AIG 2006 Annual Report Download - page 114

American International Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
these events and circumstances in accordance with Statement of tions derive substantially all their revenues from hedged financial
Financial Accounting Standards No. 144, ‘‘Accounting for the positions entered into in connection with counterparty transac-
Impairment or Disposal of Long-Lived Assets’’ (FAS 144). ILFC has tions rather than from speculative transactions. AIGFP also
not recognized any impairment related to its fleet in 2006, 2005 participates as a dealer in a wide variety of financial derivatives
and 2004. ILFC has been able to re-lease the aircraft without transactions. AIGFP economically hedges the market risks arising
diminution in lease rates that would result in an impairment under from its transactions, although hedge accounting under FAS 133
FAS 144. was not being applied during 2006, 2005 and 2004 to any of the
derivatives and related assets and liabilities. Accordingly, reve-
nues and operating income were exposed to volatility resulting
Aircraft Leasing Results
from differences in the timing of revenue recognition between the
2006 and 2005 Comparison derivatives and the hedged assets and liabilities. Revenues and
operating income of the Capital Markets operations and the
ILFC’s operating income decreased in 2006 compared to 2005 by percentage change in these amounts for any given period are also
$40 million, or 6 percent. Rental revenues increased by $536 mil- significantly affected by the number, size and profitability of
lion or 16 percent, driven by a larger aircraft fleet, increased transactions entered into by these subsidiaries during that period
utilization and higher lease rates. During 2006, ILFC’s fleet relative to those entered into during the prior period. Generally,
subject to operating leases increased by 78 airplanes to a total of the realization of transaction revenues as measured by the receipt
824. The increase in rental revenues was offset in part by of funds is not a significant reporting event as the gain or loss on
increases in depreciation expense and interest expense, charges AIGFP’s trading transactions is currently reflected in operating
related to bankrupt airlines, as well as the settlement of a tax income as the fair values change from period to period.
dispute in Australia related to the restructuring of ownership of Derivative transactions are entered into in the ordinary course
aircraft. Depreciation expense increased by $200 million, or of AIGFP operations. Derivatives are recorded at fair value,
14 percent, in line with the increase in the size of the aircraft determined by reference to the mark to market value of the
fleet. Interest expense increased by $317 million, or 28 percent, derivative or their estimated fair value where market prices are
driven by rising cost of funds, a weaker U.S. dollar against the not readily available. The resulting aggregate unrealized gains or
Euro and the British Pound and additional borrowings funding losses from the derivatives are reflected in the consolidated
aircraft purchases. As noted above, ILFC’s interest expense did income statement. Where AIGFP cannot verify significant model
not reflect the benefit of hedging these exposures. Gains or inputs to observable market data and cannot verify the model
losses on derivatives for ILFC are reported in AIG’s Other value to market transactions, AIGFP values the contract at the
category. transaction price at inception and, consequently, records no initial
gain or loss in accordance with Emerging Issues Task Force Issue
2005 and 2004 Comparison No. 02-03, ‘‘Issues Involved in Accounting for Derivative Contracts
ILFC’s operating income increased in 2005 compared to 2004 by Held for Trading Purposes and Contracts Involved in Energy
$37 million, or 6 percent. Rental revenues increased by $499 mil- Trading and Risk Management Activities’’ (EITF 02-03). Such initial
lion, or 17 percent, driven by a larger aircraft fleet and increased gain or loss is recognized over the life of the transaction. AIGFP
utilization. During 2005, ILFC’s fleet subject to operating leases periodically reevaluates its revenue recognition under EITF 02-03
increased by 79 airplanes to a total of 746. The increase in rental based on the observability of market parameters. The mark to fair
revenues was offset in part by increases in depreciation expense, value of derivative transactions is reflected in the consolidated
interest expense, leasing-related costs and other reserves. Depre- balance sheet in the captions ‘‘Unrealized gain on swaps, options
ciation expense increased by $111 million, or 9 percent, in line and forward transactions’’ and ‘‘Unrealized loss on swaps,
with the increase in the size of the aircraft fleet. Interest expense options and forward transactions.’’ Unrealized gains represent the
increased by $132 million, or 13 percent, driven by rising cost of present value of the aggregate of each net receivable, by
funds and additional borrowings funding aircraft purchases. counterpar ty, and the unrealized losses represent the present
value of the aggregate of each net payable, by counterparty, as of
Capital Markets December 31, 2006. These amounts will change from one period
to the next due to changes in interest rates, currency rates, equity
Capital Markets represents the operations of AIGFP, which and commodity prices and other market variables, as well as cash
engages as principal in a wide variety of financial transactions, movements, execution of new transactions and the maturing of
including standard and customized financial products involving existing transactions.
commodities, credit, currencies, energy, equities and rates. AIGFP Spread income on investments and borrowings is recorded on
also invests in a diversified portfolio of securities and principal an accrual basis over the life of the transaction. Investments are
investments and engages in borrowing activities involving issuing classified as securities available for sale and are carried at fair
standard and structured notes and other securities, and entering value with the resulting unrealized gains or losses reflected in
into GIAs. accumulated other comprehensive income. U.S. dollar denomi-
As Capital Markets is a transaction-oriented operation, current nated borrowings are carried at cost, while borrowings in any
and past revenues and operating results may not provide a basis currency other than the U.S. dollar result in unrealized foreign
for predicting future per formance. AIG’s Capital Markets opera-
64 AIG 2006 Form 10-K