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 and the adoption of FAS No. 157, ‘‘Fair Value Measurements’’ distribution opportunities and operational efficiencies pending (FAS 157). Life Insurance & Retirement Services elected the fair regulatory approval. value option under FAS No. 159, ‘‘The Fair Value Option for Full deregulation of banks in Japan with respect to insurance Financial Assets and Financial Liabilities’’ (FAS 159), for two product sales became effective in December 2007, and AIG products beginning January 1, 2008 - a closed block of single expects that it will be able to leverage its existing bank premium variable life business in Japan and an investment-linked relationships and innovative product expertise to expand sales of life insurance product sold principally in Asia. After adoption on both life and accident and health products in 2008. Deregulation January 1, 2008, subsequent changes in fair value for these of Japan Post is also expected to provide additional growth products will be reported in operating income. The adoption of opportunities during 2008 and beyond. FAS 159 for these products is expected to result in a decrease to Although the Japanese Yen strengthened in the fourth quarter opening 2008 retained earnings of approximately $600 million. of 2007, historical volatility of Japanese Yen-dollar exchange rates For a description of these accounting standards, see Note 1 to has resulted in higher than normal surrenders, and if that trend Consolidated Financial Statements. returns, an acceleration of the amortization of deferred policy Life Insurance & Retirement Services uses various derivative acquisition costs could occur. instruments to hedge cash flows related to certain foreign Outside of Japan, ALICO continues to execute its strategy of currencies and fixed income related instruments. Although these diversifying distribution channels and developing new products. In derivatives are purchased to mitigate the economic effect of particular, ALICO’s Central and Eastern European operations movements in foreign exchange rates and interest rates, reported performed well and demographic and economic conditions in earnings may be volatile due to certain hedges not qualifying for these countries provide excellent opportunities for continued hedge accounting under FAS 133. The change in fair value of growth. derivative instruments is reported in net realized capital gains AIG’s operations in China continue to expand, but AIG expects (losses). Life Insurance & Retirement Services engages in hedging competition in China to remain strong. AIG’s success in China will programs that use derivatives and other instruments to hedge the depend on its ability to execute its growth strategy. Key growth guaranteed living benefits associated with variable products. strategies in 2008 include expansion of sales and service Nevertheless, short-term market movements will vary from long- centers, increased bank distribution and entering into strategic term expectations underlying the product pricing assumptions and alliances with key partners. In Southeast Asia, AIG’s operations may cause volatility in reported earnings. The inclusion of risk are focused on growing market share and profits in Singapore, margins in the valuation of embedded derivatives under FAS 157 Malaysia, Thailand and Hong Kong with products focused on the will increase earnings volatility as differences emerge between the life savings-oriented consumer along with high net worth consumchange in fair value of embedded derivatives and the change in ers through the newly formed Wealth Management Group. fair value of hedging instruments. As variable products with Domestically, AIG plans to continue expansion of its Life guaranteed living benefits continue to grow, the reported earnings Insurance & Retirement Services businesses through direct volatility associated with these programs will likely increase. marketing and independent agent distribution channels. The aging Life Insurance & Retirement Services may continue to experi- population in the United States provides a growth opportunity for ence volatility in net realized capital gains (losses) due to other- a variety of products, including longevity, guaranteed income and than-temporary impairment writedowns of the fair value of invest- supplemental accident and health products. Certain other demoments, primarily related to the significant disruption in the graphic groups that have traditionally been underserved provide residential mortgage and credit markets and foreign currency additional growth opportunities. The Domestic Life Insurance related losses. operations showed positive momentum in the second half of 2007 In Japan, given AIG’s multi-channel, multi-product strategy, AIG resulting from new products and expanded distribution. Domestic expects its Life Insurance & Retirement Services operations to group life/health operations continue to face competitors with exceed industry growth in the long term, although downward greater scale in group benefits. pressure on earnings growth rates is anticipated due to the The fixed annuities business experienced a difficult year as difficult market conditions. Market conditions remain challenging surrenders increased in 2007 due to both an increasing number as a result of increased competition due to new market entrants, of policies coming out of their surrender charge period and the increasing financial strength of the domestic companies as increased competition from bank deposit products. While surrenthe economy has recovered, the effect of additional regulatory ders are expected to continue to be higher than normal, the oversight, changes to the tax deductibility of insurance premiums current interest rate environment should provide opportunities for and the regulatory claims review which has negatively affected improvements in net flows during 2008. AIG believes that consumer perceptions of the industry. While the market shift to improvement in net flows in the individual variable annuity market variable products with living benefits will constrain fixed annuity will be driven by variable annuity products with living benefits while sales, AIG is positioned to grow annuity sales overall with its the group retirement products will continue to experience a shift annuity products designed to meet the needs of consumers in a from group annuities to lower margin mutual fund products. range of market conditions. In addition, AIG expects that the Since the beginning of 2000, the yield available on Taiwanese planned integration of AIG Star Life and AIG Edison Life, which is 10-year government bonds dropped from approximately 6 percent anticipated to be completed in 2009, will provide enhanced to less than 3 percent at December 31, 2007. Yields on most 32 AIG 2007 Form 10-K
American International Group, Inc. and Subsidiaries next 12 to 18 months by AIGFP’s counterparties as they implement models compliant with the new Basel II Accord. As of February 26, 2008, $54 billion in notional exposures have either been terminated or are in the process of being terminated. AIGFP was not required to make any payments as part of these terminations and in certain cases was paid a fee upon termination. In light of this experience to date and after other comprehensive analyses, AIG did not recognize an unrealized market valuation adjustment for this regulatory capital relief portfolio for the year ended December 31, 2007. AIG will continue to assess the valuation of this portfolio and monitor developments in the marketplace. There can be no assurance that AIG will not recognize unrealized market valuation losses from this portfolio in future periods. These transactions contributed approximately $210 million to AIGFP’s revenues in 2007. If AIGFP is not successful in replacing the revenues generated by these transactions, AIGFP’s operating results could be materially adversely affected. For additional information on the AIGFP super senior credit default swap portfolio, see Risk Management — Segment Risk Management — Financial Services — Capital Markets Deriva- tive Transactions and Note 8 to Consolidated Financial Statements. In March 2007, the U.S. Treasury Department published proposed regulations that, had they been adopted in 2007, would have had the effect of limiting the ability of AIG to claim foreign tax credits with respect to certain transactions entered into by AIGFP. AIGFP is no longer a participant in those transactions and therefore, the proposed regulations, if adopted in their current form in 2008 or subsequent years, would not be expected to have any material effect on AIG’s ability to claim foreign tax credits. Effective January 1, 2008, AIGFP elected to apply the fair value option to all eligible assets and liabilities, other than equity method investments. The adoption of FAS 159 with respect to elections made by AIGFP is currently being evaluated for the effect of recently issued draft guidance by the FASB, anticipated to be issued in final form in early 2008, and its potential effect on AIG’s consolidated financial statements. other invested assets have correspondingly dropped over the same period. New regulatory capital requirements being developed in Taiwan, combined with growth opportunities in bancassurance and variable annuities with living benefits, may potentially create a need for capital contributions in 2008 and beyond to support local solvency requirements. Financial Services Within Financial Services, demand for International Lease Finance Corporation (ILFC’s) modern, fuel efficient aircraft remains strong, and ILFC plans to increase its fleet by purchasing 73 aircraft in 2008. However, ILFC’s margins may be adversely affected by increases in interest rates. AIG Financial Products Corp. and AIG Trading Group Inc. and their respective subsidiaries (collectively, AIGFP) expect opportunities for growth across their product segments, but AIGFP is a transaction-oriented business, and its operating results will depend to a significant extent on actual transaction flow, which is affected by market conditions and other variables outside its control. AIG continues to explore opportunities to expand its Consumer Finance operations into new domestic and foreign markets. The ongoing disruption in the U.S. residential mortgage and credit markets and the recent downgrades of residential mortgage- backed securities and CDO securities by rating agencies continue to adversely affect the fair value of the super senior credit default swap portfolio written by AIGFP. AIG expects that continuing limitations on the availability of market observable data will affect AIG’s determinations of the fair value of these derivatives, including by preventing AIG, for the foreseeable future, from recognizing the beneficial effect of the differential between credit spreads used to price a credit default swap and spreads implied from prices of the CDO bonds referenced by such swap. The fair value of these derivatives is expected to continue to fluctuate, perhaps materially, in response to changing market conditions, and AIG’s estimates of the value of AIGFP’s super senior credit derivative portfolio at future dates could therefore be materially different from current estimates. AIG continues to believe that the unrealized market valuation losses recorded on the AIGFP super senior credit default swap portfolio are not indicative of the losses AIGFP may realize over time. Under the terms of most of these credit derivatives, losses to AIG would generally result from the credit impairment of the referenced CDO bonds that AIG would acquire in satisfying its swap obligations. Based upon its most current analyses, AIG believes that any credit impairment losses realized over time by AIGFP will not be material to AIG’s consolidated financial condition, although it is possible that such realized losses could be material to AIG’s consolidated results of operations for an individual reporting period. Except to the extent of any such credit impairment losses, AIG expects the unrealized market valuation losses to reverse over the remaining life of the super senior credit default swap portfolio. Approximately $379 billion of the $527 billion in notional exposure on AIGFP’s super senior credit default swap portfolio as of December 31, 2007 were written to facilitate regulatory capital relief for financial institutions primarily in Europe. AIG expects that the majority of these transactions will be terminated within the Asset Management In the Spread-Based Investment business, the Guaranteed Invest- ment Contract (GIC) portfolio continues to run off and was replaced by the Matched Investment Program (MIP). The results from domestic GICs and the MIP have been adversely affected by the ongoing disruption in the credit markets, the weakening U.S. dollar and declining interest rates. The MIP is exposed to credit and market risk in the form of investments in, among other asset classes, U.S. residential mortgage-backed securities, asset- backed securities, commercial mortgage-backed securities and single name corporate credit default swaps entered into by the MIP. In addition, earnings volatility for the MIP may arise from investments in bank loans that are held for future collateralized loan obligations to be managed by AIG Investments. The value of the investments may fluctuate materially from period to period due to market movements, which may result in realized and unrealized net losses. Although it is difficult to estimate future movements in these markets, effective hedges exist to mitigate the effect of AIG 2007 Form 10-K 33
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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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Index of Notes to Consolidated Fina
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SHAREHOLDER INFORMATION Corporate H
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