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 Since mid-2005, AIG has been developing a firm-wide economic capital model to improve decision making and to enhance shareholder value. Economic Capital is the amount of capital the organization, its segments, profit centers, products or transactions require to cover potential, unexpected losses within a confidence level consistent with the risk appetite and risk tolerances specified by management. The Economic Capital requirement can then be compared with the Economic Capital resources available to AIG. The Economic Capital requirement is driven by exposures to risks and interrelationships among various types of risks. As a global leader in insurance and financial services, AIG is exposed to various risks including underwriting, financial and operational risks. The Economic Capital initiative has modeled these risks into five major categories: property & casualty insurance risk, life insurance risk, market risk, credit risk and operational risk. Within each risk category, there are sub-risks that have been modeled in greater detail. The Economic Capital initiative also analyzes the interrelationships among various types of risk, aggregate exposure accumulation and concentration, and includes diversification benefits within and across risk categories and business segments. A primary objective of the Economic Capital initiative is to develop a comprehensive framework to discuss capital and performance on a risk-adjusted basis internally with AIG management and externally with the investment community, credit providers, regulators and rating agencies. Economic Capital analysis provides a framework to validate AIG’s capital adequacy, to measure more precisely capital efficiency at various levels throughout the organization, to allocate capital consistently among Through 2007, the overall credit quality of AGF’s finance receivables portfolio deteriorated modestly primarily due to negative economic fundamentals, a higher proportion of non-real estate loans and retail sales finance loans and the aging of the real estate loan portfolio. As of December 31, 2007, the 60-day delinquency rate for the entire portfolio increased by 78 basis points to 2.84 percent compared to 2006, while the 60-day delinquency rate for the real estate loans increased by 88 basis points to 2.64 percent. In 2007, AGF’s net charge-off rate increased to 1.16 percent compared to 0.95 percent in 2006, which reflected $6 million of non-recurring recoveries. Further weakening in the U.S. housing market or the overall U.S. economy may adversely affect the credit quality of AGF’s finance receivables. AIGCFG monitors the quality of its finance receivable portfolio and determines the appropriate level of the allowance for losses through several internal committees. These committees base their conclusions on quantitative analysis, qualitative factors, current economic conditions and trends, political and regulatory implications, competition and the judgment of the committees’ members. AIG’s Consumer Finance operations are exposed to credit risk and risk of loss resulting from adverse fluctuations in interest rates and payment defaults. Credit loss exposure is managed through a combination of underwriting controls, mix of finance receivables, collateral and collection efficiency. Large product programs are subject to CRC approval. Over half of the finance receivables are real estate loans which are collateralized by the related properties. With respect to credit losses, the allowance for losses is maintained at a level considered adequate to absorb anticipated credit losses existing in that portfolio as of the balance sheet date. Asset Management AIG’s Asset Management operations are exposed to various forms of credit, market and operational risks. Asset Management complies with AIG’s corporate risk management guidelines and framework and is subject to periodic reviews by the CRC. In addition, transactions are referred to the Asset Management investment committees for approval of investment decisions. The majority of the credit and market risk exposures within Asset Management results from the Spread-Based Investment business and the investment activities of AIG Global Real Estate. In the Spread-Based Investment businesses, GIC and MIP, the primary risk is investment risk, which represents the exposure to loss resulting from the cash flows from the invested assets being less than the cash flows required to meet the obligations of the liabilities and the necessary return on investments. Credit risk is also a significant component of the investment strategy for these businesses. Market risk is taken in the form of duration and convexity risk. While AIG generally maintains a matched assetliability relationship, it may occasionally determine that it is economically advantageous to be in an unmatched duration position. The risks in the spread-based businesses are managed through exposure limitations, active management of the investment portfolios and close oversight of the asset-liability relationship. AIG Global Real Estate is exposed to the general conditions in global real estate markets and the credit markets. Such exposure can subject Asset Management to delays in real estate property development and sales, additional carrying costs and in turn affect operating results within the segment. These risks are mitigated through the underwriting process, transaction and contract terms and conditions and portfolio diversification by type of project, sponsor, real estate market and country. AIG’s exposure to real estate investments is monitored on an ongoing basis by the Asset Management Real Estate Investment Committee. Asset Management is also exposed to market risk with respect to the warehoused investing activities of AIG Investments. During the warehousing period, AIG bears the cost and risks associated with carrying these investments and consolidates them on its balance sheet and records the operating results until the investments are transferred, sold or otherwise divested. Changes in market conditions may negatively affect the fair value of these warehoused investments. Market conditions may impede AIG from launching new investment products for which these warehoused assets are being held, which could result in AIG not recovering its investment upon transfer or divestment. In the event that AIG is unable to transfer or otherwise divest its interest in the warehoused investment to third parties, AIG could be required to hold these investments indefinitely. Economic Capital 126 AIG 2007 Form 10-K
American International Group, Inc. and Subsidiaries AIG’s businesses, to quantify the specific areas of diversification businesses, segments, geographies and product lines. Commencbenefits and to assess relative economic value added by a ing in 2008, the economic value added for each of AIG’s business business, product or transaction to AIG as a whole. The Economic segments will be considered as an element, alongside other Capital initiative will also provide necessary and relevant analyses existing measures, in the evaluation of senior management and inputs in developing a more efficient capital structure. Other performance. The capital planning and allocation process will key areas of Economic Capital applications include strategic continue to be enhanced by incorporating the regulatory, rating decision-making for mergers, acquisitions and divestitures, risk agency and economic capital requirements for business segments accumulation and concentration, risk retention, reinsurance and as well as the assessment of the mobility of excess economic hedging strategies and product development and pricing. capital. During 2006, AIG developed a methodology framework that incorporates financial services industry best practices, maintains Recent Accounting Standards consistency with regulatory frameworks and reflects AIG’s distinct global business and management strategies. By utilizing stochastic Accounting Changes simulation techniques, where appropriate, AIG enhanced In September 2005, the American Institute of Certified Public existing models or developed new ones through a collaborative Accountants (AICPA) issued Statement of Position 05-1, ‘‘Accounteffort among business executives, actuaries, finance specialists ing by Insurance Enterprises for Deferred Acquisition Costs in and risk professionals. The initial assessments provided useful Connection with Modifications or Exchanges of Insurance insight into the overall capital strength of AIG and its segments. Contracts.’’ Throughout 2007, AIG’s focus has been on a wide range of In February 2006, the Financial Accounting Standards Board business applications of the model together with the continued (FASB) issued FAS 155, ‘‘Accounting for Certain Hybrid Financial enhancement of the granularity of the model. Key methodology Instruments — an amendment of FAS 140 and FAS 133.’’ enhancements introduced during 2007 include capital fungibility In July 2006, the FASB issued FASB Interpretation No. 48, and diversification among legal entities, business units and ‘‘Accounting for Uncertainty in Income Taxes — an interpretation of geographic regions, consistent economic scenarios in developed FASB Statement No. 109.’’ and developing markets, and extensive catastrophic scenario In July 2006, the FASB issued FASB Staff Position analysis and stress testing. Furthermore, AIG enhanced its (FSP) No. 13-2, ‘‘Accounting for a Change or Projected Change in comprehensive set of risk governance structures to support the the Timing of Cash Flows Relating to Income Taxes Generated by model’s inputs, assumptions and methodologies. Finally, AIG has a Leveraged Lease Transaction.’’ engaged a panel of independent experts to provide further In September 2006, the FASB issued FAS No. 157, ‘‘Fair Value assurance to AIG’s senior management, business segment execu- Measurements.’’ tives and external constituents as to the validity of the model and In September 2006, the FASB issued FAS 158, ‘‘Employers’ its results for business segments and for AIG in the aggregate. Accounting for Defined Benefit Pension and Other Postretirement Besides model enhancements and firm-wide capital strength Plans — an amendment of FASB Statements No. 87, 88, 106 and analysis, during 2007 AIG also incorporated its Economic Capital 132R.’’ model and analysis into a number of specific business issues and In February 2007, the FASB issued FAS No. 159, ‘‘The Fair in developing new business strategies. For example, economic Value Option for Financial Assets and Financial Liabilities.’’ capital analysis is being incorporated into the assessment phase In June 2007, the AICPA issued Statement of Position for mergers, acquisitions and divestures, and in the development No. 07-1, ‘‘Clarification of the Scope of the Audit and Accounting of capital markets solutions. In the reinsurance area, economic Guide ’Audits of Investment Companies’ and Accounting by Parent capital considerations are fundamental to the development of Companies and Equity Method Investors for Investments in optimal risk retention and reinsurance strategies and management Investment Companies.’’ (Indefinitely deferred by the FASB) of credit exposures to reinsurance counterparties. In the Life In December 2007, the FASB issued FAS No. 141 (revised Insurance & Retirement Services segment, the Economic Capital 2007), ‘‘Business Combinations.’’ model has been used for product development, pricing and In December 2007, the FASB issued FAS No. 160, ‘‘Nonconhedging strategies for living benefits in the variable annuity trolling Interests in Consolidated Financial Statements, an amendbusiness. For life insurance products in Asian markets, enhanced ment of ARB No. 51.’’ asset-liability management strategies have been formulated for For further discussion of these recent accounting standards long duration liability structures and low interest rate environand their application to AIG, see Note 1(hh) to Consolidated ments in certain markets using the technology developed for AIG’s Financial Statements. Economic Capital model. In 2008, AIG plans to extend the model’s application by building on the work performed in 2007 for a wider range of AIG 2007 Form 10-K 127
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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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Page 191 and 192: Index of Notes to Consolidated Fina
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SHAREHOLDER INFORMATION Corporate H
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