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ITEM 8 / NOTE 6. FAIR VALUE MEASUREMENTS.....................................................................................................................................................................................interest rates for receivables measured at fair value. This methodology considers such factors as the coupon rateand yield curves.Separate Account Assets..............................................................................................................................................................................................Separate account assets are composed primarily of registered and unregistered open-end mutual funds thatgenerally trade daily and are measured at fair value in the manner discussed above for equity securities traded inactive markets.Freestanding Derivatives..............................................................................................................................................................................................Derivative assets and liabilities can be exchange-traded or traded over-the-counter (OTC). We generally valueexchange-traded derivatives such as futures and options using quoted prices in active markets for identicalderivatives at the balance sheet date.OTC derivatives are valued using market transactions and other market evidence whenever possible, includingmarket-based inputs to models, model calibration to market clearing transactions, broker or dealer quotations oralternative pricing sources with reasonable levels of price transparency. When models are used, the selection of aparticular model to value an OTC derivative depends on the contractual terms of, and specific risks inherent in theinstrument, as well as the availability of pricing information in the market. We generally use similar models to valuesimilar instruments. Valuation models require a variety of inputs, including contractual terms, market prices and rates,yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs. For OTCderivatives that trade in liquid markets, such as generic forwards, swaps and options, model inputs can generally becorroborated by observable market data by correlation or other means, and model selection does not involvesignificant management judgment.For certain OTC derivatives that trade in less liquid markets, where we generally do not have corroborating marketevidence to support significant model inputs and cannot verify the model to market transactions, the transaction pricemay provide the best estimate of fair value. Accordingly, when a pricing model is used to value such an instrument,the model is adjusted so the model value at inception equals the transaction price. We will update valuation inputs inthese models only when corroborated by evidence such as similar market transactions, third party pricing servicesand/or broker or dealer quotations, or other empirical market data. When appropriate, valuations are adjusted forvarious factors such as liquidity, bid/offer spreads and credit considerations. Such adjustments are generally basedon available market evidence. In the absence of such evidence, management’s best estimate is used.Embedded Policy Derivatives..............................................................................................................................................................................................Certain variable annuity and equity-indexed annuity and life contracts contain embedded policy derivatives that webifurcate from the host contracts and account for separately at fair value, with changes in fair value recognized inearnings. We have concluded these contracts contain (i) written option guarantees on minimum accumulation value,(ii) a series of written options that guarantee withdrawals from the highest anniversary value within a specific periodor for life, or (iii) equity-indexed written options that meet the criteria of derivatives that must be bifurcated.The fair value of embedded policy derivatives contained in certain variable annuity and equity-indexed annuity andlife contracts is measured based on actuarial and capital market assumptions related to projected cash flows over theexpected lives of the contracts. These cash flow estimates primarily include benefits and related fees assessed,when applicable, and incorporate expectations about policyholder behavior. Estimates of future policyholder behaviorare subjective and based primarily on our historical experience.With respect to embedded policy derivatives in our variable annuity contracts, because of the dynamic and complexnature of the expected cash flows, risk neutral valuations are used. Estimating the underlying cash flows for theseproducts involves judgments regarding expected market rates of return, market volatility, correlations of market indexreturns to funds, fund performance, discount rates and policyholder behavior. With respect to embedded policyderivatives in our equity-indexed annuity and life contracts, option pricing models are used to estimate fair value,taking into account assumptions for future equity index growth rates, volatility of the equity index, future interest..................................................................................................................................................................................................................................236 AIG 2012 Form 10-K