Derivatives

As discussed under “Derivatives” in Note A — “Accounting Policies,” 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, 2018				December 31, 2017
Derivative	Balance Sheet Line	Asset		Liability		Asset		Liability
MBS with embedded derivatives	Fixed maturities	$	110	$	—	$	105	$	—
Public company warrants	Equity securities	3		—		4		—
Fixed-indexed and variable-indexed annuities (embedded derivative)	Annuity benefits accumulated	—		3,105		—		2,542
Equity index call options	Equity index call options	759		—		701		—
Equity index put options	Other liabilities	—		—		—		—
Reinsurance contracts (embedded derivative)	Other liabilities	—		2		—		4
		$	872	$	3,107	$	810	$	2,546

The MBS with embedded derivatives consist of interest-only and principal-only MBS. 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 are required to be carried at fair value through earnings.

AFG’s fixed-indexed and variable-indexed annuities provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market or other financial index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase and sale of call and put options on the appropriate index. AFG receives collateral from certain counterparties to support its purchased call option assets (net of collateral required under put option contracts with the same counterparties). This collateral ($545 million at September 30, 2018 and $389 million at December 31, 2017) 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 the change in the fair value of the call and put options will generally offset the economic change in the liabilities from the index participation. Both the index-based component of the annuities and the related call and put 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, AFG has a reinsurance contract that is considered to contain an embedded derivative.

The following table summarizes the gains (losses) included in AFG’s 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 2018 and 2017 (in millions):



		Three months ended September 30,						Nine months ended September 30,
Derivative	Statement of Earnings Line	2018			2017			2018			2017
MBS with embedded derivatives	Realized gains (losses) on securities	$	(3	)	$	—		$	(8	)	$	(3	)
Public company warrants	Realized gains (losses) on securities	1			(1		)	—			(1		)
Fixed-indexed and variable-indexed annuities (embedded derivative) (*)	Annuity benefits	(223		)	(127		)	(286		)	(386		)
Equity index call options	Annuity benefits	219			116			271			338
Equity index put options	Annuity benefits	—			—			—			—
Reinsurance contract (embedded derivative)	Net investment income	—			—			2			(2		)
		$	(6	)	$	(12	)	$	(21	)	$	(54	)


(*)	The change in fair value of the embedded derivative for the nine months ended September 30, 2018 includes a $44 million charge in the second quarter of 2018 related to the unlocking of actuarial assumptions.

Derivatives Designated and Qualifying as Cash Flow Hedges As of September 30, 2018, AFG has entered into fourteen interest rate swaps that are designated and qualify as highly effective cash flow hedges to mitigate interest rate risk related to certain floating-rate securities included in AFG’s portfolio of fixed maturity securities. 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 short-term LIBOR.

Under the terms of the swaps, AFG receives fixed-rate interest payments in exchange for variable interest payments based on short-term LIBOR. The notional amounts of the interest rate swaps generally decline over each swap’s respective life (the swaps expire between August 2019 and June 2030) in anticipation of the expected decline in AFG’s portfolio of fixed maturity securities with floating interest rates based on short-term LIBOR. The total outstanding notional amount of AFG’s interest rate swaps was $2.17 billion at September 30, 2018 compared to $1.58 billion at December 31, 2017, reflecting four new swaps with an aggregate notional amount at issuance of $697 million entered into in the first nine months of 2018, partially offset by the scheduled amortization discussed above. The fair value of the effective portion of the interest rate swaps in an asset position and included in other assets was zero at September 30, 2018 and less than $1 million at December 31, 2017. The fair value of the effective portion of the interest rate swaps in a liability position and included in other liabilities was $81 million at September 30, 2018 and $31 million at December 31, 2017. The net unrealized gain or loss on cash flow hedges is included in AOCI, net of DPAC and deferred taxes. Amounts reclassified from AOCI (before DPAC and taxes) to net investment income were losses of $1 million and $2 million during the third quarter and first nine months of 2018 as compared to income of $1 million and $4 million in the third quarter and first nine months of 2017, respectively. There was no ineffectiveness recorded in net earnings during these periods. A collateral receivable supporting these swaps of $126 million at September 30, 2018 and $70 million at December 31, 2017 is included in other assets in AFG’s Balance Sheet.