In addition, our General Insurance companies own offices in 13 foreign countries and jurisdictions including Bermuda, Ecuador, Japan, Mexico, the UK and Venezuela. The remainder of the office space we use is leased. We believe that our leases and properties are sufficient for our current purposes.
As of December 31, 2018, approximately 15 percent of our consolidated assets were located outside the U.S. and Canada, including $413 million of cash and securities on deposit with regulatory authorities in those locations.
| Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Annual Report on Form 10-K and other publicly available documents may include, and officers and representatives of AIG may from time to time make and discuss, 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 a 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 “will,” “believe,” “anticipate,” “expect,” “intend,” “plan,” “focused on achieving,” “view,” “target,” “goal” or “estimate.” These projections, goals, assumptions and statements may relate to future actions, prospective services or products, future performance or results of current and anticipated services or products, sales efforts, expenses, the outcome of contingencies such as legal proceedings, anticipated organizational, business or regulatory changes, anticipated sales, monetization and/or acquisitions of businesses or assets, or successful integration of acquired businesses, management succession and retention plans, exposure to risk, trends in operations and financial results.
• our ability to successfully reorganize our businesses and execute on our initiatives to improve our underwriting capabilities and reinsurance programs, as well as improve profitability, without negatively impacting client relationships or our competitive position;
• the impact of potential information technology, cybersecurity or data security breaches, including as a result of cyber-attacks or security vulnerabilities;
• changes in judgments concerning the recognition of deferred tax assets and goodwill impairment; and
- this Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) of this Annual Report.
Adjusted after-tax income attributable to AIG is derived by excluding the tax effected adjusted pre-tax income (APTI) adjustments described below and the following tax items from net income attributable to AIG:
• all net realized capital gains and losses except earned income (periodic settlements and changes in settlement accruals) on derivative instruments used for non-qualifying (economic) hedging or for asset replication. Earned income on such economic hedges is reclassified from net realized capital gains and losses to specific APTI line items based on the economic risk being hedged (e.g. net investment income and interest credited to policyholder account balances);
• restructuring and other costs related to initiatives designed to reduce operating expenses, improve efficiency and simplify our organization;
- Ratios: We, along with most property and casualty insurance companies, use the loss ratio, the expense ratio and the combined ratio as measures of underwriting performance. These ratios are relative measurements that describe, for every $100 of net premiums earned, the amount of losses and loss adjustment expenses (which for General Insurance excludes net loss reserve discount), and the amount of other underwriting expenses that would be incurred. A combined ratio of less than 100 indicates underwriting income and a combined ratio of over 100 indicates an underwriting loss. Our ratios are calculated using the relevant segment information calculated under GAAP, and thus may not be comparable to similar ratios calculated for regulatory reporting purposes. The underwriting environment varies across countries and products, as does the degree of litigation activity, all of which affect such ratios. In addition, investment returns, local taxes, cost of capital, regulation, product type and competition can have an effect on pricing and consequently on profitability as reflected in underwriting income and associated ratios.
- 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. Natural and man-made catastrophe losses are generally weather or seismic events having a net impact on AIG in excess of $10 million each and also include certain man-made events, such as terrorism and civil disorders that exceed the $10 million threshold. We believe that as adjusted ratios are meaningful measures of our underwriting results on an ongoing basis as they exclude catastrophes and the impact of reserve discounting which are outside of management’s control. We also exclude prior year development to provide transparency related to current accident year results.
· valuation of liabilities for guaranteed benefit features of variable annuity products;
· valuation of embedded derivatives for fixed index annuity and life products;
· impairment charges, including other-than-temporary impairments on available for sale securities, impairments on other invested assets, including investments in life settlements, and goodwill impairment;
· the determination of the appropriate groupings of similar product lines and, in some cases, the disaggregation of dissimilar losses within a product line.
Our loss reserves can generally be categorized into two distinct groups. Short-tail reserves consists principally of U.S. Property and Special Risks, Europe Property and Special Risks, U.S. Personal Insurance, and Europe and Japan Personal Insurance. Long-tail reserves include U.S. Workers’ Compensation, U.S. Excess Casualty, U.S. Other Casualty, U.S. Financial Lines, Europe Casualty and Financial Lines, and U.S. Run-off Long Tail Insurance Lines.
· Loss cost trend factors are used to establish expected loss ratios for subsequent accident years based on the projected loss ratios for prior accident years.
· Expected loss ratios are used for the latest accident year (i.e., accident year 2018 for the year-end 2018 loss reserve analysis) and, in some cases for accident years prior to the latest accident year. The expected loss ratio generally reflects the projected loss ratio from prior accident years, adjusted for the loss cost trend and the effect of rate changes and other quantifiable factors on the loss ratio. For low-frequency, high-severity lines of business such as excess casualty, expected loss ratios generally are used for at least the three most recent accident years.
• Claim by claim reviews, often facilitated by third party specialists, to determine the stability and likelihood of settling an injured worker’s indemnity and medical benefits;
• The effects of various run-off loss management strategies that have been developed by our run-off unit.
The tail factor is typically the most critical assumption, and small changes in the selected tail factor can have a material effect on our carried reserves. For example, the tail factors beyond twenty years for guaranteed cost business could vary by one and one-half percent below to two percent above those actually indicated in the 2018 loss reserve review. For excess of deductible business, in our judgment, it is reasonably likely that tail factors beyond twenty years could vary by four percent below to six percent above those actually indicated in the 2018 loss reserve review.
We utilize various loss cost trend assumptions for different segments of the portfolio. After evaluating the historical loss cost trends from prior accident years since the early 1990s, in our judgment, it is reasonably likely that actual loss cost trends applicable to the year-end 2018 loss reserve review for U.S. Excess Casualty may range five percent lower or higher than this estimated loss trend. The loss cost trend assumption is critical for the U.S. Excess Casualty class of business due to the long-tail nature of the losses, and is applied across many accident years. Thus, there is the potential for the loss reserves with respect to a number of accident years (the expected loss ratio years) to be significantly affected by changes in loss cost trends that were initially relied upon in setting the loss reserves. These changes in loss trends could be attributable to changes in inflation or in the judicial environment, or in other social or economic conditions affecting losses.
The selected loss development factors are also an important assumption, but are less critical than for U.S. Excess Casualty. Because these classes are written on a claims made basis, the loss reporting and development tail is much shorter than for U.S. Excess Casualty. However, the high severity nature of the losses does create the potential for significant deviations in loss development patterns from one year to the next. Similar to U.S. Excess Casualty, after evaluating the historical loss development factors from prior accident years since the early 1990s, in our judgment, it is reasonably likely that actual loss development factors could change by an amount equivalent to a shift by six months from those actually utilized in the year-end 2018 reserve review.
U.S. Run-off Long Tail Insurance lines is an extremely long-tail class of business, with a much greater than normal uncertainty as to the appropriate loss development factors for the tail of the loss development. Specifically for excess workers’ compensation, after evaluating the historical loss development factors for prior accident years since the 1980s as well as the development over the past several years of the ground up loss projections utilized to help select the loss development factors in the tail for this class of business, in our judgment, it is reasonably likely that the tail factor beyond 30 years could vary by 10 percent above or below that actually indicated in the 2018 loss reserve review.
• To determine investment returns used in loss recognition tests, we typically match liabilities with assets of comparable duration, to the extent practicable, and then project future cash flows on those assets. Assets supporting insurance liabilities are primarily comprised of a diversified portfolio of high to medium quality fixed maturity securities, and may also include, to a lesser extent, alternative investments. 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 most recent loss recognition tests, we assumed a modest and gradual increase in long-term interest rates over time.
The fair value of the embedded derivatives is based on actuarial and capital market assumptions related to projected cash flows over the expected lives of the contracts. Key assumptions include:
· Allocation of fees between the embedded derivative and host contract
The following table summarizes the sensitivity of changes in certain assumptions for DAC and SIA, embedded derivatives and other reserves related to guaranteed benefits and URR, measured as the related hypothetical impact on December 31, 2018 balances and the resulting hypothetical impact on pre-tax income, before hedging.
(a) Represents the net impact of a one percent increase or decrease in long-term equity returns for GMDB reserves and net impact of a one percent increase or decrease in the S&P 500 index on the value of the GMWB embedded derivative.
• whether the reinsurer is financially troubled (i.e., liquidated, insolvent, in receivership or otherwise subject to formal or informal regulatory restriction); and
At December 31, 2018, the allowance for estimated unrecoverable reinsurance was $140 million, or less than one percent of the consolidated reinsurance recoverable.
At each balance sheet date, we evaluate our available for sale securities holdings with unrealized losses to determine if an other-than-temporary impairment has occurred. We also evaluate our other invested assets for impairment; these include equity method investments in private equity funds, hedge funds and other entities as well as investments in real estate.
For a discussion of goodwill impairment see Part I, Item 1A. Risk Factors - Estimates and Assumptions and Note 12 to the Consolidated Financial Statements. In 2018, 2017 and 2016, for substantially all of the reporting units we 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 our business projections that inherently include judgments regarding business trends.
We estimate and record a liability for potential losses that may arise from regulatory and government investigations and actions and litigation and other forms of dispute resolution to the extent such losses are probable and can be estimated. Determining a reasonable estimate of the amount of such losses requires significant management judgment. In many cases, it is not possible to determine whether a liability has been incurred or to estimate the ultimate or minimum amount of that liability until the matter is close to resolution. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases that are in the early stages of litigation or in which claimants seek substantial or indeterminate damages, we often cannot predict the outcome or estimate the eventual loss or range of reasonably possible losses related to such matters. Given the inherent unpredictability of such matters, the outcome of certain matters could, from time to time, have a material adverse effect on the company’s consolidated financial condition, results of operations or cash flows.
On December 22, 2017, the U.S. enacted Public Law 115-97, known informally as the Tax Cuts and Jobs Act (the Tax Act). The Tax Act reduced the statutory rate of U.S. federal corporate income tax to 21 percent and enacted numerous other changes impacting AIG and the insurance industry. Additionally, the SEC staff issued Staff Accounting Bulletin 118 (SAB 118), which provided guidance on accounting for the tax effects of the Tax Act. SAB 118 addressed situations where accounting for certain income tax effects of the Tax Act under ASC 740 may be incomplete upon issuance of an entity’s financial statements and provided a one-year measurement period from the enactment date to complete the accounting under ASC 740. As of December 31, 2017, we had not fully completed our accounting for the tax effects of the Tax Act and our provision for income taxes was based in part on a reasonable estimate of the effects on existing deferred tax balances and of certain provisions of the Tax Act.
The Tax Act includes a provision for Global Intangible Low-Taxed Income (GILTI) under which taxes on foreign income are imposed on the excess of a deemed return on tangible assets of certain foreign subsidiaries and for Base Erosion and Anti-Abuse Tax (BEAT) under which taxes are imposed on certain base eroding payments to affiliated foreign companies. There are substantial uncertainties in the interpretation of BEAT and GILTI and while certain formal guidance was issued by the U.S. tax authority, there are still aspects of the Tax Act that remain unclear and additional guidance is expected in 2019. Such guidance may result in changes to the interpretations and assumptions we made and actions we may take, which may impact amounts recorded with respect to international provisions of the Tax Act. Consistent with accounting guidance, we treat BEAT as a period tax charge in the period the tax is incurred and have made an accounting policy election to treat GILTI taxes in a similar manner.
Decrease in Net loss attributable to AIG in 2018 compared to 2017. Excluding the $6.7 billion tax charge related to the enactment of the Tax Act in 2017, we recorded a Net loss attributable to AIG in 2018 compared to Net income attributable to AIG in 2017 primarily due to:
• lower investment returns primarily driven by lower hedge fund performance, a decline in income from fixed maturity securities for which the fair value option was elected when compared to higher returns on this portfolio in 2017 as a result of significant spread tightening that occurred, losses on our fair value option equities portfolio, and lower invested assets resulting from the funding of the adverse development reinsurance agreement with National Indemnity Company (NICO), a subsidiary of Berkshire Hathaway Inc. (Berkshire), late in the first quarter of 2017;
• lower losses from General Insurance operations, reflecting $1.0 billion of pre-tax unfavorable prior year loss reserve development in 2017 driven by higher than expected loss emergence in General Insurance primarily related to accident year 2016 compared to $5.4 billion in 2016, partially offset by higher catastrophe losses;
• a net favorable adjustment from the update of Life and Retirement actuarial assumptions in 2017 compared to a net unfavorable adjustment in in the prior year;
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 2018, characterized by factors such as the impact of historically low interest rates, uncertainties in the annuity marketplace resulting from legislative and regulatory initiatives aimed at re-evaluating the standard of care for sales of investment products and services, historically high levels of catastrophic events, slowing growth in China and Euro-Zone economies, global trade tensions and the UK’s pending withdrawal from its membership in the European Union (the EU) (commonly referred to as Brexit). Brexit has also affected the U.S. dollar/British pound exchange rate and increased the volatility of exchange rates among the euro, British pound and the Japanese yen (the Major Currencies), which may continue for some time.
liability management, including spread management strategies for our investment-oriented products and economic hedging of interest rate risk from guarantee features in our variable and fixed index annuities.
The sustained low interest rate environment has a significant impact on the annuity industry. Low long-term interest rates put pressure on investment returns, which may negatively affect sales of interest rate sensitive products and reduce future profits on certain existing fixed rate products. However, our disciplined rate setting has helped to mitigate some of the pressure on investment spreads. Rapidly rising interest rates could create the potential for increased sales, but may also drive higher surrenders. Customers are, however, currently buying fixed annuities with surrender charge periods of four to seven years in pursuit of higher returns, which may help mitigate increased early surrenders in a rising rate environment. In addition, older contracts that have higher minimum interest rates and continue to be attractive to the contract holders have driven better than expected persistency in Fixed Annuities, although the reserves for such contracts have continued to decrease over time in amount and as a percentage of the total annuity portfolio. We will closely monitor surrenders of Fixed Annuities as contracts with lower minimum interest rates come out of the surrender charge period in a more attractive rate environment. Low interest rates have also driven growth in our fixed index annuity products, which provide additional interest crediting, tied to favorable performance in certain equity market indices and the availability of guaranteed living benefits. Changes in interest rates significantly impact the valuation of our liabilities for annuities with guaranteed income features and the value of the related hedging portfolio.
Of the aggregate fixed account values of our Individual Retirement and Group Retirement annuity products, 66 percent were crediting at the contractual minimum guaranteed interest rate at December 31, 2018. The percentage of fixed account values of our annuity products that are currently crediting at rates above one percent was 66 percent and 69 percent at December 31, 2018 and 2017, respectively. These businesses continue to focus on pricing discipline and strategies to manage the minimum guaranteed interest crediting rates offered on new sales in the context of regulatory requirements and competitive positioning. In the core universal life business in our Life Insurance business, 65 percent of the account values were crediting at the contractual minimum guaranteed interest rate at December 31, 2018.
In addition, for our General Insurance segment and General Insurance Run-Off Lines reported within the Legacy Portfolio, sustained low interest rates may unfavorably affect the net loss reserve discount for workers’ compensation, and to a lesser extent could favorably impact assumptions about future medical costs, the combined net effect of which could result in higher net loss reserves.
On September 7, 2017, the UK Ministry of Justice announced a proposal to increase the Ogden rate from negative 0.75 percent to between zero and one percent. Following this announcement, on December 20, 2018 the UK Parliament passed the Civil Liability Act 2018 which implements a new framework for determining the Ogden rate and requires the UK Ministry of Justice to start a review of the Ogden rate within 90 days of its commencement and review periodically thereafter. The Ministry of Justice concluded a public call for evidence on January 30, 2019 prior to beginning its first review. We will continue to monitor the progress of potential changes to the Ogden rate.
The following section provides a comparative discussion of our Consolidated Results of Operations on a reported basis for the three-year period ended December 31, 2018. Factors that relate primarily to a specific business are discussed in more detail within the business segment operations section.
(b) For 2017 and 2016, because we reported a net loss attributable to AIG common shareholders from continuing operations, all common stock equivalents are anti-dilutive and are therefore excluded from the calculation of diluted shares and diluted per share amounts. However, because we reported adjusted after-tax income, the calculation of adjusted after-tax income per diluted share includes 22,412,682 dilutive shares and 30,326,772 dilutive shares for 2017 and 2016, respectively.
- Life and Retirement guaranteed living benefits, net of hedges, which reflected net realized capital gains in 2018 compared to net realized capital losses in 2017, primarily due to changes in the movement in the non-performance or “own credit” risk adjustment (NPA), which is not hedged as part of our economic hedging program (see Insurance Reserves - Life and Annuity Reserves and DAC - Variable Annuity Guaranteed Benefits and Hedging Results);
• movement in the NPA, driven by tightening credit spreads and lower expected GMWB payments due to higher equity markets, and higher derivative losses from variable annuity GMWB, net of hedges, including losses from guaranteed living benefit embedded derivatives, net of hedging, primarily due to a higher net unfavorable adjustment from updates of actuarial assumptions; and
Changes specific to the insurance industry include the calculation of insurance tax reserves and related transition adjustments, amortization of specified policy acquisition expenses, treatment of separate account dividends received deductions and computation of pro-ration adjustments. Provisions of the Tax Act with broader application include reductions or elimination of deductions for certain items, e.g., reductions to corporate dividends received deductions, disallowance of entertainment expenses and limitations on the deduction of certain executive compensation costs. These provisions, generally, result in an increase in AIG’s taxable income.
During the period ended December 31, 2018, we have completed our review of the impact of the Tax Act on our forecasts of taxable income, made certain assumptions related to interpretation of relevant new rules, and incorporated guidance issued by the U.S. tax authority. While the prescribed SAB 118 measurement period has ended, there are still certain aspects of the Tax Act that remain unclear, including the complex interplay of the new tax rules with the rules governing the utilization of our tax attributes, and formal guidance from the U.S. tax authority is still pending. We will continue to review the impact of any additional guidance issued by the U.S. tax authority on our valuation allowance analysis in accordance with the relevant accounting guidance. Accordingly, as of December 31, 2018, we consider the determination of the need for a valuation allowance related to the Tax Act to be complete based on our analysis of existing tax law and relevant tax guidance, and no measurement period adjustment was recorded.
As a result of the Tax Act, the majority of accumulated foreign earnings that were previously untaxed are subject to a one-time deemed repatriation tax. Going forward, foreign earnings not taxed as part of the one-time deemed repatriation (or otherwise taxed currently under the GILTI or subpart F regimes) will generally be exempt from U.S. tax upon repatriation. Notwithstanding the changes, U.S. tax on foreign exchange gain or loss and certain non-U.S. withholding taxes will continue to be applicable upon future repatriations of foreign earnings. For 2018, we consider our foreign earnings with respect to certain operations in Canada, South Africa, the Far East, Latin America, Bermuda as well as the European, Asia Pacific and Middle East regions to be indefinitely reinvested. These earnings relate to ongoing operations and have been reinvested in active business operations. While, following the enactment of the Tax Act, distributions from foreign affiliates are, generally, not subject to U.S. income tax, such distributions may be subject to local withholding taxes. A deferred tax liability of approximately $100 million to $150 million related to such withholding taxes has not been recorded for those foreign subsidiaries whose earnings are considered to be indefinitely reinvested. Deferred taxes, if necessary, have been provided on earnings of non-U.S. affiliates whose earnings are not indefinitely reinvested.
We have completed our review of post-1986 earnings and profits of our foreign affiliates. Incorporating additional IRS guidance issued with respect to the deemed repatriation tax, as well as the relevant basis adjustments, we recognized a measurement period tax charge of $62 million. The effect of deemed repatriation tax, which has now been determined to be complete, resulted in a liability of $24 million.
- $48 million net charge primarily related to the accrual of IRS interest (including interest related to uncertain tax positions),
- $72 million of reclassifications from accumulated other comprehensive income to income from continuing operations related to the disposal of available for sale securities,
The effect of foreign operations is primarily related to income and losses in our foreign operations taxed at statutory tax rates different than 21 percent and foreign income subject to U.S. taxation.
Personal Lines: Products include personal auto and property in selected markets and insurance for high net worth individuals offered through AIG Private Client Group (PCG) in the U.S. that covers auto, homeowners, umbrella, yacht, fine art and collections. In addition, we offer extended warranty insurance and services covering electronics, appliances, and HVAC.
• over capacity in certain lines of business that creates downward market pressure on pricing;
The Commercial Lines market continues to be highly competitive, due to increased market capacity and ample availability of capital. Despite this, we continue to grow our most profitable segments and diversify our portfolio across all regions by expanding into new product lines (e.g. cyber), new client segments (e.g. middle market) and new distribution channels (e.g. digital and national brokers) while remaining a market leader in key developed and developing markets. We are maintaining our underwriting discipline and continuing our risk selection strategy to improve profitability.
Prior year development, net of (additional) return premium on loss sensitive business
(c) As a result of the merger of AIUI Japan and Fuji Fire and Marine Insurance Company (Fuji), Fuji’s fiscal reporting period was conformed to that of AIUI Japan (Japan Merger Impact). Therefore, 2018 includes approximately $300 million for two additional months of Net premiums written from Fuji. This also resulted in Fuji’s annual policy renewal period being reported in the second quarter of 2018 compared to the third quarter of the prior year.
(c) Flooding events reported in 2017 are a subset of windstorm events.
(e) The amounts presented for 2018, are net of $207 million of recoveries, $96 million in North America and $111 million in International, under aggregate reinsurance contracts. Eligible incurred losses under these agreements exceeded the applicable aggregate attachment point in the third quarter of 2018. The amount presented for 2017 is net of $121 million of recoveries, $65 million in North America and $56 million in International, under an aggregate reinsurance contract. Eligible incurred losses under this agreement exceeded the applicable aggregate attachment point in the fourth quarter of 2017. There were no aggregate recoveries included in the amounts presented or 2016.
Adjusted pre-tax loss decreased in the year ended December 31, 2018 compared to the prior year, primarily due to lower catastrophe losses and lower unfavorable prior year loss reserve development, partially offset by lower net investment income mainly due to lower investment returns on alternative investments and higher severe losses. Net premiums written increased primarily due to growth in Personal Insurance, lower ceded premiums driven by changes in the 2018 reinsurance programs and the inclusion of the Validus acquisition.
• lower unfavorable prior year loss reserve development (decrease by $4.9 billion);
• lower ceded premiums due to changes in the 2018 reinsurance programs; and
• exiting of certain businesses in Accident & Health in 2017.
• lower production primarily in Casualty, commercial property within Property, D&O products within Financial Lines and programs business due to continued underwriting actions to strengthen our portfolio and to maintain pricing discipline; and
• the growth of PCG business within Personal Lines and travel insurance within Accident & Health;
The decrease in the combined ratio reflected a decrease in the loss ratio partially offset by an increase in the expense ratio.
• higher catastrophe losses primarily driven by hurricanes Harvey, Irma and Maria, and the California wildfires; and
• a slightly elevated current accident year loss ratio, as adjusted, driven primarily by higher severe losses and an increase in loss estimates in Casualty and Financial Lines reflecting the result of 2017 detailed valuation reviews, partially offset by lower current accident year losses in Personal Insurance.
(a) As a result of the Japan Merger Impact, 2018 includes two additional months of operating earnings increasing Net premiums written, Net premiums earned, Losses and loss adjustment expenses incurred, and Adjusted pre-tax income by approximately $300 million, $300 million, $200 million and $15 million, respectively.
Net premiums written, excluding the impact of foreign exchange, increased primarily due to the inclusion of the Validus acquisition and business growth, partially offset by the sale of certain insurance operations and assets to Fairfax.
• lower net investment income driven by weaker market performance of equity securities for which the fair value option was elected, a decrease in alternative investments portfolio holdings and lower income from equity method investments.
• higher prior year unfavorable loss reserve development impacted by unfavorable loss emergence in Europe Casualty and Property; and
• higher current accident year loss ratio, as adjusted, in Europe Casualty, partially offset by improvements in our Europe and Japan Personal Insurance businesses.
• the sale of our interest in the Ascot business and certain of our insurance operations to Fairfax; and
• a higher current accident year loss ratio, as adjusted, driven primarily by higher severe losses; and
The slight increase in the expense ratio was primarily driven by a higher acquisition ratio mainly due to changes in business mix combined with changes in 2018 reinsurance programs.
The increase in the combined ratio reflected a higher loss ratio partially offset by a decrease in the expense ratio.
• higher catastrophe losses primarily driven by hurricanes Maria, Harvey and Irma;
• a higher current accident year loss ratio, as adjusted, in Europe Casualty driven by an increase in loss estimates as a result of 2017 year-end detailed reserve valuation reviews slightly offset by lower severe losses and improved current accident year performance in Europe and Japan Personal Insurance.
Retail Mutual Funds: Includes our mutual fund sales and related administration and servicing operations. Retail Mutual Funds are distributed primarily through broker-dealers.
Life Insurance: In the U.S., products primarily include term life and universal life insurance distributed through independent marketing organizations, independent insurance agents, financial advisors and direct marketing. International operations include the distribution of life and health products in the U.K. and Ireland.
Deliver Value Creation and Manage Capital by striving to deliver solid earnings through disciplined pricing, sustainable underwriting improvements, expense reductions, and diversification of risk, while optimizing capital allocation and efficiency within insurance entities to enhance return on equity.
· increasingly complex new and proposed regulatory requirements, which have affected industry growth; and
For additional discussion of the impact of market interest rate movement on our Life and Retirement business see Executive Summary - AIG’s Outlook - Industry and Economic Factors - Impact of Changes in the Interest Rate Environment.
Excluding the impact of the review and update of actuarial assumptions, adjusted pre-tax income decreased in 2018 compared to 2017 and 2016. In 2018 compared to 2017, results reflect decreased Fixed Annuity base spread income primarily due to lower reinvestment yields and decreased gains on securities for which the fair value option was elected, and higher Variable Annuity DAC amortization and reserves due to lower equity market performance. Partially offsetting these decreases were higher policy and advisory fees, and increased base spread income for Index Annuities. In 2017 compared to 2016, results reflected higher gains on securities for which the fair value option was elected, higher net investment spread for Indexed Annuities, higher policy fees, and higher returns from alternative investments. Offsetting these increases were decreased net investment income due to reduction of the size of the hedge fund portfolio as well as impact of the sale of the Advisor Group in May 2016 resulting in decreased advisory fee income, advisory fee expenses, and general operating expenses. In addition, Fixed Annuities base net investment spread in 2017 declined compared to 2016 primarily due to lower reinvestment yields.
· a net unfavorable adjustment from the review and update of actuarial assumptions of $52 million in 2018, compared to a net favorable adjustment of $242 million in the prior year;
· a decline in net investment income, primarily from lower gains on fixed maturity securities for which the fair value option was elected when compared to 2017 where returns were higher as a result of significant spread tightening that occurred and lower bond call and tender income;
· a decline in Fixed Annuity base spread income primarily driven by lower reinvestment yields and volumes; and
· higher Variable Annuity DAC amortization and reserves due to lower equity market performance.
· higher policy fees primarily driven by asset growth in Index and Variable Annuities.
· higher base net investment spread primarily in Variable and Index Annuities driven by growth in invested assets, and disciplined pricing and active crediting rate management; and
· excluding the impact of actuarial assumption updates, higher DAC amortization due to system conversions and model refinements, partially offset by a decrease driven by improved equity market performance;
· higher commission expense primarily due to growth in account values driven by improved equity market performance and the allocation of reinsurance risk charges, as all U.S. Life and Retirement segments benefited from the reduction in the required statutory capital resulting from a reinsurance agreement entered into in 2016 involving certain whole life, term life and universal life businesses (life insurance reinsurance transactions); and
For Individual Retirement, premiums primarily represent amounts received on life-contingent payout annuities. Premiums decreased in 2018 compared to 2017, primarily due to competitive market rates. Premiums decreased in 2017 compared to 2016, primarily due to strong annuity sales in 2016 driven by higher equity market volatility, which made immediate annuities more attractive to customers seeking less volatile returns.
The following table presents reserves for Fixed Annuities and Variable and Index Annuities by surrender charge category:
• Variable and Index Annuities premiums and deposits increased primarily due to higher index annuity sales driven by expanded distribution and market growth, partially offset by lower variable annuity sales driven by lower bank and broker dealer distribution sales. Sales were also positively impacted by easing industry uncertainty caused by the DOL Fiduciary Rule, which was vacated in June 2018. Index annuity net flows increased primarily due to higher sales but were partially offset by increased surrenders. Variable annuity net flows remained negative and deteriorated primarily due to lower sales and higher surrenders.
• Variable and Index Annuities premiums and deposits and net flows declined, reflecting a continued decrease in variable annuity industry sales due in part to uncertainty around the implementation of the DOL Fiduciary Rule at the time, partially offset by slightly higher index annuity sales. Lower premiums and deposits combined with higher surrenders resulted in a decrease in net flows.
• higher Variable Annuity DAC amortization and reserves due to lower equity market performance.
• higher net investment income, which included higher gains on securities for which the fair value option was elected and higher returns on alternative investments, partially offset by a reduction in the overall size of the hedge fund portfolio;
• lower base net investment spread primarily due to lower reinvestment yields, partially mitigated by effective crediting rate management; and
Net flows deteriorated and continued to be negative primarily due to higher surrenders, including approximately $1.6 billion of large plan surrenders, partially offset by increased deposits. External factors including consolidation of healthcare providers and other employers in target markets, continue to impact Group Retirement customer retention. Premiums and deposits in 2018 reflected deposits from FHLB funding agreement, which were excluded from reported net flows.
Life Insurance is focused on selling profitable new products through strategic channels to enhance future returns. Results for 2018 reflect growth in universal life deposits, and growth in term and international life and health premiums, offset by lower group benefits premiums. Adjusted pre-tax income increased in 2018 compared to 2017 primarily due to higher net investment income driven by growth in invested assets, favorable mortality, and actuarial reserve and reinsurance refinements, offset by higher general operating expenses. Adjusted pre-tax income increased in 2017 compared to 2016 reflecting the impact of favorable actuarial assumption updates in 2017 compared to net unfavorable adjustments in 2016, improved group benefit results, decreased general operating expenses and favorable individual life mortality.
• higher net investment income primarily due to increases in base portfolio income driven by growth in invested assets and higher alternative returns; and
• higher general operating expenses primarily due to growth in international life offset by a reduction in group benefits expenses. In addition, prior-year general operating expenses were reduced by the impact of new business reinsurance.
• lower commissions and general operating expenses primarily due to the strategic decision to refocus the group benefits business, partially offset by the allocation of reinsurance risk charges from life insurance reinsurance transactions. In addition, lower general operating expenses in 2017 reflected the impact of new business reinsurance;
• favorable loss experience and a reserve reduction in group benefits business;
• excluding the impact of the actuarial assumption updates, lower DAC amortization primarily due to lapse assumptions on international life.
Premiums for Life Insurance represent amounts received on traditional life insurance policies, primarily term life, international life and health and group benefits. Premiums, excluding the effect of foreign exchange, increased in 2018 compared to 2017 and 2016. Premiums for 2018 included favorable ceded premium reinsurance refinements in domestic life business.
Premiums and deposits for Life Insurance is a non-GAAP financial measure that includes direct and assumed premiums as well as deposits received on universal life insurance.
Institutional Markets continued to opportunistically grow its assets under management, which drove the increase in net investment spread over recent years. Product distribution continues to be strong and the business is focused on maintaining pricing discipline to achieve attractive risk adjusted return.
• a decrease in policy fees due to lower stable value wrap notional amounts; and
· Legacy Life and Retirement Run-Off Lines - Reserves consist of certain structured settlements, pension risk transfer annuities and single premium immediate annuities written prior to April 2012. Also includes exposures to whole life, long-term care and exited accident & health product lines.
· Legacy Investments - Includes investment classes that we have placed into run-off including holdings in direct investments as well as investments in global capital markets and global real estate.
Subject to certain adjustments specified in the Purchase Agreement, we will receive total consideration of approximately $476 million, which is based on Fortitude Re’s total shareholder’s equity of $2.9 billion as of March 31, 2018 excluding planned distributions that the parties will seek to cause to be paid to us on a non-pro rata basis prior to the end of the 18th month following the Fortitude Re Closing, subject to regulatory approvals (the Target Distribution). $381 million of the purchase price was paid at the Fortitude Re Closing and up to $95 million will be paid following December 31, 2023 (the Deferred Payment), subject to the purchase price adjustment described below. To the extent we do not receive all or a portion of the Target Distribution within 18 months of the Fortitude Re Closing, TCG will pay us up to an additional $100 million.
The affiliated reinsurance transactions executed in the first quarter of 2018 with Fortitude Re resulted in prepaid insurance assets on the ceding subsidiaries’ balance sheets of approximately $2.5 billion (after-tax). These assets have been eliminated in AIG’s consolidated financial statements since the counterparties were wholly owned. In the event of a sale of a controlling interest in
We have also agreed to a post-closing purchase price adjustment wherein we will reimburse TCG for certain changes in property casualty related reserves, based on an agreed methodology, that occurs on or prior to December 31, 2023, up to the value of TCG’s investment in Fortitude Holdings. Any amount due to TCG in respect of this will be offset by the amount of the Deferred Payment otherwise due from TCG to us.
In February 2018, we used $2.6 billion of existing Legacy Portfolio cash and investment assets to capitalize Fortitude Re in order to enable it to assume insurance risk and other economic risk from U.S. and Bermudian insurance companies. These assets included approximately $1.6 billion of capital released by Eaglestone, an affiliated entity, to AIG Parent as a result of the commutation of certain property and casualty risks from other AIG subsidiaries, which were subsequently ceded to Fortitude Re. Fortitude Re also has additional eligible regulatory capital under the Bermuda Monetary Authority capital framework in the form of $550 million in letter of credit agreements with guarantees from AIG Parent. In 2018, Fortitude Re disbursed $444 million of tax sharing payments to AIG Parent.
Our investment strategies are tailored to the specific business needs of each operating unit. The investment objectives are driven by the respective operating segments and AIG Parent. The primary objectives are generation of investment income, preservation of capital, liquidity management and growth of surplus to support the insurance products. The majority of assets backing our insurance liabilities consist of fixed maturity securities.
· We continued to make investments in structured securities and other fixed maturity securities and increased lending activities in mortgage loans with favorable risk compared to return characteristics to improve yields and increase net investment income.
· Blended investment yields on new investments were lower than blended rates on investments that were sold, matured or called.
· In the first quarter of 2018, we sold our remaining interest in Arch, which we received as part of the consideration for selling United Guaranty to Arch in 2016.
• Outside of the U.S., fixed maturity securities held by General Insurance companies consist primarily of high-grade securities generally denominated in the currencies of the countries in which we operate.
For the General Insurance companies, the duration of liabilities for long-tail casualty lines is greater than that of other lines. As a result, the investment strategy within the General Insurance companies focuses on growth of surplus and preservation of capital, subject to liability and other business considerations.
Fixed maturity securities of the General Insurance companies’ domestic operations, with an average duration of 3.8 years, are currently comprised of corporate bonds, structured securities, taxable municipal bonds and government and agency bonds as well as tax-exempt securities, which provide attractive risk-adjusted after-tax returns. The majority of these high quality investments are rated A or higher based on composite ratings.
Fixed maturity securities held in the General Insurance companies’ foreign operations are of high quality, primarily rated A or higher based on composite ratings, with an average duration of 3.3 years.
The Life and Retirement companies use asset-liability management as a primary tool to monitor and manage risk in their businesses. The Life and Retirement companies' fundamental investment strategy is to maintain a diversified, high to medium quality portfolio of fixed maturity securities that, to the extent practicable, complements 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, which may require us to further extend the duration of the investment portfolio.
Fixed maturity securities held in the Life and Retirement companies foreign operations are of high quality, primarily rated A or higher based on composite ratings, with an average duration of 17.0 years.
(a) At December 31, 2018 and 2017, the fair value of bonds available for sale held by us that were below investment grade or not rated totaled $28.8 billion and $31.5 billion, respectively.
At December 31, 2018, the U.S. municipal bond portfolio was composed primarily of essential service revenue bonds and high-quality tax-exempt bonds with 91 percent of the portfolio rated A or higher.
* At December 31, 2018 and December 31, 2017, respectively, approximately 89 and 91 percent of these investments were rated investment grade.
Our investments in the energy category, as a percentage of total investments in available-for-sale fixed maturities, was 5.4 percent and 5.5 percent at December 31, 2018 and December 31, 2017, respectively. While the energy investments are primarily investment grade and are actively managed, the category continues to experience volatility that could adversely affect credit quality and fair value.
(a) Includes approximately $10.3 billion and $12.3 billion at December 31, 2018, and December 31, 2017, respectively, of certain RMBS that had experienced deterioration in credit quality since their origination. For additional discussion on Purchased Credit Impaired (PCI) Securities see Note 6 to the Consolidated Financial Statements.
The fair value of CMBS holdings remained stable throughout 2018. 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, 2018, we had direct commercial mortgage loan exposure of $32.9 billion. All commercial mortgage loans were current or performing according to their restructured terms.
(a) Upon the adoption of the Financial Instruments Recognition and Measurement Standard on January 1, 2018, equity securities are no longer required to be evaluated for other-than-temporary impairments.
* Includes other-than-temporary impairment charges on private equity funds, hedge funds and direct private equity investments. Upon the adoption of the Financial Instruments Recognition and Measurement Standard on January 1, 2018, equity securities are no longer required to be evaluated for other-than-temporary impairments.
We recorded other-than-temporary impairment charges in the years ended December 31, 2018, 2017 and 2016 related to:
(b) Represents the percentage by which fair value is less than cost at December 31, 2018.
The change in net unrealized gains and losses on investments in 2018 was primarily attributable to decreases in the fair value of fixed maturity securities. For 2018, net unrealized losses related to fixed maturity securities decreased by $9.9 billion due primarily to an increase in rates and a widening of credit spreads.
The change in net unrealized gains and losses on investments in 2017 was primarily attributable to increases in the fair value of fixed maturity securities. For 2017, net unrealized gains related to fixed maturity and equity securities increased by $4.3 billion due primarily to a decrease in rates and a narrowing of credit spreads.
Variable annuity embedded derivatives, net of related hedges, reflected gains in 2018 compared to losses in 2017 primarily due to changes in the non-performance or “own credit” risk adjustment used in the valuation of the variable annuities with guaranteed minimum withdrawal benefits (GMWB) embedded derivative, which are not hedged as part of our economic hedging program.
During 2018, we recognized adverse prior year net loss reserve development of $362 million net. This unfavorable development was primarily a result of the following:
• Unfavorable development in U.S. Financial Lines, primarily from Directors & Officers (D&O) and Employment Practices Liability (EPLI) policies covering Corporate and National Insureds as well as Private and Not-for-Profit insureds. This development was predominantly in accident years 2014-2017 and resulted largely from increases in severity as the frequency of class action lawsuits increased in those years.
• Favorable development in US Commercial Property and Specialty Lines due to reductions in our estimates for 2017 Catastrophes and favorable development from the attritional losses in Commercial Property and Specialty .
• Unfavorable development in US Personal Lines reflecting an increase in estimates in respect of the California Wildfires and Hurricane Irma in 2017.
• Higher than expected losses emerging across several casualty product lines, especially in recent accident years (generally, 2011 to 2015) driven by increased frequency and severity of claims. This recent accident year loss emergence caused us to increase loss development factors applied across many accident years.
• Loss development factors including workers’ compensation tail factors, also increased due to an observed lengthening of loss reporting patterns relative to prior expectations.
For a description of AIG’s catastrophe reinsurance protection for 2018, see Enterprise Risk Management - Insurance Risks - General Insurance Companies Key Risks - Natural Catastrophe Risk.
The table below shows the calculation of the deferred gain on the adverse development reinsurance agreement as of December 31, 2018 and 2017, showing the effect of discounting of loss reserves and amortization of the deferred gain.
(a) Prior year reserve development ceded to NICO under the retroactive reinsurance agreement is deferred under U.S. GAAP.
The lines of business subject to this agreement have been the source of the majority of the prior year adverse development charges over the past several years. The agreement is expected to result in lower capital charges for reserve risks at our U.S. insurance subsidiaries. In addition, we would expect future net investment income to decline as a result of lower invested assets.
The Life Insurance Companies review and update estimated gross profit projections used to amortize DAC and related items (which may include VOBA, SIA, guaranteed benefit reserves and unearned revenue reserves) for investment-oriented products. Estimated gross profit projections include assumptions for investment-related returns and spreads, product-related fees and expenses, mortality gains and losses, policyholder behavior and other factors. In estimating future gross profits, lapse assumptions require judgment and can have a material impact on DAC amortization. If the assumptions used for estimated gross profits change significantly, DAC and related reserves are recalculated using the new projections, and any resulting adjustment is included in income. Updating such projections may result in acceleration of amortization in some products and deceleration of amortization in other products.
The Life Insurance Companies also review assumptions related to their respective GMWB living benefits that are accounted for as embedded derivatives and measured at fair value. The fair value of these embedded derivatives is based on actuarial assumptions, including policyholder behavior, as well as capital market assumptions.
Various assumptions were updated, including the following effective September 30, 2018:
In addition to the third quarter annual assumption update, the life companies adjusted assumptions and models on the Legacy Life and Retirement Run-Off Lines during the fourth quarter resulting in loss recognition of $105 million.
The following table presents the increase (decrease) in Adjusted pre-tax income resulting from the update of actuarial assumptions for the domestic life insurance companies, by segment and product line:
In 2018, Adjusted pre-tax income included a net unfavorable adjustment of $208 million, primarily in Variable Annuities driven by reductions to the GMWB full surrender assumption, in Life Insurance primarily due to strengthening reserves for certain riders and interest crediting model refinements, and in Legacy Accident & Health Insurance loss recognition. The unfavorable adjustments were partially offset by favorable adjustments in Life Insurance primarily due to lower lapse and mortality assumptions and a reduction in IBNR reserves and in Individual Retirement due to lower lapse assumptions in Fixed Annuities and refinements to partial withdrawal assumptions in Variable Annuities.
In 2016, adjusted pre-tax income included a net unfavorable adjustment of $384 million, primarily driven by $622 million of loss recognition reserves for pre-2010 payout annuities in the Legacy Portfolio, and an increase in Life Insurance reserves for universal life with secondary guarantees. These unfavorable adjustments were partially offset by favorable adjustments, primarily due to lower lapse assumptions in Fixed Annuities.
The adjustments related to the update of actuarial assumptions in each period are discussed by segment below.
In Group Retirement, the update of estimated gross profit assumptions resulted in a favorable adjustment of $17 million in 2018, primarily due to improved premium persistency assumptions. In 2017, a net favorable adjustment of $13 million was primarily due to an increase in the reversion to the mean rate used for projecting future estimated gross profit for variable annuity products and changes in maintenance expense assumptions. The net favorable adjustment was partially offset by a decrease in the separate account long-term asset growth rate assumption from 7.5 percent to 7.0 percent (before expenses that reduce the asset base from which future fees are projected) and decreases in fixed annuity spread and separate account fee assumptions. In 2016, a net unfavorable adjustment of $47 million was primarily due to refinements in lapse and partial withdrawal assumptions and a decrease in the separate account long-term asset growth rate assumption from 8.5 percent to 7.5 percent (before expenses that reduce the asset base from which future fees are projected).
The change in the fair value of the embedded derivatives and the change in the value of the hedging portfolio are not expected to be fully offsetting, primarily due to the differences in valuation between the economic hedge target, the U.S. GAAP embedded derivatives and the fair value of the hedging portfolio, as discussed above. When corporate credit spreads widen, the change in the NPA spread generally reduces the fair value of the embedded derivative liabilities, resulting in a gain, and when corporate credit spreads narrow or tighten, the change in the NPA spread generally increases the fair value of the embedded derivative liabilities, resulting in a loss. In addition to changes driven by credit market-related movements in the NPA spread, the NPA balance also reflects changes in business activity and in the net amount at risk from the underlying guaranteed living benefits.
The net impact on pre-tax income from the GMWB embedded derivatives and related hedges in 2018 (excluding related DAC amortization) was primarily driven by gains from the impact of widening credit spreads on the NPA spread, and higher interest rates, partially offset by losses from the impact of the change in credit spreads and the move from an economic to a GAAP discount basis. In 2017, the net impact on pre-tax income was primarily driven by losses from actuarial assumption updates to lapse and volatility assumptions, tightening credit spreads on the NPA spread and the impact on the NPA volume of lower expected GMWB payments, driven by higher equity markets. In 2016, the net impact on pre-tax income was primarily driven by the impact of rising interest rates and equity markets late in the fourth quarter of 2016, which resulted in fair value losses in the hedging portfolio, which were not offset by decreases in the embedded derivative liabilities as the risk margins and other assumptions used in the U.S. GAAP valuation caused the embedded derivatives to be less sensitive to market changes than the related hedge portfolio. In addition, 2016 included losses from actuarial assumption updates due to lapse and mortality assumptions.
The change in the fair value of the GMWB embedded derivatives, excluding NPA and update of actuarial assumptions, in 2018 reflected losses from lower equity markets and the impact of moving from an economic to a GAAP discount basis, offset by increases in interest rates and widening credit spreads. In 2018, the hedge losses were driven by losses from higher interest rates and widening credit spreads, offset by gains from lower equity markets. In 2017, the change in the fair value of embedded derivatives, excluding update of actuarial assumptions and NPA, was largely offset by the related hedging portfolio. However, in 2016, the change in fair value of embedded derivatives, excluding update of actuarial assumptions and NPA, reflected losses on the hedging portfolio driven by improvements in both interest rates and equity markets late in the fourth quarter of 2016, which were not offset by decreases in embedded derivative liabilities.
• Changes in the fair value of fixed maturity securities, primarily corporate bonds for which the fair value option has been elected, are used as a capital-efficient way to economically hedge interest rate and credit spread-related risk. The change in the fair value of the corporate bond hedging program in 2018 reflected losses due to increases in interest rates, and widening of credit spreads. The net gains in 2017 were primarily due to tightening of credit spreads. The net gains in 2016 reflected the impact of credit spreads tightening and decreases in market interest rates in the first nine months of 2016, partially offset by an increase in rates in the fourth quarter of 2016. The change in the fair value of the hedging bonds, which is excluded from the adjusted pre-tax income of the Individual Retirement and Group Retirement segments, is reported in net investment income on the Consolidated Statements of Income (Loss).
* DAC balance excluding the amount related to unrealized depreciation (appreciation) of investments was $9.4 billion, $8.9 billion and $8.4 billion at December 31, 2018, 2017 and 2016, respectively.
In 2017, we updated the long-term annual growth assumption applied to subsequent periods used in our reversion to the mean methodology for estimating future estimated gross profits for variable annuity products, from 7.5 percent to 7.0 percent (before expenses that reduce the asset base from which future fees are projected). The five-year reversion to the mean period has met the criteria for adjustment in 2017. As a result, the average gross long-term return measurement start date was reset to December 31, 2011 for Individual Retirement and June 30, 2013 for Group Retirement; the reversion to the mean rates (gross of fees) were increased to 3.74 percent in Individual Retirement and 3.78 percent in Group Retirement. Sustained favorable equity market performance in excess of long-term assumptions could result in additional unlocking in the Individual Retirement or Group Retirement variable annuity product lines in the future, with a positive effect on pre-tax income in the period of the unlocking.
In 2016, the long-term annual asset growth assumption was updated from 8.5 percent to 7.5 percent. The five-year reversion to the mean period did not meet the criteria for adjustment in 2016.
For additional discussion of assumptions related to our reversion to the mean methodology see Critical Accounting Estimates - Estimated Gross Profits for Investment-Oriented Products.
DAC and Reserves for universal life and investment-type products (collectively, investment-oriented products) are adjusted at each balance sheet date to reflect the change in DAC, unearned revenue, and benefit reserves with an offset to Other comprehensive income (OCI) as if securities available for sale had been sold at their stated aggregate fair value and the proceeds reinvested at current yields (shadow Investment-Oriented Adjustments). Similarly, for long-duration traditional products, significant unrealized appreciation of investments in a sustained low interest rate environment may cause additional future policy benefit liabilities (shadow Loss Adjustments) with an offset to OCI to be recorded.
Change in fair value of underlying assets and reserve accretion, net of
Capital refers to the long-term financial resources available to support the operation of our businesses, fund business growth, and cover financial and operational needs that arise from adverse circumstances. Our primary source of ongoing capital generation is derived from the profitability of our insurance subsidiaries. We must comply with numerous constraints on our minimum capital positions. These constraints drive the requirements for capital adequacy at AIG and the individual businesses and are based on internally-defined risk tolerances, regulatory requirements, rating agency and creditor expectations and business needs. Actual capital levels are monitored on a regular basis, and using ERM’s stress testing methodology, we evaluate the capital impact of potential macroeconomic, financial and insurance stresses in relation to the relevant capital constraints of both AIG and our insurance subsidiaries.
We believe that we have sufficient liquidity and capital resources to satisfy future requirements and meet our obligations to policyholders, customers, creditors and debt-holders, including those arising from reasonably foreseeable contingencies or events.
AIG Parent also received a net amount of $938 million in tax sharing payments in the form of cash from our insurance businesses in 2018, reflecting $120 million that was reimbursed by AIG Parent to our insurance businesses during the fourth quarter of 2018 primarily as a result of adjustments made to prior-year tax sharing payments. The tax sharing payments may be subject to further adjustment in future periods.
In May 2018, we redeemed all of our outstanding 8.000% Series A-7 Junior Subordinated Debentures and 8.625% Series A-8 Junior Subordinated Debentures in each case for a redemption price of 100 percent of the principal amount, plus accrued and unpaid interest, for approximately $15 million and $7 million, respectively.
We also made other repurchases of and repayments on debt instruments of approximately $3.2 billion during 2018. AIG Parent made interest payments on its debt instruments totaling $914 million during 2018.
In October 2018, Validus redeemed all of its outstanding Preference Shares at a redemption price of $26,000 per Preference Share for approximately $416 million in the aggregate.
We paid a cash dividend of $0.32 per share on AIG Common Stock during each quarter of 2018 totaling $1.1 billion.
• approximately $1.1 billion in the aggregate to pay a dividend of $0.32 per share on AIG Common Stock in each quarter of 2018;
• approximately $1.1 billion in net inflows from the issuance and repayment of long-term debt.
• approximately $1.2 billion in the aggregate to pay a dividend of $0.32 per share on AIG Common Stock in each quarter of 2017;
• approximately $1.4 billion in the aggregate to pay a dividend of $0.32 per share on AIG Common Stock in each quarter of 2016;
Certain of our U.S. insurance companies are members of the Federal Home Loan Banks (FHLBs) in their respective districts. Borrowings from FHLBs are used to supplement liquidity or for other uses deemed appropriate by management. Our U.S. General Insurance companies had outstanding borrowings from FHLBs in an aggregate amount of approximately $115 million and $190 million at December 31, 2018 and December 31, 2017, respectively. Our U.S. Life and Retirement companies had no outstanding borrowings in the form of cash advances from FHLBs at both December 31, 2018 and 2017, respectively. In addition, $3.4 billion and $606 million were due to FHLBs in the respective districts of our U.S. Life and Retirement companies at December 31, 2018 and December 31, 2017, respectively, under funding agreements issued through our Individual Retirement, Group Retirement and Institutional Markets operating segments, which were reported in Policyholder contract deposits.
Certain of our U.S. Life and Retirement companies have programs, which began in 2012, that lend securities from their investment portfolio to supplement liquidity or for other uses as deemed appropriate by management. Under these programs, these U.S. Life and Retirement companies lend securities to financial institutions and receive cash as collateral equal to 102 percent of the fair value of the loaned securities. Cash collateral received is invested in short-term investments. Additionally, the aggregate amount of securities that a Life and Retirement company is able to lend under its program at any time is limited to five percent of its general account statutory-basis admitted assets. Our U.S. Life and Retirement companies had $884 million and $2.9 billion of securities subject to these agreements at December 31, 2018 and December 31, 2017, respectively, and $904 million and $3.0 billion of liabilities to borrowers for collateral received at December 31, 2018 and December 31, 2017, respectively.
(b) Primarily includes contracts to purchase future services and other capital expenditures.
(c) Does not reflect unrecognized tax benefits of $4.7 billion. See Note 23 to the Consolidated Financial Statements for additional information.
We believe that our Life and Retirement companies have adequate financial resources to meet the payments actually required under these obligations. These subsidiaries have substantial liquidity in the form of cash and short-term investments. In addition, our Life and Retirement companies maintain significant levels of investment grade rated fixed maturity securities, including substantial holdings in government and corporate bonds, and could seek to monetize those holdings in the event operating cash flows are
insufficient. We expect liquidity needs related to GIC liabilities to be funded through cash flows generated from maturities and sales of invested assets.
(e) Excludes commitments with respect to pension plans. The annual pension contribution for 2019 is expected to be approximately $79 million for U.S. and non-U.S. plans.
(c) Includes primarily borrowings with Federal Home Loan Banks by our U.S. insurance companies. These borrowings are short term in nature and related activity is presented net of issuances and maturities and repayments.
The following table summarizes maturing debt at December 31, 2018 of AIG (excluding $8.4 billion of borrowings of consolidated investments) for the next four quarters:
Credit ratings estimate a company’s ability to meet its obligations and may directly affect the cost and availability of financing to that company. The following table presents the credit ratings of AIG and certain of its subsidiaries as of February 8, 2019. 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.
These credit ratings are current opinions of the rating agencies. They may be changed, suspended or withdrawn at any time by the rating agencies as a result of changes in, or unavailability of, information or based on other circumstances. Ratings may also be withdrawn at our request.
In the event of a downgrade of AIG’s long-term senior debt ratings, AIGFP and certain other AIG entities would be required to post additional collateral under some derivative and other transactions, or certain of the counterparties of AIGFP or of such other AIG entities would be permitted to terminate such transactions early.
On February 8, 2018, our Board of Directors declared a cash dividend on AIG Common Stock of $0.32 per share, payable on March 29, 2018 to shareholders of record on March 15, 2018. On May 2, 2018, our Board of Directors declared a cash dividend on AIG Common Stock of $0.32 per share, payable on June 28, 2018 to shareholders of record on June 14, 2018. On August 2, 2018, our Board of Directors declared a cash dividend on AIG Common Stock of $0.32 per share, payable on September 28, 2018 to shareholders of record on September 17, 2018. On October 31, 2018, our Board of Directors declared a cash dividend on AIG Common Stock of $0.32 per share, payable on December 26, 2018 to shareholders of record on December 12, 2018.
On February 13, 2019, our Board of Directors declared a cash dividend on AIG Common Stock of $0.32 per share, payable on March 29, 2019 to shareholders of record on March 15, 2019. The payment of any future dividends will be at the discretion of our Board of Directors and will depend on various factors, as discussed further in Note 17 to the Consolidated Financial Statements.
On February 13, 2019, our Board of Directors authorized an additional increase to its previous repurchase authorization of AIG Common Stock of $1.5 billion, resulting in an aggregate remaining authorization on such date of approximately $2.0 billion. Shares may be repurchased from time to time in the open market, private purchases, through forward, derivative, accelerated repurchase or automatic repurchase transactions or otherwise (including through the purchase of warrants). Certain of our share repurchases have been and may from time to time be effected through Exchange Act Rule 10b5-1 repurchase plans. The timing of any future share repurchases will depend on market conditions, our business and strategic plans, financial condition, results of operations, liquidity and other factors.
We have an integrated process for managing risks throughout our organization in accordance with our firm-wide risk appetite. Our Board of Directors has oversight responsibility for the management of risk. Our Enterprise Risk Management (ERM) Department supervises and integrates the risk management functions in each of our business units, providing senior management with a consolidated view of AIG’s major risk positions. Within each business unit, senior leaders and executives approve risk-taking policies and targeted risk tolerance within the framework provided by ERM. ERM supports our businesses and management by embedding risk management in our key day-to-day business processes and in identifying, assessing, quantifying, managing, monitoring, reporting, and mitigating the risks taken by our businesses and AIG overall. Nevertheless, our risk management efforts may not always be successful and material adverse effects on our business, results of operations, cash flows, liquidity or financial condition may occur.
Our Board of Directors oversees the management of risk through its Risk and Capital Committee (RCC) and Audit Committee. Those committees regularly interact with other committees of the Board of Directors described below. Our Chief Risk Officer (CRO) reports to both the RCC and our Chief Executive Officer (CEO).
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. In addition, various working groups (e.g. reputational risk, control agenda) are in place in support of the GRC to manage and monitor the various risks across the organization.
• Board-level risk tolerances are AIG’s aggregate capital and liquidity limits. They define the minimum level of capital and liquidity that we should maintain. These board-level risk tolerances require RCC approval.
• AIG management level limits are risk type specific limits at the AIG consolidated level. These limits are defined and calibrated to constrain our concentration in specific risk types, to protect against taking risks that exceed the amount of overall capital AIG has available, and to protect against excess earnings volatility. These limits are approved by our CRO with consultation from the GRC.
The business units are responsible for measuring and monitoring their risk exposures. ERM is responsible for monitoring compliance with limits and providing 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.
We devote considerable resources to managing our direct and indirect credit exposures. These exposures may arise from, but are not limited to, fixed income investments, equity securities, deposits, commercial paper investments, reverse repurchase agreements and repurchase agreements, corporate and consumer loans, leases, reinsurance recoverables, counterparty risk arising from derivatives activities, collateral extended to counterparties, insurance risk cessions to third parties, financial guarantees, letters of credit, and certain General Insurance businesses.
• managing a system of credit and program limits, as well as the approval process for credit transactions, above limit exposures, and concentrations of risk that may exist or be incurred;
a comprehensive credit risk delegation framework from the Chief Credit Officer (CCO) to authorized credit professionals throughout the company
including the ongoing analysis and assessment of credit risks, trending of those risks and reporting of other key risk metrics and limits to the CCO and senior management, as may be required
including but not limited to development of a proper framework, policies and procedures for establishing accurate identification of (i) Allowance for Loan and Lease Losses, and (ii) other-than-temporary impairments for securities portfolios
The scope and magnitude of our market risk exposures is managed under a robust framework that contains defined risk limits and minimum standards for managing market risk in a manner consistent with our risk appetite statement. Our market risk management framework focuses on quantifying the financial repercussions of changes in these broad market observables, as opposed to the idiosyncratic risks associated with individual assets that are addressed through our credit risk management function.
Many of our market risk exposures, including exposures to interest rates and equity, are associated with the asset and liability exposures of our Life and Retirement companies. These exposures are generally long-term in nature. Examples of liability-related exposures include interest rate sensitive surrenders in our fixed deferred annuity product portfolio. Also, we have equity market risk sensitive surrenders in our variable annuity product portfolio. These interactive asset-liability types of risk exposures are regularly monitored in accordance with the risk governance framework noted above.
Market risk focuses on quantifying the financial repercussions of changes in broad, external, predominantly market-observable risks. Financial repercussions can include an adverse impact on results of operations, financial condition, liquidity and capital.
Interest rate risk can arise from a mismatch in the interest rate exposure of assets versus liabilities. Lower interest rates generally result in lower investment income and make some of our product offerings less attractive to investors. Conversely, higher interest rates are typically beneficial for the opposite reasons. However, when rates rise quickly, there can be an asymmetric GAAP accounting effect where the existing securities lose market value, which is largely reported in Other comprehensive income, and the offsetting decrease in the value of certain liabilities may not be recognized. Changes in interest rates can affect the valuation of fixed maturity securities, financial liabilities, insurance contracts including but not limited to universal life, fixed rate annuities, variable annuities and derivative contracts. Additionally, for Variable Annuity, Index Annuity, and Equity Indexed Universal Life products, deviations in actual versus expected policyholder behavior can be driven by fluctuations in various market variables, including interest rates. Policies with guaranteed living benefit options or riders are also subject to the risk of actual benefit utilization being different than expected.
We are a globally diversified enterprise with income, assets and liabilities denominated in, and capital deployed in, a variety of currencies. Changes in FX rates can affect the valuation of a broad range of balance sheet and income statement items as well as the settlement of cash flows exchanged in specific transactions.
measures the impact from a unit change in a market risk input
• a one basis point increase in yield on fixed maturity securities,
uses historical, hypothetical, or forward-looking macroeconomic scenarios to assess and report exposures
• a 100 basis point parallel shift in the yield curve, or
• a 20 percent immediate and simultaneous decrease in world-wide equity markets.
(a) The economic effect is the difference between the estimated fair value and the effect of a 100 bps parallel increase in all yield curves on the estimated fair value. The estimated fair values for Mortgage and other loans receivable, Policyholder contract deposits (Investment-type contracts) and Long-term debt were $40,152 million, $121,374 million and $23,929 million at December 31, 2018, respectively. The estimated fair values for Mortgage and other loans receivable, Policyholder contract deposits (Investment-type contracts) and Long-term debt were $29,523 million, $122,196 million and $25,970 million at December 31, 2017, respectively.
(c) Beginning in the third quarter of 2018, the economic effect presented for Policyholder contract deposits - investment-type contracts has been refined to better reflect the economic effect on the balance sheet and is calculated as the change to the estimated fair value from a 100 bps parallel increase in all yield curves on the estimated fair value. Historically, the calculation was the change between the carrying value and the estimated fair value from a 100 bps parallel increase in all yield curves on the estimated fair value. Prior period presentation has been revised to conform to the current period approach.
(e) The balance sheet exposures for equity contracts and variable annuity and other embedded derivatives are also reflected under “Interest rate sensitive liabilities” above, and are not additive.
(g) The majority of the foreign currency exposure is reported on a one quarter lag.
We evaluate our equity price risk without the effect of any correlation among other key market risks or other assumptions used for calculating the fair value of our financial assets and liabilities. This scenario considers the direct impact of declines in equity prices and not changes in asset-based fees, changes in the estimated gross profits used for amortizing DAC, or changes in any other assumptions used to calculate the fair value of the embedded derivatives related to the living benefit features within variable annuity products. In addition, this scenario does not reflect the impact of basis risk, such as projections about the future performance of the underlying contract holder funds and actual fund returns, which we use as a basis for developing our hedging strategy.
The sensitivity factors utilized for 2018 and presented above were selected based on historical data from 1998 to 2018, as follows (see the table below):
For further information on our three-tiered hierarchy of limits see Risk Appetite, Limits, Identification, and Measurement - Risk Limits herein.
Assets may not be readily transformed into cash due to unfavorable market conditions. Market liquidity risk may limit our ability to sell assets at reasonable values to meet liquidity needs.
Minimum Liquidity Limits specify the amount of assets required to be maintained in order to meet obligations as they arise over a specified time horizon under stressed liquidity conditions.
Operational risk is defined as the risk of loss, or other adverse consequences, resulting from inadequate or failed internal processes, people, systems, or from external events. Operational risk includes legal, regulatory, technology, compliance, third party and business continuity risks, but excludes business and strategy risks.
Our operational risk governance sets the requirements necessary to embed a risk management culture throughout the organization. AIG and its consolidated subsidiaries establish and maintain operational risk and controls governance forums that include representatives from the relevant business units and functions to appropriately manage significant operational risk exposures. At an enterprise level, the GRC oversees operational risk along with the Risk Officers.
Operational risk is overseen at the corporate level within ERM through the Head of Operational Controls and Governance, who reports directly to our CRO. The Head of Operational Controls and Governance is responsible for the development and maintenance of the operational risk framework that includes policies, standards and deployment of systems.
• Risk Assessments - allows for the assessment, measurement and management of the key operational risks within our business units and helps inform on the efficacy of our control environment.
ORM, working together with other control and assurance functions (e.g., Compliance, Financial Controls Unit / Sarbanes Oxley, Global Business Continuity, and Internal Audit) through the risk and control framework, provides an independent view of operational risks for each business, and works with the business unit CRO and business unit Owner of the Control Agenda, whose responsibilities include coordinating identification, assessment, control and mitigation of risks to the operating environment and promoting awareness, to facilitate implementation of the above programs. This includes coverage of operational risks related to core insurance activities, investing, model risk, technology (including cyber security, identify and access management, data privacy and data security), third-party providers, as well as compliance and regulatory matters. Based on the results of the risk identification and assessment efforts above, business leaders are accountable for tracking and remediating identified issues in line with our risk-monitoring procedures. Governance committees support these efforts and promote transparency enabling improved management decision making.
The risk and control framework facilitates the identification and mitigation of operational risk issues and is designed to:
· ensure first line accountability and ownership of risks and controls;
· proactively address potential risk issues and assign clear ownership and accountability for risk treatment; and
Cybersecurity risk is an important, constant, and evolving focus for AIG and the insurance and financial services industries in general. The increased sophistication and activities of unauthorized parties attempting to access our systems and fraudulently induce employees, clients, vendors or other third parties or users of our systems to disclose sensitive information is an ever-present risk and frequent attack vector against AIG. The goal of such unauthorized parties is to gain access to AIG’s data and systems to learn confidential information, destroy data, disrupt or degrade service, sabotage systems or cause other damage. Cybersecurity risks may also derive from human error, fraud or malice on the part of AIG employees or third parties who have authorized access to AIG’s systems or information.
ERM works closely with and supports the risk management practices of the business units and functions that form the first line of defense against the cybersecurity risks that we face, including the risks that emerge as a result of the execution of our business strategies and our corresponding exposure to new products, clients, industry segments and regions, through initiatives such as investments in technological infrastructure, education and training for employees and vendors, and monitoring of industry developments. As part of our overarching cybersecurity strategy, we employ a variety of tactics to monitor and assess threat levels, remediate our exposures and enhance our systems and applications security. We also seek to build upon our capabilities by recruiting talent in the fields of information technology and data security. In addition to being required to comply with a vast array of privacy, data protection and cybersecurity laws, AIG participates in discussions of cybersecurity risks with law enforcement, government officials, as well as peer and industry groups.
Insurance risk is defined as the risk of actual claims experience and/or policyholder behavior being materially different than expected at the inception of an insurance contract. Uncertainties related to insurance risk include the amount and timing of cash flows from premiums, commissions, expenses, claims and claim settlement expenses paid or received under a contract.
We operate our insurance businesses on a global basis, and we are exposed to a wide variety of risks with different time horizons. We manage these risks throughout the organization, both centrally and locally, through a number of procedures:
• review and challenge of reserves to ensure comprehensive analysis with established escalation procedures to provide appropriate transparency in reserving decisions and judgments made in the establishment of reserves;
• Life and Retirement companies - risks include mortality and morbidity in the insurance-oriented products and insufficient cash flows to cover contract liabilities, longevity risk in the retirement savings-oriented products and policyholder behavior. We manage risks through product design, sound medical and non-medical underwriting, and external reinsurance programs.
We use third-party catastrophe risk models and other tools to evaluate and simulate frequency and severity of catastrophic events and associated losses to our portfolios of exposures. We apply a proprietary multi-model approach to account for relative strengths and weaknesses of vendor models and make adjustments to modeled losses to account for loss adjustment expenses, model biases, data quality and non-modeled risks.
(e) Taxed at the statutory tax rate of 21 percent for both the U.S. and Japanese modeled losses. The majority of Japan exposures are ceded to our U.S. Pool.
AIG’s 1-in-100 worldwide all peril OEP has reduced more than 15 percent from prior year, inclusive of Validus. The OEP estimates provided above reflect our in-force portfolios for exposures at October 1, 2018 for Validus and September 30, 2018 for the remainder of the exposure. The catastrophe reinsurance program is as of January 1, 2019. Other reinsurance covers are as of December 31, 2018.
• Aggregate protection utilizing the $2 billion of shared limit attaching excess $750 Million for 40% of the limit and excess $1 billion for 60% of the limit, with a $100 million per occurrence deductible
• A $275 million occurrence catastrophe cover specific to our U.S. high net worth personal lines business, with varying attachment points tailored towards specific geographies
• Japan per occurrence coverage of $550 million excess of $200 million and includes both personal and commercial exposure
• Rest of World per occurrence coverage up to $425 million, with a retention of either $50 million, $75 million or $125 million depending on the zone/country
After reflecting our product risk-mitigating features, we hedge our remaining economic exposure to market risk within GLB features through our variable annuity hedging program, which is designed to offset certain changes in the economic value of these GLB embedded derivatives, within established thresholds. The hedging program is designed to provide additional protection against large and combined movements in interest rates, equity prices, credit spreads and market volatility under multiple scenarios.
Our hedging program utilizes an economic hedge target, which represents our estimate of the underlying economic risks in our GLB riders, based on the present value of the future expected benefit payments for the GLB, less the present value of future GLB rider fees, over numerous stochastic scenarios. This stochastic projection method uses best estimate assumptions for policyholder behavior (including mortality, lapses, withdrawals and benefit utilization) in conjunction with market scenarios calibrated to observable equity and interest rate option prices. Policyholder behaviors are regularly evaluated to compare current assumptions to actual experience and, if appropriate, changes are made to the policyholder behavior assumptions. The risk of changes in policyholder behavior is not explicitly hedged and such differences between expected and actual policyholder behaviors will result in hedge ineffectiveness.
Due to differences between the calculation of the economic hedge target and U.S. GAAP valuation of the embedded derivative, which include differences in the treatment of rider fees and exclusion of certain risk margins and other differences in discount rates, we expect relative movements in the economic hedge target and the U.S. GAAP embedded derivative valuation will vary over time with changes in equity markets, interest rates and credit spreads.
In designing our hedging portfolio for our variable annuity hedging program, we make assumptions and projections about the future performance of the underlying contract holder funds. To project future account value changes, we make assumptions about how each of the underlying funds will perform. We map the contract holder funds to a set of publicly traded indices that we believe best represent the liability to be hedged. Basis risk exists due to the variance between these assumptions and actual fund returns, which may result in variances between changes in the hedging portfolio and changes in the economic hedge target. Net hedge results and the cost of hedging are also impacted by differences between realized volatility and implied volatility.
To manage the capital market exposures embedded within the economic hedge target, we identify and hedge market sensitivities to changes in equity markets, interest rates, volatility and for variable annuities, credit spreads. Each hedge program purchases derivative instruments or securities having sensitivities that offset corresponding sensitivities in the associated economic hedge targets, within internally defined threshold limits. Since the relative movements of the hedging portfolio and the economic hedge target vary over time or with market changes, the net exposure can be outside the threshold limits, and adjustments to the hedging portfolio are made periodically to return the net exposure to within the threshold limits.
Our hedging programs utilize various derivative instruments, including but not limited to equity options, futures contracts, interest rate swaps and swaptions, as well as other hedging instruments. In addition, within the variable annuities hedging program, we purchase certain fixed income securities and elect the fair value option as a capital efficient way to manage interest rate and credit spread exposures. To minimize counterparty credit risk the majority of the derivative instruments utilized within the hedging programs are cleared through global exchanges. Over the counter derivatives utilized within the hedging programs are highly collateralized.
The hedging programs are monitored on a daily basis to ensure that the economic hedge targets and the associated derivative portfolios are within the threshold limits, pursuant to the approved hedging strategy. Daily risk monitoring verifies that the net risk exposures are within the approved net risk exposure threshold limits. In addition, monthly stress tests are performed to determine the program’s effectiveness relative to the applicable limits, under an array of combined severe market stresses in equity prices, interest rates, volatility and credit spreads. Finally, hedging strategies are reviewed regularly to gauge their effectiveness in managing our market exposures in the context of our overall risk appetite.
• Ceded loss reserves - ultimate ceded reserves for losses and loss adjustment expenses, including reserves for claims reported but not yet paid and estimates for IBNR.
At December 31, 2018, total reinsurance recoverable assets were $38.2 billion. These assets include general reinsurance paid losses recoverable of $1.5 billion, ceded loss reserves of $32.0 billion including reserves for incurred but not reported (IBNR) claims, and ceded reserves for unearned premiums of $3.0 billion, as well as life reinsurance recoverable of $1.7 billion. The methods used to estimate IBNR and to establish the resulting ultimate losses involve projecting the frequency and severity of losses over multiple years. These methods are continually reviewed and updated by management. Any adjustments are reflected in income. We believe that the amount recorded for ceded loss reserves at December 31, 2018 reflects a reasonable estimate of the ultimate losses recoverable. Actual losses may, however, differ from the reserves currently ceded.
The Reinsurance Credit Department (RCD) conducts periodic detailed assessments of the financial strength and condition of current and potential reinsurers, both foreign and domestic. The RCD monitors both the financial condition of reinsurers as well as the total reinsurance recoverable ceded to reinsurers, and sets limits with regard to the amount and type of exposure we are willing to take with reinsurers. As part of these assessments, we attempt to identify whether a reinsurer is appropriately licensed, assess its financial capacity and liquidity, and evaluate the local economic and financial environment in which a foreign reinsurer operates. The RCD reviews the nature of the risks ceded and the need for measures, including collateral to mitigate credit risk. For example, in our treaty reinsurance contracts, we frequently include provisions that require a reinsurer to post collateral or use other measures to reduce exposure when a referenced event occurs. Furthermore, we limit our unsecured exposure to reinsurers through the use of credit triggers such as insurer financial strength rating downgrades, declines in regulatory capital, or relevant risk-based capital (RBC) ratios fall below certain levels. We also set maximum limits for reinsurance recoverable exposure, which in some cases is the recoverable amount plus an estimate of the maximum potential exposure from unexpected events for a reinsurer. In addition, credit executives within ERM review reinsurer exposures and credit limits and approve reinsurer credit limits above specified levels. Finally, even where we conclude that uncollateralized credit risk is acceptable, we require collateral from active reinsurance counterparties where it is necessary for our subsidiaries to recognize the reinsurance recoverable assets for statutory accounting purposes. At December 31, 2018, we held $20.2 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.
At December 31, 2018, we had no significant reinsurance recoverable due from any individual reinsurer that was financially troubled. Reinsurer capital levels continued to increase in 2018, thereby increasing the industry’s underwriting capacity, which resulted in continued competition and lower rates for 2019 renewals. Reduced profitability associated with lower rates could potentially result in reduced capacity or rating downgrades for some reinsurers. The RCD, in conjunction with the credit executives within ERM, reviews these developments, monitors compliance with credit triggers that may require the reinsurer to post collateral, and seeks to use other appropriate means to mitigate any material risks arising from these developments.
The fair value of our interest rate, currency, credit, commodity and equity swaps, options, swaptions, and forward commitments, futures, and forward contracts reported as a component of Other assets, was approximately $0.9 billion at both December 31, 2018 and December 31, 2017. Where applicable, these amounts have been determined in accordance with the respective master netting agreements.
Base Yield Net investment income excluding income from alternative investments and other enhancements, as a percentage of average base invested asset portfolio, which excludes alternative investments, other bond securities and certain other investments for which the fair value option has been elected.
Book value per common share, excluding accumulated other comprehensive income (AOCI) and Book value per common share, excluding AOCI and deferred tax assets (DTA) (Adjusted book value per common share) are non-GAAP measures and are 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. Adjusted book value per common share is derived by dividing total AIG shareholders’ equity, excluding AOCI and DTA (Adjusted Shareholders’ Equity), by total common shares outstanding.
Return on equity - Adjusted after-tax income excluding AOCI and DTA (Adjusted Return on equity) is a non-GAAP measure and is used to show the rate of return on shareholders’ equity. Adjusted Return on equity is derived by dividing actual or annualized adjusted after-tax income attributable to AIG by average Adjusted Shareholders’ Equity.
Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2018, 2017 and 2016
Summary of Investments - Other than Investments in Related Parties at December 31, 2018
Supplementary Insurance Information at December 31, 2018, 2017 and 2016 and for the years then ended
Valuation and Qualifying Accounts at December 31, 2018, 2017 and 2016 and for the years then ended
To the Board of Directors and Shareholders of American International Group, Inc.:
We have audited the accompanying consolidated balance sheets of American International Group, Inc. and its subsidiaries (the “Company”) as of December 31, 2018 and 2017, and the related consolidated statements of income, comprehensive income (loss), equity, and cash flows for each of the three years in the period ended December 31, 2018, including the related notes and financial statement schedules listed in the accompanying index (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
As described in Management’s Report on Internal Control over Financial Reporting, management has excluded Validus Holdings, Ltd. and Glatfelter Insurance Group (the “Acquired Businesses”) from its assessment of internal control over financial reporting as of December 31, 2018 because they were acquired by the Company in purchase business combinations during 2018. We have also excluded the Acquired Businesses from our audit of internal control over financial reporting. The Acquired Businesses are wholly-owned subsidiaries whose total assets and total revenues excluded from management’s assessment and our audit of internal control over financial reporting collectively represent approximately 2 percent and 3 percent, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2018.
Short-term investments, including restricted cash of $142 in 2018 and $58 in 2017
Treasury stock, at cost; 2018 - 1,040,062,063 shares; 2017 - 1,007,626,835 shares of common stock
American International Group, Inc. (AIG) is a leading global insurance organization serving customers in more than 80 countries and jurisdictions. AIG companies serve commercial and individual customers through one of the most extensive worldwide property-casualty networks of any insurer. In addition, AIG companies are leading providers of life insurance and retirement services in the United States. AIG Common Stock, par value $2.50 per share (AIG Common Stock), is listed on the New York Stock Exchange (NYSE: AIG). On December 3, 2018, AIG’s Common Stock was voluntarily delisted from the Tokyo Stock Exchange. Unless the context indicates otherwise, the terms “AIG,” “we,” “us” or “our” mean American International Group, Inc. and its consolidated subsidiaries and the term “AIG Parent” means American International Group, Inc. and not any of its consolidated subsidiaries.
On July 18, 2018, we completed the purchase of Validus Holdings, Ltd. (Validus), a leading provider of reinsurance, primary insurance, and asset management services, for $5.5 billion in cash. The results of Validus following the date of the acquisition are included in our General Insurance segment starting in the third quarter of 2018. Our North America results include the results of Validus Reinsurance, Ltd. and Western World Insurance Group, Inc., while our International results include the results of Talbot Holdings Ltd.
For additional information relating to the acquisition of Validus, see Note 4.
On October 18, 2016, we entered into an agreement to sell certain insurance operations to Fairfax Financial Holdings Limited (Fairfax). The agreement included the sale of our subsidiary operations in Argentina, Chile, Colombia, Uruguay, Venezuela and Turkey. Fairfax acquired renewal rights for the portfolios of local business written by our operations in Bulgaria, the Czech Republic, Hungary, Poland, Romania and Slovakia, and assume certain of our operating assets and employees. Substantially all of the operations and renewal rights that we agreed to sell to Fairfax were sold by December 31, 2017.
• valuation of embedded derivatives for fixed index annuity and life products;
• income tax assets and liabilities, including recoverability of our net deferred tax asset and the predictability of future tax operating profitability of the character necessary to realize the net deferred tax asset and estimates associated with the Tax Act.
For the year ended December 31, 2016, we recorded out of period adjustments relating to prior years that increased Net loss attributable to AIG by $174 million and increased Loss from continuing operations before income taxes by $57 million. The out of period adjustments are primarily related to income tax liabilities and ceded loss adjustment expenses.
Reinsurance premiums for assumed business are estimated based on information received from brokers, ceding companies and reinsureds. Any subsequent differences that arise regarding such estimates are recorded in the periods in which they are determined.
We offer sales inducements which include enhanced crediting rates or bonus payments to contract holders (bonus interest) on certain annuity and investment contract products. Sales inducements provided to the contract holder are recognized in Policyholder contract deposits in the Consolidated Balance Sheets. Such amounts are deferred and amortized over the life of the contract using the same methodology and assumptions used to amortize DAC (see Note 9 herein). To qualify for such accounting treatment, the bonus interest must be explicitly identified in the contract at inception. We must also demonstrate that such amounts are incremental to amounts we credit on similar contracts without bonus interest, and are higher than the contract’s expected ongoing crediting rates for periods after the bonus period. The deferred bonus interest and other deferred sales inducement assets totaled $752 million and $738 million at December 31, 2018 and 2017, respectively. The amortization expense associated with these assets is reported within Interest credited to policyholder account balances in the Consolidated Statements of Income. Such amortization expense totaled $156 million, $94 million and $77 million for the years ended December 31, 2018, 2017 and 2016, respectively.
The cost of buildings and furniture and equipment is depreciated principally on the straight-line basis over their estimated useful lives (maximum of 40 years for buildings and 10 years for furniture and equipment). Expenditures for maintenance and repairs are charged to income as incurred and expenditures for improvements are capitalized and depreciated. We periodically assess the carrying amount of our real estate for purposes of determining any asset impairment. Capitalized software costs, which represent costs directly related to obtaining, developing or upgrading internal use software, are capitalized and amortized using the straight-line method over a period generally not exceeding five years.
Securities sold but not yet purchased represent sales of securities not owned at the time of sale. The obligations arising from such transactions are recorded on a trade-date basis and carried at fair value. Fair values of securities sold but not yet purchased are based on current market prices.
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. Income statement accounts expressed in functional currencies are translated using average exchange rates during the period. 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 remeasured into that entity’s functional currency resulting in exchange gains or losses recorded in income. The adjustments resulting from translation of financial statements of foreign entities operating in highly inflationary economies are recorded in income.
We adopted the standard on its effective date of January 1, 2018 using a modified retrospective approach. The adoption of this standard did not have a material impact on our reported consolidated financial condition, results of operations, cash flows or required disclosures.
We adopted the standard retrospectively on its effective date of January 1, 2018. The standard addresses presentation of restricted cash in the Consolidated Statement of Cash Flows only and had no impact on our reported consolidated financial condition, results of operations or required disclosures.
We adopted this standard on its effective date of January 1, 2018 using the modified retrospective approach. Based on our evaluation, the adoption of this standard did not have a material impact on our reported consolidated financial condition, results of operations, cash flows or required disclosures.
We prospectively adopted this standard on its effective date of January 1, 2018 and the standard did not have a material impact on our reported consolidated financial condition, results of operations, cash flows or required disclosures.
In February 2016, the FASB issued an accounting standard that will require lessees with lease terms of more than 12 months to recognize a right of use asset and a corresponding lease liability on their balance sheets. For income statement purposes, the FASB retained a dual model, requiring leases to be classified as either operating leases or finance leases. Lessor accounting remained largely the same, with the exception of certain specified changes. The standard is effective for annual periods beginning after December 15, 2018, and interim periods within those years, using a modified retrospective approach, and provides for certain practical expedients in transition. During 2018, the FASB issued several amendments and targeted improvements to ease with the application of the standard, including the addition of a transition approach that gives the Company the option of applying the standard at either the beginning of the earliest comparative period presented or the beginning of the period of adoption.
We plan to adopt the standard on its effective date of January 1, 2019, by recognizing a cumulative-effect adjustment to the opening balance of retained earnings for leases existing at the date of adoption. We will also elect certain practical expedients that allow us not to reassess existing leases under the new guidance. Based on our analysis, the vast majority of the Company’s lease obligation pertained to real estate utilized in the operation of our businesses. Consequently, the primary impact of adoption will result in the recognition of a right of use asset and a lease liability for operating leases pertaining to our real estate portfolio that are expected to represent less than one percent of the Company’s Total Assets and Total Liabilities, respectively. We do not expect the standard to have a material effect on our reported consolidated financial condition, results of operations, cash flows or required disclosures. See Note 16, Contingencies, Commitments and Guarantees for additional information.
We plan to adopt the standard on its effective date of January 1, 2020. We are continuing to develop our implementation plan to adopt the standard and are assessing the impact of the standard on our reported consolidated financial condition, results of operations, cash flows and required disclosures. While we expect an increase in our allowances for credit losses for the financial instruments within scope of the standard, given the objective of the new standard, the amount of any change will be dependent on our portfolios’ composition and quality at the adoption date as well as economic conditions and forecasts at that time.
The standard is effective on January 1, 2019, with early adoption permitted. We will adopt the standard on its effective date. The standard’s impact is not material to our reported consolidated financial condition, results of operations, cash flows and required disclosures.
• Simplifies the amortization of deferred acquisition costs (DAC) to a constant level basis over the expected term of the related contracts with adjustments for unexpected terminations, but no longer requires an impairment test.
• Increased disclosures of disaggregated roll-forwards of policy benefits, account balances, market risk benefits, separate account liabilities and information about significant inputs, judgments and methods used in measurement and changes thereto and impact of those changes.
ITEM 8 | Notes to Consolidated Financial Statements | 3. Segment Information
On December 31, 2016, we completed the sale of United Guaranty to Arch. See Note 1 for a further discussion.
* Revenues are generally reported according to the geographic location of the reporting unit. International revenues consists of revenues from our General Insurance International operating segment.
On July 18, 2018, we completed the purchase of a 100 percent voting interest in Validus, a leading provider of reinsurance, primary insurance, and asset management services, for $5.5 billion in cash. This transaction was made with the intent to strengthen our global General Insurance business by expanding our current product portfolio through additional distribution channels and advancing the tools available to enhance underwriting. The impact of the acquisition on Total revenues, Net income (loss), and Net income (loss) attributable to AIG was $1.4 billion, $(206) million, and $(206) million, respectively, for 2018. Integration and transaction costs associated with the acquisition of Validus were $101 million for 2018 and are included in General operating and other expenses in our Consolidated Statement of Income.
The purchase was accounted for under the acquisition method. Accordingly, the total purchase price was allocated to the estimated fair values of assets acquired and liabilities assumed. This allocation resulted in the purchase price exceeding the fair value of net assets acquired, which results in a difference recorded as goodwill. Goodwill generated from the acquisition is attributable to expected synergies from future growth and potential future monetization opportunities. Goodwill related to the purchase of Validus assigned to our General Insurance operating segments was $1.8 billion for North America and $157 million for International.
In addition, Validus participates in the market for insurance-linked securities (ILS) primarily through AlphaCat Managers, Ltd (AlphaCat Manager). AlphaCat Manager is an asset manager primarily for third-party investors and in connection with the issuance of ILS invests in AlphaCat funds which are considered variable interest entities (VIEs). ILS are financial instruments for which the values are determined based on insurance losses caused primarily by natural catastrophes such as major earthquakes and hurricanes. We report the investment in AlphaCat funds, which is approximately $116 million at December 31, 2018, in Other Invested Assets in the Consolidated Balance Sheet.
ITEM 8 | Notes to Consolidated Financial Statements | 4. Business Combination
(c) Reported in Deferred policy acquisition costs in the Consolidated Balance Sheet and Amortization of deferred policy acquisition costs in the Consolidated Statement of Income (Loss).
In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety.
Because of the dynamic and complex nature of the projected cash flows with respect to embedded derivatives in our variable annuity contracts, risk neutral valuations are used, which are calibrated to observable interest rate and equity option prices. Estimating the underlying cash flows for these products involves judgments regarding expected market rates of return, market volatility, credit spreads, correlations of certain market variables, fund performance, discount rates and policyholder behavior. The portion of fees attributable to the fair value of expected benefit payments are included within the fair value measurement of these embedded derivatives, and related fees are classified in net realized gain/loss as earned, consistent with other changes in the fair value of these embedded policy derivatives. Any portion of the fees not attributed to the embedded derivatives are excluded from the fair value measurement and classified in policy fees as earned.
Other liabilities measured at fair value include certain securities sold under agreements to repurchase and certain securities sold but not yet purchased. Liabilities arising from securities sold under agreements to repurchase are generally treated as collateralized borrowings. We estimate the fair value of liabilities arising under these agreements by using market-observable interest rates. This methodology considers such factors as the coupon rate, yield curves and other relevant factors. Fair values for securities sold but not yet purchased are based on current market prices.
(c) Includes guaranteed investment agreements (GIAs), notes, bonds, loans and mortgages payable.
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, 2018 and 2017 may include changes in fair value that were attributable to both observable (e.g., changes in market interest rates) and unobservable inputs (e.g., changes in unobservable long-dated volatilities).
During the years ended December 31, 2018 and 2017, transfers into Level 3 assets primarily included certain investments in private placement corporate debt, RMBS, CMBS and CDO/ABS. Transfers of private placement corporate debt and certain ABS into Level 3 assets were primarily the result of limited market pricing information that required us to determine fair value for these securities based on inputs that are adjusted to better reflect our own assumptions regarding the characteristics of a specific security or associated market liquidity. The transfers of investments in RMBS, CMBS and CDO and certain ABS into Level 3 assets were due to decreases in market transparency and liquidity for individual security types.
There were no significant transfers of derivative or other liabilities into or out of Level 3 for the years ended December 31, 2018 and 2017.
We consider unobservable inputs to be those for which market data is not available and that are developed using the best information available to us about the assumptions that market participants would use when pricing the asset or liability. Relevant inputs vary depending on the nature of the instrument being measured at fair value. The following paragraphs provide a general description of sensitivities of significant unobservable inputs along with interrelationships between and among the significant unobservable inputs and their impact on the fair value measurements. The effect of a change in a particular assumption in the sensitivity analysis below is considered independently of changes in any other assumptions. In practice, simultaneous changes in assumptions may not always have a linear effect on the inputs discussed below. Interrelationships may also exist between observable and unobservable inputs. Such relationships have not been included in the discussion below. For each of the individual relationships described below, the inverse relationship would also generally apply.
The significant unobservable input used in the fair value measurement of certain investments in obligations of states, municipalities and political subdivisions is yield. In general, increases in the yield would decrease the fair value of investments in obligations of states, municipalities and political subdivisions.
The significant unobservable input used in fair value measurements for CMBS is the yield. Prepayment assumptions for each mortgage pool are factored into the yield. CMBS generally feature a lower degree of prepayment risk than RMBS because commercial mortgages generally contain a penalty for prepayment. In general, increases in the yield would decrease the fair value of CMBS.
The following table includes information related to our investments in certain other invested assets, including private equity funds, hedge funds and other alternative investments that calculate net asset value per share (or its equivalent). For these investments, which are measured at fair value on a recurring basis, we use the net asset value per share to measure fair value.
* Beginning in the third quarter of 2018, Growth Equity and Mezzanine private equity fund categories are shown separately. Prior periods were revised to conform to the current period presentation.
Private equity fund investments included above are not redeemable, because distributions from the funds will be received when underlying investments of the funds are liquidated. Private equity funds are generally expected to have 10-year lives at their inception, but these lives may be extended at the fund manager’s discretion, typically in one or two-year increments. At December 31, 2018, assuming average original expected lives of 10 years for the funds, 14 percent of the total fair value using net asset value per share (or its equivalent) presented above would have expected remaining lives of three years or less, 43 percent between four and six years and 43 percent between seven and 10 years.
During 2017 and 2016, we recognized gains of $4 million and $22 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.
• Impairments for Other investments for the period ended December 31, 2016 primarily relate to certain investments in aircraft, the fair values of which are determined based on third-party independent appraisals that use industry specific appraisal standards and methodologies. Impairments for Other investments for the period ended December 31, 2017 primarily relate to commercial mortgage loans, the fair values of which are determined based on independent broker quotations or valuation models using unobservable inputs, as well as the estimated fair value of the underlying collateral or the present value of the expected future cash flows. The rest of the impairments relate to real estate investments, the fair values of which are determined based on third-party independent appraisals or discounted cash-flow models, as well as certain investments in aircraft, the fair values of which are determined based on third-party independent appraisals that use industry-specific appraisal standards and methodologies. Impairments for Other investments for the period ended December 31, 2018 primarily relate to real estate investments as well as commercial mortgage loans, the fair value determination for which is discussed above under the heading Valuation Methodologies of Financial Instruments Measured at Fair Value.
• Impairments of Investments in Life Settlements were measured using their fair values as determined using a discounted cash flow methodology that incorporates the best available market assumptions for mortality as well as market yields based on reported transactions or the anticipated sale price, as appropriate. We sold the remaining portion of our life settlements portfolio in 2017.
• Long-term debt: Fair values of these obligations were determined by reference to quoted market prices, when available and appropriate, or discounted cash flow calculations based upon our current market-observable implicit-credit-spread rates for similar types of borrowings with maturities consistent with those remaining for the debt being valued.
undiscounted expected future cash flows and the recorded investment in the securities represents the initial accretable yield, which is to be accreted into net investment income over the securities’ remaining lives on an effective level-yield basis. Subsequently, effective yields recognized on PCI securities are recalculated and adjusted prospectively to reflect changes in the contractual benchmark interest rates on variable rate securities and any significant increases in undiscounted expected future cash flows arising due to reasons other than interest rate changes.
(a) As a result of the adoption of the Financial Instruments Recognition and Measurement Standard on January 1, 2018, equity securities are no longer classified and accounted for as available for sale securities.
At December 31, 2018, we held 16,876 individual fixed maturity securities that were in an unrealized loss position, of which 5,127 individual fixed maturity securities were in a continuous unrealized loss position for 12 months or more. We did not recognize the unrealized losses in earnings on these fixed maturity securities at December 31, 2018 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 analyses 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.
(b) At December 31, 2018, approximately 74 percent of our hedge fund portfolio is available for redemption in 2019. The remaining 26 percent will be available for redemption between 2020 and 2027.
Certain hedge funds, private equity funds, and other investment partnerships for which we have elected the fair value option are reported at fair value with changes in fair value recognized in Net investment income with the exception of investments of AIG’s Other Operations, for which such changes are reported in Other income.
The following table presents the carrying amount and ownership percentage of equity method investments at December 31, 2018 and 2017:
Also included in Other invested assets are real estate held for investment. These investments are reported at cost, less depreciation and are subject to impairment review, as discussed below.
During 2017 and 2016, income recognized on investments in life settlements was $266 million and $453 million, respectively, and is included in Net investment income in the Consolidated Statements of Income. We sold the remaining portion of our life settlements portfolio in 2017.
• Realized and unrealized gains and losses from investments in other securities and investments for which we elected the fair value option.
(a) Upon the adoption of the Financial Instruments Recognition and Measurement Standard on January 1, 2018, the change in fair value of all equity securities is included in Net investment income.
(b) Includes income from hedge funds, private equity funds and affordable housing partnerships. Hedge funds for which we elected the fair value option are recorded as of the balance sheet date. Other hedge funds are generally reported on a one-month lag. Private equity funds are generally reported on a one-quarter lag.
• Sales or full redemptions of available for sale fixed maturity securities, available for sale equity securities, real estate and other alternative investments.
• Changes in fair value of derivatives except for (1) those derivatives at AIGFP and (2) those instruments that are designated as hedging instruments when the change in the fair value of the hedged item is not reported in Net realized capital gains (losses).
(a) In 2016, includes realized gains on the sale of a portion of our holdings in People’s Insurance Company (Group) of China Limited and PICC Property & Casualty Company Limited (collectively, our PICC Investment).
Net gains and losses recognized during the period on equity securities
Unrealized gains and losses recognized during the reporting period on equity
The following tables present information on our PCI securities, which are included in bonds available for sale:
We also enter into agreements in which securities are purchased by us under agreements to resell (reverse repurchase agreements), which are accounted for as secured financing transactions and reported as short-term investments or other assets, depending on their terms. These agreements are recorded at their contracted resale amounts plus accrued interest, other than those that are accounted for at fair value. In all reverse repurchase transactions, we take possession of or obtain a security interest in the related securities, and we have the right to sell or repledge this collateral received.
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 $202 million and $93 million of stock in FHLBs at December 31, 2018 and 2017, respectively. In addition, our subsidiaries have pledged securities available for sale and residential loans associated with borrowings and funding agreements from FHLBs, with a fair value of $4.2 billion and $2.1 billion, respectively, at December 31, 2018 and $2.7 billion and $471 million, respectively, at December 31, 2017.
Certain GIAs have provisions that require collateral to be posted or payments to be made by us upon a downgrade of our long-term debt ratings. The actual amount of collateral required to be posted to the counterparties in the event of such downgrades, and the aggregate amount of payments that we could be required to make, depend on market conditions, the fair value of outstanding affected transactions and other factors prevailing at and after the time of the downgrade. The fair value of securities pledged as collateral with respect to these obligations was approximately $1.6 billion and $2.0 billion at December 31, 2018 and 2017, respectively. This collateral primarily consists of securities of the U.S. government and government- sponsored entities and generally cannot be repledged or resold by the counterparties.
* Of the total allowance at the end of the year, $3 million, $5 million and $11 million relates to individually assessed credit losses on $54 million, $82 million and $280 million of commercial mortgages as of December 31, 2018, 2017 and 2016, respectively.
Retroactive reinsurance agreements are reinsurance agreements under which our reinsurer agrees to reimburse us as a result of past insurable events. For these agreements, the excess of the amounts ultimately collectible under the agreement over the consideration paid is recognized as a deferred gain liability and amortized into income over the settlement period of the ceded reserves. The amount of the deferral is recalculated each period based on loss payments and updated estimates. If the consideration paid exceeds the ultimate losses collectible under the agreement, the net loss on the agreement is recognized in income immediately. Ceded loss reserves under retroactive agreements were $13.8 billion and $13.4 billion, and the deferred gain liability was $1.8 billion and $1.6 billion, as of December 31, 2018 and 2017, respectively. The effect on income from amortization of the deferred gain was $394 million, $316 million and $30 million for the years ended December 31, 2018, 2017, and 2016, respectively.
Long-duration reinsurance recoveries, which reduced Policyholder benefits and losses incurred, was $778 million for the year ended December 31, 2018 and approximately $1.0 billion for both the years ended December 31, 2017 and 2016.
Long-duration insurance in-force assumed as a percentage of gross long-duration insurance in-force was 0.03 percent at December 31, 2018, 2017 and 2016; and premiums assumed represented 10 percent, 5 percent and 3 percent of gross premiums for the years ended December 31, 2018, 2017 and 2016, respectively.
The U.S. Life and Retirement companies manage the capital impact of their statutory reserve requirements, including those resulting from the NAIC Model Regulation “Valuation of Life Insurance Policies” (Regulation XXX) and NAIC Actuarial Guideline 38 (Guideline AXXX), through unaffiliated and affiliated reinsurance transactions. Effective July 1, 2016, one of the U.S. Life and Retirement companies entered into an agreement to cede approximately $5 billion of statutory reserves for certain whole life and universal life policies to an unaffiliated reinsurer. Effective December 31, 2016, the same life insurance subsidiary recaptured term and universal life reserves subject to Regulation XXX and Guideline AXXX, previously ceded to an affiliate, and ceded approximately $14 billion of such statutory reserves to an unaffiliated reinsurer under an amendment to the July 1, 2016 agreement. Under GAAP, these unaffiliated reinsurance transactions use deposit accounting with a reinsurance risk charge recorded in income, whereas such affiliated transactions are eliminated in consolidation. Under one affiliated reinsurance arrangement, one of the U.S. Life and Retirement companies obtains letters of credit to support statutory recognition of the ceded reinsurance. As of December 31, 2018, this subsidiary had two bilateral letters of credit totaling $450 million, which were issued on February 7, 2014 and expire on February 7, 2022. The letters of credit are subject to reimbursement by AIG Parent in the event of a drawdown.
For additional information on the use of affiliated reinsurance for Regulation XXX and Guideline AXXX reserves see Note 19.
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 due from reinsurers exceeding 5 percent of our total reinsurance assets were approximately $18.9 billion and $18.0 billion at December 31, 2018 and 2017, respectively, of which approximately $3.7 billion and $7.6 billion at December 31, 2018 and 2017, respectively, was not secured by collateral.
Investment-oriented contracts: Certain policy acquisition costs and policy issuance costs related to universal life and investment-type products (collectively, investment-oriented products) are deferred and amortized, with interest, in relation to the incidence of estimated gross profits to be realized over the estimated lives of the contracts. Estimated gross profits include net investment income and spreads, net realized capital gains and losses, fees, surrender charges, expenses, and mortality gains and losses. In each reporting period, current period amortization expense is adjusted to reflect actual gross profits. If estimated gross profits change significantly, DAC is recalculated using the new assumptions, and any resulting adjustment is included in income. If the new assumptions indicate that future estimated gross profits are higher than previously estimated, DAC will be increased resulting in a decrease in amortization expense and increase in income in the current period; if future estimated gross profits are lower than previously estimated, DAC will be decreased resulting in an increase in amortization expense and decrease in income in the current period. Updating such assumptions may result in acceleration of amortization in some products and deceleration of amortization in other products. DAC is grouped consistent with the manner in which the insurance contracts are acquired, serviced and measured for profitability and is reviewed for recoverability based on the current and projected future profitability of the underlying insurance contracts.
To estimate future estimated gross profits for variable annuity products, a long-term annual asset growth assumption is applied to determine 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 long-term annual rate assumptions 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 in 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.
Shadow DAC and Shadow Loss Recognition: DAC related to investment-oriented products is also adjusted to reflect the effect of unrealized gains or losses on fixed maturity securities available for sale and prior to 2018, equity securities at fair value on estimated gross profits, with related changes recognized through Other comprehensive income (shadow DAC). The adjustment is made at each balance sheet date, as if the securities had been sold at their stated aggregate fair value and the proceeds reinvested at current yields. Similarly, for long-duration traditional insurance contracts, if the assets supporting the liabilities are in a net unrealized gain position at the balance sheet date, loss recognition testing assumptions are updated to exclude such gains from future cash flows by reflecting the impact of reinvestment rates on future yields. If a future loss is anticipated under this basis, any additional shortfall indicated by loss recognition tests is recognized as a reduction in accumulated other comprehensive income (shadow loss recognition). Similar to other loss recognition on long-duration insurance contracts, such shortfall is first reflected as a reduction in DAC and secondly as an increase in liabilities for future policy benefits. The change in these adjustments, net of tax, is included with the change in net unrealized appreciation of investments that is credited or charged directly to Other comprehensive income.
Value of Business Acquired (VOBA) is determined at the time of acquisition and is reported in the Consolidated Balance Sheets with DAC. This value is based on the present value of future pre-tax profits discounted at yields applicable at the time of purchase. For participating life, traditional life and accident and health insurance products, VOBA is amortized over the life of the business in a manner similar to that for DAC based on the assumptions at purchase. For investment-oriented products, VOBA is amortized in relation to estimated gross profits and adjusted for the effect of unrealized gains or losses on fixed maturity securities available for sale and prior to 2018, equity securities at fair value in a manner similar to DAC.
(b) Includes $101 million of VOBA from the acquisition of Validus, the majority of which will be amortized within the next 12 to 18 months.
DAC, VOBA and SIA for insurance-oriented and investment-oriented products are reviewed for recoverability, which involves estimating the future profitability of current business. This review involves significant management judgment. If actual profitability is substantially lower than estimated, AIG’s DAC, VOBA and SIA may be subject to an impairment charge and AIG’s results of operations could be significantly affected in future periods.
(c) Comprised primarily of Other liabilities at December 31, 2018 and 2017.
(b) At December 31, 2018 and 2017, $7.4 billion and $9.8 billion, respectively, of our total unconsolidated VIE assets were recorded as Other invested assets.
Through our insurance operations and AIG Global Real Estate, we are an investor in various real estate investment entities, some of which are VIEs. These investments are typically with unaffiliated third-party developers via a partnership or limited liability company structure. The VIEs’ activities consist of the development or redevelopment of commercial, industrial and residential real estate. Our involvement varies from being a passive equity investor or finance provider to actively managing the activities of the VIEs.
For additional information on embedded derivatives see Notes 5 and 14 herein.
(b) As of December 31, 2018 and 2017, included CDSs on super senior multi-sector CDOs with a net notional amount of $592 million and $685 million (fair value liability of $224 million and $254 million), respectively. The net notional amount represents the maximum exposure to loss on the portfolio. As of December 31, 2018 and 2017, there were no super senior corporate debt/CLOs remaining.
Collateral posted by us to third parties for derivative transactions was $1.7 billion and $2.9 billion at December 31, 2018 and 2017, respectively. In the case of collateral posted under derivative transactions that are not subject to clearing, this collateral can generally be repledged or resold by the counterparties. Collateral provided to us from third parties for derivative transactions was $2.1 billion and $1.3 billion at December 31, 2018 and 2017, respectively. In the case of collateral provided to us under derivative transactions that are not subject to clearing, we generally can repledge or resell collateral.
We use foreign currency denominated debt and cross-currency swaps as hedging instruments in net investment hedge relationships to mitigate the foreign exchange risk associated with our non-U.S. dollar functional currency foreign subsidiaries. For net investment hedge relationships where issued debt is used as a hedging instrument, we assess the hedge effectiveness and measure the amount of ineffectiveness based on changes in spot rates. For net investment hedge relationships that use derivatives as hedging instruments, we assess hedge effectiveness and measure hedge ineffectiveness using changes in forward rates. For the years ended December 31, 2018, 2017, and 2016 we recognized gains (losses) of $34 million, $(106) million and $123 million, respectively, included in Change in foreign currency translation adjustment in Other comprehensive income related to the net investment hedge relationships.
We invest in hybrid securities (such as credit-linked notes) with the intent of generating income, and not specifically to acquire exposure to embedded derivative risk. As is the case with our other investments in RMBS, CMBS, CDOs and ABS, our 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 $3.9 billion and $4.4 billion at December 31, 2018 and 2017, respectively. These securities have par amounts of $8.5 billion and $9.1 billion at December 31, 2018 and 2017, respectively, and have remaining stated maturity dates that extend to 2052.
If the estimated fair value of an operating segment exceeds its carrying amount, goodwill is not impaired. If the carrying value of an operating segment exceeds its estimated fair value, goodwill associated with that operating segment potentially is impaired. The amount of impairment, if any, is measured as the excess of the carrying value of the goodwill over the implied fair value of the goodwill. The implied fair value of the goodwill is measured as the excess of the fair value of the operating segment over the amounts that would be assigned to the operating segment’s assets and liabilities in a hypothetical business combination. An impairment charge is recognized in earnings to the extent of the excess of carrying value over fair value.
Goodwill was not impaired at December 31, 2018 based on the results of the goodwill impairment test.
(b) Includes amounts related to the acquisition of Glatfelter in October 2018, Validus in July 2018 and Blackboard U.S. Holdings Inc. in 2017.
(d) Includes discount on retroactive insurance in the amount of $180 million and $1.5 billion for the periods ended December 31, 2018 and 2017, respectively.
• Unfavorable development in US Excess Casualty, driven by the combination of construction defect and construction wrap claims from accident year 2015 and prior where we reacted to significant increases in severity and longer claim reporting patterns, as well as higher than expected loss severity in accident years 2016 and 2017, which led to an increase in estimates for these accident years;
• Unfavorable development in U.S. Financial Lines, primarily from Directors & Officers (D&O) and Employment Practices Liability (EPLI) policies covering Corporate and National Insureds as well as Private and Not-for-Profit insureds. This development was predominantly in accident years 2014-2017 and resulted largely from increases in severity associated with an increase in frequency of class action lawsuits from those years.
• Unfavorable development in US Personal Lines reflecting the adverse development on the 2017 California Wildfires and Hurricane Irma in 2017.
• Higher than expected losses for UK/Europe Casualty and Financial Lines. We observed a significant increase in large claims activity in our UK/Europe long-tail business, with a large proportion emanating from accident year 2016. In addition, we increased our loss reserves as a result of the decision made by the U.K. Ministry of Justice to reduce the discount rate applied to lump-sum bodily injury payouts, known as the Ogden rate.
The following is information about incurred and paid loss developments as of December 31, 2018, net of reinsurance. The cumulative number of reported claims, the total of IBNR liabilities and expected development on reported loss included within the net incurred loss amounts are presented in the following section.
· Paid Development method: The Paid Development method estimates ultimate losses by reviewing paid loss patterns and selecting paid ultimate loss development factors. These factors are then applied to paid losses by applying them to accident years, with further expected changes in paid loss. Since the method does not rely on case reserves, it is not directly influenced by changes in the adequacy of case reserves.
· Incurred Development method: The Incurred Development method is similar to the Paid Development method, but it uses case incurred losses instead of paid losses. Since this method uses more data (case reserves in addition to paid losses) than the Paid Development method, the incurred development patterns may be less variable than paid development patterns.
· Average Loss method: The Average Loss method multiplies a projected number of ultimate claims by an estimated ultimate severity average loss for each accident year to produce ultimate loss estimates. Since projections of the ultimate number of claims are often less variable than projections of ultimate loss, this method can provide more reliable results for reserve categories where loss development patterns are inconsistent or too variable to be relied on exclusively.
· changes in the legal, regulatory, judicial and social environment, including changes in road safety, public health and cleanup standards;
· changes in medical cost trends (inflation, intensity and utilization of medical services) and wage inflation trends;
· third-party actuarial reviews that are periodically performed for key classes of business;
· Groupings: We believe our groupings have homogenous risk characteristics with similar development patterns and would generally be subject to similar trends and reflect our reportable segments. The incurred losses and loss adjustment expenses and paid losses in the following tables for the current reporting year are allocated to the line of business and accident years based on an initial allocation methodology and updated for the final allocation in the subsequent reporting year. The difference between the initial and the final allocation does not have a material impact on the loss tables.
· Reinsurance: Our reinsurance program varies by exposure type. Historically we have leveraged facultative and treaty reinsurance, both on a pro-rata and excess of loss basis. Our reinsurance program may change from year to year, which may affect the comparability of the data presented in our tables.
· Adverse Development Reinsurance Agreement: We have provided the impact of the Adverse Development Reinsurance Agreement (ADC) in an additional table below our Incurred Losses and Allocated Loss Adjustment Expenses (ALAE) tables. The impact of the ADC is shown beginning in 2016 given the retroactive date of the contract and coincides with the effective date of the contract. For the lines of business covered by the agreement (U.S. Workers' Compensation, U.S. Excess Casualty, U.S. Other Casualty, U.S. Financial Lines, U.S. Property and Special Risks and U.S. Personal Insurance or collectively, the "Covered Lines"), an attribution of the loss recoveries to the line of business by calendar year and accident year is performed based on the underlying distribution of the losses subject to the agreement. Specifically, the future claim payments for all subject incurred losses were projected into future years based on the same actuarial assumptions underlying the related reserves. Also, refer to the additional table presented after discussion of prior year development by line of business, which reconciles the changes in net ultimates to our overall prior year development and provides the reattribution of loss recoveries for the Covered Lines. The reinsurance terms of the ADC were then used to identify the future claims payments for which 80% will be reimbursed by NICO. At each reporting period, the attribution of the ADC recoveries is performed. The factors that could cause the attribution to lines of business and accident year to change include changes in underlying actuarial assumptions as to timing and amount of future claim payments.
· Data excluded from tables: Information with respect to accident years older than ten years is excluded from the development tables. Unallocated loss adjustment expenses are also excluded.
· Acquisitions: We include acquisitions from all accident years presented in the tables. For purposes of this disclosure, we have applied the retrospective method for the acquired reserves, including incurred and paid claim development histories throughout the relevant tables. It should be noted that historical reserves for the acquired businesses were established by the acquired companies using methods, assumptions and procedures then in effect which may differ from our current reserving bases. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on the aggregated historical results shown in the triangles.
· Dispositions: We exclude dispositions from all accident years presented in the tables.
· Claim counts: We consider a reported claim to be one claim for each claimant or feature for each loss occurrence. Claims relating to losses that are 100 percent reinsured are excluded from the reported claims in the tables below. Reported claims for losses from assumed reinsurance contracts are not available and hence not included in the reported claims.
· There are limitations that should be considered on the reported claim count data in the tables below, including:
Supplemental Information: The information about incurred and paid loss development for all periods preceding year ended December 31, 2018 and the related historical claims payout percentage disclosure is unaudited and is presented as supplementary information.
U.S. Workers’ Compensation is an extremely long-tail line of business, with loss emergence extending for decades. We generally use a combination of loss development, frequency/severity and expected loss ratio methods for workers’ compensation.
During 2018, we recognized $51 million of adverse prior year development in US Workers Compensation business with higher claim development factors at older ages (tail factors) for non-California, non-New York and loss sensitive business in older accident years being offset by favorable emergence in recent years. Accident year 2017 was adversely impacted by a change in ceded reinsurance estimates. For our Defense Base Act (DBA) business, adverse development in recent years was offset by an expansion of the definition of reimbursable War Hazard claims by the US Government.
During 2017, we recognized $254 million of unfavorable prior year development in Excess Casualty, net of external reinsurance but before ADC cessions, driven by higher than expected loss emergence.
During 2018, we recognized $1,274 million of adverse development driven largely by construction defect and construction wrap claims where actual emergence was significantly worse than expected and our updated analysis significantly increased the severity assumptions and lengthened the claim reporting pattern to recognize the significant deterioration seen in recent calendar periods. We also increased the expected loss ratio assumptions in recent accident years to reflect the high initial reported loss ratios for those years and the incidence of several unusually large claims.
During 2017, we recognized $254 million of unfavorable prior year development driven in large part by emerging loss experience in accident year 2016 where frequency and severity to date has exceeded initial expectations and is coinciding with increased loss severity in the underlying primary auto and general liability segments. In addition, we experienced increased development from claims related to construction defects and construction wrap business. The majority of this experience came from accident years 2006 and prior.
In 2018, we recognized $127 million of favorable prior year development in Other Casualty, net of external reinsurance but before ADC cessions, primarily as a result of favorable loss emergence in accident years 2011-2016.
In 2017, we recognized $216 million of unfavorable prior year development in Other Casualty, net of external reinsurance but before ADC cessions, primarily as a result of increased loss severity in recent accident years.
Liabilities for losses and allocated loss adjustment expenses before 2009, net of reinsurance
In 2018, we increased our ultimate loss estimates for prior accident years by $214 million mainly due to Construction Casualty business, particularly construction defect (CD) claims. Our updated analyses for the construction casualty business reacted to increased severity of claims for both CD and non-CD claims and lengthened the claim reporting pattern for CD claims.
In 2017, we increased our ultimate loss estimates for prior accident years by $42 million. A majority of this development related to accident year 2016 where reported loss experience has been emerging greater than expected, driven by an increase in the frequency of large claims. We have experienced severity trends in recent accident years that have been at much higher levels than what has been reflected in the historic data, although we did see some signs of abatement during the second half of the year.
During 2017, we recognized favorable loss development of $23 million. Reported loss development was less than expected in aggregate; although we did continue to see higher loss severity in the more recent accident years. Premium volume has declined significantly over the last several years and certain segments such as physicians and surgeons, medical products, and nursing homes business (in certain jurisdictions) have been exited entirely.
Our analysis is segmented by major coverages, such as D&O, E&O, etc. and then further segmented by major industry groups (e.g. corporate accounts, national accounts, financial institutions, private/not-for-profit, etc.). We also separately review primary business from excess business for certain product lines.
Frequency/severity methods are generally not used in isolation for these product lines as the overall losses are driven by large losses more than by claim frequency. Severity trends have varied significantly from accident year to accident year and care is required in analyzing these trends by claim type. We also give weight to claim department ground-up projections of ultimate loss on a claim-by-claim basis as these may be more predictive of ultimate loss values, especially for older accident years.
During 2018, we recognized $298 million of unfavorable prior year development particularly across accident years 2014-2017. The largest share of the unfavorable development came from D&O and EPLI for Corporate and National accounts and resulted largely from increases in severity as the costs of security class actions increased. Excess D&O also contributed adverse development due to similar causes.
During 2017, we recognized $345 million of unfavorable prior year development particularly in accident year 2016. The largest share of the unfavorable development came from D&O for privately owned and not-for -profit insureds and resulted largely from increases in bankruptcy-related claims and fiduciary liability claims for large educational institutions. Other segments of the portfolio contributed largely offsetting favorable and unfavorable development; notably, development was unfavorable for excess D&O and employment practices liability while development was favorable for fidelity and D&O for corporate and national accounts.
During 2017, we recognized $115 million of unfavorable prior year development in U.S. Property and Special Risks, net of external reinsurance but before ADC cessions, mainly due to unfavorable development from the commercial auto portion of the Program business unit, which offers multiline policies to small and mid-sized insureds.
During 2017, we recognized $115 million of unfavorable prior year development primarily driven by commercial auto business in the program business unit. A significant portion of this development came from accident year 2016 with much of it related to programs that have been terminated over the past year. We also experienced some individual severe loss experience, also mostly related to accident year 2016 in other lines of business including aviation, surety, and marine; however, this was largely offset by favorable development in commercial property.
During 2017, we recognized $16 million of unfavorable prior year development in U.S. Personal Insurance, net of external reinsurance but before ADC cessions, mainly due to homeowners business in accident year 2016. This was partially offset by favorable development in accident and health business.
During 2017, we recognized $507 million of unfavorable prior year development in UK/Europe Casualty and Financial Lines, net of external reinsurance, driven by continued higher than expected loss emergence.
Incurred Losses and Allocated Loss Adjustment Expenses, Undiscounted and Net of Reinsurance*
During 2018, we recognized $58 million of unfavorable prior year development in UK/Europe Casualty and Financial Lines driven by increased large loss activity in recent accident years, particularly related to directors and officers class action suits against insureds with global exposure; and increased severity in excess casualty.
During 2016, we recognized $320 million of unfavorable prior year development. Within UK/Europe Financial Lines, we recognized $232 million of unfavorable development primarily from the D&O line in UK and Continental Europe as result of the unfavorable actual versus expected loss emergence in 2016 due to increased frequency and severity resulting from increasing litigation. In UK/Europe Casualty we recognized $123 million of unfavorable development primarily from the unexpected emergence of several large excess casualty claims. The actual versus expected loss emergence for UK/Europe Casualty and Financial Lines was more than expected.
During 2017, we recognized $157 million of unfavorable prior year development in the UK/Europe Property and Special Risks segment, net of external reinsurance, driven primarily by unexpected development on large claims, primarily from accident years 2015 and 2016.
During 2016, we recognized $11 million of unfavorable prior year development, primarily from the property segment.
During 2018, we recognized $116 million of favorable prior year development in UK/Europe and Japan Personal Insurance, net of external reinsurance.
We primarily segment our analysis by line of business (and by country for UK/Europe and Japan business) and may separately review various sub-segments, such as specific accident and health products and property damage versus liability for other personal lines products.
During 2018, the U.S. Run-Off Long Tail Insurance Lines experienced favorable prior year development of $4 million, net of external reinsurance.
During 2017, the U.S. Run-Off Long Tail Insurance Lines experienced favorable prior year development of $30 million, net of external reinsurance, driven primarily by favorable asbestos development.
U.S. Run-Off Long Tail Insurance lines include run-off lines for asbestos and environmental (1986 and prior), excess workers’ compensation, and other casualty coverages consisting of environmental impairment liability and related coverages, medical malpractice, workers’ compensation, and general liability. In some cases, the exposures in the more recent years have declined since the portfolio is in run-off.
Loss reserves for asbestos and environmental claims cannot be estimated using conventional reserving techniques such as those that rely on historical accident year loss development factors. The methods used to determine asbestos and environmental loss estimates and to establish the resulting reserves are continually reviewed and updated by management.
During 2017, the U.S. Run-Off long tail insurance lines recognized $30 million of favorable prior year development.
In 2018, we recognized no change on the retained portion of asbestos claims. The development on the portion of the asbestos business ceded to NICO was unfavorable by $96 million on a gross basis, but had no net impact. For environmental, we recognized $150 million in unfavorable prior year development as a result of adverse claim emergence and top-down actuarial analyses performed during the year.
In 2016, we increased gross undiscounted asbestos incurred losses by $106 million and decreased net undiscounted asbestos incurred losses by $20 million. The gross undiscounted change reflects an increase in estimates related to our accounts retroceded to NICO. The favorable development of the net incurred losses was largely a result of higher estimated external reinsurance recoveries on our retained asbestos exposures. For environmental, we increased incurred losses by $211 million primarily due to unfavorable development on several large clean-up sites and related accounts as well as a result of top down actuarial analyses performed during the year.
(b) Reattribution of the ADC recovery takes place annually as we model the future payments on the subject reserves covered by the ADC to determine when the aggregate payments will exceed the attachment. ADC recoverables are then reallocated by line based on payments expected to be made after attachment point is exceeded.
The discount consists of $603 million of tabular discount and $1.4 billion of non-tabular discount for workers’ compensation for 2018. During the years ended December 31, 2018, 2017, and 2016 the benefit/(charge) from changes in discount of $371 million, ($187) million and $422 million, respectively, were recorded as part of the policyholder benefits and losses incurred in the Condensed Consolidated Statement of Income.
During 2017 and 2016, effective interest rates declined due to a decrease in the forward yield curve component of the discount rates reflecting a decline in U.S. Treasury rates along with the changes in payout pattern assumptions. This resulted in a decrease in the loss reserve discount by $71 million in 2017 and $106 million in 2016.
The liability for Policyholder contract deposits is primarily recorded at accumulated value (deposits received and net transfers from separate accounts, plus accrued interest credited at rates ranging from 0.3 percent to 10.0 percent at December 31, 2018, less withdrawals and assessed fees). Deposits collected on investment-oriented products are not reflected as revenues, because they are recorded directly to Policyholder contract deposits upon receipt. Amounts assessed against the contract holders for mortality, administrative, and other services are included in revenues.
For universal life policies with secondary guarantees, we recognize certain liabilities in addition to policyholder account balances. For universal life policies with secondary guarantees, as well as other universal life policies for which profits followed by losses are expected at contract inception, a liability is recognized based on a benefit ratio of (a) the present value of total expected payments, in excess of the account value, over the life of the contract, divided by (b) the present value of total expected assessments over the life of the contract. For universal life policies without secondary guarantees, for which profits followed by losses are first expected after contract inception, we establish a liability, in addition to policyholder account balances, so that expected future losses are recognized in proportion to the emergence of profits in the earlier (profitable) years. Universal life account balances as well as these additional liabilities related to universal life products are reported within Policyholder contract deposits in the Consolidated Balance Sheet. These additional liabilities are also adjusted to reflect the effect of unrealized gains or losses on fixed maturity securities available for sale and prior to 2018, equity securities at fair value on accumulated assessments, with related changes recognized through Other comprehensive income.
Other policyholder funds include unearned revenue reserves (URR). URR consist of front-end loads on investment-oriented contracts, representing those policy loads that are non-level and typically higher in initial policy years than in later policy years. URR for investment-oriented contracts are generally deferred and amortized, with interest, in relation to the incidence of estimated gross profits (EGPs) to be realized over the estimated lives of the contracts and are subject to the same adjustments due to changes in the assumptions underlying EGPs as DAC. Amortization of URR is recorded in Policy fees. Similar to Shadow DAC, URR related to investment-oriented products is also adjusted to reflect the effect of unrealized gains or losses on fixed maturity securities available for sale and also, prior to 2018, equity securities at fair value on estimated gross profits, with related changes recognized through Other comprehensive income (shadow URR).
For a discussion of the fair value measurement of guaranteed benefits that are accounted for as embedded derivatives see Note 5.
The following table presents maturities of long-term debt (including unamortized original issue discount, hedge accounting valuation adjustments and fair value adjustments, when applicable), excluding $8.4 billion of debt of consolidated investments:
In connection with our acquisition of AIG Life Holdings, Inc. (AIGLH) in 2001, we entered into arrangements with AIGLH with respect to outstanding AIGLH capital securities. In 1996, AIGLH issued capital securities through a trust to institutional investors and funded the trust with AIGLH junior subordinated debentures issued to the trust with the same terms as the capital securities.
The following table presents the future minimum lease payments under operating leases at December 31, 2018:
In connection with AIGFP’s business activities, AIGFP has issued, in a limited number of transactions, standby letters of credit or similar facilities to equity investors of structured leasing transactions in an amount equal to the termination value owing to the equity investor by the lessee in the event of a lessee default (the equity termination value). The total amount outstanding at December 31, 2018 was $85 million. In those transactions, AIGFP has agreed to pay such amount if the lessee fails to pay. The amount payable by AIGFP is, in certain cases, partially offset by amounts payable under other instruments typically equal to the present value of scheduled payments to be made by AIGFP. In the event that AIGFP is required to make a payment to the equity investor, the lessee is unconditionally obligated to reimburse AIGFP. To the extent that the equity investor is paid the equity termination value from the standby letter of credit and/or other sources, including payments by the lessee, AIGFP takes an assignment of the equity investor’s rights under the lease of the underlying property. Because the obligations of the lessee under the lease transactions are generally economically defeased, lessee bankruptcy is the most likely circumstance in which AIGFP would be required to pay without reimbursement.
• For additional disclosures about guarantees of outstanding debt of AIG Life Holdings, Inc. (AIGLH), see Note 25 to the Consolidated Financial Statements.
Dividends are payable on AIG Common Stock only when, as and if declared by our Board of Directors in its discretion, from funds legally available for this purpose. In considering whether to pay a dividend on or purchase shares of AIG Common Stock, our Board of Directors considers a number of factors, including, but not limited to: the capital resources available to support our insurance operations and business strategies, AIG’s funding capacity and capital resources in comparison to internal benchmarks, expectations for capital generation, rating agency expectations for capital, regulatory standards for capital and capital distributions, and such other factors as our Board of Directors may deem relevant.
The following table presents declaration date, record date, payment date and dividends paid per share on AIG Common Stock:
* In 2017, we repurchased 185,000 warrants to purchase shares of AIG Common Stock.
Our Board of Directors has authorized the repurchase of shares of AIG Common Stock and warrants to purchase shares of AIG Common Stock through a series of actions. On May 3, 2017, our Board of Directors authorized an increase of $2.5 billion to its previous share repurchase authorization. As of December 31, 2018, approximately $512 million remained under our share repurchase authorization. Shares may be repurchased from time to time in the open market, private purchases, through forward, derivative, accelerated repurchase or automatic repurchase transactions or otherwise (including through the purchase of warrants). Certain of our share repurchases have been and may from time to time be effected through Exchange Act Rule 10b5-1 repurchase plans.
* Includes net unrealized gains attributable to businesses held for sale.
At December 31, 2018 and 2017, our domestic insurance subsidiaries used the following permitted practices that resulted in reported statutory surplus or risk-based capital that is significantly different from the statutory surplus or risk based capital that would have been reported had NAIC statutory accounting practices or the prescribed regulatory accounting practices of their respective state regulator been followed in all respects:
During 2018, performance share units (PSUs), restricted stock units (RSUs), stock options and deferred stock units (DSUs) (collectively, units) were granted under the Omnibus Plan and 37,211,710 shares are available for future grants as of December 31, 2018. Units are issued to employees as part of our long-term incentive program, generally in March of any given year, and are also issued for off-cycle grants, which are made from time to time during the year generally as sign-on awards to new hires or as a result of a change in employee status.
The number of PSUs issued on the grant date (the target) provides the opportunity for the LTIP participant to receive shares of AIG Common Stock based on AIG achieving specified performance goals at the end of a three-year performance period. These performance goals are pre-established by AIG’s Compensation and Management Resources Committee (CMRC) for each annual grant and may differ from year to year. The actual number of PSUs earned can vary from zero to 200 percent of the target for the 2017 and 2018 awards or zero to 150 percent of the target for the 2014 through 2016 awards, depending on AIG’s performance relative to a specified peer group or against pre-established financial goals, as applicable.
LTI awards granted in 2015 and thereafter accrue dividend equivalent units (DEUs) in the form of additional PSUs and/or RSUs whenever a cash dividend is declared on shares of AIG Common Stock; the DEUs are subject to the same vesting terms and conditions as the underlying unit.
The fair value of time-vesting RSUs as well as PSUs that are earned based on certain company-specific metrics was based on the closing price of AIG Common Stock on the grant date; while the fair value of PSUs that are earned based on AIG’s relative total shareholder return (TSR) was determined on the grant date using a Monte Carlo simulation.
(d) At December 31, 2018, the total unrecognized compensation cost for outstanding RSUs and PSUs was $215 million and the weighted-average and expected period of years over which that cost is expected to be recognized are 0.96 year and 2 years.
(b) The expected volatility is based on the implied volatility of 24 months stock option estimated by the Bloomberg Professional service as of the valuation date.
(c) The risk-free interest rate is the continuously compounded interest rate for the term between the valuation date and the expiration date that is assumed to be constant and equal to the interpolated value between the closet data points on the U.S. dollar LIBOR-swap curve as of the valuation date.
We granted 1,385,929 off-cycle time-vesting RSUs in 2018 primarily pertaining to replacement awards granted to Validus employees. We recognized $43.3 million of expense related to these RSU grants in 2018. Total unrecognized compensation cost related to these grants was $57 million and the weighted-average and expected period of years over which that cost is expected to be recognized are 1.14 years and 4.25 years at December 31, 2018.
In the U.S. we also sponsor non-qualified unfunded defined benefit plans, such as the AIG Non-Qualified Retirement Income Plan (AIG NQRIP) for certain employees, including key executives, designed to supplement pension benefits provided by the qualified plan. The AIG NQRIP provides a benefit equal to the reduction in benefits under the qualified plan as a result of federal tax limitations on compensation and benefits payable.
* Includes non-qualified unfunded plans of which the aggregate projected benefit obligation was $250 million and $272 million for the U.S. at December 31, 2018 and 2017, respectively, and $201 million and $211 million for the non-U.S at December 31, 2018 and 2017, respectively.
The estimated net loss and prior service cost that will be amortized from Accumulated other comprehensive income into net periodic benefit cost over the next fiscal year are $38 million and $2 million, respectively, for our combined defined benefit pension plans. For the defined benefit postretirement plans, the estimated amortization from Accumulated other comprehensive income for net gain and prior service credit that will be amortized into net periodic benefit cost over the next fiscal year is a $3 million credit in the aggregate.
* The non-U.S. plans reflect those assumptions that were most appropriate for the local economic environments of the subsidiaries providing such benefits.
There were no shares of AIG Common Stock included in the U.S. and non-U.S. pension plans assets at December 31, 2018 or 2017.
The following table presents the asset allocation percentage by major asset class for the U.S. qualified plan and the target allocation for 2019 based on the plan’s funded status at December 31, 2018:
The U.S. pension plan holds a group annuity contract with U.S. Life, one of our subsidiaries, which totaled $18 million and $20 million at December 31, 2018 and 2017, respectively.
Our policy is to record transfers of assets 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. We had no material transfers between Level 1 and Level 2 during the years ended December 31, 2018 and 2017.
We record transfers of assets 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. During the year ended December 31, 2018, we had no material transfers in or out of Level 3.
Our annual pension contribution in 2019 is expected to be approximately $79 million for our U.S. and non-U.S. pension plans. This estimate is subject to change, since contribution decisions are affected by various factors including our liquidity, market performance and management’s discretion.
A Schedule 13G/A filed on February 11, 2019 reports aggregate ownership of 67,664,554 shares, or approximately 7.8 percent (based on the AIG Common Stock outstanding) of AIG Common Stock as of December 31, 2018, by The Vanguard Group, Inc. and various subsidiaries thereof.
ITEM 8 | Notes to Consolidated Financial Statements | 23. Income Taxes
During December 2017, the SEC staff issued Staff Accounting Bulletin 118 (SAB 118), which provided guidance on accounting for the tax effects of the Tax Act. SAB 118 addressed situations where accounting for certain income tax effects of the Tax Act under ASC 740 may be incomplete upon issuance of an entity’s financial statements and provides a one-year measurement period from the enactment date to complete the accounting under ASC 740. In accordance with SAB 118, a company was required to reflect the following:
At December 31, 2017, we originally recorded a provisional estimate of income tax effects of the Tax Act of $6.7 billion, including a tax charge of $6.7 billion attributable to the reduction in the U.S. corporate income tax rate and tax benefit of $38 million related to the deemed repatriation tax. Our provisional estimate of $6.7 billion was based in part on a reasonable estimate of the effects of the statutory income tax rate reduction on existing deferred tax balances and of certain provisions of the Tax Act. We filed our 2017 consolidated U.S. income tax return and have completed our review of the primary impact of the Tax Act provisions on our deferred taxes. As a result, we consider the accounting for the effects of the rate change on deferred tax balances to be complete and no material measurement period changes were recorded for this item. As further guidance is issued by the U.S. tax authority, any resulting changes in our estimates will be treated in accordance with the relevant accounting guidance.
The Tax Act modified computations of insurance reserves for both life and general insurance companies. For life insurance companies, tax reserves are now computed with reference to NAIC reserves. For general insurance companies, the Tax Act extends the discount period for certain long-tail lines of business from 10 years to 24 years and increases the discount rate, replacing the applicable federal rate for a higher-yield corporate bond rate, and eliminates the election allowing companies to use their historical loss payment patterns for loss reserve discounting. Adjustments related to the differences in insurance reserves balances computed under the old tax law versus the Tax Act have to be taken into income over eight years by both life and general insurance companies. Accordingly, these changes give rise to new deferred tax liabilities. At December 31, 2017, we recorded a provisional estimate of $1.9 billion with respect to such deferred tax liabilities. This increase in deferred tax liabilities was offset by an increase in the deferred tax asset related to insurance reserves as a result of applying the new provisions of the Tax Act.
As of December 31, 2018, we have completed our review of the tax reserve computations for both life and general insurance companies, and recorded offsetting decreases of $1.4 billion to both our deferred tax liabilities and deferred tax assets.
The Tax Act may affect the results in certain investments and partnerships in which we are a non-controlling interest owner. At December 31, 2017, the information needed to determine a provisional estimate was not available (such as for interest deduction limitations in those entities and the changed definition of a U.S. Shareholder), and accordingly, no provisional estimates were recorded. We have since completed our review of these investments and partnerships. We consider the accounting for this item to be complete and no measurement period change was recorded.
For the year ended December 31, 2016, the effective tax rate on loss from continuing operations was not meaningful. The effective tax rate on loss from continuing operations differs from the statutory tax rate of 35 percent primarily due to tax charges of $234 million associated with effect of foreign operations, $216 million of tax charges and related interest associated with increases in uncertain tax positions related to cross border financing transactions, $118 million related to disposition of subsidiaries, $102 million related to non-deductible transfer pricing charges, and $83 million related to increases in the deferred tax asset valuation allowances associated with U.S. federal and certain foreign jurisdictions, partially offset by tax benefits of $253 million of tax exempt income, $164 million associated with a portion of the U.S. Life Insurance companies capital loss carryforwards previously treated as expired that was restored and utilized, $116 million related to the impact of an agreement reached with the Internal Revenue Service (IRS) related to certain tax issues under audit, and $132 million of reclassifications from accumulated other comprehensive income to income from continuing operations related to the disposal of available for sale securities. Effect of foreign operations is primarily related to foreign exchange losses incurred by our foreign subsidiaries related to the weakening of the British pound following the Brexit vote taxed at a statutory tax rate lower than 35 percent.
The following table presents our U.S. consolidated income tax group tax losses and credits carryforwards as of December 31, 2018.
For the year ended December 31, 2018, recent changes in market conditions, including rising interest rates, impacted the unrealized tax gains and losses in the U.S. Life Insurance Companies’ available for sale securities portfolio, resulting in a deferred tax asset related to net unrealized tax capital losses. The deferred tax asset relates to the unrealized losses for which the carryforward period has not yet begun, and as such, when assessing its recoverability, we consider our ability and intent to hold the underlying securities to recovery. As of December 31, 2018, based on all available evidence, we concluded that a valuation allowance should be established on a portion of the deferred tax asset related to unrealized losses that are not more-likely-than-not to be realized. For the year ended December 31, 2018, we established $290 million of valuation allowance associated with the unrealized tax losses in the U.S. Life Insurance Companies’ available for sale securities portfolio, all of which was allocated to other comprehensive income.
Deferred Tax Asset Valuation Allowance of U.S. Consolidated FEDERAL Income Tax Group
At December 31, 2018 and 2017, we had net deferred tax assets (liabilities) of $488 million and $366 million, respectively, related to foreign subsidiaries, state and local tax jurisdictions, and certain domestic subsidiaries that file separate tax returns.
At December 31, 2018 and 2017, we had deferred tax asset valuation allowances of $1.4 billion and $1.3 billion, respectively, related to foreign subsidiaries, state and local tax jurisdictions, and certain domestic subsidiaries that file separate tax returns. We maintained these valuation allowances following our conclusion that we could not demonstrate that it was more likely than not that the related deferred tax assets will be realized. This was primarily due to factors such as cumulative losses in recent years and the inability to demonstrate profits within the specific jurisdictions over the relevant carryforward periods.
* For the three-month period ended December 31, 2018, our results include out of period adjustments relating to prior periods that decreased Net income attributable to AIG by $87 million, and decreased Income from continuing operations before income taxes by $132 million. The out of period adjustments for the three-month period are primarily related to decreases in Premiums and decreases in Net realized capital gains and losses. We determined that these adjustments were not material to the current quarter or to any previously reported quarterly financial statements. Had these adjustments been recorded in their appropriate periods, Net income attributable to AIG for the three-month period ended September 30, 2018 would have decreased by $40 million with no impact to the three-month periods ended June 30, 2018 and March 31, 2018, respectively.
The following Condensed Consolidating Financial Statements reflect the results of AIG Life Holdings, Inc. (AIGLH), a holding company and a wholly owned subsidiary of AIG. AIG provides a full and unconditional guarantee of all outstanding debt of AIGLH.
(a) At December 31, 2018, includes restricted cash of $124 million and $18 million for American International Group, Inc. (As Guarantor) and Other Subsidiaries, respectively. At December 31, 2017, includes restricted cash of $4 million and $54 million for American International Group, Inc. (As Guarantor) and Other Subsidiaries, respectively.
(d) At December 31, 2018, includes restricted cash of $1 million and $342 million for American International Group, Inc. (As Guarantor) and Other Subsidiaries, respectively. At December 31, 2017, includes restricted cash of $1 million and $316 million for American International Group, Inc. (As Guarantor) and Other Subsidiaries, respectively.
ITEM 8 | Notes to Consolidated Financial Statements | 25. Information Provided in Connection with Outstanding Debt
On February 13, 2019, our Board of Directors declared a cash dividend on AIG Common Stock of $0.32 per share, payable on March 29, 2019 to shareholders of record on March 15, 2019.