For additional geographic information see Note 3 to the Consolidated Financial Statements.
Adjusted revenues exclude Net realized capital gains (losses), income from non-operating litigation settlements (included in Other income for GAAP purposes) and changes in fair value of securities used to hedge guaranteed living benefits (included in Net investment income for GAAP purposes). Adjusted revenues is a GAAP measure for our operating segments.
· Policyholder behavior, including mortality, lapses, withdrawals and benefit utilization. Estimates of future policyholder behavior are subjective and based primarily on our historical experience
Currency volatility remains acute. Such volatility affected line item components of income for those businesses with substantial international operations. In particular, growth trends in net premiums written reported in U.S. dollars can differ significantly from those measured in original currencies. The net effect on underwriting results, however, is significantly mitigated, as both revenues and expenses are similarly affected.
• lower investment returns primarily driven by lower hedge fund performance, a decline in income from fixed maturity securities for which the fair value option was elected compared to higher returns on this portfolio in 2017 as a result of significant spread tightening that occurred, losses on our fair value option equities portfolio, and lower invested assets resulting from the funding of the adverse development reinsurance agreement with NICO late in the first quarter of 2017;
The Tax Act requires companies to pay a one-time transition tax, net of tax credits, related to applicable foreign taxes paid, on previously untaxed current and accumulated earnings and profits of certain of our foreign subsidiaries. We were able to reasonably estimate the deemed repatriation tax and originally recorded a provisional estimated tax benefit of $38 million at December 31, 2017.
- $62 million measurement period adjustment related to the deemed repatriation tax,
- $660 million of tax charges and related interest associated with increases in uncertain tax positions primarily related to cross border financing transactions and other open tax issues,
• higher acquisition ratio primarily driven by changes in portfolio mix, higher insurance taxes, licenses and fees, and changes in the 2018 reinsurance programs; and
• higher current accident year loss ratio, as adjusted, driven primarily by higher severe losses; and
Net premiums written, excluding the impact of foreign exchange, increased due to:
• higher ceded premiums due to changes in 2018 reinsurance programs; and
Changes in the interest rate environment can have a significant impact on sales, surrender rates, investment returns, guaranteed income features, and spreads in the annuity industry.
· the sale of the Advisor Group in May 2016, which drove the decreases in advisory fee income, advisory expenses and general operating expenses, and resulted in a net $13 million decrease in adjusted pre-tax income.
• Fixed Annuities premiums and deposits increased primarily due to higher broker dealer and bank distribution sales driven by favorable market conditions. Net flows continued to be negative but improved primarily due to higher premiums and deposits, partially offset by increased surrenders.
• higher general operating expenses, which reflected continued investments in people and technology, and higher legal expenses; and
For Group Retirement, premiums primarily represent amounts received on life-contingent payout annuities. Premiums in 2018, which primarily represent immediate annuities, increased compared to 2017 and 2016. Overall, premiums is not a significant driver of the Group Retirement results.
Parent and Other adjusted pre-tax loss increased compared to the prior year as a result of higher interest expense due to debt issuances totaling $2.5 billion at the end of the first quarter of 2018 and decreases in other income as a result of lower income on securities for which we elected the fair value option and available for sale investments. The pre-tax loss increase was partially offset by declines in general operating expenses related to one time payments for executive leadership in 2017.
For Legacy investments, our business strategy is to maximize liquidity to AIG Parent and minimize book value impairments while sourcing for our insurance companies attractive assets for their portfolios.
In connection with the sale, we agreed to certain investment commitment targets into various Carlyle strategies and to certain minimum investment management fee payments within thirty-six months following the closing. We also will be required to pay a proportionate amount of an agreed make-whole fee to the extent we fail to satisfy such investment commitment targets.
As contemplated by the Purchase Agreement, we, Fortitude Holdings and TCG entered into an Amended and Restated Limited Liability Company Operating Agreement of Fortitude Holdings, governing the rights of the parties thereto. In addition, Fortitude Re and certain of our U.S. based insurance subsidiaries entered into (1) Investment Management Agreements with an affiliate of TCG (the Investment Manager), pursuant to which the Investment Manager will provide certain investment management and advisory services with respect to certain asset classes and (2) Fortitude Re entered into an Exclusivity Agreement with TCG pursuant to which the Investment Manager will be the exclusive provider of investment management and advisory services with respect to certain new business acquired by Fortitude Re following the Fortitude Re Closing with respect to certain asset classes. For additional information relating to the sale of a 19.9 percent ownership interest in Fortitude Holdings, see Note 1 to the Consolidated Financial Statements.
· increased Legacy Life and Retirement adjusted pre-tax income due to the absence of any significant loss recognition on certain payout annuities from the update of actuarial assumptions in 2017 compared to 2016. Loss recognition from the update to actuarial assumptions in 2017 was $14 million mainly attributable to the Long-Term Care portfolio;
· A rise in interest rates and widening credit spreads, as well as the adoption of the Recognition and Measurement of Financial Assets and Financial Liabilities Standard (Financial Instruments Recognition and Measurement Standard) on January 1, 2018, which resulted in the reclassification of unrealized gains in our equity securities to retained earnings, and in a net unrealized loss in our investment portfolio. Net unrealized gains in our available for sale portfolio decreased to approximately $3.6 billion as of December 31, 2018 from approximately $13.9 billion as of December 31, 2017.
* Excludes $2.6 billion of fixed maturity securities for which no NAIC Designation is available because they are held in legal entities within U.S. Insurance Companies that do not require a statutory filing.
Our investments in life settlements are monitored for impairment on a contract-by-contract basis quarterly. An investment in life settlements is considered impaired if the undiscounted cash flows resulting from the expected proceeds would not be sufficient to recover our estimated future carrying amount. This amount is defined as the current carrying amount for the investment in life settlements plus anticipated undiscounted future premiums and other capitalizable future costs, if any. Impaired investments in life settlements are written down to their estimated fair value. This is determined on a discounted cash flow basis, incorporating current market mortality assumptions and market yields or by repricing to the anticipated sale price as appropriate.
The following tables present other-than-temporary impairment charges recorded in earnings on fixed maturity securities, equity securities, private equity funds and hedge funds.
For a discussion of our other-than-temporary impairment accounting policy see Note 6 to the Consolidated Financial Statements.
The life insurance companies review and update actuarial assumptions at least annually, generally in the third quarter. Assumption setting standards vary between investment-oriented products and traditional long-duration products.
• we lowered our ultimate projected yields on invested assets by approximately three to six basis points on most annuity deposits and by approximately 12 to 19 basis points on most life insurance deposits. Projected yields are graded from a weighted average net GAAP book yield of existing assets supporting the business based on the value of the assets to a weighted average yield based on the duration of the assets excluding assets that mature during the grading period. The grading period is three years for annuity products and five years for life insurance products.
If the settlement agreements in principle are concluded in our ongoing dispute related to the disallowance of foreign tax credits associated with cross border financing transactions, we will be required to make a payment to the U.S. Treasury. Although we can provide no assurance regarding whether the non-binding settlements will be finalized, the amount we currently expect to pay based on current proposed settlement terms is approximately $1.7 billion, including obligations of AIG Parent and subsidiaries. This amount is net of payments previously made with respect to cross border financing transactions involving matters dating back to 1997 and other matters largely related to the same tax years. There remains uncertainty with regard to whether the settlements in principle will ultimately be approved by the relevant authorities as well as the amount and timing of any potential payments, which are not likely to be made before sometime in early 2020.
For a further discussion of our involvement with VIEs see Note 10 to the Consolidated Financial Statements.
For a discussion of our regulation and supervision by different regulatory authorities in the United States and abroad, including with respect to our liquidity and capital resources see Item 1. Business - Regulation and Item 1A. Risk Factors - Regulation.
We are engaged in a variety of insurance, investment and other financial services businesses that expose us to market risk, directly and indirectly. We are exposed to market risks primarily within our insurance and capital markets activities, on both the asset and liability side of our balance sheet through on- and off-balance sheet exposures. The Risk Officer within each business is responsible for creating a framework to properly identify these risks, then ensuring that they are appropriately measured, monitored and managed in accordance with the risk governance framework established by the Chief Market Risk Officer (CMRO).
The following table provides estimates of sensitivity to changes in yield curves, equity prices and foreign currency exchange rates on our financial instruments and excludes approximately $168.9 billion and $163.6 billion as of December 31, 2018 and December 31, 2017, respectively, of insurance liabilities. AIG believes that the interest rate sensitivities of these insurance and other liabilities serve as an offset to the net interest rate risk of the financial assets presented in the table below.
Cash Flow Forecasts measure the liquidity needed for a specific legal entity over a specified time horizon.
· manage the development of technology solutions that support the objectives above.
We monitor concentrations of exposure through insurance limits aggregated along dimensions such as geography, industry, or counterparty.
• Reinsurance - Since we use reinsurance to limit our losses, we are exposed to risks associated with reinsurance including the unrecoverability of expected payments from reinsurers due to either an inability or unwillingness to pay, contracts that do not respond properly to the event or actual reinsurance coverage that is different than anticipated. The inability or unwillingness to pay is considered credit risk and is monitored through our credit risk management framework.
• Longevity risk - represents the risk of an increase in value of a policy or benefit as a result of actual mortality rates being lower than the expected mortality rates. This risk could arise from medical advancement and longer-term societal health changes. This risk exists in a number of our product lines but is most significant for our annuity products, structured settlements and pension risk transfer business.
Our Individual and Group Retirement businesses offer variable annuity products with guaranteed living benefit (GLB) riders that guarantee a certain level of lifetime benefits. GLBs are accounted for as embedded derivatives measured at fair value, with changes in the fair value recorded in Other realized capital gains (losses). GLB features subject the Life and Retirement companies to market risk, including exposure to changes in interest rates, equity prices, credit spreads and market volatility.
Condensed Financial Information of Registrant at December 31, 2018 and 2017 and for the years ended December 31, 2018, 2017 and 2016
Other invested assets (portion measured at fair value: 2018 - $5,894; 2017 - $6,248)
Principal payments received on and sales of mortgage and other loans receivable
On August 31, 2016, we sold our controlling interest in NSM Insurance Group LLC (NSM), a managing general agent to ABRY Partners, a private equity firm, for consideration of $201 million resulting in a pre-tax gain of approximately $105 million in the third quarter of 2016. We retained an equity interest in a newly formed joint venture, which we subsequently sold on May 11, 2018 to White Mountains Catskill Holdings, Inc. We will continue to provide underwriting capacity to NSM.
The preparation of financial statements in accordance with GAAP requires the application of accounting policies that often involve a significant degree of judgment. Accounting policies that we believe are most dependent on the application of estimates and assumptions are considered our critical accounting estimates and are related to the determination of:
· Income earned on real estate based investments and related realized gains and losses from sales, property level impairments and financing costs.
In February 2017, the FASB issued an accounting standard that clarifies the scope of the derecognition guidance for the sale, transfer and derecognition of non-financial assets to noncustomers that aligns with the new revenue recognition principles. The standard also adds new accounting for partial sales of nonfinancial assets (including real estate) that requires an entity to derecognize a nonfinancial asset when it 1) ceases to have a controlling financial interest in the legal entity that holds the asset based on the consolidation model and 2) transfers control of the asset based on the revenue recognition model.
* Includes all net realized capital gains and losses except earned income (periodic settlements and changes in settlement accruals) on derivative instruments used for non-qualifying (economic) hedging or for asset replication.
With respect to embedded 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 our ability to adjust the participation rate and the cap on equity-indexed credited rates in light of market conditions and policyholder behavior assumptions.
During the year ended December 31, 2017, we transferred $392 million of securities issued by non-U.S. government entities from Level 1 to Level 2, because they are no longer considered actively traded. We had no material transfers of securities issued by non-U.S. government entities from Level 1 to Level 2 during the year ended December 31, 2018. For similar reasons, during the years ended December 31, 2018 and 2017, we transferred $806 million and $113 million, respectively, of securities issued by the U.S. government and government-sponsored entities from Level 1 to Level 2. Additionally, we transferred $126 million of preferred stock from Level 1 to Level 2 during the year ended December 31, 2017. We had no material transfers of preferred stock from Level 1 to Level 2 during the year ended December 31, 2018. There were no material transfers from Level 2 to Level 1 during the years ended December 31, 2018 and 2017.
The following table presents the gross components of purchases, sales, issuances and settlements, net, shown above for years ended December 31, 2018 and 2017 related to Level 3 assets and liabilities in the Consolidated Balance Sheet:
Securities of companies that are in default, under bankruptcy protection or troubled
There were no mortgage or other loans receivable for which the fair value option was elected that were 90 days or more past due or in non-accrual status at December 31, 2018 or 2017.
• Other invested assets: The majority of Other invested assets that are not measured at fair value in 2016 represent investments in life settlements. The fair value of investments in life settlements is determined using a discounted cash flow methodology that incorporates the best available market assumptions for longevity as well as market yields based on reported transactions. Due to the individual life nature of each investment in life settlements and the illiquidity of the existing market, significant inputs to the fair value are unobservable. The majority of the Other invested assets that are not measured at fair value in 2017 and 2018 represent time deposits with the original maturity at purchase greater than one year. The fair value of long-term time deposits is determined using the expected discounted future cash flow.
(a) The debt service coverage ratio compares a property’s net operating income to its debt service payments, including principal and interest. Our weighted average debt service coverage ratio was 1.9X and 2.1X at December 31, 2018 and 2017, respectively.
(a) Net of reductions in DAC of $1.0 billion, $1.3 billion, and $842 million at December 31, 2018, 2017 and 2016, respectively, related to the effect of net unrealized gains and losses on available for sale securities (shadow DAC).
Loss reserves represent the accumulation of estimates of unpaid claims, including estimates for claims incurred but not reported and loss adjustment expenses (IBNR), less applicable discount. We regularly review and update the methods used to determine loss reserve estimates. Any adjustments resulting from this review are reflected currently in pre-tax income. Because these estimates are subject to the outcome of future events, changes in estimates are common given that loss trends vary and time is often required for changes in trends to be recognized and confirmed. Reserve changes that increase previous estimates of ultimate cost are referred to as unfavorable or adverse development or reserve strengthening. Reserve changes that decrease previous estimates of ultimate cost are referred to as favorable development.
During 2017, we recognized $345 million of unfavorable prior year development in U.S. Financial Lines, net of external reinsurance but before ADC cessions, primarily due to adverse experience in the Directors and Officers (D&O) subset of business.
During 2017 and 2016, we recognized $58 million and $82 million of favorable development, respectively, mainly driven by the accident and health business.
We increased the reserves for these coverages by $190 million during 2016 to reflect updated assumptions about future loss development. The increase was driven by runoff public entity business where we reacted to the adverse emergence over the last year by increasing our loss development factors to reflect the portfolio’s experience especially in the loss tail instead of relying on the overall excess casualty loss development factors.
At December 31, 2018, the loss reserves reflect a net loss reserve discount of $2.0 billion, including tabular and non-tabular calculations based upon the following assumptions:
* Excludes $(9) million and $8 million of discount related to certain long tail liabilities in the United Kingdom at December 31, 2018 and 2017, respectively.
Assumptions used to determine the GMDB liability include interest rates, which vary by year of issuance and products; mortality rates, which are based upon actual experience modified to allow for variations in policy form; lapse rates, which are based upon actual experience modified to allow for variations in policy form; investment returns, using assumptions from a randomly generated model; and asset growth assumptions, which include a reversion to the mean methodology, similar to that applied for DAC.
(a) AIG Parent guarantees all such debt, except for MIP notes payable and Series AIGFP matched notes and bonds payable, which are direct obligations of AIG Parent. Collateral posted to third parties was $1.5 billion and $2.0 billion at December 31, 2018 and December 31, 2017, respectively. This collateral primarily consists of securities of the U.S. government and government sponsored entities and generally cannot be repledged or resold by the counterparties.
We have issued unconditional guarantees with respect to the prompt payment, when due, of all present and future payment obligations and liabilities of AIGFP and of AIG Markets arising from transactions entered into by AIG Markets.
• For additional discussion on commitments and guarantees associated with VIEs see Note 10 to the Consolidated Financial Statements.
The LTIP provides for an annual award to certain employees, including our senior executive officers and other highly compensated employees that may be comprised of PSUs, RSUs and/or stock options.
For the year ended December 31, 2018, the effective tax rate on income from continuing operations was 59.9 percent. The effective tax rate on income from continuing operations differs from the statutory tax rate of 21 percent primarily due to a $62 million measurement period adjustment related to the deemed repatriation tax, $48 million net charge primarily related to the accrual of IRS interest (including interest related to uncertain tax positions), $44 million associated with the effect of foreign operations, $29 million of non-deductible transfer pricing charges, $21 million of additional U.S. taxes imposed on income of our foreign subsidiaries under international provisions of the Tax Act, and $21 million of valuation allowance activity related to certain foreign subsidiaries and state jurisdictions, partially offset by tax benefits of $75 million associated with tax exempt income, and $72 million of reclassifications from accumulated other comprehensive income to income from continuing operations related to the disposal of available for sale securities. Effect of foreign operations is primarily related to income and losses in our foreign operations taxed at statutory tax rates different than 21 percent and foreign income subject to U.S. taxation.
Interest and penalties related to unrecognized tax benefits are recognized in income tax expense. At December 31, 2018, 2017, and 2016, we had accrued liabilities of $2.2 billion, $2.0 billion, and $1.2 billion, respectively, for the payment of interest (net of the federal benefit) and penalties. For the years ended December 31, 2018, 2017, and 2016, we accrued expense of $190 million, $776 million and $26 million, respectively, for the payment of interest and penalties. The activity for the period ended December 31, 2017, is primarily related to a decrease in the expected federal benefit of interest due to the U.S. corporate tax rate reduction and to an increase in interest and penalties associated with cross border financing transactions.