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 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, and prior to 2015 certain liabilities of the CLOs.

Under new guidance adopted in the first quarter of 2015, discussed in Note A — “Accounting Policies — Managed Investment Entities,” AFG has elected to set the carrying value of the CLO liabilities equal to the fair value of the CLO assets (which have more observable fair values) as an alternative to reporting those liabilities at separately measured fair values. Following the adoption of the new guidance, the CLO liabilities are categorized within the fair value hierarchy on the same basis (proportionally) as the related CLO assets. Since the portion of the CLO liabilities allocated to Level 3 is derived from the fair value of the CLO assets, beginning with the first quarter of 2015, these amounts are excluded from the progression of Level 3 financial instruments.

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.

In April 2015, AFG reached an agreement to sell all of its run-off long-term care insurance business. As discussed in Note B — “Acquisitions and Sale of Businesses,” AFG recorded a loss in the first quarter of 2015 to write down the net carrying value of the assets and liabilities to be disposed to the estimated net sale proceeds of $14 million (estimated fair value less costs to sell). The estimate of fair value was derived using significant unobservable inputs (Level 3).

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
March 31, 2015
Assets:
Available for sale (“AFS”) fixed maturities:
U.S. Government and government agencies	$	123	$	192	$	15	$	330
States, municipalities and political subdivisions	—		7,045		61		7,106
Foreign government	—		184		—		184
Residential MBS	—		4,019		306		4,325
Commercial MBS	—		2,359		44		2,403
Asset-backed securities (“ABS”)	—		4,013		211		4,224
Corporate and other	38		12,775		583		13,396
Total AFS fixed maturities	161		30,587		1,220		31,968
Trading fixed maturities	13		260		—		273
Equity securities	1,388		238		84		1,710
Assets of managed investment entities (“MIE”)	120		3,130		29		3,279
Variable annuity assets (separate accounts) (*)	—		667		—		667
Other investments — derivatives	—		318		—		318
Total assets accounted for at fair value	$	1,682	$	35,200	$	1,333	$	38,215
Liabilities:
Liabilities of managed investment entities	$	108	$	2,818	$	26	$	2,952
Derivatives in annuity benefits accumulated	—		—		1,243		1,243
Other liabilities — derivatives	—		13		—		13
Total liabilities accounted for at fair value	$	108	$	2,831	$	1,269	$	4,208

December 31, 2014
Assets:
Available for sale fixed maturities:
U.S. Government and government agencies	$	164	$	174	$	15	$	353
States, municipalities and political subdivisions	—		6,647		100		6,747
Foreign government	—		194		—		194
Residential MBS	—		4,142		300		4,442
Commercial MBS	—		2,407		44		2,451
Asset-backed securities	—		3,661		226		3,887
Corporate and other	36		12,078		546		12,660
Total AFS fixed maturities	200		29,303		1,231		30,734
Trading fixed maturities	12		254		—		266
Equity securities	1,306		297		93		1,696
Assets of managed investment entities	174		2,903		31		3,108
Variable annuity assets (separate accounts) (*)	—		662		—		662
Other investments — derivatives	—		322		—		322
Total assets accounted for at fair value	$	1,692	$	33,741	$	1,355	$	36,788
Liabilities:
Liabilities of managed investment entities	$	118	$	—	$	2,701	$	2,819
Derivatives in annuity benefits accumulated	—		—		1,160		1,160
Other liabilities — derivatives	—		13		—		13
Total liabilities accounted for at fair value	$	118	$	13	$	3,861	$	3,992

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

Transfers between Level 1 and Level 2 for all periods presented were a result of increases or decreases in trade frequency. During the first three months of 2015, there was one common stock and two perpetual preferred stocks with aggregate fair values of $53 million and $5 million, respectively, transferred from Level 2 to Level 1. During the first three months of 2014, eight perpetual preferred stocks with an aggregate fair value of $55 million were transferred from Level 1 to Level 2.

Approximately 3.5% of the total assets carried at fair value on March 31, 2015, were Level 3 assets. Approximately 75% ($990 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 1% of the total assets measured at fair value and approximately 6% 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 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 $1.24 billion at March 31, 2015. 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		0.40% – 1.75% over the risk free rate
Risk margin for uncertainty in cash flows		0.52% reduction in the discount rate
Surrenders		4% – 16% of indexed account value
Partial surrenders		2% – 10% of indexed account value
Annuitizations		1% – 1.5% of indexed account value
Deaths		1.5% – 3.0% of indexed account value
Budgeted option costs		2.0% – 3.25% 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 5% to 11% 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 first three months of 2015 and 2014 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 December 31, 2014			Impact of accounting change (*)		Net income			Other comprehensive income (loss)			Purchases and issuances			Sales and settlements			Transfer into Level 3		Transfer out of Level 3			Balance at March 31, 2015
AFS fixed maturities:
U.S. government agency	$	15		$	—	$	—		$	—		$	—		$	—		$	—	$	—		$	15
State and municipal	100			—		—			—			—			—			—		(39		)	61
Residential MBS	300			—		(1		)	3			—			(7		)	41		(30		)	306
Commercial MBS	44			—		—			—			—			—			—		—			44
Asset-backed securities	226			—		—			—			5			(41		)	21		—			211
Corporate and other	546			—		—			6			44			(13		)	—		—			583
Equity securities	93			—		—			(2		)	10			—			—		(17		)	84
Assets of MIE	31			—		(2		)	—			—			—			—		—			29
Liabilities of MIE	(2,701		)	2,701		—			—			—			—			—		—			—
Embedded derivatives	(1,160		)	—		(50		)	—			(47		)	14			—		—			(1,243		)


(*)	The impact of implementing new guidance adopted in 2015, as discussed above and in Note A — “Accounting Policies — 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 March 31, 2014
AFS fixed maturities:
U.S. government agency	$	15		$	—		$	—	$	—		$	—		$	—	$	—		$	15
State and municipal	61			—			—		—			—			—		—			61
Residential MBS	316			1			4		—			(8		)	32		(73		)	272
Commercial MBS	28			—			—		—			—			—		—			28
Asset-backed securities	75			—			1		50			(1		)	81		—			206
Corporate and other	335			1			3		1			(16		)	—		(2		)	322
Equity securities	31			1			2		30			(9		)	—		(14		)	41
Assets of MIE	30			(1		)	—		—			—			—		—			29
Liabilities of MIE (*)	(2,411		)	1			—		(45		)	133			—		—			(2,322		)
Embedded derivatives	(804		)	(54		)	—		(55		)	9			—		—			(904		)


(*)	Total realized/unrealized gains (losses) included in net income includes gains of $4 million related to liabilities outstanding as of March 31, 2014. 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
March 31, 2015
Financial assets:
Cash and cash equivalents	$	1,212	$	1,212	$	1,212	$	—	$	—
Mortgage loans	1,091		1,100		—		—		1,100
Policy loans	226		226		—		—		226
Total financial assets not accounted for at fair value	$	2,529	$	2,538	$	1,212	$	—	$	1,326
Financial liabilities:
Annuity benefits accumulated (*)	$	24,209	$	23,966	$	—	$	—	$	23,966
Long-term debt	1,061		1,197		—		1,123		74
Total financial liabilities not accounted for at fair value	$	25,270	$	25,163	$	—	$	1,123	$	24,040

December 31, 2014
Financial assets:
Cash and cash equivalents	$	1,343	$	1,343	$	1,343	$	—	$	—
Mortgage loans	1,117		1,124		—		—		1,124
Policy loans	228		228		—		—		228
Total financial assets not accounted for at fair value	$	2,688	$	2,695	$	1,343	$	—	$	1,352
Financial liabilities:
Annuity benefits accumulated (*)	$	23,561	$	23,187	$	—	$	—	$	23,187
Long-term debt	1,061		1,180		—		1,106		74
Total financial liabilities not accounted for at fair value	$	24,622	$	24,367	$	—	$	1,106	$	23,261


(*)	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.