Derivatives

As discussed under “Derivatives” in Note A — “Accounting Policies” to the financial statements, 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, 2014				December 31, 2013
Derivative	Balance Sheet Line	Asset		Liability		Asset		Liability
MBS with embedded derivatives	Fixed maturities	$	159	$	—	$	140	$	—
Public company warrants	Equity securities	17		—		19		—
Interest rate swaptions	Other investments	—		—		2		—
Fixed-indexed annuities (embedded derivative)	Annuity benefits accumulated	—		1,026		—		804
Equity index call options	Other investments	313		—		272		—
Reinsurance contracts (embedded derivative)	Other liabilities	—		13		—		10
		$	489	$	1,039	$	433	$	814

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 $200 million notional amount of pay-fixed interest rate swaptions (options to enter into pay-fixed/receive floating interest rate swaps at future dates expiring in 2015) outstanding at June 30, 2014, which are used to mitigate interest rate risk in its annuity operations. AFG paid $4 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 one-half of annuity benefits accumulated at June 30, 2014, 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 receives collateral from its counterparties to support its purchased call option assets. This collateral ($278 million at June 30, 2014) is included in other assets in AFG’s Balance Sheet with an offsetting liability to return the collateral, which is included in other liabilities. 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. Fluctuations in interest rates and the stock market, among other factors, can cause volatility in the periodic measurement of fair value of the embedded derivative that management believes can be inconsistent with the long-term economics of these products.

As discussed under “Reinsurance” in Note A to the financial statements, 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 2014 and 2013 (in millions):



		Three months ended June 30,						Six months ended June 30,
Derivative	Statement of Earnings Line	2014			2013			2014			2013
MBS with embedded derivatives	Realized gains on securities	$	4		$	(3	)	$	7		$	(1	)
Public company warrants	Realized gains on securities	—			(1		)	(2		)	1
Interest rate swaptions	Realized gains on securities	(1		)	1			(2		)	1
Fixed-indexed annuities (embedded derivative)	Annuity benefits	(78		)	3			(132		)	(77		)
Equity index call options	Annuity benefits	63			16			93			93
Reinsurance contracts (embedded derivative)	Net investment income	(1		)	4			(3		)	5
		$	(13	)	$	20		$	(39	)	$	22