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 suffer losses after significant subordination. Credit losses would Continued have to erode all tranches junior to the super senior tranche before AIGFP would suffer any realized losses. The subordination At December 31, 2007 and 2006, the notional amounts level required for each transaction is determined based on and unrealized market valuation loss of the super senior internal modeling and analysis of the pool of underlying assets credit default swap portfolio by asset classes were as and is not dependent on ratings determined by the rating follows: agencies. While the credit default swaps written on corporate debt Notional Unrealized Market obligations are cash settled, the majority of the credit default Amount Valuation Loss swaps written on CDOs and CLOs require physical settlement. (in billions) (in millions) Under a physical settlement arrangement, AIGFP would be re- Corporate loans (a) $230 $ — quired to purchase the referenced super senior note obligation at Prime residential mortgages (a) 149 — par in the event of a non-payment on that security. Corporate Debt/CLOs 70 226 Certain of these credit derivatives are subject to collateral Multi-sector CDO (b) 78 11,246 posting provisions. These provisions differ among counterparties Total $527 $11,472 and asset classes. In the case of most of the multi-sector CDO (a) Predominantly represent transactions written to facilitate regulatory transactions, the amount of collateral required is determined capital relief. based on the change in value of the underlying cash security that (b) Approximately $61.4 billion, in notional amount, of the multi-sector represents the super senior risk layer subject to credit protection, CDO pools includes some exposure to U.S. subprime mortgages. and not the change in value of the super senior credit derivative. Approximately $379 billion 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 portfolios of various debt U.S. residential mortgage subprime collateral of 2006 and 2007 securities or loans they own, thus improving their regulatory vintages has been added to the collateral pools. At December 31, capital position. These derivatives are generally expected to 2007, U.S. residential mortgage subprime collateral of 2006 and terminate at no additional cost to the counterparty upon the 2007 vintages comprised approximately 4.9 percent of the total counterparty’s adoption of models compliant with the Basel II collateral pools underlying the entire portfolio of CDOs with credit Accord. AIG expects that the majority of these transactions will protection. terminate within the next 12 to 18 months. As of February 26, AIGFP has written maturity-shortening puts that allow the 2008, approximately $54 billion in notional exposures have either holders of the securities issued by certain multi-sector CDOs to been terminated or are in the process of being terminated. AIGFP treat the securities as eligible short-term 2a-7 investments under was not required to make any payments as part of these the Investment Company Act of 1940 (2a-7 Puts). Holders of terminations and in certain cases was paid a fee upon termina- securities are permitted, in certain circumstances, to tender their tion. In light of this experience to date and after other comprehen- securities to the issuers at par. If an issuer’s remarketing agent sive analyses, AIG did not recognize an unrealized market is unable to resell the securities so tendered, AIGFP must valuation adjustment for this regulatory capital relief portfolio for purchase the securities at par as long as the securities have not the year ended December 31, 2007. AIG will continue to assess experienced a default. During 2007, AIGFP repurchased securities the valuation of this portfolio and monitor developments in the with a principal amount of approximately $754 million pursuant to marketplace. There can be no assurance that AIG will not these obligations. In certain transactions, AIGFP has contracted recognize unrealized market valuation losses from this portfolio in with third parties to provide liquidity for the notes if they are put future periods. In addition to writing credit protection on the super to AIGFP for up to a three-year period. Such liquidity facilities senior risk layer on designated portfolios of loans or debt totaled approximately $3 billion at December 31, 2007. As of securities, AIGFP also wrote protection on tranches below the February 26, 2008, AIGFP has not utilized these liquidity facilities. super senior risk layer. At December 31, 2007 the notional At December 31, 2007, AIGFP had approximately $6.5 billion of amount of the credit default swaps in the regulatory capital relief notional exposure on 2a-7 Puts, included as part of the multiportfolio written on tranches below the super senior risk layer was sector CDO portfolio discussed herein. $5.8 billion, with an estimated fair value of $(25) million. As of January 31, 2008, a significant majority of AIGFP’s super AIGFP has also written credit protection on the super senior senior exposures continued to have tranches below AIGFP’s risk layer of diversified portfolios of investment grade corporate attachment point that have been explicitly rated AAA or, in AIGFP’s debt, collateralized loan obligations (CLOs) and multi-sector CDOs. judgment, would have been rated AAA had they been rated. AIGFP is at risk only on the super senior portion related to a AIGFP’s portfolio of credit default swaps undergoes regular diversified portfolio of credits referenced to loans or debt monitoring, modeling and analysis and contains protection through securities. The super senior risk portion is the last tranche to collateral subordination. 164 AIG 2007 Form 10-K
American International Group, Inc. and Subsidiaries 8. Derivatives and Hedge Accounting Continued 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 deteriorat- ing 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. 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 the likelihood of AIGFP having a payment obligation under the transaction to be greater than super senior risk. Other Derivative Users AIG and its subsidiaries (other than AIGFP) also use derivatives and other instruments as part of their financial risk management programs. Interest rate derivatives (such as interest rate swaps) are used to manage interest rate risk associated with investments in fixed income securities, commercial paper issuances, medium- and long-term note offerings, and other interest rate sensitive assets and liabilities. In addition, foreign exchange derivatives (principally cross currency swaps, forwards and options) are used to economically mitigate risk associated with non-U.S. dollar denominated debt, net capital exposures and foreign exchange transactions. The derivatives are effective economic hedges of the exposures they are meant to offset. In 2007, AIG and its subsidiaries other than AIGFP designated certain derivatives as either fair value or cash flow hedges of their debt. The fair value hedges included (i) interest rate swaps that were designated as hedges of the change in the fair value of fixed rate debt attributable to changes in the benchmark interest rate and (ii) foreign currency swaps designated as hedges of the change in fair value of foreign currency denominated debt attributable to changes in foreign exchange rates and/or the benchmark interest rate. With respect to the cash flow hedges, (i) interest rate swaps were designated as hedges of the changes in cash flows on floating rate debt attributable to changes in the benchmark interest rate, and (ii) foreign currency swaps were designated as hedges of changes in cash flows on foreign AIG 2007 Form 10-K 165
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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 167 and 168: American International Group, Inc.
Page 191 and 192: Index of Notes to Consolidated Fina
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SHAREHOLDER INFORMATION Corporate H
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