AIG 2010 Annual Report Download - page 263

American International Group, Inc., and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 derivative counterparty’s net credit exposure to AIG is determined based on master netting
agreements, when applicable, which take into consideration all derivative positions with AIG, as well as cash
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 cash collateral posted by the counterparty at the balance sheet date.
A 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 periodic 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 periodic 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).
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
incorporate counterparty credit risk by using discount rates that take into consideration cash issuance spreads for
similar instruments or other observable information.
The cost of credit protection is determined under a discounted present value approach considering the market
levels for single name CDS 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 an interest rate based on the benchmark London
Interbank Offered Rate (LIBOR) curve to derive its discount rates.
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.
Fixed Maturity Securities — Trading and Available for Sale
Whenever available, AIG obtains quoted prices in active markets for identical assets at the balance sheet date
to measure fixed maturity securities at fair value in its trading and available for sale portfolios. Market price data
is generally obtained from dealer markets.
Management is responsible for the determination of the value of the investments carried at fair value and the
supporting methodologies and assumptions. AIG employs independent third-party valuation service providers to
gather, analyze, and interpret market information and derive fair values based upon relevant methodologies and
assumptions for individual instruments. When AIG’s valuation service providers are unable to obtain sufficient
market observable information upon which to estimate the fair value for a particular security, fair value is
determined either by requesting brokers who are knowledgeable about these securities to provide a quote, which is
generally non-binding, or by employing widely accepted internal valuation models.
AIG 2010 Form 10-K 247