AIG and its subsidiaries operate from approximately 2,300 offices in the United States, 6 offices in Canada and numerous offices in approximately 100 foreign countries. The offices in Greensboro and Winston-Salem, North Carolina; Springfield, Illinois; Amarillo, Ft. Worth and Houston, Texas; Wilmington, Delaware; San Juan, Puerto Rico; Tampa, Florida; Livingston, New Jersey; Evansville, Indiana; Nashville, Tennessee; 70 Pine Street, 72 Wall Street and 175 Water Street in New York, New York; and offices in more than 30 foreign countries and jurisdictions including Bermuda, Chile, Hong Kong, the Philippines, Japan, United Kingdom, Singapore, Malaysia, Switzerland, Taiwan and Thailand are located in buildings owned by AIG and its subsidiaries. The remainder of the office space utilized by AIG subsidiaries is leased.
Includes the effect of hedging activities that did not qualify for hedge accounting treatment under FAS 133, including the related foreign exchange gains and losses. For 2006, 2005, 2004, 2003 and 2002, respectively, the effect was $(1.86) billion, $2.02 billion, $385 million, $(1.50) billion and $(216) million in revenues and $(1.86) billion, $2.02 billion, $671 million, $(1.22) billion and $(58) million in operating income. These amounts result primarily from interest rate and foreign currency derivatives that are economically hedging available for sale securities and borrowings.
Includes the effect of out of period adjustments related to the accounting for certain interests in unit investment trusts. For 2006 the effect was an increase of $490 million in both revenues and operating income for General Insurance and an increase of $240 million and $169 million in revenues and operating income, respectively, for Life Insurance & Retirement Services.
Including that portion of long-term debt maturing in less than one year. See also Note 9 of Notes to Consolidated Financial Statements.
Management’s Discussion and Analysis of Financial Condition and Results of Operations is designed to provide the reader a narrative explanation of AIG’s operations, financial condition and liquidity and certain other significant matters.
AIG identifies its reportable segments by product or service line, consistent with its management structure. AIG’s major product and service groupings are General Insurance, Life Insurance & Retirement Services, Financial Services and Asset Management. AIG’s operations in 2006 were conducted by its subsidiaries through these segments. Through these segments, AIG provides insurance, financial and investment products and services to both businesses and individuals in more than 130 countries and jurisdictions. This geographic, product and service diversification is one of AIG’s major strengths and sets it apart from its competitors. AIG’s Other category consists of items not allocated to AIG’s operating segments.
AIG’s subsidiaries serve commercial, institutional and individual customers through an extensive property-casualty and life insurance and retirement services network. In the United States, AIG companies are the largest underwriters of commercial and industrial insurance and are among the largest life insurance and retirement services operations as well. AIG’s Financial Services businesses include commercial aircraft and equipment leasing, capital markets operations and consumer finance, both in the United States and abroad. AIG also provides asset management services to institutions and individuals. As part of its spread-based business activities, AIG issues various debt instruments in the public and private markets.
AIG patiently builds relationships in markets around the world where it sees long-term growth opportunities. For example, the fact that AIG has the only wholly owned foreign life insurance operations in eleven cities in China is the result of relationships developed over nearly 30 years. AIG’s more recent extensions of operations into India, Vietnam, Russia and other emerging markets reflect the same growth strategy. Moreover, AIG believes in investing in the economies and infrastructures of these countries and growing with them. When AIG companies enter a new jurisdiction, they typically offer both basic protection and savings products. As the economies evolve, AIG’s products evolve with them, to more sophisticated and investment-oriented models.
Losses caused by catastrophes can fluctuate widely from year to year, making comparisons of results more difficult. With respect to catastrophe losses, AIG believes that it has taken appropriate steps, such as careful exposure selection and adequate reinsurance coverage, to reduce the effect of possible future losses. The occurrence of one or more catastrophic events of unanticipated frequency or severity, such as a terrorist attack, earthquake or hurricane, that causes insured losses, however, could have a material adverse effect on AIG’s results of operations, liquidity or financial condition.
AIG’s operations in China continue to expand, but AIG expects competition in China to remain strong and AIG’s success in China will depend on its ability to execute its growth strategy.
In India, AIG expects to grow all segments, both organically and through acquisitions and joint ventures.
In Japan, AIG expects its Life Insurance & Retirement Services earnings growth may be challenged by increased competition in light of a new industry-wide mortality table, the continued runoff of the older, higher-margin in-force business of AIG Star Life and AIG Edison Life and lower consumer demand for certain accident and health products in light of tax law changes. The flat yield curve and declining Yen foreign exchange environment may continue to constrain certain fixed annuity production. To leverage
Through new operations in Bahrain designed to comply with Islamic law, AIG is tapping into a growing market. Islamic insurance, called Takaful, is an alternative to conventional insurance based on the concept of mutual assistance through pooling of resources.
Domestically, AIG plans to continue expansion of its Life Insurance & Retirement Services businesses through direct marketing and independent agent distribution channels. The aging population in the U.S. provides a growth opportunity for a variety of products, including longevity, guaranteed income and supplemental accident and health products. Certain other demographic groups that have traditionally been underserved provide additional growth opportunities. The home service operation, a slow growth business, has not met business objectives, although its cash flow has been steady. Domestic group life/health operations continue to face competitors with greater scale in group benefits. At the end of 2006, AIG exited the financial institutions credit life business in the U.S. as a result of competition from bank products and low profit margins. The individual fixed annuities business will continue to be challenged due to the interest rate environment and increased competition from bank products, while lower margin variable annuity products with living benefits will continue to be the product of consumer choice in the individual variable annuity markets. The group annuity market is undergoing a transition from group annuities to mutual fund products that have lower profit margins.
Globally, heightened regulatory scrutiny of financial services companies in many jurisdictions has the potential to affect future financial results through higher compliance costs. This is particularly true in Japan and Southeast Asia where financial institutions have received remediation orders affecting consumer and policyholder rights.
The following table summarizes AIG’s consolidated revenues, income before income taxes, minority interest and cumulative effect of accounting changes and net income for the years ended December 31, 2006, 2005 and 2004:
2005 reflected the negative effect of $3.28 billion (pre-tax) in catastrophe-related losses incurred that year. Net income in 2005 also reflected the charges related to regulatory settlements, as described in Item 3. Legal Proceedings, and the fourth quarter charge resulting from the annual review of General Insurance loss and loss adjustment reserves.
Throughout 2006, as part of its continuing remediation efforts, AIG recorded out of period adjustments. The net effect of out of period adjustments relating to prior years increased 2006 net income by $65 million. The more significant adjustments included increases in unit investment trust income of $773 million ($428 million after tax) (more fully described below) and other expenses of $356 million ($231 million after tax), and a decrease in revenues for certain derivative transactions of $300 million ($145 million after tax).
During the fourth quarter, as part of its ongoing remediation efforts, AIG recorded out of period adjustments. These adjustments collectively increased net income in the fourth quarter by $56 million but were offset by fourth quarter charges to expense within Domestic Life for the adverse ruling in the Superior National arbitration of $125 million ($81 million after tax) and a charge of $66 million ($43 million after tax) in connection with the exit of the financial institutions credit life business. The more significant out of period adjustments included the following: a decrease in income tax expense of $181 million relating to AIG’s ongoing remediation of internal controls over income tax accounting, an increase in other expenses of $167 million ($109 million after tax) relating to AIG’s remediation of internal controls over reconciliation of certain balance sheet accounts, an increase in incurred policy losses and benefits of $103 million ($67 million after tax) in Domestic General Insurance for corrections of certain reserves for losses and loss expenses, a reduction in incurred policy benefits in the Foreign Life participating policyholder fund stemming from deferred tax adjustments in Foreign Life of $190 million ($124 million after tax), an increase in insurance operating expenses of $61 million ($40 million after tax) within Foreign Life for corrections of expense allocations to certain par fund accounts, and a $79 million ($51 million after tax) charge related to purchases of life insurance policies for AIG’s life settlements portfolio that were issued by AIG subsidiaries.
Results for 2006 were negatively affected by a one-time charge relating to the Starr tender offer ($54 million before and after tax) and an additional allowance for losses in AIG Credit Card Company (Taiwan) ($94 million before and after tax).
The effective income tax rate increased from 28.0 percent for 2005 to 30.1 percent for 2006, reflecting changes in the sources of foreign taxable income, the effect of the phase out of synfuel tax credits, the effect of consolidating certain limited partnerships and a reduction in the proportion of total income derived from tax exempt income, which was partially offset by the aforementioned out of period income tax adjustments.
Includes $312 million and $96 million in catastrophe-related losses from partially owned companies in 2005 and 2004, respectively.
The following table summarizes the operations of each principal segment for the years ended December 31, 2006, 2005 and 2004. See also Note 2 of Notes to Consolidated Financial Statements.
Includes the effect of hedging activities that did not qualify for hedge accounting treatment under FAS 133, including the related foreign exchange gains and losses. For 2006, 2005 and 2004, respectively, the effect was $(1.86) billion, $2.02 billion and $385 million in revenues and $(1.86) billion, $2.02 billion and $671 million in operating income. These amounts result primarily from interest rate and foreign currency derivatives that are hedging available for sale securities and borrowings.
Includes the effect of out of period adjustments related to the accounting for certain interests in unit investment trusts. For 2006, the effect was an increase of $490 million in both revenues and operating income for General Insurance and an increase of $240 million and $169 million in revenues and operating income, respectively, for Life Insurance & Retirement Services.
Includes the effect of hedging activities that did not qualify for hedge accounting treatment under FAS 133, including the related foreign exchange gains and losses. For 2006, 2005 and 2004, respectively, the effect was $(1.82) billion, $2.01 billion, and $(122) million in both revenues and operating income for Capital Markets. These amounts result primarily from interest rate and foreign currency derivatives that are economically hedging available for sale securities and borrowings. For 2004, the effect was $(27) million in operating income for Aircraft Leasing. During 2006 and 2005, Aircraft Leasing derivative gains and losses were reported as part of AIG’s Other category, and were not reported in Aircraft Leasing operating income.
Represents income before income taxes, minority interest, and cumulative effect of accounting changes.
Includes current year catastrophe-related losses of $3.28 billion and $1.16 billion in 2005 and 2004, respectively. There were no significant catastrophe-related losses in 2006. Includes additional losses incurred and net reinstatement premiums related to prior year catastrophes of $165 million and $292 million in 2006 and 2005, respectively.
Life Insurance & Retirement Services operating income increased 13 percent in 2006 compared to 2005 on higher GAAP premiums and an increase in net investment income. Net investment income in 2006 included the effect of an out of period adjustment related to the accounting for certain interests in unit investment trusts. Realized capital gains included in revenues and operating income were $88 million in 2006 compared to realized capital losses of $158 million in 2005. Results for 2006 were particularly strong in the Foreign Life operations that were helped by increased net investment income, higher realized gains and lower acquisition costs. Domestic Life Insurance & Retirement Services operating income declined from the prior year on lower realized gains, the charge discussed above relating to the Superior National arbitration and the exiting of the financial institutions credit insurance business.
AIG considers its most critical accounting estimates to be those relating to reserves for losses and loss expenses, future policy benefits for life and accident and health contracts, recoverability of DAC, estimated gross profits for investment-oriented products, fair value determinations for certain Capital Markets assets and liabilities, other-than-temporary declines in the value of investments and flight equipment recoverability. These accounting estimates require the use of assumptions about matters, some of which are highly uncertain at the time of estimation. To the extent actual experience differs from the assumptions used, AIG’s results of operations would be directly affected.
Throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations, AIG’s critical accounting estimates are discussed in detail. The major categories for which assumptions are developed and used to establish each critical accounting estimate are highlighted below. For a discussion regarding the significant accounting policies relating to these estimates, see Note 1 of Notes to Consolidated Financial Statements.
Recoverability: based on current and future expected profitability, which is affected by interest rates, foreign exchange rates, mortality experience, and policy persistency.
Recoverability and eligibility: based upon the current terms and profitability of the underlying insurance contracts.
SD Valuation models: utilizing factors, such as market liquidity and current interest, foreign exchange and volatility rates.
• Market price data: AIG attempts to secure reliable and independent current market price data, such as published exchange rates from external subscription services such as Bloomberg or Reuters or third-party broker quotes for use in its models. When such data is not available, AIG uses an internal methodology, which includes interpolation and extrapolation from verifiable prices from trades occurring on dates nearest to the dates of the transactions.
• The occurrence of a discrete credit event resulting in the debtor defaulting or seeking bankruptcy or insolvency protection or voluntary reorganization; or
• The probability of non-realization of a full recovery on its investment, irrespective of the occurrence of one of the foregoing events.
In periods subsequent to the recognition of an other-than-temporary impairment loss for debt securities, AIG amortizes the discount or reduced premium over the remaining life of the security in a prospective manner based on the amount and timing of estimated future cash flows.
AIG’s General Insurance subsidiaries are multiple line companies writing substantially all lines of commercial property and casualty insurance and various personal lines both domestically and abroad.
As previously noted, AIG believes it should present and discuss its financial information in a manner most meaningful to its financial statement users. Accordingly, in its General Insurance business, AIG uses certain regulatory measures, where AIG has determined these measurements to be useful and meaningful.
AIG, along with most general insurance companies, uses the loss ratio, the expense ratio and the combined ratio as measures of underwriting performance. The loss ratio is the sum of losses and loss expenses incurred divided by net premiums earned. The expense ratio is statutory underwriting expenses divided by net premiums written. These ratios are relative measurements that describe, for every $100 of net premiums earned or written, the
cost of losses and statutory expenses, respectively. The combined ratio is the sum of the loss ratio and the expense ratio. The combined ratio presents the total cost per $100 of premium production. A combined ratio below 100 demonstrates underwriting profit; a combined ratio above 100 demonstrates underwriting loss.
Net premiums written are initially deferred and earned based upon the terms of the underlying policies. The net unearned premium reserve constitutes deferred revenues which are generally earned ratably over the policy period. Thus, the net unearned premium reserve is not fully recognized in income as net premiums earned until the end of the policy period.
The underwriting environment varies from country to country, as does the degree of litigation activity. Regulation, product type and competition have a direct effect on pricing and consequently on profitability as reflected in underwriting profit and statutory general insurance ratios.
General Insurance operating income is comprised of statutory underwriting results, changes in DAC, net investment income and realized capital gains and losses. Operating income, as well as net premiums written, net premiums earned, net investment income and realized capital gains (losses) and statutory ratios for 2006, 2005 and 2004 were as follows:
Income statement accounts expressed in non-functional currencies are translated into U.S. dollars using average exchange rates.
AIG transacts business in most major foreign currencies. The following table summarizes the effect of changes in foreign currency exchange rates on the growth of General Insurance net premiums written for the years ended December 31, 2006 and 2005.
General Insurance operating income increased in 2006 compared to 2005 due to growth in net premiums, a reduction in both catastrophe losses and prior accident year development, and growth in net investment income. The combined ratio improved to 89.1, a reduction of 15.6 points from 2005, including an improvement in the loss ratio of 16.5 points. The reduction in catastrophe losses represented 6.9 points and the reduction in prior year adverse development represented 11.5 points of the overall reduction. Net premiums written increased $3.0 billion or 7 percent in 2006 compared to 2005. Domestic General accounted for $1.6 billion of the increase as property rates improved and submission activity increased due to the strength of AIG’s capacity, commitment to difficult markets and diverse product offerings. Foreign General contributed $1.4 billion to the increase in net premiums written. In 2005, Domestic General net premiums written increased by $300 million and Foreign General net premiums written decreased by the same amount as a result of the commutation of the Richmond reinsurance contract. The commutation partially offset the increase in Domestic General net premiums written in 2006 compared to 2005 and increased Foreign General net premiums written in 2006 compared to 2005.
General Insurance operating income in 2005 decreased from 2004 due to higher catastrophe-related losses and the fourth quarter 2005 increase in reserves and changes in estimates related to remediation of the material weakness in reconciliation of balance sheet accounts. Catastrophe-related losses were $2.89 billion and $1.05 billion in 2005 and 2004, respectively. These decreases in operating income were partially offset by strong growth in statutory underwriting profit and increases in net investment income. General Insurance operating income in 2004 also included a $232 million charge reflecting a change in estimate for salvage and subrogation recoveries.
The loss ratio for 2006 declined 24.9 points to 69.4. The 2005 loss ratio was negatively affected by catastrophe-related losses of $1.7 billion and related reinstatement premiums of $122 million. Adverse development on reserves for loss and loss adjustment expenses declined to $110 million in 2006 compared to $4.9 billion in 2005, accounting for 21.0 points of the decrease in the loss ratio.
DBG’s net premiums written increased modestly in 2005 compared to 2004, reflecting generally improving renewal retention rates and a modest change in the mix of business towards smaller accounts for which DBG purchases less reinsurance. DBG also continued to expand its relationships with a larger number and broader range of brokers. DBG saw improvement in domestic property rates as well as increases in submission activity in the aftermath of the 2005 hurricanes. DBG attributes the increase in submissions to its overall financial strength in comparison to many insurers that experienced significant losses and reductions of surplus as a result of the hurricanes.
The DBG expense ratio increased in 2005 from 2004, principally due to an increase in net commissions resulting from the replacement of certain ceded quota share reinsurance, for which DBG earns a ceding commission, with excess-of-loss reinsurance, which generally does not include a ceding commission. Increases in other underwriting expenses reflect a change in estimates for salvage and subrogation recoveries.
DBG’s net investment income increased in 2005 compared to 2004 due to strong cash flows, higher interest rates and increased partnership income.
Transatlantic’s net premiums written and net premiums earned for 2005 decreased compared to 2004, principally due to competitive market conditions and increased ceding company retentions in certain classes of business, largely resulting from Transatlantic’s domestic operations. Operating income decreased principally as a result of the increased level of catastrophe losses.
UGC’s operating income declined $35 million in 2006, down 10 percent from 2005 due primarily to unfavorable loss experience on third-party originated second lien business with a credit quality lower than typical for UGC and a softening U.S. housing market. This increased UGC’s consolidated loss ratio for 2006 to 47.2 compared to 26.0 in 2005. The writing of this second lien coverage, which began in 2005, was discontinued as of year end 2006. Losses in the second lien business have been mitigated by a policy year aggregate limitation provision that is typically established for each lender.
Net premiums written increased 38 percent from growth in the domestic second lien and international businesses as well as improved persistency in the domestic first lien business. The
expense ratio remained flat as premium growth covered increased expenses related to expansion internationally and continued investment in risk management resources. UGC had approximately $27 billion of guaranty risk in force at December 31, 2006.
Net premiums written increased $1.4 billion or 14 percent (15 percent in original currency) in 2006 compared to 2005, reflecting growth in both commercial and consumer lines driven by new business from both established and new distribution channels, including a wholly owned insurance company in Vietnam and Central Insurance Co., Ltd. in Taiwan. Ascot also contributed to the growth in net premiums written as a result of rate increases on its U.S. business. Consumer lines in Latin America and commercial lines in Europe, including the U.K., also contributed to the increase. Net premiums written for 2005 were reduced by reinstatement premiums related to catastrophes and a portfolio transfer of unearned premium reserves to DBG related to the Richmond commutation, accounting for 3 percent of the increase in 2006 compared to 2005.
The 2006 combined ratio declined to 83.7, a decrease of 1.9 points from 2005. The 2005 catastrophes added 3.5 points to the 2005 loss ratio. The expense ratio in 2006 increased by 1.3 points as a result of increased amortization of deferred advertising costs and a continued change in the business mix towards products with higher acquisition costs but historically lower loss ratios. The loss ratio decreased 3.2 points in 2006 as the absence of significant catastrophes in 2006 resulted in a decrease of 3.5 points, rate increases and lower current year losses by Ascot on its U.S. book of business accounted for 1.3 points of the decrease and lower asbestos and environmental reserve increases accounted for 1.2 points of the decrease. These declines were partially offset by lower favorable loss development from prior accident years and adverse development on 2005 hurricanes.
Net investment income increased $540 million or 57 percent in 2006 compared to 2005 primarily due to a $424 million out of period adjustment related to the accounting for interests in unit investment trusts.
The 2005 combined ratio of 85.6 decreased 5.3 points from 2004. The loss ratio decreased 8.0 points in 2005 from 2004. The loss ratio decreased 4.7 points due to favorable loss development from prior accident years, excluding catastrophes, and 2.3 points related to a 2004 loss reserve restatement adjustment. The loss ratio increased 0.9 points due to higher catastrophe losses in 2005 related to hurricanes. The expense ratio increased 2.7 points in 2005 from 2004 principally due to the portfolio transfer of Richmond’s unearned premium reserves to DBG in 2005, loyalty business initiatives in the consumer business lines, which have higher acquisition costs, and also due to reinstatement premiums.
AIG’s gross reserve for losses and loss expenses represents the accumulation of estimates of ultimate losses, including IBNR and loss expenses. The methods used to determine loss reserve estimates and to establish the resulting reserves are continually reviewed and updated by management. Any adjustments resulting therefrom are reflected in operating income currently. Because loss reserve estimates are subject to the outcome of future events, changes in estimates are unavoidable given that loss trends vary and time is often required for changes in trends to be recognized and confirmed. Reserve changes that increase previous estimates of ultimate cost are referred to as unfavorable or adverse development or reserve strengthening. Reserve changes that decrease previous estimates of ultimate cost are referred to as favorable development.
At December 31, 2006 and 2005, respectively, Foreign General loss reserves include approximately $2.87 billion and $2.15 billion related to business reported in DBG’s statutory filings.
Beginning in 1998, DBG ceded a quota share percentage of its other liability occurrence and products liability occurrence business to AIRCO. The quota share percentage ceded was 40 percent in 1998, 65 percent in 1999, 75 percent in 2000 and 2001, 50 percent in 2002 and 2003, 40 percent in 2004, 35 percent in 2005 and 20 percent in 2006 and covered all business written in these years for these lines by participants in the American Home/ National Union pool. In 1998 the cession reflected only the other liability occurrence business, but in 1999 and subsequent years included products liability occurrence. AIRCO’s loss reserves relating to these quota share cessions from DBG are recorded on a discounted basis. As of year-end 2006, AIRCO carried a discount of approximately $330 million applicable to the $3.66 billion in undiscounted reserves it assumed from the American Home/ National Union pool via this quota share cession. AIRCO also carries approximately $467 million in net loss reserves relating to Foreign General insurance business. These reserves are carried on an undiscounted basis.
Beginning in 1997, the Personal Lines division ceded a percentage of all business written by the companies participating in the personal lines pool to the American Home/ National Union pool. As noted above, the total reserves carried by participants in the American Home/ National Union pool relating to this cession amounted to $861 million as of year-end 2006.
General reserves are carried by AIUO, AIRCO, and other smaller AIG subsidiaries domiciled outside the United States. Statutory filings in the U.S. by AIG companies reflect all the business written by U.S. domiciled entities only, and therefore exclude business written by AIUO, AIRCO, and all other internationally domiciled subsidiaries. The total reserves carried at year-end 2006 by AIUO and AIRCO were approximately $4.57 billion and $3.80 billion, respectively. AIRCO’s $3.80 billion in total general insurance reserves consists of approximately $3.33 billion from business assumed from the American Home/ National Union pool and an additional $467 million relating to Foreign General Insurance business.
Excess Casualty: Excess Casualty reserves experienced significant adverse loss development in 2004 and 2005, but in 2006 there was only a relatively minor amount of adverse development. The adverse development for all periods shown related principally to accident years 2000 and prior, and to a lesser extent 2001, and resulted from significant loss cost increases due to both frequency and severity of claims. The increase in loss costs resulted primarily from medical inflation, which increased the economic loss component of tort claims, advances in medical care, which extended the life span of severely injured claimants, and larger jury verdicts, which increased the value of severe tort claims. An additional factor affecting AIG’s excess casualty experience in recent years has been the accelerated exhaustion of underlying primary policies for homebuilders. This has led to increased construction defect-related claims activity on AIG’s excess policies. Many excess casualty policies were written on a multi-year basis in the late 1990s, which limited AIG’s ability to respond to emerging market trends as rapidly as would otherwise be the case. In subsequent years, AIG responded to these emerging trends by increasing rates and implementing numerous policy form and coverage changes. This led to a significant improvement in experience beginning with accident year 2001.
For the year-end 2006 loss reserve review, AIG claims staff updated the separate review for accounts with significant exposure to construction defect-related claims in order to assist the actuaries in determining the proper reserve for this exposure. AIG’s actuaries determined that no significant changes in the assumptions were required. Prior accident year loss development in 2006 was adverse by approximately $100 million, a relatively minor amount for this class of business. However, AIG continues to experience adverse development for this class for accident years prior to 2003.
D&O and Related Management Liability Classes of Business: These classes of business experienced significant adverse development in 2004 and 2005, but experienced slightly favorable development in 2006. The adverse development in 2004 and 2005 related principally to accident years 2002 and prior. This adverse development resulted from significant loss cost escalation due to a variety of factors, including the following: the increase in frequency and severity of corporate bankruptcies; the increase in frequency of financial statement restatements; the sharp rise in market capitalization of publicly traded companies; and the increase in the number of initial public offerings, which led to an unprecedented number of IPO allocation/laddering suits in 2001. In addition, extensive utilization of multi-year policies during this period limited AIG’s ability to respond to emerging trends as rapidly as would otherwise be the case. AIG experienced significant adverse loss development since 2002 as a result of these issues. AIG responded to this development with rate increases and policy form and coverage changes to better contain future loss costs in this class of business.
For the year-end 2006 loss reserve review, AIG’s actuaries determined that no significant changes in the assumptions were required. Prior accident year loss development in 2006 was favorable by approximately $20 million, an insignificant amount for these classes. AIG’s actuaries continued to benchmark the loss reserve indications to the ground up claim projections provided by AIG claims staff for this class of business. For the year-end 2006 loss reserve review, the ground up claim projections included all accident years through 2005.
Loss reserves pertaining to D&O and related management liability classes of business are included in the Other liability claims made line of business, as presented in the table on page 37.
Excess Workers Compensation: This class of business experienced significant adverse development in 2005, and a relatively minor amount of adverse development in 2006. The adverse development in 2005 related to 2002 and prior accident years. This adverse development resulted primarily from significant loss cost increases, primarily attributable to rapidly increasing medical inflation and advances in medical care, which increased the cost of covered medical care and extended the life span of severely injured workers. The effect of these factors on excess workers compensation claims experience is leveraged, as frequency is increased by the rising number of claims that reach the excess layers.
In response to the significantly adverse loss development in 2005, an additional study was conducted for the 2005 year-end actuarial reserve analysis for DBG pertaining to the selection of loss development factors for this class of business. Claims for excess workers compensation exhibit an exceptionally long-tail of loss development, running for decades from the date the loss is incurred. Thus, the adequacy of loss reserves for this class is sensitive to the estimated loss development factors, as such factors may be applied to many years of loss experience. In order to better estimate the tail development for this class, AIG claims staff conducted a claim-by-claim projection of the expected ultimate paid loss for each open claim for 1998 and prior accident years as these are the primary years from which the tail factors are derived. The objective of the study was to provide a benchmark against which loss development factors in the tail could be evaluated. The resulting loss development factors utilized by the actuaries in the year-end 2005 study reflected an increase of approximately 18 percent from the factors used in the prior year study without the benefit of the claims benchmark. In addition, the loss cost trend assumption for excess workers compensation was increased from approximately 2.5 percent to 6 percent for the 2005 study.
The General Insurance loss reserves can generally be categorized into two distinct groups. One group is short-tail classes of business consisting principally of property, personal lines and certain casualty classes. The other group is long-tail casualty classes of business which includes excess and umbrella liability, D&O, professional liability, medical malpractice, workers compensation, general liability, products liability, and related classes.
including changes in claims handling, exposure and policy forms, current and future estimates of monetary inflation and social inflation and increases in litigation and awards. These factors are periodically reviewed and adjusted, as appropriate, to reflect emerging trends which are based upon past loss experience. Thus, many factors are implicitly considered in estimating the year to year growth in loss costs.
A number of actuarial assumptions are generally made in the review of reserves for each class of business. For longer tail classes of business, actuarial assumptions generally are made with respect to the following:
Expected loss ratios for the latest accident year (i.e., accident year 2006 for the year-end 2006 loss reserve analysis) and, in some cases for accident years prior to the latest accident year. The expected loss ratio generally reflects the projected loss ratio from prior accident years, adjusted for the loss trend (see above) and the effect of rate changes and other quantifiable factors on the loss ratio. For low-frequency, high-severity classes such as excess casualty, expected loss ratios generally are used for at least the three most recent accident years.
AIG records quarterly changes in loss reserves for each of its many General Insurance classes of business. The overall change in AIG’s loss reserves is based on the sum of these classes of business changes. For most long-tail classes of business, the process of recording quarterly loss reserve changes involves determining the estimated current loss ratio for each class of coverage. This loss ratio is multiplied by the current quarter’s net earned premium for that class of coverage to determine the current accident quarter’s total estimated net incurred loss and loss expense. The change in loss reserves for the quarter for each class is thus the difference between the net incurred loss and loss expense, estimated as described above, and the net paid losses and loss expenses in the quarter. Also any change in estimated ultimate losses from prior accident years, either positive or negative, is reflected in the loss reserve for the current quarter.
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. 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
D&O: AIG generally utilizes a combination of loss development methods and expected loss ratio methods for D&O and related management liability classes of business. Expected loss ratio methods are given more weight in the two most recent accident years, whereas loss development methods are given more weight in more mature accident years. Beginning with the year-end 2005 loss reserve review, AIG’s actuaries began to utilize claim projections provided by AIG claims staff as a benchmark for determining the indicated ultimate losses for accident years 2004 and prior. For the year end 2006 loss reserve review, claims projections for accident years 2005 and prior were utilized. In prior years, AIG’s actuaries had utilized these claims projections as a benchmark for profitability studies for major classes of D&O and related management liability business. The track record of these claims projections has indicated a very low margin of error, thus providing support for their usage as a benchmark in determining the estimated loss reserve. These classes of business reflect claims made coverage, and losses are characterized by low frequency and high severity. Thus, the claim projections can produce an accurate overall indicator of the ultimate loss exposure for these classes by identifying and estimating all large losses. Frequency/severity methods are generally not utilized for these classes as the overall losses are driven by large losses more than by claim frequency. Severity trends have varied significantly from accident year to accident year.
Excess Workers Compensation: AIG generally utilizes a combination of loss development methods and expected loss ratio methods. Loss development methods are given the greater weight for mature accident years such as 2000 and prior. Expected loss ratio methods are given the greater weight for the more recent accident years. Excess workers compensation is an extremely long-tail class of business, with loss emergence extending for decades. Therefore there is limited credibility in the reported losses for many of the more recent accident years. Beginning with the year-end 2005 loss reserve review, AIG’s actuaries began to utilize claims projections provided by AIG claims staff to help determine the loss development factors for this class of business.
utilize frequency/severity methods to test reserves for this business, due to significant changes and growth in AIG’s general liability and products liability business over the years.
Aviation: AIG generally uses a combination of loss development methods and expected loss ratio methods for aviation exposures. Aviation claims are not very long-tail in nature; however, they are driven by claim severity. Thus a combination of both development and expected loss ratio methods are used for all but the latest accident year to determine the loss reserves. Expected loss ratio methods are used to determine the loss reserves for the latest accident year. Frequency/severity methods are not employed due to the high severity nature of the claims and different mix of claims from year to year.
International: Business written by AIG’s Foreign General Insurance sub-segment includes both long-tail and short-tail classes of business. For long-tail classes of business, the actuarial methods utilized would be analogous to those described above. However, the majority of business written by Foreign General Insurance is short-tail, high frequency and low severity in nature. For this business, loss development methods are generally employed to test the loss reserves. AIG maintains a data base of detailed historical premium and loss transactions in original currency for business written by Foreign General Insurance, thereby allowing AIG actuaries to determine the current reserves without any distortion from changes in exchange rates over time. In testing the Foreign General Insurance reserves, AIG’s actuaries segment the data by region, country or class of business as appropriate to determine the optimal balance between homogeneity and credibility.
Loss Adjustment Expenses: AIG determines reserves for legal defense and cost containment loss adjustment expenses for each
class of business by one or more actuarial methods. The methods generally include development methods analogous to those described for loss development methods. The developments could be based on either the paid loss adjustment expenses or the ratio of paid loss adjustment expenses to paid losses, or both. Other methods include the utilization of expected ultimate ratios of paid loss expense to paid losses, based on actual experience from prior accident years or from similar classes of business. AIG generally determines reserves for adjuster loss adjustment expenses based on calendar year ratios of adjuster expenses paid to losses paid for the particular class of business. AIG generally determines reserves for other unallocated loss adjustment expenses based on the ratio of the calendar year expenses paid to overall losses paid. This determination is generally done for all classes of business combined, and reflects costs of home office claim overhead as a percent of losses paid.
Catastrophes: Special analyses are conducted by AIG in response to major catastrophes in order to estimate AIG’s gross and net loss and loss expense liability from the event. These analyses may include a combination of approaches, including modeling estimates, ground up claim analysis, loss evaluation reports from on-site field adjusters, and market share estimates.
For the excess casualty class of business, the assumed loss development factors are also a key assumption. After evaluating the historical loss development factors from prior accident years since the early 1990s, in AIG’s judgment, it is reasonably likely that actual loss development factors will range from approximately 3.25 percent below those actually utilized in the year-end 2006 reserve review to approximately ten percent above those factors actually utilized. If the loss development factor assumptions were changed by 3.25 percent and ten percent, respectively, the net loss reserves for the excess casualty class would decrease by approximately $450 million under the lower assumptions or increase by approximately $1.25 billion under the higher assumptions. Generally, actual historical loss development factors are used to project future loss development. However there can be no assurance that future loss development patterns will be the same as in the past, or that they will not deviate by more than the amounts illustrated above. Moreover, as excess casualty is a long-tail class of business, any deviation in loss cost trends or in loss development factors might not be discernible for an extended period of time subsequent to the recording of the initial loss reserve estimates for any accident year. Thus, there is the potential for the reserves with respect to a number of accident years to be significantly affected by changes in the loss cost trends or loss development factors that were initially relied upon in setting the reserves. These changes in loss trends or loss development factors could be attributable to changes in inflation or in the judicial environment, or in other social or economic conditions affecting claims. Thus, there is the potential for
variations greater than the amounts cited above, either positively or negatively.
For D&O and related management liability classes of business, the assumed loss development factors are also an important assumption but less critical than for excess casualty. Because these classes are written on a claims made basis, the loss reporting and development tail is much shorter than for excess casualty. However, the high severity nature of the claims does create the potential for significant deviations in loss development patterns from one year to the next. After evaluating the historical loss development factors for these classes of business for accident years since the early 1990s, in AIG’s judgment, it is reasonably likely that actual loss development factors will range approximately five percent lower or higher than those factors actually utilized in the year-end 2006 loss reserve review for these classes. If the loss development factor assumptions were changed by five percent, the net loss reserves for these classes would be estimated to increase or decrease by approximately $200 million. As noted above for excess casualty, actual historical loss development factors are generally used to project future loss development. However, there can be no assurance that future loss development patterns will be the same as in the past, or that they will not deviate by more than the five percent.
Excess Workers Compensation: For excess workers compensation business, loss costs were trended at six percent per annum. After reviewing actual industry loss trends for the past ten years, in AIG’s judgment, it is reasonably likely that actual loss cost trends applicable to the year-end 2006 loss reserve review for excess workers compensation will range five percent lower or higher than this estimated loss trend. A five percent change in the assumed loss cost trend would cause approximately a $350 million increase or a $225 million decrease in the net loss reserves for this business. It should be emphasized that the actual loss cost trend could vary significantly from this assumption, and there can be no assurance that actual loss costs will not deviate, perhaps materially, by greater than five percent.
The vast majority of these asbestos and environmental claims emanate from policies written in 1984 and prior years. Commencing in 1985, standard policies contained an absolute exclusion for pollution-related damage and an absolute asbestos exclusion was also implemented. The current environmental policies that AIG underwrites on a claims-made basis have been excluded from the analysis herein.
To determine the appropriate loss reserve as of December 31, 2006 for its asbestos and environmental exposures, AIG performed a series of top-down and ground-up reserve analyses. In order to ensure it had the most comprehensive analysis possible, AIG engaged a third-party actuary to assist in a review of these exposures, including ground-up estimates for both asbestos reserves and environmental reserves consistent with the 2005 review. Prior to 2005, AIG’s reserve analyses for asbestos and environmental exposures was focused around a report year projection of aggregate losses for both asbestos and environmental reserves. Additional tests such as market share analyses were also performed. Ground-up analyses take into account policy-
For environmental claims, an analogous series of frequency/ severity tests are produced. Environmental claims from future report years, (i.e., IBNR) are projected out ten years, i.e., through the year 2016.
At year-end 2006, AIG considered a number of factors and recent experience in addition to the results of the respective top-down and ground-up analyses performed for asbestos and environmental reserves. AIG considered the significant uncertainty that remains as to AIG’s ultimate liability relating to asbestos and environmental claims. This uncertainty is due to several factors including:
The long latency period between asbestos exposure and disease manifestation and the resulting potential for involvement of multiple policy periods for individual claims;
The increase in the volume of claims by currently unimpaired plaintiffs;
After carefully considering the results of the ground-up analysis, which AIG updates on an annual basis, as well as all of the above factors, including the recent report year experience, AIG determined its best estimate was to recognize an increase of $256 million in its carried net asbestos reserves, and a decrease of $58 million in its carried net environmental reserves at December 31, 2006. The corresponding changes in gross reserves were an increase of approximately $570 million for asbestos and a decrease of approximately $230 million for environmental, respectively. A minor amount of additional incurred loss emergence pertaining to asbestos was reflected in 2006, primarily attributable to the general reinsurance operations of Transatlantic. The majority of the increase in asbestos reserves resulting from the 2006 review is attributable to higher than expected emergence of claims pertaining to new asbestos policy exposures. A significant portion of this increase pertains to higher layers of excess coverage for certain major asbestos defendants on business written by DBG. Approximately $80 million of the overall $256 million net asbestos reserve increase is attributable to business written by Foreign General, approximately $30 million of which is in turn ceded to DBG. In 2006, Foreign General enhanced its capability to identify asbestos exposures, resulting in the identification of additional asbestos defendants in 2006, as well as higher layers of exposure for certain existing defendants. As described above, the ground up analysis as of 2006 now models over 1,000 asbestos defendants and over 95 percent of all known reported asbestos claims.
Includes increases to gross losses and loss expense reserves of $2.0 billion and $1.2 billion in the fourth quarter of 2005 and 2004, respectively, and increases to net losses and loss expense reserves of $843 million and $650 million for the fourth quarter of 2005 and 2004, respectively.
Includes increases to gross losses and loss expense reserves of $56 million and $250 million in the fourth quarter of 2005 and 2004, respectively, and increases to net losses and loss expense reserves of $30 million and $200 million for the fourth quarter of 2005 and 2004, respectively.
A summary of asbestos and environmental claims count activity for the years ended December 31, 2006, 2005 and 2004 was as follows:
AIG’s survival ratios for asbestos and environmental claims, separately and combined were based upon a three-year average payment. These ratios for the years ended December 31, 2006, 2005 and 2004 were as follows:
AIG’s Life Insurance & Retirement Services subsidiaries offer a wide range of insurance and retirement savings products both domestically and abroad.
Domestically, AIG’s Life Insurance & Retirement Services operations offer a broad range of protection products, such as life insurance and group life and health products, including disability income products and payout annuities, which include single premium immediate annuities, structured settlements and terminal funding annuities. Home service operations include an array of life insurance, accident and health and annuity products sold primarily through career agents. In addition, home service includes a small block of runoff property and casualty coverage. Retirement services include group retirement products, individual fixed and variable annuities sold through banks, broker-dealers and exclusive sales representatives, and annuity runoff operations, which include previously acquired “closed blocks” and other fixed and variable annuities largely sold through distribution relationships that have been discontinued.
Japan and Other consists of all operations in Japan and the operations of ALICO and its subsidiaries worldwide.
Domestic insurance in-force for 2005 includes the effect of the non-renewal of a single large group life case of $36 billion.
Includes the effect of out of period adjustments related to the accounting for certain interests in unit investment trusts. For 2006, the effect was an increase of $32 million in both net investment income and operating income.
AIG transacts business in most major foreign currencies and therefore premiums reported in U.S. dollars vary by volume and from changes in foreign currency translation rates. The following table summarizes the effect of changes in foreign currency exchange rates on the growth of the Foreign Life Insurance & Retirement Services GAAP premiums for the year ended December 31, 2006 and 2005:
Total revenues for Japan and Other increased $743 million in 2006, to $16.0 billion, compared to 2005. Operating income grew $773 million, due to growth in the underlying retirement services businesses and realized capital gains of $406 million. The 2006 results for the reporting unit were negatively affected by the weakening of the Japanese Yen against the U.S. dollar during 2006. In addition, operating income was negatively affected by the continued runoff of the older, higher margin in-force business of AIG Star Life and AIG Edison Life.
Life insurance GAAP premiums declined in 2006 compared to 2005 primarily due to the effect of foreign exchange. Foreign exchange negatively affected GAAP premiums by approximately $250 million, most notably as a result of the weakening in the Japanese Yen. Life insurance operating income grew $445 million, primarily due to an increase of $368 million of realized capital gains. Life insurance growth improved due to an increase in single premium life insurance sales in Japan as a result of further bank deregulation effective in December 2005. The expansion of the bank distribution platform for single premium life insurance products adds to the existing multiple distribution platforms in Japan, where AIG remains the leading foreign insurance provider.
Personal accident revenues grew $258 million or 7 percent resulting in operating income growth of $71 million or 7 percent. Personal accident operating income includes the effect of higher terminations of certain accident and health policies in Japan which increased expenses by $54 million in 2006. The higher terminations are a result of a change in the Japanese tax regulations that reduced the tax deduction for premiums. AIG’s Japanese operations have experienced lower sales and higher terminations of these contracts. DAC related to these accident
and health policies in force at December 31, 2006 totaled $214 million. In response to the tax law change, AIG has introduced new products, both life and health, to meet the needs of clients in that market. AIG continues to believe that the effect of future policy terminations will not be material to AIG’s consolidated financial condition or results of operations.
Revenues from group products increased in 2006 by $320 million, to $2.3 billion, resulting in an increase in operating income of $81 million to $272 million. Fixed annuity reserves continued to grow due to positive net flows, but demand for U.S. dollar fixed annuities has slowed due to a weaker Japanese Yen. The individual fixed annuity revenues grew $302 million to $2.3 billion resulting in an increase in operating income of $163 million to $553 million. Growth in variable annuity deposits has accelerated compared to 2005 due to new product offerings and stronger equity markets, resulting in higher fees and policy charges included in GAAP premiums. Variable annuity revenues declined in 2006 compared to 2005 due to lower policyholder trading gains which comprise the entirety of variable annuity net investment income. Policyholder trading gains are offset by an equal increase in policy benefits expense, as all investment returns for these variable annuities accrue to the benefit of the policyholder.
lower realized capital gains. Personal accident operating income declined primarily due to realized capital losses in 2005 compared to realized capital gains in 2004. Group products GAAP premiums dropped in 2005 compared to 2004. 2004 GAAP premiums included premiums of approximately $640 million from a single reinsurance transaction involving terminal funding business, which is offset by a similar increase in benefit reserves.
Domestic Life Insurance results, presented on a sub-product basis for 2006, 2005 and 2004 were as follows:
GAAP Premiums and Total Revenues include structured settlements, single premium immediate annuities and terminal funding annuities.
The following table reflects periodic Domestic Life insurance sales by product for 2006, 2005 and 2004, respectively:
GAAP premiums for Domestic Life Insurance were $5.5 billion in 2006, a 2 percent increase compared to 2005. Overall, periodic life insurance sales grew by 16 percent, compared to 2005, reflecting increased growth from the independent distribution platform. During the second half of 2006, certain universal life products were re-priced and underwriting standards were tightened, which could affect future periodic life insurance sales. GAAP premiums from AGLA, AIG’s home service business, declined slightly in 2006 as the reduction of premium in-force from normal lapses and maturities exceeded sales growth for the period. GAAP premiums for group life/health for 2006 declined over the prior year primarily due to restructuring efforts in certain product lines, including the financial institutions credit life business and the employer benefits business. The GAAP premium growth from payout annuities for 2006 reflects increased sales of single premium annuities and structured settlements when compared to 2005. At December 31, 2006, AIG effectively exited the financial institutions credit business through a third party indemnity reinsurance agreement. The transaction is expected to close in the first quarter of 2007, subject to normal closing requirements, including regulatory approval. GAAP premiums in 2006 related to this business were approximately $100 million.
Domestic Retirement Services total deposits decreased slightly for 2006 compared to 2005. The decrease in total deposits reflects lower fixed annuity sales that continued to face increased competition from bank deposit products and money market funds offering very competitive short-term rates in the flat yield curve environment. This was partially offset by substantially higher individual variable annuity sales and group mutual fund deposits. Individual variable annuity deposits grew 29 percent in 2006 from 2005, reflecting growth in products with living benefit guarantee features. Group retirement deposits grew 6 percent in 2006, reflecting 51 percent growth in group mutual fund sales partially offset by a 1 percent sales drop in annuity deposits. Over time, this will result in a gradual reduction in overall profit margins of this business driven by the growth in the lower-margin mutual fund products relative to the annuity products. Fixed annuity surrender rates increased in 2006 compared to 2005 due to products coming out of their surrender charge period and the increased competition from banks. Individual fixed annuity net flows for 2006 were negative $2.7 billion compared to positive net flows of $1.3 billion in 2005, reflecting both the lower deposits and higher surrenders, caused by the flat or inverted yield curve.
Total domestic retirement service operating income for 2006 of $2.3 billion increased 7 percent from 2005. Group retirement products total revenues were flat in 2006 primarily due to improvements in partnership income and variable annuity fees being offset by increased capital losses. The flat revenues, coupled with higher amortization of deferred acquisition costs related to internal replacements of existing contracts into new contracts, resulted in a 4 percent decrease in group retirement operating income. Total revenues for individual fixed annuities were up 7 percent in 2006 and operating income was up 21 percent primarily driven by higher partnership and yield enhancement income. Individual variable annuity total revenues were up 7 percent in 2006, primarily driven by higher variable annuity fees resulting from the increase in the equity markets. Offsetting somewhat the growth in total revenues was an increase in DAC amortization resulting from increased surrender activity in the first half of 2006, with operating income up 2 percent for the year. In 2006, the individual annuities runoff operating income increased $15 million even though the underlying reserves decreased. The higher income in 2006 was primarily due to increased net spreads as a result of higher investment yields partially offset by increased realized capital losses and lower volumes due to the continued runoff of the business.
The Domestic Retirement Services businesses faced a challenging environment in 2005, as deposits declined approximately 18 percent from 2004. The decrease in AIG’s individual variable annuity product sales in 2005 was largely attributable to significant variable annuity sales declines at several of AIG’s largest distribution firms due to lackluster equity markets, more intense industry competition with regard to living benefit product features and heightened compliance procedures over selling practices. AIG’s introduction of more competitive guaranteed minimum withdrawal features was delayed until late in the fourth quarter of 2005 due to filing delays associated with the restatements. During 2005, the interest yield curve flattened and, as a result, competing bank products such as certificates of deposit and other
money market instruments with shorter durations than AIG’s individual fixed annuity products became more attractive.
Total Domestic Retirement Services operating income for 2005 of $2.2 billion increased 5 percent compared to 2004 operating income of $2.1 billion. Total revenues for the group retirement products increased 5 percent in 2005 compared to 2004 while operating income increased 7 percent, primarily due to higher variable annuity fee income and lower realized capital losses. Individual fixed annuity total revenues were up 6 percent in 2005 primarily due to an increase in net investment income, partially offset by higher realized capital losses. Operating income for individual fixed annuities increased primarily due to the increase in net investment income from growth in average reserves and higher surrender charges, partially offset by the higher level of realized capital losses. Individual variable annuities total revenues were up 9 percent in 2005, primarily driven by higher variable annuity fees resulting from the increase in the equity markets in the fourth quarter of 2004 and an increase in realized capital gains. The 7 percent growth in individual variable annuities income was consistent with the overall growth in reserves. In 2005, the individual annuities runoff operating income increased $22 million even though the underlying reserves decreased. The higher income in 2005 was due to lower interest crediting rates and lower DAC amortization due to lower surrenders.
The following table presents the amount of reserves by surrender charge category as of December 31, 2006:
In 2006, surrender rates increased for individual fixed annuities, group retirement products and individual variable annuities. The increase in surrender rate for fixed annuities continues to be driven by the shape of the yield curve and general aging of the in-force block; however, less than 20 percent of the individual fixed annuity reserves as of December 31, 2006 were available to be surrendered without charge. Surrender rates for group retirement products increased only slightly as a result of successful retention efforts. In 2006, new products were introduced to retain assets and AIG has retained or attracted over $1 billion in assets. Individual variable annuity surrender rates for 2006 primarily reflect higher shock-lapses that occur following expiration of the surrender charge period on certain 3-year and 7-year contracts, although the trend moderated during the year. Reflecting a widespread industry phenomenon, this lapse rate, much of which was anticipated when the products were issued, has recently been affected by investor demand to exchange existing policies for new-generation contracts with living benefits or lower fees. In addition, the high lapse rates are in part due to the surrenders within certain acquired blocks of business.
Life Insurance & Retirement Services Net Investment Income and Realized Capital Gains (Losses)
Relates principally to assets held in various trading securities accounts that do not qualify for separate account treatment under SOP 03-1. These amounts are offset by an equal change included in incurred policy losses and benefits.
The following table summarizes Domestic Life Insurance & Retirement Services partnership income (losses) by sub-product line for 2006, 2005 and 2004:
Net investment income increased 7 percent for 2006 compared to 2005 as income from fixed maturity and equity securities increased as levels of invested assets grew. Net investment income in 2006 also included out of period adjustments relating to the accounting for certain interests in unit investment trusts of $240 million. Partially offsetting this growth were lower policyholder trading gains (losses) in 2006. Net Investment income for certain operations include investments in structured notes linked to emerging market sovereign debt that incorporates both interest rate risk and currency risk. In addition, period to period comparisons of investment income for some lines of business are affected by yield enhancement activity, particularly partnership income as shown in the above table. See also Insurance and Asset Management Invested Assets herein.
The growth in net investment income in 2005 compared to 2004 reflects growth in general account reserves and surplus for both Foreign and Domestic Life Insurance & Retirement Services companies. Also, net investment income was positively affected by the compounding of previously earned and reinvested net investment income along with the addition of new cash flow from operations available for investment. The global flattening of the yield curve put additional pressure on yields and spreads, which was partially offset with income generated from other investment sources, including income from partnerships.
Net of allocations to participating policyholders of $88 million, $109 million and $65 million for 2006, 2005 and 2004, respectively.
Realized capital gains (losses) include normal portfolio transactions as well as derivative gains (losses) for transactions that did not qualify for hedge accounting treatment under FAS 133, transactional foreign exchange gains and losses and other-than-temporary declines in the value of investments. Realized capital gains (losses) for derivatives in Foreign Life Insurance & Retirement Services are related primarily to hedging of fixed income instruments denominated in a currency other than the functional currency of the respective country to such functional currency. The related currency gain or loss of the available for sale fixed income instrument is deferred until the date of the sale.
The following table summarizes the major components of the changes in DAC and Value of Business Acquired (VOBA) for 2006 and 2005:
In 2006, sales inducement assets were reclassified to Other assets in the consolidated balance sheet. All periods have been adjusted to reflect this reclassification.
Revenues, shown net of interest expense of $3.2 billion, $3.0 billion and $2.3 billion, in 2006, 2005 and 2004, respectively, were primarily from hedged financial positions entered into in connection with counterparty transactions and the effect of hedging activities that did not qualify for hedge accounting treatment under FAS 133 described in (a) above.
Certain transactions entered into by AIGFP generate tax credits and benefits which are included in income taxes in the consolidated statement of income. The amounts of such tax credits and benefits for the years ended December 31, 2006, 2005 and 2004, respectively, are $50 million, $67 million and $107 million.
Includes specific reserves recorded during 2006 in the amount of $42 million related to two commercial lending transactions.
Financial Services operating income decreased in 2006 compared to 2005 and increased in 2005 compared to 2004, due primarily to the effect of hedging activities that did not qualify for hedge accounting under FAS 133. AIG is reinstituting hedge accounting in the first quarter of 2007 for AIGFP and later in 2007 for the balance of the Financial Services operations.
ILFC’s sources of revenue are principally from scheduled and charter airlines and companies associated with the airline industry. The airline industry is sensitive to changes in economic conditions and is cyclical and highly competitive. Airlines and related companies may be affected by political or economic instability, terrorist activities, changes in national policy, competitive pressures on certain air carriers, fuel prices and shortages, labor stoppages, insurance costs, recessions, world health issues and other political or economic events adversely affecting world or regional trading markets.
ILFC’s revenues and operating income may be adversely affected by the volatile competitive environment in which its customers operate. ILFC manages the risk of nonperformance by its lessees with security deposit requirements, repossession rights, overhaul requirements and close monitoring of industry conditions through its marketing force. However, there can be no assurance that ILFC would be able to successfully manage the risks relating to the effect of possible future deterioration in the airline industry. Approximately 90 percent of ILFC’s fleet is leased to non-U.S. carriers, and the fleet, comprised of the most efficient aircraft in the airline industry, continues to be in high demand from such carriers.
Management formally reviews regularly, and no less frequently than quarterly, issues affecting ILFC’s fleet, including events and circumstances that may cause impairment of aircraft values. Management evaluates aircraft in the fleet as necessary based on
these events and circumstances in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (FAS 144). ILFC has not recognized any impairment related to its fleet in 2006, 2005 and 2004. ILFC has been able to re-lease the aircraft without diminution in lease rates that would result in an impairment under FAS 144.
ILFC’s operating income decreased in 2006 compared to 2005 by $40 million, or 6 percent. Rental revenues increased by $536 million or 16 percent, driven by a larger aircraft fleet, increased utilization and higher lease rates. During 2006, ILFC’s fleet subject to operating leases increased by 78 airplanes to a total of 824. The increase in rental revenues was offset in part by increases in depreciation expense and interest expense, charges related to bankrupt airlines, as well as the settlement of a tax dispute in Australia related to the restructuring of ownership of aircraft. Depreciation expense increased by $200 million, or 14 percent, in line with the increase in the size of the aircraft fleet. Interest expense increased by $317 million, or 28 percent, driven by rising cost of funds, a weaker U.S. dollar against the Euro and the British Pound and additional borrowings funding aircraft purchases. As noted above, ILFC’s interest expense did not reflect the benefit of hedging these exposures. Gains or losses on derivatives for ILFC are reported in AIG’s Other category.
ILFC’s operating income increased in 2005 compared to 2004 by $37 million, or 6 percent. Rental revenues increased by $499 million, or 17 percent, driven by a larger aircraft fleet and increased utilization. During 2005, ILFC’s fleet subject to operating leases increased by 79 airplanes to a total of 746. The increase in rental revenues was offset in part by increases in depreciation expense, interest expense, leasing-related costs and other reserves. Depreciation expense increased by $111 million, or 9 percent, in line with the increase in the size of the aircraft fleet. Interest expense increased by $132 million, or 13 percent, driven by rising cost of funds and additional borrowings funding aircraft purchases.
As Capital Markets is a transaction-oriented operation, current and past revenues and operating results may not provide a basis for predicting future performance. AIG’s Capital Markets operations derive substantially all their revenues from hedged financial positions entered into in connection with counterparty transactions rather than from speculative transactions. AIGFP also participates as a dealer in a wide variety of financial derivatives transactions. AIGFP economically hedges the market risks arising from its transactions, although hedge accounting under FAS 133 was not being applied during 2006, 2005 and 2004 to any of the derivatives and related assets and liabilities. Accordingly, revenues and operating income were exposed to volatility resulting from differences in the timing of revenue recognition between the derivatives and the hedged assets and liabilities. Revenues and operating income of the Capital Markets operations and the percentage change in these amounts for any given period are also significantly affected by the number, size and profitability of transactions entered into by these subsidiaries during that period relative to those entered into during the prior period. Generally, the realization of transaction revenues as measured by the receipt of funds is not a significant reporting event as the gain or loss on AIGFP’s trading transactions is currently reflected in operating income as the fair values change from period to period.
Derivative transactions are entered into in the ordinary course of AIGFP operations. Derivatives are recorded at fair value, determined by reference to the mark to market value of the derivative or their estimated fair value where market prices are not readily available. The resulting aggregate unrealized gains or losses from the derivatives are reflected in the consolidated income statement. Where AIGFP cannot verify significant model inputs to observable market data and cannot verify the model value to market transactions, AIGFP values the contract at the transaction price at inception and, consequently, records no initial gain or loss in accordance with Emerging Issues Task Force Issue No. 02-03, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities” (EITF 02-03). Such initial gain or loss is recognized over the life of the transaction. AIGFP periodically reevaluates its revenue recognition under EITF 02-03 based on the observability of market parameters. The mark to fair value of derivative transactions is reflected in the consolidated balance sheet in the captions “Unrealized gain on swaps, options and forward transactions” and “Unrealized loss on swaps, options and forward transactions.” Unrealized gains represent the present value of the aggregate of each net receivable, by counterparty, and the unrealized losses represent the present value of the aggregate of each net payable, by counterparty, as of December 31, 2006. These amounts will change from one period to the next due to changes in interest rates, currency rates, equity and commodity prices and other market variables, as well as cash movements, execution of new transactions and the maturing of existing transactions.
To the extent the Financial Services subsidiaries, other than AIGFP, use derivatives to economically hedge their assets or liabilities with respect to their future cash flows, and such hedges did not qualify for hedge accounting treatment under FAS 133, the changes in fair value of such derivatives were recorded in realized capital gains (losses) or other income. Amounts recorded in realized capital gains (losses) are reported as part of AIG’s Other category.
Capital Markets operating income in 2006 decreased by $3.53 billion compared to 2005. Improved results, primarily from increased transaction flow in AIGFP’s credit, commodity index, energy and equity products, were more than offset by the loss resulting from the effect of derivatives not qualifying for hedge accounting treatment under FAS 133. This loss was $1.82 billion in 2006 compared to a gain of $2.01 billion in 2005, a decrease of $3.83 billion. A large part of the net loss on AIGFP’s derivatives recognized in 2006 was due to the weakening of the U.S. dollar, primarily against the British Pound and Euro, resulting in a decrease in the fair value of the foreign currency derivatives hedging AIGFP’s available for sale securities. The majority of the net gain on AIGFP’s derivatives in 2005 was due to the strengthening of the U.S. dollar, primarily against the British Pound and Euro, which increased the fair value of the foreign currency derivatives hedging available for sale securities. To a lesser extent, the net gain in 2005 was due to the decrease in long-term U.S. interest rates, which increased the fair value of derivatives hedging AIGFP’s assets and liabilities.
AIG elected to early adopt FAS 155, “Accounting for Certain Hybrid Financial Instruments” (FAS 155), in 2006 and AIGFP elected to apply the fair value option to its structured notes and other financial liabilities containing embedded derivatives outstanding as of January 1, 2006. The cumulative effect of the adoption of FAS 155 on these instruments at January 1, 2006 was a pre-tax loss of $29 million. The effect of these hybrid financial instruments reflected in AIGFP’s operating income in 2006 was a pretax loss of $287 million, largely offset by gains on economic hedge positions also reflected in AIGFP’s operating income.
Capital Markets operating income in 2005 increased by $2 billion compared to 2004, primarily due to a gain related to derivatives not qualifying for hedge accounting treatment of $2.01 billion in 2005 compared to a loss of $122 million in 2004. The majority of the net gain on AIGFP’s derivatives recognized in 2005 was due to the strengthening of the U.S. dollar against the Euro and British Pound, which resulted in an increase in the fair value of the foreign currency derivatives hedging available for sale securities. To a lesser extent, the net gain was also due to the fall in long-term U.S. interest rates, which resulted in an increase in the fair value of AIGFP’s interest rate derivatives hedging its assets and liabilities. The majority of the net loss on AIGFP’s derivatives recognized in 2004 was due to the weakening of the U.S. dollar against the Euro and British Pound, which resulted in a decrease in the fair value of the foreign currency derivatives hedging available for sale securities. This loss was partially offset by an increase in the fair value of its interest rate derivatives hedging its assets and liabilities as a result of the decrease in long-term U.S. interest rates.
Financial market conditions in 2005 compared to 2004 were characterized by a general flattening of interest rate yield curves across fixed income markets globally, some tightening of credit spreads, higher equity valuations and a stronger U.S. dollar. AIGFP’s 2005 results were adversely affected by customer uncertainty surrounding the negative actions of the rating agencies and the investigations, as well as the negative effect on its structured notes business of AIG being unable to fully access the capital markets during 2005.
Capital Markets operating income was also negatively affected in 2004 by the costs of the PNC settlement.
with borrower payment options that allow for negative amortization of the principal balance. The secured non-real estate loans are secured by consumer goods, automobiles or other personal property. Both secured and unsecured non-real estate loans and retail sales finance receivables generally have a maximum term of 60 months. The core of AGF’s originations is sourced through its branches. However, a significant volume of real estate loans is also originated through broker relationships, and to lesser extents, through correspondent relationships and direct mail solicitations. In the first quarter of 2006, two wholly owned subsidiaries of AGF discontinued originating real estate loans through an arrangement with AIG Federal Savings Bank, a federally chartered thrift, and began originating such loans under their own state licenses.
AIG’s foreign consumer finance operations are principally conducted through AIGCFG. AIGCFG operates primarily in emerging and developing markets. AIGCFG has operations in Argentina, China, Hong Kong, Mexico, Philippines, Poland, Taiwan and Thailand. Certain of the AIGCFG operations are owned in part or in whole by Life Insurance subsidiaries. Accordingly, the financial results of those companies are shared between Financial Services and Life Insurance & Retirement Services according to their ownership percentages. While products vary by market, the businesses generally provide credit cards, unsecured and secured non-real estate loans, term deposits, savings accounts, retail sales finance and real estate loans. AIGCFG originates finance receivables through its branches and direct solicitation. AIGCFG also originates finance receivables indirectly through relationships with retailers, auto dealers, and independent agents.
Domestically, the relatively low interest rate environment contributed to a high level of mortgage refinancing activity. AGF’s real estate loans increased 21 percent during 2005 compared to 2004. AGF’s short-term borrowing rates rose to 3.58 percent in 2005 compared to 2.68 percent in 2004. AGF’s long-term borrowing rates were 4.41 percent in 2005 compared to 4.28 percent in 2004. Despite high energy costs, the U.S. economy continued to expand during 2005, improving consumer credit quality. Both AGF’s net charge-off ratio and delinquency ratio improved in 2005 compared to 2004. AGF’s net charge-off ratio improved to 1.19 percent in 2005 from 1.60 percent in 2004. The improvement in the net charge-off ratio in 2005 was primarily due to the improving economy and a higher proportion of average net receivables that were real estate loans. AGF’s delinquency ratio at December 31, 2005 was 1.93 percent compared to 2.31 percent at December 31, 2004. However, AGF incurred charges of approximately $62 million for the estimated effect of hurricane Katrina on customers in the Gulf Coast areas affected by the storm. At December 31, 2005, AGF’s allowance ratio was 2.20 percent compared to 2.26 percent at December 31, 2004.
Asset Management results for 2006, 2005 and 2004 were as follows:
Includes the effect of hedging activities that did not qualify for hedge accounting treatment under FAS 133, including the related foreign exchange gains and losses. For 2004, the effect was a gain of $313 million in operating income. During 2006 and 2005, these derivative gains and losses were reported as part of AIG’s Other category, and were not reported in Asset Management operating income.
Asset Management operating income increased 4 percent in 2006 compared to 2005 on revenues that increased 9 percent.
Operating income related to the Spread-Based Investment Business declined 20 percent in 2006 compared to 2005 due primarily to the continued runoff of GIC balances and spread compression related to increases in short-term interest rates. A significant portion of the remaining GIC portfolio consists of floating rate obligations. AIG has entered into hedges to manage against increases in short-term interest rates. AIG believes these hedges are economically effective, but they did not qualify for hedge accounting treatment under FAS 133. Income or loss from these hedges are classified as realized capital gains or losses and are included in AIG’s Other category. The decline in operating income was partially offset by improved partnership income, particularly during the fourth quarter of 2006. Partnership income is primarily derived from alternative investments and is affected by performance in the equity markets. Thus, revenues, operating income and cash flow attributable to GICs will vary among reporting periods. Commencing with transactions initiated in the first quarter of 2007, AIG is reinstituting hedge accounting for derivative transactions related to the MIP.
Asset Management operating income increased in 2005 compared to 2004 as a result of growth in institutional assets under management, and the associated fee revenue, along with strong realized gains on sales of real estate investments and performance fees earned on various private equity investments. The increase in operating income was achieved despite the runoff of the existing GIC portfolio and the delay in the MIP. The decline in GIC operating income compared to 2004 reflects tighter spreads in the GIC portfolio, partially offset by improved partnership returns. Spread compression occurred as the base portfolio yield declined due to an increase in the cost of funds in the short-term floating rate portion of the GIC portfolio, only partially offset by increased investment income from the floating rate assets backing the portfolio.
The operating loss of AIG’s Other category for the years ended December 31, 2006, 2005 and 2004 was as follows:
Operating loss for AIG’s Other category declined to $1.7 billion in 2006 compared to $2.5 billion in 2005, largely due to regulatory settlement costs of $1.6 billion in 2005 as described under Item 3. Legal Proceedings. Interest expense grew in 2006 as a result of increased borrowings by the parent holding company. Unallocated corporate expenses increased $142 million due to increases in general corporate expenses primarily resulting from ongoing efforts to improve internal controls, higher stock compensation expenses and expenses relating to executive departures in 2005 and 2006. AIG expects these compensation expenses to continue to increase as these improvement efforts progress. Operating income in 2006 also includes realized capital losses of $295 million, primarily reflecting the effect of hedging activities in the Financial Services and Asset Management segments that did not qualify for hedge accounting treatment under FAS 133. Also reflected in Other operating loss in 2006 is an out of period charge of $61 million with respect to the SICO Plans and a one-time charge related to the Starr tender offer of $54 million. For a further discussion of these items, see Note 16 of Notes to Consolidated Financial Statements. These declines were partially
At December 31, 2006, AIG had total consolidated shareholders’ equity of $101.68 billion and total consolidated borrowings of $148.68 billion. At that date, $131.55 billion of such borrowings were not guaranteed by AIG, were matched borrowings by AIG or AIGFP, or represented liabilities connected to trust preferred stock.
In 2007, AIG expects to issue capital securities in one or more series. The proceeds will be used to repurchase shares of common stock or to otherwise improve the efficiency of AIG’s capital structure.
At December 31, 2006, AIG’s net borrowings were $17.13 billion after reflecting amounts that were matched borrowings by AIG and AIGFP, amounts not guaranteed by AIG and liabilities connected to trust preferred stock. The following table summarizes borrowings outstanding at December 31, 2006 and 2005:
Borrowings issued or guaranteed by AIG and those borrowings not guaranteed by AIG at December 31, 2006 and 2005 were as follows:
AIG intends to continue its customary practice of issuing debt securities from time to time to meet its financing needs and those of certain of its subsidiaries for general corporate purposes, as well as for the MIP. In July 2006, AIG filed and had declared effective a post-effective amendment to its universal shelf registration statement to sell up to $25.1 billion of debt securities, preferred and common stock and other securities.
In October 2006, AIG established a medium term note program under its shelf registration statement providing for the issuance of up to $25.1 billion of AIG debt securities. The proceeds from the issuance of these debt securities may be used (i) by AIG for general corporate purposes, (ii) by AIGFP as it would use the proceeds from its own borrowings as discussed below or (iii) to fund the MIP. As of December 31, 2006, $1.8 billion principal amount of notes were outstanding under the medium term note program, of which (i) $749 million was used for AIG’s general corporate purposes, (ii) $72 million was used by AIGFP and (iii) $1.0 billion was used to fund the MIP. The maturity dates of these notes range from 2011 to 2046. To the extent deemed appropriate, AIG may enter into swap transactions to manage its effective borrowing with respect to these notes.
In November 2006, AIG established an Australian dollar debt program under which senior notes with an aggregate amount of up to 5 billion Australian dollars may be outstanding at any one time. The program provides that additional notes may be issued to replace matured or redeemed notes. Although as of December 31, 2006 there were no outstanding notes under the Australian program, AIG intends to use the program opportunistically to fund the MIP or for AIG’s general corporate purposes.
As backup for the commercial paper program and for other general corporate purposes, AIG and AIG Funding maintain revolving credit facilities, which, as of December 31, 2006, had an aggregate of $5.8 billion available to be drawn and which are summarized below under Revolving Credit Facilities.
ILFC fulfills its short-term cash requirements through operating cash flows and the issuance of commercial paper. The issuance of commercial paper is subject to the approval of ILFC’s Board of Directors and is not guaranteed by AIG. ILFC maintains syndicated revolving credit facilities which, as of December 31, 2006, aggregated $6.5 billion and which are summarized below under Revolving Credit Facilities. These facilities are used as back up for ILFC’s maturing debt and other obligations.
As a well-known seasoned issuer, ILFC has filed an automatic shelf registration statement with the SEC allowing ILFC immediate access to the U.S. public debt markets. For 2006, $1.90 billion of debt securities were issued under this registration statement and $3.52 billion were issued under a prior registration statement. In addition, ILFC has a Euro medium term note program for $7.0 billion, under which $4.28 billion in notes were sold through December 31, 2006. Notes issued under the Euro medium term note program are included in ILFC Notes and bonds payable in the preceding table of borrowings. The foreign exchange adjustment for the foreign currency denominated debt was $733 million at December 31, 2006 and $197 million at December 31, 2005. ILFC has substantially eliminated the currency exposure arising from foreign currency denominated notes by economically hedging the portion of the note exposure not already offset by Euro-denominated operating lease payments, although such hedges did not qualify for hedge accounting treatment under FAS 133.
ILFC had a $4.3 billion Export Credit Facility for use in connection with the purchase of approximately 75 aircraft delivered through 2001. This facility was guaranteed by various European Export Credit Agencies. The interest rate varies from 5.75 percent to 5.90 percent on these amortizing ten-year borrowings depending on the delivery date of the aircraft. At December 31, 2006, ILFC had $1.0 billion outstanding under this facility. The debt is collateralized by a pledge of the shares of a subsidiary of ILFC, which holds title to the aircraft financed under the facility.
The proceeds of ILFC’s debt financing are primarily used to purchase flight equipment, including progress payments during the construction phase. The primary sources for the repayment of this debt and the interest expense thereon are the cash flow from operations, proceeds from the sale of flight equipment and the rollover and refinancing of the prior debt. AIG does not guarantee the debt obligations of ILFC. See also Operating Review - Financial Services Operations and Liquidity herein.
AGF’s funding sources include a medium term note program, private placement debt, retail note issuances, securitizations of finance receivables that AGF accounts for as on-balance-sheet secured financings and bank financings. In addition, AGF has become an established issuer of long-term debt in the international capital markets.
In addition to debt refinancing activities, proceeds from the collection of finance receivables may be used to pay the principal and interest on AGF’s debt. AIG does not guarantee any of the debt obligations of AGF. See also Operating Review - Financial Services Operations and Liquidity herein.
AIG, ILFC and AGF maintain the following committed, unsecured revolving credit facilities in order to support their respective commercial paper programs and for general corporate purposes. AIG, ILFC and AGF expect to replace or extend these credit facilities on or prior to their expiration. Some of the facilities, as noted below, contain a “term-out option” allowing for the conversion by the borrower of any outstanding loans at expiration into one-year term loans.
Moody’s Investors Service (Moody’s). Moody’s appends numerical modifiers 1, 2 and 3 to the generic rating categories to show relative position within rating categories.
AIG guarantees all obligations of AIG Financial Products Corp. and AIG Funding, Inc.
AIG believes that any of its own or its subsidiaries’ contractual obligations that are subject to “ratings triggers” or financial covenants relating to “ratings triggers” would not have a material adverse effect on its financial condition or liquidity. Ratings downgrades could also trigger the application of termination provisions in certain of AIG’s contracts, principally agreements entered into by AIGFP and assumed reinsurance contracts entered into by Transatlantic.
The maturity schedule of contractual obligations of AIG and its consolidated subsidiaries at December 31, 2006 was as follows:
Excludes commercial paper and obligations included as debt pursuant to FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (FIN 46R), and includes hybrid financial instrument liabilities recorded at fair value. See also Note 9 of Notes to Consolidated Financial Statements.
Includes commitments to invest in limited partnerships, private equity and hedge funds and real estate.
AIG’s consolidated shareholders’ equity increased during 2006 and 2005 as follows:
Reflects the effects of employee stock transactions and in 2006 also reflects the cumulative effect of accounting changes, including the adoption of FAS 158. See Note 1(hh) of Notes to Consolidated Financial Statements.
In February 2007, AIG’s Board of Directors adopted a new dividend policy, to take effect with the dividend to be declared in the second quarter of 2007, providing that under ordinary circumstances, AIG’s plan will be to increase its common stock dividend by approximately 20 percent annually.
During 2006, AIG did not purchase any shares of its common stock under its existing share repurchase authorization. At December 31, 2006, an additional 36,542,700 shares could be purchased under the then current authorization by AIG’s Board of Directors. In February 2007, AIG’s Board of Directors increased the repurchase program by authorizing the repurchase of shares with an aggregate purchase price of $8 billion. AIG or its subsidiaries from time to time may buy shares of its common stock in the open market for general corporate purposes, including to satisfy its obligations under various employee benefit plans. During 2006, ILFC purchased 17,000 shares of AIG common stock at an average cost of $72.18 per share to satisfy its obligations under an employee benefit plan. See Capital Resources and Liquidity - Liquidity for a discussion of possible share repurchases in 2007.
AIG’s insurance subsidiaries, in common with other insurers, are subject to regulation and supervision by the states and jurisdictions in which they do business. In the U.S., the NAIC has developed Risk-Based Capital (RBC) requirements. RBC relates an individual insurance company’s statutory surplus to the risk inherent in its overall operations.
In connection with the filing of the 2005 statutory financial statements for AIG’s Domestic General Insurance companies, AIG agreed with the relevant state insurance regulators on the statutory accounting treatment of various items. The regulatory authorities have also permitted certain of the domestic and foreign insurance subsidiaries to support the carrying value of their investments in certain non-insurance and foreign insurance subsidiaries by utilizing the AIG audited consolidated financial statements to satisfy the requirement that the U.S. GAAP-basis equity of such entities be audited. In addition, the regulatory authorities have permitted the Domestic General Insurance companies to utilize audited financial statements prepared on a basis of accounting other than U.S. GAAP to value investments in joint ventures, limited partnerships and hedge funds. AIG has received similar permitted practices authorizations from insurance regulatory authorities in connection with the 2006 statutory financial statements. These permitted practices did not affect the Domestic General Insurance companies’ compliance with minimum regulatory capital requirements.
dividends under AIG’s new dividend policy and repurchases of common stock.
In addition to the combined insurance operating cash flow, AIG’s insurance operations held $11.2 billion in cash and short-term investments at December 31, 2006. Operating cash flow and the cash and short-term balances held provided AIG’s insurance operations with a significant amount of liquidity. This liquidity is available, among other things, to purchase predominately high quality and diversified fixed income securities and, to a lesser extent, marketable equity securities, and to provide mortgage loans on real estate, policy loans, and collateral loans. This cash flow coupled with proceeds of approximately $126 billion from the maturities, sales and redemptions of fixed income securities and from the sale of equity securities was used to purchase approximately $161 billion of fixed income securities and marketable equity securities during 2006.
General Insurance operating cash flow is derived from underwriting and investment activities. With respect to General Insurance operations, if paid losses accelerated beyond AIG’s ability to fund such paid losses from current operating cash flows, AIG might need to liquidate a portion of its General Insurance investment portfolio and/or arrange for financing. Potential events causing such a liquidity strain could be the result of several significant catastrophic events occurring in a relatively short period of time. Additional strain on liquidity could occur if the investments liquidated to fund such paid losses were sold into a depressed market place and/or reinsurance recoverable on such paid losses became uncollectible or collateral supporting such reinsurance recoverable significantly decreased in value.
Life Insurance & Retirement Services operating cash flow is derived from underwriting and investment activities. If a substantial portion of the Life Insurance & Retirement Services operations bond portfolio diminished significantly in value and/or defaulted, AIG might need to liquidate other portions of its Life Insurance & Retirement Services investment portfolio and/or arrange financing. Potential events causing such a liquidity strain could be the result of economic collapse of a nation or region in which Life Insurance & Retirement Services operations exist, nationalization, terrorist acts, or other economic or political upheaval. In addition, a significant rise in interest rates leading to a major increase in policyholder surrenders could also create a liquidity strain.
AIG’s major Financial Services operating subsidiaries consist of AIGFP, ILFC, AGF and AIGCFG. Sources of funds considered in meeting the liquidity needs of AIGFP’s operations include GIAs, issuance of long-term and short-term debt, proceeds from maturities, sales of securities available for sale and securities and spot commodities leased or sold under repurchase agreements. ILFC, AGF and AIGCFG utilize the commercial paper markets, bank loans and bank credit facilities as sources of liquidity. ILFC and AGF also fund in the domestic and international capital markets without reliance on any guarantee from AIG. An additional source of liquidity for ILFC is the use of export credit facilities. AIGCFG also uses wholesale and retail bank deposits as sources of funds. On occasion, AIG has provided equity capital to ILFC, AGF and AIGCFG and provides intercompany loans to AIGCFG.
AIG funds its short-term working capital needs through commercial paper issued by AIG Funding. As of December 31, 2006, AIG Funding had $4.8 billion of commercial paper outstanding with an average maturity of 28 days. As additional liquidity, AIG and AIG Funding maintain revolving credit facilities that, as of December 31, 2006, had an aggregate of $5.8 billion available to be drawn, which are summarized above under Revolving Credit Facilities.
The following tables summarize the composition of AIG’s invested assets by segment, at December 31, 2006 and 2005:
At December 31, 2005, approximately 70 percent and 30 percent of invested assets were held in domestic and foreign investments, respectively.
Fixed income assets held in Foreign General Insurance are of high quality and short to intermediate duration, averaging 4.2 years compared to 7.2 years for those in Domestic General Insurance.
General Insurance invested assets grew by $21.3 billion, or 22 percent, during 2006 as bond holdings grew by $17 billion, or 24 percent. Listed equity holdings remained essentially flat at $6.5 billion.
the maturity of the initial investments may be at a yield below that of the interest required for the accretion of the policy liabilities. Additionally, there exists a future investment risk associated with certain policies currently in-force which will have premium receipts in the future. That is, the investment of these future premium receipts may be at a yield below that required to meet future policy liabilities.
AIG may use alternative investments in certain foreign jurisdictions where interest rates remain low and there are limited long-dated bond markets, including equities, real estate and foreign currency denominated fixed income instruments to extend the duration or increase the yield of the investment portfolio to more closely match the requirements of the policyholder liabilities and DAC recoverability. This strategy has been effectively used in Japan and more recently by Nan Shan in Taiwan. In Japan, foreign assets, excluding those matched to foreign liabilities, were approximately 30 percent of statutory assets, which is below the maximum allowable percentage under current local regulation. Foreign assets comprised approximately 32 percent of Nan Shan’s invested assets at December 31, 2006, slightly below the maximum allowable percentage under current local regulation. The majority of Nan Shan’s in-force policy portfolio is traditional life and endowment insurance products with implicit interest rate guarantees. New business with lower interest rate guarantees are gradually reducing the overall interest requirements, but asset portfolio yields have declined faster due to the prolonged low interest rate environment. As a result, although the investment margins for a large block of in-force policies are negative, the block remains profitable because the mortality and expense margins presently exceed the negative investment spread. In response to the low interest rate environment and the volatile exchange rate of the NT dollar, Nan Shan is emphasizing new products with lower implied guarantees, including participating endowments and investment linked products. Although the risks of a continued low interest rate environment coupled with a volatile NT dollar could increase net liabilities and require additional capital to maintain adequate local solvency margins, Nan Shan currently believes it has adequate resources to meet all future policy obligations.
The cash used for the purchase of flight equipment is derived primarily from the proceeds of ILFC’s debt financings. The primary sources for the repayment of this debt and the related interest expense are ILFC’s cash flow from operations, proceeds from the sale of flight equipment and the rollover and refinancing of the prior debt. During 2006, ILFC acquired flight equipment costing $6.0 billion. For a further discussion of ILFC’s borrowings, see Operating Review - Financial Services Operations - Aircraft Leasing and Capital Resources - Borrowings herein.
Capital Markets derivative transactions are carried at market value or at estimated fair value when market prices are not readily available. AIGFP reduces its economic risk exposure through similarly valued offsetting transactions including swaps, trading securities, options, forwards and futures. The estimated fair values of these transactions represent assessments of the present value of expected future cash flows. These transactions would be exposed to liquidity risk if AIGFP were required to sell or close out the transactions prior to maturity. AIG believes that the effect of any such event would not be significant to AIG’s financial condition or its overall liquidity. For a further discussion on the use of derivatives by Capital Markets, see Operating Review - Financial Services Operations - Capital Markets and Risk Management - Derivatives herein and Note 19 of Notes to Consolidated Financial Statements.
Securities available for sale is predominately a diversified portfolio of high grade fixed income securities, where the individual securities have varying degrees of credit risk. At December 31, 2006, the average credit rating of this portfolio was in the AA+ category or the equivalent thereto as determined through rating agencies or internal review. AIGFP has also entered into credit derivative transactions to economically hedge its credit risk associated with $128 million of these securities. Securities deemed below investment grade at December 31, 2006 amounted to approximately $340 million in fair value, representing 0.7 percent of the total AIGFP securities available for sale. There have been no significant downgrades through February 15, 2007. If its securities available for sale portfolio were to suffer significant default and the collateral held declined significantly in value with no replacement or the credit default swap counterparty failed to perform, AIGFP could have a liquidity strain. AIG guarantees AIGFP’s payment obligations, including its debt obligations.
AIGFP’s exposure management objective is to minimize interest rate, currency, commodity and equity risks associated with its securities available for sale. That is, when AIGFP purchases a security for its securities available for sale investment portfolio, it simultaneously enters into an offsetting internal hedge such that the payment terms of the hedging transaction offset the payment terms of the investment security, which achieves the economic result of converting the return on the underlying security to U.S. dollar LIBOR plus or minus a spread based on the underlying profit on each security on the initial trade date. The market risk associated with such internal hedges is managed on a portfolio basis, with third-party hedging transactions executed as necessary. As hedge accounting treatment was not achieved in 2006, the unrealized gains and losses on the derivative transactions with unaffiliated third parties were reflected in operating income. The unrealized gains and losses on the underlying securities available for sale resulting from changes in interest rates and currency rates and commodity and equity prices were included in Accumulated other comprehensive income, or in operating income, as appropriate. When a security is sold, the realized gain or loss with respect to this security is then included in operating income.
The gross unrealized gains and gross unrealized losses of Capital Markets operations included in the financial services assets and liabilities at December 31, 2006 were as follows:
These amounts are also presented as the respective balance sheet amounts.
AIGFP actively manages the exposures to limit potential losses, while maximizing the rewards afforded by these business opportu-
AIG’s Consumer Finance operations provide a wide variety of consumer finance products, including real estate and other consumer loans, credit card loans, retail sales finance and credit-related insurance to customers both domestically and overseas, particularly in emerging markets. These products are funded through a combination of deposits and various borrowings, including commercial paper and medium-term notes. AIG’s Consumer Finance operations are exposed to credit risk and risk of loss resulting from adverse fluctuations in interest rates. Over half of the finance receivables are real estate loans which are substantially collateralized by the related properties.
With respect to credit losses, the allowance for losses is maintained at a level considered adequate to absorb anticipated credit losses existing in that portfolio as of the balance sheet date.
Asset Management invested assets are primarily comprised of assets supporting AIG’s spread-based investment business, which includes AIG’s MIP and domestic GIC programs as well as AIG’s foreign spread-based business. Asset Management invested assets also include assets attributable to certain consolidated partnerships and variable interest entities. A portion of these consolidated assets is offset by minority interest liabilities attributable to unaffiliated investor entities in AIG-sponsored investment vehicles.
The spread-based investment business strategy is to produce cash flows greater than maturing liabilities. The asset-liability relationship is managed actively, leveraging the organization’s experience in the Life Insurance & Retirement Services segment. Margins are emphasized while maintaining satisfactory investment quality and liquidity. The invested assets are predominantly fixed income securities for the spread-based investment business.
The valuation of AIG’s investment portfolio involves obtaining a market value for each security. The source for the fair value is generally from market exchanges or dealer quotations, with the exception of nontraded securities. AIG considers nontraded securities to mean certain fixed income investments, certain structured securities, direct private equities, limited partnerships, and hedge funds.
The aggregate carrying value of AIG’s nontraded securities at December 31, 2006 was approximately $67 billion. The methodology used to estimate fair value of nontraded fixed income investments is by reference to traded securities with similar attributes and using a matrix pricing methodology. This methodology takes into account such factors as the issuer’s industry, the security’s rating and tenor, its coupon rate, its position in the capital structure of the issuer, and other relevant factors. The change in fair value is recognized as a component of Accumulated other comprehensive income, net of tax.
AIG obtains the fair value of its investments in limited partnerships and hedge funds from information provided by the general partner or manager of each of these investments, the accounts of which generally are audited on an annual basis.
As a result of these policies, AIG recorded, in realized capital gains (losses), other-than-temporary impairment pretax losses of $944 million, $598 million and $684 million in 2006, 2005 and 2004, respectively. Just over half of other-than-temporary impairment charges in 2006 were a result of the decision not to hold these investment securities until they fully recover in value. The writedowns recorded in 2005 and 2004 were primarily the result of adverse changes in the creditworthiness of the issuer.
No impairment charge with respect to any one single credit was significant to AIG’s consolidated financial condition or results of operations, and no individual impairment loss exceeded 1.0 percent of consolidated net income for 2006.
Excluding the other-than-temporary impairments noted above, the changes in fair value for AIG’s available for sale portfolio, which constitutes the vast majority of AIG’s investments, were recorded in Accumulated other comprehensive income as unrealized gains or losses, net of tax.
For the year ended December 31, 2006, the pretax realized losses incurred with respect to the sale of fixed maturities and equity securities were $1.3 billion. The aggregate fair value of securities sold was $43 billion, which was approximately 97 percent of amortized cost. The average period of time that securities sold at a loss during the year ended December 31, 2006 were trading continuously at a price below book value was approximately four months. See Risk Management - Investments herein for an additional discussion of investment risks associated with AIG’s investment portfolio.
The major risks to which AIG is exposed include the following:
Insurance risk - the potential loss resulting from ultimate claims and expenses exceeding held reserves.
Operational risk - the potential loss resulting from inadequate or failed internal processes, people, and systems, or from external events.
AIG’s major risks are addressed at the corporate level through the Enterprise Risk Management Department (ERM). ERM is headed by AIG’s Chief Risk Officer (CRO) and is responsible for assisting AIG’s business leaders, executive management and the Board of Directors to identify, assess, quantify, manage and mitigate the risks incurred by AIG. An important goal of ERM is to ensure that once appropriate governance, authorities, procedures and policies have been established, aggregated risks do not result in inappropriate concentrations.
Senior management defines the policies, has established general operating parameters for its global businesses and has established various oversight committees to monitor the risks attendant to its businesses:
The Foreign Exchange Committee (FEC) monitors trends in foreign exchange rates, reviews AIG’s foreign exchange exposures, and provides recommendations on foreign currency asset allocation and remittance hedging.
Manage the approval process for all requests for credit limits, program limits and transactions.
Administer regular portfolio credit reviews of all investment, derivative and credit-incurring business units.
AIG’s single largest industry credit exposure is to the highly-rated global financial institutions sector, accounting for 72 percent of total shareholders’ equity at December 31, 2006.
AIG’s other industry credit concentrations in excess of 10 percent of total shareholders’ equity at December 31, 2006 exist to the following industries (in descending order by approximate size):
AIG seeks to minimize market risks by matching the market risks in its assets with the market risks in its liabilities. Nevertheless, AIG does have net exposure to market risks, primarily within its insurance businesses. These asset-liability exposures are predominantly structural in nature, and not the result of speculative positioning to take advantage of short-term market opportunities. The Market Risk Management Department (MRM), which reports to the CRO, is responsible for control and oversight of market risks in all aspects of AIG’s financial services, insurance, and investment activities.
AIG analyzes market risk using various statistical techniques including Value at Risk (VaR). VaR is a summary statistical measure that uses the estimated volatility and correlation of market factors to calculate the maximum loss that could occur over a defined period of time given a certain probability. VaR measures not only the size of individual exposures but also the interaction between different market exposures, thereby providing a portfolio approach to measuring market risk. Substantially similar VaR methodologies are used to determine capital requirements for market risk within AIG’s economic capital framework.
While VaR models are relatively sophisticated, their results are limited by the assumptions and parameters used in these models. AIG believes that statistical models alone do not provide a reliable method of monitoring and controlling market risk. Therefore, such models are tools and do not substitute for the experience or judgment of senior management.
AIG has performed one comprehensive VaR analysis across all of its non-trading businesses, and a separate VaR analysis for its trading business at AIGFP. The comprehensive VaR is categorized by AIG business segment (General Insurance, Life Insurance & Retirement Services, Financial Services and Asset Management) and also by market risk factor (interest rate, currency and equity).
For the insurance segments, assets included are invested assets (excluding real estate and investment income due and accrued), and liabilities included are reserve for losses and loss expenses, reserve for unearned premiums, future policy benefits for life and accident and health insurance contracts and other policyholders’ funds. For financial services companies, loans and leases represent the majority of assets represented in the VaR calculation, while bonds and notes issued represent the majority of liabilities.
Strong governance sets the appropriate tone to enable effective management of the risks inherent in each of AIG’s businesses, as well as aid in the management of reputational risk. Each AIG business is responsible for maintaining appropriate governance over its management of operational risk. This respon-
sibility includes developing and implementing policies, procedures, management oversight processes, and other governance-related activities consistent with AIG’s overall operational risk management process.
AIG’s operational risk management program includes a self assessment process. The self assessment process is used to identify key operational risks in a business and evaluate the effectiveness of existing controls to mitigate those risks, as well as develop corrective action plans for identified deficiencies.
AIG enters into intercompany reinsurance transactions, primarily through AIRCO, for its General Insurance and Life Insurance & Retirement Services operations. AIG enters into these transactions as a sound and prudent business practice in order to maintain underwriting control and spread insurance risk among AIG’s various legal entities. AIG generally obtains letters of credit from third-party financial institutions in order to obtain statutory recognition of these intercompany reinsurance transactions. At December 31, 2006, approximately $4.0 billion of letters of credit were outstanding to cover intercompany reinsurance transactions with AIRCO or other General Insurance subsidiaries.
Although reinsurance arrangements do not relieve AIG subsidiaries from their direct obligations to insureds, an efficient and effective reinsurance program substantially limits AIG’s exposure to potentially significant losses. AIG continually evaluates the reinsurance markets and the relative attractiveness of various arrangements for coverage, including structures such as catastrophe bonds, insurance risk securitizations and “sidecar” and similar vehicles.
Effective July 15, 2006, Lexington and Concord Re Limited (Concord Re), a “sidecar” reinsurer that was established exclusively to reinsure Lexington, entered into a quota share reinsurance agreement covering the U.S. commercial property insurance business written by Lexington. Concord Re was capitalized with approximately $730 million through the issuance of equity securities and loans from third party investors. AIG and its subsidiaries invest in a wide variety of investment vehicles managed by third parties where AIG has no control over investment decisions. Accordingly, there can be no assurance that such vehicles do not, or will not, hold securities of Concord Re.
AIG’s consolidated general reinsurance assets amounted to $21.8 billion at December 31, 2006. AIG manages the credit risk in its reinsurance relationships by transacting with reinsurers that it considers financially sound, and when necessary AIG holds substantial collateral in the form of funds, securities and/or irrevocable letters of credit. This collateral can be drawn on for amounts that remain unpaid beyond specified time periods on an individual reinsurer basis. At December 31, 2006, approximately 54 percent of the general reinsurance assets were from unauthorized reinsurers. Many of these balances were collateralized, permitting statutory recognition. Additionally, with the approval of insurance regulators, AIG posted approximately $2 billion of letters of credit issued by commercial banks in favor of certain Domestic General Insurance companies to permit those companies statutory recognition of balances otherwise uncollateralized at December 31, 2006. The remaining 46 percent of the general reinsurance assets were from authorized reinsurers. The terms authorized and unauthorized pertain to regulatory categories, not creditworthiness. At December 31, 2006, approximately 85 percent of the balances with respect to authorized reinsurers are from reinsurers rated A (excellent) or better, as rated by A.M. Best, or A (strong) or better, as rated by S&P. These ratings are measures of financial strength.
Life Insurance & Retirement Services - risks include mortality and morbidity in the insurance-oriented products and insufficient cash flows to cover contract liabilities in the retirement savings-oriented products. In the Life Insurance & Retirement Services segment, risk is aggregated and limited by individual/group, product group, country and catastrophic risk events.
AIG closely manages insurance risk by overseeing and controlling the nature and geographic location of the risks in each line of business underwritten, the terms and conditions of the underwriting and the premiums charged for taking on the risk. Concentrations of risk primarily arise from external events, such as wind, flood, earthquake, terrorism and pandemics, which are analyzed using various modeling techniques.
AIG is a major purchaser of reinsurance for its insurance operations. The use of reinsurance facilitates insurance risk management (retention, volatility, concentrations) and capital planning locally (branch and subsidiary). Pooling of AIG’s reinsurance risks enables AIG to purchase reinsurance more efficiently at a consolidated level, manage global counterparty risk and relationships and manage global catastrophe risks, both for the General Insurance and Life Insurance & Retirement Services businesses.
In General Insurance, underwriting risks are managed through the application approval process, exposure limitations as well as through exclusions, coverage limits and reinsurance. The risks covered by AIG are managed through limits on delegated under-
Natural disasters such as hurricanes, earthquakes and other catastrophes have the potential to adversely affect AIG’s operating results. Other risks, such as an outbreak of a pandemic disease, such as the Avian Influenza A Virus (H5N1), could adversely affect AIG’s business and operating results to an extent that may be only partially offset by reinsurance programs.
These estimates are inherently uncertain and may not reflect AIG’s maximum exposures to these events. It is highly likely that AIG’s losses will vary, perhaps significantly, from these estimates.
The modeled results provided in the table below were based on the aggregate exceedence probability (AEP) losses which represent total property and workers compensation losses that may occur in any single year from one or more natural events. The model, which has been updated to reflect 2005 catastrophes, generally used exposure data as of mid-year 2006 and the current reinsurance program structure. The values provided were based on 100-year return period losses, which have a one percent likelihood of being exceeded in any single year. Thus, the model projects that there is a one percent probability that AIG could incur in any year losses in excess of the modeled amounts for these perils.
The combined earthquake and tropical cyclone 100-year return period modeled losses for Ascot and Transatlantic together are estimated to be $1.1 billion, on a gross basis, $761 million, net of reinsurance, and $494 million, net after income taxes, or 0.5 percent of total shareholders’ equity at December 31, 2006.
In addition, AIG evaluates potential single event earthquake and hurricane losses that may be incurred. The single events utilized are a subset of potential events identified and utilized by Lloyd’s(1) and referred to as Realistic Disaster Scenarios (RDSs). The purpose of this analysis is to utilize these RDSs to provide a reference frame and place into context the model results. However, it is important to note that the specific events used for this analysis do not necessarily represent the worst case loss that AIG could incur from this type of an event in these regions. The losses associated with the RDSs are included in the table below.
Exposure to loss from terrorist attack is controlled by limiting the aggregate accumulation of workers compensation and property insurance that is underwritten within defined target locations. Modeling is used to provide projections of probable maximum loss by target location based upon the actual exposures of AIG policyholders.
In Life Insurance & Retirement Services, the primary risks are (i) underwriting, which represents the exposure to loss resulting from the actual policy experience emerging adversely in comparison to the assumptions made in the product pricing associated with mortality, morbidity, termination and expenses; and (ii) investment risk which represents the exposure to loss resulting from the cash flows from the invested assets being less than the cash flows required to meet the obligations of the expected policy and contract liabilities and the necessary return on investments. AIG businesses manage these risks through exposure limitations and the active management of the asset-liability relationship in their operations. The emergence of significant adverse experience would require an adjustment to DAC and benefit reserves that could have a material adverse effect on AIG’s consolidated results of operations for a particular period.
The contagion and mortality rates of any mutated H5N1 virus that can be transmitted from human to human are highly speculative. AIG continues to monitor the developing facts. A significant global outbreak could have a material adverse effect on Life Insurance & Retirement Services operating results and liquidity from increased mortality and morbidity rates. AIG continues to analyze its exposure to this serious threat and has engaged an external risk management firm to model loss scenarios associated with an outbreak of Avian Flu. Using a 1 in 100-year return period, AIG estimates its after-tax net losses under its life insurance policies due to Avian Flu at less than 1 percent of consolidated shareholders’ equity as of December 31, 2006. This estimate was calculated over a 3-year period, although the majority of the losses would be incurred in the first year. The modeled losses calculated were based on 2005 policy data representing approximately 90 percent of AIG’s individual life, group life and credit life books of business, net of reinsurance. This estimate does not include claims that could be made under other policies, such as business interruption or general liability
policies, and does not reflect estimates for losses resulting from disruption of AIG’s own business operations that may arise out of such a pandemic. The model used to generate this estimate has only recently been developed. The reasonableness of the model and its underlying assumptions cannot readily be verified by reference to comparable historical events. As a result, AIG’s actual losses from a pandemic influenza outbreak are likely to vary significantly from those predicted by the model.
At December 31, 2006, approximately 57 percent of the fixed maturities investments were domestic securities. Approximately 39 percent of such domestic securities were rated AAA by one or more of the principal rating agencies. Approximately five percent were below investment grade or not rated.
A significant portion of the foreign fixed income portfolio is rated by Moody’s, S&P or similar foreign rating services. Rating services are not available in all overseas locations. The CRC closely reviews the credit quality of the foreign portfolio’s non-rated fixed income investments. At December 31, 2006, approximately 20 percent of the foreign fixed income investments were either rated AAA or, on the basis of AIG’s internal analysis, were equivalent from a credit standpoint to securities so rated. Approximately five percent were below investment grade or not rated at that date. A large portion of the foreign fixed income portfolio is sovereign fixed maturity securities supporting the policy liabilities in the country of issuance.
The senior management of AIG defines the policies and establishes general operating parameters for Capital Markets operations. AIG’s senior management has established various oversight committees to monitor on an ongoing basis the various financial market, operational and credit risk attendant to the Capital Markets operations. The senior management of AIGFP reports the results of its operations to and reviews future strategies with AIG’s senior management.
AIGFP actively manages its exposures to limit potential losses, while maximizing the rewards afforded by these business opportunities. In doing so, AIGFP must continually manage a variety of exposures including credit, market, liquidity, operational and legal risks.
will be an equity layer covering the first credit losses in respect of the portfolio up to a specified percentage of the total portfolio, and then successive layers that are rated, generally a BBB-rated layer, an A-rated layer, an AA-rated layer, and one or more AAA-rated layers. In transactions that are rated, the risk layer or tranche that is immediately junior to the threshold level above which AIGFP’s payment obligation would generally arise is rated AAA by the rating agencies. In transactions that are not rated, AIGFP applies the same risk criteria for setting the threshold level for its payment obligations. Therefore, the risk layer assumed by AIGFP with respect to the designated portfolio in these transactions is often called the “super senior” risk layer, defined as the layer of credit risk senior to a risk layer that has been rated AAA by the credit rating agencies, or if the transaction is not rated, equivalent thereto.
Financial Services securities available for sale is predominately a diversified portfolio of high grade fixed income securities. At December 31, 2006, the average credit rating of this portfolio was in the AA+ category or the equivalent thereto as determined through rating agencies or internal review. AIGFP has also entered into credit derivative transactions to economically hedge its credit risk associated with $128 million of these securities. Securities deemed below investment grade at December 31, 2006 amounted to approximately $340 million in fair value representing 0.7 percent of the total AIGFP securities available for sale. There have been no significant downgrades through February 15, 2007. If its securities available for sale portfolio were to suffer significant default and the collateral held declined significantly in value with no replacement or the credit default swap counterparty failed to perform, AIGFP could have a liquidity strain. AIG guarantees AIGFP’s payment obligations, including its debt obligations.
In addition, AIGFP utilizes various credit enhancements, including letters of credit, guarantees, collateral, credit triggers, credit derivatives and margin agreements to reduce the credit risk relating to its outstanding financial derivative transactions. AIGFP requires credit enhancements in connection with specific transactions based on, among other things, the creditworthiness of the counterparties, and the transaction’s size and maturity. Furthermore, AIGFP generally seeks to enter into agreements that have the benefit of set-off and close-out netting provisions. These provisions provide that, in the case of an early termination of a transaction, AIGFP can set-off its receivables from a counterparty against its payables to the same counterparty arising out of all covered transactions. As a result, where a legally enforceable netting agreement exists, the fair value of the transaction with the counterparty represents the net sum of estimated positive fair values. The fair value of AIGFP’s interest rate, currency, commodity and equity swaps, options, swaptions, and forward commitments, futures, and forward contracts approximated $19.25 billion at December 31, 2006 and $18.70 billion at December 31, 2005. Where applicable, these amounts have been determined in accordance with the respective close-out netting provisions.
AIGFP independently evaluates the counterparty credit quality by reference to ratings from rating agencies or, where such ratings are not available, by internal analysis consistent with the risk rating policies of the CRC. In addition, AIGFP’s credit approval process involves pre-set counterparty and country credit exposure limits and, for particularly credit-intensive transactions, requires approval from the CRC. AIG estimates that the average credit rating of Capital Markets derivatives counterparties, measured by reference to the fair value of its derivative portfolio as a whole, is equivalent to the AA rating category.
AIGFP maintains a very conservative market risk profile and minimizes risk in interest rates, equities, commodities and foreign exchange. Market exposures in option implied volatilities, correlations and basis risks are also minimized over time but those are the main types of market risks that AIGFP manages. As a result, AIGFP’s operating income due to changes in market prices and rates is generally a very small percentage of its overall operating income.
In the calculation of VaR for AIGFP, AIG uses the historical simulation methodology that entails repricing all transactions under explicit changes in market rates within a specific historical time period. AIGFP attempts to secure reliable and independent current market prices, such as published exchange prices, external subscription services such as Bloomberg or Reuters, or third-party broker quotes. When such prices are not available, AIGFP uses an internal methodology which includes extrapolation from observable and verifiable prices nearest to the dates of the transactions. Historically, actual results have not deviated from these models in any material respect.
The following table presents the year-end, average, high, and low VaRs on a diversified basis and of each component of market risk for Capital Markets operations for the years 2006 and 2005. The diversified VaR is usually smaller than the sum of its components due to correlation effects.
AIG’s Consumer Finance operations are exposed to credit risk and risk of loss resulting from adverse fluctuations in interest rates and payment defaults. Credit loss exposure is managed through a combination of underwriting controls, mix of finance receivables, collateral and collection efficiency. Large product programs are subject to CRC approval.
The majority of the credit and market risk exposures within Asset Management results from the spread-based investment business and the investment activities of AIG Global Real Estate Investment Corp.
Within AIG Global Real Estate Investment Corp., AIG is exposed to the general conditions in global real estate markets and the credit markets. Such exposure can subject Asset Management to delays in real estate sales, additional carrying costs and in turn affect operating results within the segment. These risks are mitigated through the underwriting process, transaction and contract terms and conditions and portfolio diversification by type of project, sponsor, real estate market and country. AIG’s exposure to real estate investments is monitored on an ongoing basis by the Asset Management real estate investment committee.
The Economic Capital requirement is driven by exposures to risks and correlations among various types of risks. As a global financial conglomerate, AIG is exposed to various risks including underwriting, financial and operational risks. The Economic Capital initiative has modeled these risks into five major categories: property & casualty insurance risk, life insurance risk, market risk, credit risk and operational risk. Within each risk category, there are sub-risks that have been modeled in greater detail. The Economic Capital initiative also analyzes and includes diversification benefits within and across risk categories and business segments.
The initial assessments were made at the corporate, segment and major business unit level, and detailed analyses of selected businesses and products were undertaken. AIG also developed assessments of diversification benefits across lines of business, geographic regions and risk categories. Given the breadth and global nature of AIG’s businesses, these benefits were found to be significant.
Throughout 2007, AIG will continue to enhance the methodology to provide assurance regarding the completeness and relevance of the model’s results. AIG will continue discussions with the rating agencies concerning its enterprise risk management processes and the results of its new economic capital model for their consideration in the rating process. AIG’s analysis and conclusions concerning the economic capital support of its segments and major business units will be further extended to include consideration for capital availability and mobility. The framework and process will increasingly provide assistance in management’s decision-making concerning capital management and capital allocation, mergers, acquisitions and divestitures, risk retention, reinsurance and hedging strategies and product development and pricing.
At the March 2004 meeting, the Emerging Issues Task Force (EITF) reached a consensus with respect to Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” On September 30, 2004, the FASB issued FASB Staff Position (FSP) EITF Issue 03-1-1, Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments.” In November 2005, the FASB issued FSP FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” which replaces the measurement and recognition guidance set forth in Issue No. 03-1 and codifies certain existing guidance on impairment.
On September 19, 2005, the FASB issued Statement of Position 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts.”
On February 16, 2006, the FASB issued FAS No. 155, “Accounting for Certain Hybrid Financial Instruments.”
On January 17, 2007, the FASB issued Statement 133 Implementation Issue No. B40, “Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets” (Issue B40).
On July 13, 2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (FIN 48).
Effective January 1, 2006, AIG adopted the fair value recognition provisions of Statement of FAS No. 123R “Share-Based Payments” (FAS 123R). For further discussion of this recent accounting standard and its application to AIG, see Note 14 of Notes to Consolidated Financial Statements.
In September 2006, the FASB issued FAS No. 157, “Fair Value Measurements” (FAS 157).
For further discussion of these recent accounting standards and their application to AIG, see Note 1(hh) of Notes to Consolidated Financial Statements.
We have completed integrated audits of American International Group, Inc.’s consolidated financial statements and of its internal control over financial reporting as of December 31, 2006, in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Also, we have audited management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that AIG did not maintain effective internal control over financial reporting as of December 31, 2006 because of the effect of the material weakness relating to controls over income tax accounting, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). AIG’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of AIG’s internal control over financial reporting based on our audit.
A material weakness is a control deficiency, or a combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. As of December 31, 2006, a material weakness relating to the controls over income tax accounting has been identified and included in management’s assessment.
Controls over income tax accounting: AIG did not maintain effective controls over the determination and reporting of certain components of the provision for income taxes and related income tax balances. Specifically, AIG did not maintain effective controls to review and monitor the accuracy of the components of the income tax provision calculations and related income tax balances and to monitor the differences between the income tax basis and the financial reporting basis of assets and liabilities to effectively
reconcile the differences to the deferred income tax balances. These control deficiencies resulted in adjustments to income tax expense, income taxes payable and deferred income tax asset and liability accounts in the 2006 annual and interim consolidated financial statements. Furthermore, these control deficiencies could result in a material misstatement of the annual or interim AIG consolidated financial statements that would not be prevented or detected. Accordingly, AIG management has concluded that these control deficiencies constitute a material weakness.
The consolidated financial statements include the accounts of AIG and its majority owned subsidiaries. AIG consolidates subsidiaries in which it holds a controlling financial interest. Entities that AIG does not consolidate but of which it holds 20 percent to 50 percent of the voting rights and/or has the ability to exercise significant influence are accounted for under the equity method.
It was determined during 2006 that for certain deferred sales inducement assets, the asset and related amortization expense had historically been reported within deferred policy acquisition costs on the consolidated balance sheet and income statement. Under Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts” (SOP 03-1), such assets should be classified separately from DAC and the amortization reported in benefit expense. Accordingly, the December 31, 2005 consolidated balance sheet reflects a revision of $1.1 billion from DAC to other assets, and the consolidated income statement includes a revision from acquisition expense to policy benefit expense of $153 million and $149 million in the years ended December 31, 2005 and 2004, respectively, to conform to the current year’s presentation. This revision did not have any effect on consolidated pre-tax income, net income or shareholders’ equity.
In 2006 AIG determined that certain products that were historically reported as separate account assets under SOP 03-1 should have been reported as general account assets. Accordingly, AIG revised the classification of approximately $2.7 billion of assets from separate account assets in prior years to general account assets, and the same amount of liabilities from separate account liabilities to policyholders’ contract deposits at December 31, 2006. As a result, Net investment income and Incurred policy losses and benefits each increased approximately $258 million for the earnings on the general account assets that accrue directly to the benefit of the policyholders. This revision did not have any effect on consolidated income before income taxes, net income, or shareholders’ equity for any period presented.
Premiums and other Considerations: Premiums for short duration contracts and considerations received from retailers in connection with the sale of extended service contracts are earned primarily on a pro rata basis over the term of the related coverage. The reserve for unearned premium includes the portion of premiums written and other considerations relating to the unexpired terms of coverage. Premiums for long duration insurance products and life contingent annuities are recognized as revenues when due. Estimates for premiums due but not yet collected are accrued. Consideration for universal life and investment-type products consist of policy charges for the cost of insurance, administration, and surrenders during the period. Policy charges collected with respect to future services are deferred and recognized in a manner similar to DAC related to such products.
Unrealized gains and losses from investments in trading securities and hybrid financial instruments.
Sales of fixed maturity securities, equity securities, real estate, investments in joint ventures and limited partnerships and other types of investments.
Changes in fair value of derivatives used for other than hedging activities.
Realized gains and losses from the sale of available for sale securities and investments in private equities, joint ventures and limited partnerships.
Reductions to the cost basis of equity securities for other-than-temporary impairments.
(b) Foreign Currency: Financial statement accounts expressed in foreign currencies are translated into U.S. dollars in accordance with Statement of Financial Accounting Standards (FAS) 52, “Foreign Currency Translation” (FAS 52). Under FAS 52, functional currency assets and liabilities are translated into U.S. dollars generally using current rates of exchange prevailing at the balance sheet date of each respective subsidiary and the related translation adjustments are recorded as a separate component of other comprehensive income, net of any related taxes, in consolidated shareholders’ equity. Functional currencies are generally the currencies of the local operating environment. Income statement accounts expressed in functional currencies are translated using average exchange rates. The adjustments resulting from translation of financial statements of foreign entities operating in highly inflationary economies are recorded in income. Exchange gains and losses resulting from foreign currency transactions are recorded in income currently.
(d) Contingencies: Amounts are accrued for the financial resolution of claims that have either been asserted or are deemed probable of assertion if, in the opinion of management, it is both probable that a liability has been incurred and the amount
of the liability can be reasonably estimated. In many cases, it is not possible to determine whether a liability has been incurred or to estimate the ultimate or minimum amount of that liability until years after the contingency arises, in which case no accrual is made until that time.
(e) Investments in Fixed Maturities and Equity Securities: Bonds held to maturity are principally owned by the insurance subsidiaries and are carried at amortized cost where AIG has the ability and positive intent to hold these securities until maturity.
Where AIG may not have the positive intent to hold bonds until maturity and such securities are not designated as trading, these securities are considered to be available for sale and carried at current fair values.
Premiums and discounts arising from the purchase of bonds are treated as yield adjustments over their estimated lives, until maturity, or call date, if applicable.
AIG may also enter into dollar roll agreements. These are agreements to sell mortgage-backed securities and to repurchase substantially similar securities at a specified price and date in the future. At December 31, 2006, 2005 and 2004, there were no dollar roll agreements outstanding.
In general, a security is considered a candidate for other-than-temporary impairment if it meets any of the following criteria:
(g) Financial Services - Flight Equipment: Flight equipment is stated at cost, net of accumulated depreciation. Major additions, modifications and interest are capitalized. Normal maintenance and repairs, airframe and engine overhauls and compliance with return conditions of flight equipment on lease are provided by and paid for by the lessee. Under the provisions of most leases for certain airframe and engine overhauls, the lessee is reimbursed for certain costs incurred up to but not exceeding contingent rentals paid to AIG by the lessee. AIG provides a charge to income for such reimbursements based upon the expected reimbursements during the life of the lease. Depreciation and amortization are computed on the straight-line basis to a residual value of approximately 15 percent over the estimated useful lives of the related assets but not exceeding 25 years. Aircraft in the fleet are evaluated, as necessary, based on these events and circumstances in accordance with FAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (FAS 144). FAS 144 requires that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets is measured by comparing the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. These evaluations for impairment are significantly affected by estimates of future revenues and other factors which involve some amount of uncertainty.
This caption also includes deposits for aircraft to be purchased. At the time the assets are retired or disposed of, the cost and associated accumulated depreciation and amortization are removed from the related accounts and the difference, net of proceeds, is recorded as a gain or loss in Other income.
(l) Financial Services - Trading Assets and Trading Liabilities: Trading assets and trading liabilities include option premiums paid and received and receivables from and payables to counterparties which relate to unrealized gains and losses on futures, forwards, and options and balances due from and due to clearing brokers and exchanges.
(m) Financial Services - Securities Purchased (Sold) Under Agreements to Resell (Repurchase), at contract value: Purchases of securities under agreements to resell and sales of securities under agreements to repurchase are accounted for as collateralized borrowing or lending transactions and are recorded at their contracted resale or repurchase amounts, plus accrued interest. AIG’s policy is to take possession of or obtain a security interest in securities purchased under agreements to resell.
(n) Financial Services - Finance Receivables: Finance receivables, which are net of unearned finance charges, are held for both investment purposes and for sale. Finance receivables held for investment purposes are carried at amortized cost which includes accrued finance charges on interest bearing finance receivables, unamortized deferred origination costs, and unamortized net premiums and discounts on purchased finance receivables. The allowance for finance receivable losses is established through the provision for finance receivable losses charged to expense and is maintained at a level considered adequate to absorb estimated credit losses in the existing portfolio. The portfolio is periodically evaluated on a pooled basis and factors such as economic conditions, portfolio composition, and loss and delinquency experience are considered in the evaluation of the allowance.
Finance receivables originated and intended for sale in the secondary market are carried at the lower of cost or market value, as determined by aggregate outstanding commitments from investors or current investor yield requirements. AGF recognizes net unrealized losses through a valuation allowance by charges to income.
(o) Securities Lending Collateral and Securities Lending Payable, at fair value: AIG’s insurance and asset management operations lend their securities and primarily take cash as collateral with respect to the securities lent. Invested collateral consists primarily of floating rate bonds. Income earned on invested collateral, net of interest payable to the collateral provider, is recorded in net investment income.
The fair value of securities pledged under securities lending arrangements was $69 billion and $59 billion as of December 31, 2006 and 2005, respectively. These securities are included in bonds available for sale in AIG’s consolidated balance sheet.
With respect to hedge funds and limited partnerships in which AIG holds in the aggregate a five percent or greater interest or less than a five percent interest but where AIG has more than a minor influence over the operations of the investee, AIG’s carrying value is its share of the net asset value of the funds or the partnerships. The changes in such net asset values, accounted for under the equity method, are recorded in earnings through net investment income.
Also included in other invested assets are real estate held for investment, aircraft asset investments held by non-financial services subsidiaries and investments in life settlement contracts. See Notes 8(g) and 8(h) herein for further information.
(q) Short-term Investments: Short-term investments consist of interest bearing cash equivalents, time deposits, and investments with original maturities within one year, such as commercial paper.
The DAC for investment-oriented products is also adjusted with respect to estimated gross profits as a result of changes in the net unrealized gains or losses on debt and equity securities available for sale. That is, as debt and equity securities available for sale are carried at aggregate fair value, an adjustment is made to DAC equal to the change in amortization that would have been recorded if such securities had been sold at their stated aggregate fair value and the proceeds reinvested at current yields. The change in this adjustment, net of tax, is included with the change in net unrealized gains/losses on debt and equity
(u) Investments in Partially Owned Companies: At December 31, 2006, AIG’s significant investments in partially owned companies included its 19.4 percent interest in Allied World Assurance Holdings, Ltd., its 26 percent interest in Tata AIG Life Insurance Company, Ltd., its 26 percent interest in Tata AIG General Insurance Company, Ltd. and its 24.5 percent interest in The Fuji Fire and Marine Insurance Co., Ltd. This balance sheet caption also includes investments in less significant partially owned companies. The amounts of dividends received from unconsolidated entities where AIG’s ownership interest is less than 50 percent were $28 million, $146 million and $22 million in 2006, 2005 and 2004, respectively. The undistributed earnings of unconsolidated entities where AIG’s ownership interest is less than 50 percent were $300 million, $179 million and $445 million as of December 31, 2006, 2005 and 2004, respectively.
(v) Real Estate and Other Fixed Assets: The costs of buildings and furniture and equipment are depreciated principally on a straight-line basis over their estimated useful lives (maximum of 40 years for buildings and ten years for furniture and equipment). Expenditures for maintenance and repairs are charged to income as incurred; expenditures for betterments are capitalized and depreciated.
Also included in Real Estate and Other Fixed Assets are capitalized software costs, which represent costs directly related to obtaining, developing or upgrading internal use software. Such costs are capitalized and amortized using the straight-line method over a period generally not to exceed five years.
(y) Other Assets: Other assets consist of prepaid expenses, including deferred advertising costs, sales inducement assets and derivatives assets at fair value, other than derivatives in AIGFP, and other deferred charges.
Generally, advertising costs are expensed as incurred except for certain direct response stand-alone cost pools, which are deferred over the expected future benefit period in accordance with Statement of Position 93-7, “Reporting on Advertising Costs.” In instances where AIG can demonstrate that its customers have responded specifically to direct-response advertising, whose primary purpose is to elicit sales to customers and where it can be shown that such advertising results in probable future economic benefits, the advertising costs are capitalized. Deferred advertising costs are amortized on a cost-pool by cost-pool basis over the expected economic future benefit period and are reviewed regularly for recoverability. Deferred advertising costs amounted to $1.05 billion and $915 million at December 31, 2006 and 2005, respectively. The amount of expense amortized into earnings was $359 million, $272 million and $244 million, for 2006, 2005, and 2004, respectively.
AIG offers sales inducements, which include enhanced crediting rates or bonus payments to contract holders (bonus interest) on certain annuity and investment contract products. Sales inducements provided to the contractholder are recognized as part of the liability for policyholders’ contract deposits on the consolidated balance sheet. Such amounts are deferred and amortized over the life of the contract using the same methodology and assumptions used to amortize DAC. To qualify for such accounting treatment, the bonus interest must be explicitly identified in the contract at inception, and AIG must demonstrate that such amounts are incremental to amounts AIG credits on similar contracts without bonus interest, and are higher than the contract’s expected ongoing crediting rates for periods after the bonus period. The deferred bonus interest and other deferred
sales inducement assets amounted to $1.3 billion and $1.1 billion at December 31, 2006 and 2005, respectively. The amortization expense associated with these assets is reported within Incurred policy losses and benefits expense on the consolidated statement of income. Such amortization expense totaled $135 million, $127 million and $104 million for the years ended December 31, 2006, 2005 and 2004, respectively.
(cc) Financial Services - Securities and Spot Commodities Sold but not yet Purchased, at market value: Securities and spot commodities sold but not yet purchased represent sales of securities and spot commodities not owned at the time of sale. The obligations arising from such transactions are recorded on a trade-date basis and carried at fair value. Also included are obligations under gold leases, which are accounted for as a debt host with an embedded gold derivative.
(ee) Liabilities Connected to Trust Preferred Stock: Liabilities connected to trust preferred stock principally relates to outstanding securities issued by American General Corporation (AGC), a wholly owned subsidiary of AIG. Cash distributions on such preferred stock are accounted for as interest expense.
(ff) Other Liabilities: Other liabilities consist of other funds on deposit, derivatives liabilities at fair value, other than derivatives in AIGFP, and other payables. See Note 19 herein for a discussion of Derivatives. AIG has entered into certain insurance and reinsurance contracts, primarily in its general insurance segment, that do not contain sufficient insurance risk to be accounted for as insurance or reinsurance. Accordingly, these transactions are recorded based upon deposit accounting, and the premiums received, after deduction for certain related expenses, are recorded as deposits within Other liabilities on the consolidated balance sheet. 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.
In December 2004, the FASB issued FAS 123, “Share-Based Payment” (FAS 123R). FAS 123R and its related interpretive guidance replaces FAS 123, “Accounting for Stock-Based Compensation” (FAS 123), which superseded Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and amended FAS 95, “Statement of Cash Flows.” FAS 123, as originally issued in 1995, established as preferable a fair-value-based method of accounting for share-based payment transactions with employees. On January 1, 2003, AIG adopted the recognition provisions of FAS 123. See also Note 14 herein. AIG adopted the provisions of the revised FAS 123R and its related interpretive guidance on January 1, 2006.
AIG’s share-based plans generally provide for accelerated vesting after the participant turns 65 and retires. For awards
At the June 2005 meeting, the FASB’s Emerging Issues Task Force (EITF) reached a consensus with respect to Issue No. 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights” (EITF 04-5). EITF 04-5 addresses what rights held by the limited partner(s) preclude consolidation in circumstances in which the sole general partner would consolidate the limited partnership in accordance with generally accepted accounting principles absent the existence of the rights held by the limited partner(s). Based on that consensus, the EITF 04-5 also agreed to amend the consensus in Issue No. 96-16, “Investor’s Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholders Have Certain Approval or Veto Rights.” The guidance in this Issue was effective after June 29, 2005 for general partners of all new limited partnerships formed and for existing limited partnerships for which the partnership agreements are modified. For general partners in all other limited partnerships, the guidance in this Issue was effective beginning January 1, 2006. The effect of the adoption of this EITF Issue was not material to AIG’s consolidated financial condition or results of operations.
On June 29, 2005, the FASB issued Statement 133 Implementation Issue No. B38, “Embedded Derivatives: Evaluation of Net Settlement with Respect to the Settlement of a Debt Instrument through Exercise of an Embedded Put Option or Call Option.” This implementation guidance relates to the potential settlement of the debtor’s obligation to the creditor that would occur upon exercise of the put option or call option, which meets the net settlement criterion in FAS 133. The effective date of the implementation guidance was January 1, 2006. The adoption of this guidance did not have a material effect on AIG’s consolidated financial condition or results of operations.
On June 29, 2005, the FASB issued Statement 133 Implementation Issue No. B39, “Application of Paragraph 13(b) to Call Options That Are Exercisable Only by the Debtor.” The conditions in FAS 133 paragraph 13(b) do not apply to an embedded call option in a hybrid instrument containing a debt host contract if the right to accelerate the settlement of the debt can be exercised only by the debtor (issuer/borrower). This guidance does not apply to other embedded derivative features that may be present in the same hybrid instrument. The effective date of the implementation guidance was January 1, 2006. The adoption of this guidance did not have a material effect on AIG’s consolidated financial condition or results of operations.
On February 16, 2006, the FASB issued FAS 155, “Accounting for Certain Hybrid Financial Instruments” (FAS 155), an amendment of FAS 140 and FAS 133. FAS 155 allows AIG to include changes in fair value in earnings on an instrument-by-instrument basis for any hybrid financial instrument that contains an embedded derivative that would otherwise be required to be bifurcated and accounted for separately under FAS 133. The election to measure the hybrid instrument at fair value is irrevocable at the acquisition or issuance date.
In connection with AIG’s early adoption of FAS 155, structured note liabilities of $8.9 billion, other structured liabilities in conjunction with equity derivative transactions of $111 million, and hybrid financial instruments of $522 million at December 31, 2006 are now carried at fair value. The effect on earnings for 2006, for changes in the fair value of hybrid financial instruments, was a pre-tax loss of $313 million, of which $287 million is reflected in Other income and is largely offset by gains on economic hedge positions which are also reflected in operating income, and $26 million is reflected in Net investment income.
In January 2007, the FASB issued Statement 133 Implementation Issue No. B40, “Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets” (Issue B40). Issue B40 provides guidance for when prepayment risk needs to be considered in determining whether mortgage-backed and other asset-backed securities contain an embedded derivative requiring bifurcation. Effective with AIG’s adoption of FAS 155 beginning January 1, 2006, AIG has been treating derivatives embedded in securitized interests in prepayable financial assets in accordance with the guidance in Issue B40. Therefore, the adoption of this guidance did not have a material effect on AIG’s consolidated financial condition or results of operations.
On March 27, 2006, the FASB issued FSP FTB 85-4-1, “Accounting for Life Settlement Contracts by Third-Party Investors” (FSP 85-4-1), an amendment of FTB 85-4, “Accounting for Purchases of Life Insurance.” Life settlements are designed to assist life insurance policyholders in monetizing the existing value of life insurance policies. FSP 85-4-1 allows AIG to measure life settlement contracts using either the investment method or fair value method. The election is made on an instrument-by-instrument basis and is irrevocable. AIG elected to early adopt FSP 85-4-1 as of January 1, 2006 using the investment method for pre-existing investments held at December 31, 2005. The effect of this adoption resulted in a $319 million after-tax ($487 million pre-tax)
In September 2006, the FASB issued FAS 157, “Fair Value Measurements” (FAS 157). FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. AIG is currently assessing the effect of implementing this guidance.
AIG’s Personal Lines operations provide automobile insurance through AIG Direct, a mass marketing operation, Agency Auto Division and 21st Century Insurance Group (21st Century), as well as a broad range of coverages for high net-worth individuals through the AIG Private Client Group.
Mortgage Guaranty operations provide guaranty insurance primarily on conventional first mortgage loans on single family dwellings and condominiums.
AIG’s principal Domestic Life Insurance & Retirement Services operations are American General Life Insurance Company (AG Life), The United States Life Insurance Company in the City of New York (USLIFE), American General Life and Accident Insurance Company (AGLA and, collectively with AG Life and USLIFE, the Domestic Life Insurance internal reporting unit), AIG Annuity Insurance Company (AIG Annuity), The Variable Annuity Life Insurance Company (VALIC) and AIG Retirement Services, Inc (AIG SunAmerica and, collectively with AIG Annuity and VALIC, the Domestic Retirement Services internal reporting unit).
AIG’s Capital Markets operations are conducted through AIGFP. As Capital Markets is a transaction-oriented operation, current and past revenues and operating results may not provide a basis for predicting future performance.
Consumer Finance operations include American General Finance Inc. (AGF) as well as AIG Consumer Finance Group Inc. (AIGCFG). AGF and AIGCFG provide a wide variety of consumer finance products, including non-conforming real estate mortgages, consumer loans, retail sales finance and credit-related insurance to customers both domestically and overseas, particularly in emerging markets.
Asset Management: AIG’s Asset Management operations comprise a wide variety of investment-related services and investment products including institutional and retail asset management, broker-dealer services and institutional spread-based investment business. Such services and products are offered to individuals and institutions both domestically and overseas.
The following table summarizes AIG’s General Insurance operations by major internal reporting unit for the years ended December 31, 2006, 2005 and 2004:
There were no significant catastrophe-related losses in 2006. Catastrophe-related losses for 2005 and 2004 by reporting unit were:
The following table summarizes AIG’s Life Insurance & Retirement Services operations by major internal reporting unit for the years ended December 31, 2006, 2005 and 2004:
Revenues and operating income include realized capital gains (losses) of $(404) million, $(277) million and $(207) million for 2006, 2005 and 2004, respectively. Includes the effect of hedging activities that did not qualify for hedge accounting treatment under FAS 133 and the application of FAS 52, which were $(46) million, $(12) million and $(14) million for 2006, 2005 and 2004, respectively.
Represents primarily the sum of aircraft lease rentals from ILFC, AIGFP hedged financial positions entered into in connection with counterparty transactions, the effect of hedging activities that did not qualify for hedge accounting treatment under FAS 133, including the related foreign exchange gains and losses, and finance charges from consumer finance operations.
Includes catastrophe-related losses of $62 million recorded in 2005 resulting from hurricane Katrina, which were reduced by $35 million in 2006 as a result of reevaluation of the remaining estimated losses.
Including revenues from General Insurance operations in Canada of $691 million, $638 million and $549 million in 2006, 2005 and 2004, respectively.
Represents the sum of General Insurance net premiums earned, Life Insurance & Retirement Services GAAP premiums, net investment income, Financial Services interest, lease and finance charges, Asset Management net investment income with respect to spread-based products and advisory and management fees, and realized capital gains (losses).
Approximately 90 percent of ILFC’s fleet is operated by foreign airlines.
In addition, for the years ended September 30, 1993 and 1994, a Notice of Deficiency assessing additional taxes has been issued to AIG Retirement Services Inc., which has filed a petition for redetermination with the United States Tax Court challenging the Notice. Revenue Agents’ Reports for the years ended September 30, 1995 and 1996 and for the period from September 30, 1997 to December 31, 1998 have also been issued to AIG Retirement Services Inc., and Letters of Protest contesting the proposed assessments have been filed with the IRS. Similarly, SunAmerica Life Insurance Company (SunAmerica Life) has also received a proposed assessment and has filed a protest for the year ended December 31, 1999.
The U.S. federal income tax rate was 35 percent for 2006, 2005 and 2004. Actual tax expense on income differs from the “expected” amount computed by applying the federal income tax rate because of the following:
AIG has recorded alternative minimum tax credit carry forwards of $222 million and $192 million at December 31, 2006 and 2005, respectively. The alternative minimum tax credits do not expire.
Included in the above table is the VOBA, an intangible asset recorded during purchase accounting, which is amortized in a manner similar to DAC. Amortization of VOBA was $239 million, $291 million and $407 million while the unamortized balance was $1.98 billion, $2.14 billion and $2.52 billion for 2006, 2005 and 2004, respectively. The percentage of the unamortized balance of VOBA at 2006 expected to be amortized for 2007 through 2012 by year is: 11.3 percent, 10.0 percent, 8.8 percent, 7.3 percent and 6.0 percent, respectively, with 56.6 percent being amortized after five years. These projections are based on current estimates for investment, persistency, mortality, and morbidity assumptions. The DAC amortization charged to income includes the increase or decrease of amortization for FAS 97-related realized capital gains (losses), primarily in the Domestic Retirement Services business. For 2006, 2005 and 2004, respectively, the rate of amortization expense decreased by $98 million, $46 million and $41 million.
In the ordinary course of business, AIG’s General Insurance and Life Insurance companies place reinsurance with other insurance companies in order to provide greater diversification of AIG’s business and limit the potential for losses arising from large risks. In addition, AIG’s General Insurance subsidiaries assume reinsurance from other insurance companies.
General Insurance premiums written and earned were comprised of the following:
For the years ended December 31, 2006, 2005 and 2004, reinsurance recoveries, which reduced loss and loss expenses incurred, amounted to $8.3 billion, $20.7 billion and $12.1 billion, respectively.
Life Insurance: Life reinsurance is effected principally under yearly renewable term treaties. The premiums with respect to these treaties are considered prepaid reinsurance premiums and are recognized as a reduction of premiums earned over the contract period in proportion to the protection provided. Amounts recoverable from life reinsurers are estimated in a manner consistent with the assumptions used for the underlying policy benefits and are presented as a component of reinsurance assets.
Life Insurance & Retirement Services premiums were comprised of the following:
Life Insurance assumed represented 0.1 percent, 0.8 percent and 0.7 percent of gross Life Insurance in force at December 31, 2006, 2005 and 2004, respectively, and Life Insurance & Retirement Services premiums assumed represented 0.1 percent, 0.3 percent and 2.5 percent of gross GAAP premiums for the years ended December 31, 2006, 2005 and 2004, respectively.
6. Reserve for Losses and Loss Expenses and Future Life Policy Benefits and Policyholders’ Contract Deposits
Interest rates (exclusive of immediate/terminal funding annuities), which vary by territory, year of issuance and products, range from 1.0 percent to 12.5 percent within the first 20 years. Interest rates on immediate/terminal funding annuities are at a maximum of 11.5 percent and grade to not greater than 6.0 percent.
Mortality and surrender rates are based upon actual experience by geographical area modified to allow for variations in policy form. The weighted average lapse rate, including surrenders, for individual and group life approximated 7.4 percent.
The portions of current and prior net income and of current unrealized appreciation of investments that can inure to the benefit of AIG are restricted in some cases by the insurance contracts and by the local insurance regulations of the countries in which the policies are in force.
Interest rates on corporate life insurance products are guaranteed at 4.0 percent and the weighted average rate credited in 2006 was 5.2 percent.
The universal life funds have credited interest rates of 1.5 percent to 7.0 percent and guarantees ranging from 1.5 percent to 5.5 percent depending on the year of issue. Additionally, universal life funds are subject to surrender charges that amount to 12.2 percent of the aggregate fund balance grading to zero over a period not longer than 20 years.
Includes catastrophe losses, net of tax, of $1.9 billion and $660 million in 2005 and 2004, respectively.
AIG’s insurance subsidiaries file financial statements prepared in accordance with statutory accounting practices prescribed or permitted by domestic and foreign insurance regulatory authorities. The differences between statutory financial statements and financial statements prepared in accordance with U.S. GAAP vary between domestic and foreign by jurisdiction. The principal differences are that statutory financial statements do not reflect DAC, some bond portfolios may be carried at amortized cost, assets and liabilities are presented net of reinsurance, policyholder liabilities are valued using more conservative assumptions and certain assets are non-admitted.
(a) Statutory Deposits: Cash and securities with carrying values of $16.5 billion and $11.8 billion were deposited by AIG’s insurance subsidiaries under requirements of regulatory authorities as of December 31, 2006 and 2005, respectively.
Net unrealized gains included in the Consolidated Income Statement from investment securities classified as trading securities for 2006, 2005 and 2004 were $938 million, $1.1 billion and $269 million, respectively.
The gross realized gains and gross realized losses on AIG’s consolidated available for sale securities were as follows:
At December 31, 2006 and 2005, fixed maturities held by AIG that were below investment grade or not rated totaled $21.24 billion and $20.54 billion, respectively.
Contractual maturities include mortgage backed securities with an amortized cost and estimated fair value of $48.2 billion and $48.1 billion, respectively. Such securities have been allocated to the contractual maturities based on estimated future cash flows.
As of December 31, 2006, AIG held 20,172 and 1,750 of individual bond and stock investments, respectively, that were in an unrealized loss position, of which 10,846 individual investments were in an unrealized loss position continuously for 12 months or more.
(g) Other Invested Assets: Other invested assets as of December 31, 2006 were $42.1 billion, consisting primarily of hedge funds and limited partnerships. Approximately $5.3 billion relates to available for sale investments carried at fair value, with unrealized gains and losses recorded in a separate component of Other comprehensive income, net of deferred taxes, with almost all of the remaining investments being accounted for on the equity method of accounting. All of the investments are subject to impairment testing (see Note 1(e) herein). The gross unrealized loss on the investments accounted for as available for sale as of December 31, 2006 was $167 million, the majority of which represents investments that have been in a continuous unrealized loss position for less than 12 months.
(h) Investments in Life Settlement Contracts: In June 2006, AIG restructured its ownership of life settlement contracts with no effect on the economic substance of these investments. At the same time, AIG paid $610 million to its former co-investors to acquire all the remaining interests in life settlement contracts held in previously non-consolidated trusts. The life insurers for a small portion of these newly consolidated life settlement contracts include AIG subsidiaries. As a result, amounts related to life insurance issued by AIG subsidiaries are eliminated in consolidation.
At December 31, 2006, the carrying value of AIG’s life settlement contracts was $1.1 billion, and is included in Other invested assets on the consolidated balance sheet. These investments are monitored for impairment on a contract by contract basis quarterly. During 2006, income recognized on life settlement contracts previously held in non-consolidated trusts was $38 million, and is included in net investment income on the consolidated statement of income. Further information regarding life settlement contracts as of December 31, 2006 is as follows:
(j) Fair Value of Fixed Maturities and Unrealized Appreciation of Investments - Capital Markets
The amortized cost and estimated fair value of Capital Markets securities available for sale at December 31, 2006 and 2005 were as follows:
The amortized cost and estimated fair values of Capital Markets securities available for sale at December 31, 2006, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
At December 31, 2006, long-term borrowings were $98.68 billion and short-term borrowings were $34.6 billion, excluding $3.25 billion with respect to VIE debt required to be consolidated under the provisions of FIN 46R. Long-term borrowings exclude that portion of long-term debt maturing in less than one year.
Excludes $880 million of VIE commercial paper required to be consolidated under the provisions of FIN 46R.
(i) Notes and bonds issued by AIG: In October 2006, AIG established a medium term note program under its shelf registration statement providing for the issuance of up to $25.1 billion of AIG debt securities. The proceeds from the issuance of these debt securities may be used (i) by AIG (ii) by AIGFP as it would use the proceeds from its own borrowings as discussed below or (iii) to fund the Matched Investment Program (MIP). As of December 31, 2006, $1.8 billion principal amount of notes were outstanding under the medium term note program, of which (i) $749 million was used for AIG’s general corporate purposes, (ii) $72 million was used by AIGFP and (iii) $1.0 billion was used to fund the MIP. The maturity dates of these notes range from 2011 to 2046. To the extent deemed appropriate, AIG may enter into swap transactions to manage its effective borrowing rate with respect to these notes.
As of December 31, 2006, the equivalent of $5.7 billion of notes were outstanding under AIG’s Euro medium term note program, of which the proceeds from $3.7 billion of notes were used to fund the MIP and the remainder was used for AIG’s general corporate purposes. AIG has hedged the currency exposure arising from foreign currency denominated notes by economically hedging that exposure, although such hedges did not qualify for hedge accounting treatment under FAS 133.
In November 2006, AIG filed a shelf registration statement in Japan, providing for the issuance of up to Japanese Yen 300 billion principal amount of senior notes in the aggregate. In December 2006, AIG issued the equivalent of $429 million under this shelf registration statement, the proceeds of which were used for AIG’s general corporate purposes.
(iii) Redemption of Zero Coupon Convertible Senior Debentures: On November 9, 2006, AIG redeemed all of its outstanding Zero Coupon Convertible Senior Debentures initially issued in 2001 for an aggregate redemption price of $1.07 billion.
At December 31, 2006, AIGFP’s notes and bonds outstanding, the proceeds of which are invested in a diversified portfolio of securities and derivative transactions, were as follows:
(iii) Hybrid financial instrument liabilities: AIGFP’s notes and bonds include structured debt instruments whose payment terms are linked to one or more financial or other indices (such as an equity index or commodity index or another measure that is not considered to be clearly and closely related to the debt instrument). These notes contain embedded derivatives that otherwise would be required to be accounted for separately under FAS 133. Upon AIG’s early adoption of FAS 155, AIGFP elected the fair value option for these notes. The notes that are accounted for using the fair value option are reported separately under hybrid financial instrument liabilities at fair value.
(e) Liabilities Connected to Trust Preferred Stock: AGC issued Junior Subordinated Debentures (liabilities) to certain trusts established by AGC, which represent the sole assets of the trusts. The trusts have no independent operations. The trusts issued mandatory redeemable preferred stock to investors. The interest terms and payment dates of the liabilities correspond to those of the preferred stock. AGC’s obligations with respect to the liabilities and related agreements, when taken together, constitute a full and unconditional guarantee by AGC of payments due on the preferred securities. AIG guarantees the obligations of AGC with respect to these liabilities and related agreements. The liabilities are redeemable, under certain conditions, at the option of AGC on a proportionate basis.
As of December 31, 2006, the preferred stock outstanding consisted of $300 million liquidation value of 8.5 percent preferred stock issued by American General Capital II in June 2000, $500 million liquidation value of 8.125 percent preferred stock issued by American General Institutional Capital B in March 1997, and $500 million liquidation value of 7.57 percent preferred stock issued by American General Institutional Capital A in December 1996.
As a well-known seasoned issuer, ILFC has filed an automatic shelf registration statement with the Securities and Exchange Commission (SEC) allowing ILFC immediate access to the U.S. public debt markets. During 2006, $1.9 billion of debt securities were issued under this registration statement and $3.52 billion were issued under a prior registration statement. In addition, ILFC has a Euro medium term note program for $7.0 billion, under which $4.28 billion in notes were sold through December 31, 2006. The foreign exchange adjustment for the foreign currency denominated debt was $733 million at December 31, 2006 and $197 million at December 31, 2005. ILFC has substantially eliminated the currency exposure arising from foreign currency denominated notes by economically hedging the portion of the note exposure not already offset by Euro-denominated operating lease payments, although such hedges did not qualify for hedge accounting treatment under FAS 133.
(g) AGF Borrowings: As of December 31, 2006, notes and bonds aggregating $19.59 billion were outstanding with maturity dates ranging from 2007 to 2031 at interest rates ranging from
AGF uses the proceeds from the issuance of notes and bonds for the funding of its finance receivables. AIG does not guarantee any of the debt obligations of AGF.
(j) Interest Expense for All Indebtedness: Total interest expense for all indebtedness, net of capitalized interest, aggregated $6.95 billion in 2006, $5.7 billion in 2005 and $4.4 billion in 2004. Capitalized interest was $59 million in 2006, $64 million in 2005 and $59 million in 2004. Cash distributions on the preferred shareholders’ equity in subsidiary companies of ILFC and liabilities connected to trust preferred stock of AGC subsidiaries are accounted for as interest expense in the consolidated statement of income. The cash distributions for ILFC were approximately $5 million, $5 million and $4 million for the years ended December 31, 2006, 2005 and 2004, respectively. The cash distributions for AGC subsidiaries were approximately $107 million, $112 million and $123 million for the years ended December 31, 2006, 2005 and 2004, respectively.
As of December 31, 2006, preferred shareholders’ equity in subsidiary companies represents preferred stocks issued by ILFC, a wholly owned subsidiary of AIG.
At December 31, 2006, the preferred stock consists of 1,000 shares of market auction preferred stock (MAPS) in two series (Series A and B) of 500 shares each. Each of the MAPS shares has a liquidation value of $100,000 per share and is not convertible. The dividend rate, other than the initial rate, for each dividend period for each series is reset approximately every seven weeks (49 days) on the basis of orders placed in an auction. During 2006, ILFC extended each of the MAPS dividend periods for three years. At December 31, 2006, the dividend rate for Series A MAPS was 4.70 percent and the dividend rate for Series B MAPS was 5.59 percent.
Basic earnings per share are based on the weighted average number of common shares outstanding, retroactively adjusted to reflect all stock dividends and stock splits. Diluted earnings per share are based on those shares used in basic earnings per share plus shares that would have been outstanding assuming issuance of common shares for all dilutive potential common shares outstanding, retroactively adjusted to reflect all stock dividends and stock splits.
Certain shares arising from employee stock plans were not included in the computation of diluted earnings per share where the exercise price of the options exceeded the average market price and would have been antidilutive. The number of shares excluded were 13 million, 19 million and 7 million for 2006, 2005 and 2004, respectively.
Litigation Arising from Insurance Operations - Gunderson. A subsidiary of AIG has been named as a defendant in a putative class action lawsuit in the 14th Judicial District Court for the State of Louisiana. The Gunderson complaint alleges failure to comply with certain provisions of the Louisiana Any Willing Provider Act (the Act) relating to discounts taken by defendants on bills submitted by Louisiana medical providers and hospitals that provided treatment or services to workers compensation claimants and seeks monetary penalties and injunctive relief. On July 20, 2006, the court denied defendants’ motion for summary judgment and granted plaintiffs’ partial motion for summary judgment, holding that the AIG subsidiary was a “group purchaser” and, therefore, potentially subject to liability under the Act. On November 28, 2006, the court issued an order certifying a class of providers and hospitals. In an unrelated action also arising under the Act, a Louisiana appellate court ruled that the district court lacked jurisdiction to adjudicate the claims at issue. In response, defendants in Gunderson filed an exception for lack of subject matter jurisdiction. On January 19, 2007, the court denied the motion, holding that it has jurisdiction over the putative class claims. The AIG subsidiary is appealing the class certification ruling and intends to seek an appeal from the jurisdictional ruling. While AIG believes that it has meritorious defenses to plaintiffs’ claims, it cannot currently estimate the likelihood of prevailing in this action or reasonably estimate the likely damages, if any.
The remaining escrowed funds, which amounted to $385 at December 31, 2006, are set aside for settlements with certain AIG policyholders specified in the settlements who claimed to have been harmed by AIG’s insurance brokerage practices. Any funds remaining at the end of the escrow period will be used to resolve claims asserted by policyholders relating to such insurance brokerage practices, including those described in Private Litigation below.
At the current time, AIG cannot predict the outcome of the matters described above, or estimate any potential additional cost related to these matters.
Also, as part of the settlements, AIG has agreed to retain, for a period of three years, an independent consultant who will conduct a review that will include, among other things, the adequacy of AIG’s internal control over financial reporting, the policies, procedures and effectiveness of AIG’s regulatory, compli-
ERISA Action. Between November 30, 2004 and July 1, 2005, several ERISA actions were filed on behalf of purported class of participants and beneficiaries of three pension plans sponsored by AIG or its subsidiaries. A consolidated complaint filed on September 26, 2005 alleges a class period between September 30, 2000 and May 31, 2005 and names as defendants AIG, the members of AIG’s Retirement Board and the Administrative Boards of the plans at issue, and four present or former members of AIG’s Board of Directors. The factual allegations in the complaint are essentially identical to those in the securities actions described above. Plaintiffs allege that defendants violated duties under ERISA by allowing the plans to offer AIG stock as a permitted investment, when defendants allegedly knew it was not a prudent investment, and by failing to provide participants with accurate information about AIG stock. AIG’s motion to dismiss was denied by order dated December 12, 2006. Discovery will be consolidated with proceedings in the securities actions.
Derivative Actions - Southern District of New York. Between October 25, 2004 and July 14, 2005, seven separate derivative actions were filed in the Southern District of New York, five of which were consolidated into a single action. The New York derivative complaint contains nearly the same types of allegations made in the securities fraud and ERISA actions described above. The named defendants include current and former officers and directors of AIG, as well as Marsh & McLennan Companies, Inc. (Marsh), SICO, Starr, ACE Limited and subsidiaries (ACE), General Reinsurance Corporation, PwC, and certain employees or officers of these entity defendants. Plaintiffs assert claims for breach of fiduciary duty, gross mismanagement, waste of corporate assets, unjust enrichment, insider selling, auditor breach of contract, auditor professional negligence and disgorgement from AIG’s former Chief Executive Officer and Chief Financial Officer of incentive-based compensation and AIG share proceeds under Section 304 of the Sarbanes-Oxley Act, among others. Plaintiffs seek, among other things, compensatory damages, corporate governance reforms, and a voiding of the election of certain AIG directors. AIG’s Board of Directors has appointed a special committee of independent directors (special committee) to review the matters asserted in the operative consolidated derivative complaint. The court has approved agreements staying the derivative case pending in the Southern District of New York while the special committee performs its work. The current stay extends until March 14, 2007.