AIG and its subsidiaries operate from over 400 offices in the United States and approximately 600 offices in over 75 foreign countries. The following offices are located in buildings in the United States owned by AIG and its subsidiaries:
In addition, AIG Property Casualty owns offices in approximately 20 foreign countries and jurisdictions including Argentina, Bermuda, Colombia, Ecuador, Japan, Mexico, the U.K., Taiwan, and Venezuela. The remainder of the office space utilized by AIG and its subsidiaries is leased. AIG believes that its leases and properties are sufficient for its current purposes.
Selected Financial Data and throughout this MD&A, we present our financial condition and results of operations in the way we believe will be most meaningful, representative and most transparent. Some of the measurements we use are "non-GAAP financial measures" under SEC rules and regulations. GAAP is the acronym for "accounting principles generally accepted in the United States." The non-GAAP financial measures we present may not be comparable to similarly-named measures reported by other companies.
We use the following operating performance measures because we believe they enhance understanding of the underlying profitability of continuing operations and trends of AIG and our business segments. We believe they also allow for more meaningful comparisons with our insurance competitors. When we use these measures, reconciliations to the most comparable GAAP measure are provided in the Results of Operations section of this MD&A.
•AIG - After-tax operating income (loss) attributable to AIG is derived by excluding the following items from net income (loss) attributable to AIG: income (loss) from discontinued operations, net loss (gain) on sale of divested businesses and properties, income from divested businesses, legacy tax adjustments primarily related to certain changes in uncertain tax positions and other tax adjustments, legal reserves (settlements) related to "legacy crisis matters," deferred income tax valuation allowance (releases) charges, changes in fair value of AIG Life and Retirement fixed maturity securities designated to hedge living benefit liabilities (net of interest expense), changes in benefit reserves and deferred policy acquisition costs (DAC), value of business acquired (VOBA), and sales inducement assets (SIA) related to net realized capital (gains) losses, AIG Property Casualty other (income) expense - net, (gain) loss on extinguishment of debt, net realized capital (gains) losses, non-qualifying derivative hedging activities, excluding net realized capital (gains) losses, and bargain purchase gain. "Legacy crisis matters" include favorable and unfavorable settlements related to events leading up to and resulting from our September 2008 liquidity crisis and legal fees incurred by AIG as the plaintiff in connection with such legal matters.
•Pre-tax operating income (loss): includes both underwriting income (loss) and net investment income, but excludes net realized capital (gains) losses, other (income) expense - net, legal settlements related to legacy crisis matters described above, and bargain purchase gain. Underwriting income (loss) is derived by reducing net premiums earned by claims and claims adjustment expenses incurred, acquisition expenses and general operating expenses.
•Ratios: AIG Property Casualty, along with most property and casualty insurance companies, uses the loss ratio, the expense ratio and the combined ratio as measures of underwriting performance. These ratios are relative measurements that describe, for every $100 of net premiums earned, the amount of claims and claims adjustment expense, and the amount of other underwriting expenses that would be incurred. A combined ratio of less than 100 indicates underwriting income and a combined ratio of over 100 indicates an underwriting loss. The underwriting environment varies across countries and products, as does the degree of litigation activity, all of which affect such ratios. In addition, investment returns, local taxes, cost of capital, regulation, product type and competition can have an effect on pricing and consequently on profitability as reflected in underwriting income and associated ratios.
•Premiums and deposits: includes direct and assumed amounts received on traditional life insurance policies, group benefit policies and deposits on life-contingent payout annuities, as well as deposits received on universal life, investment-type annuity contracts, guaranteed investment contracts (GICs) and mutual funds.
This overview of management's discussion and analysis highlights selected information and may not contain all of the information that is important to current or potential investors in AIG's securities. You should read this Annual Report on Form 10-K in its entirety for a complete description of events, trends, uncertainties, risks and critical accounting estimates affecting AIG and its subsidiaries.
Net realized capital gains improved in 2013 compared to 2012 due to lower levels of other-than-temporary impairments on investments, partially offset by impairments on investments in life settlements.
* Includes operating borrowings of other subsidiaries and consolidated investments and hybrid debt securities.
We maintained financial flexibility at AIG Parent in 2013 through $4.1 billion in cash dividends from AIG Property Casualty subsidiaries and $4.4 billion in cash dividends and loan repayments from AIG Life and Retirement subsidiaries.
Our Board of Directors authorized the repurchase of shares of AIG Common Stock on August 1, 2013, with an aggregate purchase price of up to $1.0 billion, from time to time in the open market, private purchases, through forward, derivative, accelerated repurchase or automatic repurchase transactions or otherwise. During 2013, we repurchased approximately 12 million shares of AIG Common Stock, par value $2.50 per share (AIG Common Stock) under this authorization at a total cost of approximately $597 million.
Our Board of Directors increased our AIG Common Stock share repurchase authorization by $1.0 billion on February 13, 2014, resulting in an aggregate remaining repurchase authorization of approximately $1.4 billion.
Although there was a rise in interest rates in the U.S. fixed income market during the second half of 2013, interest rates remain low relative to historical levels, which has affected our industry by reducing investment returns. In
addition, current market conditions may not necessarily permit insurance companies to increase pricing across all our product lines.
•Pursue initiatives that continue to reduce expenses and improve efficiencies to best meet the needs of our customers, including centralizing work streams to lower-cost locations and creating a more streamlined organization.
Growth and Business Mix - Grow higher value business to increase profitability and expand in attractive growth economies.
Claims Best Practices - Improve claims practices, analytics and tools to improve customer service, increase efficiency and lower the loss ratio.
Capital Efficiency - Enhance capital management through initiatives to streamline our legal entity structure, optimize our reinsurance program and improve tax efficiency.
Investment Strategy - Execute our investment strategy, which includes increased asset diversification and yield-enhancement opportunities that meet our liquidity, capital, risk and return objectives.
We continue to further enhance our risk selection process and refine technical pricing and producer management, through enhanced tools and analytics. In addition, we remain focused on reducing exposure to capital intensive long-tail lines. We believe that accident year loss ratios will continue to improve due to these actions.
•Simplification of the ownership structure of the Admitted and Surplus Lines Pool members, allowing for the combination of our Admitted Lines and Surplus Lines pools, which became effective January 1, 2014. We also transferred the majority of the existing intercompany reinsurance to the pools. In addition, we transferred the majority of the existing intercompany reinsurance held by one of our Bermuda entities to the Admitted Lines pool. We paid dividends of approximately $1.8 billion to AIG during 2013 as a result of these activities.
See Segment Results - AIG Property Casualty Operations - AIG Property Casualty Results - AIG Property Casualty Net Investment Income and Net Realized Capital Gains (Losses) and Note 6 to the Consolidated Financial Statements for additional information.
Product Diversity and Capacity for Growth - Continue to expand our comprehensive portfolio with superior, differentiated product solutions that meet consumer needs for financial and retirement security, using our scale and capital strength to pursue growth opportunities.
Effective Risk and Capital Management - Deliver solid earnings through disciplined pricing and diversification of risk and increase capital efficiency within our life insurance entities to enhance return on equity.
The interest rate environment has a significant impact on the life and annuity industry. Low long-term interest rates put pressure on long-term investment returns, negatively affect sales of interest rate sensitive products such as fixed annuities, and reduce future profits on certain existing fixed rate products. Low interest rates may also affect future investment margins, and may affect the recoverability and amortization rate of DAC assets in our variable annuity, fixed annuity and universal life businesses. While long-term interest rates remain low relative to historical levels, the increase in rates since the second half of 2013 has caused demand for fixed annuities products to improve, and continued stable or modestly rising interest rates provide favorable market conditions for our fixed annuity sales and future profitability.
We will continue to actively manage renewal crediting rates and use a disciplined approach to pricing new sales of interest rate sensitive products, including minimum rate guarantees. Also, as market conditions change, we manage our asset and liability interest rate exposures and strategic asset allocation to emphasize lower or higher durations in our investment portfolio.
The life insurance marketplace continues to be highly competitive and driven by price and service, with key players in this market acquiring an increasing market share. Industry sales of universal life have slowed, particularly sales of guaranteed universal life products, which was expected following the implementation of regulatory changes that increased minimum reserving requirements for these guaranteed products.
We expect to continue to expand our comprehensive portfolio of products by developing superior, differentiated product solutions that meet consumer needs for financial and retirement security while incorporating volatility risk controls. Our scale and capital base provide competitive advantages that enable us to pursue market opportunities for growth.
We are continuing to invest in initiatives to enable a simpler and more agile low-cost operating model that provides superior service and will position our operating platforms to accommodate significant future growth. For example, our One Life initiative is focused on leveraging our most efficient systems environments and increased automation of our underwriting processes.
equity market volatility and changes in interest rates. Additionally, our scale and the breadth of our product offerings provide diversification of risk across our product portfolio.
Interest rate increases in late 2013 reduced the refinancing activity that drove much of the increased volume in the mortgage loan industry during the year. As a result, UGC anticipates a decrease in new insurance written during 2014 compared to 2013. However, the majority of UGC's new business written during 2013 was originated from home purchases as opposed to refinancing, and we expect the growth in home purchase lending in 2014 to partially offset the decline in refinancing activity. UGC believes the increase in home purchases will be driven by increased buyer confidence arising from home price appreciation and interest rates remaining at low levels relative to historical levels.
During 2014, UGC expects to continue to be a leading provider of mortgage insurance and will differentiate itself from its competitors by providing superior products to our customers and utilizing its proprietary risk-based pricing strategy. This pricing strategy provides UGC's customers with mortgage insurance products that are priced commensurate with the underwriting risk, which we believe will result in an appropriately priced, high-quality book of business. UGC plans to continue to execute this strategy in 2014. The business generated under this strategy, which was initiated during 2009, accounts for approximately 53 percent of net premiums earned in 2013.
The remaining derivatives portfolio of AIGFP consists primarily of hedges of the assets and liabilities of the DIB and a portion of the legacy hedges for AIG and its subsidiaries. AIGFP's derivative portfolio consists primarily of interest rate, currency, credit, commodity and equity derivatives. Additionally, AIGFP has a credit default swap portfolio that is being managed for economic benefit and with limited risk. The AIGFP portfolio continues to be wound down and is managed consistent with our risk management objectives. Although the portfolio may experience periodic fair value volatility, it consists predominantly of transactions that we believe are of low complexity, low risk or currently not economically appropriate to unwind based on a cost versus benefit analysis.
Income from continuing operations before income tax expense was $9.4 billion in 2013 compared to $2.9 billion in 2012, and reflected the following:
For the fourth consecutive year we posted a full year profit.
Our total AIG Property Casualty accident year loss ratio, as adjusted, improved each year during the past four years.
•pre-tax income from insurance operations of $2.0 billion, $3.8 billion and $15 million from AIG Property Casualty, AIG Life and Retirement and Mortgage Guaranty in 2012, respectively, compared to pre-tax income (loss) of $2.1 billion, $3.0 billion and $(77) million for these operations in 2011. Included in 2012 pre-tax income for AIG Property Casualty were catastrophe losses of $2.7 billion, largely arising from Storm Sandy, and severe losses of $326 million. Included in 2011 pre-tax income for AIG Property Casualty were catastrophe losses of $3.3 billion, largely arising from Hurricane Irene, U.S. tornadoes and the Great Tohoku Earthquake & Tsunami in Japan (the Tohoku Catastrophe) and severe losses of $296 million. See Note 3 to the Consolidated Financial Statements for further information;
•increases in fair value of AIG's interest in AIA ordinary shares of $2.1 billion and $1.3 billion in 2012 and 2011, respectively. The increase in fair value in 2012 included a gain on sale of AIA ordinary shares of approximately $0.8 billion;
•an increase in estimated litigation liability of approximately $783 million for 2012 based on developments in several actions;
•litigation settlement income of $210 million in 2012 from settlements with three financial institutions who participated in the creation, offering and sale of RMBS from which AIG and its subsidiaries suffered losses either directly on their own account or in connection with their participation in AIG's securities lending program; and
For the year ended December 31, 2013, the effective tax rate on pre-tax operating income was 28.9 percent. The significant factors that contributed to the difference from the statutory rate included tax benefits resulting from tax exempt interest income and other permanent tax items, and the impact of discrete tax benefits.
AIG Life and Retirement - Pre-tax income increased in 2013 compared to 2012, primarily due to increased fee income from growth in our variable annuity account value and continued active spread management related to our interest rate sensitive businesses, income from legal settlements and alternative investments. These increases were partially offset by the absence of fair value gains recognized in 2012 from our investment in ML II, which was liquidated in March 2012. Net realized capital gains increased in 2013 compared to 2012, primarily due to gains in connection with our program to utilize capital loss carryforwards, which were partially offset by the triggering of additional loss recognition reserves, reflected in Policyholder benefits and claims incurred, from the subsequent reinvestment of the proceeds from these sales at lower yields.
AIG Property Casualty - Pre-tax income decreased slightly in 2012 compared to 2011 due to higher acquisition costs as a result of the change in business mix from Commercial Insurance to Consumer Insurance and higher general operating expenses and lower net realized capital gains. Partially offsetting the decrease were lower underwriting losses due to the impact of lower catastrophe losses, underwriting improvements related to rate increases and enhanced risk selection, higher net investment income due to asset diversification by reducing the concentration in tax-exempt municipal instruments and increasing investments in private placement debt and structured securities.
Other Operations - Other Operations recorded a decline in pre-tax loss in 2012 compared to 2011 due to fair value and realized gains in our interest in AIA ordinary shares, and in our interest in ML III, partially offset by an increase in estimated litigation liability, and a loss on extinguishment of debt of $3.3 billion in 2011 in connection with the termination of the FRBNY Credit Facility.
The net loss on divested businesses in 2012 includes a loss associated with the announced sale of ILFC.
The following table presents reconciliations of pre-tax income (loss) to pre-tax operating income (loss) by reportable segment and after-tax operating income attributable to AIG, which are non-GAAP measures. See Use of Non-GAAP Measures for additional information.
* Reflects income from settlements with financial institutions that participated in the creation, offering and sale of RMBS from which AIG realized losses during the financial crisis.
We are developing new value-based metrics that provide management with enhanced measures to evaluate our profitability, such as a risk-adjusted profitability model. Along with underwriting results, this risk-adjusted profitability model incorporates elements of capital allocations, costs of capital and net investment income. We believe that such performance measures will allow us to better assess the true economic returns of our business.
Net premiums written decreased slightly in 2013, compared to the prior year, due to the effect of foreign exchange as a result of the strengthening of the U.S. dollar against the Japanese yen, which primarily impacted the Consumer Insurance businesses. This decrease was largely offset by an increase in the Commercial Insurance net premiums written due to rate increases, improved retention, growth in new business and changes in our reinsurance program. Excluding the effect of foreign exchange, net premiums written increased by approximately 4 percent compared to the prior year.
The loss ratio improved by 7.2 points in 2013, compared to the prior year, primarily due to positive pricing, continued improvement from our change in business mix and lower catastrophe losses. These improvements were partially offset by an increase in severe losses and adverse prior year development, which added 0.8 points and 0.1 point to the loss ratio, respectively, compared to the prior year. Additionally, an increase in discount for certain workers' compensation reserves improved the loss ratio by 1.0 points compared to the prior year.
Net investment income increased by 10 percent in 2013, compared to the prior year, primarily due to increases in alternative investment returns and income associated with the PICC P&C shares that are accounted for under the fair value option.
We provided $4.3 billion of dividends to AIG Parent during the year ended December 31, 2013, including non-cash dividends of $222 million (including dividends of $1.8 billion related to restructuring activities).
* Certain 2013 severance expenses totaling $263 million for AIG Property Casualty are included in AIG's Other Operations. As these expenses are related to an overall AIG initiative to centralize work streams into lower cost locations, and create a more streamlined organization, they have not been allocated to the AIG Property Casualty segment.
* The operations reported as part of Other do not have meaningful levels of Net premiums written.
Pre-tax operating income increased in 2013, compared to the prior year, primarily due to a decrease in catastrophe losses to $710 million from $2.3 billion in the prior year, partially offset by a decrease in allocated net investment income as a result of a decrease in the risk-free rates used in our investment income allocation model. The lower underwriting loss in 2013 compared to the prior year was primarily due to lower catastrophe losses, rate increases,
Acquisition expenses decreased in 2013, compared to the prior year, primarily due to the change in business mix which was partially offset by costs in growth-targeted lines of business. Direct marketing expenses, excluding commissions, for the year ended December 31, 2013 were $440 million, compared to $452 million in the prior year. These expenses, while not deferrable, are expected to generate business that has an average expected overall persistency of approximately five years and, in Japan, approximately nine years. Excluding the effect of foreign exchange, direct marketing expenses increased by approximately $46 million in 2013 compared to the prior year.
General operating expenses decreased in 2013, compared to the prior year, primarily due to reduced costs for strategic initiatives, which were partially offset by the increase in employee incentive plan expense previously discussed and the strategic expansion into growth economy nations.
General operating expenses decreased as a result of lower expenses related to strategic initiatives.
Pre-tax operating income increased in 2012, compared to the prior year, primarily due to a decrease in catastrophe losses to $2.7 billion from $3.3 billion in the prior year. In addition, net investment income increased due to asset
Acquisition expenses increased due to the change in business mix to higher value lines of business and the change in business mix from Commercial Insurance to Consumer Insurance.
Acquisition expenses increased primarily as a result of higher commission expense due to the restructuring of the U.S. Casualty, primarily loss-sensitive business, as we move towards higher value lines of business.
Casualty net premiums written decreased in 2013, compared to the prior year, primarily due to the execution of our strategy to enhance risk selection, particularly in the Americas and EMEA, as well as to increase specific reinsurance purchases to better manage our exposures. Changes in reinsurance strategy decreased net premiums written by approximately $185 million in 2013, compared to the prior year. In line with our strategy, Casualty net premiums written decreased 17.1 percent since 2011 due to the capital intensive nature of the long-tail Casualty book of business. We implemented rate increases in retained business, especially in the U.S., that partially offset these premium decreases.
The increase in net premiums written was partially offset by the effect of catastrophe bond transactions which provide coverage for several years with ceded written premium recognized at the inception of the transaction. In 2013, we entered into two multi-year catastrophe bond transactions, which will provide $525 million of indemnity protection, in the aggregate, against U.S., Caribbean and Gulf of Mexico named storms, and U.S. and Canadian earthquakes through the end of 2018. These transactions reduced net premiums written in 2013 by $140 million. Our previous catastrophe bond issuance occurred in the fourth quarter of 2011.
Financial lines net premiums written increased in 2013 compared to the prior year, reflecting growth in new business related to targeted growth products, particularly in the EMEA region as well as an improved rate environment globally. Global professional indemnity net premiums written increased by $86 million in 2013, due to improved rates, strong new business growth and the restructuring of our reinsurance program, as part of our decision to retain more favorable risks while continuing to manage aggregate exposure.
A&H net premiums written, excluding the effect of foreign exchange, increased slightly compared to the prior year, primarily due to our focus on the growth of Fuji Life products, direct marketing, individual A&H in Asia Pacific, and travel business which continued to increase in most geographies across the globe.
Casualty net premiums written decreased in 2012, compared to the prior year, as planned, primarily due to the execution of our strategy to improve loss ratios. Our enhanced risk selection process, and adherence to pricing targets resulted in the non-renewal of approximately $800 million of net premiums written, primarily within the workers' compensation business in the Americas, and within the Primary Casualty business in EMEA. In addition, the restructuring of the loss-sensitive programs decreased Casualty net premiums written by approximately $260 million in 2012. The additional premiums associated with prior year development in the loss-sensitive business also decreased by approximately $120 million. We also entered into a quota share reinsurance treaty in the U.S. for the Excess Casualty business that decreased net premiums written by approximately $60 million. We implemented rate increases in retained business, especially in the U.S., that partially offset the premium decreases noted above.
Property net premiums written increased in 2012, compared to the prior year, due to rate increases, primarily in the U.S., reduced catastrophe bond purchases in 2012, and the restructuring of the per-risk reinsurance program as part
of our decision to retain more favorable risks while continuing to manage aggregate exposure. Catastrophe exposed business retained in the Americas and Asia Pacific region also benefitted from rate increases.
During 2011, as part of the reinsurance strategy discussed above, we secured a three-year catastrophe bond with an industry index, first occurrence trigger, providing for $575 million in protection for U.S. hurricanes and earthquakes. The bond transaction reduced net premiums written by approximately $201 million in 2011. There were no catastrophe bond purchases in 2012.
Specialty net premiums written increased in 2012, compared to the prior year, due to the restructuring of the aerospace reinsurance program to retain more favorable risks while continuing to manage aggregate exposure. This increase was slightly offset by our strategic initiatives related to improved risk selection, particularly within products provided to small and medium sized enterprises in the Americas and EMEA regions. We continue to shift our business mix towards higher value lines, particularly in aerospace.
Financial lines net premiums written increased in 2012, compared to the prior year, reflecting strong business growth in all regions, despite targeted decreases where the business did not meet our risk selection and internal performance criteria. Financial lines net premiums written for year ended December 31, 2011 benefited from a multi-year Errors and Omissions policy in the Americas that produced net premiums written of $148 million.
Personal lines net premiums written increased in 2012, compared to the prior year, primarily due to the execution of our strategic initiative to grow higher value lines of business in non-automobile products and rate increases in Japan automobile products. Growth in non-automobile net premiums written outpaced growth in automobile net premiums written, increasing its proportion to total net premiums written, due to our focus on diversifying the global product mix.
Given the nature of the lines of business and the expenses included in Other, we have determined that the traditional underwriting measures of loss ratio, acquisition ratio, general operating expense ratio and combined ratio do not provide an appropriate measure of underwriting performance. Therefore, these ratios are not presented for Other.
See Liability for Unpaid Claims and Claims Adjustment Expense for further discussion of discounting of reserves and prior year development.
The following tables present AIG Property Casualty accident year catastrophe losses by region and number of events:
(a) Events shown in the above table are catastrophic insured events having a net impact in excess of $10 million each. Severe losses are defined as non-catastrophe individual first party losses and surety losses greater than $10 million, net of related reinsurance.
(c) On March 11, 2011, a major earthquake occurred near the northeast coast of Honshu, Japan, triggering a tsunami in the Pacific Ocean. This disaster is referred to as the Tohoku Catastrophe. In 2011, we recorded $1,191 million in losses related to this event.
The accident year combined ratio, as adjusted, improved by 3.6 points for the year ended December 31, 2013.
The accident year combined ratio, as adjusted, increased by 2.3 points for the year ended December 31, 2013.
The accident year loss ratio, as adjusted, increased by 1.2 points, primarily due to the effect of higher losses associated with a warranty retail program, group accident, and travel business in the U.S. and Canada, which in the aggregate increased the loss ratio by 1.6 points. This was partially offset by improvements in automobile and personal property, as a result of rate and underwriting actions taken in current and prior years. The higher losses associated with a warranty retail program were largely offset by a decrease in related profit sharing arrangement.
The general operating expense ratio increased by 0.6 points compared to the prior year. The general operating expense ratio increased primarily due to the increase in employee incentive compensation expense previously discussed, partially offset by lower infrastructure project costs.
The improvement in the accident year loss ratio, as adjusted, in 2012, reflects the realization of benefits from the continued execution of our multi-faceted strategy to enhance risk selection, pricing discipline, exposure management and claims processing. Although the execution of these strategies resulted in a reduction of Casualty net premiums written, it also improved the accident year loss ratio as we remediated our primary and excess Casualty books in both the Americas and EMEA regions. Financial lines improved due to rate strengthening and restructuring and re-underwriting of certain products. Property improved due to rate strengthening, enhanced engineering and exposure management.
The general operating expense ratio increased by 2.4 points due to increases in bad debt expense, investments in strategic initiatives and human resources, coupled with a lower net premiums earned base. The lower net premiums earned base contributed approximately 0.2 points to the increase in the general operating expense ratio. Bad debt expense increased by approximately $143 million, which contributed approximately 0.7 points to the general operating expense ratio increase in the year ended December 31, 2012. For the year ended December 31, 2012, investments in strategic initiatives, commercial lines platform, our scientific group, underwriting and pricing tools totaled approximately $51 million, representing an increase of approximately $41 million over the prior year. The remainder of the general operating expense ratio increase was primarily due to higher personnel costs, as part of AIG's continued investment in its employees.
The accident year combined ratio, as adjusted, increased by 1.5 points for the year ended December 31, 2012.
The general operating expense ratio increased by 0.9 points as a result of incurring additional expenses to grow key lines of business across a number of geographic areas and strategic expansion in growth economy nations. For the year ended December 31, 2012, investments in strategic initiatives, including investments in an integrated consumer lines platform and information systems infrastructure totaled approximately $44 million, representing an increase of approximately $27 million or 0.2 points over the prior year. The remainder of the increase was primarily due to higher personnel costs, as we continue our efforts to align employee performance across the globe with our strategic goals.
AIG Property Casualty Net Investment Income and Net Realized Capital Gains (Losses)
The following table presents AIG Property Casualty's net investment income and net realized capital gains (losses):
Net realized capital gains (losses) and Other income (expense) - net are not allocated to Commercial Insurance and Consumer Insurance, but are reported as part of the Other category.
Net investment income is influenced by a number of factors, including equity market performance, changes in overall asset allocation, changes in the timing and amount of expected cash flows on certain structured securities, and the movements of interest rates. Net investment income increased by $487 million or 10 percent in 2013, compared to 2012, primarily due to increased alternative investment income derived from equity market performance and income associated with the PICC P&C shares that are accounted for under the fair value option. This alternative investment performance was most visible in investments in hedge funds, which benefited from the equity market performance. Fair value increases also contributed to the net investment income increase. The portion of our investment in PICC P&C shares accounted for under the fair value option, contributed $110 million to net investment income. Although interest rates remained at historically low levels, there were upward movements in rates throughout the year, with the ten year U.S. Treasury yield increasing 126 basis points during the year. These increasing rates, coupled with continued portfolio diversification, helped mitigate the effects of runoff rates on matured or sold investments exceeding new investment yields. The combination of improving yield differential and above average alternative investment returns increased the return on invested assets by approximately 0.4 points to 4.2 percent.
The following discussion of the consolidated liability for unpaid claims and claims adjustment expense (loss reserves) presents loss reserves for AIG Property Casualty as well as the loss reserves pertaining to the Mortgage Guaranty reporting unit, which is reported in Other Operations.
* Includes $1.6 billion of reinsurance recoverable under a retroactive reinsurance agreement at both December 31, 2013 and 2012.
(a) The 2012 amounts have been revised to conform the presentation of the total discount. The impact of this revision was an increase to Commercial Insurance of $654 million and a corresponding decrease to Other of $654 million, with no income statement or balance sheet impact.
domiciled in Delaware. New York discounting rules generally do not permit non-tabular discounting on IBNR and only prescribes a 5 percent rate for application to case reserves. We also expect to receive a permitted practice from the Delaware Department of Insurance to allow discounting on the same basis as Pennsylvania domiciled companies described above. The $100 million anticipated impact arises from the application of non-tabular discount to the IBNR transferred out of New York companies to Pennsylvania and Delaware companies, offset partially by a decrease in the effective discount rate from the 5 percent prescribed rate in New York.
AIG net loss reserves represent our best estimate of our liability for net losses and loss expenses as of December 31, 2013. While we regularly review the adequacy of established loss reserves, there can be no assurance that our ultimate loss reserves will not develop adversely and materially exceed our loss reserves as of December 31, 2013. In our opinion, such adverse development and resulting increase in reserves are not likely to have a material adverse effect on our consolidated financial condition, although such events could have a material adverse effect on our consolidated results of operations for an individual reporting period.
The following table summarizes development, (favorable) or unfavorable, of incurred losses and loss expenses for prior years, net of reinsurance, by major class of business:
During 2013, the adverse prior year loss development net of premium accruals was $438 million. The increase was primarily due to the increases in reserves by $108 million for Storm Sandy, $219 million for U.S. construction primary general liability lines and $238 million for the run-off environmental (1987 to 2004) book.
In addition, we recognized additional premiums on loss-sensitive business of $89 million, $54 million and $172 million for the years ended December 31, 2013, 2012 and 2011, respectively.
For the year ended December 31, 2013, we incurred reinstatement premiums of $27 million, compared to $0 for both years 2012 and 2011.
In determining the loss development from prior accident years, we analyze and evaluate the change in estimated ultimate loss for each accident year by class of business. For example, if loss emergence for a class of business is different than expected for certain accident years, we examine the indicated effect such emergence would have on
During 2012, the Excess Casualty class of business experienced $157 million of adverse development based on worse than expected Umbrella Excess emergence, primarily from adverse outcomes relating to certain large claims from older accident years, from the legacy public entity excess casualty class of business and from a refined analysis applied to claims in excess of $10 million. This refined analysis considered the impact of changing attachment points (primarily impacting frequency of excess claims) and limit structures (primarily impacting severity of excess claims) throughout the loss development period.
In 2013, our analysis of pollution products reflected an updated review of individual cases which indicated large increases in the value of certain previously reported cases due to new developments such as the discovery of additional contamination in certain sites, legislative changes, court rulings, expansion of plaintiff damages and increased cost of remediation technologies. Additionally, the number and severity of newly reported claims was higher than expected. As a result, we increased our estimate of ultimate losses by approximately $269 million with approximately $201 million of this relating to policies written in 2003 and prior. Significant changes in underwriting during 2004 changed the terms and conditions materially for policies written after 2003 to reduce our exposure to these events.
Primary Casualty includes Workers' Compensation and General Liability in Commercial Risk, Specialty Workers' Compensation, Energy Business units, Worldsource and Non-Admitted business.
During 2013, we updated our analysis of Excess Workers' Compensation reserves and determined that no changes to our carried reserves were needed. During the 2012 loss reserve review, we augmented traditional reserve methodologies with an analysis of underlying claims cost drivers to inform our judgment of the ultimate loss costs for open reported claims from accident years 2003 and prior (representing approximately 95 percent of all open reported claims) and used the refined analysis to inform our judgment of the ultimate loss cost for claims that have not yet been reported using a frequency/severity approach for these accident years.
The following table summarizes development, (favorable) or unfavorable, of incurred losses and loss expenses for prior years, net of reinsurance, by accident year:
For 2011, the adverse development from accident years 2003 and prior was largely driven by runoff pollution products (written between 1987and 2003) and toxic tort claims. Adverse development from accident year 2010 was largely driven by primary workers' compensation and loss-sensitive primary business. Favorable development from accident years 2005 to 2008 was driven by financial lines, claims-made excess classes and other casualty classes.
For certain categories of claims (e.g., construction defect claims and environmental claims) and for reinsurance recoverables, losses may sometimes be reclassified to an earlier or later accident year as more information about the date of occurrence becomes available to AIG. These reclassifications are shown as development in the respective years in the table above.
•the difficulty in estimating the allocation of remediation cost among various parties with respect to environmental claims. We engaged an independent third-party actuarial firm to assist in assessing asbestos exposures. This external study was completed in early 2011, based on losses evaluated in 2010.The ground-up study conducted by this firm used a proprietary model to calculate the loss exposure on an insured-by-insured basis. We believe that the accuracy of the reserve estimate is greatly enhanced through the combination of the actuarial firm's industry modeling techniques and industry knowledge and our own specific account-level experience.
In 2012, after we carefully considered the recent experience compared to the results of the 2010 ground-up analysis, as well as all of the above factors related to uncertainty, no adjustment to gross and net asbestos reserves was recognized in 2012. Additionally in 2012, a moderate amount of incurred loss pertaining to the asbestos loss reserve discount is reflected in the table below and is related to the reserves not subject to the NICO reinsurance agreement. Upon completion of a top-down analysis performed for environmental in the fourth quarter of 2012, we concluded that the $150 million gross reserve strengthening and $75 million net reserve strengthening recognized in the first half of 2012 was adequate.
strategy to reduce our overall loss reserve development risk. This transaction covers potentially volatile U.S.-related asbestos exposures. It does not, however, cover asbestos accounts that we believe have already been reserved to their limit of liability or certain other ancillary asbestos exposure assumed by AIG Property Casualty subsidiaries.
The following table presents the estimate of the gross and net IBNR included in the Liability for unpaid claims and claims adjustment expense, relating to asbestos and environmental claims:
(a) The number of environmental claims dismissed or otherwise resolved, increased substantially during 2012 as a result of AIG Property Casualty's determination that certain methyl tertiary-butyl ether (MTBE) claims presented no further potential for exposure since these underlying claims were resolved through dismissal, settlement, or trial for all of the accounts involved. All of these accounts were fully reserved at the account level and included adequate reserves for those underlying individual claims that contributed to the actual losses. These individual claim closings, therefore, had no impact on AIG Property Casualty's environmental reserves.
ITEM 7 / RESULTS OF OPERATIONS / LIABILITY FOR UNPAID CLAIMS AND CLAIMS ADJUSTMENT EXPENSE
Pre-tax income increased in 2013 compared to 2012, reflecting the increases in pre-tax operating income as well as increases in legal settlements with financial institutions that participated in the creation, offering and sale of RMBS from which AIG and its subsidiaries realized losses during the financial crisis. Additionally, pre-tax income increased due to net realized capital gains from continued investment sales to utilize capital loss carryforwards, which increased in 2013 compared to 2012. However, reinvestment of these sales proceeds at lower current yields has contributed to lower future investment returns, reducing spreads in interest-sensitive product lines, and resulting in loss recognition for certain traditional products in 2013 and 2012, which was reported in Changes in benefit reserves and DAC, VOBA and SIA related to net realized capital gains (losses). See AIG Life and Retirement Reserves and DAC - Other Reserve Changes for additional discussion of loss recognition.
Pre-tax operating income increased in 2013 compared to 2012, reflecting higher fee income from variable annuities driven by growth in assets under management, continued active spread management in interest rate sensitive product lines and higher net investment income. Net investment income increased in 2013 compared to 2012, due to higher income from alternative investments, partially offset by ML II fair value gains recognized in 2012 and reinvestment of investment proceeds at lower rates. Pre-tax operating income in 2013 included a net increase of $153 million from adjustments to update certain gross profit assumptions used to amortize DAC and related items in our investment-oriented product lines.
The increase in pre-tax operating income in 2013 compared to the prior year also reflected additional expenses recorded in 2012, which were related to the resolution of multi-state regulatory examinations of death claims practices and additional reserves for long-term care products in the Retail operating segment, and a comprehensive review of reserves for the GIC portfolio in the Institutional operating segment.
Pre-tax operating income for our Institutional operating segment increased in 2013 compared to 2012, due in part to higher fee income in the Group Retirement product line, which benefited from growth in separate account assets under management driven by favorable equity market performance. In addition, we continued active spread management in our interest rate sensitive product lines, which included lowering renewal crediting rates and disciplined new business pricing in our Group Retirement product line. Pre-tax operating income for the Institutional operating segment in 2013 was reduced by $45 million of net unfavorable adjustments primarily to update estimated gross profit assumptions for annuity spreads, partially offset by an increase in the assumption for separate account asset long-term growth rates in the Group Retirement product line. See Critical Accounting Estimates - Estimated Gross Profits for Investment-Oriented Products (AIG Life and Retirement) for additional discussion of estimated gross profit assumptions. The increase in pre-tax operating income compared to 2012 also reflected $110 million of expenses recorded in 2012 resulting from a comprehensive review of reserves for the GIC portfolio.
Premiums represent amounts received on traditional life insurance policies, group benefit policies and deposits on life-contingent payout annuities. Premiums and deposits is a non-GAAP financial measure that includes direct and assumed premiums as well as deposits received on universal life insurance, investment-type annuity contracts, GICs and mutual funds.
The following table presents premiums and deposits by operating segment and product line:
Net flows are presented for our investment product lines, which include Fixed Annuities, Retirement Income Solutions, Retail Mutual Funds and Group Retirement. Net flows from annuities, which are included in the Fixed Annuities, Retirement Income Solutions and Group Retirement product lines, represent premiums and deposits less death, surrender and other withdrawal benefits. Mutual fund net flows, which are included in the Retail Mutual Funds and Group Retirement product lines, represent deposits less withdrawals.
* Excludes activity related to closed blocks of fixed and variable annuities, which have reserves of approximately $6 billion at each of December 31, 2013 and 2012.
Total net flows from annuities and mutual funds increased in 2013 compared to 2012, and decreased in 2012 compared to 2011. A discussion of the significant variances in net flows for each of these product lines follows, including variances in premiums and deposits, a key component of net flows.
Fixed Annuities net flows and premiums and deposits showed improvement in 2013 compared to 2012, due to modest increases in interest rates and steepening of the yield curve in the second half of 2013, which made fixed annuity products more attractive in the marketplace compared to competing products such as bank deposits. The relatively low level of deposits in 2013 and 2012 compared to 2011, however, resulted in negative net flows for this product line in both 2013 and 2012, reflecting the challenges of the sustained low interest rate environment, as consumers were reluctant to purchase these products at the relatively low crediting rates offered, which have been priced to maintain our targeted spreads. Negative net flows have moderated since the second half of 2013 from the increase in deposits.
The Securities Valuation Office (SVO) of the 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 our 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. See Investments - Credit Ratings herein for a full description of the composite AIG credit ratings.
The following table presents the fixed maturity security portfolio of AIG Life and Retirement categorized by NAIC Designation, at fair value:
Opportunistic investments in structured securities, private placement corporate debt securities and commercial mortgage loans continue to be made to improve yields, increase net investment income and help to offset the impact of the lower interest rate environment.
We maintain investment portfolios for each product line which, to the extent practicable, match established duration targets based on the characteristics of our liabilities. We allocate net investment income from assets that support liabilities to the product line they support. Net investment income from investments in excess of liabilities, which include the majority of our alternative investments, is allocated to the product lines using a capital-based internal allocation model.
Net investment income increased in 2012 compared to 2011, reflecting higher base portfolio yields of 9 basis points due to the reinvestment of significant amounts of cash and short-term investments during 2011, opportunistic investments in structured securities, fair value gains on MLII and other structured securities, a fair value gain of approximately $57 million on the investment in PICC Group, lower impairment charges on investments in leased commercial aircraft and higher returns on alternative investments.
•New sales of fixed annuity products generally have minimum interest rate guarantees of 1 percent.
The following table presents our universal life and fixed annuity account values by contractual minimum guaranteed interest rate and current crediting rates:
* Fixed annuities include fixed options within variable annuities sold in Group Retirement and Retirement Income Solutions product lines.
Changes in fair value of fixed maturity securities designated to hedge living benefit liabilities, which are excluded from Pre-tax operating income, are a component of AIG Life and Retirement's dynamic hedging program designed to manage economic risk exposure associated with changes in equity markets, interest rates and volatilities related to embedded derivative liabilities contained in guaranteed benefit features of variable annuities. We substantially hedge our exposure to equity markets, and the majority of our interest rate exposure is hedged with derivative instruments and, to a lesser extent, with U.S. Treasury bonds that we began purchasing in 2012 as a capital-efficient strategy to reduce our interest rate risk exposure over time. As a result of increases in interest rates on U.S. Treasury bonds during 2013, the fair value of the U.S. Treasury bonds used for hedging, net of financing costs, decreased by $161 million in 2013, compared to an increase in fair value of $37 million in 2012.
* Other reserve changes include loss recognition in Retail of $135 million and $189 million, and in Institutional of $1.3 billion and $1.0 billion, in 2013 and 2012, respectively.
Loss recognition attributable to our program to utilize capital loss carryforwards is excluded from Pre-tax operating income and reported within Changes in benefit reserves and DAC, VOBA and SIA related to net realized capital gains (losses) in the AIG Life and Retirement Results table herein. See Note 9 to the Consolidated Financial Statements and Critical Accounting Estimates - Future Policy Benefits for Life and Accident and Health Insurance Contracts (AIG Life and Retirement) for additional information on loss recognition.
DAC for investment-oriented products is adjusted at each balance sheet date to reflect the change in DAC as if fixed maturity and equity securities available for sale had been sold at their stated aggregate fair value and the proceeds reinvested at current yields. The change in DAC related to unrealized appreciation of investments generally moves in the opposite direction of the changes in unrealized appreciation of the available for sale securities portfolio. When market interest rates rose in 2013, the fair value and unrealized appreciation of the portfolio decreased, resulting in an increase in DAC. In 2012 and 2011, when interest rates were declining and unrealized gains in the portfolio increased, DAC and reserves related to unrealized appreciation decreased.
The following table summarizes the major components of the changes in AIG Life and Retirement DAC:
* Balance excluding the amount related to unrealized appreciation of investments was $7.8 billion, $7.5 billion and $7.9 billion at December 31, 2013, 2012 and 2011, respectively.
Policy acquisition costs and policy issuance costs related to universal life and investment-type products (collectively, investment-oriented products) are deferred and amortized, with interest, in relation to the incidence of estimated gross profits to be realized over a period that approximates the estimated lives of the contracts. Estimated gross profits include net investment income and spreads, net realized investment gains and losses, fees, surrender charges, expenses, and mortality gains and losses. If the assumptions used for estimated gross profits change significantly, DAC and related reserves are recalculated using the new assumptions, and any resulting adjustment is included in income. Updating such assumptions may result in acceleration of amortization in some products and deceleration of amortization in other products. See Critical Accounting Estimates - Estimated Gross Profits for Investment-Oriented Products (AIG Life and Retirement) for additional information on these assumptions.
Pre-tax operating income in 2013 included a net increase of $153 million from adjustments to update certain gross profit assumptions used to amortize DAC and related items in our investment-oriented product lines. These
ITEM 7 / RESULTS OF OPERATIONS / AIG LIFE AND RETIREMENT
The result of the comprehensive annual review, which was completed in the third quarter of 2013, was a $118 million net increase in Pre-tax operating income in 2013, which included a $198 million net increase in our Retail operating segment and an $80 million decrease in our Institutional operating segment. The net increase in Retail pre-tax operating income was primarily due to a favorable adjustment in our Fixed Annuities product line from updated spread assumptions due to active management of crediting rates and higher future investment yields than those previously assumed. In the Life Insurance and A&H, Retirement Income Solutions and Group Retirement product lines, the update of assumptions for variable annuity spreads, surrender rates, and life insurance mortality had an unfavorable impact on pre-tax operating income. The life insurance mortality assumptions, while unfavorable compared to the previous assumption set, are still within pricing expectations.
The $118 million increase in pre-tax operating income to reflect updated assumptions was comprised of a $98 million net decrease in DAC amortization expense, a $61 million decrease in SIA amortization expense within Interest credited to policyholder account balances, and a $28 million increase in unearned revenue amortization within Policy fees, partially offset by a $69 million increase in Future policy benefits for life and health insurance contracts.
Mortgage Guaranty recorded pre-tax operating income in 2012 compared to a pre-tax operating loss in 2011. The decrease in claims and claims adjustment expenses reflected decreases in first and second-lien businesses partially offset by an increase in international claims and claims adjustment expenses. Claims and claims adjustment expenses in 2012 included favorable prior year loss development in second liens, student loans, and international business, partially offset by unfavorable development in first liens. The decrease in first-lien claims and claims adjustment expenses reflected lower levels of newly reported delinquencies, an improvement in the cure rate and lower unfavorable loss development in 2012 compared to 2011. The unfavorable development in 2012 resulted from delinquencies for which claim requests were not made, partially offset by favorable development arising from the claims requests sent to lenders. The decline in second-lien business claims and claims adjustment expenses reflected a decrease in claims and claims adjustment expenses paid as more business reached the respective stop loss limits. The increased claims and claims adjustment expenses in the international business reflected a reduction in claim reserves in 2011 due to a settlement of certain delinquencies with a major European lender.
These items were partially offset by a decline in first-lien net premiums earned, reflecting higher premium refunds due to the rescissions arising from the claims requests sent to lenders during the fourth quarter of 2011 and continuing throughout 2012. Additionally, net premiums earned declined on second-lien and international businesses, both of which were placed into run-off during 2008. Underwriting expenses increased driven primarily by an increase in underwriting, sales and product initiatives, all of which supported the increase in new insurance written for the year.
GCM's pre-tax income and pre-tax operating income increased in 2013 compared to 2012 primarily due to an improvement in net credit valuation adjustments on derivative assets and liabilities, partially offset by a decline in unrealized market valuation gains related to the super senior credit default swap (CDS) portfolio and an increase in operating expenses.
Net credit valuation adjustment gains of $195 million were recognized in 2013 compared to net credit valuation adjustment losses of $30 million in 2012. The improvement resulted primarily from lower losses on derivative liabilities due to less significant tightening of AIG's credit spreads in 2013 compared to 2012 and higher gains on derivative assets due to more significant tightening of counterparty credit spreads in 2013 compared to 2012.
Unrealized market valuation gains on the CDS portfolio of $617 million and $339 million were recognized in 2012 and 2011, respectively. The improvement resulted primarily from amortization and price movements within the CDS portfolio. For 2012, the remaining portfolio of AIGFP continued to be wound down and was managed consistent with AIG's risk management objectives. The active wind-down of the AIGFP derivatives portfolio was completed by the end of the second quarter of 2011.
Fair value appreciation on ABS CDOs was $954 million for 2013 driven primarily by improved collateral pricing due to improvements in home price indices and amortization of the underlying collateral.
Net credit valuation adjustment gains of $444 million and $789 million were recognized for 2013 and 2012, respectively. The decrease resulted primarily from a decline in the portfolio size due to sales and maturities as well as lower gains on assets due to less significant tightening of counterparty credit spreads, partially offset by lower losses on liabilities due to less significant tightening of AIG's credit spreads in 2013 compared to 2012.
DIB pre-tax income increased in 2012 compared to 2011 primarily due to a capital gain on the sale of common units of The Blackstone Group L.P. mentioned above and improvements in pre-tax operating income. DIB pre-tax operating income increased in 2012 compared to 2011 primarily due to improvement in net credit valuation adjustments on assets and liabilities for which the fair value option was elected. Net credit valuation adjustment gains of $789 million and $380 million were recognized for 2012 and 2011, respectively. The improvement resulted primarily from gains on assets due to the tightening of counterparty credit spreads, partially offset by losses on liabilities due to the tightening of AIG's credit spreads.
required, and a decline in interest expense as a result of the repayment of the FRBNY Credit Facility and the exchange of outstanding junior subordinated debentures for senior unsecured notes in 2011.
The increase in loss on extinguishment of debt in 2013 compared to the prior year resulted from redemptions and repurchases of, and cash tender offers for, certain debt securities in 2013. The loss on extinguishment of debt in 2011 includes a $3.3 billion charge primarily consisting of the accelerated amortization of the remaining prepaid commitment fee asset resulting from the termination of the FRBNY Credit Facility.
Aircraft Leasing reported a pre-tax loss in 2013 compared to pre-tax income in 2012, primarily due to certain adjustments to ILFC's assets and liabilities classified as held for sale. See Note 4 to the Consolidated Financial Statements for more information regarding Aircraft Leasing.
Aircraft Leasing reported pre-tax income in 2012 compared to a pre-tax loss in 2011 primarily due to a decrease in impairment charges, fair value adjustments and lease-related charges on aircraft and lower losses on extinguishment of debt. This was partially offset by lower lease revenue and increased costs due to early returns of aircraft by lessees who ceased operations, lower lease revenue earned on re-leased aircraft in ILFC's fleet, charges relating to
In 2012, we recognized a pre-tax loss of $6.7 billion associated with the announced sale of ILFC.
Significant items affecting the comparison of results from discontinued operations included the following:
•a gain on the sale of AIG Star Life Insurance Co., Ltd. (AIG Star) and AIG Edison Life Insurance Company (AIG Edison) in 2011;
•tax effects of the above transactions, notably the impact of non-deductible goodwill impairment and the change in investment in subsidiaries, which was principally related to changes in the estimated U.S. tax liability with respect to the planned sales. See Note 4 to the Consolidated Financial Statements for further discussion of discontinued operations.
Liquidity refers to the ability to generate sufficient cash resources to meet our payment obligations. It is defined as cash and unencumbered assets that can be monetized in a short period of time at a reasonable cost. We manage our liquidity prudently through various risk committees, policies and procedures, and a stress testing and liquidity framework established by Enterprise Risk Management (ERM). Our liquidity framework is designed to measure both the amount and composition of our liquidity to meet financial obligations in both normal and stressed markets. See Enterprise Risk Management - Risk Appetite, Identification, and Measurement and - Enterprise Risk Management - Liquidity Risk Management below for additional information.
Capital refers to the long-term financial resources available to support the operation of our businesses, fund business growth, and cover financial and operational needs that arise from adverse circumstances. Our primary source of ongoing capital generation is the profitability of our insurance subsidiaries. We and our insurance subsidiaries must comply with numerous constraints on our minimum capital positions. These constraints drive the requirements for capital adequacy for both AIG and the individual businesses and are based on internally-defined risk tolerances, regulatory requirements, rating agency and creditor expectations and business needs. Actual capital levels are monitored on a regular basis, and using ERM's stress testing methodology, we evaluate the capital impact of potential macroeconomic, financial and insurance stresses in relation to the relevant capital constraints of both AIG and our insurance subsidiaries.
We believe that we have sufficient liquidity and capital resources to satisfy future requirements and meet our obligations to policyholders, customers, creditors and debt-holders, including reasonably foreseeable contingencies or events.
We collected $8.7 billion in cash dividends and loan repayments from our insurance subsidiaries - $4.1 billion in cash dividends from AIG Property Casualty, $4.4 billion in cash dividends and loan repayments from AIG Life and Retirement and $90 million in cash dividends from Mortgage Guaranty. Infrequent events at our insurance subsidiaries including capital management initiatives at AIG Property Casualty and proceeds from legal settlements at AIG Life and Retirement resulted in higher than usual dividends.
On August 26, 2013, we agreed to the termination of an interest rate swap agreement with Brookfield Asset Management, Inc. and Brysons International, Ltd, in exchange for a payment to AIGFP of $905 million.
We received $1.0 billion from settlements with financial institutions that participated in the creation, offering and sale of RMBS from which we realized losses during the financial crisis.
On August 9, 2013, we issued $1.0 billion aggregate principal amount of 3.375% senior notes due 2020. On October 2, 2013, we issued $1.0 billion aggregate principal amount of 4.125% senior notes due 2024.
•for an aggregate purchase price of approximately $1 billion, approximately 77 million British pounds aggregate principal amount of our 8.625% Series A-8 Junior Subordinated Debentures, approximately 182 million Euro aggregate principal amount of our 8.000% Series A-7 Junior Subordinated Debentures, approximately $79 million aggregate principal amount of our 6.25% Series A-1 Junior Subordinated Debentures and approximately $366 million aggregate principal amount of our 8.175% Series A-6 Junior Subordinated Debentures;
•for an aggregate purchase price of approximately $211 million, approximately $19 million liquidation amount of 81/2% Capital Trust Pass-Through Securities, approximately $114 million liquidation amount of 7.57% Capital Securities, Series A and approximately $29 million liquidation amount of 81/8% Capital Securities, Series B, all of which were issued by statutory trusts controlled by AIG Life Holdings, Inc; and
•for an aggregate purchase price of approximately $61 million, approximately $62 million aggregate principal amount of 5.60% Senior Debentures we had assumed that were originally issued by SunAmerica Inc.
We also made other repayments of approximately $6.3 billion. AIG Parent repaid $4.2 billion of debt, including $1.1 billion of MIP and $300 million of Series AIGFP long-term debt, and made interest payments on our debt instruments totaling $2.0 billion.
We paid approximately $25 million in the first quarter 2013 in the aggregate to purchase a warrant issued to the Department of the Treasury in 2008 that provided the right to purchase approximately 2.7 million shares of AIG Common Stock at $50.00 per share and a warrant issued to the Department of the Treasury in 2009 that provided the right to purchase up to 150 shares of AIG Common Stock at $0.00002 per share.
AIG Parent repaid $0.5 billion of its $1.1 billion outstanding loan from ILFC in the fourth quarter of 2013.
* In January 2014, AIG reduced DIB debt by $2.2 billion through a redemption of $1.2 billion aggregate principal amount of its 4.250% Notes due 2014 and a repurchase of $1.0 billion of its 8.25% Notes due 2018 using cash and short term investments allocated to the DIB.
The following table presents a summary of AIG's Consolidated Statement of Cash Flows:
Interest payments totaled $3.9 billion in 2013 compared to $4.0 billion in 2012. Excluding interest payments, AIG generated positive operating cash flow of $9.7 billion and $7.7 billion in 2013 and 2012, respectively.
Insurance companies generally receive most premiums in advance of the payment of claims or policy benefits. The ability of insurance companies to generate positive cash flow is affected by the frequency and severity of losses under their insurance policies, policy retention rates and operating expenses.
Cash provided by AIG Life and Retirement operating activities was $4.3 billion in 2013 compared to $2.9 billion in 2012, primarily due to higher pre-tax operating income and the receipt of approximately $800 million of legal settlement proceeds in 2013.
Net cash provided by operating activities improved in 2012 compared to 2011, principally due to cash paid for interest in 2011 by AIG Parent of $6.4 billion in accrued compounded interest and fees under the FRBNY Credit Facility, partially offset by a decline in cash provided by operating activities of foreign life subsidiaries of $3.4 billion due to the sale of those subsidiaries (AIA, ALICO, AIG Star, AIG Edison and Nan Shan Life Insurance Company, LTD. (Nan Shan)) in 2011.
Net cash provided by investing activities for 2013 includes approximately $0.9 billion of cash collateral received in connection with the securities lending program launched during 2012 by AIG Life and Retirement.
•payments of approximately $8.5 billion received in connection with the dispositions of ML III assets by the FRBNY;
•approximately $9.3 billion to repay long term debt; see Debt - Debt Maturities below.
•total payments of approximately $13.0 billion for the purchase of shares of AIG Common Stock. Net cash used in financing activities for 2011 primarily includes repayment of the FRBNY Credit Facility and the $12.4 billion partial repayment of the AIA SPV Preferred Interests and the ALICO SPV in connection with the Recapitalization and use of proceeds received from the sales of foreign life insurance entities in 2011.
We utilize our capital resources to support our businesses, with the majority of capital allocated to our core insurance operations. Should we have or generate more capital than is needed to support our business strategies (including organic growth or acquisition opportunities) or mitigate risks inherent to our business, we may develop plans to distribute such capital to shareholders via dividend or share repurchase authorizations or deploy such capital towards liability management.
In developing plans to distribute capital, AIG considers a number of factors, including, but not limited to: the capital resources available to support our core insurance operations and business strategies, AIG's funding capacity and capital resources in comparison to internal benchmarks, expectations for capital generation, rating agency expectations for capital, as well as regulatory standards for capital and capital distributions.
(b) $5.9 billion and $4.6 billion of cash and short-term investments as of December 31, 2013 and 2012, respectively, are allocated toward future maturities of liabilities and contingent liquidity stress needs of DIB and GCM.
(d) For additional information relating to this syndicated credit facility, see Credit Facilities below.
National Union Fire Insurance Company of Pittsburgh, Pa. (NUFI) is a member of the Federal Home Loan Bank (FHLB) of Pittsburgh, AIG Specialty Insurance Company (ASI) is a member of the FHLB of Chicago and Lexington Insurance Company (Lexington) is a member of the FHLB of Boston. FHLB membership provides participants with access to various services, including access to low-cost advances through pledging of certain mortgage-backed securities, government and agency securities and other qualifying assets. These advances may be used to provide an additional source of liquidity for balance sheet management or contingency funding purposes. As of December 31, 2013, there were no FHLB advances outstanding for NUFI, CSI or Lexington.
AIG Property Casualty's subsidiaries may require additional funding to meet capital or liquidity needs under certain circumstances.
AIG Parent, AIG Property Casualty Inc. and certain AIG Property Casualty domestic insurance subsidiaries are parties to a consolidated CMA. Among other things, the CMA provides that AIG Parent will maintain the total adjusted capital of these AIG Property Casualty insurance subsidiaries, measured as a group (the Fleet), at or above the specified minimum percentage of the Fleet's projected total authorized control level Risk-Based Capital (RBC). In addition, the CMA provided that if the total adjusted capital of the Fleet exceeds that same specified minimum percentage of the Fleet's total authorized control level RBC, subject to approval by their respective boards, and compliance with applicable insurance laws, the AIG Property Casualty insurance subsidiaries would declare and pay ordinary dividends to their respective equity holders up to an amount necessary to reduce the Fleet's projected or actual total adjusted capital to a level equal to or not materially greater than such specified minimum percentage. On February 18, 2014, the CMA was recharacterized as a capital support agreement and amended to remove the exclusion of deferred tax assets from the calculation of total adjusted capital and remove the dividend requirement of the Fleet. The specified minimum percentage in the CMA was also reduced from 325 percent to 300 percent. AIG will continue to manage capital flows between AIG Parent and the AIG Property Casualty insurance subsidiaries through internal, Board-approved policies and guidelines.
AIG Property Casualty paid cash and non-cash dividends totaling $4.3 billion to AIG Parent in 2013, including $2.6 billion of cash dividends in the fourth quarter of 2013. For the years ended December 31, 2013 and 2012, AIG Parent received approximately $4.3 billion and $2.3 billion, respectively, in dividends from AIG Property Casualty Inc. that were made under the CMAs then in place, and AIG Parent was not required to make any capital contributions in either period pursuant to the CMAs then in place.
We expect that AIG Life and Retirement subsidiaries will be able to continue to satisfy reasonably foreseeable future liquidity requirements and meet their obligations, including those arising from reasonably foreseeable contingencies or events, through cash from operations and, to the extent necessary, monetization of invested assets. AIG Life and Retirement subsidiaries' liquidity resources are held in the form of cash, short-term investments and publicly traded, investment grade rated fixed maturity securities.
AIG Parent is party to CMAs with certain AIG Life and Retirement insurance subsidiaries. Among other things, the CMAs provide that AIG Parent will maintain the total adjusted capital of each of these AIG Life and Retirement insurance subsidiaries at or above a specified minimum percentage of the subsidiary's projected NAIC Company Action Level RBC. In addition, the CMAs provided that if the total adjusted capital of these AIG Life and Retirement insurance subsidiaries is in excess of that same specified minimum percentage of their respective total company action level RBC, subject to approval by their respective boards and compliance with applicable insurance laws, the subsidiaries would declare and pay ordinary dividends to their respective equity holders up to an amount necessary to reduce projected or actual total adjusted capital to a level equal to or not materially greater than such specified minimum percentage. On February 18, 2014, the CMAs were recharacterized as capital support agreements and amended to remove the dividend requirement of the AIG Life and Retirement insurance subsidiaries. The specified minimum percentage in the CMAs remained at 385 percent, except for the CMA with AGC Life Insurance Company, where the specified minimum percentage remained at 250 percent. AIG will continue to manage capital between AIG Parent and these AIG Life and Retirement insurance subsidiaries through internal, Board-approved policies and guidelines.
We expect that Mortgage Guaranty subsidiaries will be able to continue to satisfy reasonably foreseeable future liquidity requirements and meet their obligations, including those arising from reasonably foreseeable contingencies or events, through cash from operations and, to the extent necessary, monetization of invested assets. Mortgage Guaranty's liquidity resources are held in the form of cash, short-term investments and publicly traded, investment grade rated, fixed maturity securities. These securities could be monetized in the event liquidity levels are insufficient to meet obligations.
In 2013, Mortgage Guaranty paid $90 million of cash dividends to AIG Parent. No dividends were paid, and AIG Parent was not required to make any capital contributions, under the CMA in 2013.
As of December 31, 2013 and December 31, 2012, respectively, GCM had total assets of $7.7 billion and $8.0 billion and total liabilities of $3.1 billion and $4.9 billion. GCM's assets consist primarily of cash, short-term investments, other receivables, net of allowance, and unrealized gains on swaps, options and forwards. GCM's liabilities consist primarily of trade payables and unrealized losses on swaps, options and forwards. Collateral posted by GCM to third parties was $3.0 billion and $4.2 billion at December 31, 2013 and December 31, 2012, respectively. GCM obtained collateral from third parties totaling $572 million and $846 million at December 31, 2013 and December 31, 2012, respectively. The collateral amounts reflect counterparty netting adjustments available under ISDA Master Agreements and are inclusive of collateral that exceeded the fair value of derivatives as of the reporting date.
Collateral posted by operations included in the DIB to third parties was $4.2 billion at December 31, 2013 and $4.3 billion December 31, 2012. This collateral primarily consists of securities of the U.S. government and government sponsored entities and generally cannot be repledged or resold by the counterparties.
We maintain a committed revolving four-year syndicated credit facility (the Four-Year Facility) as a potential source of liquidity for general corporate purposes. The Four-Year Facility also provides for the issuance of letters of credit. We
AIG Parent has access to a contingent liquidity facility of up to $500 million as a potential source of liquidity for general corporate purposes. Under this facility, we have the unconditional right, prior to December 15, 2015, to issue up to $500 million in senior debt to the counterparty, based on a put option agreement between AIG Parent and the counterparty.
Our ability to borrow under this facility is not contingent on our credit ratings.
We believe that AIG Life and Retirement subsidiaries have adequate financial resources to meet the payments actually required under these obligations. These subsidiaries have substantial liquidity in the form of cash and short-term investments. In addition, AIG Life and Retirement businesses maintain significant levels of investment-grade rated fixed maturity securities, including substantial holdings in government and corporate bonds, and could seek to monetize those holdings in the event operating cash flows are insufficient. We expect liquidity needs related to GIC liabilities to be funded through cash flows generated from maturities and sales of invested assets.
(a) Includes residual value guarantees associated with aircraft and AIG Life and Retirement construction guarantees connected to affordable housing investments. Excludes potential amounts for indemnification obligations included in asset sales agreements. See Note 15 to the Consolidated Financial Statements for further information on indemnification obligations.
(e) Excludes $21.4 billion and $24.3 billion related to ILFC as it is classified as a held-for-sale business at December 31, 2013 and 2012, respectively.
(a) There is no debt related to AIG general borrowings set to mature in 2014. This debt will begin maturing in 2015.
agency's rating categories; that ranking refers only to the major rating category and not to the modifiers assigned by the rating agencies.
(d) AIG guarantees all obligations of AIG Financial Products Corp. and AIG Funding, Inc.
In the event of adverse actions on our long-term debt ratings by the major rating agencies, AIGFP and certain other GCM entities would be required to post additional collateral under some derivative transactions, or could experience termination of the transactions. Such transactions could adversely affect our business, our consolidated results of operations in a reporting period or our liquidity. In the event of a further downgrade of AIG's long-term senior debt ratings, AIGFP and certain other GCM entities would be required to post additional collateral, and certain of the counterparties of AIGFP or of certain other GCM entities would be permitted to terminate their contracts early.
The actual amount of collateral that we would be required to post to counterparties in the event of such downgrades, or the aggregate amount of payments that we could be required to make, depend on market conditions, the fair value of outstanding affected transactions and other factors prevailing at the time of the downgrade.
On August 1, 2013, our Board of Directors declared a cash dividend on AIG Common Stock of $0.10 per share, which was paid on September 26, 2013 to shareholders of record on September 12, 2013.
On February 13, 2014, our Board of Directors declared a cash dividend on AIG Common Stock of $0.125 per share, payable on March 25, 2014 to shareholders of record on March 11, 2014. The payment of any future dividends will be at the discretion of our Board of Directors and will depend on various factors, including the regulatory framework applicable to us, as discussed further in Note 16 to the Consolidated Financial Statements.
Our investment strategies are tailored to the specific business needs of each operating unit. The investment objectives are driven by the respective business models for AIG Property Casualty, AIG Life and Retirement, and AIG Parent including the DIB. The primary objectives are generation of investment income, preservation of capital, liquidity management and growth of surplus to support the insurance products. The majority of assets backing our insurance liabilities consist of intermediate and long duration fixed maturity securities.
•We continued to make investments in structured securities, other fixed maturity securities and mortgage loans with favorable risk versus return characteristics to improve yields and increase net investment income.
•Net investment income benefited from higher returns on alternative investments primarily due to strong equity market performance.
Investment strategies are based on considerations that include the local market, general market conditions, liability duration and cash flow characteristics, rating agency and regulatory capital considerations, legal investment limitations, tax optimization and diversification.
•Fixed maturity securities held by the domestic insurance companies included in AIG Property Casualty consist of a mix of tax-exempt municipal bonds and taxable instruments that meet our current risk-return, tax, liquidity, credit quality, and diversification objectives.
At December 31, 2013, approximately 89 percent of fixed maturity securities were held by our domestic entities. Approximately 17 percent of such securities were rated AAA by one or more of the principal rating agencies, and approximately 16 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.
A significant portion of our foreign entities' fixed maturity securities portfolio is rated by Moody's, S&P or similar foreign rating services. 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, 2013, approximately 15 percent of the foreign entities' fixed maturity securities were either rated AAA or, on the basis of our internal analysis, were equivalent from a credit standpoint to securities rated AAA, and approximately 5 percent were rated below investment grade or not rated at that date. Approximately 45 percent of the foreign entities' fixed maturity securities portfolio is comprised of sovereign fixed maturity securities supporting policy liabilities in the country of issuance.
For AIG Property Casualty, the duration of liabilities for long-tail casualty lines is greater than that for other lines. As opposed to the focus in AIG Life and Retirement, the focus is not on asset-liability matching, but on preservation of capital and growth of surplus.
Fixed maturity securities of AIG Property Casualty's domestic operations, with an average duration of 3.9 years, are currently comprised primarily of tax-exempt securities, which provide attractive risk-adjusted after-tax returns, as well as taxable municipal bonds, government and agency bonds, and corporate bonds. The majority of these high quality investments are rated A or higher based on composite ratings.
Fixed maturity securities held in AIG Property Casualty's foreign operations are of high quality being rated A or higher based on composite ratings, and are of short to intermediate duration, averaging 4.3 years.
While invested assets backing reserves are primarily invested in conventional fixed maturity securities in AIG Property Casualty's domestic operations, a modest portion of surplus is allocated to alternative investments, including private equity and hedge funds. These investments provide a combination of added diversification and attractive long-term returns.
Our investment strategy is to maximize net investment income and portfolio value, subject to liquidity requirements, capital constraints, diversification requirements, asset-liability matching and available investment opportunities.
We use asset-liability management as a primary tool to monitor and manage risk in our businesses. Our objective is to maintain an investment portfolio with assets having weighted average durations that are matched to the duration and cash flow profile of our liabilities, to the extent practicable. The investment portfolio of each product line is tailored to the specific characteristics of its insurance liabilities, and as a result, certain portfolios are shorter in duration and others are longer in duration. An extended low interest rate environment may result in a lengthening of liability durations from initial estimates, primarily due to lower lapses.
AIG Life and Retirement monitors fixed income markets, including the level of interest rates, credit spreads and the shape of the yield curve. AIG Life and Retirement frequently reviews its interest rate assumptions and actively manages the crediting rates used for its new and in force business. Business strategies continue to evolve to maintain profitability of the overall business in a historically low interest rate environment. The low interest rate environment makes it more difficult to profitably price attractive guaranteed return products and puts margin pressure on existing products, due to the challenge of investing recurring premiums and deposits and reinvesting investment portfolio cash flows in the low rate environment while maintaining satisfactory investment quality and liquidity. In addition, there is investment risk associated with future premium receipts from certain in-force business. That is, the investment of these future premium receipts may be at a yield below that required to meet future policy liabilities.
With respect to over-the-counter derivatives, we deal with highly rated counterparties and do not expect the counterparties to fail to meet their obligations under the contracts. We have controls in place to monitor credit exposures by limiting transactions with specific counterparties within specified dollar limits and assessing the creditworthiness of counterparties periodically. We generally use ISDA Master Agreements and Credit Support Annexes (CSAs) with bilateral collateral provisions to reduce counterparty credit exposures.
Fixed maturity securities of AIG Life and Retirement, with an average duration of 6.4 years, are comprised 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 our composite ratings.
* At December 31, 2013 and December 31, 2012, bonds available for sale held by us that were below investment grade or not rated totaled $32.6 billion and $29.6 billion, respectively.
The following table presents the fair value of our aggregate United Kingdom and European credit exposures by major sector for our fixed maturity securities:
At December 31, 2013, the U.S. municipal bond portfolio of AIG Property Casualty was composed primarily of essential service revenue bonds and high quality tax-backed bonds with over 97 percent of the portfolio rated A or higher.
* Commencing in the second quarter of 2011, we began purchasing certain RMBS that had experienced deterioration in credit quality since their origination. See Note 6 to the Consolidated Financial Statements, Investments - Purchased Credit Impaired (PCI) Securities, for additional discussion. Includes approximately $11.3 billion and $8.8 billion at December 31, 2013 and 2012, respectively, of these securities.
The following table presents our RMBS available for sale investments by credit rating:
* The increase in value is primarily attributable to net purchases of approximately $3.0 billion of highly rated CMBS securities, partially offset by changes in net unrealized losses.
The fair value of CMBS holdings remained stable throughout 2013. The majority of our investments in CMBS are in tranches that contain substantial protection features through collateral subordination. The majority of CMBS holdings are traditional conduit transactions, broadly diversified across property types and geographical areas.
The following table presents our CDO available for sale investments by credit rating:
In 2011, we revised the valuation table for estimating the future net cash flows from investments in life settlements. This resulted in an increase in the number of investments in life settlements identified as potentially impaired compared to previous analyses. Since that time, we have continued to monitor the longevity experience of the portfolio, new medical information as it becomes available regarding insureds, as well as U.S. industry experience studies that have become available for portfolios with similar insureds. The cumulative mortality experience through December 31, 2013, was sufficiently lower than the prior assumptions indicating that it was appropriate to revise our future mortality assumptions, despite the small number of lives in the portfolio.
Our new mortality assumptions are based on an industry table that was supplemented with proprietary data on the older age mortality of U.S. insured lives. In addition, mortality improvement factors were applied to our new assumptions based on our view of future mortality improvements likely to apply to the U.S. insured lives population. These mortality improvement assumptions were based on our analysis of various public industry sources and proprietary research conducted by our specialist advisors. Using these new mortality assumptions coupled with the adopted future mortality improvement rates, we revised our estimate of future net cash flows from the investments in life settlements. This resulted in a significant increase in the number of investments in life settlements identified as impaired as of December 31, 2013.
Additional impairments are expected to occur in the future due to the fact that continued payment of premiums required to maintain policies will cause the expected lifetime undiscounted cash flows for some policies to become negative in future reporting periods, even in the absence of future changes to the mortality assumptions. Impairments may also occur due to our future sale or lapse of select policies at a value that is below carrying value.
•securities that experienced severe market valuation declines; In addition, impairments are also recorded on real estate and investments in life settlements.
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 recovery value over the remaining life of the security. The accretion that was recognized for these securities in earnings was $774 million in 2013,
$915 million in 2012, and $542 million in 2011. For a discussion of AIG's other-than-temporary impairment accounting policy, see Note 6 to the Consolidated Financial Statements.
(b) Represents the percentage by which fair value is less than cost at December 31, 2013.
The change in net unrealized gains and losses on investments in 2012 were primarily attributable to the appreciation in the fair value of bonds available for sale due to continued improvements in financial market conditions and significant narrowing of credit spreads partially offset by higher U.S. Treasury rates.
We have an integrated process for managing risks throughout our organization in accordance with our firm-wide risk appetite. Our Board of Directors has oversight responsibility for the management of risk. Our Enterprise Risk Management (ERM) Department supervises and integrates the risk management functions in each of our business units, providing senior management with a consolidated view of the firm's major risk positions. Within each business unit, senior leaders and executives approve risk-taking policies and targeted risk tolerance within the framework provided by ERM. ERM supports our businesses and management in the embedding of enterprise risk management in our key day-to-day business processes and in identifying, assessing, quantifying, managing and mitigating the risks taken by us and our businesses. Nevertheless, our risk management efforts may not always be successful and material adverse effects on our business, results of operations, cash flows, liquidity or financial condition may occur.
Our ERM framework provides senior management with a consolidated view of our risk appetite and major risk positions.
Risk management is an integral part of how we manage our core businesses.
Business Unit Risk and Capital Committees: Each of our major insurance businesses has established a risk and capital committee (BU RCC) that serves as the senior management committee responsible for risk oversight at the individual business unit level. The BU RCCs are responsible for the identification, assessment and monitoring of all sources of risk within their respective portfolios. Specific responsibilities include setting risk tolerances, approving capital management strategies (including asset allocation and risk financing), insurance portfolio optimization, risk management policies and providing oversight of economic capital models. In addition to its BU RCC, each major insurance business has established subordinate committees which identify, assess and monitor the specific operational, transactional and financial risks inherent in its respective business. Together, the BU RCCs and AIG Risk Committees described above provide comprehensive risk oversight throughout the organization.
Risk oversight activities also continue to be coordinated with ILFC, a held for sale operation, until the pending ILFC sale transaction is closed.
Our Risk Appetite Framework integrates stakeholder interests, strategic business goals and available financial resources. We intend to balance these by taking measured risks that are expected to generate repeatable, sustainable earnings and produce long-term value for our shareholders. The framework includes a Statement of Risk Appetite approved by the Board of Directors or a committee thereof and a set of supporting tools, including risk tolerances, risk limits and policies, which we use to manage our risk profile and financial resources.
A key component of our Risk Appetite Framework is setting appropriate limits on the material risks that are core to our business. The monitoring and reporting of those risk limits serves as an early warning indicator to us and is designed to provide timely oversight and enforceability to meet both internal and external stakeholders' expectations. We also have instituted other control measures, including policies and related procedures, to govern business practices that may impact our risk profile.
The stress testing framework assesses our aggregate exposure to our most significant financial and insurance risks, including the risk in each of our insurance company subsidiaries in relation to its statutory capital needs under stress, risks inherent in our non-insurance company subsidiaries, and risks to AIG consolidated capital. Using our stress testing methodology, we evaluate the capital and earnings impact of potential stresses in relation to the relevant capital constraint of each business operation. We use this information to determine the resources needed at the AIG Parent level to support our subsidiaries and capital resources required to maintain consolidated company target capitalization levels.
Credit risk is defined as the risk that our customers or counterparties are unable or unwilling to repay their contractual obligations when they become due. Credit risk may also result from a downgrade of a counterparty's credit ratings or a widening of its credit spreads.
We devote considerable resources to managing our direct and indirect credit exposures. These exposures may arise from fixed income investments, equity securities, deposits, commercial paper investments, reverse repurchase agreements and repurchase agreements, corporate and consumer loans, leases, reinsurance recoverables, counterparty risk arising from derivatives activities, collateral extended to counterparties, insurance risk cessions to third parties, financial guarantees and letters of credit.
Our credit risks are managed at the corporate level within ERM. ERM is assisted by credit functions headed by highly experienced credit officers in the business units, whose primary role is to assure appropriate credit risk management in accordance with our credit policies and procedures and relative to our credit risk parameters. Our Chief Credit Officer (CCO) and credit executives are primarily responsible for the development and maintenance of these credit risk policies and procedures.
•conducting credit research on countries, sectors and asset classes where risk concentrations may exist;
Equity market prices. We are exposed to equity market prices affecting a variety of instruments. These include direct investments in publicly-traded shares, investments in private equity, hedge funds and mutual funds, exchange-traded funds and other equity-linked capital market instruments as well as other equity-linked insurance products, including but not limited to equity-indexed annuities, variable annuities, universal life insurance, and variable universal life insurance.
Interest rates. Interest rate risk can arise from a mismatch in the interest rate exposure of assets versus liabilities. Low interest rates mean less investment income and potentially less attractive insurance products. Conversely, higher interest rates are typically beneficial for the opposite reasons. However, when rates rise quickly, there can be a temporary asymmetric GAAP accounting effect where the existing securities lose market value, which is reported in Other comprehensive income, and the offsetting decrease in the value of related liabilities may not be recognized.
•independent measurement, monitoring and reporting for line of business, business unit and enterprise-wide market risks; and
These components facilitate the CMRO's identification, measurement, monitoring, reporting and management of our market risks.
Our risk appetite is currently defined in terms of capital and liquidity levels under specified stress tests. In addition, we continue to develop economic, U.S. GAAP accounting and statutory capital-based risk measures at the market risk level, business-unit level and firm-wide levels. This process aims to ensure that we have a comprehensive view of the impact of our market risk exposures.
Sensitivity analysis. Sensitivity analysis measures the impact from a unit change in a market risk input. Examples of such sensitivities include a one basis point increase in yield on fixed maturity securities, a one basis point increase in credit spreads on fixed maturity securities, and a one percent increase in price on equity securities.
Stress testing. Stress testing is a special form of scenario analysis in which the scenarios are designed to lead to a material adverse outcome. Examples of such scenarios include the stock market crash of October 1987 or the widening of yields or spread of RMBS or CMBS during 2008.
(b) Prior period amounts have been revised to conform to the current period presentation.
Exposures to equity and alternative investment prices include investments in common stock, preferred stocks, mutual funds, hedge funds, private equity funds, commercial real estate and real estate funds and exclude consolidated separate account assets, consolidated partnerships and consolidated funds. Total exposure in these areas at December 31, 2013 increased 3.4 percent, or approximately $958 million, compared to exposure at December 31, 2012, primarily due to an increase of $2.1 billion related to hedge fund investments and an increase in common equity securities of $401 million. These increases were partially offset by a decrease in private equity investments of $1.4 billion and a decrease in aircraft asset investments of $221 million.
currency exchange rate exposures with the objective of protecting statutory capital at the regulated insurance entity level. We manage cash flow risk on our foreign currency-denominated debt issued by AIG Parent, and use a variety of techniques to mitigate this risk, including but not limited to the execution of cross-currency swaps and the issuance of new foreign currency-denominated debt to replace equivalent maturing debt. At the AIG Parent level, we monitor our foreign currency exposures against single currency and aggregate currency portfolio limits. As a matter of general practice, we do not typically hedge our foreign currency exposures to net investments in subsidiaries. However, we may utilize either cross-currency swaps or our foreign currency- denominated debt as a net investment hedge of our capital in subsidiaries.
The sensitivity factors utilized for 2013 and presented above were selected based on historical data from 1993 to 2013, as follows (see the table below):
•a 10 percent depreciation of foreign currency exchange rates is consistent with a one standard deviation movement in the U.S. dollar (USD)/Great Britain pound (GBP) exchange rate.
•catastrophic events, including natural and man-made disasters, that can increase policyholder claims. The principal objective of our liquidity risk framework is to protect our liquidity position and identify a diversity of funding sources available to meet actual and contingent liabilities during both normal and stress periods. This framework is guided by the liquidity risk tolerance. AIG Parent liquidity risk tolerance levels are established for base and stress scenarios over a time horizon covering a period greater than one year. We maintain a liquidity buffer designed to ensure that funding needs are met under varying market conditions. If we project that we will breach the tolerance, 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.
We strive to manage our liquidity prudently at a legal entity level across AIG Parent and the operating companies. Key components of the framework include effective corporate governance and policy, maintaining diversified sources of liquidity, contingency funding plans, and regular review of liquidity metrics in both normal and stress conditions. We view each component of the framework together to achieve our goal of sound liquidity risk management.
A strong operational risk management program facilitates the identification and mitigation of operational risk issues. To accomplish this, our operational risk management program is designed to:
As part of the ORM framework, we deploy an integrated risk assessment approach which includes top-down risk assessments to identify our most significant operational risks, a Risk and Control Self Assessment (RCSA) process to identify key operational risks conducted at the business units and corporate functions and the identification of emerging risks through our Vulnerability Identification (VID) process which considers risks that have not yet fully manifested but could become significant over time. Corrective action plans are developed to address identified issues. Businesses are accountable for tracking and remediating these issues.
Except as described above, we manage our business risk oversight activities through our insurance operations.
Our insurance businesses are conducted on a global basis and expose us to a wide variety of risks with different time horizons. We manage these risks throughout the organization, both centrally and locally, through a number of procedures:
•review and establishment of reserves. We closely manage insurance risk by monitoring and controlling the nature and geographic location of the risks in each line of business underwritten, the terms and conditions of the underwriting and the premiums we charge for taking on the risk. We analyze concentrations of risk using various modeling techniques, including both probability distributions (stochastic) and single-point estimates (deterministic) approaches.
•Life Insurance & Retirement Services (AIG Life and Retirement) - risks include mortality and morbidity in the insurance-oriented products and insufficient cash flows to cover contract liabilities in the retirement savings-oriented products. We manage risks through product design, sound medical underwriting, and external traditional reinsurance programs.
•Mortgage Guaranty (United Guaranty Corporation) - We manage risks in the mortgage insurance business through geographic location of the insured properties, the relative economic conditions in the local housing markets, credit attributes of the borrowers, and the loan amount relative to the value of the respective collateral. We purchase reinsurance for our insurance operations. Reinsurance facilitates insurance risk management (retention, volatility, concentrations) and capital planning. We may purchase reinsurance on a pooled basis. Pooling of our reinsurance risks enables us to purchase reinsurance more efficiently at a consolidated level, manage global counterparty risk and relationships and manage global catastrophe risks, both for AIG Property Casualty and AIG Life and Retirement.
•Unpaid Loss and Loss Expense Reserves - The potential inadequacy of the liabilities we establish for unpaid losses and loss expenses is a key risk faced by AIG Property Casualty. There is significant uncertainty in factors that may drive the ultimate development of losses compared to our estimates of losses and loss expenses. We manage this uncertainty through internal controls and oversight of the loss reserve setting process, as well as reviews by external experts. See Item 1. Business - A review of Liability for unpaid claims and claims adjustment expense herein for further details.
•Catastrophe Exposure - Our business is exposed to various catastrophic events in which multiple losses can occur and affect multiple lines of business in any calendar year. Natural disasters, such as hurricanes, earthquakes and other catastrophes, have the potential to adversely affect our operating results. Other risks, such as man-made catastrophes or pandemic disease, could also adversely affect our business and operating results to the extent they are covered by our insurance products. Concentration of exposure in certain industries or geographies may cause us to suffer disproportionate losses.
•Reinsurance - Since we use reinsurance to limit our losses, we are exposed to risks associated with reinsurance including the unrecoverability of expected payments from reinsurers either due to an inability or unwillingness to pay, contracts that do not respond properly to the event, or that actual reinsurance coverage is different than anticipated.
We manage catastrophe exposure with multiple approaches such as setting risk limits based on aggregate Probable Maximum Loss (PML) modeling, monitoring overall exposures and risk accumulations, and purchasing catastrophe reinsurance through both traditional reinsurance markets and capital markets in addition to other reinsurance protections.
In addition, we perform post-catastrophe event studies to identify model weaknesses, underwriting gaps and lessons, and improvement opportunities. Lessons learned from post-catastrophe event studies are incorporated into the modeling and underwriting process of risk pricing and selection. The majority of policies exposed to catastrophic risks are one-year contracts which allow us to adjust our underwriting guidelines and exposures accumulation in a relatively short period.
The estimates below are the Occurrence Exceedance Probability (OEP) losses, which reflect losses that may occur in any single year due to the defined peril. The 1-in-100 and 1-in-250 PMLs are the probable maximum losses from a single natural catastrophe event with probability of 1 percent and 0.4 percent, respectively.
The following table presents an overview of modeled losses (OEP) for top perils and countries.
(a) The U.S. hurricane amount includes losses to property from hurricane hazards of wind and storm surge.
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 recoverable may not be fully collectible. In particular, the use of catastrophe bonds may not provide commensurate levels of protection compared to traditional reinsurance transactions. Some catastrophe bond transactions may be based on an industry loss index rather than on actual losses incurred by us, which would result in residual risk. Therefore, these estimates are inherently uncertain and may not accurately reflect our exposure to these events.
We also have exposure to terrorist attacks due to coverage at airport locations for airline hull, airline and airport property. The exposure is expected to be less than the exposure in New York City to losses from a conventional five-ton bomb attack.
•Ceded loss reserves - ultimate ceded reserves for losses and loss expenses, including reserves for claims reported but not yet paid and estimates for IBNR.
•Ceded reserves for unearned premiums. At December 31, 2013, total reinsurance recoverable assets were $23.8 billion. These assets include general reinsurance paid losses recoverable of $1.3 billion, ceded loss reserves of $17.3 billion including reserves for IBNR, and ceded reserves for unearned premiums of $3.4 billion, as well as life reinsurance recoverables of $1.8 billion. The methods used to estimate IBNR and to establish the resulting ultimate losses involve projecting the frequency and severity of losses over multiple years. These methods are continually reviewed and updated by management. Any adjustments are reflected in income. We believe that the amount recorded for ceded loss reserves at December 31, 2013 reflect a reasonable estimate of the ultimate losses recoverable. Actual losses may, however, differ, perhaps materially, from the reserves currently ceded.
(d) Includes $1.6 billion recoverable under the 2011 retroactive reinsurance transaction pursuant to which a large portion of AIG Property Casualty's net domestic asbestos liabilities were transferred to NICO. Does not include reinsurance assets ceded to other reinsurers for which NICO has assumed the collection risk. See Liability for Unpaid Claims and Claim Adjustment Expense - Transfer of Domestic Asbestos Liabilities.
•Mortality risk - represents the risk of loss arising from actual mortality rates being higher than expected mortality rates. This risk could arise from pandemics or other events, including longer-term societal changes that cause higher than expected mortality. This risk exists in a number of our product lines but is most significant for our life insurance products.
•Pricing risk - represents the potential exposure to loss if actual policy experience emerges adversely in comparison to the assumptions made in product pricing. This may be related to adverse economic conditions, prepayment of policies, investment results, and expenses. UGC manages the quality of the loans it insures through use of a proprietary risk quality index. UGC uses this index to determine an insurability threshold as well as to manage the risk distribution of its new business. Along with traditional mortgage underwriting variables, UGC's risk-based pricing model uses rating factors such as geography and the historical quality of a lender's origination process to establish premium rates.
A counterparty may default on any obligation to us, including a derivative contract. Credit risk is a consequence of extending credit and/or carrying trading and investment positions. Credit risk exists for a derivative contract when that contract has a positive fair value to AIG. The maximum potential exposure will increase or decrease during the life of the derivative commitments as a function of maturity and market conditions. To help manage this risk, GCM's credit department operates within the guidelines set by the credit function within ERM. Transactions that fall outside these pre-established guidelines require the specific approval of ERM. It is also AIG's policy to record credit valuation adjustments for potential counterparty default when necessary.
GCM evaluates the counterparty credit quality by reference to ratings from rating agencies or, where such ratings are not available, by internal analysis consistent with the risk rating policies of ERM. In addition, GCM's credit approval process involves pre-set counterparty and country credit exposure limits subject to approval by ERM and, for particularly credit-intensive transactions, requires approval from ERM.
The following table presents the fair value of GCM's derivatives portfolios by counterparty credit rating:
See Critical Accounting Estimates below and Note 11 to the Consolidated Financial Statements for additional discussion related to derivative transactions.
•an inability of ILFC to access the capital markets to finance operations and meet contractual obligations due to prevailing economic and market conditions. ILFC uses security deposit requirements, repossession rights and overhaul requirements, while also closely monitoring industry conditions, to manage the risk of nonperformance by its lessees. At December 31, 2013, more than 93 percent of ILFC's lease revenue came from non-U.S. carriers, and its fleet continues to be in high demand from such carriers. Quarterly, ILFC's management evaluates the need to perform a recoverability assessment of aircraft in its fleet, including events and circumstances that may cause impairment of aircraft values, and performs this assessment at least annually for all aircraft in its fleet. Management evaluates aircraft in the fleet as necessary based on these events and circumstances. As new and more fuel-efficient aircraft enter the marketplace and negatively affect the demand for older aircraft, lease rates on older aircraft may deteriorate and ILFC may incur additional losses on sales or record impairment charges and fair value adjustments.
•classification of ILFC as held for sale and related fair value measurement;
•valuation of future policy benefit liabilities and timing and extent of loss recognition;
•impairment charges, including other-than-temporary impairments on available for sale securities, impairments on investments in life settlements and goodwill impairment;
These accounting estimates require the use of assumptions about matters, some of which are highly uncertain at the time of estimation. To the extent actual experience differs from the assumptions used, our consolidated financial condition, results of operations and cash flows could be materially affected.
We report a business as held for sale when management has approved or received approval to sell the business and is committed to a formal plan, the business is available for immediate sale, the business is being actively marketed, the sale is anticipated to occur during the next 12 months, which may require significant judgment, and certain other specified criteria are met. A business classified as held for sale is recorded at the lower of its carrying amount or estimated fair value less cost to sell. If the carrying amount of the business exceeds its estimated fair value, a loss is recognized.
The estimate of the Liability for unpaid claims and claims adjustment expense consists of several key judgments:
•the determination of the appropriate groupings of similar classes and, in some cases, the segmentation of dissimilar claims within a class. We use numerous assumptions in determining the best estimate of reserves for each class of business. The importance of any specific assumption can vary by both class of business and accident year. Because actual experience can differ from key assumptions used in establishing reserves, there is potential for significant variation in
the development of loss reserves. This is particularly true for long-tail casualty classes of business such as excess casualty, asbestos, D&O, and primary or excess workers' compensation.
For operations writing short-tail coverages, such as property coverages, the process of recording quarterly loss reserves is generally geared toward maintaining an appropriate reserve for the outstanding exposure, rather than determining an expected loss ratio for current business. For example, the IBNR reserve required for a class of property business might be expected to approximate 20 percent of the latest year's earned premiums. This level of reserve would generally be maintained regardless of the loss ratio emerging in the current quarter. The 20 percent factor would be adjusted to reflect changes in rate levels, loss reporting patterns, known exposure to unreported losses, or other factors affecting the particular class of business. For some classes, a loss development factor method may be used.
We generally make a number of actuarial assumptions in the review of reserves for each class of business.
•third-party actuarial reviews that are periodically performed for key classes of business.
Loss reserve development can also be affected by commutations of assumed and ceded reinsurance agreements.
the losses. For example, for a long-tail class of business for which only 10 percent of the losses are expected to be reported at the end of the accident year, the expected loss ratio would be applied to the 90 percent of the losses still unreported. The actual reported losses at the end of the accident year would be added to determine the total ultimate loss estimate for the accident year. Subtracting the reported paid losses and loss expenses would result in the indicated loss reserve. In the example above, the expected loss ratio of 70 percent would be multiplied by 90 percent. The result of 63 percent would be applied to the earned premium of $10 million resulting in an estimated unreported loss of $6.3 million. Actual reported losses would be added to arrive at the total ultimate losses. If the reported losses were $1 million, the ultimate loss estimate under the "Bornhuetter Ferguson" method would be $7.3 million versus the $7 million amount under the expected loss ratio method described above. Thus, the "Bornhuetter Ferguson" method gives partial credibility to the actual loss experience to date for the class of business. Loss development methods generally give full credibility to the reported loss experience to date. In the example above, loss development methods would typically indicate an ultimate loss estimate of $10 million, as the reported losses of $1 million would be estimated to reflect only 10 percent of the ultimate losses.
A key advantage of loss development methods is that they respond quickly to any actual changes in loss costs for the class of business. Therefore, if loss experience is unexpectedly deteriorating or improving, the loss development method gives full credibility to the changing experience. Expected loss ratio methods would be slower to respond to the change, as they would continue to give more weight to the expected loss ratio, until enough evidence emerged to modify the expected loss ratio to reflect the changing loss experience. On the other hand, loss development methods have the disadvantage of overreacting to changes in reported losses if the loss experience is not credible. For example, the presence or absence of large losses at the early stages of loss development could cause the loss development method to overreact to the favorable or unfavorable experience by assuming it will continue at later stages of development. In these instances, expected loss ratio methods such as "Bornhuetter Ferguson" have the advantage of recognizing large losses without extrapolating unusual large loss activity onto the unreported portion of the losses for the accident year.
•Analysis of the potential for future deterioration in medical condition unlikely to be picked up by a claim file review and associated with potentially costly medical procedures (i.e., increases in both utilization and intensity of medical care) over the course of the injured worker's lifetime;
•The effects of various runoff claims management strategies that have been developed by AIG's run-off unit. Overall, our loss reserve reviews for long-tail classes typically utilize a combination of both loss development and expected loss ratio methods, supplemented by structural drivers analysis of frequency/severity where available. Loss development methods are generally given more weight for accident years and classes of business where the loss experience is highly credible. Expected loss ratio methods are given more weight where the reported loss experience is less credible, or is driven more by large losses. Expected loss ratio methods require sufficient information to determine the appropriate expected loss ratio. This information generally includes the actual loss ratios for prior accident years, and rate changes as well as underwriting or other changes which would affect the loss ratio. Further, an estimate of the loss cost trend or loss ratio trend is required to allow for the effect of inflation and other factors which may increase or otherwise change the loss costs from one accident year to the next.
Known asbestos claims are managed in a similar manner. Over two decades ago we established a specialized toxic tort claims unit, which historically investigated and adjusted all such asbestos claims. As part of the above mentioned NICO transaction, effective January 1, 2011, NICO assumed responsibility for claims handling related to the majority of AIG's domestic asbestos liabilities.
The effect of these deviations is expected to be smaller than the effect on the classes noted below
Loss development factors: The percentage deviations noted in the table below are not considered the highest possible deviations that might be expected, but rather what we consider to reflect a reasonably likely range of potential deviation. While multiple scenarios are performed, the assumed loss development factors are a key assumption. Generally, actual historical loss development factors are used to project future loss development. Future loss development patterns may be different from those in the past, or may deviate by more than the amounts noted above and discussed below.
AIG's loss reserve analyses do not generally provide a range of loss reserve estimates. A large portion of the loss reserves from AIG Property Casualty business relates to longer-tail casualty classes of business, such as excess casualty and D&O, which are driven by severity rather than frequency of claims. Using the reserving methodologies described above, our actuaries determine their actuarial central estimates of the loss reserves and advise management on their final recommendation for management's best estimate of the recorded reserves. Subject matter experts from underwriting and claims play an important part in informing the actuarial assumptions and methods. The governance process over the establishment of loss reserves also ensures robust considerations of the changes in the loss trends, terms and conditions, claims handling practices, and large loss impact when determining the methods, assumptions and the estimations. This multi-disciplinary process engages underwriting, claims, risk management, business unit executives and senior management and involves several iterative levels of feedback and response during the regular reserving process.
The sensitivity analysis below addresses each major class of business for which there is a possibility of a material deviation from our overall reserve position. The analysis uses what we believe is a reasonably likely range of potential deviation for each class. Actual reserve development may not be consistent with either the original or the
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 2013.
The estimation of reinsurance recoverable involves a significant amount of judgment, particularly for latent exposures, such as asbestos, due to their long-tail nature. Reinsurance assets include reinsurance recoverable on unpaid claims and claim adjustment expenses that are estimated as part of our loss reserving process and, consequently, are subject to similar judgments and uncertainties as the estimation of gross loss reserves.
We assess the collectability of reinsurance recoverable balances through either detailed reviews of the underlying nature of the reinsurance balance or comparisons with historical trends of disputes and credit events. We record adjustments to reflect the results of these assessments through an allowance for uncollectable reinsurance that reduces the carrying value of reinsurance assets in the balance sheet. This estimate requires significant judgment for which key considerations include:
•whether the balance is in dispute or subject to legal collection;
Future Policy Benefits for Life and Accident and Health Insurance Contracts (AIG Life and Retirement)
For long-duration traditional business, a "lock-in" principle applies. The assumptions used to calculate the benefit liabilities and DAC are set when a policy is issued and do not change with changes in actual experience,
Loss recognition occurs if observed changes in actual experience or estimates result in projected future losses under loss recognition testing. To determine whether loss recognition exists, we determine whether a future loss is expected based on updated current assumptions. If a loss recognition exists, we recognize the loss by first reducing DAC through amortization expense, and, if DAC is depleted, record additional liabilities through a charge to policyholder benefit expense. See Note 9 to the Consolidated Financial Statements for additional information on loss recognition. Because of the long-term nature of many of our liabilities subject to the "lock-in" principle, small changes in certain assumptions may cause large changes in the degree of reserve adequacy. In particular, changes in estimates of future invested asset returns have a large effect on the degree of reserve deficiency.
•For mortality assumptions, key judgments include the extent of industry versus own experience to base future assumptions as well as the extent of expected mortality improvements in the future. The latter judgment is based on a combination of historical mortality trends, advice from industry public health and demography specialists that were consulted by AIG's actuaries and published industry information.
•For surrender rates, a key judgment involves the correlation between expected increases/decreases in interest rates and increases/decreases in surrender rates. To support this judgment, we compare crediting rates on our products relative to expected rates on competing products under different interest scenarios.
•For in-force long-term care insurance, rate increases are allowed but must be approved by state insurance regulators. Consequently, the extent of rate increases that may be assumed requires judgment. In establishing our assumption for rate increases for long-term care insurance, we consider historical experience as to the frequency and level of rate increases approved by state regulators. In connection with our program to utilize capital loss carryforwards, we sold investment securities in 2013 and 2012. These and other investment sales with subsequent reinvestment at lower yields triggered recording of loss recognition reserves of $1.5 billion and $1.2 billion, primarily related to certain long-term payout annuity contracts, in 2013 and 2012, respectively.
Significant unrealized appreciation on investments in a prolonged low interest rate environment may cause DAC to be adjusted and additional future policy benefit liabilities to be recorded through a charge directly to accumulated other comprehensive income ("shadow loss recognition"). These charges are included, net of tax, with the change in net unrealized appreciation of investments. See Note 9 to the Consolidated Financial Statements for additional information on shadow loss recognition. In applying shadow loss recognition, the Company overlays unrealized gains onto loss recognition tests without revising the underlying test. Accordingly, there is limited additional judgment in this process.
Estimated Gross Profits for Investment - Oriented Products (AIG Life and Retirement)
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 deferred and amortized, with interest, in relation to the incidence of estimated gross profits to be realized over a period that approximates the estimated lives of the contracts. Estimated gross profits include net investment income and spreads, net realized investment gains and losses, fees, surrender charges, expenses, and mortality gains and losses. 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 the fourth quarter of 2013, we revised the growth rate assumptions for the five-year reversion to the mean period for the Group Retirement product line, because annual growth assumptions indicated for this period had fallen below our floor of zero percent due to the recent favorable performance of equity markets. For this five-year reversion to the mean period, the growth rate assumption was adjusted to a point between the long-term growth rate assumption and zero percent. This adjustment, which increased DAC by $31 million, increased SIA by $2 million and reduced the GMDB liability by $2 million, was recorded as a decrease in current period amortization expense, and increased pre-tax income by $35 million in 2013. Had we readjusted the growth rate assumption for the five-year reversion to the mean period to use the long-term rate assumption of 8.5%, pre-tax income would have been higher by approximately $30 million. Conversely, had the growth rate assumption for the five-year reversion to the mean period been readjusted to a floor of zero percent, pre-tax income would have been lower by approximately $30 million. For variable annuities in our Retirement Income Solutions product line, the assumed annual growth rate remained above zero percent for the five-year reversion to the mean period so it did not meet our criteria for adjustment; however, additional favorable equity market performance in excess of long-term assumptions could also result in "unlocking" in this product line in future periods with a positive effect on pre-tax income in the period of the unlocking.
The following table summarizes the sensitivity of changes in certain assumptions in the amortization of DAC/SIA, guaranteed benefit reserves and unearned revenue liability and the related hypothetical impact on year-end 2013 balances. The effect of changes in net investment spread primarily affects our Fixed Annuities
product line. Changes in the equity markets and volatility primarily impact individual variable annuities in our Retirement Income Solutions and Group Retirement product lines. The effect of changes in mortality primarily impacts the universal life insurance business.
At each balance sheet date, we evaluate our available for sale securities holdings with unrealized losses.
See the discussion in Note 6 to the Consolidated Financial Statements for additional information on the methodology and significant inputs, by security type, that we use to determine the amount of other-than-temporary impairment on fixed maturity and equity securities.
For a discussion of goodwill impairment, see Note 2 to the Consolidated Financial Statements. In 2013 and 2012, AIG elected to bypass the qualitative assessment and therefore, performed quantitative assessments that supported a conclusion that the fair value of each of the two reporting units tested exceeded their book value. In determining fair value, we primarily use a discounted expected future cash flow analysis based on AIG's business projections that inherently include judgments regarding business trends.
We estimate and record a liability for potential losses that may arise from litigation and regulatory proceedings to the extent such losses are probable and can be estimated. Determining a reasonable estimate of the amount of such losses requires significant management judgment. In many cases, it is not possible to determine whether a liability has been incurred or to estimate the ultimate or minimum amount of that liability until the matter is close to resolution. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases that are in the early stages of litigation or in which claimants seek substantial or indeterminate damages, we often cannot predict the outcome or estimate the eventual loss or range of reasonably possible losses related to such matters.
The following paragraphs describe the methods we use to measure fair value on a recurring basis for super senior credit default swaps classified in Level 3. See Note 5 to the Consolidated Financial Statements for discussion of the valuation methodologies for other assets classified in Level 3, including certain fixed maturity securities and certain other invested assets, as well as a discussion of transfers of Level 3 assets and liabilities.
Certain entities included in GCM wrote credit protection on the super senior risk layer of collateralized loan obligations (CLOs), multi-sector CDOs and diversified portfolios of corporate debt and prime residential mortgages through 2006. In these transactions, we are at risk of credit performance on the super senior risk layer related to such assets.
(b) The discount curve is an input at the CDO level. A calculation of sensitivity to this input by type of security is not possible. Furthermore, for this input it is not possible to disclose a weighted average input because a discount curve consists of a series of data points.
Accident year loss ratio, as adjusted the loss ratio excluding catastrophe losses and related reinstatement premiums, prior year development, net of premium adjustments, and the impact of reserve discounting.
Acquisition ratio acquisition costs divided by net premiums earned. Acquisition costs are those costs incurred to acquire new and renewal insurance contracts and also include the amortization of value of business acquired (VOBA) and deferred policy acquisition costs (DAC). Acquisition costs vary with sales and include, but are not limited to, commissions, premium taxes, direct marketing costs, certain costs of personnel engaged in sales support activities such as underwriting, and the change in DAC. Acquisition costs that are incremental and directly related to successful sales efforts are deferred and recognized over the coverage periods of related insurance contracts. Acquisition costs that are not incremental and directly related to successful sales efforts are recognized as incurred.
AIG Life and Retirement - Pre-tax operating income (loss) Pre-tax operating income (loss) is derived by excluding the following items from pre-tax income (loss): legal settlements related to legacy crisis matters, changes in fair values of fixed maturity securities designated to hedge living benefit liabilities (net of interest expense), net realized capital (gains) losses, and changes in benefit reserves and DAC, VOBA, and SIA related to net realized capital (gains) losses.
AIG Life and Retirement - Surrender rate represents annualized surrenders and withdrawals as a percentage of average reserves.
AIG Property Casualty - Net premiums written represent the sales of an insurer, adjusted for reinsurance premiums assumed and ceded, during a given period. Net premiums earned are the revenue of an insurer for covering risk during a given period. Net premiums written are a measure of performance for a sales period while Net premiums earned are a measure of performance for a coverage period. From the period in which the premiums are written until the period in which they are earned, the amount is presented as Unearned premium reserves in the Consolidated Balance Sheets.
AIG Property Casualty - Pre-tax operating income (loss) includes both underwriting income (loss) and net investment income, but excludes net realized capital (gains) losses, other (income) expense - net, legal settlements
Book Value Per Common Share Excluding Accumulated Other Comprehensive Income (loss) (AOCI) is a non-GAAP measure and is used to show the amount of our net worth on a per-share basis. Book Value Per Common Share Excluding AOCI is derived by dividing Total AIG shareholders' equity, excluding AOCI, by Total common shares outstanding.
LAE Loss Adjustment Expenses The expenses of settling claims, including legal and other fees and the portion of general expenses allocated to claim settlement costs.
Loss Ratio Claims and claims adjustment expenses incurred divided by net premiums earned. Claims adjustment expenses are directly attributed to settling and paying claims of insureds and include, but are not limited to, legal fees, adjuster's fees, and claims department personnel costs.
Loss Recognition Related to Unrealized Appreciation (Depreciation) of Investments An adjustment to DAC and future policy benefits for long-duration traditional products, equal to the adjustments that would be required if fixed maturity and equity securities available for sale had been sold at their stated aggregate fair value and the proceeds reinvested at current yields, and such reinvestment would not be sufficient to recover DAC and meet policyholder obligations (also referred to as "shadow loss recognition"). The change in this adjustment, net of tax, is included with the change in net unrealized appreciation (depreciation) of investments that is credited or charged directly to Other comprehensive income (loss).
Net premiums written Represent the sales of an insurer, adjusted for reinsurance premiums assumed and ceded, during a given period. Net premiums earned are the revenue of an insurer for covering risk during a given period. Net premiums written are a measure of performance for a sales period while Net premiums earned are a measure of performance for a coverage period. From the period in which the premiums are written until the period in which they are earned, the amount is presented as Unearned premium reserves in the Consolidated Balance Sheets.
Pool A reinsurance arrangement whereby all of the underwriting results of the pool members are combined and then shared by each member in accordance with its pool participation percentage. Our members in the admitted lines pool are licensed to write standard lines of business by the individual state departments of insurance, and the policy forms and rates are regulated by those departments. Our members in the surplus lines pool provide policyholders with
SLHC Savings and Loan Holding Company A company (other than a bank holding company) that controls a savings association or that controls another company that is a savings and loan holding company. Savings and loan holding companies are subject to regulation and supervision by the Board of Governors of the Federal Reserve System.
GAAP Accounting principles generally accepted in the United States of America
Consolidated Statements of Equity for the years ended December 31, 2013, 2012 and 2011
Condensed Financial Information of Registrant at December 31, 2013 and 2012 and for the years ended December 31, 2013, 2012 and
Supplementary Insurance Information at December 31, 2013, 2012 and 2011 and for the years then ended
(b) Excludes gains of $2 million, $222 million and $552 million in 2013, 2012 and 2011, respectively, attributable to redeemable noncontrolling interests and net income attributable to noncontrolling nonvoting, callable, junior and senior preferred interests held by the Federal Reserve Bank of New York (FRBNY) of $0, $0 and $74 million in 2013, 2012 and 2011, respectively.
The consolidated financial statements include the accounts of AIG Parent, our controlled subsidiaries (generally through a greater than 50 percent ownership of voting rights of a voting interest entity), and variable interest entities (VIEs) of which we are the primary beneficiary. Equity investments in entities that we do not consolidate, including corporate entities in which we have significant influence and partnership and partnership-like entities in which we have more than minor influence over operating and financial policies, are accounted for under the equity method unless we have elected the fair value option.
Advisory fee income, and the related commissions and advisory fee expenses of AIG Life and Retirement's broker dealer business, are now being presented on a gross basis within Other income and Other expenses, respectively. Previously, these amounts were included on a net basis within Policy fees in AIG's Consolidated Statements of Income and in AIG Life and Retirement's segment results.
In addition, policyholder benefits related to certain payout annuities, primarily with life contingent features, are now being presented in the Consolidated Balance Sheets as Future policy benefits for life and accident and health insurance contracts instead of as Policyholder contract deposits.
Prior period amounts were conformed to the current period presentation. These changes did not affect Income from continuing operations before income tax expense, Net income attributable to AIG or Total liabilities.
Policy fees represent fees recognized from universal life and investment-type products consisting of policy charges for the cost of insurance, policy administration charges, surrender charges and amortization of unearned revenue reserves.
•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.
•Income earned on real estate based investments and related realized gains and losses from sales, property level impairments and financing costs.
•Reductions to the cost basis of securities available for sale for other-than-temporary impairments.
Other assets consists of sales inducement assets, prepaid expenses, deposits, other deferred charges, real estate, other fixed assets, capitalized software costs, goodwill, intangible assets other than goodwill, and restricted cash.
If the estimated fair value of a reporting unit exceeds its carrying value, goodwill is not impaired. If the carrying value of a reporting unit exceeds its estimated fair value, goodwill associated with that reporting unit potentially is impaired. The amount of impairment, if any, is measured as the excess of the carrying value of the goodwill over the implied fair value of the goodwill. The implied fair value of the goodwill is measured as the excess of the fair value of the reporting unit over the amounts that would be assigned to the reporting unit's assets and liabilities in a hypothetical business combination. An impairment charge is recognized in earnings to the extent of the excess. AIG Property Casualty manages its assets on an aggregate basis and does not allocate its assets, other than goodwill, between its operating segments. Therefore, the carrying value of the reporting units was determined by allocating the carrying value of AIG Property Casualty to those units based on an internal capital allocation model.
Other policyholder funds are reported at cost and include any policyholder funds on deposit that encompass premium deposits and similar items, including liabilities for dividends arising out of participating business, reserves for experience-rated group products and unearned revenue reserves (URR). URR consist of front end loads on interest-sensitive contracts, representing those policy loads that are non-level and typically higher in initial policy years than in later policy years. URR for interest-sensitive life insurance policies are generally deferred and amortized, with interest, in relation to the incidence of estimated gross profits (EGPs) for investment-oriented products to be realized
Foreign currency: Financial statement accounts expressed in foreign currencies are translated into U.S. dollars. Functional currency assets and liabilities are translated into U.S. dollars generally using rates of exchange prevailing at the balance sheet date of each respective subsidiary and the related translation adjustments are recorded as a separate component of Accumulated other comprehensive income, net of any related taxes, in Total AIG shareholders' equity. Functional currencies are generally the currencies of the local operating environment. Financial statement accounts expressed in currencies other than the functional currency of a consolidated entity are translated into that entity's functional currency. Income statement accounts expressed in functional currencies are translated using average exchange rates during the period. The adjustments resulting from translation of financial statements of foreign entities operating in highly inflationary economies are recorded in income. Exchange gains and losses resulting from foreign currency transactions are recorded in income.
The standard became effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. We adopted the standard on its required effective date of January 1, 2013. The adoption of this standard had no material effect on our consolidated financial condition, results of operations or cash flows.
Inclusion of the Federal Funds Effective Swap Rate as a Benchmark Interest Rate for Hedge Accounting Purposes
In July 2013, the FASB issued an accounting standard that permits the Federal Funds Effective Swap Rate (or Overnight Index Swap Rate) to be used as a U.S. benchmark interest rate for hedge accounting purposes in addition to U.S. Treasury rates and LIBOR. The standard also removes the prohibition on the use of differing benchmark rates when entering into similar hedging relationships.
The standard became effective on a prospective basis for qualifying new or redesignated hedging relationships entered into on or after July 17, 2013 to the extent the Federal Funds Effective Swap Rate is used as a U.S. benchmark interest rate for hedge accounting purposes. We adopted the standard on its effective date of July 17, 2013. The adoption of this standard had no material effect on our consolidated financial condition, results of operations or cash flows.
The standard is effective for fiscal years and interim periods beginning after December 15, 2013, but earlier adoption is permitted. Upon adoption, the standard should be applied retrospectively to all prior periods presented. We plan to adopt the standard on its required effective date of January 1, 2014 and do not expect the adoption of the standard to have a material effect on our consolidated financial condition, results of operations or cash flows.
Under this standard, the entire amount of the cumulative translation adjustment associated with the foreign entity should be released into earnings when there has been: (i) a sale of a subsidiary or group of net assets within a foreign entity and the sale represents a complete or substantially complete liquidation of the foreign entity in which the subsidiary or the net assets had resided; (ii) a loss of a controlling financial interest in an investment in a foreign entity; or (iii) a change in accounting method from applying the equity method to an investment in a foreign entity to consolidating the foreign entity.
In June 2013, the FASB issued an accounting standard that amends the criteria a company must meet to qualify as an investment company, clarifies the measurement guidance, and requires new disclosures for investment companies. An entity that is regulated by the Securities and Exchange Commission under the Investment Company Act of 1940 (the 1940 Act) qualifies as an investment company. Entities that are not regulated under the 1940 Act must have certain fundamental characteristics and must consider other characteristics to determine whether they qualify as investment companies. An entity's purpose and design must be considered when making the assessment.
The AIG Property Casualty segment is presented as two operating segments - Commercial Insurance and Consumer Insurance, in addition to an AIG Property Casualty Other category.
AIG Life and Retirement fully implemented these changes during the first quarter of 2013 and now presents its operating results in the following two operating segments:
The following table presents AIG's consolidated operations and long-lived assets by major geographic area:
The following table summarizes the components of ILFC assets and liabilities held-for-sale on the Consolidated Balance Sheets as of December 31, 2013 and 2012:
On December 16, 2013 we entered into a definitive agreement with AerCap and AerCap Ireland Limited (AerCap Ireland), a wholly-owned subsidiary of AerCap, for the sale of 100 percent of the common stock of ILFC (the AerCap Agreement) for consideration consisting of $3.0 billion of cash, a portion of which will be funded by a special dividend of $600 million to be paid by ILFC to AIG upon consummation of the transaction, and approximately 97.6 million newly-issued AerCap common shares. The consideration has a value of approximately $5.4 billion based on AerCap's pre-announcement closing price per share of $24.93 on December 13, 2013. In connection with the AerCap Agreement, we entered into a credit agreement for a senior unsecured revolving credit facility between AerCap Ireland as borrower and AIG as lender (the Revolving Credit Facility). The Revolving Credit Facility provides for an aggregate commitment of $1 billion and permits loans for general corporate purposes after the closing of the AerCap Transaction. The transaction is subject to required regulatory approvals, including all applicable U.S. and foreign regulatory reviews and approvals, as well as other customary closing conditions. The AerCap Transaction was approved by AerCap shareholders on February 13, 2014. We determined ILFC met the criteria for held-for-sale accounting at December 31, 2013. Because we expect to hold approximately 46 percent of the common stock of combined company upon closing of the transaction, ILFC no longer qualifies for discontinued operations presentation in the Consolidated Statements of Income. Consequently, ILFC's results are presented in continuing operations for all periods presented.
Certain other sales completed during the periods presented were not classified as discontinued operations because we continued to generate significant direct revenue-producing or cost-generating cash flows from the businesses or because associated assets, liabilities and results of operations were not material, individually or in the aggregate, to our consolidated financial position or results of operations for any period presented.
•Level 3: Fair value measurements based on valuation techniques that use significant inputs that are unobservable. Both observable and unobservable inputs may be used to determine the fair values of positions classified in Level 3. The circumstances for using these measurements include those in which there is little, if any, market activity for the asset or liability. Therefore, we must make certain assumptions about the inputs a hypothetical market participant would use to value that asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety. The following is a description of the valuation methodologies used for instruments carried at fair value. These methodologies are applied to assets and liabilities across the levels discussed above, and it is the observability of the inputs used that determines the appropriate level in the fair value hierarchy for the respective asset or liability.
•Our Own Credit Risk. Fair value measurements for certain liabilities incorporate our own credit risk by determining the explicit cost for each counterparty to protect against its net credit exposure to us at the balance sheet date by reference to observable AIG CDS or cash bond spreads. A derivative counterparty's net credit exposure to us is determined based on master netting agreements, when applicable, which take into consideration all derivative positions with us, as well as collateral we post with the counterparty at the balance sheet date. We calculate the effect of these credit spread changes using discounted cash flow techniques that incorporate current market interest rates.
discussed further below, control processes are applied to the fair values received from third-party valuation services to ensure the accuracy of these values.
Valuation service providers typically obtain data about market transactions and other key valuation model inputs from multiple sources and, through the use of market-accepted valuation methodologies, which may utilize matrix pricing, financial models, accompanying model inputs and various assumptions, provide a single fair value measurement for individual securities. The inputs used by the valuation service providers include, but are not limited to, market prices from completed transactions for identical securities and transactions for comparable securities, benchmark yields, interest rate yield curves, credit spreads, currency rates, quoted prices for similar securities and other market-observable information, as applicable. If fair value is determined using financial models, these models generally take into account, among other things, market observable information as of the measurement date as well as the specific attributes of the security being valued, including its term, interest rate, credit rating, industry sector, and when applicable, collateral quality and other security or issuer-specific information. When market transactions or other market observable data is limited, the extent to which judgment is applied in determining fair value is greatly increased.
When our 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, 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 third party valuation services, 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 are adjusted to reflect illiquidity and non-transferability, and such adjustments generally are 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.
For short-term investments that are measured at fair value, the carrying values of these assets approximate fair values because of the relatively short period of time between origination and expected realization, and their limited exposure to credit risk. Securities purchased under agreements to resell (reverse repurchase agreements) are generally treated as collateralized receivables. We report certain receivables arising from securities purchased under agreements to resell as Short-term investments in the Consolidated Balance Sheets. We use market-observable interest rates for receivables measured at fair value. This methodology considers such factors as the coupon rate and yield curves.
For certain OTC derivatives that trade in less liquid markets, where we generally do not have corroborating market evidence to support significant model inputs and cannot verify the model to market transactions, the transaction price may provide the best estimate of fair value. Accordingly, when a pricing model is used to value such an instrument,
The fair value of embedded policy derivatives contained in certain variable annuity and equity-indexed annuity and life contracts is measured based on actuarial and capital market assumptions related to projected cash flows over the expected lives of the contracts. These cash flow estimates primarily include benefits and related fees assessed, when applicable, and incorporate expectations about policyholder behavior. Estimates of future policyholder behavior are subjective and based primarily on our historical experience.
With respect to embedded policy derivatives in our variable annuity contracts, because of the dynamic and complex nature of the expected cash flows, risk neutral valuations are used. Estimating the underlying cash flows for these products involves judgments regarding expected market rates of return, market volatility, correlations of market index returns to funds, fund performance, discount rates and policyholder behavior. With respect to embedded policy derivatives in our equity-indexed annuity and life contracts, option pricing models are used to estimate fair value, taking into account assumptions for future equity index growth rates, volatility of the equity index, future interest rates, and determinations on adjusting the participation rate and the cap on equity-indexed credited rates in light of market conditions and policyholder behavior assumptions. These methodologies incorporate an explicit risk margin to take into consideration market participant estimates of projected cash flows and policyholder behavior.
Our valuation methodologies for the super senior credit default swap portfolio have evolved over time in response to market conditions and the availability of market observable information. We have sought to calibrate the methodologies to available market information and to review the assumptions of the methodologies on a regular basis.
Multi-sector CDO portfolios: We use a modified version of the Binomial Expansion Technique (BET) model to value our credit default swap portfolio written on super senior tranches of multi-sector CDOs of ABS. The BET model was developed in 1996 by a major rating agency to generate expected loss estimates for CDO tranches and derive a credit rating for those tranches, and remains widely used.
Corporate debt/Collateralized loan obligation (CLO) portfolios: For credit default swaps written on portfolios of investment-grade corporate debt, we use a mathematical model that produces results that are closely aligned with prices received from third parties. This methodology uses the current market credit spreads of the names in the portfolios along with the base correlations implied by the current market prices of comparable tranches of the relevant market traded credit indices as inputs.
We estimate the fair value of our obligations resulting from credit default swaps written on CLOs to be equivalent to the par value less the current market value of the referenced obligation. Accordingly, the value is determined by obtaining third-party quotations on the underlying super senior tranches referenced under the credit default swap contract.
Borrowings under obligations of guaranteed investment agreements (GIAs), which are guaranteed by us, are recorded at fair value using discounted cash flow calculations based on interest rates currently being offered for similar contracts and our current market observable implicit credit spread rates with maturities consistent with those remaining for the contracts being valued. Obligations may be called at various times prior to maturity at the option of the counterparty. Interest rates on these borrowings are primarily fixed, vary by maturity and range up to 9.8 percent.
(b) Represents cash collateral posted and received. Securities collateral posted for derivative transactions that is reflected in Fixed maturity securities in the Consolidated Balance Sheet, and collateral received, not reflected in the Consolidated Balance Sheet, was $1.3 billion and $120 million, respectively, at December 31, 2013 and $1.9 billion and $299 million, respectively, at December 31, 2012.
The following tables present changes during the years ended December 31, 2013 and 2012 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, 2013 and 2012:
Both observable and unobservable inputs may be used to determine the fair values of positions classified in Level 3 in the tables above. As a result, the unrealized gains (losses) on instruments held at December 31, 2013 and 2012 may include changes in fair value that were attributable to both observable (e.g., changes in market interest rates) and unobservable (e.g., changes in unobservable long-dated volatilities) inputs.
During the years ended December 31, 2013 and 2012, transfers into Level 3 assets primarily included certain investments in private placement corporate debt, RMBS, CMBS, CDO, ABS, and investments in hedge funds and private equity funds.
•Certain investments in hedge funds were transferred into Level 3 as a result of limited market activity due to fund-imposed redemption restrictions.
•Transfers of certain investments in municipal securities, RMBS, CMBS, CDO and certain 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.
•The removal or easing of fund-imposed redemption restrictions, as well as certain fund investments becoming subject to the equity method of accounting resulted in the transfer of certain hedge fund and private equity fund investments out of Level 3 assets.
There were no significant transfers of derivative or other liabilities into or out of Level 3 for the year ended December 31, 2013.
Embedded derivatives within Policyholder contract deposits relate to guaranteed minimum withdrawal benefits (GMWB) within variable annuity products and certain enhancements to interest crediting rates based on market indices within equity-indexed annuities and guaranteed investment contracts (GICs). GMWB represents our largest exposure of these embedded derivatives, although the carrying value of the liability fluctuates based on the performance of the equity markets and therefore, at a point in time, can be low relative to the exposure. The principal unobservable input used for GMWBs and embedded derivatives in equity-indexed annuities measured at fair value is equity implied volatility. For GMWBs, other significant unobservable inputs include base and dynamic lapse rates, mortality rates, and utilization rates. Lapse, mortality, and utilization rates may vary significantly depending upon age groups and duration. In general, increases in volatility and utilization rates will increase the fair value of the liability associated with GMWB, while increases in lapse rates and mortality rates will decrease the fair value of the liability. Significant unobservable inputs used in valuing embedded derivatives within GICs include long-term forward interest rates and foreign exchange rates. Generally, the embedded derivative liability for GICs will increase as interest rates decrease or if the U.S. dollar weakens compared to the euro.
The significant unobservable inputs used for Derivatives liabilities - credit contracts are recovery rates, diversity scores, and the weighted average life of the portfolio. AIG non-performance risk is also considered in the measurement of the liability.
increments. At December 31, 2013, assuming average original expected lives of 10 years for the funds, 62 percent of the total fair value using net asset value per share (or its equivalent) presented above would have expected remaining lives of three years or less, 34 percent between four and six years and 4 percent between seven and 10 years.
The hedge fund investments included above are generally redeemable monthly (14 percent), quarterly (44 percent), semi-annually (22 percent) and annually (20 percent), with redemption notices ranging from one day to 180 days. At December 31, 2013, however, investments representing approximately 57 percent of the total fair value of the hedge fund investments cannot be redeemed, either in whole or in part, because the investments include various contractual restrictions. 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 and are generally expected to be lifted by the end of 2015. The fund investments for which redemption is restricted only in part generally relate to certain hedge funds that hold at least one investment that the fund manager deems to be illiquid.
Under the fair value option, we may elect to measure at fair value financial assets and financial liabilities that are not otherwise required to be carried at fair value. Subsequent changes in fair value for designated items are reported in earnings. We elect the fair value option for certain hybrid securities given the complexity of bifurcating the economic components associated with the embedded derivatives. Refer to Note 11 for additional information related to embedded derivatives.
Interest income and dividend income on assets measured under the fair value option are recognized and included in Net investment income in the Consolidated Statements of Income with the exception of activity within AIG's Other Operations, which is included in Other income. Interest on liabilities measured under the fair value option is recognized in interest expense in the Consolidated Statements of Income. See Note 6 herein for additional information about our policies for recognition, measurement, and disclosure of interest and dividend income and interest expense.
•Mortgage and other loans receivable: Fair values of loans on real estate and other loans receivable were estimated for disclosure purposes using discounted cash flow calculations based on discount rates that we believe market participants would use in determining the price that they would pay for such assets. For certain loans, our current incremental lending rates for similar types of loans are used as the discount rates, because we believe this
•Policyholder contract deposits associated with investment-type contracts: Fair values for policyholder contract deposits associated with investment-type contracts not accounted for at fair value were estimated using discounted cash flow calculations based on interest rates currently being offered for similar contracts with maturities consistent with those of the contracts being valued. When no similar contracts are being offered, the discount rate is the appropriate swap rate (if available) or current risk-free interest rate consistent with the currency in which the cash flows are denominated.
For the year ended December 31, 2013, 2012 and 2011, the aggregate fair value of available for sale securities sold was $35.9 billion, $40.3 billion and $44.0 billion, which resulted in net realized capital gains of $2.5 billion, $3.1 billion and $2.1 billion, respectively.
* Includes $1.0 billion and $0.9 billion of U.S. Government agency backed ABS at December 31, 2013 and 2012, respectively.
The following table summarizes the carrying values of other invested assets:
(c) Consist primarily of AIG Life and Retirement investments in aircraft equipment held in consolidated trusts.
investments was $15 million and $68 million at December 31, 2013 and 2012, respectively, the majority of which pertains to investments in private equity funds and hedge funds that have been in continuous unrealized loss positions for less than 12 months.
Also included in Other invested assets are real estate held for investment and aircraft asset investments held by non-Aircraft Leasing subsidiaries. These investments are reported at cost, less depreciation and subject to impairment review, as discussed below.
Investments in life settlements are accounted for under the investment method. Under the investment method, we recognize 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, increase the carrying value of the investment. We recognize income on individual investments in life settlements when the insured dies, at an amount equal to the excess of the investment proceeds over the carrying amount of the investment at that time. These investments are subject to impairment review, as discussed below.
At December 31, 2013, management's best estimate of the life insurance premiums required to keep the investments in life settlements in force, payable in the 12 months ending December 31, 2014 and the four succeeding years ending December 31, 2018 are $549 million, $575 million, $590 million, $613 million and $638 million, respectively.
•Interest income and related expenses, including amortization of premiums and accretion of discounts on bonds with changes in the timing and the amount of expected principal and interest cash flows reflected in the yield, as applicable.
Net realized capital gains and losses are determined by specific identification. The net realized capital gains and losses are generated primarily from the following sources:
•Sales of available for sale fixed maturity securities, available for sale equity securities and real estate.
We consider severe price declines in our assessment of potential credit impairments. We may also modify our model inputs when we determine that price movements in certain sectors are indicative of factors not captured by the cash flow models.
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 prospectively accrete into earnings the difference between the new amortized cost and the expected undiscounted recovery value over the remaining expected holding period of the security.
Our investments in private equity funds and hedge funds are evaluated for impairment similar to the evaluation of equity securities for impairments as discussed above. Such evaluation considers market conditions, events and
volatility that may impact the recoverability of the underlying investments within these private equity funds and hedge funds and is based on the nature of the underlying investments and specific inherent risks. Such risks may evolve based on the nature of the underlying investments.
In general, fair value estimates for the investments in life settlements are calculated using cash flows based on medical underwriting ratings of the policies from a third-party underwriter, applied to an industry mortality table. Our new mortality assumptions are based on an industry table that was supplemented with proprietary data on the older age mortality of U.S. insured lives. In addition, mortality improvement factors were applied to our new assumptions based on our view of future mortality improvements likely to apply to the U.S. insured lives population. These mortality improvement assumptions were based on our analysis of various public industry sources and proprietary research. Using these new mortality assumptions coupled with the adopted future mortality improvement rates, we revised our estimate of future net cash flows from the investments in life settlements. This resulted in a significant increase in the number of investments in life settlements identified as impaired as of December 31, 2013.
Secured financing transactions also include securities sold under agreements to repurchase (repurchase agreements), in which we transfer securities in exchange for cash, with an agreement by us to repurchase the same or substantially similar securities. In the majority of these repurchase agreements, the securities transferred by us may be sold or repledged by the counterparties. Repurchase agreements entered into by the DIB are carried at fair value based on market-observable interest rates. All other repurchase agreements are recorded at their contracted repurchase amounts plus accrued interest.
The following table presents the fair value of securities pledged to counterparties under secured financing transactions:
Prior to January 1, 2012, in the case of repurchase agreements where we did not obtain collateral sufficient to fund substantially all of the cost of purchasing identical replacement securities during the term of the contract (generally less than 90 percent of the security value), we accounted for the transaction as a sale of the security and reported the obligation to repurchase the security as a derivative contract. The fair value of securities transferred under repurchase agreements accounted for as sales was $2.1 billion at December 31, 2011. Effective January 1, 2012, the level of collateral received by the transferor in a repurchase agreement or similar arrangement is no longer relevant in determining whether the transaction should be accounted for as a sale. There were no repurchase agreements accounted for as sales as of December 31, 2013.
Certain GIAs have provisions that require collateral to be posted or payments to be made by us upon a downgrade of our long-term debt ratings. The actual amount of collateral required to be posted to the counterparties in the event of such downgrades, and the aggregate amount of payments that we could be required to make, depend on market conditions, the fair value of outstanding affected transactions and other factors prevailing at and after the time of the downgrade. The fair value of securities pledged as collateral with respect to these obligations approximated $4.2 billion and $4.4 billion at December 31, 2013 and December 31, 2012, 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.
* Commercial mortgages primarily represent loans for office, retail and industrial properties, with exposures in California and New York representing the largest geographic concentrations (18 percent and 17 percent, respectively, at December 31, 2013 and 22 percent and 15 percent, respectively, at December 31, 2012).
(a) Loans that have been modified in troubled debt restructurings and are performing according to their restructured terms. See discussion of troubled debt restructurings below.
Mortgage and other loans receivable are considered impaired when collection of all amounts due under contractual terms is not probable. For commercial mortgage loans in particular, the impairment is measured based on the fair value of underlying collateral, which is determined based on the present value of expected net future cash flows of the collateral, less estimated costs to sell. For other loans, the impairment may be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or based on the loan's observable market price, where available. An allowance is typically established for the difference between the impaired value of the loan and its current carrying amount. Additional allowance amounts are established for incurred but not specifically identified impairments, based on the analysis of internal risk ratings and current loan values. Internal risk ratings are assigned based on the consideration of risk factors including past due status, debt service coverage, loan-to-value ratio or the ratio of the loan balance to the estimated value of the property, property occupancy, profile of the borrower and of the major property tenants, economic trends in the market where the property is located, and condition of the property. These factors and the resulting risk ratings also provide a basis for determining the level of monitoring performed at both the individual loan and the portfolio level. When all or a portion of a commercial mortgage loan is deemed uncollectible, the uncollectible portion of the carrying value of the loan is charged off against the allowance. Interest income on impaired loans is recognized as cash is received.
A significant majority of commercial mortgage loans in the portfolio are non-recourse loans and, accordingly, the only guarantees are for specific items that are exceptions to the non-recourse provisions. It is therefore extremely rare for us to have cause to enforce the provisions of a guarantee on a commercial real estate or mortgage loan.
We modify loans to optimize their returns and improve their collectability, among other things. When we undertake such a modification with a borrower that is experiencing financial difficulty and the modification involves us granting a concession to the troubled debtor, the modification is a troubled debt restructuring (TDR). We assess whether a borrower is experiencing financial difficulty based on a variety of factors, including the borrower's current default on any of its outstanding debt, the probability of a default on any of its debt in the foreseeable future without the modification, the insufficiency of the borrower's forecasted cash flows to service any of its outstanding debt (including both principal and interest), and the borrower's inability to access alternative third-party financing at an interest rate that would be reflective of current market conditions for a non-troubled debtor. Concessions granted may include extended maturity dates, interest rate changes, principal forgiveness, payment deferrals and easing of loan covenants.
Long-duration reinsurance recoveries, which reduced Policyholder benefits and claims incurred, were approximately $714 million, $758 million and $611 million, respectively, for the years ended December 31, 2013, 2012 and 2011.
Long-duration insurance in force assumed represented 0.05 percent of gross long-duration insurance in force at December 31, 2013, 0.05 percent at December 31, 2012 and 0.07 percent at December 31, 2011, and premiums assumed by AIG Life and Retirement represented 0.4 percent, 0.6 percent and 0.7 percent of gross premiums for the years ended December 31, 2013, 2012 and 2011, respectively.
AIG Life and Retirement utilizes internal and third-party reinsurance relationships to manage insurance risks and to facilitate capital management strategies. As a result of these reinsurance arrangements, AIG Life and Retirement is able to minimize the use of letters of credit and utilize capital more efficiently. Pools of highly-rated third-party reinsurers are utilized to manage net amounts at risk in excess of retention limits.
AIG Life and Retirement manages the capital impact on its insurance subsidiaries of statutory reserve requirements under Regulation XXX and Guideline AXXX through intercompany reinsurance transactions. Under GAAP, these intercompany reinsurance transactions are eliminated in consolidation. Under one of these intercompany arrangements, AIG Life and Retirement obtains letters of credit to support statutory recognition of the ceded reinsurance. As of December 31, 2013, AIG Life and Retirement had obtained for this purpose a $260 million syndicated letter of credit facility and a $190 million bilateral letter of credit. As of December 31, 2013, all of the $450 million of letters of credit were due to mature on December 31, 2015. On February 7, 2014, these letters of
credit were replaced with two new, renegotiated bilateral letters of credit totaling $450 million. These new letters of credit expire on February 7, 2018, but will be automatically extended without amendment by one year on each anniversary of the issuance date, unless the issuer provides notice of non-renewal. See Note 19 for additional information on the use of affiliated reinsurance for Regulation XXX and Guideline AXXX reserves.
Long-duration insurance contracts: Policy acquisition costs for participating life, traditional life and accident and health insurance products are generally deferred and amortized, with interest, over the premium paying period. The assumptions used to calculate the benefit liabilities and DAC for these traditional products are set when a policy is issued and do not change with changes in actual experience, unless a loss recognition event occurs. These "locked-in" assumptions include mortality, morbidity, persistency, maintenance expenses and investment returns, and include margins for adverse deviation to reflect uncertainty given that actual experience might deviate from these assumptions. Loss recognition exists when there is a shortfall between the carrying amounts of future policy benefit liabilities net of DAC and the amount the future policy benefit liabilities net of DAC would be when applying updated current assumptions. When we determine a loss recognition exists, we first reduce any DAC related to that block of business through amortization of acquisition expense, and after DAC is depleted, record additional liabilities through a charge to Policyholder benefits and claims incurred. Groupings for loss recognition testing are consistent with our manner of acquiring and servicing the business and applied by product groupings. We perform separate loss recognition tests for traditional life products, payout annuities and long-term care products. Once loss recognition has been recorded for a block of business, the old assumption set is replaced and the assumption set used for the loss recognition would then be subject to the lock-in principle.
Internal Replacements of Long-duration and Investment-oriented Products: For some products, policyholders can elect to modify product benefits, features, rights or coverages by exchanging a contract for a new contract or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. These transactions are known as internal replacements. If the modification does not substantially change the contract, we do not change the accounting and amortization of existing DAC and related actuarial balances. If an internal replacement represents a substantial change, the original contract is considered to be extinguished and any related DAC or other policy balances are charged or credited to income whereas any new deferrable costs associated with the replacement contract are deferred.
DAC, VOBA and SIA for insurance-oriented and investment-oriented products are reviewed for recoverability, which involves estimating the future profitability of current business. This review involves significant management judgment. If actual future profitability is substantially lower than estimated, AIG's DAC, VOBA and SIA may be subject to an impairment charge and AIG's results of operations could be significantly affected in future periods.
For all other VIEs, the primary beneficiary is the entity that has both (1) the power to direct the activities of the VIE that most significantly affect the entity's economic performance and (2) the obligation to absorb losses or the right to receive benefits that could be potentially significant to the VIE. While also considering these factors, the consolidation conclusion depends on the breadth of our decision-making ability and our ability to influence activities that significantly affect the economic performance of the VIE.
(c) At December 31, 2013 and 2012, off-balance sheet exposure primarily consisting of commitments to real estate and investments funds was $50.8 million and $48.7 million, respectively.
We created VIEs that hold investments, primarily in investment-grade debt securities, 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 impacts 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.
SunAmerica Affordable Housing Partners, Inc. (SAAHP) organizes and invests in limited partnerships that develop and operate affordable housing qualifying for federal tax credits, in addition to a few market rate properties across the United States. The general partners in the operating partnerships are generally unaffiliated third-party developers.
We do not consolidate an operating partnership if the general partner is an unaffiliated entity. Through approximately 1,000 partnerships, SAAHP has investments in developments with approximately 130,000 apartment units nationwide, and as of December 31, 2013, has syndicated approximately $7.7 billion in partnership equity to other investors who will receive, among other benefits, tax credits under certain sections of the Internal Revenue Code. The pre-tax income of SAAHP is reported, along with other AIG Life and Retirement partnership income, as a component of the AIG Life and Retirement segment.
We created two VIEs for the purpose of acquiring, owning, leasing, maintaining, operating and selling aircraft. Our subsidiaries hold beneficial interests, including all the equity interests in these entities. These beneficial interests include passive investments by our insurance operations in non-voting preferred equity interests and in the majority of the debt issued by these entities. We maintain the power to direct the activities of the VIEs that most significantly impact the entities' economic performance, and bear the obligation to absorb economic losses or receive economic benefits that could potentially be significant to the VIEs. As a result, we have determined that we are the primary beneficiary and we consolidate the assets and liabilities of these entities, which totaled $0.9 billion and $0.2 billion, respectively at December 31, 2013 and $1.2 billion and $0.3 billion at December 31, 2012, respectively. The debt of these entities is not an obligation of, or guaranteed by, us or any of our subsidiaries. Under a servicing agreement, ILFC acts as servicer for the aircraft owned by these entities.
Through the DIB, we also invest in CDOs and similar structures, which can be cash-based or synthetic and are managed by third parties. The role of DIB is generally limited to that of a passive investor in structures we do not manage.
Our maximum exposure in these types of structures is limited to our investment in securities issued by these entities. Based on the nature of our investments and our passive involvement in these types of structures, we have determined that we are not the primary beneficiary of these entities. We have not included these entities in the above tables; however, the fair values of our investments in these structures are reported in Notes 5 and 6 herein.
ILFC created wholly-owned subsidiaries for the purpose of purchasing aircraft and obtaining financing secured by such aircraft. A portion of the secured debt has been guaranteed by the European Export Credit Agencies and the Export-Import Bank of the United States. These entities are VIEs because they do not have sufficient equity to operate without ILFC's subordinated financial support in the form of intercompany notes which serve as equity. ILFC fully consolidates the entities, controls all the activities of the entities and guarantees the activities of the entities. AIG has not included these entities in the above table as they are wholly-owned and there are no other variable interests other than those of ILFC and the lenders.
(c) Notional amount of derivative assets and fair value of derivative assets include $23.2 billion and $107 million, respectively, at December 31, 2013 related to bifurcated embedded derivatives. There were no bifurcated embedded derivative assets at December 31, 2012. Notional amount of derivative liabilities and fair values of derivative liabilities include $6.7 billion and $424 million, respectively, at December 31, 2013 and $23 billion and $1.3 billion, respectively at December 31, 2012 related to bifurcated embedded derivatives. A bifurcated embedded derivative is generally presented with the host contract in the Consolidated Balance Sheets.
of a default on, or affecting any, one derivative transaction or a termination event affecting all, or a specified group of, derivative transactions.
(b) Includes embedded derivative gains (losses) of $1.2 billion, $(166) million and $(397) million for the years ended December 31, 2013, 2012 and 2011, respectively.
(a) Net notional amounts presented are net of all structural subordination below the covered tranches. The decrease in the total net notional amount from December 31, 2012 to December 31, 2013 was due to amortization of $1.0 billion and terminations and maturities of $69 million, partially offset by increases due to foreign exchange rate movement of $313 million.
The expected weighted average maturity of the super senior credit derivative portfolios as of December 31, 2013 was six years for the multi-sector CDO arbitrage portfolio and two years for the corporate debt/CLO portfolio.
In addition to hedging activities, we also enter into derivative instruments with respect to investment operations, which include, among other things, credit default swaps and purchasing investments with embedded derivatives, such as equity-linked notes and convertible bonds.
12. LIABILITY FOR UNPAID CLAIMS AND CLAIMS ADJUSTMENT EXPENSE, FUTURE POLICY BENEFITS FOR LIFE AND ACCIDENT AND HEALTH INSURANCE CONTRACTS, AND POLICYHOLDER CONTRACT DEPOSITS
Our gross loss reserves before reinsurance and discount are net of contractual deductible recoverable amounts due from policyholders of approximately $12.0 billion and $11.7 billion at December 31, 2013 and 2012, respectively. These recoverable amounts are related to certain policies with high deductibles (primarily for U.S. commercial casualty business) where 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. At December 31, 2013 and 2012, we held collateral totaling $9.0 billion and $8.3 billion, respectively, for these deductible recoverable amounts, consisting primarily of letters of credit and trust agreements.
(b) In 2013, includes $144 million, $269 million, $498 million and $54 million related to excess casualty, environmental and pollution, primary casualty and healthcare, respectively. In 2012, includes $157 million, $200 million, $531 million and $68 million related to excess casualty, environmental and pollution, primary casualty and healthcare, respectively. In 2011, includes $(588) million, $385 million, $686 million and $45 million related to excess casualty, environmental and pollution, primary casualty and healthcare, respectively
At December 31, 2013, the liability for unpaid claims and claims adjustment expense reflects a net loss reserve discount of $3.6 billion, including tabular and non-tabular calculations based upon the following assumptions:
•Certain asbestos business that was written by AIG Property Casualty is 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 this business.
•The tabular workers' compensation discount is calculated using a 3.5 percent interest rate and the 1979 - 81 Decennial Mortality Table.
Future policy benefits primarily include reserves for traditional life and annuity payout contracts, which represent an estimate of the present value of future benefits less the present value of future net premiums. Included in Future policy benefits are liabilities for annuities issued in structured settlement arrangements whereby a claimant has agreed to settle a general insurance claim in exchange for fixed payments over a fixed determinable period of time with a life contingency feature. Future policy benefits also include certain guaranteed benefits of variable annuity products that are not considered embedded derivatives, primarily guaranteed minimum death benefits. See Note 13 for additional information on liabilities for guaranteed benefits included in Future policy benefits.