AIG 2005 Annual Report Download - page 180

Notes to Consolidated Financial Statements Continued
Risks arise as a result of movements in current market prices
20. Derivatives
from contracted prices, and the potential inability of the
Continued
counterparties to meet their obligations under the contracts.
options, AIGFP generally receives an option premium and At December 31, 2005, the contractual amount of Capital
then manages the risk of any unfavorable change in the value Markets futures, forward and option contracts approximated
of the underlying commodity, currency or index by entering $321.1 billion.
into offsetting transactions with third-party market participants.
The following table presents Capital Markets futures, forward and option contracts portfolio by maturity and type of derivative at
December 31, 2005 and 2004:
Remaining Life
One Two Through Six Through After Ten Total Total
(in millions) Year Five Years Ten Years Years 2005 2004
Futures, forward and options contracts:
Exchange traded futures and options contracts
contractual amount $ 19,182 $ 4,768 $1,287 $61 $ 25,298 $ 27,456
Over the counter forward contracts
contractual amount 287,894 7,017 867 – 295,778 277,935
Total $307,076 $11,785 $2,154 $61 $321,076 $305,391
AIGFP enters into credit derivative transactions in the 11 percent first loss threshold amount and thereby bear risk
ordinary course of its business. The majority of AIGFP’s credit that is senior to the AAA-rated risk layer.
derivatives require AIGFP to provide credit protection on a AIGFP continually monitors the underlying portfolios to
designated portfolio of loans or debt securities. AIGFP provides determine whether the credit loss experience for any particular
such credit protection on a ‘‘second loss’’ basis, under which portfolio has caused the likelihood of AIGFP having a
AIGFP’s payment obligations arise only after credit losses in payment obligation under the transaction to be greater than
the designated portfolio exceed a specified threshold amount or super senior risk. AIGFP maintains the ability opportunistically
level of ‘‘first losses.’’ The threshold amount of credit losses to economically hedge specific securities in a portfolio and
that must be realized before AIGFP has any payment obliga- thereby further limit its exposure to loss and has hedged
tion is negotiated by AIGFP for each transaction to provide outstanding transactions in this manner on occasion. AIGFP
that the likelihood of any payment obligation by AIGFP under has never had a payment obligation under these credit
each transaction is remote, even in severe recessionary market derivatives transactions where AIGFP is providing credit
scenarios. protection on the super senior risk. Furthermore, based on
In certain cases, the credit risk associated with a designated portfolio credit losses experienced as of December 31, 2005
portfolio is tranched into different layers of risk, which are under all such outstanding transactions, no transaction has
then analyzed and rated by the credit rating agencies. experienced credit losses in an amount that has made the
Typically, there will be an equity layer covering the first credit likelihood of AIGFP having to make a payment, in AIGFP’s
losses in respect of the portfolio up to a specified percentage of view, to be greater than remote, even in severe recessionary
the total portfolio, and then successive layers that are rated, market scenarios. At December 31, 2005, the notional amount
generally a BBB-rated layer, an A-rated layer, an AA-rated with respect to the Capital Markets credit derivative portfolio
layer, and an AAA-rated layer. In transactions that are rated, (including the super senior transactions) was $387.2 billion.
the risk layer or tranche that is immediately junior to the AIGFP utilizes various credit enhancements, including
threshold level above which AIGFP’s payment obligation letters of credit, guarantees, collateral, credit triggers, credit
would generally arise is rated AAA by the rating agencies. In derivatives, and margin agreements to reduce the credit
transactions that are not rated, AIGFP applies the same risk exposure relating to derivative financial instruments. AIGFP
criteria for setting the threshold level for its payment requires credit enhancements in connection with specific
obligations. Therefore the risk layer assumed by AIGFP with transactions based on, among other things, the creditworthiness
respect to the designated portfolio in these transactions is often of the counterparties, and the transaction’s size and maturity.
called the ‘‘super senior’’ risk layer, defined as the layer of In addition, Capital Markets derivative transactions are gener-
credit risk senior to a risk layer that has been rated AAA by ally documented under ISDA Master Agreements. Management
the credit rating agencies or if the transaction is not rated, believes that such agreements provide for legally enforceable
equivalent thereto. For example, in a transaction with an set-off and close-out netting of exposures to specific
equity layer covering credit losses from zero to two percent of counterparties. Under such agreements, in connection with an
the total portfolio, a BBB-rated layer covering credit losses early termination of a transaction, AIGFP is permitted to set-
from two to four percent, an A-rated layer from four to off its receivables from a counterparty against its payables to
six percent, an AA-rated layer from six to eight percent, and a the same counterparty arising out of all included transactions.
AAA-rated layer from eight to 11 percent. AIGFP would cover As a result, the fair value represents the net sum of estimated
credit losses arising in respect of the portfolio that exceeded an positive fair values after the application of such strategies and
128 AIG m Form 10-K