AIG 2008 Annual Report Download - page 275

Non-AIGFP Derivatives
AIG and its subsidiaries (other than AIGFP) also use derivatives and other instruments as part of their financial
risk management programs. Interest rate derivatives (such as interest rate swaps) are used to manage interest rate
risk associated with investments in fixed income securities, commercial paper issuances, medium- and long-term
note offerings, and other interest rate sensitive assets and liabilities. In addition, foreign exchange derivatives
(principally cross currency swaps, forwards and options) are used to economically mitigate risk associated with
non-U.S. dollar denominated debt, net capital exposures and foreign exchange transactions. The derivatives are
effective economic hedges of the exposures they are meant to offset.
In addition to hedging activities, AIG also uses derivative instruments with respect to investment operations,
which include, among other things, credit default swaps, and purchasing investments with embedded derivatives,
such as equity linked notes and convertible bonds. All changes in the fair value of these derivatives are recorded in
earnings. AIG bifurcates an embedded derivative where: (i) the economic characteristics of the embedded
instruments are not clearly and closely related to those of the remaining components of the financial instrument;
(ii) the contract that embodies both the embedded derivative instrument and the host contract is not remeasured at
fair value; and (iii) a separate instrument with the same terms as the embedded instrument meets the definition of a
derivative under FAS 133.
Matched Investment Program Written Credit Default Swaps
The Matched Investment Program (MIP) has entered into CDS contracts as a writer of protection, with the
intention of earning spread income on credit exposure in an unfunded form. The portfolio of CDS contracts are
single-name exposures and, at inception, are predominantly high grade corporate credits.
The MIP invested in written CDS contracts through an affiliate which then transacts directly with unaffiliated
third parties under ISDA agreements. As of December 31, 2008, the notional amount of written CDS contracts was
$4.1 billion with an average credit rating of BBB+. The average maturity of the written CDS contracts is March
2012, or 3.3 years. As of December 31, 2008, the fair value (which represents the carrying value) of the MIP’s
written CDS was $(351) million.
The majority of the ISDA agreements include credit support annex provisions, which provide for collateral
postings at various ratings and threshold levels. At December 31, 2008, $128.9 million of collateral was posted for
CDS contracts related to the MIP. The notional amount represents the maximum exposure to loss on the written
CDS contracts. However, due to the average investment grade rating and expected default recovery rates, actual
losses are expected to be less. AIG Investments, as investment manager for MIP, manages the credit exposure
through its corporate credit risk process.
Upon a triggering event (e.g., a default) with respect to the underlying credit, the MIP would normally have the
option to settle the position through an auction process (cash settlement) or pay the notional amount of the contract
to the counterparty in exchange for a bond issued by the underlying credit (physical settlement).
AIG 2008 Form 10-K 269
American International Group, Inc., and Subsidiaries
Notes to Consolidated Financial Statements — (Continued)