AIG 2009 Annual Report Download - page 245

American International Group, Inc., and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 RMBS, CMBS and
CDO/ABS, corporate debt, certain municipal and sovereign debt, 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:
Valuation Methodologies
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 or cash bond 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.
•Counterparty Credit Risk. Fair value measurements for freestanding derivatives incorporate counterparty credit
by determining the explicit cost for AIG to protect against its net credit exposure to each counterparty at the
balance sheet date by reference to observable counterparty credit default swap spreads, when available. When
not available, other directly or indirectly observable credit spreads will be used to derive the best estimates of
the counterparty spreads. AIG’s net credit exposure to a counterparty is determined based on master netting
agreements, which take into consideration all derivative positions with the counterparty, as well as collateral
posted by the counterparty at the balance sheet date.
The cost of credit protection is determined under a discounted present value approach considering the market
levels for single name credit default swap spreads for each specific counterparty, the mid market value of the net
exposure (reflecting the amount of protection required) and the weighted average life of the net exposure. CDS
spreads are provided to AIG by an independent third party. AIG utilizes a LIBOR-based interest rate curve to derive
its discount rates.
This type of CDS is a derivative contract that allows the transfer of third party credit risk from one party to the
other. The buyer of the CDS pays an upfront and/or annual premium to the seller. The seller’s payment obligation is
triggered by the occurrence of a credit event under a specified reference security and is determined by the loss on that
specified reference security. The present value of the amount of the annual and/or upfront premium therefore
represents a market-based expectation of the likelihood that the specified reference party will fail to perform on the
reference obligation, a key market observable indicator of non-performance risk (the CDS spread).
While this approach does not explicitly consider all potential future behavior of the derivative transactions or
potential future changes in valuation inputs, AIG believes this approach provides a reasonable estimate of the fair
value of the assets and liabilities, including consideration of the impact of non-performance risk.
Fair values for fixed maturity securities based on observable market prices for identical or similar instruments
implicitly incorporate counterparty credit risk. Fair values for fixed maturity securities based on internal models
237 AIG 2009 Form 10-K