As of December 31, 2013, approximately 9 percent of the consolidated assets of AIG were located outside the U.S. and Canada, including $295 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 6 to the Consolidated Financial Statements for total carrying values of cash and securities deposited by our insurance subsidiaries under requirements of regulatory authorities.
Book Value Per Common Share Excluding Accumulated Other Comprehensive Income (Loss) (AOCI) is used to show the amount of our net worth on a per-share basis. We believe Book Value Per Common 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 securities portfolio and foreign currency translation adjustments. Book Value Per Common Share Excluding AOCI is derived by dividing Total AIG shareholders' equity, excluding AOCI, by Total common shares outstanding. The reconciliation to book value per common share, the most comparable GAAP measure, is presented in Item 6. Selected Financial Data.
•Accident year loss and combined ratios, as adjusted: both the accident year loss and combined ratios, as adjusted, exclude catastrophe losses and related reinstatement premiums, prior year development, net of premium adjustments, and the impact of reserve discounting. Catastrophe losses are generally weather or seismic events having a net impact on AIG Property Casualty in excess of $10 million each.
•Pre-tax operating income (loss): is derived by excluding the following items from pre-tax 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 of interest expense), net realized capital (gains) losses, and changes in benefit reserves and DAC, VOBA, and SIA related to net realized capital (gains) losses.
•Other Operations - Pre-tax operating income (loss): pre-tax income (loss) excluding certain legal reserves (settlements) related to legacy crisis matters described above, (gain) loss on extinguishment of debt, net realized capital (gains) losses, net loss (gain) on sale of divested businesses and properties, change in benefit reserves and DAC, VOBA, and SIA related to net realized capital (gains) losses and income from divested businesses, including Aircraft Leasing. Results from discontinued operations are excluded from all of these measures.
AIG Property Casualty pre-tax operating income improved in 2013 compared to 2012. Underwriting performance improved in 2013, as evidenced by the accident year combined ratio, as adjusted, which declined compared to the prior year. The improvement in pre-tax operating income also reflected lower catastrophe losses, and an increase in reserve discount compared to the prior year, partially offset by adverse prior year development. Net investment income increased in 2013 compared to 2012 due to an increase in alternative investment income and income associated with PICC P&C shares, which are accounted for under the fair value option.
Our investment portfolio performance, excluding gains recognized in 2012 from our previous investments in Maiden Lane II LLC (ML II), Maiden Lane III LLC (ML III) and AIA Group Limited (AIA), improved in 2013 compared to 2012 primarily due to an increase in alternative investment income largely as a result of favorable equity market performance, partially offset by the effect of our reinvestment of the proceeds from investment activities in a low interest rate environment.
We reduced our debt in 2013 as a result of maturities, repayments and repurchases of $9.7 billion. Partially offsetting this decrease were the issuances of $1.0 billion aggregate principal amount of 3.375% senior notes due 2020 and $1.0 billion aggregate principal amount of 4.125% senior notes due 2024.
We paid a cash dividend on AIG Common Stock of $0.10 per share on each of September 26, 2013 and December 19, 2013.
On February 13, 2014, our Board of Directors declared a cash dividend on AIG Common Stock of $0.125 per share, payable on March 25, 2014 to shareholders of record on March 11, 2014.
We announced an agreement to sell ILFC, which will support our capital management initiatives, sharpen our business focus, and enable us to redeploy assets in a more productive manner.
Additional discussion and other liquidity and capital resources developments are included in Note 16 to the Consolidated Financial Statements and Liquidity and Capital Resources herein.
Net investment income for our insurance operations increased by approximately $645 million in 2013 compared to 2012, due to higher alternative investment income in 2013, driven primarily by favorable equity market performance, which was partially offset by gains recognized in 2012 from our previous investment in ML II. While corporate debt securities represented the core of new investment allocations, we continued to make investments in structured securities and fixed income securities with favorable risk versus return characteristics to improve yields and increase net investment income.
Net unrealized gains in our available for sale portfolio declined to approximately $12 billion as of December 31, 2013 from approximately $25 billion as of December 31, 2012 due to rising interest rates over the period and the realization of approximately $2.5 billion in gains from sales of securities.
Other-than-temporary impairments were significantly lower relative to the prior year period partly driven by strong performance in our structured products portfolios due to favorable developments in the housing sector.
The overall credit rating of our fixed maturity portfolio was largely unchanged from last year. Impairments on investments in life settlements increased in 2013 compared to 2012 as a result of updated longevity assumptions in the valuation tables used to estimate future expected cash flows.
An enhanced risk governance structure that supports consistent and transparent decision making. We have 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.
We continue to promote awareness and accountability for key risk, business decisions, and performance.
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 AIG Parent.
Prior period revenues and expenses were conformed to the current period presentation. These changes did not affect Net income attributable to AIG. The results of the investments in life settlements, including investment income and impairment losses, were reclassified from AIG Property Casualty operations to AIG's Other Operations. Also, as a result of the interest in AerCap to be acquired by AIG in connection with the announced agreement to sell ILFC to AerCap, ILFC operating results, which were previously presented as discontinued operations, have been classified as continuing operations in all periods. The associated assets and liabilities of ILFC continue to be classified as held-for-sale at December 31, 2013 and 2012. For further discussion, see Notes 1, 3 and 4 to the Consolidated Financial Statements.
Our business is affected by industry and economic factors such as interest rates, credit and equity market conditions, catastrophic claims events, regulation, tax policy, competition, and general economic, market and political conditions. We continued to operate under difficult market conditions in 2013, characterized by factors such as historically low interest rates, instability in the global markets due to the negotiations over the U.S. debt ceiling, the U.S. Government shutdown and slow growth in the U.S. economy.
•Enhance the yield on our investments while maintaining focus on credit quality;
•Manage our capital more efficiently by improving our capital structure and redeploying capital to areas that promote profitable growth;
•Work with the Board of Governors of the Federal Reserve System (the FRB) in its capacity as our principal regulator; and
The outlook for each of our businesses and management initiatives to improve growth and performance in 2014 and over the longer term is summarized below.
Operating Expense Discipline - Apply operating expense discipline and increase efficiencies by taking full advantage of our global footprint.
In the U.S., our exposure to terrorism risk is mitigated by the Terrorism Risk Insurance Program Reauthorization Act of 2007 (TRIPRA) in addition to limited private reinsurance protections. TRIPRA is set to expire on December 31, 2014. We are closely monitoring the legislative developments related to the TRIPRA renewal or expiration, and have implemented appropriate business strategies for potential legislation outcomes, including non-renewal of the law. For additional information on TRIPRA, see Item 1A. Risk Factors - Reserves and Exposures and Item 7. MD&A - Enterprise Risk Management - Insurance Operations Risks - AIG Property Casualty Key Insurance Risks - Terrorism Risk.
We continue efforts to better segment our business by industry, geography and type of coverage, to enhance our decision making about risk acceptance and pricing. For example, within workers' compensation we have observed different experience and trends based on this segmentation, which helps inform our risk appetite, pricing and loss mitigation decisions.
As part of our strategy to expand our consumer operations in growth economies, on May 29, 2013, we entered into a joint venture agreement with PICC Life, a subsidiary of PICC Group, to form an agency distribution company in China. Products under consideration to be distributed by the joint venture company include jointly developed life and retirement insurance products, existing PICC Life products, PICC P&C insurance products, AIG Property Casualty products, as well as other products aimed at meeting the needs of this developing market. We will own 24.9 percent of the joint venture company with PICC Life holding the remaining 75.1 percent. Our participation in the joint venture will be managed by AIG Property Casualty. The joint venture is planned to commence operations in 2014 subject to regulatory approval.
We continue to reduce loss costs by realizing greater efficiencies in servicing customer claims, introducing improved claims analytics and services, developing knowledge of the economic drivers of losses which collectively are expected to mitigate reserve development and legal costs, and improve customer insights and pricing.
We continue to execute capital management initiatives by enhancing broad-based risk tolerance guidelines for our operating units, implementing underwriting strategies to increase return on equity by line of business and reducing exposure to businesses with inadequate pricing and increased loss trends. In addition, we remain focused on enhancing our global reinsurance strategy to improve overall capital efficiency, but with periodic income statement volatility.
We continue to streamline our legal entity structure to enhance transparency with regulators and optimize capital and tax efficiency. In 2013, we completed a series of legal entity and branch restructuring transactions resulting in a simpler legal ownership structure with fewer ownership tiers and cross ownership. These legal entity restructuring initiatives enhanced our dividend capacity, reduced required capital, and provided tax benefits. Additionally, the restructurings are allowing us to simplify our reinsurance arrangements which further facilitate increased capital optimization. As of February 2014, through branch incorporations, legal entity mergers, and reinsurance changes, we established three key insurance operating units: one insurance pool in the United States with 12 direct writing entities; one pan-European insurance entity in the United Kingdom with 25 branches throughout Europe; and one Japan insurance holding company directly owning all of our operating units in that country. Key highlights include:
Our overall legal entity restructuring is expected to be substantially completed in 2014 (2015 or later for Japan) subject to regulatory approvals in the relevant jurisdictions.
AIG Life and Retirement has been able to meet the demand for guaranteed products and grow sales while managing risk. We offer competitive products with strong de-risking features, such as volatility control funds, rider fees indexed to a market volatility index and required minimum allocations to fixed accounts, and we employ a dynamic risk hedging program. In addition to individual variable annuities, our Retirement Income Solutions product line is expanding our offerings of index annuities, including those with guarantee features, to provide additional solutions for consumers approaching retirement.
Sales of our fixed annuities are expected to benefit in 2014 from anticipated increasing interest rates and steepening of the yield curve, as these market conditions make fixed annuity products more attractive compared to alternatives such as bank deposits. Our Fixed Annuities product line is also introducing new delayed-income annuities, products that are experiencing significant growth in the marketplace as they provide both flexibility and a guaranteed income stream to consumers approaching retirement.
Our Institutional Markets product line is expected to continue contributing to growth in assets under management with stable value wraps and utilizing a disciplined approach to growth and diversification of our business by pursuing select opportunities in areas such as the terminal funding and pension buyout business.
In the highly competitive life insurance marketplace, we are continuing to execute our strategy of leveraging our scale advantage, utilizing our expertise in risk selection and disciplined approach to pricing new business, and creating differentiated product offerings based on consumer-focused research.
We intend to expand relationships with key distribution partners to fully realize the benefits of our diverse product offerings across multiple channels, and implement a more uniform branding strategy. Our focus on ease of doing business for consumers and producers includes enhancements to our Group Retirement platform and services and other initiatives to improve the recruitment, training and productivity of our affiliated distribution partners, which are expected to enhance sales and service through these channels.
Our investment strategy for AIG Life and Retirement is to maximize net investment income and portfolio value, subject to liquidity requirements, capital constraints, diversification requirements, asset-liability matching and available investment opportunities. Our objective is to maintain a diversified, high quality portfolio of fixed maturity securities having weighted average durations that are matched to the duration and cash flow profile of our liabilities, to the extent practicable.
We intend to continue to enhance profitability and capital efficiency within our insurance entities through disciplined pricing and effective management of risk. Volatility risk controls within our product design and our comprehensive dynamic hedging program are critical tools for managing volatility for products where we have significant exposure to
See Results of Operations - Segment Results - AIG Life and Retirement Results for additional information.
Risk Selection - Ensure the high quality of our new business through disciplined underwriting and our multi-variant risk-based pricing model.
Ease of Use - Reduce complexity in the mortgage insurance process.
Expense Management - Streamline our processes through the use of technology and shared services.
Although increasing interest rates may have an unfavorable impact on new mortgage loan volumes, UGC expects that increasing interest rates will have a favorable impact on the persistency of business written over the last several quarters since refinancing of mortgage loans would be unattractive to homeowners who originated mortgages at the historically low interest rates prevalent during the last several periods. We expect that this higher persistency will continue to benefit our results throughout 2014 and into 2015.
UGC expects cure rates to improve as a result of home value appreciation since such appreciation will encourage homeowners with delinquent mortgages to sell and purchase another home, or to refinance their existing mortgages. We believe the combination of higher persistency and improving cure rates, partially offset by changes in new mortgage loan volumes, will continue to strengthen UGC's operating results throughout 2014.
AIG Markets acts as the derivatives intermediary between AIG and its subsidiaries and third parties to provide hedging services for AIG entities. The derivative portfolio of AIG Markets consists primarily of interest rate and currency derivatives.
The DIB consists of a portfolio of assets and liabilities held directly by AIG Parent in the MIP and certain non-derivative assets and liabilities of AIGFP. The DIB portfolio is being wound down and is managed with the objective of ensuring that at all times it maintains the liquidity we believe is necessary to meet all of its liabilities as they come due, even under stress scenarios, and to maximize returns consistent with our risk management objectives.
The following section provides a comparative discussion of our Results of Operations on a reported basis for the three-year period ended December 31, 2013. Factors that relate primarily to a specific business segment are discussed in more detail within that business segment discussion. For a discussion of the Critical Accounting Estimates that affect the Results of Operations, see the Critical Accounting Estimates section of this MD&A.
pre-tax income from insurance operations of $5.1 billion, $6.5 billion and $213 million from AIG Property Casualty, AIG Life and Retirement and Mortgage Guaranty in 2013, respectively, compared to pre-tax income of $2.0 billion, $3.8 billion and $15 million for these operations in 2012. Net investment income, excluding gains recognized in 2012 from our previous investments in ML II, ML III and AIA, improved in 2013 compared to 2012 due to higher returns on alternative investments, primarily due to the performance of equity markets. In addition, 2013 includes income from legal settlements related to the financial crisis of $1.0 billion. Included in 2012 pre-tax income for AIG Property Casualty were catastrophe losses of $2.7 billion, largely arising from Storm Sandy and severe losses of $326 million. See Note 3 to the Consolidated Financial Statements for further information;
loss on extinguishment of debt of $651 million in 2013 resulting from redemptions and repurchases of, and cash tender offers for, certain debt securities; and
We enhanced spread income and actively managed through the low interest rate environment.
Our investment portfolio performance, excluding gains recognized in 2012 from our previous investments in ML II, ML III and AIA, improved due to higher returns on alternative investments, driven primarily by equity market gains.
For the year ended December 31, 2013, the effective tax rate on income from continuing operations was 3.8 percent. The effective tax rate on income from continuing operations differs from the statutory tax rate of 35 percent primarily due to tax benefits of $2.8 billion related to a decrease in AIG Life and Retirement's capital loss carryforward valuation allowance, $396 million related to a decrease in certain other valuation allowances associated with foreign jurisdictions and $298 million associated with tax exempt interest income. These items were partially offset by charges of $632 million related to uncertain tax positions.
Income from continuing operations before income tax expense was $2.9 billion in 2012 compared to $(0.9) billion in 2011 and reflected the following:
The following table presents a reconciliation of net income attributable to AIG to after-tax operating income (loss) attributable to AIG:
After-tax operating income attributable to AIG increased in 2012 compared to 2011 primarily due to increases in income from insurance operations and in the fair value gains on AIG's interests in AIA ordinary shares and AIG's interest in ML III, discussed above. This was partially offset by an increase in income tax expense in 2012 compared to an income tax benefit in 2011.
For the year ended December 31, 2012, the effective tax rate on pre-tax operating income was 31.6 percent. The significant factors that contributed to the difference from the statutory rate was primarily due to tax exempt interest income and other permanent tax items.
For the year ended December 31, 2011, the effective tax rate on pre-tax operating income was (9.6) percent. The significant factors that contributed to the difference from the statutory rate included tax benefits resulting from tax exempt interest income, tax benefits associated with noncontrolling interests, and the impact of discrete tax benefits.
We report the results of our operations through two reportable segments: AIG Property Casualty and AIG Life and Retirement. The Other Operations category consists of businesses and items not allocated to our reportable segments.
The following table summarizes the operations of each reportable segment and Other Operations. See also Note 3 to the Consolidated Financial Statements.
AIG Property Casualty - Pre-tax income increased in 2013 compared to 2012, primarily as a result of improved underwriting results. The improved underwriting results are attributable to lower catastrophe losses, an improvement in current year losses, reflecting the continued shift to higher value business, enhanced risk selection and improved pricing. The improvement in pre-tax income also reflected higher net investment income in 2013 compared to 2012 due to the strong performance of alternative investments and income associated with the PICC P&C shares that are accounted for under the fair value option.
offset by an increase in pre-tax income from GCM and Mortgage Guaranty. The pre-tax income in 2012 included fair value gains from our previously held interests in AIA ordinary shares and ML III.
Mortgage Guaranty's pre-tax operating income increased in 2013 compared to 2012 due to higher net premiums earned in the first-lien business, a decline in newly reported delinquencies and improving cure rates.
Mortgage Guaranty recorded a pre-tax operating income in 2012 compared to a pre-tax operating loss in 2011 due to a decrease in claims and claims adjustment expense.
AIG Property Casualty presents its financial information in two operating segments - Commercial Insurance and Consumer Insurance - as well as an Other category.
Pre-tax Operating Income increased in 2013, compared to the prior year, due to lower catastrophe losses, improvements in underwriting results and strong investment performance. AIG Property Casualty continued to shift its mix of business to higher value products and regions, while benefiting from positive rate trends.
The acquisition ratio decreased by 0.2 points in 2013, compared to the prior year. Decreases in the Commercial Insurance acquisition ratio, related to changes in business mix and reinsurance structures, partially offset by increased commission rates in Consumer Insurance, driven by increases in growth targeted lines of business.
The general operating expense ratio increased by 0.2 points in 2013, compared to the prior year. An increase in the cost of our employee incentive plans was partially offset by the decrease in bad debt expense and reduced costs for strategic initiatives. In addition, for 2013, the lower net premiums earned base contributed to the increase, primarily due to the fixed expense base that generally does not vary with production.
Pre-tax operating income increased in 2013, compared to the prior year, due to an improvement in underwriting results and an increase in net investment income. The improvement in underwriting results reflected lower catastrophe losses, an improvement in current accident year losses, and an increase in reserve discount compared to the prior year. Net investment income increased due to increases in alternative investment returns and income associated with the PICC P&C shares that are accounted for under the fair value option. The asset diversification strategies that we executed during 2012 enabled us to maintain similar yields in the portfolio despite the continued low interest rate environment in 2013. Catastrophe losses were $787 million and $2.7 billion for the years ended December 31, 2013 and 2012, respectively. The net benefit in reserve discount was $309 million and $63 million for the years ended December 31, 2013 and 2012, respectively. As discussed further in the Discounting of Reserves section, we revised our estimate for discounting of loss reserves with the agreement of our Pennsylvania regulator. We previously applied different Pennsylvania-prescribed discounting practices and factors to our primary and excess workers' compensation reserves in Commercial Insurance and Other. Our revised estimate provides a more consistent approach that better aligns our discount rate with our future expected risk-adjusted yield on the underlying assets and payout patterns.
Acquisition expenses decreased in 2013, compared to the prior year, primarily due to the timing of certain guaranty funds and other assessments, and the change in reinsurance structures in Commercial Insurance, which were partially offset by an increase in acquisition expenses in Consumer Insurance due to the change in business mix.
General operating expenses decreased in 2013, compared to the prior year, due to decreases in bad debt expense and reduced costs for strategic initiatives. Bad debt expense decreased by $149 million from $134 million in the prior year. The decrease in bad debt expense was primarily due to reductions in prior year reserves, as collections exceeded the originally estimated recoveries. Strategic initiatives which include infrastructure project expenses and those severance charges borne by AIG Property Casualty, decreased by $158 million from $455 million in the prior year. These decreases were partially offset by an increase in the cost of our employee incentive plans of $247 million. The increase in the cost of our employee incentive plans was primarily due to the alignment of employee performance with the overall performance of the organization, including our stock performance, and accelerated vesting provisions for retirement-eligible individuals in the 2013 share-based plan.
and enhanced risk selection and loss mitigation activities. As discussed further in the Discounting of Reserves section, our 2013 results included a $322 million charge primarily for the change in reserve discount compared to a $100 million benefit in 2012 from an increase in reserve discount. Prior year adverse development increased by $58 million compared to 2012. The current accident year losses for 2013 included severe losses of $569 million compared to the severe losses of $293 million incurred in the prior year. This increase was driven largely by a large property loss and related contingent business interruption claims, totaling $131 million and by an increased frequency of severe losses compared to prior periods. Net adverse development, including related premium adjustments was $294 million in 2013, which includes $149 million of adverse development related to Storm Sandy, compared to $236 million in the prior year. The adverse development related to Storm Sandy resulted from higher severities on a small number of existing large and complex commercial claims. These increased severities were driven by a number of factors, including the extensive damage caused to properties in the downtown New York metropolitan area.
Acquisition expenses decreased in 2013, compared to the prior year, due to changes in reinsurance, the timing of guaranty funds and other assessments, as well as change in business mix.
General operating expenses increased slightly in 2013, compared to the prior year, primarily due to the increase in employee incentive plan expense, as previously discussed, and strategic initiatives, which was partially offset by a decrease in bad debt expense.
Pre-tax operating income increased in 2013, compared to the prior year, primarily due to a lower underwriting loss, which is partially offset by a decrease in allocated net investment income. Underwriting results improved primarily due to lower catastrophe losses and higher net favorable development, coupled with lower acquisition and general operating expenses. Allocated net investment income decreased due to a decrease in the risk-free rates used in our investment income allocation model. Catastrophe losses in 2013 were $77 million, compared to $382 million during the prior year. Net favorable development was $155 million in 2013, compared to $20 million in the prior year. The year ended December 31, 2013 included approximately $41 million of favorable development from Storm Sandy driven primarily by the reduction of reserves for excess flood policies indicated from completed property inspections and lower than expected severity on certain other policy claims.
diversification, from concentration in tax-exempt municipal instruments into investments in private placement debt and structured securities. Net prior year adverse development, including premium adjustments, was $445 million for 2012 compared to $39 million for 2011.
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.
Pre-tax operating income decreased in 2012, compared to the prior year, 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 higher acquisition and general operating expenses, and higher adverse prior year development, partially offset by 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.
General operating expenses increased due to an increase in bad debt expense of approximately $143 million and investments in strategic initiatives.
Pre-tax operating income increased in 2012, compared to the prior year, 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 expenses increased in 2012, compared to the prior year, 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.
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, these costs totaled $391 million, representing an increase of approximately $195 million over the prior year.
The following table presents AIG Property Casualty net premiums written by major line of business:
During 2013, Commercial Insurance continued to focus on the execution of its strategic objectives.
Property net premiums written increased in 2013, compared to the prior year, primarily due to growth in new business across all regions, favorable retention in renewal businesses and increases in coverage limits and changes to our per-risk reinsurance program to retain more favorable risks, while continuing to manage aggregate exposure. Catastrophe-exposed businesses in the Americas also benefitted from rate increases.
Specialty net premiums written increased in 2013 compared to the prior year, primarily due to rate increases in environmental business, small-and medium-sized enterprise markets in the Americas region, new business growth in EMEA, as well as the restructuring of our reinsurance program to retain more favorable risks while continuing to manage aggregate exposure, which increased net premiums written by $144 million, compared to the prior year.
Consumer Insurance net premiums written decreased in 2013, compared to the prior year, primarily due to the impact of foreign exchange as the U.S. dollar strengthened against the Japanese yen. Excluding the impact of foreign exchange, net premiums written increased compared to the prior year as the business continued to build momentum through multiple distribution channels and continued focus on direct marketing. In 2013, excluding the impact of foreign exchange, net premiums written generated by direct marketing increased by approximately 5.1 percent compared to the prior year, and accounted for approximately 16.4 percent of Consumer Insurance net premiums written.
Personal lines net premiums written, excluding the effects of foreign exchange, increased in 2013 compared to the prior year. The increases were driven by growth in U.S. private client group and warranty business, automobile products and the continued execution of our strategic initiative to grow higher value lines of business in non-automobile products. In addition, the impact of the timing of recognizing the excess of loss ceded premiums written in the second quarter and of the catastrophe bond issuances reduced net premiums written by approximately $58 million compared to the prior year.
A&H net premiums written increased in 2012, compared to the prior year, due to the growth of group personal accident business in the Americas and Asia Pacific, strong growth of new business sales in Fuji Life, travel insurance business, direct marketing programs in Japan and other Asia Pacific nations and growth in individual personal accident in other Asia Pacific nations. This was partially offset by the continuing strategies to reposition U.S. direct marketing operations, as well as pricing and underwriting actions in Europe.
AIG Property Casualty's business is transacted in most major foreign currencies. The following table presents the average of the quarterly weighted average exchange rates of the currencies that have the most significant impact to our businesses:
The Americas net premiums written increased in 2013, compared to the prior year, primarily due to the rate increases in Commercial Insurance and continued growth in the personal property and private client group and rate actions for the warranty retail program in Consumer Insurance. This was partially offset by decreases in casualty businesses reflecting the execution of our strategy to enhance risk selection and the effect of the timing of the catastrophe bond issuances.
EMEA net premiums written increased in 2013, compared to the prior year, due to Commercial Insurance new business growth, particularly in Property and Financial lines, a change in reinsurance strategies to retain more favorable risks in those lines, and rate improvements on retained business, as well as growth in all lines of Consumer Insurance.
Asia Pacific net premiums written increased in 2012 primarily due to an increase in Consumer Insurance reflecting growth of personal property business, group personal accident insurance, and direct marketing business in Japan. The expansion in Asia Pacific countries outside Japan also continued in 2012, supported by growth in individual personal accident insurance, direct marketing and personal lines products. Commercial Insurance increased in the region primarily due to organic growth and rate increases in Property and moderate organic growth in Specialty and Financial lines.
The following tables present the AIG Property Casualty combined ratios based on GAAP data and reconciliation to the accident year combined ratio, as adjusted:
(b) On October 29, 2012, Storm Sandy, one of the largest Atlantic hurricanes on record, came ashore in the U.S. When the storm made landfall, it was categorized as a tropical cyclone, not a hurricane. Storm Sandy was the second-costliest Atlantic hurricane in history, only surpassed by Hurricane Katrina in 2005. Storm Sandy caused widespread flooding and wind damage across the mid-Atlantic states. In 2012, we recorded $2,013 million in losses related to this event.
The improvement in the accident year loss ratio, as adjusted, reflects the realization of benefits from the continued execution of our multi-faceted strategy to enhance risk selection, pricing discipline, exposure management and claims processing. Although the execution of these strategies resulted in a reduction of Casualty net premiums written in both the Americas and EMEA regions, it also improved the accident year loss ratio, as adjusted. Severe losses represented approximately 2.8 points compared to 1.4 points in the prior year, and are included in the accident year loss ratio, as adjusted. In 2013, one single event, totaling $131 million, accounted for approximately 0.6 points of the increase.
The general operating expense ratio increased by 0.3 points in 2013, compared to the prior year. The increase in employee incentive plan expense contributed approximately 1.0 point to the increase in the general operating expense ratio. A reduction in bad debt expense in 2013 represented a decrease to the general operating ratio of approximately 0.8 points compared to the prior year.
The acquisition ratio increased by 0.5 points, primarily due to the combined effect of a lower net premiums earned base, change in business mix and higher costs in growth-targeted lines of business. This was partially offset by a reduction in a profit sharing arrangement in a warranty retail program.
The accident year combined ratio, as adjusted, improved by 1.2 points in 2012.
The acquisition ratio increased by 2.0 points primarily due to our strategy of growing higher value lines, which typically incur higher acquisition costs, and the restructuring of our Casualty lines, especially the loss-sensitive business in the U.S. In addition, ceding commissions decreased as a result of restructuring of the Property and Specialty reinsurance program as part of the strategic decision to retain more profitable business while continuing to manage aggregate exposures.
We manage and account for our invested assets on a legal entity basis in conformity with regulatory requirements. Within a legal entity, invested assets are available to pay claims and expenses of both Commercial Insurance and Consumer Insurance operating segments as well as the Other category. Invested assets are not segregated or otherwise separately identified for the Commercial Insurance and Consumer Insurance operating segments.
Corporate debt securities continued to be the largest asset category. We continued to focus on risk-weighted opportunistic investments in higher yielding assets such as structured securities and commercial mortgage loans. In addition we continued to maintain a defensive strategy on interest rates in the current rising rate environment by increasing our mix of floating rate 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 2014 to meet our liquidity, duration and credit quality objectives as well as current risk-return and tax objectives.
Our invested asset portfolio decreased by approximately $8 billion, or 6 percent during the year, due to a decline in unrealized appreciation from rising interest rates, foreign currency translation adjustment losses in our international portfolio as the dollar strengthened against the yen, and approximately $4.3 billion in dividend remittances to AIG Parent.
Net investment income increased $527 million or 12 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.
Our invested asset portfolio grew by approximately $4.3 billion, or 3.0 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 $231 million in 2012 compared to 2011, of which $113 million was attributed to the strong performance of alternative investments, following a 16 percent increase in the S&P 500 Index during 2012. Other investment income also increased by $69 million due to the strategic group benefits partnership with AIG Life and Retirement, all of which is reported in Consumer Insurance.
Net realized capital gains in 2012 were driven by gains recognized on the sale of fixed maturity and equity securities, which were partially offset by an other-than-temporary impairments charge attributed to a decrease in recoverable values for structured securities, as well as alternative and equity security investments that were in an unrealized loss position for 12 months. Net realized capital gains were less than 2011, due to fewer gains on sales in our fixed maturity securities portfolio and derivative losses as opposed to derivative gains in 2011 resulting from long term interest rate movements.
* Presented by lines of business pursuant to statutory reporting requirements as prescribed by the National Association of Insurance Commissioners.
AIG's gross loss reserves represent the accumulation of estimates of ultimate losses, including estimates for incurred but not reported (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 operating 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.
See Note 12 to the Consolidated Financial Statements for additional information on discounting of loss reserves.
We discount loss reserves, in a manner consistent with rates and factors approved or prescribed by state regulatory authorities. Effective for the fourth quarter of 2013, our Pennsylvania regulator approved use of a consistent discount rate (U.S. Treasury rate plus a liquidity premium) for all of our workers' compensation reserves in our Pennsylvania-domiciled companies, as well as our use of updated payout patterns specific to our primary and excess workers' compensation portfolios. Prior to this change, workers' compensation reserves held by a Pennsylvania-domiciled insurer were discounted as follows: i) for loss reserves associated with accident year 2001 and prior accident years, a prescribed discount factor based on a rate of 6 percent and industry payout patterns, were applied, ii) for loss reserves associated with accident year 2002 and subsequent accident years, a rate of 4.25 percent and our own payout patterns were applied; and iii) for a portion of loss reserves comprising excess workers' compensation reserves that were assumed into Pennsylvania-domiciled insurers from New York-domiciled insurers during 2011, we applied New York discounting rules, which include a prescribed rate of 5 percent on case reserves only (no discounting of IBNR reserves). The new discount rates more closely approximate the expected risk-adjusted yield on the underlying invested assets over the expected payout periods.
As a result of these changes, the total net discount for workers' compensation reserves increased by $427 million. This amount was partially offset by normal accretion expense of $100 million (associated with maturing reserves partially offset by discounts applied to newly established reserves) for a full year net benefit of $327 million. The net benefit consisted of a $322 million reduction within the Commercial Insurance operating segment, primarily from application of a lower discount rate on primary workers' compensation reserves, and a benefit of $649 million in Other, primarily from increased payout patterns specific to excess workers' compensation reserves (as opposed to the prescribed discount factors), which were only partially offset by the lower U.S. Treasury-based discount rates. In addition, this amount was offset by $18 million of amortization of asbestos reserves.
In addition, commencing January 1, 2014, we will be merging our two internal pooling arrangements into one pool, and will be changing the participation percentages of the pool members. We expect that this will result in an additional workers' compensation loss reserve discount benefit of approximately $100 million to be recorded during the first quarter of 2014. As a result of the participation percentages and domiciliary states of the participants of the combined pool, a portion of the workers' compensation reserves currently held net in New York subsidiaries and discounted pursuant to New York discounting rules, will be transferred to Lexington Insurance Company (Lexington),
(b) See tables below for details of prior year development by business unit, accident year and major class of business.
the reserves of that class of business. In some cases, the higher or lower than expected emergence may result in no clear change in the ultimate loss estimate for the accident years in question, and no adjustment would be made to the reserves for the class of business for prior accident years. In other cases, the higher or lower than expected emergence may result in a larger change, either favorable or unfavorable. As appropriate, we make adjustments for the difference between the actual and expected loss emergence for each accident year. As part of our reserving process, we also consider notices of claims received with respect to emerging and/or evolving issues.
The following is a discussion of the primary reasons for the development in 2013, 2012 and 2011 of those classes of business that experienced significant prior accident year development during the three-year period. See Critical Accounting Estimates for a description of our loss reserving process.
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, 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. For reserve reporting purposes, we now combine the Umbrella Excess casualty business with the high layer Catastrophic Casualty business that attaches when losses exceed $50 million.
During 2013, Excess Casualty experienced $144 million of favorable emergence due to favorable outcomes on some large cases from 2010 and lower than expected emergence in high layer Catastrophic Casualty business.
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 which provides cost overrun protection, in some cases over long time periods. 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 under "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 specialists in environmental law and engineering science, toxicologists and other specialists, 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, $200 million of prior year adverse development was recognized during 2012, including $166 million for pollution products 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 pollution 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 and subsequently, 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 Pollution Products reserves in 2011 by $385 million, partly due to large reserve increases on several individual claims. Of this amount, $382 million was included in the AIG Property Casualty Other reporting unit. Approximately 80 percent of the 2011 development was associated with accident years 2003 and prior.
In addition to reserving actions, we have made significant changes to the ongoing environmental business included in Commercial with the goal of ensuring that the current policies are being written to earn an appropriate risk adjusted profit. Underwriting guidelines have been revised to no longer cover known or expected clean up costs, which were a significant driver of historical claims, and a "new emerging contaminants" team has been formed within the dedicated environmental engineering staff to track any new cleanup standards that may be set by federal or state regulators. Further, engineering reviews are required for specific business segments (such as oil and gas, and landfills) that have traditionally generated higher losses.
The Commercial Risk division writes casualty insurance for businesses with revenues of less than $700 million. The majority of the business is workers' compensation. The Energy division writes casualty insurance (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 2013, we continued to refine the segmentation of our analyses of primary workers' compensation, which indicated that prior year development was flat after taking into account the initiatives that our claim function has undertaken to manage high risk claims.
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.
During 2013, this class recognized $54 million of favorable prior year development due to lower than expected loss emergence in many classes such as Excess Hospital Liability.
Healthcare business written by AIG Property Casualty's Americas region produced moderate favorable development in 2011. 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.
This 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.
During 2013, we experienced adverse development from Storm Sandy totaling $108 million, or 5.4 percent of the December 31, 2012 estimate. This development resulted from higher severities on a small number of large and
complex commercial claims driven by a number of factors including the extensive damage caused to properties in the downtown New York metropolitan area.
During 2012, we experienced favorable development from the Tohoku Catastrophe due to commercial claim severities being less than previously reserved.
See Item 7. MD&A - Critical Accounting Estimates - Liability for Unpaid Claims and Claims Adjustment Expense for further discussion of our loss reserving process.
For 2013, the favorable development from accident year 2012 was driven primarily by consumer lines and lower losses in domestic commercial property, while the favorable development from accident year 2010 was primarily the result of favorable claims emergence from domestic excess casualty and from liability and financial lines coverage policies that are on a claims-made basis. The adverse development from accident year 2011 was driven by large losses in financial lines and adverse development in primary casualty including loss-sensitive business. The adverse development from accident year 2009 was driven by large losses in financial lines and adverse development in primary casualty including loss-sensitive business. Also for the same periods, the adverse development from accident years 2003 and prior was primarily driven by loss development on toxic claims tort construction general liability claims and pollution product claims.
For 2012, the favorable development from accident year 2011 was driven primarily by the favorable development on natural catastrophes, primarily the Tohoku Catastrophe, and the adverse development from accident years 2003 and prior was primarily the result of the increase in reserves on runoff pollution product business (policies written between 1987and 2003).
•claims filed under the non-aggregate premises or operations section of general liability policies;
•the number of insureds seeking bankruptcy protection and the effect of prepackaged bankruptcies;
For asbestos, these tests project the losses expected to be reported through 2027. This projection was based on the actual losses reported through 2011 and the expected future loss emergence for these claims. Three scenarios were tested, with a series of assumptions ranging from more optimistic to more conservative. For environmental claims, a comparable series of frequency/severity tests were produced. As a result of the studies, we concluded that no additional strengthening was required for asbestos and environmental in 2011.
In addition to the U.S. asbestos and environmental reserve amounts shown in the tables below, AIG Property Casualty also has asbestos reserves relating to foreign risks written by non-U.S. entities of $134 million gross and $108 million net as of December 31, 2013 compared to $140 million gross and $116 million net as of December 31, 2012.
The following table provides a summary of reserve activity, including estimates for applicable IBNR, relating to asbestos and environmental claims:
(a) Re-estimation of amounts recoverable under retroactive reinsurance contracts includes effect of changes in reserve estimates and changes in discount. Additionally, the 2011 Net amount includes the effect on net loss reserves of the initial cession to NICO.
Upon the closing of this transaction, but effective as of January 1, 2011, we ceded the bulk of AIG Property Casualty's net domestic asbestos liabilities to NICO under a retroactive reinsurance agreement with an aggregate limit of $3.5 billion. Within this aggregate limit, NICO assumed collection risk for existing third-party reinsurance recoverable associated with these liabilities. AIG Property Casualty paid NICO approximately $1.67 billion as consideration for this cession and NICO assumed approximately $1.82 billion of net U.S. asbestos liabilities. As a result of this transaction, AIG Property Casualty recorded a deferred gain of $150 million in the second quarter of 2011, which is being amortized into income over the settlement period of the underlying claims.
Under retroactive reinsurance arrangements any recoveries for development associated with the ceded losses are not recognized immediately; rather this development increases or decreases the deferred gain, and is amortized into income as described above. During 2013, we recognized approximately $87 million of adverse loss development that was ceded under this reinsurance arrangement, which was partially offset by $15 million of deferred gain amortization. Prior years' amounts were immaterial. This development, net of the deferred gain amortization, is being reported in Other income/expense, consistent with the way we manage the business and assess performance and is therefore excluded from net losses incurred and our loss ratios to avoid distortion related to our ongoing insurance business.
* Net IBNR includes the reduction due to the NICO reinsurance transaction of $1,284 million, $1,310 million and $1,414 million as of December 31, 2013, 2012 and 2011, respectively. A significant part of the reduction in IBNR in 2012 is due to the reclassification of estimated liabilities on a retained account from IBNR to case reserves.
The following table presents AIG's survival ratios for asbestos and environmental claims at December 31, 2013, 2012 and 2011. The survival ratio is derived by dividing the current carried loss reserve by the average payments for the three most recent calendar years for these claims. Therefore, the survival ratio is a simplistic measure estimating the
number of years it would take before the current ending loss reserves for these claims would be paid off using recent year average payments.
* Survival ratios are calculated consistent with the basis on historical reserve excluding the effects of the NICO reinsurance transaction.
AIG Life and Retirement presents its operating results in two operating segments - Retail and Institutional.
Premiums and deposits improved significantly in 2013 compared to 2012, primarily from strong sales of annuities in our Retirement Income Solutions and Fixed Annuities product lines and increased Retail Mutual Fund sales. The improvement in Retirement Income Solutions resulted from our efforts to increase sales while managing risk by meeting the strong market demand for guaranteed features with innovative variable annuity products and expanded distribution. As a result of the 2013 increase in premiums and deposits, net flows on investment products improved in 2013 compared to 2012. Net flows from our Fixed Annuities product line, while still negative in 2013, improved compared to 2012 as a result of the modest rise in interest rates in the second half of 2013, which has increased the demand for fixed annuities.
Pre-tax operating income increased in 2013 compared to 2012 due to higher fee income from growth in variable annuity assets under management and active spread management in our interest rate sensitive product lines. The increase in net investment income in 2013 compared to 2012 reflected higher alternative investment income, partially offset by fair value gains on ML II in 2012 that did not recur in 2013 and reinvestment of investment proceeds at lower rates. Pre-tax operating income in 2013 also included a $153 million net increase from adjustments to update certain estimated gross profit assumptions used to amortize DAC and related items in our investment-oriented product lines. These adjustments increased 2013 pre-tax operating income in our Retail operating segment by $198 million and decreased 2013 pre-tax operating income in our Institutional operating segment by $45 million. See Critical Accounting Estimates - Estimated Gross Profits for Investment-Oriented Products (AIG Life and Retirement) for additional discussion of updated estimated gross profit assumptions. Pre-tax operating income in 2012 also included $234 million of expenses related to the resolution of multi-state regulatory examinations of death claims practices and additional reserves for long-term care products and the GIC portfolio.
Dividends and loan repayments paid by AIG Life and Retirement subsidiaries to AIG Parent increased to $4.4 billion in 2013 from $2.9 billion in 2012 from strong pre-tax income, as we continue to pursue capital efficiency and leverage our streamlined legal structure. The increase in dividends in 2013 compared to 2012 is primarily due to legal settlement proceeds in 2013.
Pre-tax operating income for our Retail operating segment increased in 2013 compared to 2012, due in part to higher fee income in the Retirement Income Solutions product line, which reflected growth in variable annuity assets under management driven by strong sales and positive equity market performance. Base spreads (defined as net investment income excluding alternative investments and yield-enhancement activities, less interest credited) improved in 2013 compared to 2012, as a result of active spread management in our interest-sensitive product lines. The impact of life insurance mortality on pre-tax operating income improved in 2013 compared to 2012. Pre-tax operating income for the Retail operating segment in 2013 included $198 million of net favorable adjustments to update estimated gross profit assumptions for annuity spreads, surrender rates and life insurance mortality. See Critical Accounting Estimates - Estimated Gross Profits for Investment-Oriented Products (AIG Life and Retirement) for additional discussion of estimated gross profit assumptions.
Pre-tax operating income increased in 2012 compared to 2011, reflecting active spread management in interest rate sensitive product lines and higher net investment income. The increase in net investment income compared to 2011 included reinvestment of significant amounts of cash and short-term investments, higher fair value gains from ML II and PICC Group, lower impairment charges on investments in leased commercial aircraft and higher income from alternative investments. Benefit expense and DAC amortization expense for variable annuity products were lower in 2012 compared to 2011, primarily due to the favorable impact of separate account performance, which more than offset higher life insurance mortality costs. Pre-tax operating income also increased due to lower expenses in 2012 compared to 2011 related to the resolution of multi-state regulatory examinations of death claims practices in the Retail operating segment. Offsetting these increases in Pre-tax operating income were additional reserves for the GIC portfolio in 2012, and a decrease due to legal settlement proceeds of $226 million received in resolution of a litigation matter and included in Other income in 2011.
Pre-tax operating income for our Retail operating segment increased in 2012 compared to 2011, reflecting active spread management in interest rate sensitive product lines and higher net investment income. The increase in net investment income included reinvestment of significant amounts of cash and short-term investments, higher fair value gains from ML II and PICC Group, lower impairment charges on investments in leased commercial aircraft and higher income from alternative investments. Benefit expense and DAC amortization expense related to variable annuity products in the Retirement Income Solutions product line were lower in 2012 than 2011, primarily due to the favorable impact of separate account performance, which more than offset higher mortality costs in the Life Insurance and A&H product line. Pre-tax operating income also increased due to lower expenses of $57 million in 2012 compared to $202 million in 2011 related to the resolution of multi-state regulatory examinations of death claims practices. Offsetting these positive variances was a decrease due to legal settlement proceeds included in Other income in 2011.
Pre-tax operating income for our Institutional operating segment increased in 2012 compared to 2011 due to active spread management in our Group Retirement product line, which included lowering renewal crediting rates and disciplined new business pricing. Net investment income increased in 2012 compared to 2011 due to reinvestment of significant amounts of cash and short-term investments, higher fair value gains from ML II and PICC Group, lower impairment charges on investments in leased commercial aircraft and higher income from alternative investments. Offsetting these positive variances were decreases in pre-tax operating income compared to 2011 from legal
settlement proceeds included in Other income in 2011 and $110 million of expenses recorded in 2012 resulting from a comprehensive review of reserves for the GIC portfolio.
Premiums increased slightly in 2013 compared to 2012, primarily from higher structured settlement and terminal funding annuity premiums in the Institutional Markets product line and higher immediate annuity premiums in the Fixed Annuities product line. Premiums decreased slightly in 2012 compared to 2011, due to lower Group Benefit premiums partially offset by higher term life insurance premiums.
Premiums and deposits improved significantly in 2013 compared to 2012, primarily from strong sales of annuities in our Retirement Income Solutions and Fixed Annuities product lines and increased sales of Retail Mutual Funds and Group Retirement mutual funds. Within the Group Retirement product line, the increase from mutual funds was largely offset by lower variable annuity deposits, due in part to the historically low interest rate environment making deposits into fixed options less attractive. Premiums and deposits decreased in 2012 compared to 2011, primarily due to the impact of the historically low interest rate environment on fixed annuity sales and on Group Retirement deposits into fixed options.
Retirement Income Solutions premiums and deposits and net flows increased significantly in 2013 and 2012 compared to 2011, reflecting higher variable annuity sales, which have benefitted from innovative product
enhancements and expanded distribution as well as a more favorable competitive environment. The surrender rate for this product line improved in 2013 compared to 2012 due to the significant increase in average reserves driven by strong sales and positive equity market performance.
Retail Mutual Fund deposits and net flows increased in 2013 and 2012 compared to 2011, driven primarily by sales of our Focused Dividend Strategy product offerings.
Group Retirement net flows, which include net flows from mutual funds in group retirement plans, decreased in 2013 and 2012 compared to 2011, and were negative in 2013, primarily as a result of higher surrenders of individual participant contracts as well as higher large group surrenders. As discussed above, premiums and deposits for this product line included increases in mutual fund deposits largely offset by lower annuity deposits.
(a) Excludes mutual fund assets under management of $15.1 billion and $11.8 billion at December 31, 2013 and 2012, respectively.
In addition, we seek to enhance our returns through investments in a diversified portfolio of private equity funds, hedge funds and affordable housing partnerships. Although these alternative investments are subject to periodic earnings fluctuations, they have historically achieved yields in excess of the fixed maturity portfolio yields. Our investment portfolio also includes, to a lesser extent, common and preferred stocks and yield-enhancement items, such as our investment in PICC Group and securities for which the fair value option has been elected, as well as ML II prior to its liquidation in 2012.
Our fundamental investment strategy is to maintain a diversified, high quality portfolio of fixed maturity securities with the intent to largely match the characteristics of our liabilities, including duration, which is a measure of sensitivity to changes in interest rates. The investment portfolio of each product line is tailored to the specific characteristics of its insurance liabilities, and as a result, certain portfolios are shorter in duration and others are longer in duration. See Investments for additional discussion of our asset liability management process.
* Excludes $449 million of fixed maturity securities for which no NAIC Designation is available because they are not held in legal entities within AIG Life and Retirement that require a statutory filing.
The following table presents the fixed maturity security portfolio of AIG Life and Retirement categorized by composite AIG credit rating, at fair value:
Overall, our yields declined in 2013 as investment purchases were made at yields lower than the weighted average yield of the existing portfolio. In 2012, the impact of lower yields on new purchases was largely offset by reinvestment of significant amounts of cash and short-term investments during 2011. During prolonged periods of low or declining interest rates, we generally must invest new net flows and reinvest the cash flows from investment sales, interest and maturities of our portfolio in lower yielding securities.
Net investment income increased slightly in 2013 compared to 2012, as reinvestment in the low interest rate environment resulted in a 13 basis point decrease in the base portfolio yield in 2013, which was offset by growth in average assets from positive net flows, a $613 million increase in alternative investment income and a $50 million increase in call and tender income. The increase in alternative investment yield to almost 16 percent in 2013 from approximately 10 percent in 2012 reflected higher hedge fund income due to favorable equity market conditions and several large redemptions from hedge funds that are not accounted for using the equity method. This increase in alternative investment income was partially offset by decreases in other investment income enhancement items in 2013, which included net fair value losses of $23 million in 2013 from our investment in PICC Group compared to gains of $57 million in 2012; a $38 million decrease in accretion of discount for certain highly rated structured securities, driven by recent increases in market interest rates; and fair value gains of $246 million recognized in 2012 on our investment in ML II, which was liquidated in March 2012 when we received a distribution of $1.6 billion from the sale by the FRBNY of the securities held in ML II.
The contractual provisions for renewal of crediting rates and guaranteed minimum crediting rates included in our products may have the effect, in a continued low interest rate environment, of reducing our spreads and thus reducing future profitability. Although we partially mitigate this interest rate risk through our asset-liability management process, product design elements and crediting rate strategies, a prolonged low interest rate environment may negatively affect future profitability.
Disciplined pricing on new business resulted in lower new fixed annuity deposits in the first six months of 2013 relative to the same period in 2012, due to the relatively low crediting rates offered. However, deposits improved in the latter half of 2013 due to the modest increases in market interest rates, resulting in an overall increase in deposits for 2013 compared to 2012. In the historically low interest rate environment experienced in 2013 and 2012, we have continued to pursue new sales of life and annuity products at targeted net investment spreads. We have a dynamic product management process to ensure that new business offerings appropriately reflect the current interest rate environment. To the extent that we cannot achieve targeted net investment spreads on new business, products
are re-priced or no longer sold. Additionally, current products with higher minimum rate guarantees have been re-filed with lower rates as permitted under state insurance product regulations.
•Universal life insurance interest rate guarantees are generally 2 to 3 percent on new non-indexed products and zero to 2 percent on new indexed products, and are designed to be sufficient to meet targeted net investment spreads. We are in the process of lowering the minimum guaranteed interest rates on new products, and expect this process to be substantially completed in 2014. Active management of renewal crediting rates is done under contractual provisions in our annuity and universal life products that were designed to allow crediting rates to be reset at pre-established intervals subject to minimum crediting rate guarantees. We have adjusted, and will continue to adjust, crediting rates to maintain targeted net investment spreads on both new business and in-force business where crediting rates are above minimum guarantees. In addition to annuity and universal life products, certain traditional long-duration products for which we do not have the ability to adjust interest rates, such as payout annuities, are exposed to reduced earnings and potential loss recognition reserve increases in a prolonged low interest rate environment. See AIG Life and Retirement Reserves and DAC - Other Reserve Changes for additional discussion of loss recognition.
Included in 2012 was an additional $110 million of interest credited expense resulting from a comprehensive review of reserves for the GIC portfolio.
As indicated in the table below, approximately 73 percent of our annuity and universal life account values were at their minimum crediting rates as of December 31, 2013, an increase from 63 percent at December 31, 2012. These products have minimum guaranteed interest rates as of December 31, 2013 ranging from 1 percent to 5.5 percent, with the higher rates representing guarantees on older products.
The following table presents AIG Life and Retirement insurance reserves and mutual fund assets under management:
Other reserve changes in the table above include loss recognition, primarily on certain long-term payout annuity contracts. In connection with our program to utilize capital loss carryforwards, we sold investment securities in 2013 and 2012. These and other investment sales with subsequent reinvestment at lower yields triggered recording of loss recognition reserves of $1.5 billion and $1.2 billion on certain long-term payout annuity contracts in 2013 and 2012, respectively. There were loss recognition reserves related to unrealized appreciation of investments as of December 31, 2011, but no actual loss recognition recorded in 2011. Assumptions related to investment yields, mortality experience and expenses are reviewed periodically and updated as appropriate, which could also result in additional loss recognition reserves.
adjustments resulted from our comprehensive annual review and update of estimated gross profit assumptions, and from a change in long-term asset growth rate assumptions for Group Retirement variable annuity products, which was driven by sustained favorable equity market performance.
In estimating future gross profits for variable annuity products, a long-term annual asset growth assumption is applied to estimate the future growth in assets and related asset-based fees. In determining the asset growth rate, the effect of short-term fluctuations in the equity markets is partially mitigated through the use of a "reversion to the mean" methodology, whereby short-term asset growth above or below the long-term annual rate assumption will impact the growth assumption applied to the five-year period subsequent to the current balance sheet date. In the fourth quarter of 2013, we revised the growth rate assumptions for the five-year reversion to the mean period for the Group Retirement product line in our Institutional segment. This adjustment, which increased DAC by $31 million, increased SIA by $2 million and reduced the GMDB liability by $2 million, was recorded as a decrease in current period amortization expense and increased our Retail pre-tax operating income by $35 million in 2013. For variable annuities in our Retirement Income Solutions product line, the assumed annual growth rate remained above zero percent for the five-year reversion to the mean period and therefore did not meet our criteria for adjustment; however, additional favorable equity market performance in excess of long-term assumptions could result in "unlocking" in this product line in the future with a positive effect on pre-tax income in the period of the unlocking.
(a) Includes $263 million of severance expense attributable to AIG Property Casualty.
(b) Reflects income from settlements with financial institutions that participated in the creation, offering and sale of RMBS from which AIG and its subsidiaries realized losses during the financial crisis.
Pre-tax operating income in 2013 increased compared to the prior year due to improved underwriting income as a result of an increase in net premiums earned in the first-lien business, and decreases in claims and claims adjustment expenses incurred. Partially offsetting these increases were declines in net premiums earned in second-lien, student loan and international businesses, all of which were placed into run-off during 2008, and an increase in underwriting expenses related to higher volumes of new business.
The first-lien net premiums earned increased $127 million resulting from a 32 percent growth of the book of business and a decline in premium refunds as a result of lower rescissions during 2013 compared to 2012. The decline in claims and claims adjustment expenses incurred reflected decreases in first-lien and student loan claims and claims
adjustment expenses of $157 million and $22 million, respectively, which were partially offset by a $34 million increase in second-lien and international claims and claims adjustment expenses. The decline in first-lien claims and claims adjustment expenses incurred was primarily the result of lower newly reported delinquencies and higher cure rates, which were partially offset by $46 million of unfavorable prior year development in 2013 compared to unfavorable prior year development of $17 million in 2012. The decline in student loan claims and claims adjustment expenses reflect recoveries on prior paid losses and the commutation of a significant portion of the business in early 2013. Second-lien claims and claims adjustment expenses increased primarily due to increased overturns of previously denied claims. International claims adjustment expense increased due to increases to reserves as the portfolio continued to run-off.
New insurance written, which represents the original principal balance of the insured mortgages, increased 33 percent due to elevated levels of refinancing activity during 2013 and the acceptance of UGC's risk-based pricing model by approximately 300 new lenders.
Unrealized market valuation gains on the CDS portfolio of $550 million and $617 million were recognized in 2013 and 2012, respectively. The decline resulted primarily from amortization, price movements, terminations and maturities within the CDS portfolio.
GCM reported pre-tax income and pre-tax operating income in 2012 compared to pre-tax loss and pre-tax operating loss in 2011 primarily due to improvement in unrealized market valuations related to the super senior CDS portfolio, a decrease in operating expenses and lower costs related to the wind-down of AIGFP's businesses and portfolios.
DIB pre-tax income decreased in 2013 compared to 2012 primarily due to a one-time realized capital gain of $426 million recorded in 2012 on the sale of 35.7 million common units of The Blackstone Group L.P., partially offset by improvements in pre-tax operating income. DIB pre-tax operating income increased in 2013 compared to 2012 primarily due to fair value appreciation on ABS CDOs that were acquired in the fourth quarter of 2012, partially offset by a decline in net credit valuation adjustments on assets and liabilities for which the fair value option was elected.
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 was recorded in Other invested assets and accounted for under the fair value option.
Change in the Fair Value of the MetLife Securities Prior to Their Sale
We recognized a loss in 2011, representing the decline in the securities' value, due to market conditions, from December 31, 2010 through the date of their sale in the first quarter of 2011.
Corporate & Other reported lower operating losses in 2012 compared to 2011 primarily due to a reduction in expense of $211 million in 2012 resulting from settlements of the liability for the Department of the Treasury's underwriting fees for the sale of AIG Common Stock at amounts lower than had been estimated at the time the accrual was established, and AIG purchased a significant amount of shares for which no payment to the underwriters was
Other non-core businesses declined due to lower gains on real estate dispositions and higher equity losses on real estate investments in 2012 compared to 2011.
reserves recorded for potential exposure under aircraft assets value guarantees and an increase in depreciation expense due to the change in depreciable lives and residual value of certain aircraft.
Includes impairments on investments in life settlements of $971 million, $309 million and $312 million in 2013, 2012, and 2011, respectively. Also included in 2012 is a $426 million gain on the sale of common units of The Blackstone Group L.P. Impairments on investments in life settlements increased in 2013 compared to 2012 as a result of updated longevity assumptions in the valuation tables used to estimate future expected cash flows. These updates were due to observed experience deviating significantly compared to prior expectations.
•a pre-tax gain of $150 million for 2013 in connection with the sale of American Life Insurance Company (ALICO) primarily attributable to the refund of taxes, interest and penalties, together with other matters;
Depending on market conditions, regulatory and rating agency considerations and other factors, we may take various liability and capital management actions. Liability management actions may include, but are not limited, to repurchasing or redeeming outstanding debt, issuing new debt or engaging in debt exchange offers. Capital management actions may include, but are not limited to, paying dividends to our shareholders and share repurchases.
•$1.1 billion aggregate principal amount of our 7.70% Series A-5 Junior Subordinated Debentures and $750 million aggregate principal amount of our 6.45% Series A-4 Junior Subordinated Debentures, in each case for a redemption price of 100 percent of the principal amount, plus accrued and unpaid interest; and
•$500 million aggregate principal amount of our 3.650% senior notes due 2014 for a redemption price of 101.1 percent of the principal amount, plus accrued and unpaid interest.
We paid cash dividends of $0.10 per share on AIG Common Stock in each of the third and fourth quarters of 2013.
We repurchased a total of approximately 12 million shares of AIG Common Stock in the third and fourth quarters of 2013, for an aggregate purchase price of approximately $597 million.
Cash provided by AIG Property Casualty operating activities was $0.4 billion in 2013 compared to $1.1 billion in 2012, primarily reflecting the timing of the payments related to catastrophe losses.
Cash provided by operating activities of business held for sale was $2.9 billion for each of 2013 and 2012.
•payments received relating to the sale of the underlying assets held by ML II of approximately $1.6 billion;
•gross proceeds of approximately $14.5 billion from the sale of AIA ordinary shares; and
•approximately $2.1 billion of cash collateral received in connection with the securities lending program launched during 2012 by AIG Life and Retirement. Net cash provided by investing activities for 2011 includes:
•the utilization of $26.4 billion of restricted cash generated from the AIA initial public offering and ALICO sale in connection with the Recapitalization and $9.6 billion from the disposition of MetLife securities;
•approximately $294 million in the aggregate to pay dividends of $0.10 per share on AIG Common Stock in each of the third and fourth quarters of 2013;
•approximately $597 million to repurchase approximately 12 million shares of AIG Common Stock; and
•approximately $4.9 billion in repayments of long term debt of business held-for-sale. Net cash used in financing activities for 2012 includes:
•$8.6 billion to pay down the Department of the Treasury's preferred interests (AIA SPV Preferred Interests) in the special purpose vehicle holding the AIA ordinary shares; and
As of December 31, 2013, AIG Parent had approximately $17.6 billion in liquidity sources. AIG Parent's liquidity sources are held in the form of cash, short-term investments and publicly traded, intermediate-term investment grade rated fixed maturity securities. Fixed maturity securities consist of U.S. government and government sponsored entity securities, U.S. agency mortgage-backed securities, and corporate and municipal bonds. AIG Parent actively manages its assets and liabilities in terms of products, counterparties and duration. During 2013, upon an assessment of its immediate and longer-term funding needs, AIG Parent purchased publicly traded, intermediate-term investment grade rated fixed maturity securities that can be readily monetized through sales or repurchase agreements. These securities allow us to diversify sources of liquidity while reducing the cost of maintaining sufficient liquidity. AIG Parent liquidity sources are monitored through the use of various internal liquidity risk measures. AIG Parent's primary sources of liquidity are dividends, distributions, loans, and other payments from subsidiaries, as well as credit and contingent liquidity facilities. AIG Parent's primary uses of liquidity are for debt service, capital and liability management, operating expenses and subsidiary capital needs.
In the normal course, it is expected that a portion of the capital generated by our core insurance operations through earnings or through the utilization of AIG's deferred tax assets may be available for distribution to shareholders. Additionally, it is expected that capital associated with businesses or investments that do not directly support our core insurance operations may be available for distribution to shareholders or deployment towards liability management upon their monetization.
(a) Cash and short-term investments include reverse repurchase agreements totaling $6.9 billion and $8.9 billion as of December 31, 2013 and 2012, respectively.
(e) For additional information relating to the contingent liquidity facility, see Contingent Liquidity Facilities below.
We expect that AIG Property Casualty subsidiaries will be able to continue to satisfy reasonably foreseeable future liquidity requirements and meet their obligations, including those arising from reasonably foreseeable contingencies or events, through cash from operations, portfolio interest, scheduled investment maturities and, to the extent necessary, monetization of invested assets. AIG Property Casualty's subsidiaries' liquidity resources are held in the form of cash, short-term investments and publicly traded, investment grade rated fixed maturity securities.
Large catastrophes may require AIG to provide additional support to our affected operations. Downgrades in AIG's credit ratings could put pressure on the insurer financial strength ratings of AIG's subsidiaries, which could result in non-renewals or cancellations by policyholders and adversely affect the subsidiary's ability to meet its own obligations. Increases in market interest rates may adversely affect the financial strength ratings of our subsidiaries, as rating agency capital models may reduce the amount of available capital relative to required capital. Other potential events that could cause a liquidity strain include an economic collapse of a nation or region significant to
our operations, nationalization, catastrophic terrorist acts, pandemics or other events causing economic or political upheaval.
Certain AIG Life and Retirement insurance subsidiaries are members of the FHLBs in their respective districts. As of December 31, 2013, AIG Life and Retirement had outstanding borrowings of $50 million from the FHLBs. Borrowings from the FHLBs are used to supplement liquidity or for other general corporate purposes.
AIG Life and Retirement executes programs, which began in 2012, that lend securities from its investment portfolio to supplement liquidity or for other uses as deemed appropriate by management. Under these programs, AIG Life and Retirement insurance 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 liquid investments. Additionally, the aggregate amount of securities that an AIG Life and Retirement insurance company may lend under its program at any time is limited to five percent of its general account admitted assets. AIG Life and Retirement's liability to borrowers for collateral received was $4.0 billion as of December 31, 2013.
In 2013, AIG Life and Retirement provided $4.4 billion of liquidity to AIG Parent in the form of cash dividends and loan repayments, including $1.3 billion of liquidity in the fourth quarter of 2013, which was funded by the payment of cash dividends from AIG Life and Retirement's insurance subsidiaries that were made under the CMAs. AIG Parent was not required to make any capital contributions to AIG Life and Retirement subsidiaries in either period under the CMAs then in place.
On July 1, 2013, AIG Parent entered into a CMA with a Mortgage Guaranty insurance subsidiary. Among other things, the CMA provides that AIG Parent will maintain capital and surplus of this Mortgage Guaranty insurance subsidiary at or above a specified minimum required capital based on a specified risk-to-capital ratio. In addition, the CMA provides that if capital and surplus of this Mortgage Guaranty insurance subsidiary is in excess of that same specified minimum required capital, subject to board approval and compliance with applicable insurance laws, this Mortgage Guaranty insurance subsidiary would declare and pay ordinary dividends to its equity holders up to an amount necessary to reduce projected or actual capital and surplus to a level equal to or not materially greater than such specified minimum required capital. As structured, the CMA contemplates that the specified minimum required capital would be reviewed and agreed upon at least annually. As of December 31, 2013, the minimum required capital is based on a risk-to-capital ratio of 21 to 1.
Derivative transactions between AIG and its subsidiaries and third parties are generally centralized through GCM, specifically AIG Markets. Commencing June 10, 2013, GCM was required to clear certain derivatives transactions through central regulated clearing organizations pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). To the extent a derivatives transaction is subject to a clearing obligation, GCM is required to post collateral in amounts determined by the relevant clearing organization and GCM's clearing agreements with its futures commission merchants. To the extent a derivatives transaction is not subject to a clearing obligation, these derivative transactions are governed by bilateral master agreements, the form of which is published by the International Swaps and Derivatives Association, Inc. (ISDA). Many of these agreements, primarily between GCM and third party financial institutions, require collateral postings. Many of GCM's transactions with AIG and its
In addition, most of GCM's CDSs within AIGFP are subject to collateral posting provisions. The collateral posting provisions contained in the ISDA Master Agreements and related transaction documents with respect to CDSs differ among counterparties and asset classes. The amount of future collateral posting requirements for super senior CDSs is a function of our credit ratings, the rating of the relevant reference obligations and the market value of the relevant reference obligations, with market value being the most significant factor. We estimate the amount of potential future collateral postings associated with the super senior CDSs using various methodologies. The contingent liquidity requirements associated with such potential future collateral postings are incorporated into our liquidity planning assumptions.
During 2013, the DIB funded maturities and repurchased debt in the open market in the amount of $2.5 billion. The repurchased debt resulted in a loss on extinguishment of debt of $15 million.
currently expect to replace or extend the Four-Year Facility on or prior to its expiration in October 2016, although no assurance can be given that the Four-Year Facility will be replaced on favorable terms or at all.
The Four-Year Facility provides for $4.0 billion of unsecured revolving loans, which includes a $2.0 billion letter of credit sublimit. As of December 31, 2013, a total of approximately $3.9 billion remains available under the Four-Year Facility, of which approximately $1.9 billion remains available for letters of credit. During each of the third and fourth quarters of 2013, we reduced our utilization of letters of credit under the Four-Year Facility. Our ability to borrow under the Four-Year Facility is not contingent on our credit ratings. However, our ability to borrow under the Four-Year Facility is conditioned on the satisfaction of certain legal, operating, administrative and financial covenants and other requirements contained in the Four-Year Facility. These include covenants relating to our maintenance of a specified total consolidated net worth and total consolidated debt to total consolidated capitalization. Failure to satisfy these and other requirements contained in the Four-Year Facility would restrict our access to the Four-Year Facility and could have a material adverse effect on our financial condition, results of operations and liquidity. We expect to borrow under the Four-Year Facility from time to time, and may use the proceeds for general corporate purposes.
(a) Includes $21.4 billion of borrowings related to ILFC, which is reported as held for sale.
(c) Does not reflect unrecognized tax benefits of $4.3 billion ($4.0 billion excluding ILFC), the timing of which is uncertain.
Loss reserves relate to the AIG Property Casualty and the Mortgage Guaranty businesses, 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 AIG Property Casualty and Mortgage Guaranty subsidiaries maintain adequate financial resources to meet the actual required payments under these obligations.
(c) Does not include guarantees, capital maintenance agreements or other support arrangements among AIG consolidated entities.
(e) Excludes commitments with respect to pension plans. The annual pension contribution for 2014 is expected to be approximately $177 million for U.S. and non-U.S. plans
(f) Includes $333 million attributable to ILFC, which is reported as held for sale.
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 15 to the Consolidated Financial Statements.
(a) On July 11, 2013, AIGLH junior subordinated debentures with the same terms as the trust preferred securities were distributed to holders of the trust preferred securities, and the trust preferred securities were cancelled.
(d) At December 31, 2013, includes debt of consolidated investments primarily held through AIG Global Real Estate Investment Corp., AIG Property Casualty U.S., AIG Credit Corp. and AIG Life and Retirement of $1.5 billion, $58 million, $111 million and $201 million, respectively.
The decrease in total debt outstanding as of December 31, 2013 compared to December 31, 2012 was primarily due to maturities and repayments of debt, including cash tender offers, redemptions and repurchases of certain debt securities discussed above.
(b) In January 2014, AIG reduced DIB debt by $2.2 billion through a redemption of $1.2 billion aggregate principal amount of its 4.250% Notes due 2014 and a repurchase of $1.0 billion of its 8.25% Notes due 2018 using cash and short term investments allocated to the DIB.
See Note 14 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 of financing to that company. The following table presents the credit ratings of AIG and certain of its subsidiaries as of February 1, 2014. Figures in parentheses indicate the relative ranking of the ratings within the
We are party to some agreements that contain "ratings triggers". Depending on the ratings maintained by one or more rating agencies, these triggers could result in (i) the termination or limitation of credit availability or a requirement for accelerated repayment, (ii) the termination of business contracts or (iii) a requirement to post collateral for the benefit of counterparties.
For a discussion of the effects of downgrades in the financial strength ratings of our insurance companies or our credit ratings, see Note 11 to the Consolidated Financial Statements and Part I, Item 1A. Risk Factors - Liquidity, Capital and Credit.
On October 31, 2013, our Board of Directors declared a cash dividend on AIG Common Stock of $0.10 per share, which was paid on December 19, 2013 to shareholders of record on December 5, 2013.
Dividend payments to AIG Parent by our insurance subsidiaries are subject to certain restrictions imposed by regulatory authorities. With respect to our domestic insurance subsidiaries, the payment of any dividend requires formal notice to the insurance department in which the particular insurance subsidiary is domiciled. Foreign jurisdictions may restrict the ability of our foreign insurance subsidiaries to pay dividends, and dividends from foreign subsidiaries may also have unfavorable income tax consequences. There are also various local restrictions limiting cash loans and advances to AIG Parent by our subsidiaries. See Note 19 to the Consolidated Financial Statements for additional discussion of restrictions on payments of dividends by AIG and its subsidiaries.
•An increase in interest rates on investment grade fixed maturity securities, partially offset by narrowing spreads of high yield securities, resulted in net unrealized losses in the investment portfolio. Net unrealized gains in our available-for-sale portfolio declined to approximately $12 billion as of December 31, 2013 from approximately $25 billion as of December 31, 2012.
•Blended investment yields on new AIG Life and Retirement and AIG Property Casualty investments were lower than blended rates on investments that were sold, matured or called.
•Other-than-temporary-impairment charges on fixed maturity securities, equity securities, private equity funds and hedge funds remained at low levels, with a small portion of impairments attributable to structured securities.
•Impairments on investments in life settlements increased in 2013 compared to 2012 as a result of updated longevity assumptions in the valuation tables used to estimate future expected cash flows.
•While more of a focus is placed on asset-liability matching in AIG Life and Retirement, our fundamental strategy across all of our investment portfolios is to match the duration characteristics of the liabilities with assets of comparable duration, to the extent practicable.
•Outside of the U.S., fixed maturity securities held by AIG Property Casualty consist primarily of intermediate duration high-grade securities generally denominated in the currencies of the countries in which we operate.
•AIG Parent's liquidity resources are held in the form of cash, short- term investments and publicly traded, intermediate duration investment grade rated fixed maturity securities. AIG Parent actively manages its assets and liabilities in terms of products, counterparties and tenor. During 2013, upon an assessment of its immediate and longer-term funding needs, AIG Parent purchased publicly traded, intermediate term, investment grade rated fixed maturity securities that can be readily monetized through sales or repurchase agreements. These securities allow us to diversify sources of liquidity while reducing the cost of maintaining sufficient liquidity.
See Enterprise Risk Management herein for a discussion of credit risks associated with Investments.
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 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.
The following table presents the fair value of our aggregate credit exposures to non-U.S. governments and their agencies, financial institutions and local governments for our fixed maturity securities:
* At December 31, 2013 and December 31, 2012, approximately 93 percent and 94 percent of these investments were rated investment grade, respectively.
(b) The weighted average expected life was 7 years at December 31, 2013 and 6 years at December 31, 2012.
The following table presents the fair value of our CMBS holdings by rating agency designation and by vintage year:
The following table presents our CMBS available for sale investments by geographic region:
See Note 6 to the Consolidated Financial Statements for further discussion.
We recorded other-than-temporary impairment charges in the years ended December 31, 2013, 2012 and 2011 related to:
•adverse changes in estimated cash flows on certain structured securities; and
See also Note 6 to the Consolidated Financial Statements for further discussion of our investment portfolio.
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 ERM to mitigate risks across the firm.
Our Board of Directors oversees the management of risk through its Finance and Risk Management Committee (FRMC) and Audit Committee. Those committees regularly interact with other committees of the Board. Our Chief Risk Officer (CRO) reports to both the FRMC and AIG's Chief Executive Officer (CEO).
Financial Risk Group (FRG): The FRG is responsible for the oversight of financial risks taken by AIG and its subsidiaries. Its mandate includes overseeing our aggregate credit, market, interest rate, liquidity and model risks, as well as asset-liability management, derivatives activity, and foreign exchange transactions. Membership of the FRG includes our EVP - Investments, Deputy AIG Chief Investment Officer, as well as our CFO, and other senior executives from Finance and ERM. Our CRO serves as Chair of the FRG.
Operational Risk Committee (ORC): This committee oversees operational risk management activities across AIG's businesses, functions, and geographic locations. The ORC reviews the enterprise-wide identification, escalation and mitigation of operational risks that may arise from inadequate or failed internal processes, people, systems, or external events. The ORC also monitors current and emerging operational risks, as well as management actions taken to reduce risks to acceptable levels. The Committee approves the Operational Risk Management (ORM) Policy and ORM Framework, which includes the identification, assessment, monitoring and measurement of risks. The Committee 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 and provides a forum for senior management to assess our operational risk profile and to discuss operational risks that may affect our strategic objectives.
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, human resources, finance and operational risk, as well as business continuity management and the chief risk officers of our business units.
We articulate our aggregate risk-taking by setting risk tolerances on capital and liquidity measures. These measures are set at the AIG Parent, as well as the business unit, level and cover consolidated and insurance company capital and liquidity ratios. We must comply with standards for capital adequacy and maintain sufficient liquidity to meet all our obligations as they come due in accordance with our internal capital management and liquidity policies. The risk tolerances for our insurance operations inform the requirements for capital adequacy for individual businesses. Our risk tolerances take into consideration regulatory requirements, rating agency expectations, and business needs. The GRC routinely reviews the level of risk taken by the consolidated organization in relation to the established risk tolerances. A consolidated risk report is also presented to the FRMC by our CRO.
One tool we use to inform our Risk Appetite Framework is risk identification. We conduct risk identification through a number of processes at the business unit and corporate level focused on capturing our material risks and key areas of focus for follow-up risk management actions. In 2013, we initiated a more formal and integrated bottom-up risk identification and assessment process down to the product-line level. These processes are used as a critical input to enhance and develop our analytics for measuring and assessing risks across the organization.
•administering regular portfolio credit reviews of investment, derivative and credit risk-incurring business units and recommending corrective actions where required;
•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 and report them regularly to senior management for review.
See Investments - Available for Sale Investments herein for further information on our credit concentrations and credit exposures.
Market risk is defined as the potential loss arising from adverse fluctuations in equity and commodity prices, residential and commercial real estate values, interest rates, credit spreads, foreign currencies, inflation, and their levels of volatility.
We are exposed to market risks primarily within our insurance and capital markets businesses. The chief risk officer within each such business is responsible for properly identifying these risks, then ensuring that they are appropriately measured, monitored and managed in accordance with the written risk governance framework established by the Chief Market Risk Officer (CMRO).
Our market risk management framework focuses on quantifying the financial repercussions of changes in these broad market observables, distinct from the idiosyncratic risks associated with individual assets that are addressed through our credit risk management function.
Market risk quantifies the adverse impact on us due to broad, systemic movements in one or more of the following market risk drivers:
Residential and commercial real estate values. Our investment portfolios are exposed to the risk of changing values in a variety of residential and commercial real estate investments. Residential investments include residential mortgages, residential mortgage-backed securities and other structured securities with underlying assets that include residential mortgages: trusts that include real estate and/or mortgages (REITs), and mortgage insurance contracts. Commercial exposures include mortgage loans, commercial mortgage backed securities and other structured securities with underlying assets that include commercial mortgages: trusts, REITs, and other investments.
Credit spread or risk premium. Credit spreads measure an instrument's risk premium or yield relative to that of a comparable duration, default-free instrument. Much like higher interest rates, wider credit spreads mean more investment income in the long-term. In the short term, quickly rising spreads will cause a loss in the value of existing securities, which is reported in Other comprehensive income. A precipitous rise in credit spreads may also signal a fundamental weakness in the credit-worthiness of bond obligors, potentially resulting in default losses.
Commodity Prices. Changes in the value of commodities can affect the valuation of publicly-traded commodities, commodity indices and derivatives.
Market risk is managed at the corporate level within ERM through the CMRO, which reports directly to the AIG CRO. The CMRO is supported by a dedicated team of professionals within ERM who work in partnership with the senior management of our finance, treasury and investment management corporate functions. The CMRO is primarily responsible for the development and maintenance of a risk management framework that includes the following key components:
•written policies, standards and procedures that define the rules for our market risk-taking activities and provide clear guidance regarding their execution and management;
•a limit framework that aligns with our Board-approved Risk Appetite Statement;
•clearly defined authorities for all individuals and committee roles and responsibilities related to market risk management.
Scenario analysis. Scenario analysis uses historical, hypothetical, or forward-looking macroeconomic scenarios to assess and report exposures. Examples of hypothetical scenarios include a 100 basis point parallel shift in the yield curve or a 20 percent immediate and simultaneous decrease in world-wide equity markets.
(d) The majority of the foreign currency exposure is reported on a one quarter lag.
Exposures to yield curve movements include fixed maturity securities and loans and exclude consolidated separate account assets and short-term investments. Total interest-rate sensitive assets decreased 0.6 percent or approximately $1.8 billion compared to December 31, 2012, primarily due to a net decrease in fixed maturity securities of $1.0 billion, and a decrease in mortgage and other loans receivable of $0.8 billion.
Foreign currency-denominated net asset position reflects our consolidated non-U.S. dollar assets less our consolidated non-U.S dollar liabilities on a U.S. GAAP basis. We use a bottom-up approach in managing our foreign
At December 31, 2013, our five largest foreign currency net asset positions were denominated in British pounds, Canadian dollars, Euro, Hong Kong dollars and Japanese yen. Foreign currency-denominated net asset position at December 31, 2013 increased 13.7 percent, or $1.2 billion, compared to December 31, 2012. This was primarily due to an increase in our Hong Kong dollar position of $523 million and $337 million resulting from AIG Life and Retirement's and AIG Property Casualty's investments in PICC Group and PICC P&C, respectively; an increase in our British pound position of $730 million as a result of AIG Parent repurchasing outstanding British pound-denominated debt; an increase in our Japanese yen position of $513 million resulting from AIG Property Casualty Japan's operations and unrealized appreciation of investments; and an increase in our Israeli shekel position of $128 million resulting from the increase in our ownership of AIG Israel Insurance Company Limited. These increases were partially offset by a decrease in our British pound position of $400 million resulting from AI Overseas Association (AIOA) IBNR reserves adjustments; a decrease in our Canadian dollar position of $389 million, primarily from the operations of AIG Insurance Company of Canada; and a decrease of $225 million, resulting from the weakening of other currencies against the U.S. dollar.
For illustrative purposes, we modeled our sensitivities based on a 100 basis point increase in yield curves, a 20 percent decline in equities and alternative assets, and a 10 percent depreciation of all foreign currency exchange rates against the U.S. dollar. This should not be taken as a prediction, but only as a demonstration of the potential effects of such events.
•a 100 basis point parallel shift in the yield curve is consistent with a one standard deviation movement of the benchmark ten-year treasury yield;
To control our exposure to market risk, we rely on a three-tiered system of limits that the CMRO closely monitors and reports to our CRO, senior management and risk committees.
Our CRO and CMRO establish market risk limits that are consistent with our Risk Appetite Statement and approved by each of the FRG and the GRC. These limits are tiered to accommodate product line, business unit and enterprise-wide needs and risk profiles. Consolidated company-level limits define our aggregate maximum exposure for the various market risk factors. Business unit limits are designed to control specific, material market risk activities on a more granular level and additional limits are allocated into individual regions, lines of business and portfolios to address idiosyncratic risks not captured by the higher-level limits, as well as to address the requirements of
regulators and rating agencies. All limits are reviewed by the FRG and GRC on a periodic basis and revisions, if applicable, are proposed by our CRO and the CMRO for approval by those committees.
•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 limit our ability to sell 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;
Operational risk is inherent in each of our business units and corporate functions. Operational risks may lead to the following impacts: unintended economic losses or gains, reputational harm due to negative publicity, censure from supervisory agencies, operational and business disruptions, and/or damage to customer relationships.
Our ORM function, which supports our ORC, has the responsibility to provide an aggregate view of our operational risk profile. Our ORM function oversees the Operational Risk policy and framework, which includes risk identification, assessment, monitoring and measurement.
Each business unit is primarily responsible for managing its operational risks and implementing the components of the operational risk management program. In addition, certain corporate control functions have been assigned accountability for enterprise-wide risk management for their respective areas. These control functions include: Sarbanes-Oxley (SOX), Business Continuity Management (BCM), Information Technology Security Risk, Compliance, Model Validation and Vendor Management. Senior business operational risk executives report to their respective business unit CRO and to the Head of our ORM. This reporting structure is designed to enable close alignment with the businesses while ensuring consistent implementation of operational risk management practices.
•assign clear ownership and accountability for addressing identified operational risk issues.
•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.
We manage insurance risks through risk review and selection processes, exposure limitations, exclusions, deductibles, self-insured retentions, coverage limits, attachment points, and reinsurance. This management is supported by sound underwriting practices, pricing procedures and the use of actuarial analysis to help determine overall adequacy of provisions for insurance. Underwriting practices and pricing procedures incorporate historical experience, current regulation and judicial decisions as well as proposed or anticipated regulatory changes.
•Underwriting - The potential inadequacy of premiums charged for future risk periods on 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.
Our natural catastrophe exposure is primarily driven by the U.S. and Japan, though our overall exposure is diversified across multiple countries. For example, we have exposures to additional perils such as European windstorms and flood. Within the U.S., we have significant hurricane exposure in Florida, the Gulf of Mexico and the Northeast U.S. and mid-Atlantic regions. Events impacting the Northeast U.S. and the mid-Atlantic may result in a higher share of industry losses than other regions primarily due to our relative share of exposure in those regions. Within the U.S., we have significant earthquake exposure in California and the Pacific Northwest and New Madrid regions. Earthquakes impacting the Pacific Northwest region may result in a higher share of industry losses than other regions primarily due to our relative share of exposure in that region.
(b) U.S. earthquake loss estimates represent exposure to Property, Workers' Compensation (U.S.) and A&H business lines.
The OEP estimates provided above reflect our in-force portfolios at September 30, 2013, for U.S. exposures, and at June 30, 2013 for Japan exposures. The catastrophe reinsurance program is as of January 1, 2014.
AIG Property Casualty natural catastrophe modeled losses relative to an industry benchmark over different return periods are presented in the chart below. AIG Property Casualty natural catastrophe net modeled losses across all
perils worldwide are higher than the industry benchmark in the case of more likely events, and lower in the case of tail events.
AIG Property Casualty Natural Catastrophe exposure vs. Industry benchmark*, worldwide net aggregate exceedance probability as a percentage of AIG Property Casualty statutory surplus:
* Benchmark referenced is from the Moody's P&C rating Methodology Update, May 2013.
AIG Property Casualty utilizes industry-recognized catastrophe models and applies its proprietary modeling processes and assumptions to arrive at loss estimates. The use of different methodologies and assumptions could materially change the projected losses. Since there is no industry standard for assumptions and preparation of insured data for use in models, modeled losses may not be comparable to estimates made by other companies.
Our 2014 catastrophe reinsurance program includes coverage for natural catastrophes and some coverage for terrorism events. It consists of a large North American occurrence cover (without reinstatement) to protect against a large U.S. loss, and a worldwide aggregate cover to protect against multiple smaller losses. The attachment point for this reinsurance program is at $3 billion.
We actively monitor terrorism risk and manage exposures to losses from terrorist attacks. We have set risk limits based on modeled losses from certain terrorism attack scenarios. Terrorism risks are modeled using third-party vendor models and various terrorism attack models and scenarios. Adjustments are made to account for vendor model gaps and the nature of AIG Property Casualty exposures. Examples of modeled scenarios are conventional bombs of different sizes, anthrax attacks and nuclear attacks.
Our largest terrorism exposures are in New York City, and estimated losses are largely driven by the Property and Workers' Compensation lines of business. At our largest exposure location, modeled losses for a five-ton bomb attack net of the Terrorism Risk Insurance Program Reauthorization Act of 2007 (TRIPRA) and reinsurance recoveries are estimated to be $3.3 billion as of September 30, 2013. We also have smaller terrorism exposure in Canadian cities and in London.
Our exposure to terrorism risk is mitigated by TRIPRA in addition to limited private reinsurance protections. TRIPRA covers terrorist attacks in the United States only and excludes certain lines of business as specified by applicable law. TRIPRA covers 85 percent of insured losses above a deductible. The current estimate of our deductible is about $2.8 billion for 2013. TRIPRA is set to expire on December 31, 2014. We are closely monitoring the legislative developments related to TRIPRA renewal or expiration, and developing appropriate business strategies for potential legislation outcomes, including non-renewal of TRIPRA.
The Reinsurance Credit Department (RCD) conducts periodic detailed assessments of the financial strength and condition of current and potential reinsurers, both foreign and domestic. The RCD monitors both the financial condition of reinsurers as well as the total reinsurance recoverable ceded to reinsurers, and set limits with regard to the amount and type or exposure we are willing to take with reinsurers. As part of these assessments, we attempt to identify whether a reinsurer is appropriately licensed, assess its financial capacity and liquidity; and evaluate the local economic and financial environment in which a foreign reinsurer operates. The RCD reviews the nature of the risks ceded and the need for measures, including collateral to mitigate credit risk. For example, in our treaty reinsurance contracts, we frequently include provisions that require a reinsurer to post collateral or use other measures to reduce exposure when a referenced event occurs. Furthermore, we limit our unsecured exposure to reinsurers through the use of credit triggers such as insurer financial strength rating downgrades, declines in regulatory capital, or specified declines in risk-based capital (RBC) ratios. We also set maximum limits for reinsurance recoverable exposure, which in some cases is the recoverable amount plus an estimate of the maximum potential exposure from unexpected events for a reinsurer. In addition, credit executives within ERM review reinsurer exposures and credit limits and approve reinsurer credit limits above specified levels. Finally, even where we conclude that uncollateralized credit risk is acceptable, we require collateral from active reinsurance counterparties where it is necessary for our subsidiaries to recognize the reinsurance recoverable assets for statutory accounting purposes. At December 31, 2013, we held $7.5 billion of collateral, in the form of funds withheld, securities in reinsurance trust accounts and/or irrevocable letters of credit, in support of reinsurance recoverable assets from unaffiliated reinsurers. We believe that no exposure to a single reinsurer represents an inappropriate concentration of risk to AIG, nor is our business substantially dependent upon any single reinsurance contract.
(b) Total reinsurance assets include both AIG Property Casualty and AIG Life and Retirement reinsurance recoverable.
At December 31, 2013, we had no significant general reinsurance recoverable due from any individual reinsurer that was financially troubled. Reinsurance underwriting profits in 2013 generally have increased reinsurer capital levels and therefore the industry's underwriting capacity. This increased capacity has resulted in increased competition and lower rates for 2014 renewals. Reduced profitability associated with lower rates could potentially result in reduced capacity or rating downgrades for some reinsurers. The RCD, in conjunction with the credit executives within ERM, reviews these developments, monitors compliance with credit triggers that may require the reinsurer to post collateral, and seeks to use other appropriate means to mitigate any material risks arising from these developments.
•Client behavioral risk including surrender/lapse risk - there are many assumptions made when products are sold including how long the contracts will persist. Actual experience can vary significantly from these assumptions. This risk is impacted by a number of factors including changes in market conditions and policyholder preferences. This risk exists in the majority of our product lines.
•Interest rate risk - represents the potential for loss due to a change in interest rates. Interest rate risk is measured with respect to assets, liabilities (both insurance-related and financial), and derivatives. This risk manifests itself when interest rates move significantly in a short period of time (interest rate shock) but can also manifest itself over a longer period of time such as a persistent low interest rate environment.
•Equity risk - represents the potential for loss due to changes in equity prices. It affects equity-linked insurance products, including but not limited to equity-indexed annuities, variable annuities (and associated guaranteed living and death benefits), universal life insurance, and variable universal life insurance. It also affects our equity
investments and equity-related investments. In addition, changes in the volatility of equity prices can affect the valuation of those insurance products that are accounted for in a manner similar to equity derivatives.
•Mortgage Underwriting 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.
UGC's risk appetite framework establishes various concentration limits on the business UGC insures (for example, geography), and defines underwriting characteristics for which UGC will not insure loans.
GCM actively manages its exposures to limit potential economic losses, and in doing so, GCM must continually manage a variety of exposures including credit, market, liquidity, operational and legal risks. The senior management of AIG defines the policies and establishes general operating parameters for GCM's operations. Our senior management has established various oversight committees to regularly monitor various financial market, operational and credit risks related to GCM's operations. The senior management of GCM reports the results of its operations to and reviews future strategies with AIG's senior management.
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 enters into certain agreements that have the benefit of set-off and close-out netting provisions; such as ISDA Master Agreements, repurchase agreements and securities lending agreements. 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 $1.4 billion at December 31, 2013 and $3.2 billion at December 31, 2012. Where applicable, these amounts have been determined in accordance with the respective master netting agreements.
Risks inherent in ILFC's business, which are managed at the business unit level, include the following:
•that aircraft and related assets cannot be disposed of at the time and in a manner desired;
•losses on sales or impairment charges and fair value adjustments on older aircraft; and
•estimated gross profits to value deferred acquisition costs for investment-oriented products;
On December 9, 2012, AIG Parent, AIG Capital Corporation (Seller), a wholly-owned direct subsidiary of AIG Parent and the sole shareholder of ILFC, and Jumbo Acquisition Limited (Jumbo) entered into a definitive agreement (the Jumbo Share Purchase Agreement) for the sale of 80.1 percent of the common stock of ILFC for approximately $4.2 billion in cash (the ILFC Transaction). Jumbo was granted an option to purchase an additional 9.9 percent of the common stock of ILFC for $522.5 million (the Option). We determined ILFC met the criteria for held for sale and discontinued operations accounting at December 31, 2012 and, consequently, we recorded a $4.4 billion after-tax loss for the year ended December 31, 2012. As of December 15, 2013, the closing of the ILFC Transaction had not occurred and on December 16, 2013, AIG Parent and Seller terminated the amended Jumbo Share Purchase Agreement.
On December 16, 2013, AIG Parent and Seller entered into a definitive agreement with AerCap Holdings N.V. (AerCap) and AerCap Ireland Limited for the sale of 100 percent of the common stock of ILFC (the AerCap Agreement) for consideration consisting of $3.0 billion of cash and approximately 97.6 million newly issued AerCap
common shares. The consideration has a value of approximately $5.4 billion based on AerCap's pre-announcement closing price per share of $24.93 on December 13, 2013. Upon closing of the transaction, AIG will record the 97.6 million AerCap shares received at their then fair value and adjust the final gain (loss) on sale. The transaction is subject to required regulatory approvals, including all applicable U.S. and foreign regulatory reviews and approvals, as well as other customary closing conditions. The AerCap Transaction was approved by AerCap shareholders on February 13, 2014. We determined ILFC met the criteria for held-for-sale accounting at December 31, 2013. Because we expect to hold approximately 46 percent of the common stock of AerCap upon closing of the transaction, however, ILFC does not qualify for discontinued operations presentation in the Consolidated Statements of Income. Consequently, ILFC's operating results are presented in continuing operations for all periods presented.
We consider a number of factors to reliably estimate future taxable income, so we can determine the extent of our ability to realize net operating losses (NOLs), foreign tax credits (FTCs), capital loss and other carryforwards. These factors include forecasts of future income for each of our businesses and actual and planned business and operational changes, both of which include assumptions about future macroeconomic and AIG-specific conditions and events. We subject the forecasts to stresses of key assumptions and evaluate the effect on tax attribute utilization. We also apply stresses to our assumptions about the effectiveness of relevant prudent and feasible tax planning strategies. Our income forecasts, coupled with our tax planning strategies and stress scenarios, all resulted in sufficient taxable income to achieve realization of the tax attributes (other than capital loss carryforwards) prior to their expiration.
Liability for Unpaid Claims and Claims Adjustment Expense (AIG Property Casualty and Mortgage Guaranty)
AIG Property Casualty loss reserves can generally be categorized into two distinct groups. Short-tail classes of business consist principally of property, personal lines and certain casualty classes. Long-tail casualty classes of business include excess and umbrella liability, D&O, professional liability, medical malpractice, workers' compensation, general liability, products liability and related classes.
To estimate net losses for long-tail casualty classes of business, we use a variety of actuarial methods and assumptions and other analytical techniques as described below. A detailed reserve review is generally performed at least once per year to allow for comprehensive actuarial evaluation and collaboration with claims, underwriting, business unit management, risk management and senior management.
For longer-tail classes of business, we generally make actuarial assumptions with respect to the following:
•Loss cost trend factors which are used to establish expected loss ratios for subsequent accident years based on the projected loss ratios for prior accident years.
•Expected loss ratios for the latest accident year (i.e., accident year 2013 for the year-end 2013 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.
We continue to consult 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 help inform our judgments. In 2013, the third party actuarial reviews covered the majority of net reserves held for our Commercial long-tail classes of business, and run-off portfolios reported in Other.
•changes in the legal, regulatory, judicial and social environment including changes in road safety, public health and cleanup standards;
•changes in medical cost trends (inflation, intensity and utilization of medical services) and wage inflation trends;
•underlying policy pricing, terms and conditions including attachment points and policy limits;
•third-party claims reviews that are periodically performed for key classes of claims such as toxic tort, environmental and other complex casualty claims and
The actuarial methods we use for most long-tail casualty classes of business include loss development methods, expected loss ratio methods, including "Bornhuetter Ferguson" methods described below, and frequency/severity models. Loss development methods utilize the actual loss development patterns from prior accident years to project the reported losses to an ultimate basis for subsequent accident years. Loss development methods generally are most appropriate for classes of business which exhibit a stable pattern of loss development from one accident year to the next, and for which the components of the classes have similar development characteristics. For example, property exposures would generally not be combined into the same class as casualty exposures, and primary casualty exposures would generally not be combined into the same class as excess casualty exposures. In 2013, we continued to refine our loss reserving techniques for the domestic primary casualty classes of business and adopted further segmentations based on our analysis of the differing emerging loss patterns for certain classes of insureds. We generally use expected loss ratio methods in cases where the reported loss data lacks sufficient credibility to utilize loss development methods, such as for new classes of business or for long-tail classes at early stages of loss development. Frequency/severity models may be used where sufficient frequency counts are available to apply such approaches.
Expected loss ratio methods rely on the application of an expected loss ratio to the earned premium for the class of business to determine the loss reserves. For example, an expected loss ratio of 70 percent applied to an earned premium base of $10 million for a class of business would generate an ultimate loss estimate of $7 million. Subtracting any reported paid losses and loss expense would result in the indicated loss reserve for this class. Under the "Bornhuetter Ferguson" methods, the expected loss ratio is applied only to the expected unreported portion of
Structural drivers analytics seek to explain the underlying drivers of frequency/severity. A structural drivers analysis of frequency/severity is particularly useful for understanding the key drivers of uncertainty in the ultimate loss cost. For example, for the excess workers' compensation class of business, we have attempted to corroborate our judgment by considering the impact on severity of the future propensity for deterioration of an injured worker's medical condition, the impact of price inflation on the various categories of medical expense and cost of living adjustments on indemnity benefits, the impact of injured worker mortality and claim specific settlement and loss mitigation strategies, etc., using the following:
•Claim by claim reviews to determine the stability and likelihood of settling an injured worker's indemnity and medical benefits - the claim file review was facilitated by third party specialists experienced in workers' compensation claims;
•Ground-up consideration of the reinsurance recoveries expected for the class of business for reported claims with extrapolation for unreported claims;
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 below for several other years. Loss trends may deviate by more than the amounts noted above and discussed below.
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.
•whether the reinsurer is financially troubled (i.e., liquidated, insolvent, in receivership or otherwise subject to formal or informal regulatory restriction); and
See Note 8 to the Consolidated Financial Statements for additional information on reinsurance.
unless a loss recognition event occurs. The assumptions include mortality, morbidity, persistency, maintenance expenses, and investment returns. These assumptions are typically consistent with pricing inputs. The assumptions also include margins for adverse deviation, principally for key assumptions such as mortality and interest rates used to discount cash flows, to reflect uncertainty given that actual experience might deviate from these assumptions. Establishing margins at contract inception requires management judgment. The extent of the margin for adverse deviation may vary depending on the uncertainty of the cash flows, which is affected by the volatility of the business and the extent of our experience with the product.
•To determine investment returns used in loss recognition tests, we typically segregate assets that match liabilities and then project future cash flows on those assets. Our projections include a reasonable allowance for investment expenses and expected credit losses over the projection horizon. A critical assumption in the projection of expected investment income is the assumed net rate of investment return at which excess cash flows are to be reinvested. For products in which asset and liability durations are matched relatively well, this is less of a consideration since interest on excess cash flows are not a significant component of future cash flows. For the reinvestment rate assumption, anticipated future changes to the yield curves could have a large effect. Given the interest rate environment applicable at the date of our loss recognition tests, we assumed a modest and gradual increase in long-term interest rates over time.
Guaranteed Benefit Features of Variable Annuity Products (AIG Life and Retirement)
Variable annuity products offered by our Retirement Income Solutions and Group Retirement product lines offer guaranteed benefit features. These guaranteed features include guaranteed minimum death benefits (GMDB) and guaranteed minimum income benefits (GMIB) that are payable in the event of death, and living benefits that are payable in the event of annuitization, or, in other instances, at specified dates during the accumulation period. Living benefits include guaranteed minimum withdrawal benefits (GMWB) and guaranteed minimum account value benefits (GMAV). See Note 13 to the Consolidated Financial Statements for additional information on these features. At December 31, 2013, variable annuity account values subject to these features included $63 billion with GMDB, $3 billion with GMIB, $28 billion with GMWB and $627 million with GMAV. For GMDB, our most widely offered guaranteed benefit feature, the liabilities included in Future policyholder benefits at December 31, 2013 and 2012 were $355 million and $374 million, respectively.
The liabilities for GMDB and GMIB, which are recorded in Future policyholder benefits, represent the expected value of benefits in excess of the projected account value, with the excess recognized ratably over the accumulation period based on total expected assessments, through Policyholder benefits and claims. The liabilities for GMWB and GMAV, which are recorded in Policyholder contract deposits, are accounted for as embedded derivatives measured at fair value, with changes in the fair value of the liabilities recorded in Other realized capital gains (losses).
Our exposure to the guaranteed amounts is equal to the amount by which the contract holder's account balance is below the amount provided by the guaranteed feature. A variable annuity contract may include more than one type of guaranteed benefit feature; for example, it may have both a GMDB and a GMWB. However, a policyholder can only receive payout from one guaranteed feature on a contract containing a death benefit and a living benefit, i.e. the features are mutually exclusive, so the exposure to the guaranteed amount for each feature is not additive to that of other features. A policyholder cannot purchase more than one living benefit on one contract. Declines in the equity markets, increased volatility and a sustained low interest rate environment increase our exposure to potential benefits under the guaranteed features, leading to an increase in the liabilities for those benefits. See Critical Accounting Estimates - Estimated Gross Profits for Investment-Oriented Products herein for sensitivity analysis which includes the sensitivity of reserves for guaranteed benefit features to changes in the assumptions for equity market returns, volatility and mortality. For a further discussion of the risks related to guaranteed benefit features of variable annuities, our dynamic hedging program and risks of AIG's unhedged exposures, see Item 1A. - Risk Factors - Business and Operations.
If the assumptions used for estimated gross profits change significantly, DAC and related reserves, including VOBA, SIA, guaranteed benefit reserves and unearned revenue reserves (URR), are recalculated using the new assumptions, and any resulting adjustment is included in income. Updating such assumptions may result in acceleration of amortization in some products and deceleration of amortization in other products. In the third quarter of 2013, we completed our comprehensive annual review and update of estimated gross profit assumptions used to amortize DAC and related items for our investment-oriented products. The result of this review was a $118 million net increase in pre-tax operating income in 2013, which included a $198 million net increase in our Retail operating segment and an $80 million decrease in our Institutional operating segment. The net increase in Retail pre-tax operating income was primarily due to a favorable adjustment in our Fixed Annuities product line from updated spread assumptions due to active management of crediting rates and higher future investment yields than those previously assumed. In the Life Insurance and A&H, Retirement Income Solutions and Group Retirement product lines, the update of assumptions for variable annuity spreads, surrender rates, and life insurance mortality had an unfavorable impact on pre-tax operating income. The life insurance mortality assumptions, while unfavorable compared to the previous assumption set, are still within pricing expectations.
The $118 million increase in pre-tax operating income to reflect updated assumptions was comprised of three favorable developments, a $98 million net decrease in DAC amortization expense, a $61 million decrease in SIA amortization expense within Interest credited to policyholder account balances, and a $28 million increase in unearned revenue amortization within Policy fees; partially offset by a $69 million increase in Future policy benefits for life and health insurance contracts.
In estimating future gross profits for variable annuity products, a long-term annual asset growth assumption of 8.5% (before expenses that reduce the asset base from which future fees are projected) is applied to estimate the future growth in assets and related asset-based fees. In determining the asset growth rate, the effect of short-term fluctuations in the equity markets is partially mitigated through the use of a "reversion to the mean" methodology, whereby short-term asset growth above or below the long-term annual rate assumption impact the growth assumption applied to the five-year period subsequent to the current balance sheet date. The reversion to the mean methodology allows us to maintain our long-term growth assumptions, while also giving consideration to the effect of actual investment performance. When actual performance significantly deviates from the annual long-term growth assumption, as evidenced by growth assumptions for the five-year reversion to the mean period falling below a certain rate (floor) or above a certain rate (cap) for a sustained period, judgment may be applied to revise or "unlock" the growth rate assumptions to be used for both the five-year reversion to the mean period as well as the long-term annual growth assumption applied to subsequent periods. The use of a reversion to the mean assumption is common within the industry; however, the parameters used in the methodology are subject to judgment and vary within the industry.
(a) Represents the net impact of 1 percent increase or decrease in long-term equity returns for GMDB and GMIB reserves and negligible net impact of 1 percent increase or decrease in the S&P 500 index for living benefit reserves.
(b) Represents the net impact of 1 percentage point increase or decrease in implied volatility.
The analysis of DAC, guaranteed benefits reserve and unearned revenue liability is a dynamic process that considers all relevant factors and assumptions described above. We estimate each of the above factors individually, without the effect of any correlation among the key assumptions. An assessment of sensitivity associated with changes in any single assumption would not necessarily be an indicator of future results.
For a discussion of impairments on investments in life settlements, see Investments in this MD&A and Note 6 to the Consolidated Financial Statements.
(a) Includes $26.5 billion for which the primary source is broker quotes.
See Notes 5 and 11 to the Consolidated Financial Statements for information about the regulatory capital, multi-sector CDO, corporate debt/ CLO and other portfolios.
The following table presents key inputs used in the BET model, and the potential increase (decrease) to the fair value of the derivative liability by ABS category at December 31, 2013 corresponding to changes in these key inputs:
$ (2 ) $ (5 ) $ (44 ) $ (32 ) $ (8 ) $ (8 )
These results are calculated by stressing a particular assumption independently of changes in any other assumption. No assurance can be given that the actual levels of the key inputs will not exceed, perhaps significantly, the ranges assumed by us for purposes of the above analysis. No assumption should be made that results calculated from the use of other changes in these key inputs can be interpolated or extrapolated from the results set forth above.
Additional premium/Return premium is a premium due either to or from an insured as a result of a change in coverage (e.g. increase or decrease in limits or risk) or cancellation of an existing policy. In addition, certain policies provide for adjustments to the original premium amount charged based on the experience of the policy, e.g. workers' compensation policies and loss sensitive policies where changes to the original premium are based on variances of the loss history against estimates built into the determination of the original premium.
AIG Life and Retirement - Premiums and deposits includes direct and assumed amounts received on traditional life insurance policies, group benefit policies and deposits on life-contingent payout annuities, as well as deposits received on universal life, investment-type annuity contracts, guaranteed investment contracts and mutual funds.
related to legacy crisis matters and bargain purchase gain. Underwriting income (loss) is derived by reducing net premiums earned by claims and claims adjustment expenses incurred, acquisition expenses and general operating expenses.
CVA Credit Valuation Adjustment The CVA adjusts the valuation of derivatives to account for nonperformance risk of our counterparty with respect to all net derivative assets positions. Also, the CVA reflects the fair value movement in the DIB's asset portfolio that is attributable to credit movements only without the impact of other market factors such as interest rates and foreign exchange rates. Finally, the CVA also accounts for our own credit risk, in the fair value measurement of all net derivative liabilities positions and liabilities where AIG has elected the fair value option, when appropriate.
DAC Deferred Policy Acquisition Costs Deferred costs that are incremental and directly related to the successful acquisition of new business or renewal of existing business.
DAC Related to Unrealized Appreciation (Depreciation) of Investments An adjustment to DAC for investment-oriented products, equal to the change in DAC amortization that would have been recorded if fixed maturity and equity securities available for sale had been sold at their stated aggregate fair value and the proceeds reinvested at current yields (also referred to as "shadow DAC"). The change in this adjustment, net of tax, is included with the change in net unrealized appreciation (depreciation) of investments that is credited or charged directly to Other comprehensive income (loss).
Loss reserve development The increase or decrease in incurred claims and claims adjustment expenses as a result of the re-estimation of claims and claims adjustment expense reserves at successive valuation dates for a given group of claims.
Other Operations - Pre-tax operating income (loss): pre-tax income (loss) excluding certain legal reserves (settlements) related to legacy crisis matters, (gain) loss on extinguishment of debt, Net realized capital (gains) losses, net loss (gain) on sale of divested businesses and properties, change in benefit reserves and DAC, VOBA, and SIA related to net realized capital (gains) losses and income from divested businesses, including Aircraft Leasing.
insurance coverage for risks which are generally not available in the standard insurance market. Surplus lines policy forms and rates are not regulated by the insurance departments.
Rescission Denial of claims and termination of coverage on loans related to fraudulent or undocumented claims, underwriting guideline violations and other deviations from contractual terms.
Retained Interest Category within AIG's Other Operations that includes the fair value gains or losses, prior to their sale, of the AIA ordinary shares retained following the AIA Group Limited initial public offering and the MetLife, Inc. securities that were received as consideration from the sale of American Life Insurance Company and the fair value gains or losses, prior to the FRBNY liquidation of Maiden Lane III LLC assets in 2012, on the retained interest in Maiden Lane III LLC.
SIA Sales Inducement Asset Represents amounts that are credited to policyholder account balances related to the enhanced crediting rates that a seller offers on certain of its annuity products.
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 2016.
SSDMF Social Security Death Master File A database of deceased individuals, most of whom were issued a social security number during their lifetimes, maintained by the U.S. Social Security Administration.
Unearned premium reserve Liabilities established by insurers and reinsurers to reflect unearned premiums which are usually refundable to policyholders if an insurance or reinsurance contract is canceled prior to expiration of the contract term.
TARP Troubled Asset Relief Program of the Department of the Treasury
Summary of Investments - Other than Investments in Related Parties at December 31, 2013
Reinsurance at December 31, 2013, 2012 and 2011 and for the years then ended
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of American International Group, Inc. and its subsidiaries (AIG) at December 31, 2013 and 2012, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2013 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, AIG maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on criteria established in the 1992 Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). AIG's management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management's Report on Internal Control Over Financial Reporting appearing under Item 9A in the 2013 Form 10-K. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on AIG's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
* 2011 includes payment of the FRBNY credit facility accrued compounded interest of $4.7 billion, before the facility was terminated on January 14, 2011 in connection with the Recapitalization.
Certain of our foreign subsidiaries included in the consolidated financial statements report on different annual fiscal year bases, in most cases ending November 30. The effect on our consolidated financial condition and results of operations of all material events occurring at these subsidiaries between such fiscal year end and December 31 for all periods presented in these consolidated financial statements has been recorded.
•valuation of liabilities for guaranteed benefit features of variable annuity products;
•fair value measurements of certain financial assets and liabilities. These accounting estimates require the use of assumptions about matters, some of which are highly uncertain at the time of estimation. To the extent actual experience differs from the assumptions used, our consolidated financial condition, results of operations and cash flows could be materially affected.
Liability for Unpaid Claims and Claims Adjustment Expense, and Future Policy Benefits for Life and Accident and Health Insurance Contracts, and Policyholder Contract Deposits
Premiums for short-duration contracts are recorded as written on the inception date of the policy. Premiums are earned primarily on a pro rata basis over the term of the related coverage. Sales of extended services contracts are reflected as premiums written and earned on a pro rata basis over the term of the related coverage. The reserve for unearned premiums includes the portion of premiums written relating to the unexpired terms of coverage. Reinsurance premiums under a reinsurance contract are typically earned over the same period as the underlying policies, or risks, covered by the contracts. As a result, the earnings pattern of a reinsurance contract may extend up to 24 months, reflecting the inception dates of the underlying policies throughout the year.
Aircraft leasing revenue from flight equipment under operating leases is recognized over the life of the leases as rental payments become receivable under the provisions of the leases or, in the case of leases with varying payments, under the straight-line method over the noncancelable term of the leases. In certain cases, leases provide for additional payments contingent on usage. In those cases, rental revenue is recognized at the time such usage occurs, net of estimated future contractual aircraft maintenance reimbursements. Gains on sales of flight equipment are recognized when flight equipment is sold and the risk of ownership of the equipment is passed to the new owner.
Other income includes unrealized gains and losses on derivatives, including unrealized market valuation gains and losses associated with the Global Capital Markets (GCM) super senior credit default swap (CDS) portfolio, advisory fee income from AIG Life and Retirement's broker dealer business, income from the Direct Investment book (DIB), as well as legal settlements of $1.2 billion and $200 million from legacy crisis and other matters in 2013 and 2012, respectively.
Other income from our Other Operations category consists of the following:
•Earnings from private equity funds and hedge fund investments accounted for under the equity method.
•Gains and losses recognized in earnings on derivatives for the effective portion and their related hedged items. Aircraft leasing expenses consist of ILFC interest expense, depreciation expense, impairment charges, fair value adjustments and lease-related charges on aircraft as well as selling, general and administrative expenses and other expenses incurred by ILFC.
Premiums and other receivables - net includes premium balances receivable, amounts due from agents and brokers and policyholders, trade receivables for the DIB and GCM and other receivables. Trade receivables for GCM include cash collateral posted to derivative counterparties that is not eligible to be netted against derivative liabilities. The allowance for doubtful accounts on premiums and other receivables was $554 million and $619 million at December 31, 2013 and 2012, respectively.
The cost of buildings and furniture and equipment is depreciated principally on the straight-line basis over their estimated useful lives (maximum of 40 years for buildings and 10 years for furniture and equipment). Expenditures for maintenance and repairs are charged to income as incurred and expenditures for improvements are capitalized and depreciated. We periodically assess the carrying value of our real estate for purposes of determining any asset impairment. Capitalized software costs, which represent costs directly related to obtaining, developing or upgrading internal use software, are capitalized and amortized using the straight-line method over a period generally not exceeding five years. Real estate, fixed assets and other long-lived assets are assessed for impairment when impairment indicators exist.
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's Commercial Insurance and Consumer Insurance operating segments.
If the qualitative test is not performed or if the test indicates a potential impairment is present, we estimate the fair value of each reporting unit and compare the estimated fair value with the carrying amount of the reporting unit, including allocated goodwill. The estimate of a reporting unit's fair value involves management judgment and is based on one or a combination of approaches including discounted expected future cash flows, market-based earnings multiples of the unit's peer companies, external appraisals or, in the case of reporting units being considered for sale, third-party indications of fair value, if available. We consider one or more of these estimates when determining the fair value of a reporting unit to be used in the impairment test.
At December 31, 2013, we performed our annual goodwill impairment test. Based on the results of the goodwill impairment test, we concluded that the remaining goodwill was not impaired.
over the estimated lives of the contracts and are subject to the same adjustments due to changes in the assumptions underlying EGPs as DAC.
Other liabilities consist of other funds on deposit, other payables, securities sold under agreements to repurchase and securities 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 Sheets. Net proceeds of these deposits are invested and generate Net investment income. As amounts are paid, consistent with the underlying contracts, the deposit liability is reduced. Also included in Other liabilities are trade payables for the DIB and GCM, which include option premiums received and payables to counterparties that relate to unrealized gains and losses on futures, forwards, and options and balances due to clearing brokers and exchanges. Trade payables for GCM also include cash collateral received from derivative counterparties that contractually cannot be netted against derivative assets.
In July 2012, the Financial Accounting Standards Board (FASB) issued an accounting standard that allows a company, as a first step in an impairment review, to assess qualitatively whether it is more likely than not that an indefinite-lived intangible asset is impaired. We are not required to calculate the fair value of an indefinite-lived intangible asset and perform a quantitative impairment test unless we determine, based on the results of the qualitative assessment, that it is more likely than not the asset is impaired.
In February 2013, the FASB issued an accounting standard that requires us to measure obligations resulting from joint and several liability arrangements for which the total amount of the obligation is fixed at the reporting date as the sum of (i) the amount we agreed to pay on the basis of our arrangement among our co-obligors and (ii) any additional amount we expect to pay on behalf of our co-obligors.
In July 2013, the FASB issued an accounting standard that requires a liability related to unrecognized tax benefits to be presented as a reduction to the related deferred tax asset for a net operating loss carryforward or a tax credit carryforward. When the carryforwards are not available at the reporting date under the tax law of the applicable jurisdiction or the tax law of the applicable jurisdiction does not require, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit will be presented in the financial statements as a liability and will not be combined with the related deferred tax asset.
The standard is effective for fiscal years and interim periods beginning after December 15, 2013, but earlier adoption is permitted. Upon adoption, the standard should be applied prospectively to unrecognized tax benefits that existed at the effective date. Retrospective application is permitted. We plan to adopt the standard prospectively on its required effective date of January 1, 2014 and do not expect the adoption of the standard to have a material effect on our consolidated financial condition, results of operations or cash flows.
We report the results of our operations consistent with the manner in which AIG's chief operating decision makers review the business to assess performance and to allocate resources through two reportable segments: AIG Property Casualty and AIG Life and Retirement. We evaluate performance based on revenues and 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 sale of ILFC discussed in Note 4, Aircraft Leasing is no longer presented as a reportable segment in all periods presented.
In the fourth quarter of 2013, to reduce investment concentration, we transferred the holdings of investments in life settlements from AIG Property Casualty operations to AIG's Other Operations. AIG Property Casualty has retained debt instruments associated with the investments in life settlements, repayment of which is expected to result from cash flows from the investments in life settlements. To align our segment reporting with this change, the results of the investments in life settlements, including investment income and impairment losses, were reclassified to AIG's Other Operations for all periods presented.
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.
In 2012, AIG Life and Retirement announced several key organizational structure and management changes intended to better serve the organization's distribution partners and customers. Key aspects of the new structure include distinct product manufacturing divisions, shared annuity and life operations platforms and a unified all-channel distribution organization with access to all AIG Life and Retirement products.
Retail - product lines include Life Insurance and Accident and Health (A&H), Fixed Annuities, Retirement Income Solutions (including variable and index annuities), Brokerage Services and Retail Mutual Funds.
Institutional - product lines include Group Retirement, Group Benefits and Institutional Markets. The Institutional Markets product line consists of stable value wrap products, structured settlement and terminal funding annuities, high net worth products, guaranteed investment contracts (GICs), and corporate- and bank-owned life insurance.
Prior period amounts have been revised to reflect the new structure, which did not affect previously reported pre-tax income from continuing operations for AIG Life and Retirement. Prior to the first quarter of 2013, AIG Life and Retirement was presented as two operating segments: Life Insurance and Retirement Services.
•Retained Interests, which represents the fair value gains or losses, prior to their sale in 2012, of 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 FRBNY liquidation of Maiden Lane III LLC (ML III) assets, on the retained interest in ML III;
The following table presents AIG's year-end identifiable assets and capital expenditures by reportable segment:
(a) AIG Property Casualty manages its assets on an aggregate basis and does not allocate its assets, other than goodwill, between its operating segments.
(b) 2013 and 2012 include Aircraft Leasing assets classified as assets held-for-sale on the Consolidated Balance Sheets.
* Revenues are generally reported according to the geographic location of the reporting unit.
We report a business as held for sale when management has approved or received approval to sell the business and is committed to a formal plan, the business is available for immediate sale, the business is being actively marketed, the sale is anticipated to occur during the next 12 months and certain other specified criteria are met. A business classified as held for sale is recorded at the lower of its carrying amount or estimated fair value less cost to sell. If the carrying amount of the business exceeds its estimated fair value, a loss is recognized. Depreciation and amortization expense is not recorded on assets of a business after it is classified as held for sale. Assets and liabilities related to a business classified as held for sale are segregated in the Consolidated Balance Sheets in the period in which the business is classified as held for sale.
On December 9, 2012, we entered into a definitive agreement (the Share Purchase Agreement) with Jumbo Acquisition Limited (Jumbo) for the sale of 80.1 percent of the common stock of ILFC for approximately $4.2 billion in cash. We determined ILFC met the criteria for held for sale and discontinued operations accounting at December 31, 2012 and, consequently, we recorded a $6.7 billion pre-tax loss and a $4.4 billion after tax loss for the year ended December 31, 2012. ILFC's operating results do not include depreciation and amortization expense because depreciation and amortization expense is not recorded on the assets of a business after the business is classified as held for sale. As of December 15, 2013, the sale of ILFC to Jumbo had not closed and on December 16, 2013, we terminated the amended Share Purchase Agreement with Jumbo.
fuel-efficient aircraft, and the success of competing aircraft models resulted in a contracting operator base for these aircraft types. These factors, together with the latest updates to airline fleet plans and efforts to remarket these aircraft resulted in the impairment charge. Approximately $1.0 billion of the $1.1 billion impairment charge related to the four-engine widebody aircraft and, in particular, the Airbus A340-600s. This had no effect on our consolidated financial condition, results of operations, or cash flows as a result of the loss on sale of ILFC we recognized for the year ended December 31, 2012.
The results of operations for the following businesses are presented as discontinued operations in our Consolidated Statements of Income.
On January 12, 2011, we entered into an agreement to sell our 97.57 percent interest in Nan Shan Life Insurance Company, Ltd. (Nan Shan) to a Taiwan-based consortium. The transaction was consummated on August 18, 2011 for net proceeds of $2.15 billion in cash. We recorded a pre-tax loss of $1.0 billion for the year ended December 31, 2011 largely offsetting Nan Shan operating results for the period, which is reflected in Income (loss) from discontinued operations in the Consolidated Statements of Income. The net proceeds from the transaction were used to pay down a portion of the liquidation preference of the Department of the Treasury's preferred interests (AIA SPV Preferred Interests) in the special purpose vehicle holding the proceeds of the AIA initial public offering (the AIA SPV).
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 Life Insurance Co., Ltd. (AIG Star) and AIG Edison Life Insurance Company (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 Statements of Income.
Nan Shan, AIG Star and AIG Edison previously were components of the AIG Life and Retirement reportable segment. Results from discontinued operations for 2011 include the results of Nan Shan, AIG Star and AIG Edison through the date of disposition.
ITEM 8 / NOTE 4. HELD-FOR-SALE CLASSIFICATION, DIVESTED BUSINESSES AND DISCONTINUED OPERATIONS
The following table presents the components of income from discontinued operations:
Assets and liabilities recorded at fair value in the Consolidated Balance Sheets are measured and classified in accordance with a fair value hierarchy consisting of three "levels" based on the observability of inputs available in the marketplace used to measure the fair values as discussed below:
•Level 2: Fair value measurements based on inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.
•Counterparty Credit Risk. Fair value measurements for freestanding derivatives incorporate counterparty credit by determining the explicit cost for us to protect against our net credit exposure to each counterparty at the balance sheet date by reference to observable counterparty CDS spreads, when available. When not available, other directly or indirectly observable credit spreads will be used to derive the best estimates of the counterparty spreads. Our net credit exposure to a counterparty is determined based on master netting agreements, which take into consideration all derivative positions with the counterparty, as well as collateral posted by the counterparty at the balance sheet date. Fair values for fixed maturity securities based on observable market prices for identical or similar instruments implicitly incorporate counterparty credit risk. Fair values for fixed maturity securities based on internal models incorporate counterparty credit risk by using discount rates that take into consideration cash issuance spreads for similar instruments or other observable information.
We employ independent third-party valuation service providers to gather, analyze, and interpret market information to derive fair value estimates for individual investments, based upon market-accepted methodologies and assumptions. The methodologies used by these independent third-party valuation services are reviewed and understood by management, through periodic discussion with and information provided by the valuation services. In addition, as
We have control processes designed to ensure that the fair values received from third party valuation services are accurately recorded, that their data inputs and valuation techniques are appropriate and consistently applied and that the assumptions used appear reasonable and consistent with the objective of determining fair value. We assess the reasonableness of individual security values received from valuation service providers through various analytical techniques, and have procedures to escalate related questions internally and to the third party valuation services for resolution. To assess the degree of pricing consensus among various valuation services for specific asset types, we have conducted comparisons of prices received from available sources. We have used these comparisons to establish a hierarchy for the fair values received from third party valuation services to be used for particular security classes. We also validate prices for selected securities through reviews by members of management who have relevant expertise and who are independent of those charged with executing investing transactions.
We estimate the fair value of mortgage and other loans receivable that are measured at fair value by using dealer quotations, discounted cash flow analyses and/or internal valuation models. The determination of fair value considers inputs such as interest rate, maturity, the borrower's creditworthiness, collateral, subordination, guarantees, past-due status, yield curves, credit curves, prepayment rates, market pricing for comparable loans and other relevant factors.
OTC derivatives are valued using market transactions and other market evidence whenever possible, including market-based inputs to models, model calibration to market clearing transactions, broker or dealer quotations or alternative pricing sources with reasonable levels of price transparency. When models are used, the selection of a particular model to value an OTC derivative depends on the contractual terms of, and specific risks inherent in the instrument, as well as the availability of pricing information in the market. We generally use similar models to value similar instruments. Valuation models require a variety of inputs, including contractual terms, market prices and rates, yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs. For OTC derivatives that trade in liquid markets, such as generic forwards, swaps and options, model inputs can generally be corroborated by observable market data by correlation or other means, and model selection does not involve significant management judgment.
the model is adjusted so the model value at inception equals the transaction price. We will update valuation inputs in these models only when corroborated by evidence such as similar market transactions, third party pricing services and/or broker or dealer quotations, or other empirical market data. When appropriate, valuations are adjusted for various factors such as liquidity, bid/offer spreads and credit considerations. Such adjustments are generally based on available market evidence. In the absence of such evidence, management's best estimate is used.
We also incorporate our own risk of non-performance in the valuation of the embedded policy derivatives associated with variable annuity and equity-indexed annuity and life contracts. Historically, the expected cash flows were discounted using the interest rate swap curve (swap curve), which is commonly viewed as being consistent with the credit spreads for highly-rated financial institutions (S&P AA-rated or above). A swap curve shows the fixed-rate leg of a non-complex swap against the floating rate (for example, LIBOR) leg of a related tenor. The swap curve was adjusted, as necessary, for anomalies between the swap curve and the U.S. Treasury yield curve.
The valuation of the super senior credit derivatives is complex because of the limited availability of market observable information due to the lack of trading and price transparency in certain structured finance markets. These market conditions have increased the reliance on management estimates and judgments in arriving at an estimate of fair value for financial reporting purposes. Further, disparities in the valuation methodologies employed by market participants and the varying judgments reached by such participants when assessing volatile markets have increased the likelihood that the various parties to these instruments may arrive at significantly different estimates as to their fair values.
Prices for the individual securities held by a CDO are obtained in most cases from the CDO collateral managers, to the extent available. CDO collateral managers provided market prices for 46 percent and 59 percent of the underlying securities used in the valuation at December 31, 2013 and 2012. When a price for an individual security is not provided by a CDO collateral manager, we derive the price through a pricing matrix using prices from CDO collateral managers for similar securities. Matrix pricing is a mathematical technique used principally to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the relationship of the security to other benchmark quoted securities. Substantially all of the CDO collateral managers who provided prices used dealer prices for all or part of the underlying securities, in some cases supplemented by third-party pricing services.
•A risk margin that market participants would require for a market return and the uncertainty inherent in the model inputs. The change in fair value of these policyholder contract deposits is recorded as Policyholder benefits and claims incurred in the Consolidated Statements of Income.
Assets and Liabilities Measured at Fair Value on a Recurring Basis
Our policy is to record transfers of assets and liabilities between Level 1 and Level 2 at their fair values as of the end of each reporting period, consistent with the date of the determination of fair value. Assets are transferred out of Level 1 when they are no longer transacted with sufficient frequency and volume in an active market. Conversely, assets are transferred from Level 2 to Level 1 when transaction volume and frequency are indicative of an active market. During the years ended December 31, 2013 and 2012, we transferred $944 million and $464 million,
respectively, of securities issued by Non-U.S. government entities from Level 1 to Level 2, because they are no longer considered actively traded. For similar reasons, during the years ended December 31, 2013 and 2012, we transferred $356 million and $888 million, respectively, of securities issued by the U.S. government and government-sponsored entities from Level 1 to Level 2. We had no material transfers from Level 2 to Level 1 during the years ended December 31, 2013 and 2012.
* Total Level 3 derivative exposures have been netted in these tables for presentation purposes only.
(a) There were no issuances during year ended December 31, 2013 and 2012.
(b) Includes $7.1 billion of securities purchased through the FRBNY's auction of ML III assets.
•The transfer of investments in RMBS, CMBS and CDO and certain ABS into Level 3 assets were due to decreases in market transparency and liquidity for individual security types.
•Transfers of private placement corporate debt and certain ABS into Level 3 assets were primarily the result of limited market pricing information that required us to determine fair value for these securities based on inputs that are adjusted to better reflect our own assumptions regarding the characteristics of a specific security or associated market liquidity.
•Certain private equity fund investments were transferred into Level 3 due to these investments being carried at fair value and no longer being accounted for using the equity method of accounting. Assets are transferred out of Level 3 when circumstances change such that significant inputs can be corroborated with market observable data. This may be due to a significant increase in market activity for the asset, a specific event, one or more significant input(s) becoming observable or a long-term interest rate significant to a valuation becoming short-term and thus observable. In addition, transfers out of Level 3 assets also occur when investments are no longer carried at fair value as the result of a change in the applicable accounting methodology, given changes in the nature and extent of our ownership interest.
During the years ended December 31, 2013 and 2012, transfers out of Level 3 assets primarily related to certain investments in municipal securities, private placement corporate debt, RMBS, CMBS, CDO/ABS, and investments in hedge funds and private equity funds.
•Transfers of private placement corporate debt and certain ABS out of Level 3 assets were primarily the result of using observable pricing information that reflects the fair value of those securities without the need for adjustment based on our own assumptions regarding the characteristics of a specific security or the current liquidity in the market.
The table below presents information about the significant unobservable inputs used for recurring fair value measurements for certain Level 3 instruments, and includes only those instruments for which information about the inputs is reasonably available to us, such as data from third-party valuation service providers and from internal valuation models. Because input information from third-parties with respect to certain Level 3 instruments (primarily CDO/ABS) may not be reasonably available to us, balances shown below may not equal total amounts reported for such Level 3 assets and liabilities:
We consider unobservable inputs to be those for which market data is not available and that are developed using the best information available to us about the assumptions that market participants would use when pricing the asset or liability. Relevant inputs vary depending on the nature of the instrument being measured at fair value. The following is a general description of sensitivities of significant unobservable inputs along with interrelationships between and among the significant unobservable inputs and their impact on the fair value measurements. The effect of a change in a particular assumption in the sensitivity analysis below is considered independently of changes in any other assumptions. In practice, simultaneous changes in assumptions may not always have a linear effect on the inputs discussed below. Interrelationships may also exist between observable and unobservable inputs. Such relationships have not been included in the discussion below. For each of the individual relationships described below, the inverse relationship would also generally apply.
The significant unobservable inputs used in fair value measurements of RMBS and certain CDO/ABS valued by third-party valuation service providers are constant prepayment rates (CPR), loss severity, constant default rates (CDR), and yield. A change in the assumptions used for the probability of default will generally be accompanied by a corresponding change in the assumption used for the loss severity and an inverse change in the assumption used for prepayment rates. In general, increases in CPR, loss severity, CDR, and yield, in isolation, would result in a decrease in the fair value measurement. Changes in fair value based on variations in assumptions generally cannot be extrapolated because the relationship between the directional change of each input is not usually linear.
The significant unobservable inputs used for certain CDO/ABS securities valued using the BET are recovery rates, diversity score, and the weighted average life of the portfolio. An increase in recovery rates and diversity score will increase the fair value of the portfolio. An increase in the weighted average life will decrease the fair value.
Private equity fund investments included above are not redeemable, as distributions from the funds will be received when underlying investments of the funds are liquidated. Private equity funds are generally expected to have 10-year lives at their inception, but these lives may be extended at the fund manager's discretion, typically in one or two-year
Additionally, beginning in the third quarter of 2012 we elected the fair value option for investments in certain private equity funds, hedge funds and other alternative investments when such investments are eligible for this election. We believe this measurement basis is consistent with the applicable accounting guidance used by the respective investment company funds themselves. Refer to Note 6 herein for additional information.
During 2013, 2012 and 2011, we recognized losses of $54 million, losses of $641 million and gains of $420 million, respectively, attributable to the observable effect of changes in credit spreads on our own liabilities for which the fair value option was elected. We calculate the effect of these credit spread changes using discounted cash flow techniques that incorporate current market interest rates, our observable credit spreads on these liabilities and other factors that mitigate the risk of nonperformance such as cash collateral posted.
FAIR VALUE INFORMATION ABOUT FINANCIAL INSTRUMENTS NOT MEASURED AT FAIR VALUE
rate approximates the rates market participants would use. The fair values of policy loans are generally estimated based on unpaid principal amount as of each reporting date or, in some cases, based on the present value of the loans using a discounted cash flow model. No consideration is given to credit risk because policy loans are effectively collateralized by the cash surrender value of the policies.
•Other invested assets: The majority of Other invested assets that are not measured at fair value represent investments in life settlements. The fair value of investments in life settlements is determined using a discounted cash flow methodology that incorporates best available market assumptions for longevity as well as market yields based on reported transactions. Due to the individual life nature of each investment in life settlements and the illiquidity of the existing market, significant inputs to the fair value are unobservable.
•Cash and short-term investments: The carrying values of these assets approximate fair values because of the relatively short period of time between origination and expected realization, and their limited exposure to credit risk.
•Other liabilities: The majority of Other liabilities that are financial instruments not measured at fair value represent secured financing arrangements, including repurchase agreements. The carrying values of these liabilities approximate fair value, because the financing arrangements are short-term and are secured by cash or other liquid collateral.
Bonds held to maturity are carried at amortized cost when we have the ability and positive intent to hold these securities until maturity. When we do not have the ability or positive intent to hold bonds until maturity, these securities are classified as available for sale or are measured at fair value at our election. None of our fixed maturity securities met the criteria for held to maturity classification at December 31, 2013 or 2012.