AIG 2010 Annual Report Download - page 207

American International Group, Inc., and Subsidiaries
Arbitrage Portfolio — Corporate Debt/CLOs
The valuation of credit default swaps written on portfolios of investment-grade corporate debt and CLOs is less
complex than the valuation of super senior multi-sector CDO credit default swaps and the valuation inputs are
more transparent and readily available.
During the third quarter of 2009, AIGFP enhanced its valuation methodology for credit default swaps written
on portfolios of investment-grade corporate debt. This new methodology uses a mathematical model that produces
results that are more closely aligned with prices received from third parties, rather than relying on market indices.
This methodology is widely used by other market participants and uses the current market credit spreads of the
names in the portfolios along with the base correlations implied by the current market prices of comparable
tranches of the relevant market traded credit indices as inputs. As of December 31, 2010, one transaction,
representing two percent of the total notional amount of the corporate arbitrage transactions, is valued using
third-party quotes given its unique attributes.
AIGFP estimates the fair value of its obligations resulting from credit default swaps written on CLOs to be
equivalent to the par value less the current market value of the referenced obligation. Accordingly, the value is
determined by obtaining third-party quotes on the underlying super senior tranches referenced under the credit
default swap contract.
No assurance can be given that the fair value of AIGFP’s arbitrage credit default swap portfolio would not
change materially if other market indices or pricing sources were used to estimate the fair value of the portfolio.
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 this portfolio. As of December 31, 2010, AIGFP estimated that the weighted average expected maturity of the
portfolio was 3.16 years. AIGFP has not been required to make any payments as part of terminations initiated by
counterparties.
AIGFP does not expect to make any payment under these contracts based on current portfolio conditions and
stress analyses performed. Over the contractual life of the transactions, AIGFP is owed contractual premiums over
an extended period. However, the expectation that the counterparties will be willing and able to terminate these
transactions in the very near term based on the contract provisions and market conditions significantly reduces the
expected future cash flows to be received. Consequently, the future expected cash flows validate the observable
market transactions used to price the portfolio.
In light of early termination experience to date and after other analyses, AIG determined that there was no
unrealized market valuation adjustment for this regulatory capital relief portfolio for the year ended December 31,
2010 other than (1) for transactions where AIGFP believes the counterparty is no longer using the transaction to
obtain regulatory capital relief and (2) for transactions where the counterparty has failed to terminate the
transaction early as expected and no longer has any rights to terminate early in the future. During 2009, AIGFP
effected the early termination of a CDS transaction written on a European RMBS security of $1.5 billion in net
notional amount that was reported as part of Regulatory Capital — Other at a level approximating its fair value at
that time. Given its unique structure and concentrated exposure to high loan-to-value Spanish residential
mortgages, this transaction had exposed AIGFP to a relatively higher level of liquidity and credit risk than any
other regulatory capital CDS exposure, and AIG felt it prudent to terminate the transaction to avoid further
deterioration.
AIG will continue to assess the valuation of this portfolio and monitor developments in the marketplace. Given
the potential for further significant deterioration in the credit markets and the risk that AIGFP’s expectations with
respect to the termination of these transactions by its counterparties may not materialize, there can be no
assurance that AIG will not recognize unrealized market valuation losses from this portfolio in future periods.
AIG 2010 Form 10-K 191