AIG 2006 Annual Report Download - page 215

American International Group, Inc. and Subsidiaries
AIG’s insurance operations). AIG had no hedges that were
18. Variable Interest Entities
considered fair value hedges or net investment hedges at
Continued
December 31, 2006. At December 31, 2006, AIG’s hedge
default swaps and certain total return swaps, and the amount accounting was limited to cash flow hedge accounting primarily
invested in the debt or equity issued by the VIE. related to the hedge of forecasted transactions.
AIG assesses, both at the hedge’s inception and on an
19. Derivatives ongoing basis, whether the derivatives used in hedging transac-
tions are highly effective in offsetting changes in fair values or
Derivatives are financial arrangements among two or more parties
cash flows of hedged items.
with returns linked to or ‘‘derived’’ from some underlying equity,
As of January 1, 2006 and December 31, 2006, the related
debt, commodity or other asset, liability, or index. Derivative
balance of accumulated derivative net loss arising from cash flow
payments may be based on interest rates and exchange rates
hedges, net of tax, was $25 million and $28 million, respectively.
and/or prices of certain securities, commodities, or financial or
Of the change in accumulated derivative net loss $3 million
commodity indices or other variables. Collateral is required, at the
represents current period reclassifications to operating income.
discretion of AIG, on certain transactions based on the
In addition to hedging activities, AIG also uses derivative
creditworthiness of the counterparty.
instruments with respect to investment operations, which include,
AIG carries all derivatives in the consolidated balance sheet at
among other things, credit default swaps, and purchasing invest-
fair value. The changes in fair value of the derivative transactions
ments with embedded derivatives, such as equity linked notes and
of AIGFP are presented as a component of AIG’s operating
convertible bonds. All changes in the fair value of these
income. However, in certain instances, when income is not
derivatives are recorded in earnings. AIG bifurcates an embedded
recognized up front under EITF 02-03, income is recognized over
derivative where: (i) the economic characteristics of the embedded
the life of the contract, where appropriate.
instruments are not clearly and closely related to those of the
The discussion below relates to the derivative activities of AIG
remaining components of the financial instrument; (ii) the contract
(other than those of AIGFP) that qualify for hedge accounting
that embodies both the embedded derivative instrument and the
treatment under FAS 133.
host contract is not remeasured at fair value; and (iii) a separate
For derivatives designated as hedges, on the date the
instrument with the same terms as the embedded instrument
derivative contract is entered into, AIG designates the derivative
meets the definition of a derivative under FAS 133.
as: (i) a hedge of the subsequent changes in the fair value of a
The overwhelming majority of AIG’s derivatives activities are
recognized asset or liability or of an unrecognized firm commit-
conducted by AIGFP. AIGFP becomes a party to derivative financial
ment (‘‘fair value’’ hedge); (ii) a hedge of a forecasted transac-
instruments in the normal course of business and to reduce
tion, or the variability of cash flows to be received or paid related
currency, interest rate, commodity, and equity exposures. Such
to a recognized asset or liability (‘‘cash flow’’ hedge); or (iii) a
instruments are reflected in the consolidated financial statements
hedge of a net investment in a foreign operation. Fair value and
and are carried at a market or a fair value, whichever is
cash flow hedges may involve foreign currencies (‘‘foreign currency
appropriate. The recorded estimated fair values of such instru-
hedges’’). The gain or loss in the fair value of a derivative that is
ments may be different from the values that might be realized if
appropriately and contemporaneously documented, designated
AIGFP was required to sell or close out the transactions prior to
and is highly effective as a fair value hedge is recorded in current
maturity.
period earnings, along with the loss or gain on the hedged item
AIGFP, in the ordinary course of operations and as principal,
attributable to the hedged risk. The gain or loss in the fair value
structures and enters into derivative transactions to meet the
of a derivative that is appropriately and contemporaneously
needs of counterparties who may be seeking to hedge certain
documented, designated and is highly effective as a cash flow
aspects of such counterparties’ operations or obtain a desired
hedge is recorded in other comprehensive income, until earnings
financial exposure. AIGFP also enters into derivative transactions
are affected by the variability of cash flows in the hedged item. Of
to hedge the financial exposures arising from its counterparty
the amount deferred in Other comprehensive income at Decem-
transactions. Such derivative transactions include interest rate,
ber 31, 2006, AIG does not expect a material amount to be
currency, commodity, credit and equity swaps, swaptions, and
reclassified into earnings over the next twelve months. The portion
forward commitments. Interest rate swap transactions generally
of the gain or loss in the fair value of a derivative in a cash flow
involve the exchange of fixed and floating rate interest payment
hedge that represents hedge ineffectiveness is recognized imme-
obligations without the exchange of the underlying notional
diately in current period earnings. The amount of ineffectiveness
amounts. AIGFP typically becomes a principal in the exchange of
was not material for 2006, 2005 and 2004. The gain or loss in
interest payments between the parties and, therefore, is exposed
the fair value of a derivative that is appropriately and contempora-
to counterparty credit risk and may be exposed to loss, if
neously documented, designated and is highly effective as a
counterparties default. Currency, commodity, and equity swaps
hedge of a net investment in a foreign operation is recorded in
are similar to interest rate swaps, but involve the exchange of
the foreign currency translation adjustments account within other
specific currencies or cashflows based on the underlying commod-
comprehensive income. Changes in the fair value of derivatives
ity, equity securities or indices. Also, they may involve the
used for other than hedging activities are reported in current
exchange of notional amounts at the beginning and end of the
period earnings (principally in realized capital gains and losses for
Form 10-K 2006 AIG 165