2007 Annual Report - AIG.com

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American International Group, Inc. and Subsidiaries Management’s Discussion and Analysis of Financial Condition and Results of Operations Continued by AIGFP for each transaction to provide that the likelihood of any not required to make any payments as part of these terminations payment obligation by AIGFP under each transaction is remote, and in certain cases was paid a fee upon termination. In light of even in severe recessionary market scenarios. The underwriting this experience to date and after other comprehensive analyses, process for these derivatives included assumptions of severely AIG did not recognize an unrealized market valuation adjustment stressed recessionary market scenarios to minimize the likelihood for this regulatory capital relief portfolio for the year ended of realized losses under these obligations. December 31, 2007. AIG will continue to assess the valuation of In certain cases, the credit risk associated with a designated this portfolio and monitor developments in the marketplace. There portfolio is tranched into different layers of risk, which are then can be no assurance that AIG will not recognize unrealized market analyzed and rated by the credit rating agencies. Typically, there valuation losses from this portfolio in future periods. In addition will be an equity layer covering the first credit losses in respect of to writing credit protection on the super senior risk layer on the portfolio up to a specified percentage of the total portfolio, designated portfolios of loans or debt securities, AIGFP also wrote and then successive layers ranging from generally a BBB-rated protection on tranches below the super senior risk layer. At layer to one or more AAA-rated layers. In transactions that are December 31, 2007 the notional amount of the credit default rated with respect to the risk layer or tranche that is immediately swaps in the regulatory capital relief portfolio written on tranches junior to the threshold level above which AIGFP’s payment below the super senior risk layer was $5.8 billion, with an obligation would generally arise, a significant majority are rated estimated fair value of $(25) million. AAA by the rating agencies. In transactions that are not rated, AIGFP has also written credit protection on the super senior AIGFP applies the same risk criteria for setting the threshold level risk layer of diversified portfolios of investment grade corporate for its payment obligations. Therefore, the risk layer assumed by debt, collateralized loan obligations (CLOs) and multi-sector CDOs. AIGFP with respect to the designated portfolio in these transac- AIGFP is at risk only on the super senior portion related to a tions is often called the ‘‘super senior’’ risk layer, defined as the diversified portfolio referenced to loans or debt securities. The layer of credit risk senior to a risk layer that has been rated AAA super senior risk portion is the last tranche to suffer losses after by the credit rating agencies, or if the transaction is not rated, significant subordination. Credit losses would have to erode all equivalent thereto. tranches junior to the super senior tranche before AIGFP would suffer any realized losses. The subordination level required for At December 31, 2007 the notional amounts and unrealized market each transaction is determined based on internal modeling and valuation loss of the super senior credit default swap portfolio by analysis of the pool of underlying assets and is not dependent on asset classes were as follows: ratings determined by the rating agencies. While the credit default Notional Unrealized Market swaps written on corporate debt obligations are cash settled, the Amount Valuation Loss majority of the credit default swaps written on CDOs and CLOs (in billions) (in millions) require physical settlement. Under a physical settlement arrange- Corporate loans (a) $230 $ — ment, AIGFP would be required to purchase the referenced super Prime residential mortgages (a) 149 — senior security at par in the event of a non-payment on that Corporate Debt/CLOs 70 226 security. Multi-sector CDO (b) 78 11,246 Certain of these credit derivatives are subject to collateral Total $527 $11,472 posting provisions. These provisions differ among counterparties (a) Predominantly represent transactions written to facilitate regulatory and asset classes. In the case of most of the multi-sector CDO capital relief. transactions, the amount of collateral required is determined (b) Approximately $61.4 billion in notional amount of the multi-sector CDO based on the change in value of the underlying cash security that pools include some exposure to U.S. subprime mortgages. represents the super senior risk layer subject to credit protection, Approximately $379 billion (consisting of the corporate loans and not the change in value of the super senior credit derivative. and prime residential mortgages) of the $527 billion in notional AIGFP is indirectly exposed to U.S. residential mortgage exposure of AIGFP’s super senior credit default swap portfolio as subprime collateral in the CDO portfolios, the majority of which is of December 31, 2007 represents derivatives written for financial from 2004 and 2005 vintages. However, certain of the CDOs on institutions, principally in Europe, for the purpose of providing which AIGFP provided credit protection permit the collateral them with regulatory capital relief rather than risk mitigation. In manager to substitute collateral during the reinvestment period, exchange for a minimum guaranteed fee, the counterparties subject to certain restrictions. As a result, in certain transactions, receive credit protection in respect of diversified loan portfolios U.S. residential mortgage subprime collateral of 2006 and 2007 they own, thus improving their regulatory capital position. These vintages has been added to the collateral pools. At December 31, derivatives are generally expected to terminate at no additional 2007, U.S. residential mortgage subprime collateral of 2006 and cost to the counterparty upon the counterparty’s adoption of 2007 vintages comprised approximately 4.9 percent of the total models compliant with the Basel II Accord. AIG expects that the collateral pools underlying the entire portfolio of CDOs with credit majority of these transactions will be terminated within the next protection. 12 to 18 months by AIGFP’s counterparties as they implement AIGFP has written 2a-7 Puts in connection with certain multimodels compliant with the new Basel II Accord. As of Februsector CDOs that allow the holders of the securities to treat the ary 26, 2008, $54 billion in notional exposures have either been securities as eligible short-term 2a-7 investments under the terminated or are in the process of being terminated. AIGFP was 122 AIG 2007 Form 10-K
American International Group, Inc. and Subsidiaries Investment Company Act of 1940. Holders of securities are permitted, in certain circumstances, to tender their securities to the issuers at par. If an issuer’s remarketing agent is unable to resell the securities so tendered, AIGFP must purchase the securities at par as long as the security has not experienced a default. During 2007, AIGFP repurchased securities with a principal amount of approximately $754 million pursuant to these obligations. In certain transactions, AIGFP has contracted with third parties to provide liquidity for the securities if they are put to AIGFP for up to a three-year period. Such liquidity facilities totaled approximately $3 billion at December 31, 2007. As of February 26, 2008, AIGFP has not utilized these liquidity facilities. At December 31, 2007, AIGFP had approximately $6.5 billion of notional exposure on 2a-7 Puts, included as part of the multisector CDO portfolio discussed herein. As of January 31, 2008, a significant majority of AIGFP’s super senior exposures continued to have tranches below AIGFP’s attachment point that have been explicitly rated AAA or, in AIGFP’s judgment, would have been rated AAA had they been rated. AIGFP’s portfolio of credit default swaps undergoes regular monitoring, modeling and analysis and contains protection through collateral subordination. AIGFP accounts for its credit default swaps in accordance with FAS 133 ‘‘Accounting For Derivative Instruments and Hedging Activities’’ and Emerging Issues Task Force 02-3, ‘‘Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities’’ (EITF 02-3). In accordance with EITF 02-3, AIGFP does not recognize income in earnings at the inception of each transaction because the inputs to value these instruments are not derivable from observable market data. The valuation of the super senior credit derivatives has become increasingly challenging given the limitation on the availability of market observable information due to the lack of trading and price transparency in the structured finance market, particularly in the fourth quarter of 2007. These market conditions have increased the reliance on management estimates and judgments in arriving at an estimate of fair value for financial reporting purposes. Further, disparities in the valuation methodologies employed by market participants and the varying judgments reached by such participants when assessing volatile markets has increased the likelihood that the various parties to these instruments may arrive at significantly different estimates as to their fair values. AIGFP’s valuation methodologies for the super senior credit default swap portfolio have evolved in response to the deteriorating market conditions and the lack of sufficient market observable information. AIG has sought to calibrate the model to market information and to review the assumptions of the model on a regular basis. AIGFP employs a modified version of the BET model to value its super senior credit default swap portfolio, including the 2a-7 Puts. The BET model utilizes default probabilities derived from credit spreads implied from market prices for the individual securities included in the underlying collateral pools securing the CDOs. AIGFP obtained prices on these securities from the CDO collateral managers. The BET model also utilizes diversity scores, weighted average lives, recovery rates and discount rates. The determination of some of these inputs require the use of judgment and estimates, particularly in the absence of market observable data. AIGFP also employed a Monte Carlo simulation to assist in quantifying the effect on valuation of the CDO of the unique features of the CDO’s structure such as triggers that divert cash flows to the most senior level of the capital structure. The credit default swaps written by AIGFP cover only the failure of payment on the super senior CDO security. AIGFP does not own the securities in the CDO collateral pool. The credit spreads implied from the market prices of the securities in the CDO collateral pool incorporate the risk of default (credit risk), the market’s price for liquidity risk and in distressed markets, the risk aversion costs. Spreads on credit derivatives tend to be narrower because, unlike in the case of investing in a bond, there is no need to fund the position (except when an actual credit event occurs). In times of illiquidity, the difference between spreads on cash securities and derivative instruments (the ‘‘negative basis’’) may be even wider for high quality assets. AIGFP was unable to reliably verify this negative basis due to the accelerating severe dislocation, illiquidity and lack of trading in the asset backed securities market during the fourth quarter of 2007 and early 2008. The valuations produced by the BET model therefore represent the valuations of the underlying super senior CDO cash securities with no recognition of the effect of the basis differential on that valuation. AIGFP also considered the valuation of the super senior CDO securities provided by third parties, including counterparties to these transactions, and made adjustments as necessary. As described above, AIGFP uses numerous assumptions in determining its best estimate of the fair value of the super senior credit default swap portfolio. The most significant assumption utilized in developing the estimate is the pricing of the securities within the CDO collateral pools. If the actual pricing of the securities within the collateral pools differs from the pricing used in estimating the fair value of the super senior credit default swap portfolio, there is potential for significant variation in the fair value estimate. A decrease by five points (for example, from 87 cents per dollar to 82 cents per dollar) in the aggregate price of the securities would cause an additional unrealized market valuation loss of approximately $3.7 billion, while an increase in the aggregate price of the securities by five points (for example, from 90 cents per dollar to 95 cents per dollar) would reduce the unrealized market valuation loss by approximately $3 billion. The effect on the unrealized market valuation loss is not proportional to the change in the aggregate price of the securities. In the case of credit default swaps written on investment grade corporate debt and CLOs, AIGFP estimated the value of its obligations by reference to the relevant market indices or third party quotes on the underlying super senior tranches where available. AIGFP monitors the underlying portfolios to determine whether the credit loss experience for any particular portfolio has caused AIG 2007 Form 10-K 123
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AMERICAN INTERNATIONAL GROUP, INC.
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FINANCIAL HIGHLIGHTS (in millions,
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overall financial condition, althou
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Group Executive Committee We are ad
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AIG’s life insurance network is t
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We have also begun to address the e
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WHAT WE SEE The ability to see and
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The Major Accounts Practice within
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Around the world, the middle class
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WE SEE GROWTH OPPORTUNITIES IN EMER
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To grow the strength of the AIG glo
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Since 2003, the AIG Disaster Relief
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RESPECT Respect encompasses how we
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Life Insurance & Retirement Service
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Domestic Brokerage Group— Gross P
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In the summer of 2007, widespread f
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in gross premiums written. It launc
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It grew new business premiums from
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emerging markets for its services,
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ILFC—Revenues by Region Total = $
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AIG Investments acquired a 94 perce
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and changing interest rates, as wel
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American International Group, Inc.
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UNITED STATES SECURITIES AND EXCHAN
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SHAREHOLDER INFORMATION Corporate H
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