AIG 2006 Annual Report Download - page 138

American International Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
While VaR models are relatively sophisticated, their results are
Market Risk Management
limited by the assumptions and parameters used in these models.
AIG seeks to minimize market risks by matching the market risks AIG believes that statistical models alone do not provide a reliable
in its assets with the market risks in its liabilities. Nevertheless, method of monitoring and controlling market risk. Therefore, such
AIG does have net exposure to market risks, primarily within its models are tools and do not substitute for the experience or
insurance businesses. These asset-liability exposures are judgment of senior management.
predominantly structural in nature, and not the result of specula-
tive positioning to take advantage of short-term market opportuni- Insurance, Asset Management and Non-Trading Financial Services
ties. The Market Risk Management Department (MRM), which VaR
reports to the CRO, is responsible for control and oversight of
AIG has performed one comprehensive VaR analysis across all of
market risks in all aspects of AIG’s financial services, insurance,
its non-trading businesses, and a separate VaR analysis for its
and investment activities.
trading business at AIGFP. The comprehensive VaR is categorized
AIG’s market exposures arise from the following: by AIG business segment (General Insurance, Life Insurance &
(AIG is a globally diversified enterprise with capital deployed in a Retirement Services, Financial Services and Asset Management)
variety of currencies. Capital deployed in AIG’s overseas and also by market risk factor (interest rate, currency and equity).
businesses, when converted into U.S. dollars for financial For the insurance segments, assets included are invested
reporting purposes, constitutes a ‘‘long foreign currency/short assets (excluding real estate and investment income due and
U.S. dollar’’ market exposure on AIG’s balance sheet. Similarly, accrued), and liabilities included are reserve for losses and loss
overseas earnings denominated in foreign currency also repre- expenses, reserve for unearned premiums, future policy benefits
sent a ‘‘long foreign currency/short U.S. dollar’’ market for life and accident and health insurance contracts and other
exposure on AIG’s income statement. policyholders’ funds. For financial services companies, loans and
(Much of AIG’s domestic capital is invested in fixed income or leases represent the majority of assets represented in the VaR
equity securities, leading to exposures to U.S. yields and equity calculation, while bonds and notes issued represent the majority
markets. of liabilities.
(Several of AIG’s Foreign Life subsidiaries operate in developing AIG calculated the VaR with respect to net fair values as of
markets where maturities on longer-term life insurance liabili- December 31, 2006 and 2005. The VaR number represents the
ties exceed the maximum maturities of available local currency maximum potential loss as of those dates that could be incurred
assets. with a 95 percent confidence (i.e., only five percent of historical
AIG analyzes market risk using various statistical techniques scenarios show losses greater than the VaR figure) within a one-
including Value at Risk (VaR). VaR is a summary statistical month holding period. AIG uses the historical simulation methodol-
measure that uses the estimated volatility and correlation of ogy that entails repricing all assets and liabilities under explicit
market factors to calculate the maximum loss that could occur changes in market rates within a specific historical time period.
over a defined period of time given a certain probability. VaR AIG uses the most recent three years of historical market
measures not only the size of individual exposures but also the information for interest rates, foreign exchange rates, and equity
interaction between different market exposures, thereby providing index prices. For each scenario, each transaction was repriced.
a portfolio approach to measuring market risk. Substantially Segment and AIG-wide scenario values are then calculated by
similar VaR methodologies are used to determine capital require- netting the values of all the underlying assets and liabilities.
ments for market risk within AIG’s economic capital framework.
88 AIG 2006 Form 10-K