AIG 2012 Annual Report Download - page 253

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interest rates for receivables measured at fair value. This methodology considers such factors as the coupon rate
and yield curves.
Separate Account Assets
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Separate account assets are composed primarily of registered and unregistered open-end mutual funds that
generally trade daily and are measured at fair value in the manner discussed above for equity securities traded in
active markets.
Freestanding Derivatives
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Derivative assets and liabilities can be exchange-traded or traded over-the-counter (OTC). We generally value
exchange-traded derivatives such as futures and options using quoted prices in active markets for identical
derivatives at the balance sheet date.
OTC derivatives are valued using market transactions and other market evidence whenever possible, including
market-based inputs to models, model calibration to market clearing transactions, broker or dealer quotations or
alternative pricing sources with reasonable levels of price transparency. When models are used, the selection of a
particular model to value an OTC derivative depends on the contractual terms of, and specific risks inherent in the
instrument, as well as the availability of pricing information in the market. We generally use similar models to value
similar instruments. Valuation models require a variety of inputs, including contractual terms, market prices and rates,
yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs. For OTC
derivatives that trade in liquid markets, such as generic forwards, swaps and options, model inputs can generally be
corroborated by observable market data by correlation or other means, and model selection does not involve
significant management judgment.
For certain OTC derivatives that trade in less liquid markets, where we generally do not have corroborating market
evidence to support significant model inputs and cannot verify the model to market transactions, the transaction price
may provide the best estimate of fair value. Accordingly, when a pricing model is used to value such an instrument,
the model is adjusted so the model value at inception equals the transaction price. We will update valuation inputs in
these models only when corroborated by evidence such as similar market transactions, third party pricing services
and/or broker or dealer quotations, or other empirical market data. When appropriate, valuations are adjusted for
various factors such as liquidity, bid/offer spreads and credit considerations. Such adjustments are generally based
on available market evidence. In the absence of such evidence, management’s best estimate is used.
Embedded Policy Derivatives
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Certain variable annuity and equity-indexed annuity and life contracts contain embedded policy derivatives that we
bifurcate from the host contracts and account for separately at fair value, with changes in fair value recognized in
earnings. We have concluded these contracts contain (i) written option guarantees on minimum accumulation value,
(ii) a series of written options that guarantee withdrawals from the highest anniversary value within a specific period
or for life, or (iii) equity-indexed written options that meet the criteria of derivatives that must be bifurcated.
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 our historical experience.
With respect to embedded policy derivatives in our 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 judgments 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 our 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
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AIG 2012 Form 10-K236
ITEM 8 / NOTE 6. FAIR VALUE MEASUREMENTS