UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarterly Period Ended March 31, 2011		Commission File No. 1-13653

AMERICAN FINANCIAL GROUP, INC.

Incorporated under the Laws of Ohio		IRS Employer I.D. No. 31-1544320

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes þ No o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company:

Large Accelerated Filer þ		Accelerated Filer o		Non-Accelerated Filer o		Smaller Reporting Company o

Indicate by check mark whether the Registrant is a shell company. Yes o No þ

As of May 1, 2011, there were 103,449,744 shares of the Registrant’s Common Stock outstanding, excluding 14.9 million shares owned by subsidiaries.

 

 

AMERICAN FINANCIAL GROUP, INC.

TABLE OF CONTENTS

		Page
Part I — Financial Information
Item 1 — Financial Statements:
Consolidated Balance Sheet			2
Consolidated Statement of Earnings			3
Consolidated Statement of Changes in Equity			4
Consolidated Statement of Cash Flows			5
Notes to Consolidated Financial Statements			6
Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations			31
Item 3 — Quantitative and Qualitative Disclosure of Market Risk			47
Item 4 — Controls and Procedures			47
Part II - Other Information
Item 1 — Legal Proceedings			47
Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds			48
Item 6 — Exhibits			48
Signatures			48
Exhibit 12
Exhibit 31.A
Exhibit 31.B
Exhibit 31.C
Exhibit 32
EX-101 INSTANCE DOCUMENT
EX-101 SCHEMA DOCUMENT
EX-101 CALCULATION LINKBASE DOCUMENT
EX-101 LABELS LINKBASE DOCUMENT
EX-101 PRESENTATION LINKBASE DOCUMENT
EX-101 DEFINITION LINKBASE DOCUMENT

AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES

		March 31,				December 31,
		2011				2010
Assets:
Cash and cash equivalents		$	1,499			$	1,099
Investments:
Fixed maturities, available for sale at fair value (amortized cost — $18,755 and $18,490)			19,630				19,328
Fixed maturities, trading at fair value			397				393
Equity securities, at fair value (cost — $498 and $458)			743				690
Mortgage loans			551				468
Policy loans			258				264
Real estate and other investments			459				428
Total cash and investments			23,537				22,670
Recoverables from reinsurers			2,852				2,964
Prepaid reinsurance premiums			395				422
Agents’ balances and premiums receivable			520				535
Deferred policy acquisition costs			1,228				1,244
Assets of managed investment entities			2,570				2,537
Other receivables			407				674
Variable annuity assets (separate accounts)			635				616
Other assets			618				606
Goodwill			186				186
Total assets		$	32,948			$	32,454
Liabilities and Equity:
Unpaid losses and loss adjustment expenses		$	6,279			$	6,413
Unearned premiums			1,448				1,534
Annuity benefits accumulated			13,405				12,905
Life, accident and health reserves			1,668				1,650
Payable to reinsurers			228				320
Liabilities of managed investment entities			2,388				2,323
Long-term debt			949				952
Variable annuity liabilities (separate accounts)			635				616
Other liabilities			1,336				1,121
Total liabilities			28,336				27,834
Shareholders’ equity:
Common Stock, no par value - 200,000,000 shares authorized - 103,483,152 and 105,168,366 shares outstanding			103				105
Capital surplus			1,159				1,166
Retained earnings:
Appropriated — managed investment entities			162				197
Unappropriated			2,536				2,523
Accumulated other comprehensive income, net of tax			503				479
Total shareholders’ equity			4,463				4,470
Noncontrolling interests			149				150
Total equity			4,612				4,620
Total liabilities and equity		$	32,948			$	32,454

AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES

		Three months ended
		March 31,
		2011				2010
Revenues:
Property and casualty insurance premiums		$	599			$	579
Life, accident and health premiums			110				115
Investment income			300				295
Realized gains (losses) on:
Securities (*)			—				4
Subsidiaries			(3	)			—
Income (loss) of managed investment entities:
Investment income			25				22
Loss on change in fair value of assets/liabilities			(33	)			(25	)
Other income			41				44
Total revenues			1,039				1,034
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses			341				304
Commissions and other underwriting expenses			212				204
Annuity benefits			116				108
Life, accident and health benefits			96				96
Annuity and supplemental insurance acquisition expenses			53				49
Interest charges on borrowed money			21				18
Expenses of managed investment entities			18				9
Other operating and general expenses			87				99
Total costs and expenses			944				887
Operating earnings before income taxes			95				147
Provision for income taxes			46				59
Net earnings, including noncontrolling interests			49				88
Less: Net earnings (loss) attributable to noncontrolling interests			(34	)			(18	)
Net Earnings Attributable to Shareholders		$	83			$	106
Earnings Attributable to Shareholders per Common Share:
Basic		$	.80			$	.94
Diluted		$	.79			$	.93
Average number of Common Shares:
Basic			104.6				112.0
Diluted			106.2				113.1
Cash dividends per Common Share		$	.1625			$	.1375
(*) Consists of the following:
Realized gains before impairments		$	10			$	25
Losses on securities with impairment			(7	)			(14	)
Non-credit portion recognized in other comprehensive income (loss)			(3	)			(7	)
Impairment charges recognized in earnings			(10	)			(21	)
Total realized gains (losses) on securities		$	—			$	4

AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES

						Shareholders’ Equity
						Common Stock												Accum.								Noncon-
		Common				and Capital				Retained Earnings								Other Comp								trolling				Total
		Shares				Surplus				Appro.				Unappro.				Inc. (Loss)				Total				Interests				Equity
Balance at December 31, 2010			105,168,366			$	1,271			$	197			$	2,523			$	479			$	4,470			$	150			$	4,620
Net earnings			—				—				—				83				—				83				(34	)			49
Other comprehensive income (loss), net of tax:
Change in unrealized gain (loss) on securities			—				—				—				—				17				17				—				17
Change in foreign currency translation			—				—				—				—				7				7				—				7
Total comprehensive income (loss)																							107				(34	)			73
Allocation of losses of managed investment entities			—				—				(35	)			—				—				(35	)			35				—
Dividends on Common Stock			—				—				—				(16	)			—				(16	)			—				(16	)
Shares issued:
Exercise of stock options			436,127				11				—				—				—				11				—				11
Other benefit plans			332,337				7				—				—				—				7				—				7
Dividend reinvestment plan			4,043				—				—				—				—				—				—				—
Stock-based compensation expense			—				3				—				—				—				3				—				3
Shares acquired and retired			(2,457,721	)			(30	)			—				(54	)			—				(84	)			—				(84	)
Other			—				—				—				—				—				—				(2	)			(2	)
Balance at March 31, 2011			103,483,152			$	1,262			$	162			$	2,536			$	503			$	4,463			$	149			$	4,612
Balance at December 31, 2009			113,386,343			$	1,344			$	—			$	2,274			$	163			$	3,781			$	138			$	3,919
Cumulative effect of accounting change			—				—				261				4				(4	)			261				—				261
Net earnings			—				—				—				106				—				106				(18	)			88
Other comprehensive income (loss), net of tax:
Change in unrealized gain (loss) on securities			—				—				—				—				127				127				2				129
Change in foreign currency translation			—				—				—				—				4				4				1				5
Total comprehensive income (loss)																							237				(15	)			222
Allocation of losses of managed investment entities			—				—				(20	)			—				—				(20	)			20				—
Dividends on Common Stock			—				—				—				(16	)			—				(16	)			—				(16	)
Shares issued:
Exercise of stock options			312,661				6				—				—				—				6				—				6
Other benefit plans			337,993				4				—				—				—				4				—				4
Dividend reinvestment plan			4,753				—				—				—				—				—				—				—
Stock-based compensation expense			—				3				—				—				—				3				—				3
Shares acquired and retired			(2,911,834	)			(34	)			—				(41	)			—				(75	)			—				(75	)
Other			—				—				—				—				—				—				(1	)			(1	)
Balance at March 31, 2010			111,129,916			$	1,323			$	241			$	2,327			$	290			$	4,181			$	142			$	4,323

AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES

		Three months ended
		March 31,
		2011				2010
Operating Activities:
Net earnings, including noncontrolling interests		$	49			$	88
Adjustments:
Depreciation and amortization			52				47
Annuity benefits			116				108
Realized (gains) losses on investing activities			3				(4	)
Net purchases of trading securities			(5	)			(15	)
Deferred annuity and life policy acquisition costs			(56	)			(45	)
Change in:
Reinsurance and other receivables			446				570
Other assets			23				9
Insurance claims and reserves			(202	)			(288	)
Payable to reinsurers			(92	)			(106	)
Other liabilities			57				43
Other operating activities, net			(2	)			(14	)
Net cash provided by operating activities			389				393
Investing Activities:
Purchases of:
Fixed maturities			(1,044	)			(1,312	)
Equity securities			(34	)			(6	)
Mortgage loans			(91	)			(36	)
Real estate, property and equipment			(20	)			(38	)
Proceeds from:
Maturities and redemptions of fixed maturities			590				508
Repayments of mortgage loans			10				5
Sales of fixed maturities			291				497
Sales of equity securities			6				1
Sales of real estate, property and equipment			—				1
Managed investment entities:
Purchases of investments			(352	)			(141	)
Proceeds from sales and redemptions of investments			400				210
Other investing activities, net			(13	)			8
Net cash used in investing activities			(257	)			(303	)
Financing Activities:
Annuity receipts			672				387
Annuity surrenders, benefits and withdrawals			(311	)			(311	)
Managed investment entities’ retirement of liabilities			(4	)			(28	)
Issuances of Common Stock			11				7
Repurchases of Common Stock			(84	)			(75	)
Cash dividends paid on Common Stock			(16	)			(15	)
Other financing activities, net			—				(5	)
Net cash provided by (used in) financing activities			268				(40	)
Net Change in Cash and Cash Equivalents			400				50
Cash and cash equivalents at beginning of period			1,099				1,120
Cash and cash equivalents at end of period		$	1,499			$	1,170

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

INDEX TO NOTES

	A.		Accounting Policies
	B.		Acquisition
	C.		Segments of Operations
	D.		Fair Value Measurements
	E.		Investments
	F.		Derivatives
	G.		Deferred Policy Acquisition Costs
	H.		Managed Investment Entities
	I.		Goodwill and Other Intangibles
	J.		Long-Term Debt
	K.		Shareholders’ Equity
	L.		Income Taxes
	M.		Contingencies
	N.		Condensed Consolidating Information

A.

Accounting Policies

Basis of Presentation The accompanying consolidated financial statements for American Financial Group, Inc. (“AFG”) and subsidiaries are unaudited; however, management believes that all adjustments (consisting only of normal recurring accruals unless otherwise disclosed herein) necessary for fair presentation have been made. The results of operations for interim periods are not necessarily indicative of results to be expected for the year. The financial statements have been prepared in accordance with the instructions to Form 10-Q and therefore do not include all information and footnotes necessary to be in conformity with U.S. generally accepted accounting principles.

Certain reclassifications have been made to prior periods to conform to the current year’s presentation. All significant intercompany balances and transactions have been eliminated. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. Events or transactions occurring subsequent to March 31, 2011, and prior to the filing date of this Form 10-Q, have been evaluated for potential recognition or disclosure herein.

The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates.

Fair Value Measurements Accounting standards define fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The standards establish a hierarchy of valuation techniques based on whether the assumptions that market participants would use in pricing the asset or liability (“inputs”) are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect AFG’s assumptions about the assumptions market participants would use in pricing the asset or liability. In the first quarter of 2011, AFG did not have any significant nonrecurring fair value measurements of nonfinancial assets and liabilities.

Investments Fixed maturity and equity securities classified as “available for sale” are reported at fair value with unrealized gains and losses included in accumulated other comprehensive income (loss) in AFG’s Balance Sheet. Fixed maturity and equity securities classified as “trading” are reported at fair value with changes in unrealized holding gains or losses during the period included in investment income. Mortgage and policy loans are carried primarily at the aggregate unpaid balance.

Premiums and discounts on fixed maturity securities are amortized using the interest method; mortgage-backed securities (“MBS”) are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Gains or losses on securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other-than-temporary at the balance sheet date, a provision for impairment is charged to earnings (included in realized gains (losses)) and the cost basis of that investment is reduced.

In 2009, AFG adopted new accounting guidance relating to the recognition and presentation of other-than-temporary impairments. Under the guidance, if management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will have to sell the security before recovery of its amortized cost basis, then an entity may separate other-than-temporary impairments into two components: 1) the amount related to credit losses (recorded in earnings) and 2) the amount related to all other factors (recorded in other comprehensive income (loss)). The credit-related portion of an other-than-temporary impairment is measured by comparing a security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. Both components are required to be shown in the Statement of Earnings. If management intends to sell an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge to earnings is required to reduce the amortized cost of that security to fair value.

Derivatives Derivatives included in AFG’s Balance Sheet are recorded at fair value and consist primarily of (i) components of certain fixed maturity securities (primarily interest-only MBS) and (ii) the equity-based component of certain annuity products (included in annuity benefits accumulated) and related call options (included in other investments) designed to be consistent with the characteristics of the liabilities and used to mitigate the risk embedded in those annuity products. Changes in the fair value of derivatives are included in earnings.

Goodwill Goodwill represents the excess of cost of subsidiaries over AFG’s equity in their underlying net assets. Goodwill is not amortized, but is subject to an impairment test at least annually.

Reinsurance Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. AFG’s property and casualty insurance subsidiaries report as assets (a) the estimated reinsurance recoverable on paid and unpaid losses, including an estimate for losses incurred but not reported, and (b) amounts paid to reinsurers applicable to the unexpired terms of policies in force. Payable to reinsurers includes ceded premiums due to reinsurers as well as ceded premiums retained by AFG’s property and casualty insurance subsidiaries under contracts to fund ceded losses as they become due. AFG’s insurance subsidiaries also assume reinsurance from other companies. Earnings on reinsurance assumed is recognized based on information received from ceding companies.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Certain annuity and supplemental insurance subsidiaries cede life insurance policies to a third party on a funds withheld basis whereby the subsidiaries retain the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. These reinsurance contracts are considered to contain embedded derivatives (that must be adjusted to fair value) because the yield on the payables is based on specific blocks of the ceding companies’ assets, rather than the overall creditworthiness of the ceding company. AFG determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. The securities related to these transactions are classified as “trading.” The adjustment to fair value on the embedded derivatives offsets the investment income recorded on the adjustment to fair value of the related trading portfolios.

Deferred Policy Acquisition Costs (“DPAC”) Policy acquisition costs (principally commissions, premium taxes and other marketing and underwriting expenses) related to the production of new business are deferred. DPAC also includes capitalized costs associated with sales inducements offered to fixed annuity policyholders such as enhanced interest rates and premium and persistency bonuses.

For the property and casualty companies, DPAC is limited based upon recoverability without any consideration for anticipated investment income and is charged against income ratably over the terms of the related policies. A premium deficiency is recognized if the sum of expected claims costs, claims adjustment expenses, unamortized acquisition costs and policy maintenance costs exceed the related unearned premiums. A premium deficiency is first recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency is greater than unamortized acquisition costs, a liability is accrued for the excess deficiency and reported with unpaid losses and loss adjustment expenses.

DPAC related to annuities is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of actual and expected gross profits on the policies. Expected gross profits consist principally of estimated future investment margin (estimated future net investment income less interest credited on policyholder funds) and surrender, mortality, and other life and variable annuity policy charges, less death and annuitization benefits in excess of account balances and estimated future policy administration expenses. To the extent that realized gains and losses result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains (losses).

DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues.

DPAC related to annuities is also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in unrealized gains on marketable securities, a component of accumulated other comprehensive income in AFG’s Balance Sheet.

New accounting guidance issued in October 2010 specifies that a cost must be directly related to the successful acquisition of an insurance contract to qualify for deferral. The guidance is effective January 1, 2012, with retrospective application permitted, but not required. This guidance will result in fewer acquisition costs being capitalized by AFG. Management continues assessing the impact of adoption and expects that adoption will be reported retrospectively.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

DPAC includes the present value of future profits on business in force of annuity and supplemental insurance companies acquired (“PVFP”). PVFP represents the portion of the costs to acquire companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. PVFP is amortized with interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.

Managed Investment Entities In 2009, the Financial Accounting Standards Board issued a new standard changing how a company determines if it is the primary beneficiary of, and therefore must consolidate, a variable interest entity (“VIE”). This determination is based primarily on a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance and the obligation to absorb losses of, or receive benefits from, the entity that could potentially be significant to the VIE.

AFG manages, and has minor investments in, six collateralized loan obligations (“CLOs”) that are VIEs (see Note H — “Managed Investment Entities”). Both the management fees (payment of which are subordinate to other obligations of the CLOs) and the investments in the CLOs are considered variable interests. Based on the new accounting guidance, AFG has determined that it is the primary beneficiary of the CLOs because (i) its role as asset manager gives it the power to direct the activities that most significantly impact the economic performance of the CLOs and (ii) it has exposure to CLO losses (through its investments in the CLO subordinated debt tranches) and the right to receive benefits (through its subordinated management fees and returns on its investments), both of which could potentially be significant to the CLOs. Accordingly, AFG began consolidating these entities on January 1, 2010.

Because AFG has no right to use the CLO assets and no obligation to pay the CLO liabilities, the assets and liabilities of the CLOs are shown separately in AFG’s Balance Sheet. As permitted under the new standard, the assets and liabilities of the CLOs have been recorded at fair value upon adoption of the new standard on January 1, 2010. At that date, the $261 million excess of fair value of the assets over the fair value of the liabilities was included in AFG’s Balance Sheet as appropriated retained earnings — managed investment entities, representing the cumulative effect of adopting the new standard that ultimately will inure to the benefit of the CLO debt holders.

AFG has elected the fair value option for reporting on the CLO assets and liabilities to improve the transparency of financial reporting related to the CLOs. The net gain or loss from accounting for the CLO assets and liabilities at fair value subsequent to January 1, 2010, is separately presented in AFG’s Statement of Earnings. CLO earnings attributable to AFG’s shareholders represent the change in fair value of AFG’s investments in the CLOs and management fees earned. All other CLO earnings (losses) are not attributable to AFG’s shareholders and will ultimately inure to the benefit of the other CLO debt holders. As a result, such CLO earnings (losses) are included in net earnings (loss) attributable to noncontrolling interests in AFG’s Statement of Earnings and in appropriated retained earnings — managed investment entities in the Balance Sheet. As the CLOs approach maturity (2016 to 2022), it is expected that losses attributable to noncontrolling interests will reduce appropriated retained earnings towards zero as the fair values of the assets and liabilities converge and the CLO assets are used to pay the CLO debt.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Unpaid Losses and Loss Adjustment Expenses The net liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based upon (a) the accumulation of case estimates for losses reported prior to the close of the accounting period on direct business written; (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of unreported losses (including possible development on known claims) based on past experience; (d) estimates based on experience of expenses for investigating and adjusting claims; and (e) the current state of the law and coverage litigation. Establishing reserves for asbestos, environmental and other mass tort claims involves considerably more judgment than other types of claims due to, among other things, inconsistent court decisions, an increase in bankruptcy filings as a result of asbestos-related liabilities, novel theories of coverage, and judicial interpretations that often expand theories of recovery and broaden the scope of coverage.

Loss reserve liabilities are subject to the impact of changes in claim amounts and frequency and other factors. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the Statement of Earnings in the period in which determined. Despite the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.

Annuity Benefits Accumulated Annuity receipts and benefit payments are recorded as increases or decreases in annuity benefits accumulated rather than as revenue and expense. Increases in this liability for interest credited are charged to expense and decreases for surrender charges are credited to other income.

For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses and excess benefits expected to be paid on future deaths and annuitizations (“EDAR”). The liability for EDAR is accrued for and modified using assumptions consistent with those used in determining DPAC and DPAC amortization, except that amounts are determined in relation to the present value of total expected assessments. Total expected assessments consist principally of estimated future investment margin, surrender, mortality, and other life and variable annuity policy charges, and unearned revenues once they are recognized as income.

Life, Accident and Health Reserves Liabilities for future policy benefits under traditional life, accident and health policies are computed using the net level premium method. Computations are based on the original projections of investment yields, mortality, morbidity and surrenders and include provisions for unfavorable deviations. Claim reserves and liabilities established for accident and health claims are modified as necessary to reflect actual experience and developing trends.

Variable Annuity Assets and Liabilities Separate accounts related to variable annuities represent the fair value of deposits invested in underlying investment funds on which AFG earns a fee. Investment funds are selected and may be changed only by the policyholder, who retains all investment risk.

AFG’s variable annuity contracts contain a guaranteed minimum death benefit (“GMDB”) to be paid if the policyholder dies before the annuity payout period commences. In periods of declining equity markets, the GMDB may exceed the value of the policyholder’s account. A GMDB liability is established for future excess death benefits using assumptions together with a range of reasonably possible scenarios for investment fund performance that are consistent with DPAC capitalization and amortization assumptions.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Premium Recognition Property and casualty premiums are earned generally over the terms of the policies on a pro rata basis. Unearned premiums represent that portion of premiums written which is applicable to the unexpired terms of policies in force. On reinsurance assumed from other insurance companies or written through various underwriting organizations, unearned premiums are based on information received from such companies and organizations. For traditional life, accident and health products, premiums are recognized as revenue when legally collectible from policyholders. For interest-sensitive life and universal life products, premiums are recorded in a policyholder account, which is reflected as a liability. Revenue is recognized as amounts are assessed against the policyholder account for mortality coverage and contract expenses.

Noncontrolling Interests For Balance Sheet purposes, noncontrolling interests represents the interests of shareholders other than AFG in consolidated entities. In the Statement of Earnings, net earnings and losses attributable to noncontrolling interests represents such shareholders’ interest in the earnings and losses of those entities.

Income Taxes Deferred income taxes are calculated using the liability method. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases and are measured using enacted tax rates. Deferred tax assets are recognized if it is more likely than not that a benefit will be realized.

AFG records a liability for the inherent uncertainty in quantifying its income tax provisions. Related interest and penalties are recognized as a component of tax expense.

Stock-Based Compensation All share-based grants are recognized as compensation expense on a straight-line basis over their vesting periods based on their calculated “fair value” at the date of grant. AFG uses the Black-Scholes pricing model to measure the fair value of employee stock options. See Note K - “Shareholders’ Equity” for further information.

Benefit Plans AFG provides retirement benefits to qualified employees of participating companies through the AFG 401(k) Retirement and Savings Plan, a defined contribution plan. AFG makes all contributions to the retirement fund portion of the plan and matches a percentage of employee contributions to the savings fund. Company contributions are expensed in the year for which they are declared. AFG and many of its subsidiaries provide health care and life insurance benefits to eligible retirees. AFG also provides postemployment benefits to former or inactive employees (primarily those on disability) who were not deemed retired under other company plans. The projected future cost of providing these benefits is expensed over the period employees earn such benefits.

Earnings Per Share Basic earnings per share is calculated using the weighted average number of shares of common stock outstanding during the period. The calculation of diluted earnings per share includes adjustments to weighted average common shares of 1.6 million for the first quarter of 2011 and 1.1 million for the first quarter of 2010 related to stock-based compensation plans.

AFG’s weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: first quarter 2011 and 2010 — 1.8 million and 5.0 million, respectively. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were nominal in the 2011 and 2010 periods.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Statement of Cash Flows For cash flow purposes, “investing activities” are defined as making and collecting loans and acquiring and disposing of debt or equity instruments and property and equipment. “Financing activities” include obtaining resources from owners and providing them with a return on their investments, borrowing money and repaying amounts borrowed. Annuity receipts, benefits and withdrawals are also reflected as financing activities. All other activities are considered “operating.” Short-term investments having original maturities of three months or less when purchased are considered to be cash equivalents for purposes of the financial statements.

B.

Acquisition

Vanliner Group, Inc. (“Vanliner”) In July 2010, National Interstate (“NATL”), a 52%-owned subsidiary of AFG, completed the acquisition of Vanliner, a market leader in providing insurance for the moving and storage industry, for $114 million (including post-closing adjustments). Vanliner’s moving and storage insurance premiums associated with policies in force as of December 31, 2010, totaled approximately $90 million, representing approximately 78% of its total business.

C.

Segments of Operations

AFG manages its business as three segments: (i) property and casualty insurance, (ii) annuity and supplemental insurance and (iii) other, which includes holding company costs and operations of the managed investment entities.

AFG reports its property and casualty insurance business in the following Specialty sub-segments: (i) Property and transportation, which includes physical damage and liability coverage for buses, trucks and recreational vehicles, inland and ocean marine, agricultural-related products and other property coverages, (ii) Specialty casualty, which includes primarily excess and surplus, general liability, executive liability, umbrella and excess liability, customized programs for small to mid-sized businesses and California workers’ compensation, and (iii) Specialty financial, which includes risk management insurance programs for lending and leasing institutions (including collateral and mortgage protection insurance), surety and fidelity products and trade credit insurance. AFG’s annuity and supplemental insurance business markets traditional fixed and indexed annuities and a variety of supplemental insurance products such as Medicare supplement. AFG’s reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

The following tables (in millions) show AFG’s revenues and operating earnings before income taxes by significant business segment and sub-segment.

		Three months ended
		March 31,
		2011				2010
Revenues
Property and casualty insurance:
Premiums earned:
Specialty
Property and transportation		$	255			$	216
Specialty casualty			216				218
Specialty financial			112				128
Other			16				17
Total premiums earned			599				579
Investment income			73				92
Realized gains (losses)			—				10
Other income			15				15
Total property and casualty insurance			687				696
Annuity and supplemental insurance:
Investment income			226				202
Life, accident and health premiums			110				115
Realized gains (losses)			(3	)			(6	)
Other income			23				25
Total annuity and supplemental insurance			356				336
Other			(4	)			2
Total revenues		$	1,039			$	1,034
Operating Earnings Before Income Taxes
Property and casualty insurance:
Underwriting income (loss):
Specialty
Property and transportation		$	33			$	32
Specialty casualty			2				18
Specialty financial			10				21
Other			1				6
Other lines			—				(6	)
Total underwriting			46				71
Investment and other income, net			68				81
Realized gains (losses)			—				10
			114				162
Annuity and supplemental insurance:
Operations			52				44
Realized gains (losses)			(3	)			(6	)
Total annuity and supplemental insurance			49				38
Other (*)			(68	)			(53	)
Total operating earnings before income taxes		$	95			$	147

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

D.

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. 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, including liabilities of managed investment entities, 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.

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. 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.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Assets and liabilities measured at fair value are summarized below (in millions):

		Level 1				Level 2				Level 3				Total
March 31, 2011
Assets:
Available for sale (“AFS”) fixed maturities:
U.S. Government and government agencies		$	236			$	192			$	—			$	428
States, municipalities and political subdivisions			—				3,058				21				3,079
Foreign government			—				280				—				280
Residential MBS			—				3,580				271				3,851
Commercial MBS			—				2,287				9				2,296
All other corporate			10				9,262				424				9,696
Total AFS fixed maturities			246				18,659				725				19,630
Trading fixed maturities			—				396				1				397
Equity securities			516				206				21				743
Assets of managed investment entities (“MIE”)			112				2,404				54				2,570
Variable annuity assets (separate accounts) (a)			—				635				—				635
Other investments			—				117				—				117
Total assets accounted for at fair value		$	874			$	22,417			$	801			$	24,092
Liabilities:
Liabilities of managed investment entities		$	72			$	—			$	2,316			$	2,388
Derivatives in annuity benefits accumulated			—				—				234				234
Total liabilities accounted for at fair value		$	72			$	—			$	2,550			$	2,622
December 31, 2010
Assets:
Available for sale (“AFS”) fixed maturities:
U.S. Government and government agencies		$	249			$	218			$	—			$	467
States, municipalities and political subdivisions			—				2,919				20				2,939
Foreign government			—				278				—				278
Residential MBS			—				3,563				312				3,875
Commercial MBS			—				2,117				6				2,123
All other corporate			9				9,201				436				9,646
Total AFS fixed maturities			258				18,296				774				19,328
Trading fixed maturities			—				390				3				393
Equity securities			461				208				21				690
Assets of managed investment entities (“MIE”)			96				2,393				48				2,537
Variable annuity assets (separate accounts) (a)			—				616				—				616
Other investments			—				98				—				98
Total assets accounted for at fair value		$	815			$	22,001			$	846			$	23,662
Liabilities:
Liabilities of managed investment entities		$	65			$	—			$	2,258			$	2,323
Derivatives in annuity benefits accumulated			—				—				190				190
Total liabilities accounted for at fair value		$	65			$	—			$	2,448			$	2,513

During the first quarter of 2011, there were no significant transfers between Level 1 and Level 2. Approximately 3% of the total assets measured at fair value on March 31, 2011, were Level 3 assets. Approximately 35% of these assets were MBS whose fair values were determined primarily using non-binding broker quotes; the balance was primarily private placement debt securities whose fair values were determined internally using significant unobservable inputs, including the evaluation of underlying collateral and issuer creditworthiness, as well as certain Level 2 inputs such as comparable yields and multiples on similar publicly traded issues. The fair values of the liabilities of managed investment entities were determined using non-binding broker quotes, which were reviewed by AFG’s investment professionals.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Changes in balances of Level 3 financial assets and liabilities during the first quarter of 2011 and 2010 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
										Other
		Balance at								comp.				Purchases								Transfer				Transfer				Balance at
		Dec. 31,				Net				income				and				Sales and				into				out of				March 31,
		2010				income				(loss)				issuances				Settlements				Level 3				Level 3				2011
AFS fixed maturities:
State and municipal		$	20			$	—			$	1			$	—			$	—			$	—			$	—			$	21
Residential MBS			312				1				—				—				(13	)			7				(36	)			271
Commercial MBS			6				—				—				—				—				3				—				9
All other corporate			436				(2	)			—				45				(11	)			22				(66	)			424
Trading fixed maturities			3				—				—				—				—				—				(2	)			1
Equity securities			21				—				2				—				(2	)			—				—				21
Assets of MIE			48				(1	)			—				7				(4	)			6				(2	)			54
Liabilities of MIE (*)			(2,258	)			(62	)			—				—				4				—				—				(2,316	)
Embedded derivatives			(190	)			(19	)			—				(30	)			5				—				—				(234	)

										Total
										realized/unrealized
										gains (losses)
										included in
						Consolidate								Other				Purchases,
		Balance at				Managed								comp.				sales,				Transfer				Transfer				Balance at
		Dec. 31,				Inv.				Net				income				issuances and				into				out of				March 31,
		2009				Entities				income				(loss)				settlements				Level 3				Level 3				2010
AFS fixed maturities:
State and municipal		$	23			$	—			$	—			$	—			$	—			$	—			$	(17	)		$	6
Residential MBS			435				—				1				1				18				—				(83	)			372
Commercial MBS			—				—				—				—				6				—				—				6
All other corporate			311				(6	)			(1	)			(1	)			45				23				(15	)			356
Trading fixed maturities			1				—				—				—				4				—				(1	)			4
Equity securities			25				—				—				(1	)			—				—				—				24
Assets of MIE			—				90				4				—				6				—				—				100
Liabilities of MIE			—				(2,100	)			(106	)			—				28				—				—				(2,178	)
Embedded derivatives			(113	)			—				(12	)			—				(6	)			—				—				(131	)

Fair Value of Financial Instruments The following table presents (in millions) the carrying value and estimated fair value of AFG’s financial instruments at March 31, 2011 and December 31, 2010.

		March 31, 2011								December 31, 2010
		Carrying				Fair				Carrying				Fair
		Value				Value				Value				Value
Assets:
Cash and cash equivalents		$	1,499			$	1,499			$	1,099			$	1,099
Fixed maturities			20,027				20,027				19,721				19,721
Equity securities			743				743				690				690
Mortgage loans			551				552				468				469
Policy loans			258				258				264				264
Other investments — derivatives			117				117				98				98
Assets of managed investment entities			2,570				2,570				2,537				2,537
Variable annuity assets (separate accounts)			635				635				616				616
Liabilities:
Annuity benefits accumulated(*)		$	13,196			$	12,590			$	12,696			$	12,233
Long-term debt			949				1,033				952				1,023
Liabilities of managed investment entities			2,388				2,388				2,323				2,323
Variable annuity liabilities (separate accounts)			635				635				616				616
Other liabilities — derivatives			14				14				14				14