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):



		June 30, 2015				December 31, 2014
Derivative	Balance Sheet Line	Asset		Liability		Asset		Liability
MBS with embedded derivatives	Fixed maturities	$	170	$	—	$	158	$	—
Public company warrants	Equity securities	—		—		19		—
Interest rate swaptions	Other investments	—		—		—		—
Fixed-indexed annuities (embedded derivative)	Annuity benefits accumulated	—		1,258		—		1,160
Equity index call options	Other investments	278		—		322		—
Reinsurance contracts (embedded derivative)	Other liabilities	—		9		—		13
		$	448	$	1,267	$	499	$	1,173

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 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 exercised its most significant warrant position in the first quarter of 2015.

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 the fourth quarter of 2015) outstanding at June 30, 2015, 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 just over one-half of annuity benefits accumulated at June 30, 2015, 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 ($265 million at June 30, 2015) 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 second quarter and first six months of 2015 and 2014 (in millions):



		Three months ended June 30,						Six months ended June 30,
Derivative	Statement of Earnings Line	2015			2014			2015			2014
MBS with embedded derivatives	Realized gains on securities	$	(1	)	$	4		$	(3	)	$	7
Public company warrants	Realized gains on securities	—			—			—			(2		)
Interest rate swaptions	Realized gains on securities	—			(1		)	—			(2		)
Fixed-indexed annuities (embedded derivative)	Annuity benefits	19			(78		)	(31		)	(132		)
Equity index call options	Annuity benefits	3			63			23			93
Reinsurance contracts (embedded derivative)	Net investment income	3			(1		)	3			(3		)
		$	24		$	(13	)	$	(8	)	$	(39	)

Derivatives Designated and Qualifying as Cash Flow Hedges In the second quarter of 2015, AFG entered into two interest rate swaps (a five-year, $195 million notional amount swap and a fifteen-year, $132 million notional amount swap) under which AFG receives fixed-rate interest payments in exchange for variable interest payments based on three-month LIBOR. 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 each of these swaps is to effectively convert a portion of AFG’s floating rate fixed maturity securities to fixed rates by offsetting the variability in cash flows attributable to changes in LIBOR.

The notional amounts amortize down over each swap’s respective life in anticipation of an expected decline in AFG’s portfolio of fixed maturity securities with floating interest rates based on LIBOR ($673 million and $401 million total notional amounts at June 30, 2015 and December 31, 2014, respectively). The fair value of the effective portion of the interest rate swaps in an asset position and included in other assets was $1 million and less than $1 million at June 30, 2015 and December 31, 2014, respectively. The fair value of the effective portion of interest rate swaps in a liability position and included in other liabilities was $1 million at June 30, 2015. The net unrealized gain or loss on cash flow hedges is included in AOCI, net of DPAC and tax. During the second quarter and first six months of 2015, $1 million and $2 million, respectively, was reclassified from AOCI to net investment income. There was no ineffectiveness recorded in Net Earnings during these periods.

Derivative Designated and Qualifying as a Fair Value Hedge In June 2015, AFG entered into an interest rate swap to mitigate the interest rate risk associated with its fixed-rate 9-7/8% Senior Notes due June 2019 by effectively converting the interest rate on those notes to a floating rate of three-month LIBOR plus 8.099% (8.3847% at June 30, 2015). Since the terms of the interest rate swap match the terms of the hedged debt, changes in the fair value of the interest rate swap are offset by changes in the fair value of the hedged debt attributable to changes in interest rates. The fair value of the interest rate swap (an asset of $2 million at June 30, 2015) and the offsetting adjustment to the carrying value of the 9-7/8% Senior Notes are both included in long-term debt on AFG’s Balance Sheet. Accordingly, the net impact on AFG’s current period earnings is that the interest expense associated with the hedged debt is effectively recorded at the floating rate. The net reduction in interest expense from the swap for the second quarter of 2015 was less than $1 million.