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, 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 25 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.

On December 24, 2015, AFG completed the sale of substantially all of its run-off long-term care insurance business. Based on the status of ongoing negotiations at the end of the first quarter of 2015, management determined that the potential sale of the run-off long-term care insurance business met GAAP “held for sale” criteria as of March 31, 2015. Accordingly, 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 used to determine that loss 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, 2016
Assets:
Available for sale (“AFS”) fixed maturities:
U.S. Government and government agencies	$	105	$	218		$	15	$	338
States, municipalities and political subdivisions	—		6,960			92		7,052
Foreign government	—		147			—		147
Residential MBS	—		3,559			213		3,772
Commercial MBS	—		2,098			38		2,136
Asset-backed securities (“ABS”)	—		4,629			501		5,130
Corporate and other	37		14,579			730		15,346
Total AFS fixed maturities	142		32,190			1,589		33,921
Trading fixed maturities	10		239			—		249
Equity securities — AFS and trading	1,359		131			158		1,648
Assets of managed investment entities (“MIE”)	177		3,705			24		3,906
Variable annuity assets (separate accounts) (*)	—		595			—		595
Other investments — equity index call options	—		274			—		274
Other assets — derivatives	—		13			—		13
Total assets accounted for at fair value	$	1,688	$	37,147		$	1,771	$	40,606
Liabilities:
Liabilities of managed investment entities	$	165	$	3,468		$	23	$	3,656
Derivatives in annuity benefits accumulated	—		—			1,450		1,450
Derivatives in long-term debt	—		(8		)	—		(8		)
Other liabilities — derivatives	—		10			—		10
Total liabilities accounted for at fair value	$	165	$	3,470		$	1,473	$	5,108

December 31, 2015
Assets:
Available for sale fixed maturities:
U.S. Government and government agencies	$	100	$	192		$	15	$	307
States, municipalities and political subdivisions	—		6,767			89		6,856
Foreign government	—		154			—		154
Residential MBS	—		3,305			224		3,529
Commercial MBS	—		2,148			39		2,187
Asset-backed securities	—		4,464			470		4,934
Corporate and other	50		13,634			633		14,317
Total AFS fixed maturities	150		30,664			1,470		32,284
Trading fixed maturities	13		241			—		254
Equity securities — AFS and trading	1,362		217			140		1,719
Assets of managed investment entities	309		3,712			26		4,047
Variable annuity assets (separate accounts) (*)	—		608			—		608
Other investments — equity index call options	—		241			—		241
Other assets — derivatives	—		2			—		2
Total assets accounted for at fair value	$	1,834	$	35,685		$	1,636	$	39,155
Liabilities:
Liabilities of managed investment entities	$	289	$	3,468		$	24	$	3,781
Derivatives in annuity benefits accumulated	—		—			1,369		1,369
Derivatives in long-term debt	—		(2		)	—		(2		)
Other liabilities — derivatives	—		8			—		8
Total liabilities accounted for at fair value	$	289	$	3,474		$	1,393	$	5,156


(*)	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 observable trade activity.

During the first three months of 2016, there was one perpetual preferred stock with a fair value of $8 million that transferred from Level 2 to Level 1 and three perpetual preferred stocks with an aggregate fair value of $6 million that transferred from Level 1 to Level 2. 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. There were no transfers from Level 1 to Level 2 in the first three months of 2015.

Approximately 4% of the total assets carried at fair value on March 31, 2016, were Level 3 assets. Approximately 73% ($1.29 billion) 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 10% of AFG’s shareholders’ equity, any justifiable 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 $1.45 billion at March 31, 2016. 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		0.20% – 3.20% over the risk free rate
	Risk margin for uncertainty in cash flows		0.58% reduction in the discount rate
	Surrenders		3% – 21% of indexed account value
	Partial surrenders		2% – 10% of indexed account value
	Annuitizations		0.25% – 1.0% of indexed account value
	Deaths		1.5% – 4.0% of indexed account value
	Budgeted option costs		1.75% – 3.5% 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 10% in the majority of future calendar years (3% to 18% 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 2016 and 2015 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, 2015			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, 2016
AFS fixed maturities:
U.S. government agency	$	15		$	—		$	—		$	—		$	—		$	—	$	—		$	15
State and municipal	89			—			3			—			—			—		—			92
Residential MBS	224			1			—			—			(7		)	11		(16		)	213
Commercial MBS	39			—			—			—			(1		)	—		—			38
Asset-backed securities	470			—			(6		)	4			(8		)	41		—			501
Corporate and other	633			(2		)	15			86			(7		)	5		—			730
Total AFS fixed maturities	1,470			(1		)	12			90			(23		)	57		(16		)	1,589
Equity securities	140			(17		)	8			12			—			15		—			158
Assets of MIE	26			(2		)	—			—			—			—		—			24
Total Level 3 assets	$	1,636		$	(20	)	$	20		$	102		$	(23	)	$	72	$	(16	)	$	1,771

Embedded derivatives	$	(1,369	)	$	(17	)	$	—		$	(82	)	$	18		$	—	$	—		$	(1,450	)
Total Level 3 liabilities (a)	$	(1,369	)	$	(17	)	$	—		$	(82	)	$	18		$	—	$	—		$	(1,450	)



						Total realized/unrealized gains (losses) included in
	Balance at December 31, 2014			Impact of accounting change (b)		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
Total AFS fixed maturities	1,231			—		(1		)	9			49			(61		)	62		(69		)	1,220
Equity securities	93			—		—			(2		)	10			—			—		(17		)	84
Assets of MIE	31			—		(2		)	—			—			—			—		—			29
Total Level 3 assets	$	1,355		$	—	$	(3	)	$	7		$	59		$	(61	)	$	62	$	(86	)	$	1,333

Liabilities of MIE	$	(2,701	)	$	2,701	$	—		$	—		$	—		$	—		$	—	$	—		$	—
Embedded derivatives	(1,160		)	—		(50		)	—			(47		)	14			—		—			(1,243		)
Total Level 3 liabilities (a)	$	(3,861	)	$	2,701	$	(50	)	$	—		$	(47	)	$	14		$	—	$	—		$	(1,243	)


(a)	As discussed above, these tables exclude the portion of MIE liabilities allocated to Level 3, which are derived from the fair value of the MIE assets.


(b)	The impact of implementing new guidance adopted in 2015, as discussed above and in Note A — “Accounting Policies — 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		Fair Value
	Value		Total		Level 1		Level 2		Level 3
March 31, 2016
Financial assets:
Cash and cash equivalents	$	1,231	$	1,231	$	1,231	$	—	$	—
Mortgage loans	1,097		1,108		—		—		1,108
Policy loans	198		198		—		—		198
Total financial assets not accounted for at fair value	$	2,526	$	2,537	$	1,231	$	—	$	1,306
Financial liabilities:
Annuity benefits accumulated (*)	$	27,613	$	27,210	$	—	$	—	$	27,210
Long-term debt	1,006		1,125		—		1,110		15
Total financial liabilities not accounted for at fair value	$	28,619	$	28,335	$	—	$	1,110	$	27,225

December 31, 2015
Financial assets:
Cash and cash equivalents	$	1,220	$	1,220	$	1,220	$	—	$	—
Mortgage loans	1,067		1,074		—		—		1,074
Policy loans	201		201		—		—		201
Total financial assets not accounted for at fair value	$	2,488	$	2,495	$	1,220	$	—	$	1,275
Financial liabilities:
Annuity benefits accumulated (*)	$	26,422	$	25,488	$	—	$	—	$	25,488
Long-term debt	1,000		1,120		—		1,105		15
Total financial liabilities not accounted for at fair value	$	27,422	$	26,608	$	—	$	1,105	$	25,503


(*)	Excludes $199 million and $200 million of life contingent annuities in the payout phase at March 31, 2016 and December 31, 2015, respectively.

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.