AIG 2015 Annual Report Download - page 188

ITEM 7 / ENTERPRISE RISK MANAGEMENT
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embedded derivatives measured at fair value, with changes in the fair value recorded in Other realized capital gains (losses).
GMWB and GMAB features subject the Life Insurance Companies to market risk, including exposure to changes in interest
rates, equity prices, credit spreads and market volatility.
Variable annuity product design is the first step in managing our exposure to these market risks. Risk mitigation features of our
variable annuity product design include GMWB rider fees indexed to an equity market volatility index, which can provide
additional fee assessments in periods of market volatility, required minimum allocations to fixed accounts to reduce overall
equity exposure, and the utilization of volatility control funds, which reduce equity exposure in the funds in response to
changes in market volatility, even under sudden or extreme market movements.
After reflecting our product risk-mitigating features, we hedge our remaining economic exposure to market risk within GMWB
and GMAB features through our variable annuity hedging program, which is designed to offset certain changes in the
economic value of these GMWB and GMAB embedded derivatives, within established thresholds. The hedging program is
designed to provide additional protection against large and combined movements in interest rates, equity prices, credit
spreads and market volatility under multiple scenarios.
Our hedging program utilizes an economic hedge target, which represents our estimate of the underlying economic drivers of
these embedded derivatives, based on the present value of the future expected benefit payments for the GMWB and GMAB,
less the present value of future rider fees, over numerous stochastic scenarios. This stochastic projection method uses best
estimate assumptions for policyholder behavior (including mortality, lapses, withdrawals and benefit utilization) in conjunction
with market scenarios calibrated to observable equity and interest rate option prices. Policyholder behaviors are regularly
evaluated to compare current assumptions to actual experience and, if appropriate, changes are made to the policyholder
behavior assumptions. The risk of changes in policyholder behavior is not explicitly hedged and such differences between
expected and actual policyholder behaviors may result in hedge ineffectiveness.
Due to differences between the calculation of the economic hedge target and U.S. GAAP valuation of the embedded
derivative, which include differences in the treatment of rider fees and exclusion of certain risk margins and other differences in
discount rates, we expect relative movements in the economic hedge target and the U.S. GAAP embedded derivative
valuation will vary over time with changes in equity markets, interest rates and credit spreads. See Results of Operations –
Life Insurance Companies DAC and Reserves - Variable Annuity Guaranteed Benefit Features and Hedging Program for
information on the impact on our consolidated pre-tax income from the change in fair value of the embedded derivatives and
the hedging portfolio, as well as additional discussion of differences between the economic hedge target and the valuation of
the embedded derivatives.
In designing our hedging portfolio, we make assumptions and projections about the future performance of the underlying
contract holder funds. To project future account value changes, we make assumptions about how each of the underlying funds
will perform. We map the contract holder funds to a set of publicly traded indices that we believe best represent the liability to
be hedged. Basis risk exists due to the variance between these assumptions and actual fund returns, which may result in
variances between changes in the hedging portfolio and changes in the economic hedge target. Net hedge results and the
cost of hedging are also impacted by differences between realized volatility and implied volatility.
To manage the capital market exposures embedded within the economic hedge target, we identify and hedge market
sensitivities to changes in equity markets, interest rates, volatility and credit spreads. The hedge program purchases
derivative instruments or securities having sensitivities that offset those in the economic hedge target, within internally defined
threshold levels. Since the relative movements of the hedging portfolio and the economic hedge target vary over time or with
market changes, the net exposure can be outside the threshold limits, and adjustments to the hedging portfolio are made
periodically to return the net exposure to within threshold limits.
Our hedging program utilizes various derivative instruments, including but not limited to equity options, futures contracts,
interest rate swaps and swaption contracts, as well as other hedging instruments. In addition, we purchase certain fixed
income securities and elect the fair value option as a capital efficient way to manage interest rate and credit spread exposures.
To minimize counterparty credit risk, the majority of our derivative instrument hedges are implemented using exchange-traded
futures and options, cleared through global exchanges. Over the counter derivatives are highly collateralized.
The hedging program is monitored on a daily basis to ensure that the economic hedge target and derivative portfolio are within
the threshold limits, pursuant to the approved hedge strategy. Daily risk monitoring verifies that the net risk exposures, as
measured through sensitivities to a large set of market shocks, are within the approved net risk exposure threshold limits. In
addition, monthly stress tests are performed to determine the program’s effectiveness relative to the applicable limits, under an