ANNUITY INVESTORS LIFE INSURANCE COMPANY Financial Statements Years ended December 31, 2016, 2015 and Contents

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2 Financial Statements Years ended December 31, 2016, 2015 and 2014 Contents Report of Independent Registered Public Accounting Firm... 1 Audited Financial Statements Balance Sheet... 2 Statement of Earnings... 3 Statement of Comprehensive Income... 4 Statement of Changes in Shareholder s Equity... 5 Statement of Cash Flows... 6 Notes to Financial Statements... 7

3 Ernst & Young LLP 1900 Scripps Center 312 Walnut Street Cincinnati, OH Tel: Fax: ey.com Board of Directors Annuity Investors Life Insurance Company Report of Independent Registered Public Accounting Firm We have audited the accompanying balance sheets of Annuity Investors Life Insurance Company (the Company), an indirect wholly-owned subsidiary of Great American Financial Resources, Inc., as of December 31, 2016 and 2015, and the related statements of earnings, comprehensive income, changes in stockholder s equity, and cash flows for each of the three years in the period ended December 31, These financial statements are the responsibility of the Company s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Annuity Investors Life Insurance Company at December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. April 27,

4 BALANCE SHEET (Dollars in Thousands, Except Share Data) Assets: December Cash and cash equivalents $ 41,153 $ 28,170 Investments: Fixed maturities, available for sale at fair value (amortized cost - $2,319,233 and $2,282,511) 2,387,341 2,347,772 Equity securities - available for sale - at fair value Common stocks (cost - $5,517 and $5,702) 5,573 5,220 Perpetual preferred stocks (cost - $1,000 and $1,000) Policy loans 58,267 59,246 Total cash and investments 2,493,327 2,441,407 Deferred policy acquisition costs: (including the impact of unrealized gains on securities of $28,492 and $27,956) 94, ,539 Accrued investment income 24,380 23,510 Variable annuity assets (separate accounts) 600, ,154 Equity options - fixed indexed annuities 13,411 7,114 Funds held as collateral Other assets 2,315 1,808 Total assets $ 3,227,566 $ 3,187,922 Liabilities and Equity: Annuity benefits accumulated: (including the impact of unrealized gains on securities of $1,195 and $1,111) $ 2,235,359 $ 2,206,101 Variable annuity liabilities (separate accounts) 600, ,154 Current federal income tax payable to affiliate 1,214 1,939 Liability for funds held as collateral Net deferred tax liabilities 34,401 37,181 Other liabilities 4,484 5,283 Shareholder's Equity: Total liabilities 2,875,562 2,859,048 Common stock, par value - $125 per share: - 25,000 shares authorized - 20,000 shares issued and outstanding 2,500 2,500 Capital surplus 176, ,909 Retained earnings 147, ,253 Accumulated other comprehensive income, net of tax 25,006 23,212 Total shareholder's equity 352, ,874 Total liabilities and equity $ 3,227,566 $ 3,187,922 See notes to financial statements. 2

5 STATEMENT OF EARNINGS (In Thousands) Year ended December Revenues: Net investment income $ 112,929 $ 113,897 $ 114,373 Realized gains on securities (*) 4,103 1,538 3,302 Policy charges 12,603 13,746 14,900 Other income 1,373 1,490 1,542 Total revenues 131, , ,117 Costs and Expenses: Annuity benefits 60,648 58,825 62,168 Insurance acquisition expenses, net 24,210 21,327 27,075 Other expenses 14,639 14,711 15,579 Total costs and expenses 99,497 94, ,822 Earnings before income taxes 31,511 35,808 29,295 Provision for income taxes 10,175 11,758 8,969 Net Earnings Attributable to Shareholder $ 21,336 $ 24,050 $ 20,326 (*) Consists of the following: Realized gains before impairments $ 4,443 $ 2,620 $ 3,303 Losses on securities with impairment (303) (1,046) (1) Non-credit portion of impairment recognized in other comprehensive income (loss) (37) (36) - Impairment impact recognized in earnings (340) (1,082) (1) Total realized gains on securities $ 4,103 $ 1,538 $ 3,302 See notes to financial statements. 3

6 STATEMENT OF COMPREHENSIVE INCOME (In Thousands) Year ended December Comprehensive Income (Loss): Net earnings $ 21,336 $ 24,050 $ 20,326 Other comprehensive income (loss), net of tax: Net unrealized gains (losses) on securities: Unrealized holding gains (losses) on securities arising during the period 4,461 (24,029) 18,722 Reclassification adjustment for realized gains included in net earnings (2,667) (1,000) (2,146) Total net unrealized gains (losses) on securities 1,794 (25,029) 16,576 Total comprehensive income (loss), net of tax $ 23,130 $ (979) $ 36,902 See notes to financial statements. 4

7 STATEMENT OF CHANGES IN SHAREHOLDER S EQUITY (Dollars in Thousands) Common Stock Accumulated Total Common and Capital Retained Other Comp Shareholder's Shares Surplus Earnings Inc. (Loss) Equity Balance at December 31, ,000 $ 179,409 $ 81,877 $ 31,665 $ 292,951 Net earnings ,326-20,326 Other comprehensive loss ,576 16,576 Balance at December 31, ,000 $ 179,409 $ 102,203 $ 48,241 $ 329,853 Net earnings ,050-24,050 Other comprehensive income (25,029) (25,029) Balance at December 31, ,000 $ 179,409 $ 126,253 $ 23,212 $ 328,874 Net earnings ,336-21,336 Other comprehensive loss ,794 1,794 Balance at December 31, ,000 $ 179,409 $ 147,589 $ 25,006 $ 352,004 See notes to financial statements. 5

8 STATEMENT OF CASH FLOWS (In Thousands) Year ended December Operating Activities: Net earnings $ 21,336 $ 24,050 $ 20,326 Adjustments: Depreciation and amortization (5,777) (5,792) (7,971) Annuity benefits 60,648 58,825 62,168 Realized gains on investments (4,103) (1,538) (3,302) Deferred annuity policy acquisition costs (9,995) (10,703) (11,224) Amortization of insurance acquisition costs 19,716 16,405 22,422 Change in: Accrued investment income (870) (826) (87) Payables to affiliates, net (4,470) 3,427 (4,773) Funds held as collateral 350 2,830 - Other assets (463) (861) 13,967 Liability for funds held as collateral (350) (2,830) - Other liabilities 261 (648) (2,777) Other operating activities, net (72) (61) (115) Net cash provided by operating activities 76,211 82,278 88,634 Investing Activities: Purchases of: Fixed maturities (415,832) (310,601) (378,077) Equity securities (133) (1,000) - Equity options - fixed indexed annuities (9,536) (9,016) - Proceeds from: Maturities and redemptions of fixed maturities 345, , ,330 Sales of fixed maturities 41,801 18,407 3,729 Sales of equity maturities - 1, Exercise of equity options - fixed indexed annuities 6,792 12,084 - Other investing activities, net 979 1,150 (355) Net cash used in investing activities (30,121) (61,855) (103,809) Financing Activities: Annuity receipts 193, , ,217 Annuity surrenders, benefits and withdrawals (268,385) (272,375) (260,466) Net transfers from variable annuity assets 41,802 42,635 43,395 Net cash provided by (used in) financing activities (33,107) (14,151) 12,146 Net Change in Cash and Cash Equivalents 12,983 6,272 (3,029) Cash and cash equivalents at beginning of year 28,170 21,898 24,927 Cash and cash equivalents at end of year $ 41,153 $ 28,170 $ 21,898 See notes to financial statements. 6

9 NOTES TO FINANCIAL STATEMENTS A. Accounting Policies Basis of Presentation Annuity Investors Life Insurance Company ( AILIC or the Company ), a stock life insurance company domiciled in the State of Ohio, is an indirect wholly-owned subsidiary of Great American Financial Resources, Inc., ( GAFRI ), a financial services holding company wholly-owned by American Financial Group, Inc. ( AFG ). AILIC s products include fixed, fixed-indexed and variable annuities. The products are marketed in 48 states and the District of Columbia to educational institutions, hospitals, and other qualified and non-qualified markets, through independent agents, payroll deduction plans and financial institutions. The Company operates in a single segment called Annuity. The preparation of the financial statements in conformity with U.S. generally accepted accounting principles ( GAAP ) 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. Certain reclassifications have been made to prior years to conform to the current year s presentation. Events or transactions occurring subsequent to December 31, 2016, and prior to the filing of these audited financial statements, have been evaluated for potential recognition or disclosure herein. 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 AILIC s assumptions about the assumptions market participants would use in pricing the asset or liability. AILIC did not have any significant nonrecurring fair value measurements of nonfinancial assets and liabilities in 2016 or 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 ( AOCI ) in AILIC s Balance Sheet. Policy loans are carried primarily at the aggregate unpaid balance. In January 2016, the Financial Accounting Standards Board issued Accounting Standards Update , which, among other things, will require all equity securities currently classified as available for sale to be reported at fair value, with holding gains and losses recognized in net income instead of AOCI. AILIC will be required to adopt this guidance effective January 1, 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) on securities) 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: (i) the amount related to credit losses (recorded in earnings) and (ii) the amount related to all other factors (recorded in other comprehensive income). 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 AILIC s Balance Sheet are recorded at fair value. Changes in fair value of derivatives are included in earnings, unless the derivatives are designated and qualify as highly effective cash flow hedges. Derivatives that do not qualify for hedge accounting under GAAP 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 designed to be consistent with the characteristics of the liabilities and used to mitigate the risk embedded in those annuity products. 7

10 NOTES TO FINANCIAL STATEMENTS CONTINUED To qualify for hedge accounting, at the inception of a derivative contract, AILIC formally documents the relationship between the terms of the hedge and the hedged items and its risk management objective. This documentation includes defining how hedge effectiveness and ineffectiveness will be measured on a retrospective and prospective basis. Changes in the fair value of derivatives that are designated and qualify as highly effective cash flow hedges are recorded in AOCI and are reclassified into earnings when the variability of the cash flows from the hedged items impacts earnings. Any hedge ineffectiveness is immediately recorded in current period earnings. When the change in the fair value of a qualifying cash flow hedge is included in earnings, it is included in the same line item in the Consolidated Statement of Earnings as the cash flows from the hedged item. Deferred Policy Acquisition Costs ( DPAC ) Policy acquisition costs (principally commissions, premium taxes and certain underwriting and policy issuance costs) directly related to the successful acquisition or renewal of an insurance contract 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. 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 annuity policy charges, less death, annuitization and guaranteed withdrawal 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) on securities. DPAC and certain other balance sheet amounts related to the annuity business are also adjusted, net of tax, for the change in expense that would have been recorded if the unrealized gains (losses) from securities had actually been realized. These adjustments are included in unrealized gains (losses) on marketable securities, a component of AOCI in AILIC s Balance Sheet. Funds Held as Collateral AILIC receives collateral from its counterparties to support its purchased call option assets. The fair value of this collateral is recorded as an asset and the offsetting obligation to return the collateral is recorded as a liability. 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 policy charges are credited to policy charges revenue. For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses, guaranteed withdrawals and excess benefits expected to be paid on future deaths and annuitizations ( EDAR ). The liabilities for EDAR and guaranteed withdrawals are 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 annuity policy charges, and unearned revenues once they are recognized as income. Reserves for traditional fixed annuities are generally recorded at the stated account value. Reserves for indexed annuities are recorded at a value reflecting the fixed guarantees in the product plus the fair value of the equity participation in the contract. Variable Annuity Assets and Liabilities Separate accounts related to variable annuities represent the fair value of deposits invested in underlying investment funds on which AILIC earns a fee. Investment funds are selected and may be changed only by the policyholder, who retains investment risk. The Company 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. 8

11 NOTES TO FINANCIAL STATEMENTS CONTINUED Income Taxes The Company has an intercompany tax allocation agreement with AFG. Pursuant to the agreement, the Company s tax expense is determined based upon its inclusion in the consolidated tax return of AFG and its includable subsidiaries. Estimated payments are made quarterly during the year. Following year-end, additional settlements are made on the original due date of the return and, when extended, at the time the return is filed. The method of allocation among the companies under the agreement is based upon separate return calculations with current credit for losses to the extent the losses provide a benefit in the consolidated return. 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. A valuation allowance is established to reduce total deferred tax assets to an amount that will more likely than not be realized. AILIC recognizes the tax benefits of uncertain tax positions only when the position is more likely than not to be sustained under examination by the appropriate taxing authority. Interest and penalties on AILIC s reserve for uncertain tax positions are recognized as a component of tax expense. 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. 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. Annuity receipts, surrenders, 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. 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). AILIC s Level 1 financial instruments consist of publicly traded equity securities and highly liquid government bonds for which quoted market prices in active markets are available. 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. AILIC s Level 2 financial instruments include separate account assets, corporate and municipal fixed maturity securities, MBS and equity index call options priced using observable inputs. Level 2 inputs include benchmark yields, reported trades, corroborated broker/dealer quotes, issuer spreads and benchmark securities. When non-binding broker quotes can be corroborated by comparison to similar securities priced using observable inputs, they are classified as Level 2. Level 3 - Valuations derived from market valuation techniques generally consistent with those used to estimate the fair values of Level 2 financial instruments in which one or more significant inputs are unobservable or when the market for a security exhibits significantly less liquidity relative to markets supporting Level 2 fair value measurements. The unobservable inputs may include management s own assumptions about the assumptions market participants would use based on the best information available in the circumstances. AILIC s Level 3 is comprised of financial instruments whose fair value is estimated based on non-binding broker quotes or internally developed using significant inputs not based on, or corroborated by, observable market information. 9

12 NOTES TO FINANCIAL STATEMENTS CONTINUED AILIC 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. The Company s internal investment professionals are a group of approximately 25 analysts whose primary responsibility is to manage AFG s investment portfolio. These professionals monitor individual investments as well as overall industries and are active in the financial markets on a daily basis. The group is led by AFG s chief investment officer, who reports directly to one of AFG s Co-CEOs. Valuation techniques utilized by pricing services and prices obtained from external sources are reviewed by AFG s internal investment professionals who are familiar with the securities being priced and the markets in which they trade to ensure the fair value determination is representative of an exit price. To validate the appropriateness of the prices obtained, these investment managers consider widely published indices (as benchmarks), recent trades, changes in interest rates, general economic conditions and the credit quality of the specific issuers. In addition, the Company communicates directly with the pricing services regarding the methods and assumptions used in pricing, including verifying, on a test basis, the inputs used by the service to value specific securities. Assets and liabilities measured and carried at fair value in the financial statements are summarized below (in thousands): December 31, 2016 Level 1 Level 2 Level 3 Total Assets: Available for sale ("AFS") fixed maturities: U.S. Government and government agencies $ 1,493 $ 5,770 $ - $ 7,263 States, municipalities and political subdivisions - 378, ,087 Residential MBS - 190,975 8, ,775 Commercial MBS - 130,695 1, ,090 Asset-backed securities - 267,061 15, ,540 Corporate and other - 1,369,902 17,684 1,387,586 Total AFS fixed maturities 1,493 2,342,490 43,358 2,387,341 Equity securities: Common stocks 5, ,573 Perpetual preferred stocks Variable annuity assets (separate accounts) (*) - 600, ,064 Equity options - fixed indexed annuities - 13,411-13,411 Total assets accounted for at fair value $ 8,059 $ 2,955,965 $ 43,358 $ 3,007,382 Liabilities: Derivatives in annuity benefits accumulated $ - $ - $ 67,794 $ 67,794 Total liabilities accounted for at fair value $ - $ - $ 67,794 $ 67,794 December 31, 2015 Level 1 Level 2 Level 3 Total Assets: Available for sale fixed maturities: U.S. Government and government agencies $ 1,495 $ 6,510 $ - $ 8,005 States, municipalities and political subdivisions - 375, ,801 Residential MBS - 219,835 12, ,055 Commercial MBS - 219,846 3, ,023 Asset-backed securities - 224,076 13, ,855 Corporate and other - 1,254,016 17,017 1,271,033 Total AFS fixed maturities 1,495 2,300,084 46,193 2,347,772 Equity securities: Common stocks 5, ,220 Perpetual preferred stocks Variable annuity assets (separate accounts) (*) - 608, ,154 Equity options - fixed indexed annuities - 7,114-7,114 Total assets accounted for at fair value $ 7,714 $ 2,915,352 $ 46,193 $ 2,969,259 Liabilities: Derivatives in annuity benefits accumulated $ - $ - $ 58,172 $ 58,172 Total liabilities accounted for at fair value $ - $ - $ 58,172 $ 58,172 (*) Variable annuity liabilities equal the fair value of variable annuity assets. 10

13 NOTES TO FINANCIAL STATEMENTS - CONTINUED There were no material transfers between Level 1 and Level 2 in 2016 or Less than 2% of total assets carried at fair value on December 31, 2016, were Level 3 assets. Approximately 24% of the Level 3 assets were MBS whose fair values were determined primarily using non-binding broker quotes for which there is a lack of transparency as to the inputs used to determine fair value. Details as to the quantitative inputs are neither provided by the brokers nor otherwise reasonably obtainable by AILIC. Since internally developed Level 3 asset fair values represent less than 4% of AILIC s shareholder s equity, any justifiable changes in unobservable inputs used to determine internally developed fair values would not have a material impact on AILIC s financial position. The only significant Level 3 assets or liabilities carried at fair value in the financial statements that were not measured using broker quotes are the derivatives embedded in AILIC s fixed-indexed annuity liabilities, which are measured using a discounted cash flow approach and had a fair value of $67.8 million at December 31, The following table presents information about the unobservable inputs used by management in determining fair value of these embedded derivatives. See Note D Derivatives. Unobservable Input Adjustment for credit risk Risk margin for uncertainty in cash flows Surrenders Partial surrenders Annuitizations Deaths Budgeted option costs Range 0.4% - 2.9% over the risk free rate 0.68% reduction in the discount rate 3% - 21% of indexed account value 2% - 10% of indexed account value 0.1% - 1.0% of indexed account value 1.5% - 8.0% of indexed account value 2.4% - 3.6% of indexed account value The range of adjustments for credit risk reflects credit spread variations across the yield curve. The range of projected surrender rates reflects the specific surrender charges and other features of AILIC s individual fixed-indexed annuity products with an expected range of 6% to 10% in the majority of future calendar years (3% to 21% over all periods). Increasing the budgeted option cost or risk margin for uncertainty in cash flows assumptions in the table above would increase the fair value of the fixed-indexed annuity embedded derivatives, while increasing any of the other unobservable inputs in the table above would decrease the fair value of the embedded derivatives. 11

14 NOTES TO FINANCIAL STATEMENTS - CONTINUED Changes in balances of Level 3 financial assets and liabilities carried at fair value during 2016, 2015, and 2014 are presented below (in thousands). 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 Net comp. Purchases Sales Transfer Transfer Balance at December 31, earnings income and and into out of December 31, 2015 (loss) (loss) issuances settlements Level 3 Level AFS fixed maturities: Residential MBS $ 12,220 $ 722 $ (177) $ 734 $ (2,754) $ - $ (1,945) $ 8,800 Commercial MBS 3,177 (22) (57) - (981) - (722) 1,395 Asset-backed securities 13,779 (13) (38) 2,000 (2,338) 4,689 (2,600) 15,479 Corporate and other 17,017 (5) (747) - (1,025) 2,444-17,684 Embedded derivatives (*) (58,172) (8,600) - (5,554) 4, (67,794) (*) Total realized/unrealized gains (losses) included in net earnings (loss) for the embedded derivatives reflects losses related to the unlocking of actuarial assumptions of $2.1 million in Total realized/unrealized gains (losses) included in Other Balance at Net comp. Purchases Sales Transfer Transfer Balance at December 31, earnings income and and into out of December 31, 2014 (loss) (loss) issuances settlements Level 3 Level AFS fixed maturities: Residential MBS $ 20,310 $ 498 $ (42) $ - $ (2,440) $ 2,221 $ (8,327) $ 12,220 Commercial MBS 3,615 (46) (132) - (260) - - 3,177 Asset-backed securities 14,899 (14) (68) 1,000 (4,342) 4,205 (1,901) 13,779 Corporate and other 17, (413) - (1,967) 1,937-17,017 Embedded derivatives (*) (55,653) (841) - (5,569) 3, (58,172) (*) Total realized/unrealized gains (losses) included in net earnings (loss) for the embedded derivatives reflects losses related to the unlocking of actuarial assumptions of $1.0 million in Total realized/unrealized gains (losses) included in Other Balance at Net comp. Purchases Sales Transfer Transfer Balance at December 31, earnings income and and into out of December 31, 2013 (loss) (loss) issuances settlements Level 3 Level AFS fixed maturities: Residential MBS $ 25,677 $ 248 $ (244) $ - $ (2,483) $ 7,323 $ (10,211) $ 20,310 Commercial MBS 1,580 (22) (5) - - 2,062-3,615 Asset-backed securities 4, (79) 7,674 (3,212) 5,907 (995) 14,899 Corporate and other 10, (2,831) 8,690-17,228 Other assets 3, (3,424) Embedded derivatives (*) (41,798) (11,683) - (5,735) 3, (55,653) (*) Total realized/unrealized gains (losses) included in net earnings (loss) for the embedded derivatives reflects losses related to the unlocking of actuarial assumptions of $2.4 million in

15 NOTES TO FINANCIAL STATEMENTS - CONTINUED Fair Value of Financial Instruments The carrying value and fair value of financial instruments that are not carried at fair value in the financial statements at December 31 are summarized below (in thousands): Carrying Fair Value Value Level 1 Level 2 Level Financial assets: Cash and cash equivalents $ 41,153 $ 41,153 $ 41,153 $ - $ - Policy loans 58,267 58, ,267 Total financial assets not accounted for at fair value $ 99,420 $ 99,420 $ 41,153 $ - $ 58,267 Financial liabilities: Annuity benefits accumulated (*) $ 2,226,094 $ 2,170,494 $ - $ - $ 2,170,494 Total financial liabilities not accounted for at fair value $ 2,226,094 $ 2,170,494 $ - $ - $ 2,170, Financial assets: Cash and cash equivalents $ 28,170 $ 28,170 $ 28,170 $ - $ - Policy loans 59,246 59, ,246 Total financial assets not accounted for at fair value $ 87,416 $ 87,416 $ 28,170 $ - $ 59,246 Financial liabilities: Annuity benefits accumulated (*) $ 2,197,148 $ 2,115,229 $ - $ - $ 2,115,229 Total financial liabilities not accounted for at fair value $ 2,197,148 $ 2,115,229 $ - $ - $ 2,115,229 (*) Excludes $9,265 and $8,953 of life contingent annuities in the payout phase at December 31, 2016 and 2015, respectively. The carrying amount of cash and cash equivalents approximates fair value. The fair value of policy loans is estimated to approximate carrying value; policy loans have no defined maturity dates and are inseparable from insurance contracts. The fair value of annuity benefits accumulated was estimated based on expected cash flows discounted using forward interest rates adjusted for the Company s credit risk and includes the impact of maintenance expenses and capital costs. 13

16 NOTES TO FINANCIAL STATEMENTS - CONTINUED C. Balance Sheet Impact of Net Unrealized Gains on Securities In addition to adjusting equity securities and fixed maturity securities classified as available for sale to fair value, GAAP requires that deferred policy acquisition costs and certain other balance sheet amounts related to the annuity business be adjusted to the extent that unrealized gains and losses from securities would result in adjustment to those balances had the unrealized gains or losses actually been realized. The following table shows (in thousands) the components of the net unrealized gain on securities is included in AOCI in AILIC s Balance Sheet: December 31, 2016 Asset Carrying (Liability) Impact of Value of before Unrealized Asset Unrealized Gains (Liability) Fixed maturities $ 2,319,233 $ 68,108 $ 2,387,341 Equity securities 6, ,566 Deferred policy acquisition costs 122,521 (28,492) 94,029 Annuity benefits accumulated (2,234,164) (1,195) (2,235,359) Unrealized gain, pretax 38,470 Deferred tax on unrealized gain (13,464) Unrealized gain, after tax (included in AOCI) $ 25,006 December 31, 2015 Fixed maturities $ 2,282,511 $ 65,261 $ 2,347,772 Equity securities 6,702 (483) 6,219 Deferred policy acquisition costs 133,495 (27,956) 105,539 Annuity benefits accumulated (2,204,990) (1,111) (2,206,101) Unrealized gain, pretax 35,711 Deferred tax on unrealized gain (12,499) Unrealized gain, after tax (included in AOCI) $ 23,212 14

17 NOTES TO FINANCIAL STATEMENTS - CONTINUED D. Investments Fixed maturities and equity securities at December 31 consisted of the following (in thousands): Fixed Maturities: U.S. Government and Amortized Fair Gross Unrealized Amortized Fair Gross Unrealized Cost Value Gains Losses Cost Value Gains Losses government agencies $ 6,909 $ 7,263 $ 354 $ - $ 7,484 $ 8,005 $ 522 $ (1) States, municipalities and political subdivisions 368, ,087 13,367 (3,681) 365, ,801 13,933 (3,844) Residential MBS 180, ,775 20,039 (610) 209, ,055 23,650 (627) Commercial MBS 128, ,090 4,155 (107) 215, ,023 7,805 (4) Asset-backed securities 283, ,540 1,461 (2,730) 237, ,855 1,694 (1,717) Corporate and other 1,351,726 1,387,586 45,164 (9,304) 1,247,183 1,271,033 43,411 (19,561) Total fixed maturities $ 2,319,233 $ 2,387,341 $ 84,540 $ (16,432) $ 2,282,511 $ 2,347,772 $ 91,015 $ (25,754) Common stocks $ 5,517 $ 5,573 $ 239 $ (183) $ 5,702 $ 5,220 $ 194 $ (676) Perpetual preferred stocks $ 1,000 $ 993 $ - $ (7) $ 1,000 $ 999 $ - $ (1) The non-credit related portions of other-than-temporary impairment charges are included in other comprehensive income. Cumulative non-credit charges taken for securities still owned at December 31, 2016 and 2015, respectively, were $21.0 million and $22.4 million. Gross unrealized gains on such securities at December 31, 2016 and December 31, 2015 were $11.7 million and $12.0 million, respectively. Gross unrealized losses on such securities at December 31, 2016 and December 31, 2015 were $0.3 million and $0.4 million, respectively. These amounts represent the non-credit other-than-temporary impairment charges recorded in AOCI adjusted for subsequent changes in fair values and all relate to residential MBS. 15

18 NOTES TO FINANCIAL STATEMENTS - CONTINUED The following tables show gross unrealized losses (in thousands) on fixed maturities and equity securities by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2016 and Less Than Twelve Months Twelve Months or More Unrealized Fair Fair Value as Unrealized Fair Fair Value as 2016 Loss Value % of Cost Loss Value % of Cost Fixed Maturities: U.S. Government and government agencies $ - $ % $ - $ - - % States, municipalities and political subdivisions (3,613) 107,822 97% (68) 1,556 96% Residential MBS (265) 18,068 99% (345) 9,251 96% Commercial MBS (107) 8,954 99% % Asset-backed securities (1,716) 87,233 98% (1,014) 33,454 97% Corporate and other (7,762) 318,017 98% (1,542) 25,600 94% Total fixed maturities $ (13,463) $ 540,304 98% $ (2,969) $ 69,861 96% Common stocks $ (183) $ 2,944 94% $ - $ - - % Perpetual preferred stocks $ (7) $ % $ - $ - - % Less Than Twelve Months Twelve Months or More Unrealized Fair Fair Value as Unrealized Fair Fair Value as 2015 Loss Value % of Cost Loss Value % of Cost Fixed Maturities: U.S. Government and government agencies $ (1) $ % $ - $ - - % States, municipalities and political subdivisions (3,103) 104,825 97% (741) 13,949 95% Residential MBS (110) 8,368 99% (517) 9,708 95% Commercial MBS (4) 5, % % Asset-backed securities (1,177) 106,046 99% (540) 26,700 98% Corporate and other (15,337) 340,446 96% (4,224) 24,075 85% Total fixed maturities $ (19,732) $ 565,292 97% $ (6,022) $ 74,432 93% Common stocks $ (676) $ 4,983 88% $ - $ - - % Perpetual preferred stocks $ (1) $ % $ - $ - - % At December 31, 2016, the gross unrealized losses on fixed maturities of $16.4 million relate to approximately 373 securities. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 89% of the gross unrealized loss and 93% of the fair value. The determination of whether unrealized losses are other-than-temporary requires judgment based on subjective as well as objective factors. Factors considered and resources used by management include: a) whether the unrealized loss is credit-driven or a result of changes in market interest rates, b) the extent to which fair value is less than cost basis, c) cash flow projections received from independent sources, d) historical operating, balance sheet and cash flow data contained in issuer SEC filings and news releases, e) near-term prospects for improvement in the issuer and/or its industry, f) third party research and communications with industry specialists, g) financial models and forecasts, h) the continuity of dividend payments, maintenance of investment grade ratings and hybrid nature of certain investments, i) discussions with issuer management, and j) ability and intent to hold the investment for a period of time sufficient to allow for anticipated recovery in fair value. 16

19 NOTES TO FINANCIAL STATEMENTS - CONTINUED AILIC analyzes its MBS for other-than-temporary impairment each quarter based upon expected future cash flows. Management estimates expected future cash flows based upon its knowledge of the MBS market, cash flow projections (which reflect loan to collateral values, subordination, vintage and geographic concentration) received from independent sources, implied cash flows inherent in security ratings and analysis of historical payment data. For 2016, AILIC recorded less than $1 million in other-than-temporary impairment charges related to its residential MBS. Management believes AILIC will recover its cost basis in the securities with unrealized losses and that AILIC has the ability to hold the securities until they recover in value and had no intent to sell them at December 31, A progression of the credit portion of other-than-temporary impairments on fixed maturity securities for which the non-credit portion of an impairment has been recognized in other comprehensive income is shown below (in thousands) Balance at January 1 $ 19,054 $ 19,756 $ 22,140 Additional credit impairments on: Previously impaired securities Securities without prior impairments Reductions - disposals (949) (796) (2,384) Balance at December 31 $ 18,207 $ 19,054 $ 19,756 The table below sets forth the scheduled maturities of available for sale fixed maturities as of December 31, 2016 (in thousands). Securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers. Amortized Cost Fair Value Amount % Maturity One year or less $ 47,300 $ 48,216 2% After one year through five years 473, ,766 21% After five years through ten years 936, ,802 40% After ten years 269, ,152 11% 1,727,036 1,772,936 74% MBS (average life of approximately 4 1/2 years) 308, ,865 14% Asset-backed securities (average life of approximately 4 1/2 years) 283, ,540 12% Total $ 2,319,233 $ 2,387, % Certain risks are inherent in connection with fixed maturity securities, including loss upon default, price volatility in reaction to changes in interest rates, and general market factors and risks associated with reinvestment of proceeds due to prepayments or redemptions in a period of declining interest rates. 17

20 NOTES TO FINANCIAL STATEMENTS - CONTINUED There were no investments in individual issuers that exceeded 10% of Shareholder s Equity at December 31, 2016 or The following table shows (in thousands) investment income earned and investment expenses incurred Investment income: Fixed maturities $ 108,661 $ 109,750 $ 109,679 Equity securities Policy loans 4,043 4,031 3,949 Other Gross investment income 113, , ,568 Investment expenses (594) (740) (195) Net investment income $ 112,929 $ 113,897 $ 114,373 AILIC s investment portfolio is managed by a subsidiary of AFG. Investment expenses included investment management fees charged by this subsidiary of $0.4 million in 2016, $0.5 million in 2015 and less than $0.1 million in Realized gains (losses) and changes in unrealized appreciation (depreciation) related to fixed maturity and equity security investments are summarized as follows (in thousands): Fixed Equity Maturities Securities Other* Tax Effects Total Year ended December 31, 2016 Realized before impairments $ 3,930 $ 65 $ 448 $ (1,555) $ 2,888 Realized - impairments (282) (185) (221) Change in unrealized 2, (620) (965) 1,794 Year ended December 31, 2015 Realized before impairments $ 2,354 $ - $ 266 $ (917) $ 1,703 Realized - impairments (1,495) (200) (703) Change in unrealized (68,424) (1,004) 30,923 13,476 (25,029) Year ended December 31, 2014 Realized before impairments $ 2,509 $ 361 $ 433 $ (1,156) $ 2,147 Realized - impairments - (1) - - (1) Change in unrealized 39, (14,673) (8,923) 16,576 *Primarily adjustments to deferred policy acquisition costs related to annuities. 18

21 NOTES TO FINANCIAL STATEMENTS CONTINUED Gross realized gains and losses (excluding impairment write-downs and mark-to-market of derivatives) on available for sale fixed maturity and equity security investment transactions included in the statement of cash flows consisted of the following (in thousands): Fixed maturities: Gross gains $ 4,457 $ 2,524 $ 2,514 Gross losses (505) (176) (5) Equity securities: Gross gains Gross losses E. Derivatives As discussed under Derivatives in Note A Accounting Policies to the financial statements, AILIC 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 AILIC s Balance Sheet at fair value (in thousands): December 31, 2016 December 31, 2015 Derivative Balance Sheet Line Asset Liability Asset Liability MBS with embedded derivatives Fixed maturities $ 516 $ - $ 644 $ - Fixed-indexed annuities (embedded derivatives) Annuity benefits accumulated - 67,794-58,172 Equity index call options Equity options - fixed indexed annuities 13,411-7,114 - $ 13,927 $ 67,794 $ 7,758 $ 58,172 The MBS with embedded derivatives consist primarily of interest-only MBS with interest rates that float inversely with shortterm rates. AILIC records the entire change in the fair value of these securities in earnings. These investments are part of AILIC s overall investment strategy and represent a small component of AILIC s overall investment portfolio. AILIC s fixed-indexed annuities, which represent approximately one-third of annuity benefits accumulated at December 31, 2016, provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market index. AILIC attempts to mitigate the risk in the index-based component of these products through the purchase of call options on the appropriate index. AILIC s strategy is designed so that an increase in the liabilities, due to an increase in the market index, will be generally offset by unrealized and realized gains on the call options purchased by AILIC. 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. 19

22 NOTES TO FINANCIAL STATEMENTS CONTINUED The following table summarizes the gain (loss) included in the Statement of Earnings for changes in the fair value of these derivatives that do not qualify for hedge accounting for 2016, 2015 and 2014 (in thousands): Statement of Derivative Earnings Line MBS with embedded derivatives Realized gains on securities $ (34) $ (62) $ 42 Fixed-indexed annuities (embedded derivatives)(*) Annuity benefits (8,600) (841) (11,683) Equity index call options Annuity benefits (3,553) (1,327) 6,594 $ (12,187) $ (2,230) $ (5,047) (*)The change in fair value of the embedded derivative includes gains (losses) related to unlocking of actuarial assumptions of ($2.1) million in 2016, ($1.0) million in 2015 and ($2.4) million in F. Deferred Policy Acquisition Costs A progression of deferred policy acquisition costs is presented below (in thousands): Deferred Sales Costs Inducements Unrealized Total Balance at December 31, 2013 $ 126,630 $ 26,671 $ (44,244) $ 109,057 Additions 11,224 1,900-13,124 Amortization: Periodic amortization (19,555) (3,470) - (23,025) Annuity unlocking (2,867) (1,202) - (4,069) Included in realized gains Change in unrealized - - (13,966) (13,966) Balance at December 31, ,836 23,930 (58,210) 81,556 Additions 10,703 1,612-12,315 Amortization: Periodic amortization (20,852) (3,435) - (24,287) Annuity unlocking 4, ,836 Included in realized gains Change in unrealized ,254 30,254 Balance at December 31, ,883 22,612 (27,956) 105,539 Additions 9,995 1,216-11,211 Amortization: Periodic amortization (18,679) (3,034) - (21,713) Annuity unlocking (1,037) (19) - (1,056) Included in realized gains Change in unrealized - - (536) (536) Balance at December 31, 2016 $ 101,682 $ 20,839 $ (28,492) $ 94,029 20

23 NOTES TO FINANCIAL STATEMENTS - CONTINUED G. Shareholder s Equity Accumulated Other Comprehensive Income, Net of Tax ( AOCI ) Comprehensive income is defined as all changes in Shareholder s Equity except those arising from transactions with shareholders. Comprehensive income includes net earnings and other comprehensive income, which consists of changes in net unrealized gains or losses on available for sale securities. The progression of the components of accumulated other comprehensive income follows (in thousands): Other Comprehensive Income AOCI Beginning Balance Pretax Tax Net of tax AOCI Ending Balance Year ended December 31, 2016 Net unrealized gains on securities: Unrealized holding gains (losses) on securities arising during the period $ 6,862 $ (2,401) $ 4,461 Reclassification adjustment for realized (gains) losses included in net earnings (a) (4,103) 1,436 (2,667) Total net unrealized gains on securities (b) $ 23,212 $ 2,759 $ (965) $ 1,794 $ 25,006 Year ended December 31, 2015 Net unrealized gains on securities: Unrealized holding gains (losses) on securities arising during the period $ (36,967) $ 12,938 $ (24,029) Reclassification adjustment for realized (gains) losses included in net earnings (a) (1,538) 538 (1,000) Total net unrealized gains on securities (b) $ 48,241 $ (38,505) $ 13,476 $ (25,029) $ 23,212 Year ended December 31, 2014 Net unrealized gains on securities: Unrealized holding gains (losses) on securities arising during the period $ 28,801 $ (10,079) $ 18,722 Reclassification adjustment for realized (gains) losses included in net earnings (a) (3,302) 1,156 (2,146) Total net unrealized gains on securities (b) $ 31,665 $ 25,499 $ (8,923) $ 16,576 $ 48,241 (a) The reclassification adjustment out of net unrealized gains on securities affected the following lines in AILIC s Statement of Earnings OCI component Pretax Tax Affected line in the Statement of Earnings Realized gains on securities Provision for income taxes (b) Includes net unrealized gains of $4.2 million at both December 31, 2016 and 2015, and $4.6 million at December 31, 2014, respectively, related to securities for which only the credit portion of an other-than-temporary impairment has been recorded in earnings. 21