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 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 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
June 30, 2014
Assets:
Available for sale (“AFS”) fixed maturities:
U.S. Government and government agencies	$	168	$	166	$	15	$	349
States, municipalities and political subdivisions	—		6,167		61		6,228
Foreign government	—		138		—		138
Residential MBS	—		4,428		256		4,684
Commercial MBS	—		2,555		28		2,583
Asset-backed securities (“ABS”)	—		3,015		204		3,219
Corporate and other	30		11,444		313		11,787
Total AFS fixed maturities	198		27,913		877		28,988
Trading fixed maturities	31		312		—		343
Equity securities	1,185		207		81		1,473
Assets of managed investment entities (“MIE”)	232		2,540		27		2,799
Variable annuity assets (separate accounts) (*)	—		681		—		681
Other investments — derivatives	—		313		—		313
Total assets accounted for at fair value	$	1,646	$	31,966	$	985	$	34,597
Liabilities:
Liabilities of managed investment entities	$	177	$	—	$	2,322	$	2,499
Derivatives in annuity benefits accumulated	—		—		1,026		1,026
Other liabilities — derivatives	—		13		—		13
Total liabilities accounted for at fair value	$	177	$	13	$	3,348	$	3,538

December 31, 2013
Assets:
Available for sale fixed maturities:
U.S. Government and government agencies	$	147	$	152	$	15	$	314
States, municipalities and political subdivisions	—		5,311		61		5,372
Foreign government	—		208		—		208
Residential MBS	—		3,994		316		4,310
Commercial MBS	—		2,696		28		2,724
Asset-backed securities	—		2,418		75		2,493
Corporate and other	28		10,672		335		11,035
Total AFS fixed maturities	175		25,451		830		26,456
Trading fixed maturities	—		305		—		305
Equity securities	1,023		125		31		1,179
Assets of managed investment entities	266		2,592		30		2,888
Variable annuity assets (separate accounts) (*)	—		665		—		665
Other investments — derivatives	—		274		—		274
Total assets accounted for at fair value	$	1,464	$	29,412	$	891	$	31,767
Liabilities:
Liabilities of managed investment entities	$	156	$	—	$	2,411	$	2,567
Derivatives in annuity benefits accumulated	—		—		804		804
Other liabilities — derivatives	—		10		—		10
Total liabilities accounted for at fair value	$	156	$	10	$	3,215	$	3,381

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

During the three months and six months ended June 30, 2014, one perpetual preferred stock with a fair value of less than $1 million and nine perpetual preferred stocks with an aggregate fair value of $55 million, respectively, were transferred from Level 1 to Level 2 due to insufficient trade data to warrant classification in Level 1. During the first six months of 2013, there were no transfers from Level 1 to Level 2. During the first six months of 2014, there were no transfers from Level 2 to Level 1. During the first six months of 2013 (all in the second quarter), five preferred stocks with an aggregate fair value of $11 million were transferred from Level 2 to Level 1 due to increases in trade frequency, resulting in trade data sufficient to warrant classification in Level 1. Approximately 3% of the total assets carried at fair value on June 30, 2014, were Level 3 assets. Approximately 85% ($838 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 approximately 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 fixed-indexed annuity liabilities, which are measured using a discounted cash flow approach and had a fair value of $1.03 billion at June 30, 2014. 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		0.35% – 1.60% over the risk free rate
Risk margin for uncertainty in cash flows		0.3% reduction in the discount rate
Surrenders		4% – 16% of indexed account value
Partial surrenders		2% – 6% of indexed account value
Annuitizations		1% – 2% of indexed account value
Deaths		1.5% – 2.5% of indexed account value
Budgeted option costs		2.5% – 4.0% of indexed account value

The range of adjustments for insurance subsidiary’s credit risk 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 annuity products with an expected range of 6% to 12% in the majority of future calendar years (4% to 16% over all periods). 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 second quarter and first six months of 2014 and 2013 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, 2014			Net income			Other comprehensive income (loss)		Purchases and issuances			Sales and Settlements			Transfer into Level 3		Transfer out of Level 3			Balance at June 30, 2014
AFS fixed maturities:
U.S. government agency	$	15		$	—		$	—	$	—		$	—		$	—	$	—		$	15
State and municipal	61			—			—		—			—			—		—			61
Residential MBS	272			2			2		—			(7		)	6		(19		)	256
Commercial MBS	28			—			—		—			—			—		—			28
Asset-backed securities	206			3			—		10			(15		)	—		—			204
Corporate and other	322			4			—		20			(30		)	—		(3		)	313
Equity securities	41			—			2		16			—			22		—			81
Assets of MIE	29			(1		)	—		—			(1		)	—		—			27
Liabilities of MIE (*)	(2,322		)	(9		)	—		(155		)	164			—		—			(2,322		)
Embedded derivatives	(904		)	(78		)	—		(56		)	12			—		—			(1,026		)


(*)	Total realized/unrealized gains (losses) included in net income includes gains of $1 million related to liabilities outstanding as of June 30, 2014. See Note H — “Managed Investment Entities.”



				Total realized/unrealized gains (losses) included in
	Balance at March 31, 2013			Net income			Other comprehensive income (loss)			Purchases and issuances			Sales and settlements			Transfer into Level 3		Transfer out of Level 3			Balance at June 30, 2013
AFS fixed maturities:
U.S. government agency	$	20		$	—		$	—		$	—		$	—		$	—	$	—		$	20
State and municipal	54			—			(1		)	10			—			—		—			63
Residential MBS	354			2			(7		)	—			(17		)	9		(12		)	329
Commercial MBS	30			(2		)	—			—			—			—		—			28
Asset-backed securities	245			2			(2		)	—			(39		)	—		(26		)	180
Corporate and other	244			—			(10		)	44			(4		)	25		(4		)	295
Equity securities	49			—			(1		)	39			—			—		(9		)	78
Assets of MIE	30			1			—			6			(6		)	—		—			31
Liabilities of MIE (*)	(2,501		)	(14		)	—			(406		)	439			—		—			(2,482		)
Embedded derivatives	(555		)	3			—			(32		)	7			—		—			(577		)


(*)	Total realized/unrealized gains (losses) included in net income includes losses of $9 million related to liabilities outstanding as of June 30, 2013. See Note H — “Managed Investment Entities.”



				Total realized/unrealized gains (losses) included in
	Balance at December 31, 2013			Net income			Other comprehensive income (loss)		Purchases and issuances			Sales and settlements			Transfer into Level 3		Transfer out of Level 3			Balance at June 30, 2014
AFS fixed maturities:
U.S. government agency	$	15		$	—		$	—	$	—		$	—		$	—	$	—		$	15
State and municipal	61			—			—		—			—			—		—			61
Residential MBS	316			3			6		—			(15		)	38		(92		)	256
Commercial MBS	28			—			—		—			—			—		—			28
Asset-backed securities	75			3			1		60			(16		)	81		—			204
Corporate and other	335			5			3		21			(46		)	—		(5		)	313
Equity securities	31			1			4		46			(9		)	22		(14		)	81
Assets of MIE	30			(2		)	—		—			(1		)	—		—			27
Liabilities of MIE (*)	(2,411		)	(8		)	—		(200		)	297			—		—			(2,322		)
Embedded derivatives	(804		)	(132		)	—		(111		)	21			—		—			(1,026		)


(*)	Total realized/unrealized gains (losses) included in net income includes gains of $5 million related to liabilities outstanding as of June 30, 2014. See Note H — “Managed Investment Entities.”



				Total realized/unrealized gains (losses) included in
	Balance at December 31, 2012			Net income			Other comprehensive income (loss)			Purchases and issuances			Sales and settlements			Transfer into Level 3		Transfer out of Level 3			Balance at June 30, 2013
AFS fixed maturities:
U.S. government agency	$	20		$	—		$	—		$	—		$	—		$	—	$	—		$	20
State and municipal	58			—			(1		)	10			—			—		(4		)	63
Residential MBS	371			4			(1		)	6			(29		)	25		(47		)	329
Commercial MBS	22			(1		)	—			—			—			7		—			28
Asset-backed securities	253			3			(2		)	12			(45		)	—		(41		)	180
Corporate and other	236			—			(10		)	55			(6		)	24		(4		)	295
Equity securities	37			—			2			48			—			—		(9		)	78
Assets of MIE	40			(3		)	—			6			(6		)	—		(6		)	31
Liabilities of MIE (*)	(2,745		)	(39		)	—			(406		)	689			—		19			(2,482		)
Embedded derivatives	(465		)	(77		)	—			(49		)	14			—		—			(577		)


(*)	Total realized/unrealized gains (losses) included in net income includes losses of $24 million related to liabilities outstanding as of June 30, 2013. See Note H — “Managed Investment Entities.”

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 Value		Fair Value		Level 1		Level 2		Level 3
June 30, 2014
Financial assets:
Cash and cash equivalents	$	2,116	$	2,116	$	2,116	$	—	$	—
Mortgage loans	920		917		—		—		917
Policy loans	233		233		—		—		233
Total financial assets not accounted for at fair value	$	3,269	$	3,266	$	2,116	$	—	$	1,150
Financial liabilities:
Annuity benefits accumulated (*)	$	22,314	$	21,888	$	—	$	—	$	21,888
Long-term debt	912		1,036		—		961		75
Total financial liabilities not accounted for at fair value	$	23,226	$	22,924	$	—	$	961	$	21,963

December 31, 2013
Financial assets:
Cash and cash equivalents	$	1,639	$	1,639	$	1,639	$	—	$	—
Mortgage loans	781		779		—		—		779
Policy loans	238		238		—		—		238
Total financial assets not accounted for at fair value	$	2,658	$	2,656	$	1,639	$	—	$	1,017
Financial liabilities:
Annuity benefits accumulated (*)	$	20,741	$	19,959	$	—	$	—	$	19,959
Long-term debt	913		985		—		909		76
Total financial liabilities not accounted for at fair value	$	21,654	$	20,944	$	—	$	909	$	20,035

(*) 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.