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, 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, asset-backed securities (“ABS”), mortgage-backed securities (“MBS”), non-affiliated common stocks, equity index call options 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 at the valuation date. 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.

As discussed in Note A — “Accounting Policies — Managed Investment Entities,” AFG has set the carrying value of its 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. As a result, 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 services regarding the methods and assumptions used in pricing, including verifying, on a test basis, the inputs used by the service to value specific securities.

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
September 30, 2018
Assets:
Available for sale (“AFS”) fixed maturities:
U.S. Government and government agencies	$	142	$	84	$	8	$	234
States, municipalities and political subdivisions	—		6,715		60		6,775
Foreign government	—		139		—		139
Residential MBS	—		2,564		145		2,709
Commercial MBS	—		866		57		923
Asset-backed securities	—		8,316		991		9,307
Corporate and other	29		18,482		1,646		20,157
Total AFS fixed maturities	171		37,166		2,907		40,244
Trading fixed maturities	9		94		—		103
Equity securities	1,462		76		289		1,827
Equity index call options	—		759		—		759
Assets of managed investment entities (“MIE”)	258		4,718		22		4,998
Variable annuity assets (separate accounts) (*)	—		650		—		650
Total assets accounted for at fair value	$	1,900	$	43,463	$	3,218	$	48,581
Liabilities:
Liabilities of managed investment entities	$	248	$	4,537	$	22	$	4,807
Derivatives in annuity benefits accumulated	—		—		3,105		3,105
Other liabilities — derivatives	—		83		—		83
Total liabilities accounted for at fair value	$	248	$	4,620	$	3,127	$	7,995

December 31, 2017
Assets:
Available for sale fixed maturities:
U.S. Government and government agencies	$	122	$	112	$	8	$	242
States, municipalities and political subdivisions	—		6,975		148		7,123
Foreign government	—		127		—		127
Residential MBS	—		3,105		122		3,227
Commercial MBS	—		926		36		962
Asset-backed securities	—		7,218		744		7,962
Corporate and other	30		17,662		1,044		18,736
Total AFS fixed maturities	152		36,125		2,102		38,379
Trading fixed maturities	44		304		—		348
Equity securities	1,411		86		165		1,662
Equity index call options	—		701		—		701
Assets of managed investment entities	307		4,572		23		4,902
Variable annuity assets (separate accounts) (*)	—		644		—		644
Total assets accounted for at fair value	$	1,914	$	42,432	$	2,290	$	46,636
Liabilities:
Liabilities of managed investment entities	$	293	$	4,372	$	22	$	4,687
Derivatives in annuity benefits accumulated	—		—		2,542		2,542
Other liabilities — derivatives	—		35		—		35
Total liabilities accounted for at fair value	$	293	$	4,407	$	2,564	$	7,264


(*)	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 third quarter there were no transfers between Level 1 and Level 2. During the first nine months of 2018, there were two preferred stocks with an aggregate fair value of $6 million that transferred from Level 1 to Level 2. During the third quarter of 2017, there was one preferred stock with an aggregate fair value of $1 million that transferred from Level 2 to Level 1. During the first nine months of 2017, there were three preferred stocks with an aggregate fair value of $17 million that transferred from Level 2 to Level 1.

Approximately 7% of the total assets carried at fair value at September 30, 2018, were Level 3 assets. Approximately 68% ($2.18 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 approximately 18% of AFG’s Shareholders’ Equity, any justifiable changes in unobservable inputs used to determine internally developed fair values would not be expected to 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 and variable-indexed annuity liabilities, which are measured using a discounted cash flow approach and had a fair value of $3.11 billion at September 30, 2018. The following table presents information about the unobservable inputs used by management in determining fair value of these embedded derivatives. See Note E — “Derivatives.”



	Unobservable Input		Range
	Adjustment for insurance subsidiary’s credit risk		0.4% – 1.6% over the risk free rate
	Risk margin for uncertainty in cash flows		0.70% reduction in the discount rate
	Surrenders		3% – 23% of indexed account value
	Partial surrenders		2% – 9% of indexed account value
	Annuitizations		0.1% – 1% of indexed account value
	Deaths		1.6% – 8.0% of indexed account value
	Budgeted option costs		2.4% – 3.6% 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 and variable-indexed annuity products with an expected range of 7% to 11% in the majority of future calendar years (3% to 23% over all periods). Increasing the budgeted option cost or risk margin for uncertainty in cash flow assumptions in the table above would increase the fair value of the fixed-indexed and variable-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 third quarter and first nine months of 2018 and 2017 are presented below (in millions). The transfers into and out of Level 3 were due to changes in the availability of market observable inputs and $29 million of equity securities transferred into Level 3 in the first quarter of 2018 related to a small number of limited partnerships and similar investments carried at cost under the prior guidance that are carried at fair value through net earnings under new guidance adopted on January 1, 2018, as discussed in Note A — “Accounting Policies — Investments.” 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 June 30, 2018			Net earnings			Other comprehensive income (loss)			Purchases and issuances			Sales and settlements			Transfer into Level 3		Transfer out of Level 3			Balance at September 30, 2018
AFS fixed maturities:
U.S. government agency	$	8		$	—		$	—		$	—		$	—		$	—	$	—		$	8
State and municipal	61			—			—			—			(1		)	—		—			60
Residential MBS	147			(2		)	(2		)	—			(6		)	13		(5		)	145
Commercial MBS	56			2			—			(1		)	—			—		—			57
Asset-backed securities	1,004			—			(3		)	13			(23		)	—		—			991
Corporate and other	1,408			—			(3		)	312			(59		)	—		(12		)	1,646
Total AFS fixed maturities	2,684			—			(8		)	324			(89		)	13		(17		)	2,907
Equity securities	230			(5		)	—			81			—			—		(17		)	289
Assets of MIE	23			(1		)	—			—			—			—		—			22
Total Level 3 assets	$	2,937		$	(6	)	$	(8	)	$	405		$	(89	)	$	13	$	(34	)	$	3,218

Embedded derivatives	$	(2,776	)	$	(223	)	$	—		$	(151	)	$	45		$	—	$	—		$	(3,105	)
Total Level 3 liabilities (*)	$	(2,776	)	$	(223	)	$	—		$	(151	)	$	45		$	—	$	—		$	(3,105	)



				Total realized/unrealized gains (losses) included in
	Balance at June 30, 2017			Net earnings			Other comprehensive income (loss)			Purchases and issuances			Sales and settlements			Transfer into Level 3		Transfer out of Level 3			Balance at September 30, 2017
AFS fixed maturities:
U.S. government agency	$	8		$	—		$	—		$	—		$	—		$	—	$	—		$	8
State and municipal	143			—			—			—			(1		)	10		—			152
Residential MBS	153			2			1			—			(6		)	15		(21		)	144
Commercial MBS	45			1			—			—			(10		)	—		—			36
Asset-backed securities	498			(2		)	1			13			(26		)	163		(111		)	536
Corporate and other	953			(9		)	—			172			(59		)	—		(7		)	1,050
Total AFS fixed maturities	1,800			(8		)	2			185			(102		)	188		(139		)	1,926
Equity securities	168			(3		)	(4		)	2			—			—		—			163
Assets of MIE	23			(4		)	—			2			—			—		—			21
Total Level 3 assets	$	1,991		$	(15	)	$	(2	)	$	189		$	(102	)	$	188	$	(139	)	$	2,110

Embedded derivatives	$	(2,129	)	$	(127	)	$	—		$	(65	)	$	28		$	—	$	—		$	(2,293	)
Total Level 3 liabilities (*)	$	(2,129	)	$	(127	)	$	—		$	(65	)	$	28		$	—	$	—		$	(2,293	)


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



				Total realized/unrealized gains (losses) included in
	Balance at December 31, 2017			Net earnings			Other comprehensive income (loss)			Purchases and issuances			Sales and settlements			Transfer into Level 3		Transfer out of Level 3			Balance at September 30, 2018
AFS fixed maturities:
U.S. government agency	$	8		$	—		$	—		$	—		$	—		$	—	$	—		$	8
State and municipal	148			—			(2		)	—			(2		)	—		(84		)	60
Residential MBS	122			(9		)	(2		)	—			(17		)	70		(19		)	145
Commercial MBS	36			1			—			20			—			—		—			57
Asset-backed securities	744			(2		)	(6		)	353			(80		)	—		(18		)	991
Corporate and other	1,044			2			(21		)	784			(138		)	—		(25		)	1,646
Total AFS fixed maturities	2,102			(8		)	(31		)	1,157			(237		)	70		(146		)	2,907
Equity securities	165			9			—			106			(4		)	30		(17		)	289
Assets of MIE	23			(6		)	—			5			—			—		—			22
Total Level 3 assets	$	2,290		$	(5	)	$	(31	)	$	1,268		$	(241	)	$	100	$	(163	)	$	3,218

Embedded derivatives (a)	$	(2,542	)	$	(286	)	$	—		$	(395	)	$	118		$	—	$	—		$	(3,105	)
Total Level 3 liabilities (b)	$	(2,542	)	$	(286	)	$	—		$	(395	)	$	118		$	—	$	—		$	(3,105	)



				Total realized/unrealized gains (losses) included in
	Balance at December 31, 2016			Net earnings			Other comprehensive income (loss)		Purchases and issuances			Sales and settlements			Transfer into Level 3		Transfer out of Level 3			Balance at September 30, 2017
AFS fixed maturities:
U.S. government agency	$	8		$	—		$	—	$	—		$	—		$	—	$	—		$	8
State and municipal	140			—			4		—			(2		)	10		—			152
Residential MBS	190			—			3		1			(37		)	35		(48		)	144
Commercial MBS	25			2			—		15			(10		)	4		—			36
Asset-backed securities	484			(2		)	3		117			(62		)	199		(203		)	536
Corporate and other	712			(4		)	8		460			(124		)	29		(31		)	1,050
Total AFS fixed maturities	1,559			(4		)	18		593			(235		)	277		(282		)	1,926
Equity securities	174			(19		)	9		22			(3		)	—		(20		)	163
Assets of MIE	29			(10		)	—		6			—			—		(4		)	21
Total Level 3 assets	$	1,762		$	(33	)	$	27	$	621		$	(238	)	$	277	$	(306	)	$	2,110

Embedded derivatives	$	(1,759	)	$	(386	)	$	—	$	(224	)	$	76		$	—	$	—		$	(2,293	)
Total Level 3 liabilities (b)	$	(1,759	)	$	(386	)	$	—	$	(224	)	$	76		$	—	$	—		$	(2,293	)


(a)	Total realized/unrealized gains (losses) included in net earnings for the embedded derivatives reflects losses related to the unlocking of actuarial assumptions of $44 million in the first nine months of 2018.


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

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
September 30, 2018
Financial assets:
Cash and cash equivalents	$	2,009	$	2,009	$	2,009	$	—	$	—
Mortgage loans	1,152		1,130		—		—		1,130
Policy loans	176		176		—		—		176
Total financial assets not accounted for at fair value	$	3,337	$	3,315	$	2,009	$	—	$	1,306
Financial liabilities:
Annuity benefits accumulated (*)	$	35,729	$	33,923	$	—	$	—	$	33,923
Long-term debt	1,302		1,260		—		1,257		3
Total financial liabilities not accounted for at fair value	$	37,031	$	35,183	$	—	$	1,257	$	33,926

December 31, 2017
Financial assets:
Cash and cash equivalents	$	2,338	$	2,338	$	2,338	$	—	$	—
Mortgage loans	1,125		1,119		—		—		1,119
Policy loans	184		184		—		—		184
Total financial assets not accounted for at fair value	$	3,647	$	3,641	$	2,338	$	—	$	1,303
Financial liabilities:
Annuity benefits accumulated (*)	$	33,110	$	32,461	$	—	$	—	$	32,461
Long-term debt	1,301		1,354		—		1,351		3
Total financial liabilities not accounted for at fair value	$	34,411	$	33,815	$	—	$	1,351	$	32,464


(*)	Excludes $229 million and $206 million of life contingent annuities in the payout phase at September 30, 2018 and December 31, 2017, 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.