AIG 2006 Annual Report Download - page 147

American International Group, Inc. and Subsidiaries
conclusions on quantitative analysis, qualitative factors, current tions require to cover potential, unexpected losses within a
economic conditions and trends, political and regulatory implica- confidence level consistent with the risk profile selected by
tions, competition and the judgment of the committees’ members. management. The Economic Capital requirement can then be
AIG’s Consumer Finance operations are exposed to credit risk compared with the economic capital resources available to AIG.
and risk of loss resulting from adverse fluctuations in interest The Economic Capital requirement is driven by exposures to
rates and payment defaults. Credit loss exposure is managed risks and correlations among various types of risks. As a global
through a combination of underwriting controls, mix of finance financial conglomerate, AIG is exposed to various risks including
receivables, collateral and collection efficiency. Large product underwriting, financial and operational risks. The Economic Capital
programs are subject to CRC approval. initiative has modeled these risks into five major categories:
Over half of the finance receivables are real estate loans which property & casualty insurance risk, life insurance risk, market risk,
are collateralized by the related properties. With respect to credit credit risk and operational risk. Within each risk category, there are
losses, the allowance for losses is maintained at a level sub-risks that have been modeled in greater detail. The Economic
considered adequate to absorb anticipated credit losses existing Capital initiative also analyzes and includes diversification benefits
in that portfolio as of the balance sheet date. within and across risk categories and business segments.
A primary objective of the Economic Capital initiative is to
develop a comprehensive framework to discuss capital and
Asset Management
performance on a risk-adjusted basis internally with AIG manage-
AIG’s Asset Management operations are exposed to various forms ment and externally with the investment community, credit
of credit, market and operational risks. Asset Management providers, regulators and rating agencies. Economic Capital analy-
complies with AIG’s corporate risk management guidelines and sis provides a framework to validate AIG’s capital adequacy, to
framework and is subject to periodic reviews by the CRC. In measure more precisely capital efficiency at various levels
addition, transactions are referred to the Asset Management throughout the organization, to allocate capital consistently among
investment committees for approval of investment decisions. AIG’s businesses, to quantify the specific areas of diversification
The majority of the credit and market risk exposures within benefits and to assess relative economic value added by a
Asset Management results from the spread-based investment business, product or transaction to AIG as a whole. The Economic
business and the investment activities of AIG Global Real Estate Capital initiative will also be a component in developing a more
Investment Corp. efficient capital structure. Other key areas of Economic Capital
In the spread-based investment businesses, GIC and MIP, the applications include strategic decision-making for mergers, acqui-
primary risk is investment risk, which represents the exposure to sitions and divestitures, risk retention, reinsurance and hedging
loss resulting from the cash flows from the invested assets being strategies and product development and pricing.
less than the cash flows required to meet the obligations of the During 2006, AIG developed a methodology framework that
liabilities and the necessary return on investments. Credit risk is incorporates financial services industry best practices, maintains
also a significant component of the investment strategy for these consistency with regulatory frameworks and reflects AIG’s distinct
businesses. Market risk is taken in the form of duration and global business and management strategies. By utilizing stochas-
convexity risk. While AIG generally maintains a matched asset- tic simulation techniques, where appropriate, AIG enhanced
liability relationship, it may occasionally determine that it is existing models or developed new ones through a collaborative
economically advantageous to be in an unmatched duration effort among business executives, actuaries, finance specialists
position. The risks in the spread-based businesses are managed and risk professionals. Initial assessments of Economic Capital
through exposure limitations, active management of the investment were made and AIG began reviewing its economic capital model
portfolios and close oversight of the asset-liability relationship. methodology with the rating agencies.
Within AIG Global Real Estate Investment Corp., AIG is exposed The initial assessments were made at the corporate, segment
to the general conditions in global real estate markets and the and major business unit level, and detailed analyses of selected
credit markets. Such exposure can subject Asset Management to businesses and products were undertaken. AIG also developed
delays in real estate sales, additional carrying costs and in turn assessments of diversification benefits across lines of business,
affect operating results within the segment. These risks are geographic regions and risk categories. Given the breadth and
mitigated through the underwriting process, transaction and con- global nature of AIG’s businesses, these benefits were found to
tract terms and conditions and portfolio diversification by type of be significant.
project, sponsor, real estate market and country. AIG’s exposure to The initial assessments have provided useful insight into the
real estate investments is monitored on an ongoing basis by the overall capital strength of the corporation and its segments and,
Asset Management real estate investment committee. to date, the initiative has introduced guidance concerning
processes to assess economic risk and returns for selected
Economic Capital issues, including funding and investment strategies for the MIP,
product development, pricing, hedging for living benefits in the
Since mid 2005, AIG has been developing a firm-wide economic
variable annuity business and asset-liability management strate-
capital model to improve decision making and to enhance
gies for life insurance products, particularly in Asian markets.
shareholder value. Economic Capital is the amount of capital the
organization, its segments, profit centers, products or transac-
Form 10-K 2006 AIG 97