AIG 2005 Annual Report Download - page 119

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
tax adjusted future flight equipment lease revenue, and the the derivatives portfolio. The results from these analyses are
financial instrument liabilities which included the future regularly reviewed by AIG management.
servicing of the current debt. The estimated effect of the As described above, Capital Markets operations are exposed
current derivative positions was also taken into account. to the risk of loss of fair value from adverse fluctuations in
AIG calculated the VaR with respect to the net fair value interest rate and foreign currency exchange rates and equity
of Aircraft Finance operations using the historical simulation and commodity prices as well as implied volatilities thereon.
methodology, as previously described. For the years 2005 and AIG statistically measures the losses of fair value through the
2004, the average VaR with respect to the net fair value of application of a VaR model across Capital Markets.
Aircraft Finance operations was approximately $135 million Capital Markets asset and liability portfolios for which the
and $70 million, respectively. VaR analyses were performed included over the counter and
Capital Markets operations are exposed to market risk due exchange traded investments, derivative instruments and com-
to changes in the level and volatility of interest rates, foreign modities. Because the market risk with respect to securities
currency exchange rates, equity prices and commodity prices. available for sale, at market, is substantially hedged, segregation
AIGFP hedges its exposure to these risks primarily through of market sensitive instruments into trading and other than
swaps, options, forwards, and futures. To economically hedge trading was not deemed necessary. The VaR calculation is
interest rate risks, AIGFP may also purchase U.S. and foreign unaffected by the accounting treatment of hedged transactions
government obligations. under FAS 133.
AIGFP does not seek to manage the market risk of each In the calculation of VaR for Capital Markets operations,
transaction through an individual third-party offsetting transac- AIG uses the same historical simulation methodology, de-
tion. Rather, AIGFP takes a portfolio approach to the scribed under Insurance above, which entails repricing all
management of its market risk exposures. AIGFP values the assets and liabilities under explicit changes in market rates
predominant portion of its market-sensitive transactions by within a specific historical time period. In 2004, AIGFP
marking them to market currently through income. A smaller enhanced its library of factors by including implied option
portion is priced by estimated fair value based upon an volatilities to construct the historical scenarios for simulation.
extrapolation of market factors. There is another limited The following table presents the VaR on a combined basis and
portion of transactions where the initial fair value is not of each component of market risk for Capital Markets
recorded through income currently and gains or losses are operations as of December 31, 2005 and 2004. Due to
recognized over the life of the transactions. These valuations diversification effects, the combined VaR is always smaller
represent an assessment of the present values of expected than the sum of its components.
future cash flows and may include reserves for such risks as are
deemed appropriate by AIGFP and AIG management. (in millions) 2005 2004
The recorded values of these transactions may be different Combined $22 $17
from the values that might be realized if AIGFP were required Interest rate 911
to sell or close out the transactions prior to maturity. AIG Currency 34
believes that such differences are not significant to financial Equity 14 16
condition or liquidity. Such differences would be immediately Commodity 97
recognized when the transactions are sold or closed out prior to
maturity. The following table presents the average, high, and low VaRs
AIGFP attempts to secure reliable and independent current on a combined basis and of each component of market risk
market prices, such as published exchange prices, external for Capital Markets operations for the years 2005 and 2004.
subscription services such as from Bloomberg or Reuters or Due to diversification effects, the combined VaR is always
third-party broker quotes for use in this model. When such smaller than the sum of its components.
prices are not available, AIGFP uses an internal methodology
which includes extrapolation from observable and verifiable 2005 2004
prices nearest to the dates of the transactions. Historically, (in millions) Average High Low Average High Low
actual results have not materially deviated from these models Combined $ 17 $22 $13 $19 $24 $13
in any material respect. Interest rate 911 6 912 5
Systems used by Capital Markets operations can monitor Currency 463 443
each unit’s respective market positions on an intraday basis. Equity 916 5 13 16 5
Commodity 810 7 674
AIGFP operates in major business centers overseas and
therefore is open for business essentially 24 hours a day. Thus,
the market exposure and offset strategies are monitored, Recent Accounting Standards
reviewed and coordinated around the clock.
In December 2003, FASB issued a revision to Interpretation
AIGFP applies various testing techniques which reflect
No. 46 (FIN46R). In March 2005, FASB issued
significant potential market movements in interest rates,
FSP FIN46R-5, ‘‘Implicit Variable Interests under FASB
foreign exchange rates, commodity and equity prices, volatility
Interpretation No. 46 (revised December 2003), Consolidation
levels, and the effect of time. These techniques vary by
currency and are regularly changed to reflect factors affecting
AIG m Form 10-K 67