Fair Value Measurements

9 Months Ended

Sep. 30, 2012

Fair Value Disclosures [Abstract]

Fair Value Disclosures

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.

Assets and liabilities measured and carried at fair value in the financial statements are summarized below (in millions):

	Level 1		Level 2		Level 3		Total
September 30, 2012
Assets:
Available for sale (“AFS”) fixed maturities:
U.S. Government and government agencies	$	198	$	143	$	20	$	361
States, municipalities and political subdivisions	—		4,268		58		4,326
Foreign government	—		264		—		264
Residential MBS	—		3,953		367		4,320
Commercial MBS	—		2,924		21		2,945
All other corporate	4		11,031		495		11,530
Total AFS fixed maturities	202		22,583		961		23,746
Trading fixed maturities	—		308		1		309
Equity securities	883		112		36		1,031
Assets of managed investment entities (“MIE”)	221		2,846		35		3,102
Variable annuity assets (separate accounts) (a)	—		577		—		577
Other investments	—		153		—		153
Total assets accounted for at fair value	$	1,306	$	26,579	$	1,033	$	28,918
Liabilities:
Liabilities of managed investment entities	$	247	$	—	$	2,506	$	2,753
Derivatives in annuity benefits accumulated	—		—		497		497
Other liabilities — derivatives	—		18		—		18
Total liabilities accounted for at fair value	$	247	$	18	$	3,003	$	3,268
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	—		—		361		361
Other liabilities — derivatives	—		23		—		23
Total liabilities accounted for at fair value	$	194	$	23	$	2,954	$	3,171

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

During the first nine months of 2012, six preferred stocks with an aggregate fair value of $35 million were transferred from Level 1 to Level 2. All of these transfers occurred in the first quarter. 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 September 30, 2012, were Level 3 assets. Approximately 90% ($907 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 3% of AFG’s shareholders’ equity, changes in unobservable inputs used to determine internally developed fair values would not have a material impact on AFG’s financial position.

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

The only significant Level 3 assets or liabilities carried at fair value in the financial statements that were not measured using broker quotes are the derivatives embedded in AFG’s fixed-indexed annuity liabilities, which are measured using a discounted cash flow approach and had a fair value of $497 million at September 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% – 2.05% 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 fixed-indexed annuity embedded derivatives, while increasing any of the other unobservable inputs in the table above would decrease the fair value of the embedded derivatives.

Changes in balances of Level 3 financial assets and liabilities carried at fair value during the third quarter and first nine 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 June 30, 2012			Net income			Other comprehensive income (loss)		Purchases and issuances			Sales and Settlements			Transfer into Level 3		Transfer out of Level 3			Balance at September 30, 2012
AFS fixed maturities:
U.S. government	$	20		$	—		$	—	$	—		$	—		$	—	$	—		$	20
State and municipal	86			—			2		—			(6		)	4		(28		)	58
Residential MBS	320			3			7		15			(11		)	86		(53		)	367
Commercial MBS	20			1			—		—			—			—		—			21
All other corporate	537			2			6		67			(19		)	1		(99		)	495
Trading fixed maturities	1			—			—		—			—			—		—			1
Equity securities	41			—			—		4			—			9		(18		)	36
Assets of MIE	54			—			—		—			(1		)	—		(18		)	35
Liabilities of MIE (*)	(2,429		)	(52		)	—		(97		)	72			—		—			(2,506		)
Embedded derivatives	(444		)	(41		)	—		(19		)	7			—		—			(497		)

(*) Total realized/unrealized loss included in net income includes losses of $49 million related to liabilities outstanding as of September 30, 2012. See Note H — “Managed Investment Entities.”

				Total realized/unrealized gains (losses) included in
	Balance at June 30, 2011			Net income			Other comprehensive income (loss)			Purchases and Issuances			Sales and Settlements			Transfer into Level 3		Transfer out of Level 3			Balance at September 30, 2011
AFS fixed maturities:
State and municipal	$	84		$	—		$	4		$	—		$	(3	)	$	—	$	(13	)	$	72
Residential MBS	255			1			(5		)	25			(9		)	24		(7		)	284
Commercial MBS	10			—			—			9			—			9		—			28
All other corporate	382			2			12			32			(14		)	46		(24		)	436
Trading fixed maturities	1			—			—			—			—			—		—			1
Equity securities	21			—			(1		)	2			—			2		—			24
Assets of MIE	53			(6		)	—			5			(7		)	—		(5		)	40
Liabilities of MIE (*)	(2,322		)	89			—			—			51			—		—			(2,182		)
Embedded derivatives	(279		)	32			—			(62		)	4			—		—			(305		)

(*) Total realized/unrealized loss included in net income includes losses of $89 million related to liabilities outstanding as of September 30, 2011. See Note H — “Managed Investment Entities.”

				Total realized/unrealized gains (losses) included in
	Balance at December 31, 2011			Net income			Other comprehensive income (loss)		Purchases and Issuances			Sales and Settlements			Transfer into Level 3		Transfer out of Level 3			Balance at September 30, 2012
AFS fixed maturities:
U.S. government	$	—		$	—		$	—	$	20		$	—		$	—	$	—		$	20
State and municipal	83			—			4		19			(7		)	9		(50		)	58
Residential MBS	361			5			11		86			(29		)	167		(234		)	367
Commercial MBS	19			1			1		—			—			—		—			21
All other corporate	519			9			18		124			(57		)	29		(147		)	495
Trading fixed maturities	1			—			—		—			—			—		—			1
Equity securities	11			—			—		30			—			13		(18		)	36
Assets of MIE	44			—			—		13			(13		)	14		(23		)	35
Liabilities of MIE (*)	(2,593		)	(155		)	—		(463		)	705			—		—			(2,506		)
Embedded derivatives	(361		)	(97		)	—		(57		)	18			—		—			(497		)

(*) Total realized/unrealized loss included in net income includes losses of $99 million related to liabilities outstanding as of September 30, 2012. See Note H — “Managed Investment Entities.”

				Total realized/unrealized gains (losses) included in
	Balance at December 31, 2010			Net income			Other comprehensive income (loss)			Purchases and Issuances			Sales and Settlements			Transfer into Level 3		Transfer out of Level 3			Balance at September 30, 2011
AFS fixed maturities:
State and municipal	$	20		$	—		$	5		$	53		$	(3	)	$	10	$	(13	)	$	72
Residential MBS	312			2			(8		)	42			(29		)	31		(66		)	284
Commercial MBS	6			—			—			9			—			13		—			28
All other corporate	436			1			17			123			(51		)	70		(160		)	436
Trading fixed maturities	3			—			—			—			—			—		(2		)	1
Equity securities	21			—			1			2			(2		)	2		—			24
Assets of MIE	48			(7		)	—			21			(13		)	8		(17		)	40
Liabilities of MIE (*)	(2,258		)	17			—			—			59			—		—			(2,182		)
Embedded derivatives	(181		)	4			—			(142		)	14			—		—			(305		)

(*) Total realized/unrealized loss included in net income includes losses of $19 million related to liabilities outstanding as of September 30, 2011. See Note H — “Managed Investment Entities.”

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 Value		Fair Value		Level 1		Level 2		Level 3
September 30, 2012
Financial assets:
Cash and cash equivalents	$	1,626	$	1,626	$	1,626	$	—	$	—
Mortgage loans	566		575		—		—		575
Policy loans	229		229		—		—		229
Total financial assets not accounted for at fair value	$	2,421	$	2,430	$	1,626	$	—	$	804
Financial liabilities:
Annuity benefits accumulated (*)	$	17,040	$	17,452	$	—	$	—	$	17,452
Long-term debt	966		1,085		—		976		109
Total financial liabilities not accounted for at fair value	$	18,006	$	18,537	$	—	$	976	$	17,561

(*)    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.