AIG 2005 Annual Report Download - page 117

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
defined as Variable Interest Entities (VIEs). In December 2003, fall outside these pre-established guidelines require the specific
FASB issued a revision to Interpretation No. 46 (FIN 46R). approval of the AIG Credit Risk Committee. It is also AIG’s
AIG has guidelines with respect to the formation of and policy to establish reserves for potential credit impairment
investment in SPVs and off balance sheet arrangements. In when necessary.
addition, AIG has expanded the responsibility of its Complex In addition, AIGFP utilizes various credit enhancements,
Structured Financial Transaction Committee (CSFT) to in- including letters of credit, guarantees, collateral, credit triggers,
clude the review of any transaction that could subject AIG to credit derivatives, and margin agreements to reduce the credit
heightened legal, reputational, regulatory, accounting or other risk relating to its outstanding financial derivative transactions.
risk. See ‘‘Management’s Report on Internal Control Over AIGFP requires credit enhancements in connection with
Financial Reporting’’ in Item 9A of Part II for a further specific transactions based on, among other things, the
discussion of the CSFT. creditworthiness of the counterparties, and the transaction’s
For additional information related to AIG’s activities with size and maturity.
respect to VIEs and certain guarantees see ‘‘Recent Accounting AIG’s Derivatives Review Committee provides an indepen-
Standards’’ herein and also Notes 1 and 19 of Notes to dent review of any proposed derivative transaction or program
Consolidated Financial Statements. Also, for additional disclo- except those derivative transactions entered into by AIGFP
sure regarding AIG’s commercial commitments (including with third parties. The committee examines, among other
guarantors), see ‘‘Contractual Obligations and Other Commer- things, the nature and purpose of the derivative transaction, its
cial Commitments’’ herein. potential credit exposure, if any, and the estimated benefits.
FAS 133 requires that third-party derivatives used for
hedging must be specifically matched with the underlying
Derivatives
exposures to an outside third party and documented contempo-
Derivatives are financial instruments among two or more raneously to qualify for hedge accounting treatment. In most
parties with returns linked to or ‘‘derived’’ from some cases, AIG did not meet these hedging requirements with
underlying equity, debt, commodity or other asset, liability, or respect to certain hedging transactions. Not meeting the
index. Derivatives payments may be based on interest rates and requirements of FAS 133 does not result in any changes in
exchange rates and/or prices of certain securities, commodities, AIG’s liquidity or its overall financial condition even though
financial or commodity indices, or other variables. The more inter-period volatility of earnings is increased.
significant types of derivative arrangements in which AIG See also Note 20 of Notes to Consolidated Financial
transacts are swaps, forwards, futures and options. In the Statements for detailed information relating to AIG’s deriva-
normal course of business, with the agreement of the original tive activities, and Note 1(ee) of Notes to Consolidated
counterparty, these contracts may be terminated early or Financial Statements for AIG’s derivative accounting policies.
assigned to another counterparty.
The overwhelming majority of AIG’s derivatives activities Managing Market Risk
are conducted by the Capital Markets operations, thus permit-
ting AIG to participate in the derivatives dealer market acting Market risk is the risk of loss of fair value resulting from
primarily as principal. In these derivative operations, AIG adverse fluctuations in interest rates, foreign currencies, equities
structures transactions that generally allow its counterparties to and commodity prices. AIG has exposures to these risks.
obtain, or hedge, exposure to changes in interest and foreign AIG analyzes market risk using various statistical techniques
currency exchange rates, credit events, securities’ prices and including Value at Risk (VaR). VaR is a summary statistical
certain commodities and financial or commodity indices. AIG’s measure that applies the estimated volatility and correlation of
customers — such as corporations, financial institutions, mul- market factors to AIG’s market positions. The output from the
tinational organizations, sovereign entities, government agen- VaR calculation is the maximum loss that could occur over a
cies and municipalities — use derivatives to hedge their own defined period of time given a certain probability. While VaR
market exposures. For example, a futures, forward or option models are relatively sophisticated, the quantitative market risk
contract can be used to protect the customers’ assets or information generated is limited by the assumptions and
liabilities against price fluctuations. parameters established in creating the related models. AIG
A counterparty may default on any obligation to AIG, believes that statistical models alone do not provide a reliable
including a derivative contract. Credit risk is a consequence of method of monitoring and controlling market risk. Therefore,
extending credit and/or carrying trading and investment such models are tools and do not substitute for the experience
positions. Credit risk exists for a derivative contract when that or judgment of senior management.
contract has a positive fair value to AIG. To help manage this
risk, AIGFP’s credit department operates within the guidelines Insurance
set by the AIG Credit Risk Committee. This committee AIG has performed a separate VaR analysis for the General
establishes the credit policy, sets limits for counterparties and Insurance and Life Insurance & Retirement Services segments
provides limits for derivative transactions with counterparties and for each market risk within each segment. For purposes of
having different credit ratings. In addition to credit ratings, the VaR calculation, the insurance assets and liabilities from
this committee takes into account other factors, including the GICs are included in the Life Insurance & Retirement Services
industry and country of the counterparty. Transactions which
AIG m Form 10-K 65