AIG 2008 Annual Report Download - page 237

information on an ongoing basis. An other-than-active market is one in which there are few transactions, the prices
are not current, price quotations vary substantially either over time or among market makers, or in which little
information is released publicly for the asset or liability being valued. Pricing observability is affected by a number
of factors, including the type of financial instrument, whether the financial instrument is new to the market and not
yet established, the characteristics specific to the transaction and general market conditions.
Fair Value Hierarchy
Beginning January 1, 2008, assets and liabilities recorded at fair value in the consolidated balance sheet are
measured and classified in a hierarchy for disclosure purposes consisting of three “levels” based on the
observability of inputs available in the marketplace used to measure the fair values as discussed below:
•Level 1: Fair value measurements that are quoted prices (unadjusted) in active markets that AIG has the
ability to access for identical assets or liabilities. Market price data generally is obtained from exchange or
dealer markets. AIG does not adjust the quoted price for such instruments. Assets and liabilities measured at
fair value on a recurring basis and classified as Level 1 include certain government and agency securities,
actively traded listed common stocks and derivative contracts, most separate account assets and most mutual
funds.
•Level 2: Fair value measurements based on inputs other than quoted prices included in Level 1 that are
observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for
similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the
asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.
Assets and liabilities measured at fair value on a recurring basis and classified as Level 2 generally include
certain government securities, most investment-grade and high-yield corporate bonds, certain ABS, certain
listed equities, state, municipal and provincial obligations, hybrid securities, mutual fund and hedge fund
investments, derivative contracts, GIAs at AIGFP and physical commodities.
•Level 3: Fair value measurements based on valuation techniques that use significant inputs that are
unobservable. These measurements include circumstances in which there is little, if any, market activity for
the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the
fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value
measurement in its entirety falls is determined based on the lowest level input that is significant to the fair
value measurement in its entirety. AIG’s assessment of the significance of a particular input to the fair value
measurement in its entirety requires judgment. In making the assessment, AIG considers factors specific to
the asset or liability. Assets and liabilities measured at fair value on a recurring basis and classified as Level 3
include certain distressed ABS, structured credit products, certain derivative contracts (including AIGFP’s
super senior credit default swap portfolio), policyholder contract deposits carried at fair value, private equity
and real estate fund investments, and direct private equity investments. AIG’s non-financial-instrument
assets that are measured at fair value on a non-recurring basis generally are classified as Level 3.
The following is a description of the valuation methodologies used for instruments carried at fair value:
Incorporation of Credit Risk in Fair Value Measurements
•AIG’s Own Credit Risk. Fair value measurements for AIGFP’s debt, GIAs, structured note liabilities and
freestanding derivatives incorporate AIG’s own credit risk by determining the explicit cost for each
counterparty to protect against its net credit exposure to AIG at the balance sheet date by reference to
observable AIG credit default swap spreads. A counterparty’s net credit exposure to AIG is determined
based on master netting agreements, when applicable, which take into consideration all positions with AIG,
as well as collateral posted by AIG with the counterparty at the balance sheet date.
Fair value measurements for embedded policy derivatives and policyholder contract deposits take into
consideration that policyholder liabilities are senior in priority to general creditors of AIG and therefore are
much less sensitive to changes in AIG credit default swap or cash issuance spreads.
AIG 2008 Form 10-K 231
American International Group, Inc., and Subsidiaries
Notes to Consolidated Financial Statements — (Continued)