2007 Annual Report - AIG.com

American International Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements Continued
8. Derivatives and Hedge Accounting
instruments are not clearly and closely related to those of the
Continued
remaining components of the financial instrument; (ii) the contract
that embodies both the embedded derivative instrument and the
currency denominated debt attributable to changes in the benchhost
contract is not remeasured at fair value; and (iii) a separate
mark interest rate and foreign exchange rates.
instrument with the same terms as the embedded instrument
AIG assesses, both at the hedge’s inception and on an
meets the definition of a derivative under FAS 133.
ongoing basis, whether the derivatives used in hedging transactions
are highly effective in offsetting changes in fair values or
9. Reserve for Losses and Loss Expenses and
cash flows of hedged items. Regression analysis is employed to
Future Life Policy Benefits and Policyholders’
assess the effectiveness of these hedges both on a prospective
Contract Deposits
and retrospective basis. AIG does not utilize the shortcut,
matched terms or equivalent methods to assess hedge
The following analysis provides a reconciliation of the
effectiveness.
activity in the reserve for losses and loss expenses:
The change in fair value of derivatives designated and effective
as fair value hedges along with the gain or loss on the hedged
Years Ended December 31,
(in millions) 2007 2006 2005
item are recorded in current period earnings. Upon discontinuation
At beginning of year:
of hedge accounting, the cumulative adjustment to the carrying
Reserve for losses and loss
value of the hedged item resulting from changes in the benchmark
expenses $79,999 $ 77,169 $ 61,878
interest rate or exchange rate is amortized into income using the
Reinsurance recoverable (17,369) (19,693) (14,624)
effective yield method over the remaining life of the hedged item.
Amounts excluded from the assessment of hedge effectiveness Total 62,630 57,476 47,254
are recognized in current period earnings. During the year ended Foreign exchange effect 955 741 (628)
December 31, 2007, AIG recognized a loss of $1 million in
Acquisitions (a) 317 55 —
earnings related to the ineffective portion of the hedging instru- Losses and loss expenses
ments. During the year ended December 31, 2007, AIG also
incurred:
recognized gains of $3 million related to the change in the Current year 30,261 27,805 28,426
hedging instruments forward points excluded from the assess- Prior years, other than
ment of hedge effectiveness. accretion of discount (656) (53) 4,680 (b)
The effective portion of the change in fair value of a derivative Prior years, accretion of
qualifying as a cash flow hedge is recorded in Accumulated other discount 327 300 (15)
comprehensive income (loss), until earnings are affected by the Total 29,932 28,052 33,091
variability of cash flows in the hedged item. The ineffective portion
Losses and loss expenses
of these hedges is recorded in net realized capital gains (losses).
paid:
During the year ended December 31, 2007, AIG recognized gains
Current year 9,684 8,368 7,331
of $1 million in earnings representing hedge ineffectiveness. At
Prior years 14,862 15,326 14,910
December 31, 2007, $36 million of the deferred net loss in
Accumulated other comprehensive income is expected to be
Total 24,546 23,694 22,241
recognized in earnings during the next 12 months. All components At end of year:
of the derivatives’ gains and losses were included in the
Net reserve for losses and
assessment of hedge effectiveness. There were no instances of loss expenses 69,288 62,630 57,476
the discontinuation of hedge accounting in 2007.
Reinsurance recoverable 16,212 17,369 19,693
In addition to hedging activities, AIG also uses derivative Total $85,500 $ 79,999 $ 77,169
instruments with respect to investment operations, which include,
(a) Reflects the opening balance with respect to the acquisition of WüBa
among other things, credit default swaps, and purchasing investand
the Central Insurance Co., Ltd. in 2007 and 2006, respectively.
ments with embedded derivatives, such as equity linked notes and
(b) Includes a fourth quarter charge of $1.8 billion resulting from the
convertible bonds. All changes in the fair value of these
annual review of General Insurance loss and loss adjustment reserves.
derivatives are recorded in earnings. AIG bifurcates an embedded
derivative where: (i) the economic characteristics of the embedded
166 AIG 2007 Form 10-K