AIG 2005 Annual Report Download - page 108

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
varying degrees of credit risk. At December 31, 2005, the discussions under ‘‘Capital Resources’’ herein and Note 20 of
average credit rating of this portfolio was AA+ or the Notes to Consolidated Financial Statements.
equivalent thereto as determined through rating agencies or Trading securities, at market value, and securities and spot
internal review. AIGFP has also entered into credit derivative commodities sold but not yet purchased, at market value, are
transactions to economically hedge its credit risk associated marked to market daily with the unrealized gain or loss being
with $125 million of these securities. Securities deemed below recognized in income at that time. These trading securities are
investment grade at December 31, 2005 amounted to approxi- held to meet the short-term risk management objectives of
mately $166 million in fair value representing 0.4 percent of Capital Markets operations.
the total AIGFP securities available for sale. There have been The gross unrealized gains and gross unrealized losses of
no significant downgrades through March 1, 2006. If its Capital Markets operations included in the financial services
securities available for sale portfolio were to suffer significant assets and liabilities at December 31, 2005 were as follows:
default and the collateral held declined significantly in value
with no replacement or the credit default swap counterparty Gross Gross
failed to perform, AIGFP could have a liquidity strain. AIG Unrealized Unrealized
(in millions) Gains Losses
guarantees AIGFP’s payment obligations, including its debt
obligations. Securities available for sale, at market
value(a) $ 802 $ 863
AIGFP’s risk management objective is to minimize interest Unrealized gain/loss on swaps, options
rate, currency, commodity and equity risks associated with its and forward transactions(b) 18,695 12,740
securities available for sale. That is, when AIGFP purchases a (a) See also Note 8(h) of Notes to Consolidated Financial Statements.
security for its securities available for sale investment portfolio, (b) These amounts are also presented as the respective balance sheet
it simultaneously enters into an offsetting internal hedge such amounts.
that the payment terms of the hedging transaction offset the
payment terms of the investment security, which achieves the The senior management of AIG defines the policies and
economic result of converting the return on the underlying establishes general operating parameters for Capital Markets
security to U.S. dollar LIBOR plus or minus a spread based on operations. AIG’s senior management has established various
the underlying profit on each security on the initial trade date. oversight committees to review the various financial market,
The market risk associated with such internal hedges is operational and credit issues of the Capital Markets operations.
managed on a portfolio basis, with third-party hedging transac- The senior management of AIGFP reports the results of its
tions executed as necessary. As hedge accounting treatment is operations to and reviews future strategies with AIG’s senior
not achieved in accordance with FAS 133, the unrealized gains management.
and losses on the securities related economic hedges are AIGFP actively manages the exposures to limit potential
reflected in operating income, whereas the unrealized gains and losses, while maximizing the rewards afforded by these business
losses on the underlying securities resulting from changes in opportunities. In doing so, AIGFP must continually manage a
interest rates, currency rates, commodity and equity prices, are variety of exposures including credit, market, liquidity, opera-
recorded in accumulated other comprehensive income. When a tional and legal risks.
security is sold, the related hedging transaction is terminated, AIGFP held a large portfolio of privately negotiated
and the realized gain or loss with respect to this security is financing transactions with institutional counterparties in the
then recorded in operating income. United Kingdom. Certain provisions in the UK Finance Bill
Securities purchased under agreements to resell are treated that was published by the House of Commons on March 22,
as collateralized financing transactions. AIGFP takes possession 2005 caused AIGFP’s counterparties to exercise early unwind
of or obtains a security interest in securities purchased under rights and terminate these transactions during the first and
agreements to resell. AIGFP further minimizes its credit risk by second quarters of 2005. Although the unwinding of these
monitoring counterparty credit exposure and, when it deems transactions did not cause AIGFP to suffer any losses, the
necessary, it requires additional collateral to be deposited. unwinds did result in AIGFP not realizing spread income that
AIGFP also conducts, as principal, trading activities in AIGFP expected it would have realized had the transactions
foreign exchange, and commodities, primarily precious metals. remained outstanding. The aggregate reduction in 2005 operat-
AIGFP owns inventories in the commodities, which it records ing income attributable to such foregone accrual earnings was
at the lower of cost or market, in which it trades and may approximately $75 million.
reduce the exposure to market risk through the use of swaps, Asset Management Operations
forwards, futures, and option contracts. AIGFP uses derivatives
to manage the economic exposure of its various trading AIG’s Asset Management operations comprise a wide variety of
positions and transactions from adverse movements of interest investment-related services and investment products including
rates, foreign currency exchange rates and commodity prices. institutional and retail asset management, broker dealer ser-
AIGFP supports its trading activities largely through trading vices and spread-based investment business from the sale of
liabilities, unrealized losses on swaps, short-term borrowings, GICs. Such services and products are offered to individuals and
securities sold under agreements to repurchase and securities institutions both domestically and overseas.
and commodities sold but not yet purchased. See also the
56 AIG m Form 10-K