MetLife 2008 Annual Report Download - page 17

maturity and equity securities is reduced accordingly. The Company does not change the revised cost basis for subsequent recoveries in
value.
The determination of the amount of allowances and impairments on other invested asset classes is highly subjective and is based upon
the Company’s periodic evaluation and assessment of known and inherent risks associated with the respective asset class. Such
evaluations and assessments are revised as conditions change and new information becomes available. Management updates its
evaluations regularly and reflects changes in allowances and impairments in operations as such evaluations are revised.
Recognition of Income on Certain Investment Entities
The recognition of income on certain investments (e.g. loan-backed securities, including mortgage-backed and asset-backed
securities, certain structured investment transactions, trading securities, etc.) is dependent upon market conditions, which could result
in prepayments and changes in amounts to be earned.
Application of the Consolidation Rules to Certain Investments
Additionally, the Company has invested in certain structured transactions that are VIEs under Financial Accounting Standards Board
(“FASB”) Interpretation (“FIN”) No. 46(r), Consolidation of Variable Interest Entities — An Interpretation of Accounting Research Bulletin
No. 51 (“FIN 46(r)”). These structured transactions include reinsurance trusts, asset-backed securitizations, trust preferred securities, joint
ventures, limited partnerships and limited liability companies. The Company is required to consolidate those VIEs for which it is deemed to
be the primary beneficiary. The accounting rules under FIN 46(r) for the determination of when an entity is a VIE and when to consolidate a
VIE are complex. The determination of the VIE’s primary beneficiary requires an evaluation of the contractual rights and obligations
associated with each party involved in the entity, an estimate of the entity’s expected losses and expected residual returns and the
allocation of such estimates to each party involved in the entity. FIN 46(r) defines the primary beneficiary as the entity that will absorb a
majority of a VIE’s expected losses, receive a majority of a VIE’s expected residual returns if no single entity absorbs a majority of expected
losses, or both.
When determining the primary beneficiary for structured investment products such as asset-backed securitizations and collateralized
debt obligations, the Company uses historical default probabilities based on the credit rating of each issuer and other inputs including
maturity dates, industry classifications and geographic location. Using computational algorithms, the analysis simulates default scenarios
resulting in a range of expected losses and the probability associated with each occurrence. For other investment structures such as trust
preferred securities, joint ventures, limited partnerships and limited liability companies, the Company gains an understanding of the design
of the VIE and generally uses a qualitative approach to determine if it is the primary beneficiary. This approach includes an analysis of all
contractual rights and obligations held by all parties including profit and loss allocations, repayment or residual value guarantees, put and
call options and other derivative instruments. If the primary beneficiary of a VIE can not be identified using this qualitative approach, the
Company calculates the expected losses and expected residual returns of the VIE using a probability-weighted cash flow model. The use
of different methodologies, assumptions and inputs in the determination of the primary beneficiary could have a material effect on the
amounts presented within the consolidated financial statements.
Derivative Financial Instruments
The Company enters into freestanding derivative transactions including swaps, forwards, futures and option contracts. The Company
uses derivatives primarily to manage various risks. The risks being managed are variability in cash flows or changes in estimated fair values
related to financial instruments and currency exposure associated with net investments in certain foreign operations. To a lesser extent, the
Company uses credit derivatives, such as credit default swaps, to synthetically replicate investment risks and returns which are not readily
available in the cash market.
The estimated fair value of derivatives is determined through the use of quoted market prices for exchange-traded derivatives and
financial forwards to sell residential mortgage-backed securities or through the use of pricing models for over-the-counter derivatives. The
determination of estimated fair value, when quoted market values are not available, is based on market standard valuation methodologies
and inputs that are assumed to be consistent with what other market participants would use when pricing the instruments. Derivative
valuations can be affected by changes in interest rates, foreign currency exchange rates, financial indices, credit spreads, default risk
(including the counterparties to the contract), volatility, liquidity and changes in estimates and assumptions used in the pricing models.
The significant inputs to the pricing models for most over-the-counter derivatives are inputs that are observable in the market or can be
derived principally from or corroborated by observable market data. Significant inputs that are observable generally include: interest rates,
foreign currency exchange rates, interest rate curves, credit curves, and volatility. However, certain over-the-counter derivatives may rely
on inputs that are significant to the estimated fair value that are not observable in the market or cannot be derived principally from or
corroborated by observable market data. Significant inputs that are unobservable generally include: independent broker quotes, credit
correlation assumptions, references to emerging market currencies, and inputs that are outside the observable portion of the interest rate
curve, credit curve, volatility, or other relevant market measure. These unobservable inputs may involve significant management judgment
or estimation. Even though unobservable, these inputs are based on assumptions deemed appropriate given the circumstances and
consistent with what other market participants would use when pricing such instruments. Most inputs for over-the-counter derivatives are
mid market inputs but, in certain cases, bid level inputs are used when they are deemed more representative of exit value. Market liquidity
as well as the use of different methodologies, assumptions and inputs may have a material effect on the estimated fair values of the
Company’s derivatives and could materially affect net income. Also, fluctuations in the estimated fair value of derivatives which have not
been designated for hedge accounting may result in significant volatility in net income.
The credit risk of both the counterparty and the Company are considered in determining the estimated fair value for all over-the-counter
derivatives after taking into account the effects of netting agreements and collateral arrangements. Credit risk is monitored and
consideration of any potential credit adjustment is based on a net exposure by counterparty. This is due to the existence of netting
agreements and collateral arrangements which effectively serve to mitigate credit risk. The Company values its derivative positions using
the standard swap curve which includes a credit risk adjustment. This credit risk adjustment is appropriate for those parties that execute
trades at pricing levels consistent with the standard swap curve. As the Company and its significant derivative counterparties consistently
execute trades at such pricing levels, additional credit risk adjustments are not currently required in the valuation process. The need for
such additional credit risk adjustments is monitored by the Company. The Company’s ability to consistently execute at such pricing levels is
14 MetLife, Inc.