Derivatives

As discussed under “Derivatives” in Note A — “Accounting Policies” to the financial statements, AFG uses derivatives in certain areas of its operations.

Derivatives That Do Not Qualify for Hedge Accounting The following derivatives that do not qualify for hedge accounting under GAAP are included in AFG’s Balance Sheet at fair value (in millions):



		September 30, 2014				December 31, 2013
Derivative	Balance Sheet Line	Asset		Liability		Asset		Liability
MBS with embedded derivatives	Fixed maturities	$	161	$	—	$	140	$	—
Public company warrants	Equity securities	17		—		19		—
Interest rate swaptions	Other investments	—		—		2		—
Fixed-indexed annuities (embedded derivative)	Annuity benefits accumulated	—		1,085		—		804
Equity index call options	Other investments	288		—		272		—
Reinsurance contracts (embedded derivative)	Other liabilities	—		12		—		10
		$	466	$	1,097	$	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 September 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 September 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 ($252 million at September 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 derivatives that do not qualify for hedge accounting for the third quarter and first nine months of 2014 and 2013 (in millions):



		Three months ended September 30,						Nine months ended September 30,
Derivative	Statement of Earnings Line	2014			2013			2014			2013
MBS with embedded derivatives	Realized gains on securities	$	—		$	1		$	7		$	—
Public company warrants	Realized gains on securities	—			—			(2		)	1
Interest rate swaptions	Realized gains on securities	—			—			(2		)	1
Fixed-indexed annuities (embedded derivative)	Annuity benefits	(21		)	(33		)	(153		)	(110		)
Equity index call options	Annuity benefits	19			32			112			125
Reinsurance contracts (embedded derivative)	Net investment income	1			2			(2		)	7
		$	(1	)	$	2		$	(40	)	$	24

Derivatives Designated and Qualifying as Cash Flow Hedges In the third quarter of 2014, AFG entered into a five-year $431 million notional amount interest rate swap under which AFG receives fixed rate interest payments in exchange for variable interest payments based on one-month LIBOR. The purpose of the swap is to effectively convert a portion of AFG’s floating rate MBS to fixed rate by offsetting the variability in cash flows attributable to changes in one-month LIBOR. The notional amount of the swap amortizes down over its five-year life in anticipation of an expected decline in AFG’s portfolio of MBS with interest rates based on one-month LIBOR. The fair value of the effective portion of the interest rate swap was less than $1 million at September 30, 2014, and is included in AOCI. In the third quarter of 2014, less than $1 million was reclassified from AOCI to net investment income and there was no ineffectiveness recorded in Net Earnings.