AIG 2012 Annual Report Download - page 254

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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.
We also incorporate our 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 non-complex swap against the floating rate (for example, LIBOR) leg of a related tenor. The swap curve was
adjusted, as necessary, for anomalies between the swap curve and the U.S. Treasury yield curve. During the fourth
quarter of 2010, we revised the non-performance risk adjustment to reflect a market participant’s view of AIG Life
and Retirement’s claims paying ability. As a result, in 2010, we 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 was partially offset by $173 million of DAC amortization.
Super Senior Credit Default Swap Portfolio
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We value 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. We have 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.
Our 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. We have sought to calibrate the
methodologies to available market information and to review the assumptions of the methodologies on a regular
basis.
In the case of credit default swaps written to facilitate regulatory capital relief, we
estimate 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. We continue to reassess the
expected maturity of the portfolio. There has been no requirement to make any payments as part of terminations of
super senior regulatory capital CDSs initiated by counterparties. In assessing the fair value of the regulatory capital
CDS transactions, we also consider other market data, to the extent relevant and available.
We use a modified version of the Binomial Expansion Technique (BET) model to
value our credit default swap portfolio written on super senior tranches of multi-sector CDOs of ABS. The BET model
was developed in 1996 by a major rating agency to generate expected loss estimates for CDO tranches and derive a
credit rating for those tranches, and remains widely used.
We have adapted the BET model to estimate the price of the super senior risk layer or tranche of the CDO. We
modified the BET model to imply default probabilities from market prices for the underlying securities and not from
rating agency assumptions. To generate the estimate, the model uses the price estimates for the securities
comprising the portfolio of a CDO as an input and converts those estimates to credit spreads over current LIBOR-
based interest rates. These credit spreads are used to determine implied probabilities of default and expected losses
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AIG 2012 Form 10-K 237
Regulatory capital portfolio:
Multi-sector CDO portfolios:
ITEM 8 / NOTE 6. FAIR VALUE MEASUREMENTS