AIG 2011 Annual Report Download - page 306

American International Group, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
counterparty credit risk and may be exposed to loss, if counterparties default. Currency, commodity and equity
swaps are similar to interest rate swaps but involve the exchange of specific currencies or cash flows based on the
underlying commodity, equity securities or indices. Also, they may involve the exchange of notional amounts at the
beginning and end of the transaction. Swaptions are options where the holder has the right but not the obligation
to enter into a swap transaction or cancel an existing swap transaction.
AIGFP follows a policy of minimizing interest rate, currency, commodity, and equity risks associated with
investment securities by entering into offsetting positions, thereby offsetting a significant portion of the unrealized
appreciation and depreciation. In addition, to reduce its credit risk, at December 31, 2011, AIGFP has entered
into credit derivative transactions with respect to $196 million of securities to economically hedge its credit risk.
The timing and the amount of cash flows relating to AIGFP’s foreign exchange forwards and exchange traded
futures and options contracts are determined by each of the respective contractual agreements.
Futures and forward contracts are contracts that obligate the holder to sell or purchase foreign currencies,
commodities or financial indices in which the seller/purchaser agrees to make/take delivery at a specified future
date of a specified instrument, at a specified price or yield. Options are contracts that allow the holder of the
option to purchase or sell the underlying commodity, currency or index at a specified price and within, or at, a
specified period of time. As a writer of options, AIGFP generally receives an option premium and then manages
the risk of any unfavorable change in the value of the underlying commodity, currency or index by entering into
offsetting transactions with third-party market participants. Risks arise as a result of movements in current market
prices from contracted prices, and the potential inability of the counterparties to meet their obligations under the
contracts.
AIGFP Super Senior Credit Default Swaps
AIGFP entered into credit default swap transactions with the intention of earning revenue on credit exposure.
In the majority of AIGFP’s credit default swap transactions, AIGFP sold credit protection on a designated
portfolio of loans or debt securities. Generally, AIGFP provides such credit protection on a ‘‘second loss’’ basis,
meaning that AIGFP would incur credit losses only after a shortfall of principal and/or interest, or other credit
events, in respect of the protected loans and debt securities, exceeds a specified threshold amount or level of ‘‘first
losses.’’
Typically, the credit risk associated with a designated portfolio of loans or debt securities has been tranched into
different layers of risk, which are then analyzed and rated by the credit rating agencies. At origination, there is
usually an equity layer covering the first credit losses in respect of the portfolio up to a specified percentage of
the total portfolio, and then successive layers ranging generally from a BBB-rated layer to one or more
AAA-rated layers. A significant majority of AIGFP transactions that were rated by rating agencies had risk layers
or tranches rated AAA at origination that are immediately junior to the threshold level above which AIGFP’s
payment obligation would generally arise. In transactions that were not rated, AIGFP applied equivalent risk
criteria for setting the threshold level for its payment obligations. Therefore, the risk layer assumed by AIGFP
with respect to the designated portfolio of loans or debt securities in these transactions is often called the ‘‘super
senior’’ risk layer, defined as a layer of credit risk senior to one or more risk layers rated AAA by the credit
rating agencies, or, if the transaction is not rated, structured to be the equivalent thereto.
292 AIG 2011 Form 10-K