AIG 2010 Annual Report Download - page 268

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.
AIG also incorporates its own risk of non-performance in the valuation of the embedded policy derivatives
associated with variable annuity and equity-indexed annuity and life contracts. Historically, the expected cash flows
were discounted using the interest rate swap curve (swap curve), which is commonly viewed as being consistent
with the credit spreads for highly-rated financial institutions (S&P AA-rated or above). A swap curve shows the
fixed-rate leg of a plain vanilla swap against the floating LIBOR leg of a related tenor. The swap curve was
adjusted, as necessary, for anomalies between the swap curve and the treasury yield curve. During the fourth
quarter of 2010, AIG revised the non-performance risk adjustment to reflect a market participant’s view of
SunAmerica’s claims paying ability. As a result, in 2010 AIG incorporated an additional spread to the swap curve
used to value embedded policy derivatives, thereby reducing the fair value of the embedded derivative liabilities by
$336 million, which is partially offset by $173 million of DAC amortization.
AIGFP’s Super Senior Credit Default Swap Portfolio
AIGFP values AIGFP’s 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 is challenging given the limitation on the availability of
market observable information due to the lack of trading and price transparency in certain structured finance
markets. 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.
AIG’s valuation methodologies for the super senior credit default swap portfolio have evolved over time in
response to market conditions and the availability of 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.
252 AIG 2010 Form 10-K