2007 Annual Report - AIG.com

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American International Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements Continued 8. Derivatives and Hedge Accounting The change in fair value of the derivative that qualifies under the requirements of FAS 133 as a fair value hedge is recorded in current period earnings along with the gain or loss on the hedged item for the hedged risk. For interest rate hedges, the adjust- ments to the carrying value of the hedged items are amortized into income using the effective yield method over the remaining life of the hedged item. Amounts excluded from the assessment of hedge effectiveness are recognized in current period earnings. For the year ended December 31, 2007, AIGFP recognized net losses of $0.7 million in earnings, representing hedge ineffectiveness, and also recognized net losses of $456 million related to the portion of the hedging instruments excluded from the assessment of hedge effectiveness. AIGFP’s derivative transactions involving interest rate swap transactions generally involve the exchange of fixed and floating rate interest payment obligations without the exchange of the underlying notional amounts. AIGFP typically becomes a principal in the exchange of interest payments between the parties and, therefore, is exposed to counterparty credit risk and may be exposed to loss, if counterparties default. Currency, commodity, and equity swaps are similar to interest rate swaps, but involve the exchange of specific currencies or cashflows based on the underlying commodity, equity securities or indices. Also, they may involve the exchange of notional amounts at the beginning and end of the transaction. Swaptions are options where the holder has the right but not the obligation to enter into a swap transaction or cancel an existing swap transaction. At Decem- ber 31, 2007, the aggregate notional amount of AIGFP’s outstand- ing swap transactions approximated $2,133 billion, primarily related to interest rate swaps of approximately $1,167 billion. AIGFP follows a policy of minimizing interest rate, currency, commodity, and equity risks associated with securities available for sale by entering into internal offsetting positions, on a security by security basis within its derivatives portfolio, thereby offsetting a significant portion of the unrealized appreciation and deprecia- tion. In addition, to reduce its credit risk, AIGFP has entered into credit derivative transactions with respect to $82 million of securities available for sale to economically hedge its credit risk. As previously discussed, these economic offsets did not meet the hedge accounting requirements of FAS 133 and, therefore, are recorded in Other income in the Consolidated Statement of Income. Notional amount represents a standard of measurement of the volume of swaps business of Capital Markets operations. Notional amount is not a quantification of market risk or credit risk and is not recorded on the consolidated balance sheet. Notional amounts generally represent those amounts used to calculate contractual cash flows to be exchanged and are not paid or received, except for certain contracts such as currency swaps. The timing and the amount of cash flows relating to Capital Markets foreign exchange forwards and exchange traded futures and options contracts are determined by each of the respective contractual agreements. AIG uses derivatives and other financial instruments as part of its financial risk management programs and as part of its investment operations. AIGFP also transacts in derivatives as a dealer. Derivatives, as defined in FAS 133, are financial arrangements among two or more parties with returns linked to or ‘‘derived’’ from some underlying equity, debt, commodity or other asset, liability, or foreign exchange rate or other index or the occurrence of a specified payment event. Derivative payments may be based on interest rates, exchange rates, prices of certain securities, commodities, or financial or commodity indices or other variables. Unless subject to a scope exclusion, AIG carries all derivatives on the consolidated balance sheet at fair value. The changes in fair value of the derivative transactions of AIGFP are presented as a component of AIG’s operating income. AIGFP AIGFP, in the ordinary course of operations and as principal, structures and enters into derivative transactions to meet the needs of counterparties who may be seeking to hedge certain aspects of such counterparties’ operations or obtain a desired financial exposure. In most cases AIGFP does not hedge its exposures related to the credit default swaps it has written. AIGFP also enters into derivative transactions to mitigate risk in its exposures (interest rates, currencies, commodities, credit and equities) arising from such transactions. Such instruments are carried at market or fair value, whichever is appropriate, and are reflected on the balance sheet in ‘‘Unrealized gain on swaps, options and forward transactions’’ and ‘‘Unrealized loss on swaps, options and forward contracts.’’ Beginning in 2007, AIGFP designated certain interest rate swaps as fair value hedges of the benchmark interest rate risk on certain of its interest bearing financial assets and liabilities. In these hedging relationships, AIG is hedging its fixed rate available for sale securities and fixed rate borrowings. AIGFP also designated foreign currency forward contracts as fair value hedges for changes in spot foreign exchange rates of the non-U.S. dollar denominated available for sale debt securities. Under these strategies, all or portions of individual or multiple derivatives may be designated against a single hedged item. At inception of each hedging relationship, AIGFP performs and documents its prospective assessments of hedge effectiveness to demonstrate that the hedge is expected to be highly effective. For hedges of interest rate risk, AIGFP uses regression to demonstrate the hedge is highly effective, while it uses the periodic dollar offset method for its foreign currency hedges. AIGFP uses the periodic dollar offset method to assess whether its hedging relationships were highly effective on a retrospective basis. The prospective and retrospective assessments are updated on a daily basis. The passage of time component of the hedging instruments and the forward points on foreign currency hedges are excluded from the assessment of hedge effectiveness and measurement of hedge ineffectiveness. AIGFP does not utilize the shortcut, matched terms or equivalent methods to assess hedge effectiveness. 162 AIG 2007 Form 10-K
American International Group, Inc. and Subsidiaries 8. Derivatives and Hedge Accounting Continued The following table presents the notional amounts by remaining maturity of Capital Markets’ interest rate, credit default and currency swaps and swaptions derivatives portfolio at December 31, 2007 and 2006: Remaining Life of Notional Amount* One Two Through Six Through After Ten Total Total (in millions) Year Five Years Ten Years Years 2007 2006 Interest rate swaps $441,801 $ 554,917 $156,634 $14,112 $1,167,464 $1,058,279 Credit default swaps 184,924 286,069 85,792 5,028 561,813 483,648 Currency swaps 38,384 135,187 41,675 9,029 224,275 218,091 Swaptions, equity and commodity swaps 57,709 62,849 35,270 23,139 178,967 180,040 Total $722,818 $1,039,022 $319,371 $51,308 $2,132,519 $1,940,058 * Notional amount is not representative of either market risk or credit risk and is not recorded in the consolidated balance sheet. receives an option premium and then manages the risk of any unfavorable change in the value of the underlying commodity, currency or index by entering into offsetting transactions with third-party market participants. Risks arise as a result of movements in current market prices from contracted prices, and the potential inability of the counterparties to meet their obligations under the contracts. Futures and forward contracts are contracts that obligate the holder to sell or purchase foreign currencies, commodities or financial indices in which the seller/purchaser agrees to make/take delivery at a specified future date of a specified instrument, at a specified price or yield. Options are contracts that allow the holder of the option to purchase or sell the underlying commodity, currency or index at a specified price and within, or at, a specified period of time. As a writer of options, AIGFP generally The following table presents Capital Markets futures, forward and option contracts portfolio by maturity and type of derivative at December 31, 2007 and 2006: Remaining Life One Two Through Six Through After Ten Total Total (in millions) Year Five Years Ten Years Years 2007 2006 Exchange traded futures and options contracts contractual amount $ 27,588 $1,359 $ — $ — $ 28,947 $ 27,271 Over the counter forward contracts contractual amount 485,332 5,864 1,850 — 493,046 492,913 Total $512,920 $7,223 $1,850 $ — $521,993 $520,184 AIGFP Credit Default Swaps AIGFP enters into credit derivative transactions in the ordinary course of its business. The majority of AIGFP’s credit derivatives require AIGFP to provide credit protection on a designated portfolio of loans or debt securities. AIGFP provides such credit protection on a ‘‘second loss’’ basis, under which AIGFP’s payment obligations arise only after credit losses in the designated portfolio exceed a specified threshold amount or level of ‘‘first losses.’’ The threshold amount of credit losses that must be realized before AIGFP has any payment obligation is negotiated by AIGFP for each transaction to provide that the likelihood of any payment obligation by AIGFP under each transaction is remote. The underwriting process for these derivatives included assump- tions of severely stressed recessionary market scenarios to minimize the likelihood of realized losses under these obligations. In certain cases, the credit risk associated with a designated portfolio is tranched into different layers of risk, which are then analyzed and rated by the credit rating agencies. Typically, there will be an equity layer covering the first credit losses in respect of the portfolio up to a specified percentage of the total portfolio, and then successive layers ranging from generally a BBB-rated layer to one or more AAA-rated layers. In transactions that are rated with respect to the risk layer or tranche that is immediately junior to the threshold level above which AIGFP’s payment obligation would generally arise, a significant majority are rated AAA by the rating agencies. In transactions that are not rated, AIGFP applies the same risk criteria for setting the threshold level for its payment obligations. Therefore, the risk layer assumed by AIGFP with respect to the designated portfolio in these transactions is often called the ‘‘super senior’’ risk layer, defined as the layer of credit risk senior to a risk layer that has been rated AAA by the credit rating agencies, or if the transaction is not rated, equivalent thereto. AIG 2007 Form 10-K 163
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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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