AIG 2005 Annual Report Download - page 82

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
ESTIMATED GROSS PROFITS (LIFE INSURANCE & Operating Review
RETIREMENT SERVICES):
General Insurance Operations
Estimated gross profits to be realized over the estimated
duration of the contracts (investment-oriented products) affect AIG’s General Insurance subsidiaries are multiple line compa-
the carrying value of deferred policy acquisition costs under nies writing substantially all lines of property and casualty
FAS 97. Estimated gross profits include investment income and insurance both domestically and abroad. See ‘‘General Insur-
gains and losses on investments less required interest, actual ance Operations’’ in Item 1. Business for more information
mortality and other expenses. relating to General Insurance subsidiaries.
DEFERRED POLICY ACQUISITION COSTS (LIFE As previously noted, AIG believes it should present and
INSURANCE & RETIREMENT SERVICES): discuss its financial information in a manner most meaningful
mRecoverability based on current and future expected profit- to its investors. Accordingly, in its General Insurance business,
ability, which is affected by interest rates, foreign exchange AIG uses certain non-GAAP measures, where AIG has
rates, mortality experience, and policy persistency. determined these measurements to be useful and meaningful.
A critical discipline of a successful general insurance
DEFERRED POLICY ACQUISITION COSTS (GENERAL business is the objective to produce operating income from
INSURANCE): underwriting exclusive of investment-related income. When
mRecoverability and eligibility based upon the current terms underwriting is not profitable, premiums are inadequate to pay
and profitability of the underlying insurance contracts. for insured losses and underwriting related expenses. In these
situations, the addition of general insurance related investment
FAIR VALUE DETERMINATIONS OF CERTAIN ASSETS income and realized capital gains may, however, enable a
AND LIABILITIES (FINANCIAL SERVICES): general insurance business to produce operating income. For
mValuation models: utilizing factors, such as market liquidity these reasons, AIG views underwriting profit to be critical in
and current interest, foreign exchange and volatility rates. the overall evaluation of performance. Although in and of
mPricing data: AIG attempts to secure reliable and indepen- itself not a GAAP measurement, AIG believes that underwrit-
dent current market price data, such as published exchange ing profit is a useful and meaningful disclosure. See also the
rates from external subscription services such as Bloomberg discussion under ‘‘Liquidity’’ herein.
or Reuters or third-party broker quotes for use in its models. Underwriting profit is measured in two ways: statutory
When such prices are not available, AIG uses an internal underwriting profit and GAAP underwriting profit.
methodology, which includes interpolation and extrapola- Statutory underwriting profit is derived by reducing net
tion from verifiable prices from trades occurring on dates premiums earned by net losses and loss expenses incurred and
nearest to the dates of the transactions. net expenses incurred. Statutory accounting generally requires
immediate expense recognition and ignores the matching of
OTHER-THAN-TEMPORARY DECLINES IN THE VALUE revenues and expenses as required by GAAP. That is, for
OF INVESTMENTS: statutory purposes, expenses are recognized immediately, not
over the same period that the revenues are earned.
Securities are considered a candidate for other-than-temporary
GAAP accounting requires the recognition of expenses at
impairment based upon the following criteria:
the same time revenues are earned, the accounting principle of
mTrading at a significant (25 percent or more) discount to par
matching. Therefore, to convert underwriting results to a
or amortized cost (if lower) for an extended period of time
GAAP basis, acquisition expenses are deferred (deferred policy
(nine months or longer).
acquisition costs (DAC)) and amortized over the period the
mThe occurrence of a discrete credit event resulting in the
related net premiums written are earned. Accordingly, the
debtor defaulting or seeking bankruptcy or insolvency
statutory underwriting profit has been adjusted as a result of
protection or voluntary reorganization.
acquisition expenses being deferred as required by GAAP.
mThe probability of non-realization of a full recovery on its
DAC is reviewed for recoverability, and such review requires
investment, irrespective of the occurrence of one of the
management judgment. See also ‘‘Critical Accounting Esti-
foregoing events.
mates’’ herein and Notes 1 and 4 of Notes to Consolidated
FLIGHT EQUIPMENT — RECOVERABILITY (FINANCIAL Financial Statements.
SERVICES) AIG, along with most General Insurance companies, uses
the loss ratio, the expense ratio and the combined ratio as
mExpected undiscounted future net cash flows: based upon measures of underwriting performance. The loss ratio is the
current lease rates, projected future lease rates and estimated sum of losses and loss expenses incurred divided by net
terminal values of each aircraft based on third party premiums earned. The expense ratio is statutory underwriting
information. expenses divided by net premiums written. The combined ratio
is the sum of the loss ratio and the expense ratio. These ratios
are relative measurements that describe, for every $100 of net
premiums earned or written, the cost of losses and statutory
expenses, respectively. The combined ratio presents the total
30 AIG m Form 10-K