AIG 2011 Annual Report Download - page 257

American International Group, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
•Counterparty Credit Risk. Fair value measurements for freestanding derivatives incorporate counterparty
credit by determining the explicit cost for AIG to protect against its net credit exposure to each counterparty
at the balance sheet date by reference to observable counterparty CDS spreads, when available. When not
available, other directly or indirectly observable credit spreads will be used to derive the best estimates of
the counterparty spreads. AIG’s net credit exposure to a counterparty is determined based on master netting
agreements, which take into consideration all derivative positions with the counterparty, as well as collateral
posted by the counterparty at the balance sheet date.
A CDS is a derivative contract that allows the transfer of third-party credit risk from one party to the other.
The buyer of the CDS pays an upfront and/or periodic premium to the seller. The seller’s payment obligation is
triggered by the occurrence of a credit event under a specified reference security and is determined by the loss on
that specified reference security. The present value of the amount of the upfront and/or periodic premium
therefore represents a market-based expectation of the likelihood that the specified reference party will fail to
perform on the reference obligation, a key market observable indicator of non-performance risk (the CDS spread).
Fair values for fixed maturity securities based on observable market prices for identical or similar instruments
implicitly incorporate counterparty credit risk. Fair values for fixed maturity securities based on internal models
incorporate counterparty credit risk by using discount rates that take into consideration cash issuance spreads for
similar instruments or other observable information.
The cost of credit protection is determined under a discounted present value approach considering the market
levels for single name CDS spreads for each specific counterparty, the mid market value of the net exposure
(reflecting the amount of protection required) and the weighted average life of the net exposure. CDS spreads are
provided to AIG by an independent third party. AIG utilizes an interest rate based on the benchmark London
Interbank Offered Rate (LIBOR) curve to derive its discount rates.
While this approach does not explicitly consider all potential future behavior of the derivative transactions or
potential future changes in valuation inputs, AIG believes this approach provides a reasonable estimate of the fair
value of the assets and liabilities, including consideration of the impact of non-performance risk.
Fixed Maturity Securities – Trading and Available for Sale
Whenever available, AIG obtains quoted prices in active markets for identical assets at the balance sheet date
to measure fixed maturity securities at fair value in its trading and available for sale portfolios. Market price data
is generally obtained from dealer markets.
Management is responsible for the determination of the value of the investments carried at fair value and the
supporting methodologies and assumptions. AIG employs independent third-party valuation service providers to
gather, analyze, and interpret market information in order to derive fair value estimates for individual investments,
based upon market-accepted methodologies and assumptions. The methodologies used by these independent third-
party valuation services are reviewed and understood by AIG management, via periodic discussion with and
information provided by the valuation services. In addition, as discussed further below, control processes are
applied to the fair values received from third-party valuation services to ensure the accuracy of these values.
Valuation service providers typically obtain data about market transactions and other key valuation model inputs
from multiple sources and, through the use of widely accepted valuation methodologies, which may utilize matrix
pricing, financial models, accompanying model inputs and various assumptions, provide a single fair value
measurement for individual securities. The inputs used by the valuation service providers include, but are not
limited to, market prices from completed transactions for identical securities and transactions for comparable
securities, benchmark yields, interest rate yield curves, credit spreads, currency rates, quoted prices for similar
securities and other market-observable information, as applicable. If fair value is determined using financial
models, these models generally take into account, among other things, market observable information as of the
measurement date as well as the specific attributes of the security being valued, including its term, interest rate,
AIG 2011 Form 10-K 243