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):



		September 30, 2012				December 31, 2011
Derivative	Balance Sheet Line	Asset		Liability		Asset		Liability
MBS with embedded derivatives	Fixed maturities	$	96	$	—	$	99	$	—
Interest rate swaptions	Other investments	1		—		5		—
Fixed-indexed annuities (embedded derivative)	Annuity benefits accumulated	—		497		—		361
Equity index call options	Other investments	152		—		66		—
Reinsurance contracts (embedded derivative)	Other liabilities	—		18		—		23
		$	249	$	515	$	170	$	384

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.

AFG’s fixed-indexed annuities, which represented approximately 40% of annuity benefits accumulated at September 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 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 third quarter and first nine months of 2012 and 2011 (in millions):



		Three months ended						Nine months ended
		September 30,						September 30,
Derivative	Statement of Earnings Line	2012			2011			2012			2011
MBS with embedded derivatives	Realized gains	$	1		$	3		$	4		$	—
Interest rate swaptions	Realized gains	(1		)	(15		)	(4		)	(22		)
Fixed-indexed annuities (embedded derivative)	Annuity benefits	(41		)	32			(97		)	4
Equity index call options	Annuity benefits	30			(50		)	67			(30		)
Reinsurance contracts (embedded derivative)	Investment income	(4		)	(6		)	(7		)	(10		)
		$	(15	)	$	(36	)	$	(37	)	$	(58	)