AIG 2014 Annual Report Download - page 250

ITEM 8 / NOTE 5. FAIR VALUE MEASUREMENTS
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Freestanding Derivatives
Derivative assets and liabilities can be exchange-traded or traded over-the-counter (OTC). We generally value exchange-
traded derivatives such as futures and options using quoted prices in active markets for identical derivatives at the balance
sheet date.
OTC derivatives are valued using market transactions and other market evidence whenever possible, including market-based
inputs to models, model calibration to market clearing transactions, broker or dealer quotations or alternative pricing sources
with reasonable levels of price transparency. When models are used, the selection of a particular model to value an OTC
derivative depends on the contractual terms of, and specific risks inherent in the instrument, as well as the availability of pricing
information in the market. We generally use similar models to value similar instruments. Valuation models require a variety of
inputs, including contractual terms, market prices and rates, yield curves, credit curves, measures of volatility, prepayment
rates and correlations of such inputs. For OTC derivatives that trade in liquid markets, such as generic forwards, swaps and
options, model inputs can generally be corroborated by observable market data by correlation or other means, and model
selection does not involve significant management judgment.
For certain OTC derivatives that trade in less liquid markets, where we generally do not have corroborating market evidence to
support significant model inputs and cannot verify the model to market transactions, the transaction price may provide the best
estimate of fair value. Accordingly, when a pricing model is used to value such an instrument, the model is adjusted so the
model value at inception equals the transaction price. We will update valuation inputs in these models only when corroborated
by evidence such as similar market transactions, independent third-party valuation service providers and/or broker or dealer
quotations, or other empirical market data. When appropriate, valuations are adjusted for various factors such as liquidity,
bid/offer spreads and credit considerations. Such adjustments are generally based on available market evidence. In the
absence of such evidence, management’s best estimate is used.
Embedded Policy Derivatives
Certain variable annuity and equity-indexed annuity and life contracts contain embedded policy derivatives that we bifurcate
from the host contracts and account for separately at fair value, with changes in fair value recognized in earnings. These
embedded derivatives are classified within Policyholder contract deposits. We have concluded these contracts contain
(i) written option guarantees on minimum accumulation value, (ii) a series of written options that guarantee withdrawals from
the highest anniversary value within a specific period or for life, or (iii) equity-indexed written options that meet the criteria of
derivatives that must be bifurcated.
The fair value of embedded policy derivatives contained in certain variable annuity and equity-indexed annuity and life
contracts is measured based on actuarial and capital market assumptions related to projected cash flows over the expected
lives of the contracts. These cash flow estimates primarily include benefits and related fees assessed, when applicable, and
incorporate expectations about policyholder behavior. Estimates of future policyholder behavior are subjective and based
primarily on our historical experience.
With respect to embedded policy derivatives in our variable annuity contracts, because of the dynamic and complex nature of
the expected cash flows, risk neutral valuations are used. Estimating the underlying cash flows for these products involves
judgments regarding expected market rates of return, market volatility, correlations of market variables to funds, fund
performance, discount rates and policyholder behavior. The portion of fees attributable to the fair value of expected benefit
payments are included within the fair value measurement of these embedded policy derivatives and related fees are classified
in net realized gain/loss as collected consistent with other changes in the fair value of these embedded policy derivatives. Any
additional fees not attributed to the embedded derivative are excluded from the fair value measurement and classified in policy
fees as collected.
With respect to embedded policy derivatives in our equity-indexed annuity and life contracts, option pricing models are used to
estimate fair value, taking into account assumptions for future equity index growth rates, volatility of the equity index, future
interest 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.