AIG 2012 Annual Report Download - page 264

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Sensitivity to Changes in Unobservable Inputs
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We consider unobservable inputs to be those for which market data is not available and that are developed using the
best information available to us about the assumptions that market participants would use when pricing the asset or
liability. Relevant inputs vary depending on the nature of the instrument being measured at fair value. The following
is a general description of sensitivities of significant unobservable inputs along with interrelationships between and
among the significant unobservable inputs and their impact on the fair value measurements. The effect of a change
in a particular assumption in the sensitivity analysis below is considered independently of changes in any other
assumptions. In practice, simultaneous changes in assumptions may not always have a linear effect on the inputs
discussed below. Interrelationships may also exist between observable and unobservable inputs. Such relationships
have not been included in the discussion below. For each of the individual relationships described below, the inverse
relationship would also generally apply.
Corporate Debt
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Corporate debt securities included in Level 3 are primarily private placement issuances that are not traded in active
markets or that are subject to transfer restrictions. Fair value measurements consider illiquidity and
non-transferability. When observable price quotations are not available, fair value is determined based on discounted
cash flow models using discount rates based on credit spreads, yields or price levels of publicly-traded debt of the
issuer or other comparable securities, considering illiquidity and structure. The significant unobservable input used in
the fair value measurement of corporate debt is the yield. The yield is affected by the market movements in credit
spreads and U.S. Treasury yields. In addition, the migration in credit quality of a given security generally has a
corresponding effect on the fair value measurement of the securities. For example, a downward migration of credit
quality would increase spreads. Holding U.S. Treasury rates constant, an increase in corporate credit spreads would
decrease the fair value of corporate debt.
RMBS and Certain CDO/ABS
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The significant unobservable inputs used in fair value measurements of RMBS and certain CDO/ABS valued by third-
party valuation service providers are constant prepayment rates (CPR), constant default rates (CDR), loss severity,
and yield. A change in the assumptions used for the probability of default will generally be accompanied by a
corresponding change in the assumption used for the loss severity and an inverse change in the assumption used for
prepayment rates. In general, increases in yield, CPR, CDR, and loss severity, in isolation, would result in a
decrease in the fair value measurement. Changes in fair value based on variations in assumptions generally cannot
be extrapolated because the relationship between the directional change of each input is not usually linear.
CMBS
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The significant unobservable input used in fair value measurements for CMBS is the yield. Prepayment assumptions
for each mortgage pool are factored into the yield. CMBS generally feature a lower degree of prepayment risk than
RMBS because commercial mortgages generally contain a penalty for prepayment. In general, increases in the yield
would decrease the fair value of CMBS.
CDO/ABS – Direct Investment book
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The significant unobservable inputs used for certain CDO/ABS securities valued using the BET are recovery rates,
diversity score, and the weighted average life of the portfolio. An increase in recovery rates and diversity score will
have a directionally similar corresponding impact on the fair value of the portfolio. An increase in the weighted
average life will decrease the fair value.
Policyholder contract deposits
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The significant unobservable inputs used for embedded derivatives in policyholder contract deposits measured at fair
value, mainly guaranteed minimum withdrawal benefits (GMWB) for variable annuity products, are equity volatility,
mortality rates, lapse rates and utilization rates. Mortality, lapse and utilization rates may vary significantly depending
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AIG 2012 Form 10-K 247
ITEM 8 / NOTE 6. FAIR VALUE MEASUREMENTS