AIG 2013 Annual Report Download - page 251

the model is adjusted so the model value at inception equals the transaction price. We will update valuation inputs in
these models only when corroborated by evidence such as similar market transactions, third party pricing services
and/or broker or dealer quotations, or other empirical market data. When appropriate, valuations are adjusted for
various factors such as liquidity, bid/offer spreads and credit considerations. Such adjustments are generally based
on available market evidence. In the absence of such evidence, management’s best estimate is used.
Certain variable annuity and equity-indexed annuity and life contracts contain embedded policy derivatives that we
bifurcate from the host contracts and account for separately at fair value, with changes in fair value recognized in
earnings. We have concluded these contracts contain (i) written option guarantees on minimum accumulation value,
(ii) a series of written options that guarantee withdrawals from the highest anniversary value within a specific period
or for life, or (iii) equity-indexed written options that meet the criteria of derivatives that must be bifurcated.
The fair value of embedded policy derivatives contained in certain variable annuity and equity-indexed annuity and
life contracts is measured based on actuarial and capital market assumptions related to projected cash flows over the
expected lives of the contracts. These cash flow estimates primarily include benefits and related fees assessed,
when applicable, and incorporate expectations about policyholder behavior. Estimates of future policyholder behavior
are subjective and based primarily on our historical experience.
With respect to embedded policy derivatives in our variable annuity contracts, because of the dynamic and complex
nature of the expected cash flows, risk neutral valuations are used. Estimating the underlying cash flows for these
products involves judgments regarding expected market rates of return, market volatility, correlations of market index
returns to funds, fund performance, discount rates and policyholder behavior. With respect to embedded policy
derivatives in our equity-indexed annuity and life contracts, option pricing models are used to estimate fair value,
taking into account assumptions for future equity index growth rates, volatility of the equity index, future interest
rates, and determinations on adjusting the participation rate and the cap on equity-indexed credited rates in light of
market conditions and policyholder behavior assumptions. These methodologies incorporate an explicit risk margin to
take into consideration market participant estimates of projected cash flows and policyholder behavior.
We also incorporate our own risk of non-performance in the valuation of the embedded policy derivatives associated
with variable annuity and equity-indexed annuity and life contracts. Historically, the expected cash flows were
discounted using the interest rate swap curve (swap curve), which is commonly viewed as being consistent with the
credit spreads for highly-rated financial institutions (S&P AA-rated or above). A swap curve shows the fixed-rate leg
of a non-complex swap against the floating rate (for example, LIBOR) leg of a related tenor. The swap curve was
adjusted, as necessary, for anomalies between the swap curve and the U.S. Treasury yield curve.
We value CDS transactions written on the super senior risk layers of designated pools of debt securities or loans
using internal valuation models, third-party price estimates and market indices. The principal market was determined
to be the market in which super senior credit default swaps of this type and size would be transacted, or have been
transacted, with the greatest volume or level of activity. We have determined that the principal market participants,
therefore, would consist of other large financial institutions who participate in sophisticated over-the-counter
derivatives markets. The specific valuation methodologies vary based on the nature of the referenced obligations and
availability of market prices.
The valuation of the super senior credit derivatives is complex because of the limited availability of market
observable information due to the lack of trading and price transparency in certain structured finance markets. These
market conditions have increased the reliance on management estimates and judgments in arriving at an estimate of
fair value for financial reporting purposes. Further, disparities in the valuation methodologies employed by market
participants and the varying judgments reached by such participants when assessing volatile markets have increased
the likelihood that the various parties to these instruments may arrive at significantly different estimates as to their
fair values.
Embedded Policy Derivatives
Super Senior Credit Default Swap Portfolio
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AIG 2013 Form 10-K 233
ITEM 8 / NOTE 5. FAIR VALUE MEASUREMENTS
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