AIG 2013 Annual Report Download - page 248

•Level 3: Fair value measurements based on valuation techniques that use significant inputs that are unobservable.
Both observable and unobservable inputs may be used to determine the fair values of positions classified in
Level 3. The circumstances for using these measurements include those in which there is little, if any, market
activity for the asset or liability. Therefore, we must make certain assumptions about the inputs a hypothetical
market participant would use to value that asset or liability. In certain cases, the inputs used to measure fair value
may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within
which the fair value measurement in its entirety falls is determined based on the lowest level input that is
significant to the fair value measurement in its entirety.
The following is a description of the valuation methodologies used for instruments carried at fair value. These
methodologies are applied to assets and liabilities across the levels discussed above, and it is the observability of the
inputs used that determines the appropriate level in the fair value hierarchy for the respective asset or liability.
•Our Own Credit Risk. Fair value measurements for certain liabilities incorporate our own credit risk by
determining the explicit cost for each counterparty to protect against its net credit exposure to us at the balance
sheet date by reference to observable AIG CDS or cash bond spreads. A derivative counterparty’s net credit
exposure to us is determined based on master netting agreements, when applicable, which take into consideration
all derivative positions with us, as well as collateral we post with the counterparty at the balance sheet date. We
calculate the effect of these credit spread changes using discounted cash flow techniques that incorporate current
market interest rates.
•Counterparty Credit Risk. Fair value measurements for freestanding derivatives incorporate counterparty credit
by determining the explicit cost for us to protect against our 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. Our 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.
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 us
by an independent third party. We utilize an interest rate based on the benchmark London Interbank Offered Rate
(LIBOR) curve to derive our discount rates.
While this approach does not explicitly consider all potential future behavior of the derivative transactions or potential
future changes in valuation inputs, we believe this approach provides a reasonable estimate of the fair value of the
assets and liabilities, including consideration of the impact of non-performance risk.
Whenever available, we obtain quoted prices in active markets for identical assets at the balance sheet date to
measure fixed maturity securities at fair value. Market price data is generally obtained from dealer markets.
We employ independent third-party valuation service providers to gather, analyze, and interpret market information 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
management, through periodic discussion with and information provided by the valuation services. In addition, as
Valuation Methodologies of Financial Instruments Measured at Fair Value
Incorporation of Credit Risk in Fair Value Measurements
Fixed Maturity Securities
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AIG 2013 Form 10-K230
ITEM 8 / NOTE 5. FAIR VALUE MEASUREMENTS
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