Derivatives

As discussed under “Derivatives” in Note A — “Accounting Policies,” 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, 2013				December 31, 2012
Derivative	Balance Sheet Line	Asset		Liability		Asset		Liability
MBS with embedded derivatives	Fixed maturities	$	130	$	—	$	110	$	—
Public company warrants	Equity securities	15		—		—		—
Interest rate swaptions	Other investments	2		—		1		—
Fixed-indexed annuities (embedded derivative)	Annuity benefits accumulated	—		577		—		465
Equity index call options	Other investments	185		—		132		—
Reinsurance contracts (embedded derivative)	Other liabilities	—		12		—		17
		$	332	$	589	$	243	$	482

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.

Warrants to purchase shares of publicly traded companies, which represent a small component of AFG’s overall investment portfolio, are considered to be derivatives that must be marked to market through earnings.

AFG has $700 million notional amount of pay-fixed interest rate swaptions (options to enter into pay-fixed/receive floating interest rate swaps at future dates expiring between 2013 and 2015) outstanding at June 30, 2013 which are used to mitigate interest rate risk in its annuity operations. AFG paid $20 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 June 30, 2013, 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 mark-to-market on the embedded derivative and call options both resulted in gains in the second quarter of 2013. The $16 million increase in fair value of call options reflects the increase in the stock market during the quarter. However, the offsetting unfavorable impact of stock market performance on the embedded derivative was outweighed by the favorable impact of higher market interest rates resulting in a $3 million overall gain from the mark-to-market of the embedded derivative. In the second quarter of 2012, poor stock market performance resulted in a $21 million loss from the mark-to-market of the call options. In that period, the offsetting favorable impact of poor stock market performance on the embedded derivative was mitigated by the negative impact of lower market interest rates resulting in a $3 million overall gain from the mark-to-market of the embedded derivative.

As discussed under “Reinsurance” in Note A, certain reinsurance contracts 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 2013 and 2012 (in millions):



		Three months ended June 30,						Six months ended June 30,
Derivative	Statement of Earnings Line	2013			2012			2013			2012
MBS with embedded derivatives	Realized gains	$	(3	)	$	(1	)	$	(1	)	$	3
Public company warrants	Realized gains	(1		)	—			1			—
Interest rate swaptions	Realized gains	1			(3		)	1			(3		)
Fixed-indexed annuities (embedded derivative)	Annuity benefits	3			3			(77		)	(57		)
Equity index call options	Annuity benefits	16			(21		)	93			36
Reinsurance contracts (embedded derivative)	Investment income	4			(4		)	5			(3		)
		$	20		$	(26	)	$	22		$	(24	)