AIG 2009 Annual Report Download - page 248

American International Group, Inc., and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Embedded Policy Derivatives
The fair value of embedded policy derivatives contained in certain variable annuity and equity-indexed annuity and
life contracts is measured based on actuarial and capital market assumptions related to projected cash flows over the
expected lives of the contracts. These cash flow estimates primarily include benefits and related fees assessed, when
applicable, and incorporate expectations about policyholder behavior. Estimates of future policyholder behavior are
subjective and based primarily on AIG’s historical experience. With respect to embedded policy derivatives in AIG’s
variable annuity contracts, because of the dynamic and complex nature of the expected cash flows, risk neutral
valuations are used. Estimating the underlying cash flows for these products involves many estimates and judgments,
including those regarding expected market rates of return, market volatility, correlations of market index returns to
funds, fund performance, discount rates and policyholder behavior. With respect to embedded policy derivatives in
AIG’s equity-indexed annuity and life contracts, option pricing models are used to estimate fair value, taking into
account assumptions for future equity index growth rates, volatility of the equity index, future interest rates, and
determinations on adjusting the participation rate and the cap on equity indexed credited rates in light of market
conditions and policyholder behavior assumptions. These methodologies incorporate an explicit risk margin to take
into consideration market participant estimates of projected cash flows and policyholder behavior.
AIGFP’s Super Senior Credit Default Swap Portfolio
AIGFP values its CDS transactions written on the super senior risk layers of designated pools of debt securities or
loans using internal valuation models, third-party price estimates and market indices. The principal market was
determined to be the market in which super senior credit default swaps of this type and size would be transacted, or
have been transacted, with the greatest volume or level of activity. AIG has determined that the principal market
participants, therefore, would consist of other large financial institutions who participate in sophisticated
over-the-counter derivatives markets. The specific valuation methodologies vary based on the nature of the referenced
obligations and availability of market prices.
The valuation of the super senior credit derivatives continues to be challenging given the limitation on the
availability of market observable information due to the lack of trading and price transparency in the structured
finance market, particularly during and since the second half of 2007. These market conditions have increased the
reliance on management estimates and judgments in arriving at an estimate of fair value for financial reporting
purposes. Further, disparities in the valuation methodologies employed by market participants and the varying
judgments reached by such participants when assessing volatile markets have increased the likelihood that the various
parties to these instruments may arrive at significantly different estimates as to their fair values.
AIGFP’s valuation methodologies for the super senior credit default swap portfolio have evolved in response to the
deteriorating market conditions and the lack of sufficient market observable information. AIG has sought to calibrate
the methodologies to available market information and to review the assumptions of the methodologies on a regular
basis.
Regulatory capital portfolio: In the case of credit default swaps written to facilitate regulatory capital relief, AIGFP
estimates the fair value of these derivatives by considering observable market transactions. The transactions with the
most observability are the early terminations of these transactions by counterparties. AIGFP continues to reassess the
expected maturity of the portfolio. As of December 31, 2009, AIG estimated that the weighted average expected
maturity of the portfolio was 1.35 years. AIGFP has not been required to make any payments as part of terminations
initiated by counterparties. The regulatory benefit of these transactions for AIGFP’s financial institution
counterparties is generally derived from the terms of the Capital Accord of the Basel Committee on Banking
Supervision (Basel I) that existed through the end of 2007 and which is in the process of being replaced by the Revised
Framework for the International Convergence of Capital Measurement and Capital Standards issued by the Basel
Committee on Banking Supervision (Basel II). It was expected that financial institution counterparties would have
transitioned from Basel I to Basel II by the end of the two-year adoption period on December 31, 2009, after which
they would have received little or no additional regulatory benefit from these CDS transactions, except in a small
AIG 2009 Form 10-K 240