2007 Annual Report - AIG.com
2007 Annual Report - AIG.com
2007 Annual Report - AIG.com
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American International Group, Inc. and Subsidiaries<br />
Notes to Consolidated Financial Statements Continued<br />
8. Derivatives and Hedge Accounting<br />
The change in fair value of the derivative that qualifies under<br />
the requirements of FAS 133 as a fair value hedge is recorded in<br />
current period earnings along with the gain or loss on the hedged<br />
item for the hedged risk. For interest rate hedges, the adjust-<br />
ments to the carrying value of the hedged items are amortized<br />
into in<strong>com</strong>e using the effective yield method over the remaining<br />
life of the hedged item. Amounts excluded from the assessment<br />
of hedge effectiveness are recognized in current period earnings.<br />
For the year ended December 31, <strong>2007</strong>, <strong>AIG</strong>FP recognized net<br />
losses of $0.7 million in earnings, representing hedge ineffective-<br />
ness, and also recognized net losses of $456 million related to the<br />
portion of the hedging instruments excluded from the assessment<br />
of hedge effectiveness.<br />
<strong>AIG</strong>FP’s derivative transactions involving interest rate swap<br />
transactions generally involve the exchange of fixed and floating<br />
rate interest payment obligations without the exchange of the<br />
underlying notional amounts. <strong>AIG</strong>FP typically be<strong>com</strong>es a principal<br />
in the exchange of interest payments between the parties and,<br />
therefore, is exposed to counterparty credit risk and may be<br />
exposed to loss, if counterparties default. Currency, <strong>com</strong>modity,<br />
and equity swaps are similar to interest rate swaps, but involve<br />
the exchange of specific currencies or cashflows based on the<br />
underlying <strong>com</strong>modity, equity securities or indices. Also, they may<br />
involve the exchange of notional amounts at the beginning and<br />
end of the transaction. Swaptions are options where the holder<br />
has the right but not the obligation to enter into a swap<br />
transaction or cancel an existing swap transaction. At Decem-<br />
ber 31, <strong>2007</strong>, the aggregate notional amount of <strong>AIG</strong>FP’s outstand-<br />
ing swap transactions approximated $2,133 billion, primarily<br />
related to interest rate swaps of approximately $1,167 billion.<br />
<strong>AIG</strong>FP follows a policy of minimizing interest rate, currency,<br />
<strong>com</strong>modity, and equity risks associated with securities available<br />
for sale by entering into internal offsetting positions, on a security<br />
by security basis within its derivatives portfolio, thereby offsetting<br />
a significant portion of the unrealized appreciation and deprecia-<br />
tion. In addition, to reduce its credit risk, <strong>AIG</strong>FP has entered into<br />
credit derivative transactions with respect to $82 million of<br />
securities available for sale to economically hedge its credit risk.<br />
As previously discussed, these economic offsets did not meet the<br />
hedge accounting requirements of FAS 133 and, therefore, are<br />
recorded in Other in<strong>com</strong>e in the Consolidated Statement of<br />
In<strong>com</strong>e.<br />
Notional amount represents a standard of measurement of the<br />
volume of swaps business of Capital Markets operations. Notional<br />
amount is not a quantification of market risk or credit risk and is<br />
not recorded on the consolidated balance sheet. Notional<br />
amounts generally represent those amounts used to calculate<br />
contractual cash flows to be exchanged and are not paid or<br />
received, except for certain contracts such as currency swaps.<br />
The timing and the amount of cash flows relating to Capital<br />
Markets foreign exchange forwards and exchange traded futures<br />
and options contracts are determined by each of the respective<br />
contractual agreements.<br />
<strong>AIG</strong> uses derivatives and other financial instruments as part of its<br />
financial risk management programs and as part of its investment<br />
operations. <strong>AIG</strong>FP also transacts in derivatives as a dealer.<br />
Derivatives, as defined in FAS 133, are financial arrangements<br />
among two or more parties with returns linked to or ‘‘derived’’<br />
from some underlying equity, debt, <strong>com</strong>modity or other asset,<br />
liability, or foreign exchange rate or other index or the occurrence<br />
of a specified payment event. Derivative payments may be based<br />
on interest rates, exchange rates, prices of certain securities,<br />
<strong>com</strong>modities, or financial or <strong>com</strong>modity indices or other variables.<br />
Unless subject to a scope exclusion, <strong>AIG</strong> carries all derivatives<br />
on the consolidated balance sheet at fair value. The changes in<br />
fair value of the derivative transactions of <strong>AIG</strong>FP are presented as<br />
a <strong>com</strong>ponent of <strong>AIG</strong>’s operating in<strong>com</strong>e.<br />
<strong>AIG</strong>FP<br />
<strong>AIG</strong>FP, in the ordinary course of operations and as principal,<br />
structures and enters into derivative transactions to meet the<br />
needs of counterparties who may be seeking to hedge certain<br />
aspects of such counterparties’ operations or obtain a desired<br />
financial exposure. In most cases <strong>AIG</strong>FP does not hedge its<br />
exposures related to the credit default swaps it has written. <strong>AIG</strong>FP<br />
also enters into derivative transactions to mitigate risk in its<br />
exposures (interest rates, currencies, <strong>com</strong>modities, credit and<br />
equities) arising from such transactions. Such instruments are<br />
carried at market or fair value, whichever is appropriate, and are<br />
reflected on the balance sheet in ‘‘Unrealized gain on swaps,<br />
options and forward transactions’’ and ‘‘Unrealized loss on<br />
swaps, options and forward contracts.’’<br />
Beginning in <strong>2007</strong>, <strong>AIG</strong>FP designated certain interest rate<br />
swaps as fair value hedges of the benchmark interest rate risk on<br />
certain of its interest bearing financial assets and liabilities. In<br />
these hedging relationships, <strong>AIG</strong> is hedging its fixed rate available<br />
for sale securities and fixed rate borrowings. <strong>AIG</strong>FP also desig-<br />
nated foreign currency forward contracts as fair value hedges for<br />
changes in spot foreign exchange rates of the non-U.S. dollar<br />
denominated available for sale debt securities. Under these<br />
strategies, all or portions of individual or multiple derivatives may<br />
be designated against a single hedged item.<br />
At inception of each hedging relationship, <strong>AIG</strong>FP performs and<br />
documents its prospective assessments of hedge effectiveness to<br />
demonstrate that the hedge is expected to be highly effective. For<br />
hedges of interest rate risk, <strong>AIG</strong>FP uses regression to demonstrate<br />
the hedge is highly effective, while it uses the periodic dollar offset<br />
method for its foreign currency hedges. <strong>AIG</strong>FP uses the periodic<br />
dollar offset method to assess whether its hedging relationships<br />
were highly effective on a retrospective basis. The prospective and<br />
retrospective assessments are updated on a daily basis. The<br />
passage of time <strong>com</strong>ponent of the hedging instruments and the<br />
forward points on foreign currency hedges are excluded from the<br />
assessment of hedge effectiveness and measurement of hedge<br />
ineffectiveness. <strong>AIG</strong>FP does not utilize the shortcut, matched terms<br />
or equivalent methods to assess hedge effectiveness.<br />
162 <strong>AIG</strong> <strong>2007</strong> Form 10-K