AIG 2013 Annual Report Download - page 252

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.
Multi-sector CDO portfolios: 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
on the underlying securities. This data is then aggregated and used to estimate the expected cash flows of the super
senior tranche of the CDO.
Prices for the individual securities held by a CDO are obtained in most cases from the CDO collateral managers, to
the extent available. CDO collateral managers provided market prices for 46 percent and 59 percent of the
underlying securities used in the valuation at December 31, 2013 and 2012. When a price for an individual security is
not provided by a CDO collateral manager, we derive the price through a pricing matrix using prices from CDO
collateral managers for similar securities. Matrix pricing is a mathematical technique used principally to value debt
securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the
relationship of the security to other benchmark quoted securities. Substantially all of the CDO collateral managers
who provided prices used dealer prices for all or part of the underlying securities, in some cases supplemented by
third-party pricing services.
The BET model also uses diversity scores, weighted average lives, recovery rates and discount rates. We employ a
Monte Carlo simulation to assist in quantifying the effect on the valuation of the CDO of the unique aspects of the
CDO’s structure such as triggers that divert cash flows to the most senior part of the capital structure. The Monte
Carlo simulation is used to determine whether an underlying security defaults in a given simulation scenario and, if it
does, the security’s implied random default time and expected loss. This information is used to project cash flow
streams and to determine the expected losses of the portfolio.
In addition to calculating an estimate of the fair value of the super senior CDO security referenced in the credit
default swaps using our internal model, we also consider the price estimates for the super senior CDO securities
provided by third parties, including counterparties to these transactions, to validate the results of the model and to
determine the best available estimate of fair value. In determining the fair value of the super senior CDO security
referenced in the credit default swaps, we use a consistent process that considers all available pricing data points
and eliminates the use of outlying data points. When pricing data points are within a reasonable range an averaging
technique is applied.
Corporate debt/Collateralized loan obligation (CLO) portfolios: For credit default swaps written on portfolios
of investment-grade corporate debt, we use a mathematical model that produces results that are closely aligned with
prices received from third parties. This methodology uses the current market credit spreads of the names in the
portfolios along with the base correlations implied by the current market prices of comparable tranches of the
relevant market traded credit indices as inputs.
We estimate the fair value of our obligations resulting from credit default swaps written on CLOs to be equivalent to
the par value less the current market value of the referenced obligation. Accordingly, the value is determined by
obtaining third-party quotations on the underlying super senior tranches referenced under the credit default swap
contract.
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AIG 2013 Form 10-K234
ITEM 8 / NOTE 5. FAIR VALUE MEASUREMENTS
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