Derivatives

As discussed under “Derivatives” in Note A — “Accounting Policies,” AFG uses derivatives in certain areas of its operations.

Derivatives That Do Not Qualify for Hedge Accounting The following derivatives that do not qualify for hedge accounting under GAAP are included in AFG’s Balance Sheet at fair value (in millions):



		December 31, 2017				December 31, 2016
Derivative	Balance Sheet Line	Asset		Liability		Asset		Liability
MBS with embedded derivatives	Fixed maturities	$	105	$	—	$	107	$	—
Public company warrants	Equity securities	4		—		4		—
Fixed-indexed annuities (embedded derivative)	Annuity benefits accumulated	—		2,542		—		1,759
Equity index call options	Equity index call options	701		—		492		—
Reinsurance contract (embedded derivative)	Other liabilities	—		4		—		8
		$	810	$	2,546	$	603	$	1,767

The MBS with embedded derivatives consist primarily of interest-only MBS with interest rates that float inversely with short-term rates. AFG records the entire change in the fair value of these securities in earnings. These investments are part of AFG’s overall investment strategy and represent a small component of AFG’s overall investment portfolio.

Warrants to purchase shares of publicly traded companies, which represent a small component of AFG’s overall investment portfolio, are considered to be derivatives that are required to be carried at fair value through earnings.

AFG’s fixed-indexed annuities provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market or other financial index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase of call options on the appropriate index. AFG receives collateral from certain of its counterparties to support its purchased call option assets. This collateral ($389 million at December 31, 2017 and $380 million at December 31, 2016) is included in other assets in AFG’s Balance Sheet with an offsetting liability to return the collateral, which is included in other liabilities. AFG’s strategy is designed so that the change in the fair value of the call option assets will generally offset the economic change in the liabilities from the index participation. Both the index-based component of the annuities and the related call options are considered derivatives. Fluctuations in interest rates and the stock market, among other factors, can cause volatility in the periodic measurement of fair value of the embedded derivative that management believes can be inconsistent with the long-term economics of these products.

As discussed under “Reinsurance” in Note A, AFG has a reinsurance contract that is considered to contain an embedded derivative.

The following table summarizes the gain (loss) included in AFG’s Statement of Earnings for changes in the fair value of derivatives that do not qualify for hedge accounting for 2017, 2016 and 2015 (in millions):



Derivative	Statement of Earnings Line	2017			2016			2015
MBS with embedded derivatives	Realized gains (losses) on securities	$	(6	)	$	(9	)	$	(16	)
Public company warrants	Realized gains (losses) on securities	—			—			—
Fixed-indexed annuities (embedded derivative) (*)	Annuity benefits	(589		)	(211		)	(17		)
Equity index call options	Annuity benefits	494			141			(56		)
Reinsurance contracts (embedded derivative)	Net investment income	(2		)	(1		)	6
		$	(103	)	$	(80	)	$	(83	)


(*)	The change in fair value of the embedded derivative includes losses related to unlocking of actuarial assumptions of $25 million in 2017 compared to $17 million in 2016 and $28 million in 2015.

Derivatives Designated and Qualifying as Cash Flow Hedges As of December 31, 2017, AFG has entered into ten interest rate swaps that are designated and qualify as highly effective cash flow hedges to mitigate interest rate risk related to certain floating-rate securities included in AFG’s portfolio of fixed maturity securities. The purpose of each of these swaps is to effectively convert a portion of AFG’s floating-rate fixed maturity securities to fixed rates by offsetting the variability in cash flows attributable to changes in short-term LIBOR.

Under the terms of the swaps, AFG receives fixed-rate interest payments in exchange for variable interest payments based on short-term LIBOR. The notional amounts of the interest rate swaps generally decline over each swap’s respective life (the swaps expire between August 2019 and June 2030) in anticipation of the expected decline in AFG’s portfolio of fixed maturity securities with floating interest rates based on short-term LIBOR. The total outstanding notional amount of AFG’s interest rate swaps increased to $1.58 billion at December 31, 2017 compared to $1.08 billion at December 31, 2016, reflecting three new swaps with an aggregate notional amount at issuance of $663 million entered into in 2017, partially offset by the scheduled amortization discussed above. The fair value of the effective portion of the interest rate swaps in an asset position and included in other assets was less than $1 million at December 31, 2017 and $1 million at December 31, 2016. The fair value of the effective portion of interest rate swaps in a liability position and included in other liabilities was $31 million at December 31, 2017 and $22 million at December 31, 2016. The net unrealized gain or loss on cash flow hedges is included in AOCI, net of DPAC and deferred taxes. Amounts reclassified from AOCI (before DPAC and taxes) to net investment income were $6 million in 2017, $7 million in 2016 and $6 million in 2015. There was no ineffectiveness recorded in net earnings during these periods. A collateral receivable supporting these swaps of $70 million at December 31, 2017 and $60 million at December 31, 2016 is included in other assets in AFG’s Balance Sheet.

Derivative Designated and Qualifying as a Fair Value Hedge In June 2015, AFG entered into an interest rate swap to mitigate the interest rate risk associated with its fixed-rate 9-7/8% Senior Notes due June 2019 by effectively converting the interest rate on those notes to a floating rate of three-month LIBOR plus 8.099%. In connection with redemption of the 9-7/8% Senior Notes in December 2017, AFG paid the counterparty $1 million to settle the interest rate swap.

Since the terms of the interest rate swap matched the terms of the hedged debt, changes in the fair value of the interest rate swap were offset by changes in the fair value of the hedged debt attributable to changes in interest rates. The fair value of the interest rate swap (asset of $1 million at December 31, 2016) and the offsetting adjustment to the carrying value of the 9-7/8% Senior Notes were both included in long-term debt on AFG’s Balance Sheet. Accordingly, the net impact on AFG’s earnings during the period that the swap was outstanding was that the interest expense associated with the hedged debt was effectively recorded at the floating rate. The net reduction in interest expense from the swap for 2017, 2016 and 2015 was $2 million, $3 million and $2 million, respectively.