We operate from approximately 166 offices in the United States and approximately 351 offices in approximately 56 foreign countries. The following offices are located in buildings in the United States owned by us:
For additional information see Item 1A. Risk Factors - Business and Operations.
• our ability to successfully dispose of, monetize and/or acquire businesses or assets or successfully integrate acquired businesses;
• disruptions in the availability of our electronic data systems or those of third parties;
• the effectiveness of our strategies to recruit and retain key personnel and our ability to implement effective succession plans;
• the requirements, which may change from time to time, of the global regulatory framework to which we are subject;
- Part I, Item 1A. Risk Factors of this Annual Report; and
• net tax charge related to the enactment of the Tax Cuts and Jobs Act (Tax Act).
Adjusted pre-tax income is derived by excluding the items set forth below from income from continuing operations before income tax. This definition is consistent across our segments. These items generally fall into one or more of the following broad categories: legacy matters having no relevance to our current businesses or operating performance; adjustments to enhance transparency to the underlying economics of transactions; and measures that we believe to be common to the industry. APTI is a GAAP measure for our segments. Excluded items include the following:
• the portion of favorable or unfavorable prior year reserve development for which we have ceded the risk under retroactive reinsurance agreements and related changes in amortization of the deferred gain; and
The accounting policies that we believe are most dependent on the application of estimates and assumptions, which are critical accounting estimates, are related to the determination of:
· estimated gross profits to value deferred acquisition costs for investment-oriented products;
· income tax assets and liabilities, including recoverability of our net deferred tax asset and the predictability of future tax operating profitability of the character necessary to realize the net deferred tax asset and estimates associated with the Tax Act.
We continue to receive claims asserting injuries and damages from toxic waste, hazardous substances, and other environmental pollutants and alleged claims to cover the cleanup costs of hazardous waste dump sites, referred to collectively as environmental claims, and indemnity claims asserting injuries from asbestos. The vast majority of these asbestos and environmental losses emanate from policies written in 1984 and prior years. Commencing in 1985, standard policies contained absolute exclusions for pollution-related damage and asbestos. The current environmental policies that we specifically price and underwrite for environmental risks on a claims-made basis have been excluded from the analysis.
After evaluating the historical loss development factors from prior accident years since the early 1990s, in our judgment, it is reasonably likely that the actual loss development factors could vary by an amount equivalent to a six month shift from those actually utilized in the year-end 2018 reserve review. This would impact projections both for accident years where the selections were directly based on loss development methods as well as the a priori loss ratio assumptions for accident years with selections based on Bornhuetter-Ferguson or Cape Cod methods. Similar to loss cost trends, these changes in loss development factors could be attributable to changes in inflation or in the judicial environment, or in other social or economic conditions affecting losses.
The loss cost trends for U.S. D&O business vary by year and subset, but for the most recent accident years, it is assumed to have been generally close to zero. After evaluating the historical loss cost levels from prior accident years since the early 1990s, including the potential effect of losses relating to the credit crisis, in our judgment, it is reasonably likely that the actual variation in loss cost levels for these subsets could vary by approximately 10 percent lower or higher on a year-over-year basis than the assumptions actually utilized in the year-end 2018 reserve review. Because U.S. D&O business has exhibited highly volatile loss trends from one accident year to the next, there is the possibility of an exceptionally high deviation. In our analysis, the effects of loss cost trend assumptions affect the results through the a priori loss ratio assumptions used for the Bornhuetter-Ferguson and Cape Cod methods, which impact the projections for the more recent accident years.
Loss adjustment expenses (LAE) are separated into two broad categories, allocated loss adjustment expenses (ALAE), also referred to as legal defense and cost containment or “legal” and unallocated loss adjustment expenses (ULAE), which includes certain claims adjuster fees and other internal claim management costs.
The following sensitivity analysis table summarizes the effect on the loss reserve position of using certain alternative loss cost trend (for accident years where we use expected loss ratio methods) or loss development factor assumptions rather than the assumptions actually used in determining our estimates in the year-end loss reserve analyses in 2018:
Our exposure to the guaranteed amounts is equal to the amount by which the contract holder’s account balance is below the amount provided by the guaranteed feature. A variable annuity contract may include more than one type of guaranteed benefit feature; for example, it may have both a GMDB and a GMWB. However, a policyholder can generally only receive payout from one guaranteed feature on a contract containing a death benefit and a living benefit, i.e., the features are generally mutually exclusive (except a surviving spouse who has a rider to potentially collect both a GMDB upon their spouse’s death and a GMWB during his or her lifetime). A policyholder cannot purchase more than one living benefit on one contract. Declines in the equity markets, increased volatility and a sustained low interest rate environment increase our exposure to potential benefits under the guaranteed features, leading to an increase in the liabilities for those benefits.
· 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
· In applying asset growth assumptions for the valuation of GMWBs, we use market-consistent assumptions calibrated to observable interest rate and equity option prices
Policy acquisition costs and policy issuance costs that are incremental and directly related to the successful acquisition of new or renewal of existing insurance contracts related to universal life and investment-type products (collectively, investment-oriented products) are generally deferred and amortized, with interest, in relation to the incidence of estimated gross profits to be realized over the expected lives of the contracts, except in instances where significant negative gross profits are expected in one or more periods. Estimated gross profits include current and expected interest rates, net investment income and spreads, net realized capital gains and losses, fees, surrender rates, mortality experience and equity market returns and volatility. In estimating future gross profits, lapse assumptions require judgment and can have a material impact on DAC amortization. For fixed deferred annuity contracts, the future spread between investment income and interest credited to policyholders is a significant judgment, particularly in a low interest rate environment.
In estimating future gross profits for variable annuity products as of December 31, 2018, a long-term annual asset growth assumption of 7.0 percent (before expenses that reduce the asset base from which future fees are projected) was applied to estimate the future growth in assets and related asset-based fees. In determining the asset growth rate, the effect of short-term fluctuations in the equity markets is partially mitigated through the use of a reversion to the mean methodology, whereby short-term asset growth above or below the long-term annual rate assumption impacts the growth assumption applied to the five-year period subsequent to the current balance sheet date. The reversion to the mean methodology allows us to maintain our long-term growth assumptions, while also giving consideration to the effect of actual investment performance. When actual performance significantly deviates from the annual long-term growth assumption, as evidenced by growth assumptions for the five-year reversion to the mean period falling below a certain rate (floor) or above a certain rate (cap) for a sustained period, judgment may be applied to revise or “unlock” the growth rate assumptions to be used for both the five-year reversion to the mean period as well as the long-term annual growth assumption applied to subsequent periods. The use of a reversion to the mean assumption is common within the industry; however, the parameters used in the methodology are subject to judgment and vary within the industry.
(c) Represents the net impact of one percent parallel shift in the yield curve on the value of the GMWB embedded derivative. Does not represent interest rate spread compression on investment-oriented products.
The sensitivity ranges of 10 basis points, one percent and 10 percent are included for illustrative purposes only and do not reflect the changes in net investment spreads, equity return, volatility, interest rate, mortality or lapse used by AIG in its fair value analyses or estimates of future gross profits to value DAC and related reserves. Changes in excess of those illustrated may occur in any period.
For a further discussion on guaranteed benefit features of our variable annuities and the related hedging program see Enterprise Risk Management Insurance Risks - Life and Retirement Companies Key Risks - Variable Annuity Risk Management and Hedging Program, Insurance Reserves - Life and Annuity Reserves and DAC - DAC - Variable Annuity Guaranteed Benefits and Hedging Results, and Notes 5 and 14 to the Consolidated Financial Statements.
For additional information on the methodology and significant inputs, by investment type, that we use to determine the amount of impairment see the discussion in Note 6 to the Consolidated Financial Statements.
For additional information about the measurement of fair value of financial assets and financial liabilities and our accounting policy regarding the incorporation of credit risk in fair value measurements see Note 5 to the Consolidated Financial Statements.
(a) Includes $15.6 billion for which the primary source is broker quotes.
Assets and liabilities recorded at fair value in the Consolidated Balance Sheets are measured and classified in a hierarchy for disclosure purposes consisting of three levels based on the observability of inputs available in the marketplace used to measure the fair value.
We consider a number of factors to reliably estimate future taxable income so we can determine the extent of our ability to realize net operating losses (NOLs), foreign tax credits (FTCs), realized capital loss and other carryforwards. These factors include forecasts of future income for each of our businesses and actual and planned business and operational changes, both of which include assumptions about future macroeconomic and AIG specific conditions and events. We subject the forecasts to stresses of key assumptions and evaluate the effect on tax attribute utilization. We also apply stresses to our assumptions about the effectiveness of relevant prudent and feasible tax planning strategies. In 2018, we have also considered the impact of the Tax Act on our forecasts of taxable income, made certain assumptions related to interpretation of relevant new rules, and incorporated guidance issued by the U.S. tax authority. Our analysis also reflected the effect of slower utilization of our tax credits due to a reduction in the U.S. statutory tax rate as a result of the Tax Act. Our income forecasts, coupled with our tax planning strategies, all resulted in sufficient taxable income to achieve realization of the U.S. tax attributes prior to their expiration.
We also assess the recoverability of deferred tax assets related to unrealized tax capital losses in the U.S. life insurance companies’ available for sale portfolio. For the year ended December 31, 2018, recent changes in market conditions, including interest rate fluctuations, impacted the unrealized tax gains and losses in the U.S. life insurance companies’ available for sale securities portfolio, resulting in a deferred tax asset related to net unrealized tax capital losses. The deferred tax asset relates to the unrealized losses for which the carryforward period has not yet begun, and as such, when assessing its recoverability, we consider our ability and intent to hold the underlying securities to recovery. As of December 31, 2018, based on all available evidence, we concluded that a valuation allowance should be established on a portion of the deferred tax asset related to unrealized losses that are not more-likely-than-not to be realized.
Our accounting for income taxes, including uncertain tax positions, represents management’s best estimate of various events and transactions, and requires judgment. FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48) now incorporated into Accounting Standards Codification, 740, Income Taxes (ASC 740) prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of an income tax position taken or expected to be taken in a tax return. The standard also provides guidance on derecognition, classification, interest and penalties and additional disclosures. We determine whether it is more likely than not that a tax position will be sustained, based on technical merits, upon examination by the relevant taxing authorities before any part of the benefit can be recognized in the financial statements. A tax position is measured at the largest amount of benefit that is greater than 50 percent likely to be realized upon settlement.
As of December 31, 2018, we have completed our accounting for the tax effects of the Tax Act. As further guidance is issued by the U.S. tax authority, any resulting changes in our estimates will be treated in accordance with the relevant accounting guidance.
On July 18, 2018, we completed our acquisition of Validus Holdings, Ltd. (Validus), a leading provider of reinsurance, primary insurance, and asset management services, for approximately $5.5 billion in cash. This transaction strengthens our global General Insurance business by expanding our current product portfolio through additional distribution channels and advancing the tools available to enhance underwriting. The results of Validus following the date of the acquisition are included in our General Insurance segment starting in the third quarter of 2018. Our North America results include the results of Validus Reinsurance, Ltd. and Western World Insurance Group, Inc., while our International results include the results of Talbot Holdings Ltd.
In February 2018, we closed a series of affiliated reinsurance transactions impacting the Legacy Portfolio. These transactions were designed to consolidate most of our Legacy Insurance Run-Off Lines into a single legal entity, Fortitude Re, formerly known as DSA Reinsurance Company, Ltd., a Bermuda domiciled composite reinsurer. The transactions include the cession of approximately $31 billion of reserves from our Legacy Life and Retirement Run-Off Lines and approximately $4 billion of reserves from our Legacy General Insurance Run-Off Lines relating to business written by multiple AIG legal entities, which represented over 83 percent of the insurance reserves in the Legacy Portfolio as of December 31, 2018. Fortitude Re has approximately $40 billion of total assets, primarily managed by AIG Investments, and is AIG’s main run-off reinsurer with its own dedicated management team.
On November 6, 2018 we completed our acquisition of Glatfelter Insurance Group, a full-service broker and insurance company providing services for specialty programs and retail operations.
On December 31, 2018 AIG Life Ltd., a U.K. AIG Life and Retirement company, completed its acquisition of Ellipse, a specialist provider of group life risk protection in the U.K.
• a net favorable adjustment from the update of Life and Retirement actuarial assumptions in 2017 compared to a net unfavorable adjustment in the prior year;
This increase was partially offset by a loss on sale of divested businesses in 2017 compared to a gain on sale of divested businesses in 2016.
• 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 when 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;
• a net unfavorable adjustment from the review and update of Life and Retirement actuarial assumptions compared to a net favorable adjustment in the prior year; and
General operating and other expenses increased in 2018 compared to 2017 due to the acquisition of Validus, business growth and continued investments in business platforms. General operating and other expenses declined in 2017 compared to 2016 due to lower employee-related expenses and professional fee reductions related to our ongoing efficiency program and divestitures of businesses, including United Guaranty, AIG Advisor Group, Fuji Life and NSM Insurance Group LLC (NSM).
In keeping with our broad and ongoing efforts to transform for long-term competitiveness, general operating and other expenses for 2018, 2017 and 2016 included approximately $395 million, $413 million and $694 million of pre-tax restructuring and other costs, respectively, which were primarily comprised of employee severance charges related to efficiency initiatives.
While interest rates remain low by historical standards, interest rates during 2018, particularly in the United States, have risen, in some cases close to highs of the last five to ten years. In early 2019, the Federal Open Market Committee of the Federal Reserve System indicated that it expects the pace of rate increases to slow. The low interest rate environment negatively affects sales of interest rate sensitive products in our industry and may negatively impact the profitability of our existing business as we reinvest cash flows from investments, including increased calls and prepayments of fixed maturity securities and mortgage loans, at rates below the average yield of our existing portfolios. As rates rise, some of these impacts may abate while there may be different impacts, some of which are highlighted below. We actively manage our exposure to the interest rate environment through portfolio selection and asset-
The following table presents fixed annuity and universal life account values of our Individual Retirement, Group Retirement and Life Insurance operating segments by contractual minimum guaranteed interest rate and current crediting rates:
The impact of low interest rates on our General Insurance segment is primarily on our long-tail Casualty line of business. We expect limited impacts on our existing long-tail Casualty business as the duration of our assets is slightly longer than that of our liabilities. Sustained low interest rates would potentially impact new and renewal business for the long-tail Casualty line as we may not be able to adjust our future pricing consistent with our profitability objectives to fully offset the impact of investing at lower rates. However, we will continue to maintain pricing discipline and risk selection.
The SEC, federal and state lawmakers and state insurance regulators continue their efforts at evaluating what is an appropriate regulatory framework around a standard of care for the sale of investment products and services. For example, on April 18, 2018, the SEC proposed a package of rulemakings and interpretations designed to address the standard of care issues and the transparency of retail investors’ relationships with investment advisors and broker-dealers. Additionally, on July 18, 2018, the New York State Department of Financial Services adopted a best interest standard of care regulation applicable to annuity and life transactions through issuance of the First Amendment to Insurance Regulation 187 - Suitability and Best Interests in Life Insurance and Annuity Transactions (Regulation 187). The compliance date for Regulation 187 is August 1, 2019 for annuity products and February 1, 2020 for life products. As amended, Regulation 187 requires producers to act in their client’s best interest when making point-of-sale and in-force recommendations, and provide in writing the basis for the recommendation, as well as the facts and analysis to support the recommendation. The amended regulation also imposes additional duties on life insurance companies in relation to these transactions, such as requiring insurers to establish and maintain procedures designed to prevent financial exploitation and abuse. We will implement and enhance processes and procedures, where needed, to comply with this regulation. Other states, such as Nevada, Maryland and New Jersey, have also proposed similar standard of care regulations applicable to insurance producers and/or insurance companies. We continue to closely follow these proposals and other relevant federal and state-level regulatory and legislative developments in this area. While we cannot predict the long-term impact of these developments on our Life and Retirement businesses, we believe our diverse product offerings and distribution relationships position us to compete effectively in this evolving marketplace.
(a) 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.
- Partially offset by losses on the sale of securities in 2018 due to a decline in the credit and equity markets in the fourth quarter of 2018 compared to gains in the prior year.
• a net favorable adjustment from the update of Life and Retirement actuarial assumptions compared to a net unfavorable adjustment in the prior year;
- foreign exchange gains in 2017 compared to foreign exchange losses in the prior year due to $910 million of remeasurement losses for a short-term intercompany balance in 2016; and
• gains in the prior year on the sale of a portion of our investment in People’s Insurance Company (Group) of China Limited and PICC Property & Casualty Company Limited (collectively, our PICC Investment).
On December 22, 2017, the U.S. enacted Public Law 115-97, known informally as the Tax Cuts and Jobs Act (the Tax Act). The Tax Act reduced the statutory rate of U.S. federal corporate income tax to 21 percent and enacted numerous other changes impacting AIG and the insurance industry. At December 31, 2017, we originally recorded a provisional estimate of income tax effects of the Tax Act of $6.7 billion, including a tax charge of $6.7 billion attributable to the reduction in the U.S. corporate income tax rate and tax benefit of $38 million related to the deemed repatriation tax. Our provisional estimate of $6.7 billion was based in part on a reasonable estimate of the effects of the statutory income tax rate reduction on existing deferred tax balances and of certain provisions of the Tax Act. We filed our 2017 consolidated U.S. income tax return and have completed our review of the primary impact of the Tax Act provisions on our deferred taxes. As a result, we consider the accounting for the effects of the rate change on deferred tax balances to be complete and no material measurement period changes were recorded for this item.
The Tax Act includes provisions for Global Intangible Low-Taxed Income (GILTI) under which taxes on foreign income are imposed on the excess of a deemed return on tangible assets of certain foreign subsidiaries and for Base Erosion and Anti-Abuse Tax (BEAT) under which taxes are imposed on certain base eroding payments to affiliated foreign companies. There are substantial uncertainties in the interpretation of BEAT and GILTI and while certain formal guidance was issued by the U.S. tax authority, there are still aspects of the Tax Act that remain unclear and additional guidance is either still pending or expected in 2019. Such guidance may result in changes to the interpretations and assumptions we made and actions we may take, which may impact amounts recorded with respect to international provisions of the Tax Act, possibly materially. Consistent with accounting guidance, we treat BEAT as a period tax charge in the period the tax is incurred and have made an accounting policy election to treat GILTI taxes in a similar manner.
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
- $21 million of additional U.S. taxes imposed on income of our foreign subsidiaries under international provisions of the Tax Act,
- $40 million of excess tax deductions related to share based compensation payments recorded through the income statement in accordance with relevant accounting literature.
- $132 million of reclassifications from accumulated other comprehensive income to income from continuing operations related to the disposal of available for sale securities.
General Insurance consists of two operating segments: North America and International. Life and Retirement consists of four operating segments: Group Retirement, Individual Retirement, Life Insurance and Institutional Markets. Other Operations consists of businesses and items not allocated to our other businesses, which are primarily AIG Parent, Blackboard and Fuji Life, which was sold on April 30, 2017. Our Legacy Portfolio consists of our Legacy Life and Retirement Run-Off Lines, Legacy General Insurance Run-Off Lines, and Legacy Investments. Effective February 2018, Fortitude Re is included in our Legacy Portfolio.
We serve our business and individual customers on a global basis - from the largest multinational corporations to local businesses and individuals. Our clients benefit from our substantial underwriting expertise.
• tort environment volatility in certain jurisdictions and lines of business; and
Commercial Lines over recent years has experienced challenging market conditions, with widespread surplus capacity increasing competition and suppressing rates across multiple classes of business. However, we are seeing growing market support for rate increases in certain U.S. liability segments (outside of workers’ compensation), with increasing traction in excess casualty, D&O and commercial auto, where rates are supported by a trend of higher loss cost inflation. On the shorter tailed lines, the market is supporting higher rates for accounts which suffered losses from major catastrophe events in 2017 and 2018. We continue to achieve positive rate increases across a number of lines and classes of business as a result of our disciplined underwriting strategy and focus on risk selection. Further, we continue to achieve growth in several of our Commercial Lines high margin businesses, although these market segments remain highly competitive.
Personal Insurance focuses on individual customers, as well as group and corporate clients. Although market competition within Personal Insurance has increased, we continue to benefit from the underwriting quality, portfolio diversity, and low volatility of the short-tailed risk in these business lines.
(a) As a result of the Validus acquisition, 2018 includes additional Net premiums written for North America and International of $500 million and $371 million, respectively.
(b) As a result of the Glatfelter acquisition, 2018 includes additional Net premiums written for North America of $27 million.
(b) Natural and man-made catastrophe losses are generally weather or seismic events having a net impact on AIG in excess of $10 million each and also include certain man-made events, such as terrorism and civil disorders that exceed the $10 million threshold.
The North America General Insurance business is focused on making progress towards improved underwriting results and efficiencies. This includes strengthening our talent base; ongoing investment in pricing and monitoring tools; continuous review of our risk appetite combined with enhanced focus on portfolio management and individual business strategy; reduction of our gross and net limits; and increased use of reinsurance.
For a discussion of 2018 reinsurance programs see Part II, Item 7 Management's Discussion and Analysis of Financial Condition Results of Operation - Enterprise Risk Management.
• lower investment returns on alternative investments, primarily driven by less robust private equity and hedge fund performance compared to 2017, and a decline in income from securities for which the fair value option was elected as well as lower interest and dividends due to lower invested assets resulting from the first quarter 2017 funding of the adverse development reinsurance agreement with NICO;
• higher general operating expenses due to the inclusion of the Validus and Glatfelter acquisition; however general operating expense ratio decreased slightly.
• lower production primarily in Property, Programs business, and D&O products within Financial Lines mainly due to underwriting actions taken to strengthen our portfolio and to maintain pricing discipline; and
The decrease in the combined ratio reflected a decrease in the loss ratio slightly offset by an increase in the expense ratio.
The increase in the expense ratio was primarily due to a higher general operating expense ratio primarily driven by a decrease in net premiums earned reflecting portfolio optimization, which more than offset expense reductions.
Adjustment for ceded premiums under reinsurance contracts related to prior accident years
Adjusted pre-tax loss decreased in 2018 compared to the same period in the prior year primarily due to significantly lower unfavorable prior year loss reserve development, partially offset by higher severe and catastrophe losses and lower net investment income.
For further discussion on prior year loss reserve development see Insurance Reserves.
These were partially offset by lower general operating expenses driven by lower employee-related expenses and other expense reduction initiatives.
• growth in Accident & Health and Personal Lines business in Asia Pacific and in the Financial Lines business in Europe;
• lower business production in Japan because of delayed product introduction related to the Japan Merger Impact and exit from unprofitable distribution channels;
This decrease in the loss ratio was primarily driven by significantly lower unfavorable prior year loss reserve development partially offset by:
• a lower general operating expense ratio driven by lower employee-related expenses and other expense reduction initiatives; and
Group Retirement: Products and services include group mutual funds, group fixed annuities, group variable annuities, individual annuity and investment products, and financial planning and advisory services.
Products and services are marketed by The Variable Annuity Life Insurance Company (VALIC) under the VALIC brand and include investment offerings and plan administrative and compliance services. VALIC career financial advisors and independent financial advisors provide retirement plan participants with enrollment support and comprehensive financial planning services.
Federal Home Loan Bank (FHLB) Funding Agreements are issued through our Individual Retirement, Group Retirement and Institutional Markets operating segments. Funding agreements are issued by our U.S. Life and Retirement companies to FHLBs in their respective districts at floating rates over specified periods, which can be prepaid at our discretion. Proceeds are generally invested in fixed income securities and other suitable investments to generate spreads. These investment contracts do not have mortality or morbidity risk and are similar to GICs.
Enhance Operational Effectiveness by simplifying processes and operating environments to increase competitiveness, improve service and product capabilities and facilitate delivery of our target customer experience. We continue to invest in technology to improve operating efficiency and ease of doing business for our distribution partners and customers. We believe that simplifying our operating models will enhance productivity and support further profitable growth.
· a sustained low interest rate environment, which makes it difficult to profitably price new products and puts margin pressure on existing business due to lower reinvestment yields;
· increased competition in our primary markets, including aggressive pricing of annuities by private equity-backed annuity writers, increased competition and consolidation of employer groups in the group retirement planning market, and peers with different profitability targets in the pension risk transfer space;
· upgrading our technology and underwriting processes while managing general operating expenses.
Consumers have a significant need for life insurance, whether it is used for income replacement for their surviving family, estate planning or wealth transfer. Additionally, consumers use life insurance to provide living benefits in case of chronic, critical or terminal illnesses, and to supplement retirement income.
Our insurance companies generate significant revenues from investment activities. As a result, the operating segments in Life and Retirement are subject to variances in net investment income on the asset portfolios that support insurance liabilities and surplus.
The market environment continues to reflect uncertainties in the annuity business resulting from a sustained low interest rate environment. While interest rates increased during 2018, rates remain low relative to historical levels. Premiums and deposits improved in 2018 compared to 2017 but were lower than 2016. Premiums and deposits in 2018 included deposits from FHLB funding agreements. Net flows in 2018 deteriorated compared to 2017 and 2016 and continued to be negative primarily due to higher surrenders and withdrawals, mainly in Retail Mutual Funds.
· higher Index Annuity base portfolio income reflecting growth in assets from increased sales; and
· higher net investment income, which included higher gains on securities for which the fair value option was elected and higher returns on alternative investments, partially offset by a reduction in the overall size of the hedge fund portfolio;
· higher policy fees due to growth in annuity account values driven by improved equity market performance.
· lower net favorable adjustment from the review and update of actuarial assumptions which was $242 million in 2017 compared to $369 million in 2016;
Individual Retirement annuities are typically subject to a four- to seven-year surrender charge period, depending on the product. For Fixed Annuities, the proportion of reserves subject to surrender charge at December 31, 2018 has increased compared to December 31, 2017 due to improved net flows driven by higher Fixed Annuity sales, combined with fewer policyholders reaching the end of the surrender charge period in 2018 compared to 2017. The increase in reserves with no surrender charge contributed to the increase in the surrender rate for Variable and Index Annuities in 2018 compared to the prior year. Increases in market interest rates in 2018 contributed to the increase in the surrender rate for Fixed Annuities in 2018 compared to the prior year.
• Funding Agreements premiums and deposits in 2018 reflected deposits from FHLB funding agreements, which were excluded from reported net flows.
• Retail Mutual Funds net flows remained negative and deteriorated reflecting lower deposits and higher withdrawals due to continued negative industry trends in U.S. equity actively managed funds and the impact of underperformance within our largest fund.
• Retail Mutual Funds had negative net flows compared to positive net flows in 2016, reflecting lower deposits and higher withdrawals due to negative industry trends in U.S. equity actively managed funds and uncertainty surrounding the DOL Fiduciary Rule at the time.
Group Retirement is focused on implementing initiatives to grow its business. However, external factors, including increased competition and the consolidation of healthcare providers and other employers in target markets, continue to impact Group Retirement’s customer retention. Premiums and deposits increased in 2018 compared to 2017 and decreased slightly in 2017 compared to 2016. Premiums and deposits in 2018 included deposits from FHLB funding agreement. Net flows deteriorated in 2018 compared to 2017 and 2016 and continued to be negative primarily due to higher surrenders, partially offset by increased premiums and deposits in 2018 and slightly decreased premiums and deposits in 2017 compared to 2016.
Excluding the impact of the review and update of actuarial assumptions, adjusted pre-tax income decreased in 2018 compared to 2017 due to increases in general operating expenses and higher variable annuity DAC amortization and reserves due to lower equity market performance partially offset by higher policy fees and net investment income. Excluding the impact of the review and update of actuarial assumptions, adjusted pre-tax income increased in 2017 compared to 2016. In 2017, results reflected higher gains on securities for which the fair value option was elected, higher returns from alternative investments, increased policy and advisory fees, and lower general operating expenses. Partially offsetting these increases were lower base net investment yields partially mitigated by crediting rate management and a reduction in the overall size of the hedge fund portfolio.
• higher policy and advisory fees, net of expenses, primarily driven by growth in assets; and
• a net favorable adjustment from the review and update of actuarial assumptions of $13 million in 2017 compared to a $47 million net unfavorable adjustment in 2016;
• higher policy and advisory fees, net of expenses, due to growth in account values driven by improved equity market performance; and
• higher commission expense primarily due to the allocation of reinsurance risk charges from life insurance reinsurance transactions.
Premiums and deposits is a non-GAAP financial measure that includes, in addition to direct and assumed premiums, deposits received on investment-type annuity contracts, FHLB funding agreement and mutual funds under administration.
Net flows for annuity products included in Group Retirement represent premiums and deposits less death, surrender and other withdrawal benefits. Net flows for mutual funds represent deposits less withdrawals. Deposits from FHLB funding agreement was excluded from net flows of Group Retirement, as net flows from this funding agreement is not considered part of the metric to measure Group Retirement’s core recurring performance.
(a) Excludes mutual fund assets under administration of $17.9 billion and $20.2 billion at December 31, 2018 and 2017, respectively.
(b) Group Retirement amounts in this category include General Account reserves of approximately $6.3 billion, at December 31, 2018 and 2017, which are subject to 20 percent annual withdrawal limitations at the participant level and General Account reserves of $4.7 billion and $4.5 billion at December 31, 2018 and 2017 respectively, which are subject to 20 percent annual withdrawal limitations at the plan level.
Group Retirement annuities are typically subject to a five- to seven-year surrender charge period, depending on the product. At December 31, 2018, Group Retirement annuity reserves decreased compared to December 31, 2017 primarily due to a decrease in separate account assets. The surrender rate in 2018 increased compared to 2017 primarily due to higher surrenders, including approximately $1.6 billion of large plan surrenders.
Net flows declined and continued to be negative primarily due to surrenders, including plan surrenders of approximately $460 million. In addition, premiums and deposits decreased slightly primarily due to lower index annuity sales, partially offset by significantly higher deposits from plan acquisitions.
• a net unfavorable adjustment from the annual review and update of actuarial assumptions of $63 million compared to a net favorable adjustment in the prior year for $29 million; and
• a net favorable adjustment from the review and update of actuarial assumptions of $29 million in 2017 compared to a $92 million net unfavorable adjustment in 2016;
Premiums and deposits, excluding the effect of foreign exchange, increased in 2018 compared to 2017 and in 2017 compared to 2016, primarily due to growth in universal life, term life and international life and health, including assumed premiums on business distributed by Laya Healthcare. This increase was partially offset by lower group benefits premiums.
• higher general operating expenses due to investment in business growth.
Increases in premiums and policyholder benefits were primarily due to pension risk transfer business written in 2017. Growth in reserves and assets under management drove the increase in net investment income with similar impact to policyholder benefits.
Premiums for Institutional Markets primarily represent amounts received on pension risk transfer or structured settlement annuities with life contingencies. Premiums decreased in 2018 compared to 2017 and increased in 2017 compared to 2016 primarily driven by the pension risk transfer business written in 2017.
Premiums and deposits for Institutional Markets is a non-GAAP financial measure that includes direct premiums as well as deposits received on investment-type annuity contracts, including GICs and FHLB funding agreements. Deposits increased in 2018 compared to 2017 due to FHLB funding agreements.
Parent and Other adjusted pre-tax loss decreased as a result of gains on securities for which we elected the fair value option, partially offset by higher general operating expenses related to one time payments for executive leadership changes in 2017.
Legacy Portfolio represents exited or discontinued product lines, policy forms or distribution channels. Effective February 2018, our Bermuda-domiciled composite reinsurer, Fortitude Re, formerly known as DSA Reinsurance Company, Ltd. is included in our Legacy Portfolio.
· Legacy General Insurance Run-Off Lines - Reserves consist of excess workers’ compensation, environmental exposures and exposures to other products within General Insurance that are no longer actively marketed. Also includes the remaining reserves in Eaglestone Reinsurance Company (Eaglestone).
For Legacy insurance lines, securing the interests of our policyholders and insureds is paramount. We have considered and continue to evaluate the following strategies for these lines:
• Third-party and affiliated reinsurance and retrocessions to improve capital efficiency
Fortitude Re was established during the first quarter of 2018 in connection with a series of affiliated reinsurance transactions related to our Legacy Portfolio. Those reinsurance transactions were designed to consolidate most of our Legacy Insurance Run-Off Lines into a single legal entity. As of December 31, 2018, the affiliated transactions included the cession of approximately $31 billion of reserves from our Legacy Life and Retirement Run-Off Lines and approximately $4 billion of reserves from our Legacy General Insurance Run-Off Lines related to business written by multiple wholly-owned AIG subsidiaries. In the second quarter of 2018, we formed Fortitude Holdings, a wholly-owned subsidiary of AIG, to act as a holding company for Fortitude Re.
On November 13, 2018, we completed the sale of a 19.9 percent ownership interest in Fortitude Holdings to TCG, an affiliate of The Carlyle Group L.P. (Carlyle) (the Fortitude Re Closing). Fortitude Holdings owns 100 percent of the outstanding common shares of Fortitude Re and AIG has an 80.1 percent ownership interest in Fortitude Holdings.
As part of the establishment of Fortitude Re, we implemented a capital maintenance agreement (CMA) with Fortitude Re that remains in effect so long as we own at least 50 percent of Fortitude Re. If there are any CMA funding obligations that occur within 18 months of the Fortitude Re Closing, we will fund those obligations on a non-dilutive basis to TCG, but only if, and to the extent, we actually receive the Target Distribution prior to the expiration of such period.
Fortitude Holdings, our Legacy Portfolio may recognize a loss for the portion of the unamortized balance of these assets and related deferred acquisition costs of $0.5 billion (after-tax) that are not recoverable, if any, in the period in which our interest in Fortitude Holdings becomes non-controlling. This loss would be incremental to any gain or loss recognized on the sale of our controlling interest in Fortitude Holdings.
lower Legacy Life and Retirement earnings compared to 2017 due to lower net investment income and loss recognition from the update to actuarial assumptions in 2018 of $105 million mainly attributable to higher claims costs on the cancer products portfolio;
Legacy Investment earnings compared to 2017 due to continued dispositions of non- insurance investment assets, primarily driven by the sale of the life settlements portfolio in 2017 and lower gain on fair value option portfolios in 2018
· increased Legacy General Insurance adjusted pre-tax income due to the absence of any significant prior year development in 2017 compared to 2016.
· Lower investment returns in our hedge fund portfolio and a decline in income from fixed maturity securities for which the fair value option was elected when compared to 2017 where returns were higher as a result of significant spread tightening that occurred, as well as negative performance of our fair value option equity securities portfolio.
· During 2018, we reduced our hedge fund portfolio by approximately $1.8 billion as a result of redemptions consistent with our planned reduction of exposure.
· Our acquisition of Validus closed in the third quarter of 2018 and our acquisition of Glatfelter closed during the fourth quarter of 2018, increasing our investment portfolio by approximately $6.6 billion and $0.4 billion, respectively.
· We agreed to sell certain private equity funds in our portfolio during the second half of 2018.
• Our fundamental strategy across all of our investment portfolios is to optimize the duration characteristics of the assets within a target range based on comparable liability characteristics, to the extent practicable.
For General Insurance - North America and International and Legacy General Insurance Run-Off Lines, we estimate investable funds based primarily on loss reserves and unearned premiums. The allocation of net investment income of the General Insurance companies to segments is calculated based on these estimated investable funds, consistent with the approximate duration of the liabilities and the required economic capital allocation for each segment
In addition, a portion of the surplus of General Insurance is invested in a diversified portfolio of alternative investments which seeks to balance liquidity, volatility and growth. Although these alternative investments are subject to periodic earnings fluctuations, they have historically achieved yields in excess of the fixed maturity portfolio yields and have provided added diversification to the broader portfolio.
In addition, the Life and Retirement companies seek to enhance returns through investments in a diversified portfolio of alternative investments. Although these alternative investments are subject to periodic earnings fluctuations, they have historically achieved
yields in excess of the fixed maturity portfolio yields. While a diversified portfolio of alternative investments remains a fundamental component of the investment strategy of the Life and Retirement companies, we have reduced the overall size of the hedge fund portfolio, in light of changing market conditions and perceived market opportunities, and to continue reducing the size of the private equity portfolio.
Fixed maturity securities of the Life and Retirement companies domestic operations, with an average duration of 7.0 years, are comprised primarily of taxable corporate bonds, as well as taxable municipal and government bonds, and agency and non-agency structured securities. The majority of these investments are held in the available for sale portfolio and are rated investment grade based on its composite ratings.
The Securities Valuation Office (SVO) of the National Association of Insurance Companies (NAIC) evaluates the investments of U.S. insurers for statutory reporting purposes and assigns fixed maturity securities to one of six categories called ‘NAIC Designations.’ In general, NAIC Designations of ‘1’ highest quality, or ‘2’ high quality, include fixed maturity securities considered investment grade, while NAIC Designations of ‘3’ through ‘6’ generally include fixed maturity securities referred to as below investment grade. The NAIC has adopted revised rating methodologies for certain structured securities, including non-agency RMBS and CMBS, which are intended to enable a more precise assessment of the value of such structured securities and increase the accuracy in assessing expected losses to better determine the appropriate capital requirement for such structured securities. These methodologies result in an improved NAIC Designation for such securities compared to the rating typically assigned by the three major rating agencies. The following tables summarize the ratings distribution of U.S. Insurance Companies fixed maturity security portfolio by NAIC Designation, and the distribution by composite AIG credit rating, which is generally based on ratings of the three major rating agencies.
At December 31, 2018, approximately 88 percent of our fixed maturity securities were held by our domestic entities. Approximately 17 percent of these securities were rated AAA by one or more of the principal rating agencies, and approximately 15 percent were rated below investment grade or not rated. Our investment decision process relies primarily on internally generated fundamental analysis and internal risk ratings. Third-party rating services’ ratings and opinions provide one source of independent perspective for consideration in the internal analysis.
Moody’s Investors Service Inc. (Moody’s), Standard & Poor’s Financial Services LLC, a subsidiary of S&P Global Inc. (S&P), or similar foreign rating services rate a significant portion of our foreign entities’ fixed maturity securities portfolio. Rating services are not available for some foreign-issued securities. Our Credit Risk Management department closely reviews the credit quality of the foreign portfolio’s non-rated fixed maturity securities. At December 31, 2018, approximately 24 percent of such investments were either rated AAA or, on the basis of our internal analysis, were equivalent from a credit standpoint to securities rated AAA, and approximately 7 percent were below investment grade or not rated. Approximately 28 percent of the foreign entities’ fixed maturity securities portfolio is comprised of sovereign fixed maturity securities supporting policy liabilities in the country of issuance.
The following table presents the composite AIG credit ratings of our fixed maturity securities calculated on the basis of their fair value:
(b) As a result of the adoption of the Financial Instruments Recognition and Measurement Standard on January 1, 2018, equity securities are no longer classified and accounted for as available for sale securities.
The following table presents the fair values of our available for sale U.S. municipal bond portfolio by state and municipal bond type:
Impairments on life settlements in 2016 were partially attributable to an increase in policy premiums required to keep policies in force which resulted in lower future expected net cash flows that were insufficient to recover our net investment on certain policies. Impairments on life settlements in 2017 were mainly attributable to write-downs of the policies to the purchase price as agreed in the sale of the life settlements portfolio. We sold the remaining portion of our life settlements portfolio in 2017.
To determine other-than-temporary impairments, we use fundamental credit analyses of individual securities without regard to rating agency ratings. Based on this analysis, we expect to receive cash flows sufficient to cover the amortized cost of all below investment grade securities for which credit impairments were not recognized.
In periods subsequent to the recognition of an other-than-temporary impairment charge for available for sale fixed maturity securities that is not foreign-exchange related, we generally prospectively accrete into earnings the difference between the new amortized cost and the expected undiscounted recoverable value over the remaining life of the security. The accretion that was recognized for these securities in earnings was $530 million in 2018, $669 million in 2017 and $767 million in 2016.
The following table shows the aging of the pre-tax unrealized losses of fixed maturity securities, the extent to which the fair value is less than amortized cost or cost, and the number of respective items in each category:
(b) In 2018, primarily includes $96 million and $49 million of realized gains on the sale of shares of OneMain Holdings, Inc. and an investment in Castle Holdings LLC’s aircraft assets, respectively. In 2016, primarily includes $107 million of realized gains due to a purchase price adjustment on the sale of Class B shares of Prudential Financial, Inc. and losses of $253 million from the sale of a portion of our Life Settlements portfolio.
Net realized capital losses decreased in 2017 compared to 2016 due primarily to foreign exchange gains in 2017 compared to losses in the prior year and lower other-than-temporary impairments. Net realized capital losses in 2017 consisted primarily of losses on variable annuity embedded derivatives, net of related hedges, and impairments, which were partially offset by gains on the sales of securities and foreign exchange gains.
For additional discussion of market risk management related to these product features see MD&A - Enterprise Risk Management - Insurance Risks - Life and Retirement Companies Key Risks - Variable Annuity Risk Management and Hedging Programs. For more information on the economic hedging target and the impact to pre-tax income of this program see Insurance Reserves - Life and Annuity Reserves and DAC - Variable Annuity Guaranteed Benefits and Hedging Results in this MD&A.
* Includes loss reserve discount of $2.0 billion and $1.8 billion for the years ended December 31, 2018, and 2017, respectively. For discussion of loss reserve discount see Note 13 to the Consolidated Financial Statements.
* Includes the amortization attributed to the deferred gain at inception from the NICO adverse development reinsurance agreement of $233 million and $288 million in the year ended December 31, 2018 and 2017, respectively. Consistent with our definition of APTI, prior year development excludes the portion of (favorable) unfavorable prior year reserve development for which we have ceded the risk under the NICO reinsurance agreements of $834 million and $359 million for the year ended December 31, 2018 and 2017, respectively, and related changes in amortization of the deferred gain of $162 million and $56 million over those same periods
• Unfavorable development in US Excess Casualty, driven by the combination of construction Defect and construction wrap claims from accident year 2015 and prior where we reacted to significant increases in severity and longer claim reporting patterns, as well as higher than expected loss severity in accident years 2016 and 2017, which led to an increase in estimates for these accident years;
• Adverse development in Financial Lines in Europe and other areas across the world that have seen increases in the frequency and severity of large losses.
• Unfavorable development in U.S. Excess Casualty and U.S. Other Casualty, driven primarily by increases in underlying severity and greater than expected emerging loss experience in accident year 2016 as well as increased development from claims related to construction defects and construction wrap business (largely from accident years 2006 and prior).
• Higher than expected losses for Europe Casualty and Financial Lines, including a significant increase in large claims activity in our Europe long-tail business, with a large proportion emanating from accident year 2016. In addition, we increased our loss reserves as a result of the decision made by the UK Ministry of Justice to reduce the discount rate applied to lump-sum bodily injury payouts, known as the Ogden rate.
We note that for certain categories of claims (e.g., construction defect claims and environmental claims) and for reinsurance recoverable, losses may sometimes be reclassified to an earlier or later accident year as more information about the date of occurrence becomes available to us. These reclassifications are shown as development in the respective years in the tables above.
(a) For the period from inception to December 31, 2018, the accretion of discount and a reduction in effective interest rates was offset by changes in estimates of the amount and timing of future recoveries under the adverse development reinsurance agreement.
For a summary of significant reinsurers see Item 7. MD&A - Enterprise Risk Management - Insurance Operations Risks - General Insurance Companies Key Insurance Risks - Reinsurance Recoverable.
The reversion to the mean rate is updated quarterly based on market returns and can change dramatically in periods where market returns move significantly. Effective December 31, 2018, the reversion to the mean rate (gross of fees) was 5.38 percent for the Variable Annuity product line in Individual Retirement and 5.48 percent for the Variable Annuity product line in Group Retirement.
For traditional long-duration products, which include whole life insurance, term life insurance, accident and health insurance, long-term care insurance, and life-contingent single premium immediate annuities and structured settlements, 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. Loss recognition occurs if observed changes in actual experience or estimates result in projected future losses under loss recognition testing. Underlying assumptions are reviewed periodically and updated as appropriate.
The update of actuarial assumptions resulted in net favorable (unfavorable) adjustments to adjusted pre-tax income of Individual Retirement of $(52) million, $242 million and $369 million in 2018, 2017 and 2016, respectively.
In Fixed Annuities, the update of estimated gross profit assumptions resulted in a net favorable adjustment of $40 million and $130 million in 2018 and 2017, respectively, which reflected lower lapse assumptions, partially offset by lower spread assumptions. In 2016, a net favorable adjustment of $330 million reflected lower lapse assumptions, primarily due to lower long-term interest rates, as well as updates to spread assumptions.
In Variable and Index Annuities, the update of estimated gross profit assumptions resulted in a net unfavorable adjustment of $92 million in 2018, primarily due to refinements to the GMWB partial withdrawal assumptions in Variable Annuities and the multi-year index strategy crediting parameters in Index Annuities. The unfavorable adjustments were partially offset by lower GMWB lapse assumptions in Variable Annuities. In 2017, a net favorable adjustment of $112 million was primarily due to an increase in the reversion to the mean rate used for projecting future estimated gross profit for variable annuity products and changes in volatility assumptions. The net favorable adjustment was partially offset by a decrease in the separate account long-term asset growth rate assumption from 7.5 percent to 7.0 percent (before expenses that reduce the asset base from which future fees are projected) and an unfavorable adjustment in connection with the conversion to a new modeling platform for Index Annuities. In 2016, a net favorable adjustment of $39 million was primarily due to favorable updates to assumptions for volatility, lapses, mortality and policy expenses, partially offset by a decrease in the separate account long-term asset growth rate assumption from 8.5 percent to 7.5 percent (before expenses that reduce the asset base from which future fees are projected). The net favorable adjustment included a net unfavorable adjustment of approximately $24 million in connection with the conversion to a new modeling platform for variable annuities, primarily due to refinements to assumptions for guaranteed minimum interest rates and investment fees, partially offset by the impact of other refinements identified during the conversion.
In Life Insurance, the update of actuarial assumptions resulted in a net unfavorable adjustment of $63 million in 2018, primarily due to strengthening reserves for certain riders, decreased lapses and interest crediting model refinements. The unfavorable adjustments were partially offset by favorable adjustments driven by updates to mortality assumptions and a reduction to IBNR reserves. In 2017, a net favorable adjustment of $29 million was primarily due to improved mortality assumptions, partially offset by lower spread assumptions. In 2016, a net unfavorable adjustment of $92 million was primarily due to refinement to reserves for universal life insurance with secondary guarantees due to lower assumed lapse rates. The update to Life Insurance assumptions in 2016 also included lower spread assumptions.
In Legacy Portfolio, the update of actuarial assumptions resulted in a net unfavorable adjustment of $110 million in 2018, primarily due to $105 million of loss recognition expense on accident and health business (other than long-term care) in the Legacy Life and Retirement Run-Off Lines resulting from assumption and model refinements. In 2017, a net unfavorable adjustment of $14 million was primarily due to $13 million of loss recognition expense on long-term care business in the Legacy Life and Retirement Run-Off Lines resulting from model enhancements. In 2016, Legacy Life and Retirement Run-Off Lines recorded $622 million of loss recognition expense on payout annuities. The loss recognition reflected the establishment of additional reserves primarily as a result of mortality experience studies, which indicated increased longevity, particularly on disabled lives on a block of structured settlements underwritten prior to 2010.
The following table presents a reconciliation between the fair value of the U.S. GAAP embedded derivatives and the value of our economic hedge target:
The changes in the fair value of the economic hedge target and, to a lesser extent, the embedded derivative valuation under U.S. GAAP, were offset in part by the following changes in the fair value of the variable annuity hedging portfolio:
• The change in the fair value of equity derivative contracts, which included futures and options, resulted in gains in 2018, and losses in 2017 and 2016, which varied based on the relative change in equity market returns in the respective periods.
The net adjustments to DAC amortization from the update of actuarial assumptions for estimated gross profits, including those reported within change in DAC related to net realized capital gains (losses), represented four percent, two percent and four percent of the DAC balance excluding the amount related to unrealized depreciation (appreciation) of investments as of December 31, 2018, 2017 and 2016, respectively.
The reversion to the mean rate is updated quarterly based on market returns and can change dramatically in periods where market returns move significantly. The five-year reversion to the mean period did not meet the criteria for adjustment in 2018 which would have otherwise required a reset of the start date used in the calculation of the average gross long-term return rate. The long-term growth assumption used in our reversion to the mean methodology remained unchanged at 7.0 percent in 2018.
Shadow adjustments to DAC and unearned revenue generally move in the opposite direction of the change in unrealized appreciation of the available for sale securities portfolio, reducing the reported DAC and unearned revenue balance when market interest rates decline. Conversely, shadow adjustments to benefit reserves generally move in the same direction as the change in unrealized appreciation of the available for sale securities portfolio, increasing reported future policy benefit liabilities balance when market interest rates decline.
Market interest rates increased in 2018, which resulted in a $8.3 billion decrease in the unrealized appreciation of fixed maturity securities held to support businesses in the Life and Retirement companies at December 31, 2018 compared to December 31, 2017. At December 31, 2018, the shadow Investment-Oriented Adjustments reflected increases in DAC and unearned revenues and a decrease in future policy benefit liabilities compared to December 31, 2017, while the shadow Loss Adjustments reflected a decrease in future policy benefit liabilities.
The following table presents a rollforward of insurance reserves by operating segments for Life and Retirement, including future policy benefits, policyholder contract deposits, other policy funds, and separate account liabilities, as well as Retail Mutual Funds and Group Retirement mutual fund assets under administration:
Insurance reserves of Life and Retirement, as well as Retail Mutual Funds and Group Retirement mutual fund assets under administration, were comprised of the following balances:
Depending on market conditions, regulatory and rating agency considerations and other factors, we may take various liability and capital management actions. Liability management actions may include, but are not limited to, repurchasing or redeeming outstanding debt, issuing new debt or engaging in debt exchange offers. Capital management actions may include, but are not limited to, paying dividends to our shareholders and share and/or warrant repurchases.
During 2018, AIG Parent received $4.2 billion in dividends from subsidiaries. Of this amount, $1.7 billion consisted of dividends in the form of cash and fixed maturity securities from our General Insurance companies, $2.5 billion consisted of dividends and loan repayments in the form of cash from our Life and Retirement companies and $48 million consisted of dividends in the form of cash from our Other category.
In March 2018, we issued $750 million aggregate principal amount of 4.200% Notes Due 2028; $1.0 billion aggregate principal amount of 4.750% Notes Due 2048; and $750 million aggregate principal amount of 5.750% Fixed-To-Floating Rate Series A-9 Junior Subordinated Debentures Due 2048 (Junior Subordinated Debentures). We used the net proceeds from these offerings for general corporate purposes, including funding a portion of the consideration for the acquisition of Validus.
In November 2018, we completed our sale of a non-controlling interest in Fortitude Re for $476 million. We received $381 million of the purchase price at closing and will receive up to $95 million of deferred compensation which is subject to certain purchase price adjustments. To the extent we do not receive all or a portion of the Target Distribution within 18 months of the Fortitude Re Closing, TCG will pay us up to an additional $100 million.
On July 18, 2018, we completed our acquisition of Validus for approximately $5.5 billion in cash. Following the consummation of the acquisition, AIG executed a guarantee, dated July 26, 2018, with respect to Validus’ outstanding Series A Preference Shares and Series B Preference Shares (together, the Preference Shares), pursuant to which AIG provided a full and unconditional guarantee of Validus’ obligations with respect to the Preference Shares. In addition, AIG executed a guarantee, dated July 26, 2018, with respect to Validus’ aggregate outstanding 8.875% Senior Notes due 2040 (the Notes), pursuant to which AIG provided a full and unconditional guarantee of Validus’ obligations with respect to the Notes. AIG also entered into certain letter of credit agreements in support of the Validus companies.
We repurchased approximately 36.5 million shares of AIG Common Stock during 2018, for an aggregate purchase price of approximately $1.7 billion.
Interest payments totaled $1.3 billion in 2018 compared to $1.2 billion in 2017 and $1.3 billion in 2016. Excluding interest payments, AIG had operating cash inflows of $1.4 billion in 2018 compared to operating cash outflows of $6.6 billion in 2017 and operating cash inflows of $4.8 billion in 2016. The operating cash outflows in 2017 were primarily due to payment for the adverse development reinsurance agreement entered into with NICO.
Net cash used in investing activities in 2018 was $0.2 billion compared to cash provided by investing activities of $14.0 billion in 2017 and $3.3 billion in 2016. Net cash used in investing activities in 2018 included our acquisition of Validus for approximately $5.5 billion in cash. Net cash provided by investing activities in 2017 primarily included sales of certain investments to fund the adverse development reinsurance agreement entered into with NICO. Net cash provided by investing activities in 2016 primarily included $2.8 billion of net cash proceeds from the sales of United Guaranty, Ascot and AIG Advisor Group.
• approximately $1.7 billion to repurchase approximately 36.5 million shares of AIG Common Stock; and
As of December 31, 2018, AIG Parent had approximately $8.3 billion in liquidity sources. AIG Parent’s liquidity sources are primarily held in the form of cash, short-term investments and publicly traded, investment grade rated fixed maturity securities. Fixed maturity securities primarily include U.S. government and government sponsored entity securities, U.S. agency mortgage-backed securities, corporate and municipal bonds and certain other highly rated securities. AIG Parent actively manages its assets and liabilities in terms of products, counterparties and duration. Based upon an assessment of funding needs, the liquidity sources can be readily monetized through sales or repurchase agreements or contributed as admitted assets to regulated insurance companies. AIG Parent liquidity is monitored through the use of various internal liquidity risk measures. AIG Parent’s primary sources of liquidity are dividends, distributions, loans and other payments from subsidiaries and credit facilities. AIG Parent’s primary uses of liquidity are for debt service, capital and liability management, and operating expenses.
In the normal course, it is expected that a portion of the capital released by our insurance operations, by our other operations or through the utilization of AIG’s deferred tax assets may be available to support our business strategies, for distribution to shareholders or for liability management.
(a) Cash and short-term investments include reverse repurchase agreements totaling $22 million and $1.7 billion as of December 31, 2018 and December 31, 2017, respectively.
AIG generally manages capital between AIG Parent and our insurance companies through internal, Board-approved policies and limits, as well as management standards. In addition, AIG Parent has unconditional capital maintenance agreements (CMAs) in place with certain subsidiaries. Nevertheless, regulatory and other legal restrictions could limit our ability to transfer capital freely, either to or from our subsidiaries.
In February 2018, AIG Parent entered into a CMA with Fortitude Re. Among other things, the CMA provides that AIG Parent will maintain available statutory capital and surplus in each of Fortitude Re’s long term business fund and general business account at or above a stress threshold percentage of its projected enhanced capital requirement in respect of the applicable fund, as defined under Bermuda law. As of December 31, 2018, the stress threshold percentage under this CMA was 125 percent.
AIG Parent and/or certain subsidiaries are parties to several letter of credit agreements with various financial institutions, which issue letters of credit from time to time in support of our insurance companies. Letters of credit issued in support of the General Insurance companies totaled approximately $3.9 billion at December 31, 2018. Letters of credit issued in support of the Life and Retirement companies totaled approximately $907 million at December 31, 2018. Letters of credit issued in support of Fortitude Re totaled $550 million at December 31, 2018.
During 2016, we created a new Switzerland-domiciled international holding company, AIG International Holdings, GmbH (AIGIH), which is intended to be the ultimate holding company for all of our international entities. This international holding company structure is part of our ongoing efforts to simplify our organizational structure, and is expected to facilitate the optimization of our international capital strategy from both a regulatory and a tax perspective. Through February 12, 2019, substantially all of our international operations have been transferred to AIGIH. We will continue to monitor our international holding company structure in light of regulatory, tax and other developments, to ensure that this strategy continues to be effective.
In 2018, our General Insurance companies collectively paid a total of approximately $1.7 billion in dividends in the form of cash and fixed maturity securities to AIG Parent. The fixed maturity securities primarily included U.S. government and government-sponsored entity securities, U.S. agency mortgage-backed securities, corporate and municipal bonds and certain other highly rated securities.
In 2018, our Life and Retirement companies collectively paid a total of approximately $2.5 billion in dividends and loan repayments in the form of cash to AIG Parent.
As of December 31, 2018, a total of $4.5 billion remains available under the Facility. Our ability to utilize the Facility is not contingent on our credit ratings. However, our ability to utilize the Facility is conditioned on the satisfaction of certain legal, operating, administrative and financial covenants and other requirements contained in the Facility. These include covenants relating to our maintenance of a specified total consolidated net worth and total consolidated debt to total consolidated capitalization. Failure to satisfy these and other requirements contained in the Facility would restrict our access to the Facility and could have a material adverse effect on our financial condition, results of operations and liquidity. We expect to utilize the Facility from time to time, and may use the proceeds for general corporate purposes.
(a) Excludes potential amounts for indemnification obligations included in asset sales agreements. For further information on indemnification obligations see Note 16 to the Consolidated Financial Statements.
(b) Includes commitments to invest in private equity funds, hedge funds and other funds and commitments to purchase and develop real estate in the United States and abroad. The commitments to invest in private equity funds, hedge funds and other funds are called at the discretion of each fund, as needed for funding new investments or expenses of the fund. The expiration of these commitments is estimated in the table above based on the expected life cycle of the related fund, consistent with past trends of requirements for funding. Investors under these commitments are primarily insurance and real estate subsidiaries.
(d) Primarily represents liquidity facilities provided in connection with certain municipal swap transactions and collateralized bond obligations.
(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 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.
(d) At December 31, 2018, includes debt of consolidated investment vehicles related to real estate investments of $3.7 billion, affordable housing partnership investments of $1.8 billion and other securitization vehicles of $2.9 billion. At December 31, 2017, includes debt of consolidated investment vehicles related to real estate investments of $2.5 billion, affordable housing partnership investments of $1.8 billion and other securitization vehicles of $1.7 billion.
(c) Fitch ratings may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories.
Financial Strength ratings estimate an insurance company’s ability to pay its obligations under an insurance policy. The following table presents the ratings of our significant insurance subsidiaries as of February 8, 2019.
Our Board of Directors has authorized the repurchase of shares of AIG Common Stock and warrants to purchase shares of AIG Common Stock through a series of actions. On May 3, 2017, our Board of Directors approved an increase of $2.5 billion to the share repurchase authorization.
During 2018, we repurchased approximately 36.5 million shares of AIG Common Stock for an aggregate purchase price of approximately $1.7 billion pursuant to this authorization.
For a discussion of restrictions on payments of dividends by our subsidiaries see Note 19 to the Consolidated Financial Statements.
Our risk governance structure fosters the development and maintenance of a risk and control management culture that encompasses all significant risk categories impacting our lines of business and functions. Accountability for the implementation and oversight of risk policies is aligned with individual corporate executives, with the risk committees receiving regular reports regarding compliance with each policy to support risk governance at our corporate level as well as in each business unit. We review our governance and committee structure on a regular basis and make changes as appropriate to continue to effectively manage and govern our risks and risk-taking.
The Group Risk Committee (GRC): The GRC is the senior management group responsible for assessing all significant risk issues on a global basis to protect our financial strength, optimize our intrinsic value, and protect our reputation. The GRC is chaired by our CRO. Its membership includes the Executive Leadership Team (ELT) and other senior executives from across our corporate functions and business units. Our CRO reports periodically on behalf of the GRC to both the RCC and the Audit Committee of the Board of Directors. Our CRO is also a member of the ELT providing ERM the opportunity to contribute to, review, monitor and consider the impact of changes in strategy.
Business Unit Risk Committees: Each of our major insurance businesses has established a risk committee that serves as the senior management committee responsible for risk oversight at the individual business unit level. The risk committees are responsible for the identification, assessment and monitoring of all sources of risk within their respective portfolios. Specific responsibilities include setting risk tolerances, reviewing the capital allocation framework, insurance portfolio optimization, and providing oversight of risk-adjusted metrics. Together, these committees provide comprehensive risk oversight throughout the organization.
• BU and legal entity level limits are set to address key risks identified by ERM for the business unit and legal entities, protect capital and liquidity at legal entities and/or meet legal entity specific requirements of regulators and rating agencies. These limits are defined by the business unit and legal entity Risk Officers.
The stress testing framework assesses our aggregate exposure to our most significant financial and insurance risks, including the risk in each of our key insurance company subsidiaries in relation to its capital needs under stress, risks inherent in our non-insurance company subsidiaries, and risks to AIG consolidated capital. The framework measures risk over multiple time horizons and under different levels of stress, and includes multi-factor stresses as well as single factor sensitivities that are designed to reflect AIG’s risk characteristics. We use this information to support the assessment of resources needed at the AIG Parent level to support our subsidiaries and capital resources required to maintain consolidated company target capitalization levels.
• a limit framework that aligns with our Board-approved risk appetite statement;
• independent measurement, monitoring and reporting for line of business, business unit and enterprise-wide market risks; and
• clearly defined authorities for all individuals and committee roles and responsibilities related to market risk management.
(b) At December 31, 2018, the analysis covered $278.4 billion of $285.8 billion interest-rate sensitive assets. Excluded were $3.5 billion of loans. In addition, $3.9 billion of assets across various asset categories were excluded due to modeling limitations. At December 31, 2017, the analysis covered $276.8 billion of $289.6 billion interest-rate sensitive assets. Excluded were $8.2 billion of loans. In addition, $4.6 billion of assets across various asset categories were excluded due to modeling limitations.
(d) At December 31, 2018, the analysis excluded $8.4 billion of long-term debt related to debt of consolidated investments, $643 million of AIGLH borrowings, $359 million of Validus borrowings, $168 million of borrowings from FHLB and $331 million of AIG Japan Holdings loans. At December 31, 2017, the analysis excluded $6.0 billion of long-term debt related to debt of consolidated investments, $642 million of AIGLH borrowings, $190 million of borrowings from the FHLB and $334 million of AIG Japan Holdings loans.
(f) Beginning in the third quarter of 2018, the economic effect calculation presented for Derivatives - equity contracts is calculated using an internal risk calculation model. The prior period presentation of the economic effect was calculated as the effect of a 20 percent decline on the estimated fair value. Prior period presentation has been revised to conform to the current period approach.
Interest rate sensitivity is defined as change in its value with respect to plus a 100 basis point change in the interest rate environment, calculated as: scenario value minus base value, where base value is the value of the derivative under the yield curves as of the period end and scenario value is the value reflecting a 100 basis point parallel increase in all yield curves.
We evaluate our interest rate risk without the effect of any correlation among other key market risks or other assumptions used for calculating the fair value of our financial assets and liabilities. This scenario does not measure changes in value resulting from non-parallel shifts in the yield curve, which could produce different results.
Foreign currency-denominated net asset position reflects our consolidated non-U.S. dollar assets less our consolidated non-U.S dollar liabilities on a GAAP basis, with certain adjustments. We use a bottom-up approach in managing our foreign currency exchange rate exposures with the objective of protecting statutory capital at the regulated insurance entity level. At the AIG consolidated level, we monitor our foreign currency exposures against single currency and aggregate currency portfolio limits.
AIG Parent liquidity risk tolerance levels are designed to allow us to meet our financial obligations for a minimum of six months under a liquidity stress scenario. We maintain liquidity limits and minimum coverage ratios designed to ensure that funding needs are met under varying stress conditions. If we project that we will breach these tolerances, we will assess and determine appropriate liquidity management actions. However, the market conditions in effect at that time may not permit us to achieve an increase in liquidity sources or a reduction in liquidity requirements.
Asset liquidity and Coverage Ratios are re-measured under defined liquidity stress scenarios that will impact net cash flows, liquid assets and/or other funding sources.
The ORM function within ERM oversees the operational risk policy and risk and control framework, which includes risk identification, assessment, measurement, management and monitoring of operational risk exposures. ORM supports the Head of Operational Controls and Governance and has responsibility to provide an aggregate view of our operational risk profile. As part of the framework, we employ a Three Lines of Defense model whereby the first line consists of business units and functions that own and manage AIG risks, the second line consists of ERM and other control functions and serves as an independent advisor to the first line and has risk oversight responsibilities, and the third line consists of our Internal Audit Group that provides independent assurance covering aspects of the First and Second Lines of Defense, in each case, to strengthen the governance, capability and delivery of operational risk management tools and methods. As a part of our ongoing transformation efforts, the business leaders assume full ownership and accountability for the risks and controls in their operating units, including support functions, for the operational risks that arise in their own processes and activities and ERM performs an independent review and challenge function. In line with the Three Lines of Defense Model, the ORM programs include, but are not limited to, several key components outlined below:
• Risk Event Capture - enables every employee to identify, document, and escalate operational risk events, with a view to enhancing processes and promoting lessons learned.
· promote role clarity among the business and risk and control functions;
· foster greater consistency in identifying, measuring and ranking material risks;
AIG’s Board of Directors and its Technology Committee are regularly briefed by management on AIG’s cybersecurity matters, including threats, policies, practices and ongoing efforts to improve security. As part of our disclosure controls and procedures, ERM and Internal Audit are charged with ensuring that the members of management responsible for disclosure controls are informed in a timely manner of known cybersecurity risks and incidents that may materially impact our operations so that timely public disclosure can be made as appropriate. There is no guarantee that the measures AIG takes and the resources AIG devotes to protect against cybersecurity risk will provide absolute security or recoverability of AIG’s systems given the complexity and frequency of the risk, which AIG may not always be able to anticipate or adequately address. For additional information regarding the data protection and cybersecurity regulations to which we are subject, see Item 1. Business - Regulation - U.S. Regulation - Privacy, Data Protection and Cybersecurity and - International Regulation - Privacy, Data Protection and Cybersecurity. For additional discussion of cybersecurity risks, see Part I, Item 1A. Risk Factors - Business and Operations.
• risk transfer tools such as reinsurance, both internal and third-party;
• business line actuarial briefings and actuarial financial judgment regular reviews with ERM and business management;
• risk reporting and active risk management which includes meetings and collaboration between ERM and the business;
• clearly defined authorities for all individuals and committee roles and responsibilities related to insurance risk management.
In addition, there are risk specific assessment tools in place to better manage the variety of insurance risks to which we are exposed.
Our natural catastrophe exposure is primarily driven by the U.S. and Japan, though our overall exposure is diversified across multiple countries. For example, we have exposures to additional perils such as European windstorms and floods and seismic events across the Pacific Rim. Within the U.S., we have significant hurricane exposure in Florida, the Gulf of Mexico, the Northeast U.S. and mid-Atlantic regions. Events impacting the Northeast U.S. and the mid-Atlantic may result in a higher share of industry losses than other regions primarily due to our relative share of exposure in those regions. Within the U.S., we have significant earthquake exposure in California, the Pacific Northwest and New Madrid regions. Earthquakes impacting the Pacific Northwest and New Madrid regions may result in a higher share of industry losses than other regions primarily due to our relative share of exposure in these regions.
(a) The U.S. hurricane loss estimate includes losses to Commercial and Personal Property from hurricane hazards of wind and storm surge.
(b) The U.S. earthquake loss estimates represent exposure to Commercial and Personal Property, Workers’ Compensation (U.S.) and A&H business lines.
(c) Japan Typhoon loss estimate represents exposure to Commercial and Personal Property.
(d) Japan Earthquake loss estimate represents exposure to Commercial and Personal Property and A&H business lines.
Also, the modeled results are based on the assumption that all reinsurers fulfill their obligations to us under the terms of the reinsurance arrangements. However, reinsurance recoverables may not be fully collectible. Therefore, these estimates are inherently uncertain and may not accurately reflect our exposure to these events.
Our 2019 catastrophe reinsurance program provides protection on both an aggregate and occurrence basis. It is a worldwide program that provides differing per occurrence and aggregate attachment points for North America, Japan, and Rest of World (that also has some regional/country variations). The program includes $2 billion of limit for either per occurrence or aggregate exposure that is shared across the regional towers.
• Per occurrence protection of up to $4 billion excess of $750 million, including $2 billion of limit in excess of $2.75 billion that is shared across the regional occurrence and aggregate towers
• Up to $500 million of aggregate or occurrence North America specific limit to supplement the shared limit in the event that this erodes
• Rest of World and Japan dedicated aggregate protection of $250 million excess $250 million with a $20 million per occurrence deductible
• Rest of World and Japan $2 billion of per occurrence or aggregate shared limit
For Validus Reinsurance Limited, our catastrophe protection comes from a variety of reinsurance protections but is largely providing $400 million of limit excess $300 million of retention from world-wide exposure via an aggregate excess of loss cover with an additional $450 million of limit excess $700 million via the Tailwind Re Cat Bond for US, Puerto Rico and Canada named storm losses.
Our largest terrorism exposures are in New York City, and estimated losses are largely driven by the Property and Workers’ Compensation lines of business. At our largest exposure location, modeled losses for a five-ton bomb attack net of the Terrorism Risk Insurance Program (TRIP) and reinsurance recoveries are estimated to be $2.8 billion based on the exposures as of September 30, 2018.
Our exposure to terrorism risk in the U.S. is mitigated by TRIP in addition to limited private reinsurance protections. TRIP covers terrorist attacks within the United States or U.S. missions and against certain U.S. carriers or vessels and excludes certain lines of business as specified by applicable law. In 2019, TRIP covers 81 percent of insured losses above a deductible, decreasing to 80 percent in 2020. The current estimate of our deductible is approximately $2.0 billion for 2018.
We manage risk through product design, experience monitoring, pricing actions, risk limitations, reinsurance and active monitoring and management of the relationships between assets and liabilities, including hedging.
• Morbidity risk - represents the risk arising from actual morbidity (e.g. illness, disability or disease) incidence rate being higher than expected or the length of the claims extending longer than expected resulting in a higher overall benefit payout. This risk could arise from longer-term medical advances in detection and treatment for various diseases and medical conditions. This risk exists in a number of our product lines such as group benefits and long-term care businesses - which are in run-off or no longer being sold.
• Policyholder behavior risk (including full and partial surrender/lapse risk) - represents the risk that actual policyholder behavior differs from expected behavior in a manner that has an adverse effect on our operating results. There are many related assumptions made when products are sold, including how long the contracts will persist and other assumptions which impact the expected utilization of contract benefits, options and guarantees. Actual experience can vary significantly from these assumptions. This risk is impacted by a number of factors including changes in market conditions, especially changes in the levels of interest rate and equity markets, tax law, regulations, competitive landscape and policyholder preferences. This risk exists in many of our product lines, but most notably within the annuity portfolio of business.
For additional discussion of the impact of actual and expected experience on DAC and benefit reserves see Critical Accounting Estimates - Future Policy Benefits for Life and Accident and Health Insurance Contracts and Critical Accounting Estimates - Guaranteed Benefit Features of Variable Annuity Products. For additional discussion of business risks see Item 1A. Risk Factors - Business and Operations.
Variable annuity product design is the first step in managing our exposure to these market risks. Risk mitigation features of our variable annuity product design include GLB rider fees indexed to an equity market volatility index, which can provide additional fee assessments in periods of increased market volatility, required minimum allocations to fixed accounts to reduce overall equity exposure, and for some of the variable annuity products, the utilization of volatility control funds, which reduce equity exposure in the funds in response to changes in market volatility, even under sudden or extreme market movements.
(a) The financial strength ratings reflect the ratings of the various reinsurance subsidiaries of the companies listed as of January 29, 2019.
(d) Includes $13.8 billion recoverable under the 2011 retroactive asbestos reinsurance transaction and the 2017 Adverse Development Reinsurance agreement.
IBNR Incurred But Not Reported Estimates of claims that have been incurred but not reported to us.
ISDA Master Agreement An agreement between two counterparties, which may have multiple derivative transactions with each other governed by such agreement, that generally provides for the net settlement of all or a specified group of these derivative transactions, as well as pledged collateral, through a single payment, in a single currency, in the event of a default on, or affecting any, one derivative transaction or a termination event affecting all, or a specified group of, derivative transactions.
LAE Loss Adjustment Expenses The expenses directly attributed to settling and paying claims of insureds and include, but are not limited to, legal fees, adjuster’s fees and the portion of general expenses allocated to claim settlement costs.
Loss reserve development The increase or decrease in incurred losses and loss adjustment expenses related to prior years as a result of the re-estimation of loss reserves at successive valuation dates for a given group of claims.
Natural catastrophe and man-made losses are generally weather or seismic events having a net impact on AIG in excess of $10 million each and also include certain man-made events, such as terrorism and civil disorders that exceed the $10 million threshold.
Premiums and deposits - Life and Retirement include direct and assumed amounts received on traditional life insurance policies and group benefit policies, and deposits on life-contingent payout annuities, as well as deposits received on universal life, investment-type annuity contracts, FHLB funding agreements and mutual funds.
Return premium represents amounts given back to the insured in the case of a cancellation, an adjustment to the rate or an overpayment of an advance premium.
Reinsurance at December 31, 2018, 2017 and 2016 and for the years then ended
Bonds available for sale, at fair value (amortized cost: 2018 - $225,780; 2017 - $225,461)
Mortgage and other loans receivable, net of allowance (portion measured at fair value: 2018 - $0; 2017 - $5)
Other assets, including restricted cash of $343 in 2018 and $317 in 2017
(portion measured at fair value: 2018 - $973; 2017 - $922)
Policyholder contract deposits (portion measured at fair value: 2018 - $4,116; 2017 - $4,150)
Other liabilities (portion measured at fair value: 2018 - $1,265; 2017 - $1,124)
Long-term debt (portion measured at fair value: 2018 - $2,213; 2017 - $2,888)
Common stock, $2.50 par value; 5,000,000,000 shares authorized; shares issued: 2018 - 1,906,671,492 and
Change in fair value of liabilities under fair value option attributable to changes in own credit risk
Equity in loss from equity method investments, net of dividends or distributions
* Includes funds held for tax sharing payments to AIG Parent, security deposits, replacement reserve deposits related to our affordable housing investments, and security deposits for certain leased aircraft and escrow funds related to our investment in Castle Holdings LLC’s aircraft assets, which was sold in 2018.
Certain of our foreign subsidiaries included in the Consolidated Financial Statements report on fiscal-period ending November 30. The effect on our consolidated financial condition and results of operations of all material events occurring at these subsidiaries through the date of each of the periods presented in these Consolidated Financial Statements has been considered for adjustment and/or disclosure.
On December 31, 2018, AIG Life Ltd., a U.K. AIG Life and Retirement company, completed the acquisition of Ellipse, a specialist provider of group life risk protection in the U.K.
On December 31, 2016, we sold our 100 percent interest in United Guaranty Corporation (United Guaranty) and certain related affiliates to Arch Capital Group Ltd. (Arch) for total consideration of $3.3 billion, consisting of $2.2 billion of cash and approximately $1.1 billion of newly issued Arch convertible non-voting common-equivalent preferred stock and reported a pre-tax gain of approximately $697 million. We also received $261 million in pre-closing dividends from United Guaranty in the fourth quarter of 2016. However, due to pending regulatory approvals, United Guaranty Asia was not included in the December 31, 2016 closing and $40 million of cash consideration was retained by Arch. The sale of United Guaranty Asia was completed on July 1, 2017 and we received the $40 million cash proceeds. In the first quarter of 2018, we sold our remaining interest in Arch, which we received as part of the consideration for selling United Guaranty to Arch in 2016.
Concurrent with the closing, we entered into reinsurance agreements with Arch, including an amended and restated 50 percent quota share reinsurance agreement and an aggregate excess of loss reinsurance agreement, pursuant to which we will continue to be exposed to certain United Guaranty policies written between 2009 and 2016.
On November 17, 2016, an AIG sponsored Fund (the Korea Fund), completed the sale of mixed-use commercial complex in Seoul, South Korea commonly known as the Seoul International Finance Center to Brookfield Properties for a total consideration of $2.5 billion, of which $1.2 billion was used to repay the fund’s debt. The sale resulted in a pre-tax gain ☐ f $1.1 billi ☐ n included in Other Income, of which $464 million was attributable to AIG’s controlling interest.
On November 13, 2018, we completed the sale of a 19.9 percent ownership interest in Fortitude Holdings to TCG, an affiliate of The Carlyle Group L.P. (Carlyle). Fortitude Holdings owns 100 percent of the outstanding common shares of Fortitude Re and AIG has an 80.1 percent ownership interest in Fortitude Holdings. We received $381 million in cash and will receive up to $95 million of deferred compensation which is subject to certain purchase price adjustments. To the extent we do not receive all or a portion of the planned distributions within 18 months of the Fortitude Re Closing, TCG will pay us up to an additional $100 million. 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.
• impairment charges, including other-than-temporary impairments on available for sale securities, impairments on other invested assets, including investments in life settlements, and goodwill impairment;
For the year ended December 31, 2018, our results include out of period adjustments relating to prior periods that decreased net income attributable to AIG by $77 million, and decreased Income from continuing operations before income taxes by $98 million. The out of period adjustments are primarily related to decreases in deferred policy acquisition costs and increases in policyholder contract deposits. We determined that these adjustments were not material to the current year or to any previously reported annual financial statements. Had these adjustments been recorded in their appropriate periods, Net income attributable to AIG for the years ended December 31, 2017, and December 31, 2016 would have increased by $95 million, and by $117 million, respectively.
Other income includes advisory fee income from the Life and Retirement broker dealer business, as well as legal recoveries of $11 million, $27 million and $44 million from legacy crisis and other matters in 2018, 2017 and 2016, respectively.
· Changes in the fair value of other securities sold but not yet purchased, futures, hybrid financial instruments, securities purchased under agreements to resell, and securities sold under agreements to repurchase.
Other liabilities consist of other funds on deposit, other payables, securities sold under agreements to repurchase, securities sold but not yet purchased, derivative liabilities and deferred gains on retroactive reinsurance agreements. We have entered into certain insurance and reinsurance contracts, primarily in our General Insurance companies, that do not contain sufficient insurance risk to be accounted for as insurance or reinsurance. Accordingly, the premiums received on such contracts, after deduction for certain related expenses, are recorded as deposits within Other liabilities in the Consolidated Balance Sheets. Net proceeds of these deposits are invested and generate Net investment income. As amounts are paid, consistent with the underlying contracts, the deposit liability is reduced. Also included in Other liabilities are trade payables for the DIB and GCM, which include option premiums received and payables to counterparties that relate to unrealized gains and losses on futures, forwards, and options and balances due to clearing brokers and exchanges. Trade payables for GCM also include cash collateral received from derivative counterparties that contractually cannot be netted against derivative assets.
We adopted the standard using the modified retrospective approach on its required effective date of January 1, 2018. Our analysis of revenues indicated that substantially all of our revenues were from sources excluded from the scope of the standard. For those revenue sources within the scope of the standard, there were no material changes in the timing or measurement of revenues based upon the guidance. As substantially all of our revenue sources were excluded from the scope of the standard, the adoption of the standard did not have a material impact on our reported consolidated financial condition, results of operations, cash flows or required disclosures.
In January 2016, the FASB issued an accounting standard that requires equity investments that do not follow the equity method of accounting or are not subject to consolidation to be measured at fair value with changes in fair value recognized in earnings, while financial liabilities for which fair value option accounting has been elected, changes in fair value due to instrument-specific credit risk are presented separately in other comprehensive income. The standard allows the election to record equity investments without readily determinable fair values at cost, less impairment, adjusted for subsequent observable price changes with changes in the carrying value of the equity investments recorded in earnings. The standard also updates certain fair value disclosure requirements for financial instruments carried at amortized cost.
We adopted the standard on its effective date of January 1, 2018 using the modified retrospective approach. The impact of the adoption is primarily related to the reclassification of unrealized gains of equity securities resulting in a net decrease to beginning Accumulated other comprehensive income and a corresponding net increase to beginning Retained earnings of $824 million.
We adopted the standard retrospectively on its effective date of January 1, 2018. The standard addresses presentation in the statement of cash flows only and did not have a material impact on our reported consolidated financial condition, results of operations or required disclosures.
In October 2016, the FASB issued an accounting standard that requires an entity to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs, rather than when the asset is sold to a third party.
In November 2016, the FASB issued an accounting standard that provides guidance on the presentation of restricted cash in the Statement of Cash Flows. Entities are required to explain the changes during a reporting period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents in the statement of cash flows.
In February 2018, the FASB issued an accounting standard that allows the optional reclassification of stranded tax effects within accumulated other comprehensive income to retained earnings that arise due to the enactment of the Tax Cuts and Jobs Act of 2017 (Tax Act). The amount of the reclassification would reflect the impact of the change in the U.S. federal corporate income tax rate on the gross deferred tax amounts and related valuation allowances, if any, at the date of enactment of the Tax Act and other income tax effects of the Tax Act on items remaining in accumulated other comprehensive income.
We adopted the standard effective January 1, 2018. The impact of the adoption of the standard resulted in an increase to beginning Accumulated other comprehensive income and a corresponding decrease to beginning Retained earnings of $248 million. For more information on the adoption of the Tax Act, see Note 23.
In January 2017, the FASB issued an accounting standard that eliminates the requirement to calculate the implied fair value of goodwill, through a hypothetical purchase price allocation, to measure a goodwill impairment charge. Instead, entities will record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value not to exceed the total amount of goodwill allocated to that reporting unit. An entity should also consider income tax effects from tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable.
We plan to adopt the standard retrospectively on its effective date of January 1, 2019. We do not expect the standard to have a material impact on our reported consolidated financial condition, results of operations, cash flows or required disclosures.
In August 2018, the FASB issued an accounting standard update with the objective of making targeted improvements to the existing recognition, measurement, presentation, and disclosure requirements for long-duration contracts issued by an insurance entity. The standard prescribes significant and comprehensive changes to recognition, measurement, presentation and disclosure as summarized below:
• Requires the review and if necessary update of future policy benefit assumptions at least annually for traditional and limited pay long duration contracts, with the recognition and separate presentation of any resulting re-measurement gain or loss (except for discount rate changes as noted below) in the income statement.
• Requires the discount rate assumption to be updated at the end of each reporting period using an upper medium grade (low-credit risk) fixed income instrument yield that maximizes the use of observable market inputs and recognizes the impact of changes to discount rates in other comprehensive income.
• Requires the measurement of all market risk benefits associated with deposit (or account balance) contracts at fair value through the income statement with the exception of instrument-specific credit risk changes, which will be recognized in other comprehensive income.
We plan to adopt the standard on its effective date of January 1, 2021. We are evaluating the method of adoption and impact of the standard on our reported consolidated financial condition, results of operations, cash flows and required disclosures. The adoption of this standard is expected to have a significant impact on our consolidated financial condition, results of operations, cash flows and required disclosures, as well as systems, processes and controls.
· International - consists of insurance businesses in Japan, the United Kingdom, Europe, Asia Pacific, Latin America, Puerto Rico, Australia, the Middle East and Africa. This also includes the results of Talbot Holdings, Ltd. as of the acquisition date.
- Personal Insurance - consists of Personal Lines and Accident and Health.
· Income from assets held by AIG Parent and other corporate subsidiaries.
Legacy Portfolio represents exited or discontinued product lines, policy forms or distribution channels. Effective February 2018, our Bermuda domiciled composite reinsurer, Fortitude Reinsurance Company Ltd. (Fortitude Re), formerly known as DSA Reinsurance Company, Ltd., is included in our Legacy Portfolio.
In the second quarter of 2015, a United Guaranty subsidiary and certain of our General Insurance companies entered into a 50 percent quota share reinsurance agreement whereby the United Guaranty subsidiary (1) ceded 50 percent of the risk relating to policies written in 2014 that were current as of January 1, 2015 and (2) ceded 50 percent of the risk relating to all policies written in 2015 and 2016, each in exchange for a 30 percent ceding commission and reimbursements of 50 percent of the losses and loss adjustment expenses incurred on covered policies. Beginning in the third quarter of 2016, the effect of this intercompany reinsurance arrangements is included in the results of Property and Special Risks and Other Operations for all periods presented. Previously, this arrangement was eliminated for purposes of segment reporting. Concurrent with the closing of the sale of United Guaranty, we amended and restated this arrangement and expect the results of this arrangement to continue to be reported in Property and Special Risks.
The following table summarizes the estimated provisional fair values of major classes of identifiable assets acquired and liabilities assumed as of July 18, 2018:
* Reported in Deferred policy acquisition costs in the Consolidated Balance Sheet.
The following unaudited summarized pro forma consolidated income statement information assumes that the acquisition of Validus occurred as of January 1, 2017. The pro forma amounts are for comparative purposes only, may not necessarily reflect the results of operations that would have resulted had the acquisition been completed at the beginning of the applicable period and may not be indicative of the results that will be attained in the future.
* Pro forma adjustments were made to Validus external reporting results prior to the acquisition date for the deconsolidation of certain asset management entities consistent with AIG’s post acquisition accounting, which had no impact on Net income attributable to Validus.
(b) Amortization is reported in General operating and other expenses in the Consolidated Statement of Income (Loss).
When our independent third-party valuation service providers are unable to obtain sufficient market observable information upon which to estimate the fair value for a particular security, fair value is determined either by requesting brokers who are knowledgeable about these securities to provide a price quote, which is generally non-binding, or by employing market accepted valuation models. Broker prices may be based on an income approach, which converts expected future cash flows to a single present value amount, with specific consideration of inputs relevant to particular security types. For structured securities, such inputs may include ratings, collateral types, geographic concentrations, underlying loan vintages, loan delinquencies and defaults, loss severity assumptions, prepayments, and weighted average coupons and maturities. When the volume or level of market activity for a security is limited, certain inputs used to determine fair value may not be observable in the market. Broker prices may also be based on a market approach that considers recent transactions involving identical or similar securities. Fair values provided by brokers are subject to similar control processes to those noted above for fair values from independent third-party valuation service providers, including management reviews. For those corporate debt instruments (for example, private placements) that are not traded in active markets or that are subject to transfer restrictions, valuations reflect illiquidity and non-transferability, based on available market evidence. When observable price quotations are not available, fair value is determined based on discounted cash flow models using discount rates based on credit spreads, yields or price levels of comparable securities, adjusted for illiquidity and structure. Fair values determined internally are also subject to management review to ensure that valuation models and related inputs are reasonable.
Projected cash flows are discounted using the interest rate swap curve (swap curve), which is commonly viewed as being consistent with the credit spreads for highly-rated financial institutions (S&P AA-rated or above). A swap curve shows the fixed-rate leg of a non-complex swap against the floating rate (for example, LIBOR) leg of a related tenor. We also incorporate our own risk of non-performance in the valuation of the embedded derivatives associated with variable annuity and equity-indexed annuity and life contracts. The non-performance risk adjustment reflects a market participant’s view of our claims-paying ability by incorporating an additional spread to the swap curve used to discount projected benefit cash flows in the valuation of these embedded derivatives. The non-performance risk adjustment is calculated by constructing forward rates based on a weighted average of observable corporate credit indices to approximate the claims-paying ability rating of our Life and Retirement companies.
(b) As a result of the adoption of the Recognition and Measurement of Financial Assets and Financial Liabilities standard on January 1, 2018 (Financial Instruments Recognition and Measurement Standard), equity securities are no longer classified and accounted for as available for sale securities.
(c) Excludes investments that are measured at fair value using the net asset value (NAV) per share (or its equivalent), which totaled $5.0 billion and $6.0 billion as of December 31, 2018 and December 31, 2017, respectively.
Our policy is to record transfers of assets and liabilities between Level 1 and Level 2 at their fair values as of the end of each reporting period, consistent with the date of the determination of fair value. Assets are transferred out of Level 1 when they are no longer transacted with sufficient frequency and volume in an active market. Conversely, assets are transferred from Level 2 to Level 1 when transaction volume and frequency are indicative of an active market.
The following tables present changes during the years ended December 31, 2018 and 2017 in Level 3 assets and liabilities measured at fair value on a recurring basis, and the realized and unrealized gains (losses) related to the Level 3 assets and liabilities in the Consolidated Balance Sheets at December 31, 2018 and 2017:
We record transfers of assets and liabilities into or out of Level 3 classification at their fair values as of the end of each reporting period, consistent with the date of the determination of fair value. The Net realized and unrealized gains (losses) included in income (loss) or Other comprehensive income (loss) as shown in the table above excludes $33 million of net gains and $64 million of net losses related to assets and liabilities transferred into Level 3 during 2018 and 2017, respectively, and includes $18 million and $36 million of net losses related to assets and liabilities transferred out of Level 3 during 2018 and 2017, respectively.
During the years ended December 31, 2018 and 2017, transfers out of Level 3 assets primarily included private placement and other corporate debt, CMBS, RMBS, CDO/ABS and certain investments in municipal securities. Transfers of certain investments in municipal securities, corporate debt, RMBS, CMBS and CDO/ABS out of Level 3 assets were based on consideration of market liquidity as well as related transparency of pricing and associated observable inputs for these investments. Transfers of certain investments in private placement corporate debt and certain ABS out of Level 3 assets were primarily the result of using observable pricing information that reflects the fair value of those securities without the need for adjustment based on our own assumptions regarding the characteristics of a specific security or the current liquidity in the market.
Embedded derivatives reported within Policyholder contract deposits include GMWB within variable annuity products and interest crediting rates based on market indices within index annuities, indexed life and guaranteed investment contracts (GICs). For any given contract, assumptions for unobservable inputs vary throughout the period over which cash flows are projected for purposes of valuing the embedded derivative. The following unobservable inputs are used for valuing embedded derivatives measured at fair value:
• Equity / interest rate correlation estimates the relationship between changes in equity returns and interest rates in the economic scenario generator used to value our GMWB embedded derivatives. In general, a higher positive correlation assumes that equity markets and interest rates move in a more correlated fashion, which generally increases the fair value of the liability.
The hedge fund investments included above, which are carried at fair value, are generally redeemable monthly (35 percent), quarterly (32 percent), semi-annually (9 percent) and annually (24 percent), with redemption notices ranging from one day to 180 days. At December 31, 2018, investments representing approximately 51 percent of the total fair value of these hedge fund investments had partial contractual redemption restrictions. These partial redemption restrictions are generally related to one or more investments held in the hedge funds that the fund manager deemed to be illiquid. The majority of these contractual restrictions, which may have been put in place at the fund’s inception or thereafter, have pre-defined end dates. The majority of these restrictions are generally expected to be lifted by the end of 2019.
For additional information related to embedded derivatives refer to Note 11 herein.
As a result of the adoption of the Financial Instruments Recognition and Measurement Standard on January 1, 2018, we are required to record unrealized gains and losses attributable to the observable effect of changes in credit spreads on our liabilities for which the fair value option was elected in Other Comprehensive Income. An unrealized gain of $4 million was recognized in Other Comprehensive Income for year ended December 31, 2018.
The following table presents the difference between fair values and the aggregate contractual principal amounts of mortgage and other loans receivable and long-term debt for which the fair value option was elected:
We measure the fair value of certain assets on a non-recurring basis, generally quarterly, annually or when events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. These assets include cost and equity-method investments, commercial mortgage loans, investments in life settlements, investments in real estate and other fixed assets, goodwill and other intangible assets.
(a) Impairments in 2017 included $35 million related to Other assets of $179 million that were sold during the three-month period ended June 30, 2017.
• Other liabilities: The majority of Other liabilities that are financial instruments not measured at fair value represent secured financing arrangements, including repurchase agreements. The carrying amounts of these liabilities approximate fair value, because the financing arrangements are short-term and are secured by cash or other liquid collateral.
Bonds held to maturity are carried at amortized cost when we have the ability and positive intent to hold these securities until maturity. When we do not have the ability or positive intent to hold bonds until maturity, these securities are classified as available for sale or are measured at fair value at our election. None of our fixed maturity securities met the criteria for held to maturity classification at December 31, 2018 or 2017.
On January 1, 2018, AIG adopted ASU 2016-01, the Financial Instruments Recognition and Measurement standard for equity securities which eliminates the available for sale classification and treatment for equity securities. As a result, equity securities that do not follow the equity method of accounting, are measured at fair value with changes in fair value recognized in earnings.
Premiums and discounts arising from the purchase of bonds classified as available for sale are treated as yield adjustments over their estimated holding periods, until maturity, or call date, if applicable. For investments in certain RMBS, CMBS and CDO/ABS, (collectively, structured securities), recognized yields are updated based on current information regarding the timing and amount of expected undiscounted future cash flows. For high credit quality structured securities, effective yields are recalculated based on actual payments received and updated prepayment expectations, and the amortized cost is adjusted to the amount that would have existed had the new effective yield been applied since acquisition with a corresponding charge or credit to net investment income. For structured securities that are not high credit quality, effective yields are recalculated and adjusted prospectively based on changes in expected undiscounted future cash flows. For purchased credit impaired (PCI) securities, at acquisition, the difference between the
The following table presents the amortized cost or cost and fair value of our available for sale securities(a):
(b) Represents the amount of other-than-temporary impairments recognized in Accumulated other comprehensive income (loss). Amount includes unrealized gains and losses on impaired securities relating to changes in the fair value of such securities subsequent to the impairment measurement date.
(c) At December 31, 2018 and 2017, bonds available for sale held by us that were below investment grade or not rated totaled $28.8 billion and $31.5 billion, respectively.
The following table summarizes the fair value and gross unrealized losses on our available for sale securities, aggregated by major investment category and length of time that individual securities have been in a continuous unrealized loss position(a):
For the years ended December 31, 2018, 2017 and 2016, the aggregate fair value of available for sale securities sold was $25.1 billion, $31.3 billion and $30.2 billion, which resulted in net realized capital gains (losses) of $(129) million, $0.5 billion and $1.1 billion, respectively.
(a) At December 31, 2018, included hedge funds of $4.2 billion, private equity funds of $4.3 billion, and affordable housing partnerships of $438 million. At December 31, 2017, included hedge funds of $5.8 billion, private equity funds of $5.0 billion, and affordable housing partnerships of $543 million.
(c) Net of accumulated depreciation of $598 million and $515 million in 2018 and 2017, respectively.
Prior to January 1, 2018, other investments in hedge funds, private equity funds and other investment partnerships in which our insurance operations do not hold aggregate interests sufficient to exercise more than minor influence over the respective partnerships were reported at fair value with changes in fair value recognized as a component of Accumulated other comprehensive income. These investments were subject to other-than-temporary impairment evaluations. The gross unrealized loss recorded in Accumulated other comprehensive income on such investments was $45 million at December 31, 2017, the majority of which pertained to investments in private equity funds and hedge funds that have been in continuous unrealized loss positions for less than 12 months. Effective January 1, 2018, upon the adoption of the Financial Instruments Recognition and Measurement standard, these investments are no longer accounted for as available for sale securities. The new standard requires these investments to be measured at fair value with the change in fair value recognized in earnings. As a result, beginning in 2018, these investments are no longer subject to the other-than-temporary impairment evaluation.
Investments in life settlements were accounted for under the investment method. Under the investment method, we recognized our initial investment in life settlements at the transaction price plus all initial direct external costs. Continuing costs to keep the policy in force, primarily life insurance premiums, increased the carrying amount of the investment. We recognized income on individual investments in life settlements upon the death of the insured, at an amount equal to the excess of the investment proceeds over the carrying amount of the investment at that time. These investments were subject to impairment review, as discussed below.
(b) Excludes net unrealized losses attributable to businesses held for sale.
The following table summarizes the unrealized gains and losses recognized during the reporting period on equity securities still held at the reporting date:
Less: Net gains and losses recognized during the year on equity securities
The determination that an equity security was other-than-temporarily impaired required the judgment of management and consideration of the fundamental condition of the issuer, its near-term prospects and all the relevant facts and circumstances. In addition to the above criteria, all equity securities that have been in a continuous decline in value below cost over 12 months are impaired. We also considered circumstances of a rapid and severe market valuation decline (50 percent or more) discount to cost, in which we could not reasonably assert that the impairment period would be temporary (severity losses).
Our investments in aircraft assets and real estate are periodically evaluated for recoverability whenever changes in circumstances indicate the carrying amount of an asset may be impaired. When impairment indicators are present, we compare expected investment cash flows to carrying amount. When the expected cash flows are less than the carrying amount, the investments are written down to fair value with a corresponding charge to earnings. We sold the remaining portion of our aircraft assets in 2018.
At December 31, 2018 and 2017, amounts borrowed under repurchase and securities lending agreements totaled $1.2 billion and $4.5 billion, respectively.
We do not currently offset any secured financing transactions. All such transactions are collateralized and margined daily consistent with market standards and subject to enforceable master netting arrangements with rights of set off.
The total carrying value of cash and securities deposited by our insurance subsidiaries under requirements of regulatory authorities or other insurance-related arrangements, including certain annuity-related obligations and certain reinsurance treaties, was $7.9 billion and $4.9 billion at December 31, 2018 and 2017, respectively.
Investments held in escrow accounts or otherwise subject to restriction as to their use were $273 million and $255 million, comprised of bonds available for sale and short term investments at December 31, 2018 and 2017, respectively.
* Commercial mortgages primarily represent loans for apartments, offices and retail properties, with exposures in New York and California representing the largest geographic concentrations (aggregating approximately 22 percent and 11 percent, respectively, at December 31, 2018, and 23 percent and 12 percent, respectively, at December 31, 2017).
ITEM 8 | Notes to Consolidated Financial Statements | 7. Lending Activities
(b) The loan-to-value ratio compares the current unpaid principal balance of the loan to the estimated fair value of the underlying property collateralizing the loan. Our weighted average loan-to-value ratio was 58 percent and 57 percent at December 31, 2018, and 2017, respectively.
The following table presents the credit quality performance indicators for commercial mortgages:
Loans that had been modified in TDRs during the year ended December 31, 2018 have been fully paid off. During the year ended December 31, 2017, loans with a carrying value of $237 million were modified in troubled debt restructurings.
In the ordinary course of business, our insurance companies may use both treaty and facultative reinsurance to minimize their net loss exposure to any single catastrophic loss event or to an accumulation of losses from a number of smaller events or to provide greater diversification of our businesses. In addition, our general insurance subsidiaries assume reinsurance from other insurance companies. We determine the portion of the incurred but not reported (IBNR) loss that will be recoverable under our reinsurance contracts by reference to the terms of the reinsurance protection purchased. This determination is necessarily based on the estimate of IBNR and accordingly, is subject to the same uncertainties as the estimate of IBNR. Reinsurance assets include the balances due from reinsurance and insurance companies under the terms of our reinsurance agreements for paid and unpaid losses and loss adjustment expenses incurred, ceded unearned premiums and ceded future policy benefits for life and accident and health insurance contracts and benefits paid and unpaid. Amounts related to paid and unpaid losses and benefits and loss expenses with respect to these reinsurance agreements are substantially collateralized. We remain liable to the extent that our reinsurers do not meet their obligation under the reinsurance contracts, and as such, we regularly evaluate the financial condition of our reinsurers and monitor concentration of our credit risk. The estimation of the allowance for doubtful accounts requires judgment for which key inputs typically include historical trends regarding uncollectible balances, disputes and credit events as well as specific reviews of balances in dispute or subject to credit impairment. The allowance for doubtful accounts on reinsurance assets was $140 million and $187 million at December 31, 2018 and 2017, respectively. Changes in the allowance for doubtful accounts on reinsurance assets are reflected in Policyholder benefits and losses incurred within the Consolidated Statements of Income.
The following table provides supplemental information for loss and benefit reserves, gross and net of ceded reinsurance:
Short-duration reinsurance is effected under reinsurance treaties and by negotiation on individual risks. Certain of these reinsurance arrangements consist of excess of loss contracts that protect us against losses above stipulated amounts. Ceded premiums are considered prepaid reinsurance premiums and are recognized as a reduction of premiums earned over the contract period in proportion to the protection received. Amounts recoverable from reinsurers on short-duration contracts are estimated in a manner consistent with the claims liabilities associated with the reinsurance and presented as a component of Reinsurance assets. Reinsurance premiums for assumed business are estimated based on information received from brokers, ceding companies and reinsurers. Any subsequent differences arising on such estimates are recorded in the periods in which they are determined. Assumed reinsurance premiums are earned primarily on a pro-rata basis over the terms of the reinsurance contracts and the portion of premiums relating to the unexpired terms of coverage is included in the reserve for unearned premiums. Reinsurance premiums for assumed business are estimated based on information received from brokers, ceding companies and reinsureds. Any subsequent differences arising on such estimates are recorded in the periods in which they are determined. For both ceded and assumed reinsurance, risk transfer requirements must be met for reinsurance accounting to apply. If risk transfer requirements are not met, the contract is accounted for as a deposit, resulting in the recognition of cash flows under the contract through a deposit asset or liability and not as revenue or expense. To meet risk transfer requirements, a reinsurance contract must include both insurance risk, consisting of both underwriting and timing risk, and a reasonable possibility of a significant loss for the assuming entity. Similar risk transfer criteria are used to determine whether directly written insurance contracts should be accounted for as insurance or as a deposit.
For the years ended December 31, 2018, 2017 and 2016, reinsurance recoveries, which reduced losses and loss adjustment expenses incurred, amounted to $9.8 billion, $1.5 billion and $2.1 billion, respectively.
The percentage of the unamortized balance of VOBA at December 31, 2018 expected to be amortized in 2019 through 2023 by year is: 8.6 percent, 7.7 percent, 6.7 percent, 6.3 percent and 6.0 percent, respectively, with 64.8 percent being amortized after five years. These projections are based on current estimates for investment income and spreads, persistency, mortality and morbidity assumptions.
(a) Comprised primarily of Short-term investments and Other assets at December 31, 2018 and 2017.
(b) The assets of each VIE can be used only to settle specific obligations of that VIE.
We created certain VIEs that hold investments, primarily in investment-grade debt securities and loans, and issued beneficial interests in these investments. The majority of these beneficial interests are owned by our insurance operations and we maintain the power to direct the activities of the VIEs that most significantly impact their economic performance and bear the obligation to absorb losses or receive benefits from the entities that could potentially be significant to the entities. Accordingly, we consolidate these entities and those beneficial interests issued to third-parties are reported as Long-term debt. Total assets of consolidated securitization vehicles are $16.9 billion, of which $16.0 billion represents amounts owed to Parent or its subsidiaries.
(a) Fair value amounts are shown before the effects of counterparty netting adjustments and offsetting cash collateral.
(e) Represents cash collateral posted and received that is eligible for netting.
(f) Freestanding derivatives only, excludes embedded derivatives. Derivative instrument assets and liabilities are recorded in Other Assets and Liabilities, respectively. Fair value of assets related to bifurcated embedded derivatives was zero at both December 31, 2018 and December 31, 2017. Fair value of liabilities related to bifurcated embedded derivatives was $4.1 billion and $4.1 billion, respectively, at December 31, 2018 and December 31, 2017. A bifurcated embedded derivative is generally presented with the host contract in the Consolidated Balance Sheets. Embedded derivatives are primarily related to guarantee features in variable annuity products, which include equity and interest rate components.
We estimate that at December 31, 2018, based on our outstanding financial derivative transactions, a downgrade of our long-term senior debt ratings to BBB or BBB- by Standard & Poor’s Financial Services LLC, a subsidiary of S&P Global Inc., and/or a downgrade to Baa2 or Baa3 by Moody’s Investors’ Service, Inc. would permit counterparties to make additional collateral calls and permit certain counterparties to elect early termination of contracts, resulting in corresponding collateral postings and termination payments in the total amount of up to approximately $61 million. The aggregate fair value of our derivatives that were in a net liability position and that contain such credit risk-related contingencies which can be triggered below our long-term senior debt ratings of BBB+ or Baa1 was approximately $423 million and $572 million at December 31, 2018 and 2017, respectively. The aggregate fair value of assets posted as collateral under these contracts at December 31, 2018 and 2017, was approximately $453 million and $676 million, respectively.
Goodwill represents the future economic benefits arising from assets acquired in a business combination that are not individually identified and separately recognized. Goodwill is tested for impairment annually or more frequently if circumstances indicate an impairment may have occurred. At December 31, 2018, the operating segments with goodwill are our General Insurance business - North America and International operating segments, our Life and Retirement business - Life Insurance operating segment and our Other Operations and Legacy Portfolio operating segments. When a business is transferred from one reporting unit to another, as occurred as part of the 2017 segment changes, goodwill from the original operating segment is allocated among reporting units based on the fair value of business transferred, relative to business retained by a reporting unit.
* Includes goodwill of $2.0 billion, $492 million and $46 million relating to the acquisitions of Validus, Glatfelter and Ellipse, respectively.
ITEM 8 | Notes to Consolidated Financial Statements | 13. Insurance Liabilities
Our gross loss reserves before reinsurance and discount are net of contractual deductible recoverable amounts due from policyholders of approximately $12.3 billion and $12.6 billion at December 31, 2018 and 2017, respectively. These recoverable amounts are related to certain policies with high deductibles (in excess of high dollar amounts retained by the insured through self-insured retentions, deductibles, retrospective programs, or captive arrangements, each referred to generically as “deductibles”), primarily for U.S. commercial casualty business. With respect to the deductible portion of the claim, we manage and pay the entire claim on behalf of the insured and are reimbursed by the insured for the deductible portion of the claim. Thus, these recoverable amounts represent a credit exposure to us. At December 31, 2018 and 2017, we held collateral of approximately $9.2 billion and $9.5 billion, respectively, for these deductible recoverable amounts, consisting primarily of letters of credit and funded trust agreements.
Net Liability for unpaid loss and loss adjustment expenses, beginning of year
(a) Includes $51 million and $25 million for the retroactive reinsurance agreement with NICO covering U.S. asbestos exposures for the year ended December 31, 2018 and 2017, respectively.
(c) Includes amounts related to dispositions through the date of disposition. Includes sale of insurance operations to Fairfax, United Guaranty and Ascot Underwriting Holdings Limited, and Ascot Employees Corporate Member Limited (Ascot).
(e) Represents change in loss reserves included in our sale of certain of our insurance operations and certain assets to Fairfax for the period ended December 31, 2016. Upon consummation of the sale, we retained a portion of these reserves through reinsurance arrangements.
• Favorable development in US Commercial Property and Specialty Lines due to reductions in our estimates for 2017 Catastrophes , favorable attritional losses in Commercial Property and favorable Specialty emergence.
• Unfavorable development in International Financial Lines driven by increased large loss activity in recent accident years, particularly related to directors and officers class action suits against insureds with global exposure.
Our analyses and conclusions about prior year reserves also help inform our judgments about the current accident year loss and loss adjustment expense ratios we selected.
• In addition we also observed higher than expected losses in UK/Europe property and special risks business driven by unexpected development on various large claims across the property, aviation, marine, and trade credit segments.
• Increases in loss trend assumptions to reflect the latest observed increases in frequency and severity and the impact of these increased loss trends on expected loss ratios.
• Changes in weights we apply to the various actuarial methods to better align with updated trends.
The loss development tables below include loss development data by major lines of business for the last ten accident years. The drivers of prior year development are discussed following each of the loss development tables.
The table below presents the reconciliation of the net liability for unpaid losses and loss adjustment expenses in the following tables to Loss Reserves in the Consolidated Balance Sheets for the year ended December 31, 2018:
· Expected Loss Ratio method: The Expected Loss Ratio method multiplies premiums by an expected loss ratio to produce ultimate loss estimates for each accident year. This method may be useful if loss development patterns are inconsistent, losses emerge very slowly, or there is relatively little loss history from which to estimate future losses.
· Cape Cod method: The Cape Cod method is mechanically similar to the Bornhuetter-Ferguson method with the difference being that the Expected Loss Ratio estimates are determined based on a weighting of the loss estimates that come from the Paid/Incurred Development Methods. This method may be more responsive to recent loss trends than the Bornhuetter-Ferguson method.
In updating our loss reserve estimates, we consider and evaluate inputs from many sources, including actual claims data, the performance of prior reserve estimates, observed industry trends, our internal peer review processes, including challenges and recommendations from our Enterprise Risk Management group, as well as the views of third-party actuarial firms. We use these inputs to improve our evaluation techniques, and to analyze and assess the change in estimated ultimate loss for each accident year by product line. Our analyses produce a range of indications from various methods, from which we select our best estimate.
· an assessment of economic conditions, including real GDP growth, inflation, employment rates or unemployment duration, stock market volatility and changes in corporate bond spreads;
· change in claims handling philosophy, operating model, processes, and related ongoing enhancements;
· third-party claims reviews that are periodically performed for key classes of claims such as toxic tort, environmental and other complex casualty claims;
· Table organization: The tables are organized by accident year and include policies written on an occurrence and claims- made basis. We note that for certain categories of claims (e.g., construction defect claims and environmental claims) and for reinsurance recoverable, losses may sometimes be reclassified to an earlier or later accident year as more information about the date of occurrence becomes available to us. These reclassifications are shown as development in the respective years in the tables below. Financial Lines business is primarily written on a claims-made basis, while the majority of the workers’ compensation, excess casualty, other casualty, and run-off property and casualty lines of business are written on an occurrence basis. Primarily, all short-tail lines in Property and Special Risks and Personal Insurance are written on an occurrence basis.
· Incurred but not reported liabilities (IBNR): We include development from past reported losses in IBNR.
· Foreign exchange: The loss development for operations outside of the U.S. is presented for all accident years using the current exchange rate at December 31, 2018. Although this approach requires restating all prior accident year information, the changes in exchange rates do not impact incurred and paid loss development trends.
During 2017, we recognized $31 million of favorable prior year development, net of external reinsurance but before ADC cessions.
Incurred Losses and Allocated Loss Adjustment Expenses, Undiscounted and Net of Reinsurance
Total of IBNR Liabilities Net of Impact of Adverse Development Reinsurance Agreement
Many of our primary casualty policies contain risk-sharing features, including high deductibles, self-insured retentions or retrospective rating features, in addition to a traditional insurance component. These risk-sharing programs generally are large and complex, comprising multiple products, years and structures, and are subject to amendment over time. We group guaranteed cost and excess of deductible business separately and then further by state and industry subset to the extent that meaningful differences are determined to exist. We also separately analyze certain subsets of the portfolio that have unique characteristics (e.g., U.S. government sub-contractor accounts and construction wrap-up business). For excess of deductible business, we also segment by size of deductible and whether the claim is handled by AIG or an outside third-party administrator (TPA). The proportion of large deductible business has increased over time, which has slowed the reporting pattern of claims.
During 2017, we recognized $31 million of favorable prior year development in U.S. workers’ compensation business, particularly guaranteed cost business in the states of California and New York. Actual loss emergence during the year, particularly for guaranteed cost business in these two states, was significantly less than expected on a reported loss basis. We did recognize some offsetting unfavorable development in our Defense Based Act (DBA) business that covers government contractors in U.S. and non-U.S. military installations, as well as from a Pennsylvania Supreme Court decision that overturned a ruling that provided limitations on payments for certain permanent injuries (the Protz decision).
During 2016, we recognized $1.9 billion of unfavorable prior year development in primary workers’ compensation coverages primarily driven by the risk-sharing programs where we provide coverage in excess of large deductibles. For this excess of large deductible business, in 2016, we observed actual loss emergence and development at significantly greater levels than expected based on our previous experience in particular from losses in excess of $1 million. Since these policies respond to larger claims, the loss reporting pattern is much longer than observed in guaranteed cost workers’ compensation and it takes several years to discern credible changes in the pattern. Furthermore, implementation of claims settlement and loss mitigation strategies over the past several years has made the recent evaluation of data more challenging as historical development patterns may not yet fully reflect these claim and mitigation activities. During 2016, we refined our actuarial methodology by combining data across previously segregated underwriting portfolios to improve our ability to analyze the loss development trends and patterns that had been altered by the mix, claims handling and loss mitigation changes we have made during the last five years. We also developed further segmentations by deductible size and other key parameters, such as claims handled by TPA staff and not our claims department. As a result, we determined that the loss emergence patterns had changed and lengthened significantly from our prior expectation and therefore, we increased our loss development factors.
U.S Other Casualty includes general liability, commercial auto, medical malpractice, and various other casualty lines of business.
In 2016, we continued to observe increases in both the frequency and severity of claims occurring in accident years since the recent U.S. economic downturn. These claims have significantly outpaced both our accident year loss ratio assumptions made in 2015 and the pricing rate increases implemented during the same period. As a result, we recognized $352 million of unfavorable development during 2016 as we increased the expected loss ratios for recent accident years to reflect continued market deterioration in the trends observed in 2016 and the higher reported losses in very recent accident years.
During 2017, we recognized favorable loss development of $133 million. The key drivers of this activity were favorable development on loss-sensitive casualty business, environmental impairment liability business, extra-contractual obligations, and business internally reinsured from other business units.
During 2018, we recognized $298 million of unfavorable prior year development in U.S. Financial Lines, net of external reinsurance but before ADC cessions, due to adverse experience in the Directors and Officers (D&O) subset of business
U.S. Financial Lines business includes D&O, Errors and Omissions (E&O), Employment Practices Liability Insurance (EPLI) and various professional liability subsets of business, as well as the fidelity book of business. This includes cyber coverage and mergers and acquisitions coverage, which have been a growing and evolving portion of this portfolio. These product lines are predominantly claims-made in nature, losses are characterized by low frequency and high severity, and results are often significantly impacted by external economic conditions.
We generally use loss development methods for fidelity exposures for all but the latest accident year. We also use claim department projections of the ultimate value of each reported claim to supplement and inform the standard actuarial approaches and some weight is given to this method in the more recent accident years. For surety exposures, we generally use the same method as for short-tail classes whereby frequency/severity methods, loss development methods, and IBNR factor methods are used alone or in combination to set reserves.
During 2016, we recognized $306 million of unfavorable prior year development as we reacted to the unfavorable actual versus expected in 2016 driven by higher than expected settlements on several large claims from the financial crisis for accident years 2006 to 2010, as well as unfavorable emergence of errors and omissions losses relative to historical expectations. In addition to the unfavorable emergence, we also updated our loss development factor assumptions, expected loss ratio assumptions and the weights given to the various methods in recent accident years.
For program business, we use methods which vary by line of business. For property classes, we use methods similar to those noted above. For liability classes, we use methods similar to those described in the casualty sections detailed above.
During 2018, we recognized $255 million of adverse prior year development in US Personal Insurance driven largely by development on the California Wildfires and Hurricane Irma in 2017.
During 2016, we recognized $32 million of favorable development mainly driven by accident and health business.
* The losses reported in the table are not covered by the Adverse Development Reinsurance Agreement.
During 2018, we recognized $22 million of favorable prior year development in the UK/Europe Property and Special Risks segment, net of external reinsurance.
UK/Europe Property products include commercial, industrial and energy-related property insurance products and services that cover exposures to manmade and natural disasters, including business interruption. UK/Europe Special Risk products include aerospace, environmental, political risk, trade credit, surety and marine insurance, and various small and medium sized enterprises insurance lines.
IBNR factor methods are used when the nature of losses is low frequency/high severity. The IBNR factors, when applied to earned premium, generate the ultimate expected losses (or other exposure measure) yet to be reported. The factors are determined based on prior accident quarters’ loss costs adjusted to reflect current cost levels and the historical emergence of those loss costs. The factors are continually reevaluated to reflect emerging claim experience, rate changes or other factors that could affect the adequacy of the IBNR factor being employed.
During 2017, we recognized $157 million of unfavorable prior year development, primarily from accident years 2015 and 2016. This was largely driven by large individual claim development in the property, aviation, marine, and trade credit lines of business.
During 2017, we recognized $58 million of favorable prior year development in UK/Europe and Japan Personal Insurance, net of external reinsurance, mainly due to accident and health business.
Asbestos coverage has been excluded from AIG policies commencing in 1985. Most of AIG’s asbestos claims exposures are ceded to National Indemnity Company (NICO) under a retroactive reinsurance arrangement entered into in 2011. Many of other asbestos-related exposures are very long-tailed in nature and with exposures dating back 30 years or more. We consider a number of factors and recent experience in addition to the results of both external and internal analyses, to estimate asbestos and pre-1986 environmental loss reserves. We primarily base our determination of these loss reserves on a combination of ground-up and top-down analyses of historical claims and available insurance coverages. Nonetheless, we believe that significant uncertainty remains as to our ultimate liability for asbestos and environmental claims, which is due to several factors, including:
Loss and loss adjustment expense liability estimates for excess workers’ compensation exposures are subject to additional uncertainties, due to the following:
• claim settlement time is longer than most other casualty lines, due to the lifetime benefits that can be expected to payout on certain claims;
As noted above, other legacy exposures include environmental impairment liability and related coverages, medical malpractice, workers’ compensation, and general liability. Depending on the individual class or lines of business reviewed, either traditional methods (i.e. paid loss development, incurred loss development), non-traditional methods (such as paid survival ratio or IBNR-to-case ratio methods) or a combination of the two are used. In addition, for some of the environmental impairment liability related coverage, approaches based on individual claim department estimates for large remediation sites are extensively included as part of the overall actuarial estimates for environmental impairment liability related exposures.
During 2016, the U.S. Run-Off long tail insurance lines recognized $390 million of unfavorable prior year development.
We did not recognize any material development in this segment during 2018, 2017 or 2016. The proactive management of settlement negotiations and other claims mitigation strategies minimized the volatility observed during this period.
The table below presents the reconciliation of change in net ultimates from tables above to prior year development for the year ended December 31, 2018:
(a) Change in net ultimate loss and LAE excludes the portion of prior year development for which we have ceded to the Asbestos Loss Portfolio Transfer (LPT) and the Adverse Development Cover (ADC), both of which are provided by NICO and are considered retroactive reinsurance under US GAAP. Amounts shown exclude $30 million of pre-acquisition prior year development from Validus. Validus' pre-acquisition development is included in the 10-year triangles shown above but is not included in AIG's financial results.
The previous development tables include only accident years 2009 to 2018. The following table summarizes (favorable) unfavorable development, of incurred losses and loss adjustment expenses for accident year 2008 and prior by operating segment and major class of business:
The following table presents the historical average annual percentage claims payout on an accident year basis at the same level of disaggregation as presented in the claims development table.
Certain asbestos claims are discounted when allowed by the regulator and when payments are fixed and determinable, based on the investment yields of the companies and the payout pattern for the claims. At December 31, 2016, the discount for asbestos reserves was amortized.
* Excludes $163 million and $173 million of discount related to certain long tail liabilities in the United Kingdom at December 31, 2018 and 2017, respectively.
Other policyholder funds also include provisions for future dividends to participating policyholders, accrued in accordance with all applicable regulatory or contractual provisions. Participating life business represented approximately 1.7 percent of gross insurance in force at December 31, 2018 and 2.4 percent of gross domestic premiums and other considerations in 2018. The amount of annual dividends to be paid is approved locally by the boards of directors of the Life and Retirement companies. Provisions for future dividend payments are computed by jurisdiction, reflecting local regulations. The portions of current and prior net income and of current unrealized appreciation of investments that can inure to our benefit are restricted in some cases by the insurance contracts and by the local insurance regulations of the jurisdictions in which the policies are in force.
Policy values for variable products and investment contracts are expressed in terms of investment units. Each unit is linked to an asset portfolio. The value of a unit increases or decreases based on the value of the linked asset portfolio. The current liability at any time is the sum of the current unit value of all investment units in the separate accounts, plus any liabilities for guaranteed minimum death benefits (GMDB) or guaranteed minimum withdrawal benefits (GMWB) included in Future policy benefits or Policyholder contract deposits, respectively.
Variable annuity contracts may include certain contractually guaranteed benefits to the contract holder. These guaranteed features include GMDB that are payable in the event of death, and living benefits that are payable in the event of annuitization, or, in other instances, at specified dates during the accumulation period. Living benefits primarily include GMWB. A variable annuity contract may include more than one type of guaranteed benefit feature; for example, it may have both a GMDB and a GMWB. However, a policyholder can only receive payout from one guaranteed feature on a contract containing a death benefit and a living benefit, i.e. the features are mutually exclusive (except a surviving spouse who has a rider to potentially collect both a GMDB upon their spouse’s death and a GMWB during their lifetime). A policyholder cannot purchase more than one living benefit on one contract. The net amount at risk for each feature is calculated irrespective of the existence of other features; as a result, the net amount at risk for each feature is not additive to that of other features.
The liabilities for GMWB, which are recorded in Policyholder contract deposits, are accounted for as embedded derivatives measured at fair value, with changes in the fair value of the liabilities recorded in Other net realized capital gains (losses). The fair value of these embedded derivatives was a net liability of $1.9 billion and $2.0 billion at December 31, 2018 and 2017, respectively.
We had account values subject to GMWB that totaled $41 billion and $45 billion at December 31, 2018 and 2017, respectively. The net amount at risk for GMWB represents the present value of minimum guaranteed withdrawal payments, in accordance with contract terms, in excess of account value, assuming no lapses. The net amount at risk related to the GMWB guarantees was $215 million and $450 million at December 31, 2018 and 2017, respectively. We use derivative instruments and other financial instruments to mitigate a portion of our exposure that arises from GMWB benefits.
The following table lists our total debt outstanding at December 31, 2018 and 2017. The interest rates presented in the following table are the range of contractual rates in effect at December 31, 2018, including fixed and variable-rates:
(b) At December 31, 2018, includes debt of consolidated investment vehicles related to real estate investments of $3.7 billion, affordable housing partnership investments of $1.8 billion and other securitization vehicles of $2.9 billion. At December 31, 2017, includes debt of consolidated investment vehicles related to real estate investments of $2.5 billion, affordable housing partnership investments of $1.8 billion and other securitization vehicles of $1.7 billion.
We lease office space and equipment in various locations across jurisdictions in which the Company operates. Rent expense was $283 million, $269 million and $331 million for the years ended December 31, 2018, 2017 and 2016, respectively.
In the normal course of business, we enter into commitments to invest in limited partnerships, private equity funds and hedge funds and to purchase and develop real estate in the U.S. and abroad. These commitments totaled $6.0 billion at December 31, 2018.
The timing of any future repurchases will depend on market conditions, our business and strategic plans, financial condition, results of operations, liquidity and other factors.
(b) Dilutive shares included our share-based employee compensation plans and a weighted average portion of the warrants issued to AIG shareholders as part of AIG’s recapitalization in January 2011. The number of shares excluded from diluted shares outstanding were 19.6 million, 1.7 million and 0.2 million for the years ended December 31, 2018, 2017 and 2016, respectively, because the effect of including those shares in the calculation would have been anti-dilutive.
The following table presents statutory net income (loss) and capital and surplus for our General Insurance companies and our Life and Retirement companies in accordance with statutory accounting practices:
(b) In aggregate, the 2017 General Insurance companies and Life and Retirement companies statutory net income increased by $207 million and the 2017 General Insurance companies and Life and Retirement companies statutory capital and surplus decreased by $273 million, compared to the amounts previously reported in our Annual Report on Form 10-K for the year ended December 31, 2017, due to finalization of statutory filings.
Our insurance subsidiaries file financial statements prepared in accordance with statutory accounting practices prescribed or permitted by domestic and foreign insurance regulatory authorities. The principal differences between statutory financial statements and financial statements prepared in accordance with U.S. GAAP for domestic companies are that statutory financial statements do not reflect DAC, some bond portfolios may be carried at amortized cost, investment impairments are determined in accordance with statutory accounting practices, assets and liabilities are presented net of reinsurance, policyholder liabilities are generally valued using more conservative assumptions and certain assets are non-admitted.
For domestic insurance subsidiaries, aggregate minimum required statutory capital and surplus is based on the greater of the RBC level that would trigger regulatory action or minimum requirements per state insurance regulation. Capital and surplus requirements of our foreign subsidiaries differ from those prescribed in the U.S., and can vary significantly by jurisdiction. At both December 31, 2018 and 2017, all domestic and foreign insurance subsidiaries individually exceeded the minimum required statutory capital and surplus requirements and all domestic insurance subsidiaries individually exceeded RBC minimum required levels.
• In 2015, a domestic life insurance subsidiary domiciled in Texas adopted a permitted statutory accounting practice to report derivatives used to hedge interest rate risk on product-related embedded derivatives at amortized cost instead of fair value. In 2018, the permitted practice was expanded to include additional derivative instruments utilized for the same purpose and to also include an additional domestic life insurance subsidiary domiciled in Texas. This permitted practice resulted in an increase in the statutory surplus of our subsidiaries of $438 million and $407 million at December 31, 2018 and 2017, respectively.
• As described in Note 13, our domestic property and casualty insurance subsidiaries domiciled in New York, Pennsylvania and Delaware discount non-tabular workers’ compensation reserves based on applicable prescribed or approved regulations, or in the case of our Delaware subsidiary, based on a permitted practice. This practice did not have a material impact on our statutory surplus, statutory net income (loss) or risk-based capital.
Payments of dividends to us by our insurance subsidiaries are subject to certain restrictions imposed by regulatory authorities. With respect to our domestic insurance subsidiaries, the payment of any dividend requires formal notice to the insurance department in which the particular insurance subsidiary is domiciled. For example, unless permitted by the Superintendent of Financial Services, property casualty companies domiciled in New York generally may not pay dividends to shareholders that, in any 12-month period, exceed the lesser of 10 percent of such company’s statutory policyholders’ surplus or 100 percent of its “adjusted net investment income,” for the previous year, as defined. Generally, less severe restrictions applicable to both property casualty and life insurance companies exist in most of the other states in which our insurance subsidiaries are domiciled. Under the laws of many states, an insurer may pay a dividend without prior approval of the insurance regulator when the amount of the dividend is below certain regulatory thresholds. Other foreign jurisdictions may restrict the ability of our foreign insurance subsidiaries to pay dividends. Various other regulatory restrictions also limit cash loans and advances to us by our subsidiaries.
Largely as a result of these restrictions, approximately $41.6 billion of the statutory capital and surplus of our consolidated insurance subsidiaries were restricted from transfer to AIG Parent without prior approval of state insurance regulators at December 31, 2018.
At December 31, 2018, our ability to pay dividends is not subject to any significant contractual restrictions, but remains subject to regulatory restrictions.
For additional information about our ability to pay dividends to our shareholders see Note 17 herein.
(a) We recognized $48 million, $141 million and $105 million for immediately vested stock-settled awards issued to retirement eligible employees in 2018, 2017 and 2016, on their respective grant dates. It is our policy to reverse compensation expense for forfeited awards when they occur.
(b) We also recognized $9 million of excess tax benefits due to share settlements occurring in 2018.
The Company sponsors several stock compensation programs under the AIG Long Term Incentive Plan and its predecessor plan, the AIG 2013 Long Term Incentive Plan (each as applicable, the LTIP), which are governed by the AIG 2013 Omnibus Incentive Plan (Omnibus Plan). Our share-settled awards are settled with previously acquired shares held in AIG’s treasury.
The Omnibus Plan, which replaced the AIG 2010 Stock Incentive Plan (2010 Plan), was adopted at the 2013 Annual Meeting of Shareholders and provides for the grants of share-based awards to our employees and non-employee directors. The total number of shares that may be granted under the Omnibus Plan (the reserve) is the sum of 1) 45 million shares of AIG Common Stock, plus 2) the number of authorized shares that remained available for issuance under the 2010 Plan when the Omnibus Plan became effective, plus 3) the number of shares of AIG Common Stock relating to outstanding awards under the 2010 Plan at the time the Omnibus Plan became effective that subsequently are forfeited, expired, terminated or otherwise lapse or are settled in cash. Each share-based unit granted under the Omnibus Plan reduces the number of shares available for future grants by one share. However, shares with respect to awards that are forfeited, expired or settled for cash, and shares withheld for taxes on awards (other than options and stock appreciation rights awards) are returned to the reserve.
During the fourth quarter of 2017, the Company modified the LTI awards by issuing time-vesting RSUs and canceling some performance based units. The modification applied to most recipients who participate in the 2015, 2016 and 2017 LTI awards, excluding the Company’s senior executives. The newly granted RSUs vest in installments over a period of up to three years. We incurred incremental compensation expense of $142 million as a result of these actions. We recognized $71 million in 2017, $48 million in 2018 and the remainder will be recognized through December 2020.
(b) Except for the 2014 LTI and 2015 LTI awards, PSUs represent target amount granted, and does not reflect potential increases or decreases that could result from the final outcome of the performance goals for the respective awards, which is determined in the quarter after the applicable performance period ends.
Stock options were issued in 2018 as part of the 2018 LTI awards and in 2017 and 2018 to certain newly hired senior executives. The fair value of the options was estimated on the grant date using the Black-Scholes model for the time-vesting options, and a Monte Carlo simulation for the hurdle-vesting options using the assumptions noted in the following table.
The weighted average grant-date fair value of stock options granted during 2018 was $11.08. As of December 31, 2018, we recognized $26.4 million of expense, while $24 million was unrecognized and is expected to be amortized up to 2.75 years.
A 100 basis point increase in the discount rate or expected long-term rate of return would decrease the 2018 pension expense by approximately $5 million and $45 million, respectively, with all other items remaining the same. Conversely, a 100 basis point decrease in the discount rate or expected long-term rate of return would increase the 2018 pension expense by approximately $24 million and $45 million, respectively, with all other items remaining the same.
(a) The non-U.S. plans reflect those assumptions that were most appropriate for the local economic environments of each of the subsidiaries providing such benefits.
A one percent point change in the assumed healthcare cost trend rate would have the following effect on our postretirement benefit obligations:
The projected benefit cash flows under the U.S. AIG Retirement Plan were discounted using the spot rates derived from the Mercer U.S. Pension Discount Yield Curve at December 31, 2018 and 2017, which resulted in a single discount rate that would produce the same liability at the respective measurement dates. The discount rates were 4.22 percent at December 31, 2018 and 3.61 percent at December 31, 2017. The methodology was consistently applied for the respective years in determining the discount rates for the other U.S. pension plans.
The projected benefit obligation for AIG’s Japan pension plans represents approximately 52 percent and 50 percent of the total projected benefit obligations for our non-U.S. pension plans at December 31, 2018 and 2017, respectively. The weighted average discount rate of 0.72 percent and 0.66 percent at December 31, 2018 and 2017, respectively, was selected by reference to the Mercer Yield Curve for Japan.
The assets of the qualified plan are monitored by the AIG U.S. Investment Committee and actively managed by the investment managers, which involves allocating the plan’s assets among approved asset classes within ranges as permitted by the strategic allocation. The long-term strategic asset allocation historically has been reviewed and revised approximately every three years. The investment strategy is focused on de-risking the Plan via regular monitoring through liability driven investing and the glide path approach, where the glide path defines the target allocation for the “Return-Seeking” portion of the portfolio (i.e., growth assets) based on the funded ratio. Under this approach, the allocation to growth assets is reduced and the allocation to liability-hedging assets is increased as the Plan’s funded ratio increases in accordance with the defined glide path.
The expected long-term rate of return for the plan was 6.75 percent and 7.0 percent for 2018 and 2017, respectively. The expected rate of return is an aggregation of expected returns within each asset class category, weighted for the investment mix of the assets. The combination of the expected asset return and any contributions made by us are expected to maintain the plan’s ability to meet all required benefit obligations. The expected asset return for each asset class was developed based on an approach that considers key fundamental drivers of the asset class returns in addition to historical returns, current market conditions, asset volatility and the expectations for future market returns.
The assets of AIG’s Japan pension plans represent approximately 59 percent and 56 percent of total non-U.S. assets at December 31, 2018 and 2017, respectively. The expected long term rate of return was 2.22 percent and 2.43 percent, for 2018 and 2017, respectively, and is evaluated by the Japanese Pension Investment Committee on a quarterly and annual basis along with various investment managers, and is revised to achieve the optimal allocation to meet targeted funding levels if necessary. In addition, the funding policy is revised in accordance with local regulation every five years.
The expected weighted average long-term rate of return for all our non-U.S. pension plans was 2.78 percent and 2.92 percent for the years ended December 31, 2018 and 2017, respectively. It is an aggregation of expected returns within each asset class that was generally developed based on the building block approach that considers historical returns, current market conditions, asset volatility and the expectations for future market returns.
(e) Represents investments in collateralized loan obligations. As of December 31, 2017, the plan held additional asset-backed securities.
(g) Excludes investments that are measured at fair value using the NAV per share (or its equivalent), which totaled $1,138 million and $777 million at December 31, 2018 and 2017, respectively.
The inputs or methodologies used for valuing securities are not necessarily an indication of the risk associated with investing in these securities. Based on our investment strategy, we had no significant concentrations of risks at December 31, 2018.
Funding for the qualified plan ranges from the minimum amount required by ERISA to the maximum amount that would be deductible for U.S. tax purposes. Contributed amounts in excess of the minimum amounts are deemed voluntary. Amounts in excess of the maximum amount would be subject to an excise tax and may not be deductible under the Internal Revenue Code. There are no minimum required cash contributions in 2018 for the AIG Retirement Plan. The non-qualified and postretirement plans’ benefit payments are deductible when paid to participants.
ITEM 8 | Notes to Consolidated Financial Statements | 21. Employee Benefits
We sponsor several defined contribution plans for U.S. employees that provide for pre-tax salary reduction contributions by employees. The most significant plan is the AIG Incentive Savings Plan, for which the matching contribution is 100 percent of the first six percent of a participant’s contributions, subject to the IRS-imposed limitations. Effective January 1, 2016, participants in the AIG Incentive Savings Plan receive an additional fully vested, non-elective, non-discretionary contribution equal to three percent of the participant’s annual base compensation for the plan year, paid each pay period regardless of whether the participant currently contributes to the plan, and subject to the IRS-imposed limitations. Our pre-tax expenses associated with these plans were $210 million, $209 million and $236 million in 2018, 2017 and 2016, respectively.
A Schedule 13G/A filed on February 14, 2019 reports aggregate ownership of 47,237,956 shares, or approximately 5.5 percent (based on the AIG Common Stock outstanding) of AIG Common Stock as of December 31, 2018, by Capital Research Global Investors, a division of Capital Research and Management Company.
A Schedule 13G/A filed on February 11, 2019 reports aggregate ownership of 64,768,700 shares, or approximately 7.5 percent (based on the AIG Common Stock outstanding) of AIG Common Stock as of December 31, 2018, by Blackrock, Inc. and various subsidiaries thereof.
On December 22, 2017, the U.S. enacted Public Law 115-97, known informally as the Tax Cuts and Jobs Act (the Tax Act). The Tax Act reduced the statutory rate of U.S. federal corporate income tax to 21 percent and enacted numerous other changes impacting AIG and the insurance industry.
• Income tax effects of those aspects of the Tax Act for which accounting under ASC 740 is complete
• Provisional estimate of income tax effects of the Tax Act to the extent accounting is incomplete but a reasonable estimate is determinable
• If a provisional estimate cannot be determined, ASC 740 should still be applied on the basis of tax law provisions that were in effect immediately before the enactment of the Tax Act.
The Tax Act includes provisions for Global Intangible Low-Taxed Income (GILTI) under which taxes on foreign income are imposed on the excess of a deemed return on tangible assets of certain foreign subsidiaries and for Base Erosion and Anti-Abuse Tax (BEAT) under which taxes are imposed on certain base eroding payments to affiliated foreign companies. There are substantial uncertainties in the interpretation of BEAT and GILTI and while certain formal guidance was issued by the U.S. tax authority, there are still aspects of the Tax Act that remain unclear and additional guidance is expected in 2019. Such guidance may result in changes to the interpretations and assumptions we made and actions we may take, which may impact amounts recorded with respect to international provisions of the Tax Act, possibly materially. Consistent with accounting guidance, we treat BEAT as a period tax charge in the period the tax is incurred and have made an accounting policy election to treat GILTI taxes in a similar manner.
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. We have completed our review of post-1986 earnings and profits of our foreign affiliates. Incorporating additional IRS guidance issued with respect to the deemed repatriation tax, as well as the relevant basis adjustments, we recognized a measurement period tax charge of $62 million. The effect of the deemed repatriation tax, which has been determined to be complete, resulted in a liability of $24 million.
During 2018, we completed our review of the impact of the Tax Act on our forecasts of taxable income, made certain assumptions related to interpretation of relevant new rules, and incorporated guidance issued by the U.S. tax authority. While the prescribed SAB 118 measurement period has ended, there are still certain aspects of the Tax Act that remain unclear, including the complex interplay of the new tax rules with the rules governing the utilization of our tax attributes, and formal guidance from the U.S. tax authority is still pending. We will continue to review the impact of any additional guidance issued by the U.S. tax authority on our valuation allowance analysis in accordance with the relevant accounting guidance. Accordingly, as of December 31, 2018, we consider the determination of the need for a valuation allowance related to the Tax Act to be complete based on our analysis of existing tax law and relevant tax guidance, and no measurement period adjustment was recorded.
At December 31, 2017, our accounting for the following elements of the Tax Act was incomplete and we continued accounting for them in accordance with ASC 740 on the basis of the tax laws in effect before enactment of the Tax Act.
At December 31, 2017, due to minimal formal guidance issued by state and local jurisdictions, provisional estimates were not recorded for the impact of any state and local corporate income tax implications of the Tax Act. Guidance from state and local jurisdictions has varied and most have not formally passed law specific to the treatment of the Tax Act. While we have not identified any material impact at this point in time, we continue to review any guidance issued by those states that have passed tax legislation related to the Tax Act and continue to work through the state and local corporate income tax implications of the Tax Act. We expect further guidance throughout 2019, and the impact, if any, will be recorded when the related guidance is issued. We consider the accounting for this item to be complete and no measurement period adjustment was recorded.
As of December 31, 2018, we have completed our accounting for the tax effects of the Tax Act. Although the prescribed measurement period has ended, there are aspects of the Tax Act that remain unclear and additional guidance from the U.S. tax authority is pending. As further guidance is issued by the U.S. tax authority, any resulting changes in our estimates will be treated in accordance with the relevant accounting guidance.
For the year ended December 31, 2018, we consider our foreign earnings with respect to certain operations in Canada, South Africa, the Far East, Latin America, Bermuda as well as the European, Asia Pacific and Middle East regions to be indefinitely reinvested. These earnings relate to ongoing operations and have been reinvested in active business operations. While, following the enactment of the Tax Act, distributions from foreign affiliates are, generally, not subject to U.S. income tax, such distributions may be subject to non-U.S. withholding taxes. A deferred tax liability of approximately $100 million to $150 million related to such withholding taxes has not been recorded for those foreign subsidiaries whose earnings are considered to be indefinitely reinvested. Deferred taxes, if necessary, have been provided on earnings of non-U.S. affiliates whose earnings are not indefinitely reinvested.
* Includes other carryforwards, i.e. general business credits of $30 million and refundable Alternative Minimum Tax Credits of $39 million on a U.S. GAAP basis.
We have U.S. federal consolidated net operating loss and tax credit carryforwards of approximately $10.2 billion. The carryforward periods for our foreign tax credits begin to expire in 2019. As detailed in the Assessment of Deferred Tax Asset Valuation Allowance section of this footnote, we determined that it is more likely than not that our U.S. federal consolidated tax attribute carryforwards will be realized prior to their expiration.
In performing our assessment of the recoverability of the deferred tax asset under this framework, we consider tax laws governing the utilization of the net operating loss, capital loss and foreign tax credit carryforwards in each applicable jurisdiction. Under U.S. tax law, a company generally must use its net operating loss carryforwards before it can use its foreign tax credit carryforwards, even though the carryforward period for the foreign tax credit is shorter than for the net operating loss. Our U.S. federal consolidated income tax group includes both life companies and non-life companies. While the U.S. taxable income of our non-life companies can be offset by our net operating loss carryforwards, only a portion (no more than 35 percent) of the U.S. taxable income of our life companies can be offset by those net operating loss carryforwards. The remaining tax liability of our life companies can be offset by the foreign tax credit carryforwards. Accordingly, we utilize both the net operating loss and foreign tax credit carryforwards concurrently which enables us to realize our tax attributes prior to expiration. As of December 31, 2018, based on all available evidence, it is more likely than not that the U.S. net operating loss and foreign tax credit carryforwards will be utilized prior to expiration and, thus, no valuation allowance has been established.
For the year ended December 31, 2018, we recognized a net increase of $21 million in our deferred tax asset valuation allowance associated with certain foreign subsidiaries and state jurisdictions, primarily attributable to current year activity.
At December 31, 2018 and 2017, our U.S. consolidated income tax group had net deferred tax assets after valuation allowance of $14.6 billion and $13.4 billion, respectively. At December 31, 2018 and 2017, our U.S. consolidated income tax group had valuation allowances of $405 million and $86 million, respectively.
The statute of limitations for all tax years prior to 2000 has expired for our consolidated federal income tax return. We are currently under examination for the tax years 2000 through 2013.
In January 2018, the parties reached non-binding agreements in principle on issues presented in the dispute and are currently reviewing the computations reflecting the settlement terms. The resolution is not final and is subject to various reviews. The litigation has been stayed pending the outcome of the review process. We can provide no assurance regarding the outcome of any such litigation or whether binding compromised settlements with the parties will ultimately be reached. We currently believe that we have adequate reserves for the potential liabilities that may result from these matters.
At December 31, 2018, 2017 and 2016, our unrecognized tax benefits, excluding interest and penalties, were $4.7 billion, $4.7 billion and $4.5 billion, respectively. The activity for the year ended December 31, 2018 is not material. The activity for the years ended December 31, 2017 and 2016, includes increases for amounts associated with cross border financing transactions and the impact of settlement discussions with the IRS related to certain other open tax issues unrelated to the cross border financing transactions. With respect to cross border financing transactions, the increases are the result of consideration of court decisions upholding the disallowance of foreign tax credits claimed by other corporate entities not affiliated with AIG. In addition, the year ended December 31, 2017 reflects the agreement reached in the fourth quarter of 2017 by the parties in the cross border financing dispute to pursue a potential settlement.
At December 31, 2018, 2017 and 2016, our unrecognized tax benefits related to tax positions that, if recognized, would not affect the effective tax rate because they relate to such factors as the timing, rather than the permissibility, of the deduction were $38 million, $28 million and $66 million, respectively. Accordingly, at December 31, 2018, 2017 and 2016, the amounts of unrecognized tax benefits that, if recognized, would favorably affect the effective tax rate were $4.7 billion, $4.7 billion and $4.4 billion, respectively.
(b) Includes intercompany derivative positions, which are reported at fair value before credit valuation adjustment.
On February 13, 2019, our Board of Directors authorized an additional increase to its previous repurchase authorization of AIG Common Stock of $1.5 billion, resulting in an aggregate remaining authorization on such date of approximately $2.0 billion.