The following are significant developments that affected multiple periods and financial statement captions.
We completed the sale of International Lease Finance Corporation (ILFC) on May 14, 2014, and in 2015 we sold all of our ordinary shares of AerCap Holdings N.V. (AerCap) received as part of the consideration for the sale of ILFC, as further discussed in Note 1 to the Consolidated Financial Statements. We also executed multiple asset dispositions in 2016. See Item 7. MD&A - Executive Summary for further discussion.
The following table presents a reconciliation of Book value per common share to Book value per common share, excluding AOCI, Book value per common share, excluding AOCI and DTA (Adjusted book value per common share), and Adjusted book value per common share, including dividend growth, which are non-GAAP measures. See Item 7. MD&A - Use of Non-GAAP Measures for additional information.
* Prior to the third quarter of 2015, dividends per share were $0.125.
The following table presents a reconciliation of Return on equity to Adjusted Return on equity, which is a non-GAAP measure. See Item 7. MD&A - Use of Non-GAAP Measures for additional information.
ITEM 7 | Management’s Discussion and Analysis of Financial Condition and Results of Operations
• exposures to subprime mortgages, monoline insurers, the residential and commercial real estate markets, state and municipal bond issuers, sovereign bond issuers, the energy sector and currency exchange rates;
• restructuring of business operations, including anticipated restructuring charges and annual cost savings;
We are not under any obligation (and expressly disclaim any obligation) to update or alter any projections, goals, assumptions or other statements, whether written or oral, that may be made from time to time, whether as a result of new information, future events or otherwise.
In Item 1. Business, Item 6. Selected Financial Data and throughout this MD&A, we present our financial condition and results of operations in the way we believe will be most meaningful and representative of our business results. Some of the measurements we use are “non-GAAP financial measures” under SEC rules and regulations. GAAP is the acronym for “accounting principles generally accepted in the United States.” The non-GAAP financial measures we present may not be comparable to similarly-named measures reported by other companies.
After-tax operating income attributable to AIG is derived by excluding the tax effected pre-tax operating income (PTOI) adjustments described below and the following tax items from net income attributable to AIG.
We use the following operating performance measures because we believe they enhance the understanding of the underlying profitability of continuing operations and trends of our business segments. We believe they also allow for more meaningful
· Consumer Insurance: Individual Retirement, Group Retirement, and Life Insurance; Other Operations: Institutional Markets
- Premiums and deposits: includes direct and assumed amounts received and earned on traditional life insurance policies, group benefit policies and life-contingent payout annuities, as well as deposits received on universal life, investment-type annuity contracts and mutual funds.
· valuation of future policy benefit liabilities and timing and extent of loss recognition;
· fair value measurements of certain financial assets and liabilities; and
· income tax assets and liabilities, including recoverability of our net deferred tax asset and the predictability of future tax operating profitability of the character necessary to realize the net deferred tax assets.
· the determination of the appropriate groupings of similar product lines and, in some cases, the groupings of dissimilar losses within a product line.
Our loss reserves can generally be categorized into two distinct groups. Short-tail reserves consists principally of U.S. and Europe Property and Special Risks, and U.S., Europe and Japan Personal Insurance. Long-tail reserves include U.S. Workers’ Compensation, U.S. Excess Casualty, U.S. Other Casualty, U.S. Financial Lines, Europe Casualty and Financial Lines, and U.S. Run-off Long Tail Insurance Lines.
For our short-tail coverages, such as property, where the nature of claims is generally high frequency but with short reporting periods, with volatility arising from occasional severe events, the process for recording non-catastrophe quarterly loss reserves is geared toward maintaining IBNR based on percentages of net earned premiums for that business, rather than projecting ultimate loss ratios based on reported losses. For example, the IBNR reserve required for the latest accident quarter for a product line of property business such as Personal Lines automobile might be approximately 20 percent of the quarter’s earned premiums. This level of reserve would generally be recorded regardless of the actual losses reported in the current quarter, thus allowing the recognition of severe events as they occur. The percent of premium factor reflects both our expectation of the ultimate loss costs associated with the line of business and the expectation of the percentage of ultimate loss costs that have not yet been reported. The expected ultimate loss costs generally reflect the average loss costs from a period of preceding accident quarters that have been adjusted for changes in rate and loss cost levels, mix of business, known exposure to unreported losses, or other factors affecting the particular line of business. The expected percentage of ultimate loss costs that have not yet been reported would be derived from historical loss emergence patterns. For more mature quarters, loss development methods would be used to determine the IBNR. For other product lines where the nature of claims is high frequency but low severity, methods including loss development, frequency/severity or a multiple of average monthly losses may be used to determine IBNR reserves. IBNR for claims arising from catastrophic events or events of unusual severity would be determined in close collaboration with the claims department’s knowledge of known information, using alternative techniques or expected percentages of ultimate loss cost emergence based on historical loss emergence of similar claim types.
Estimation of ultimate net losses and loss adjustment expenses (net losses) for our long-tail casualty lines of business is a complex process and depends on a number of factors, including the product line and volume of business, as well as estimates of the reinsurance recoverable. Experience in the more recent accident years generally provides limited statistical credibility of reported net losses on long-tail casualty lines of business. That is because in the more recent accident years, a relatively low proportion of estimated ultimate net incurred losses are reported or paid. Therefore, IBNR reserves constitute a relatively high proportion of net losses.
The process of determining the current loss ratio for each product line of business is based on a variety of factors. These include considerations such as: prior accident year and policy year loss ratios; rate changes; and changes in coverage, reinsurance, or mix of business. Other considerations include actual and anticipated changes in external factors such as trends in loss costs, real gross domestic product (GDP) growth, inflation, employment rates or unemployment duration, stock market volatility, corporate bond spreads, or in the legal and claims environment. The current loss ratio for each product line of business is intended to represent our best estimate after reflecting all of the relevant factors. At the close of each quarter, the assumptions and data underlying the loss ratios are reviewed to determine whether the loss ratios remain appropriate. This process includes a review of the actual loss experience in the quarter, actual rate changes achieved, actual changes in reinsurance, quantifiable changes in coverage or mix of business, and changes in other factors that may affect the loss ratio. When this review suggests that the previously determined loss ratio is no longer appropriate, the loss ratio is changed to reflect the revised estimates.
We develop explicit ranges of reasonable estimates around the actuarial best estimate for certain product lines using multiple methodologies and varying assumptions. Where we have ranges, we use them to inform our selection of best estimates of loss reserves by major product line of business. Our range of reasonable estimates is not intended to cover all possibilities or extreme values and is based on known data and facts at the time of estimation.
A critical component of our detailed valuation reviews is a peer review of our reserving analyses and conclusions, where actuaries independent of the initial review evaluate the reasonableness of assumptions used, methods selected and weightings given to different methods. In addition, each detailed valuation review is subjected to a review and challenge process by specialists in our Enterprise Risk Management group.
· changes in the legal, regulatory, judicial and social environment including changes in road safety, public health and cleanup standards;
· changes in claims handling philosophy, operating model, processes and related ongoing enhancements;
· third-party actuarial reviews that are periodically performed for key product lines of business;
Our actuaries determine the most appropriate actuarial methods and segmentation. This determination is based on a variety of factors including the nature of the losses associated with the product line of business, such as the frequency or severity of the claims. In addition to determining the actuarial methods, the actuaries determine the appropriate loss reserve groupings of data. This determination is a judgmental, dynamic process and refinements to the groupings are made every year. The changes to groupings may be driven by and may change to reflect observed or emerging patterns within and across product lines, or to differentiate different risk characteristics (for example, size of deductibles and extent of third party claims specialists used by our insureds). As an example of reserve segmentation, we write many unique subsets of professional liability. For pricing or other purposes, it is appropriate to evaluate the profitability of each subset individually. However, for purposes of estimating the liability for loss reserves and loss adjustment expenses for many product lines of business, we believe it is appropriate to combine the subsets into larger groups to produce a greater degree of credibility in the loss experience. This determination of data segmentation and related actuarial methods is assessed, reviewed and updated at least annually.
The actuarial methods we use most commonly include paid and incurred loss development methods, expected loss ratio methods, including “Bornhuetter Ferguson” and “Cape Cod”, and frequency/severity models. Loss development methods utilize the actual loss development patterns from prior accident years updated through the current year to project the reported losses to an ultimate basis for all accident years. We also use this information to update our current accident year loss selections. Loss development methods are generally most appropriate for classes of business that exhibit a stable pattern of loss development from one accident year to the next, and for which the components of the product line have similar development characteristics. For example, property exposures would generally not be combined into the same product line as casualty exposures, and primary casualty exposures would generally not be combined into the same product line as excess casualty exposures. We continually refine our loss reserving techniques for the domestic primary casualty product line of business and adopt further segmentations based on our analysis of differing emerging loss patterns for certain product lines. We generally use expected loss ratio methods in cases where the reported loss data lacked sufficient credibility to utilize loss development methods, such as for new product lines of business or for long-tail product lines 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 product line of business to determine the liability for loss reserves and loss adjustment expenses. For example, an expected loss ratio of 70 percent applied to an earned premium base of $10 million for a product line of business would generate an ultimate loss estimate of $7 million. Subtracting any paid losses and loss adjustment expenses would result in the indicated loss reserve for this product line. Under the Bornhuetter Ferguson methods, the expected loss ratio is applied only to the expected unreported portion of the losses. For example, for a long-tail product line of business for which only 10 percent of the losses are expected to be reported at the end of the accident year, the expected loss ratio would be used to represent the 90 percent of losses still unreported. The actual reported losses at the end of the accident year would be added to determine the total ultimate loss estimate for the accident year. Subtracting the reported paid losses and loss adjustment expenses would result in the indicated loss reserve. In the example above, the expected loss ratio of 70 percent would be multiplied by 90 percent. The result of 63 percent would be applied to the earned premium of $10 million resulting in an estimated unreported loss of $6.3 million. Actual reported losses would be added to arrive at the total ultimate losses. If the reported losses were $1 million, the ultimate loss estimate under the Bornhuetter Ferguson method would be $7.3 million versus the $7 million amount under the expected loss ratio method described above. Thus, the Bornhuetter Ferguson method gives partial credibility to the actual loss experience to date for the product line of business. Loss development methods generally give full credibility to the reported
loss experience to date. In the example above, loss development methods would typically indicate an ultimate loss estimate of $10 million, as the reported losses of $1 million would be estimated to reflect only 10 percent of the ultimate losses.
The majority of our exposures for asbestos and environmental losses are related to excess casualty coverages, not primary coverages. The litigation costs are treated in the same manner as indemnity amounts, with litigation expenses included within the limits of the liability we incur. Individual significant loss reserves, where future litigation costs are reasonably determinable, are established on a case-by-case basis.
We generally use a combination of loss development methods and expected loss ratio methods for U.S. Workers’ Compensation. U.S. Workers’ Compensation is a long-tail class of business, and our business reflects a very significant volume of losses, particularly in more recent accident years.
The loss cost trend assumption is not believed to be material with respect to our loss reserves. This is primarily because our actuaries are generally able to use loss development projections for all but the most recent accident year’s reserves, so there is limited need to rely on loss cost trend assumptions for primary workers’ compensation business.
After evaluating the historical loss development factors from prior accident years since the early 1990s, in our judgment, it is reasonably likely that the actual loss development factors could vary by an amount equivalent to a six month shift from those actually utilized in the year-end 2016 reserve review. This would impact projections both for accident years where the selections were directly based on loss development methods as well as the a priori loss ratio assumptions for accident years with selections based on Bornhuetter-Ferguson or Cape Cod methods. Similar to loss cost trends, these changes in loss development factors could be attributable to changes in inflation or in the judicial environment, or in other social or economic conditions affecting losses.
The key uncertainties for other casualty lines are similar to excess casualty, as the underlying business is long-tailed and can be subject to variability in loss cost trends and changes in loss development factors. These may differ significantly by line of business as coverages such as general liability, medical malpractice and environmental may be subject to different risk drivers.
The assumed loss development factors are also an important assumption, but are less critical than for U.S. Excess Casualty. Because these classes are written on a claims made basis, the loss reporting and development tail is much shorter than for U.S. Excess Casualty. However, the high severity nature of the losses does create the potential for significant deviations in loss development patterns from one year to the next. Similar to Excess Casualty, after evaluating the historical loss development factors from prior accident years since the early 1990s, in our judgment, it is reasonably likely that actual loss development factors could change by an amount equivalent to a shift by six months from those actually utilized in the year-end 2016 reserve review.
Similar to U.S. business, European Casualty and Financial Lines can be significantly impacted by loss cost trends and changes in loss development factors. The variation in such factors can differ significantly by product and region.
The bulk of adjuster expenses are allocated and charged to individual claim files. For these expenses, we generally determine reserves based on calendar year ratios of adjuster expenses paid to losses paid for the particular product line of business. For other internal claim costs, which generally relate to specific claim department expenses that are not specifically allocated to claim files such as technology costs and other broad initiatives, we look at historic and expected expenditures for these items and project these into the future.
The incidence of LAE are directly related to the frequency, complexity and level of underlying claims. As a result, key drivers of variability in LAE is the variability in the overall claims, particularly for long tail lines.
Future Policy Benefits for Life and Accident and Health Insurance Contracts
• Interest rates, which vary by year of issuance and products
In applying asset growth assumptions for the valuation of the GMDB liability, we use a reversion to the mean methodology, similar to that applied for DAC. For a description of this methodology, see Estimated Gross Profits for Investment-Oriented Products (Life Insurance Companies) below.
GMWB living benefits are embedded derivatives that are required to be bifurcated from the host contract and carried at fair value. See Note 14 to the Consolidated Financial Statements for additional information on how we reserve for variable annuity products with guaranteed benefit features, and Note 5 to the Consolidated Financial Statements for information on fair value measurement of these embedded derivatives, including how we incorporate our own non-performance risk.
below the long-term annual rate assumption impacts the growth assumption applied to the five-year period subsequent to the current balance sheet date. The reversion to the mean methodology allows us to maintain our long-term growth assumptions, while also giving consideration to the effect of actual investment performance. When actual performance significantly deviates from the annual long-term growth assumption, as evidenced by growth assumptions 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. See Insurance Reserves - Life and Annuity Reserves and DAC - Reversion to the Mean for additional discussion.
(c) Represents the net impact of 10 basis point parallel shift in the yield curve on the reserves for GMWB living benefit features. Does not represent interest rate spread compression on investment-oriented products.
The analysis of DAC, embedded derivatives and other reserves related to guaranteed benefits, and unearned revenue reserve 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. The effects on pre-tax income in the sensitivity analysis table above do not reflect the related effects from our economic hedging program, which utilizes derivative and other financial instruments and is designed so that changes in value of those instruments move in the opposite direction of changes in the guaranteed benefit embedded derivative liabilities. For a further discussion on guaranteed benefit features of our variable annuities and the related hedging program, see Enterprise Risk Management - Life Insurance Companies Key Insurance Risks - Variable
Annuity Risk Management and Hedging Program, Insurance Reserves - Life and Annuity Reserves and DAC - Variable Annuity Guaranteed Benefits and Hedging Results, and Notes 5 and 14 to the Consolidated Financial Statements.
Impairments to investments in life settlements may occur in the future due to the fact that continued payment of premiums required to maintain policies will cause the expected lifetime undiscounted cash flows for some policies to be insufficient to recover our estimated future carrying amount, even in the absence of future changes to the mortality assumptions. Impairments may also occur due to our future sale or lapse of select policies at a value that is below carrying amount.
For a discussion of impairments on investments in life settlements, see Note 6 to the Consolidated Financial Statements.
For a discussion of goodwill impairment, see Note 12 to the Consolidated Financial Statements. In 2016, 2015 and 2014, AIG elected to bypass the qualitative assessment of whether goodwill impairment may exist and, therefore, performed quantitative assessments that supported a conclusion that the fair value of all of the reporting units tested exceeded their book value. To determine fair value, we primarily use a discounted expected future cash flow analysis that estimates and discounts projected future distributable earnings. Such analysis is principally based on AIG’s business projections that inherently include judgments regarding business trends.
such matters, particularly in cases that are in the early stages of litigation or in which claimants seek substantial or indeterminate damages, we often cannot predict the outcome or estimate the eventual loss or range of reasonably possible losses related to such matters. Given the inherent unpredictability of litigation, the outcome of certain matters could, from time to time, have a material adverse effect on the company’s consolidated financial condition, results of operations or cash flows.
The following table presents the fair value of fixed maturity and equity securities by source of value determination:
(a) Includes $17.3 billion for which the primary source is broker quotes.
See Note 5 to the Consolidated Financial Statements for discussion of the valuation methodologies for assets and liabilities measured at fair value, as well as a discussion of transfers of Level 3 assets and liabilities.
See Note 23 to the Consolidated Financial Statements for a discussion of our framework for assessing the recoverability of our deferred tax asset.
This overview of the MD&A highlights selected information and may not contain all of the information that is important to current or potential investors in our securities. You should read this Annual Report in its entirety for a more detailed description of events, trends, uncertainties, risks and critical accounting estimates affecting us.
In the fourth quarter of 2016, we completed the reorganization of our financial results into our new modular management framework. We believe our new modular management framework gives our shareholders greater transparency into our operating businesses, makes our leaders more accountable for their performance, and will increase efficiency so we can focus on profitability. See Item 1. Business for a further discussion on these actions.
• In May 2016, we completed the sale of AIG Advisor Group to investment funds affiliated with Lightyear Capital LLC and PSP Investments.
• In August 2016, we sold our controlling interest in NSM, a managing general agent, to ABRY Partners for consideration of $201 million. We retained an equity interest in a newly formed joint venture and we continue to provide underwriting capacity to NSM.
• On November 17, 2016, an AIG sponsored Fund (the Korea Fund), completed the sale of a mixed-use commercial complex in Seoul, South Korea commonly known as the Seoul International Finance Center to Brookfield Properties for a total consideration of $2.5 billion, of which $1.2 billion was used to repay the fund’s debt. The remaining cash proceeds were allocated between AIG and the noncontrolling interests in accordance with the Korea Fund’s partnership agreement.
• On December 30, 2016, we sold a portion of our life settlements portfolio with face value (death benefits) of approximately $4.5 billion, which was 30 percent of the face value of the life settlements portfolio. As of December 31, 2016, our life settlements portfolio carrying value was $2.5 billion, with a face value (death benefits) of $9.8 billion.
• In October 2016, we entered into an agreement with Fairfax Financial Holdings Limited (Fairfax), as part of a strategic partnership that we believe will further focus and streamline our global insurance operations. We agreed to sell to Fairfax our country subsidiary operations in Argentina, Chile, Colombia, Uruguay, Venezuela, as well as insurance operations in Turkey. Fairfax will also acquire renewal rights for the portfolios of local business written by our operations in Bulgaria, Czech Republic, Hungary, Poland, Romania, and Slovakia, and assume certain of our operating assets and employees. Total cash consideration to us is expected to be approximately $240 million. The transactions are subject to obtaining the relevant regulatory approvals and other customary closing conditions.
• Effective January 1, 2016, we entered into a two-year reinsurance arrangement with the Swiss Reinsurance Company Ltd., under which we ceded a proportional share of our new and renewal U.S. Casualty portfolio.
• Effective December 31, 2016, our domestic life insurance subsidiary amended the July 1, 2016 reinsurance agreement discussed above to also cede certain statutory reserves for term and universal life products that are above economic requirements, which were previously managed through affiliated reinsurance. This transaction is expected to result in a tax sharing payment by the Life Insurance Companies to AIG Parent in 2017.
• In January 2017, we announced that we have entered into an adverse development reinsurance agreement with National Indemnity Company (NICO), a subsidiary of Berkshire Hathaway Inc., under which we transferred to NICO 80 percent of reserve risk on substantially all of our U.S. Commercial long-tail exposures for accident years 2015 and prior. Under this agreement, we ceded to NICO 80 percent of net paid losses on subject business on or after January 1, 2016 in excess of $25 billion of net paid losses, up to an aggregate limit of $25 billion. At NICO’s 80 percent share, NICO’s limit of liability under the contract is $20 billion. We will account for this transaction as retroactive reinsurance. The consideration for this agreement is $9.8 billion plus interest at four percent per annum from January 1, 2016 to the date of payment, which was paid in full as of February 17, 2017. The consideration paid to NICO will be placed into a collateral trust account as security for NICO’s claim payment obligations, and Berkshire Hathaway, Inc. has provided a parental guarantee to secure NICO’s obligations under the agreement.
Declined primarily due to a decrease in income from insurance operations, reflecting $5.6 billion of pre-tax prior year adverse reserve development in Commercial Insurance in 2016 compared to $3.3 billion pre-tax in 2015. In addition, we recorded net realized capital losses in 2016 compared to net realized capital gains in 2015. These decreases were partially offset by improved performance from Consumer Insurance.
Declined primarily due to a decrease in income from insurance operations, reflecting $3.3 billion of pre-tax prior year adverse development in Commercial Insurance in 2015 compared to $503 million pre-tax in 2014, and lower net investment income.
• favorable adjustments to reserves and DAC in Consumer Insurance, including higher net positive adjustments from the update of actuarial assumptions in Individual Retirement and Life Insurance;
Declined $2.1 billion since 2014, which included a foreign exchange benefit of $0.5 billion, due to lower employee-related expenses, rationalized employee benefits and professional fee reductions related to our ongoing efficiency program.
* Non-GAAP measure - see Consolidated Results of Operations for reconciliation of Non-GAAP to GAAP measure.
We have returned $30.4 billion in capital to our shareholders through dividends and share and warrant repurchases since the beginning of 2014 as a result of our strategy to actively return capital to shareholders.
Interest rates increased late in 2016, but have remained at historically low levels. Certain markets in which we operate have experienced negative interest rates. A sustained low interest rate environment negatively affects sales of interest rate sensitive products in our industry and may negatively impact the profitability of our existing business as we reinvest cash flows from investments, including increased calls and prepayments of fixed maturity securities and mortgage loans, at rates below the average yield of our existing portfolios. We actively manage our exposure to the interest rate environment through asset-liability management including spread management strategies for our investment-oriented products and economic hedging of interest rate risk from guarantee features in our variable and fixed index annuities.
The sustained low interest rate environment has a significant impact on the annuity industry. Low long-term interest rates put pressure on investment returns, which may negatively affect sales of interest rate sensitive products and reduce future profits on certain existing fixed rate products. However, our disciplined rate setting has helped to mitigate some of the pressure on investment spreads. As long as the low interest rate environment continues, conditions will be challenging for the fixed annuity market. Rapidly rising interest rates could create the potential for increased sales, but may also drive higher surrenders. Customers are, however, currently buying fixed annuities with longer surrender periods in pursuit of higher returns, which may help mitigate the rate of increase in surrenders in a rapidly rising rate environment. In addition, older contracts that have higher minimum interest rates and continue to be attractive to the contract holders are driving better than expected persistency, although the reserves for such contracts have continued to decrease over time in amount and as a percentage of the total annuity portfolio. Low interest rates have also driven growth in our fixed index annuity products, which provide additional interest crediting tied to favorable performance in certain equity market indices and the availability of guaranteed living benefits. Changes in interest rates significantly impact the valuation of our liabilities for guaranteed products with income features and the value of the related hedging portfolio.
We actively monitor fixed income markets, including the level of interest rates, credit spreads and the shape of the yield curve. We also frequently review our interest rate assumptions and actively manage the crediting rates used for new and in-force business. Business strategies continue to evolve to maintain profitability of the overall business in a historically low interest rate environment. The low interest rate environment makes it more difficult to profitably price many of our products and puts margin pressure on existing products, due to the challenge of investing recurring premiums and deposits and reinvesting investment portfolio cash flows in the low rate environment while maintaining satisfactory investment quality and liquidity. In addition, there is investment risk associated with future premium receipts from certain in-force business. Specifically, the investment of these future premium receipts may be at a yield below that required to meet future policy liabilities.
The following table presents Fixed Annuities and Group Retirement base net investment spread:
In Fixed Annuities and Group Retirement, average interest crediting rates decreased slightly in 2016 and 2015 compared to the preceding years due to active crediting rate management. However, the decline in base investment yields, driven by investment purchases and investment of portfolio cash flows at rates below the weighted average yield of the existing portfolio in the sustained low interest rate environment, resulted in base spread compression. See Investments for additional information on our investment and asset-liability management strategies.
The following table presents fixed annuity and universal life account values of our Core Individual Retirement, Group Retirement and Life Insurance businesses by contractual minimum guaranteed interest rate and current crediting rates:
Spreads and surrender rates are important components of the future profit assumptions that drive the rate we use to amortize DAC and related reserves for investment-oriented products. If future profit assumptions change significantly, we may be required to recalculate DAC and related reserves, and reflect any resulting adjustments in current period income. In addition to investment-oriented products, certain traditional long-duration products for which we do not have the ability to adjust interest rates, such as structured settlements and payout annuities, are exposed to reduced earnings and potential loss recognition reserve increases in a sustained low interest rate environment. See Insurance Reserves - Life and Annuity Reserves and DAC - Update of Actuarial Assumptions for discussion of such adjustments recorded in 2016, 2015 and 2014 in our Consumer Insurance and Legacy Life Insurance Run-Off Lines.
not be able to adjust our future pricing consistent with our profitability objectives to fully offset the impact of investing at lower rates. However, we will continue to maintain pricing discipline and risk selection.
Our Individual Retirement and Group Retirement operating segments provide products and services to certain employee benefit plans that are subject to restrictions imposed by ERISA and the Internal Revenue Code, including the requirements of the DOL Fiduciary Rule. For additional information about the DOL Fiduciary Rule, see Part I, Item 1. Business - Regulation. We have been analyzing the DOL Fiduciary Rule’s potential impact on our customers, distribution partners, financial advisors and our Individual Retirement and Group Retirement businesses, and preparing to implement the necessary adjustments to achieve compliance with the DOL Fiduciary Rule. Overall, the DOL Fiduciary Rule as currently promulgated would result in increased compliance costs and, as currently promulgated, may create increased exposure to legal claims under certain circumstances, including class actions. The DOL has also issued interpretive guidance on the DOL Fiduciary Rule, and we are evaluating whether or not this guidance would affect the actions we would need to take to comply with the DOL Fiduciary Rule.
Currency volatility in 2016 and 2015 was acute compared to recent years, as the British pound weakened considerably against the U.S. dollar in 2016, although the Japanese yen strengthened against the U.S. dollar. The euro also weakened modestly against the U.S. dollar. Such volatility affected line item components of income for those businesses with substantial international operations. In particular, growth trends in net premiums written reported in U.S. dollars can differ significantly from those measured in original currencies. The net effect on underwriting results, however, is significantly mitigated, as both revenues and expenses are similarly affected.
The following section provides a comparative discussion of our Consolidated Results of Operations for the three-year period ended December 31, 2016. Factors that relate primarily to a specific business are discussed in more detail within the business segment operations section. For a discussion of the Critical Accounting Estimates that affect our results of operations, see the Critical Accounting Estimates section of this MD&A.
The following table presents a reconciliation of pre-tax income/net income (loss) attributable to AIG to pre-tax operating income/after-tax operating income attributable to AIG:
- foreign exchange losses in 2016 compared to foreign exchange gains in 2015 primarily due to $910 million of remeasurement losses for a short-term intercompany balance;
- a net decrease of $1.4 billion related to guaranteed living benefits, net of hedges, primarily due to movement in the non-performance or “own credit” risk adjustment (NPA) component of the embedded derivative fair value measurement and 2016 actuarial assumption updates to surrender and mortality assumptions (see Insurance Reserves - Life and Annuity Reserves and DAC - Variable Annuity Guaranteed Benefits and Hedging Results).
· favorable adjustments to reserves and DAC in Consumer Insurance, including higher net positive adjustments in 2016 to reflect the update of actuarial assumptions in Individual Retirement and Life Insurance;
• lower loss on extinguishment of debt from ongoing liability management activities; and
Pre-tax income decreased in 2015 compared to 2014 primarily due to:
· less favorable adjustments to reserves and DAC in Consumer Insurance, including a lower net positive adjustment to reflect the update of actuarial assumptions in Individual Retirement and additional reserves for Life Insurance, as well as higher catastrophe losses and lower net favorable prior year loss reserve development in Personal Insurance;
• lower Other income primarily due to lower appreciation on assets for which the fair value option was elected and lower fair value income on derivative positions; and
• higher net realized gains compared to prior period due to:
- a $264 million increase from the change in the fair value of GMWB embedded derivatives related to variable annuity guaranteed living benefits, net of all related economic hedges (See Insurance Reserves -Life and Annuity Reserves and DAC - Variable Annuity Guaranteed Benefits and Hedging Results for additional discussion); and
- $216 million of tax and related interest associated with increases in uncertain tax positions related to cross border financing transactions,
- $83 million related to increases in the deferred tax asset valuation allowances associated with U.S. federal and certain foreign jurisdictions;
Effect of foreign operations is primarily related to foreign exchange losses incurred by our foreign subsidiaries related to the weakening of the British pound following the Brexit vote taxed at a statutory tax rate lower than 35 percent.
For the year ended December 31, 2016, our repatriation assumptions with respect to certain European operations remain unchanged and related foreign earnings continue to be indefinitely reinvested. Our repatriation assumptions related to certain operations in Canada, South Africa and Asia Pacific region have changed and related foreign earnings are now considered to be indefinitely reinvested. These earnings relate to ongoing operations and have been reinvested in active non-U.S. business operations. Further, we do not intend to repatriate these earnings to fund U.S. operations. As a result, U.S. deferred taxes have not been provided on $2 billion of accumulated earnings, including accumulated other comprehensive income, of these non-U.S. affiliates. Potential U.S. income tax liabilities related to such earnings would be offset, in whole or in part, by allowable foreign tax credits resulting from foreign taxes paid to foreign jurisdictions in which such operations are located. As a result, we currently believe that any incremental U.S. income tax liabilities relating to indefinitely reinvested foreign earnings would not be significant. Deferred taxes have been provided on earnings of non-U.S. affiliates whose earnings are not indefinitely reinvested. See Note 23 to the Consolidated Financial Statements for additional information.
Our business operations consist of Commercial Insurance, Consumer Insurance, Other Operations, and a Legacy Portfolio.
Commercial Insurance consists of two modules: Liability and Financial Lines and Property and Special Risks. Consumer Insurance consists of four modules: Group Retirement, Individual Retirement, Life Insurance and Personal Insurance. Other Operations consists of businesses and items not allocated to our other businesses, which are primarily AIG Parent, Institutional Markets, United Guaranty and Fuji Life. Our Legacy Portfolio consists of our Legacy Property and Casualty Run-Off Insurance Lines, Legacy Life Insurance Run-Off Lines and Legacy Investments.
See Note 3 to the Consolidated Financial Statements for further information on our segment changes.
The following table summarizes our business segment operations. See also Note 3 to the Consolidated Financial Statements.
Liability: Products include general liability, environmental, commercial automobile liability, workers’ compensation, excess casualty and crisis management insurance products. Casualty also includes risk- sharing and other customized structured programs for large corporate and multinational customers.
Special Risks: Products include aerospace, political risk, trade credit, portfolio solutions, surety and marine insurance.
Commercial Insurance products are primarily distributed through a network of independent retail and wholesale brokers.
Customer: We provide commercial insurance solutions to the full spectrum of enterprises - from large, multinational, and mid-sized companies to small businesses, entrepreneurs, and non-profit organizations across the globe. We expect that investments in underwriting, claims services, client risk services, science and data will continue to differentiate us from our peers and drive a superior client experience.
Sharpen Commercial Focus: Create a leaner, more focused, and more profitable Commercial Insurance organization. Deliver a more competitive return on equity across our businesses primarily through improvements in our loss ratio. Optimize our business portfolio through risk selection by using enhanced data, analytics and the application of science to deliver superior risk-adjusted returns. Exit or remediate targeted sub-segments of underperforming portfolios or non-core businesses that do not meet our risk acceptance or profitability objectives. Maintain and grow profitable accounts and deliver a better client experience.
Operating in a highly competitive industry, Commercial Insurance competes against several hundred companies, specialty insurance organizations, mutual companies and other underwriting organizations in the U.S. In international markets, we compete for business with the foreign insurance operations of large global insurance groups and local companies in specific market areas and product types. Insurance companies compete through a combination of risk acceptance criteria, product pricing, service and terms and conditions. Commercial Insurance seeks to distinguish itself in the insurance industry primarily based on its well-established brand, global franchise, multinational capabilities, financial and capital strength, innovative products, claims expertise to handle complex claims, expertise in providing specialized coverages and customer service.
Below is a discussion of the industry and economic factors impacting our specific business:
Liability and Financial Lines has large international exposure within the total Commercial Insurance portfolio and will therefore remain sensitive to volatility in foreign currencies.
(b) Consistent with our definition of Pre-tax operating income, excludes loss reserve discount.
The following table presents Commercial Insurance net premiums written by module, showing change on both reported and constant dollar basis:
The following tables present Commercial accident year catastrophes and severe losses by geography(a) and number of events:
(b) Natural catastrophe losses are generally weather or seismic events having a net impact on AIG in excess of $10 million each. Catastrophes also include certain man-made events, such as terrorism and civil disorders that meet the $10 million threshold.
The net premiums written decrease in 2016 was driven by the Swiss Re quota share treaty, portfolio optimization and execution on our pricing strategy, partially offset by growth in targeted lines of business. The increase in net losses was driven by net adverse prior year reserve development. The acquisition expense decrease was primarily related to the 2016 Swiss Re quota share treaty. The general operating expense decrease was driven by lower employee-related expenses and other expense savings initiatives. Lower net investment income was driven primarily by lower alternative investment returns due to weaker performance in equity markets compared to prior years.
We continue to reduce the relative size of our U.S. casualty portfolio within Liability and Financial Lines and consequently expect that net premiums written will continue to decline through 2017, in large part driven by the impact of our continued strategy on risk selection, disciplined underwriting and execution of our reinsurance strategy to further reduce risk.
• lower net investment income due to lower income on alternative investments and lower interest and dividends.
• higher net adverse prior year loss reserve development (increase by $2.9 billion); and
• the effect of the reinsurance arrangement with the Swiss Re Group;
• continued execution of our strategy to enhance risk selection and optimize our product portfolio, including non-renewals, and revising rates, terms and conditions in certain underperforming products, particularly U.S. casualty;
These decreases were partially offset by growth in certain targeted lines of business.
• reserve strengthening mainly in U.S. Workers’ compensation U.S. Other casualty and Financial lines; and
Our sale of the Ascot business at the end of 2016 will also lead to a decline in net premiums written in 2017.
• favorable impact of $87 million from the 50 percent quota share reinsurance agreement with UGC which became effective in the first quarter of 2015; and
• lower net investment income due to lower income on alternative investments as well as lower income on investments accounted for under the fair value option;
• slightly higher general operating expenses due to the NSM acquisition, which was consolidated commencing in the second quarter of 2015;
• lower new and renewal business reflecting the continued adherence to our underwriting discipline in the current competitive environment; and
• the favorable impact of $392 million from the 50 percent quota share reinsurance agreement with UGC which became effective in the first quarter of 2015
• higher accident year loss ratio, as adjusted, driven by higher attritional loss ratio in the U.S. Programs business;
• higher general operating expense ratio due to timing of premium reduction, which more than offset expense reduction; and
• decrease in the loss ratio partially offset by an increase in the acquisition ratio.
• lower attritional loss ratio in Special Risks which reflected the effect of the 50 percent quota share reinsurance agreement with UGC; and
• partially offset by an increase of 1.3 points in severe losses.
Individual: Products include personal auto and property in Japan and other selected international markets and insurance for high net worth individuals offered through AIG Private Client Group, including auto, homeowners, umbrella, yacht, fine art and collections insurance with a focus on the U.S. and multi-national coverage offerings. Products are distributed through various channels, including agents and brokers.
Customer: Strive to be our clients’ most valued insurer through our unique franchise, which brings together a broad portfolio of retirement, life insurance and personal insurance products offered through multiple distribution networks. Consumer Insurance focuses on ease of doing business, offering valuable solutions, and expanding and deepening its distribution relationships across multiple channels.
Operational Effectiveness: Simplify processes and enhance operating environments to increase competitiveness, improve service and product capabilities and facilitate delivery of our target customer experience. We continue to invest in technology to improve operating efficiency and ease of doing business for our distribution partners and customers. In the U.S. Life business, we are focused on leveraging our most efficient systems and increasing automation of our underwriting process. We believe that simplifying our operating models will enhance productivity and support further profitable growth.
Balance Sheet Management: Lead a rigorous product and portfolio approach with enhanced product design and high quality investments that match our asset and liability exposures and are designed to ensure our ability to meet cash and liquidity needs under all operating scenarios.
Consumer Insurance remains competitive due to its long-standing market leading positions, innovative products, distribution relationships across multiple channels, customer-focused service, multi-national capabilities and strong financial ratings.
Below is a discussion of the industry and economic factors impacting our specific modules:
Changes in the interest rate environment have a significant impact on sales, surrender rates, investment returns, guaranteed income features, and spreads in the annuity industry. See AIG’s Outlook -Industry and Economic Factors - Changes in the Interest Rate Environment for additional discussion of the impact of market interest rate movement on our Group Retirement business.
Group Retirement provides products and services to certain employee benefit plans that are subject to the requirements of the DOL Fiduciary Rule. For additional information on the DOL Fiduciary Rule, including the recent decision by the new administration to request a further review of the DOL Fiduciary Rule, see Part I, Item 1. Business - Regulation.
Consumers have increased needs for financial protection for beneficiaries, estate planning and wealth creation. Life Insurance addresses the need for protection against the risk of premature death through a broad spectrum of products that include both term and permanent life insurance. In addition, Life Insurance offers products and benefits that offset other risks such as chronic and critical illness.
In response to a sustained low interest rate environment, Life Insurance has been actively re-pricing products and shifting its focus away from products with long-duration interest rate guarantees by introducing new products with shorter guarantees as well as indexed universal life products. See AIG’s Outlook -Industry and Economic Factors - Changes in the Interest Rate Environment for additional discussion of the impact of market interest rate movement on our Life Insurance business.
In Japan, the competition for auto insurance has intensified, in part driven by a decline in new car sales and the existence of fewer but larger insurers. In addition, the overall market size in homeowners insurance contracted after the duration restriction on long-term fire insurance became effective in October 2015. In the U.S., we compete in the high net worth market and will continue to expand our innovative products and services to distribution partners and clients. Outside of Japan and the U.S., our Personal Insurance module continues to invest selectively in markets, which we believe have higher potential for sustainable profitability.
Our insurance companies generate significant revenues from investment activities. As a result, the modules in Consumer Insurance are subject to variances in net investment income on the asset portfolios that support insurance liabilities and surplus. See Investments for additional information on our investment strategy, asset-liability management process and invested asset composition.
• better equity market performance which contributed to a decrease in policyholder benefit expense and DAC amortization. This was partially offset by higher DAC amortization, excluding the impact of actuarial assumption updates and equity market performance, which reflected a higher rate of amortization in Fixed Annuities and growth in Index Annuities;
• lower general operating expenses due to decreases in employee-related expenses.
Individual Retirement GAAP Premiums, Premiums and Deposits, Surrenders and Net Flows
For Individual Retirement, premiums primarily represent amounts received on life-contingent payout annuities. Premiums increased in 2016 compared to 2015, primarily due to higher rates in the first half of 2016. Premiums decreased in 2015 compared to 2014, primarily due to lower market interest rates through October 2015.
The following table presents a reconciliation of Individual Retirement premiums and deposits to GAAP premiums:
The following table presents surrenders as a percentage of average reserves:
• Variable and Index Annuities net flows in 2016 were significantly lower due to a decrease in premiums and deposits, primarily due to lower sales of variable annuities, which reflected a strategic decision to scale back living benefits during the period of very low interest rates, as well as an industry-wide slowdown and uncertainty around the effect of the new DOL Fiduciary Rule.
• Retail Mutual Funds net flows increased in 2016 due to improvement in the level of deposits, which was partially offset by higher surrenders, both driven by activity within the Focused Dividend Strategy Portfolio fund.
• Variable and Index Annuities premiums and deposits and net flows reflected lower Variable Annuities sales in 2015, due to market uncertainty around the DOL Fiduciary Rule and equity market volatility, partially offset by an increase in Index Annuity sales.
Group Retirement showed significant improvement in net flows in 2016 compared to 2015 and 2014, due to lower surrenders as well as record sales, resulting in part from its investment in talent, group plan administration record-keeping capabilities and digital functionality. Pressure on investment spread from reinvestment in the low interest rate environment has been partially mitigated by effective crediting rate management. Net investment income results included volatility from alternative investments, mortgage loan prepayments and fair value option assets. Pre-tax operating income also included adjustments in each year to update actuarial assumptions.
• a net negative adjustment of $47 million in 2016 from the review and update of actuarial assumptions compared to a net positive adjustment of $48 million in 2015;
Pre-tax operating income decreased in 2015 compared to 2014 primarily due to:
• lower net investment income primarily due to lower returns on alternative investments in hedge funds and lower reinvestment yields in the low interest rate environment, partially offset by additional accretion income, higher bond call and tender income and gains on securities for which the fair value option was elected;
• lower interest credited due to effective crediting rate management and lower volume of fixed account values;
• lower general operating expenses due primarily to lower legal expenses, partially offset by higher pension costs and higher taxes, licenses and fees.
The following table presents Group Retirement surrenders as a percentage of average reserves and mutual funds under administration:
(a) Excludes mutual fund assets under administration of $16.3 billion and $14.5 billion at December 31, 2016 and 2015, respectively.
Net flows were negative in both periods but improved in 2015, primarily due to lower surrender activity. The improvement in the surrender rate was due in part to lower group plan surrenders, which were approximately $1.5 billion in 2015, compared to $2.7 billion in 2014. Group Retirement’s surrenders were impacted in both years by the consolidation of healthcare providers and other employers and increased competition in its target markets.
Life Insurance new individual life sales in 2016 continued at prior year levels despite strategic actions to exit certain group benefits distribution channels. Life Insurance is focused on selling profitable new products through strategic channels to enhance future returns. Pre-tax operating losses in 2016 and 2015 were primarily due to reserve increases from the update of actuarial assumptions and lower alternative investment income, as well as poor morbidity experience in the group business, which Life Insurance has addressed through strategic actions. We acquired AIG Life Limited in the UK in December 2014, and sales growth with early year losses in this young organization has contributed to the pre-tax operating losses in Life Insurance. Domestic general operating expenses decreased in 2016 compared to 2015, primarily due to the strategic decision to refocus the group benefits business and other reductions in staffing.
• a lower net negative adjustment from the review and update of actuarial assumptions, which was $92 million in 2016 compared to $118 million in 2015, reflected in policy fees, policyholder benefits and amortization of DAC;
Pre-tax operating income in 2015 decreased compared to 2014 primarily due to:
• lower net investment income primarily due to lower returns on alternative investments in hedge funds and, to a lesser extent, a decrease due to lower yields on the base portfolio;
• a higher net negative adjustment to reflect updated actuarial assumptions, which was $118 million in 2015 compared to $32 million in 2014; and
The increase in other income was due to commission and profit sharing revenues received by Laya Healthcare, acquired in March 2015, which was offset by related operating expenses.
The following table presents a reconciliation of Life Insurance premiums and deposits to GAAP premiums:
A discussion of the significant variances in premiums and deposits follows:
The following tables present Personal Insurance accident year catastrophes and severe losses by geography(a) and the number of events:
- strategic actions to reduce expenses and refocus direct marketing activities; and
• lower underwriting results and lower net investment income reflecting reduced income on alternative investments. The lower underwriting results were driven by:
- increase in other acquisition expenses, primarily related to investments to grow automobile and property businesses and higher profit share expenses related to warranty service programs, partially offset by a decrease in direct marketing expenses.
• a decrease in expense ratio due to strategic actions to reduce expenses; and
The slight increase in accident year loss ratio, as adjusted, reflects:
• lower employee-related expenses arising from organization realignment together with lower strategic investment expenditures.
• higher large but not severe losses in automobile and personal property businesses, partially offset by a decrease in losses in warranty service programs and lower severe losses.
Pre-tax operating loss before eliminations increased primarily due to higher Parent and Other corporate general operating expenses partially offset by lower interest expense. Parent and Other general operating expenses increased in 2016 due to higher technology costs as a result of our investment in our infrastructure, offset by lower professional fees and employee related costs, consistent with our strategy to reduce expenses. In addition, 2015 included a $175 million pension curtailment credit. Parent and Other interest expense decreased primarily as a result of liability management activities.
Pre-tax operating income of Fuji Life increased primarily as a result of increases in underwriting and net investment income. The increase in underwriting income was primarily as a result of new products launched during 2016. Net investment income increased primarily as a result of increased investment in bonds.
Legacy Property and Casualty Run-Off Insurance Lines - include excess workers’ compensation, asbestos and environmental exposures.
Legacy Investments - include investment classes that we have placed into run-off (life settlements, Legacy Global Real Estate, the Direct Investment book) and equity-like securities with high yield high-risk characteristics.
In 2015 and 2016, the Legacy Portfolio executed on several transactions that monetized approximately $7.1 billion of its portfolio. Approximately $6 billion came from external sales and internal securitizations of Legacy Investments to the insurance companies. The most significant transactions in 2016 were as follows:
Pre-tax operating income remained relatively stable; however, there were fluctuations within the portfolios due to:
• lower Legacy Property and Casualty pre-tax operating loss driven primarily by lower underwriting losses due to a decrease in net adverse prior year loss reserve development; and
Our investment strategies are tailored to the specific business needs of each operating unit. The investment objectives are driven by the respective business modules and AIG Parent. The primary objectives are generation of investment income, preservation of capital, liquidity management and growth of surplus to support the insurance products. The majority of assets backing our insurance liabilities consist of fixed maturity securities.
• Narrowing of credit spreads more than offset the rise in interest rates, resulting in a net unrealized gain position in our investment portfolio. Net unrealized gains in our available for sale portfolio increased to approximately $9.7 billion as of December 31, 2016 from approximately $8.8 billion as of December 31, 2015.
• Fixed maturity securities held by the U.S. insurance companies included in Property Casualty Insurance Companies consist of a mix of instruments that meet our current risk-return, tax, liquidity, credit quality and diversification objectives.
• Outside of the U.S., fixed maturity securities held by Property Casualty Insurance Companies consist primarily of high-grade securities generally denominated in the currencies of the countries in which we operate.
• While more of a focus is placed on asset-liability management in Life Insurance Companies, our fundamental strategy across all of our investment portfolios is to optimize the duration characteristics of the assets within a target range based on comparable liability characteristics, to the extent practicable.
(b) Includes changes in fair value of certain fixed maturity securities where the fair value option has been elected and which are used to economically hedge interest rate and other risks related to our variable annuity guaranteed living benefits. For the years ended December 31, 2016, 2015 and 2014, the net investment income (loss) recorded on these securities was $120 million, $(43) million and $260 million, respectively.
Net investment income in 2016 was marginally higher than 2015 as lower income on alternative investments and lower reinvestment yields were approximately offset by an increase in income on life settlements and higher gains on securities for which the fair value option was elected.
For Commercial Insurance - Liability and Financial Lines, Property and Special Risks and Consumer Insurance - Personal Insurance, we estimate investable funds based primarily on loss reserves and unearned premiums. The allocation of net investment income of the Property Casualty Insurance Companies to modules is calculated based on these estimated investable funds, consistent with the approximate duration of the liabilities and the capital allocation for each module.
For Consumer Insurance - Individual Retirement, Group Retirement, and Life Insurance, Other Operations - Institutional Markets and Legacy Life Insurance Run-Off Lines, net investment income is attributed based on invested assets from segregated product line portfolios held in our Life Insurance Companies. All invested assets of the Life Insurance Companies in excess of liabilities are allocated based on estimates of required economic capital for each product line.
Fixed maturity investments held in the Property Casualty Insurance Companies foreign operations are of high quality, primarily rated A or higher based on composite ratings, with an average duration of 3.5 years.
The investment strategy of the Life Insurance Companies is to maximize net investment income and portfolio value, subject to liquidity requirements, capital constraints, diversification requirements, asset-liability management and available investment opportunities.
Fixed maturity investments of the Life Insurance Companies domestic operations, with an average duration of 6.8 years, are comprised primarily of taxable corporate bonds, as well as taxable municipal and government bonds, and agency and non-agency structured securities. The majority of these investments are held in the available for sale portfolio and are rated investment grade based on its composite ratings.
Fixed maturity investments held in the Life Insurance Companies foreign operations are of high quality, primarily rated A or higher based on composite ratings, with an average duration of 21.2 years.
Moody’s Investors’ Service Inc. (Moody’s), Standard & Poor’s Financial Services LLC, a subsidiary of S&P Global Inc. (S&P), or similar foreign rating services rate a significant portion of our foreign entities’ fixed maturity securities portfolio. Rating services are not available for some foreign-issued securities. Our Credit Risk Management department closely reviews the credit quality of the foreign portfolio’s non-rated fixed maturity securities. At December 31, 2016, approximately 19 percent of such investments were either rated AAA or, on the basis of our internal analysis, were equivalent from a credit standpoint to securities rated AAA, and approximately 8 percent were below investment grade or not rated. Approximately 36 percent of the foreign entities’ fixed maturity securities portfolio is comprised of sovereign fixed maturity securities supporting policy liabilities in the country of issuance.
With respect to our fixed maturity investments, the credit ratings in the table below and in subsequent tables reflect: (a) a composite of the ratings of the three major rating agencies, or when agency ratings are not available, the rating assigned by the NAIC SVO (over 99 percent of total fixed maturity investments), or (b) our equivalent internal ratings when these investments have not been rated by any of the major rating agencies or the NAIC. The “Non-rated” category in those tables consists of fixed maturity securities that have not been rated by any of the major rating agencies, the NAIC or us.
* At December 31, 2016 and 2015, the fair value of bonds available for sale held by us that were below investment grade or not rated totaled $33.6 billion and $34.9 billion, respectively.
The following table presents the fair value of our aggregate credit exposures to non-U.S. governments for our fixed maturity securities:
* Decrease at December 31, 2016 is attributable to reclassification of AIG Fuji Life to Held for Sale.
The following table presents the fair value of our aggregate European credit exposures by major sector for our fixed maturity securities:
At December 31, 2016, the U.S. municipal bond portfolio was composed primarily of essential service revenue bonds and high-quality tax-backed bonds with over 95 percent of the portfolio rated A or higher.
(a) We did not have material credit exposure to the government of Puerto Rico.
* At both December 31, 2016 and December 31, 2015, approximately 91 percent of these investments were rated investment grade.
* Includes approximately $12.9 billion and $13.2 billion at December 31, 2016, and December 31, 2015, respectively, of certain RMBS that had experienced deterioration in credit quality since their origination. See Note 6 to the Consolidated Financial Statements for additional discussion on Purchased Credit Impaired (PCI) Securities.
(a) Includes certain RMBS that had experienced deterioration in credit quality since their origination. See Note 6 to the Consolidated Financial Statements for additional discussion on PCI Securities.
(b) The weighted average expected life was six years at both December 31, 2016 and December 31, 2015.
The fair value of CMBS holdings remained stable throughout 2016. The majority of our investments in CMBS are in tranches that contain substantial protection features through collateral subordination. The majority of CMBS holdings are traditional conduit transactions, broadly diversified across property types and geographical areas.
See Note 6 to the Consolidated Financial Statements for additional discussion on commercial mortgage loans.
Our investments in life settlements are monitored for impairment on a contract-by-contract basis quarterly. An investment in life settlements is considered impaired if the undiscounted cash flows resulting from the expected proceeds would not be sufficient to recover our estimated future carrying amount. This amount is defined as the current carrying amount for the investment in life settlements plus anticipated undiscounted future premiums and other capitalizable future costs, if any. Impaired investments in life settlements are written down to their estimated fair value. This is determined on a discounted cash flow basis, incorporating current market mortality assumptions and market yields.
We recorded other-than-temporary impairment charges in the years ended December 31, 2016, 2015 and 2014 related to:
(b) Represents the percentage by which fair value is less than cost at December 31, 2016.
The change in net unrealized gains and losses on investments in 2015 was primarily attributable to decreases in the fair value of fixed maturity securities. For 2015, net unrealized gains related to fixed maturity and equity securities decreased by $10.2 billion due primarily to the rise in rates, widening of credit spreads, and the sale of equity securities.
Net realized capital losses in 2016 were primarily related to foreign exchange losses, derivative losses, and impairments, which were higher than the gain recognized on the sale of a portion of our PICC Investment.
Foreign exchange gains (losses) were primarily due to $910 million of remeasurement losses in 2016 for a short term intercompany balance that was matched with available for sale investments in fixed maturity securities denominated in the same foreign currencies. Unrealized gains and losses on the available for sale investments were recorded in other comprehensive income resulting in an immaterial impact on our overall equity or book value per share from this arrangement.
The following table presents the components of our gross and net loss reserves by segment and major lines of business(a)(b):
(a) Includes $1.7 billion and $1.8 billion of asbestos reinsurance recoverable under a retroactive reinsurance agreement at December 31, 2016, and December 31, 2015, respectively.
The following table summarizes incurred (favorable) unfavorable prior year development net of reinsurance by segment and major lines of business:
• Higher than expected losses emerging across several casualty classes, especially in the recent accident years (generally, 2011 to 2015) driven by increased frequency and severity of claims. This recent accident year loss emergence caused us to increase loss development factors applied across many accident years.
• U.S. Other Casualty - Primary Commercial Auto Liability 14 percent greater than expected
The following graphs summarize incurred (favorable) or unfavorable prior year development net of reinsurance, by accident year groupings (in millions):
• Accident years 2006 to 2010 - adverse development of $1.4 billion were driven by increases in large losses in U.S. Financial Lines and increases in U.S. Workers’ Compensation loss development factors.
For 2015, the adverse prior year development was primarily driven by:
• Accident years 2011 to 2014 - adverse development of $1.6 billion was driven by significantly higher actual versus expected loss emergence. We responded by increasing expected loss ratios for U.S. Excess Casualty, U.S. Other Casualty, International Liability and Financial Lines and U.S. Workers’ Compensation. In addition, our updated assumptions for bad-faith claims and unallocated loss adjustment expenses disproportionately impacted these years.
• Accident years 2005 and prior - adverse development of $1.7 billion was driven by U.S. Excess Casualty revised tail factor selections, updated loss development selections for various U.S. Run-off Casualty Insurance Lines, including updated industry experience for asbestos and revised estimates on expected future recoveries from risk-sharing policies.
For 2014, the adverse prior year development was primarily driven by:
• Accident years 2011 to 2013 - favorable development of $305 million were driven by U.S. Financial Lines, U.S. Property and Special Risks and U.S., Europe and Japan Personal Insurance.
See Item 7. MD&A - Enterprise Risk Management - Insurance Operations Risks - Property Casualty Insurance Companies Key Insurance Risks - Reinsurance Recoverable for a summary of significant reinsurers.
The Life Insurance Companies review and update estimated gross profit assumptions used to amortize DAC and related items for investment-oriented products at least annually. Estimated gross profit assumptions include net investment income and spreads, net realized capital gains and losses, fees, surrender charges, expenses, and mortality gains and losses. If the assumptions used for estimated gross profits change significantly, DAC and related reserves (which may include VOBA, SIA, guaranteed benefit reserves and unearned revenue reserves) are recalculated using the new assumptions, and any resulting adjustment is included in income. Updating such assumptions may result in acceleration of amortization in some products and deceleration of amortization in other products. The update of actuarial assumptions in 2016, 2015 and 2014 also included adjustments to reserves for universal life with secondary guarantees.
In 2015, pre-tax operating income in the aggregate was reduced by $6 million as a result of the update of actuarial assumptions. This aggregate net adjustment of $6 million included a net negative adjustment of $118 million in Life Insurance, which was offset in large part by net positive adjustments of $92 million in Fixed Annuities and $48 million in Group Retirement.
The update of actuarial assumptions resulted in net positive adjustments to pre-tax operating income of Individual Retirement of $369 million, $92 million and $200 million in 2016, 2015 and 2014, respectively.
In Fixed Annuities, the update of estimated gross profit assumptions resulted in a net positive adjustment of $330 million in 2016, which reflected lower surrender assumptions, primarily due to lower long-term interest rates, as well as updates to investment yield and crediting rate assumptions compared to those previously modeled. In 2015, the update of estimated gross profit assumptions in Fixed Annuities resulted in a net positive adjustment of $92 million, which reflected refinements to investment spread assumptions, lower terminations than previously assumed and decreases to expense assumptions. In 2014, a net positive adjustment of $196 million in Fixed Annuities was primarily due to better spreads than previously assumed.
In Variable and Index Annuities, the update of estimated gross profit assumptions resulted in a net positive adjustment of $39 million in 2016, primarily due to favorable updates to assumptions for long-term volatility, surrenders, mortality and policy expenses, partially offset by a decrease in the separate account long-term asset growth rate assumption from 8.5 percent to 7.5 percent (before expenses that reduce the asset base from which future fees are projected). The net positive adjustment in 2016 included a net negative adjustment of approximately $24 million in connection with the conversion to a more robust modeling platform for variable annuities, primarily due to refinements to assumptions for guaranteed minimum interest rates and investment fees, partially offset by the impact of other refinements identified during the conversion. In 2015, there were offsetting updates to assumed investment fees, modeled expenses, and terminations, resulting in no net adjustment to pre-tax operating income in Variable and Index Annuities compared to a $4 million net positive adjustment in 2014, which reflected the update of estimated gross profit assumptions.
A net negative adjustment of $32 million in Life Insurance in 2014 was primarily due to additions to reserves for universal life with secondary guarantees, as a result of lower investment spread and mortality assumptions which, while higher than previously assumed, were still within pricing assumptions.
In addition to risk-mitigating features in our variable annuity product design, we have an economic hedging program designed to manage market risk from GMWB, including exposures to changes in interest rates, equity prices, credit spreads and volatilities. The hedging program utilizes derivative instruments, including but not limited to equity options, futures contracts and interest rate swap and swaption contracts, as well as fixed maturity securities with a fair value election. See Enterprise Risk Management - Life Insurance Companies Key Insurance Risks - Variable Annuity Risk Management and Hedging Program for additional discussion of market risk management related to these product features.
The market value of the hedge portfolio compared to the economic hedge target at any point in time may be different and is not expected to be fully offsetting. In addition to the derivatives held in conjunction with the variable annuity hedging program, the Life Insurance Companies have cash and invested assets available to cover future claims payable under these guarantees. The primary sources of difference between the change in the fair value of the hedging portfolio and the economic hedge target include:
Change in fair value of embedded derivatives excluding NPA spread, net of hedging portfolio
The net impact on pre-tax income from the GMWB and related hedges in 2016 (excluding related DAC amortization) was primarily driven by actuarial assumption updates to surrender and mortality assumptions. The 2015 and 2014 net impacts were primarily driven by changes in the NPA spread. In addition, the impact of rising interest rates and equity markets late in the fourth quarter of 2016 resulted in fair value losses in the hedging portfolio, which were not offset by decreases in the embedded derivative liabilities, because risk margins and other assumptions used for U.S. GAAP valuation cause the embedded derivatives to be less sensitive to changes in market rates than the hedge portfolio. The changes in the economic hedge target and the largely offsetting changes in the fair value of the hedge portfolio were primarily driven by changes in equity markets and interest rates, as discussed below.
• Changes in the fair value of interest rate derivative contracts, which included swaps, swaptions and futures, resulted in net losses in 2016 as increases in rates in the fourth quarter of 2016 more than offset the impact of interest rate declines in the first nine months of 2016. The net gains in 2015 on interest rate contracts reflected decreases in market interest rates in the latter half of 2015, partially offset by the impact of increases in rates in the first six months of 2015. In 2014, rates declined throughout the year, resulting in gains from interest rate derivative contracts.
The change in embedded derivatives included increases in 2016 due to the update of actuarial assumptions, which primarily reflected lower surrender and mortality assumptions, partially offset by a decrease due to updated assumptions for utilization of withdrawal benefits. The impact of these updated assumptions, which were based on experience studies, was less significant to the embedded derivative liabilities than to the economic hedge target, because the discount rates used to value the embedded derivatives include the additional adjustment for the NPA spread, as well as other explicit risk margins. In addition, the increase in the embedded derivative liabilities from the assumption updates was largely offset by a reduction due to an update of these risk margins. See Update of Actuarial Assumptions for the amount of adjustments included in net capital realized gains (losses) related to the update of actuarial assumptions for GMWB.
The net adjustments to DAC amortization from the update of actuarial assumptions for estimated gross profits, including those reported within change in DAC related to net realized capital gains (losses), represented four percent and one percent of the DAC balance excluding the amount related to unrealized depreciation (appreciation) of investments as of December 31, 2016 and 2015, respectively.
In 2016, we updated the long-term annual growth assumption applied to subsequent periods used in our reversion to the mean methodology for estimating future estimated gross profits for variable annuity products, from 8.5 percent to 7.5 percent (before expenses that reduce the asset base from which future fees are projected). The five-year reversion to the mean period has not met the criteria for adjustment in 2016, 2015 or 2014; however, sustained favorable equity market performance in excess of long-term assumptions could result in unlocking in the Individual Retirement or Group Retirement variable annuity product lines in the future, with a positive effect on pre-tax income in the period of the unlocking. See Critical Accounting Estimates - Estimated Gross Profits for Investment-Oriented Products (Life Insurance Companies) for additional discussion of assumptions related to our reversion to the mean methodology.
DAC for universal life and investment-type products (collectively, investment-oriented products) is adjusted at each balance sheet date to reflect the change in DAC as if securities available for sale had been sold at their stated aggregate fair value and the proceeds reinvested at current yields (shadow DAC). Shadow DAC generally moves in the opposite direction of the change in unrealized appreciation of the available for sale securities portfolio, reducing the reported DAC balance when market interest rates decline. Market interest rates as of December 31, 2016 decreased compared to December 31, 2015 as a result of narrowing spreads in 2016. As a result, the unrealized appreciation of fixed maturity securities held in the Life Insurance Companies that support the Core Portfolio businesses at December 31, 2016 increased by $2.1 billion compared to December 31, 2015, which resulted in a decrease in DAC to reflect the shadow DAC adjustment.
Insurance reserves of Individual Retirement, Group Retirement and Life Insurance modules, and Retail Mutual Funds and Group Retirement mutual fund assets under administration, were comprised of the following balances:
AIG Parent also received a net amount of $1.6 billion in tax sharing payments in the form of cash and fixed maturity securities from our insurance businesses in 2016, reflecting $608 million that was reimbursed by AIG Parent to our insurance businesses during the fourth quarter of 2016 as a result of adjustments made to prior-year tax sharing payments. The tax sharing payments may continue to be subject to adjustment in future periods.
The dividends and tax sharing payments from our Property Casualty Companies and Life Insurance Companies were funded, in part, by proceeds from the sale of 740 million ordinary H shares of PICC Property & Casualty Company Limited for approximately $1.25 billion in May 2016 and by the sale of AIG Advisor Group in May 2016.
In March 2016, we issued $1.5 billion aggregate principal amount of 3.900% Notes due 2026.
In June 2016, we issued €750 million aggregate principal amount of 1.500% Notes due 2023.
In December 2016, we received proceeds from the sale of our 100 percent interest in UGC and certain related affiliates to Arch for total consideration of approximately $3.3 billion, consisting of $2.2 billion of cash, and approximately $1.1 billion of newly issued Arch convertible non-voting common-equivalent preferred stock.
During 2016, we generated approximately $3.6 billion in return of capital from Legacy Investments.
We also made other repurchases and repayments of approximately $3.5 billion during 2016. AIG Parent made interest payments on our debt instruments totaling $975 million during 2016.
We repurchased approximately 201 million shares of AIG Common Stock during 2016, for an aggregate purchase price of approximately $11.5 billion.
We repurchased approximately 17 million warrants to purchase shares of AIG Common Stock during 2016 for an aggregate purchase price of approximately $309 million.
In January 2016, AIG Parent made a capital contribution of approximately $2.9 billion to our Property Casualty Insurance Companies.
* Under Exchange Act Rule 10b5-1 repurchase plans, from January 1 to February 14, 2017, we repurchased approximately $1.2 billion of additional shares of AIG Common Stock. As of February 14, 2017, approximately $4.7 billion remained under our share repurchase authorization.
Interest payments totaled $1.3 billion in 2016 compared to $1.4 billion in 2015 and $3.4 billion in 2014. Excluding interest payments, AIG generated positive operating cash flow of $3.7 billion in 2016 compared to $4.2 billion and $8.4 billion in 2015 and 2014, respectively.
These items were partially offset by approximately $6.0 billion in proceeds from the issuance of long-term debt.
These items were partially offset by approximately $6.9 billion in proceeds from the issuance of long-term debt.
• approximately $712 million in the aggregate to pay dividends of $0.125 per share on AIG Common Stock in each quarter of 2014;
We utilize our capital resources to support our businesses, with the majority of capital allocated to our insurance operations. Should we have or generate more capital than is needed to support our business strategies (including organic growth or acquisition opportunities) or mitigate risks inherent to our business, we may develop plans to distribute such capital to shareholders via dividends or share repurchase authorizations or deploy such capital towards liability management.
In the normal course, it is expected that a portion of the capital released by our insurance operations or through the utilization of AIG’s deferred tax assets may be available for distribution to shareholders. Additionally, it is expected that a portion of the capital associated
In January 2016, AIG Parent made a capital contribution of approximately $2.9 billion to our Property Casualty Insurance Companies as a result of our fourth quarter 2015 reserve strengthening.
(a) Cash and short-term investments include reverse repurchase agreements totaling $1.0 billion and $1.5 billion as of December 31, 2016 and 2015, respectively.
Management believes that because of the size and liquidity of our Life Insurance Companies’ investment portfolios, normal deviations from projected claim or surrender experience would not create significant liquidity risk. Furthermore, our Life Insurance Companies’ products contain certain features that mitigate surrender risk, including surrender charges. However, as we saw in 2008, in times of extreme capital markets disruption, liquidity needs could outpace resources. As part of their risk management framework, our Life Insurance Companies continue to evaluate and, where appropriate, pursue strategies and programs to improve their liquidity position and facilitate their ability to maintain a fully invested asset portfolio.
Certain of our U.S. insurance companies are members of the Federal Home Loan Banks (FHLBs) in their respective districts. Borrowings from the FHLBs are used to supplement liquidity or for other uses deemed appropriate by management. Our U.S. Property Casualty Insurance Companies had outstanding borrowings from the FHLBs in an aggregate amount of approximately $733 million and zero at December 31, 2016 and 2015, respectively. The outstanding borrowings are being used primarily for interest rate risk management purposes in connection with certain reinsurance arrangements, and the balances are expected to decline as underlying premiums are collected. Our U.S. Life Insurance Companies had outstanding borrowings from the FHLBs in an aggregate
amount of approximately $2 million at both December 31, 2016 and 2015. In addition to these borrowings outstanding at December 31, 2016, $429 million was due to the FHLB of Dallas under funding agreements issued by our Institutional Markets business in 2016, which were reported in Policyholder contract deposits.
AIG Parent is party to a CMA with AGC Life Insurance Company. Among other things, the CMA provides that AIG Parent will maintain the total adjusted capital of AGC Life Insurance Company at or above a specified minimum percentage of its projected NAIC Company Action Level Risk-Based Capital (RBC). As of December 31, 2016, the specified minimum percentage under this CMA was 250 percent. AIG Parent terminated the CMA with United Guaranty Residential Insurance Company in connection with the December 2016 closing of the sale of UGC.
In 2016, UGC paid approximately $571 million in dividends in the form of cash and fixed maturity securities to AIG Parent. The fixed maturity securities primarily included U.S. government and government-sponsored entity securities, U.S. agency mortgage-backed securities, corporate and municipal bonds and certain other highly rated securities.
We maintain a committed, revolving syndicated credit facility (the Facility) as a potential source of liquidity for general corporate purposes. The Facility provides for aggregate commitments by the bank syndicate to provide unsecured revolving loans and/or standby letters of credit of up to $4.5 billion without any limits on the type of borrowings and is scheduled to expire in November 2020.
As of December 31, 2016, a total of $4.5 billion remains available under the Facility. Our ability to borrow under the Facility is not contingent on our credit ratings. However, our ability to borrow under the Facility is conditioned on the satisfaction of certain legal, operating, administrative and financial covenants and other requirements contained in the 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 Facility would restrict our access to the Facility and could have a material adverse effect on our financial condition, results of operations and liquidity. We expect to borrow under the Facility from time to time, and may use the proceeds for general corporate purposes.
expect liquidity needs related to GIC liabilities to be funded through cash flows generated from maturities and sales of invested assets.
(e) Includes a five-year senior unsecured revolving credit facility of up to $500 million between AerCap Ireland Capital Limited, as borrower, and AIG Parent, as lender (the AerCap Credit Facility) scheduled to mature in May 2019. The AerCap Credit Facility permits loans for general corporate purposes. At December 31, 2016, no amounts were outstanding under the AerCap Credit Facility.
We have recorded liabilities for certain of these arrangements where it is possible to estimate them. These liabilities are not material in the aggregate. We are unable to develop a reasonable estimate of the maximum potential payout under some of these arrangements. Overall, we believe that it is unlikely we will have to make any material payments under these arrangements.
(d) At December 31, 2016, includes debt of consolidated investment vehicles related to real estate investments of $1.9 billion, affordable housing partnership investments of $1.7 billion and other securitization vehicles of $771 million. At December 31, 2015, includes debt of consolidated investment vehicles related to real estate investments of $2.4 billion, affordable housing partnership investments of $1.5 billion and other securitization vehicles of $1.0 billion.
(e) Includes $1.1 billion related to certain real estate investments that were sold during 2016.
(g) Includes debt issuance costs of $88 million and $101 million at December 31, 2016 and 2015, respectively. See Note 2 to the Consolidated Financial Statements.
The following table summarizes maturing debt at December 31, 2016 of AIG (excluding $4.4 billion of borrowings of consolidated investments) for the next four quarters:
Credit ratings estimate a company’s ability to meet its obligations and may directly affect the cost and availability of financing to that company. The following table presents the credit ratings of AIG and certain of its subsidiaries as of February 14, 2017. Figures in parentheses indicate the relative ranking of the ratings within the agency’s rating categories; that ranking refers only to the major rating category and not to the modifiers assigned by the rating agencies.
In the event of adverse actions on our long-term debt ratings by the major rating agencies, AIGFP and certain other AIG entities would be required to post additional collateral under some derivative transactions or could experience termination of the transactions. Such requirements and terminations could adversely affect our business, our consolidated results of operations in a reporting period or our liquidity. In the event of a further downgrade of AIG’s long-term senior debt ratings, AIGFP and certain other AIG entities would be required to post additional collateral, and certain of the counterparties of AIGFP or of such other AIG entities would be permitted to terminate their contracts early.
United States Life Insurance Company in the City of New York
These financial strength ratings are current opinions of the rating agencies. They may be changed, suspended or withdrawn at any time by the rating agencies as a result of changes in, or unavailability of, information or based on other circumstances.
On February 11, 2016, our Board of Directors declared a cash dividend on AIG Common Stock of $0.32 per share, payable on March 28, 2016 to shareholders of record on March 14, 2016. On May 2, 2016, our Board of Directors declared a cash dividend on AIG Common Stock of $0.32 per share, payable on June 27, 2016 to shareholders of record on June 13, 2016. On August 2, 2016, our Board of Directors declared a cash dividend on AIG Common Stock of $0.32 per share, payable on September 29, 2016 to shareholders of record on September 15, 2016. On November 2, 2016, our Board of Directors declared a cash dividend on AIG Common Stock of $0.32 per share, payable on December 22, 2016 to shareholders of record on December 8, 2016.
Payments of dividends to AIG by its insurance subsidiaries are subject to certain restrictions imposed by regulatory authorities. See Note 19 to the Consolidated Financial Statements for a discussion of restrictions on payments of dividends by our subsidiaries.
The Group Risk Committee (GRC): The GRC is the senior management group responsible for assessing all significant risk issues on a global basis to protect our financial strength, optimize our intrinsic value, and protect our reputation. The GRC is chaired by our CRO. Its membership includes our CEO, Chief Financial Officer (CFO), and other executives from across our corporate functions and business units. Our CRO reports periodically on behalf of the GRC to both the RCC and the Audit Committee of the Board of Directors. Our CRO is also a member of the Executive Leadership Team (ELT) providing ERM the opportunity to contribute to, review, monitor and consider the impact of changes in strategy.
Technology, Operational Risk & Control Committee (TORCC): This committee oversees technology and operational risk management and control issues and activities across our businesses, functions, and geographic locations. The TORCC reviews our risk management practices and monitors current and emerging technology and operational risks, as well as management actions taken to reduce risks to acceptable levels. It primarily focuses on establishing the firm-wide framework for identifying, measuring, quantifying, and managing and mitigating technology and operational risks, and monitoring our controls. The TORCC addresses firm-wide, rather than business-specific issues and is mandated to prioritize technology and operational improvements that are significant and transformational. The TORCC also provides a forum for senior management to assess our technology and operational risk profiles that may affect our strategic objectives.
The scope of the TORCC includes, but is not limited to, Operational Risk Management, Technology Risk Management, Information Security, Compliance, Sarbanes Oxley, Disaster Recovery, Project Risk Management and Vendor Risk Management.
The TORCC is an authorized sub-committee of our GRC and supports the GRC in its risk management oversight role. The TORCC is co-chaired by our CIO, Chief Operating Officer, and our CRO. Membership of the TORCC also includes Owners of the Control Agenda, Business Information Officers, and members of the various control functions.
Business Unit Risk Committees: Each of our major insurance businesses has established a risk committee that serves as the senior management committee responsible for risk oversight at the individual business unit level. The risk committees are responsible for the identification, assessment and monitoring of all sources of risk within their respective portfolios. Specific responsibilities include setting risk tolerances, reviewing the capital allocation framework, insurance portfolio optimization, and providing oversight of risk-adjusted metrics. In addition, each business unit has established subordinate committees at the legal entity level and working groups in place that support these committees in executing their duties, such as ensuring policies are adhered to, and transactions are completed with risk appetite in mind. Together, these committees provide comprehensive risk oversight throughout the organization.
organization in relation to the established risk tolerances. A consolidated risk report is also presented periodically, as required, to the RCC by our CRO.
• Establishing risk monitoring, provide early warning indicators, and ensure timely oversight and enforceability of limits;
To support the monitoring and management of AIG’s and its business units’ material risks, ERM has an established limits framework that employs a three-tiered hierarchy:
• AIG management level limits are risk type specific limits at the AIG consolidated level. These limits are defined and calibrated to constrain our concentration in specific risk types, and to protect against taking risks that exceed the amount of overall capital AIG has available. These limits are approved by our CRO with consultation from the GRC.
All limits are reviewed by the FRG, GRC or relevant business unit risk committees on a periodic basis and revisions, if applicable, are approved by those committees.
The framework measures risk over multiple time horizons and under different levels of stress. We develop a range of stress scenarios based both on internal experience and regulatory guidance. The stress tests are intended to ensure that sufficient resources are available under both idiosyncratic and systemic market stress conditions.
We are engaged in a variety of insurance, investment and other financial services businesses that generate market risk, directly and indirectly. We are exposed to market risks primarily within our insurance and capital markets activities, on both the asset and liability side of our balance sheet through on and off-balance sheet exposures. The chief risk officer within each business is responsible for creating a framework to properly identify these risks, then ensuring that they are appropriately measured, monitored and managed in accordance with the risk governance framework established by the Chief Market Risk Officer (CMRO).
Equity prices. We are exposed to changes in equity market prices affecting a variety of instruments. Changes in equity prices can affect the valuation of publicly-traded equity shares, investments in private equity, hedge funds and mutual funds, exchange-traded funds, and other equity-linked capital market instruments as well as equity-linked insurance products, including but not limited to index annuities, variable annuities, universal life insurance and variable universal life insurance.
Interest rates. Interest rate risk can arise from a mismatch in the interest rate exposure of assets versus liabilities. Lower interest rates generally result in lower investment income and make certain of our product offerings less attractive to investors. Conversely, higher interest rates are typically beneficial for the opposite reasons. However, when rates rise quickly, there can be a temporary asymmetric GAAP accounting effect where the existing securities lose market value, which is largely reported in Other comprehensive income, and the offsetting decrease in the value of related liabilities may not be recognized. Changes in interest rates can affect the valuation of fixed maturity securities, financial liabilities, insurance contracts including but not limited to fixed rate annuities, variable annuities and derivative contracts.
Credit spreads. Credit spreads measure an instrument’s risk premium or yield relative to that of a comparable duration, default-free instrument. Changes in credit spreads can affect the valuation of fixed maturity securities, including but not limited to corporate bonds, ABS, mortgage-backed securities, AIG-issued debt obligations, credit derivatives and derivative credit valuation adjustments. Much like higher interest rates, wider credit spreads with unchanged default losses mean more investment income in the long-term. In the short term, quickly rising spreads will cause a loss in the value of existing fixed maturity securities, which is largely reported in Other comprehensive income. A precipitous widening of credit spreads may also signal a fundamental weakness in the credit-worthiness of bond obligors, potentially resulting in default losses.
Market risk is overseen at the corporate level within ERM through the CMRO, who reports directly to the AIG CRO. The CMRO is supported by a dedicated team of professionals within ERM. Market Risk is managed by our finance, treasury and investment management corporate functions, collectively, and in partnership with ERM. The CMRO is primarily responsible for the development and maintenance of a risk management framework that includes the following key components:
• written policies that define the rules for our market risk-taking activities and provide clear guidance regarding their execution and management;
Sensitivity analysis. Sensitivity analysis measures the impact from a unit change in a market risk input. Examples of such sensitivities include a one basis point increase in yield on fixed maturity securities, a one basis point increase in credit spreads of fixed maturity securities, and a one percent increase in prices of equity securities.
Stress testing. Stress testing is a special form of scenario analysis in which the scenarios are designed to lead to a material adverse outcome. Examples of such scenarios include the stock market crash of October 1987 or the widening of yields or spreads of RMBS or CMBS during 2008.
• 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;
The risk monitoring responsibilities, owned by the business units, include ensuring compliance with market risk limits and escalation and remediation of limit breaches. Such activities must be reported to the ERM Market Risk team by the relevant business unit. This monitoring approach is aligned with our overall risk limits framework.
To control our exposure to market risk, we rely on a three-tiered hierarchy of limits that the CMRO closely monitors and reports to our CRO, senior management and risk committees.
AIG and its legal entities seek to maintain sufficient liquidity during both the normal course of business and under defined liquidity stress scenarios to ensure that sufficient cash will be available to meet the obligations as they come due.
The following sources of liquidity and funding risks could impact our ability to meet short-term financial obligations as they come due.
• Market/Monetization Risk: Assets may not be readily transformed into cash due to unfavorable market conditions. Market liquidity risk may limit our ability to sell assets at reasonable values to meet liquidity needs.
• Financing Risk: We may be unable to raise additional cash on a secured or unsecured basis due to unfavorable market conditions, AIG-specific issues, or any other issue that impedes access to additional funding.
Liquidity risk is overseen at the corporate level within ERM. The AIG CRO has responsibility for the oversight of the Liquidity Risk Management Framework and delegates the day-to-day implementation of this framework to the AIG Treasurer. Our corporate treasury function manages liquidity risk, subject to ERM oversight and various control processes.
Minimum Liquidity Limits: Minimum Liquidity Limits specify the amount of assets required to be maintained in specific liquidity portfolios to meet obligations as they arise over a specified time horizon under stressed liquidity conditions.
Cash Flow Forecasts: Cash Flow Forecasts measure the liquidity needed for a specific legal entity over a specified time horizon.
• The Risk Event Capture process enables each employee to identify, document, and escalate operational risk impacts, with a view to enhancing, processes and promoting lessons learned.
• The Vulnerability Identification (VID) process identifies emerging risks, which we consider to be risks that have not yet fully manifested themselves but could become significant over time.
• The Ordinal Risk Ranking effort provides an ordinal ranking of AIG’s most significant operational risks at the Enterprise, Segment or Regional levels, with the goal of prioritizing assessment and remediation activity.
• The Risk and Control Self-Assessments (RCSAs) allow for the identification and assessment of the key operational risks within our respective business units and a determination as to whether the related controls are effective.
An integrated risk and control framework facilitates the identification and mitigation of operational risk issues. To accomplish this, our integrated risk and control framework is designed to:
• ensure first line accountability and ownership of risks and controls;
• modeling and reporting of aggregations and limit concentrations at multiple levels (policy, line of business, product group, country, individual/group, correlation and catastrophic risk events);
• Property Casualty Insurance Companies - risks covered include property, casualty, fidelity/surety, accident and health, aviation, and management liability. We manage risks in the general insurance business through aggregations and limitations of concentrations at multiple levels: policy, line of business, geography, industry and legal entity.
We purchase reinsurance for our insurance operations. Reinsurance facilitates insurance risk management (retention, volatility, concentrations) and capital planning. We may purchase reinsurance on a pooled basis. Pooling of our reinsurance risks enables us to purchase reinsurance more efficiently at a consolidated level, manage global counterparty risk and relationships and manage global catastrophe risks.
Stochastic methods. Stochastic methods are used to measure and monitor risks including natural catastrophe, reserve and premium risk. We develop probabilistic estimates of risk based on our exposures, historical observed volatility or industry-recognized models in the case of catastrophe risk.
Scenario analysis. Scenario or deterministic analysis is used to measure and monitor risks such as terrorism or to estimate losses due to man-made catastrophic scenarios.
The risk monitoring responsibilities of the business units include ensuring compliance with insurance risk limits and escalation and remediation of limit breaches. Such activities are reported to management by the relevant business unit for informative decision-making on a regular basis. This monitoring approach is aligned with our overall risk limits framework.
For Property Casualty Insurance Companies, insurance risks primarily include the following:
• Underwriting - The potential inadequacy of premiums charged for future risk periods on risks underwritten in our portfolios can impact the Property Casualty Insurance Companies’ 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. This may be driven by adverse economic conditions, unanticipated emergence of risks or increase in frequency of claims, worse than expected prepayment of policies, investment results, or unexpected or increased costs or expenses.
We perform post-catastrophe event studies to identify model weaknesses, underwriting gaps, and improvement opportunities. Lessons learned from post-catastrophe event studies are incorporated into the modeling and underwriting processes of risk pricing and selection. The majority of policies exposed to catastrophic risks are one-year contracts that allow us to adjust our underwriting guidelines, pricing and exposure accumulation in a relatively short period.
We recognize that climate change has implications for insurance industry exposure to natural catastrophe risk. With multiple levels of risk management processes in place, we actively analyze the latest climate science and policy to anticipate potential changes to our risk profile, pricing models and strategic planning. For example, we continually consider changes in climate and weather patterns as an integral part of the underwriting process. In addition, we are committed to providing innovative insurance products and services to help our clients be proactive against the threat of climate change, including expanding natural disaster resilience, promoting adaptation, and reducing greenhouse gas emissions. Our internal product development, underwriting, modeling, and sustainability practices will continue to adapt to and evolve with the developing risk exposures attributed to climate change.
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 (TRIPRA) and reinsurance recoveries are estimated to be $2.8 billion as of September 30, 2016.
In certain markets, we are required to participate on a proportional basis in reinsurance pools based on our relative share of direct writings in those markets. Such mandatory reinsurance generally covers higher-risk consumer exposures such as assigned-risk automobile and earthquake, as well as certain commercial exposures such as workers’ compensation.
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 the financial condition of reinsurers as well as the total reinsurance recoverable ceded to reinsurers, and sets limits with regard to the amount and type of exposure we are willing to cede to reinsurers. As part of these assessments, the RCD assesses the financial capacity and liquidity of reinsurers; and evaluates the local economic and financial environment in which foreign reinsurers operate. 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 allow us to 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 loss events that could be ceded to 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, 2016, we held $8.1 billion of collateral, in the form of funds withheld, securities in reinsurance trust accounts and/or evergreen 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 us.
(a) The financial strength ratings reflect the ratings of the various reinsurance subsidiaries of the companies listed as of January 3, 2017.
Our Individual Retirement, Group Retirement, Life Insurance and Institutional Markets businesses manage risk through product design, experience monitoring, pricing actions, risk limitations, reinsurance and active monitoring and management of the relationships between assets and liabilities, including hedging.
For our Individual and Group Retirement and Life Insurance products offered by the Life Insurance Companies, key insurance risks include the following:
• Longevity risk - represents the risk of a change in value of a policy or benefit as a result of actual mortality rates being lower than the expected mortality rates. This risk could arise from longer-term societal health changes as well as other factors. This risk exists in a number of our product lines but is most significant for our retirement, institutional and annuity products.
After reflecting our product risk-mitigating features, we hedge our remaining economic exposure to market risk within GMWB features through our variable annuity hedging program, which is designed to offset certain changes in the economic value of these GMWB embedded derivatives, within established thresholds. The hedging program is designed to provide additional protection against large and combined movements in interest rates, equity prices, credit spreads and market volatility under multiple scenarios.
For index annuity and universal life products, we have a hedging program designed to manage the index crediting strategies associated with index annuity and index life products. This hedging program is designed to offset the economic risk with respect to the index returns for the current crediting rate reset period, and utilizes derivative instruments, including but not limited to equity index
options and futures contracts. Similarly as with the variable annuities, there are differences between the calculation of the economic hedge target and U.S. GAAP valuation of the index annuity and index life embedded derivatives, which can lead to variances in their relative movements.
Our hedging programs utilize various derivative instruments, including but not limited to equity options, futures contracts, interest rate swaps and swaption contracts, as well as other hedging instruments. In addition, for variable annuities, we purchase certain fixed income securities and elect the fair value option as a capital efficient way to manage interest rate and credit spread exposures. To minimize counterparty credit risk, the majority of our derivative instrument hedges are implemented using exchange-traded futures and options, cleared through global exchanges. Over the counter derivatives are highly collateralized.
GIC/GIA Guaranteed Investment Contract/Guaranteed Investment Agreement A contract whereby the seller provides a guaranteed repayment of principal and a fixed or floating interest rate for a predetermined period of time.
Loss reserves Liability for unpaid losses and loss adjustment expenses. The estimated ultimate cost of settling claims relating to insured events that have occurred on or before the balance sheet date, whether or not reported to the insurer at that date.
Operating revenue excludes Net realized capital gains (losses), income from non-operating litigation settlements (included in Other income for GAAP purposes) and changes in fair value of securities used to hedge guaranteed living benefits (included in Net investment income for GAAP purposes).
Return on Equity - After-tax Operating Income Excluding AOCI and DTA (Adjusted Return on Equity) is a non-GAAP measure and is used to show the rate of return on shareholders’ equity. Adjusted Return on Equity is derived by dividing actual or annualized after-tax operating income attributable to AIG by average Adjusted Shareholders’ Equity.
Consolidated Statements of Equity for the years ended December 31, 2016, 2015 and 2014
Summary of Investments - Other than Investments in Related Parties at December 31, 2016
Condensed Financial Information of Registrant at December 31, 2016 and 2015 and for the years ended December 31, 2016, 2015 and 2014
Reinsurance at December 31, 2016, 2015 and 2014 and for the years then ended
Valuation and Qualifying Accounts at December 31, 2016, 2015 and 2014 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, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016 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, 2016, based on criteria established in the Internal Control - Integrated Framework 2013 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 Annual Report on 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.
Bonds available for sale, at fair value (amortized cost: 2016 - $232,241; 2015 - $240,968)
Common and preferred stock available for sale, at fair value (cost: 2016 - $1,697; 2015 - $1,379)
Mortgage and other loans receivable, net of allowance (portion measured at fair value: 2016 - $11; 2015 - $11)
Other invested assets (portion measured at fair value: 2016 - $6,946; 2015 - $8,912)
Other assets, including restricted cash of $193 in 2016 and $170 in 2015
Policyholder contract deposits (portion measured at fair value: 2016 - $3,058; 2015 - $2,325)
Other policyholder funds (portion measured at fair value: 2016 - $5; 2015 - $6)
On August 31, 2016, we sold our controlling interest in NSM Insurance Group (NSM), a managing general agent to ABRY Partners, a private equity firm, for consideration of $201 million resulting in a pre-tax gain of approximately $105 million in the third quarter of 2016. We retained an equity interest in a newly formed joint venture and will continue to provide underwriting capacity to NSM. We also retained exclusive renewal rights for certain business written through NSM.
In addition, see Note 4 to the Consolidated Financial Statements for information regarding expected sales of businesses that are classified as held-for-sale.
In June 2015, we sold 86.9 million ordinary shares of AerCap by means of an underwritten public offering of 71.2 million ordinary shares and a private sale of 15.7 million ordinary shares to AerCap. We received cash proceeds of approximately $3.7 billion, reflecting proceeds of approximately $3.4 billion from the underwritten offering and cash proceeds of $250 million from the private sale of shares to AerCap. In connection with the closing of the private sale of shares to AerCap, we also received $500 million of 6.50% fixed-to-floating rate junior subordinated notes issued by AerCap Global Aviation Trust and guaranteed by AerCap and certain of its subsidiaries. These notes, included in Bonds available for sale, mature in 2045 and are callable beginning in 2025. We accounted for our interest in AerCap using the equity method of accounting through the date of the June 2015 sale, and as available for sale thereafter. In August 2015, we sold our remaining 10.7 million ordinary shares of AerCap by means of an underwritten public offering and received proceeds of approximately $500 million.
• income tax assets and liabilities, including recoverability of our net deferred tax asset and the predictability of future tax operating profitability of the character necessary to realize the net deferred tax asset;
For the year ended December 31, 2016, we recorded out of period adjustments relating to prior years that increased Net loss attributable to AIG by $174 million, increased Loss from continuing operations before income taxes by $57 million and decreased pre-tax operating income by $6 million. The out of period adjustments are primarily related to income tax liabilities and ceded loss adjustment expenses. Had these adjustments, which were determined not to be material, been recorded in their appropriate periods, Net Income attributable to AIG for the years ended December 31, 2015 and 2014 would have decreased by $67 million and $12 million, respectively.
Reinsurance premiums ceded are recognized as a reduction in revenues over the period the reinsurance coverage is provided in proportion to the risks to which the premiums relate.
Premiums for long-duration insurance products and life contingent annuities are recognized as revenues when due. Estimates for premiums due but not yet collected are accrued.
Policy fees represent fees recognized from universal life and investment-type products consisting of policy charges for the cost of insurance, policy administration charges, surrender charges and amortization of unearned revenue reserves. Policy fees are recognized as revenues in the period in which they are assessed against policyholders, unless the fees are designed to compensate AIG for services to be provided in the future. Fees deferred as unearned revenue are amortized in relation to the incidence of expected gross profits to be realized over the estimated lives of the contracts, similar to DAC.
· Changes in fair value relating to financial assets and liabilities for which the fair value option has been elected.
Aircraft leasing expenses through May 14, 2014, the date of disposal of ILFC, consisted 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 of allowance include premium balances receivable, amounts due from agents and brokers and policyholders, trade receivables for the Direct Investment book (DIB) and Global Capital Markets (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 $279 million and $333 million at December 31, 2016 and 2015, respectively.
We offer sales inducements which include enhanced crediting rates or bonus payments to contract holders (bonus interest) on certain annuity and investment contract products. Sales inducements provided to the contract holder are recognized in Policyholder contract deposits in the Consolidated Balance Sheets. Such amounts are deferred and amortized over the life of the contract using the same methodology and assumptions used to amortize DAC (see Note 9 herein). To qualify for such accounting treatment, the bonus interest must be explicitly identified in the contract at inception. We must also demonstrate that such amounts are incremental to amounts we credit on similar contracts without bonus interest, and are higher than the contract’s expected ongoing crediting rates for periods after the bonus period. The deferred bonus interest and other deferred sales inducement assets totaled $808 million and $845 million at December 31, 2016 and 2015, respectively. The amortization expense associated with these assets is reported within Interest credited to policyholder account balances in the Consolidated Statements of Income. Such amortization expense totaled $77 million, $88 million and $63 million for the years ended December 31, 2016, 2015 and 2014, respectively.
We adopted the standard retrospectively on its required effective date of January 1, 2016. The adoption of this standard did not have a material effect on our consolidated financial condition, results of operations or cash flows.
In February 2015, the FASB issued an accounting standard that affects reporting entities that are required to evaluate whether they should consolidate certain legal entities. Specifically, the amendments modify the evaluation of whether limited partnerships and similar legal entities are variable interest entities (VIEs) or voting interest entities; eliminate the presumption that a general partner should consolidate a limited partnership; affect the consolidation analysis of reporting entities that are involved with VIEs, particularly those that have fee arrangements and related party relationships; and provide a scope exception from consolidation guidance for reporting entities with interests in legal entities that are required to comply with or operate in accordance with requirements that are similar to those in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds.
Disclosures for Investments in Certain Entities that Calculate Net Asset Value per Share (or its Equivalent)
In May 2015, the FASB amended standard on fair value disclosures for investments for which fair value is measured using the net asset value (NAV) per share (or its equivalent) as a practical expedient. The amendments in this update remove the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the NAV per share practical expedient. In addition, the amendment removes the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the NAV per share as a practical expedient.
Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern
In August 2014, the FASB issued an accounting standard that requires management to evaluate and disclose if there are conditions or events that raise substantial doubt about an entity’s ability to continue as a going concern even if the entity’s liquidation is not imminent. In those situations, financial statements should continue to be prepared under the going concern basis of accounting, but this new standard requires an evaluation to determine whether to disclose information about the relevant conditions and events. Currently under U.S. GAAP there is no guidance about management’s responsibility under this standard. U.S. auditing standards and federal securities law require that an auditor evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time not to exceed one year beyond the date of the financial statements being audited.
We adopted the standard on its required effective date of December 31, 2016. The adoption of this standard did not have an effect on our consolidated financial condition, results of operations or cash flows.
In March 2016, the FASB issued a standard that simplifies several aspects of the accounting for share-based compensation, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification on the statement of cash flows. The standard is effective for interim and annual reporting periods beginning after December 15, 2016, with early adoption permitted.
We elected early-adoption of the Standard, effective January 1, 2016. The adoption of this standard did not have a material effect on our consolidated financial condition, results of operations or cash flows.
In January 2016, the FASB issued an accounting standard that will require equity investments that do not follow the equity method of accounting or are not subject to consolidation to be measured at fair value with changes in fair value recognized in earnings, while financial liabilities for which fair value option accounting has been elected, changes in fair value due to instrument-specific credit risk will be presented separately in other comprehensive income. The standard allows the election to record equity investments without readily determinable fair values at cost, less impairment, adjusted for subsequent observable price changes with changes in the
The standard is effective on January 1, 2019, with early adoption permitted using a modified retrospective approach. We are assessing the impact of the standard on our reported consolidated financial condition, results of operations and cash flows. We are currently quantifying the expected gross up of our balance sheet for a right to use asset and a lease liability as required by the standard.
In March 2016, the FASB issued an accounting standard that clarifies that a change in the counterparty (novation) to a derivative instrument that has been designated as a hedging instrument does not, in and of itself, require de-designation of that hedging relationship provided that all other hedge accounting criteria continue to be met.
We will adopt the standard on its January 1, 2017 effective date, and do not expect the adoption of the standard to have a material effect on our reported consolidated financial condition, results of operations or cash flows.
The standard is effective on January 1, 2020, with early adoption permitted on January 1, 2019. We are assessing the impact of the standard on our reported consolidated financial condition, results of operations and cash flows, but we expect an increase in our allowances for credit losses. The amount of the increase will be impacted by our portfolio composition and quality at the adoption date as well as economic conditions and forecasts at that time.
The standard addresses presentation in the Statement of Cash Flows only and will have no effect on our reported consolidated financial condition or results of operations.
We will adopt the standard on its January 1, 2017 effective date, and do not expect the impact of the standard to have a material effect on our reported consolidated financial condition, results of operations or cash flows.
The standard is effective on January 1, 2018, with early adoption permitted. The standard addresses presentation of restricted cash in the Statement of Cash Flows only and will have no effect on our reported consolidated financial condition or results of operations.
The standard is effective on January 1, 2018, with early adoption permitted. We are assessing the impact of early-adopting the standard on our reported consolidated financial condition, results of operations and cash flows. Because the standard requires prospective adoption, the impact is dependent on future acquisitions and dispositions.
We report our results of operations consistent with the manner in which our chief operating decision makers review the business to assess performance and allocate resources.
In the fourth quarter of 2016, we finalized our plan to reorganize our operating model into “modular”, more self-contained business units. Prior to the fourth quarter of 2016, we reported our results as follows:
· Corporate and Other category consisted of businesses and items not allocated to our operating segments, including United Guaranty and Institutional Markets.
· Liability and Financial Lines - Liability products include general liability, environmental, commercial automobile liability, workers’ compensation, excess casualty and crisis management insurance products. Liability also includes risk-sharing and other customized structured programs for large corporate and multinational customers. Financial Lines products include professional liability insurance for a range of businesses and risks, including directors and officers liability (D&O), fidelity, employment practices, fiduciary liability, cybersecurity risk, kidnap and ransom, and errors and omissions insurance (E&O).
· Property and Special Risks - Property products include commercial, industrial and energy-related property insurance products and services that cover exposures to man-made and natural disasters, including business interruption. Specialty products include aerospace, political risk, trade credit, surety and marine insurance, and various small and medium sized enterprises insurance lines.
· Life Insurance - primary products in the U.S. include term life and universal life insurance.
· Institutional Markets - consists of stable value wrap products, structured settlement and terminal funding annuities, corporate- and bank-owned life insurance and guaranteed investment contracts (GICs).
· United Guaranty - Mortgage insurance protects mortgage lenders and investors against the increased risk of borrower default related to high loan-to-value mortgages. The sale of this business was completed on December 31, 2016.
In the second quarter of 2015, a United Guaranty subsidiary and certain of our property casualty companies entered into a 50 percent quota share reinsurance agreement whereby the United Guaranty subsidiary (1) ceded 50 percent of the risk relating to policies written in 2014 that were current as of January 1, 2015 and (2) ceded 50 percent of the risk relating to all policies written in 2015 and 2016, each in exchange for a 30 percent ceding commission and reimbursements of 50 percent of the losses and loss adjustment expenses incurred on covered policies. Beginning in the third quarter of 2016, the effect of this intercompany reinsurance arrangements is included in the results of Property and Special Risks and Other Operations for all periods presented. Previously, this arrangement was eliminated for purposes of segment reporting. Concurrent with the closing of the sale of UGC, we amended and restated this arrangement and expect the results of this arrangement to continue to be reported in Property and Special Risks.
We evaluate segment performance based on operating revenues and pre-tax operating income (loss). Operating revenues and pre-tax operating income (loss) is derived by excluding certain items from total revenues and net income (loss) attributable to AIG, respectively. See the table below for the items excluded from operating revenues and pre-tax operating income (loss).
Changes in benefit reserves and DAC, VOBA and SIA related to
Assets and liabilities related to the businesses classified as held-for-sale are separately reported in our Consolidated Balance Sheets beginning in the period in which the business is classified as held-for-sale.
At December 31, 2016, the following businesses were reported as held-for-sale:
On August 15, 2016, we entered into a definitive agreement to sell our 100 percent interest in UGC and certain related affiliates to Arch. This transaction closed on December 31, 2016 and we received proceeds of approximately $3.3 billion, consisting of $2.2 billion of cash, and approximately $1.1 billion of newly issued Arch convertible non-voting common-equivalent preferred stock. We also received $261 million in pre-closing dividends from UGC in the fourth quarter of 2016. However, due to pending regulatory approvals, United Guaranty Asia was not included in the December 31, 2016 closing and $40 million of cash consideration was retained by Arch. The closing with respect to United Guaranty Asia is expected to occur during the first quarter of 2017, at which time AIG will receive the remaining consideration.
On November 14, 2016, we entered into an agreement to sell AFLI to FWD Group, the insurance arm of Pacific Century Group. Consummation of the transaction is subject to customary closing conditions, including regulatory and other approvals. Total cash consideration to us is expected to be approximately $346 million. The sale resulted in a pre-tax loss of $467 milli ☐ n.
The following table summarizes the components of assets and liabilities held-for-sale on the Consolidated Balance Sheets at December 31, 2016:
Future policy benefits for life and accident and health insurance contracts
The following is a description of the valuation methodologies used for instruments carried at fair value. These methodologies are applied to assets and liabilities across the levels discussed above, and it is the observability of the inputs used that determines the appropriate level in the fair value hierarchy for the respective asset or liability.
• 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.
For fair values measured based on internal models, the cost of credit protection is determined under a discounted present value approach considering the market levels for single name CDS spreads for each specific counterparty, the mid-market value of the net exposure (reflecting the amount of protection required) and the weighted average life of the net exposure. CDS spreads are provided to us by an independent third party. We utilize an interest rate based on the benchmark London Interbank Offered Rate (LIBOR) curve to derive our discount rates.
For short-term investments that are measured at amortized cost, the carrying amounts of these assets approximate fair values because of the relatively short period of time between origination and expected realization, and their limited exposure to credit risk. Securities purchased under agreements to resell (reverse repurchase agreements) are generally treated as collateralized receivables. We report certain receivables arising from securities purchased under agreements to resell as Short-term investments in the Consolidated Balance Sheets. When these receivables are measured at fair value, we use market-observable interest rates to determine fair value.
(a) Excludes investments that are measured at fair value using the NAV per share (or its equivalent), which totaled $6.7 billion and $8.6 billion as of December 31, 2016 and December 31, 2015, respectively.
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, 2016 and 2015, we transferred $1.1 billion and $0.7 billion, respectively, of securities issued by Non-U.S. government entities from Level 1 to Level 2, because they are no longer considered actively traded. For similar reasons, during the years ended December 31, 2016 and 2015, we transferred $34 million and $181 million, respectively, of securities issued by the U.S. government and government-sponsored entities from Level 1 to Level 2. There were no material transfers from Level 2 to Level 1 during the years ended December 31, 2016 and 2015.
The following tables present changes during the years ended December 31, 2016 and 2015 in Level 3 assets and liabilities measured at fair value on a recurring basis, and the realized and unrealized gains (losses) related to the Level 3 assets and liabilities in the Consolidated Balance Sheets at December 31, 2016 and 2015:
(a) There were no issuances during the years ended December 31, 2016 and 2015.
Both observable and unobservable inputs may be used to determine the fair values of positions classified in Level 3 in the tables above. As a result, the unrealized gains (losses) on instruments held at December 31, 2016 and 2015 may include changes in fair value that were attributable to both observable (e.g., changes in market interest rates) and unobservable inputs (e.g., changes in unobservable long-dated volatilities).
We record transfers of assets and liabilities into or out of Level 3 at their fair values as of the end of each reporting period, consistent with the date of the determination of fair value. The Net realized and unrealized gains (losses) included in income (loss) or Other comprehensive income (loss) and as shown in the table above excludes $188 million of net losses and $2 million of net losses related to assets and liabilities transferred into Level 3 during 2016 and 2015, respectively, and includes $189 million of net losses and $36 million of net losses related to assets and liabilities transferred out of Level 3 during 2016 and 2015, respectively.
During the years ended December 31, 2016 and 2015, transfers into Level 3 assets primarily included certain investments in private placement corporate debt, RMBS, CMBS, and CDO/ABS. 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. The transfers 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.
(a) Information received from third-party valuation service providers. The ranges of the unobservable inputs for constant prepayment rate, loss severity and constant default rate relate to each of the individual underlying mortgage loans that comprise the entire portfolio of securities in the RMBS and CDO securitization vehicles and not necessarily to the securitization vehicle bonds (tranches) purchased by us. The ranges of these inputs do not directly correlate to changes in the fair values of the tranches purchased by us, because there are other factors relevant to the fair values of specific tranches owned by us including, but not limited to, purchase price, position in the waterfall, senior versus subordinated position and attachment points.
(c) Mortality inputs are shown as multipliers of the 2012 Individual Annuity Mortality Basic table for Guaranteed Minimum Withdrawal Benefits (GMWB).
• Long-term equity volatilities represent equity volatility beyond the period for which observable equity volatilities are available, with an emphasis on current expected market-based volatilities. Increases in assumed volatility will generally increase the fair value of both the projected cash flows from rider fees as well as the projected cash flows related to benefit payments. Therefore, the net change in the fair value of the liability may either decrease or increase, depending on the relative changes in projected rider fees and projected benefit payments.
• Base lapse rate assumptions are determined by company experience and are adjusted at the contract level using a dynamic lapse function, which reduces the base lapse rate when the contract is in-the-money (when the contract holder’s guaranteed value is worth more than their underlying account value). Lapse rates are also generally assumed to be lower in periods when a surrender charge applies. Increases in assumed lapse rates will generally decrease the fair value of the liability, as fewer policyholders would persist to collect guaranteed withdrawal amounts, but in certain scenarios, increases in assumed lapse rates may increase the fair value of the liability.
• Mortality rate assumptions, which vary by age and gender, are based on company experience and include a mortality improvement assumption. Increases in assumed mortality rates will decrease the fair value of the liability, while lower mortality rate assumptions will generally increase the fair value of the liability, because guaranteed payments will be made for a longer period of time. Utilization assumptions estimate the timing when policyholders with a GMWB will elect to utilize their benefit and begin taking withdrawals. The assumptions may vary by the type of guarantee, tax-qualified status, the contract’s withdrawal history and the age of the policyholder. Utilization assumptions are based on company experience, which includes partial withdrawal behavior. In 2016, we implemented a 100 percent utilization assumption which reflects an expectation that all policyholders who remain active in the contract (i.e., do not lapse or die) will utilize their GMWB guarantee by commencing systematic withdrawals under the terms of their contract. In 2015, we used as a utilization rate assumption representing the probability of first partial withdrawal, which varied by issue age and duration for different contract types. The impact of changes in utilization assumptions on the fair value of the liability may vary, depending on the expected timing as well as the overall rate of assumed utilization.
Private equity fund investments included above are not redeemable, because 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 increments. At December 31, 2016, assuming average original expected lives of 10 years for the funds, 73 percent of the total fair value using net asset value per share (or its equivalent) presented above would have expected remaining lives of three years or less, 10 percent between four and six years and 17 percent between seven and 10 years.
The hedge fund investments included above, which are carried at fair value, are generally redeemable monthly (16 percent), quarterly (37 percent), semi-annually (11 percent) and annually (36 percent), with redemption notices ranging from one day to 180 days. At December 31, 2016, investments representing approximately 72 percent of the total fair value of these hedge fund investments had partial contractual redemption restrictions. These partial redemption restrictions are generally related to one or more investments held in the hedge funds that the fund manager deemed to be illiquid. The majority of these contractual restrictions, which may have been put in place at the fund’s inception or thereafter, have pre-defined end dates. The majority of these restrictions are generally expected to be lifted by the end of 2017.
Additionally, we elect the fair value option for certain 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 2016, 2015 and 2014, we recognized gains of $22 million, and losses of $4 million and $32 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.
We measure the fair value of certain assets on a non-recurring basis, generally quarterly, annually or when events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. These assets include cost and equity-method investments, commercial mortgage loans, investments in life settlements, investments in real estate and other fixed assets, goodwill and other intangible assets. See Notes 6 and 7 herein for additional information about how we test various asset classes for impairment.
Information regarding the estimation of fair value for financial instruments measured at fair value on a non-recurring basis is discussed below:
• Impairments for Other investments for the periods ended December 31, 2015 and December 31, 2014, primarily relate to certain investments in affordable housing partnerships, the fair values of which are determined based on remaining tax credits and other residual benefits due from the respective partnerships. Residual benefits include consideration of the fair value of underlying real estate properties, which is determined based on market-appropriate capitalization rates applied to net operating income of the properties. Impairments for Other investments for the period ended December 31, 2016 primarily relate to certain investments in aircraft, the fair values of which are determined based on third party independent appraisals that use industry specific appraisal standards and methodologies.
(b) At December 31, 2016 and 2015, bonds available for sale held by us that were below investment grade or not rated totaled $33.6 billion and $34.9 billion, respectively.
The following table summarizes the carrying amounts of other invested assets:
(b) Approximately 72 percent and 15 percent of our hedge fund portfolio is available for redemption in 2017 and 2018, respectively, an additional 7 percent will be available between 2019 and 2024.
(c) Net of accumulated depreciation of $451 million and $668 million in 2016 and 2015, respectively.
Certain hedge funds, private equity funds, and other investment partnerships for which we have elected the fair value option are reported at fair value with changes in fair value recognized in Net investment income with the exception of investments of AIG’s Other Operations, for which such changes are reported in Other income. Other investments in hedge funds, private equity funds and other investment partnerships in which our insurance operations do not hold aggregate interests sufficient to exercise more than minor influence over the respective partnerships are reported at fair value with changes in fair value recognized as a component of Accumulated other comprehensive income. These investments are subject to other-than-temporary impairment evaluations (see discussion below on evaluating equity investments for other-than-temporary impairment). The gross unrealized loss recorded in Accumulated other comprehensive income on such investments was $32 million and $33 million at December 31, 2016 and 2015, respectively, the majority of which pertains to investments in private equity funds and hedge funds that have been in continuous unrealized loss positions for less than 12 months.
We account for hedge funds, private equity funds, affordable housing partnerships and other investment partnerships using the equity method of accounting unless our interest is so minor that we may have virtually no influence over partnership operating and financial policies, or we have elected the fair value option. Under the equity method of accounting, our carrying amount generally is our share of the net asset value of the funds or the partnerships, and changes in our share of the net asset values are recorded in Net investment income with the exception of investments of AIG’s Other Operations, for which such changes are reported in Other income. In applying the equity method of accounting, we consistently use the most recently available financial information provided by the general partner or manager of each of these investments, which is one to three months prior to the end of our reporting period. The financial statements of these investees are generally audited annually.
The following table presents the carrying amount and ownership percentage of equity method investments at December 31, 2016 and 2015:
Investments in life settlements are accounted for under the investment method. Under the investment method, we recognize our initial investment in life settlements at the transaction price plus all initial direct external costs. Continuing costs to keep the policy in force, primarily life insurance premiums, increase the carrying amount of the investment. We recognize income on individual investments in life settlements when the insured dies, at an amount equal to the excess of the investment proceeds over the carrying amount of the investment at that time. These investments are subject to impairment review, as discussed below.
During 2016, 2015 and 2014, income recognized on investments in life settlements was $453 million, $332 million and $407 million, respectively, and is included in Net investment income in the Consolidated Statements of Income.
Credit impaired securities fully disposed of for which there was no
Credit impaired securities for which there is a current intent or
We evaluate our available for sale equity securities for impairment by considering such securities as candidates for other-than-temporary impairment if they meet any of the following criteria:
• We have concluded that we may not realize a full recovery on our investment, regardless of the occurrence of one of the foregoing events.
Our investments in aircraft assets and real estate are periodically evaluated for recoverability whenever changes in circumstances indicate the carrying amount of an asset may be impaired. When impairment indicators are present, we compare expected investment cash flows to carrying amount. When the expected cash flows are less than the carrying amount, the investments are written down to fair value with a corresponding charge to earnings.
At December 31, 2016 and 2015, amounts borrowed under repurchase and securities lending agreements totaled $4.2 billion and $2.9 billion, respectively.
Total carrying values of cash and securities deposited by our insurance subsidiaries under requirements of regulatory authorities or other insurance-related arrangements, including certain annuity-related obligations and certain reinsurance treaties, were $4.9 billion at both December 31, 2016 and 2015.
Certain GIAs have provisions that require collateral to be posted or payments to be made by us upon a downgrade of our long-term debt ratings. The actual amount of collateral required to be posted to the counterparties in the event of such downgrades, and the aggregate amount of payments that we could be required to make, depend on market conditions, the fair value of outstanding affected transactions and other factors prevailing at and after the time of the downgrade. The fair value of securities pledged as collateral with respect to these obligations was approximately $2.2 billion and $2.4 billion at December 31, 2016 and 2015, respectively. This collateral primarily consists of securities of the U.S. government and government sponsored entities and generally cannot be repledged or resold by the counterparties.
Direct costs of originating commercial mortgages, commercial loans, and other loans and notes receivable, net of nonrefundable points and fees, are deferred and included in the carrying amount of the related receivables. The amount deferred is amortized to income as an adjustment to earnings using the interest method. Premiums and discounts on purchased residential mortgages are also amortized to income as an adjustment to earnings using the interest method.
(a) The debt service coverage ratio compares a property’s net operating income to its debt service payments, including principal and interest.
(b) The loan-to-value ratio compares the current unpaid principal balance of the loan to the estimated fair value of the underlying property collateralizing the loan.
The following table presents a rollforward of the changes in the allowance for credit losses on Mortgage and other loans receivable:
In the ordinary course of business, our insurance companies may use both treaty and facultative reinsurance to minimize their net loss exposure to any single catastrophic loss event or to an accumulation of losses from a number of smaller events or to provide greater diversification of our businesses. In addition, our general insurance subsidiaries assume reinsurance from other insurance companies. We determine the portion of the incurred but not reported (IBNR) loss that will be recoverable under our reinsurance contracts by reference to the terms of the reinsurance protection purchased. This determination is necessarily based on the estimate of IBNR and accordingly, is subject to the same uncertainties as the estimate of IBNR. Reinsurance assets include the balances due from reinsurance and insurance companies under the terms of our reinsurance agreements for paid and unpaid losses and loss adjustment expenses incurred, ceded unearned premiums and ceded future policy benefits for life and accident and health insurance contracts and benefits paid and unpaid. Amounts related to paid and unpaid losses and benefits and loss expenses with respect to these reinsurance agreements are substantially collateralized. We remain liable to the extent that our reinsurers do not meet their obligation under the reinsurance contracts, and as such, we regularly evaluate the financial condition of our reinsurers and monitor concentration of our credit risk. The estimation of the allowance for doubtful accounts requires judgment for which key inputs typically include historical trends regarding uncollectible balances, disputes and credit events as well as specific reviews of balances in dispute or subject to credit impairment. The allowance for doubtful accounts on reinsurance assets was $207 million and $272 million at December 31, 2016 and 2015, respectively. Changes in the allowance for doubtful accounts on reinsurance assets are reflected in Policyholder benefits and losses incurred within the Consolidated Statements of Income.
(a) Represents gross reinsurance assets, excluding allowances and reinsurance recoverable on paid losses.
For the years ended December 31, 2016, 2015 and 2014, reinsurance recoveries, which reduced losses and loss adjustment expenses incurred, amounted to $2.1 billion, $4.1 billion and $2.6 billion, respectively.
The following table presents premiums for our long-duration life insurance and annuity operations:
The U.S. Life Insurance Companies manage the capital impact of their statutory reserve requirements, including those resulting from the NAIC Model Regulation “Valuation of Life Insurance Policies” (Regulation XXX) and NAIC Actuarial Guideline 38 (Guideline AXXX), through unaffiliated and affiliated reinsurance transactions. Effective July 1, 2016, one of the U.S. Life Insurance Companies entered into an agreement to cede approximately $5 billion of statutory reserves for certain whole life and universal life policies to an unaffiliated reinsurer. Effective December 31, 2016, the same life insurance subsidiary recaptured term and universal life reserves subject to Regulation XXX and Guideline AXXX, previously ceded to an affiliate, and ceded approximately $14 billion of such statutory reserves to an unaffiliated reinsurer under an amendment to the July 1, 2016 agreement. Under GAAP, these unaffiliated reinsurance transactions use deposit accounting with a reinsurance risk charge recorded in income, whereas such affiliated transactions are eliminated in consolidation. Under one affiliated reinsurance arrangement, one of the U.S. Life Insurance Companies obtains letters of credit to support statutory recognition of the ceded reinsurance. As of December 31, 2016, this subsidiary had two bilateral letters of credit totaling $450 million, which were issued on February 7, 2014 and expire on February 7, 2020. The letters of credit are subject to reimbursement by AIG Parent in the event of a drawdown. See Note 19 for additional information on the use of affiliated reinsurance for Regulation XXX and Guideline AXXX reserves.
reinsurance assets with our three largest reinsurers aggregate to approximately $8.2 billion and $6.5 billion at December 31, 2016 and 2015, respectively, of which approximately $4.4 billion and $3.7 billion at December 31, 2016 and 2015, respectively, was not secured by collateral.
Shadow DAC and Shadow Loss Recognition: DAC related to investment-oriented products is also adjusted to reflect the effect of unrealized gains or losses on fixed maturity and equity securities available for sale on estimated gross profits, with related changes recognized through Other comprehensive income (shadow DAC). The adjustment is made at each balance sheet date, as if the securities had been sold at their stated aggregate fair value and the proceeds reinvested at current yields. Similarly, for long-duration traditional insurance contracts, if the assets supporting the liabilities maintain a temporary net unrealized gain position at the balance sheet date, loss recognition testing assumptions are updated to exclude such gains from future cash flows by reflecting the impact of reinvestment rates on future yields. If a future loss is anticipated under this basis, any additional shortfall indicated by loss recognition tests is recognized as a reduction in accumulated other comprehensive income (shadow loss recognition). Similar to other loss recognition on long-duration insurance contracts, such shortfall is first reflected as a reduction in DAC and secondly as an increase in liabilities for future policy benefits. The change in these adjustments, net of tax, is included with the change in net unrealized appreciation of investments that is credited or charged directly to Other comprehensive income.
Value of Business Acquired (VOBA) is determined at the time of acquisition and is reported in the Consolidated Balance Sheets with DAC. This value is based on the present value of future pre-tax profits discounted at yields applicable at the time of purchase. For participating life, traditional life and accident and health insurance products, VOBA is amortized over the life of the business in a manner similar to that for DAC based on the assumptions at purchase. For investment-oriented products, VOBA is amortized in relation to estimated gross profits and adjusted for the effect of unrealized gains or losses on fixed maturity and equity securities available for sale in a manner similar to DAC.
ITEM 8 | Notes to Consolidated Financial Statements | 10. Variable Interest Entities
(a) Comprised primarily of Short-term investments and Other assets at December 31, 2016 and 2015.
(d) Comprised primarily of Other liabilities and Derivative liabilities, at fair value, at December 31, 2016 and 2015.
(a) At December 31, 2016 and 2015, $11.7 billion and $3.8 billion, respectively, of our total unconsolidated VIE assets were recorded as Other invested assets.
We created certain VIEs that hold investments, primarily in investment-grade debt securities and loans, and issued beneficial interests in these investments. The majority of these beneficial interests are owned by our insurance operations and we maintain the power to direct the activities of the VIEs that most significantly impact their economic performance and bear the obligation to absorb losses or receive benefits from the entities that could potentially be significant to the entities. Accordingly, we consolidate these entities and those beneficial interests issued to third-parties are reported as Long-term debt. Total assets of consolidated securitization vehicles are $18.0 billion, of which $17.3 billion represents amounts owed to Parent or its subsidiaries.
Interest rate, currency, equity and commodity swaps, credit contracts, swaptions, options and forward transactions are accounted for as derivatives, recorded on a trade-date basis and carried at fair value. Unrealized gains and losses are reflected in income, when appropriate. Aggregate asset or liability positions are netted on the Consolidated Balance Sheets only to the extent permitted by qualifying master netting arrangements in place with each respective counterparty. Cash collateral posted with counterparties in conjunction with transactions supported by qualifying master netting arrangements is reported as a reduction of the corresponding net derivative liability, while cash collateral received in conjunction with transactions supported by qualifying master netting arrangements is reported as a reduction of the corresponding net derivative asset.
Derivatives, with the exception of embedded derivatives, are reported at fair value in the Consolidated Balance Sheets in Other assets and Other liabilities. Embedded derivatives are generally presented with the host contract in the Consolidated Balance Sheets. A bifurcated embedded derivative is measured at fair value and accounted for in the same manner as a free standing derivative contract. The corresponding host contract is accounted for according to the accounting guidance applicable for that instrument. See Notes 5 and 14 herein for additional information on embedded derivatives.
(b) As of December 31, 2016 and 2015, included CDSs on super senior multi-sector CDOs with a net notional amount of $0.8 billion and $1.1 billion (fair value liability of $308 million and $483 million), respectively. The expected weighted average maturity as of December 31, 2016 is six years. Because of long-term maturities of the CDSs in the portfolio, we are unable to make reasonable estimates of the periods during which any payments would be made. However, the net notional amount represents the maximum exposure to loss on the portfolio. As of December 31, 2016 and 2015, there were no super senior corporate debt/CLOs remaining.
(f) Freestanding derivatives only, excludes Embedded derivatives. Derivative instrument assets and liabilities are recorded in Other Assets and Liabilities, respectively. Fair value of assets related to bifurcated Embedded derivatives was zero at both December 31, 2016 and December 31, 2015. Fair value of liabilities related to bifurcated Embedded derivatives was $3.1 billion and $2.3 billion, respectively, at December 31, 2016 and December 31, 2015. A bifurcated Embedded derivative is generally presented with the host contract in the Consolidated Balance Sheets. Embedded derivatives are primarily related to guarantee features in variable annuity products, which include equity and interest rate components.
Collateral posted by us to third parties for derivative transactions was $4.5 billion and $3.0 billion at December 31, 2016 and 2015, respectively. In the case of collateral posted under derivative transactions that are not subject to clearing, this collateral can generally be repledged or resold by the counterparties. Collateral provided to us from third parties for derivative transactions was $1.5 billion
We use foreign currency denominated debt and cross-currency swaps as hedging instruments in net investment hedge relationships to mitigate the foreign exchange risk associated with our non-U.S. dollar functional currency foreign subsidiaries. For net investment hedge relationships where issued debt is used as a hedging instrument, we assess the hedge effectiveness and measure the amount of ineffectiveness based on changes in spot rates. For net investment hedge relationships that use derivatives as hedging instruments, we assess hedge effectiveness and measure hedge ineffectiveness using changes in forward rates. For the years ended December 31, 2016, 2015, and 2014 we recognized gains of $123 million, $90 million and $156 million, respectively, included in Change in foreign currency translation adjustment in Other comprehensive income related to the net investment hedge relationships.
ITEM 8 | Notes to Consolidated Financial Statements | 11. Derivatives and Hedge Accounting
Additional collateral postings upon downgrade are estimated based on the factors in the individual collateral posting provisions of the CSA with each counterparty and current exposure as of December 31, 2016. Factors considered in estimating the termination payments upon downgrade include current market conditions and the terms of the respective CSA provisions. Our estimates are also based on the assumption that counterparties will terminate based on their net exposure to us. The actual termination payments could differ from our estimates given market conditions at the time of downgrade and the level of uncertainty in estimating both the number of counterparties who may elect to exercise their right to terminate and the payment that may be triggered in connection with any such exercise.
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. At December 31, 2016, as a result of the 2016 segment changes, goodwill is reported within our Commercial Insurance business - Liability and Financial Lines and our Property and Special Risks operating segments, our Consumer Insurance business - Life Insurance and Personal Insurance operating segments and our Legacy Portfolio operating segment. When a business is transferred from one reporting unit to another, as occurred as part of the 2016 segment changes, goodwill from the original operating segment is allocated among reporting units based on the fair value of business transferred, relative to business retained by a reporting unit. As such, at December 31, 2016, $132 million of goodwill was re-allocated from the original reporting units to Legacy Property and Casualty Run-Off Insurance Lines and Legacy Life Insurance Run-Off Lines reporting units in the amount of $75 million and $57 million, respectively.
the qualitative assessment is not performed, or after assessing the totality of the events or circumstances, we determine it is more likely than not that the fair value of an operating segment is less than its carrying amount, the impairment assessment involves a two-step process in which a quantitative assessment for potential impairment is performed.
Our gross loss reserves before reinsurance and discount are net of contractual deductible recoverable amounts due from policyholders of approximately $12.8 billion and $12.6 billion at December 31, 2016 and 2015, respectively. These recoverable amounts are related to certain policies with high deductibles (in excess of high dollar amounts retained by the insured through self-insured retentions, deductibles, retrospective programs, or captive arrangements, each referred to generically as “deductibles”), primarily for U.S. commercial casualty business. With respect to the deductible portion of the claim, we manage and pay the entire claim on behalf of the insured and are reimbursed by the insured for the deductible portion of the claim. Thus, these recoverable amounts represent a credit exposure to us. At December 31, 2016 and 2015, we held collateral of approximately $9.7 billion and $9.6 billion, respectively, for these deductible recoverable amounts, consisting primarily of letters of credit and funded trust agreements.
Liability for unpaid loss and loss adjustment expenses, end of year:
(a) Includes amounts related to dispositions through the date of disposition. Includes sale of UGC and Ascot.
(b) Represents loss reserves included in our pending sale of certain of our insurance operations to Fairfax. Upon consummation of the sale, we may retain a portion of these reserves through reinsurance arrangements.
During 2016, we recognized adverse prior year loss reserve development of $5.8 billion. This adverse development was primarily a result of the following:
• Loss development factors including workers compensation tail factors, also increased due to an observed lengthening of loss reporting patterns relative to prior expectations.
We use a combination of methods to project ultimate losses for both long-tail and short-tail exposures, which include:
• Paid Development method: The Paid Development method estimates ultimate losses by reviewing paid loss patterns and selecting paid ultimate loss development factors. These factors are then applied to paid losses by applying them to accident years, with further expected changes in paid loss. Since the method does not rely on case reserves, it is not directly influenced by changes in the adequacy of case reserves.
• changes in the legal, regulatory, judicial and social environment, including changes in road safety, public health and cleanup standards;
• third-party actuarial reviews that are periodically performed for key classes of business;
• input from underwriters on pricing, terms, and conditions and market trends; and
The following factors are relevant to the loss development information Included in the tables below:
• Table Organization: The tables are organized by accident year and include policies written on an occurrence and claims- made basis. Financial Lines business is primarily written on a claims-made basis, while the majority of the Liability business is written on
• Groupings: We believe our groupings have homogenous risk characteristics with similar development patterns and would generally be subject to similar trends. As an example, we separated U.S. business from non-U.S. business for long-tail classes because the claims for these two product lines can be substantially different, and we only produced a table for Europe, which is the largest region in our non-U.S. portfolio for non-U.S. long-tail business.
• Reinsurance: Our reinsurance program varies by exposure type and may change from year to year. This may affect the comparability of the data presented in our tables.
During 2016, we recognized $1.9 billion of adverse prior year development primarily due to increased tail factors and loss development factors. The net earned premium has declined by approximately 72% from accident year 2007 to accident year 2016. The proportion of large deductible business has increased which has slowed the reporting pattern of claims.
U.S. Workers’ Compensation is an extremely long-tail line of business, with loss emergence extending for decades. We generally use a combination of loss development methods, frequency/severity and expected loss ratio methods for workers’ compensation.
For guaranteed cost business, expected loss ratio methods generally are given significant weight only in the most recent accident year. Workers’ compensation claims are generally characterized by high frequency, low severity, and relatively consistent loss development from one accident year to the next. We historically have been a leading writer of workers’ compensation, and thus have sufficient volume of claims experience to use development methods. We generally segregate California (CA) and New York (NY) businesses from the other states to reflect their different development patterns and changing percentage of the mix by state. The
claims development tables above are impacted by two other significant initiatives, which offset each other. In recent years, we instituted claims strategy changes and loss mitigation efforts to accelerate settlements, which we believe results in an overall reduction in claim costs. This strategy resulted in an increase in paid losses along the latest diagonals relative to prior years. In addition, we have been reducing premium volume in recent years and shifting a greater proportion of business to insured risk retention structures such as high deductible policies. These mix and volume changes slowed paid and incurred development since excess of deductible claims will typically take longer to emerge and settle.
Expected loss ratio methods for business written in excess of a deductible may be given significant weight in the most recent five accident years. In the current analysis, we have increased our tail factor estimates for states other than NY and CA for guaranteed cost business in recognition of longer medical development patterns that we have been seeing in recent years. In addition, we have reflected increases in legal costs we have seen across the portfolio, particularly in California.
During 2016, we recognized $1.9 billion of adverse prior year development in primary workers’ compensation coverages primarily driven by the risk sharing programs where we provide coverage in excess of large deductibles. For this excess of large deductible business, in 2016, we observed actual loss emergence and development at significantly greater levels than expected based on our previous experience in particular from losses in excess of $1 million. Since these policies respond to larger claims, the loss reporting pattern is much longer than observed in guaranteed cost workers’ compensation and it takes several years to discern credible changes in the pattern. Furthermore, implementation of claims settlement and loss mitigation strategies over the past several years has made the recent evaluation of data more challenging as historical development patterns may not yet fully reflect these claim and mitigation activities. During 2016, we refined our actuarial methodology by combining data across previously segregated underwriting portfolios to improve our ability to analyze the loss development trends and patterns that had been altered by the mix, claims handling and loss mitigation changes we have made during the last 5 years. We also developed further segmentations by deductible size and other key parameters, such as claims handled by third party administrator’s (TPA) staff and not our claims department. As a result, we determined that the loss emergence patterns had changed and lengthened significantly from our prior expectation and therefore, we increased our loss development factors.
During 2014, consistent with prior year studies, we continued to refine our segmentation of primary workers’ compensation into guaranteed cost and excess of large deductible businesses by deductible size group. The net result of the analysis was adverse development of $113 million for the primary workers’ compensation line of business. The key drivers of the adverse development in this line of business were increases for guaranteed cost business in California and New York, and increases for excess of large deductible business, as well as adverse experience in the construction line. Our revised selections had the greatest adverse effect on the construction line of business ($140 million adverse development) and the national accounts line of business ($125 million adverse
development). The most significant favorable effect was in the special workers’ compensation line of business ($155 million favorable development).
We recognized $1.6 billion of adverse development in Other Casualty as a result of increased frequency and severity in all three product lines. The net earned premium for Other Casualty has declined by approximately 59% from accident year 2007 to accident year 2016.
U.S. Other Casualty includes general liability, automobile liability, environmental, and medical malpractice lines of business. These lines of business are all long-tail in nature and while somewhat diverse in terms of exposures, these lines are often subject to similar trends. These lines are often significantly impacted by the underwriting cycle and external judicial trends. Many of our policies contain risk-sharing features, including high deductibles, self-insured retentions or retrospective rating features, in addition to a traditional insurance component. These risk-sharing programs generally are large and complex, comprising multiple products, years and structures, and are subject to amendment over time.
For primary general liability in 2015, we increased our ultimate loss estimates for prior accident years by $172 million largely related to coverage sold to the construction sectors as we reacted to adverse loss emergence throughout the year, by changing our assumptions about loss development and expected loss ratios. For construction, the adverse development was driven by construction defect claims. The construction class was re-underwritten to reduce New York and U.S. residential exposures.
Primary commercial auto liability. In 2016, we continued to observe increases in both the frequency and severity of claims occurring in accident years since the recent U.S. economic downturn. These claims have significantly outpaced both our accident year loss ratio assumptions made in 2015 and the pricing rate increases implemented during the same period. As a result, we recognized $352 million of adverse development during 2016 as we increased the expected loss ratios for recent accident years to reflect continued market deterioration in the trends observed in 2016 and the higher reported losses in very recent accident years.
For primary commercial auto liability in 2015, we observed increases in both the frequency and severity of claims occurring since the recovery from the recent U.S. economic downturn, which have significantly outpaced the pricing rate increases implemented during the same period. As a result, we recognized $105 million of adverse development during 2015 as we increased the expected loss ratios for recent accident years to reflect the deteriorating trends.
Medical Malpractice. During 2016, we recognized $428 million of adverse development in U.S. Other Casualty Medical Malpractice comprising primary and excess hospitals and nursing homes coverages. This was in reaction to a continued increase in the frequency of unusually large claims in these classes that drove the adverse actual versus expected loss emergence observed in 2016. Based on the observed adverse emergence and its sustained levels over the last several years, we increased our expected incurred losses and loss ratios for accident years 2011 and subsequent to reflect the distinct step change in the loss ratios from accident years 2010 and prior.
During 2015, we recognized $202 million of adverse development in U.S. Other Casualty hospitals coverages driven by deteriorating loss experience in accident years 2008 and subsequent characterized by large claims in various segments including hospitals, nursing homes, and pharmaceutical and medical products liability. Based on the review of these large claims, we increased our expected loss ratios for recent accident years and classified physicians and surgeons and pharmaceutical and medical products classes into runoff.
We recognized $306 million of adverse development during 2016 in U.S. Financial Lines primarily due to higher than expected settlements on large claims from the financial crisis. The net earned premium for U.S. Financial Lines has decreased by approximately 12 percent from accident year 2011 to accident year 2016. The mix of business has been changing over this period as we write more cyber and Mergers and Acquisitions business, which generally report claims faster.
Frequency/severity methods are generally not used in isolation for these product lines as the overall losses are driven by large losses more than by claim frequency. Severity trends have varied significantly from accident year to accident year and care is required in analyzing these trends by claim type. We also give weight to claim department ground-up projections of ultimate loss on a claim by claim basis as these may be more predictive of ultimate loss values, especially for older accident years.
During 2015, we recognized $502 million of adverse development driven largely by the adverse loss emergence that we saw in 2015, especially in D&O and professional liability. In particular, we have observed greater than expected loss costs for several claims from accident years 2006 through 2010, driven by unfavorable settlements and deterioration in known claims. We also updated our loss development factor assumptions as well as expected loss ratio assumptions.
During 2014, we recognized $160 million of adverse development driven by the D&O and Related Management Liability product lines as well as the fidelity book, somewhat offset by the Professional Liability product lines in the recent accident years due to the changing economic cycle.
Europe is our largest non-U.S. region for Liability and Financial Lines. Europe Casualty and Financial Lines is composed of third party coverages including general liability, auto liability, D&O, professional liability and various other lines of business throughout both the UK and Continental Europe. These lines of business are all long-tail in nature and while somewhat diverse in terms of exposures, these lines are often subject to similar trends. These lines are impacted by the underwriting cycle and external judicial trends. The largest share of business is in the UK, but significant business is also written in other European countries such as Germany, France, and Italy.
During 2016, we recognized $355 million of adverse development for Europe Casualty and Financial Lines. Within Europe Financial Lines, we recognized $232 million of adverse development primarily from the D&O line in UK and Continental Europe as result of the adverse actual versus expected loss emergence in 2016 due to increased frequency and severity resulting from increasing litigation. In Europe Casualty we recognized $123 million of adverse development primarily from the unexpected emergence of several large excess casualty claims as well as the impact of declining interest rates that are applied to structured claims in the UK. The actual versus expected loss emergence for Europe Casualty and Financial Lines was more than expected.
During 2014, we had $24 million of adverse development driven by financial lines D&O and professional lines in the UK and Continental Europe where severity emerged worse than expected.
Cumulative Paid Losses and Allocated Loss Adjustment Expenses, Net of Reinsurance
U.S. and Europe Property products include commercial, industrial and energy-related property insurance products and services that cover exposures to manmade and natural disasters, including business interruption. U.S. and Europe Special Risk products include aerospace, environmental, political risk, trade credit, surety and marine insurance, and various small and medium sized enterprises insurance lines.
factors are continually reevaluated to reflect emerging claim experience, rate changes or other factors that could affect the adequacy of the IBNR factor being employed.
During 2015, we recognized $128 million of favorable development from a number of large individual property claims.
Frequency/severity and loss development methods are utilized for domestic personal auto product lines.
For these classes of business, reliance is placed on frequency/severity methods as claim counts emerge quickly for personal auto. Frequency/severity methods allow for more immediate analysis of resulting loss trends and comparisons to industry and other diagnostic metrics.
In general, development for U.S., Europe and Japan Personal Insurance classes has been very stable, with only modest changes in the initial selected loss ratios for this business.
During 2016, the U.S. Run-Off Long Tail Insurance Lines experienced adverse prior year development of $390 million driven by Legacy pre-1986 pollution losses and the Run-Off public entity casualty business.
We consider a number of factors and recent experience in addition to the results of both external and internal analyses, to estimate asbestos and environmental loss reserves. We primarily base our determination of these loss reserves on a combination of ground-up and top-down analyses of historical claims and available insurance coverages. Nonetheless, we believe that significant uncertainty remains as to our ultimate liability for asbestos and environmental claims, which is due to several factors, including:
At December 31, 2016 and 2015, our net loss reserves included $670 million and $722 million, respectively, for asbestos and environmental-related claims (net of reinsurance, including retroactive reinsurance). We cede the bulk of AIG Property Casualty’s net domestic asbestos liabilities under a 2011 retroactive reinsurance agreement with NICO with an aggregate limit of $3.5 billion. Reinsurance recoverables related to this agreement was $1.7 billion and $1.8 billion, respectively, at December 31, 2016 and 2015, respectively. Under retroactive reinsurance accounting, contractual gains are deferred and amortized into income over the settlement period of the underlying reinsured claims. During 2016, 2015 and 2014, we recognized approximately $(53.4) million, $213 million and $(10.7) million, respectively, of additional recoveries under the NICO agreement for which the income statement benefit was deferred. The deferred gain associated with this retroactive reinsurance is $377 million and $430 million at December 31, 2016 and 2015, respectively, and is reported in Other Liabilities. The expense related to this increase in the deferred gain liability is reported in other income/expense rather than losses incurred.
During 2016, the Legacy U.S. Runoff Property and Casualty segment recognized $390 million of adverse prior year development.
Asbestos and Environmental (1986 and prior). In 2016, we increased gross undiscounted asbestos incurred losses by $106 million and decreased net undiscounted asbestos incurred losses by $20 million. The gross undiscounted change reflects an increase in estimates related to our accounts retroceded to NICO. The favorable development of the net incurred losses was largely a result of higher estimated external reinsurance recoveries on our retained asbestos exposures. For environmental, we increased incurred losses by $211 million primarily due to adverse development on several large clean-up sites and related accounts as well as a result of top down actuarial analyses performed during the year.
Certain asbestos claims are discounted when allowed by the regulator and when payments are fixed and determinable, based on the investment yields of the companies and the payout pattern for the claims. At December 31, 2016, the discount for asbestos reserves was fully amortized.
The following table presents the net loss reserve discount benefit (charge):
During 2015, the effective interest rate increased due to the increase in Treasury rates and credit spreads that resulted in an increase in the loss reserve discount by $225 million.
Future policy benefits primarily include reserves for traditional life and annuity payout contracts, which represent an estimate of the present value of future benefits less the present value of future net premiums. Included in Future policy benefits are liabilities for annuities issued in structured settlement arrangements whereby a claimant has agreed to settle a general insurance claim in exchange for fixed payments over a fixed determinable period of time with a life contingency feature.
The liability for long-duration future policy benefits has been established including assumptions for interest rates which vary by year of issuance and product, and range from approximately 0.1 percent to 14 percent. Mortality and surrender rate assumptions are generally based on actual experience when the liability is established.
In addition to liabilities for universal life, fixed annuities, fixed options within variable annuities, annuities without life contingencies, funding agreements and GICs, policyholder contract deposits also include our liability for (a) certain guaranteed benefits and indexed features accounted for as embedded derivatives at fair value, (b) annuities issued in a structured settlement arrangement with no life contingency and (c) certain contracts we have elected to account for at fair value. See Note 14 herein for additional information on guaranteed benefits accounted for as embedded derivatives.
Under a funding agreement-backed notes issuance program, an unaffiliated, non-consolidated statutory trust issues medium-term notes to investors, which are secured by GICs issued to the trust by one of our Life Insurance Companies through our Institutional Markets business.
Other policyholder funds also include provisions for future dividends to participating policyholders, accrued in accordance with all applicable regulatory or contractual provisions. Participating life business represented approximately 1.9 percent of gross insurance in force at December 31, 2016 and 3.1 percent of gross domestic premiums and other considerations in 2016. The amount of annual dividends to be paid is approved locally by the boards of directors of the Life Insurance Companies. Provisions for future dividend payments are computed by jurisdiction, reflecting local regulations. The portions of current and prior net income and of current unrealized appreciation of investments that can inure to our benefit are restricted in some cases by the insurance contracts and by the local insurance regulations of the jurisdictions in which the policies are in force.
ITEM 8 | Notes to Consolidated Financial Statements | 14. Variable Life and Annuity Contracts
The following summarizes GMDB and GMIB liabilities related to variable annuity contracts, excluding assumed reinsurance:
remaining guaranteed amount, and, for lifetime GMWB products, the annuity payments continue as long as the covered person(s) is living.