AIG 2014 Annual Report Download - page 215

ITEM 7 / CRITICAL ACCOUNTING ESTIMATES
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For long-duration traditional business, a “lock-in” principle applies. The assumptions used to calculate the benefit
liabilities and DAC are set when a policy is issued and do not change with changes in actual experience, 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.
The Life operating segment recorded loss recognition expense of $87 million in 2014 and $67 million in 2012 to increase
reserves for certain discontinued long-term care business as a result of updated assumptions. Sales of investment securities in
connection with our program to utilize capital loss carryforwards and other investment sales with subsequent reinvestment at
lower yields triggered recording of loss recognition expense of $30 million, $1.5 billion and $1.2 billion in 2014, 2013 and 2012,
respectively, primarily related to certain long-term payout annuity contracts in the Institutional Markets and Retirement
operating segments. See Results of Operations – Life Insurance Companies DAC and Reserves – Loss Recognition for
additional discussion.
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