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 June 30, 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 August 1, 2011, there were 100,516,338 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			33
Item 3 - Quantitative and Qualitative Disclosure of Market Risk			51
Item 4 - Controls and Procedures			51
Part II - Other Information
Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds			52
Item 6 - Exhibits			52
Signatures			53
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

PART I

ITEM I — FINANCIAL STATEMENTS

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEET (UNAUDITED)
(Dollars In Millions)

		June 30,				December 31,
		2011				2010
Assets:
Cash and cash equivalents		$	1,629			$	1,099
Investments:
Fixed maturities, available for sale at fair value (amortized cost — $19,417 and $18,490)			20,500				19,328
Fixed maturities, trading at fair value			395				393
Equity securities, at fair value (cost — $549 and $458)			779				690
Mortgage loans			340				468
Policy loans			255				264
Real estate and other investments			470				428
Total cash and investments			24,368				22,670
Recoverables from reinsurers			2,866				2,964
Prepaid reinsurance premiums			439				422
Agents’ balances and premiums receivable			705				535
Deferred policy acquisition costs			1,198				1,244
Assets of managed investment entities			2,591				2,537
Other receivables			438				674
Variable annuity assets (separate accounts)			624				616
Other assets			638				606
Goodwill			186				186
Total assets		$	34,053			$	32,454
Liabilities and Equity:
Unpaid losses and loss adjustment expenses		$	6,345			$	6,413
Unearned premiums			1,555				1,534
Annuity benefits accumulated			14,123				12,905
Life, accident and health reserves			1,685				1,650
Payable to reinsurers			302				320
Liabilities of managed investment entities			2,430				2,323
Long-term debt			940				952
Variable annuity liabilities (separate accounts)			624				616
Other liabilities			1,424				1,121
Total liabilities			29,428				27,834
Shareholders’ equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 101,020,235 and 105,168,366 shares outstanding			101				105
Capital surplus			1,138				1,166
Retained earnings:
Appropriated — managed investment entities			142				197
Unappropriated			2,512				2,523
Accumulated other comprehensive income, net of tax			579				479
Total shareholders’ equity			4,472				4,470
Noncontrolling interests			153				150
Total equity			4,625				4,620
Total liabilities and equity		$	34,053			$	32,454

AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF EARNINGS (UNAUDITED)
(In Millions, Except Per Share Data)

		Three months ended								Six months ended
		June 30,								June 30,
		2011				2010				2011				2010
Revenues:
Property and casualty insurance premiums		$	609			$	572			$	1,208			$	1,151
Life, accident and health premiums			107				113				217				228
Investment income			306				294				606				589
Realized gains (losses) on:
Securities (*)			19				11				19				15
Subsidiaries			—				—				(3	)			—
Income (loss) of managed investment entities:
Investment income			26				23				51				45
Loss on change in fair value of assets/liabilities			(22	)			(15	)			(55	)			(40	)
Other income			48				54				89				98
Total revenues			1,093				1,052				2,132				2,086
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses			413				302				754				606
Commissions and other underwriting expenses			207				207				419				411
Annuity benefits			125				118				241				226
Life, accident and health benefits			89				93				185				189
Annuity and supplemental insurance acquisition expenses			52				54				105				103
Interest charges on borrowed money			21				18				42				36
Expenses of managed investment entities			18				14				36				23
Other operating and general expenses			99				88				186				187
Total costs and expenses			1,024				894				1,968				1,781
Operating earnings before income taxes			69				158				164				305
Provision for income taxes			32				58				78				117
Net earnings, including noncontrolling interests			37				100				86				188
Less: Net earnings (loss) attributable to noncontrolling interests			(18	)			(8	)			(52	)			(26	)
Net Earnings Attributable to Shareholders		$	55			$	108			$	138			$	214
Earnings Attributable to Shareholders per Common Share:
Basic		$	.53			$	.98			$	1.33			$	1.92
Diluted		$	.52			$	.97			$	1.31			$	1.90
Average number of Common Shares:
Basic			102.7				110.2				103.7				111.1
Diluted			104.4				111.8				105.3				112.5
Cash dividends per Common Share		$	.1625			$	.1375			$	.325			$	.275

(*)    Consists of the following:
Realized gains before impairments		$	40			$	27			$	50			$	52
Losses on securities with impairment			(10	)			(20	)			(17	)			(34	)
Non-credit portion recognized in other comprehensive income (loss)			(11	)			4				(14	)			(3	)
Impairment charges recognized in earnings			(21	)			(16	)			(31	)			(37	)
Total realized gains (losses) on securities		$	19			$	11			$	19			$	15

AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CHANGES IN EQUITY (UNAUDITED)
(Dollars in Millions)

							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			—					—				—				138				—				138				(52	)			86
Other comprehensive income (loss), net of tax:
Change in unrealized gain (loss) on securities			—					—				—				—				94				94				2				96
Change in foreign currency translation			—					—				—				—				5				5				—				5
Change in unrealized pension and other postretirement benefits			—					—				—				—				1				1				—				1
Total comprehensive income (loss)																								238				(50	)			188
Allocation of losses of managed investment entities			—					—				(55	)			—				—				(55	)			55				—
Dividends on Common Stock			—					—				—				(34	)			—				(34	)			—				(34	)
Shares issued:
Exercise of stock options			654,799					16				—				—				—				16				—				16
Other benefit plans			357,042					8				—				—				—				8				—				8
Dividend reinvestment plan			7,870					—				—				—				—				—				—				—
Stock-based compensation expense			—					7				—				—				—				7				—				7
Shares acquired and retired			(5,167,842	)				(63	)			—				(115	)			—				(178	)			—				(178	)
Other			—					—				—				—				—				—				(2	)			(2	)
Balance at June 30, 2011			101,020,235				$	1,239			$	142			$	2,512			$	579			$	4,472			$	153			$	4,625
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			—					—				—				214				—				214				(26	)			188
Other comprehensive income (loss), net of tax:
Change in unrealized gain (loss) on securities			—					—				—				—				240				240				2				242
Change in foreign currency translation			—					—				—				—				(1	)			(1	)			—				(1	)
Total comprehensive income (loss)																								453				(24	)			429
Allocation of losses of managed investment entities			—					—				(33	)			—				—				(33	)			33				—
Dividends on Common Stock			—					—				—				(31	)			—				(31	)			—				(31	)
Shares issued:
Exercise of stock options			523,671					11				—				—				—				11				—				11
Other benefit plans			371,186					5				—				—				—				5				—				5
Dividend reinvestment plan			8,672					—				—				—				—				—				—				—
Stock-based compensation expense			—					6				—				—				—				6				—				6
Shares acquired and retired			(5,642,355	)				(66	)			—				(85	)			—				(151	)			—				(151	)
Other			—					(1	)			—				—				—				(1	)			(1	)			(2	)
Balance at June 30, 2010			108,647,517				$	1,299			$	228			$	2,376			$	398			$	4,301			$	146			$	4,447

AMERICAN FINANCIAL GROUP, INC. 10-Q

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Millions)

		Six months ended
		June 30,
		2011				2010
Operating Activities:
Net earnings, including noncontrolling interests		$	86			$	188
Adjustments:
Depreciation and amortization			96				97
Annuity benefits			241				226
Realized gains on investing activities			(16	)			(15	)
Net (purchases) sales of trading securities			6				(9	)
Deferred annuity and life policy acquisition costs			(126	)			(97	)
Change in:
Reinsurance and other receivables			156				571
Other assets			12				10
Insurance claims and reserves			(12	)			(329	)
Payable to reinsurers			(18	)			(185	)
Other liabilities			113				(28	)
Other operating activities, net			(4	)			32
Net cash provided by operating activities			534				461
Investing Activities:
Purchases of:
Fixed maturities			(2,302	)			(2,353	)
Equity securities			(104	)			(24	)
Mortgage loans			(91	)			(137	)
Real estate, property and equipment			(57	)			(54	)
Proceeds from:
Maturities and redemptions of fixed maturities			1,106				970
Repayments of mortgage loans			224				27
Sales of fixed maturities			374				932
Sales of equity securities			41				8
Sales of real estate, property and equipment			1				1
Managed investment entities:
Purchases of investments			(681	)			(394	)
Proceeds from sales and redemptions of investments			754				441
Other investing activities, net			(6	)			(124	)
Net cash used in investing activities			(741	)			(707	)
Financing Activities:
Annuity receipts			1,578				945
Annuity surrenders, benefits and withdrawals			(636	)			(617	)
Additional long-term borrowings			2				30
Reductions of long-term debt			(14	)			(6	)
Managed investment entities’ retirement of liabilities			(8	)			(39	)
Issuances of Common Stock			16				11
Repurchases of Common Stock			(178	)			(151	)
Cash dividends paid on Common Stock			(34	)			(31	)
Other financing activities, net			11				(5	)
Net cash provided by financing activities			737				137
Net Change in Cash and Cash Equivalents			530				(109	)
Cash and cash equivalents at beginning of period			1,099				1,120
Cash and cash equivalents at end of period		$	1,629			$	1,011

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 June 30, 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 six months 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. 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 the other-than-temporary impairment is separated 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 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 recorded 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.

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.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

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.

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.

AMERICAN FINANCIAL GROUP, INC. 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Managed Investment Entities A company is considered the primary beneficiary of, and therefore must consolidate, a variable interest entity (“VIE”) based primarily on its ability to direct the activities of the VIE that most significantly impact that 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. 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.

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 accounting guidance adopted on January 1, 2010, the assets and liabilities of the CLOs are included in AFG’s Balance Sheet at fair value. Prior to adoption of this guidance, the CLOs were not consolidated. Upon adoption of the guidance, the $261 million excess of fair value of the CLOs’ assets over the fair value of the liabilities was recorded in AFG’s Balance Sheet as appropriated retained earnings — managed investment entities, representing the cumulative effect of adopting the new guidance 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.

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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 related to stock-based compensation plans: second quarter 2011 and 2010 — 1.7 million and 1.6 million; first six months of 2011 and 2010 — 1.6 million and 1.4 million, respectively.

AFG’s weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: second quarter 2011 and 2010 — 2.4 million and 3.8 million; first six months of 2011 and 2010 — 2.1 million and 4.3 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.

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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.

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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								Six months ended
		June 30,								June 30,
		2011				2010				2011				2010
Revenues
Property and casualty insurance:
Premiums earned:
Specialty
Property and transportation		$	274			$	209			$	529			$	425
Specialty casualty			219				219				435				437
Specialty financial			100				127				212				255
Other			16				17				32				34
Total premiums earned			609				572				1,208				1,151
Investment income			75				85				148				177
Realized gains (losses)			32				13				32				23
Other income			20				21				35				36
Total property and casualty insurance			736				691				1,423				1,387
Annuity and supplemental insurance:
Investment income			230				208				456				410
Life, accident and health premiums			107				113				217				228
Realized gains (losses)			(13	)			(2	)			(16	)			(8	)
Other income			27				33				50				58
Total annuity and supplemental insurance			351				352				707				688
Other			6				9				2				11
Total revenues		$	1,093			$	1,052			$	2,132			$	2,086
Operating Earnings Before Income Taxes
Property and casualty insurance:
Underwriting income (loss):
Specialty
Property and transportation		$	—			$	8			$	33			$	40
Specialty casualty			21				23				23				41
Specialty financial			13				33				23				54
Other			5				4				6				10
Other lines (a)			(50	)			(5	)			(50	)			(11	)
Total underwriting			(11	)			63				35				134
Investment and other income, net			70				81				138				162
Realized gains (losses)			32				13				32				23
Total property and casualty insurance			91				157				205				319
Annuity and supplemental insurance:
Operations			56				46				108				90
Realized gains (losses)			(13	)			(2	)			(16	)			(8	)
Total annuity and supplemental insurance			43				44				92				82
Other (b)			(65	)			(43	)			(133	)			(96	)
Total operating earnings before income taxes		$	69			$	158			$	164			$	305

Attributable to:
AFG shareholders, including management fees		$	6			$	7			$	15			$	15
Noncontrolling interests		$	(20	)		$	(13	)		$	(55	)		$	(33	)

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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.

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

		Level 1				Level 2				Level 3				Total
June 30, 2011
Assets:
Available for sale (“AFS”) fixed maturities:
U.S. Government and government agencies		$	242			$	163			$	—			$	405
States, municipalities and political subdivisions			—				3,391				84				3,475
Foreign government			—				271				—				271
Residential MBS			—				3,587				255				3,842
Commercial MBS			—				2,361				10				2,371
All other corporate			10				9,744				382				10,136
Total AFS fixed maturities			252				19,517				731				20,500
Trading fixed maturities			—				394				1				395
Equity securities			629				129				21				779
Assets of managed investment entities (“MIE”)			125				2,413				53				2,591
Variable annuity assets (separate accounts) (a)			—				624				—				624
Other investments			—				113				—				113
Total assets accounted for at fair value		$	1,006			$	23,190			$	806			$	25,002
Liabilities:
Liabilities of managed investment entities		$	108			$	—			$	2,322			$	2,430
Derivatives in annuity benefits accumulated			—				—				299				299
Total liabilities accounted for at fair value		$	108			$	—			$	2,621			$	2,729
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 second 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 June 30, 2011, were Level 3 assets. Approximately 33% 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.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

Changes in balances of Level 3 financial assets and liabilities during the second quarter and first six months 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
		March 31,				Net				income				and				Sales and				into				out of				June 30,
		2011				income				(loss)				issuances				Settlements				Level 3				Level 3				2011
AFS fixed maturities:
State and municipal		$	21			$	—			$	—			$	53			$	—			$	10			$	—			$	84
Residential MBS			271				—				(2	)			17				(7	)			—				(24	)			255
Commercial MBS			9				—				—				—				—				1				—				10
All other corporate			424				1				6				46				(26	)			2				(71	)			382
Trading fixed maturities			1				—				—				—				—				—				—				1
Equity securities			21				—				—				—				—				—				—				21
Assets of MIE			54				—				—				9				(2	)			2				(10	)			53
Liabilities of MIE (*)			(2,316	)			(10	)			—				—				4				—				—				(2,322	)
Embedded derivatives			(234	)			(10	)			—				(60	)			5				—				—				(299	)