AIG 2010 Annual Report Download - page 206

American International Group, Inc., and Subsidiaries
4) Generation of expected losses for each underlying security using the probability of default and recovery
rate;
5) Aggregation of the cash flows for all securities to create a cash flow profile of the entire collateral pool
within the CDO;
6) Division of the collateral pool into a number of hypothetical independent identical securities based on
the CDO’s diversity score so that the cash flow effects of the portfolio can be mathematically aggregated
properly. The purpose of dividing the collateral pool into hypothetical securities is a simplifying
assumption used in all BET models as part of a statistical technique that aggregates large amounts of
homogeneous data;
7) Simulation of the default behavior of the hypothetical securities using a Monte Carlo simulation and
aggregation of the results to derive the effect of the expected losses on the cash flow pattern of the super
senior tranche taking into account the cash flow diversion mechanism of the CDO;
8) Discounting of the expected cash flows determined in step 7 using LIBOR-based interest rates to
estimate the value of the super senior tranche of the CDO; and
9) Adjustment of the model value for the super senior multi-sector CDO credit default swap for the effect
of the risk of non-performance by AIG using the credit spreads of AIG available in the marketplace and
considering the effects of collateral and master netting arrangements.
AIGFP employs a Monte Carlo simulation in step 7 above to assist in quantifying the effect on the valuation of
the CDO of the unique aspects of the CDO’s structure such as triggers that divert cash flows to the most senior
part of the capital structure. The Monte Carlo simulation is used to determine whether an underlying security
defaults in a given simulation scenario and, if it does, the security’s implied random default time and expected
loss. This information is used to project cash flow streams and to determine the expected losses of the portfolio.
In addition to calculating an estimate of the fair value of the super senior CDO security referenced in the credit
default swaps using its internal model, AIGFP also considers the price estimates for the super senior CDO
securities provided by third parties, including counterparties to these transactions, to validate the results of the
model and to determine the best available estimate of fair value. In determining the fair value of the super senior
CDO security referenced in the credit default swaps, AIGFP uses a consistent process which considers all
available pricing data points and eliminates the use of outlying data points. When pricing data points are within a
reasonable range, an averaging technique is applied.
The following table presents the net notional amount and fair value of derivative liability of the multi-sector
super senior credit default swap portfolio using the Capital Markets fair value methodology:
Net Notional Amount Fair Value Derivative Liability
At December 31,
(in millions) 2010 2009 2010 2009
BET model $ 1,819 $ 2,186 $ 886 $ 1,092
Third-party price 1,665 2,466 1,225 1,883
Average of BET model and third-party price 594 193 338 145
Third-party price (European RMBS) 2,611 3,081 1,035 1,298
Total $ 6,689 $ 7,926 $ 3,484 $ 4,418
The fair value of derivative liability recorded on AIGFP’s super senior multi-sector CDO credit default swap
portfolio represents the cumulative change in fair value of the outstanding derivatives, which represents AIG’s best
estimate of the amount it would need to pay to a willing, able and knowledgeable third-party to assume the
obligations under AIGFP’s super senior multi-sector credit default swap portfolio.
190 AIG 2010 Form 10-K