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, 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 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 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 a separately measured fair value. 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, 2017
Assets:
Available for sale (“AFS”) fixed maturities:
U.S. Government and government agencies	$	120	$	129		$	8	$	257
States, municipalities and political subdivisions	—		6,845			152		6,997
Foreign government	—		144			—		144
Residential MBS	—		3,252			144		3,396
Commercial MBS	—		974			36		1,010
Asset-backed securities (“ABS”)	—		6,860			536		7,396
Corporate and other	30		17,538			1,050		18,618
Total AFS fixed maturities	150		35,742			1,926		37,818
Trading fixed maturities	48		302			—		350
Equity securities — AFS and trading	1,397		79			163		1,639
Assets of managed investment entities (“MIE”)	368		4,378			21		4,767
Variable annuity assets (separate accounts) (*)	—		628			—		628
Equity index call options	—		629			—		629
Other assets — derivatives	—		1			—		1
Total assets accounted for at fair value	$	1,963	$	41,759		$	2,110	$	45,832
Liabilities:
Liabilities of managed investment entities	$	348	$	4,138		$	20	$	4,506
Derivatives in annuity benefits accumulated	—		—			2,293		2,293
Derivatives in long-term debt	—		—			—		—
Other liabilities — derivatives	—		31			—		31
Total liabilities accounted for at fair value	$	348	$	4,169		$	2,313	$	6,830

December 31, 2016
Assets:
Available for sale fixed maturities:
U.S. Government and government agencies	$	133	$	174		$	8	$	315
States, municipalities and political subdivisions	—		6,641			140		6,781
Foreign government	—		136			—		136
Residential MBS	—		3,445			190		3,635
Commercial MBS	—		1,468			25		1,493
Asset-backed securities	—		5,475			484		5,959
Corporate and other	29		15,484			712		16,225
Total AFS fixed maturities	162		32,823			1,559		34,544
Trading fixed maturities	30		329			—		359
Equity securities — AFS and trading	1,305		79			174		1,558
Assets of managed investment entities	380		4,356			29		4,765
Variable annuity assets (separate accounts) (*)	—		600			—		600
Equity index call options	—		492			—		492
Other assets — derivatives	—		1			—		1
Total assets accounted for at fair value	$	1,877	$	38,680		$	1,762	$	42,319
Liabilities:
Liabilities of managed investment entities	$	363	$	4,158		$	28	$	4,549
Derivatives in annuity benefits accumulated	—		—			1,759		1,759
Derivatives in long-term debt	—		(1		)	—		(1		)
Other liabilities — derivatives	—		30			—		30
Total liabilities accounted for at fair value	$	363	$	4,187		$	1,787	$	6,337


(*)	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 of 2017, there was one perpetual preferred stock with an aggregate fair value of $1 million that transferred between Level 2 and 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. During the third quarter of 2016, there was one common stock with a fair value of less than $1 million that transferred from Level 1 to Level 2. During the first nine months of 2016, there were six perpetual preferred stocks with a fair value of $35 million that transferred from Level 2 to Level 1 and five perpetual preferred stocks and one common stock with aggregate fair values of $12 million and less than $1 million, respectively, that transferred from Level 1 to Level 2.

Approximately 5% of the total assets carried at fair value at September 30, 2017, were Level 3 assets. Approximately 76% ($1.61 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 $2.29 billion at September 30, 2017. 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		0.2% – 2.4% over the risk free rate
	Risk margin for uncertainty in cash flows		0.68% reduction in the discount rate
	Surrenders		3% – 23% of indexed account value
	Partial surrenders		2% – 10% of indexed account value
	Annuitizations		0.1% – 1% of indexed account value
	Deaths		1.5% – 8.0% of indexed account value
	Budgeted option costs		2.4% – 3.7% 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 6% to 10% 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 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 third quarter and first nine months of 2017 and 2016 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 June 30, 2017			Net income			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 AFG 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	)



				Total realized/unrealized gains (losses) included in
	Balance at June 30, 2016			Net income			Other comprehensive income (loss)			Purchases and issuances			Sales and settlements			Transfer into Level 3		Transfer out of Level 3			Balance at September 30, 2016
AFS fixed maturities:
U.S. government agency	$	8		$	—		$	—		$	—		$	—		$	—	$	—		$	8
State and municipal	91			—			1			—			(1		)	—		—			91
Residential MBS	231			(2		)	—			—			(8		)	—		(2		)	219
Commercial MBS	36			—			—			—			(2		)	—		—			34
Asset-backed securities	478			(1		)	4			—			(5		)	—		(9		)	467
Corporate and other	689			—			(3		)	37			(14		)	—		—			709
Total AFS fixed maturities	1,533			(3		)	2			37			(30		)	—		(11		)	1,528
Equity securities	166			5			5			10			(21		)	—		—			165
Assets of MIE	26			(2		)	—			—			—			—		—			24
Total Level 3 assets	$	1,725		$	—		$	7		$	47		$	(51	)	$	—	$	(11	)	$	1,717

Embedded derivatives	$	(1,557	)	$	(109	)	$	—		$	(53	)	$	31		$	—	$	—		$	(1,688	)
Total Level 3 liabilities (*)	$	(1,557	)	$	(109	)	$	—		$	(53	)	$	31		$	—	$	—		$	(1,688	)


(*)	As discussed previously, 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, 2016			Net income			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 (*)	$	(1,759	)	$	(386	)	$	—	$	(224	)	$	76		$	—	$	—		$	(2,293	)



				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 September 30, 2016
AFS fixed maturities:
U.S. government agency	$	15		$	(8	)	$	1	$	—		$	—		$	—	$	—		$	8
State and municipal	89			—			4		—			(2		)	—		—			91
Residential MBS	224			—			1		—			(21		)	33		(18		)	219
Commercial MBS	39			(1		)	—		—			(4		)	—		—			34
Asset-backed securities	470			(1		)	1		15			(24		)	41		(35		)	467
Corporate and other	633			—			24		131			(89		)	15		(5		)	709
Total AFS fixed maturities	1,470			(10		)	31		146			(140		)	89		(58		)	1,528
Equity securities	140			(12		)	21		22			(21		)	15		—			165
Assets of MIE	26			(6		)	—		4			—			—		—			24
Total Level 3 assets	$	1,636		$	(28	)	$	52	$	172		$	(161	)	$	104	$	(58	)	$	1,717

Embedded derivatives	$	(1,369	)	$	(188	)	$	—	$	(207	)	$	76		$	—	$	—		$	(1,688	)
Total Level 3 liabilities (*)	$	(1,369	)	$	(188	)	$	—	$	(207	)	$	76		$	—	$	—		$	(1,688	)


(*)	As discussed previously, 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, 2017
Financial assets:
Cash and cash equivalents	$	2,349	$	2,349	$	2,349	$	—	$	—
Mortgage loans	1,043		1,040		—		—		1,040
Policy loans	186		186		—		—		186
Total financial assets not accounted for at fair value	$	3,578	$	3,575	$	2,349	$	—	$	1,226
Financial liabilities:
Annuity benefits accumulated (*)	$	32,464	$	31,857	$	—	$	—	$	31,857
Long-term debt	1,284		1,380		—		1,377		3
Total financial liabilities not accounted for at fair value	$	33,748	$	33,237	$	—	$	1,377	$	31,860

December 31, 2016
Financial assets:
Cash and cash equivalents	$	2,107	$	2,107	$	2,107	$	—	$	—
Mortgage loans	1,147		1,146		—		—		1,146
Policy loans	192		192		—		—		192
Total financial assets not accounted for at fair value	$	3,446	$	3,445	$	2,107	$	—	$	1,338
Financial liabilities:
Annuity benefits accumulated (*)	$	29,703	$	28,932	$	—	$	—	$	28,932
Long-term debt	1,284		1,356		—		1,353		3
Total financial liabilities not accounted for at fair value	$	30,987	$	30,288	$	—	$	1,353	$	28,935


(*)	Excludes $207 million and $204 million of life contingent annuities in the payout phase at September 30, 2017 and December 31, 2016, 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.