AIG 2008 Annual Report Download - page 183

they become due without the need to sell assets prematurely into a potentially distressed market. In periods of severe
market volatility, as currently being experienced, depressed and illiquid market values on otherwise performing
investments diminish shareholders’ equity even without the realization of actual credit event related losses. Such
diminution of capital strength is causing downward pressure on the market’s assessment of the financial strength
and the credit ratings of insurers.
The Market Risk Management function (MRM), which reports to the CRO, is responsible for control and
oversight of market risks in all aspects of AIG’s financial services, insurance, and investment activities.
AIG’s market exposures can be categorized as follows:
•Benchmark interest rates. Benchmark interest rates are also known as risk-free interest rates and are
associated with either the government / treasury yield curve or the swap curve. The fair value of AIG’s
significant fixed maturity securities portfolio changes as benchmark interest rates change.
•Credit spread or risk premium. Credit spread risk is the potential for loss due to a change in an instrument’s
risk premium or yield relative to that of a comparable-duration, default-free instrument.
•Equity and alternative investment prices. AIG’s exposure to equity and alternative investment prices arises
from direct investments in common stocks and mutual funds, from minimum benefit guarantees embedded
in the structure of certain variable annuity and variable life insurance products and from other equity-like
investments, such as partnerships comprised of hedge funds and private equity funds, private equity
investments, commercial real estate and real estate funds.
•Foreign currency exchange rates. AIG is a globally diversified enterprise with significant income, assets
and liabilities denominated in and significant capital deployed in a variety of currencies.
AIG uses a number of measures and approaches to measure and quantify its market risk exposure, including:
•Duration / key rate duration. Duration is the measure of the sensitivities of a fixed-income instrument to
the parallel shift in the benchmark yield curve. Key rate duration measures sensitivities to the movement at a
given term point on the yield curve.
•Scenario analysis. Scenario analysis uses historical, hypothetical, or forward-looking macro-economic
scenarios to assess and report exposures. Examples of hypothetical scenarios include a 100 basis point
parallel shift in the yield curve or a 10 percent immediate and simultaneous decrease in world-wide equity
markets.
•Value-at-Risk (VaR). VaR is a summary statistical measure that uses the estimated volatility and corre-
lation of market factors to calculate the maximum loss that could occur over a defined period of time with a
specified level of statistical confidence. VaR measures not only the size of individual exposures but also the
interaction between different market exposures, thereby providing a portfolio approach to measuring market
risk. A key shortcoming of the VaR approach is its reliance on historical data, making VaR calculations
essentially “backward looking.” This shortcoming was most evident during the current credit crisis.
•Stress testing. Stress testing is a special form of scenario analysis whereby the scenarios used are designed
to lead to a material adverse outcome (for example, the stock market crash of October 1987 or the widening
of yields or spread of RMBS or CMBS during 2008). Stress testing is often used to address VaR
shortcomings and complement VaR calculations. Particularly in times of significant volatility in financial
markets, using stress scenarios provides more pertinent and forward-looking information on market risk
exposure than VaR results based upon historical data alone.
The magnitudes of volatilities of financial markets and degree of correlation among different markets, risks
and asset classes in 2008 were unprecedented and rendered the VaR measure that is based on historical data analysis
a much less reliable and indicative risk measure. As a result, AIG believes that the historical data based VaR
measure does not effectively convey the market risks to which AIG is subject. Therefore, as an alternative, AIG has
used sensitivities under specific scenarios to convey the magnitude of its exposures to various key market risk
factors, such as yield curve, equity markets and alternative assets, and foreign currency exchange rates. For
Insurance, Asset Management, and Financial Services (excluding Capital Markets), these sensitivities and sce-
narios are shown in the table below.
AIG 2008 Form 10-K 177
American International Group, Inc., and Subsidiaries