As of December 31, 2017, approximately 11 percent of our consolidated assets were located outside the U.S. and Canada, including $491 million of cash and securities on deposit with regulatory authorities in those locations.
Operations outside the U.S. and Canada and assets held abroad may be adversely affected by political developments in foreign countries, including tax changes, nationalization and changes in regulatory policy, as well as by consequence of hostilities and unrest. The risks of such occurrences and their overall effect upon us vary from country to country and cannot be predicted. If expropriation or nationalization does occur, our policy is to take all appropriate measures to seek recovery of any affected assets. Certain of the countries in which our business is conducted have currency restrictions that generally cause a delay in a company’s ability to repatriate assets and profits.
This Annual Report on Form 10-K (Annual Report) and other publicly available documents may include, and officers and representatives of American International Group, Inc. (AIG) may from time to time make, projections, goals, assumptions and statements that may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These projections, goals, assumptions and statements are not historical facts but instead represent only our belief regarding future events, many of which, by their nature, are inherently uncertain and outside our control. These projections, goals, assumptions and statements include statements preceded by, followed by or including words such as “will,” “believe,” “anticipate,” “expect,” “intend,” “plan,” “focused on achieving,” “view,” “target,” "goal" or “estimate.” These projections, goals, assumptions and statements may address, among other things, our:
Book value per common share, excluding accumulated other comprehensive income (AOCI) and Book value per common share, excluding AOCI and deferred tax assets (DTA) (Adjusted book value per common share) are used to show the amount of our net worth on a per-share basis. We believe these measures are useful to investors because they eliminate items that can fluctuate significantly from period to period, including changes in fair value of our available for sale securities portfolio, foreign currency translation adjustments and U.S. tax attribute deferred tax assets. These measures also eliminate the asymmetrical impact resulting from changes in fair value of our available for sale securities portfolio wherein there is largely no offsetting impact for certain related insurance liabilities. We exclude deferred tax assets representing U.S. tax attributes related to net operating loss carryforwards and foreign tax credits as they have not yet been utilized. Amounts for interim periods are estimates based on projections of full-year attribute utilization. As net operating loss carryforwards and foreign tax credits are utilized, the portion of the DTA utilized is included in these book value per common share metrics. Book value per common share excluding AOCI, is derived by dividing total AIG shareholders’ equity, excluding AOCI, by total common shares outstanding. Adjusted book value per common share is derived by dividing total AIG shareholders’ equity, excluding AOCI and DTA (Adjusted Shareholders’ Equity), by total common shares outstanding. The reconciliation to book value per common share, the most comparable GAAP measure, is presented in Item 6. Selected Financial Data.
• changes in uncertain tax positions and other tax items related to legacy matters having no relevance to our current businesses or operating performance; and
• net tax charge related to the enactment of the Tax Act.
• restructuring and other costs related to initiatives designed to reduce operating expenses, improve efficiency and simplify our organization; and
· income tax assets and liabilities, including recoverability of our net deferred tax asset and the predictability of future tax operating profitability of the character necessary to realize the net deferred tax asset and provisional estimates associated with the Tax Act.
· Tail factors are development factors used for certain longer tailed lines of business (for example, excess casualty, workers’ compensation and general liability),to project future loss development for periods that extend beyond the available development data. The development of losses to the ultimate loss for a given accident year for these lines may take decades and the projection of ultimate losses for an accident year is very sensitive to the tail factors selected beyond a certain age.
· an assessment of economic conditions including inflation, employment rates or unemployment duration;
Frequency/severity methods generally rely on the determination of an ultimate number of claims and an average severity for each claim for each accident year. Multiplying the estimated ultimate number of claims for each accident year by the expected average severity of each claim produces the estimated ultimate loss for the accident year. Frequency/severity methods generally require a sufficient volume of claims in order for the average severity to be predictable. Average severity for subsequent accident years is generally determined by applying an estimated annual loss cost trend to the estimated average claim severity from prior accident years. In certain cases, a structural approach may also be used to predict the ultimate loss cost. Frequency/severity methods have the advantage that ultimate claim counts can generally be estimated more quickly and accurately than can ultimate losses. Thus, if the average claim severity can be accurately estimated, these methods can more quickly respond to changes in loss experience than other methods. However, for average severity to be predictable, the product line of business must consist of homogenous types of claims for which loss severity trends from one year to the next are reasonably consistent and where there are limited changes to deductible levels or limits. Generally these methods work best for high frequency, low severity product lines of business such as personal auto. However, frequency and severity metrics are also used to test the reasonability of results for other product lines of business and provide indications of underlying trends in the data. In addition, ultimate claim counts can be used as an alternative exposure measure to earned premiums in the Cape Cod method.
• Ground-up consideration of the reinsurance recoveries expected for the product line of business for reported claims with extrapolation for unreported claims; and
The tail factor is typically the most critical assumption, and small changes in the selected tail factor can have a material effect on our carried reserves. For example, the tail factors beyond twenty years for guaranteed cost business could vary by one and one-half percent below to two percent above those actually indicated in the 2017 loss reserve review. For excess of deductible business, in our judgment, it is reasonably likely that tail factors beyond twenty years could vary by four percent below to six percent above those actually indicated in the 2017 loss reserve review.
We utilize various loss cost trend assumptions for different segments of the portfolio. After evaluating the historical loss cost trends from prior accident years since the early 1990s, in our judgment, it is reasonably likely that actual loss cost trends applicable to the year-end 2017 loss reserve review for U.S. Excess Casualty may range five percent lower or higher than this estimated loss trend. The loss cost trend assumption is critical for the U.S. Excess Casualty class of business due to the long-tail nature of the losses, and is applied across many accident years. Thus, there is the potential for the loss reserves with respect to a number of accident years (the expected loss ratio years) to be significantly affected by changes in loss cost trends that were initially relied upon in setting the loss reserves. These changes in loss trends could be attributable to changes in inflation or in the judicial environment, or in other social or economic conditions affecting losses.
The loss cost trends for U.S. D&O business vary by year and subset, but for the most recent accident years, it is assumed to have been generally close to zero. After evaluating the historical loss cost levels from prior accident years since the early 1990s, including the potential effect of losses relating to the credit crisis, in our judgment, it is reasonably likely that the actual variation in loss cost levels for these subsets could vary by approximately 10 percent lower or higher on a year-over-year basis than the assumptions actually utilized in the year-end 2017 reserve review. Because U.S. D&O business has exhibited highly volatile loss trends from one accident year to the next, there is the possibility of an exceptionally high deviation. In our analysis, the effects of loss cost trend assumptions affect the results through the a priori loss ratio assumptions used for the Bornhuetter-Ferguson and Cape Cod methods, which impact the projections for the more recent accident years.
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 2017:
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, unless a loss recognition event occurs. The assumptions include mortality, morbidity, persistency, maintenance expenses, and investment returns. These assumptions are typically consistent with pricing inputs. The assumptions also include margins for adverse deviation, principally for key assumptions such as mortality and interest rates used to discount cash flows, to reflect uncertainty given that actual experience might deviate from these assumptions. Establishing margins at contract inception requires management judgment. The extent of the margin for adverse deviation may vary depending on the uncertainty of the cash flows, which is affected by the volatility of the business and the extent of our experience with the product.
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 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. 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 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 to expected rates on competing products under different interest rate scenarios.
We determine the GMDB liability at each balance sheet date by estimating the expected value of death benefits in excess of the projected account balance and recognizing the excess ratably over the accumulation period based on total expected fee assessments. For additional information on how we reserve for variable annuity products with guaranteed benefit features see Note 14 to the Consolidated Financial Statements.
• Mortality rates, which are based upon actual experience modified to allow for variations in policy form
• Allocation of fees between the embedded derivative and host contract
If the assumptions used for estimated gross profits change significantly, DAC and related reserves, including VOBA, SIA, guaranteed benefit reserves and unearned revenue reserve (URR), 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.
long-term growth assumption, as evidenced by growth assumptions for the five-year reversion to the mean period falling below a certain rate (floor) or above a certain rate (cap) for a sustained period, judgment may be applied to revise or “unlock” the growth rate assumptions to be used for both the five-year reversion to the mean period as well as the long-term annual growth assumption applied to subsequent periods. The use of a reversion to the mean assumption is common within the industry; however, the parameters used in the methodology are subject to judgment and vary within the industry.
At December 31, 2017, the allowance for estimated unrecoverable reinsurance was $187 million, or less than one percent of the consolidated reinsurance recoverable.
(a) Includes $16.4 billion for which the primary source is broker quotes.
For discussion of the valuation methodologies for assets and liabilities measured at fair value, as well as a discussion of transfers of Level 3 assets and liabilities see Note 5 to the Consolidated Financial Statements.
We consider a number of factors to reliably estimate future taxable income so we can determine the extent of our ability to realize net operating losses (NOLs), foreign tax credits (FTCs), realized capital loss and other carryforwards. These factors include forecasts of future income for each of our businesses and actual and planned business and operational changes, both of which include assumptions about future macroeconomic and AIG specific conditions and events. We subject the forecasts to stresses of key assumptions and evaluate the effect on tax attribute utilization. We also apply stresses to our assumptions about the effectiveness of relevant prudent and feasible tax planning strategies. Our income forecasts, coupled with our tax planning strategies, all resulted in sufficient taxable income to achieve realization of the U.S. tax attributes prior to their expiration.
We assess the recoverability of deferred tax assets related to unrealized tax capital losses in the U.S. non-life companies’ available for sale portfolio. For the year ended December 31, 2017, recent changes in market conditions, including interest rate fluctuations, impacted the unrealized tax gains and losses in the U.S. non-life companies’ available for sale securities portfolio, resulting in a deferred tax liability related to net unrealized tax capital gains. As of December 31, 2017, based on all available evidence, we have concluded no valuation allowance is necessary in the U.S. non-life companies’ available for sale securities portfolio.
Our accounting for income taxes, including uncertain tax positions, represents management’s best estimate of various events and transactions, and requires judgment. FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48) now incorporated into Accounting Standards Codification, 740, Income Taxes (ASC 740) prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of an income tax position taken or expected to be taken in a tax return. The standard also provides guidance on derecognition, classification, interest and penalties and additional disclosures. We determine whether it is more likely than not that a tax position will be sustained, based on technical merits, upon examination by the relevant taxing authorities before any part of the benefit can be recognized in the financial statements. A tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon settlement.
On December 22, 2017, the U.S. enacted Public Law 115-97, known informally as the Tax Cuts and Jobs Act (the Tax Act). The Tax Act reduces the statutory rate of U.S. federal corporate income tax to 21 percent and enacts numerous other changes impacting AIG and the insurance industry. Additionally, the SEC staff issued Staff Accounting Bulletin 118 (SAB 118), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 addresses situations where accounting for certain income tax effects of the Tax Act under ASC 740 may be incomplete upon issuance of an entity’s financial statements and provides a one-year measurement period from the enactment date to complete the accounting under ASC 740. As of December 31, 2017, we had not fully completed our accounting for the tax effects of the Tax Act. Our provision for income taxes for the periods ended December 31, 2017, is based in part on a reasonable estimate of the effects on existing deferred tax balances and of certain provisions of the Tax Act.
The Tax Act includes a provision for Global Intangible Low-Taxed Income (GILTI) under which taxes on foreign income are imposed on the excess of a deemed return on tangible assets of certain foreign subsidiaries. We have made a policy election to treat GILTI as an in period tax charge when incurred in future periods for which no deferred taxes need to be provided.
In the fourth quarter of 2017, we completed the reorganization of our operating structure. For a further discussion on these actions see Item 1. Business.
On January 21, 2018, we entered into an agreement to purchase Validus Holdings, Ltd., a leading provider of reinsurance, primary insurance, and asset management services, for $5.6 billion in cash. This transaction strengthens our global General Insurance business by expanding our current product portfolio through additional distribution channels and advancing the tools available to enhance underwriting. The transaction is expected to close mid-2018 and is subject to obtaining the relevant regulatory approvals and other customary closing conditions.
Declined primarily due to a decrease in income from insurance operations, reflecting $5.4 billion of pre-tax prior year adverse reserve development in General Insurance in 2016 compared to $3.3 billion pre-tax in 2015. In addition, we recorded net realized capital losses in 2016 compared to net realized capital gains in 2015. These decreases were partially offset by improved performance from Life and Retirement.
Decreased primarily due to adverse prior year loss reserve development in General Insurance of $5.4 billion in 2016 compared to $3.3 billion in 2015.
• favorable adjustments to reserves and DAC in Life and Retirement, including higher net positive adjustments from the update of actuarial assumptions in Individual Retirement and Life Insurance; and
Declined $3.6 billion since 2015 due to lower employee-related expenses and professional fee reductions related to our ongoing efficiency program and divestitures of businesses, including United Guaranty, AIG Advisor Group, Fuji Life and NSM Insurance Group LLC (NSM), and a favorable foreign exchange impact of $63 million.
In keeping with our broad and ongoing efforts to transform for long-term competitiveness, general operating and other expenses for 2017, 2016 and 2015 included approximately $413 million, $694 million and $496 million of pre-tax restructuring and other costs, respectively, which were primarily comprised of employee severance charges.
Interest rates have remained at historically low levels throughout 2017. Certain markets in which we operate have experienced negative interest rates. A sustained low interest rate environment negatively affects sales of interest rate sensitive products in our industry and may negatively impact the profitability of our existing business as we reinvest cash flows from investments, including increased calls and prepayments of fixed maturity securities and mortgage loans, at rates below the average yield of our existing portfolios. We actively manage our exposure to the interest rate environment through portfolio selection and asset-liability management, including spread management strategies for our investment-oriented products and economic hedging of interest rate risk from guarantee features in our variable and fixed index annuities.
The sustained low interest rate environment has a significant impact on the annuity industry. Low long-term interest rates put pressure on investment returns, which may negatively affect sales of interest rate sensitive products and reduce future profits on certain existing fixed rate products. However, our disciplined rate setting has helped to mitigate some of the pressure on investment spreads. As long as the low interest rate environment continues, conditions will be challenging for the fixed annuity market. Rapidly rising interest rates could create the potential for increased sales, but may also drive higher surrenders. Customers are, however, currently buying fixed annuities with surrender charge periods of four to seven years in pursuit of higher returns, which may help mitigate the rate of increase in surrenders in a rapidly rising rate environment. In addition, older contracts that have higher minimum interest rates and continue to be attractive to the contract holders have driven better than expected persistency in Fixed Annuities, although the reserves for such contracts have continued to decrease over time in amount and as a percentage of the total annuity portfolio. We will closely monitor surrenders of Fixed Annuities as contracts with lower minimum interest rates come out of the surrender charge period in a more attractive rate environment. Low interest rates have also driven growth in our fixed index annuity products, which provide additional interest crediting tied to favorable performance in certain equity market indices and the availability of guaranteed living benefits. Changes in interest rates significantly impact the valuation of our liabilities for guaranteed products with income features and the value of the related hedging portfolio.
We actively monitor fixed income markets, including the level of interest rates, credit spreads and the shape of the yield curve. We also frequently review our interest rate assumptions and actively manage the crediting rates used for 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 many of our 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 interest 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. Specifically, the investment of these future premium receipts may be at a yield below that required to meet future policy liabilities.
For investment-oriented products in our Individual Retirement, Group Retirement, Life Insurance and Institutional Markets businesses, our spread management strategies include disciplined pricing and product design for new business, modifying or limiting the sale of products that do not achieve targeted spreads, using asset-liability management to match assets to liabilities to the extent practicable, and actively managing crediting rates to help mitigate some of the pressure on investment spreads. Renewal crediting rate management is done under contractual provisions that were designed to allow crediting rates to be reset at pre-established intervals in accordance with state and federal laws and subject to minimum crediting rate guarantees. We will continue to adjust crediting rates on in-force business to mitigate the pressure on spreads from declining base yields, but our ability to lower crediting rates may be limited by the competitive environment, contractual minimum crediting rates, and provisions that allow rates to be reset only at pre-established intervals.
The impact of low interest rates on our General Insurance segment is primarily on our long-tail Casualty line of business. We expect limited impacts on our existing long-tail Casualty business as the duration of our assets is slightly longer than that of our liabilities. We do expect sustained low interest rates will impact new and renewal business for the long-tail Casualty line as we may not be able to adjust our future pricing consistent with our profitability objectives to fully offset the impact of investing at lower rates. However, we will continue to maintain pricing discipline and risk selection.
Our Individual Retirement and Group Retirement operating segments provide products and services that are subject to restrictions imposed by the ERISA and the Internal Revenue Code, including the requirements of the DOL Fiduciary Rule, related exemption amendments, and subsequent interpretative guidance and bulletins. Overall, the DOL Fiduciary Rule, as currently promulgated, would result in increased compliance costs and may create increased exposure to legal claims under certain circumstances, including class actions. Following the extension of the applicability dates of the DOL Fiduciary Rule and related exemptions announced by the DOL in April 2017, the new definition of fiduciary and the impartial conduct standards under the DOL Fiduciary Rule became applicable on June 9, 2017, with the remaining provisions of the rule scheduled to become applicable on January 1, 2018. On November 29, 2017, the DOL finalized an 18-month delay of the elements of the rule that have not yet taken effect.
Unless otherwise noted, references to the effects of foreign exchange in the General Insurance discussion of results of operations are with respect to movements in the Major Currencies included in the preceding table.
For a discussion of the Critical Accounting Estimates that affect our results of operations see the Critical Accounting Estimates section of this MD&A.
* For 2017 and 2016, because we reported a net loss, all common stock equivalents are anti-dilutive and are therefore excluded from the calculation of diluted shares and diluted per share amounts. However, because we reported adjusted after-tax income, the calculation of adjusted after-tax income per diluted share includes 22,412,682 dilutive shares and 30,326,772 dilutive shares for 2017 and 2016, respectively.
• lower general operating and other expenses reflecting strategic actions to reduce expenses and divestitures of businesses, including United Guaranty, AIG Advisor Group, Inc. (AIG Advisor Group), Fuji Life and NSM;
• a net positive adjustment from the update of Life and Retirement actuarial assumptions compared to a net negative adjustment in the prior year;
• adverse prior year loss reserve development in General Insurance of $5.4 billion in 2016 compared to $3.3 billion in 2015; and
- the sale of Class B shares of Prudential Financial Inc. and common shares of Springleaf Holdings, Inc. (Springleaf, now known as OneMain Holdings, Inc.) in 2015; and
• higher income from divested businesses due to gains on the sales of United Guaranty, AIG Advisor Group and NSM, partially offset by losses on the agreements to sell Fuji Life to FWD Group and certain insurance operations and assets to Fairfax.
Changes specific to the insurance industry include the calculation of insurance tax reserves and related transition adjustments, amortization of specified policy acquisition expenses, treatment of separate account dividends received deductions, and computation of pro-ration adjustments. Provisions of the Tax Act with broader application include reductions or elimination of deductions for certain items, e.g., reductions to corporate dividends received deductions, disallowance of entertainment expenses, and limitations on the deduction of certain executive compensation costs. These provisions, generally, will result in an increase in AIG’s taxable income in the years beginning after December 31, 2017.
Consistent with current income tax accounting requirements, we have remeasured our deferred tax assets and liabilities with reference to the statutory income tax rate of 21 percent and taking into consideration other provisions of the Tax Act. As of December 31, 2017, we had not fully completed our accounting for the tax effects of the Tax Act. Our provision for income taxes for the period ended December 31, 2017, is based in part on a reasonable estimate of the effects on existing deferred tax balances and of certain provisions of the Tax Act. To the extent a reasonable estimate of the impact of certain provisions was determinable, we recorded provisional estimates as a component of our provision for income taxes on continuing operations. To the extent a reasonable estimate of the impact of certain provisions was not determinable, we have not recorded any adjustments and have continued accounting for them in accordance with ASC 740 on the basis of the tax laws in effect before enactment of the Tax Act. Please refer to Note 23 to the Consolidated Financial Statements for further information about these provisions.
The Tax Act includes provisions for Global Intangible Low-Taxed Income (GILTI) under which taxes on foreign income are imposed on the excess of a deemed return on tangible assets of certain foreign subsidiaries and for Base Erosion and Anti-Abuse Tax (BEAT) under which taxes are imposed on certain base eroding payments to affiliated foreign companies. Consistent with accounting guidance, we will treat BEAT as an in period tax charge when incurred in future periods for which no deferred taxes need to be provided and have made an accounting policy election to treat GILTI taxes in a similar manner. Accordingly, no provision for income taxes related to GILTI or BEAT was recorded as of December 31, 2017.
In our assessment of the realizability of our deferred tax assets, we made certain assumptions related to the impact of the Tax Act on our future taxable income. Generally, the Tax Act provisions result in an increase in our taxable income and, thus, accelerate utilization of our tax attribute deferred tax asset. Accordingly, we do not currently anticipate that our reliance on provisional estimates would have a material impact on our determination of the realizability of our deferred tax assets.
As a result of the Tax Act, the majority of accumulated foreign earnings that were previously untaxed will become subject to a one-time deemed repatriation tax. Going forward, foreign earnings not taxed as part of the one-time deemed repatriation (or otherwise taxed currently under the GILTI or subpart F regimes) will generally be exempt from U.S. tax upon repatriation. Notwithstanding the changes, U.S. tax on foreign exchange gain or loss and certain non-U.S. withholding taxes will continue to be applicable upon future repatriations of foreign earnings. For the year ended December 31, 2017, we consider our foreign earnings with respect to certain operations in Canada, South Africa, the Far East, Latin America, Bermuda as well as the European, Asia Pacific and Middle East regions to be indefinitely reinvested. These earnings relate to ongoing operations and have been reinvested in active business operations. Deferred taxes have been provided on earnings of non-U.S. affiliates whose earnings are not indefinitely reinvested.
Impact to Effective Tax Rate on Future Consolidated Results of Operations
- $69 million associated with the effect of foreign operations, and
- $184 million of reclassifications from accumulated other comprehensive income to income from continuing operations related to the disposal of available for sale securities, and
- $116 million related to the impact of an agreement reached with the Internal Revenue Service (IRS) related to certain tax issues under audit, and
General Insurance consists of two operating segments: North America and International. Life and Retirement consists of four operating segments: Group Retirement, Individual Retirement, Life Insurance and Institutional Markets. Other Operations consists of businesses and items not allocated to our other businesses, which are primarily AIG Parent, Blackboard, Fuji Life, which was sold on April 30, 2017, and United Guaranty, which was sold on December 31, 2016. Our Legacy Portfolio consists of our Legacy General Insurance Run-Off Lines, Legacy Life and Retirement Run-Off Lines and Legacy Investments. Effective in 2018, our newly formed Bermuda domiciled composite reinsurer, DSA Re. will be part of our Legacy Portfolio.
We modified the presentation of our segment results in 2017 to reflect our new operating structure and prior periods’ presentation has been revised to conform to our new structure.
Reinsurance Optimization: Strategically partner with reinsurers to reduce exposure to losses arising from frequency of large catastrophic events and the severity from individual risk losses. We will optimize our reinsurance program to manage volatility and protect the balance sheet from tail events and unpredictable net losses in support of our profitable growth objectives.
Operating in a highly competitive industry, General Insurance competes against several hundred companies, specialty insurance organizations, mutual companies and other underwriting organizations in the U.S. In international markets, we compete for business with the foreign insurance operations of large global insurance groups and local companies in specific market areas and product types. Insurance companies compete through a combination of risk acceptance criteria, product pricing, service and terms and conditions. General Insurance seeks to distinguish itself in the insurance industry primarily based on its well-established brand, global franchise, multinational capabilities, financial and capital strength, innovative products, claims expertise to handle complex claims, expertise in providing specialized coverages and customer service.
• long-tail Commercial Lines exposures that create added challenges to pricing and risk management;
Commercial Lines continues to face challenging market conditions, with excess capacity negatively impacting the rate environment and suppressing margins. However, we continue to achieve positive rate increases across a number of lines and sub-segments as a result of our disciplined underwriting strategy and focus on risk selection. We continue to observe higher loss cost trends in Casualty, in particular Excess Casualty. We anticipate a positive impact on market pricing for Property following recent catastrophe activity, and observed progressive rate improvements throughout the fourth quarter of 2017. The more profitable segments of Commercial Lines remain highly competitive; however, we continue to achieve growth in several of our high margin businesses.
The following table presents General Insurance net premiums written by operating segment, showing change on both reported and constant dollar basis:
(b) Natural and man-made catastrophe losses are generally weather or seismic events having a net impact on AIG in excess of $10 million each and also include certain man-made events, such as terrorism and civil disorders that meet the $10 million threshold.
(d) Severe losses are defined as non-catastrophe individual first party losses, surety losses and trade credit losses greater than $10 million, net of related reinsurance and salvage and subrogation.
The adjusted pre-tax loss decreased in 2017 primarily due to significantly lower unfavorable prior year loss reserve development. This decrease in adjusted pre-tax loss was partially offset by higher severe losses and higher catastrophe losses due to hurricanes Harvey, Irma and Maria, and the California wildfires during the second half of 2017. Net premiums written decreased primarily due to continued underwriting actions to strengthen our portfolio and increased rate pressure.
The increase in net investment income was driven by higher income on alternative investments and gains on securities where we elected the fair value option partially offset by lower interest and dividends due to lower invested assets resulting from the first quarter 2017 funding of the adverse development reinsurance agreement with NICO.
• higher net investment income reflecting higher income on alternative investments and gains on securities where we elected the fair value option partially offset by lower interest and dividends due to lower invested assets resulting from the first quarter 2017 funding of the adverse development reinsurance agreement with NICO.
• higher catastrophe losses primarily driven by hurricanes Harvey, Irma and Maria and the California wildfires.
Adjusted pre-tax loss in 2016 compared to adjusted pre-tax income in 2015 was primarily due to:
• lower acquisition expenses primarily due to reduced production and the ceding commissions related to the reinsurance arrangement with Swiss Re Group; and
• the growth of PCG business within Personal Lines and travel insurance within Accident and Health;
• recognition of ceded return premiums on our excess of loss reinsurance covers; and
• the effect of the reinsurance arrangement with the Swiss Re Group partially offset by the effect of the reinsurance agreement with United Guaranty; and
The decrease in the loss ratio was primarily due to lower prior year unfavorable development. Prior year reserve development is net of the losses ceded under the NICO reinsurance agreement as well as the amortization of the related deferred gain.
The increase in the combined ratio reflected an increase in the loss ratio slightly offset by a decrease in the expense ratio.
The decrease in the expense ratio reflected lower acquisition expense ratio driven primarily by higher commission income from the reinsurance agreement with Swiss Re Group.
The adjusted pre-tax loss in 2017 resulted primarily from higher unfavorable prior year loss reserve development and higher catastrophe losses mainly driven by hurricanes Maria, Harvey and Irma. These were partially offset by lower general operating expenses driven by lower employee-related expenses and other expense reduction initiatives. Net premiums written decreased primarily due to the sale of our interest in Ascot Underwriting Holdings Limited and Ascot Employees Corporate Member Limited (Ascot) and certain of our insurance operations to Fairfax, and lower production in Japan.
Adjusted pre-tax loss in 2017 compared to adjusted pre-tax income in 2016 was primarily due to:
Adjusted pre-tax income increased due to lower general operating expenses primarily due to lower employee-related expenses and other expense reduction initiatives, as well as lower acquisition costs reflecting strategic actions to refocus direct marketing activities.
• lower production in our Japan business reflecting our focus on profitability combined with a competitive market environment.
• a lower acquisition ratio driven by the sale of our interest in the Ascot business.
The decrease in the combined ratio reflected a lower expense ratio partially offset by an increase in the loss ratio.
• a higher current accident year loss ratio, as adjusted, in Europe Casualty and Property driven by an increase in loss estimates as a result of 2016 year-end detailed reserve valuation reviews partially offset by severe losses; and
Variable Annuities: Products include variable annuities that offer a combination of growth potential, death benefit features and income protection features. Variable annuities are distributed primarily through banks, wirehouses, and regional and independent broker-dealers.
Fixed Annuities: Products include single premium fixed annuities, immediate annuities and deferred income annuities. The Fixed Annuities product line maintains its industry-leading position in the U.S. bank distribution channel by designing products collaboratively with banks and offering an efficient and flexible administration platform.
Life Insurance: In the U.S., products primarily include term life and universal life insurance. International operations include the distribution of life and health products in the UK and Ireland. Life products in the U.S. are primarily distributed through independent marketing organizations, independent insurance agents, financial advisors and direct marketing.
• investments to upgrade our technology and underwriting processes challenge our management of general operating expenses.
Increasing life expectancy and reduced expectations for traditional retirement income from defined benefit programs and fixed income securities are leading Americans to seek additional financial security as they approach retirement. The strong demand for individual variable and fixed index annuities with guaranteed income features has attracted increased competition in this product space. In response to the continued low interest rate environment, which has added pressure to profit margins, we have developed guaranteed income benefits for both variable and fixed index annuities with margins that are less sensitive to the level of interest rates.
Individual Retirement provides products and services that are subject to the requirements of the DOL Fiduciary Rule.
Group Retirement competes in the defined contribution market under the VALIC brand. VALIC is a leading retirement plan provider in the U.S. for K-12 schools and school districts, higher education, healthcare, government and other not-for-profit institutions. The defined contribution market is a highly efficient and competitive market that requires support for both plan sponsors and individual participants. To meet this challenge, VALIC is investing in a client-focused technology platform to support improved compliance and self-service functionality. VALIC’s service model pairs self-service tools with its career financial advisors who provide individual plan participants with enrollment support and comprehensive financial planning services.
Group Retirement provides products and services that are subject to the requirements of the DOL Fiduciary Rule.
Consumers have a significant need for life insurance, whether it is used for income replacement for their surviving family, estate planning or wealth transfer. Additionally, consumers use life insurance to provide living benefits in case of chronic, critical or terminal illnesses, as well as to supplement retirement income.
In response to consumer needs and a sustained low interest rate environment, our Life Insurance product portfolio has been evolving. We will continue to place a strong focus on indexed universal life products and de-emphasize products with long-duration interest rate guarantees.
Changes in interest rate environment can have significant impact on investment returns and net investment spread, as well as reduce the tax efficiency associated with institutional life insurance products, dampening organic growth opportunities. Tax reform may lead to new opportunities in the stable value wrap market.
For additional information on the impact of the DOL Fiduciary Rule on our Individual Retirement and Group Retirement businesses see Executive Summary - AIG’s Outlook - Industry and Economic Factors - Department of Labor Fiduciary Rule and Related Regulatory Developments.
For the amount of adjustments recorded to reflect such assumption updates by product line and financial statement line item and for related discussion of the assumption changes that resulted in these adjustments see Insurance Reserves - Life and Annuity Reserves and DAC - Update of Actuarial Assumptions.
Fixed Annuities base net investment spread decreased slightly in 2017 compared to 2016 and 2015, primarily due to lower reinvestment yields partially mitigated by disciplined pricing and active crediting rate management.
• net investment income, which included higher gains on securities for which the fair value option was elected and higher returns on alternative investments, partially offset by a reduction in the overall size of the hedge fund portfolio;
• higher base net investment spread primarily in Variable and Index Annuities driven by growth in invested assets, and disciplined pricing and active crediting rate management; and
• higher policy fees due to growth in annuity account values driven by improved equity market performance.
• lower net positive adjustment from the review and update of actuarial assumptions which was $242 million in 2017 compared to $369 million in 2016;
• increases in reserves primarily due to additional reserves for guaranteed benefits in 2017 compared to a reduction in 2016;
• the sale of AIG Advisor Group in May 2016, which drove the decreases in advisory fee income, advisory expenses and general operating expenses, and resulted in a net $13 million decrease in adjusted pre-tax income.
• a higher net positive adjustment from the review and update of actuarial assumptions, which was $369 million in 2016 compared to $92 million in 2015;
For Individual Retirement, premiums primarily represent amounts received on life-contingent payout annuities. Premiums decreased in 2017 compared to 2016, primarily due to strong annuity sales in 2016 driven by higher equity market volatility, which made immediate annuities more attractive to customers seeking less volatile returns. Premiums increased in 2016 compared to 2015, primarily due to higher rates in the first half of 2016.
Individual Retirement annuities are typically subject to a four- to seven-year surrender charge period, depending on the product. For Variable and Index Annuities, the proportion of reserves subject to surrender charges at December 31, 2017 has decreased compared to December 31, 2016 due to normal aging of the business and slower sales, which were due in part to uncertainty around the implementation of the DOL Fiduciary Rule. The increase in reserves with no surrender charge contributed to the increase in the surrender rate for variable and index annuities in 2017 compared to 2016.
• Retail Mutual Funds had negative net flows compared to positive net flows in 2016, reflecting lower deposits and higher withdrawals due to negative industry trends in U.S. equity actively managed funds and uncertainty surrounding the DOL Fiduciary Rule.
• Fixed Annuities deposits increased primarily due to higher sales in the bank and broker-dealer distribution channels as a result of customers favoring the safety of fixed annuities in response to equity market volatility. Net flows were negative, but improved compared to 2015 due to higher sales.
Group Retirement premiums remained flat and premiums and deposits decreased slightly in 2017 compared to 2016 and increased in 2016 compared to 2015. Net flows in 2017 declined and continued to be negative primarily due to higher surrenders reflecting continued pressure from the consolidation of healthcare providers and other employers in our target markets. Net flows in 2016 showed significant improvement compared to 2015 primarily due to lower surrenders as well as record sales, resulting in part from investment in talent, group plan administration record-keeping capabilities and digital functionality. Higher deposits from group acquisitions in 2017 and 2016 partially mitigated the negative impact of surrenders to net flows and of lower index annuity sales in 2017.
Low base net investment yields continued to pressure investment spreads, partially mitigated by crediting rate management. In 2017, net investment income included higher gains on securities for which the fair value option was elected and higher returns from alternative investments, partially offset by a reduction in the overall size of the hedge fund portfolio. In 2016 and 2015, net investment income included the impact of volatility from alternative investments, fair value option assets and commercial mortgage loan prepayments. Adjusted pre-tax income also included adjustments in each year to update actuarial assumptions, which were net positive adjustments in 2017 and 2015 compared to a net negative adjustment in 2016.
• higher policy fees and advisory fees, net of expenses, due to growth in account values driven by improved equity market performance; and
• lower general operating expenses primarily due to reduced legal expenses, partially offset by higher spending for implementation of the DOL Fiduciary Rule.
• lower policy fees primarily due to a decrease in separate account assets driven by negative net flows.
(b) Group Retirement amounts in this category include reserves of approximately $6.3 billion, at both December 31, 2017 and 2016, which are subject to 20 percent annual withdrawal limitations.
Group Retirement annuities are typically subject to a five- to seven-year surrender charge period, depending on the product. The increase in the amount and proportion of Group Retirement annuity reserves that have no surrender charge at December 31, 2017 compared to December 31, 2016 was primarily due to normal aging of this book of business, withdrawal limitations on certain plan assets and lower than expected surrenders of older contracts with higher minimum interest rates on fixed account balances that have continued to be attractive to the contract holders in the low interest rate environment.
Net flows improved significantly due to both record deposits and improved surrender activity, which included group plan surrenders of approximately $631 million in 2016 compared to $1.5 billion in 2015. The group plan market has been impacted by the consolidation of healthcare providers and other employers in target markets, but group plan acquisitions improved, due in part to investments in talent, group plan administration record-keeping capabilities and digital functionality.
Individual life premiums and deposits in 2017 reflected higher universal life deposits and term life premiums compared to 2016. Life Insurance is focused on selling profitable new products through strategic channels to enhance future returns. General operating expenses decreased in 2017 compared to the prior year, primarily due to the strategic decision to refocus the group benefits business. Adjusted pre-tax income also included adjustments in each year to update actuarial assumptions, which was a net positive adjustment in 2017 compared to net negative adjustments in 2016 and 2015.
• a net positive adjustment from the review and update of actuarial assumptions, which was $29 million in 2017 compared to a $92 million net negative adjustment in 2016;
• lower commissions and general operating expenses primarily due to the strategic decision to refocus the group benefits business, partially offset by the allocation of reinsurance risk charges from Life Insurance Reinsurance Transactions. In addition, lower general operating expenses in 2017 reflected the impact of new business reinsurance;
• reserve increases in individual life, and individual and group benefits products;
• higher international general operating expenses, due in part to the acquisition in March 2015 of Laya Healthcare, an Irish healthcare distributor and administrator; and
Premiums and deposits, excluding the effect of foreign exchange, grew by seven percent in 2017 compared to 2016, and increased by five percent in 2016 compared to 2015, primarily due to assumed premiums related to business distributed by Laya Healthcare and growth in international life and health. Premiums and deposits in 2017 also reflected growth in universal life and term life business, partially offset by lower group benefits premiums.
Premiums and deposits increased in 2017 compared to 2016 primarily driven by higher pension risk transfer business, partially offset by lower structured settlement sales. In 2016, premiums and deposits increased compared to 2015 primarily due to higher GIC deposits, partially offset by lower pension risk transfer business.
Parent and Other adjusted pre-tax loss decreased as a result of gains on securities where we elected the fair value option, partially offset by higher general operating expenses related to one time payments for recent executive leadership changes.
Fuji Life adjusted pre-tax results increased primarily as a result of increases in underwriting income as a result of new products launched during 2016 as well as growth within existing product lines. Fuji Life was sold on April 30, 2017.
United Guaranty adjusted pre-tax income decreased primarily as a result of the 50 percent quota share reinsurance agreement between United Guaranty and our subsidiaries for business originated from 2014 to 2016.
Fuji Life adjusted pre-tax income increased primarily as a result of increases in underwriting and net investment income. The increase in underwriting income was primarily as a result of new products launched during 2016. Net investment income increased primarily as a result of increased investment in bonds.
Legacy Investments - include investment classes that we have placed into run-off.
• lower Legacy General Insurance adjusted pre-tax loss due to lower unfavorable prior year development in 2016 compared to 2015; and
• During 2017, we reduced our hedge fund portfolio by approximately $2.4 billion as a result of redemptions consistent with our planned reduction of exposure. Our hedge fund portfolio experienced above average returns in 2017 due to higher equity market performance.
• While more of a focus is placed on asset-liability management in Life and Retirement companies, our fundamental strategy across all of our investment portfolios is to optimize the duration characteristics of the assets within a target range based on comparable liability characteristics, to the extent practicable.
• AIG Parent, included in Other Operations, actively manages its assets and liabilities in terms of products, counterparties and duration. AIG Parent’s liquidity sources are held primarily in the form of cash, short-term investments and publicly traded, investment-grade rated fixed maturity securities. Based upon an assessment of its immediate and longer-term funding needs, AIG Parent purchases publicly traded, investment-grade rated fixed maturity securities that can be readily monetized through sales or repurchase agreements. These securities allow us to diversify sources of liquidity while reducing the cost of maintaining sufficient liquidity.
The General Insurance companies invest primarily in fixed maturity securities issued by corporations, municipalities and other governmental agencies and also invest in structured securities collateralized by, among other assets, residential and commercial real estate and commercial mortgage loans. While invested assets backing reserves of the General Insurance companies are primarily invested in conventional fixed maturity securities, we have continued to allocate a portion of our investment activity into asset classes that offer higher yields, particularly in the domestic operations. In addition, we continue to invest in both fixed rate and floating rate asset-backed investments for their risk-return attributes, as well as to manage our exposure to potential changes in interest rates. This asset diversification has maintained stable average yields while the overall credit ratings of our fixed maturity securities were largely unchanged. We expect to continue to pursue this investment strategy to meet the General Insurance companies’ liquidity, duration and credit quality objectives as well as current risk-return and tax objectives.
In addition, the General Insurance companies seek to enhance returns through selective investments in a diversified portfolio of alternative investments. Although these alternative investments are subject to periodic earnings fluctuations, they have historically achieved yields in excess of the fixed maturity portfolio yields and have provided added diversification to the broader portfolio.
Fixed maturity securities held in the General Insurance companies’ foreign operations are of high quality, primarily rated A or higher based on composite ratings, with an average duration of 3.6 years.
In addition, the Life and Retirement companies seek to enhance returns through investments in a diversified portfolio of alternative investments. Although these alternative investments are subject to periodic earnings fluctuations, they have historically achieved yields in excess of the fixed maturity portfolio yields. While a diversified portfolio of alternative investments remains a fundamental
Fixed maturity securities of the Life and Retirement companies domestic operations, with an average duration of 7.3 years, are comprised primarily of taxable corporate bonds, as well as taxable municipal and government bonds, and agency and non-agency structured securities. The majority of these investments are held in the available for sale portfolio and are rated investment grade based on its composite ratings.
Fixed maturity securities held in the Life and Retirement companies foreign operations are of high quality, primarily rated A or higher based on composite ratings, with an average duration of 21.1 years.
For a full description of the composite AIG credit ratings see Investments - Credit Ratings.
The following table presents the fixed maturity security portfolio of U.S. Insurance Companies categorized by composite AIG credit rating, at fair value:
Moody’s Investors’ Service Inc. (Moody’s), Standard & Poor’s Financial Services LLC, a subsidiary of S&P Global Inc. (S&P), or similar foreign rating services rate a significant portion of our foreign entities’ fixed maturity securities portfolio. Rating services are not available for some foreign-issued securities. Our Credit Risk Management department closely reviews the credit quality of the foreign portfolio’s non-rated fixed maturity securities. At December 31, 2017, approximately 22 percent of such investments were either rated AAA or, on the basis of our internal analysis, were equivalent from a credit standpoint to securities rated AAA, and approximately 8 percent were below investment grade or not rated. Approximately 36 percent of the foreign entities’ fixed maturity securities portfolio is comprised of sovereign fixed maturity securities supporting policy liabilities in the country of issuance.
* At December 31, 2017 and 2016, the fair value of bonds available for sale held by us that were below investment grade or not rated totaled $31.5 billion and $33.6 billion, respectively.
At December 31, 2017, the U.S. municipal bond portfolio was composed primarily of essential service revenue bonds and high-quality tax-exempt bonds with over 92 percent of the portfolio rated A or higher.
* At both December 31, 2017 and December 31, 2016, approximately 91 percent of these investments were rated investment grade.
(b) The weighted average expected life was six years at both December 31, 2017 and December 31, 2016.
(a) Impairments include $360 million related to investments in our life settlements portfolio that were sold in 2017.
(b) Impairments include $35 million related to other assets that were sold during the three-month period ended June 30, 2017.
Impairments on life settlements in 2017 were mainly attributable to write-downs of the policies to the purchase price as agreed in the sale of the remainder of the life settlements portfolio.
We recorded other-than-temporary impairment charges in the years ended December 31, 2017, 2016 and 2015 related to:
• securities that we intend to sell or for which it is more likely than not that we will be required to sell;
Variable annuity embedded derivatives, net of related hedge losses were primarily a result of the non-performance or “own credit” risk adjustment used in the valuation of the variable annuities with guaranteed minimum withdrawal benefits (GMWB) embedded derivative impacted by interest rates and equity market performance in 2017 and changes in actuarial assumptions in our variable annuity program, both of which are not hedged as part of our economic hedging program.
Net realized capital losses in 2016 were primarily related to foreign exchange losses, derivative losses, and impairments, which were higher than the gain recognized on the sale of a portion of our PICC Investment. Foreign exchange gains (losses) were primarily due to $910 million of remeasurement losses in 2016 for a short term intercompany balance that was matched with available for sale investments in fixed maturity securities denominated in the same foreign currencies. Unrealized gains and losses on the available for sale investments were recorded in other comprehensive income resulting in an immaterial impact on our overall equity or book value per share from this arrangement.
* Includes loss reserve discount of $1.8 billion and $3.6 billion for the years ended December 31, 2017, and 2016, respectively. For discussion of loss reserve discount see Note 13 to the Consolidated Financial Statements.
* Includes the amortization attributed to the deferred gain at inception from the NICO adverse development reinsurance agreement of $228 million in the year ended December 31, 2017. Consistent with our definition of APTI, the year ended December 31, 2017 excludes the portion of unfavorable prior year reserve development for which we have ceded the risk under the NICO reinsurance agreements of $359 million, and related changes in amortization of the deferred gain of $56 million.
During 2017, we recognized unfavorable prior year loss reserve development of $978 million. This unfavorable development was primarily a result of the following:
• In addition, we also observed higher than expected losses in our Europe Property and Special Risks business driven by unexpected development on various large claims across the property, aviation, marine, and trade credit segments.
For further details of prior year development by line of business, see Note 13 to the Consolidated Financial Statements. For a discussion of actuarial methods employed for major classes of business, see also Critical Accounting Estimates.
The following tables summarize incurred (favorable) unfavorable prior year development net of reinsurance, by segment and major lines of business, and by accident year groupings:
For accident year 2016, the unfavorable development of $820 million was spread across multiple segments, with the drivers being U.S. Excess Casualty, U.S. Financial Lines, Europe Casualty and Financial Lines, and Europe Property and Special Risks. As noted above, we have seen unexpected loss severity in these portfolios at this early stage of development.
For accident years 2015 and prior, the unfavorable development of $158 million was primarily driven by Europe Casualty and Financial Lines. For North America, development was favorable, primarily reflecting the benefit of the prior year development ceded to NICO and the amortization on the adverse development reinsurance agreement.
In 2017, we entered into an adverse development reinsurance agreement with NICO, a subsidiary of Berkshire Hathaway Inc., under which we transferred to NICO 80 percent of the reserve risk on substantially all of our U.S. Commercial long-tail exposures for accident years 2015 and prior. Under this agreement, we ceded to NICO 80 percent of the losses on subject business paid on or after January 1, 2016 in excess of $25 billion of net paid losses, up to an aggregate limit of $25 billion. At NICO’s 80 percent share, NICO’s limit of liability under the contract is $20 billion. The covered losses ceded to NICO were $13.1 billion and the unexpired limit was $6.9 billion at December 31, 2017. We account for this transaction as retroactive reinsurance. We paid total consideration, including interest, of $10.2 billion. The consideration was placed into a collateral trust account as security for NICO’s claim payment obligations, and Berkshire Hathaway Inc. has provided a parental guarantee to secure the obligations of NICO under the agreement. This transaction resulted in a gain, which under U.S. GAAP retroactive reinsurance accounting is deferred and amortized into income over the settlement period.
The table below shows the calculation of the deferred gain on the adverse development reinsurance agreement at inception and as of December 31, 2017, showing the effect of discounting of loss reserves and amortization of the deferred gain.
(a) For the period from inception to December 31, 2017, the accretion of discount and a reduction in effective interest rates was offset by changes in estimates of the amount and timing of future recoveries under the Adverse Development Reinsurance Agreement.
(b) Represents amortization of the deferred gain recognized in APTI and under U.S. GAAP.
The following section provides discussion of life and annuity reserves and deferred policy acquisition costs.
The Life and Retirement companies review and update estimated gross profit projections used to amortize DAC and related items for investment-oriented products at least annually. Estimated gross profit projections include assumptions for investment-related returns and spreads, product-related fees and expenses, mortality gains and losses, policyholder behavior and other factors. In estimating future gross profits, lapse assumptions require judgment and can have a material impact on DAC amortization. If the assumptions used for estimated gross profits change significantly, DAC and related reserves (which may include VOBA, SIA, guaranteed benefit reserves and unearned revenue reserves) are recalculated using the new projections, and any resulting adjustment is included in income. Updating such projections may result in acceleration of amortization in some products and deceleration of amortization in other products.
The Life and Retirement companies also review assumptions related to the valuation of variable annuity GMWB living benefits which are accounted for as embedded derivatives and measured at fair value. The fair value of these embedded derivatives is based on actuarial assumptions, including policyholder behavior, as well as capital market assumptions.
• we reduced our separate account long-term asset growth rate assumption related to equity market performance by 50 basis points to 7.0 percent and increased our reversion to the mean rates (gross of fees) to 3.74 percent for the Variable Annuity product line in Individual Retirement and 3.78 percent for the Variable Annuity product line in Group Retirement; and
The following table presents the increase (decrease) in adjusted pre-tax income resulting from the update of actuarial assumptions for the domestic life and retirement companies, by segment and product line:
The following table presents the increase (decrease) in pre-tax income resulting from the update of actuarial assumptions in the domestic life and retirement companies, by line item as reported in Results of Operations:
In 2015, adjusted pre-tax income included a net negative adjustment of $6 million, primarily driven by a net negative adjustment of $118 million in Life Insurance, which was offset in large part by net positive adjustments of $92 million in Fixed Annuities and $48 million in Group Retirement.
The update of actuarial assumptions resulted in net positive adjustments to adjusted pre-tax income of Individual Retirement of $242 million, $369 million and $92 million in 2017, 2016 and 2015, respectively.
In 2015, there were offsetting updates to assumed investment fees, modeled expenses, and terminations, resulting in no net adjustment to adjusted pre-tax income in Variable and Index Annuities.
In Group Retirement, the update of estimated gross profit assumptions resulted in a net positive adjustment of $13 million in 2017, primarily due to an increase in the reversion to the mean rate used for projecting future estimated gross profit for variable annuity products and changes in maintenance expense assumptions. The net positive adjustment was partially offset by a decrease in the separate account long-term asset growth rate assumption from 7.5 percent to 7.0 percent (before expenses that reduce the asset base from which future fees are projected) and decreases in fixed annuity spread and separate account fee assumptions. In 2016, a net negative adjustment of $47 million was primarily due to refinements in lapse and partial withdrawal assumptions and a decrease in the separate account long-term asset growth rate assumption from 8.5 percent to 7.5 percent (before expenses that reduce the asset base from which future fees are projected). In 2015, a net positive adjustment of $48 million was primarily due to revisions to mortality and lapse assumptions, partially offset by decreased spread assumptions.
Our Individual Retirement and Group Retirement businesses offer variable annuity products with GMWB riders that provide guaranteed living benefit features. The liabilities for GMWB are accounted for as embedded derivatives measured at fair value. The fair value of the embedded derivatives may fluctuate significantly based on market interest rates, equity prices, credit spreads, market volatility, policyholder behavior and other factors.
For additional discussion of market risk management related to these product features see Enterprise Risk Management - Insurance Risks - Life and Retirement Companies Key Risks - Variable Annuity Risk Management and Hedging Programs.
• The economic hedge target uses best estimate actuarial assumptions and excludes explicit risk margins used for U.S. GAAP valuation, such as margins for policyholder behavior, mortality, and volatility; and
Change in fair value of embedded derivatives excluding update of actuarial assumptions
Fair value gains or losses in the hedging portfolio are typically not fully offset by increases or decreases in liabilities on a U.S. GAAP basis, due to the NPA and other risk margins used for U.S. GAAP valuation that cause the embedded derivatives to be less sensitive to changes in market rates than the hedge portfolio. On an economic basis, the changes in the fair value of the hedge portfolio were partially offset by the decrease in the economic hedge target, as discussed below.
The decrease in the economic hedge target liability in 2017 was primarily due to positive equity markets, partially offset by tighter credit spreads and lower equity volatility. The increase in the economic hedge target liability in 2016 was primarily due to the update of actuarial assumptions offset by reductions from positive equity markets and increases in interest rates, particularly in the fourth quarter of 2016.
• Changes in the fair value of fixed maturity securities, primarily corporate bonds for which the fair value option has been elected, are used as a capital-efficient way to economically hedge interest rate and credit spread-related risk. In 2017, the change in the fair value of the corporate bond hedging program reflected gains primarily due to tightening of credit spreads. The net gains in 2016 reflected the impact of credit spreads tightening and decreases in market interest rates in the first nine months of 2016, partially offset by an increase in rates in the fourth quarter of 2016. The net losses in 2015 reflected increases in market interest rates in the first six months of 2015 and credit spreads widening. The change in the fair value of the hedging bonds, which is excluded from the adjusted pre-tax income of the Individual Retirement and Group Retirement segments, is reported in net investment income on the Consolidated Statements of Income (Loss).
• Changes in the fair value of interest rate derivative contracts, which included swaps, swaptions and futures, resulted in a small net loss in 2017, which reflected increases in rates in the latter half of 2017, partially offset by the impact of interest rate declines in the first half of 2017. The net losses in 2016 reflected increases in rates in the fourth quarter of 2016, which more than offset the impact of interest rate declines in the first nine months of 2016. The net gains in 2015 reflected decreases in market interest rates in the latter half of 2015, partially offset by the impact of increases in rates in the first half of 2015.
* DAC balance excluding the amount related to unrealized depreciation (appreciation) of investments was $8.9 billion, $8.4 billion and $7.7 billion at December 31, 2017, 2016 and 2015, respectively.
In 2016, the long-term annual asset growth assumption was updated from 8.5 percent to 7.5 percent. The five-year reversion to the mean period has not met the criteria for adjustment in 2016 and 2015.
DAC and Reserves for universal life and investment-type products (collectively, investment-oriented products) are adjusted at each balance sheet date to reflect the change in DAC, unearned revenue, and benefit reserves with an offset to Other comprehensive income as if securities available for sale had been sold at their stated aggregate fair value and the proceeds reinvested at current yields (shadow Investment-Oriented Adjustments). Shadow Investment-Oriented Adjustments to DAC and unearned revenue generally move in the opposite direction of the change in unrealized appreciation of the available for sale securities portfolio, reducing the reported DAC and unearned revenue balance when market interest rates decline. Conversely, shadow Investment-Oriented Adjustments to benefit reserves generally move in the same direction as the change in unrealized appreciation of the available for sale securities portfolio, increasing reported future policy benefit liabilities balance when market interest rates decline. Market interest rates decreased in 2017. As a result, the unrealized appreciation of fixed maturity securities held in the Life and Retirement companies that support the businesses at December 31, 2017 increased by $3.4 billion compared to December 31, 2016, which resulted in a decrease in DAC and unearned revenues and an increase in future policy benefit liabilities to reflect the shadow Investment-Oriented Adjustments.
Similarly, for long-duration traditional products, significant unrealized appreciation of investments in a sustained low interest rate environment may cause additional future policy benefit liabilities (shadow loss reserves) with an offset to Other comprehensive income to be recorded. At December 31, 2017, future policy benefit liabilities increased to reflect additional shadow loss reserves.
During 2017, AIG Parent received $1.9 billion in dividends from subsidiaries. Of this amount, $350 million was dividends in the form of cash and fixed maturity securities from our General Insurance companies, $1.5 billion was dividends and loan repayments in the form of cash and fixed maturity securities from our Life and Retirement companies and $2 million was cash dividends from AIG Federal Savings Bank.
In June 2017, we issued €1.0 billion aggregate principal amount ($1.1 billion at closing) of 1.875% Notes Due 2027.
On September 25, 2017, we redeemed $420 million aggregate principal amount of our outstanding 4.90% Callable Notes Due September 25, 2045.
We also made other repurchases of and repayments on debt instruments of approximately $3.1 billion during 2017. AIG Parent made interest payments on our debt instruments totaling $948 million during 2017.
The following table presents a summary of AIG’s Consolidated Statement of Cash Flows:
Net cash provided by investing activities in 2017 was $14.7 billion compared to investing cash inflows of $4.7 billion in 2016, which included $2.8 billion of net cash proceeds from the sales of United Guaranty, Ascot and AIG Advisor Group. Net cash provided by investing activities for 2015 included $4.2 billion of net cash proceeds from the sale of ordinary shares of AerCap. Net cash provided by investing activities in 2017 primarily included sales of certain investments to fund the adverse development reinsurance agreement entered into with NICO.
• approximately $309 million to repurchase approximately 17 million warrants to purchase shares of AIG Common Stock; and
• approximately $1.9 billion in net inflows from the issuance and repayment of long-term debt.
(c) For additional information relating to this syndicated credit facility see Credit Facilities below.
Our General Insurance companies may require additional funding to meet capital or liquidity needs under certain circumstances. Large catastrophes may require us to provide additional support to our affected operations. Downgrades in our credit ratings could put pressure on the insurer financial strength ratings of our subsidiaries, which could result in non-renewals or cancellations by policyholders and adversely affect the subsidiary’s ability to meet its own obligations. Increases in market interest rates may adversely affect the financial strength ratings of our subsidiaries, as rating agency capital models may reduce the amount of available capital relative to required capital. Other potential events that could cause a liquidity strain include an economic collapse of a nation or region significant to our operations, nationalization, catastrophic terrorist acts, pandemics or other events causing economic or political upheaval.
Certain of our U.S. insurance companies are members of the Federal Home Loan Banks (FHLBs) in their respective districts. Borrowings from the FHLBs are used to supplement liquidity or for other uses deemed appropriate by management. Our U.S. General Insurance companies had outstanding borrowings from the FHLBs in an aggregate amount of approximately $190 million and $733 million at December 31, 2017 and December 31, 2016, respectively. The outstanding borrowings are being used primarily for interest rate risk management purposes in connection with certain reinsurance arrangements, and the related balances are expected to decline as underlying premiums are collected. Our U.S. Life and Retirement companies had no outstanding borrowings in the form of cash advances from the FHLBs at December 31, 2017, and aggregate borrowings in the form of cash advances of approximately $2 million at December 31, 2016. In addition, $606 million and $429 million were due to the FHLB of Dallas at December 31, 2017 and December 31, 2016, respectively, under funding agreements issued by our Institutional Markets business, which were reported in Policyholder contract deposits.
AIG Parent and/or certain subsidiaries are parties to several letter of credit agreements with various financial institutions. These financial institutions issue letters of credit from time to time to certain of our General Insurance companies for insurance regulatory and reinsurance collateral purposes or for capital support, and the total outstanding amount of issued letters of credit for these purposes was approximately $3.1 billion at year end 2017. Letters of credit issued in support of the Life and Retirement companies totaled approximately $900 million at year end 2017.
In 2017, our General Insurance companies paid approximately $350 million in dividends in the form of cash and fixed maturity securities to AIG Parent. The fixed maturity securities primarily included U.S. government and government-sponsored entity securities, U.S. agency mortgage-backed securities, corporate and municipal bonds and certain other highly rated securities.
(b) Does not reflect obligations in connection with the agreement to purchase Validus Holdings, Ltd., which was entered into on January 21, 2018 and is expected to close mid-2018 subject to obtaining the relevant regulatory approvals and other customary closing conditions. For further discussion of the purchase of Validus Holdings, Ltd. see Note 26 to the Consolidated Financial Statements. Also does not reflect unrecognized tax benefits of $4.7 billion. See Note 23 to the Consolidated Financial Statements for additional information.
(e) Includes a senior unsecured revolving credit facility between AerCap Ireland Capital Designated Activity Company (formerly AerCap Ireland Capital Limited), as borrower, and AIG Parent, as lender (the AerCap Credit Facility). The AerCap Credit Facility permits loans for general corporate purposes. In December 2017, the aggregate commitment under the AerCap Credit Facility was reduced to $200 million from $500 million and the termination date of the facility was extended to October 2019 from May 2019. At December 31, 2017, no amounts were outstanding under the AerCap Credit Facility.
(f) Excludes commitments with respect to pension plans. The annual pension contribution for 2018 is expected to be approximately $64 million for U.S. and non-U.S. plans.
If the settlement agreements in principle are concluded in our ongoing dispute related to the disallowance of foreign tax credits associated with cross border financing transactions, we will be required to make a payment to the U.S. Treasury. Although we can provide no assurance regarding whether the non-binding settlements will be finalized, the amount we currently expect to pay based on current proposed settlement terms is approximately $1.3 billion. This amount is net of payments previously made with respect to cross border financing transactions involving matters dating back to 1997 and other matters largely related to the same tax years. There remains uncertainty with regard to whether the settlements in principle will ultimately be approved by the relevant authorities as well as the amount and timing of any potential payments, which are not likely to be made before sometime in 2019.
(d) At December 31, 2017, includes debt of consolidated investment vehicles related to real estate investments of $2.5 billion, affordable housing partnership investments of $1.8 billion and other securitization vehicles of $1.7 billion. At December 31, 2016, includes debt of consolidated investment vehicles related to real estate investments of $1.9 billion, affordable housing partnership investments of $1.7 billion and other securitization vehicles of $771 million.
The following table summarizes maturing debt at December 31, 2017 of AIG (excluding $6.0 billion of borrowings of consolidated investments) for the next four quarters:
Credit ratings estimate a company’s ability to meet its obligations and may directly affect the cost and availability of financing to that company. The following table presents the credit ratings of AIG and certain of its subsidiaries as of February 8, 2018. Figures in parentheses indicate the relative ranking of the ratings within the agency’s rating categories; that ranking refers only to the major rating category and not to the modifiers assigned by the rating agencies.
Financial Strength ratings estimate an insurance company’s ability to pay its obligations under an insurance policy. The following table presents the ratings of our significant insurance subsidiaries as of February 8, 2018.
Our Board of Directors has authorized the repurchase of shares of AIG Common Stock and warrants to purchase shares of AIG Common Stock through a series of actions. On May 3, 2017, our Board of Directors approved an additional increase of $2.5 billion to the share repurchase authorization. As of February 8, 2018, approximately $2.3 billion remained under the authorization. Shares may be repurchased from time to time in the open market, private purchases, through forward, derivative, accelerated repurchase or automatic repurchase transactions or otherwise (including through the purchase of warrants). Certain of our share repurchases have been and may from time to time be effected through Exchange Act Rule 10b5-1 repurchase plans. The timing of any future share repurchases will depend on market conditions, our business and strategic plans, financial condition, results of operations, liquidity and other factors.
Payments of dividends to AIG by its insurance subsidiaries are subject to certain restrictions imposed by regulatory authorities.
Risk management includes the identification and measurement of various forms of risk, the establishment of risk thresholds and the creation of processes intended to maintain risks within these thresholds while optimizing returns. We consider risk management an integral part of managing our core businesses and a key element of our approach to corporate governance.
Financial Risk Group (FRG): The FRG is responsible for the oversight of financial risks taken by AIG and our subsidiaries. Its mandate includes overseeing our aggregate credit, market, interest rate, capital, liquidity and model risks, as well as asset-liability management, derivatives activity, and foreign exchange transactions. It provides the primary corporate-level review function for all proposed transactions and business practices that are significant in size, complex in scope, or that present heightened legal, reputational, accounting or regulatory risks. The FRG is chaired by our CRO. Membership of the FRG also includes our CFO, Chief Investment Officer (CIO) and Treasurer.
Technology, Operational Risk & Control Committee (TORCC): This committee oversees technology and operational risk management and control issues and activities across our businesses, functions, and geographic locations. The TORCC reviews our risk management practices and monitors current and emerging technology and operational risks, as well as management actions taken to reduce such risks to acceptable levels within our risk appetite. It primarily focuses on establishing the firm-wide framework for identifying, assessing, measuring, managing and monitoring technology and operational risks. The TORCC addresses firm-wide, rather than business-specific issues and is mandated to prioritize technology and operational improvements that are significant and transformational. The TORCC also provides a forum for senior management to assess our business technology and operational risk profiles that may affect our strategic objectives.
The TORCC is an authorized sub-committee of our GRC and supports the GRC in its risk management oversight role. The TORCC is co-chaired by our CRO and our CIO. Membership of the TORCC also includes Owners of the Control Agenda (OCA), Business Information Officers, and members of the various control and assurance functions.
Business Unit Risk Committees: Each of our major insurance businesses has established a risk committee that serves as the senior management committee responsible for risk oversight at the individual business unit level. The risk committees are responsible for the identification, assessment and monitoring of all sources of risk within their respective portfolios. Specific responsibilities include setting risk tolerances, reviewing the capital allocation framework, insurance portfolio optimization, and providing oversight of risk-adjusted metrics. In addition, each business unit has established subordinate committees at the legal entity level and has working groups in place that support these committees in executing their duties, such as ensuring policies are adhered to, and transactions are completed with risk appetite in mind. Together, these committees provide comprehensive risk oversight throughout the organization.
Our Risk Appetite Framework integrates stakeholder interests, strategic business goals and available financial resources. We balance these by seeking to take measured risks that are expected to generate repeatable, sustainable earnings and create long-term value for our shareholders. The framework includes our risk appetite statement 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.
We articulate our aggregate risk-taking by setting risk tolerances and thresholds on capital and liquidity measures. These measures are set at the AIG Parent level as well as the legal entity level and cover consolidated and insurance company capital and liquidity ratios. We must comply with standards for capital adequacy and maintain sufficient liquidity to meet all our obligations as they come due in accordance with our internal capital management and liquidity policies. Our risk tolerances take into consideration regulatory requirements, rating agency expectations, and business needs. The GRC routinely reviews the level of risk taken by the consolidated organization in relation to the established risk tolerances. A consolidated risk report is also presented periodically, as required, to the RCC by our CRO.
• Establishing risk monitoring, providing early warning indicators, and ensuring timely oversight and enforceability of limits;
One tool we use to inform our Risk Appetite Framework is risk identification. We conduct risk identification through a number of processes at the business unit and corporate level focused on capturing our material risks and key areas of focus for follow-up risk management actions. A key initiative is our integrated bottom-up risk identification and assessment process down to the product-line level. These processes are used as a critical input to enhance and develop our analytics for measuring and assessing risks across the organization.
The internal capital framework quantifies our aggregate economic risk at a given confidence interval, after taking into account a level of diversification benefits between risk factors and business lines. We leverage the internal capital framework to help inform our consolidated risk consumption and profile as well as risk and capital allocation for our businesses.
The stress testing framework measures risk over multiple time horizons and under different levels of stress. We develop a range of stress scenarios based on both internal experience and regulatory guidance. The stress tests are intended to ensure that sufficient resources are available under both idiosyncratic and systemic market stress conditions.
• approving delegated credit authorities to our credit executives and qualified credit professionals;
• approving appropriate credit reserves, credit-related other-than-temporary impairments and corresponding methodologies for all credit portfolios.
We are exposed to changes in equity market prices affecting a variety of instruments. Changes in equity prices can affect the valuation of publicly traded equity shares, investments in private equity, hedge funds and mutual funds, exchange-traded funds, and other equity-linked capital market instruments as well as equity-linked insurance products, including but not limited to index annuities, variable annuities, indexed universal life insurance and variable universal life insurance.
Credit spreads measure an instrument’s risk premium or yield relative to that of a comparable duration, default-free instrument. Changes in credit spreads can affect the valuation of fixed maturity securities, including but not limited to corporate bonds, ABS, mortgage-backed securities, AIG-issued debt obligations, credit derivatives and derivative credit valuation adjustments. Much like higher interest rates, wider credit spreads with unchanged default losses mean more investment income in the long term. In the short term, quickly rising spreads will cause a loss in the value of existing fixed maturity securities, which is largely reported in Other comprehensive income. A precipitous widening of credit spreads may also signal a fundamental weakness in the credit worthiness of bond obligors, potentially resulting in default losses.
Market risk is overseen at the corporate level within ERM through the CMRO, who reports directly to the CRO. The CMRO is supported by a dedicated team of professionals within ERM. Market Risk is managed by our finance, treasury and investment management corporate functions, collectively, and in partnership with ERM. The CMRO is primarily responsible for the development and maintenance of a risk management framework that includes the following key components:
• These components facilitate the CMRO’s identification, measurement, monitoring, reporting and management of our market risks.
Our market risk measurement framework was developed with the main objective of communicating the range and scale of our market risk exposures. At the firm-wide level market risk is measured in a manner that is consistent with AIG’s risk appetite statement. This is designed to ensure that we remain within our stated risk tolerance levels and can determine how much additional market risk taking capacity is available within our framework. Our risk appetite is currently defined in terms of capital and liquidity levels. At the market risk level, the framework measures our overall exposure to each systemic market risk change on an economic basis.
The sensitivity analysis is an estimate and should not be viewed as predictive of our future financial performance. We cannot ensure that our actual losses in any particular period will not exceed the amounts indicated above.
We use duration and convexity metrics to measure price sensitivity to interest rate changes for interest rate sensitive assets excluding derivatives and long-term debt. Duration measures the relative sensitivity of the fair value of a financial instrument to changes in interest rates. Convexity measures the rate of change of duration with respect to changes in interest rates.
We evaluate our interest rate risk without the effect of any correlation among other key market risks or other assumptions used for calculating the fair value of our financial liabilities and embedded derivatives. This scenario does not measure changes in value resulting from non-parallel shifts in the yield curve, which could produce different results.
The sensitivity factors utilized for 2017 and presented above were selected based on historical data from 1997 to 2017, as follows (see the table below):
Additional funding may be required as the result of a trigger event. Event funding risk comes in many forms and may result from a downgrade in credit ratings, a market event, or some other event that creates a funding obligation or limits existing funding options.
We may be unable to raise additional cash on a secured or unsecured basis due to unfavorable market conditions, AIG-specific issues, or any other issue that impedes access to additional funding.
We use a number of approaches to measure our liquidity risk exposure, including:
Minimum Liquidity Limits specify the amount of assets required to be maintained in specific liquidity portfolios to meet obligations as they arise over a specified time horizon under stressed liquidity conditions.
Operational risk is defined as the risk of loss, or other adverse consequences, resulting from inadequate or failed internal processes, people, systems, or from external events. Operational risk includes legal, regulatory, and compliance risks, and excludes business and strategy risks.
Our operational risk governance sets the requirements necessary to embed a risk management culture throughout the organization. AIG and its consolidated subsidiaries establish and maintain operational risk and controls governance forums that include representatives from the relevant business units and corporate functions to appropriately manage significant operational risk exposures. At an enterprise level, the TORCC oversees operational risk. The TORCC addresses firm-wide rather than business-specific issues and is mandated to prioritize technology and operational improvements that are significant and transformational.
The ORM function within ERM oversees the operational risk policy and integrated risk and control framework, which includes risk identification, assessment, measurement, management and monitoring of operational risk exposures. ORM supports the TORCC and has responsibility to provide an aggregate view of our operational risk profile. As part of the framework, we employ a Three Lines of Defense model whereby the first line consists of business units and corporate functions that own and manage AIG risks, the second line consists of ERM and other control functions and serves as an independent advisor to the first line and has risk oversight
• Key Risk Indicators - enhances the ongoing monitoring and mitigation of operational risks and facilitate risk reporting.
ORM, working together with other control and assurance functions (e.g., Compliance, Financial Controls Unit / Sarbanes Oxley, Global Business Continuity, and Internal Audit) through the integrated risk and control framework, provides an independent view of operational risks for each business, and works with the business unit CRO and business unit OCA to facilitate implementation of the above programs. This includes coverage of operational risks related to core insurance activities, investing, model risk, technology (including cyber security, identify and access management, data privacy and data security), third-party providers, as well as compliance and regulatory matters. Based on the results of the risk identification and assessment efforts above, business leaders are accountable for tracking and remediating identified issues in line with our risk-monitoring procedures. Governance committees support these efforts and promote transparency enabling improved management decision making.
• promote role clarity among the business and risk and control functions;
• proactively address potential risk issues and assign clear ownership and accountability for risk treatment; and
• manage the development of technology solutions that support the objectives above.
Insurance risk is defined as risk arising from the uncertainty around the actual experience and/or policyholder behavior being materially different than expected at the inception of an insurance contract. These uncertainties include the amount and timing of cash flows from premiums, commissions, expenses, claims and claim settlement expenses paid or received under a contract.
• review and challenge of reserves to ensure comprehensive analysis with established escalation procedures to provide appropriate transparency in reserving decisions and judgments made in the establishment of reserves.
• General Insurance companies - risks covered include property, casualty, fidelity/surety, accident and health, aviation, and management liability. We manage risks in the General Insurance business through aggregations and limitations of concentrations at multiple levels: policy, line of business, geography, industry and legal entity.
Insurance risks are monitored at the business unit level within ERM and overseen by the business unit chief risk officer, who reports directly to our CRO. The framework includes the following key components:
• a limit framework focused on key insurance risks that aligns with our Board-approved risk appetite statement; and
We use a number of approaches to measure our insurance risk exposure, including:
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 the traditional reinsurance and capital markets in addition to other reinsurance protections.
Also, the modeled results are based on the assumption that all reinsurers fulfill their obligations to us under the terms of the reinsurance arrangements and all catastrophe bonds attach and pay as modeled. 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. Therefore, these estimates are inherently uncertain and may not accurately reflect our exposure to these events.
Additional multi-year coverages purchased in prior years provide additional coverage at various points of the program, including $125 million that is part of $500 million excess of $4.5 billion coverage from the catastrophe bond reinsurance contract we entered into with Tradewynd Re Ltd. in 2014.
In addition, we continue to purchase specific covers to protect against catastrophic events in Japan and have also purchased protection against severe losses for other international locations on a global basis.
For additional information see also Item 1A. Risk Factors - Reserves and Exposures.
We actively monitor terrorism risk and manage exposures to losses from terrorist attacks. We have set risk limits based on modeled losses from certain terrorism attack scenarios. Terrorism risks are modeled using a third-party vendor model for various terrorism attack modes and scenarios. Adjustments are made to account for vendor model gaps and the nature of the General Insurance companies’ exposures. Examples of modeled scenarios are conventional bombs of different sizes, anthrax attacks and nuclear attacks.
Our largest terrorism exposures are in New York City, and estimated losses are largely driven by the Property and Workers’ Compensation lines of business. At our largest exposure location, modeled losses for a five-ton bomb attack net of the Terrorism Risk Insurance Program (TRIP) and reinsurance recoveries are estimated to be $2.4 billion as of September 30, 2017.
Our exposure to terrorism risk in the U.S. is mitigated by TRIP in addition to limited private reinsurance protections. TRIP covers terrorist attacks within the United States or U.S. missions and against certain U.S. carriers or vessels and excludes certain lines of business as specified by applicable law. In 2018, TRIP covers 82 percent of insured losses above a deductible, decreasing by one percent each year to 80 percent in 2020. The current estimate of our deductible is approximately $2.2 billion for 2017.
• Morbidity risk - represents the risk arising from actual morbidity (i.e,. illness, disability or disease) incidence being higher than expected or the length of the claims extending longer than expected resulting in a higher overall benefit payout. This risk could arise from longer-term medical advances in detection and treatment for various diseases and medical conditions, as well as other factors. This risk exists in certain product lines such as group benefits, health and long-term care businesses.
• Policyholder behavior risk including full and partial surrender/lapse risk - represents the risk that actual policyholder behavior differs from expected behavior in a manner that has an adverse effect on our operating results. There are many related assumptions made when products are sold, including how long the contracts will persist and other assumptions which impact the expected utilization of contract benefits and features. Actual experience can vary significantly from these assumptions. This risk is impacted by a number of factors including changes in market conditions, especially changes in the levels of interest rate and equity markets, tax law, regulations, competitive landscape and policyholder preferences. This risk exists in the majority of our product lines.
Our hedging program utilizes an economic hedge target, which represents our estimate of the underlying economic risks in our GMWB riders, based on the present value of the future expected benefit payments for the GMWB, less the present value of future rider fees, over numerous stochastic scenarios. This stochastic projection method uses best estimate assumptions for policyholder behavior (including mortality, lapses, withdrawals and benefit utilization) in conjunction with market scenarios calibrated to observable equity and interest rate option prices. Policyholder behaviors are regularly evaluated to compare current assumptions to actual experience and, if appropriate, changes are made to the policyholder behavior assumptions. The risk of changes in policyholder behavior is not explicitly hedged and such differences between expected and actual policyholder behaviors will result in hedge ineffectiveness.
The hedging programs are monitored on a daily basis to ensure that the economic hedge target and derivative portfolio are within the threshold limits, pursuant to the approved hedge strategy. Daily risk monitoring verifies that the net risk exposures, as measured through sensitivities to a large set of market shocks, are within the approved net risk exposure threshold limits. In addition, monthly stress tests are performed to determine the program’s effectiveness relative to the applicable limits, under an array of combined severe market stresses in equity prices, interest rates, volatility and credit spreads. Finally, hedge strategies are reviewed regularly to gauge their effectiveness in managing our market exposures in the context of our overall risk appetite.
Reinsurance is used primarily to manage overall capital adequacy and mitigate the insurance loss (Life and Non-Life) exposure related to certain events such as natural and man-made catastrophes or death events. Our subsidiaries operate worldwide primarily by underwriting and accepting risks for their direct account on a gross basis and reinsuring a portion of the exposure on either an individual risk or an aggregate basis to the extent those risks exceed the desired retention level. In addition, as a condition of certain direct underwriting transactions, we may be required by clients, agents or regulation to cede all or a portion of risks to specified reinsurance entities, such as captives, other insurers, local reinsurers and compulsory pools.
• Traditional local and global reinsurance markets including those in the United States, Bermuda, London and Europe, accessed directly and through reinsurance intermediaries;
• Capital markets through insurance-linked securities and collateralized reinsurance transactions, such as catastrophe bonds, sidecars and similar vehicles; and
• proportional reinsurance, whereby we cede a specified percentage of premiums and losses to reinsurers;
• Life and Annuity reinsurance recoverables (ceded policy and claim reserves).
At December 31, 2017, total reinsurance recoverable assets were $33.0 billion. These assets include general reinsurance paid losses recoverable of $1.4 billion, ceded loss reserves of $26.9 billion including reserves for incurred but not reported (IBNR) claims, and ceded reserves for unearned premiums of $3.1 billion, as well as life reinsurance recoverable of $1.6 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, 2017 reflects a reasonable estimate of the ultimate losses recoverable. Actual losses may, however, differ from the reserves currently ceded.
(a) The financial strength ratings reflect the ratings of the various reinsurance subsidiaries of the companies listed as of February 8, 2018.
(b) Total reinsurance assets include both Property Casualty and Life and Retirement reinsurance recoverable.
At December 31, 2017, we had no significant reinsurance recoverable due from any individual reinsurer that was financially troubled. Reinsurer capital levels continued to increase in 2017, thereby increasing the industry’s underwriting capacity, which resulted in continued competition and lower rates for 2018 renewals. Reduced profitability associated with lower rates could potentially result in reduced capacity or rating downgrades for some reinsurers. The RCD, in conjunction with the credit executives within ERM, reviews these developments, monitors compliance with credit triggers that may require the reinsurer to post collateral, and seeks to use other appropriate means to mitigate any material risks arising from these developments.
The fair value of our interest rate, currency, credit, commodity and equity swaps, options, swaptions, and forward commitments, futures, and forward contracts reported as a component of Other assets, was approximately $0.9 billion at December 31, 2017 and $1.8 billion at December 31, 2016. Where applicable, these amounts have been determined in accordance with the respective master netting agreements.
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 VOBA and DAC. Acquisition costs vary with sales and include, but are not limited to, commissions, premium taxes, direct marketing costs and certain costs of personnel engaged in sales support activities such as underwriting.
Adjusted revenues exclude Net realized capital gains (losses), income from non-operating litigation settlements (included in Other income for GAAP purposes) and changes in fair value of securities used to hedge guaranteed living benefits (included in Net investment income for GAAP purposes).
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.
Return on equity - Adjusted after-tax income excluding AOCI and DTA (Adjusted Return on Equity) is a non-GAAP measure and is used to show the rate of return on shareholders’ equity. Adjusted Return on Equity is derived by dividing actual or annualized adjusted after-tax income attributable to AIG by average Adjusted Shareholders’ Equity.
Salvage The amount that can be recovered by an insurer for the sale of damaged goods for which a policyholder has been indemnified (and to which title was transferred).
Solvency II Legislation in the European Union which reforms the insurance industry’s solvency framework, including minimum capital and solvency requirements, governance requirements, risk management and public reporting standards. The Solvency II Directive (2009/138/EEC) was adopted on November 25, 2009 and became effective on January 1, 2016.
VOBA Value of Business Acquired Present value of projected future gross profits from in-force policies of acquired businesses.
Summary of Investments - Other than Investments in Related Parties at December 31, 2017
Condensed Financial Information of Registrant at December 31, 2017 and 2016 and for the years ended December 31, 2017, 2016 and 2015
We have audited the accompanying consolidated balance sheets of American International Group, Inc. and its subsidiaries as of December 31, 2017 and 2016, and the related consolidated statements of income, comprehensive income (loss), equity, and cash flows for each of the three years in the period ended December 31, 2017, including the related notes and financial statement schedules listed in the accompanying index (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
Other invested assets (portion measured at fair value: 2017 - $6,248; 2016 - $6,946)
(portion measured at fair value: 2017 - $922; 2016 - $1,809)
Other policyholder funds (portion measured at fair value: 2017 - $0; 2016 - $5)
American International Group, Inc. (AIG) is a leading global insurance organization serving customers in more than 80 countries and jurisdictions. AIG companies serve commercial and individual customers through one of the most extensive worldwide property-casualty networks of any insurer. In addition, AIG companies are leading providers of life insurance and retirement services in the United States. AIG Common Stock, par value $2.50 per share (AIG Common Stock), is listed on the New York Stock Exchange (NYSE: AIG) and the Tokyo Stock Exchange. Unless the context indicates otherwise, the terms “AIG,” “we,” “us” or “our” mean American International Group, Inc. and its consolidated subsidiaries and the term “AIG Parent” means American International Group, Inc. and not any of its consolidated subsidiaries.
On December 31, 2016, we sold our 100 percent interest in United Guaranty Corporation (United Guaranty) and certain related affiliates to Arch Capital Group Ltd. (Arch) for total consideration of $3.3 billion, consisting of $2.2 billion of cash and approximately $1.1 billion of newly issued Arch convertible non-voting common-equivalent preferred stock and reported a pre-tax gain of approximately $697 million. We also received $261 million in pre-closing dividends from United Guaranty in the fourth quarter of 2016. However, due to pending regulatory approvals, United Guaranty Asia was not included in the December 31, 2016 closing and $40 million of cash consideration was retained by Arch. The sale of United Guaranty Asia was completed on July 1, 2017 and we received the $40 million cash proceeds.
On September 16, 2016, we entered into an agreement to sell our 20 percent interest in Ascot Underwriting Holdings Ltd. and our 100 percent interest in the related syndicate-funding subsidiary Ascot Corporate Name Ltd. to Canada Pension Plan Investment Board (CPPIB). Total consideration for the transaction was $1.1 billion resulting in a pre-tax gain of approximately $162 million attributable to AIG’s controlling interest, inclusive of CPPIB’s recapitalization of Syndicate 1414’s Funds at Lloyd’s (FAL) capital requirements. The transaction closed on November 18, 2016, and we received approximately $244 million in net cash proceeds.
• estimated gross profits to value deferred policy acquisition costs for investment-oriented products;
and changes in loss reserves and income tax liabilities. Had these adjustments, which were determined not to be material, been recorded in their appropriate periods, Net income attributable to AIG for the year ended December 31, 2014 would have decreased by $51 million.
Reinsurance premiums ceded under prospective reinsurance agreements are recognized as a reduction in revenues over the period the reinsurance coverage is provided in proportion to the risks to which the premiums relate.
· Changes in the fair value of derivatives at AIG Financial Products Corp. and related subsidiaries (collectively AIGFP).
Separate accounts represent funds for which investment income and investment gains and losses accrue directly to the policyholders who bear the investment risk. Each account has specific investment objectives and the assets are carried at fair value. The assets of each account are legally segregated and are not subject to claims that arise from any of our other businesses. The liabilities for these accounts are equal to the account assets. Separate accounts may also include deposits for funds held under stable value wrap funding agreements, although the majority of stable value wrap sales are measured based on the notional amount included in assets under management and do not include the receipt of funds. For a more detailed discussion of separate accounts see Note 14 herein.
Other liabilities consist of other funds on deposit, other payables, securities sold under agreements to repurchase, securities sold but not yet purchased, derivative liabilities and deferred gains on retroactive reinsurance agreements. We have entered into certain insurance and reinsurance contracts, primarily in our General Insurance companies, that do not contain sufficient insurance risk to be accounted for as insurance or reinsurance. Accordingly, the premiums received on such contracts, after deduction for certain related expenses, are recorded as deposits within Other liabilities in the Consolidated Balance Sheets. Net proceeds of these deposits are invested and generate Net investment income. As amounts are paid, consistent with the underlying contracts, the deposit liability is reduced. Also included in Other liabilities are trade payables for the DIB and GCM, which include option premiums received and
In October 2016, the FASB issued an accounting standard that amends the consolidation analysis for a reporting entity that is the single decision maker of a variable interest entity (VIE). The new guidance will require the decision maker’s evaluation of its interests held through related parties that are under common control on a proportionate basis (rather than in their entirety) when determining whether it is the primary beneficiary of that VIE. The amendment does not change the characteristics of a primary beneficiary.
We adopted the standard on October 1, 2017. The impact of the standard is primarily related to our investments in real estate. As a result of the adoption, we anticipate that future acquisitions of certain real estate investments will no longer meet the definition of a business and will be treated as asset acquisitions. As a result, no goodwill would be recognized from these investments and certain costs can be capitalized as part of asset acquisitions. The adoption of this standard did not have a material effect on our consolidated financial condition, results of operations or cash flows.
In May 2014, the FASB issued an accounting standard that supersedes most existing revenue recognition guidance. The standard excludes from its scope the accounting for insurance contracts, leases, financial instruments, and certain other agreements that are governed under other GAAP guidance, but could affect the revenue recognition for certain of our other activities.
We will adopt this standard using the modified retrospective approach on its required effective date of January 1, 2018. Our analysis of revenues indicates that substantially all of our revenues are from sources excluded from the scope of the standard. For those revenue sources within the scope of the standard, there are no material changes in the timing or measurement of revenues based upon the guidance. As substantially all of our revenue sources are excluded from the scope of the standard, the adoption of the standard will not have a material effect on our reported consolidated financial condition, results of operations, cash flows or required disclosures.
We will adopt this standard on its effective date of January 1, 2018 using the modified retrospective approach. Based on our review, substantially all of our assets and liabilities are not within the scope of the standard. The adoption of the standard will not have a material effect on our reported consolidated financial condition, results of operations, cash flows or required disclosures.
In February 2016, the FASB issued an accounting standard that will require lessees with lease terms of more than 12 months to recognize a right of use asset and a corresponding lease liability on their balance sheets. For income statement purposes, the FASB retained a dual model, requiring leases to be classified as either operating leases or finance leases.
The standard is effective on January 1, 2020, with early adoption permitted on January 1, 2019. We are continuing to develop our implementation plan to adopt the standard and are assessing the impact of the standard on our reported consolidated financial condition, results of operations, cash flows and required disclosures. While we expect an increase in our allowances for credit losses for the financial instruments within scope of the standard, given the objective of the new standard, the amount of any change will be dependent on our portfolios’ composition and quality at the adoption date as well as economic conditions and forecasts at that time.
In October 2016, the FASB issued an accounting standard that will require an entity to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs, rather than when the asset is sold to a third party.
We will adopt the standard on its effective date of January 1, 2018 using a modified retrospective approach. The adoption of this standard will not have a material impact on our reported consolidated financial condition, results of operations, cash flows or required disclosures.
In November 2016, the FASB issued an accounting standard that provides guidance on the presentation of restricted cash in the Statement of Cash Flows. Entities will be required to explain the changes during a reporting period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents in the statement of cash flows.
Improving the Presentation of Net Periodic Pension and Postretirement Benefit Cost
In March 2017, the FASB issued an accounting standard that requires entities to report the service cost component of net periodic pension and postretirement benefit costs in the same line item as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net periodic benefit costs are required to be separately presented in the income statement. The amendments also allow only the service cost component to be eligible for capitalization when applicable.
We will adopt this standard on its effective date of January 1, 2018. The standard primarily addresses the presentation of the service cost component of net periodic benefit costs in the income statement. AIG’s U.S. pension plans are frozen and no longer accrue benefits, which are reflected as service costs. Therefore, the standard will have no material effect on our reported consolidated financial condition, results of operations, cash flows or required disclosures.
The standard is effective on January 1, 2019, with early adoption permitted. We are evaluating the timing of adoption and are assessing the impact of the standard on our reported consolidated financial condition, results of operations, cash flows and required disclosures.
· Commercial Insurance business included our Liability and Financial Lines and Property and Special Risks operating segments;
· Consumer Insurance business included our Individual Retirement, Group Retirement, Life Insurance and Personal Insurance operating segments
· Other Operations category consisted of businesses and items not allocated to our operating segments, including Institutional Markets, United Guaranty and Fuji Life.
· Legacy Portfolio segment consisted of Legacy Insurance Lines representing exited or discontinued product lines, policy forms or distribution channels.
· North America - consists of insurance businesses in the United States, Canada and Bermuda.
· International - consists of insurance businesses in Japan, United Kingdom, Europe, Asia Pacific, Latin America, Puerto Rico, Australia, the Middle East and Africa.
Results are presented before internal reinsurance transactions. North America and International operating segments consist of the following products:
· Institutional Markets - consists of stable value wrap products, structured settlement and pension risk transfer annuities, corporate- and bank-owned life insurance and guaranteed investment contracts (GICs).
· Fuji Life - consists of term insurance, life insurance, endowment policies and annuities. The sale of this business was completed on April 30, 2017.
· Legacy General Insurance Run-Off Lines - consists of asbestos and environmental exposures and other exposures within certain Property and Casualty profit centers no longer actively marketed, including excess workers’ compensation, environmental impairment liability, public entity liability, accident & health, physicians and surgeons professional liability, and various other workers’ compensation and general liability exposures.
· Legacy Life and Retirement Run-Off Lines - include whole life, long-term care and exited accident & health product lines. Also includes certain structured settlement, pension risk transfer annuities and single premium immediate annuities written prior to April 2012.
· Legacy Investments - include investment classes that we have placed into run-off.
We evaluate segment performance based on adjusted revenues and adjusted pre-tax income (loss). Adjusted revenues and adjusted pre-tax income (loss) are derived by excluding certain items from total revenues and net income (loss) attributable to AIG, respectively. For the items excluded from adjusted revenues and adjusted pre-tax income (loss) see the table below.
On November 14, 2016, we entered into an agreement to sell Fuji Life to FWD Group, the insurance arm of Pacific Century Group. Total cash consideration to us was approximately $333 million. The sale resulted in a pre-tax loss of $591 milli ☐ n. The sale of Fuji Life was completed on April 30, 2017.
ITEM 8 | Notes to Consolidated Financial Statements | 5. Fair Value Measurements
• 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.
Whenever available, we obtain quoted prices in active markets for identical assets at the balance sheet date to measure fixed maturity securities at fair value. Market price data is generally obtained from dealer markets.
For certain OTC derivatives that trade in less liquid markets, where we generally do not have corroborating market evidence to support significant model inputs and cannot verify the model to market transactions, the transaction price may provide the best estimate of fair value. Accordingly, when a pricing model is used to value such an instrument, the model is adjusted so the model value at inception equals the transaction price. We will update valuation inputs in these models only when corroborated by evidence such as similar market transactions, independent third-party valuation service providers and/or broker or dealer quotations, or other empirical market data. When appropriate, valuations are adjusted for various factors such as liquidity, bid/offer spreads and credit considerations. Such adjustments are generally based on available market evidence. In the absence of such evidence, management’s best estimate is used.
We value our super senior credit default swap portfolio using prices obtained from vendors and/or counterparties. The valuation of the super senior credit derivatives is complex because of the limited availability of market observable information due to the lack of trading and price transparency in certain structured finance markets. Our valuation methodologies for the super senior CDS 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.
The following table presents information about assets and liabilities measured at fair value on a recurring basis and indicates the level of the fair value measurement based on the observability of the inputs used:
(b) Represents netting of derivative exposures covered by qualifying master netting agreements.
During the years ended December 31, 2017 and 2016, we transferred $0.4 billion and $1.1 billion, respectively, of securities issued by Non-U.S. government entities from Level 1 to Level 2, because they are no longer considered actively traded. For similar reasons, during the years ended December 31, 2017 and 2016, we transferred $113 million and $34 million, respectively, of securities issued by the U.S. government and government-sponsored entities from Level 1 to Level 2. Additionally, we transferred $126 million of preferred stock from Level 1 to Level 2 during the year ended December 31, 2017. We had no material transfers of preferred stock from Level 1 to Level 2 during the year ended December 31, 2016. There were no material transfers from Level 2 to Level 1 during the years ended December 31, 2017 and 2016.
The following table presents the gross components of purchases, sales, issuances and settlements, net, shown above for years ended December 31, 2017 and 2016 related to Level 3 assets and liabilities in the Consolidated Balance Sheet:
(a) There were no issuances during the years ended December 31, 2017 and 2016.
During the years ended December 31, 2017 and 2016, transfers out of Level 3 assets primarily included private placement and other corporate debt, CMBS, RMBS, CDO/ABS and certain investments in municipal securities. Transfers of certain investments in municipal securities, corporate debt, RMBS, CMBS and CDO/ABS out of Level 3 assets were based on consideration of market liquidity as well as related transparency of pricing and associated observable inputs for these investments. Transfers of certain investments in private placement corporate debt and certain ABS out of Level 3 assets were primarily the result of using observable pricing information that reflects the fair value of those securities without the need for adjustment based on our own assumptions regarding the characteristics of a specific security or the current liquidity in the market.
The table below presents information about the significant unobservable inputs used for recurring fair value measurements for certain Level 3 instruments, and includes only those instruments for which information about the inputs is reasonably available to us, such as data from independent third-party valuation service providers and from internal valuation models. Because input information from third-parties with respect to certain Level 3 instruments (primarily CDO/ABS) may not be reasonably available to us, balances shown below may not equal total amounts reported for such Level 3 assets and liabilities:
(c) Mortality inputs are shown as multipliers of the 2012 Individual Annuity Mortality Basic table.
The ranges of reported inputs for Obligations of states, municipalities and political subdivisions, Corporate debt, RMBS, CDO/ABS, and CMBS valued using a discounted cash flow technique consist of one standard deviation in either direction from the value-weighted average. The preceding table does not give effect to our risk management practices that might offset risks inherent in these Level 3 assets and liabilities.
• Mortality rate assumptions, which vary by age and gender, are based on company experience and include a mortality improvement assumption. Increases in assumed mortality rates will decrease the fair value of the liability, while lower mortality rate assumptions will generally increase the fair value of the liability, because guaranteed payments will be made for a longer period of time.
Securities of companies that are in default, under bankruptcy protection, or troubled
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 category, which is included in Other income. Interest expense on liabilities measured under the fair value option is reported in Other Income in the Consolidated Statements of Income.
During 2017, 2016 and 2015, we recognized gains of $4 million and $22 million, and loss of $4 million, respectively, attributable to the observable effect of changes in credit spreads on our own liabilities for which the fair value option was elected. We calculate the effect of these credit spread changes using discounted cash flow techniques that incorporate current market interest rates, our observable credit spreads on these liabilities and other factors that mitigate the risk of nonperformance such as cash collateral posted.
For additional information about how we test various asset classes for impairment see Notes 6 and 7 herein.
The following table presents assets measured at fair value on a non-recurring basis at the time of impairment and the related impairment charges recorded during the periods presented:
* Impairments include $35 million related to other assets that were sold in 2017.
• Other invested assets: The majority of Other invested assets that are not measured at fair value in 2016 represent investments in life settlements. The fair value of investments in life settlements is determined using a discounted cash flow methodology that incorporates the best available market assumptions for longevity as well as market yields based on reported transactions. Due to the individual life nature of each investment in life settlements and the illiquidity of the existing market, significant inputs to the fair value are unobservable. The majority of the Other invested assets that are not measured at fair value in 2017 represent time deposits with the original maturity at purchase greater than one year. The fair value of long-term time deposits is determined using the expected discounted future cash flow.
• Cash and short-term investments: The carrying amounts 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.
(b) At December 31, 2017 and 2016, bonds available for sale held by us that were below investment grade or not rated totaled $31.5 billion and $33.6 billion, respectively.
The following table summarizes the fair value and gross unrealized losses on our available for sale securities, aggregated by major investment category and length of time that individual securities have been in a continuous unrealized loss position:
At December 31, 2017, we held 7,448 and 74 individual fixed maturity and equity securities, respectively, that were in an unrealized loss position, of which 1,920 individual fixed maturity securities were in a continuous unrealized loss position for 12 months or more. We did not recognize the unrealized losses in earnings on these fixed maturity securities at December 31, 2017 because we neither intend to sell the securities nor do we believe that it is more likely than not that we will be required to sell these securities before recovery of their amortized cost basis. For fixed maturity securities with significant declines, we performed fundamental credit analyses on a security-by-security basis, which included consideration of credit enhancements, expected defaults on underlying collateral, review of relevant industry analyst reports and forecasts and other available market data.
The following table presents the fair value of other securities measured at fair value based on our election of the fair value option:
(a) At December 31, 2017, included hedge funds of $5.8 billion, private equity funds of $5.0 billion, and affordable housing partnerships of $543 million. At December 31, 2016, included hedge funds of $7.2 billion, private equity funds of $5.5 billion, and affordable housing partnerships of $625 million.
(d) Consists of investments in aircraft equipment held in a consolidated trust.
Certain hedge funds, private equity funds, and other investment partnerships for which we have elected the fair value option are reported at fair value with changes in fair value recognized in Net investment income with the exception of investments of AIG’s Other Operations, for which such changes are reported in Other income. Other investments in hedge funds, private equity funds and other investment partnerships in which our insurance operations do not hold aggregate interests sufficient to exercise more than minor influence over the respective partnerships are reported at fair value with changes in fair value recognized as a component of Accumulated other comprehensive income. These investments are subject to other-than-temporary impairment evaluations (see discussion below on evaluating equity investments for other-than-temporary impairment). The gross unrealized loss recorded in Accumulated other comprehensive income on such investments was $45 million and $32 million at December 31, 2017 and 2016, 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.
The following table presents the carrying amount and ownership percentage of equity method investments at December 31, 2017 and 2016:
Also included in Other invested assets are real estate held for investment and investments in aircraft equipment held in a consolidated trust. These investments are reported at cost, less depreciation and are subject to impairment review, as discussed below.
For corporate, municipal and sovereign fixed maturity securities determined to be credit impaired, management considers the fair value as the recoverable value when available information does not indicate that another value is more relevant or reliable. When management identifies information that supports a recoverable value other than the fair value, the determination of a recoverable value considers scenarios specific to the issuer and the security, and may be based upon estimates of outcomes of corporate restructurings, political and macroeconomic factors, stability and financial strength of the issuer, the value of any secondary sources of repayment and the disposition of assets.
* Represents both accretion recognized due to changes in cash flows expected to be collected over the remaining expected term of the credit impaired securities and the accretion due to the passage of time.
The determination that an equity security is other-than-temporarily impaired requires the judgment of management and consideration of the fundamental condition of the issuer, its near-term prospects and all the relevant facts and circumstances. In addition to the above criteria, all equity securities that have been in a continuous decline in value below cost over 12 months are impaired. We also consider circumstances of a rapid and severe market valuation decline (50 percent or more) discount to cost, in which we could not reasonably assert that the impairment period would be temporary (severity losses).
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 mortality assumptions are based on an industry table as supplemented with proprietary data on the older age mortality of U.S. insured lives. Mortality improvement factors are applied to these assumptions based on our view of future mortality improvements likely to apply to the U.S. insured lives population. Our mortality assumptions coupled with the mortality improvement rates are used in our estimate of future net cash flows from the investments in life settlements. We sold the remaining portion of our life settlements portfolio in 2017.
The total carrying value of cash and securities deposited by our insurance subsidiaries under requirements of regulatory authorities or other insurance-related arrangements, including certain annuity-related obligations and certain reinsurance treaties, was $4.9 billion at both December 31, 2017 and 2016.
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 was approximately $2 billion and $2.2 billion at December 31, 2017 and 2016, 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.
Mortgage and other loans receivable include commercial mortgages, residential mortgages, life insurance policy loans, commercial loans, and other loans and notes receivable. Commercial mortgages, residential mortgages, commercial loans, and other loans and notes receivable are carried at unpaid principal balances less allowance for credit losses and plus or minus adjustments for the accretion or amortization of discount or premium. Interest income on such loans is accrued as earned.
* Commercial mortgages primarily represent loans for offices, apartments and retail properties, with exposures in New York and California representing the largest geographic concentrations (aggregating approximately 23 percent and 12 percent, respectively, at December 31, 2017, and 24 percent and 12 percent, respectively, at December 31, 2016).
(a) The debt service coverage ratio compares a property’s net operating income to its debt service payments, including principal and interest. Our weighted average debt service coverage ratio was 2.1X and 1.9X at December 31, 2017 and 2016, respectively.
For the years ended December 31, 2017, 2016 and 2015, reinsurance recoveries, which reduced losses and loss adjustment expenses incurred, amounted to $1.5 billion, $2.1 billion and $4.1 billion, respectively.
$13.1 billion and the unexpired limit was $6.9 billion at December 31, 2017. We paid total consideration, including interest, of $10.2 billion. The consideration was placed into a collateral trust account as security for NICO’s claim payment obligations, and Berkshire has provided a parental guarantee to secure the obligations of NICO under the agreement.
Long-duration reinsurance is effected principally under yearly renewable term treaties. The premiums with respect to these treaties are earned over the contract period in proportion to the protection provided. Amounts recoverable from reinsurers on long-duration contracts are estimated in a manner consistent with the assumptions used for the underlying policy benefits and are presented as a component of Reinsurance assets.
Long-duration reinsurance recoveries, which reduced Policyholder benefits and losses incurred, was approximately $1.0 billion for the years ended December 31, 2017, 2016 and 2015.
The U.S. Life and Retirement companies manage the capital impact of their statutory reserve requirements, including those resulting from the NAIC Model Regulation “Valuation of Life Insurance Policies” (Regulation XXX) and NAIC Actuarial Guideline 38 (Guideline AXXX), through unaffiliated and affiliated reinsurance transactions. Effective July 1, 2016, one of the U.S. Life and Retirement companies entered into an agreement to cede approximately $5 billion of statutory reserves for certain whole life and universal life policies to an unaffiliated reinsurer. Effective December 31, 2016, the same life insurance subsidiary recaptured term and universal life reserves subject to Regulation XXX and Guideline AXXX, previously ceded to an affiliate, and ceded approximately $14 billion of such statutory reserves to an unaffiliated reinsurer under an amendment to the July 1, 2016 agreement. Under GAAP, these unaffiliated reinsurance transactions use deposit accounting with a reinsurance risk charge recorded in income, whereas such affiliated transactions are eliminated in consolidation. Under one affiliated reinsurance arrangement, one of the U.S. Life and Retirement companies obtains letters of credit to support statutory recognition of the ceded reinsurance. As of December 31, 2017, this subsidiary had two bilateral letters of credit totaling $450 million, which were issued on February 7, 2014 and expire on February 7, 2021. The letters of credit are subject to reimbursement by AIG Parent in the event of a drawdown.
Investment-oriented contracts: 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 the estimated lives of the contracts. Estimated gross profits include net investment income and spreads, net realized capital gains and losses, fees, surrender charges, expenses, and mortality gains and losses. In each reporting period, current period amortization expense is adjusted to reflect actual gross profits. If estimated gross profits change significantly, DAC is recalculated using the new assumptions, and any resulting adjustment is included in income. If the new assumptions indicate that future estimated gross profits are higher than previously estimated, DAC will be increased resulting in a decrease in amortization expense and increase in income in the current period; if future estimated gross profits are lower than previously estimated, DAC will be decreased resulting in an increase in amortization expense and decrease in income in the current period. Updating such assumptions may result in acceleration of amortization in some products and deceleration of amortization in other products. DAC is grouped consistent with the manner in which the insurance contracts are acquired, serviced and measured for profitability and is reviewed for recoverability based on the current and projected future profitability of the underlying insurance contracts.
asset growth above or below long-term annual rate assumptions impacts the growth assumption applied to the five-year period subsequent to the current balance sheet date. The reversion to the mean methodology allows us to maintain our long-term growth assumptions, while also giving consideration to the effect of actual investment performance. When actual performance significantly deviates from the annual long-term growth assumption, as evidenced by growth assumptions in the five-year reversion to the mean period falling below a certain rate (floor) or above a certain rate (cap) for a sustained period, judgment may be applied to revise or “unlock” the growth rate assumptions to be used for both the five-year reversion to the mean period as well as the long-term annual growth assumption applied to subsequent periods.
A variable interest entity (VIE) is a legal entity that does not have sufficient equity at risk to finance its activities without additional subordinated financial support or is structured such that equity investors lack the ability to make significant decisions relating to the entity’s operations through voting rights or do not substantively participate in the gains and losses of the entity. Consolidation of a VIE by its primary beneficiary is not based on majority voting interest, but is based on other criteria discussed below.
(c) Comprised primarily of Other liabilities at December 31, 2017 and 2016.
(d) At December 31, 2017 and 2016, off-balance sheet exposure primarily consisting of commitments to real estate and investment entities was $85.8 million and $106 million, respectively.
(e) At December 31, 2017 and 2016, $17.6 billion and $17.3 billion, respectively, of the total assets of consolidated securitization vehicles were owed to AIG Parent or its subsidiaries.
We calculate our maximum exposure to loss to be (i) the amount invested in the debt or equity of the VIE, (ii) the notional amount of VIE assets or liabilities where we have also provided credit protection to the VIE with the VIE as the referenced obligation, and (iii) other commitments and guarantees to the VIE. Interest holders in VIEs sponsored by us generally have recourse only to the assets and cash flows of the VIEs and do not have recourse to us, except in limited circumstances when we have provided a guarantee to the VIE’s interest holders.
Our insurance operations participate as passive investors in the equity issued by certain third-party-managed hedge and private equity funds that are VIEs. Our insurance operations typically are not involved in the design or establishment of these VIEs, nor do they actively participate in the management of the VIEs.
We use derivatives and other financial instruments as part of our financial risk management programs and as part of our investment operations. Interest rate derivatives (such as interest rate swaps) are used to manage interest rate risk associated with embedded derivatives contained in insurance contract liabilities, fixed maturity securities, outstanding medium- and long-term notes as well as other interest rate sensitive assets and liabilities. Foreign exchange derivatives (principally foreign exchange forwards and options) are used to economically mitigate risk associated with non-U.S. dollar denominated debt, net capital exposures, and foreign currency transactions. Equity derivatives are used to mitigate financial risk embedded in certain insurance liabilities. We use credit derivatives to manage our credit exposures. The derivatives are effective economic hedges of the exposures that they are meant to offset. In addition to hedging activities, we also enter into derivative instruments with respect to investment operations, which may include, among other things, CDSs and purchases of investments with embedded derivatives, such as equity-linked notes and convertible bonds.
Derivatives, with the exception of embedded derivatives, are reported at fair value in the Consolidated Balance Sheets in Other assets and Other liabilities. Embedded derivatives are generally presented with the host contract in the Consolidated Balance Sheets. A bifurcated embedded derivative is measured at fair value and accounted for in the same manner as a free standing derivative contract. The corresponding host contract is accounted for according to the accounting guidance applicable for that instrument.
(b) As of December 31, 2017 and 2016, included CDSs on super senior multi-sector CDOs with a net notional amount of $685 million and $801 million (fair value liability of $254 million and $308 million), respectively. The expected weighted average maturity as of December 31, 2017 is six years. Because of long-term maturities of the CDSs in the portfolio, we are unable to make reasonable estimates of the periods during which any payments would be made. However, the net notional amount represents the maximum exposure to loss on the portfolio. As of December 31, 2017 and 2016, there were no super senior corporate debt/CLOs remaining.
We elect to account for our investments in these hybrid securities with embedded written credit derivatives at fair value, with changes in fair value recognized in Net investment income and Other income. Our investments in these hybrid securities are reported as Other bond securities in the Consolidated Balance Sheets. The fair values of these hybrid securities were $4.4 billion and $4.8 billion at December 31, 2017 and 2016, respectively. These securities have par amounts of $9.1 billion and $10.1 billion at December 31, 2017 and 2016, respectively, and have remaining stated maturity dates that extend to 2052.
Our gross loss reserves before reinsurance and discount are net of contractual deductible recoverable amounts due from policyholders of approximately $12.6 billion and $12.8 billion at December 31, 2017 and 2016, respectively. These recoverable amounts are related to certain policies with high deductibles (in excess of high dollar amounts retained by the insured through self-insured retentions, deductibles, retrospective programs, or captive arrangements, each referred to generically as “deductibles”), primarily for U.S. commercial casualty business. With respect to the deductible portion of the claim, we manage and pay the entire claim on behalf of the insured and are reimbursed by the insured for the deductible portion of the claim. Thus, these recoverable amounts represent a credit exposure to us. At December 31, 2017 and 2016, we held collateral of approximately $9.5 billion and $9.7 billion, respectively, for these deductible recoverable amounts, consisting primarily of letters of credit and funded trust agreements.
Liability for unpaid losses and loss adjustment expenses, end of year:
(a) Includes $25 million for 2011 retroactive reinsurance agreement with NICO covering U.S. asbestos exposures for the year ended December 31, 2017.
(b) Includes amounts related to the acquisition of Blackboard U.S. Holdings Inc in 2017.
During 2017, we recognized unfavorable prior year loss reserve development of $1.6 billion. This unfavorable development was primarily a result of the following:
• Unfavorable development in U.S. Casualty lines, driven primarily by increases in underlying severity and greater than expected emerging loss experience in accident year 2016 as well as increased development from claims related to construction defects and construction wrap business (largely from accident years 2006 and prior).
During 2015, we recognized unfavorable prior year loss reserve development of $4.1 billion. This unfavorable development was primarily as a result of the following:
• Higher than expected loss emergence across U.S. Excess Casualty, U.S. Workers’ Compensation, and U.S. Other Casualty lines as well as European Financial Lines.
• Incurred Development method: The Incurred Development method is similar to the Paid Development method, but it uses case incurred losses instead of paid losses. Since this method uses more data (case reserves in addition to paid losses) than the Paid Development method, the incurred development patterns may be less variable than paid development patterns.
• Bornhuetter-Ferguson method: The Bornhuetter-Ferguson method using premiums and paid losses is a combination of the Paid Development method and the Expected Loss Ratio method where the weight given to each method is the reciprocal of the loss development factor. This method normally determines expected loss ratios similar to the method used for the Expected Loss Ratio method. The Bornhuetter-Ferguson method using premiums and incurred losses is similar to the Bornhuetter-Ferguson method using premiums and paid losses except that it uses case-incurred losses.
• Average Loss method: The Average Loss method multiplies a projected number of ultimate claims by an estimated ultimate severity average loss for each accident year to produce ultimate loss estimates. Since projections of the ultimate number of claims are often less variable than projections of ultimate loss, this method can provide more reliable results for reserve categories where loss development patterns are inconsistent or too variable to be relied on exclusively.
• changes in medical cost trends (inflation, intensity and utilization of medical services) and wage inflation trends;
• Table organization: The tables are organized by accident year and include policies written on an occurrence and claims- made basis. We note that for certain categories of claims (e.g., construction defect claims and environmental claims) and for reinsurance recoverable, losses may sometimes be reclassified to an earlier or later accident year as more information about the date of occurrence becomes available to us. These reclassifications are shown as development in the respective years in the tables below. Financial Lines business is primarily written on a claims-made basis, while the majority of the workers’ compensation, excess casualty, other casualty, and run-off property and casualty lines of business are written on an occurrence basis. Primarily, all short-tail lines in Property and Special Risks and Personal Insurance are written on an occurrence basis.
• Groupings: We believe our groupings have homogenous risk characteristics with similar development patterns and would generally be subject to similar trends and reflect our reportable segments. The incurred losses and loss adjustment expenses and paid losses in the following tables for the current reporting year are allocated to the line of business and accident years based on an initial allocation methodology and updated for the final allocation in the subsequent reporting year. The difference between the initial and the final allocation does not have a material impact on the loss tables.
• Foreign exchange: The loss development for operations outside of the U.S. is presented for all accident years using the current exchange rate at December 31, 2017. Although this approach requires restating all prior accident year information, the changes in exchange rates do not impact incurred and paid loss development trends.
- The tables below include lines of business and geographies at a certain aggregated level which may indicate different frequency and severity trends and characteristics, and may not be as meaningful as the claim count information related to the individual products within those lines of business and geographies;
- Reported claim counts are not adjusted for ceded reinsurance, which may distort the measure of frequency or severity.
During 2017, we recognized $31 million of favorable prior year development.
Expected loss ratio methods for business written in excess of a deductible may be given significant weight in the most recent five accident years. In the 2016 analysis, we increased our tail factor estimates for states other than NY and CA for guaranteed cost business in recognition of longer medical development patterns that we have been seeing in recent years. We reflected increases in legal costs we have seen across the portfolio, particularly in California.
Additionally, over the years we have written a number of very large accounts which include workers’ compensation coverage. These accounts are generally individually priced by our actuaries, and to the extent appropriate, the indicated losses based on the pricing analysis may be used to record the initial estimated loss reserves for these accounts.
During 2015, we increased our reserves by $234 million, primarily for accident years 2012 and prior in the U.S. Workers’ Compensation line, to reflect estimated increased losses and reduced expectations of future recoveries from our insureds through risk-sharing features. We also recognized $100 million of unfavorable prior year development in U.S. Workers’ Compensation coverages sold to government contractors in U.S. and non-U.S. military installations as a result of unfavorable loss emergence from
several large accounts in the recent accident years. In addition, we reacted to the unfavorable emergence by increasing our expected loss ratios in recent accident years. For the remainder of the primary workers’ compensation portfolio, our 2015 analysis was based on the refined segmentation from 2014, and indicated that prior year loss reserve development was flat after taking into account the initiatives that our claim function had undertaken to manage high risk claims.
During 2017, we recognized $254 million of unfavorable prior year development in Excess Casualty driven by higher than expected loss emergence.
Prior Year Development Excluding the Impact of Adverse Development Reinsurance Agreement
In 2016, we increased our ultimate loss estimates for prior accident years by $754 million. We increased our assumptions about loss development and expected loss ratios based on the adverse actual versus expected loss emergence driven by increases in severity, especially in the risk-sharing excess of deductible programs. In addition, our segmentation separately evaluated key structural drivers recently identified in the data. As a result, we noted the unfavorable development that was driven by construction defect claims which continue to increase in severity and which exhibit continued higher development at later ages than previously observed. We also identified and separately analyzed in 2016 certain mass tort claims and increased reserves for such claims due to their much longer claim emergence and loss development patterns than previously observed.
In 2015, we increased our ultimate loss estimates for prior accident years by $172 million largely related to coverage sold to the construction sectors as we reacted to adverse loss emergence throughout the year, by changing our assumptions about loss development and expected loss ratios. For construction, the unfavorable development was driven by construction defect claims. The construction class was re-underwritten to reduce New York and U.S. residential exposures.
For primary commercial auto liability in 2015, we observed increases in both the frequency and severity of claims occurring since the recovery from the recent U.S. economic downturn, which have significantly outpaced the pricing rate increases implemented during the same period. As a result, we recognized $105 million of unfavorable development during 2015 as we increased the expected loss ratios for recent accident years to reflect the deteriorating trends.
During 2016, we recognized $428 million of unfavorable development in U.S. Other Casualty medical malpractice comprising primary and excess hospitals and nursing homes coverages. This was in reaction to a continued increase in the frequency of unusually large claims in these classes that drove the adverse actual versus expected loss emergence observed in 2016. Based on the observed adverse emergence and its sustained levels over the last several years, we increased our expected incurred losses and loss ratios for accident years 2011 and subsequent to reflect the distinct step change in the loss ratios from accident years 2010 and prior.
During 2015, we recognized $202 million of unfavorable development in U.S. Other Casualty hospitals coverages driven by deteriorating loss experience in accident years 2008 and subsequent characterized by large claims in various segments including hospitals, nursing homes, and pharmaceutical and medical products liability. Based on the review of these large claims, we increased our expected loss ratios for recent accident years and classified physicians and surgeons and pharmaceutical and medical products classes into runoff.
During 2017, we recognized $345 million of unfavorable prior year development in U.S. Financial Lines primarily due to adverse experience in the Directors and Officers (D&O) subset of business.
During 2015, we recognized $502 million of unfavorable prior year development driven largely by the unfavorable loss emergence that we saw in 2015, especially in D&O and professional liability. In particular, we have observed greater than expected loss costs for several claims from accident years 2006 through 2010, driven by unfavorable settlements and deterioration in known claims. We also updated our loss development factor assumptions as well as expected loss ratio assumptions.
During 2017, we recognized $115 million of unfavorable prior year development in U.S. Property and Special Risks mainly due to unfavorable development from the commercial auto portion of the Program business unit, which offers multiline policies to small and mid-sized insureds.
During 2017, we recognized $16 million of unfavorable prior year development in U.S. Personal Insurance mainly due to homeowners business in accident year 2016, particularly from catastrophe activity. This was partially offset by favorable development in accident and health business.
During 2016 and 2015, we recognized $32 million, and $69 million of favorable development, respectively, mainly driven by accident and health business.
Europe is our largest non-U.S. region for Liability and Financial Lines. Europe Casualty and Financial Lines is composed of third-party coverages including general liability, auto liability, D&O, professional liability and various other lines of business throughout both the UK and Continental Europe. These lines of business are all long-tail in nature and while somewhat diverse in terms of exposures, these lines are often subject to similar trends. These lines are impacted by the underwriting cycle and external judicial trends. The largest share of business is in the UK, but significant business is also written in other European countries such as Germany, France, and Italy.
In general, the loss development for long-tail lines in Europe has been more stable than the development in U.S. long-tail lines, although some underlying drivers have affected the results in a similar manner (e.g. the impact of the financial crisis in accident years 2008 and 2009).
During 2016, we recognized $320 million of unfavorable prior year development. Within Europe Financial Lines, we recognized $232 million of unfavorable development primarily from the D&O line in UK and Continental Europe as result of the unfavorable actual versus expected loss emergence in 2016 due to increased frequency and severity resulting from increasing litigation. In Europe Casualty we recognized $123 million of unfavorable development primarily from the unexpected emergence of several large excess casualty claims. The actual versus expected loss emergence for Europe Casualty and Financial Lines was more than expected.
During 2017, we recognized $157 million of unfavorable prior year development in the Europe Property and Special Risks segment driven primarily by unexpected development on large claims, primarily from accident years 2015 and 2016.
During 2016, we recognized $11 million of unfavorable prior year development.
Europe Property products include commercial, industrial and energy-related property insurance products and services that cover exposures to manmade and natural disasters, including business interruption. Europe Special Risk products include aerospace, environmental, political risk, trade credit, surety and marine insurance, and various small and medium sized enterprises insurance lines.
During 2017, we recognized $157 million of unfavorable prior year development, primarily from accident years 2015 and 2016. This was largely driven by large individual claim development in the property, aviation, marine, and trade credit lines of business
During 2016, we recognized $82 million of favorable prior year development in Europe and Japan Personal Insurance mainly due to accident and health business.
Europe and Japan Personal Insurance lines consist of accident and health and personal lines. Accident and health products include voluntary and sponsor-paid personal accident and supplemental health products for individuals, employees, associations and other organizations as well as a broad range of travel insurance products and services for leisure and business travelers. Personal lines include automobile and homeowners’ insurance, extended warranty, and consumer specialty products, such as identity theft and credit card protection. Personal lines are generally short-tail in nature.
During 2016, the U.S. Run-Off Long Tail Insurance Lines experienced unfavorable prior year development of $390 million driven by Legacy pre-1986 pollution losses and the Run-Off public entity casualty business.
• the long latency period between asbestos exposure and disease manifestation, and pollution events occurring undetected over many years, leading to the potential for involvement of multiple policy periods for individual claims;
Excess Workers’ Compensation business was written over qualified self-insurance by various divisions beginning in the 1980’s. In 1992, this business was consolidated into one division where it continued writing business up until 2011, when it was effectively put into runoff. In this book of business, the claims are not handled (or administered) by AIG General Insurance claims personnel, but are administered by the client’s designated TPA. However, AIG General Insurance claims personnel maintain an oversight role over these TPAs and claims.
approaches based on individual claim department estimates for large remediation sites are extensively included as part of the overall actuarial estimates for environmental impairment liability related exposures.
During 2015, the reported claim activity on the assumed claims increased. We responded to this by modifying certain of our loss-reserve-related assumptions to better reflect our loss development. Additionally, we considered recent industry-wide trends regarding expanding coverage theories for liability. In 2015, both the retained accounts and retroceded accounts ground-up reviews for asbestos were updated. As a result, we increased gross undiscounted asbestos incurred losses by $13 million and increased net undiscounted asbestos incurred losses by $164 million. The net undiscounted change reflects an increase primarily due to third-party assumed reinsurance exposures. With the gross incurred loss increase less than the net incurred loss increase, the resulting ceded incurred losses were reduced. For environmental, we increased gross environmental incurred losses by $214 million and net environmental incurred losses by $117 million as a result of top down actuarial analyses performed during the year, as well as development on a large sediment site.
The previous development tables include only accident years 2008 to 2017. The following table summarizes (favorable) unfavorable development, of incurred losses and loss adjustment expenses for accident year 2007 and prior by operating segment and major class of business:
At December 31, 2017, the loss reserves reflect a net loss reserve discount of $1.8 billion, including tabular and non-tabular calculations based upon the following assumptions:
Certain asbestos claims were discounted when allowed by the regulator and when payments are fixed and determinable, based on the investment yields of the companies and the payout pattern for the claims. At December 31, 2016, the discount for asbestos reserves was fully amortized.
The non-tabular workers’ compensation discount is calculated separately for companies domiciled in New York and Pennsylvania, and follows the statutory regulations (prescribed or permitted) for each state. For New York companies, the discount is based on a 5 percent interest rate and the companies’ own payout patterns. For the Pennsylvania companies, the statute specifies discount factors for accident years 2001 and prior, which are based on a 6 percent interest rate and an industry payout pattern. For accident years 2002 and subsequent, the discount is based on the payout patterns and investment yields of the companies.
In 2013, our Pennsylvania regulator approved use of a consistent discount rate (U.S. Treasury rate plus a liquidity premium) to all of our workers’ compensation reserves in our Pennsylvania-domiciled companies, as well as our use of updated payout patterns specific to our primary and excess workers’ compensation portfolios.
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. In addition, reserves for contracts in loss recognition are adjusted to reflect the effect of unrealized gains on fixed maturity and equity securities available for sale, with related changes recognized through Other comprehensive income.
The liability for Policyholder contract deposits is primarily recorded at accumulated value (deposits received and net transfers from separate accounts, plus accrued interest credited at rates ranging from 0.2 percent to 9.0 percent at December 31, 2017, less withdrawals and assessed fees). Deposits collected on investment-oriented products are not reflected as revenues, because they are recorded directly to Policyholder contract deposits upon receipt. Amounts assessed against the contract holders for mortality, administrative, and other services are included in revenues.
For additional information on guaranteed benefits accounted for as embedded derivatives see Note 14 herein.
Depending on the contract, the GMDB feature may provide a death benefit of either (a) total deposits made to the contract less any partial withdrawals plus a minimum return (and in rare instances, no minimum return) or (b) the highest contract value attained, typically on any anniversary date minus any subsequent withdrawals following the contract anniversary. GMDB is our most widely offered benefit.
We regularly evaluate estimates used to determine the GMDB liability and adjust the additional liability balance, with a related charge or credit to Policyholder benefits and losses incurred, if actual experience or other evidence suggests that earlier assumptions should be revised.
Certain of our variable annuity contracts contain optional GMWB benefits and, to a lesser extent, guaranteed minimum accumulation benefits, which are not currently offered. With a GMWB, the contract holder can monetize the excess of the guaranteed amount over the account value of the contract only through a series of withdrawals that do not exceed a specific percentage per year of the guaranteed amount. If, after the series of withdrawals, the account value is exhausted, the contract holder will receive a series of
The following table lists our total debt outstanding at December 31, 2017 and 2016. The interest rates presented in the following table are the range of contractual rates in effect at December 31, 2017, including fixed and variable-rates:
(a) AIG Parent guarantees all such debt, except for MIP notes payable and Series AIGFP matched notes and bonds payable, which are direct obligations of AIG Parent. Collateral posted to third parties was $2.0 billion and $2.2 billion at December 31, 2017 and December 31, 2016, 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.
(b) At December 31, 2017, includes debt of consolidated investment vehicles related to real estate investments of $2.5 billion, affordable housing partnership investments of $1.8 billion and other securitization vehicles of $1.7 billion. At December 31, 2016, includes debt of consolidated investment vehicles related to real estate investments of $1.9 billion, affordable housing partnership investments of $1.7 billion and other securitization vehicles of $771 million.
Overview. In the normal course of business, AIG and our subsidiaries are, like others in the insurance and financial services industries in general, subject to regulatory and government investigations and actions, and litigation and other forms of dispute resolution in a large number of proceedings pending in various domestic and foreign jurisdictions. Certain of these matters involve potentially significant risk of loss due to potential for significant jury awards and settlements, punitive damages or other penalties. Many of these matters are also highly complex and seek recovery on behalf of a class or similarly large number of plaintiffs. It is therefore inherently difficult to predict the size or scope of potential future losses arising from these matters. In our insurance and reinsurance operations, litigation and arbitration concerning the scope of coverage under insurance and reinsurance contracts, and litigation and arbitration in which our subsidiaries defend or indemnify their insureds under insurance contracts, are generally considered in the establishment of our loss reserves. Separate and apart from the foregoing matters involving insurance and reinsurance coverage, AIG, our subsidiaries and their respective officers and directors are subject to a variety of additional types of legal proceedings brought by holders of AIG securities, customers, employees and others, alleging, among other things, breach of contractual or fiduciary duties, bad faith and violations of federal and state statutes and regulations. With respect to these other categories of matters not arising out of claims for insurance or reinsurance coverage, we establish reserves for loss contingencies when it is probable that a loss will be incurred and the amount of the loss can be reasonably estimated. In many instances, we are unable to determine whether a loss is probable or to reasonably estimate the amount of such a loss and, therefore, the potential future losses arising from legal proceedings may exceed the amount of liabilities that we have recorded in our financial statements covering these matters. While such potential future charges could be material, based on information currently known to management, management does not believe, other than may be discussed below, that any such charges are likely to have a material adverse effect on our financial position or results of operation.
As noted below, all of the actions relating to the Subprime Exposure Issues have been resolved.
On March 11, 2013, SICO filed a second amended complaint in the SICO Treasury Action alleging that its demand was wrongfully refused. On June 26, 2013, the Court of Federal Claims granted AIG’s and the United States’ motions to dismiss SICO’s derivative claims in the SICO Treasury Action due to our Board’s refusal of SICO’s demand and denied the United States’ motion to dismiss SICO’s direct, non-derivative claims.
On June 17, 2015, the Court of Federal Claims entered judgment stating that “the Credit Agreement Shareholder Class shall prevail on liability due to the Government's illegal exaction, but shall recover zero damages, and that the Reverse Stock Split Shareholder Class shall not prevail on liability or damages.” SICO filed a notice of appeal of the July 2, 2012 dismissal of SICO’s unconstitutional conditions claim, the June 26, 2013 dismissal of SICO’s derivative claims, the Court’s June 15, 2015 opinion and order, and the Court’s June 17, 2015 judgment to the United States Court of Appeals for the Federal Circuit. The United States filed a notice of cross appeal of the Court’s July 2, 2012 opinion and order denying in part its motion to dismiss, the Court’s June 26, 2013 opinion and order denying its motion to dismiss SICO’s direct claims, the Court’s June 15, 2015 opinion and order, and the Court’s June 17, 2015 judgment to the United States Court of Appeals for the Federal Circuit. On May 9, 2017, the Court of Appeals for the Federal Circuit: (i) vacated the Court of Federal Claims judgment on the Credit Agreement Shareholder Class and remanded with instructions for dismissal of that class, and (ii) affirmed the finding of no liability with respect to the Reverse Stock Split Class.
AIG believes that any indemnification obligation would arise only if: (a) SICO prevails on its appeal and ultimately receives an award of damages; (b) the United States then commences an action against AIG seeking indemnification; and (c) the United States is successful in such an action through any appellate process. If SICO prevails on its claims and the United States seeks indemnification
The following table presents the future minimum lease payments under operating leases at December 31, 2017:
In the normal course of business, we enter into commitments to invest in limited partnerships, private equity funds and hedge funds and to purchase and develop real estate in the U.S. and abroad. These commitments totaled $3.2 billion at December 31, 2017.
In connection with AIGFP’s business activities, AIGFP has issued, in a limited number of transactions, standby letters of credit or similar facilities to equity investors of structured leasing transactions in an amount equal to the termination value owing to the equity investor by the lessee in the event of a lessee default (the equity termination value). The total amount outstanding at December 31, 2017 was $139 million. In those transactions, AIGFP has agreed to pay such amount if the lessee fails to pay. The amount payable by AIGFP is, in certain cases, partially offset by amounts payable under other instruments typically equal to the present value of scheduled payments to be made by AIGFP. In the event that AIGFP is required to make a payment to the equity investor, the lessee is unconditionally obligated to reimburse AIGFP. To the extent that the equity investor is paid the equity termination value from the standby letter of credit and/or other sources, including payments by the lessee, AIGFP takes an assignment of the equity investor’s rights under the lease of the underlying property. Because the obligations of the lessee under the lease transactions are generally economically defeased, lessee bankruptcy is the most likely circumstance in which AIGFP would be required to pay without reimbursement.
• For additional disclosures about guarantees of outstanding debt see Note 25 to the Consolidated Financial Statements.
(a) The total number of shares of AIG Common Stock repurchased in 2015 includes (but the aggregate purchase price does not include) approximately 3.5 million shares of AIG Common Stock received in January 2015 upon the settlement of an accelerated stock repurchase (ASR) agreement executed in the fourth quarter of 2014.
(c) General Insurance companies recognized $200 million of capital contributions from AIG Parent in their statutory financial statements as of December 31, 2016 related to the reserve strengthening in the fourth quarter. This capital contribution was received in February 2017.
• In 2016, certain domestic property and casualty subsidiaries domiciled in New York, Pennsylvania and Delaware applied a permitted practice to present the inception date effects of the 2017 adverse loss development cover in their 2016 statutory-basis financial statements. This permitted practice resulted in an increase in the subsidiaries’ aggregate surplus as of December 31, 2016 of $1.1 billion.
Under the other intercompany reinsurance arrangement, certain Regulation XXX and Guideline AXXX reserves related to a closed block of in-force business are ceded to an affiliated off-shore life insurer, which is licensed as a class E insurer under Bermuda law. Bermuda law permits the off-shore life insurer to record an asset that effectively reduces the statutory reserves for the assumed reinsurance to the level that would be required under U.S. GAAP. Letters of credit are used to support the credit for reinsurance provided by the affiliated off-shore life insurer.
For additional information regarding these letters of credit see Note 8.
At December 31, 2017, our ability to pay dividends is not subject to any significant contractual restrictions, but remains subject to regulatory restrictions.
The Omnibus Plan was adopted at the 2013 Annual Meeting of Shareholders and provides for the grants of share-based awards to our employees and non-employee directors. The total number of shares that may be granted under the Omnibus Plan (the reserve) is the sum of 1) 45 million shares of AIG Common Stock, plus 2) the number of authorized shares that remained available for issuance under the 2010 Plan when the Omnibus Plan became effective, plus 3) the number of shares of AIG Common Stock relating to outstanding awards under the 2010 Plan at the time the Omnibus Plan became effective that subsequently are forfeited, expired, terminated or otherwise lapse or are settled in cash. Each share-based unit granted under the Omnibus Plan reduces the number of shares available for future grants by one share. However, shares with respect to awards that are forfeited, expired or settled for cash, and shares withheld for taxes on awards (other than options and stock appreciation rights awards) are returned to the reserve.
During 2017, performance share units (PSUs), restricted stock units (RSUs), stock options and deferred stock units (DSUs) (collectively, units) were granted under the Omnibus Plan and 42,780,716 shares are available for future grants as of December 31, 2017. Units are issued to employees as part of our long-term incentive program, generally in March of any given year, and are also issued for off-cycle grants, which are made from time to time during the year generally as sign-on awards to new hires or as a result of a change in employee status.
The LTIP provides for an annual award to certain employees, including our senior executive officers and other highly compensated employees. In 2017, each award recipient was granted PSUs and/or RSUs, and in 2013 through 2016, each award recipient was granted PSUs.
During the fourth quarter of 2017, the Company modified certain outstanding LTI awards by concurrently issuing service-based RSUs and canceling some previously granted PSUs. The change applied to most recipients who participate in the 2015, 2016 and 2017 LTI awards, excluding certain of the Company’s most senior executives. In addition, the Company also issued supplemental RSU grants to certain active employees, which vest in installments over a period of up to three years. We incurred incremental compensation expense of $142 million as a result of these actions. We recognized $71 million in 2017 and the remainder will be recognized through December 2020.
(d) At December 31, 2017, the total unrecognized compensation cost for outstanding LTI awards was $237 million and the weighted-average and expected period of years over which that cost is expected to be recognized are 1.02 years and 3 years.
(a) The dividend yield is based on the current quarterly dividend payment of $0.32 and the Valuation Date stock price.
The weighted average grant-date fair value of stock options granted during 2017 was $10.54. As of December 31, 2017, we recognized $7.3 million of expense, while $19 million was unrecognized and is expected to be amortized up to 2.75 years.
Our non-employee directors, who serve on our Board of Directors, receive share-based compensation in the form of fully vested DSUs with delivery deferred until retirement from the Board. DSUs granted in 2017, 2016 and 2015 accrue DEUs equal to the amount of any regular quarterly dividend that would have been paid by AIG if the shares of AIG Common Stock underlying the DSUs had been outstanding. In 2017, 2016 and 2015, we granted to non-employee directors 32,067, 41,974 and 32,342 DSUs, respectively, under the 2013 Plan, and recognized expense of $2.0 million, $2.4 million and $1.9 million, respectively.
We also provide postretirement medical care and life insurance benefits in the U.S. and in certain non-U.S. countries. Eligibility in the various plans generally is based upon completion of a specified period of eligible service and attaining a specified age. Overseas, benefits vary by geographic location.
U.S. postretirement medical and life insurance benefits are based upon the employee attaining the age of 55 and having a minimum of ten years of service. Eligible employees who have medical coverage can enroll in retiree medical upon termination of employment. Medical benefits are contributory, while the life insurance benefits generally are non-contributory. Retiree medical contributions vary from none for pre-1989 retirees to actual premium payments reduced by certain subsidies for post-1992 retirees. These contributions are subject to adjustment annually. Other cost sharing features of the medical plan include deductibles, coinsurance and Medicare coordination. Effective April 1, 2012, the retiree medical employer subsidy for the AIG postretirement plan was eliminated for employees who were not grandfathered. Additionally, new employees hired after December 31, 2012 are not eligible for retiree life insurance.
* Includes non-qualified unfunded plans of which the aggregate projected benefit obligation was $272 million and $278 million for the U.S. at December 31, 2017 and 2016, respectively, and $211 million and $199 million for the non-U.S at December 31, 2017 and 2016, respectively.
As of 2016, interest cost for pension and postretirement benefits for our U.S. plans and largest non-U.S. plans is measured by applying the specific spot rates along the yield curve to the plans’ corresponding discounted cash flows that comprise the obligation (the Spot Rate Approach). This method provides a more precise measurement of interest cost by aligning the timing of the plans’ discounted cash flows to the corresponding spot rates on the yield curve. Previously, interest cost was measured utilizing a single weighted-average discount rate derived from the yield curve used to measure the benefit obligations.
A 100 basis point increase in the discount rate or expected long-term rate of return would decrease the 2018 pension expense by approximately $4 million and $51 million, respectively, with all other items remaining the same. Conversely, a 100 basis point decrease in the discount rate or expected long-term rate of return would increase the 2018 pension expense by approximately $23 million and $51 million, respectively, with all other items remaining the same.
The projected benefit obligation for AIG’s Japan pension plans represents approximately 50 percent and 54 percent of the total projected benefit obligations for our non-U.S. pension plans at December 31, 2017 and 2016, respectively. The weighted average discount rate of 0.66 percent and 0.47 percent at December 31, 2017 and 2016, respectively, was selected by reference to the Mercer Yield Curve for Japan.
There were no shares of AIG Common Stock included in the U.S. and non-U.S. pension plans assets at December 31, 2017 or 2016.
The assets of AIG’s Japan pension plans represent approximately 56 percent of total non-U.S. assets at December 31 for both 2017 and 2016. The expected long term rate of return was 2.43 percent and 2.61 percent, for 2017 and 2016, respectively, and is evaluated by the Japanese Pension Investment Committee on a quarterly and annual basis along with various investment managers, and is revised to achieve the optimal allocation to meet targeted funding levels if necessary. In addition, the funding policy is revised in accordance with local regulation every five years.
The expected weighted average long-term rate of return for all our non-U.S. pension plans was 2.92 percent and 3.28 percent for the years ended December 31, 2017 and 2016, respectively. It is an aggregation of expected returns within each asset class that was generally developed based on the building block approach that considers historical returns, current market conditions, asset volatility and the expectations for future market returns.
(g) Excludes investments that are measured at fair value using the NAV per share (or its equivalent), which totaled $777 million and $960 million at December 31, 2017 and 2016, respectively.
Our policy is to record transfers of assets between Level 1 and Level 2 at their fair values as of the end of each reporting period, consistent with the date of the determination of fair value. Assets are transferred out of Level 1 when they are no longer transacted with sufficient frequency and volume in an active market. Conversely, assets are transferred from Level 2 to Level 1 when transaction volume and frequency are indicative of an active market. We had no material transfers between Level 1 and Level 2 during the years ended December 31, 2017 and 2016.
The SEC staff issued Staff Accounting Bulletin 118 (SAB 118), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 addresses situations where accounting for certain income tax effects of the Tax Act under ASC 740 may be incomplete upon issuance of an entity’s financial statements and provides a one-year measurement period from the enactment date to complete the accounting under ASC 740. In accordance with SAB 118, a company must reflect the following:
Consistent with current income tax accounting requirements, we have remeasured our deferred tax assets and liabilities with reference to the statutory income tax rate of 21 percent and taking into consideration other provisions of the Tax Act. As of December 31, 2017, we had not fully completed our accounting for the tax effects of the Tax Act. Our provision for income taxes for the period ended December 31, 2017, is based in part on a reasonable estimate of the effects on existing deferred tax balances and of certain provisions of the Tax Act. To the extent a reasonable estimate of the impact of certain provisions was determinable, we recorded provisional estimates as a component of our provision for income taxes on continuing operations. To the extent a reasonable estimate of the impact of certain provisions was not determinable, we have not recorded any adjustments and have continued accounting for them in accordance with ASC 740 on the basis of the tax laws in effect before enactment of the Tax Act.
Certain provisions of the Tax Act impact our projections of future taxable income used in analyzing realizability of our U.S. tax attribute deferred tax asset. As discussed above, there are specific insurance industry provisions, including changes in computations of insurance reserves, amortization of specified policy acquisition expenses, and treatment of separate account dividends received deduction. Provisional estimates have been included in our future taxable income projections for these insurance industry specific provisions to reflect application of the new tax law.
Because we have made provisional estimates related to the impact of certain aspects of the Tax Act on our future taxable income, corresponding determination of the need for a valuation allowance is also provisional. Generally, the Tax Act provisions result in an increase in our taxable income and, thus, accelerate utilization of our tax attribute deferred tax asset. Accordingly, we do not currently anticipate that our reliance on provisional estimates would have a material impact on our determination of the realizability of our deferred tax assets.
Our accounting for the following elements of the Tax Act is incomplete and we continued accounting for them in accordance with ASC 740 on the basis of the tax laws in effect before enactment of the Tax Act.
Due to minimal formal guidance issued from state and local jurisdictions, provisional estimates have not been recorded for the impact of any state and local corporate income tax implications of the Tax Act. Guidance from state and local jurisdictions is expected during 2018 and the impact, if any, will be recorded at the appropriate time.
For the year ended December 31, 2017, our repatriation assumptions with respect to certain operations in Canada, South Africa, as well as European and Asia Pacific regions remain unchanged and related foreign earnings remain indefinitely reinvested. Due to a change in the legal entity ownership through a contribution of certain affiliates to AIG International Holdings GmbH, our repatriation assumptions related to certain operations in the Far East, Latin America, Bermuda and Middle East region have changed and related foreign earnings are now considered to be indefinitely reinvested. These earnings relate to ongoing operations and have been reinvested in active business operations. Deferred taxes have been provided on earnings of non-U.S. affiliates whose earnings are not indefinitely reinvested.
We have U.S. federal consolidated net operating loss and tax credit carryforwards of approximately $10.6 billion. The carryforward periods for our foreign tax credits begin to expire in 2019. As detailed in the Assessment of Deferred Tax Asset Valuation Allowance section of this footnote, we determined that it is more likely than not that our U.S. federal consolidated tax attribute carryforwards will be realized prior to their expiration.
• the nature, frequency, and amount of cumulative financial reporting income and losses in recent years;
For the year ended December 31, 2017, recent changes in market conditions, including interest rate fluctuations, impacted the unrealized tax gains and losses in the U.S. non-life companies’ available for sale securities portfolio, resulting in a deferred tax liability related to net unrealized tax capital gains. As of June 30, 2017, based on all available evidence, we concluded that the valuation allowance should be released. As a result, for the six-month period ended June 30, 2017, we released $260 million of valuation allowance associated with the unrealized tax losses in the U.S. non-life companies’ available for sale securities portfolio, all of which was allocated to other comprehensive income. As of December 31, 2017, we continue to be in an overall unrealized tax gain position with respect to the U.S. non-life companies’ available for sale securities portfolio and thus concluded no valuation allowance is necessary in the U.S. non-life companies’ available for sale securities portfolio.
At December 31, 2017 and 2016, our U.S. consolidated income tax group had net deferred tax assets after valuation allowance of $13.4 billion and $20.9 billion, respectively. At December 31, 2017 and 2016, our U.S. consolidated income tax group had valuation allowances of $86 million and $874 million, respectively.
At December 31, 2017 and 2016, we had deferred tax asset valuation allowances of $1.3 billion and $2.0 billion, respectively, related to foreign subsidiaries, state and local tax jurisdictions, and certain domestic subsidiaries that file separate tax returns. We maintained these valuation allowances following our conclusion that we could not demonstrate that it was more likely than not that the related deferred tax assets will be realized. This was primarily due to factors such as cumulative losses in recent years and the inability to demonstrate profits within the specific jurisdictions over the relevant carryforward periods.