AIG 2015 Annual Report Download - page 246

ITEM 8 / NOTE 4. FAIR VALUE MEASUREMENTS
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The degree of judgment used in measuring the fair value of financial instruments generally inversely correlates with the level of
observable valuation inputs. We maximize the use of observable inputs and minimize the use of unobservable inputs when
measuring fair value. Financial instruments with quoted prices in active markets generally have more pricing observability and
less judgment is used in measuring fair value. Conversely, financial instruments for which no quoted prices are available have
less observability and are measured at fair value using valuation models or other pricing techniques that require more
judgment. Pricing observability is affected by a number of factors, including the type of financial instrument, whether the
financial instrument is new to the market and not yet established, the characteristics specific to the transaction, liquidity and
general market conditions.
Fair Value Hierarchy
Assets and liabilities recorded at fair value in the Consolidated Balance Sheets are measured and classified in accordance
with a fair value hierarchy consisting of three “levels” based on the observability of valuation inputs:
• Level 1: Fair value measurements based on quoted prices (unadjusted) in active markets that we have the ability to access
for identical assets or liabilities. Market price data generally is obtained from exchange or dealer markets. We do not adjust
the quoted price for such instruments.
• Level 2: Fair value measurements based on inputs other than quoted prices included in Level 1 that are observable for the
asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active
markets, quoted prices for identical or similar assets or liabilities in markets that are not active, and inputs other than quoted
prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly
quoted intervals.
• Level 3: Fair value measurements based on valuation techniques that use significant inputs that are unobservable. Both
observable and unobservable inputs may be used to determine the fair values of positions classified in Level 3. The
circumstances for using these measurements include those in which there is little, if any, market activity for the asset or
liability. Therefore, we must make certain assumptions about the inputs a hypothetical market participant would use to value
that asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value
hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls is
determined based on the lowest level input that is significant to the fair value measurement in its entirety.
The following is a description of the valuation methodologies used for instruments carried at fair value. These methodologies
are applied to assets and liabilities across the levels discussed above, and it is the observability of the inputs used that
determines the appropriate level in the fair value hierarchy for the respective asset or liability.
Valuation Methodologies of Financial Instruments Measured at Fair Value
Incorporation of Credit Risk in Fair Value Measurements
• Our Own Credit Risk. Fair value measurements for certain liabilities incorporate our own credit risk by determining the
explicit cost for each counterparty to protect against its net credit exposure to us at the balance sheet date by reference to
observable AIG CDS or cash bond spreads. We calculate the effect of credit spread changes using discounted cash flow
techniques that incorporate current market interest rates. A derivative counterparty’s net credit exposure to us is determined
based on master netting agreements, when applicable, which take into consideration all derivative positions with us, as well
as collateral we post with the counterparty at the balance sheet date. For a description of how we incorporate our own
credit risk in the valuation of embedded derivatives related to certain annuity and life insurance products, see Embedded
Derivatives within Policyholder Contract Deposits, below.
• Counterparty Credit Risk. Fair value measurements for freestanding derivatives incorporate counterparty credit by
determining the explicit cost for us to protect against our net credit exposure to each counterparty at the balance sheet date
by reference to observable counterparty CDS spreads, when available. When not available, other directly or indirectly
observable credit spreads will be used to derive the best estimates of the counterparty spreads. Our net credit exposure to