AIG 2013 Annual Report Download - page 214

unless a loss recognition event occurs. The assumptions include mortality, morbidity, persistency, maintenance
expenses, and investment returns. These assumptions are typically consistent with pricing inputs. The assumptions
also include margins for adverse deviation, principally for key assumptions such as mortality and interest rates used
to discount cash flows, to reflect uncertainty given that actual experience might deviate from these assumptions.
Establishing margins at contract inception requires management judgment. The extent of the margin for adverse
deviation may vary depending on the uncertainty of the cash flows, which is affected by the volatility of the business
and the extent of our experience with the product.
Loss recognition occurs if observed changes in actual experience or estimates result in projected future losses under
loss recognition testing. To determine whether loss recognition exists, we determine whether a future loss is
expected based on updated current assumptions. If a loss recognition exists, we recognize the loss by first reducing
DAC through amortization expense, and, if DAC is depleted, record additional liabilities through a charge to
policyholder benefit expense. See Note 9 to the Consolidated Financial Statements for additional information on loss
recognition. Because of the long-term nature of many of our liabilities subject to the ‘‘lock-in’’ principle, small changes
in certain assumptions may cause large changes in the degree of reserve adequacy. In particular, changes in
estimates of future invested asset returns have a large effect on the degree of reserve deficiency.
Groupings for loss recognition testing are consistent with our manner of acquiring and servicing the business and
applied by product groupings. We perform separate loss recognition tests for traditional life products, payout
annuities, and long-term care insurance. Once loss recognition has been recorded for a block of business, the old
assumption set is replaced and the assumption set used for the loss recognition would then be subject to the lock-in
principle. Key judgments made in loss recognition tests include the following:
• To determine investment returns used in loss recognition tests, we typically segregate assets that match liabilities
and then project future cash flows on those assets. Our projections include a reasonable allowance for investment
expenses and expected credit losses over the projection horizon. A critical assumption in the projection of
expected investment income is the assumed net rate of investment return at which excess cash flows are to be
reinvested. For products in which asset and liability durations are matched relatively well, this is less of a
consideration since interest on excess cash flows are not a significant component of future cash flows. For the
reinvestment rate assumption, anticipated future changes to the yield curves could have a large effect. Given the
interest rate environment applicable at the date of our loss recognition tests, we assumed a modest and gradual
increase in long-term interest rates over time.
• For mortality assumptions, key judgments include the extent of industry versus own experience to base future
assumptions as well as the extent of expected mortality improvements in the future. The latter judgment is based
on a combination of historical mortality trends, advice from industry public health and demography specialists that
were consulted by AIG’s actuaries and published industry information.
• For surrender rates, a key judgment involves the correlation between expected increases/decreases in interest
rates and increases/decreases in surrender rates. To support this judgment, we compare crediting rates on our
products relative to expected rates on competing products under different interest scenarios.
• For in-force long-term care insurance, rate increases are allowed but must be approved by state insurance
regulators. Consequently, the extent of rate increases that may be assumed requires judgment. In establishing our
assumption for rate increases for long-term care insurance, we consider historical experience as to the frequency
and level of rate increases approved by state regulators.
In connection with our program to utilize capital loss carryforwards, we sold investment securities in 2013 and 2012.
These and other investment sales with subsequent reinvestment at lower yields triggered recording of loss
recognition reserves of $1.5 billion and $1.2 billion, primarily related to certain long-term payout annuity contracts, in
2013 and 2012, respectively.
Significant unrealized appreciation on investments in a prolonged low interest rate environment may cause DAC to
be adjusted and additional future policy benefit liabilities to be recorded through a charge directly to accumulated
other comprehensive income (‘‘shadow loss recognition’’). These charges are included, net of tax, with the change in
net unrealized appreciation of investments. See Note 9 to the Consolidated Financial Statements for additional
information on shadow loss recognition. In applying shadow loss recognition, the Company overlays unrealized gains
onto loss recognition tests without revising the underlying test. Accordingly, there is limited additional judgment in this
process.
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AIG 2013 Form 10-K196
ITEM 7 / CRITICAL ACCOUNTING ESTIMATES
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