UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the Quarterly Period Ended September 30, 2010

Commission File No. 1-13653

AMERICAN FINANCIAL GROUP, INC.

Incorporated under the Laws of Ohio

IRS Employer I.D. No. 31-1544320

One East Fourth Street, Cincinnati, Ohio 45202
(513) 579-2121

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 November 1, 2010, there were 107,755,778 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			32
Item 3 — Quantitative and Qualitative Disclosure of Market Risk			49
Item 4 — Controls and Procedures			49
Part II — Other Information
Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds			50
Item 6 — Exhibits			50
Signatures			51
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

		September 30,				December 31,
		2010				2009
Assets:
Cash and cash equivalents		$	1,140			$	1,120
Investments:
Fixed maturities, available for sale at fair value (amortized cost — $18,237 and $16,730)			19,454				16,823
Fixed maturities, trading at fair value			385				372
Equity securities, at fair value (cost — $409 and $228)			581				411
Mortgage loans			492				376
Policy loans			267				276
Real estate and other investments			404				413
Total cash and investments			22,723				19,791
Recoverables from reinsurers			2,949				3,279
Prepaid reinsurance premiums			536				381
Agents’ balances and premiums receivable			773				554
Deferred policy acquisition costs			1,154				1,570
Assets of managed investment entities			2,491				—
Other receivables			655				774
Variable annuity assets (separate accounts)			573				549
Other assets			599				577
Goodwill			186				208
Total assets		$	32,639			$	27,683
Liabilities and Equity:
Unpaid losses and loss adjustment expenses		$	6,434			$	6,412
Unearned premiums			1,743				1,568
Annuity benefits accumulated			12,476				11,335
Life, accident and health reserves			1,643				1,603
Payable to reinsurers			446				462
Liabilities of managed investment entities			2,271				—
Long-term debt			954				828
Variable annuity liabilities (separate accounts)			573				549
Other liabilities			1,370				1,007
Total liabilities			27,910				23,764
Shareholders’ Equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 107,739,128 and 113,386,343 shares outstanding			108				113
Capital surplus			1,190				1,231
Retained Earnings:
Appropriated — managed investment entities			208				—
Unappropriated			2,464				2,274
Accumulated other comprehensive income, net of tax			607				163
Total shareholders’ equity			4,577				3,781
Noncontrolling interests			152				138
Total equity			4,729				3,919
Total liabilities and equity		$	32,639			$	27,683

AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES

		Three months ended								Nine months ended
		September 30,								September 30,
		2010				2009				2010				2009
Revenues:
Property and casualty insurance premiums		$	736			$	622			$	1,887			$	1,809
Life, accident and health premiums			112				112				340				331
Investment income			296				301				885				900
Realized gains (losses) on:
Securities (*)			57				9				72				(17	)
Subsidiaries			(22	)			(5	)			(22	)			(5	)
Income (loss) of managed investment entities:
Investment income			23				—				68				—
Loss on change in fair value of assets/liabilities			(4	)			—				(44	)			—
Other income			57				54				155				177
Total revenues			1,255				1,093				3,341				3,195
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses			446				296				1,052				846
Commissions and other underwriting expenses			222				218				633				643
Annuity benefits			114				112				340				323
Life, accident and health benefits			90				86				279				268
Annuity and supplemental insurance acquisition expenses			47				38				150				136
Interest charges on borrowed money			21				19				57				48
Expenses of managed investment entities			15				—				38				—
Other operating and general expenses			92				121				279				354
Total costs and expenses			1,047				890				2,828				2,618
Operating earnings before income taxes			208				203				513				577
Provision for income taxes			82				72				199				204
Net earnings, including noncontrolling interests			126				131				314				373
Less: Net earnings (loss) attributable to noncontrolling interests			(6	)			4				(32	)			15
Net Earnings Attributable to Shareholders		$	132			$	127			$	346			$	358
Earnings Attributable to Shareholders per Common Share:
Basic		$	1.22			$	1.10			$	3.14			$	3.09
Diluted		$	1.21			$	1.09			$	3.11			$	3.07
Average number of Common Shares:
Basic			108.2				116.1				110.1				115.8
Diluted			109.5				117.2				111.4				116.9
Cash dividends per Common Share		$	.1375			$	.13			$	.4125			$	.39
(*) Consists of the following:
Realized gains before impairments		$	68			$	35			$	120			$	136
Losses on securities with impairment			(8	)			(47	)			(42	)			(301	)
Non-credit portion recognized in other comprehensive income (loss)			(3	)			21				(6	)			148
Impairment charges recognized in earnings			(11	)			(26	)			(48	)			(153	)
Total realized gains (losses) on securities		$	57			$	9			$	72			$	(17	)

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, 2009			113,386,343			$	1,344			$	—			$	2,274			$	163			$	3,781			$	138			$	3,919
Cumulative effect of accounting change							—				245				4				(4	)			245				—				245
Net earnings			—				—				—				346				—				346				(32	)			314
Other comprehensive income (loss), net of tax:
Change in unrealized gain (loss) on securities			—				—				—				—				440				440				6				446
Change in foreign currency translation			—				—				—				—				7				7				2				9
Change in unrealized pension and other postretirement benefits			—				—				—				—				1				1				—				1
Total comprehensive income																							794				(24	)			770
Allocation of losses of managed investment entities			—				—				(37	)			—				—				(37	)			37				—
Dividends on Common Stock			—				—				—				(46	)			—				(46	)			—				(46	)
Shares issued:
Exercise of stock options			1,312,149				27				—				—				—				27				—				27
Other benefit plans			388,094				6				—				—				—				6				—				6
Dividend reinvestment plan			12,652				—				—				—				—				—				—				—
Stock-based compensation expense			—				9				—				—				—				9				—				9
Shares acquired and retired			(7,360,110	)			(87	)			—				(114	)			—				(201	)			—				(201	)
Other			—				(1	)			—				—				—				(1	)			1				—
Balance at September 30, 2010			107,739,128			$	1,298			$	208			$	2,464			$	607			$	4,577			$	152			$	4,729
Balance at December 31, 2008			115,599,169			$	1,351			$	—			$	1,842			$	(703	)		$	2,490			$	112			$	2,602
Cumulative effect of accounting change			—				—				—				17				(17	)			—				—				—
Net earnings			—				—				—				358				—				358				15				373
Other comprehensive income (loss), net of tax:
Change in unrealized gain (loss) on securities			—				—				—				—				827				827				7				834
Change in foreign currency translation			—				—				—				—				14				14				1				15
Change in unrealized pension and other postretirement benefits			—				—				—				—				1				1				—				1
Total comprehensive income																							1,200				23				1,223
Dividends on Common Stock			—				—				—				(45	)			—				(45	)			—				(45	)
Shares issued:
Exercise of stock options			903,133				16				—				—				—				16				—				16
Other benefit plans			190,629				2				—				—				—				2				—				2
Dividend reinvestment plan			16,589				—				—				—				—				—				—				—
Stock-based compensation expense			—				8				—				—				—				8				—				8
Shares exchanged in option exercises			(175,530	)			(2	)			—				(2	)			—				(4	)			—				(4	)
Other			—				3				—				—				—				3				(3	)			—
Balance at September 30, 2009			116,533,990			$	1,378			$	—			$	2,170			$	122			$	3,670			$	132			$	3,802

AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES

		Nine months ended
		September 30,
		2010				2009
Operating Activities:
Net earnings, including noncontrolling interests		$	314			$	373
Adjustments:
Depreciation and amortization			141				155
Annuity benefits			340				323
Realized (gains) losses on investing activities			(57	)			26
Net purchases of trading securities			(2	)			(25	)
Deferred annuity and life policy acquisition costs			(157	)			(128	)
Change in:
Reinsurance and other receivables			256				188
Other assets			13				85
Insurance claims and reserves			(195	)			(335	)
Payable to reinsurers			(24	)			142
Other liabilities			101				(44	)
Other operating activities, net			51				1
Net cash provided by operating activities			781				761
Investing Activities:
Purchases of:
Fixed maturities			(3,737	)			(3,245	)
Equity securities			(183	)			(20	)
Mortgage loans			(143	)			(9	)
Real estate, property and equipment			(62	)			(49	)
Subsidiaries			(128	)			(5	)
Proceeds from:
Maturities and redemptions of fixed maturities			1,474				1,388
Repayments of mortgage loans			35				6
Sales of fixed maturities			1,215				1,504
Sales of equity securities			10				41
Sales of real estate, property and equipment			3				1
Change in securities lending collateral			—				48
Managed investment entities:
Purchases of investments			(617	)			—
Proceeds from sales and redemptions of investments			658				—
Cash and cash equivalents of businesses acquired			95				—
Other investing activities, net			6				(65	)
Net cash used in investing activities			(1,374	)			(405	)
Financing Activities:
Annuity receipts			1,661				1,092
Annuity surrenders, benefits and withdrawals			(914	)			(986	)
Additional long-term borrowings			158				526
Reductions of long-term debt			(36	)			(682	)
Managed investment entities’ retirement of liabilities			(42	)			—
Change in securities lending obligation			—				(95	)
Issuances of Common Stock			27				13
Repurchases of Common Stock			(201	)			—
Cash dividends paid on Common Stock			(46	)			(45	)
Other financing activities, net			6				(8	)
Net cash provided by (used in) financing activities			613				(185	)
Net Change in Cash and Cash Equivalents			20				171
Cash and cash equivalents at beginning of period			1,120				1,264
Cash and cash equivalents at end of period		$	1,140			$	1,435

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

INDEX TO NOTES

A. Accounting Policies

B. Acquisition of Subsidiary

C. Segments of Operations

D. Fair Value Measurements

E. Investments

F. Derivatives

G. Deferred Policy Acquisition Costs

H. Managed Investment Entities

I. Goodwill and Intangible Assets

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 September 30, 2010, 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. Except for the impairment of goodwill discussed in Note I, AFG did not have any significant nonrecurring fair value measurements of nonfinancial assets and liabilities in the first nine months of 2010.

New accounting guidance adopted by AFG on January 1, 2010, requires additional disclosures about transfers between levels in the hierarchy of fair value measurements. The guidance also clarifies existing disclosure requirements related to the level of disaggregation presented and inputs used in determining fair values. Additional detail relating to the roll-forward of Level 3 fair values will be required beginning in 2011.

Investments Fixed maturity and equity securities classified as “available for sale” are reported at fair value with unrealized gains and losses included in a separate component of shareholders’ equity. 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.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

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.

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. AFG adopted this guidance effective January 1, 2009, and recorded a cumulative effect adjustment of $17 million to reclassify the non-credit component of previously recognized impairments from retained earnings to accumulated other comprehensive income (loss). Additional disclosures required by this guidance are contained in Note E — “Investments.”

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 and universal life insurance products 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 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, net of tax” in the Shareholders’ Equity section of the Balance Sheet.

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.

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. As further described in Note H, these entities issued securities in various tranches and invested the proceeds primarily in secured bank loans, which serve as collateral for the debt securities issued by each particular CLO. 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 Consolidated 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 excess of fair value of the assets ($2.382 billion) over the fair value of the liabilities ($2.137 billion) of $245 million 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.

At December 31, 2009, AFG’s investments in the CLOs were included in fixed maturity securities and had a cost of approximately $700,000 and a fair value of $6.4 million. Beginning January 1, 2010, these investments are eliminated in consolidation.

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. As further detailed in Note H - “Managed Investment Entities,” 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. Reserves 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.

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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 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 on stock options.

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 the following adjustments to weighted average common shares related to stock-based compensation plans: third quarter 2010 and 2009 — 1.3 million and 1.1 million; first nine months of 2010 and 2009 — 1.3 million and 1.1 million, respectively.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

AFG’s weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: third quarter 2010 and 2009 — 3.1 million and 4.6 million; first nine months of 2010 and 2009 — 4.0 million and 6.0 million, respectively. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were nominal in the 2010 and 2009 periods.

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 of Subsidiary In July 2010, National Interstate (“NATL”), a 52.5%-owned subsidiary of AFG, completed the acquisition of Vanliner Group, Inc., a subsidiary of UniGroup, Inc. for $128 million in cash, which was based on Vanliner’s estimated tangible book value at the date of closing and is subject to certain adjustments. The purchase price is subject to a four and one-half-year balance sheet guarantee whereby both favorable and unfavorable balance sheet developments inure to UniGroup. The preliminary allocation of the purchase price based on the estimated fair value of the assets and liabilities is subject to change upon finalizing valuations. NATL funded the acquisition primarily with cash on hand. Vanliner wrote approximately $104 million of gross premiums in 2009 in the moving and storage industry.

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 and 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, indexed and variable annuities and a variety of supplemental insurance products. 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								Nine months ended
		September 30,								September 30,
		2010				2009				2010				2009
Revenues
Property and casualty insurance:
Premiums earned:
Specialty
Property and transportation		$	407			$	239			$	832			$	676
Specialty casualty			224				237				661				692
Specialty financial			92				127				347				388
Other			13				19				47				53
			736				622				1,887				1,809
Investment income			80				102				257				313
Realized gains			46				17				69				41
Other			13				26				49				87
			875				767				2,262				2,250
Annuity and supplemental insurance:
Investment income			215				195				625				585
Life, accident and health premiums			112				112				340				331
Realized losses			(11	)			(13	)			(19	)			(63	)
Other			23				26				81				88
			339				320				1,027				941
Other			41				6				52				4
		$	1,255			$	1,093			$	3,341			$	3,195
Operating Earnings Before Income Taxes
Property and casualty insurance:
Underwriting:
Specialty
Property and transportation		$	41			$	47			$	81			$	121
Specialty casualty			(13	)			27				29				106
Specialty financial			36				29				91				96
Other			4				6				13				3
Other lines			—				(1	)			(12	)			(6	)
			68				108				202				320
Investment and other operating income			67				80				229				253
Realized gains			46				17				69				41
			181				205				500				614
Annuity and supplemental insurance:
Operations			58				46				148				127
Realized losses			(11	)			(13	)			(19	)			(63	)
			47				33				129				64
Other (*)			(20	)			(35	)			(116	)			(101	)
		$	208			$	203			$	513			$	577

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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), changes in interest rates, general economic conditions and the credit quality of the specific issuers.

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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
September 30, 2010
Assets:
Available for sale (“AFS”) fixed maturities:
U.S. Government and government agencies		$	264			$	259			$	—			$	523
States, municipalities and political subdivisions			—				2,532				21				2,553
Foreign government			—				308				—				308
Residential MBS			—				3,646				292				3,938
Commercial MBS			—				2,092				5				2,097
All other corporate			10				9,573				452				10,035
Total AFS fixed maturities			274				18,410				770				19,454
Trading fixed maturities			—				384				1				385
Equity securities			402				158				21				581
Assets of managed investment entities (“MIE”)			122				2,327				42				2,491
Variable annuity assets (separate accounts) (a)			—				573				—				573
Other investments			—				65				—				65
Total assets accounted for at fair value		$	798			$	21,917			$	834			$	23,549
Liabilities:
Liabilities of managed investment entities		$	72			$	—			$	2,199			$	2,271
Derivatives embedded in annuity benefits accumulated			—				—				170				170
Total liabilities accounted for at fair value		$	72			$	—			$	2,369			$	2,441
December 31, 2009
Assets:
Fixed maturities:
Available for sale		$	371			$	15,683			$	769			$	16,823
Trading			—				371				1				372
Equity securities			197				189				25				411
Variable annuity assets (separate accounts) (a)			—				549				—				549
Other investments			—				85				—				85
Total assets accounted for at fair value		$	568			$	16,877			$	795			$	18,240
Liabilities:
Derivatives embedded in annuity benefits accumulated		$	—			$	—			$	113			$	113

During the third quarter of 2010, there were no significant transfers between Level 1 and Level 2. Approximately 4% of the total assets measured at fair value on September 30, 2010, were Level 3 assets. Approximately 36% 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 internal 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 third quarter and first nine months of 2010 and 2009 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				Purchases,
		Balance at								comp.				sales,				Transfer				Transfer				Balance at
		June 30,				Net				income				issuances and				into				out of				September 30,
		2010				income				(loss)				settlements				Level 3				Level 3				2010
AFS fixed maturities:
State and municipal		$	21			$	—			$	—			$	—			$	—			$	—			$	21
Residential MBS			326				4				11				5				7				(61	)			292
Commercial MBS			6				(1	)			—				—				—				—				5
All other corporate			426				—				7				14				27				(22	)			452
Trading fixed maturities			1				—				—				—				—				—				1
Equity securities			24				—				—				—				—				(3	)			21
Assets of MIE			46				—				—				(4	)			—				—				42
Liabilities of MIE			(2,152	)			(51	)			—				4				—				—				(2,199	)
Embedded derivatives			(128	)			(26	)			—				(16	)			—				—				(170	)

						Total
						realized/unrealized
						gains (losses)
		Balance at				included in								Purchases,				Transfer				Balance at
		June 30,								Other comp.				sales, issuances				out of				September 30,
		2009				Net income				income (loss)				and settlements				Level 3				2009
AFS fixed maturities		$	712			$	5			$	68			$	185			$	(313	)		$	657
Trading fixed maturities			5				—				—				—				(4	)			1
Equity securities			26				(2	)			—				—				—				24
Other assets			—				—				—				—				—				—
Embedded derivatives			(93	)			(23	)			—				5				—				(111	)

										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				September 30,
		2009				Entities				income				(loss)				settlements				Level 3				Level 3				2010
AFS fixed maturities:
State and municipal		$	23			$	—			$	—			$	1			$	(3	)		$	17			$	(17	)		$	21
Residential MBS			435				—				6				22				11				9				(191	)			292
Commercial MBS			—				—				(1	)			—				6				—				—				5
All other corporate			311				(6	)			(12	)			15				101				96				(53	)			452
Trading fixed maturities			1				—				—				—				4				—				(4	)			1
Equity securities			25				—				—				(1	)			—				—				(3	)			21
Assets of MIE			—				90				5				—				(8	)			7				(52	)			42
Liabilities of MIE			—				(2,100	)			(141	)			—				42				—				—				(2,199	)
Embedded derivatives			(113	)			—				(25	)			—				(32	)			—				—				(170	)