As of December 31, 2012, approximately 11 percent of the consolidated assets of AIG were located outside the U.S. and Canada, including $260 million of cash and securities on deposit with regulatory authorities in those locations. See Note 3 to the Consolidated Financial Statements for additional geographic information. See Note 7 to the Consolidated Financial Statements for total carrying values of cash and securities deposited by our insurance subsidiaries under requirements of regulatory authorities.
Operations outside the U.S. and Canada and assets held abroad may be adversely affected by political developments in foreign countries, including tax changes, nationalization and changes in regulatory policy, as well as by consequence of hostilities and unrest. The risks of such occurrences and their overall effect upon AIG vary from country to country and cannot easily be predicted. If expropriation or nationalization does occur, AIG's policy is to take all appropriate measures to seek recovery of any affected assets. Certain of the countries in which AIG's business is conducted have currency restrictions that generally cause a delay in a company's ability to repatriate assets and profits. See also Item 1A. Risk Factors - Business and Operations for additional information.
(a) Includes the effect of the reclassification of ILFC as discontinued operations.
AIG was significantly affected by the market turmoil in late 2008 and early 2009 and recognized other-than-temporary impairment charges in 2008 related primarily to collateralized mortgage-backed securities, other structured securities and securities of financial institutions; losses related to the change in AIG's intent and ability to hold to recovery certain securities; and losses related to AIG's securities lending program.
FRBNY Activity and Effect on Interest Expense in 2008, 2009 and 2010
As a result of the closing of the Recapitalization on January 14, 2011, the remaining SPV Preferred Interests held by the FRBNY of approximately $26.4 billion were purchased by AIG and transferred to the Department of the Treasury. The SPV Preferred Interests were no longer considered permanent equity on AIG's Consolidated Balance Sheet, and were classified as redeemable non-controlling interests. See Note 18 to the Consolidated Financial Statements for further discussion.
The following table presents pro forma ratios as if the Recapitalization had been consummated in 2008 and a reconciliation of book value per share to book value per share, excluding Accumulated other comprehensive income (loss), which is a non-GAAP measure. See Item 7. MD&A - Use of Non-GAAP Measures for additional information.*
* Amounts for periods after December 31, 2008 have been revised to reflect reclassification of income taxes from AOCI to additional paid in capital to correct the presentation of components of AIG Shareholders' Equity. See Note 1 to the Consolidated Financial Statements for additional information on the reclass.
ITEM 7 / MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Annual Report on Form 10-K and other publicly available documents may include, and officers and representatives of American International Group, Inc. (AIG) may from time to time make, projections, goals, assumptions and statements that may constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These projections, goals, assumptions and statements are not historical facts but instead represent only AIG's belief regarding future events, many of which, by their nature, are inherently uncertain and outside AIG's control. These projections, goals, assumptions and statements include statements preceded by, followed by or including words such as "believe," "anticipate," "expect," "intend," "plan," "view," "target" or "estimate." These projections, goals, assumptions and statements may address, among other things:
the monetization of AIG's interests in International Lease Finance Corporation (ILFC), including whether AIG's proposed sale of up to 90 percent of ILFC will be completed and if completed, the timing and final terms of such sale;
AIG's exposures to subprime mortgages, monoline insurers, the residential and commercial real estate markets, state and municipal bond issuers and sovereign bond issuers;
AIG's return on equity and earnings per share long-term aspirational goals;
the timing and applicable requirements of any new regulatory framework to which AIG is subject as a savings and loan holding company (SLHC), and if such a determination is made, as a systemically important financial institution (SIFI);
Part I, Item 1A. Risk Factors of this Annual Report on Form 10-K.
AIG is not under any obligation (and expressly disclaims any obligation) to update or alter any projections, goals, assumptions or other statements, whether written or oral, that may be made from time to time, whether as a result of new information, future events or otherwise.
Throughout the MD&A, we use certain terms and abbreviations which are summarized in the Glossary and Acronyms on pages 195 and 199, respectively.
In Item 6. Selected Financial Data and throughout this MD&A, we present AIG's financial condition and results of operations in the way we believe will be most meaningful, representative and most transparent. Some of the measurements we use are "non-GAAP financial measures" under SEC rules and regulations. GAAP is the acronym for "accounting principles generally accepted in the United States." The non-GAAP financial measures we present may not be comparable to similarly-named measures reported by other companies.
Book Value Per Share Excluding Accumulated Other Comprehensive Income (Loss) (AOCI) is presented in Item 6. Selected Financial Data and is used to show the amount of our net worth on a per-share basis. We believe Book Value Per Share Excluding AOCI is useful to investors because it eliminates the effect of non-cash items that can fluctuate significantly from period to period, including changes in fair value of our available for sale portfolio and foreign currency translation adjustments. Book Value Per Share Excluding AOCI is derived by dividing Total AIG shareholders' equity, excluding AOCI, by Total common shares outstanding. The reconciliation to book value per share, the most comparable GAAP measure, is presented in Item 6. Selected Financial Data.
Operating income (loss): In 2012, AIG Property Casualty revised its non-GAAP income measure from underwriting income (loss) to operating income (loss), which includes both underwriting income (loss) and net investment income, but not net realized capital (gains) losses or other (income) expense, legal settlements related to legacy crisis matters described above and bargain purchase gain. Underwriting income (loss) is derived by reducing net premiums earned by claims and claims adjustment expense and underwriting expenses; which consist of the acquisition costs and general operating expenses;
Ratios: AIG Property Casualty, along with most property and casualty insurance companies, uses the loss ratio, the expense ratio and the combined ratio as measures of underwriting performance. These ratios are relative measurements that describe, for every $100 of net premiums earned, the amount of claims and claims adjustment expense, and the amount of other underwriting expenses that would be incurred. A combined ratio of less than 100 indicates an underwriting profit and a combined ratio of over 100 indicates an underwriting loss. The underwriting environment varies across countries and products, as does the degree of litigation activity, all of which affect such ratios. In addition, investment returns, local taxes, cost of capital, regulation, product type and competition can have an effect on pricing and consequently on profitability as reflected in underwriting profit and associated ratios.
Operating income (loss): In 2012, we revised our definition of operating income (loss). Operating income (loss) is derived by excluding the following items from net income (loss): legal settlements related to legacy crisis matters described above, changes in fair values of fixed maturity securities designated to hedge living benefit liabilities, net realized capital (gains) losses, and changes in benefit reserves and DAC, VOBA, and SIA related to net realized capital (gains) losses. We believe that Operating income (loss) is useful because excluding these volatile items permits investors to better assess the operating performance of the underlying business by highlighting the results from ongoing operations.
Premiums, deposits and other considerations: includes life insurance premiums and deposits on annuity contracts and mutual funds.
This overview of management's discussion and analysis highlights selected information and may not contain all of the information that is important to current or potential investors in AIG's securities. You should read this Annual Report on Form 10-K in its entirety for a complete description of events, trends and uncertainties as well as the capital, liquidity, credit, operational and market risks and the critical accounting estimates affecting AIG and its subsidiaries.
We fully repaid governmental support as a result of the Department of the Treasury's sale of its remaining shares of AIG common stock, par value $2.50 per share (AIG Common Stock).*
AIG Life and Retirement assets under management grew significantly in 2012 from deposits and net flows from individual variable annuities and retail mutual funds and appreciation due to higher equity markets. We enhanced spread income and actively managed through the low interest rate environment.
Our investment portfolio performance improved through the use of yield enhancements, including the reduction of our concentration in lower-yielding tax-exempt municipal securities and the purchase of other higher-yielding securities. These purchases include securities acquired through the Federal Reserve Bank of New York's (FRBNY) auction of Maiden Lane III LLC (ML III) assets. Realized capital gains increased because certain assets in unrealized gain positions were sold as part of a program to utilize capital loss tax carryforwards.
Our balance sheet is stronger as a result of the issuance of unsecured notes and the monetization of non-core assets.
*The Department of the Treasury continues to hold warrants to purchase approximately 2.7 million shares of AIG Common Stock.
* Reflects litigation settlement income recorded in 2012 from settlements with three financial institutions that participated in the creation, offering and sale of RMBS as to which AIG and its subsidiaries suffered losses either for their own accounts or in connection with their participation in AIG's securities lending program.
To align financial reporting with changes made during 2012 to the manner in which AIG's chief operating decision makers review the businesses to assess performance and make decisions about resources to be allocated, certain products previously reported in Commercial Insurance were reclassified to Consumer Insurance. These revisions did not affect the total AIG Property Casualty reportable segment results previously reported.
On December 9, 2012, AIG entered into an agreement to sell 80.1 percent of ILFC for approximately $4.2 billion in cash, with an option for the purchaser to buy an additional 9.9 percent stake (the ILFC Transaction). The sale is expected to close in 2013. At the closing of the transaction, in connection with the termination of intercompany arrangements between AIG and ILFC, AIG will return $1.1 billion to ILFC. As a result, ILFC operating results, which were previously presented in the Aircraft Leasing segment, have been classified as discontinued operations in all periods, and associated assets and liabilities have been classified as held-for-sale at December 31, 2012. See Note 4 to the Consolidated Financial Statements for further discussion.
In March 2012, AIG paid down in full the $8.6 billion remaining preferred interests (the AIA SPV Preferred Interests) in the special purpose vehicle holding the proceeds of the AIA initial public offering (the AIA SPV) held by the Department of the Treasury.
In addition, in 2012, the Department of the Treasury, as selling shareholder, sold its remaining shares of AIG common stock by completing five registered public offerings in March, May, August, September and December (collectively, the 2012 Offerings). The Department of the Treasury sold approximately 1.5 billion shares of AIG Common Stock for aggregate proceeds of approximately $45.8 billion in the 2012 Offerings. We purchased approximately 421 million shares of AIG Common Stock at an average price of $30.86 per share for an aggregate purchase amount of approximately $13.0 billion in the first four of the 2012 Offerings. We did not purchase any shares in the December 2012 offering.
In 2012, AIG received $10.1 billion in distributions from the FRBNY's final disposition of ML II and ML III assets. Also in 2012, we sold our entire remaining interest in AIA ordinary shares for gross proceeds of approximately $14.5 billion.
Additional discussion and other liquidity and capital resources developments are included in Note 17 to the Consolidated Financial Statements and Liquidity and Capital Resources herein.
•The unrealized appreciation of our investment portfolio grew from approximately $5.5 billion in 2011 to approximately $10.7 billion in 2012. This was driven by declining interest rates and narrowing spreads in both investment grade and high yield asset portfolios. We realized higher gains on the sales of securities compared to the prior year as we repositioned assets to meet strategic and tactical asset allocation objectives. Other-than-temporary Impairments were lower than the prior year, in part driven by favorable developments in the housing sector which drove strong performance in our structured products portfolios.
An enhanced risk governance structure that supports consistent and transparent decision making. We have recently revised our corporate policies to ensure that accountability for the implementation and oversight of each policy is better aligned with individual corporate executives while specialized risk governance committees already in operation receive regular reporting regarding policy compliance.
Risk committees at our corporate level as well as in each business unit that manage the development and maintenance of a risk and control culture encompassing all significant risk categories. Our Board of Directors oversees the management of risk through the complementary functioning of the Finance and Risk Management Committee (the FRMC) and the Audit Committee, as well as through its regular interaction with other committees of the Board.
A capital and liquidity stress testing framework to assess our aggregate exposure to our most significant risks. We conduct enterprise-wide stress tests under a range of scenarios to better understand the resources needed to support our subsidiaries and consolidated company.
We remain committed to adhering to the highest standards of risk management and corporate governance.
We continue to promote awareness and accountability for key risk and business decisions, and performance than in the past.
Consummate the sale of up to 90 percent of our interest in ILFC;
Enhance the yield on our investments while maintaining focus on credit quality;
Manage AIG's capital and interest expense more efficiently by redeploying excess capital in areas that promote profitable growth;
Work with the Board of Governors of the Federal Reserve System (the FRB) in its capacity as AIG's principal regulator; and
We anticipate that refining technical pricing account management tools and marketing analytics will further enhance our risk selection process. We believe that accident year loss ratios will continue to improve due to these actions.
We continue to make strategic investments in systems, processes and talent worldwide, which will result in elevated operating expense in the short-term, but is expected to create additional value and greater efficiency beginning in 2014.
Enhance risk selection and pricing to earn returns commensurate to the risk assumed.
Implement improved claims practices and advanced technology to lower the loss ratio.
Apply operating expense discipline and drive efficiencies by leveraging our global footprint.
Consistent with AIG's worldwide insurance investment policy, we place primary emphasis on investments in fixed maturity securities issued by corporations, municipalities and other governmental agencies, and to a lesser extent, common stocks, private equity, hedge funds and other alternative investments. We also attempt to enhance returns through investments in a diversified portfolio of private equity funds, hedge funds, and partnerships. Although these
In 2013, we expect to continue to refine our investment strategy, which includes asset diversification and yield-enhancement opportunities that meet our liquidity, duration and credit quality objectives as well as current risk-return and tax objectives.
AIG Life and Retirement's businesses and the life and annuity industry continue to be affected by the current economic environment of low interest rates and volatile equity markets. Continued low interest rates put pressure on long-term investment returns, negatively affect future sales of interest rate-sensitive products and reduce future profits on certain existing business. Also, products such as payout annuities and traditional life insurance that are not rate-adjustable may require increases in reserves if future investment yields are insufficient to support current valuation interest rates. Equity market volatility may result in higher reserves for variable annuity guarantee features, and both equity market volatility and low interest rates can affect the recoverability and amortization rate of DAC assets.
AIG Life and Retirement is focused on the following strategic initiatives:
AIG Life and Retirement's strategic focus related to life insurance and other mortality-based products includes disciplined underwriting, active expense management and product innovation. AIG Life and Retirement's distribution
strategy is to grow new sales by strengthening the core retail independent and career agent distributor channels and expanding its market presence through the development of innovative life insurance offerings based on consumer focused research to drive superior, differentiated product solutions. In addition, AIG Life and Retirement is enhancing its service and technology platform through the consolidation of its life operations and administrative systems, which is expected to result in a more efficient, cost-competitive and agile operating model.
Opportunistic investments in structured securities and other yield enhancement opportunities continue to be made with the objective of increasing net investment income. Overall base yields increased in 2012 due to the reinvestment of significant amounts of cash and short term investments during 2011. However, base yields have been declining in the latter half of 2012 as investment purchases were made at yields lower than the weighted average yield of the existing portfolio. During prolonged periods of low or declining interest rates, AIG Life and Retirement has to invest net flows and reinvest interest and principal payments from its investment portfolio in lower yielding securities.
The following are expected to continue to affect results for 2013:
Foreclosure delays - Since 2010, a variety of servicing practices have come to light that have delayed the foreclosure process in many states. Some of these practices, such as the "robo-signing" of affidavits in judicial foreclosures, have resulted in government investigations into lenders' foreclosure practices. These developments have slowed the reporting of foreclosures, which has in turn slowed the filing of mortgage insurance claims and increased the uncertainty surrounding the determination of the liability for losses and loss adjustment expenses. UGC's assumptions regarding future foreclosures on current delinquencies take into consideration this trend, although significant uncertainty remains surrounding the determination of the liability for unpaid claims and claims adjustment expenses. UGC expects that this trend may continue for 2013 and may negatively affect UGC's future financial results. Final resolution of these issues is uncertain and UGC cannot reasonably estimate the ultimate financial impact that any resolution, individually or collectively, may have on its future results of operations or financial condition.
From time to time, we may utilize cash allocated to the DIB that is not required to meet the risk target for general corporate purposes unrelated to the DIB.
The following section provides a comparative discussion of our Results of Operations on a reported basis for the three-year period ended December 31, 2012. Factors that relate primarily to a specific business segment are discussed in more detail within that business segment. For a discussion of the Critical Accounting Estimates that affect the Results of Operations, see the Critical Accounting Estimates section of Item 7. MD&A, in this Annual Report on Form 10-K.
Income from continuing operations before income taxes for 2012 and 2011 reflected the following:
In 2012, AIG recorded a loss from discontinued operations, net of income taxes, of $4.1 billion, which included a pre-tax loss of $6.7 billion on the announced sale of ILFC.
•a $3.3 billion net loss on extinguishment of debt from the termination of the FRBNY Credit Facility on January 14, 2011. This was partially offset by a $484 million gain on extinguishment of debt in the fourth quarter of 2011 due to the exchange of junior subordinated debt;
•$604 million in unfavorable fair value adjustments on AIG's economic interest in ML II and equity interest in ML III (together, the Maiden Lane Interests);
•our 2010 results included gains of $19.6 billion on sales of divested businesses. These included a $18.1 billion gain from the initial public offering and listing of AIA ordinary shares on the Hong Kong Stock Exchange on October 29, 2010, and a gain of $1.3 billion recognized in 2010 related to the sale of our headquarters building in Tokyo in 2009, which gain had been deferred until the expiration of certain lease provisions; and
•we had income in 2010 from divested businesses prior to their sale totaling $2.4 billion, primarily representing AIA. Partially offsetting these declines were:
•a decrease in interest expense of $4.1 billion primarily resulting from the January 2011 repayment of the FRBNY Credit Facility;
For the year ended December 31, 2010, the effective tax rate on pre-tax income from continuing operations was 34.5 percent. This rate differs from the statutory rate primarily due to tax benefits of $1.3 billion associated with our investment in subsidiaries and partnerships, principally the AIA SPV which is treated as a partnership for U.S. tax purposes, and $587 million associated with tax exempt interest, partially offset by an increase in the deferred tax asset valuation allowance attributable to continuing operations of $1.4 billion.
We reported after-tax operating income in 2011 compared to after-tax operating losses in 2010 primarily due to a net charge to strengthen AIG Property Casualty's loss reserves in 2010, partially offset by higher catastrophe losses in 2011.
A discussion of significant items affecting pre-tax segment income follows. Factors that affect operating income for a specific business segment are discussed in the detailed business segment analysis.
AIG Property Casualty - Pre-tax income increased slightly in 2012 compared to 2011. The increase in pre-tax income was the result of lower underwriting losses due to the impact of lower catastrophe losses, underwriting improvements related to rate increases and enhanced risk selection, higher net investment income due to asset diversification by reducing the concentration in tax-exempt municipal instruments and increasing investments in private placement debt and structured securities. These increases were partially offset by higher acquisition costs as a result of the change in business mix from Commercial Insurance to Consumer Insurance and higher general operating expenses and lower net realized capital gains.
AIG Property Casualty - AIG Property Casualty generated pre-tax income in 2011 compared to a pre-tax loss in 2010. The increase in pre-tax income was the result of lower underwriting losses primarily due to an increase in premium revenues, resulting from the consolidation of Fuji commencing in the third quarter of 2010 and lower prior year adverse development in 2011. These increases in pre-tax income were partially offset by higher catastrophe losses, and higher acquisition and general operating expenses due to a change in business mix.
Pre-tax income also increased as a result of net realized gains in 2011 compared to realized capital losses in 2010 due to an increase in gains on sales of securities, economic hedges and foreign exchange. In 2010, AIG Property Casualty recognized a bargain purchase gain from the acquisition of Fuji and a gain on divested properties.
Other Operations - Other Operations recorded a pre-tax loss in 2011 compared to pre-tax income in 2010 due to a net gain on sale of divested businesses in 2010, primarily related to AIA.
The acquisition ratio increased by 1.8 points for the year ended December 31, 2012, primarily due to the change in business mix to higher value lines and increased market competition, the restructuring of the loss-sensitive business with low commission rates, and changes in our reinsurance strategy, all resulting in higher commissions.
The general operating expense ratio increased by 2.4 points for the year ended December 31, 2012, as we continue to build, strengthen and streamline our financial and operating systems infrastructure and control environment throughout the organization, particularly in financial reporting, policy and claims administration, and human resources as a result of our continued investment in our employees. The total costs of these initiatives were approximately $455 million for the year ended December 31, 2012, an increase of approximately $233 million from the prior year. In addition, bad debt expense increased by approximately $143 million from the prior year.
We present our financial information in two operating segments - Commercial Insurance and Consumer Insurance - as well as an Other category.
Operating income increased in 2012, primarily due to a decrease in catastrophe losses to $2.7 billion from $3.3 billion in the prior year. In addition, net investment income increased due to asset diversification, from concentration in tax-exempt municipal instruments into investments in private placement debt and structured securities. This was slightly offset by an increase in acquisition costs due to the change in business mix to higher value lines of business and the change in business mix from Commercial Insurance to Consumer Insurance. General operating expenses increased due to the continued investment in strategic initiatives and human resources, as a result of AIG's continued investment in its employees. For the year ended December 31, 2012, investments in strategic initiatives totaled approximately $455 million, representing an increase of approximately $233 million over the prior year. In addition, bad debt expense increased by approximately $143 million from the prior year. Net prior year adverse development, including premium adjustments, was $445 million for 2012 compared to $39 million for 2011.
Operating income decreased in 2012, primarily due to a decrease in allocated net investment income reflecting a decrease in the risk-free rate. Underwriting losses increased slightly compared to the prior year, reflecting lower catastrophe and improved current accident year losses, the effect of rate increases and enhanced risk selection, and an increase in reserve discount of $100 million, offset by higher acquisition and general operating expenses, and higher adverse prior year development.
Acquisition costs increased primarily as a result of higher commission expense due to the restructuring of the U.S. Casualty, primarily loss-sensitive business, as we move towards higher value lines. General operating expenses increased due to an increase in bad debt expense of approximately $143 million and investments in strategic initiatives.
Consumer Insurance generated operating income in 2012 compared to an operating loss in 2011, reflecting a reduction in underwriting loss as well as an increase in allocated net investment income resulting primarily from the strategic group benefits partnership with AIG Life and Retirement. Underwriting results improved due to the combination of lower catastrophe losses, favorable loss reserve development, the effect of rate increases, enhanced risk selection and portfolio management. These improvements were offset in part by higher acquisition and general operating expenses.
Acquisition costs increased primarily due to an increase in warranty profit sharing arrangements, increased investment in direct marketing, and a decrease of approximately $49 million in the benefit from the amortization of VOBA liabilities recognized at the time of the Fuji acquisition. General operating expenses increased in 2012 due to investments in infrastructure and strategic expansion in growth economy nations.
We recognized operating income in 2011 compared to an operating loss in 2010 primarily due to an increase in premium revenues, partially offset by higher acquisition and general operating expenses. Prior year adverse loss development, net of premium adjustments, decreased from $4.8 billion in 2010 to $39 million in 2011. Catastrophe losses were $3.3 billion in 2011 compared to $1.1 billion in 2010.
Acquisition and general operating expenses increased in 2011, primarily due to the effect of including Fuji results for a full year. General operating expenses also increased due to investments in a number of strategic initiatives during 2011, including the implementation of improved regional governance and risk management capabilities, the implementation of global accounting and claims systems, preparation for Solvency II and certain other legal entity restructuring initiatives.
Consumer Insurance recognized an operating loss in 2011 compared to operating income in 2010 primarily due to an increase in catastrophe losses, which includes the Tohoku Catastrophe and Hurricane Irene. This was partially offset by an improvement in the accident year loss ratio, and an increase in allocated net investment income. Catastrophe losses for the year ended December 31, 2011 were $715 million compared to $66 million during the prior year. Net prior year adverse development was $85 million in 2011 as compared to net prior year favorable development of $63 million in 2010.
See AIG Property Casualty Underwriting Ratios below for further information on prior year development.
In 2012, Commercial Insurance focused on the execution of the previously announced strategic objectives. The overall decrease in Casualty was partially offset by increases in all the other lines of business.
Casualty net premiums written decreased, as planned, primarily due to the execution of our strategy to improve loss ratios. Our enhanced risk selection process, and adherence to pricing targets resulted in the non-renewal of approximately $800 million of net premiums written, primarily within the workers' compensation business in the Americas, and within the Primary Casualty business in EMEA. In addition, the restructuring of the loss-sensitive programs decreased Casualty net premiums written by approximately $260 million in 2012. The additional premiums associated with prior year development in the loss-sensitive business also decreased by approximately $120 million. We also entered into a quota share reinsurance treaty in the U.S. for the Excess Casualty business that decreased net premiums written by approximately $60 million. We implemented rate increases in retained business, especially in the U.S., that partially offset the premium decreases noted above.
We have continued the strategy, adopted in 2010, to improve the allocation of our reinsurance between traditional reinsurance markets and capital markets. During 2011, as part of this strategy, we secured a three-year catastrophe bond with an industry index, first occurrence trigger, providing for $575 million in protection for U.S. hurricanes and earthquakes. The bond transaction reduced net premiums written by approximately $201 million in 2011. There were no catastrophe bond purchases in 2012.
Casualty net premiums written decreased primarily due to our strategic initiatives in workers' compensation and certain other lines of business, as well as a continued commitment to maintain price discipline in lines where market rates are unsatisfactory. However, given the capital intensive nature of these classes of casualty business, we expect that over time, these actions will improve our results. Net premiums written decreased by approximately $0.6 billion as we ceased writing excess workers' compensation business as a stand-alone product. This was slightly offset by an increase in additional premiums on loss-sensitive business in the amount of approximately $164 million compared to 2010.
Specialty net premiums written increased due to the strategic initiative to grow higher value lines, including aerospace, global marine, and credit insurance, all of which benefited from the impact of rate increases as well as new business growth.
Personal lines net premiums written increased primarily driven by the full year consolidation of Fuji results and growth in auto, personal property, and specialty personal lines products. Excluding the effects of the Fuji acquisition, Personal Lines net premiums decreased one percent, primarily as a result of a management decision to not renew certain programs in the U.S. and Canada that did not meet internal performance targets. Personal Lines continued to grow in key markets, including Japan and other Asia Pacific countries, Latin America, and in key lines, such as personal property and specialty personal lines products.
The following table presents AIG Property Casualty's net premiums written by region:
The Americas net premiums written increased slightly as a result of modest growth in Commercial Insurance offset by a small decrease in Consumer Insurance. The increase in Commercial Insurance was primarily due to the pricing improvements in Property and Specialty, which was slightly offset by a decrease in Casualty due to the strategic initiative in workers' compensation. The decrease in Consumer insurance was primarily due to underwriting actions taken in private client group to meet performance targets and a decrease in warranty lines new business in the U.S. and Canada, partially offset by continued growth in travel business and A&H direct marketing in Latin America.
In EMEA, the increase in Commercial Insurance was primarily related to growth in specialty products in line with our strategic initiative to grow higher value lines. Excluding the impact of foreign exchange, Consumer Insurance decreased as the business was focused on rebuilding the direct marketing programs that we previously shared with ALICO and the non-renewal of certain business to retain underwriting discipline. These decreases were largely offset by growth in group accident insurance, automobile and specialty personal lines products.
The general operating expense ratio increased by 2.4 points due to increases in bad debt expense, investments in strategic initiatives and human resources, coupled with a lower net premiums earned base. The lower net premiums earned base contributed approximately 0.2 points to the increase in the general operating expense ratio. Bad debt expense increased by approximately $143 million, which contributed approximately 0.7 points to the general operating expense ratio increase in the year ended December 31, 2012. For the year ended December 31, 2012, investments in strategic initiatives, commercial lines platform, our newly formed scientific group, underwriting and pricing tools totaled approximately $51 million, representing an increase of approximately $41 million over the prior year. The remainder of the general operating expense ratio increase was primarily due to higher personnel costs, as part of AIG's continued investment in its employees.
We continued to invest in a number of strategic initiatives during 2012, including the implementation of global finance and information systems, preparation for Solvency II compliance, readiness for regulation by the FRB, legal entity restructuring, and underwriting and claims improvement initiatives. We also continued to streamline our finance, policy and claims administration and human resources operations. The costs of these initiatives, which are not specific to either Commercial Insurance or Consumer Insurance, are reported as part of the Other category. For the year ended December 31, 2012, such costs totaled $391 million, representing an increase of approximately $195 million over the prior year, and contributed approximately 1.1 points to the AIG Property Casualty general operating expense ratio.
The acquisition ratio increased by 0.5 point in 2011 due to a change in the mix of business from low commission casualty business to higher commission property business, due to the underwriting actions taken since 2010, partially offset by rate strengthening.
The general operating expense ratio decreased by 0.9 points in 2011 compared to 2010 due to the overall growth in the business. In addition, the expense ratio reflects the effects of continued enhancements to regional governance, risk management capabilities and investments within growth economy nations.
The accident year loss ratio, as adjusted, in the year ended December 31, 2011 decreased, primarily due to rate strengthening and underwriting actions taken since 2010 and strong results in direct marketing and individual personal accident business.
The acquisition ratio decreased by 2.7 points primarily due to the effects of the full year consolidation of Fuji results. Fuji has a lower average acquisition ratio than the rest of the Consumer Insurance business due in part to its business mix.
(c) On March 11, 2011, a major earthquake occurred near the northeast coast of Honshu, Japan, triggering a tsunami in the Pacific Ocean. This disaster is referred to as the Tohoku Catastrophe.
The following table presents AIG Property Casualty's investing and other results:
* Includes gain on divested properties of $669 million in 2010
income from the assets not attributable to the Commercial Insurance and the Consumer Insurance operating segments are assigned to the Other category.
Net realized capital gains (losses), bargain purchase gains and other income (expense) - net are not allocated to Commercial Insurance and Consumer Insurance, but are reported as part of the Other category.
Net investment income is influenced by a number of factors including the amounts and timing of inward and outward cash flows, the level of interest rates and changes in overall asset allocation. Net investment income increased $472 million or 11 percent in 2012, compared to 2011, primarily due to the impact of the overall diversification in the asset portfolio during the year. We adopted yield-enhancement initiatives in 2011, and continued through 2012, which increased the average yield of our investment portfolio by 0.3 points to 4.0 percent during 2012.
While corporate debt securities continued to be the largest asset category, we continued to reduce our concentration in lower yielding tax exempt municipal bond holdings and focus on risk weighted opportunistic investments in higher yielding assets such as structured securities. This asset diversification has achieved an increase in average yields while the overall credit ratings of our fixed maturity investments were largely unchanged. We expect to continue to refine our investment strategy in 2013 to meet our liquidity, duration and credit quality objectives as well as current risk-return and tax objectives.
Our invested asset portfolio grew by approximately $4.3 billion, or 3 percent during the year with declining interest rates and narrowing spreads in both investment grade and higher yield asset classes contributing to higher unrealized appreciation in our portfolio.
Net investment income from other investment categories increased by $160 million in 2012 compared to 2011, of which $82 million was attributed to the strong performance of equity partnership investments, following a 16 percent increase in the S&P 500 Index during 2012. Other investment income also increased by $72 million due to the strategic group benefits partnership with AIG Life and Retirement, all of which is reported in Consumer Insurance.
Net investment income decreased slightly in 2011 compared to 2010. We experienced declines in private equity and hedge fund income, as well as increases in investment expenses, which were largely offset by increases in interest income. The decrease in private equity and hedge fund income reflects the decline in the overall equity markets during the second half of 2011. The increase in investment expenses in 2011 resulted mainly from increases in both
internal and external investment management fees. The interest income increase reflects the redeployment of cash and short term instruments into longer term, higher yield securities. In addition, 2011 reflects a full year of interest income related to Fuji.
Net realized capital gains were recorded in 2011, compared to losses in 2010. We recorded gains on the sales of fixed maturity securities; a decrease in other-than-temporary impairment charges; gains from improvements in foreign currency exchange rates; and gains from derivative instruments that do not qualify for hedge accounting, resulting primarily from declining long term interest rates. These derivative instruments economically hedge products that provide benefits over an extended period of time. Net realized capital gains on sales of fixed maturity securities increased due to our strategy to better align investment allocations with current overall performance and income tax planning objectives.
These gains were partially offset by impairments within other invested assets, primarily life settlement contracts. For the years 2011 and 2010, we recorded impairment charges of $351 million and $78 million, respectively, related to life settlement contracts. These charges included approximately $38 million and $4 million of impairments, respectively, associated with life insurance policies issued by AIG Life and Retirement that are eliminated in consolidation.
During 2011, we experienced an increase in the number of life settlement contracts identified as potentially impaired, compared to previous analyses. This increase reflected a new process adopted by us, in which updated medical information on individual insured lives is requested on a routine basis. In some cases, this updated information indicates that an individual's health has improved, resulting in an impairment loss due to revised estimates of net cash flows from the related contract. In addition, our domestic operations refined our fair values based upon the availability of recent medical information.
On March 31, 2010, we purchased additional voting shares in Fuji which resulted in the effective control and consolidation of Fuji. This acquisition resulted in a bargain purchase gain of $0.3 billion, which was included in the Consolidated Statement of Income (Loss) in Other Income. The bargain purchase gain was primarily attributable to the depressed market value of Fuji's common stock, which we believed was the result of macro-economic, capital market and regulatory factors in Japan coupled with Fuji's financial condition and results of operations.
AIG's gross loss reserves represent the accumulation of estimates of ultimate losses, including estimates for IBNR and loss expenses, less applicable discount for future investment income. We regularly review and update the methods and assumptions used to determine loss reserve estimates and to establish the resulting reserves. Any adjustments resulting from this review are reflected in pre-tax income. 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 prior years' estimates of ultimate cost are referred to as unfavorable or adverse development or reserve strengthening. Reserve changes that decrease prior years' estimates of ultimate cost are referred to as favorable development.
The net loss reserves represent loss reserves reduced by reinsurance recoverable, net of an allowance for unrecoverable reinsurance, less applicable discount for future investment income.
See Note 13 to the Consolidated Financial Statements for additional information on discounting of loss reserves.
The benefit from the change in discount in the year ended December 31, 2012 includes a $100 million increase in the reserve discount due to the commutation of an internal reinsurance treaty, under which a U.S. subsidiary previously ceded workers' compensation claims to a non-U.S. subsidiary. AIG discounts its loss reserves related to workers' compensation business written by its U.S. domiciled subsidiaries as permitted by the domiciliary statutory regulatory authorities. As a result of the commutation, the reserves for these claims are now recorded in a U.S. insurance subsidiary and accordingly are being discounted commencing in the three-month period ended June 30, 2012. The commutation was implemented as part of AIG Property Casualty's efforts to simplify its internal reinsurance arrangements.
AIG net loss reserves represent our best estimate of our liability for net losses and loss expenses as of December 31, 2012. While AIG regularly reviews the adequacy of established loss reserves, there can be no assurance that AIG's ultimate loss reserves will not develop adversely and materially exceed AIG's loss reserves as of December 31, 2012. In our opinion, such adverse development and resulting increase in reserves are not likely to have a material adverse effect on AIG's consolidated financial condition, although such events could have a material adverse effect on AIG's consolidated results of operations for an individual reporting period.
(b) Includes amounts related to dispositions through the date of disposition.
For certain categories of claims (e.g., construction defect claims and environmental claims), losses may sometimes be reclassified to an earlier or later accident year as more information about the date of occurrence becomes available to AIG. These reclassifications are shown as development in the respective years in the table above.
The excess casualty segment presents unique challenges for estimating the unpaid claims. Insureds are generally required to provide notice of claims that exceed a threshold, either expressed as a proportion of the attachment (e.g., 50 percent of the attachment) or as particular types of claims (e.g., death, quadriplegia). This threshold is generally established well below our attachment point, in order to provide us with a precautionary notice of claims that could potentially pierce our layer of coverage. This means that the majority of claims close without payment because the claims never pierce our layer, while the claims that close with payment can be large and highly variable. Thus, estimates of unpaid claims carry significant uncertainty.
During 2011 the excess casualty business segment experienced better than expected loss emergence, based on the shorter-termed loss development pattern from the year-end 2010 reserve analysis. However, accident year 2010 experienced some large catastrophic losses causing its results to be worse than expected.
For the year-end 2012 loss reserve review, our actuaries took into account the favorable emergence during 2012 for several accident years, especially accident year 2010, the claims department's reviews of open claims and reduced the ultimate losses for prior years accordingly. The 2012 actuarial review also adopted a refined segmentation for this class of business with the selection of differentiated frequency and severity trends. The overall loss cost trend adopted for this class of business in 2012 from the application of the refined segmentation was slightly lower than that adopted for the 2011 review reflecting the continued favorable emergence from this class of business.
For the year-end 2011 loss reserve reviews, our actuaries took into account the favorable development from prior accident years, as well as the continuing favorable development observed in the ground-up claims projections by our claims staff over the past five years.
The approach was deemed to be most suitable for injured workers whose medical conditions had largely stabilized (i.e., at least 9 to 10 years have elapsed since the date of injury). The reserves for accident years 2004 and subsequent (13 percent of total case and IBNR reserves for this class) were determined using traditional methods. See Critical Accounting Estimates for additional information.
As part of our 2010 comprehensive loss reserve analysis, we compared and contrasted the traditional techniques that have been used for this class with an alternative approach that focuses more explicitly on projecting the effect of future calendar year trends, while placing less weight on prior-period loss development ratios due to the increased evidence of changes to the claims environment. These various actuarial analyses indicated a substantial increase in loss estimates from the prior-year level, primarily for accident years 2002 and prior.
During 2012, this class recognized $68 million of adverse prior year development due to several large claims that involved unusual coverage issues for this class. With the exception of these claims, this class experienced claim activity in line with expectations.
Healthcare business written by AIG Property Casualty's Americas region produced moderate favorable development in 2011 and 2010. Healthcare loss reserves have benefited from favorable market conditions and an improved legal environment in accident years 2002 and subsequent, following a period of adverse loss trends and market conditions that began in the mid 1990s.
We maintain an active environmental insurance business related to pollution legal liability and general liability for environmental consultants and engineers, as well as runoff business for certain environmental coverage (including Cost Cap Containment) which provides cost overrun protection. We evaluate and report reserves associated with this business separately from the 1986 and prior asbestos and environmental reserves associated with standard General Liability and Umbrella policies discussed in "Asbestos and Environmental Reserves".
Because of an increase in the frequency and severity of claims observed beginning in 2011, the 2012 loss reserve review consisted of an intensive review of reported claims by a multi-disciplinary team including external experts in environmental law and engineering science, toxicologists and other experts, our actuaries, claims managers and underwriters to reassess our indicated loss reserve need. The review improved our understanding of factors that drive claim costs such as policy term, limit, pollution conditions covered, location of incident and applicable laws and remediation standards. The analysis used these factors to segment and analyze the claim data to determine ultimate costs, in some cases, on a claim by claim basis. As a result of this analysis, $326 million of prior year adverse development was recognized during 2012, including $166 million reported in the AIG Property Casualty Other reporting unit related to lines that are now in runoff. The majority (81 percent) of the adverse development related to accident years 2003 and prior, before significant underwriting changes were adopted.
Historically, we had used traditional actuarial methods to assess the reserves for the environmental products. The comprehensive claims review provided a more refined approach for the development of actuarial estimates for toxic tort claims (which were found to have a distinctly lengthier loss development pattern than other general liability claims in the environmental portfolio) as well as a more appropriate methodology for incorporating case reserving based estimates of ultimate loss costs for complex claims involving environmental remediation and/or from policies with high policy limits (greater than $5 million per policy). Notwithstanding the refined methodology and approach applied in 2012, considerable uncertainty remains over the ultimate loss cost for this class of business, especially for business written in accident years 2003 and prior.
We strengthened our post 1986 Environmental reserves in 2011 by $413 million, partly due to large reserve increases on individual claims. Of this amount, $382 million was included in the AIG Property Casualty Other
Primary Workers' Compensation and General Liability in Commercial Risk, Specialty Workers' Compensation and Energy Business units
The Commercial Risk division writes casualty insurance accounts for businesses with revenues of less than $700 million. The majority of the business is workers' compensation. The Energy division writes casualty insurance accounts (including workers' compensation) in the mining, oil and gas and power generation sectors. The Commercial Specialty Workers' Compensation division writes small monoline guaranteed cost risks. Our Commercial Specialty Workers' Compensation business unit grew significantly in the early to mid 2000s but has reduced premium writings by nearly 70 percent since 2007.
During 2012, we significantly intensified our claims management efforts for those primary workers' compensation claims which are managed by AIG. These efforts include consulting with various specialists, including clinical and public health professionals and other advisors. We also continued to refine our actuarial methodologies for estimating ultimate loss costs incorporating a more refined segmentation by state (California and New York were analyzed separately) and a more refined approach for business subject to deductibles as well as business subject to premium adjustments (loss-sensitive business). Based on these enhanced reviews we increased reserves by $46 million. We also reviewed the General Liability (GL) loss experience of the primary casualty classes of business using a more refined segmentation for business subject to a deductible as well as loss-sensitive business. Our review focused on applying actuarial loss development analyses to those GL claims for which these techniques are appropriate. As a result of this analysis, we determined that prior year reserves needed to be increased by $235 million for the primary GL class of business in 2012 to reflect the worse than expected emergence of paid loss severities for both bodily injury and property damage claims from the more recent accident years (2008 and subsequent).
The Commercial Risk, Commercial Specialty Workers' Compensation and Energy divisions contributed $265 million, $145 million and $115 million, respectively, of adverse development in calendar year 2011. The vast majority of this adverse development emanates from primary workers' compensation exposure, which was largely from accident year 2010. In 2011, losses for accident year 2010 continued to emerge at higher levels than anticipated at prior year end. A key driver was the effect of high unemployment on the frequency of higher severity lost time claims. The poor economic environment precluded some employers from offering "light duty" return-to-work alternatives that might otherwise have mitigated lost time claims. At the same time, the increased use of pain management strategies has led to increased medical claims. The increase in lost time frequency and the adverse effects of medical cost trends resulted in higher loss ratios than anticipated at prior year end. For each of the three classes, our conclusion that the worsening experience necessitated a strengthening of the reserves was confirmed by an independent third-party actuarial review during 2011.
We recorded a total of $518 million of adverse loss development for Commercial Specialty Workers' Compensation in 2010. The need to strengthen the reserves was confirmed by an independent third-party actuarial review during the fourth quarter of 2010. Approximately 75 percent of the year-end 2010 reserve strengthening for this business pertained to accident years 2007 through 2009. For similar reasons, the Commercial Risk division strengthened workers' compensation reserves in 2010.
For more information on our Loss Reserving Process, see Critical Accounting Estimates.
As part of our more in-depth comprehensive loss-reserve review in the fourth quarter of 2010, we conducted a series of top-down and ground-up reserve analyses to determine the appropriate loss reserve estimate for our asbestos exposures. To ensure the most comprehensive analysis possible, we engaged an independent third-party actuarial firm to assist in assessing these exposures. The ground-up study conducted by this firm used a proprietary model to calculate the loss exposure on an insured-by-insured basis. We believe that the accuracy of the reserve estimate is greatly enhanced through the combination of the actuarial firm's industry modeling techniques and industry knowledge and our own specific account-level experience.
Annually, we consider a number of factors and recent experience in addition to the results of the top-down and ground-up analyses performed for asbestos and environmental reserves. We considered the significant uncertainty that remains as to our ultimate liability for asbestos and environmental claims, which is due to several factors:
•the long latency period between asbestos exposure and disease manifestation, leading to the potential for involvement of multiple policy periods for individual claims;
As a result of the studies, we determined that no additional strengthening was required for asbestos and environmental in 2011.
Upon completion of the environmental top-down analysis performed in the fourth quarter of 2012, we concluded that the $75 million net reserve strengthening recognized in the first half of 2012 was adequate.
On June 17, 2011, we completed a transaction under which the bulk of AIG Property Casualty's net domestic asbestos liabilities were transferred to NICO, a subsidiary of Berkshire Hathaway, Inc. This was part of our ongoing strategy to reduce our overall loss reserve development risk. This transaction covers potentially volatile U.S.-related asbestos exposures. It does not, however, cover asbestos accounts that we believe have already been reserved to their limit of liability or certain other ancillary asbestos exposure assumed by AIG Property Casualty subsidiaries.
The results of AIG Life and Retirement for 2012 and 2011 reflected the following:
•Investment income from the ML II investment prior to its liquidation and distribution in March 2012 increased $200 million in 2012 compared to 2011.
•More favorable separate account performance driven in large part by equity markets had a positive effect on policyholder benefits and DAC amortization expenses for 2012.
•Reserve increases related to enhanced death claim practices in connection with the resolution of multi-state examinations were lower in 2012 compared to 2011.
Commencing in the third quarter of 2012, the SunAmerica segment was renamed AIG Life and Retirement, although certain existing brands will continue to be used in the marketplace.
•Life Insurance, which focuses on mortality and morbidity-based protection products, and
Net investment income increased in 2012 reflecting higher base yields of 9 basis points due to the reinvestment of significant amounts of cash and short-term investments during 2011, opportunistic investments in structured securities, fair value gains on MLII and other structured securities, a fair value gain of approximately $57 million on the investment in PICC Group, lower impairment charges on investments in leased commercial aircraft and higher returns on alternative investments. The increase in net investment income combined with lower interest credited resulted in improved net investment spreads in 2012 compared to 2011.
Other income decreased due to legal settlement proceeds of $226 million in 2011 to resolve a litigation matter.
Interest credited decreased in 2012 due to active crediting rate management actions that included lowering renewal credited rates, maintaining discipline on new business pricing including re-filing products to lower minimum rate guarantees.
Life Insurance operating income increased in 2012 due to higher net investment income and lower reserves for death claims, principally related to the effect of multi-state unclaimed property examinations, that have not been submitted to AIG in the normal course of business. These items were partially offset by higher mortality costs, DAC amortization and loss recognition reserves related to a legacy block of long-term care insurance.
Net investment income increased in 2012, reflecting the reinvestment of significant amounts of cash and short-term investments during 2011, opportunistic investments in structured securities, fair value gains on MLII in 2012 of $76 million, a fair value gain of $28 million on the investment in PICC made in 2012, lower impairment charges on investments in leased commercial aircraft and higher returns on alternative investments.
•Mortality costs related to life insurance increased in 2012, although overall mortality results remain within pricing expectations.
•Certain long-duration products, including traditional life insurance, accident and health products, such as long-term care insurance and payout annuities, may require increases in reserves if changes in estimates of future investment returns result in projected future losses. Long term care products may also require additional reserves if future expected premium increases are not sufficient to cover future benefit cost increases not provided for in the current reserves. For these long duration traditional products, the assumptions used to calculate benefit liabilities and DAC are "locked in" at policy issuance. These assumptions are based on our estimates of mortality, morbidity, persistency, maintenance expenses, investment returns and for long-term care, future premium increases. If observed changes in actual experience or estimates result in projected future losses under loss recognition testing, DAC is adjusted and additional policyholder benefit liabilities may be recorded through a charge to policyholder benefit expense. In the fourth quarter of 2012, loss recognition reserves of $61 million were recorded for a legacy block of long-term care insurance issued prior to 2002.
•During 2012 AIG Life and Retirement resolved multi-state examinations relating to the handling of unclaimed property and the use of the Social Security Death Master File (SSDMF) to identify death claims that have not been submitted to us in the normal course of business. The final settlement of these examinations was announced on October 22, 2012. AIG Life and Retirement is now taking enhanced measures to, among other things, routinely match policyholder records with the SSDMF to determine if its insured parties, annuitants, or retained account holders have died and locate beneficiaries when a claim is payable. Charges related to the resolution of the multi-state examinations and use of the SSDMF were approximately $57 million in 2012 and $202 million in 2011. Amortization of deferred acquisition costs increased in 2012 as a result of updated assumptions for universal life products and certain blocks of fixed annuities included in the Life Insurance operating segment. The updated assumptions increased amortization by $78 million and primarily reflected the impact of spread compression in the current low interest rate environment.
Policy fees increased in 2012 as a result of growth in variable annuity assets under management due to higher net flows and separate account performance driven in large part by higher equity markets.
Policyholder benefits and claims incurred decreased in 2012 due to the impact of higher separate account returns for certain guaranteed benefit features of variable annuities.
Operating income decreased in 2011 due to lower net investment income, higher DAC amortization and higher policyholder benefit expense in its variable annuity business due to separate account performance, and an increase in death claim reserves.
Other income increased due to the previously discussed legal settlement proceeds of $226 million in 2011.
Net investment income decreased in 2011 compared to 2010 reflecting lower base yields as investment purchases in late 2010 and 2011 were made at yields lower than the weighted average yields of the existing base portfolio. Net investment income also decreased due to a $149 million decrease in fair value gains on ML II, $126 million lower call and tender income and $50 million of impairment charges on investments in leased commercial aircraft. The lower yields were partially offset by an increase in income from the reinvestment of significant amounts of cash and short term investments during 2011.
Amortization of deferred acquisition costs was lower in 2011 as a result of updating mortality and surrender rate assumptions on universal life and deferred annuity business in 2010, which resulted in an $86 million increase in DAC amortization in 2010.
Retirement services operating income decreased in 2011 due to lower net investment income, higher DAC amortization and higher policyholder benefit expense in its variable annuity business from equity market conditions, partially offset by higher income from legal settlements.
Other acquisition and insurance expenses declined due to legal expenses and state guaranty fund assessments which were higher in 2010.
AIG Life and Retirement reported net realized capital gains in 2011 compared to net realized capital losses in 2010. This was mainly due to a $981 million decline in other-than-temporary impairments, a decline in fair value losses on derivatives primarily used to hedge the effect of interest rate and foreign exchange movements on GIC reserves, and declines in the allowance for mortgage loans. These improvements were partially offset by a $465 million increase in fair value losses on variable annuity embedded derivatives which were primarily driven by declines in long-term interest rates.
Premiums represent amounts received on traditional life insurance policies, group benefit policies and deposits on life-contingent payout annuities. Premiums, deposits and other considerations is a non-GAAP measure that includes life insurance premiums and deposits on annuity contracts and mutual funds.
* Life insurance sales include periodic premiums from new business expected to be collected over a one-year period and 10 percent of single premiums and unscheduled deposits from new and existing policyholders. Annuity sales represent deposits from new and existing customers.
Total premiums, deposits and other considerations decreased in 2012 as substantial decreases in individual fixed annuities were only partially offset by significant increases in individual variable annuities and retail mutual funds.
Overall, net flows were negative in 2012, primarily due to lower fixed annuity deposits resulting from the low interest rate environment. Net flows improved in 2012 for individual variable annuities due to both the increase in deposits and favorable surrender experience. Net flows improved in 2012 for retail mutual funds due to increased deposits.
* Excludes mutual funds of $11.8 billion and $9.5 billion at December 31, 2012 and 2011, respectively.
Re-priced certain life insurance and annuity products to reflect current low rate environment
Opportunistic Investments: The majority of assets backing insurance and annuity liabilities consists of intermediate- and long-term fixed maturity securities. We generally purchase assets with the intent of matching expected maturities of the insurance liabilities. An extended low interest rate environment may result in a lengthening of liability maturities from initial estimates, primarily due to lower lapses. Opportunistic investments in structured securities, private placement corporate debt securities and mortgage loans continue to be made to improve yields, increase net investment income and help to offset the impact of the lower interest rate environment.
As indicated in the table below, approximately 63 percent of our annuity and universal life account values are at their minimum crediting rates as of December 31, 2012, an increase from 45 percent at December 31, 2011. These
products have minimum guaranteed interest rates as of December 31, 2012 ranging from 1.0 percent to 5.5 percent, with the higher rates representing guarantees on older products.
Effective Product Management: AIG Life and Retirement has a dynamic product management process designed to ensure that new business product offerings appropriately reflect the current low interest rate environment. To the extent that we cannot achieve targeted net investment spreads on new business, products are re-priced or discontinued. Additionally, current products with higher minimum rate guarantees have been re-filed with lower rates as permitted under state insurance product regulations.
* Includes interest expense of $2 million and $75 million for 2011 and 2010, respectively, allocated to discontinued operations in consolidation.
•a decrease in claims and claims adjustment expenses of $175 million. This reflects decreases in first and second-lien businesses of $95 million and $110 million, respectively, which were partially offset by an increase in international claims and claims adjustment expenses of $34 million. Claims and claims adjustment expenses in 2012 included favorable prior year loss development of $78 million, which consists of $45 million in second liens, $17 million in student loans and $33 million in the international business partially offset by unfavorable development in first liens of $17 million. This favorable prior year development was offset by current accident year losses attributable to business written in 2008 and prior;
•the $95 million decrease in first-lien claims and claims adjustment expenses reflected 20 percent lower levels of newly reported delinquencies, an improvement in the cure rate and lower unfavorable loss development of $17 million in 2012 compared to $76 million of unfavorable development in 2011. The unfavorable development of $17 million in 2012, included $117 million of favorable development arising from the claims requests sent to lenders mentioned above, offset by $134 million of unfavorable development on delinquencies for which claim requests were not made;
•the $110 million decline in second-lien business claims and claims adjustment expenses. This reflected a decrease in claims and claims adjustment expenses paid as more business reached the respective stop loss limits; and
•the increased claims and claims adjustment expenses in the international business. This reflected a reduction in claim reserves in 2011 due to a settlement of certain delinquencies with a major European lender that resulted in a $43 million benefit. These items were partially offset by:
•a decline in earned premiums on second-lien and international businesses, both of which were placed into run-off during 2008, of $41 million and $24 million respectively; and
The following table presents risk-in-force and delinquency ratio information for Mortgage Guaranty domestic business:
•declines in earned premiums from the second-lien, private student loan and international businesses, which were placed into runoff during 2008, partially offset by an increase in earned premiums from first-lien business; and
GCM reported operating income in 2012 compared to an operating loss in 2011 primarily due to improvement in unrealized market valuations related to the super senior credit default swap (CDS) portfolio, a decrease in operating expenses and lower costs related to the wind-down of AIGFP's businesses and portfolios. For 2012 and 2011,
The DIB's operating income decreased in 2011 compared to 2010 primarily due to lower net gains in credit valuation adjustments on non-derivative assets and liabilities accounted for under the fair value option and lower interest income due to approximately $4.9 billion in sales of investments during the fourth quarter of 2010 and the first quarter of 2011 to increase liquidity.
The following table presents credit valuation adjustment gains (losses) for the DIB (excluding intercompany transactions):
We recognized a $1.3 billion gain in 2011, representing a 12 percent increase in the value of AIG's then 33 percent interest in AIA, which is recorded in Other invested assets and accounted for under the fair value option. In 2010, we recognized a $638 million loss on our interest in AIA during the approximate two-month holding period following the initial public offering in late October 2010.
The gains attributable to AIG's interest in ML III for 2012 were based in part on the completion of the final auction of ML III assets by the FRBNY, in the third quarter of 2012.
•a decline in interest expense as a result of the repayment of the FRBNY Credit Facility; and
•a pre-tax loss of $6.7 billion ($4.4 billion after tax) on the announced sale of ILFC in 2012;
During 2011, the insurance operations portfolio experienced appreciation in bonds available for sale due to lower rates, which more than offset widening spreads. The ten year U.S. Treasury rate started the year at 3.30 percent, falling 188 basis points to end the year at 1.88 percent. Municipal bond rates also decreased, resulting in unrealized appreciation in both the U.S. Government securities and municipal bond portfolio. The drop in U.S. Treasury rates more than offset the widening of spreads on Investment grade securities, resulting in improved pricing and corresponding unrealized appreciation in the corporate bond portfolio during the year.
See Investments - Investment Highlights - Securities available for sale herein for a table on the gross unrealized gains (losses) of AIG's available for sale securities by type of security.
The change in DAC in 2012 compared to 2011 is primarily the result of increases in the unrealized appreciation of investments supporting interest-sensitive products. DAC for investment-oriented products is adjusted for changes in estimated gross profits that result from changes in the net unrealized gains or losses on fixed maturity and equity securities available for sale. Because fixed maturity and equity securities available for sale are carried at aggregate fair value, an adjustment is made to DAC equal to the change in DAC 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. These adjustments, net of tax, are credited or charged directly to Accumulated other comprehensive income (loss).
Primarily as a result of the increase in unrealized appreciation of investments during 2012 and 2011, we recorded additional future policy benefits through Other comprehensive income. This change in future policy benefits assumes that the securities underlying certain traditional long-duration products are sold at their stated aggregate fair value and reinvested at current yields. This increase in future policy benefits in other comprehensive income was partially offset by loss reserve recognition in net income resulting from sales of securities in unrealized gain positions.
The change in foreign currency translation adjustment was a net loss in 2012 due to the strengthening of the U.S. dollar against the Euro and Japanese Yen slightly offset by the weakening of the U.S. dollar against British pound.
The decrease in the amount of change in 2012 compared to the 2011 was primarily due to the overall decreases in discount rates resulting in a loss of approximately $636 million and $677 million in 2012 and 2011, respectively. Partially offsetting the 2012 loss was a gain from investment returns of $213 million. Adding to the loss in 2011 was a loss from investment returns of $146 million.
In 2012, the effective tax rate on pre-tax Other Comprehensive Income was 32.2 percent. The effective tax rate differed from the statutory 35 percent rate primarily due to a decrease in the deferred tax asset valuation allowance and the effect of foreign operations.
As discussed above, the 2011 increase in unrealized appreciation of investments was due to the result of appreciation in bonds available for sale due to lower rates, which more than offset widening spreads.
The reclassification adjustments included in net income on unrealized appreciation of investments decreased by $0.5 billion in 2011 compared to 2010 as a result of realized gains and losses recognized on sales of securities classified as available for sale.
The decline in foreign currency translation adjustments reflects the divestiture of multiple foreign operations, including the sales of Nan Shan, AIG Star and AIG Edison in 2011, the deconsolidation of AIA in 2010 and the sale of ALICO in 2010.
Liquidity refers to the ability to generate sufficient cash resources to meet our payment obligations. It is defined as cash and unencumbered assets that can be monetized in a short period of time at a reasonable cost. We manage our liquidity prudently through various risk committees, policies and procedures, and a stress testing and liquidity framework established by ERM. See Enterprise Risk Management - Risk Governance Structure for additional information. The liquidity framework is designed to measure both the amount and composition of our liquidity to meet financial obligations in both normal and stressed markets. See Enterprise Risk Management - Risk Appetite, Identification, and Measurement and Liquidity Risk Management for additional information.
Nevertheless, some circumstances may cause our cash or capital needs to exceed projected liquidity or capital resources. Additional collateral calls, deterioration in investment portfolios or reserve strengthening affecting statutory surplus, higher surrenders of annuities and other policies, downgrades in credit ratings, or catastrophic losses may result in significant additional cash or capital needs, loss of some sources of liquidity or capital, or both. In addition, regulatory, and other legal restrictions could limit our ability to transfer funds freely, either to or from our subsidiaries.
We sold our remaining interest of approximately 4.0 billion AIA ordinary shares for gross proceeds of approximately $14.5 billion.
We received approximately $8.5 billion in distributions from the FRBNY's dispositions of ML III assets.
Approximately $5.2 billion was paid to AIG Parent from subsidiaries in cash. In addition, AIG Parent received non-cash dividends of approximately $1.0 billion in the form of municipal bonds from AIG Property Casualty.
We received approximately $3.8 billion in proceeds in registered public note offerings.
We purchased an aggregate of approximately $13 billion of AIG Common Stock at the initial public offering price in four registered public offerings of AIG Common Stock conducted by the Department of the Treasury, as the selling shareholder. See Note 17 to the Consolidated Financial Statements for additional information on these offerings.
We made $1.2 billion in net capital contributions to subsidiaries, including a contribution of approximately $1.0 billion to AIG Property Casualty in the aftermath of Storm Sandy.
Interest payments totaled $4.0 billion in 2012 compared to $9.0 billion in 2011. Cash paid for interest in 2011 includes the payment of FRBNY Credit Facility accrued compounded interest totaling $6.4 billion. Excluding interest payments, AIG generated positive operating cash flow of $7.7 billion and $8.9 billion in 2012 and 2011, respectively.
Cash provided by operating activities of discontinued operations of $2.9 billion in 2012 compared to $6.2 billion in 2011, includes ILFC, and in 2011 and 2010, foreign life insurance subsidiaries that were divested in 2011, including Nan Shan, AIG Star and AIG Edison.
•cash provided by operating activities of foreign life subsidiaries declined by $10.4 billion due to the sale of those subsidiaries (AIA, ALICO, AIG Star, AIG Edison and Nan Shan). The subsidiaries generated operational cash inflows of $3.4 billion and $13.8 billion in 2011 and 2010, respectively; and
•the effect of catastrophes and the cession of a large portion of AIG Property Casualty's net asbestos liabilities in the U.S. to NICO. Excluding the impact of the NICO cession and catastrophes, cash provided by AIG's reportable segments in 2011 is consistent with 2010, as increases in claims paid were offset by increases in premiums collected at the insurance subsidiaries.
•gross proceeds of approximately $14.5 billion from the sale of approximately 4.0 billion AIA ordinary shares; and
Net cash used in financing activities during 2012 includes the following activities:
Net cash used in financing activities in 2010 reflected declines in policyholder contract withdrawals, due to improved conditions for the life insurance and retirement services businesses. This was partially offset by the issuance of long-term debt.
As of December 31, 2012, AIG Parent had $16.1 billion in liquidity resources. AIG Parent's primary sources of liquidity are dividends, distributions, and other payments from subsidiaries, as well as credit and contingent liquidity facilities. AIG Parent's primary uses of liquidity are for debt service, capital management, operating expenses and subsidiary capital needs.
AIG Parent's primary sources of capital are dividends and distributions from subsidiaries. AIG Parent has unconditional capital maintenance agreements (CMAs) in place with certain AIG Property Casualty and AIG Life and Retirement subsidiaries to facilitate the transfer of capital and liquidity within the consolidated company. We expect these CMAs to continue to enhance AIG's capital management practices, and help manage the flow of capital between AIG Parent and these subsidiaries. We have entered into and expect to enter into additional CMAs with certain other insurance companies in 2013. See AIG Property Casualty and AIG Life and Retirement below for additional information. Nevertheless, regulatory and other legal restrictions could limit our ability to transfer capital freely, either to or from our subsidiaries.
We believe that we have sufficient liquidity and capital resources to satisfy future requirements and meet our obligations to policyholders, customers, creditors and debt-holders. We expect to access the debt markets from time to time to meet funding requirements as needed.
(b) AIG entered into an amended and restated syndicated bank credit facility on October 5, 2012. For additional information relating to this credit facility, see Credit Facilities below.
sold our entire interest of approximately 3.9 billion AIA ordinary shares for gross proceeds of approximately $14.0 billion (excluding proceeds from the sale of AIA ordinary shares held by AIA SPV to an AIG Property Casualty subsidiary);
$400 million in dividends from the AIA SPV, representing the proceeds from the sale of shares of AIA held by the AIA SPV to an AIG Property Casualty subsidiary;
issued $1.5 billion principal amount of 4.875% Notes Due 2022. These proceeds are being used for general corporate purposes which are currently expected to include the repayment of debt maturing in 2013;
received approximately $1.0 billion that was released to AIG from an escrow that secures indemnifications provided to MetLife under the ALICO stock purchase agreement (see Note 16 to the Consolidated Financial Statements for additional information).
the common equity interest in the AIA SPV held by us,
cash held in escrow to secure indemnifications provided to MetLife under the ALICO stock purchase agreement.
We expect that AIG Property Casualty subsidiaries will be able to continue to satisfy future liquidity requirements and meet their obligations, including those arising from reasonably foreseeable contingencies or events, through cash from operations and, to the extent necessary, asset dispositions. AIG Property Casualty subsidiaries maintain substantial liquidity in the form of cash and short-term investments, totaling $8.6 billion as of December 31, 2012. Further, AIG Property Casualty subsidiaries maintain significant levels of investment-grade fixed maturity securities, including substantial holdings in government and corporate bonds, which could be monetized in the event liquidity levels are deemed insufficient.
In December 2012, AIG Parent contributed $1.0 billion of capital to AIG Property Casualty U.S. insurance companies to strengthen capital levels, as a result of the impact of Storm Sandy-related catastrophe losses.
(i)the amount (to be determined by Chartis Inc.) necessary to reduce the Fleet's projected or actual total adjusted capital to a level equal to or not materially greater than such specified minimum percentage or
The need to fund product surrenders, withdrawals and maturities creates a significant potential liquidity requirement for AIG Life and Retirement's subsidiaries. We believe that because of the size and liquidity of our investment portfolios, AIG Life and Retirement does not face a significant liquidity risk due to normal deviations from projected claim or surrender experience. As part of its risk management framework, AIG Life and Retirement continues to evaluate programs, including securities lending programs and other secured financings, to improve its liquidity position and facilitate AIG Life and Retirement's ability to maintain a fully invested asset portfolio.
During 2012, AIG Life and Retirement began utilizing programs that lend securities from its investment portfolio to supplement liquidity or for other uses as deemed appropriate by management. Under these programs, the AIG Life and Retirement subsidiaries lend securities to financial institutions and receive collateral equal to 102 percent of the fair value of the loaned securities. Reinvestment of cash collateral received is restricted to highly liquid short-term investments. AIG Life and Retirement's liability to the borrower for collateral received was $3.1 billion as of December 31, 2012. In addition, in 2011, certain AIG Life and Retirement insurance subsidiaries became members of the FHLBs in their respective districts. As of December 31, 2012, AIG Life and Retirement had outstanding borrowings of $82 million from the FHLBs.
In March 2011, AIG Parent entered into CMAs with certain AIG Life and Retirement insurance subsidiaries. Among other things, the CMAs provide that AIG Parent will maintain the total adjusted capital of each of these AIG Life and Retirement insurance subsidiaries at or above a specified minimum percentage of the subsidiary's projected Company Action Level RBC. As a result, the CMAs provide that if the total adjusted capital of these AIG Life and Retirement insurance subsidiaries falls below the specified minimum percentage of their respective Company Action Level RBC, AIG Parent will contribute cash or instruments admissible under applicable regulations to these AIG Life and Retirement insurance subsidiaries in the amount necessary to increase total adjusted capital to a level at least equal to such specified minimum percentage. Any required contribution under the CMAs would generally be made during the second and fourth quarters of each year; however, AIG Parent may also make contributions in such amounts and at such times as it deems appropriate.
•(i) the amount necessary to reduce projected or actual total adjusted capital to a level equal to or not materially greater than such specified minimum percentage or
•(ii) the maximum amount of ordinary dividends permitted under applicable insurance law. The CMAs do not prohibit, however, the payment of extraordinary dividends, subject to board and regulatory approval, to reduce projected or actual total adjusted capital to a level equal to or not materially greater than the specified minimum percentage. Any required dividend under the CMAs would generally be made on a quarterly basis. As structured, the CMAs contemplate that the specified minimum percentage would be reviewed and agreed upon at least annually. As a result of a reduction in rating agency minimum requirements and greater capital efficiency arising from the consolidation of legal entities, the specified minimum percentage decreased from 435 percent to 385 percent effective February 19, 2013, except for the CMA with AGC Life Insurance Company, where the specified minimum percentage remained at 250 percent.
GCM acts as the derivatives intermediary between AIG and its subsidiaries and third parties to provide hedging services. It executes its derivative trades under International Swaps and Derivatives Association, Inc. (ISDA) agreements. The agreements with third parties typically require collateral postings. Many of GCM's transactions with AIG and its subsidiaries also include collateral posting requirements. However, generally, no collateral is called under these contracts unless it is needed to satisfy posting requirements with third parties. Most of GCM's CDS are subject to collateral posting provisions. These provisions differ among counterparties and asset classes. The amount of future collateral posting requirements is a function of our credit ratings, the rating of the reference obligations and the market value of the relevant reference obligations, with the latter being the most significant factor. We estimate the amount of potential future collateral postings associated with the super senior CDS using various methodologies. The contingent liquidity requirements associated with such potential future collateral postings are incorporated into our liquidity planning assumptions.
The DIB's assets consist primarily of cash, short term investments, fixed maturity securities issued by U.S. government and government sponsored entities, mortgage and asset backed securities and, to a lesser extent, bank loans and mortgage loans. The DIB's liabilities consist primarily of notes and other borrowings supported by assets as well as other short-term financing obligations. As of December 31, 2012 and December 31, 2011, respectively, the DIB had total assets of $28.5 billion and $31.0 billion and total liabilities of $23.8 billion and $28.2 billion.
The overall hedging activity for the assets and liabilities of the DIB is executed by GCM. The value of hedges related to the non-derivative assets and liabilities of AIGFP in the DIB is included within the assets and liabilities and operating results of GCM and are not included within the DIB operating results, assets or liabilities.
•AIG Parent allocated cash from the MIP to pay down the AIA SPV Preferred Interests. In exchange, AIG's remaining interest in ML III and the future proceeds from the cash held in escrow to secure indemnities provided to MetLife were allocated to the MIP.
•The DIB received approximately $8.5 billion in distributions from the FRBNY's auctions of ML III assets.
See Note 15 to the Consolidated Financial Statements for further discussion of the Four-Year Facility.
(b) Loss reserves relate to the AIG Property Casualty and the Mortgage Guaranty business, and represent future loss and loss adjustment expense payments estimated based on historical loss development payment patterns. Due to the significance of the assumptions used, the payments by period presented above could be materially different from actual required payments. We believe that the AIG Property Casualty and Mortgage Guaranty subsidiaries maintain adequate financial resources to meet the actual required payments under these obligations.
We have made significant assumptions to determine the estimated undiscounted cash flows of these contractual policy benefits. These assumptions include mortality, morbidity, future lapse rates, expenses, investment returns and interest crediting rates, offset by expected future deposits and premiums on in-force policies. Due to the significance of the assumptions, the periodic amounts presented could be materially different from actual required payments. The
(a) Primarily represents liquidity facilities provided in connection with certain municipal swap transactions and collateralized bond obligations.
(b) Includes residual value guarantees associated with aircraft and AIG Life and Retirement construction guarantees connected to affordable housing investments. Excludes potential amounts for indemnification obligations included in asset sales agreements. See Note 16 to the Consolidated Financial Statements for further information on indemnification obligations. .
At December 31, 2012, there were no securities transferred under repurchase agreements accounted for as sales and no related cash collateral obtained. See Note 2 to the Consolidated Financial Statements for additional information on the modification of the criteria for determining whether securities transferred under repurchase agreements are accounted for as sales.
While AIG enters into various arrangements with variable interest entities (VIEs) in the normal course of business, our involvement with VIEs is primarily as a passive investor in fixed maturity securities (rated and unrated) and equity interests issued by VIEs. We consolidate a VIE when we are the primary beneficiary of the entity. For a further discussion of our involvement with VIEs, see Note 11 to the Consolidated Financial Statements.
We are subject to financial guarantees and indemnity arrangements in connection with our sales of businesses. These arrangements may be triggered by declines in asset values, specified business contingencies, the realization of contingent liabilities, litigation developments, or breaches of representations, warranties or covenants provided by us. These arrangements are typically subject to time limitations, defined by the contract or by operation of law, such as by prevailing statutes of limitation. Depending on the specific terms of the arrangements, the maximum potential obligation may or may not be subject to contractual limitations. For additional information regarding our indemnification agreements, see Note 16 to the Consolidated Financial Statements.
We have recorded liabilities for certain of these arrangements where it is possible to estimate them. These liabilities are not material in the aggregate. We are unable to develop a reasonable estimate of the maximum potential payout under some of these arrangements. Overall, we believe that it is unlikely we will have to make any material payments related to completed sales under these arrangements.
See Note 15 to the Consolidated Financial Statements for additional details for debt outstanding.
Credit ratings estimate a company's ability to meet its obligations and may directly affect the cost and availability to that company of financing. The following table presents the credit ratings of AIG and certain of its subsidiaries as of February 13, 2013. Figures in parentheses indicate the relative ranking of the ratings within the agency's rating categories; that ranking refers only to the major rating category and not to the modifiers assigned by the rating agencies.
To the extent that any of our insurance entities were to fall below prescribed levels of statutory surplus, it would be our intention to provide appropriate capital or other types of support to that entity, under formal support agreements, CMAs or otherwise. For additional details regarding CMAs that we have entered into with our insurance subsidiaries, see Liquidity and Capital Resources of AIG Parent and Subsidiaries - AIG Property Casualty and Liquidity and Capital Resources of AIG Parent and Subsidiaries - AIG Life and Retirement.
Our investments and investment strategies were affected by the following conditions in 2012:
•Central banks initiated actions intended to improve weakening economic conditions, including the European Central Bank's commitment to further bond purchases and the U.S. Federal Reserve's commitment to maintain the Federal Funds Rate in the zero to a quarter percent range. The Federal Reserve also committed to support the mortgage market via purchases of agency mortgage-backed securities, and extended "Operation Twist", a program of redeeming short-term U.S. Treasury securities and using the proceeds to buy longer-term U.S. Treasury securities with the objective of putting downward pressure on longer-term interest rates.
•Bond yields remained low in the U.S., as evidenced by the 10-year U.S. Treasury rate ending the year at 1.76 percent.
•Fixed maturity securities held by the domestic insurance companies included in AIG Property Casualty historically have consisted primarily of laddered holdings of tax-exempt municipal bonds, which provided attractive after-tax returns and limited credit risk. To meet the current risk-return and tax objectives of AIG Property Casualty, cash flows from the investment portfolio and insurance operations are generally being reinvested by the domestic property and casualty companies in taxable instruments which meet the companies' liquidity, duration and credit quality objectives as well as current risk-return and tax objectives.
•We continued to make risk-weighted opportunistic investments in RMBS and other structured securities to improve yields and increase net investment income.
At December 31, 2012, approximately 88 percent of fixed maturity securities were held by our domestic entities. Approximately 17 percent of such securities were rated AAA by one or more of the principal rating agencies, and approximately 15 percent were rated below investment grade or not rated. Our investment decision process relies primarily on internally generated fundamental analysis and internal risk ratings. Third-party rating services' ratings and opinions provide one source of independent perspective for consideration in the internal analysis.
A significant portion of our foreign entities' fixed maturity securities portfolio is rated by Moody's, S&P or similar foreign rating services. Rating services are not available for some foreign issued securities. Our Credit Risk Management department closely reviews the credit quality of the foreign portfolio's non-rated fixed maturity securities. At December 31, 2012, approximately 18 percent of such investments were either rated AAA or, on the basis of our internal analysis, were equivalent from a credit standpoint to securities rated AAA, and approximately 3 percent were rated below investment grade or not rated at that date. Approximately 49 percent of the foreign entities' fixed maturity securities portfolio is comprised of sovereign fixed maturity securities supporting policy liabilities in the country of issuance.
With respect to our fixed maturity investments, the credit ratings in the table below and in subsequent tables reflect: (a) a composite of the ratings of the three major rating agencies, or when agency ratings are not available, the rating assigned by the National Association of Insurance Commissioners (NAIC) Securities Valuations Office (SVO) (over 99 percent of total fixed maturity investments), or (b) our equivalent internal ratings when these investments have not been rated by any of the major rating agencies or the NAIC. The "Non-rated" category in those tables consists of fixed maturity securities that have not been rated by any of the major rating agencies, the NAIC or us, and for 2011, represents primarily our interest in ML III at December 31, 2011.
The following tables summarize the composition of AIG's investments by reportable segment:
(b) Includes $12.4 billion of AIA ordinary shares at December 31, 2011.
In our property casualty business, the duration of liabilities for long-tail casualty lines is greater than other lines. As differentiated from the life insurance and retirement services companies, the focus is not on asset-liability matching, but on preservation of capital and growth of surplus.
Fixed income holdings of AIG Property Casualty domestic operations, with an average duration of 4.0 years, are currently comprised primarily of tax-exempt securities, which provide attractive risk-adjusted after-tax returns as well
A number of guaranteed benefits, such as living benefits and guaranteed minimum death benefits, are offered on certain variable and indexed annuity products. The fair value of these benefits is measured based on actuarial and capital market assumptions related to projected cash flows over the expected lives of the contracts. We manage our exposure resulting from these long-term guarantees through reinsurance or capital market hedging instruments. We actively review underlying assumptions of policyholder behavior and persistency related to these guarantees. We have taken positions in certain derivative financial instruments in order to hedge the impact of changes in equity markets and interest rates on these benefit guarantees. We execute listed futures and options contracts on equity indexes to hedge certain guarantees of variable and indexed annuity products. We also enter into various types of futures and options contracts, primarily to hedge changes in value of certain guarantees of variable and indexed annuities due to fluctuations in interest rates. We use several instruments to hedge interest rate exposure, including listed futures on government securities, listed options on government securities and the purchase of government securities.
Fixed income holdings of AIG Life and Retirement, with an average duration of 6.3 years, are comprised of taxable corporate bonds, as well as municipal and government bonds, commercial mortgage loans, and agency and non-agency structured securities. The majority of these investments are held in the available for sale portfolio and are rated investment grade based on our composite ratings.
The following table presents the fair value of our available-for-sale securities:
The following table presents the industry categories of our available for sale corporate debt securities based on amortized cost:
* Includes approximately $10.9 billion of securities that were purchased at a significant discount to amortized cost commencing in the second quarter of 2011.
(a) Commencing in the second quarter of 2011, we began purchasing certain RMBSs that had experienced deterioration in credit quality since their origination. See Note 7 to the Consolidated Financial Statements, Investments - Purchased Credit Impaired (PCI) Securities, for additional discussion.
(b) The weighted average expected life was 6 years at both December 31, 2012 and December 31, 2011, respectively.
The fair value of CMBS holdings remained stable throughout 2012. The majority of our investments in CMBS are in tranches that contain substantial protection features through collateral subordination. As indicated in the tables, downgrades have occurred on many CMBS holdings. The majority of CMBS holdings are traditional conduit transactions, broadly diversified across property types and geographical areas.
At December 31, 2012, we had direct commercial mortgage loan exposure of $13.8 billion. At that date, over 99 percent of the loans were current.
We sold our remaining 33 percent interest in AIA ordinary shares for proceeds of $14.5 billion and a net gain of $2.1 billion through three sale transactions on March 7, September 11 and December 20, 2012.
•other impairments, including equity securities, private equity funds, hedge funds, direct private equity investments, aircraft trusts and investments in life settlement contracts. There was no significant impact to our consolidated financial condition or results of operations from other-than-temporary impairment charges for any one single credit. Also, no individual other-than-temporary impairment charge exceeded 0.11 percent, 0.20 percent and 0.20 percent of total equity at December 31, 2012, 2011 or 2010, respectively.
In periods subsequent to the recognition of an other-than-temporary impairment charge for available for sale fixed maturity securities that is not foreign-exchange related, we generally prospectively accrete into earnings the difference between the new amortized cost and the expected undiscounted recovery value over the remaining life of the security. The accretion that was recognized for these securities in earnings was $915 million in 2012, and
$542 million in 2011, and $401 million in 2010. For a discussion of AIG's other-than-temporary impairment accounting policy, see Note 7 to the Consolidated Financial Statements.
The following table shows the aging of the pre-tax unrealized losses of fixed maturity and equity securities, the extent to which the fair value is less than amortized cost or cost, and the number of respective items in each category:
As of December 31, 2012, the majority of our fixed maturity investments in an unrealized loss position of more than 50 percent for 12 months or more consisted of the unrealized loss of $138 million primarily related to CMBS and RMBS securities originally rated investment grade that are floating rate or that have low fixed coupons relative to current market yields. A total of 2 securities with an amortized cost of $12 million and a net unrealized loss of $10 million are still investment grade. As part of our credit evaluation procedures we consider the nature of both the specific securities and the market conditions for those securities. For most security types supported by real estate-related assets, current market yields continue to be higher than the yields at the time those securities were issued. In addition, for floating rate securities, persistently low LIBOR levels continue to make these securities less attractive to secondary purchasers of these assets.
We believe that these securities are trading at significant price discounts primarily due to the lack of demand for commercial and residential real estate collateral-based securities, low contractual coupons and interest rate spreads, and the deterioration in the level of collateral support due to real estate market conditions. Based on our analysis, and taking into account the level of subordination below these securities, we continue to believe that the expected cash flows from these securities will be sufficient to recover the amortized cost of our investment. We continue to monitor these positions for potential credit impairments that could result from further deterioration in commercial and residential real estate fundamentals.
In each of our business units, senior leaders and executives approve risk-taking policies and targeted risk tolerance within the ERM framework while working with AIG ERM to mitigate risks across the firm.
Transaction Approval and Business Practices Committee (TABPC): TABPC provides the primary corporate-level review function for all proposed transactions and business practices that are significant in size, complex in scope, or that present heightened legal, reputational, accounting or regulatory risks. Our EVP and Treasurer serves as TABPC Chair and additional members include our EVP and General Counsel, EVP and CRO, EVP and CFO, EVP - Investments, and a senior executive from Finance.
Operational Risk Committee (ORC): This Committee is tasked with overview of the enterprise-wide identification, escalation and mitigation of risks that may arise from inadequate or failed internal processes, people, systems, or external events. The Committee approves AIG's Operational Risk Management (ORM) framework and related policies, which includes the risk and control self assessment (RCSA), Risk Events, Key Risk Indicators (KRIs) and Scenario Analysis. The Committee monitors the adequacy of ORM staffing and ensures applicable governance structures are established to provide oversight of operational risk at each Business Unit and Corporate Function. The ORC also reviews aggregate firm-wide operational risk reports. Our Chief Administrative Officer is Chair of the ORC and our Head of Operational Risk Management serves as ORC Secretary. Other ORC members include senior AIG executives with expertise in legal, compliance, technology, finance and operational risk, as well as business continuity management and the chief risk officers of our business units.
Business Unit Risk Committees: Each of our major insurance businesses has established a risk and capital committee (BU RCC) that serves as the senior management committee responsible for risk oversight at the individual business unit level. The BU RCCs are responsible for the identification, assessment and monitoring of all sources of risk within their respective portfolios. Specific responsibilities include setting risk tolerances, approving capital management strategies (including asset allocation and risk financing), insurance portfolio optimization, risk management policies and providing oversight of economic capital models. In addition to its BU RCC, each major insurance business has established subordinate committees which identify, assess and monitor the specific operational, transactional and financial risks inherent in its respective business. Together, the BU Risk Committees and AIG Risk Committees described above provide comprehensive risk oversight throughout the organization.
The RAS articulates our risk-taking capacity by setting consolidated capital and liquidity tolerances as observed under expected and stressed business and economic conditions. RAS also reflects constraints on minimum capital positions for our insurance operations. These constraints inform the requirements for capital adequacy for individual businesses, based on capital assessments under rating agency, regulatory and other business needs. Consistent with our risk appetite, we have established risk tolerances that are reflected in our business planning and are integrated into the management of our operations. Risk tolerances cover insurance company capital ratios as well as metrics associated with AIG Parent resources, including consolidated company capital ratios and parent liquidity. Our GRC routinely reviews the level of risk taken by the consolidated organization in relation to established risk tolerances. A consolidated risk report is also presented to the FRMC by our CRO.
We employ various approaches to measure, monitor, and manage risk exposures, including the utilization of a variety of metrics and early warning indicators. We use a proprietary stress testing framework to measure our quantifiable risks. This framework is built on our existing ERM stress testing methodology for both insurance and non-insurance operations. The framework measures risk over multiple time horizons and under different levels of stress. We develop a range of stress scenarios based both on internal experience and regulatory guidance. The stress tests are intended to ensure that sufficient resources for our regulated subsidiaries and the consolidated company are available under both idiosyncratic and systemic market stress conditions.
To complement our risk policies and governance framework, we also employ an enterprise-wide vulnerability identification (VID) process. The process is designed to ensure that potential new or emerging risks are brought to the attention of senior management. On a bi-annual basis, our VID process solicits this information from a broad range of senior managers across the organization. This process enables vulnerabilities that are not captured by other risk management practices to be identified and reported to senior management on a regular basis.
Our credit risks are managed at the corporate level within ERM. ERM is assisted by credit functions headed by seasoned credit officers in all the business units, whose primary role is to assure appropriate credit risk management relative to our credit risk parameters. Our Chief Credit Officer (CCO) and credit executives are primarily responsible for the development and maintenance of credit risk policies and procedures.
•aggregating globally all credit exposure data by counterparty, country, sector and industry and reporting risk concentrations regularly to and reviewing with senior management;
•developing methodologies for quantification and assessment of credit risks, including the establishment and maintenance of our internal risk rating process; and
•approving appropriate credit reserves, credit-related other-than-temporary impairments and corresponding methodologies in all credit portfolios. We monitor and control our company-wide credit risk concentrations and attempt to avoid unwanted or excessive risk accumulations, whether funded or unfunded. To minimize the level of credit risk in some circumstances, we may require third-party guarantees, reinsurance or collateral, such as letters of credit and trust collateral accounts. We treat these guarantees, reinsurance recoverables, letters of credit and trust collateral accounts as credit exposure and include them in our risk concentration exposure data. We identify our aggregate credit exposures to our underlying counterparty risks.
Our single largest credit exposure, the U.S. Government, was 25 percent of Total equity at December 31, 2012 compared to 30 percent at December 31, 2011. Exposure to the U.S. Government primarily includes credit exposure related to U.S. Treasury and government agency securities and to direct and guaranteed exposures to U.S. government-sponsored entities, primarily the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) based upon their U.S. Government conservatorship. The reduction in exposure was primarily related to U.S. government-sponsored entities.
Based on our internal risk ratings, at December 31, 2012, our largest below investment grade-rated credit exposure, apart from ILFC leasing arrangements secured by aircraft with airlines having below investment grade ratings, was related to a non-financial corporate counterparty and that exposure was 0.6 percent of Total equity, compared to 0.5 percent at December 31, 2011.
Our total direct and guaranteed credit exposure to non-U.S. governments is $22.5 billion at December 31, 2012, compared to $26.2 billion in December 31, 2011. Our single largest concentration was to the government of Japan in the amount of $8.1 billion at December 31, 2012. Most of these securities were held in the investment portfolios of our Japanese insurance operations.
Our single largest industry credit exposure in 2012 was to the global financial institutions sector as a whole, which includes banks and finance companies, securities firms, and insurance and reinsurance companies, many of which can be highly correlated at times of market stress. As of December 31, 2012, credit exposure to this sector was $85.5 billion, or 84 percent of Total equity compared to 106 percent at December 31, 2011.
•Our aggregate credit exposure to fixed maturity securities of the financial institution sector amounted to $34.4 billion.
The result of these continuing reviews has led us to believe that our combined credit risk exposures to sovereign governments, financial institutions and non-financial corporations in the Euro-Zone are manageable risks given the type and size of exposure and the credit quality and size of the issuers.
In addition, our exposure at December 31, 2012 to European financial institutions included $10.5 billion of aggregate credit exposure to non-bank institutions, mostly insurers and reinsurers, with $7.6 billion, or 73 percent, of credit exposure representing reinsurance recoverable balances. Reinsurance recoverables were primarily to highly rated reinsurers based in Switzerland, the United Kingdom and Germany. $1.3 billion of the aggregate credit exposure at December 31, 2012 to non-banks was fixed maturity securities, of which 94 percent were considered investment grade based on our internal ratings.
Of the $19.3 billion of non-financial institution corporate exposure to Euro-Zone countries at December 31, 2012, 93 percent was to fixed maturity securities ($11.0 billion) and insurance-related products ($7.0 billion), with the majority of the insurance exposures being captive fronting programs ($3.0 billion), trade credit insurance ($1.9 billion), and surety bonds ($1.5 billion). France's exposure of $6.6 billion at December 31, 2012 represented the largest single non-financial corporate country exposure within the Euro-Zone, of which $2.6 billion were fixed maturity securities. Approximately two-thirds of the French exposures were to issuers in the utilities, oil and gas, and telecommunications industries. Euro-Zone periphery non-financial institution corporate exposures ($5.0 billion) at December 31, 2012 were heavily weighted towards large multinational corporations or issuers in relatively stable industries, such as regulated utilities (25 percent), telecommunications (17 percent), and oil and gas (13 percent).
Of the $6.1 billion at December 31, 2012 of United Kingdom and European structured product exposures (largely consisting of residential mortgage-backed, commercial mortgage-backed and other asset-backed securities), United Kingdom structured products accounted for 69 percent, while the Netherlands and Germany comprised 23 percent and 2 percent, respectively. Structured product exposures to the Euro-Zone periphery accounted for 4 percent of the total. Approximately 89 percent of the United Kingdom and European structured products exposures were rated A or better at December 31, 2012 based on external rating agency ratings.
In addition, we had commercial real estate-related net equity investments in Europe totaling $497 million at December 31, 2012 and related unfunded commitments of $105 million.
(d) Other primarily consists of derivative transactions reported at fair value.
At December 31, 2012, approximately 86 percent of fixed maturity securities in the United Kingdom and European exposures were considered investment grade based on our internal ratings. European financial institution fixed maturity securities exposure was $10.2 billion, of which $1.1 billion were covered bonds (debt securities secured by a pool of financial assets sufficient to cover any bondholder claims and that have full recourse to the issuing bank). $4.4 billion of fixed maturity securities were issued by banks domiciled in the Euro-Zone countries. Our subordinated debt holdings and Tier 1 and preference share securities in these banks totaled $901 million and $312 million, respectively, at December 31, 2012. These exposures were predominantly to the largest banks in those countries.
We have a risk concentration in the U.S. municipal sector, primarily through the investment portfolios of our insurance companies. A majority of these securities were held in available-for-sale portfolios of our domestic property and casualty insurance companies. See Investments - Available for Sale Investments herein for further details. We had $464 million of additional exposure to the municipal sector outside of our insurance company portfolios at December 31, 2012, compared to $892 million at December 31, 2011. These exposures consisted of derivatives and trading securities (at fair value), and exposure related to other insurance and financial services operations.
We also have a risk concentration in the commercial real estate sector in the form of non-agency CMBS, CDO of CMBS as well as commercial mortgage whole loans. See Investments - Available for Sale Investments and Investments - Commercial Mortgage Loans herein for further details.
We also monitor our aggregate cross-border exposures by country and region. Cross-border exposure is defined as an underlying risk that is taken within a country or jurisdiction other than the country or jurisdiction in which an AIG business unit taking the risk is domiciled. These cross-border exposures include both aggregated cross-border credit exposures to unrelated third parties and cross-border investments in our own international subsidiaries. Five countries had cross-border exposures in excess of 10 percent of Total equity at December 31, 2012 compared to six countries at December 31, 2011. Based on our internal risk ratings, at December 31, 2012, three countries were rated AAA and two were rated AA. The two largest cross-border exposures were to the United Kingdom and Bermuda.
We are exposed to market risks, primarily within our insurance and capital markets businesses. In our insurance operations, market risk results primarily from potential mismatches in our asset-liability exposures, rather than speculative positioning. Specifically, our life insurance and retirement businesses collect premiums or deposits from policyholders and invest the proceeds in predominantly long-term, fixed maturity securities. We earn a spread between the asset yield and the cost payable to policyholders. We manage the business so that the cash flows from invested assets are sufficient to meet policyholder obligations when they become due, without the need to sell assets prematurely into a potentially distressed market. In periods of severe market volatility, depressed and illiquid fair values on otherwise performing investments diminish shareholders' equity even without actual credit event related losses.
We use a number of measures and approaches to measure and quantify our market risk exposure, including:
VaR. VaR is a summary statistical measure that uses the estimated volatility and correlation of market factors, and a management-determined level of confidence, to estimate how frequently a portfolio of risk exposures could be expected to lose at least a specified amount.
Exposures to yield curve movements include fixed maturity securities, loans, finance receivables and short-term investments, but exclude consolidated separate account assets. Total yield-sensitive assets decreased 6.2 percent or approximately $20.4 billion compared to 2011, primarily due to a net decrease in fixed income securities and other fixed assets of $15.6 billion, and a decrease in cash equivalents of $4.8 billion.
Exposures to equity and alternative investment prices include investments in common stock, preferred stocks, mutual funds, hedge funds, private equity funds, commercial real estate and real estate funds, but exclude consolidated separate account assets. Total exposure in these areas decreased 30.3 percent or approximately $11.8 billion in 2012 compared to 2011. This was primarily due to a decrease of $12.4 billion related to our sale of AIA equity securities as well as decreases in mutual fund values of $129 million and other equity investments of $18 million. The decrease was partially offset by increases in other common equity securities of $125 million, partnership values of $197 million and real estate investments of $397 million.
Exposures to foreign currency exchange rates reflect our consolidated non-U.S. dollar net capital investments on a GAAP basis. Foreign currency exchange rates net exposure increased 53.7 percent or $3.2 billion in 2012 compared to 2011. This was primarily due to an increase in British pound exposure of $1.7 billion as a result of AIG Europe's foreign currency exchange hedging and investment strategy, an increase in market value of fixed maturity securities of $188 million as well as unrealized investment appreciation and positive results from AIG Europe Ltd operations of $99 million. Other increases included: changes in Canadian-dollar denominated unearned premium reserves of
The failure to appropriately manage liquidity risk can result in reduced operating flexibility, increased costs, and reputational harm. Because liquidity is critically important, our liquidity governance includes a number of liquidity and funding policies and monitoring tools to address both AIG-specific, broader industry and market related liquidity events.
•financial market movements - significant changes in interest rates can provide incentives for policyholders to surrender their policies. Changes in markets can impact collateral posting requirements or create difficulty to liquidate assets at reasonable values to meet liquidity needs due to unfavorable market conditions, inadequate market depth, or other investors seeking to sell the same or similar assets;
We have structured our consolidated risk target to maintain a minimum liquidity buffer. AIG Parent liquidity risk tolerance levels are established for base and stress scenarios over a two-year time horizon designed to ensure that funding needs are met under varying market conditions. If we project that we will breach the tolerance, we will assess and determine the appropriate liquidity management actions. However, the market conditions in effect at that time may not permit us to achieve an increase in liquidity sources or a reduction in liquidity requirements.
Additionally, each business unit is responsible for managing liquidity within a framework designed for the measurement and monitoring of liquidity risks inherent to the business. Current cash and liquidity positions are reviewed for changes and against minimum liquidity levels. Future cash inflows and outflows are tracked through cash flow forecasting. If the business unit projects a breach of the minimum liquidity levels, the amount of required liquidity resources will be identified and we will determine any actions to be taken. Business unit level key indicators are assessed to provide advance warning of potential liquidity risks.
Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, systems, or from external events. Operational risk includes legal risk and reputational harm.
Operational risk is inherent in each of our business units and corporate functions. It may extend beyond financial losses, including errors, fraudulent acts, business interruptions, inappropriate behavior of employees, or vendors that do not perform in accordance with agreed upon terms.
Our Operational Risk Management (ORM) function, which supports AIG's ORC has the responsibility to provide an aggregate view of our operational risk profile. AIG ORM oversees our Operational Risk policy and framework, which includes risk identification, measurement, monitoring and reporting.
A strong operational risk management program facilitates the identification and mitigation of operational risk issues. In order to accomplish this, our operational risk management program is designed to:
As part of the ORM framework, we use a risk and control self assessment (RCSA) process to identify key operational risks and evaluate the effectiveness of existing controls to mitigate those risks. Corrective action plans are developed to address identified issues. Businesses are accountable for tracking and resolving these issues. A standard RCSA approach is also followed firm-wide for certain key risk processes (for example, SOX, IT Security Risk, Compliance, Business Continuity Management and Vendor Management).
Property and Casualty (AIG Property Casualty) - risks covered include property, casualty, fidelity/surety, accident and health, aviation and management liability. We manage risks in the general insurance segment through aggregations and limitations of concentrations at multiple levels: policy, line of business, geography, industry and legal entity.
Domestic Life Insurance & Retirement Service (AIG Life and Retirement) - risks include mortality and morbidity in the insurance-oriented products and insufficient cash flows to cover contract liabilities in the retirement savings-oriented products. We manage risks through product design, sound medical underwriting, external traditional reinsurance programs and external catastrophe reinsurance programs.
We purchase reinsurance for our insurance operations. Reinsurance facilitates insurance risk management (retention, volatility, concentrations) and capital planning. We may purchase reinsurance on a pooled basis. Pooling of our reinsurance risks enables us to purchase reinsurance more efficiently at a consolidated level, manage global counterparty risk and relationships and manage global catastrophe risks, both for AIG Property Casualty and AIG Life and Retirement.
A primary goal in managing our AIG Property Casualty operations is to achieve an acceptable return on equity. To achieve this goal, we must be disciplined in risk selection, premium adequacy, and appropriate terms and conditions to cover the risk accepted.
Unpaid Loss and Loss Expense Reserves - The potential inadequacy of the liabilities we establish for unpaid losses and loss expenses is a key risk faced by AIG Property Casualty. There is significant uncertainty in factors that may drive the ultimate development of losses compared to the estimates of losses and loss expenses. We manage this uncertainty through internal controls and oversight of the loss reserve setting process, as well as reviews by external experts. See Item 1 Business - A review of Liability for unpaid claims and claims adjustment expense herein for further details.
Underwriting - The potential inadequacy of premium charged for risks underwritten in our portfolios can impact AIG Property Casualty's ability to achieve an underwriting profit. We develop pricing based on our estimates of losses and expenses, but factors such as market pressures and the inherent uncertainty and complexity in estimating losses may result in premiums that are inadequate to generate underwriting profit.
Catastrophe Exposure - Our business is exposed to various catastrophic events in which multiple losses can occur and affect multiple lines of business in any calendar year. Natural disasters, such as hurricanes, earthquakes and other catastrophes, have the potential to adversely affect our operating results. Other risks, such as a man-made catastrophes or pandemic disease, could also adversely affect our business and operating results to the extent they are covered by our insurance products.
Reinsurance - Since we use reinsurance to limit our losses, we are exposed to risks associated with reinsurance including the unrecoverability of expected payments from reinsurers either due to an inability or unwillingness to pay, contracts do not respond as we intended, or that actual reinsurance coverage is different than anticipated.
We use industry recognized models and other tools to evaluate catastrophic events and assess the probability and magnitude of such events. We periodically monitor the exposure risks of our worldwide AIG Property Casualty operations and adjust the models accordingly.
The purpose of this type of analysis is to provide a frame of reference and context for the model results. The specific events used for this analysis do not necessarily represent the worst case loss that we could incur from this type of an event in these regions. The losses associated with the RDS are included in the following table.
ACTUAL RESULTS IN ANY PERIOD ARE LIKELY TO VARY, PERHAPS MATERIALLY, FROM THE MODELED SCENARIOS. THE OCCURRENCE OF ONE OR MORE SEVERE EVENTS COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR FINANCIAL CONDITION, RESULTS OF OPERATIONS AND LIQUIDITY. See also Item 1A. Risk Factors - Reserves and Exposures for additional information.
We actively monitor terrorism risk and strive to control exposure to loss from terrorist attack by limiting the aggregate accumulation insurance that is underwritten in defined target locations. We use modeling to provide projections of Probable Maximum Loss (PML) by target location based upon the actual exposures of our policyholders.
We offer terrorism coverage in many other countries through various insurance products and participate in country terrorism pools when applicable. International terrorism exposure is managed through active aggregation control and targeted reinsurance purchases for lines of business such as commercial property, political risk, aviation and A&H.
(a) The financial strength ratings reflect the ratings of the various reinsurance subsidiaries of the companies listed as of February 6, 2013.
(d) Includes $1.6 billion recoverable under the 2011 transaction pursuant to which a large portion of AIG Property Casualty's net domestic asbestos liabilities were transferred to NICO. Does not include reinsurance assets ceded to other reinsurers for which NICO has assumed the collection risk. See Liability for Unpaid Claims and Claim Adjustment Expenses - Transfer of Domestic Asbestos Liabilities.
The estimation of reinsurance recoverables involves a significant amount of judgment, particularly for asbestos exposures, due to their long-tail nature. We assess the collectability of its reinsurance recoverable balances through detailed reviews of the underlying nature of the reinsurance balance, including:
•whether the balance is in dispute or a legal collection status;
•the credit quality of the underlying reinsurer. We record adjustments to reflect the results of the detailed review through an allowance for uncollectable reinsurance. At December 31, 2012, the allowance for estimated unrecoverable reinsurance was $338 million. At December 31, 2012, we had no significant general reinsurance recoverables due from any individual reinsurer that was financially troubled. In the current environment of weaker economic conditions and strained financial markets, certain reinsurers are reporting losses and could be subject to rating downgrades. Our reinsurance recoverable exposures are primarily to the regulated subsidiaries of such companies which are subject to minimum regulatory capital requirements. The RCD, in conjunction with the credit executives within ERM, reviews these developments, monitors compliance with credit triggers that may require the reinsurer to post collateral, and will seek to use other appropriate means to mitigate any material risks arising from these developments. See Note 9 to the Consolidated Financial Statements for additional information on reinsurance.
Investment risk - represents the exposure to loss if the cash flows from the invested assets are less than required to meet the obligations of the expected policy and contract liabilities and the necessary return on investments;
Equity market risk - represents the potential exposure to higher claim costs for guaranteed benefits associated with variable annuities and the potential reduction in expected fee revenue. AIG Life and Retirement manages these risks through product design, exposure limitations and active management of the relationships between assets and liabilities. The emergence of significant adverse experience would require an adjustment to DAC and benefit reserves which could have a material adverse effect on our consolidated results of operations for a particular period. For a further discussion of this risk, see Item 1A. Risk Factors - Business and Operations.
•Residential Housing Market risk - represents the potential exposure to loss due to borrower default on a first-lien residential mortgage; the primary drivers of this risk are home price depreciation, changes in the unemployment rate, changes in mortgage rates, and a borrower's willingness to pay.
•Pricing risk - represents the potential exposure to loss if actual policy experience emerges adversely in comparison to the assumptions made in product pricing. This may be related to adverse economic conditions, prepayment of policies, investment results, and expenses; UGC manages the quality of the loans it insures through use of a proprietary risk quality index. UGC uses this index to determine an insurability threshold as well as to manage the risk distribution of its new business. Along with traditional mortgage underwriting variables, UGC's risk-based pricing model uses rating factors such as geography and the quality of a lender's origination process to establish premium rates.
A counterparty may default on any obligation to us, including a derivative contract. Credit risk is a consequence of extending credit and/or carrying trading and investment positions. Credit risk exists for a derivative contract when that contract has a positive fair value to AIG. The maximum potential exposure will increase or decrease during the life of the derivative commitments as a function of maturity and market conditions. To help manage this risk, GCM's credit department operates within the guidelines set by the credit function within ERM. Transactions that fall outside these pre-established guidelines require the specific approval of the ERM. It is also AIG's policy to record credit valuation adjustments for potential counterparty default when necessary.
In addition, GCM utilizes various credit enhancements, including letters of credit, guarantees, collateral, credit triggers, credit derivatives, margin agreements and subordination to reduce the credit risk relating to its outstanding financial derivative transactions. GCM 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, GCM 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, GCM 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 fair values.
The fair value of GCM's interest rate, currency, credit, commodity and equity swaps, options, swaptions, and forward commitments, futures, and forward contracts reported in Derivative assets, at fair value, was approximately $3.2 billion at December 31, 2012 and $3.9 billion at December 31, 2011. Where applicable, these amounts have been determined in accordance with the respective master netting agreements.
The preparation of financial statements in conformity with GAAP requires the application of accounting policies that often involve a significant degree of judgment.
insurance liabilities, including property and casualty and mortgage guaranty unpaid claims and claims adjustment expenses and future policy benefits for life and accident and health contracts;
On December 9, 2012, we entered into a definitive agreement with Jumbo Acquisition Limited for the sale of 80.1 percent of the common stock of ILFC for approximately $4.23 billion in cash. Jumbo Acquisition Limited may elect to purchase an additional 9.9 percent of the common stock of ILFC for $522.5 million (the Option) by the later of March 15, 2013 and ten days after approval of the ILFC Transaction and the Option by the Committee on Foreign Investment in the United States. The transaction is subject to required regulatory approvals and other customary closing conditions. We determined ILFC met the criteria at December 31, 2012 for held for sale accounting and, consequently, we recorded a $4.4 billion after tax loss for the year ended December 31, 2012, which is reported in Income (loss) from discontinued operations in the Consolidated Statement of Operations.
The U.S. federal income tax laws applicable to determining the amount of income taxes related to differences between the book carrying values and tax bases of subsidiaries are complex. Determining the amount also requires significant judgment and reliance on reasonable assumptions and estimates.
•the determination of the appropriate groupings of similar classes and, in some cases, the segmentation of dissimilar claims within a class. We use numerous assumptions in determining the best estimate of reserves for each class of business. The importance of any specific assumption can vary by both class of business and accident year. Because actual experience can differ from key assumptions used in establishing reserves, there is potential for significant variation in the development of loss reserves. This is particularly true for long-tail casualty classes of business such as excess casualty, asbestos, D&O, and primary or excess workers' compensation.
To estimate net losses for long-tail casualty classes of business, we use a variety of actuarial methods and assumptions.
Expected loss ratios for the latest accident year (i.e., accident year 2012 for the year-end 2012 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 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.
The process of determining the current loss ratio for each class of business is based on a variety of factors. These include considerations such as: prior accident year and policy year loss ratios; rate changes; and changes in coverage, reinsurance, or mix of business. Other considerations include actual and anticipated changes in external factors such as trends in loss costs or in the legal and claims environment. The current loss ratio for each class of business is intended to represent our best estimate of the current loss ratio after reflecting all of the relevant factors. At the close of each quarter, the assumptions underlying the loss ratios are reviewed to determine if the loss ratios remain appropriate. This process includes a review of the actual claims experience in the quarter, actual rate changes achieved, actual changes in coverage, reinsurance or mix of business, and changes in other factors that may affect the loss ratio. When this review suggests that the initially determined loss ratio is no longer appropriate, the loss ratio for current business is changed to reflect the revised assumptions.
In 2012, the third party actuarial reviews covered the majority of reserves held for our US Commercial long-tail classes of business, the majority of our US Consumer classes of business and included several material international Commercial and Consumer classes of business. In addition we consulted with third party environmental litigation and engineering specialists, third party toxic tort claims professionals, third party clinical and public health specialists, third party workers' compensation claims adjusters and third party actuarial advisors to corroborate our conclusions.
In 2011 we significantly expanded the scope of our 2010 third-party actuarial reviews to cover a larger number of U.S. and international classes of business from the more complex reserves of long-tail classes of business. In 2010,
In determining the actual carried reserves, we consider both the internal actuarial central estimate and numerous other internal and external factors, including:
changes in medical cost trends (inflation, intensity and utilization of medical services)
underlying policy pricing, terms and conditions including attachment points and policy limits;
Frequency/severity methods generally rely on the determination of an ultimate number of claims and an average severity for each claim for each accident year. Multiplying the estimated ultimate number of claims for each accident year by the expected average severity of each claim produces the estimated ultimate loss for the accident year. Frequency/severity methods generally require a sufficient volume of claims in order for the average severity to be predictable. Average severity for subsequent accident years is generally determined by applying an estimated annual loss cost trend to the estimated average claim severity from prior accident years. In certain cases, a structural approach may also be used to predict the ultimate loss cost. Frequency/severity methods have the advantage that ultimate claim counts can generally be estimated more quickly and accurately than can ultimate losses. Thus, if the average claim severity can be accurately estimated, these methods can more quickly respond to changes in loss experience than other methods. However, for average severity to be predictable, the class of business must consist of homogeneous types of claims for which loss severity trends from one year to the next are reasonably consistent. Generally these methods work best for high frequency, low severity classes of business such as personal auto.
•Analysis of the cost of medical price inflation for each category of medical spend (services and devices) and for cost of living adjustments in line with statutory requirements;
Overall, our loss reserve reviews for long-tail classes typically utilize a combination of both loss development and expected loss ratio methods, supplemented by structural drivers analysis of frequency/severity where available. Loss development methods are generally given more weight for accident years and classes of business where the loss experience is highly credible. Expected loss ratio methods are given more weight where the reported loss experience is less credible, or is driven more by large losses. Expected loss ratio methods require sufficient information to determine the appropriate expected loss ratio. This information generally includes the actual loss ratios for prior accident years, and rate changes as well as underwriting or other changes which would affect the loss ratio. Further, an estimate of the loss cost trend or loss ratio trend is required in order to allow for the effect of inflation and other factors which may increase or otherwise change the loss costs from one accident year to the next.
Estimation of asbestos and environmental claims loss reserves is a subjective process. Reserves for asbestos and environmental claims cannot be estimated using conventional reserving techniques such as those that rely on historical accident year loss development factors. The methods used to determine asbestos and environmental loss estimates and to establish the resulting reserves are continually reviewed and updated by management.
In addition, we leverage case reserving based methodologies for complex claims/ latent exposures such as those involving toxic tort and other claims accumulations.
Expected loss ratio methods are generally used for at least the three latest accident years, due to the relatively low credibility of the reported losses. The loss experience is generally reviewed separately for lead umbrella classes and for other excess classes, due to the relatively shorter tail for lead umbrella business. Automobile-related claims are generally reviewed separately from non-auto claims, due to the shorter-tail nature of the automobile-related claims. Claims relating to certain latent exposures such as construction defects or exhaustion of underlying product aggregate limits are reviewed separately due to the unique emergence patterns of losses relating to these claims. The expected loss ratios used for recent accident years are based on the projected ultimate loss ratios of prior years, adjusted for rate changes, estimated loss cost trends and all other changes that can be quantified. During 2012, we also completed a third party review of certain insureds exposed to a specific class of toxic tort claims. That review considered the prior claims history for each insured account, AIG's exposed limits and the insured's role with the specific toxicant reviewed as well as a legal analysis of the exposures presented by these claims.
We generally use a combination of loss development methods and expected loss ratio methods for D&O and related management liability classes of business. Frequency/severity methods are generally not used in isolation 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 and care is required in analyzing these trends by claim type. We also give weight to claim department ground-up projections of ultimate loss on a claim by claim basis as these may be more predictive of ultimate loss values especially for older accident years.
Excess workers' compensation is an extremely long-tail class of business, with loss emergence extending for decades. The class is highly sensitive to small changes in assumptions - in the rate of medical inflation or the longevity of injured workers, for example - which can have a significant effect on the ultimate reserve estimate. Claims estimates for this line also are highly sensitive to: •
the expected impact of recently enacted health care reform on workers' compensation costs;
claims settlement trends that can materially alter the mix and ultimate cost of claims;
changes in claims reporting and management practices of insureds and their third-party administrators;
the propensity for severely injured workers' medical conditions to deteriorate in the future;
We generally use loss development methods for all but the most recent accident year for commercial automobile classes of business.
We also supplement the standard actuarial techniques by using evaluations of the ultimate losses on unusual claims by experts on those classes of claims.
The largest component of the healthcare business consists of coverage written for hospitals and other healthcare facilities. We test reserves for excess coverage separately from those for primary coverage. For primary coverages, loss development methods are generally given the majority of the weight for all but the latest three accident years, and are given some weight for all years other than the latest accident year. For excess coverages, expected loss methods are generally given all the weight for the latest three accident years, and are also given considerable weight for accident years prior to the latest three years. For other classes of healthcare coverage, an analogous weighting between loss development and expected loss ratio methods is used. The weights assigned to each method are those that are believed to result in the best combination of responsiveness and credibility.
We generally use a combination of loss development methods and expected loss ratio methods for professional liability classes of business. Frequency/severity methods are used in pricing and profitability analyses for some classes of professional liability; however, for loss reserve adequacy testing, the need to ensure sufficient credibility generally results in segmentations that are not sufficiently homogenous to utilize frequency/severity methods.
We generally use 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. Frequency/severity methods are not employed due to the high severity nature of the claims and different mix of claims from year to year.
Expected loss ratio methods are also given weight for the more recent accident years. For the latest accident year they may be given 100 percent weight.
Reserves for mortgage guaranty insurance losses and loss adjustment expenses are established for reported mortgage loan delinquencies and estimates of delinquencies that have been incurred but have not been reported by loan servicers, based upon historical reporting trends. We establish reserves using a percentage of the contractual liability (for each delinquent loan reported) that is based upon projected claim experience for each category of delinquency, consistent in total with the overall reserve estimate.
Mortgage Guaranty losses and loss adjustment expenses have been adversely affected by macroeconomic events, such as declining home prices and increasing unemployment. Because these macroeconomic events are subject to adverse or favorable change, the determination of the ultimate losses and loss adjustment expenses requires a high degree of judgment. Responding to these adverse macroeconomic influences, numerous government and lender loan modification programs have been implemented to mitigate mortgage losses. The loan modification programs have produced additional cures of delinquent loans in 2012 that may not continue in 2013 as some modification programs are phased out or retired. In addition, these loan modifications may re-default resulting in new losses for Mortgage Guaranty.
We generally use either loss development methods or IBNR factor methods to set reserves for short-tail classes such as property coverages.
Business written by AIG Property Casualty internationally includes both long-tail and short-tail classes of business. For long-tail classes of business, the actuarial methods used are comparable to those described above. However, the majority of business written by AIG Property Casualty internationally is short-tail, high frequency and low severity in nature. For this business, loss development methods are generally employed to test the loss reserves.
We maintain a database of detailed historical premium and loss transactions in original currency for business written by AIG Property Casualty internationally. This allows our actuaries to determine the current reserves without any distortion from changes in exchange rates over time. Our actuaries segment the international data by region, country or class of business as appropriate to determine an optimal balance between homogeneity and credibility.
We conduct special analyses in response to major catastrophes in order to estimate our gross and net loss and loss expense liability from those events.
Loss cost trends: The percentage deviations noted in the table below are not considered the highest possible deviations that might be expected, but rather what we consider to reflect a reasonably likely range of potential deviation. Actual loss cost trends in the early 1990s were negative for several years whereas actual loss cost trends exceeded the figures cited above for several other years. Loss trends may deviate by more than the amounts noted above and discussed below.
Loss development factors: The percentage deviations noted in the table below are not considered the highest possible deviations that might be expected, but rather what we consider to reflect a reasonably likely range of potential deviation. Except for excess workers' compensation, the assumed loss development factors are a key assumption. Generally, actual historical loss development factors are used to project future loss development. Future loss development patterns may be different from those in the past, or may deviate by more than the amounts noted above and discussed below.
The sensitivity analysis below addresses each major class of business for which there is a possibility of a material deviation from our overall reserve position. The analysis uses what we believe is a reasonably likely range of potential deviation for each class. Actual reserve development may not be consistent with either the original or the adjusted loss trend or loss development factor assumptions, and other assumptions made in the reserving process may materially affect reserve development for a particular class of business.
The assumed loss cost trend was approximately five percent. After evaluating the historical loss cost trends from prior accident years since the early 1990s, in our judgment, it is reasonably likely that actual loss cost trends applicable to the year-end 2012 loss reserve review for excess casualty will range from 0 percent to positive 10 percent, or approximately 5 percent lower or higher than the assumption actually utilized in the year-end 2012 reserve review. The loss cost trend assumption is critical for the excess casualty class of business due to the long-tail nature of the claims and therefore is applied across many accident years. Thus, there is the potential for the reserves with respect to a number of accident years (the expected loss ratio years) to be significantly affected by changes in loss cost trends that were initially relied upon in setting the reserves. These changes in loss trends could be attributable to changes in inflation or in the judicial environment, or in other social or economic conditions affecting claims.
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 our judgment, it is reasonably likely that actual loss development factors will range from approximately 6.8 percent lower to 11 percent higher than those factors actually utilized in the year-end 2012 loss reserve review for these classes.
Excess workers' compensation is an extremely long-tail class of business, with a much greater than normal uncertainty as to the appropriate loss development factors for the tail of the loss development. After evaluating the historical loss development factors for prior accident years since the 1980s as well as the development over the past several years of the ground up claim projections utilized to help select the loss development factors in the tail for this class of business, in our judgment, it is reasonably likely that actual loss development for excess workers' compensation could increase the current reserves by up to approximately $1.3 billion or decrease them by approximately $850 million.
As we experience changes over time, we update the assumptions to reflect these observed changes. Because of the long term nature of many of our liabilities subject to the "lock-in" principle, small changes in certain assumptions may cause large changes in the degree of reserve adequacy. In particular, changes in estimates of future invested asset returns have a large effect on the degree of reserve deficiency. If observed changes in actual experience or estimates result in projected future losses under loss recognition testing, we adjust DAC through amortization expense, and may record additional liabilities through a charge to policyholder benefit expense. Loss recognition testing is performed at an aggregate AIG Life and Retirement reporting segment level. Once loss recognition has been recorded for a block of business, the old assumption set is replaced (i.e., a DAC unlocking), and the assumption set used for the loss recognition would then be subject to the lock-in principle. See Note 10 to the Consolidated Financial Statements for additional information.
The key assumptions used in estimating future policy benefit reserves are:
Our future policy benefits include guaranteed minimum death benefits (GMDB). We determine the GMDB liability each period end by estimating the expected value of death benefits in excess of the projected account balance and recognizing the excess ratably over the accumulation period based on total expected fees. The estimates include assumptions about interest rates, mortality rates, lapse rates and a randomly generated model of investment returns. In addition to GMDB, our future policy benefits include, to a lesser extent, guaranteed minimum income benefits (GMIB). We determine GMIB liability each period end by estimating the expected value of the periodic income payments from annuities in excess of the projected account balance. We derive this estimate at the date the annuity converts to regular payments, and we recognize the excess ratably over the accumulation period based on total expected assessments. We periodically evaluate estimates used and adjust the additional liability balance, with a related charge or credit to benefit expense, if actual experience or other evidence suggests that earlier assumptions should be revised.
We have a dynamic hedging program designed to manage economic risk exposure associated with changes in the fair value of GMWB and GMAV liabilities caused by changes in the equity markets, interest rates and market implied volatilities. The program utilizes hedging instruments, including derivatives such as equity options, futures contracts and interest rate swap contracts, and is designed so that changes in value of the hedging instruments move in the opposite direction of changes in the GMWB and GMAV embedded derivative liabilities. We monitor the hedging positions on a daily basis in relation to the change in valuation of GMWB and GMAV embedded derivative liabilities, and rebalance those positions as needed. Differences between the change in fair value of GMWB and GMAV embedded derivative liabilities and the hedging instruments can be caused by extreme and unanticipated movements in the equity markets, interest rates and market volatility, policyholder behavior, statutory capital considerations and constraints and the ability to purchase hedging instruments at prices consistent with the desired risk and return trade-off. None of the derivative instruments described above are designated for hedge accounting.
Approximately 56 percent of our individual variable annuity account values contain either a GMWB rider or a GMAV rider as of December 31, 2012. Declines in the equity markets, increased volatility and a sustained low interest rate environment increase our exposure to potential benefits under the GMWB and GMAV contracts, leading to an increase in the existing liability for those benefits. Our exposure to the guaranteed amounts is equal to the amount by which the contract holder's account balance is below the guaranteed withdrawal or account value amount. As of December 31, 2012, our exposure to the guaranteed withdrawal and account value amount under GMWB and GMAV was $0.9 billion and $10 million, respectively.
Estimated gross profits (EGP) are subject to differing market returns and interest rate environments in any single period. EGP is composed of net investment income, net realized investment gains and losses, fees, surrender charges, expenses, and mortality and morbidity gains and losses. When assumptions are changed, the percentage of EGP used to amortize DAC may also change.
The following table summarizes the sensitivity of changes in certain assumptions in the amortization of DAC/SIA, guaranteed benefits reserve and unearned revenue liability and the related hypothetical impact on year-end 2012 balances. The effect of changes in the equity markets, volatility and interest rates primarily impacts individual variable annuities (SunAmerica Retirement Markets) and group retirement products (VALIC). The effect of changes in mortality primarily impacts the universal life insurance business.
See the discussion in Note 7 to the Consolidated Financial Statements for additional information on the methodology and significant inputs, by security type, that we use to determine the amount of other-than-temporary impairment on fixed maturity and equity securities.
We estimate and record a liability for potential losses that may arise from litigation and regulatory proceedings to the extent such losses are probable and can be estimated. Determining a reasonable estimate of the amount of such losses requires significant management judgment. In many cases, it is not possible to determine whether a liability has been incurred or to estimate the ultimate or minimum amount of that liability until the matter is close to resolution. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases in which claimants seek substantial or indeterminate damages, we often cannot predict the outcome or estimate the eventual loss or range of reasonably possible losses related to such matters.
(a) Includes $28.7 billion for which the primary source is broker quotes.
The entities included in GCM wrote credit protection on the super senior risk layer of collateralized loan obligations (CLOs), multi-sector CDOs and diversified portfolios of corporate debt, and prime residential mortgages through 2006. In these transactions, AIG is at risk of credit performance on the super senior risk layer related to such assets. To a lesser extent, those entities also wrote protection on tranches below the super senior risk layer, primarily related to regulatory capital relief transactions.
For the purposes of estimating sensitivities for the super senior multi-sector CDO credit default swap portfolio, the change in valuation derived using the Binomial Expansion Technique (BET) model is used to estimate the change in the fair value of the derivative liability. Of the total $3.9 billion net notional amount of CDS written on multi-sector CDOs outstanding at December 31, 2012, a BET value is available for $2.6 billion net notional amount. No BET value is determined for $1.3 billion of CDS written on European multi-sector CDOs as prices on the underlying securities held by the CDOs are not provided by collateral managers; instead these CDS are valued using counterparty prices. Therefore, sensitivities disclosed below apply only to the net notional amount of $2.6 billion.
(b) The discount curve is an input at the CDO level. A calculation of sensitivity to this input by type of security is not possible. Furthermore, for this input it is not possible to disclose a weighted average input as a discount curve consists of a series of data points.
Acquisition ratio acquisition costs divided by net premiums earned. Acquisition costs are those costs incurred to acquire new and renewal insurance contracts and also include the amortization of VOBA. Acquisition costs vary with sales and include, but are not limited to, commissions, premium taxes, direct marketing costs, certain costs of personnel engaged in sales support activities such as underwriting, and the change in deferred acquisition costs. Acquisition costs that are incremental and directly related to successful sales efforts are deferred and recognized over the coverage periods of related insurance contracts. Acquisition costs that are not incremental and directly related to successful sales efforts are recognized as incurred.
AIG - After-tax operating income (loss) is derived by excluding the following items from net income (loss): income (loss) from discontinued operations, net loss (gain) on sale of divested businesses, income from divested businesses, legacy FIN 48 and other tax adjustments, legal reserves (settlements) related to "legacy crisis matters," deferred income tax valuation allowance (releases) charges, amortization of the Federal Reserve Bank of New York prepaid commitment fee asset, changes in fair value of AIG Life and Retirement fixed income securities designated to hedge living benefit liabilities, change in benefit reserves and deferred policy acquisition costs (DAC), value of business acquired (VOBA), and sales inducement assets (SIA) related to net realized capital (gains) losses, (gain) loss on extinguishment of debt, net realized capital (gains) losses, non-qualifying derivative hedging activities, excluding net realized capital (gains) losses and bargain purchase gain. "Legacy crisis matters" include favorable and unfavorable settlements related to events leading up to and resulting from our September 2008 liquidity crisis. It also includes legal fees incurred by AIG as the plaintiff in connection with such legal matters.
AIG Property Casualty - Operating income (loss) In 2012, AIG Property Casualty revised its non-GAAP income measure from underwriting income (loss) to operating income (loss), which includes both underwriting income (loss) and net investment income, but not net realized capital (gains) losses or other (income) expense, legal settlements related to legacy crisis matters and bargain purchase gain. Underwriting income (loss) is derived by reducing net premiums earned by claims and claims adjustment expense and underwriting expenses, which consist of the acquisition costs and general operating expenses.
Basel I, Basel II and Basel III set of capital and liquidity standards for international financial institution established by the Basel Committee on Banking Supervision.
Book Value Per Share Excluding Accumulated Other Comprehensive Income (loss) (AOCI) is used to show the amount of our net worth on a per-share basis. Book Value Per Share Excluding AOCI is derived by dividing Total AIG shareholders' equity, excluding AOCI, by Total common shares outstanding.
Case reserves Claim department estimates of anticipated future payments to be made on each specific individual reported claim.
CSA Credit Support Annex A legal document that provides for collateral postings at various ratings and threshold levels.
Expense ratio Sum of acquisition costs and general operating expenses, divided by net premiums earned.
General operating expense ratio general operating expenses divided by net premiums earned. General operating expenses are those costs that are generally attributed to the support infrastructure of the organization and include but are not limited to personnel costs, projects and bad debt expenses. General operating expenses exclude claims adjustment expenses, acquisition expenses, and investment expenses.
IFS Insurer Financial Strength ratings IFS ratings measure the ability of an insurance company to meet its obligations to contract holders and policyholders.
Loss reserves Liability for unpaid claims and claims adjustment expense. The estimated ultimate cost of settling claims relating to insured events that have occurred on or before the balance sheet date, whether or not reported to the insurer at that date.
LTV Loan-to-Value Ratio Principal amount of loan amount divided by appraised value of collateral securing the loan.
Net premiums written Represent the sales of an insurer, adjusted for reinsurance premiums assumed and ceded, during a given period. Net premiums earned are the revenue of an insurer for covering risk during a given period. Net premiums written are a measure of performance for a sales period while Net premiums earned are a measure of performance for a coverage period. From the period in which the premiums are written until the period in which they are earned, the amount is presented as Unearned premium reserves in the Consolidated Balance Sheet.
Prior year development Increase or decrease in estimates of losses and loss expenses for prior years that is included in earnings.
RBC Risk-Based Capital A formula designed to measure the adequacy of an insurer's statutory surplus compared to the risks inherent in its business.
Reserve redundancy When actual reported reserves exceed expected reserves. This is also referred to as favorable loss development.
Second-lien Subordinate in ranking to the first-lien holder on a property in the event of default on a mortgage.
Short-Tail Reserves Reserves for claims that are generally reported and paid within a relatively short period of time during and following the policy coverage period. Short-tail classes of business consist principally of property, personal lines and certain casualty classes.
SIFI Systemically Important Financial Institutions Financial institutions are deemed systemically important (that is, the failure of the financial institution could pose a threat to the financial stability of the United States) by the Financial Stability Oversight Council (FSOC) based on a three-stage analytical process.
Solvency II Legislation in the European Union which reforms the insurance industry's solvency framework, including minimum capital and solvency requirements, governance requirements, risk management and public reporting
standards. The Solvency II Directive (2009/138/EEC), was adopted on November 25, 2009 and is expected to become effective in January 2014.
VOBA Value of Business Acquired Present value of projected future gross profits from in-force policies from acquired businesses.
Summary of Investments - Other than Investments in Related Parties at December 31, 2012
Condensed Financial Information of Registrant at December 31, 2012 and 2011 and for the years ended December 31, 2012, 2011 and 2010
Supplementary Insurance Information at December 31, 2012, 2011 and 2010 and for the years then ended
Reinsurance at December 31, 2012, 2011 and 2010 and for the years then ended
Valuation and Qualifying Accounts at December 31, 2012, 2011 and 2010 and for the years then ended
(a) Excludes gains of $222 million, $552 million and $73 million in 2012, 2011 and 2010, respectively, attributable to redeemable noncontrolling interests and net income attributable to noncontrolling nonvoting, callable, junior and senior preferred interests held by the Federal Reserve Bank of New York of $0, $74 million and $1.8 billion in 2012, 2011 and 2010, respectively.
(b) Excludes $4 million, $(2) million and $5 million attributable to redeemable noncontrolling interests for the year ended December 31, 2012, 2011 and 2010, respectively.
See Accompanying Notes to Consolidated Financial Statements, which include a summary of revisions to prior year balances in connection with a change in accounting principle.
* 2011 includes payment of FRBNY credit facility accrued compounded interest of $4.7 billion, before the facility was terminated on January 14, 2011 in connection with the Recapitalization.
American International Group, Inc. is a leading international insurance organization serving customers in more than 130 countries. AIG companies serve commercial, institutional and individual customers through one of the most extensive worldwide property-casualty networks of any insurer. In addition, AIG companies are leading providers of life insurance and retirement services in the United States. AIG Common Stock, par value $2.50 per share (AIG Common Stock), is listed on the New York Stock Exchange and the Tokyo Stock Exchange. Unless the context indicates otherwise, the terms "AIG," "we," "us" or "our" mean American International Group, Inc. and its consolidated subsidiaries and the term "AIG Parent" means American International Group, Inc. and not to any of its consolidated subsidiaries.
The consolidated financial statements include the accounts of AIG, our controlled subsidiaries (generally through a greater than 50 percent ownership of voting rights of a voting interest entity), and variable interest entities (VIEs) in which we are the primary beneficiary. Equity investments in corporate entities that we do not consolidate, but in which we hold 20 percent to 50 percent of the voting rights and investments in partnership and partnership-like entities for which we have more than minor influence over operating and financial policies, are accounted for under the equity method unless we have elected the fair value option.
Prior period amounts were reclassified to conform to the current period presentation. Significant items include:
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.
Policy fees: Policy fees represent fees recognized from universal life and investment-type products consisting of policy charges for the cost of insurance, policy administration charges, amortization of unearned revenue reserves and surrender charges.
Net investment income: For a discussion of our policies on net investment income, see Note 7 herein.
•Realized capital gains and losses from the sales of available for sale securities and investments in private equity funds and hedge funds and other investments.
•Income earned on real estate based investments and related losses from property level impairments and financing costs.
•Gains and losses recognized in earnings on derivatives for the effective portion and their related hedged items.
Policyholder benefits and claims incurred: Incurred claims and claims adjustment expense for short duration insurance contracts consist of the estimated ultimate cost of settling claims incurred within the reporting period, including incurred but not reported claims, plus changes in estimates of current and prior period losses resulting from the continuous review process, which are charged to income as incurred. Benefits for long duration insurance
(b) Held-for-sale and discontinued operations: For a discussion of our accounting policies on reporting a business as held for sale or as discontinued operations, see Note 4 herein.
Fixed maturity and equity securities: For a discussion of our accounting policies on classification, measurement and other-than-temporary impairment of fixed maturity and equity securities, see Note 7 herein.
Mortgage and other loans receivable - net: For discussion of our policies on classification, measurement and the allowance for credit losses on mortgages and other loans receivable, see Note 8 herein.
For a discussion of our accounting policies on securities purchased under agreements to resell, see Note 7 herein.
(h) Derivative assets and derivative liabilities, at fair value: For discussion of our accounting policies on derivative assets and derivative liabilities, at fair value, see Note 12 herein.
(i) Other assets: Other assets consists of sales inducement assets, prepaid expenses, deposits, other deferred charges, real estate, other fixed assets, capitalized software costs, goodwill, intangible assets other than goodwill, and restricted cash.
We offer 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 in 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 (see Note 10 herein). To qualify for such accounting treatment, the bonus interest must be explicitly identified in the contract at inception. We must also demonstrate that such amounts are incremental to amounts we credit 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 totaled $517 million and $803 million at December 31, 2012 and 2011, respectively. The amortization expense associated
with these assets is reported within Interest Credited to Policyholder Account Balances in the Consolidated Statement of Operations. Such amortization expense totaled $162 million, $239 million and $146 million for the years ended December 31, 2012, 2011 and 2010, respectively.
(j) Goodwill: Goodwill represents the future economic benefits arising from assets acquired in a business combination that are not individually identified and separately recognized. Goodwill is tested for impairment annually, or more frequently if circumstances indicate an impairment may have occurred. All of our goodwill was associated with and allocated to the AIG Property Casualty Commercial and Consumer segments at December 31, 2012.
If the estimated fair value of a reporting unit exceeds its carrying value, goodwill is not impaired. If the carrying value of a reporting unit exceeds its estimated fair value, goodwill associated with that reporting unit potentially is impaired. The amount of impairment, if any, is measured as the excess of the carrying value of the goodwill over the implied fair value of the goodwill. The implied fair value of the goodwill is measured as the excess of the fair value of the reporting unit over the amounts that would be assigned to the reporting unit's assets and liabilities in a hypothetical business combination. An impairment charge is recognized in earnings to the extent of the excess. AIG Property Casualty manages its assets on an aggregate basis and does not allocate its assets, other than goodwill, between its operating segments. Therefore, the carrying value of the reporting units was determined by allocating the carrying value of AIG Property Casualty to those units based upon an internal capital allocation model.
(l) Liability for unpaid claims and claims adjustment expense: For discussion of our accounting policies on liability for unpaid claims and claims adjustment expense, see Note 13 herein.
(o) Income taxes: For a discussion of our accounting policies on income taxes, see Note 24 herein.
(p) Other liabilities: Other liabilities consist of other funds on deposit, other payables, securities sold under agreements to repurchase and securities and spot commodities sold but not yet purchased. We have entered into certain insurance and reinsurance contracts, primarily in our AIG Property Casualty segment, that do not contain sufficient insurance risk to be accounted for as insurance or reinsurance. Accordingly, the premiums received on such contracts, after deduction for certain related expenses, are recorded as deposits within Other liabilities in the Consolidated Balance 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. Also included in Other liabilities are trade payables for the DIB and GCM, which include option premiums received and payables to counterparties that relate to unrealized gains and losses on futures, forwards, and options and balances due to clearing brokers and exchanges. Trade payables for GCM also include cash collateral received from derivative counterparties that is not contractually nettable against derivative assets.
(q) Long-term debt: For a discussion of our accounting policies on long-term debt, see Note 15 herein.
(r) Contingent liabilities: For a discussion of our accounting policies on contingent liabilities, see Note 16 herein.
(t) Noncontrolling interests: For discussion of our accounting policies on noncontrolling interests, see Note 18 herein.
In July 2012, the Financial Accounting Standards Board (FASB) issued an accounting standard that allows a company the option to first assess qualitatively whether it is more likely than not that an indefinite-lived intangible asset is impaired. A company is not required to calculate the fair value of an indefinite-lived intangible asset and perform the quantitative impairment test unless the company determines it is more likely than not the asset is impaired.
The standard is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. While early adoption was permitted, we adopted the standard on its required effective date of January 1, 2013. We do not expect adoption of the standard to have a material effect on our consolidated financial condition, results of operations or cash flows.
We also defer a portion of employee total compensation and payroll-related fringe benefits directly related to time spent performing specific acquisition or renewal activities, including costs associated with the time spent on underwriting, policy issuance and processing, and sales force contract selling. The amounts deferred are those that resulted in successful policy acquisition or renewal for each distribution channel and/or cost center from which the cost originates.
The method we use to amortize DAC for either short- or long-duration insurance contracts did not change as a result of the adoption of the standard.
(a) Includes $140 million in Total net realized capital gains attributable to the effect of the reclassification of certain derivative activity discussed in Note 1 herein. Also includes the effect of the reclassification of ILFC as discontinued operations.
(b) Includes an adjustment to the deferred tax valuation allowance of $1.8 billion in the fourth quarter of 2011.
(c) Represents the effect on the gain on sale of AIG Star and AIG Edison which were sold in first quarter of 2011.
(b) Represents the effect on the gain on sale of AIA ordinary shares, which were sold in the fourth quarter of 2010.
(c) Includes the tax impact to the AIA gain adjustment of $1.0 billion in the fourth quarter of 2010.
For short-duration insurance contracts, starting in 2012, we elected to include anticipated investment income in our determination of whether the deferred policy acquisition costs are recoverable. We believe the inclusion of anticipated investment income in the recoverability analysis is a preferable accounting policy because it includes in the recoverability analysis the fact that there is a timing difference between when premiums are collected and in turn invested and when losses and related expenses are paid. This is considered a change in accounting principle that required retrospective application to all periods presented. Because we historically have not recorded any premium deficiency on our short-duration insurance contracts even without the inclusion of anticipated investment income, there were no changes to the historical financial statements for the change in accounting principle.
In June 2011, the FASB issued an accounting standard that requires the presentation of comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In the two-statement approach, the first statement should present total net income and its components, followed consecutively by a second statement that presents total other comprehensive income and its components. The standard became effective beginning January 1, 2012 with retrospective application required. The standard did not have any effect on our consolidated financial condition, results of operations or cash flows.
In September 2011, the FASB issued an accounting standard that amends the approach to testing goodwill for impairment. The standard simplifies how entities test goodwill for impairment by permitting an entity to first assess qualitative factors to determine whether it is more likely than not the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the quantitative, two-step goodwill impairment test. The standard became effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The adoption of the standard did not have any effect on our consolidated financial condition, results of operations or cash flows.
In January 2010, the FASB issued an accounting standard that requires fair value disclosures about significant transfers between Level 1 and 2 measurement categories and separate presentation of purchases, sales, issuances, and settlements within the rollforward of Level 3 activity. Also, this fair value guidance clarifies the disclosure requirements about the level of disaggregation and valuation techniques and inputs. This guidance became effective for us beginning on January 1, 2010, except for the disclosures about purchases, sales, issuances, and settlements within the rollforward of Level 3 activity, which became effective for us beginning on January 1, 2011. See Note 6 for additional information related to fair value measurements.
The adoption of these standards did not have a material effect on our consolidated financial condition, results of operations or cash flows.
We report the results of our operations through two reportable segments: AIG Property Casualty and AIG Life and Retirement. We evaluate performance based on pre-tax income (loss), excluding results from discontinued operations, because we believe this provides more meaningful information on how our operations are performing. Prior to the fourth quarter of 2012, we also presented Aircraft Leasing as a reportable segment, which included the results of ILFC. As a result of the proposed transaction discussed in Note 4, Aircraft Leasing is no longer presented as a reportable segment and the operations of ILFC are presented as discontinued operations in all periods, and associated assets and liabilities have been classified as held-for-sale at December 31, 2012.
Our property and casualty operations are conducted through multiple-line companies writing substantially all commercial and consumer lines both domestically and abroad. AIG Property Casualty offers its products through a diverse, multi-channel distribution network that includes agents, wholesalers, global and local brokers, and direct-to-consumer platforms. Beginning in the third quarter of 2010, AIG Property Casualty includes the results of Fuji Fire & Marine Insurance Company Limited (Fuji), which writes primarily consumer lines in Japan. See Note 5 herein.
AIG Life and Retirement - The AIG Life and Retirement segment is presented as two operating segments - Life Insurance, which focuses on mortality and morbidity based protection products, and Retirement Services, which focuses on investment, retirement savings and income solutions.
•Retained Interests, which represents the fair value gains or losses, prior to their sale, on the AIA Group Limited. (AIA) ordinary shares retained following the AIA initial public offering the MetLife, Inc. (MetLife) securities that were received as consideration from the sale of American Life Insurance Company (ALICO), and the fair value gains or losses, prior to the Federal Reserve Bank of New York (FRBNY) liquidation of Maiden Lane III LLC (ML III) assets, on the retained interest in ML III;
(b) Interest expense for Other operations in 2010 includes amortization of prepaid commitment fee asset related to the FRBNY Credit Facility of $3.5 billion.
(b) 2012 includes Aircraft Leasing assets classified as assets held-for-sale on the Consolidated Balance Sheet.
The following table presents certain information relating to our sales of AIA ordinary shares:
At December 31, 2012, held-for-sale assets and liabilities consisted of ILFC.
The following table summarizes the components of assets and liabilities held-for-sale on the Consolidated Balance Sheet as of December 31, 2012:
We report the results of operations of a business as discontinued operations if the business is classified as held for sale, the operations and cash flows of the business have been or will be eliminated from our ongoing operations as a result of a disposal transaction and we will not have any significant continuing involvement in the operations of the business after the disposal transaction. The results of discontinued operations are reported in Discontinued Operations in the Consolidated Statement of Operations for current and prior periods commencing in the period in which the business meets the criteria of a discontinued operation, and include any gain or loss recognized on closing or adjustment of the carrying amount to fair value less cost to sell.
On December 9, 2012, we entered into a definitive agreement with Jumbo Acquisition Limited for the sale of 80.1 percent of the common stock of ILFC for approximately $4.2 billion in cash. Jumbo Acquisition Limited may elect to purchase an additional 9.9 percent of the common stock of ILFC for $522.5 million (the Option) by the later of March 15, 2013 and ten days after approval of the ILFC Transaction and the Option by the Committee on Foreign Investment in the United States. We will retain a 19.9 percent ownership interest in ILFC, or a 10.0 percent ownership interest in ILFC, if the Option is exercised by Jumbo Acquisition Limited, in each case subject to dilution for management issuances (which, over time, would reduce our ownership interest by approximately one percentage point). The transaction is subject to required regulatory approvals and other customary closing conditions. We determined ILFC met the criteria at December 31, 2012 for held for sale and discontinued operations accounting and, consequently, we recorded a $4.4 billion after tax loss for the year ended December 31, 2012, which is reported in Income (loss) from discontinued operations in the Consolidated Statement of Operations. At the closing of the transaction, AIG will return $1.1 billion to ILFC in connection with the termination of intercompany arrangements between AIG and ILFC.
On September 30, 2010, we entered into a definitive agreement with Prudential Financial, Inc. for the sale of our Japan-based insurance subsidiaries, AIG Star and AIG Edison, for total consideration of $4.8 billion, including the assumption of certain outstanding debt totaling $0.6 billion owed by AIG Star and AIG Edison. The transaction closed on February 1, 2011 and we recognized a pre-tax gain of $3.5 billion on the sale that is reflected in Income (loss) from discontinued operations in the Consolidated Statement of Operations. In connection with the sale, we recorded a goodwill impairment charge of $1.3 billion in the third quarter of 2010.
On the closing date, as consideration for the ALICO sale, the ALICO SPV received net cash consideration of $7.2 billion (which included an upward price adjustment of approximately $400 million pursuant to the terms of the ALICO stock purchase agreement), 78,239,712 shares of MetLife common stock, 6,857,000 shares of newly issued MetLife participating preferred stock convertible into 68,570,000 shares of MetLife common stock upon the approval of MetLife shareholders and 40,000,000 equity units of MetLife with an aggregate stated value of $3.2 billion. AIG recorded a pre-tax gain of $7.9 billion on the transaction in 2010.
ALICO, Nan Shan, AIG Star and AIG Edison previously were components of the Foreign Life Insurance & Retirement Services reportable segment and AGF previously was a component of the Financial Services reportable segment. Results from discontinued operations for 2011 and 2010 include the results of Nan Shan, AIG Star and AIG Edison through the date of disposition. Results from discontinued operations for 2010 also include the results of ALICO and AGF, which were sold during 2010. The results also include adjustments for guarantees and indemnifications related to these sold businesses.
* In 2010, includes goodwill impairment charges of $3.3 billion related to the sale of ALICO and $1.3 billion related to the sale of AIG Star and AIG Edison. In 2012, includes goodwill impairment charges of $23 million related to the ILFC Transaction. See Note 2 - Goodwill herein for further discussion.
On March 31, 2010, through an AIG Property Casualty subsidiary, we purchased additional voting shares in Fuji, a publicly traded Japanese insurance company with property/casualty insurance operations and a life insurance subsidiary. The acquisition of the additional voting shares for $145 million increased AIG Property Casualty' total voting ownership interest in Fuji from 41.7 percent to 54.8 percent, which resulted in AIG Property Casualty obtaining control of Fuji. In connection with the acquisition, we recognized a bargain purchase gain of $332 million in the Consolidated Statement of Operations for the year ended December 31, 2010. The bargain purchase gain was primarily attributable to the depressed market value of Fuji's common stock, which we believe was the result of macroeconomic, capital market and regulatory factors in Japan coupled with Fuji's financial condition and results of operations. The acquisition was consistent with AIG Property Casualty's desire to increase its share in the substantial Japanese insurance market and to achieve cost savings from synergies.
In March 2011, AIG Property Casualty completed the acquisition of approximately 305 million shares of Fuji tendered in response to a public offer at an offer price of 146 Yen per share ($1.76 per share) for a purchase price of $538 million. In August 2011, AIG Property Casualty acquired the remaining outstanding voting shares of Fuji. As a result of these actions, AIG Property Casualty now owns 100 percent of Fuji.
Level 1: Fair value measurements that are quoted prices (unadjusted) in active markets that we have the ability to access for identical assets or liabilities. Market price data generally is obtained from exchange or dealer markets. We do not adjust the quoted price for such instruments.
Level 3: Fair value measurements based on valuation techniques that use significant inputs that are unobservable. Both observable and unobservable inputs may be used to determine the fair values of positions classified in Level 3. The circumstances for using these measurements include those in which there is little, if any, market activity for the asset or liability. Therefore, we must make certain assumptions as to the inputs a hypothetical market participant would use to value that asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety. The following is a description of the valuation methodologies used for instruments carried at fair value. These methodologies are applied to assets and liabilities across the levels noted above, and it is the observability of the inputs used that determines the appropriate level in the fair value hierarchy for the respective asset or liability.