Operations outside the U.S. and Canada and assets held abroad may be adversely affected by political developments in foreign countries, including tax changes, nationalization and changes in regulatory policy, as well as by consequence of hostilities and unrest. The risks of such occurrences and their overall effect upon us vary from country to country and cannot be predicted. If expropriation or nationalization does occur, our policy is to take all appropriate measures to seek recovery of any affected assets. Certain of the countries in which our business is conducted have currency restrictions that generally cause a delay in a company’s ability to repatriate assets and profits. See also Item 1A. Risk Factors - Business and Operations for additional information.
(a) Reduced by fourth quarter reserve strengthening charges of $4.2 billion in 2010 related to the annual review of our property casualty businesses liability for unpaid losses and loss adjustment expenses.
This Annual Report on Form 10-K and other publicly available documents may include, and officers and representatives of American International Group, Inc. (AIG) may from time to time make, projections, goals, assumptions and statements that may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These projections, goals, assumptions and statements are not historical facts but instead represent only our belief regarding future events, many of which, by their nature, are inherently uncertain and outside our control. These projections, goals, assumptions and statements include statements preceded by, followed by or including words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “view,” “target” or “estimate.” These projections, goals, assumptions and statements may address, among other things, our:
• strategies to grow net investment income, efficiently manage capital and reduce expenses;
We have incorporated into this discussion a number of cross-references to additional information included throughout this Annual Report on Form 10-K to assist readers seeking additional information related to a particular subject.
In 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.
Book Value Per Share Excluding Accumulated Other Comprehensive Income (AOCI) is used to show the amount of our net worth on a per-share basis. We believe Book Value Per Share Excluding AOCI is useful to investors because it eliminates the effect of non-cash items that can fluctuate significantly from period to period, including changes in fair value of our available for sale securities portfolio and foreign currency translation adjustments. Book Value Per Share Excluding AOCI is derived by dividing Total AIG shareholders’ equity, excluding AOCI, by Total common shares outstanding. The reconciliation to book value per common share, the most comparable GAAP measure, is presented in Item 6. Selected Financial Data.
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 comparisons with our insurance competitors. When we use these measures, reconciliations to the most comparable GAAP measure are provided in the Results of Operations section of this MD&A on a consolidated basis.
After-tax operating income attributable to AIG is derived by excluding the following items from net income attributable to AIG:
• other income and expense - net, related to Corporate and Other run-off insurance lines;
• certain post-acquisition transaction expenses incurred by AerCap Holdings N.V. (AerCap) in connection with its acquisition of ILFC and the difference between expensing AerCap’s maintenance rights assets over the remaining lease term as compared to the remaining economic life of the related aircraft and related tax effects;
• legacy tax adjustments primarily related to certain changes in uncertain tax positions and other tax adjustments; and
• legal reserves and settlements related to legacy crisis matters, which include favorable and unfavorable settlements related to events leading up to and resulting from our September 2008 liquidity crisis and legal fees incurred as the plaintiff in connection with such legal matters.
· Accident year loss and combined ratios, as adjusted: both the accident year loss and combined ratios, as adjusted, exclude catastrophe losses and related reinstatement premiums, prior year development, net of premium adjustments, and the impact of reserve discounting. Catastrophe losses are generally weather or seismic events having a net impact in excess of $10 million each.
· Pre-tax operating income is derived by excluding the following items from pre-tax income:
• changes in fair values of fixed maturity securities designated to hedge living benefit liabilities (net of interest expense);
· 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.
· Corporate and Other - Pre-tax operating income and loss is derived by excluding the following items from pre-tax income and loss:
· certain post-acquisition transaction expenses incurred by AerCap in connection with its acquisition of ILFC and the difference between expensing AerCap’s maintenance rights assets over the remaining lease term as compared to the remaining economic life of the related aircraft and our share of AerCap’s income taxes; and
• Consumer property casualty business and Japan life insurance business, which were previously reported as components of AIG Property Casualty, and our retail life and retirement and institutional group retirement and group benefits businesses, which were previously reported as components of AIG Life and Retirement, are now reported as components of the Consumer Insurance reportable segment.
• Insurance run-off lines of business, which were previously reported in AIG Property Casualty's Other category, are now reported as a component of the Corporate and Other category.
We reclassified our presentation for certain Policy fees, along with a related portion of Amortization of deferred policy acquisition costs, from their respective captions to Net realized capital gains (losses) and Changes in benefit reserves and DAC, VOBA and SIA related to net realized capital gains (losses), respectively. The reclassification of these policy fees, which are related primarily to guaranteed minimum withdrawal benefits (GMWB) embedded derivatives in our variable annuity products, to realized capital gains (losses), consolidates the fees from these embedded derivatives with the associated change in fair value of such derivatives. The reclassifications reduced pre-tax operating income and after-tax operating income, but had no effect on GAAP basis Total revenues, Income from continuing operations before income tax expense (benefit) or Net income.
Also, revisions were made to change the classification of certain miscellaneous income from General operating and other expenses to premiums, and of certain broker-dealer fees from General operating and other expenses to other income, to conform with the current period presentation. There was no effect on pre-tax or after-tax operating income, income from continuing operations or net income.
Consumer Insurance pre-tax operating income decreased in 2014 compared to 2013 primarily due to lower net investment income, primarily from lower income from alternative investments, and additional reserves for IBNR death claims related to continued enhancement of claims procedures. These items more than offset favorable performance from our businesses in 2014 compared to 2013, which included growth in policy fees and assets under management primarily from strong sales of variable and index annuities in Retirement, effective crediting rate management, and higher underwriting income in Personal Insurance, primarily from improved loss experience and lower general operating expenses.
Our investment portfolio performance improved in 2014 compared to 2013 due to positive performance on bonds for which we elected the fair value option, driven by movements on interest rates.
Net realized capital gains declined in 2014 compared to 2013 due to lower capital gains from sales of investments related to capital loss carryforward utilization and higher fair value losses on embedded derivatives related to variable annuity guarantee features, net of hedges.
Net investment income increased 1.7 percent to $16.1 billion in 2014 compared to 2013.
Net unrealized gains in our available for sale portfolio increased to approximately $19.0 billion as of December 31, 2014 from approximately $11.7 billion as of December 31, 2013 due to a decline in interest rates and widening of spreads.
The overall credit rating of our fixed maturity securities portfolio remains largely unchanged from December 31, 2013.
We maintained financial flexibility at AIG Parent in 2014 through $2.6 billion in dividends in the form of cash and fixed maturity securities from our Non-Life Insurance Companies and $6.8 billion in dividends and loan repayments in the form of cash and fixed maturity securities from our Life Insurance Companies, which included approximately $829 million of legal settlement proceeds.
We paid a cash dividend on AIG Common Stock of $0.125 per share on each of March 25, 2014, June 24, 2014, September 25, 2014 and December 18, 2014.
Our Board of Directors declared a cash dividend on AIG Common Stock on February 12, 2015 of $0.125 per share, payable on March 26, 2015 to shareholders of record on March 12, 2015.
Our business is affected by industry and economic factors such as interest rates, currency exchange rates, credit and equity market conditions, catastrophic claims events, regulation, tax policy, competition, and general economic, market and political conditions. We continued to operate under difficult market conditions in 2014, characterized by factors such as historically low interest rates, instability in the global markets and slowing growth in emerging markets, China and Euro-Zone economies.
The outlook for each of our businesses and management initiatives to improve growth and performance in 2015 and over the longer term is summarized below.
Property Casualty has observed improving trends in certain key indicators that may offset the effect of current economic challenges. In recent years, Property Casualty has benefitted from favorable pricing trends, particularly in the U.S. However, such trends have tapered off in recent quarters. The property casualty insurance industry is experiencing modest growth as a result of this positive rate trend and an increase in overall exposures in certain markets. Property Casualty also expects that expansion in certain growth economies will occur at a faster pace than in developed countries, although at levels lower than those previously expected due to revised economic assumptions.
In the U.S., Property Casualty’s exposure to terrorism risk is mitigated by the Terrorism Risk Insurance Act (TRIA) in addition to limited private reinsurance protections. For additional information on TRIA, see Item 1A. Risk Factors - Reserves and Exposures and Item 7. MD&A - Enterprise Risk Management - Insurance Operations Risks - Non-Life Insurance Companies Key Insurance Risks - Terrorism Risk.
While higher residential mortgage interest rates have had an unfavorable impact on new mortgage loan volumes, particularly on refinancing activity, Mortgage Guaranty expects current residential mortgage interest rates will have a favorable impact on the persistency of business written in 2012 and 2013, since refinancing of mortgages would be unattractive to homeowners who originated mortgages at the historically low residential mortgage interest rates prevalent during that period. Mortgage Guaranty expects that this higher persistency will continue to have a positive effect on its results throughout 2015.
Commercial Insurance strives to be our customers’ most valued insurer. Our investments in engineering, underwriting, claims services, science and data together are intended to help offer our customers not only innovative products, superb service and access to an extensive global network but also a superior and rewarding customer experience.
Property Casualty’s efforts to better segment its business by industry, geography and type of coverage in order to enhance its decision making regarding risk acceptance and pricing are ongoing. For example, within workers’ compensation, Property Casualty has observed different experience and trends based on this segmentation, which helps inform its risk appetite, pricing and loss mitigation decisions.
Mortgage Guaranty expects to continue as a leading provider of mortgage insurance and seeks to differentiate itself from its competitors by utilizing its proprietary risk-based pricing strategy. This pricing strategy provides Mortgage Guaranty’s customers with mortgage insurance products that are priced commensurate with the underwriting risk, which we believe will result in an appropriately priced, high-quality book of business.
We continue to make strategic investments in systems, processes and talent worldwide, which are expected to create additional value and greater efficiency in the years ahead. In addition, along with other areas of AIG, Commercial Insurance continues to leverage its various off-shore centers, taking advantage of opportunities to centralize and standardize processes and platforms.
Commercial Insurance continues to execute capital management initiatives by enhancing broad-based risk tolerance guidelines for its operating units, implementing underwriting strategies to increase return on equity by line of business and reducing exposure to businesses with inadequate pricing and increased loss trends. In addition, Commercial Insurance remains focused on enhancing its global reinsurance strategy to improve overall capital efficiency, although this strategy may lead to periodic income statement volatility.
We also continue to streamline our legal entity structure to enhance transparency for regulators and optimize capital and tax efficiency, particularly with respect to the Non-Life Insurance Companies in the Property Casualty and Personal Insurance operating segments. Our legal entity restructuring initiatives have enhanced dividend capacity, reduced required capital, and provided tax benefits for these operations. Additionally, the restructurings allow us to simplify our reinsurance arrangements, which further facilitate increased capital optimization. In 2014, we completed the integration of our Japan operations into a holding company structure through the conversion of the American Home Assurance Company’s Japan branch to a subsidiary of the Japan holding company, American Home Assurance Japan, effective on April 1, 2014. We expect our overall legal entity restructuring to be substantially completed in 2016, subject to regulatory approvals in the relevant jurisdictions.
The sustained low interest rate environment has a significant impact on the annuity industry. Low long-term interest rates put pressure on long-term investment returns, negatively affect sales of interest rate sensitive products and reduce future profits on certain existing fixed rate products. As long as the sustained low interest rate environment continues, market conditions will be challenging for the fixed annuity market. In addition, more highly leveraged providers have entered the market offering higher crediting rates.
Populations are living longer and have increased needs for financial protection for beneficiaries, estate planning and wealth creation. The Life operating segment addresses these needs with a broad spectrum of products, ranging from the pure protection focus of term life to investment-oriented products such as indexed and variable universal life.
U.S. life insurance industry sales declined in 2014, driven by lower term and universal life sales partially offset by small gains in whole life markets. Market factors, primarily low interest rates and regulatory changes, have caused the universal life market to shift its focus from guaranteed universal life to indexed universal life products that offer attractive cash accumulation and increased living benefit options.
The overall rate level has improved in the Japanese and certain U.S. markets for auto, personal property, and accident and health products compared to prior years. In Japan, car and home sales increased in 2014 prior to the increase in the consumption tax, but prospectively, sales are expected to return to normal levels. In the U.S., overall rate level changes for auto and personal property products are expected to be positive but slow, with sales increasing as the economy continues to recover. Our Personal Insurance operating segment expects to increase its investment in growth economy nations that have a higher growth outlook for personal insurance products.
We intend to achieve rate adequacy through implementation of global underwriting practices and enhanced tools and analytics. We intend to optimize the value of our business lines through product and portfolio management and refined technical pricing. We intend to continue to enhance the customer experience and efficiency through claim best practices, and to deploy enhanced operating structures and standardized processes and systems, while managing claim-handling efficiency.
Retirement Income Solutions intends to continue capitalizing on the opportunity to meet consumer demand for guaranteed income by maintaining competitive variable annuity product offerings while managing risk, using innovative product design and well-developed economic hedging capabilities. De-risking features of its variable annuity product design include variable rider fees indexed to an equity market volatility index, required minimum allocations to fixed accounts, and the utilization of volatility control funds. Retirement Income Solutions has a dynamic risk management hedging program and continues to invest in market risk management. Strategies to diversify the Retirement Income Solutions product portfolio include growing sales of fixed index annuities with guarantee features, which provide additional income solutions for consumers approaching retirement, and introducing new investment-focused variable annuities, which offer alternative asset classes and tax benefits to investors seeking higher returns without guaranteed lifetime income.
Fixed Annuities sales will continue to be challenged by the low interest rate environment. Sales of fixed annuities could improve if interest rates rise and the yield curve steepens, as these market conditions make fixed annuity products more attractive compared to alternatives such as bank deposits. The growing market for immediate and deferred income products, driven by customers seeking guaranteed income products, provides an opportunity for Fixed Annuities to increase the diversification of its product portfolio.
Consumer Insurance continues to explore other potential life insurance and accident and health opportunities internationally.
Personal Insurance aims to provide customers with the products they need, distributed through the channels they prefer, and delivered with excellent customer service. Personal Insurance is focused on profitable growth in its selected market segments, with targeted investments in both scale businesses and emerging markets. Personal Insurance will continue to leverage its strong risk management and market expertise to foster growth by providing innovative and competitive solutions to its customers and distributors.
We intend to continue to enhance profitability and capital efficiency within our insurance entities through disciplined pricing, in-force profitability management and effective management of risk. Volatility risk controls including required minimum allocations to fixed and volatility control accounts, rider fees indexed to an equity market volatility index and our comprehensive dynamic hedging program are critical tools for products where we have significant equity market risk and exposure to changes in interest rates. Additionally, our scale and the breadth of our product offerings provide diversification of risk. Within our Non-Life Insurance Companies, we continue to streamline our legal entity structure to enhance transparency with regulators and optimize capital efficiency.
See Results of Operations - Segment Results - Consumer Insurance Results and Insurance Reserves for additional information.
The following section provides a comparative discussion of our Results of Operations on a reported basis for the three-year period ended December 31, 2014. Factors that relate primarily to a specific business segment are discussed in more detail within that business segment discussion. For a discussion of the Critical Accounting Estimates that affect the Results of Operations, see the Critical Accounting Estimates section of this MD&A.
For the year ended December 31, 2014, the effective tax rate on income from continuing operations was 27.9 percent. The effective tax rate on income from continuing operations differs from the statutory tax rate of 35 percent primarily due to tax benefits of $236 million associated with tax exempt interest income, $209 million related to a decrease in the U.S. Life Insurance Companies’ capital loss carryforward valuation allowance, $182 million of income excludable from gross income related to the global resolution of certain residential mortgage-related disputes and $68 million associated with the effect of foreign operations.
For the year ended December 31, 2013, the effective tax rate on income from continuing operations was 3.8 percent. The effective tax rate on income from continuing operations differs from the statutory tax rate of 35 percent primarily due to tax benefits of $2.8 billion related to a decrease in the U.S. Life Insurance Companies’ capital loss carryforward valuation allowance, $396 million related to a decrease in certain other valuation allowances associated with foreign jurisdictions and $298 million associated with tax exempt interest income. These items were partially offset by charges of $632 million related to uncertain tax positions.
After-tax operating income attributable to AIG increased in 2013 compared to 2012, primarily due to increases in income from insurance operations, lower income tax expense and noncontrolling interests, partially offset by fair value gains on AIG’s previously held interests in AIA ordinary shares, Maiden Lane II LLC (ML II), and ML III.
We report the results of our operations through two reportable segments: Commercial Insurance and Consumer Insurance. The Corporate and Other category consists of businesses and items not allocated to our reportable segments.
Pre-tax income increased in 2013 compared to 2012 primarily due to an increase in pre-tax operating income for both Commercial Insurance and Consumer Insurance, a $6.7 billion increase due to the loss associated with the announced sale of ILFC in 2012, an increase in legal settlements related to legacy crisis matters and an increase in net realized capital gains, driven by gains from sales of investments related to capital loss carryforward utilization in 2013, partially offset by impairments on investments in life settlements, an increase in loss on extinguishment of debt from on-going debt management activities and higher loss recognition expense reported in changes in benefit reserves and DAC, VOBA, and SIA related to net realized capital gains.
Change in certain benefit reserves, DAC, VOBA and SIA related to net realized capital gains was largely comprised of loss recognition expense in the Institutional Markets and Retirement operating segments, totaling $1.5 billion in 2013 and $1.2 billion in 2012, that was attributable primarily to investment sales related to capital loss carryforward utilization with reinvestment of the sales proceeds at lower yields. Change in certain benefit reserves, DAC, VOBA and SIA also included loss recognition expense in Corporate and Other of $98 million in 2013.
Net investment income is attributed to the operating segments of Commercial Insurance and Consumer Insurance based on internal models consistent with the nature of the underlying businesses.
For Commercial Insurance - Institutional Markets, Consumer Insurance - Retirement and Consumer Insurance - Life, net investment income is attributed based on invested assets from segregated product line portfolios. Invested assets in excess of liabilities are allocated to product lines based on internal capital estimates.
Property Casualty, International Life and Personal Insurance's business is transacted in most major foreign currencies. The following table presents the average of the quarterly weighted average exchange rates of the currencies that have the most significant impact on our businesses:
Commercial Insurance presents its financial information in three operating segments - Property Casualty, Mortgage Guaranty and Institutional Markets. The following section provides a comparative discussion of Commercial Insurance Results of Operations for 2014, 2013 and 2012 by operating segment.
Acquisition expenses decreased in 2014 compared to 2013 primarily due to a reduction in expenses related to personnel engaged in sales support activities, and lower premium taxes and guaranty fund and other assessments reflecting a change in business mix.
General operating expenses decreased in 2013, compared to 2012, primarily due to a decrease in bad debt expense and reduced costs for strategic initiatives. Bad debt expense decreased by $159 million in 2013 from $140 million in 2012. The decrease in bad debt expense was primarily due to reductions in prior year reserves, as collections exceeded the originally estimated recoveries. Strategic initiatives which include technology-related expenses and those severance charges borne by Property Casualty, decreased by $137 million in 2013 from $277 million in 2012. These decreases were partially offset by an increase in the cost of employee incentive plans primarily due to an improved alignment of employee performance with the overall performance of the organization, including our stock performance, and accelerated vesting provisions for retirement-eligible individuals in the 2013 share-based plan.
Net investment income increased in 2013, compared to 2012, primarily due to increased alternative investment income derived from equity market performance and income associated with the PICC P&C shares that are accounted for under the fair value option. This alternative investment performance was primarily due to our investments in hedge funds, which benefited from equity market performance. Fair value increases also contributed to the net investment income increase. The portion of our investment in PICC P&C shares accounted for under the fair value option contributed $110 million to net investment income. Although interest rates remained at historically low levels, there were upward movements in rates throughout the year, with the ten year U.S. Treasury yield increasing 126 basis points during 2013. These increasing rates, coupled with continued portfolio diversification, helped mitigate the effects of interest rates on matured or sold investments
exceeding new investment yields. The combination of improving yield differential and above average alternative investment returns increased the return on invested assets by approximately 0.4 points to 4.2 percent.
Casualty net premiums written decreased in 2014 compared to 2013 primarily due to the effect on renewals from our strategy to enhance risk selection, particularly in the Americas. Strong growth and new writings in certain lines of business, particularly in EMEA, were more than offset by the declines in the Americas.
We entered into a catastrophe bond reinsurance transaction, effective as of January 1, 2014, with Tradewynd Re Ltd., which provides Property Casualty and Personal Insurance with up to $400 million of indemnity reinsurance protection against U.S.,
The Americas net premiums written increased in 2013 compared to 2012, primarily due to rate increases, partially offset by decreases in Casualty business reflecting the execution of our strategy to enhance risk selection and the effect of the timing of the catastrophe reinsurance transactions.
Asia Pacific net premiums written increased in 2013 compared to 2012, primarily due to organic growth and rate increases in Property, Specialty, and Casualty. In addition, our decision to retain more favorable risks in Property and Financial lines increased net premiums written in 2013 compared to 2012.
EMEA net premiums written increased in 2013 compared to 2012, due to new business growth, particularly in Property and Financial lines, and a change in reinsurance strategies to retain more favorable risks in those lines.
See Insurance Reserves - Non-Life Insurance Companies for further discussion of discounting of reserves and prior year development.
(a) Catastrophes are generally weather or seismic events having a net impact on Commercial Insurance in excess of $10 million each.
(b) Includes Storm Sandy flooding and wind damage losses of $1.7 billion.
The accident year combined ratio, as adjusted, decreased by 0.9 points in 2014 compared 2013, primarily due to lower expense ratio which was partially offset by a higher accident year loss ratio, as adjusted.
The combined ratio decreased by 9.3 points in 2013 compared to 2012 primarily due to a decrease in the loss ratio.
The accident year combined ratio, as adjusted, improved by 4.2 points in 2013 compared to 2012, primarily due to a lower accident year loss ratio, as adjusted.
(b) Represents the full amount of second-lien loans insured reduced for contractual aggregate loss limits on certain pools of loans, which is usually 10 percent of the full amount of loans insured in each pool. Certain second-lien pools have reinstatement provisions, which will expire as the loan balances are repaid.
First-lien pre-tax operating income increased in 2014 compared to 2013, primarily due to improved underwriting income as a result of a $229 million decrease in first-lien losses and loss adjustment expenses incurred reflecting fewer new delinquencies, favorable prior year loss reserve development, and higher cure rates. In addition, first-lien pre-tax operating income increased due to a $119 million increase in first-lien net premiums earned in 2014 compared to 2013, largely from growth in the book of business, higher persistency, and, to a lesser extent, the acceleration of premiums earned as the result of the recognition of a shorter expected coverage period on certain single premium business. The decrease in first-lien losses and loss adjustment expenses incurred combined with the increase in earned premiums resulted in an improved combined ratio of 52.6 points in 2014 compared to 91.1 points in 2013.
General operating expenses increased in 2014 compared to 2013 due to increased technology expenses and an impairment charge on certain capitalized technology costs.
The Other business’ pre-tax operating income for 2014 was $82 million compared to $27 million in 2013. The increase in pre-tax operating income is due to a decline in losses and loss adjustment expenses incurred of $62 million and a $17 million reduction in underwriting expenses, partially offset by a decline in net premiums earned of $22 million and a decline in net investment income of $2 million.
Pre-tax operating income increased in 2013 compared to 2012 due to an increase in net premiums earned and a decline in incurred losses from lower delinquency rates and higher cure rates.
Acquisition expenses increased in 2013 compared to 2012, primarily as a result of the increase in new insurance written related to the increase in mortgage originations resulting from the addition and expansion in distribution channels.
General operating expenses increased in 2013 compared to 2012 due to increased servicing costs related to the growth in the in-force business.
The Other business’ pre-tax operating income for 2013 was $27 million, $56 million lower than 2012. The decline in pre-tax operating income was primarily due to a decline in net premiums earned of $32 million and an increase in losses and loss adjustment expenses incurred of $12 million, and a $2 million increase in underwriting expenses.
The delinquency inventory for domestic first lien business declined during 2014 as a result of cures and paid claims exceeding the number of newly reported delinquencies. Mortgage Guaranty’s first lien primary delinquency ratio at December 31, 2014 was 4.4 percent compared to 5.9 percent at December 31, 2013. Over the last several quarters, Mortgage Guaranty has experienced a decline in newly reported defaults and an increase in cure rates.
The delinquency inventory for domestic first lien business declined during 2013 as a result of higher cure rates and fewer newly reported delinquencies. Mortgage Guaranty’s first lien primary delinquency ratio at December 31, 2013 was 5.9 percent compared to 8.8 percent at December 31, 2012.
The following table provides a summary of activity in Mortgage Guaranty’s domestic first lien delinquency inventory:
The combined ratio decreased by 41.1 points in 2014 compared to 2013. The decrease was driven primarily by a reduction in the loss ratio due to lower losses and loss adjustment expenses incurred from fewer new delinquencies, favorable prior year loss reserve development, and higher cure rates.
The acquisition ratio decreased by 2.1 points in 2014 compared to 2013. Acquisition expenses decreased compared to an increase in net premiums earned, driven by the decreases in new insurance written in 2014 due to lower mortgage originations.
The general operating expense ratio decreased by 0.2 points in 2014 compared to 2013. The decrease was driven primarily by growth in earned premiums.
The acquisition ratio increased by 0.4 points in 2013 compared to 2012. The increase in acquisition expense was driven by the increase in mortgage originations.
General operating expenses in 2014 increased slightly compared to 2013, primarily due to investments in technology.
General operating expenses in 2013 increased compared to 2012, primarily to support increased volume in the stable value wrap business.
For Institutional Markets, premiums represent amounts received on traditional life insurance policies and life-contingent payout annuities or structured settlements. Premiums and deposits is a non-GAAP financial measure that includes direct and assumed premiums as well as deposits received on universal life insurance and investment-type annuity contracts, including GICs and stable value wrap funding agreements.
Pre-tax operating income for Retirement in 2014 was comparable to 2013, as higher policy fees and the higher positive impact of actuarial assumption updates were offset by lower net investment income from alternative investments. The increase in policy fees was driven by growth in variable annuity separate account assets from positive net flows and favorable equity markets. A higher volume of commissions and advisory fees included in Other income, net of related expenses, was driven by increased assets under management.
Pre-tax operating income in both years included a net positive impact from the update of certain estimated gross profit assumptions used to amortize DAC and related items in the investment-oriented product lines, which resulted in a $246 million net increase in pre-tax operating income in 2014, compared to a $233 million net increase in pre-tax operating income in 2013. See Insurance Reserves - Life Insurance Companies DAC and Reserves - Update of Actuarial Assumptions for amounts by product line and financial statement line item and additional discussion.
Net investment income for 2014 decreased compared to 2013, primarily due to a $158 million decrease in income from alternative investments, including higher hedge fund income in 2013, which benefited from favorable equity market conditions and several large hedge fund redemptions. The decrease in hedge fund income in 2014 compared to 2013 was partially offset by an increase in private equity fund income.
Overall, Retirement fixed maturity portfolio yields in 2014 declined compared to 2013, primarily as a result of investment purchases and investment of portfolio cash flows at rates below the weighted average yield of the existing portfolio in the historically low interest rate environment. The Fixed Annuities and Group Retirement product lines were able to maintain base spreads in 2014 at a level comparable to 2013, and Retirement Income Solutions base spread increased, as a result of active crediting rate management. See Spread Management below for additional discussion.
Pre-tax operating income in 2013 included a net increase of $233 million from adjustments to update certain gross profit assumptions used to amortize DAC and related items in investment-oriented product lines, compared to a net increase of $84 million in 2012. See Insurance Reserves - Life Insurance Companies DAC and Reserves - Update of Actuarial Assumptions for additional information on assumption updates.
Net investment income for 2013 increased compared to 2012, primarily due to higher income from alternative investments, partially offset by ML II fair value gains recognized in 2012 and lower base income due to reinvestment of investment proceeds at lower rates. The $340 million increase in alternative investment income in 2013 compared to 2012 reflected higher hedge fund income in 2013 due to favorable equity market conditions and several large redemptions from hedge funds.
The contractual provisions for renewal of crediting rates and guaranteed minimum crediting rates included in products may have the effect, in a sustained low interest rate environment, of reducing spreads and thus reducing future profitability. Although this interest rate risk is partially mitigated through the Life Insurance Companies’ asset-liability management process, product design elements and crediting rate strategies, a sustained low interest rate environment may negatively affect future profitability.
Disciplined pricing on new business is used to pursue new sales of annuity products at targeted net investment spreads in the current rate environment. Retirement has an active product management process to ensure that new business offerings appropriately reflect the current interest rate environment. To the extent that Retirement cannot achieve targeted net investment spreads on new business, products are re-priced or no longer sold. Additionally, where appropriate, existing products that had higher minimum rate guarantees have been re-filed with lower crediting rates as permitted under state insurance laws for new sales. As a result, new sales of fixed annuity products generally have minimum interest rate guarantees of one percent.
As of December 31, 2014, Retirement’s fixed annuity reserves, which include fixed options offered within variable annuities sold in the Group Retirement and Retirement Income Solutions product lines as well as reserves of the Fixed Annuities product line, had minimum guaranteed interest rates ranging from 1.0 percent to 5.5 percent, with the higher rates representing guarantees on older in-force products. As indicated in the table below, approximately 71 percent of annuity account values were at their minimum crediting rates as of December 31, 2014, compared to 74 percent at December 31, 2013. The decrease during 2014 in the percentage of annuity account values at the minimum crediting rate was primarily due to new deposits that were crediting at rates above the contractual minimum, and may include sales inducements, as well as the run-off of older business that was at minimum crediting rates. As a result of disciplined pricing on new business and the run-off of older business with higher minimum interest crediting rates, fixed annuity account values having contractual minimum guaranteed rates above 1 percent decreased from 84 percent at December 31, 2013 to 79 percent at December 31, 2014.
* Fixed annuities shown include fixed options within variable annuities sold in Group Retirement and Retirement Income Solutions product lines.
For Retirement, premiums primarily represent amounts received on life-contingent payout annuities. Premiums and deposits is a non-GAAP financial measure that includes, in addition to direct and assumed premiums, deposits received on investment-type annuity contracts and mutual funds.
The following table presents Retirement premiums and deposits and net flows by product line:
* Excludes activity related to closed blocks of fixed and variable annuities, which had reserves of approximately $5.4 billion and $6.0 billion at December 31, 2014 and 2013, respectively.
Premiums and deposits for Retirement increased in 2014 compared to 2013, primarily due to continued strong demand for variable and fixed index annuities in the Retirement Income Solutions product lines and improved sales in Fixed Annuities, partially offset by lower deposits in Retail Mutual Funds and Group Retirement. Premiums and deposits improved significantly in 2013 compared to 2012, primarily due to strong sales across all product lines. See below for additional discussion of each product line.
Net flows for annuity products included in the Fixed Annuities, Retirement Income Solutions and Group Retirement product lines represent premiums and deposits less death, surrender and other withdrawal benefits. Net flows from mutual funds, which are included in both the Retail Mutual Funds and Group Retirement product lines, represent deposits less withdrawals.
Retail Mutual Fund deposits and net flows decreased in 2014 compared to 2013 and increased in 2013 compared to 2012. These variances were primarily driven by activity in the Focused Dividend Strategy Fund, which had record sales in 2013. In 2014, the relative performance of the fund declined, putting pressure on sales and withdrawal activity.
The following table presents reserves for annuity product lines by surrender charge category:
(a) Excludes mutual fund assets under management of $14.6 billion and $15.1 billion at December 31, 2014 and 2013, respectively.
(b) Group Retirement Products in this category include reserves of approximately $6.2 billion at both December 31, 2014 and 2013 that are subject to 20 percent annual withdrawal limitations.
The following table presents surrender rates for deferred annuities by product line:
Pre-tax operating income decreased in 2014 compared to 2013, primarily due to increases in policyholder benefit reserves, lower net investment income and higher general operating expenses. Updates of actuarial assumptions also decreased pre-tax operating income by $119 million in 2014 compared to $80 million in 2013. The assumption updates in 2014 included $87 million of loss recognition expense to increase reserves for certain long-term care business. These decreases were partially offset by a $28 million increase in pre-tax operating income in 2014 compared to 2013, due to a 2013 increase in equity-indexed universal life reserves, which was reflected in Interest credited to policyholder account balances.
Net investment income decreased in 2014 compared to 2013, primarily due to lower income from alternative investments and lower yields on the base portfolio due to investment of portfolio cash flows at rates below the weighted average yield of the existing portfolio. See Investments - Life Insurance Companies for additional discussion of the investment strategy, asset-liability management process and invested assets of our Life Insurance Companies, which include the invested assets of the Life business.
General operating expenses increased in 2014 compared to 2013 primarily due to strategic investments in technology and service platforms in the U.S. and Japan.
Net investment income in 2013 decreased slightly compared to 2012, due to the absence of ML II fair value gains recognized in 2012 and reinvestment of investment proceeds at lower rates, partially offset by higher income from alternative investments.
General operating expenses decreased in 2013 compared to 2012 primarily due to operational efficiencies driven by technology improvements and process consolidation efforts.
Disciplined pricing on new business is used to continue to pursue new sales of life products at targeted net investment spreads in a low interest rate environment. Life has a dynamic product management process to ensure that new business offerings appropriately reflect the current interest rate environment. To the extent that Life cannot achieve targeted net investment spreads on new business, products are re-priced or no longer sold. Additionally, where appropriate, existing products with higher minimum rate guarantees have been re-filed with lower crediting rates as permitted under state insurance laws for new sales. Universal life insurance interest rate guarantees are generally 2 to 3 percent on new non-indexed products and zero to 2 percent on new indexed products, and are designed to be sufficiently low to meet targeted net investment spreads.
In-force Management. Crediting rates for in-force policies are adjusted in accordance with contractual provisions that were designed to allow crediting rates to be reset subject to minimum crediting rate guarantees.
The following table presents universal life account values by contractual minimum guaranteed interest rate and current crediting rates:
Premiums for Life represent amounts received on traditional life insurance policies and group benefit policies. Premiums and deposits for Life is a non-GAAP financial measure that includes direct and assumed premiums as well as deposits received on universal life insurance.
The following table presents a reconciliation of Life premiums and deposits to GAAP premiums:
General operating expenses decreased in 2014 compared to 2013. Excluding the effect of foreign exchange, general operating expenses remained flat, as efficiencies from organizational realignment initiatives were offset by increased technology-related expenses.
A&H net premiums written decreased in 2014 compared to 2013. The decrease was primarily due to our focus on maintaining underwriting discipline in certain classes of business in the U.S., partially offset by growth in Japan and Latin America.
A&H net premiums written, excluding the effect of foreign exchange, increased slightly in 2013 compared to 2012, primarily due to our focused strategy to grow sales through the direct marketing distribution channel, individual A&H in Asia Pacific, and the travel business which continued to increase in most geographies across the globe.
Personal Lines net premiums written, excluding the effects of foreign exchange, increased in 2013 compared to 2012. The increases were driven by growth in AIG Private Client Group and the warranty service programs, automobile products and the continued execution of our strategic initiative to grow higher value lines of business. In addition, the impact of excess of loss ceded premiums and of the catastrophe bond issuances reduced net premiums written by $58 million compared to 2012.
Americas net premiums written increased in 2014 compared to 2013, primarily due to an increase in all product lines in our Latin America operations and growth in U.S. personal property and automobile businesses. These were partially offset by a decrease in U.S. A&H due to our continued focus on maintaining underwriting discipline.
Americas net premiums written increased in 2013 compared to 2012, primarily due to continued growth in property, the AIG Private Client Group and rate actions related to the warranty retail program. This was partially offset by the effect of the timing of catastrophe bond reinsurance transactions.
Asia Pacific net premiums written decreased in 2013 compared to 2012, primarily due to the strengthening of the U.S. dollar against the Japanese yen. Excluding the effect of foreign exchange, net premiums written increased primarily due to our focused strategy to grow sales through the direct marketing distribution channel. The expansion of business in Asia Pacific countries outside of Japan was driven by an increase in individual personal accident insurance and personal lines products.
The following tables present the Personal Insurance combined ratios based on GAAP data and reconciliation to the accident year combined ratio, as adjusted:
The following tables present Personal Insurance accident year catastrophe and severe losses by region and the number of events:
* Catastrophes are generally weather or seismic events having a net impact on Personal Insurance in excess of $10 million each.
The accident year combined ratio, as adjusted, decreased by 2.6 points in 2014 compared to 2013, primarily due to an improved accident year loss ratio, as adjusted.
The general operating expense ratio remained unchanged in 2014 compared to 2013, reflecting the impact of efficiencies from organizational realignment initiatives, offset by increased technology-related expenses.
The combined ratio decreased by 0.6 points in 2013 compared to 2012, primarily due to a lower loss ratio, partially offset by higher acquisition and expense ratios as discussed below.
The general operating expense ratio increased by 1.0 point in 2013 compared to 2012, primarily due to the increase in employee incentive compensation expense, partially offset by lower infrastructure project costs.
Net credit valuation adjustment gains of $444 million and $789 million were recognized in 2013 and 2012, respectively. The decrease resulted primarily from a decline in the portfolio size due to sales and maturities as well as lower gains on assets due to less significant tightening of counterparty credit spreads, partially offset by lower losses on liabilities due to less significant tightening of AIG’s credit spreads in 2013 compared to 2012.
Unrealized market valuation gains on the CDS portfolio of $256 million and $550 million were recognized in 2014 and 2013, respectively. The decline resulted primarily from amortization and price movements within the CDS portfolio.
GCM’s pre-tax operating income increased in 2013 compared to 2012 primarily due to an improvement in net credit valuation adjustments on derivative assets and liabilities, partially offset by a decline in unrealized market valuation gains related to the super senior CDS portfolio and an increase in operating expenses.
Net credit valuation adjustment gains of $195 million were recognized in 2013 compared to net credit valuation adjustment losses of $30 million in 2012. The improvement resulted primarily from lower losses on derivative liabilities due to less significant tightening of AIG’s credit spreads in 2013 compared to 2012 and higher gains on derivative assets due to more significant tightening of counterparty credit spreads in 2013 compared to 2012.
Run-off insurance lines reported a pre-tax operating loss of $445 million in 2014 compared to income of $403 million in 2013, primarily as a result of a $407 million charge from a decrease in reserve discount in 2014 compared to a $631 million benefit from an increase in discount in 2013. This discounting-related charge was partially offset by a $98 million decrease in net adverse prior year loss reserve development and an improvement in current accident year loss experience, particularly in the environmental liability business (2004 and prior). The discount charge was primarily due to the decline in risk free rates during 2014 used under Pennsylvania and Delaware prescribed or permitted practices, change in payout pattern assumptions, including the effect of commutations and accelerated settlements for the certain Excess Workers’ Compensation reserves, as well as accretion. See Insurance Reserves - Discounting of Reserves for additional information.
AIG Parent and Other’s pre-tax operating losses decreased in 2014 compared to 2013 primarily due to our share of AerCap’s pre-tax operating income, which is accounted for under the equity method, and lower interest expense from ongoing debt management activities described in Liquidity and Capital Resources, partially offset by an increase in general operating expenses.
General operating expenses increased in 2014 compared to 2013 as a result of centralizing processes to lower-cost locations and increased costs related to investments in technology.
AIG Parent and Other reported an increase in pre-tax operating losses in 2013 compared to 2012 primarily due to severance charges and higher general operating expenses. These increases were partially offset by lower interest expense due to various debt management activities described in Liquidity and Capital Resources.
The gains attributable to AIG’s interest in ML III for 2012 were based in part on the completion of the final auction of ML III assets by the FRBNY, in the third quarter of 2012.
Our investment strategies are tailored to the specific business needs of each operating unit. The investment objectives are driven by the respective business models for Non-Life Insurance Companies, Life Insurance Companies, and AIG Parent including the DIB. 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 intermediate and long duration fixed maturity securities.
• Fixed maturity securities held by the U.S. insurance companies included in Non-Life 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 Non-Life Insurance Companies consist primarily of intermediate duration high-grade securities generally denominated in the currencies of the countries in which we operate.
• AIG Parent actively manages its assets and liabilities in terms of products, counterparties and duration. AIG Parent’s liquidity sources are held in the form of cash, short-term investments and publicly traded, intermediate term investment-
* At December 31, 2014, approximately 90 percent and 10 percent of investments were held by domestic and foreign entities, respectively, compared to approximately 89 percent and 11 percent, respectively, at December 31, 2013.
* 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 the interest rate risk in GMWB embedded derivatives. For the years ended December 31, 2014, 2013 and 2012, the net investment income (loss) recorded on these securities was $260 million, $(161) million and $37 million, respectively.
Net investment income for 2014 increased compared to 2013 primarily due to positive performance on bonds where we elected the fair value option, driven by movements in interest rates, partially offset by lower income on alternative investments
With respect to non-affiliate over-the-counter derivatives, the Non-Life Insurance Companies conduct business with highly rated counterparties and do not expect the counterparties to fail to meet their obligations under the contracts. The Non-Life Insurance Companies have controls in place to monitor credit exposures by limiting transactions with specific counterparties within specified dollar limits and assessing the creditworthiness of counterparties periodically. The Non-Life Insurance Companies generally use ISDA Master Agreements and CSAs with bilateral collateral provisions to reduce counterparty credit exposures.
Fixed maturity investments held in the Non-Life Insurance Companies foreign operations are of high quality, primarily rated A or higher based on composite ratings, and short to intermediate duration, averaging 3.3 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 matching and available investment opportunities.
The Life Insurance Companies use asset-liability management as a primary tool to monitor and manage risk in their businesses. The Life Insurance Companies fundamental investment strategy is to maintain a diversified, high quality portfolio of fixed maturity securities with the intent to largely match the characteristics of liabilities, including duration, which is a measure of sensitivity to changes in interest rates. The investment portfolio of each product line is tailored to the specific
characteristics of its insurance liabilities, and as a result, certain portfolios are shorter in duration and others are longer in duration. An extended low interest rate environment may result in a lengthening of liability durations from initial estimates, primarily due to lower lapses.
In addition, the Life Insurance Companies seek to enhance returns through investments in a diversified portfolio of alternative investments. Although these alternative investments are subject to periodic earnings fluctuations, they have historically achieved yields in excess of the fixed maturity portfolio yields. The Life Insurance Companies investment portfolio also includes, to a lesser extent, equity securities and yield enhancing items.
The following table presents the fixed maturity security portfolio of Life Insurance Companies categorized by composite AIG credit rating, at fair value:
* Excludes $4.3 billion of fixed maturity securities for which no NAIC Designation is available because they are not held in legal entities within Life Insurance Companies that require a statutory filing.
With respect to our fixed maturity investments, the credit ratings in the table below and in subsequent tables reflect: (a) a composite of the ratings of the three major rating agencies, or when agency ratings are not available, the rating assigned by the National Association of Insurance Commissioners (NAIC) Securities Valuations Office (SVO) (over 99 percent of total fixed maturity investments), or (b) our equivalent internal ratings when these investments have not been rated by any of the major rating agencies or the NAIC. The “Non-rated” category in those tables consists of fixed maturity securities that have not been rated by any of the major rating agencies, the NAIC or us.
* At December 31, 2014 and 2013, the fair value of bonds available for sale held by us that were below investment grade or not rated totaled $35.1 billion and $32.6 billion, respectively.
* At December 31, 2014, we had no material credit exposure to the government of Greece.
At December 31, 2014, the U.S. municipal bond portfolio of Non-Life Insurance Companies was composed primarily of essential service revenue bonds and high-quality tax-backed bonds with over 96 percent of the portfolio rated A or higher.
(b) The weighted average expected life was six years at December 31, 2014 and seven years at December 31, 2013.
The following table presents the fair value of our CMBS available for sale investments by rating agency designation and by vintage year:
The following table presents our CMBS available for sale investments by industry:
The fair value of CMBS holdings remained stable throughout 2014. 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.
At December 31, 2014, we had direct commercial mortgage loan exposure of $18.9 billion. At that date, over 99 percent of the loans were current.
The following table presents the commercial mortgage loan exposure by location and class of loan based on amortized cost:
We recorded other-than-temporary impairment charges in the years ended December 31, 2014, 2013 and 2012 related to:
• securities for which we have changed our intent from hold to sell;
• adverse changes in estimated cash flows on certain structured securities; and
In periods subsequent to the recognition of an other-than-temporary impairment charge for available for sale fixed maturity securities that is not foreign-exchange related, we generally prospectively accrete into earnings the difference between the new amortized cost and the expected undiscounted recoverable value over the remaining life of the security. The accretion that was recognized for these securities in earnings was $725 million in 2014, $774 million in 2013 and $915 million in 2012. For a discussion of our other-than-temporary impairment accounting policy, see Note 6, Investments to the Consolidated Financial Statements.
The following table presents the components of AIG’s gross loss reserves by major lines of business on a U.S. statutory basis*:
* Presented by lines of business pursuant to statutory reporting requirements as prescribed by the NAIC.
Net loss reserves represent gross loss reserves reduced by reinsurance recoverable, net of an allowance for unrecoverable reinsurance.
* Includes $1.5 billion and $1.6 billion of reinsurance recoverable under a retroactive reinsurance agreement at December 31, 2014 and 2013, respectively.
Gross loss reserves before reinsurance and discount are net of contractual deductible recoverable amounts due from policyholders of approximately $12.4 billion and $12.0 billion at December 31, 2014 and 2013, 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, where the Non-Life Insurance Companies manage and pay the entire claim on behalf of the insured and are reimbursed by the insured for the deductible portion of the claim. At December 31, 2014 and 2013, the Non-Life Insurance Companies held collateral totaling $9.4 billion and $9.0 billion, respectively, for these deductible recoverable amounts, consisting primarily of letters of credit and assets in trusts.
The following table presents the components of loss reserve discount included above:
The Non-Life Insurance Companies discount certain workers’ compensation reserves in accordance with practices prescribed or permitted by New York, Pennsylvania and Delaware. New York rules generally do not permit non-tabular discounting on IBNR and prescribe a fixed 5 percent discount rate for application to case reserves. Pennsylvania permits non-tabular discounting of IBNR and, commencing in 2013, approved a variable discount rate determined using risk-free rates based on the U.S. Treasury forward yield curve plus a liquidity margin, applicable to IBNR and case reserves. Delaware has permitted discounting on the same basis as the Pennsylvania domiciled companies.
The net reduction in workers’ compensation discount in 2014 of $456 million is primarily due to the decline in risk-free rates during 2014 used under Pennsylvania and Delaware prescribed or permitted practices, changes in the payout pattern assumptions, including the effect of commutations and accelerated settlements for certain excess workers’ compensation reserves, as well as accretion. The change in rates used for discounting was the largest driver of the charge as Treasury rates fell along the entire payout pattern horizon during 2014, and accounted for $397 million of the decrease. The accelerated settlements and commutations in the excess workers’ compensation class of business during 2014 accounted for approximately $111 million of the decrease. The effects of these changes were somewhat offset by increased discount from newly established reserves for accident year 2014 and the impact of the first quarter re-pooling described below.
During 2013, the adverse prior year loss reserve development including premium adjustments was $468 million. The increase was primarily due to the increases in reserves by $108 million for Storm Sandy, $219 million for U.S. construction primary general liability lines and $238 million for the run-off environmental (1987 to 2004) book.
In addition, we recognized additional premiums on loss sensitive business of $105 million, $89 million and $54 million for the years ended December 31, 2014, 2013 and 2012, respectively, which entirely offset adverse development in that business.
The following is a discussion of the primary reasons for the development in 2014, 2013 and 2012 of those classes of business that experienced significant prior accident year development during the three-year period. See MD&A - Critical Accounting Estimates for a description of our loss reserving process.
The excess casualty class presents unique challenges for estimating the unpaid losses. Insureds are generally required to provide notice of claims that exceed a threshold, either expressed as a proportion of the attachment (e.g., 50 percent of the attachment) or for particular types of claims (e.g., death, quadriplegia). This threshold is generally established well below our attachment point, to provide us with a precautionary notice of claims that could potentially pierce our layer of coverage. This means that the majority of claims close without payment because the claims never pierce our layer, while the claims that close with payment can be large and highly variable. Thus, estimates of unpaid losses carry significant uncertainty. For reserve reporting purposes, we combine the Umbrella Excess casualty business with the high layer Catastrophic Casualty business that attaches when losses exceed $50 million.
During 2014, Excess Casualty experienced $36 million of favorable development largely driven by savings on a few large claims. In our Excess Umbrella analysis in 2014, our revised segmentation led to lower 2005 and subsequent accident year estimates for non-mass tort claims where we expect underwriting actions and reductions in policy limits to have a favorable effect on ultimate losses from accident years 2007 to 2013 in particular. This was entirely offset by higher selected ultimate losses for accident years 2004 and prior as a result of updated loss development patterns for mass tort claims which we segmented separately from the non-mass tort claims.
In 2014, our updated analysis of environmental and pollution products resulted in adverse prior year loss reserve development of $120 million for pollution policies primarily written prior to 2004, which are managed by our run-off unit, and $91 million for pollution policies written 2004 and subsequent. The prior year loss reserve development on policies written prior to 2004 is mostly due to projected increases for individual claim estimates as determined by our run-off unit. The prior year loss reserve development on policies written in 2004 and subsequent is due to an increase in the pure IBNR by reflecting an increase in the estimated future severity for the pure IBNR claims and an increase in the expected loss ratios for recent years to reflect the emerging experience and the results of updated claim file reviews completed in 2014. Our updated reviews did not establish any discernible trends from a policy structure, industry class, or cause of loss standpoint. Rather, there were several large loss increases associated with a single accident or catastrophe. While the average policy term for new business written is close to three years, the results for more recent accident years can still be influenced by longer term policies issued in prior years. We have continued to actively monitor and adjust policy terms offered in the pollution products class of business. Transactions with policy terms greater than five years have been reduced by more than 75 percent, with policy terms in excess of five years now accounting for just four percent of the gross written premiums of the book. The new business written continues to meet risk adjusted profitability targets after the increased estimates of ultimate losses for the more recent accident years.
In 2013, our analysis of pollution products reflected an updated review of individual cases which indicated large increases in the value of certain previously reported cases due to new developments such as the discovery of additional contamination in certain sites, legislative changes, and court rulings, expansion of plaintiff damages and increased cost of remediation technologies. Additionally, the number and severity of newly reported claims was higher than expected. As a result, we increased our estimate of ultimate losses by approximately $269 million with approximately $201 million of this relating to policies written in 2003 and prior. Significant changes in underwriting during 2004 changed the terms and conditions materially for policies written after 2003 to reduce our exposure to these events.
For primary general liability in 2014, we increased our ultimate losses for prior years by $182 million. This was largely driven by the construction segment as a result of several large construction defect claims and increases in the costs of claims in New York associated with New York Labor Law. The construction results in California and New York continue to be the main sources of adverse development in our guaranteed cost primary general liability books although we did experience adverse development from construction defect claims in other states in 2014. Our large account primary non-construction general liability business was adversely impacted by claim activity in the layers excess of large insured retentions and we increased our loss development patterns for these layers to reflect the changes.
During 2013, we continued to refine the segmentation of our analyses of primary workers’ compensation, which indicated that prior year loss reserve development was flat after taking into account the initiatives that our claim function has undertaken to manage high risk claims.
In 2012, we also reviewed the general liability loss experience of the primary casualty classes of business using a more refined segmentation for business subject to a deductible as well as loss-sensitive business. Our review focused on applying actuarial loss development analyses to those general liability claims for which these techniques are appropriate. As a result of this analysis, we determined that prior year reserves needed to be increased by $235 million for the primary general liability class of business in 2012 to reflect the worse than expected emergence of paid loss severities for both bodily injury and property damage claims from the more recent accident years (2008 and subsequent).
During 2012, this class recognized $68 million of adverse prior year loss reserve development due to several large claims that involved unusual coverage issues for this class. With the exception of these claims, this class experienced claim activity in line with expectations.
Financial Lines business includes Director and Officer (D&O) and Related Management Liability, including various Professional Liability classes of business as well as the Fidelity book of business. The Financial Lines book consists mostly of the D&O class of business.
During 2014, we recognized $47 million of favorable development driven by the Professional Liability and D&O and Related Management Liability classes of business, somewhat offset by adverse development on the Fidelity book in recent accident years due to the changing economic cycle.
During 2013, we recognized $113 million of favorable development driven somewhat evenly among the Professional Liability, Fidelity and D&O and Related Management Liability classes of business. The year-end 2013 Professional Liability loss reserve actuarial review adopted a refined segmentation for this class of business with the selection of differentiated frequency and
During 2012, we recognized $283 million of favorable development in these classes of business largely driven by the D&O and Related Management Liability classes of business. For the year-end 2012 loss reserve review, our actuaries took into account the favorable emergence during 2012 for several accident years, especially accident year 2010, the claims department’s reviews of open claims and reduced the ultimate losses for prior accident years accordingly. The 2012 D&O and Related Management Liability actuarial review also used a refined segmentation for this class of business with the selection of differentiated frequency and severity trends. The overall loss cost used for this class of business in 2012 from the application of the refined segmentation was slightly lower than that adopted for the 2011 review reflecting the continued favorable emergence from the class of business
During 2013, we updated our analysis of Excess Workers’ Compensation reserves and determined that no changes to our carried reserves were needed. We also updated our analysis of underlying claims cost drivers used in 2012 through accident year 2004, discussed in more detail below.
During 2014, we experienced favorable property catastrophe prior year development of $102 million in our U.S. and Canada business, primarily due to several U.S. events in accident year 2013. We also experienced favorable property catastrophe prior year loss reserve development of $77 million from our international property class of business.
During 2012, we experienced favorable development from the Tohoku Catastrophe in Japan due to commercial claim severities being less than previously reserved.
During 2014, 2013 and 2012, we had $67 million, $40 million, and $46 million of favorable development, respectively. The favorable development in each year is due to lower than expected loss emergence in many classes and countries outside the U.S., with the majority from various countries in the EMEA region.
During 2014, we experienced favorable loss reserve development of $16 million from Natural Catastrophes, primarily related to Storm Sandy. The remaining $61 million of favorable development is primarily from Homeowners, International Accident & Health and U.S. Warranty.
The following table summarizes development, (favorable) or unfavorable, of incurred losses and loss adjustment expenses for prior years, net of reinsurance, by accident year:
For 2014, the favorable development in accident years 2013 and 2012 was driven by Financial Lines, Commercial Property and other short tailed lines, like Personal Lines. For accident year 2007, the favorable development was driven by U.S. and Canada Financial lines and Excess Casualty. For accident years 2004 and prior, the adverse development was driven by the Excess Casualty results of the mass-tort resegmentation analysis, the updated primary workers’ compensation loss development selections (principally in California, New York and the excess of deductible segments) as well as the run-off pollution products business (1987-2004) and the asbestos and environmental (1986 and prior) exposure.
For 2013, the favorable development from accident year 2012 was driven primarily by consumer lines and lower losses in domestic commercial property, while the favorable development from accident year 2010 was primarily the result of favorable claims emergence from domestic excess casualty and from liability and financial lines coverage policies that are on a claims made basis. The adverse development from accident year 2011 was driven by large losses in financial lines and adverse development in primary casualty, including the loss-sensitive business. The adverse development from accident year 2009 was driven by large losses in financial lines and adverse development in primary casualty including loss-sensitive business. For the same periods, the adverse development from accident years 2003 and prior was primarily driven by loss development on toxic tort claims, construction general liability claims and pollution product claims.
(c) Includes loss development on excess of deductible exposures in workers’ compensation, general liability and commercial auto.
(e) The effects of commutations are shown separately from the related classes of business, primarily excess workers’ compensation. Commutations are reflected for the years in which they were contractually binding.
• Update of the mass tort loss development patterns used for U.S. Excess Casualty which accounted for $301 million and other loss emergence including specific large loss development totaling $196 million across the three years;
• Update of the Environmental run-off portfolio’s losses following the 2012 comprehensive claims review that provided a more refined approach for the development of actuarial estimates for toxic tort claims (which were found to have a distinctly lengthier loss development pattern than other general liability claims in the environmental portfolio) as well as a more appropriate methodology for incorporating case reserving based estimates of ultimate loss costs for complex claims involving environmental remediation and/or from policies with high policy limits (greater than $5 million per policy). These updates which commenced in 2012 and have been applied in each subsequent year, accounted for approximately $561 million;
During the period 2012 to 2014, we completed comprehensive refinements of our reserving methodologies for U.S. mass tort, toxic tort, retained asbestos, environmental and other specific large losses. We also conducted extensive additional studies to corroborate our judgments for our U.S. primary workers compensation and excess workers’ compensation classes of business. Further, we refined our loss reserving methodologies for our U.S. Excess Casualty class of business and our U.S. Primary Casualty class of business written over excess of deductible exposures where loss development patterns may lengthen if client retentions increase over time. Collectively, the reserves for the aforementioned classes of business or loss exposures account for the majority of the remaining net loss reserves for accident years 2004 and prior.
• the long latency period between asbestos exposure and disease manifestation, leading to the potential for involvement of multiple policy periods for individual claims;
In 2014, both the retained accounts and retroceded account ground-up reviews for asbestos were updated. As a result, we decreased gross undiscounted asbestos loss reserves by $6 million and increased net undiscounted asbestos loss reserves by $64 million. The net undiscounted increase reflects a buyout settlement on a retained account as well as a reduction in estimated ceded loss reserves (prior to the retroactive reinsurance retrocession). For environmental, we increased gross environmental reserves by $140 million and net environmental reserves by $60 million as a result of top-down actuarial analyses performed during the year as well as development on a number of large accounts.
In 2013, we completed a ground-up review of all our remaining retained accounts for asbestos. In addition, a subsidiary of the retrocessionaire for our retroactive reinsurance contract completed a ground-up asbestos study for the largest accounts it assumed. As a result, we increased gross asbestos loss reserves by $169 million and net asbestos loss reserves by $6 million. The net reserve increase also reflects a small amount of estimated uncollectible reinsurance. A significant portion of these loss reserves will be recoverable under our retroactive reinsurance arrangement. For environmental, we increased gross environmental reserves by $98 million and net environmental reserves by $61 million as a result of top-down actuarial analyses performed during the year as well as development on a number of large accounts.
In 2012, after considering recent experience compared to the results of our most recent ground-up analysis, as well as all of the above factors related to uncertainty, no adjustment to gross and net asbestos reserves was recognized. Additionally in 2012, a moderate amount of incurred loss pertaining to the asbestos loss reserve discount is reflected in the table below and is related to the reserves not subject to our retroactive reinsurance agreement. Upon completion of a top-down analysis performed for environmental in the fourth quarter of 2012, we concluded that the $150 million gross reserve strengthening and $75 million net reserve strengthening recognized in the first half of 2012 was adequate.
In addition to the U.S. asbestos and environmental reserve amounts shown in the tables below, the Non - Life Insurance Companies also have asbestos reserves relating to foreign risks written by non-U.S. entities of $132 million gross and $105 million net as of December 31, 2014. The asbestos reserves relating to non-U.S. risks written by non-U.S. entities were $134 million gross and $108 million net as of December 31, 2013.
related asbestos exposures. It does not, however, cover asbestos accounts that we believe have already been reserved to their limit of liability or certain other ancillary asbestos exposure assumed by AIG Property Casualty subsidiaries.
Upon the closing of this transaction, but effective as of January 1, 2011, we ceded the bulk of AIG Property Casualty’s net domestic asbestos liabilities to NICO under a retroactive reinsurance agreement with an aggregate limit of $3.5 billion. Within this aggregate limit, NICO assumed collection risk for existing third-party reinsurance recoverable associated with these liabilities. AIG Property Casualty paid NICO approximately $1.67 billion as consideration for this cession and NICO assumed approximately $1.82 billion of net U.S. asbestos liabilities. As a result of this transaction, AIG Property Casualty recorded a deferred gain of $150 million in the second quarter of 2011, which is being amortized into income over the settlement period of the underlying claims.
The following table presents the estimate of the gross and net IBNR included in the Liability for unpaid losses and loss adjustment expenses, relating to asbestos and environmental claims:
* Net IBNR includes the reduction due to the NICO reinsurance transaction of $803 million, $1,284 million and $1,310 million as of December 31, 2014, 2013 and 2012, respectively.
Many factors, such as aggressive settlement procedures, mix of business and level of coverage provided, have a significant effect on the amount of asbestos and environmental reserves and payments and the resulting survival ratio. Additionally, we primarily base our determination of these reserves based on ground-up and top-down analyses, and not on survival ratios.
The following table summarizes the major components of the changes in Life Insurance Companies DAC, including VOBA:
(a) Other change in DAC in 2014 included (i) VOBA related to the acquisition of Ageas Protect and (ii) an increase in DAC due to a change to include interest income on assets supporting certain non-traditional insurance liabilities in the determination of estimated gross profits used to amortize both DAC and URR. The increase in the DAC asset, which principally reflected the impact of the change on periods prior to 2014, was substantially offset by a related increase in the URR liability.
(b) DAC balance excluding the amount related to unrealized depreciation (appreciation) of investments was $8.7 billion, $8.0 billion and $7.7 billion at December 31, 2014, 2013 and 2012, respectively.
In 2014, pre-tax operating income of the Life Insurance Companies in aggregate increased by $216 million as a result of the update of estimated gross profit assumptions, the most significant of which was a net positive adjustment in Fixed Annuities, primarily due to better investment spreads than previously assumed.
In 2013, pre-tax operating income of the Life Insurance Companies in the aggregate increased by a net positive adjustment of $153 million as a result of update of estimated gross profit assumptions, primarily due to a net positive adjustment in the Fixed Annuities product line in 2013, as a result of active spread management of crediting rates and higher future investment yields than those previously assumed.
Net negative adjustments in the Retirement Income Solutions and Group Retirement product lines in 2013 resulted primarily from the update of variable annuity spreads and surrender rates. In Group Retirement, these negative adjustments were partially offset by an increase in the assumption for separate account asset long-term growth rates under our reversion to the mean methodology. A negative adjustment in the Life product line resulted from the update of mortality assumptions.
The following table presents the increase (decrease) in pre-tax income resulting from the unlocking of actuarial assumptions for estimated gross profits of the domestic Life Insurance Companies, by line item as reported in Results of Operations:
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 fixed maturity and equity securities available for sale had been sold at their stated aggregate fair value and the proceeds reinvested at current yields (shadow DAC). The change in shadow DAC generally moves in the opposite direction of the change in unrealized appreciation of the available for sale securities portfolio. In addition, significant unrealized appreciation of investments in a prolonged low interest rate environment may cause additional future policy benefit liabilities to be recorded (shadow loss reserves). The increase in the Life Insurance Companies’ unrealized appreciation of investments in 2014 of $5.9 billion, which was driven by the decline in market interest rates, resulted in a decrease in shadow DAC and an increase in shadow loss reserves in 2014. Shadow loss reserves were insignificant at December 31, 2013 and increased to $1.2 billion at December 31, 2014. In 2013, shadow DAC increased and shadow loss reserves decreased due to an increase in market interest rates. The change in shadow DAC and shadow loss reserves in 2014 was greater than the change in 2013, due to a larger movement in unrealized appreciation of investments.
The Life operating segment recorded loss recognition expense of $87 million in 2014 and $67 million in 2012, which reduced pre-tax operating income in the respective periods, to increase reserves for certain long-term care business. The 2014 loss recognition was primarily a result of lower future premium increase assumptions and, to a lesser extent, lower yield assumptions. The 2012 loss recognition reflected updated assumptions for morbidity and lower premium increases. Assumptions related to investment yields, mortality experience and expenses are reviewed periodically and updated as appropriate, which could also result in additional loss recognition reserves. While the domestic Life Insurance Companies do not currently offer standalone long-term care products, these needs are addressed with various benefits and riders in the existing portfolio, such as chronic illness riders.
Liquidity refers to the ability to generate sufficient cash resources to meet our payment obligations. It is defined as cash and unencumbered assets that can be monetized in a short period of time at a reasonable cost. We manage our liquidity prudently through various risk committees, policies and procedures, and a stress testing and liquidity framework established by Enterprise Risk Management (ERM). Our liquidity framework is designed to measure both the amount and composition of our liquidity to meet financial obligations in both normal and stressed markets. See Enterprise Risk Management - Risk Appetite, Identification, and Measurement and Enterprise Risk Management - Liquidity Risk Management below for additional information.
(b) On January 15, 2015, we issued $1.2 billion aggregate principal amount of 3.875% Notes due 2035 and $800 million aggregate principal amount of 4.375% Notes due 2055.
* For 2014, cash decreased by $162 million due to reclassification of $289 million to restricted cash presented in Other assets, partially offset by $127 million reclassification from Short-term investments, to correct prior period presentation.
• approximately $2.4 billion of net cash proceeds from the sale of ILFC.
• approximately $271 million to repay long-term debt of business held-for-sale; and
• approximately $597 million to repurchase approximately 12 million shares of AIG Common Stock;
• $8.6 billion to pay down the Department of the Treasury’s preferred interests (AIA SPV Preferred Interests) in the special purpose vehicle holding the AIA ordinary shares; and
We generally manage capital flows between AIG Parent and its subsidiaries through internal, Board-approved policies and guidelines. In addition, AIG Parent has unconditional capital maintenance agreements (CMAs) in place with certain subsidiaries. Nevertheless, regulatory and other legal restrictions could limit our ability to transfer capital freely, either to or from our subsidiaries.
We utilize our capital resources to support our businesses, with the majority of capital allocated to our core 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.
(a) Cash and short-term investments include reverse repurchase agreements totaling $1.6 billion and $6.9 billion as of December 31, 2014 and 2013, respectively.
(b) $2.9 billion and $5.9 billion of cash and short-term investments as of December 31, 2014 and 2013, respectively, are allocated toward future maturities of liabilities and contingent liquidity stress needs of DIB and GCM.
We expect that our Non-Life Insurance Companies will be able to continue to satisfy reasonably foreseeable future liquidity requirements and meet their obligations, including those arising from reasonably foreseeable contingencies or events, through cash from operations and, to the extent necessary, monetization of invested assets. Our Non-Life Insurance Companies’ liquidity resources are held in the form of cash, short-term investments and publicly traded, investment grade rated fixed maturity securities.
Certain Non-Life Insurance Companies are members of the Federal Home Loan Banks (FHLBs) in their respective districts. Borrowings from the FHLBs may be used to supplement liquidity. As of December 31, 2014 and 2013, none of our Non-Life Insurance Companies had FHLB borrowings outstanding.
Our Non-Life Insurance Companies may require additional funding to meet capital or liquidity needs under certain circumstances. Large catastrophes may require us to provide additional support to our affected operations. Downgrades in our credit ratings could put pressure on the insurer financial strength ratings of our subsidiaries, which could result in non-renewals or cancellations by policyholders and adversely affect the subsidiary’s ability to meet its own obligations. Increases in market interest rates may adversely affect the financial strength ratings of our subsidiaries, as rating agency capital models may reduce the amount of available capital relative to required capital. Other potential events that could cause a liquidity strain include an economic collapse of a nation or region significant to our operations, nationalization, catastrophic terrorist acts, pandemics or other events causing economic or political upheaval.
AIG generally manages capital between AIG Parent and our Non-Life Insurance Companies through internal, Board-approved policies and guidelines. In addition, AIG Parent is party to a CMA with a Mortgage Guaranty insurance company. Among other things, the CMA provides that AIG Parent will maintain capital and surplus of this Mortgage Guaranty insurance company at or above a specified minimum required capital based on a specified risk-to-capital ratio. In addition, the CMA provides that if capital and surplus of this Mortgage Guaranty insurance company is in excess of that same specified minimum required capital, subject to its board approval and compliance with applicable insurance laws, this Mortgage Guaranty insurance company would declare and pay ordinary dividends to its equity holders up to an amount necessary to reduce projected or actual capital and surplus to a level equal to or not materially greater than such specified minimum required capital. As structured, the CMA contemplates that the specified minimum required capital would be reviewed and agreed upon at least annually. As of December 31, 2014, the minimum required capital for the CMA with the Mortgage Guaranty insurance company is based on a risk-to-capital ratio of 19 to 1.
AIG Parent was also party to a consolidated CMA with AIG Property Casualty Inc. and certain domestic Non-Life Insurance Companies. Among other things, the CMA provided that AIG Parent would maintain the total adjusted capital of these Non-Life Insurance Companies, measured as a group (the Fleet), at or above the specified minimum percentage of the Fleet’s projected total authorized control level RBC. As a result of managing capital through internal, Board-approved policies and guidelines, AIG Parent agreed with AIG Property Casualty Inc. and these domestic Non-Life Insurance Companies to terminate this CMA effective February 19, 2015. As of December 31, 2014, the specified minimum percentage in the CMA with AIG Property Casualty Inc. and these domestic Non-Life Insurance Companies was 300 percent.
In 2014, our Non-Life Insurance Companies paid approximately $2.6 billion in dividends in the form of cash and fixed maturity securities to AIG Parent. The fixed maturity securities included investment-grade government, corporate and sovereign bonds, as well as agency RMBS. In 2014, our Non-Life Insurance Companies also paid other non-cash dividends of $178 million to AIG Parent. In addition, our Non-Life Insurance Companies paid approximately $600 million of cash dividends to AIG Parent in February 2015, which represented the remainder of dividends that were declared by our Non-Life Insurance Companies in the fourth quarter of 2014. AIG Parent was not required to make any capital contributions pursuant to the CMAs.
Certain of our domestic Life Insurance Companies are members of the FHLBs in their respective districts. Borrowings from the FHLBs are used to supplement liquidity or for other uses deemed appropriate by management. Our domestic Life Insurance Companies had outstanding borrowings from the FHLBs in an aggregate amount of $44 million and $50 million as of December 31, 2014 and 2013, respectively.
The need to fund product surrenders, withdrawals and maturities creates a potential liquidity requirement for our Life Insurance Companies. 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. 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. Our Life Insurance Companies also have developed a contingent liquidity plan to address unforeseen liquidity needs.
Collateral posted by operations included in the DIB to third parties was $3.5 billion at December 31, 2014 and $4.2 billion at December 31, 2013. 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.
Derivative transactions between AIG and its subsidiaries and third parties are generally centralized through GCM, specifically through AIG Markets. GCM is required to clear certain derivatives transactions through central regulated clearing organizations pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). To the extent a derivatives transaction is subject to a clearing obligation, GCM is required to post collateral in amounts determined by the relevant clearing organization and GCM’s clearing agreements with its futures commission merchants. To the extent a derivatives transaction is not subject to a clearing obligation, these derivative transactions are governed by bilateral master agreements, the form of which is published by the International Swaps and Derivatives Association, Inc. (ISDA). Many of these agreements, primarily between GCM and third party financial institutions, require collateral postings. Many of GCM’s transactions with AIG and its subsidiaries also include collateral posting requirements, the purpose of which are to provide collateral to GCM, which in turn is used to satisfy posting requirements with third parties, including the margin requirements of clearing organizations and futures commission merchants.
In addition, most of GCM’s CDSs within AIGFP are subject to collateral posting provisions. The collateral posting provisions contained in the ISDA Master Agreements and related transaction documents with respect to CDSs differ among counterparties and asset classes. The amount of future collateral posting requirements for super senior CDSs is a function of our credit ratings, the rating of the relevant reference obligations and the market value of the relevant reference obligations, with market value being the most significant factor. We estimate the amount of potential future collateral postings associated with the super senior CDSs using various methodologies. The contingent liquidity requirements associated with such potential future collateral postings are incorporated into our liquidity planning assumptions.
As of December 31, 2014 and 2013, GCM had total assets of $4.5 billion and $7.7 billion, respectively, and total liabilities of $3.1 billion as of both dates. GCM’s assets consist primarily of cash, short-term investments, other receivables, net of allowance, and unrealized gains on swaps, options and forwards. GCM’s liabilities consist primarily of unrealized losses on swaps, options and forwards. Collateral posted by GCM to third parties was $3.0 billion at both December 31, 2014 and 2013. GCM obtained collateral from third parties totaling $1.1 billion and $572 million at December 31, 2014 and 2013, respectively. The collateral amounts reflect counterparty netting adjustments available under ISDA Master Agreements and are inclusive of collateral that exceeded the fair value of derivatives as of the reporting date.
We maintain a committed, revolving syndicated credit facility (the Five-Year Facility) as a potential source of liquidity for general corporate purposes. The Five-Year Facility provides for aggregate commitments by the bank syndicate to provide unsecured revolving loans and/or standby letters of credit of up to $4.0 billion without any limits on the type of borrowings and is scheduled to expire in June 2019.
As of December 31, 2014, a total of $4.0 billion remains available under the Five-Year Facility. Our ability to borrow under the Five-Year Facility is not contingent on our credit ratings. However, our ability to borrow under the Five-Year Facility is conditioned on the satisfaction of certain legal, operating, administrative and financial covenants and other requirements contained in the Five-Year Facility. These include covenants relating to our maintenance of a specified total consolidated net worth and total consolidated debt to total consolidated capitalization. Failure to satisfy these and other requirements contained in the Five-Year Facility would restrict our access to the Five-Year Facility and could have a material adverse effect on our financial condition, results of operations and liquidity. We expect to borrow under the Five-Year Facility from time to time, and may use the proceeds for general corporate purposes.
The following table summarizes contractual obligations in total, and by remaining maturity:
(a) Primarily includes contracts to purchase future services and other capital expenditures.
(a) Includes construction guarantees connected to affordable housing investments by our Life Insurance Companies. Excludes potential amounts for indemnification obligations included in asset sales agreements. See Note 10 to the Consolidated Financial Statements for further information on indemnification obligations.
(e) Excludes commitments with respect to pension plans. The annual pension contribution for 2015 is expected to be approximately $173 million for U.S. and non-U.S. plans.
We enter into various arrangements with variable interest entities (VIEs) in the normal course of business, and we consolidate a VIE when we are the primary beneficiary of the entity. For a further discussion of our involvement with VIEs, see Note 10 to the Consolidated Financial Statements.
(a) AIG Parent guarantees all DIB debt, except for MIP notes payable and Series AIGFP matched notes and bonds payable, which are direct obligations of AIG Parent.
The decrease in total debt outstanding as of December 31, 2014 compared to December 31, 2013 was primarily due to maturities and repayments of debt and redemptions and repurchases of certain debt securities, as discussed above.
The following table summarizes maturing debt at December 31, 2014 of AIG (excluding $3.7 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 2, 2015. 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 second, third and fourth quarters of 2014, we executed five ASR agreements with third-party financial institutions. The total number of shares of AIG Common Stock repurchased in 2014, and the aggregate purchase price of those shares, each as set forth above, reflect our payment of approximately $3.1 billion in the aggregate to the financial institutions under the ASR agreements and the receipt of approximately 53 million shares of AIG Common Stock in the aggregate, including the initial receipt of 70 percent of the total notional share equivalent, or approximately 9.2 million shares of AIG Common Stock, under an ASR agreement executed in December 2014. That ASR agreement settled in January 2015, at which time we received approximately 3.5 million additional shares of AIG Common Stock based on a formula specified by the terms of the ASR agreement.
Payments of dividends to AIG by its insurance subsidiaries are subject to certain restrictions imposed by regulatory authorities. See Note 20 to the Consolidated Financial Statements for a discussion of restrictions on payments of dividends by our subsidiaries.
Management committees that support the GRC are described below. These committees are comprised of senior executives and experienced business representatives from a range of functions and business units throughout AIG and its subsidiaries. These committees are charged with identifying, analyzing and reviewing specific risk matters within their respective mandates.
Investments, Deputy AIG Chief Investment Officer, as well as our CFO, and other senior executives from Finance and ERM. Our CRO serves as Chair of the FRG.
Operational Risk Committee (ORC): This committee oversees operational risk management activities across AIG’s businesses, functions, and geographic locations. The ORC reviews the enterprise-wide identification, escalation and mitigation of operational risks that may arise from inadequate or failed internal processes, people, systems, or external events. The ORC also monitors current and emerging operational risks, as well as management actions taken to reduce risks to acceptable levels. The Committee approves the Operational Risk Management (ORM) Policy and ORM Framework, which includes the identification, assessment, monitoring and measurement of risks. The Committee ensures applicable governance structures are established to provide oversight of operational risk at each business unit and corporate function. The ORC also reviews aggregate firm-wide operational risk reports and provides a forum for senior management to assess our operational risk profile and to discuss operational risks that may affect our strategic objectives.
ORC members include senior AIG executives with expertise in legal, compliance, technology, human resources, finance and operational risk, as well as business continuity management and the chief risk officers of our business units.
Business Unit Risk and Capital Committees: Each of our major insurance businesses has established a risk and capital committee (BU RCC) that serves as the senior management committee responsible for risk oversight at the individual business unit level. The BU RCCs are responsible for the identification, assessment and monitoring of all sources of risk within their respective portfolios. Specific responsibilities include setting risk tolerances, approving capital management strategies (including asset allocation and risk financing), insurance portfolio optimization, risk management policies and providing oversight of risk-adjusted metrics. In addition to its BU RCC, each major insurance business has established subordinate committees which identify, assess and monitor the specific operational, transactional and financial risks inherent in its respective business. Together, the BU RCCs and AIG Risk Committees described above provide comprehensive risk oversight throughout the organization.
or a committee thereof and a set of supporting tools, including risk tolerances, risk limits and policies, which we use to manage our risk profile and financial resources.
We articulate our aggregate risk-taking by setting risk tolerances on capital and liquidity measures. These measures are set at the AIG Parent as well as the legal entity level and cover consolidated and insurance company capital and liquidity ratios. We must comply with standards for capital adequacy and maintain sufficient liquidity to meet all our obligations as they come due in accordance with our internal capital management and liquidity policies. The risk appetite for our insurance operations inform the requirements for capital adequacy for individual legal entities. Our risk tolerances take into consideration regulatory requirements, rating agency expectations, and business needs. The GRC routinely reviews the level of risk taken by the consolidated organization in relation to the established risk tolerances. A consolidated risk report is also presented periodically, as required, to the RCC by our CRO.
• Monitoring of risks, providing early warning indicators, and ensuring timely oversight and enforceability;
• Defining a consistent and transparent approach to limits governance from the group-level to regional entities; and
To support the monitoring and management of AIG’s and its business units’ material risks, ERM has established a limits framework that employs a three-tiered hierarchy:
• Level II Limits are business unit level limits. They define our appetite for specific, material risk taking activities within business units and corporate functions. These key risks are identified by ERM for the business unit and/or corporate function, and risk limits are developed to meet the specific requirements of regulators and rating agencies. Level II Limits are reported to the BU RCC and FRG.
The business units are responsible for complying with all risk limits. The ERM teams and chief risk officers within each business unit monitor such compliance and provide regular, timely reporting to our senior management and risk committees. Limit breaches are required to be reported in a timely manner and are documented and escalated in accordance with their level of severity or materiality. Responsibility for addressing and/or remediating any breach rests with individuals within the specific unit that experienced the breach.
down to the product-line level. These processes are used as a critical input to enhance and develop our analytics for measuring and assessing risks across the organization.
We monitor and control our company-wide credit risk concentrations and attempt to avoid unwanted or excessive risk accumulations, whether funded or unfunded. To minimize the level of credit risk in some circumstances, we may require mitigants, such as third-party guarantees, reinsurance or collateral, including commercial bank-issued letters of credit and trust collateral accounts. We treat these guarantees, reinsurance recoverables, letters of credit and trust collateral accounts as credit exposure and include them in our risk concentration exposure data.
Market risk is defined as the risk of adverse impact due to systemic movements in one or more of the following market risk drivers: equity and commodity prices, residential and commercial real estate values, interest rates, credit spreads, foreign exchange, inflation, and their levels of volatility.
Our market risk measurement framework was developed with the main objective of communicating the range and scale of our market risk exposures. At the firm-wide level market risk is measured in a manner that is consistent with AIG’s Risk Appetite Statement. This is designed to ensure that we remain within our stated risk tolerance levels and can determine how much additional market risk taking capacity is available within our framework. Our risk appetite is currently defined in terms of capital
(b) Commencing in the first quarter of 2014, we began using a duration and convexity method to estimate the impact of a 100 basis point increase in interest rates on each security. The change in method had no material effect on the amounts presented at December 31, 2013.
The sensitivity factors utilized for 2014 and presented above were selected based on historical data from 1994 to 2014, as follows (see the table below):
• a 20 percent drop for equity and alternative investments is broadly consistent with a one standard deviation movement in the S&P 500; and
Liquidity risk is defined as the risk that our financial condition will be adversely affected by the inability or perceived inability to meet our short-term cash, collateral or other financial obligations. Failure to appropriately manage liquidity risk can result in insolvency, reduced operating flexibility, increased costs, reputational harm and regulatory action.
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 can be generated to meet the obligations as they come due.
AIG Parent liquidity risk tolerance levels are established for base and stress scenarios over a time horizon covering a period of up to one year. We maintain a liquidity buffer designed to ensure that funding needs are met under varying market conditions. If we project that we will breach the tolerance, we will assess and determine appropriate liquidity management actions. However, the market conditions in effect at that time may not permit us to achieve an increase in liquidity sources or a reduction in liquidity requirements.
• Market/Monetization Risk: Assets cannot 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.
• Cash Flow Mismatch Risk: Discrete and cumulative cash flow mismatches or gaps over short-term horizons under both expected and adverse business conditions may create future liquidity shortfalls.
The Liquidity Risk Management Framework is guided by the liquidity risk tolerance as set forth in the Board-approved Risk Appetite Statement. The principal objective of this framework is to establish minimum liquidity requirements that protect our
Our ORM function, which supports our ORC, has the responsibility to provide an aggregate view of our operational risk profile. Our ORM function oversees the Operational Risk policy and framework, which includes risk identification, assessment, monitoring and measurement. The ORM program captures various types of risk to provide an aggregate view for each business and function. This includes operational risks related to core insurance activities, investing, model risk, technology (including cyber security, access, data privacy and data security), third party providers, compliance and regulatory matters.
As part of the ORM framework, we deploy an integrated risk assessment approach which includes top-down risk assessments to identify our most significant operational risks, a Risk and Control Self Assessment (RCSA) process to identify key operational risks conducted at the business units and corporate functions and the identification of emerging risks through our Vulnerability Identification (VID) process which considers risks that have not yet fully manifested but could become significant over time. In addition, we conduct scenario analysis to identify remote but plausible potential risks that could result in severe financial losses. Corrective action plans are developed to address identified issues. Businesses are accountable for tracking and remediating these issues.
Operational risk management reporting to senior management and operational risk governance committees provides awareness of operational risk exposures, identifies key risks and facilitates management decision making. Reporting includes operational risk mitigation and monitoring, RCSA results and the status of issue resolution to senior management.
• written policies that define the rules for our insurance risk-taking activities;
Our natural catastrophe exposure is primarily driven by the U.S. and Japan, though our overall exposure is diversified across multiple countries. For example, we have exposures to additional perils such as European windstorms and floods. Within the U.S., we have significant hurricane exposure in Florida, the Gulf of Mexico, Northeast U.S. and mid-Atlantic regions. Events impacting the Northeast U.S. and the mid-Atlantic may result in a higher share of industry losses than other regions primarily
The estimates below are the Occurrence Exceedance Probability (OEP) losses, which reflect losses that may occur in any single event due to the defined peril. The 1-in-100 and 1-in-250 PMLs are the probable maximum losses from a single natural catastrophe event with probability of 1 percent and 0.4 percent, respectively.
Our 2015 catastrophe reinsurance program includes coverage for natural catastrophes and some coverage for terrorism events. It consists of a large North American occurrence cover (without reinstatement) to protect against a large U.S. loss, and a worldwide aggregate cover to protect against multiple, potentially smaller, losses. The attachment point for this reinsurance program is at $3 billion.
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
Our exposure to terrorism risk is mitigated by TRIA in addition to limited private reinsurance protections. TRIA covers terrorist attacks within the United States or U.S. missions and against certain U.S. carriers or vessels and excludes certain lines of business as specified by applicable law. In 2015, TRIA covers 85 percent of insured losses above a deductible, decreasing by one percent each year to 80 percent in 2020. The current estimate of our deductible is about $2.7 billion for 2014.
Mortgage Guaranty manages the quality of the loans it insures through use of a proprietary risk quality index. Mortgage Guaranty uses this index to determine an insurability threshold as well as to manage the risk distribution of its new business. Along with traditional mortgage underwriting variables, Mortgage Guaranty’s risk-based pricing model uses rating factors such as geography and the historical quality of a lender’s origination process to establish premium rates.
exposure from unexpected events for a reinsurer. In addition, credit executives within ERM review reinsurer exposures and credit limits and approve reinsurer credit limits above specified levels. Finally, even where we conclude that uncollateralized credit risk is acceptable, we require collateral from active reinsurance counterparties where it is necessary for our subsidiaries to recognize the reinsurance recoverable assets for statutory accounting purposes. At December 31, 2014, we held $7.4 billion of collateral, in the form of funds withheld, securities in reinsurance trust accounts and/or irrevocable letters of credit, in support of reinsurance recoverable assets from unaffiliated reinsurers. We believe that no exposure to a single reinsurer represents an inappropriate concentration of risk to AIG, nor is our business substantially dependent upon any single reinsurance contract.
See Item 7. MD&A - Critical Accounting Estimates - Reinsurance Assets for further discussion of reinsurance recoverable.
Life Insurance Companies manage these risks through product design, experience monitoring, pricing actions, risk limitations, reinsurance and active monitoring and management of the relationships between assets and liabilities, including hedging. The emergence of significant adverse experience would require an adjustment to DAC and benefit reserves, which could have a material adverse effect on our consolidated results of operations for a particular period. For a further discussion of this risk, see Item 1A. Risk Factors - Business and Operations.
• Mortality risk - represents the risk of loss arising from actual mortality rates being higher than expected mortality rates. This risk could arise from pandemics or other events, including longer-term societal changes that cause higher than expected mortality. This risk exists in a number of our product lines but is most significant for our life insurance products.
A counterparty may default on any obligation to us, including a derivative contract. Credit risk is a consequence of extending credit and/or carrying trading and investment positions. Credit risk exists for a derivative contract when that contract has a positive fair value to AIG. The maximum potential exposure will increase or decrease during the life of the derivative commitments as a function of maturity and market conditions. To help manage this risk, GCM operates within the guidelines set by the credit function within ERM. Transactions that fall outside these pre-established guidelines require the specific approval of ERM. It is also AIG’s policy to record credit valuation adjustments for potential counterparty default when necessary.
In addition, GCM utilizes various credit enhancements, including letters of credit, guarantees, collateral, credit triggers, credit derivatives, margin agreements and subordination to reduce the credit risk relating to its outstanding financial derivative transactions. GCM requires credit enhancements in connection with specific transactions based on, among other things, the creditworthiness of the counterparties, and transaction size and maturity. Furthermore, GCM enters into certain agreements that have the benefit of set-off and close-out netting provisions, such as ISDA Master Agreements, repurchase agreements and securities lending agreements. These provisions provide that, in the case of an early termination of a transaction, GCM can set off its receivables from a counterparty against its payables to the same counterparty arising out of all covered transactions. As a result, where a legally enforceable netting agreement exists, the fair value of the transaction with the counterparty represents the net sum of estimated fair values.
The following table presents the fair value of GCM’s derivatives portfolios by internal counterparty credit rating:
The preparation of financial statements in accordance with U.S. GAAP requires the application of accounting policies that often involve a significant degree of judgment.
On December 16, 2013, AIG Parent and Seller entered into a definitive agreement with AerCap Holdings N.V. (AerCap) and AerCap Ireland Limited for the sale of 100 percent of the common stock of ILFC (the AerCap Agreement) for consideration consisting of $3.0 billion of cash and approximately 97.6 million newly issued AerCap common shares. The consideration had a value of approximately $5.4 billion based on AerCap’s pre-announcement closing price per share of $24.93 on December 13, 2013. Upon closing of the transaction on May 14, 2014, we recorded the 97.6 million AerCap shares received at their then fair value of $47.01 and, together with the next cash received, recorded pre-tax and after-tax gains of approximately $2.2 billion and $1.4 billion, respectively for the year ended December 31, 2014. We determined ILFC met the criteria for held-for-sale accounting at December 31, 2013. Because we received approximately 46 percent of the common stock of AerCap upon closing of the transaction and we continued to hold such percentage at December 31, 2014, ILFC does not qualify for discontinued operations presentation in the Consolidated Statements of Income. Consequently, ILFC’s operating results are presented in continuing operations for all periods presented.
We consider a number of factors to reliably estimate future taxable income, so we can determine the extent of our ability to realize net operating losses (NOLs), foreign tax credits (FTCs), capital loss and other carryforwards. These factors include forecasts of future income for each of our businesses and actual and planned business and operational changes, both of which include assumptions about future macroeconomic and AIG-specific conditions and events. We subject the forecasts to stresses of key assumptions and evaluate the effect on tax attribute utilization. We also apply stresses to our assumptions about the effectiveness of relevant prudent and feasible tax planning strategies. Our income forecasts, coupled with our tax planning strategies, all resulted in sufficient taxable income to achieve realization of the U.S. tax attributes prior to their expiration.
Our accounting for income taxes, including uncertain tax positions, represents management’s best estimate of various events and transactions, and requires judgment. FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48) (now incorporated into Accounting Standards Codification, 740, Income Taxes) prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of an income tax position taken or expected to be taken in a tax return. The standard also provides guidance on derecognition, classification, interest and penalties and additional disclosures. We determine whether it is more likely than not that a tax position will be sustained, based on technical
• the determination of the actuarial models used as the basis for these estimates;
• the determination of the appropriate groupings of similar classes and, in some cases, the segmentation of dissimilar claims within a class.
Estimation of ultimate net losses and loss adjustment expenses (net losses) for long-tail casualty classes of business is a complex process and depends on a number of factors, including the class and volume of business, as well as estimates of the reinsurance recoverable. Experience in the more recent accident years shows limited statistical credibility in reported net losses on long-tail casualty classes of business. That is because a relatively low proportion of net incurred losses represent reported claims and expenses, and an even smaller percentage represents net losses paid. Therefore, IBNR constitutes a relatively high proportion of net losses.
We record quarterly changes in loss reserves for each of the Non-Life Insurance Companies classes of business. The overall change in our loss reserves is based on the sum of the changes for all classes of business. For most long-tail classes of business, the quarterly loss reserve changes are based on the estimated current loss ratio for each class of coverage less any amounts paid. Also, any change in estimated ultimate losses from prior accident years deemed to be necessary based on the results of our latest reserve studies or large loss analysis, either positive or negative, is reflected in the loss reserve for the current quarter.
In testing the reserves for each class of business, our actuaries determine the most appropriate actuarial methods. This determination is based on a variety of factors including the nature of the claims associated with the class of business, such as the frequency or severity of the claims. Other considerations include the loss development characteristics associated with the claims, the volume of claim data available for the applicable class, and the applicability of various actuarial methods to the class. In addition to determining the actuarial methods, the actuaries determine the appropriate loss reserve groupings of data. For example, we write many unique subclasses of professional liability. For pricing or other purposes, it is appropriate to evaluate the profitability of each subclass individually. However, for purposes of estimating the loss reserves for many classes of business, we believe it is appropriate to combine the subclasses into larger groups to produce a greater degree of credibility in the claims experience. This determination of data segmentation and actuarial methods is carefully considered for each class of business. The segmentation and actuarial methods chosen are those which together are expected to produce the most robust estimate of the loss reserves.
Expected loss ratio methods rely on the application of an expected loss ratio to the earned premium for the class of business to determine the loss reserves. For example, an expected loss ratio of 70 percent applied to an earned premium base of $10 million for a class of business would generate an ultimate loss estimate of $7 million. Subtracting any reported paid losses and loss adjustment expenses would result in the indicated loss reserve for this class. Under the “Bornhuetter Ferguson” methods, the expected loss ratio is applied only to the expected unreported portion of the losses. For example, for a long-tail class 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 applied to the 90 percent of the losses still unreported. The actual reported losses at the end
• Ground-up consideration of the reinsurance recoveries expected for the class of business for reported claims with extrapolation for unreported claims; and
During 2014, we continued to expand our analysis of structural drivers as a means of corroborating our judgments using traditional actuarial techniques. For example, we considered the impact of changes in economic activity (real GDP growth) on our emerging experience in the Commercial Auto Liability class of business, particularly business written in excess of a large insured deductible where ground up experience may take several years to pierce our layer. Further, we considered the impact of expected levels of future inflation as measured by the Personal Consumption Expenditure (PCE) Deflator (Health Services Component) published by the U.S. Bureau of Economic Analysis on our ultimate loss costs for medical benefits in the primary workers’ compensation class of business. We believe the PCE Deflator provides a more appropriate measure of workers’ compensation medical inflation as it includes medical expenditures made by employers on behalf of their employees. We also tested the sensitivity of our estimates to changes in the future path and level of inflation for this class of business.
The estimation of loss reserves relating to asbestos and environmental claims on insurance policies written many years ago is subject to greater uncertainty than other types of claims. This is due to inconsistent court decisions, as well as judicial interpretations and legislative actions that in some cases have tended to broaden coverage beyond the original intent of such policies or have expanded theories of liability. In addition, reinsurance recoverable balances relating to asbestos and environmental loss reserves are subject to greater uncertainty due to the underlying age of the claim, underlying legal issues surrounding the nature of the coverage, and determination of proper policy period. For these reasons, these balances tend to be subject to increased levels of disputes and legal collection activity when actually billed. The insurance industry as a whole is engaged in extensive litigation over these coverage and liability issues and is thus confronted with a continuing uncertainty in its efforts to quantify these exposures.
The majority of our exposures for asbestos and environmental claims are 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 claim liabilities, where future litigation costs are reasonably determinable, are established on a case-by-case basis.
involve issues such as allocation of responsibility among potentially responsible parties and the government’s refusal to release parties from liability. Future claims development also will be affected by the changes in Superfund and waste dump site coverage and liability issues.
Known asbestos claims are managed in a similar manner. Over two decades ago we established a specialized toxic tort claims unit, which historically investigated and adjusted all such asbestos claims. As part of the above mentioned NICO transaction, effective January 1, 2011, NICO assumed responsibility for claims handling related to the majority of AIG’s domestic asbestos liabilities.
The effect of these deviations is expected to be smaller than the effect on the classes noted below:
Loss cost trends: The percentage deviations noted in the table below are not considered the highest possible deviations that might be expected, but rather what we consider to reflect a reasonably likely range of potential deviation. The impacts cited
below are only for the years using an expected loss ratio approach. Actual loss cost trends in the early 1990s were negative for several years whereas actual loss cost trends exceeded the figures cited below for 1997 through 2001. Loss trends may deviate by more than the amounts noted above and discussed below.
The following sensitivity analysis table summarizes the effect on the loss reserve position of using certain alternative loss cost trend (for accident years where we use expected loss ratio methods) or loss development factor assumptions rather than the assumptions actually used in determining our estimates in the year-end loss reserve analyses in 2014.
(b) Percentages not applicable due to extremely long-tailed nature of workers’ compensation.
(c) Impact was determined based on analysis of aggregate variability of loss development assumptions.
At December 31, 2014, the allowance for estimated unrecoverable reinsurance was $258 million.
Future Policy Benefits for Life and Accident and Health Insurance Contracts (Life Insurance Companies)
Groupings for loss recognition testing are consistent with our manner of acquiring and servicing the business and applied by product groupings. We perform separate loss recognition tests for traditional life products, payout annuities, and long-term care insurance. Once loss recognition has been recorded for a block of business, the old assumption set is replaced and the assumption set used for the loss recognition would then be subject to the lock-in principle. Key judgments made in loss recognition tests include the following:
• To determine investment returns used in loss recognition tests, we typically segregate assets that match liabilities and then project future cash flows on those assets. Our projections include a reasonable allowance for investment expenses and expected credit losses over the projection horizon. A critical assumption in the projection of expected investment income is the assumed net rate of investment return at which excess cash flows are to be reinvested. For products in which asset and liability durations are matched relatively well, this is less of a consideration since interest on excess cash flows are not a significant component of future cash flows. For the reinvestment rate assumption, anticipated future changes to the yield curves could have a large effect. Given the interest rate environment applicable at the date of our loss recognition tests, we assumed a modest and gradual increase in long-term interest rates over time.
• For mortality assumptions, key judgments include the extent of industry versus own experience to base future assumptions as well as the extent of expected mortality improvements in the future. The latter judgment is based on a combination of historical mortality trends, advice from industry public health and demography specialists that were consulted by AIG’s actuaries and published industry information.
Significant unrealized appreciation on investments in a prolonged low interest rate environment may cause DAC to be adjusted and additional future policy benefit liabilities to be recorded through a charge directly to accumulated other comprehensive income (“shadow loss recognition”). These charges are included, net of tax, with the change in net unrealized appreciation of
investments. See Note 9 to the Consolidated Financial Statements for additional information on shadow loss recognition. In applying shadow loss recognition, the Company overlays unrealized gains onto loss recognition tests without revising the underlying test. Accordingly, there is limited additional judgment in this process.
Variable annuity products offered by our Retirement Income Solutions and Group Retirement product lines offer guaranteed benefit features. These guaranteed features include guaranteed minimum death benefits (GMDB) that are payable in the event of death or other instances, and living benefits that are payable in the event of annuitization, or, in other instances, at specified dates during the accumulation period. Living benefits include guaranteed minimum withdrawal benefits (GMWB), guaranteed minimum income benefits (GMIB), and guaranteed minimum account value benefits (GMAV). See Note 14 to the Consolidated Financial Statements for additional information on these features. For GMDB, our most widely offered guaranteed benefit feature, the liabilities included in Future policyholder benefits at December 31, 2014 and 2013 were $401 million and $355 million, respectively. The fair value of GMWB and GMAV embedded derivatives included in Policyholder contract deposits was a net liability of $957 million at December 31, 2014 and a net asset of $37 million at December 31, 2013.
The liabilities for GMDB and GMIB, which are recorded in Future policyholder benefits, represent the expected value of benefits in excess of the projected account value, with the excess recognized ratably over the accumulation period based on total expected assessments, through Policyholder benefits and losses incurred. The liabilities for GMWB and GMAV, which are recorded in Policyholder contract deposits, are accounted for as embedded derivatives measured at fair value, with changes in the fair value of the liabilities recorded in Other realized capital gains (losses).
Our exposure to the guaranteed amounts is equal to the amount by which the contract holder’s account balance is below the amount provided by the guaranteed feature. A variable annuity contract may include more than one type of guaranteed benefit feature; for example, it may have both a GMDB and a GMWB. However, a policyholder can only receive payout from one guaranteed feature on a contract containing a death benefit and a living benefit, i.e. the features are mutually exclusive, so the exposure to the guaranteed amount for each feature is not additive to that of other features. A policyholder cannot purchase more than one living benefit on one contract. Declines in the equity markets, increased volatility and a sustained low interest rate environment increase our exposure to potential benefits under the guaranteed features, leading to an increase in the liabilities for those benefits. See Estimated Gross Profits for Investment-Oriented Products (Life Insurance) below for sensitivity analysis which includes the sensitivity of reserves for guaranteed benefit features to changes in the assumptions for equity market returns, volatility and mortality. For a further discussion of the risks related to guaranteed benefit features of variable annuities, our dynamic hedging program and risks of AIG’s unhedged exposures, see Item 1A. - Risk Factors - Business and Operations.
If the assumptions used for estimated gross profits change significantly, DAC and related reserves, including VOBA, SIA, guaranteed benefit reserves and URR, are recalculated using the new assumptions, and any resulting adjustment is included in income. Updating such assumptions may result in acceleration of amortization in some products and deceleration of amortization in other products.
In estimating future gross profits for variable annuity products, a long-term annual asset growth assumption of 8.5% (before expenses that reduce the asset base from which future fees are projected) is applied to estimate the future growth in assets and related asset-based fees. In determining the asset growth rate, the effect of short-term fluctuations in the equity markets is partially mitigated through the use of a “reversion to the mean” methodology, whereby short-term asset growth above or
below the long-term annual rate assumption 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.
In the fourth quarter of 2013, we revised the growth rate assumptions for the five-year reversion to the mean period for the Group Retirement product line, because annual growth assumptions indicated for that period had fallen below our floor of zero percent due to the favorable performance of equity markets. For this five-year reversion to the mean period, the growth rate assumption was adjusted to a point between the long-term growth rate assumption and zero percent. This adjustment increased Retirement pre-tax operating income by $35 million in 2013. Had we readjusted the growth rate assumption for the five-year reversion to the mean period to use the long-term rate assumption of 8.5%, pre-tax income would have been higher by approximately $30 million. Conversely, had the growth rate assumption for the five-year reversion to the mean period been readjusted to a floor of zero percent, pre-tax income would have been lower by approximately $30 million. For variable annuities in our Retirement Income Solutions product line, the assumed annual growth rate has remained above zero percent for the five-year reversion to the mean period, so it has not met our criteria for adjustment; however, additional favorable equity market performance in excess of long-term assumptions could also result in “unlocking” in this product line in future periods with a positive effect on pre-tax income in the period of the unlocking.
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 become negative in future reporting periods, 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 goodwill impairment, see Note 12 to the Consolidated Financial Statements. In 2014 and 2013, 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.
For more information on legal, regulatory and litigation matters, see Note 16 to the Consolidated Financial Statements.
Assets and liabilities recorded at fair value in the Consolidated Balance Sheets are measured and classified in a hierarchy for disclosure purposes consisting of three “levels” based on the observability of inputs available in the marketplace used to measure the fair value. See Note 5 to the Consolidated Financial Statements for additional information.
Acquisition ratio Acquisition costs divided by net premiums earned. Acquisition costs are those costs incurred to acquire new and renewal insurance contracts and also include the amortization of value of business acquired (VOBA) and deferred policy acquisition costs (DAC). Acquisition costs vary with sales and include, but are not limited to, commissions, premium taxes, direct marketing costs, certain costs of personnel engaged in sales support activities such as underwriting, and the change in DAC. Acquisition costs that are incremental and directly related to successful sales efforts are deferred and recognized over the coverage periods of related insurance contracts. Acquisition costs that are not incremental and directly related to successful sales efforts are recognized as incurred.
Base Spread Net investment income excluding income from alternative investments and enhancements, less interest credited excluding amortization of sales inducement assets.
Book Value Per Common Share Excluding Accumulated Other Comprehensive Income (loss) (AOCI) is a non-GAAP measure and is used to show the amount of our net worth on a per-share basis. Book Value Per Common Share Excluding AOCI is derived by dividing Total AIG shareholders’ equity, excluding AOCI, by Total common shares outstanding.
CVA Credit Valuation Adjustment The CVA adjusts the valuation of derivatives to account for nonperformance risk of our counterparty with respect to all net derivative assets positions. Also, the CVA reflects the fair value movement in the DIB’s asset portfolio that is attributable to credit movements only without the impact of other market factors such as interest rates and foreign exchange rates. Finally, the CVA also accounts for our own credit risk, in the fair value measurement of all net derivative liabilities positions and liabilities where AIG has elected the fair value option, when appropriate.
DAC Related to Unrealized Appreciation (Depreciation) of Investments An adjustment to DAC for investment-oriented products, equal to the change in DAC amortization that would have been recorded if fixed maturity and equity securities available for sale had been sold at their stated aggregate fair value and the proceeds reinvested at current yields (also referred to as “shadow DAC”). The change in this adjustment, net of tax, is included with the change in net unrealized appreciation (depreciation) of investments that is credited or charged directly to Other comprehensive income (loss).
First-Lien Priority over all other liens or claims on a property in the event of default on a mortgage.
Loss Ratio Losses and loss adjustment expenses incurred divided by net premiums earned. Loss adjustment expenses are directly attributed to settling and paying claims of insureds and include, but are not limited to, legal fees, adjuster’s fees, and claims department personnel costs.
Prior year development Increase or decrease in estimates of losses and loss adjustment expenses incurred for prior years that is included in earnings.
Reinstatement premium Additional premiums payable to reinsurers to restore coverage limits that have been exhausted as a result of reinsured losses under certain excess of loss reinsurance treaties.
Retained Interest Category within AIG’s Corporate and Other that includes the fair value gains or losses, prior to their sale, of the AIA ordinary shares retained following the AIA Group Limited initial public offering and the fair value gains or losses, prior to the FRBNY liquidation of Maiden Lane III LLC assets in 2012, on the retained interest in Maiden Lane III LLC.
Solvency II Legislation in the European Union which reforms the insurance industry’s solvency framework, including minimum capital and solvency requirements, governance requirements, risk management and public reporting standards. The Solvency II Directive (2009/138/EEC), was adopted on November 25, 2009 and is expected to become effective on January 1, 2016.
Surrender rate represents annualized surrenders and withdrawals as a percentage of average account value.
Summary of Investments - Other than Investments in Related Parties at December 31, 2014
Supplementary Insurance Information at December 31, 2014, 2013 and 2012 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, 2014 and 2013, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2014 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, 2014, 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 2014 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.
Revisions were made to change the classification of certain miscellaneous income from General operating and other expenses to Premiums and of certain broker-dealer fees from General operating and other expenses to Other income, to conform with the current period presentation, with no effect to Income from continuing operations or Net income attributable to AIG.
• classification of ILFC as held for sale and related fair value measurement for applicable years;
• valuation of future policy benefit liabilities and timing and extent of loss recognition;
Other income from our Corporate and Other category consists of the following:
• Income earned on real estate based investments and related realized gains and losses from sales, property level impairments and financing costs.
Other liabilities consist of other funds on deposit, other payables, securities sold under agreements to repurchase and securities sold but not yet purchased. We have entered into certain insurance and reinsurance contracts, primarily in our Non-Life Insurance Companies segment, that do not contain sufficient insurance risk to be accounted for as insurance or reinsurance. Accordingly, the premiums received on such contracts, after deduction for certain related expenses, are recorded as deposits within Other liabilities in the Consolidated Balance Sheets. Net proceeds of these deposits are invested and generate Net investment income. As amounts are paid, consistent with the underlying contracts, the deposit liability is reduced. Also included in Other liabilities are trade payables for the DIB and GCM, which include option premiums received and payables to counterparties that relate to unrealized gains and losses on futures, forwards, and options and balances due to
clearing brokers and exchanges. Trade payables for GCM also include cash collateral received from derivative counterparties that contractually cannot be netted against derivative assets.
Foreign currency: Financial statement accounts expressed in foreign currencies are translated into U.S. dollars. Functional currency assets and liabilities are translated into U.S. dollars generally using rates of exchange prevailing at the balance sheet date of each respective subsidiary and the related translation adjustments are recorded as a separate component of Accumulated other comprehensive income, net of any related taxes, in Total AIG shareholders’ equity. Functional currencies are generally the currencies of the local operating environment. Financial statement accounts expressed in currencies other than the functional currency of a consolidated entity are translated into that entity’s functional currency. Income statement accounts expressed in functional currencies are translated using average exchange rates during the period. The adjustments resulting from translation of financial statements of foreign entities operating in highly inflationary economies are recorded in income. Exchange gains and losses resulting from foreign currency transactions are recorded in income.
We adopted the standard on its required effective date of January 1, 2014. The adoption of this standard had no material effect on our consolidated financial condition, results of operations or cash flows.
Parent’s Accounting for the Cumulative Translation Adjustment upon Derecognition of an Investment within a Foreign Entity or of an Investment in a Foreign Entity
In June 2013, the FASB issued an accounting standard that amends the criteria a company must meet to qualify as an investment company, clarifies the measurement guidance, and requires new disclosures for investment companies. An entity that is regulated by the Securities and Exchange Commission under the Investment Company Act of 1940 (the 1940 Act)
In January 2014, the FASB issued an accounting standard that clarifies that a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, so that the loan is derecognized and the real estate property is recognized, when either (i) the creditor obtains legal title to the residential real estate property upon completion of a foreclosure or (ii) the borrower conveys all interest in the residential real estate property to the creditor to satisfy the loan through completion of a deed in lieu of foreclosure or through a similar legal agreement.
The standard is effective for interim and annual reporting periods beginning after December 15, 2014. Early adoption is permitted. We plan to adopt the standard on its required effective date of January 1, 2015 and do not expect the adoption of the standard to have a material effect on our consolidated financial condition, results of operations or cash flows.
previously issued. We plan to adopt the standard on its required effective date of January 1, 2015 and do not expect the adoption of the standard to have a material effect on our consolidated financial condition, results of operations or cash flows.
In May 2014, the FASB issued an accounting standard that supersedes most existing revenue recognition guidance. The standard excludes from its scope the accounting for insurance contracts, leases, financial instruments, and other agreements that are governed under other GAAP guidance, but affects the revenue recognition for certain of our other activities.
The standard is effective for interim and annual reporting periods beginning after December 15, 2016 and may be applied retrospectively or through a cumulative effect adjustment to retained earnings at the date of adoption. Early adoption is not permitted. We plan to adopt the standard on its required effective date of January 1, 2017 and are assessing the impact of the standard on our consolidated financial condition, results of operations and cash flows.
In June 2014, the FASB issued an accounting standard that clarifies the accounting for share-based payments when the terms of an award provide that a performance target could be achieved after the requisite service period. The standard requires that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition.
The standard is effective for interim and annual reporting periods beginning after December 15, 2015. Early adoption is permitted. The standard may be applied prospectively to all awards granted or modified after the effective date or retrospectively to all awards with performance targets that are outstanding as of the beginning of the earliest annual period presented in the financial statements and to all new or modified awards thereafter. We plan to adopt the standard on its required effective date of January 1, 2016 and do not expect the adoption of the standard to have a material effect on our consolidated financial condition, results of operations or cash flows.
In the fourth quarter of 2014, we completed our previously announced reorganization and modified the presentation of our financial results to reflect our new operating structure. The new operating structure includes two reportable segments - Commercial Insurance and Consumer Insurance - and a Corporate and Other category. The Corporate and Other category consists of businesses and items not allocated to our reportable segments.
Prior to the fourth quarter of 2014, AIG reported its results through two reportable segments - AIG Property Casualty and AIG Life and Retirement. The AIG Property Casualty reportable segment had two operating segments - Commercial Insurance and Consumer Insurance in addition to an AIG Property Casualty Other category. The AIG Life and Retirement reportable segment had two operating segments - Retail and Institutional.
• Property Casualty - previously included as part of AIG Property Casualty’s Commercial operating segment
• Institutional Markets - previously reported in AIG Life and Retirement’s Institutional operating segment
• Life - consists of businesses previously included in AIG Life and Retirement’s Retail operating segment as well as the international life business previously included in AIG Property Casualty’s Consumer operating segment.
• Personal Insurance - consists of Personal Lines and Accident & Health product lines previously reported as a component of AIG Property Casualty’s Consumer operating segment.
The run-off insurance businesses previously reported in AIG Property Casualty’s Other category are now presented in Corporate and Other.
• Retained Interests, which represent the fair value gains or losses, prior to their sale in 2012, of the AIA Group Limited (AIA) ordinary shares retained following the AIA initial public offering; the MetLife, Inc. (MetLife) securities that were received as consideration from the sale of American Life Insurance Company (ALICO); and the fair value gains or losses, prior to the FRBNY liquidation of Maiden Lane III LLC (ML III) assets, on the retained interest in ML III
• Aircraft Leasing through May 14, 2014, the date of our sale of ILFC.
The following table presents AIG’s year-end identifiable assets and capital expenditures by reportable segment:
The following table summarizes the components of ILFC assets and liabilities held-for-sale on the Consolidated Balance Sheets at December 31, 2013:
As a result of the AerCap Transaction, we own approximately 46 percent of the outstanding common stock of AerCap. This common stock is subject to certain restrictions as to the amount and timing of potential sales as set forth in the Stockholders’ Agreement and Registration Rights Agreement between AIG and AerCap. We account for our interest in AerCap using the equity method of accounting. The difference between the carrying amount of our investment in AerCap common stock and our share of the underlying equity in the net assets of AerCap was approximately $1.4 billion at December 31, 2014. Approximately $0.4 billion of this difference was allocated to the assets and liabilities of AerCap based on their respective fair values and is being amortized into income over the estimated lives of the related assets and liabilities. The remainder was allocated to goodwill.
Fair values for fixed maturity securities based on observable market prices for identical or similar instruments implicitly incorporate counterparty credit risk. Fair values for fixed maturity securities based on internal models incorporate counterparty
credit risk by using discount rates that take into consideration cash issuance spreads for similar instruments or other observable information.
Valuation service providers typically obtain data about market transactions and other key valuation model inputs from multiple sources and, through the use of market-accepted valuation methodologies, which may utilize matrix pricing, financial models, accompanying model inputs and various assumptions, provide a single fair value measurement for individual securities. The inputs used by the valuation service providers include, but are not limited to, market prices from completed transactions for identical securities and transactions for comparable securities, benchmark yields, interest rate yield curves, credit spreads, prepayment rates, default rates, currency rates, quoted prices for similar securities and other market-observable information, as applicable. If fair value is determined using financial models, these models generally take into account, among other things, market observable information as of the measurement date as well as the specific attributes of the security being valued, including its term, interest rate, credit rating, industry sector, and when applicable, collateral quality and other security or issuer-specific information. When market transactions or other market observable data is limited, the extent to which judgment is applied in determining fair value is greatly increased.
The valuation of the super senior credit derivatives is complex because of the limited availability of market observable information due to the lack of trading and price transparency in certain structured finance markets. These market conditions have increased the reliance on management estimates and judgments in arriving at an estimate of fair value for financial reporting purposes. Further, disparities in the valuation methodologies employed by market participants and the varying judgments reached by such participants when assessing volatile markets have increased the likelihood that the various parties to these instruments may arrive at significantly different estimates of their fair values.
We have adapted the BET model to estimate the price of the super senior risk layer or tranche of the CDO. We modified the BET model to imply default probabilities from market prices for the underlying securities and not from rating agency assumptions. To generate the estimate, the model uses the price estimates for the securities comprising the portfolio of a CDO as an input and converts those estimates to credit spreads over current LIBOR-based interest rates. These credit spreads are used to determine implied probabilities of default and expected losses on the underlying securities. This data is then aggregated and used to estimate the expected cash flows of the super senior tranche of the CDO.
The BET model also uses diversity scores, weighted average lives, recovery rates and discount rates. We employ a Monte Carlo simulation to assist in quantifying the effect on the valuation of the CDO of the unique aspects of the CDO’s structure such as triggers that divert cash flows to the most senior part of the capital structure. The Monte Carlo simulation is used to determine whether an underlying security defaults in a given simulation scenario and, if it does, the security’s implied random default time and expected loss. This information is used to project cash flow streams and to determine the expected losses of the portfolio.
Borrowings under obligations of guaranteed investment agreements (GIAs), which are guaranteed by us, are recorded at fair value using discounted cash flow calculations based on interest rates currently being offered for similar contracts and our current market observable implicit credit spread rates with maturities consistent with those remaining for the contracts being valued. Obligations may be called at various times prior to maturity at the option of the counterparty. Interest rates on these borrowings are primarily fixed, vary by maturity and range up to 8.5 percent.
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, 2014 and 2013, we transferred $590 million and $944 million, respectively, of securities issued by Non-U.S. government entities from Level 1 to Level 2, because they are no longer considered actively traded. For similar reasons, during the years ended December 31, 2014 and 2013, we transferred $107 million and $356 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, 2014 and 2013.
(a) There were no issuances during the years ended December 31, 2014 and 2013.
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, 2014 and 2013 may include changes in fair value that were attributable to both observable (e.g., changes in market interest rates) and unobservable (e.g., changes in unobservable long-dated volatilities) inputs.
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. As a result, the Net realized and unrealized gains (losses) included in income or other comprehensive income and as shown in the table above excludes $22 million of net gains and $15 million of net losses related to assets and liabilities transferred into Level 3 during 2014 and 2013, respectively, and includes $62 million and $44 million of net gains related to assets and liabilities transferred out of Level 3 during 2014 and 2013, respectively.
During the years ended December 31, 2014 and 2013, transfers out of Level 3 assets primarily included CMBS, CDO/ABS, RMBS, certain investments in municipal securities, private placement and other corporate debt, and investments in hedge funds. Transfers of certain investments in municipal securities, corporate debt, RMBS, CMBS and CDO/ABS out of Level 3 assets were based on consideration of market liquidity as well as related transparency of pricing and associated observable inputs for these investments. Transfers of certain investments in private placement corporate debt and certain ABS out of Level 3 assets were primarily the result of using observable pricing information that reflects the fair value of those securities without the need for adjustment based on our own assumptions regarding the characteristics of a specific security or the
current liquidity in the market. The transfers of certain hedge fund investments out of Level 3 assets were primarily the result of easing of certain fund-imposed redemption restrictions.
(a) The unobservable inputs and ranges for the 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.
The ranges of reported inputs for Corporate debt, RMBS, CDO/ABS, and CMBS valued using a discounted cash flow technique consist of plus/minus one standard deviation in either direction from the value-weighted average. The preceding table does not give effect to our risk management practices that might offset risks inherent in these investments.
Corporate debt securities included in Level 3 are primarily private placement issuances that are not traded in active markets or that are subject to transfer restrictions. Fair value measurements consider illiquidity and non-transferability. When observable price quotations are not available, fair value is determined based on discounted cash flow models using discount rates based on credit spreads, yields or price levels of publicly-traded debt of the issuer or other comparable securities, considering illiquidity and structure. The significant unobservable input used in the fair value measurement of corporate debt is the yield. The yield is affected by the market movements in credit spreads and U.S. Treasury yields. In addition, the migration in credit quality of a given security generally has a corresponding effect on the fair value measurement of the security. For example, a downward migration of credit quality would increase spreads. Holding U.S. Treasury rates constant, an increase in corporate credit spreads would decrease the fair value of corporate debt.
Investments in Certain Entities Carried at Fair Value Using Net Asset Value per Share
Interest income and dividend income on assets measured under the fair value option are recognized and included in Net investment income in the Consolidated Statements of Income with the exception of activity within AIG’s Corporate and Other category, which is included in Other income. Interest expense on liabilities measured under the fair value option is reported in Other Income in the Consolidated Statements of Income. See Note 6 herein for additional information about our policies for recognition, measurement, and disclosure of interest and dividend income and interest expense.
During 2014, 2013 and 2012, we recognized losses of $32 million, $54 million and $641 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.
• Mortgage and other loans receivable: Fair values of loans on real estate and other loans receivable are estimated for disclosure purposes using discounted cash flow calculations based on discount rates that we believe market participants would use in determining the price that they would pay for such assets. For certain loans, our current incremental lending rates for similar types of loans are used as the discount rates, because we believe this rate approximates the rates market participants would use. The fair values of policy loans are generally estimated based on unpaid principal amount as of each reporting date or, in some cases, based on the present value of the loans using a discounted cash flow model. No consideration is given to credit risk because policy loans are effectively collateralized by the cash surrender value of the policies.
(b) At December 31, 2014 and 2013, bonds available for sale held by us that were below investment grade or not rated totaled $35.1 billion and $32.6 billion, respectively.
At December 31, 2014, we held 6,394 and 118 individual fixed maturity and equity securities, respectively, that were in an unrealized loss position, of which 2,123 individual fixed maturity securities were in a continuous unrealized loss position for longer than 12 months. We did not recognize the unrealized losses in earnings on these fixed maturity securities at December 31, 2014, because we neither intend to sell the securities nor do we believe that it is more likely than not that we will be required to sell these securities before recovery of their amortized cost basis. For fixed maturity securities with significant declines, we performed fundamental credit analysis on a security-by-security basis, which included consideration of credit enhancements, expected defaults on underlying collateral, review of relevant industry analyst reports and forecasts and other available market data.
(a) Includes $0.9 billion and $1.0 billion of U.S. Government agency backed ABS at December 31, 2014 and 2013, respectively.
The following table presents the carrying amount and ownership percentage of equity method investments at December 31, 2014 and 2013:
Also included in Other invested assets are real estate held for investment and aircraft asset investments held by non-Aircraft Leasing subsidiaries. These investments are reported at cost, less depreciation and are subject to impairment review, as discussed below.
Remaining life expectancy for year 0-1 references policies whose current life expectancy is less than 12 months as of the valuation date. Remaining life expectancy is not an indication of expected maturity. Actual maturity dates in any category may vary significantly (either earlier or later) from the remaining life expectancies reported above.
• Changes in the fair values of our interests in ML II and AIA securities prior to sale and change in the fair value of our interests in ML III prior to the FRBNY liquidation of ML III assets.
If we intend to sell a fixed maturity security or it is more likely than not that we will be required to sell a fixed maturity security before recovery of its amortized cost basis and the fair value of the security is below amortized cost, an other-than-temporary impairment has occurred and the amortized cost is written down to current fair value, with a corresponding charge to realized capital losses. When assessing our intent to sell a fixed maturity security, or whether it is more likely than not that we will be required to sell a fixed maturity security before recovery of its amortized cost basis, management evaluates relevant facts and circumstances including, but not limited to, decisions to reposition our investment portfolio, sales of securities to meet cash flow needs and sales of securities to take advantage of favorable pricing.
The following table presents a rollforward of the cumulative credit losses in other-than-temporary impairments recognized in earnings for available for sale fixed maturity securities:
The determination that an equity security is other-than-temporarily impaired requires the judgment of management and consideration of the fundamental condition of the issuer, its near-term prospects and all the relevant facts and circumstances. In addition to the above criteria, all equity securities that have been in a continuous decline in value below cost over twelve months are impaired. We also consider circumstances of a rapid and severe market valuation decline (50 percent or more) discount to cost, in which we could not reasonably assert that the impairment period would be temporary (severity losses).
The following table presents activity for the accretable yield on PCI securities:
We enter into secured financing transactions whereby certain securities are sold under agreements to repurchase (repurchase agreements), in which we transfer securities in exchange for cash, with an agreement by us to repurchase the same or substantially similar securities. In the majority of these repurchase agreements, the securities transferred by us may be sold or repledged by the counterparties. Repurchase agreements entered into by the DIB are carried at fair value based on market-observable interest rates. All other repurchase agreements are recorded at their contracted repurchase amounts plus accrued interest.
Total carrying amounts 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 agreements, were $5.9 billion and $6.7 billion at December 31, 2014 and 2013, respectively.
Certain of our subsidiaries are members of Federal Home Loan Banks (FHLBs) and such membership requires the members to own stock in these FHLBs. We owned an aggregate of $44 million and $57 million of stock in FHLBs at December 31, 2014 and 2013, respectively. To the extent an AIG subsidiary borrows from the FHLB, its ownership interest in the stock of FHLBs will be pledged to the FHLB. In addition, our subsidiaries have pledged securities available for sale with a fair value of $535 million and $80 million at December 31, 2014 and 2013, respectively, associated with advances from the FHLBs.
* Commercial mortgages primarily represent loans for apartments, offices, retail and industrial properties, with exposures in California and New York representing the largest geographic concentrations (14 percent and 18 percent, respectively, at December 31, 2014 and 18 percent and 17 percent, respectively, at December 31, 2013).
Mortgage and other loans receivable are considered impaired when collection of all amounts due under contractual terms is not probable. Impairment is measured using either i) the present value of expected future cash flows discounted at the loan’s effective interest rate, ii) the loan’s observable market price, if available, or iii) the fair value of the collateral if the loan is collateral dependent. Impairment of commercial mortgages is typically determined using the fair value of collateral while impairment of other loans is typically determined using the present value of cash flows or the loan’s observable market price. An allowance is typically established for the difference between the impaired value of the loan and its current carrying amount. Additional allowance amounts are established for incurred but not specifically identified impairments, based on the analysis of internal risk ratings and current loan values. Internal risk ratings are assigned based on the consideration of risk factors including past due status, debt service coverage, loan-to-value ratio, property occupancy, profile of the borrower and of the major property tenants, economic trends in the market where the property is located, and condition of the property. These factors and the resulting risk ratings also provide a basis for determining the level of monitoring performed at both the individual loan and the portfolio level. When all or a portion of a loan is deemed uncollectible, the uncollectible portion of the carrying amount of the loan is charged off against the allowance. Interest income on impaired loans is recognized as cash is received. For impaired loans where it has been determined that not all of the contractual principal due will be collected, any cash received is recorded as a reduction of the current carrying amount of the loan.
* Of the total allowance at the end of the year, $55 million and $93 million relates to individually assessed credit losses on $192 million and $264 million of commercial mortgage loans as of December 31, 2014 and 2013, respectively.
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 $258 million and $276 million at December 31, 2014 and 2013, 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.
Long-duration insurance in force assumed represented 0.04 percent of gross long-duration insurance in force at December 31, 2014, 0.05 percent at December 31, 2013 and 0.05 percent at December 31, 2012, and premiums assumed by the Life Insurance Companies represented 0.5 percent, 0.3 percent and 0.4 percent of gross premiums for the years ended December 31, 2014, 2013 and 2012, respectively.
Our third-party reinsurance arrangements do not relieve us from our direct obligations to our beneficiaries. Thus, a credit exposure exists with respect to both short-duration and long-duration reinsurance ceded to the extent that any reinsurer fails to meet the obligations assumed under any reinsurance agreement. We hold substantial collateral as security under related reinsurance agreements in the form of funds, securities, and/or letters of credit. A provision has been recorded for estimated unrecoverable reinsurance. We believe that no exposure to a single reinsurer represents an inappropriate concentration of credit risk to AIG. Gross reinsurance assets with our three largest reinsurers aggregate to approximately $6.2 billion and $6.0 billion at December 31, 2014 and 2013, respectively, of which approximately $3.3 billion was not secured by collateral in both years.
We also defer a portion of employee total compensation and payroll-related fringe benefits directly related to time spent performing specific acquisition or renewal activities, including costs associated with the time spent on underwriting, policy
after five years. These projections are based on current estimates for investment income and spreads, persistency, mortality and morbidity assumptions.
(c) Comprised primarily of Other liabilities and Derivative liabilities, at fair value, at both December 31, 2014 and 2013.
We also created VIEs for the purpose of acquiring, owning, leasing, maintaining, operating and selling aircraft. We hold beneficial interests, including all the equity interests, in these entities. Other beneficial interests include passive investments by our insurance operations in the majority of the debt issued by these entities. We maintain the power to direct the activities of the VIEs that most significantly impact the entities’ economic performance and bear the obligation to absorb economic losses or receive economic benefits that could potentially be significant to the VIEs. As a result, we consolidate the assets and liabilities of these entities.
Through DIB, we sponsor Nightingale Finance Ltd., a structured investment vehicle (SIV), which is a VIE. Nightingale Finance Ltd. invests in variable rate, investment-grade debt securities, the majority of which are ABS. We have no equity interest in the SIV, but we maintain the power to direct the activities of the SIV that most significantly impact the entity’s economic performance and bear the obligation to absorb economic losses that could potentially be significant to the SIV. We are the primary beneficiary and consolidate the SIV.
SunAmerica Affordable Housing Partners, Inc. (SAAHP) organizes and invests in limited partnerships that develop and operate affordable housing qualifying for federal tax credits, in addition to a few market rate properties across the United States. The operating partnerships are VIEs, whose debt is generally non-recourse in nature, and the general partners of which are mostly unaffiliated third-party developers. We do not consolidate an operating partnership if the general partner is an unaffiliated entity and we do not have the power to direct activities that most significantly impact the entities’ economic performance. Through approximately 900 partnerships, SAAHP has limited partnership investments in developments with approximately 110,000 apartment units nationwide, and as of December 31, 2014, has syndicated approximately $7.7 billion in partnership equity to other investors who will receive, among other benefits, tax credits under certain sections of the Internal Revenue Code. The pre-tax income of SAAHP is reported as a component of the Consumer Insurance segment.
Derivatives, with the exception of bifurcated embedded derivatives, are reflected in the Consolidated Balance Sheets in Derivative assets, at fair value and Derivative liabilities, at fair value. 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. A bifurcated embedded derivative is generally presented with the host contract in the Consolidated Balance Sheets. See Notes 5 and 14 herein for additional information on embedded policy derivatives.
(b) There were no derivative assets or notionals related to bifurcated embedded derivatives at December 31, 2014. Notional amount of derivative assets and fair value of derivative assets include $23.2 billion and $107 million at December 31, 2013 related to bifurcated embedded derivatives. Notional amount of derivative liabilities and fair values of derivative liabilities include $39.3 billion and $1.5 billion, respectively, at December 31, 2014 and $6.7 billion and $424 million, respectively at December 31, 2013 related to bifurcated embedded derivatives. A bifurcated embedded derivative is generally presented with the host contract in the Consolidated Balance Sheets.
The following table presents the fair values of derivative assets and liabilities in the Consolidated Balance Sheets:
We engage in derivative transactions that are not subject to a clearing requirement directly with unaffiliated third parties, in most cases, under International Swaps and Derivatives Association, Inc. (ISDA) agreements. Many of the ISDA agreements also include Credit Support Annex (CSA) provisions, which provide for collateral postings that may vary at various ratings and threshold levels. We attempt to reduce our risk with certain counterparties by entering into agreements that enable collateral to be obtained from a counterparty on an upfront or contingent basis. We minimize the risk that counterparties to transactions might be unable to fulfill their contractual obligations by monitoring counterparty credit exposure and collateral value and may require additional collateral to be posted upon the occurrence of certain events or circumstances. In addition, certain derivative transactions have provisions that require collateral to be posted upon a downgrade of our long-term debt ratings or give the counterparty the right to terminate the transaction. In the case of some of the derivative transactions, upon a downgrade of our long-term debt ratings, as an alternative to posting collateral and subject to certain conditions, we may assign the transaction to an obligor with higher debt ratings or arrange for a substitute guarantee of our obligations by an obligor with higher debt ratings or take other similar action. The actual amount of collateral required to be posted to counterparties in the event of such downgrades, or the aggregate amount of payments that we could be required to make, depends on market conditions, the fair value of outstanding affected transactions and other factors prevailing at and after the time of the downgrade.
We designated certain derivatives entered into by GCM with third parties as fair value hedges of available-for-sale investment securities held by our insurance subsidiaries. The fair value hedges include foreign currency forwards designated as hedges of the change in fair value of foreign currency denominated available-for-sale securities attributable to changes in foreign exchange rates. We previously designated certain interest rate swaps entered into by GCM with third parties as cash flow hedges of certain floating rate debt issued by ILFC, specifically to hedge the changes in cash flows on floating rate debt attributable to changes in the benchmark interest rate. We de-designated such derivatives as cash flow hedges in December 2012 in connection with ILFC being classified as held-for-sale.
The following table presents the effect of our derivative instruments not designated as hedging instruments in the Consolidated Statements of Income:
Derivative transactions between AIG and its subsidiaries and third parties are generally centralized through GCM, specifically AIG Markets. The derivatives portfolio of AIG Markets consists primarily of interest rate and currency derivatives and also
includes legacy credit derivatives that have been novated from AIGFP. AIGFP also enters into derivatives to mitigate market risk in its exposures (interest rates, currencies, credit, commodities and equities) arising from its portfolio of remaining transactions.
The following table presents the net notional amount (net of all structural subordination below the covered tranches), fair value of derivative liability before the effects of counterparty netting adjustments and offsetting cash collateral and unrealized market valuation gain of the super senior credit default swap portfolio by asset class:
(a) During 2014, we paid $67 million to counterparties with respect to multi-sector CDOs, which was previously included in the fair value of the derivative liability as an unrealized market valuation loss. Collateral postings with regards to multi-sector CDOs were $852 million and $1.1 billion at December 31, 2014 and 2013, respectively.
Because of long-term maturities of the CDSs in the arbitrage 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 super senior credit default swap portfolio.
These CDS contracts were written under ISDA Master Agreements. The majority of these ISDA Master Agreements include credit support annexes (CSAs) that provide for collateral postings that may vary at various ratings and threshold levels. At December 31, 2014 and 2013, net collateral posted by us under these contracts was $30 million and $38 million, respectively, prior to offsets for other transactions.
Our businesses, other than GCM, also use derivatives and other instruments as part of their financial risk management. Interest rate derivatives (such as interest rate swaps) are used to manage interest rate risk associated with embedded derivatives contained in insurance contract liabilities, fixed maturity securities, outstanding medium- and long-term notes as well as other interest rate sensitive assets and liabilities. Foreign exchange derivatives (principally foreign exchange forwards and options) are used to economically mitigate risk associated with non-U.S. dollar denominated debt, net capital exposures, and foreign currency transactions. Equity derivatives are used to mitigate financial risk embedded in certain insurance liabilities. The derivatives are effective economic hedges of the exposures that they are meant to offset.
We estimate that at December 31, 2014, based on our outstanding financial derivative transactions, a one-notch downgrade of our long-term senior debt ratings to BBB+ by Standard & Poor’s Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. (S&P), would permit counterparties to make additional collateral calls and permit certain counterparties to elect early termination of contracts, resulting in a negligible amount of corresponding collateral postings and termination payments; a one-notch downgrade to Baa2 by Moody’s Investors’ Service, Inc. (Moody’s) and an additional one-notch downgrade to BBB by S&P would result in approximately $46 million in additional collateral postings and termination payments, and a further one-notch downgrade to Baa3 by Moody’s and BBB- by S&P would result in approximately $153 million in additional collateral postings and termination payments.
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, 2014. Factors considered in estimating the termination payments upon downgrade include current market conditions, the complexity of the derivative transactions, historical termination experience and other observable market events such as bankruptcy and downgrade events that have occurred at other companies. Our estimates are also based on the assumption that counterparties will terminate based on their net exposure to us. The actual termination payments could significantly 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.
investments in these hybrid securities are exposed to losses only up to the amount of our initial investment in the hybrid security. Other than our initial investment in the hybrid securities, we have no further obligation to make payments on the embedded credit derivatives in the related hybrid securities.
We elect to account for our investments in these hybrid securities with embedded written credit derivatives at fair value, with changes in fair value recognized in Net investment income and Other income. Our investments in these hybrid securities are reported as Other bond securities in the Consolidated Balance Sheets. The fair values of these hybrid securities were $6.1 billion and $6.4 billion at December 31, 2014 and 2013, respectively. These securities have par amounts of $12.3 billion and $13.4 billion at December 31, 2014 and 2013, respectively, and both have remaining stated maturity dates that extend to 2052.
The liability for unpaid losses and loss adjustment expenses represents the accumulation of estimates of unpaid claims, including estimates for claims incurred but not reported and claim adjustments expenses, less applicable discount for future investment income. We continually review and update the methods used to determine loss reserve estimates and to establish the resulting reserves. Any adjustments resulting from this review are reflected currently in pre-tax income. Because these estimates are subject to the outcome of future events, changes in estimates are common given that loss trends vary and time is often required for changes in trends to be recognized and confirmed. Reserve changes that increase previous estimates of ultimate cost are referred to as unfavorable or adverse development or reserve strengthening. Reserve changes that decrease previous estimates of ultimate cost are referred to as favorable development.
• The non-tabular workers’ compensation discount is calculated separately for companies domiciled in New York and Pennsylvania, and follows the statutory regulations (prescribed or permitted) for each state. For New York companies, the discount is based on a five percent interest rate and the companies’ own payout patterns. In 2012, for Pennsylvania companies, the statute has specified discount factors for accident years 2001 and prior, which are based on a six percent interest rate and an industry payout pattern. For accident years 2002 and subsequent, the discount is based on the payout patterns and investment yields of the companies.
The discount consists of the following: $852 million of tabular discount for workers’ compensation in the domestic operations of Non-Life Insurance Companies and $2.2 billion of non-tabular discount for workers’ compensation in the domestic operations of Non-Life Insurance Companies; and $11 million - non-tabular discount for asbestos for Non-Life Insurance Companies.
Future policy benefits also include certain guaranteed benefits of variable annuity products that are not considered embedded derivatives, primarily guaranteed minimum death benefits. See Note 14 for additional information on guaranteed death benefits.
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 1 percent to 12 percent. Mortality and surrender rate assumptions are generally based on actual experience when the liability is established.
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 operating segment. During the year ended December 31, 2014, a $450 million GIC was issued in conjunction with the funding agreement-backed notes program.