

Other
(43
)
 
(42
)
Total earnings before realized gains (losses) and income taxes
229

 
267

Realized gains (losses) on securities
184

 
(93
)
Total earnings before income taxes
$
413

 
$
174

(*)
Includes holding company interest and expenses.

13
Table of Contents
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 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.

14
Table of Contents
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
March 31, 2019
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
Available for sale (“AFS”) fixed maturities:
 
 
 
 
 
 
 
U.S. Government and government agencies
$
144

 
$
81

 
$
8

 
$
233

States, municipalities and political subdivisions
—

 
6,914

 
63

 
6,977

Foreign government
—

 
148

 
—

 
148

Residential MBS
—

 
2,587

 
169

 
2,756

Commercial MBS
—

 
869

 
55

 
924

Asset-backed securities
—

 
9,348

 
670

 
10,018

Corporate and other
29

 
20,000

 
2,346

 
22,375

Total AFS fixed maturities
173

 
39,947

 
3,311

 
43,431

Trading fixed maturities
8

 
99

 
—

 
107

Equity securities
1,507

 
69

 
354

 
1,930

Equity index call options
—

 
620

 
—

 
620

Assets of managed investment entities (“MIE”)
213

 
4,553

 
20

 
4,786

Variable annuity assets (separate accounts) (*)
—

 
610

 
—

 
610

Other assets — derivatives
—

 
25

 
—

 
25

Total assets accounted for at fair value
$
1,901

 
$
45,923

 
$
3,685

 
$
51,509

Liabilities:
 
 
 
 
 
 
 
Liabilities of managed investment entities
$
204

 
$
4,370

 
$
19

 
$
4,593

Derivatives in annuity benefits accumulated
—

 
—

 
3,247

 
3,247

Other liabilities — derivatives
—

 
28

 
—

 
28

Total liabilities accounted for at fair value
$
204

 
$
4,398

 
$
3,266

 
$
7,868

 
 
 
 
 
 
 
 
December 31, 2018
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
Available for sale fixed maturities:
 
 
 
 
 
 
 
U.S. Government and government agencies
$
141

 
$
83

 
$
9

 
$
233

States, municipalities and political subdivisions
—

 
6,880

 
59

 
6,939

Foreign government
—

 
142

 
—

 
142

Residential MBS
—

 
2,547

 
197

 
2,744

Commercial MBS
—

 
864

 
56

 
920

Asset-backed securities
—

 
8,964

 
847

 
9,811

Corporate and other
28

 
19,184

 
1,996

 
21,208

Total AFS fixed maturities
169

 
38,664

 
3,164

 
41,997

Trading fixed maturities
9

 
96

 
—

 
105

Equity securities
1,410

 
68

 
336

 
1,814

Equity index call options
—

 
184

 
—

 
184

Assets of managed investment entities
203

 
4,476

 
21

 
4,700

Variable annuity assets (separate accounts) (*)
—

 
557

 
—

 
557

Other assets — derivatives
—

 
16

 
—

 
16

Total assets accounted for at fair value
$
1,791

 
$
44,061

 
$
3,521

 
$
49,373

Liabilities:
 
 
 
 
 
 
 
Liabilities of managed investment entities
$
195

 
$
4,297

 
$
20

 
$
4,512

Derivatives in annuity benefits accumulated
—

 
—

 
2,720

 
2,720

Other liabilities — derivatives
—

 
49

 
—

 
49

Total liabilities accounted for at fair value
$
195

 
$
4,346

 
$
2,740

 
$
7,281

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



15
Table of Contents
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED


During the first three months of 2019 and 2018, there were no transfers between Level 1 and Level 2.

Approximately 7% of the total assets carried at fair value at March 31, 2019, were Level 3 assets. Approximately 60% ($2.20 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.

Internally developed Level 3 asset fair values represent approximately $1.23 billion at March 31, 2019. Of this amount, approximately $743 million relates to fixed maturity securities that were priced using management’s best estimate of an appropriate credit spread over the treasury yield (of a similar duration) to discount future expected cash flows using a third party model. The credit spread applied by management is the significant unobservable input. For this group of approximately 120 securities, the average spread used was 577 basis points over the reference treasury yield and the spreads ranged from 100 basis points to 2,966 basis points (approximately 80% of the spreads were between 400 and 700 basis points). Had management used higher spreads, the fair value of this group of securities would have been lower. Conversely, if the spreads used were lower, the fair values would have been higher. For the remainder of the internally developed prices, any justifiable changes in unobservable inputs used to determine fair value would not have resulted in a material change in AFG’s financial position.
The derivatives embedded in AFG’s fixed-indexed and variable-indexed annuity liabilities are measured using a discounted cash flow approach and had a fair value of $3.25 billion at March 31, 2019. The following table presents information about the unobservable inputs used by management in determining fair value of these Level 3 liabilities. See Note E — “Derivatives.”

 
Unobservable Input
 
Range
 
 
Adjustment for insurance subsidiary’s credit risk
 
0.1% – 2.2% over the risk free rate
 
 
Risk margin for uncertainty in cash flows
 
0.73% reduction in the discount rate
 
 
Surrenders
 
4% – 23% of indexed account value
 
 
Partial surrenders
 
2% – 9% of indexed account value
 
 
Annuitizations
 
0.1% – 1% of indexed account value
 
 
Deaths
 
1.7% – 9.5% of indexed account value
 
 
Budgeted option costs
 
2.6% – 3.6% of indexed account value
 

The range of adjustments for insurance subsidiary’s credit risk is based on the Moody’s corporate A2 bond index and 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 (4% 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 first three months of 2019 and 2018 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 December 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 March 31, 2019
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agency
$
9

 
$
—

 
$
—

 
$
—

 
$
(1
)
 
$
—

 
$
—

 
$
8

State and municipal
59

 
—

 
5

 
—

 
(1
)
 
—

 
—

 
63

Residential MBS
197

 
5

 
(5
)
 
—

 
(6
)
 
—

 
(22
)
 
169

Commercial MBS
56

 
—

 
—

 
—

 
(1
)
 
—

 
—

 
55

Asset-backed securities
847

 
(3
)
 
8

 
75

 
(114
)
 
—

 
(143
)
 
670

Corporate and other
1,996

 
2

 
31

 
432

 
(88
)
 
—

 
(27
)
 
2,346

Total AFS fixed maturities
3,164

 
4

 
39

 
507

 
(211
)
 
—

 
(192
)
 
3,311

Equity securities
336

 
1

 
—

 
1

 
—

 
16

 
—

 
354

Assets of MIE
21

 
(1
)
 
—

 
—

 
—

 
—

 
—

 
20

Total Level 3 assets
$
3,521

 
$
4

 
$
39

 
$
508

 
$
(211
)
 
$
16

 
$
(192
)
 
$
3,685

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Embedded derivatives
$
(2,720
)
 
$
(462
)
 
$
—

 
$
(112
)
 
$
47

 
$
—

 
$
—

 
$
(3,247
)
Total Level 3 liabilities (*)
$
(2,720
)
 
$
(462
)
 
$
—

 
$
(112
)
 
$
47

 
$
—

 
$
—

 
$
(3,247
)


 
 
 
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 March 31, 2018
AFS fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agency
$
8

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
8

State and municipal
148

 
—

 
(1
)
 
—

 
(1
)
 
—

 
(84
)
 
62

Residential MBS
122

 
(4
)
 
—

 
—

 
(6
)
 
7

 
(4
)
 
115

Commercial MBS
36

 
(1
)
 
—

 
12

 
—

 
—

 
—

 
47

Asset-backed securities
744

 
(2
)
 
3

 
204

 
(37
)
 
—

 
—

 
912

Corporate and other
1,044

 
1

 
(14
)
 
238

 
(31
)
 
—

 
—

 
1,238

Total AFS fixed maturities
2,102

 
(6
)
 
(12
)
 
454

 
(75
)
 
7

 
(88
)
 
2,382

Equity securities
165

 
(5
)
 
—

 
9

 
(4
)
 
29

 
—

 
194

Assets of MIE
23

 
(2
)
 
—

 
3

 
—

 
—

 
—

 
24

Total Level 3 assets
$
2,290

 
$
(13
)
 
$
(12
)
 
$
466

 
$
(79
)
 
$
36

 
$
(88
)
 
$
2,600

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Embedded derivatives
$
(2,542
)
 
$
63

 
$
—

 
$
(103
)
 
$
33

 
$
—

 
$
—

 
$
(2,549
)
Total Level 3 liabilities (*)
$
(2,542
)
 
$
63

 
$
—

 
$
(103
)
 
$
33

 
$
—

 
$
—

 
$
(2,549
)

(*)
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


Fair Value of Financial Instruments   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): 
 
Carrying
 
Fair Value
 
Value
 
Total
 
Level 1
 
Level 2
 
Level 3
March 31, 2019
 
 
 
 
 
 
 
 
 
Financial assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
2,000

 
$
2,000

 
$
2,000

 
$
—

 
$
—

Mortgage loans
1,078

 
1,071

 
—

 
—

 
1,071

Policy loans
172

 
172

 
—

 
—

 
172

Total financial assets not accounted for at fair value
$
3,250

 
$
3,243

 
$
2,000

 
$
—

 
$
1,243

Financial liabilities:
 
 
 
 
 
 
 
 
 
Annuity benefits accumulated (*)
$
37,768

 
$
36,881

 
$
—

 
$
—

 
$
36,881

Long-term debt
1,423

 
1,406

 
—

 
1,403

 
3

Total financial liabilities not accounted for at fair value
$
39,191

 
$
38,287

 
$
—

 
$
1,403

 
$
36,884

 
 
 
 
 
 
 
 
 
 
December 31, 2018
 
 
 
 
 
 
 
 
 
Financial assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
1,515

 
$
1,515

 
$
1,515

 
$
—

 
$
—

Mortgage loans
1,068

 
1,056

 
—

 
—

 
1,056

Policy loans
174

 
174

 
—

 
—

 
174

Total financial assets not accounted for at fair value
$
2,757

 
$
2,745

 
$
1,515

 
$
—

 
$
1,230

Financial liabilities:
 
 
 
 
 
 
 
 
 
Annuity benefits accumulated (*)
$
36,384

 
$
34,765

 
$
—

 
$
—

 
$
34,765

Long-term debt
1,302

 
1,231

 
—

 
1,228

 
3

Total financial liabilities not accounted for at fair value
$
37,686

 
$
35,996

 
$
—

 
$
1,228

 
$
34,768


(*)
Excludes $238 million and $232 million of life contingent annuities in the payout phase at March 31, 2019 and December 31, 2018, respectively.

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.


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


D.    Investments

Available for sale fixed maturities at March 31, 2019 and December 31, 2018, consisted of the following (in millions):
 
March 31, 2019
 
December 31, 2018
Amortized
Cost
 
Gross Unrealized
 
Net
Unrealized
 
Fair
Value
 
Amortized
Cost
 
Gross Unrealized
 
Net
Unrealized
 
Fair
Value
Gains
 
Losses
 
Gains
 
Losses
Fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Government and government agencies
$
233

 
$
2

 
$
(2
)
 
$
—

 
$
233

 
$
235

 
$
1

 
$
(3
)
 
$
(2
)
 
$
233

States, municipalities and political subdivisions
6,744

 
253

 
(20
)
 
233

 
6,977

 
6,825

 
169

 
(55
)
 
114

 
6,939

Foreign government
146

 
2

 
—

 
2

 
148

 
140

 
2

 
—

 
2

 
142

Residential MBS
2,477

 
287

 
(8
)
 
279

 
2,756

 
2,476

 
277

 
(9
)
 
268

 
2,744

Commercial MBS
900

 
24

 
—

 
24

 
924

 
905

 
17

 
(2
)
 
15

 
920

Asset-backed securities
9,909

 
163

 
(54
)
 
109

 
10,018

 
9,781

 
130

 
(100
)
 
30

 
9,811

Corporate and other
22,009

 
471

 
(105
)
 
366

 
22,375

 
21,475

 
167

 
(434
)
 
(267
)
 
21,208

Total fixed maturities
$
42,418

 
$
1,202

 
$
(189
)
 
$
1,013

 
$
43,431

 
$
41,837

 
$
763

 
$
(603
)
 
$
160

 
$
41,997