Represents the sum of General Insurance net premiums earned, Life Insurance & Retirement Services GAAP premiums and net investment income, Financial Services interest, lease and finance charges, Asset Management net investment income from spread-based products and advisory and management fees, and realized capital gains (losses).
Includes current year catastrophe-related losses of $3.28 billion in 2005 and $1.16 billion in 2004. There were no significant catastrophe-related losses in 2006.
Operating income was reduced by fourth quarter charges of $1.8 billion, $850 million and $2.1 billion for 2005, 2004 and 2002, respectively, related to the annual review of General Insurance loss and loss adjustment reserves. In 2006, 2005 and 2004, changes in estimates for asbestos and environmental reserves were $198 million, $873 million and $850 million, respectively.
This Annual Report on Form 10-K and other publicly available documents may include, and AIG’s officers and representatives may from time to time make, projections concerning financial information and statements concerning future economic performance and events, plans and objectives relating to management, operations, products and services, and assumptions underlying these projections and statements. These projections and statements are not historical facts but instead represent only AIG’s belief regarding future events, many of which, by their nature, are inherently uncertain and outside AIG’s control. These projections and statements may address, among other things, the status and potential future outcome of the current regulatory and civil proceedings against AIG and their potential effect on AIG’s businesses, financial position, results of operations, cash flows and liquidity, the effect of credit rating changes on AIG’s businesses and competitive position, the unwinding and resolving of various relationships between AIG and SICO and AIG’s strategy for growth, product development, market position, financial results and reserves. It is possible that AIG’s actual results and financial condition may differ, possibly materially, from the anticipated results and financial condition indicated in these projections and statements. Factors that could cause AIG’s actual results to differ, possibly materially, from those in the specific projections and statements are discussed throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations and in Item 1A. Risk Factors of this Annual Report on Form 10-K. AIG is not under any obligation (and expressly disclaims any such obligations) to update or alter any projection or other statement, whether written or oral, that may be made from time to time, whether as a result of new information, future events or otherwise.
A central focus of AIG operations in recent years has been the development and expansion of distribution channels. In 2006, AIG continued to expand its distribution channels, which now include banks, credit card companies, television-media home shopping, affinity groups, direct response, worksite marketing and e-commerce.
Growth for AIG may be generated internally as well as through acquisitions which both fulfill strategic goals and offer adequate return on capital. During 2006, AIG acquired Travel Guard International, one of the nation’s leading providers of travel insurance programs and emergency travel assistance, and acquired Central Insurance Co., Ltd., a leading general insurance company in Taiwan.
AIG’s leadership position in the distribution of annuities through banks in Japan, ALICO launched new life products in this distribution channel. Although ALICO’s direct marketing activities in Japan could experience a contraction while it re-positions its brand and products in a very competitive market, AIG expects that further deregulation will provide additional growth opportunities. In addition, AIG expects that the planned integration of AIG Star Life and AIG Edison Life will provide enhanced distribution opportunities and scale economies with an anticipated completion date of 2009.
The GIC portfolio, which is reported within the Asset Management segment, continues to run off and the MIP has replaced the GIC program as AIG’s principal institutional spread-based investment activity. The MIP program is expected to continue to grow in 2007. Because the asset mix under the MIP does not include the alternative investments utilized in the GIC program, however, AIG does not expect that the income growth in the MIP will offset the runoff in the GIC portfolio for the foreseeable future.
For a description of important factors that may affect the operations and initiatives described above, see Item 1A. Risk Factors.
Income before income taxes, minority interest and cumulative effect of accounting changes increased 43 percent in 2006 compared to 2005, reflecting higher General Insurance and Life Insurance & Retirement Services operating income. These increases were partially offset by lower Financial Services operating income reflecting the effects of hedging activities that did not qualify for hedge accounting treatment under FAS 133. Results in
Revenues grew 12 percent in 2005 compared to 2004 primarily due to the growth in net premiums earned from General Insurance operations as well as growth in both General Insurance and Life Insurance & Retirement Services net investment income and Life Insurance & Retirement Services GAAP premiums. Hedging activities for AIGFP that did not qualify for hedge accounting treatment under FAS 133 caused an increase in Financial Services revenues of $2.01 billion in 2005 and a decrease of $122 million in 2004.
AIG’s income before income taxes, minority interest and cumulative effect of accounting changes increased 2 percent in 2005 compared to 2004. Life Insurance & Retirement Services, Financial Services and Asset Management operating income gains accounted for the increase over 2004 in both pretax income and net income. Offsetting these gains was the effect of the charges related to regulatory settlements.
During 2006, AIG identified and recorded out of period adjustments related to the accounting for certain interests in unit investment trusts in accordance with FIN 46(R), “Consolidation of Variable Interest Entities” and APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.” These investments had previously been accounted for as available for sale securities, with changes in market values being reflected in other comprehensive income, net of deferred income taxes. Beginning with the second quarter of 2006, the changes in market values are included in net investment income. The adjustments decreased unrealized appreciation (depreciation) of investments - net of reclassification adjustments, and the related deferred income tax benefit (expense), in the Consolidated Statement of Comprehensive Income (Loss) by approximately $659 million and approximately $231 million, respectively, and increased net investment income by $844 million, increased Incurred policy losses and benefits (related to certain participating policyholder funds) by $71 million, increased Income taxes by $231 million and increased minority interest expense by $114 million in the Consolidated Statement of Income. There was no effect on Total shareholders’ equity at December 31, 2006 or December 31, 2005.
Represents the sum of Life Insurance & Retirement Services GAAP premiums, net investment income and realized capital gains (losses). Included in realized capital gains (losses) and operating income is the effect of hedging activities that did not qualify for hedge accounting treatment under FAS 133 and the application of FAS 52, of $355 million, $(495) million and $(140) million for 2006, 2005 and 2004, respectively.
Represents net investment income with respect to spread-based products and management and advisory fees.
Includes consolidation and elimination adjustments which increased revenues and operating income by $296 million and $74 million, respectively, in 2006.
Includes current year catastrophe-related losses from unconsolidated subsidiaries of $312 million and $96 million in 2005 and 2004. There were no significant catastrophe-related losses in 2006.
AIG’s Life Insurance & Retirement Services operations provide insurance, financial and investment products throughout the world. Foreign operations contributed approximately 68 percent, 59 percent and 61 percent of AIG’s Life Insurance & Retirement Services operating income in 2006, 2005 and 2004, respectively.
Financial Services operating income decreased in 2006 compared to 2005 primarily due to the effects of hedging activities that did not qualify for hedge accounting treatment under FAS 133. AIG is reinstituting hedge accounting in the first quarter of 2007 for AIGFP. In addition to the effects of FAS 133, fluctuations in revenues and operating income from period to
period are not unusual because of the transaction-oriented nature of Capital Markets operations.
Asset Management operating income increased 4 percent in 2006 compared to 2005 due primarily to growth in asset management fees within Institutional Asset Management and income from the MIP. These increases were partially offset by the continued runoff of GIC balances, spread compression in the remaining GIC portfolio as well as decreased performance-based fees. Gains and losses arising from the consolidation of certain variable interest entities (VIEs) and partnerships are included in operating income, but are offset in minority interest expense, which is not a component of operating income.
AIG did not purchase shares of its common stock under its common stock repurchase authorization during 2006. In February 2007, AIG’s Board of Directors increased the repurchase program by authorizing the repurchase of shares with an aggregate purchase price of $8 billion.
AIG manages liquidity at both the subsidiary and parent company levels. At December 31, 2006, AIG’s consolidated invested assets, primarily held by its subsidiaries, included $26.8 billion in cash and short-term investments. Consolidated net cash provided from operating activities in 2006 amounted to $6.8 billion. At the parent company level, liquidity management activities are conducted in a manner to preserve and enhance funding stability, flexibility, and diversity through the full range of potential operating environments and market conditions. AIG’s primary sources of cash flow are dividends and other payments from its regulated and unregulated subsidiaries, as well as issuances of debt securities. Primary uses of cash flow are for debt service, subsidiary funding and shareholder dividend payments. Management believes that AIG’s liquid assets, cash provided by operations and access to the capital markets will enable it to meet its anticipated cash requirements, including the funding of increased dividends under AIG’s new dividend policy and repurchases of common stock.
Estimated gross profits: to be realized over the estimated duration of the contracts (investment-oriented products) affect the carrying value of DAC, unearned revenue liability and associated amortization patterns under FAS 97 and Sales Inducement Assets under SOP 03-1. Estimated gross profits include investment income and gains and losses on investments less required interest, actual mortality and other expenses.
Expected undiscounted future net cash flows: based upon current lease rates, projected future lease rates and estimated terminal values of each aircraft based on third party information.
A critical discipline of a successful general insurance business is the objective to produce profit from underwriting activities exclusive of investment-related income. When underwriting is not profitable, premiums are inadequate to pay for insured losses and underwriting related expenses. In these situations, the addition of general insurance related investment income and realized capital gains may, however, enable a general insurance business to produce operating income. For these reasons, AIG views underwriting results to be critical in the overall evaluation of performance. See also Liquidity herein.
Statutory underwriting profit is derived by reducing net premiums earned by net losses and loss expenses incurred and net expenses incurred. Statutory accounting generally requires immediate expense recognition and ignores the matching of revenues and expenses as required by GAAP. That is, for statutory purposes, expenses (including acquisition costs) are recognized immediately, not over the same period that the revenues are earned. Thus, statutory expenses exclude changes in DAC.
GAAP provides for the recognition of expenses at the same time revenues are earned, the accounting principle of matching. Therefore, acquisition expenses are deferred and amortized over the period the related net premiums written are earned. DAC is reviewed for recoverability, and such review requires management judgment. The most comparable GAAP measure to statutory underwriting profit is income before income taxes, minority interest and cumulative effect of an accounting change. A table reconciling statutory underwriting profit to income before income taxes, minority interest and cumulative effect of an accounting change is contained in footnote (g) to the following table. See also Critical Accounting Estimates herein and Notes 1 and 4 of Notes to Consolidated Financial Statements.
Includes the effect of out of period adjustments related to the accounting for certain interests in unit investment trusts in 2006. For DBG, the effect was an increase of $66 million, and for Foreign General, the effect was an increase of $424 million.
Catastrophe-related losses increased the consolidated General Insurance combined ratio for 2005 and 2004 by 7.06 points and 2.74 points, respectively. There were no significant catastrophe-related losses in 2006. Catastrophe-related losses for 2005 and 2004 by reporting unit were as follows:
Includes additional losses incurred and net reinstatement premiums related to prior year catastrophes of $199 million and $277 million, in 2006 and 2005, respectively.
In 2006, certain adjustments were made in conjunction with the remediation of the material weakness relating to balance sheet account reconciliations which increased earned premiums by $189 million and increased other expenses by $415 million. These adjustments reflect continuing progress in AIG’s ongoing remediation efforts. The combined effect of these adjustments increased the expense ratio by 0.9 points and decreased the loss ratio by 0.3 points.
General Insurance net investment income increased $1.67 billion in 2006 to $5.7 billion on higher levels of invested assets, strong cash flows, slightly higher yields and increased partnership income, and included increases from out of period adjustments of $490 million related to the accounting for certain interests in unit investment trusts, $43 million related to partnership income and $85 million related to interest earned on a DBG deposit contract. See also Capital Resources and Liquidity - Liquidity and Invested Assets herein.
General Insurance net investment income grew in 2005 compared to 2004 due to strong cash flows, higher interest rates and increased partnership income. See also Capital Resources and Liquidity - Liquidity herein and Note 8 of Notes to Consolidated Financial Statements.
DBG’s operating income increased to $5.99 billion in 2006 compared to a loss of $646 million in 2005, an improvement of $6.63 billion. The improvement is also reflected in the combined ratio, which declined to 89.4 in 2006 compared to 113.8 in 2005 primarily due to an improvement in the loss ratio of 24.9 points. The reduction in prior year adverse development and the reduction in catastrophe losses and related reinstatement premiums accounted for 21.0 points and 8.2 points, respectively, of the improvement.
DBG’s net premiums written increased 5 percent in 2006 compared to 2005 as property rates improved and submission activity increased due to the strength of AIG’s capacity, commitment to difficult markets and diverse product offerings. Net premiums written in 2005 were reduced by $122 million due to reinstatement premiums related to catastrophes, offset by increases of $300 million for the Richmond commutation and $147 million related to an accrual for workers compensation premiums for payroll not yet reported by insured employers. The combined effect of these items reduced the growth rate for net premiums written by 1.5 percent.
DBG’s expense ratio increased to 20.0 in 2006 compared to 19.5 in 2005, primarily due to an increase in other expenses that amounted to $498 million in 2006 (including out of period charges of $356 million) compared to $372 million in 2005. This increase added 0.4 points to the expense ratio. Overall allowances decreased, however, due to charge-offs against previously established allowances resulting from AIG’s remediation activities.
DBG’s net investment income increased by $1.0 billion in 2006 compared to 2005, as interest income increased $482 million on growth in the bond portfolio resulting from investment of operating cash flows and capital contributions. Partnership income
increased from 2005 due to improved performance of the underlying investments, including initial public offering activity. Net investment income in 2006 included increases relating to out of period adjustments of $109 million for the accounting for certain investments in unit investment trusts and partnerships and $85 million related to interest earned on a deposit contract that did not exist in the prior year.
The DBG loss ratio increased in 2005 from 2004 principally as a result of adverse loss development, higher catastrophe-related losses and $197 million of losses incurred in 2005 resulting from the 2004 catastrophes.
Personal Lines net premiums written and net premiums earned for 2005 increased compared to 2004 as a result of strong growth in the Private Client Group and Agency Auto divisions due to increased agent/broker appointments, greater market penetration and enhanced product offerings. AIG direct premiums in 2005 were down slightly from 2004 due to aggressive re-underwriting of the previously acquired GE business and the discontinuation of underwriting homeowners business. Involuntary auto premiums were down in 2005 due to the decline in the assigned risk marketplace. Statutory underwriting profit declined in 2005 as a result of hurricane losses and related expenses, reserve strengthening, an increase in Agency Auto’s current accident year physical damage loss ratio, and expenses incurred related to terminating AIG’s relationship with The Robert Plan effective December 31, 2005.
UGC’s net premiums written were up slightly for 2005 compared to 2004 as strong growth in the international and domestic second lien businesses was mostly offset by lower persistency in domestic first lien residential renewal premiums. Statutory underwriting profit rose from 2004 due to lower contract underwriting expenses and favorable loss development.
Foreign General’s operating income increased $661 million or 27 percent in 2006 compared to 2005 due to out of period adjustments related to the accounting for interests in unit investment trusts, the absence of significant catastrophe-related losses in 2006, rate increases and lower current accident year losses by the Lloyd’s syndicate Ascot (Ascot) on its U.S. book of business and lower asbestos and environmental reserve increases. Partially offsetting these increases in operating income were lower favorable loss development from prior accident years and adverse loss development on the 2005 hurricanes. Statutory underwriting profit increased $152 million in 2006 compared to 2005. Catastrophes in 2005 resulted in losses of $293 million and reinstatement premiums of $94 million.
The expense ratio increased 1.3 points in 2006 compared to 2005. Underwriting expenses for 2006 increased $59 million due to an out of period adjustment for amortization of deferred advertising costs and premiums were reduced by $61 million due to reconciliation remediation activities, in aggregate accounting for 0.7 points of the increase in the expense ratio. The expense ratio also increased due to growth in consumer business lines, which have higher acquisition expenses but historically lower loss ratios. The expense ratio for 2005 increased by 1.2 points due to the decline in net premiums written from reinstatement premiums related to catastrophes and the portfolio transfer of the Richmond unearned premium reserves. Due to the current mix of business, AIG expects the expense ratio to continue to increase during 2007, principally for classes of business with historically lower than average loss ratios.
Net premiums written increased 6 percent (4 percent in original currency) in 2005 compared to 2004 as a result of new business as well as new distribution channels such as the February 2005 purchase of the insurance portfolio of the Royal & Sun Alliance branch operations in Japan. The personal accident business in the Far East and the personal lines operations in Latin America also contributed to the growth. Partially offsetting these increases was the portfolio transfer of Richmond’s unearned premium reserves to DBG, which reduced net premiums in 2005 and reinstatement premiums related to catastrophes.
Foreign General net investment income increased $326 million in 2005 compared to 2004 on increased partnership income, reflecting increases in market valuations of infrastructure fund investments in Africa, Asia, China, Eastern Europe and India. Additionally, net investment income was positively affected by positive cash flows, higher interest rates and the compounding of previously earned and reinvested net investment income. Cash flow was lower in 2005 compared to 2004 due to payments for
catastrophe-related losses incurred in 2005 and 2004 and for the purchase of the Royal & Sun Alliance branch operations.
Presented by lines of business pursuant to statutory reporting requirements as prescribed by the National Association of Insurance Commissioners (NAIC).
At December 31, 2006 and 2005, respectively, DBG loss reserves include approximately $3.33 billion and $3.77 billion ($3.66 billion and $4.26 billion, respectively, before discount), related to business written by DBG but ceded to AIRCO and reported in AIRCO’s statutory filings. DBG loss reserves also include approximately $535 million and $407 million related to business included in AIUO’s statutory filings at December 31, 2006 and 2005, respectively.
At December 31, 2006 and 2005, respectively, Personal Lines loss reserves include $861 million and $878 million related to business ceded to DBG and reported in DBG’s statutory filings.
The DBG net loss reserve of $44.0 billion is comprised principally of the business of AIG subsidiaries participating in the American Home/ National Union pool (11 companies) and the surplus lines pool (Lexington, Starr Excess Liability Insurance Company and Landmark Insurance Company).
The companies participating in the American Home/ National Union pool have maintained a participation in the business written by AIU for decades. As of year-end 2006, these AIU reserves carried by participants in the American Home/ National Union pool amounted to approximately $2.87 billion. The remaining Foreign
At December 31, 2006, AIG’s overall General Insurance net loss reserves reflect a loss reserve discount of $2.26 billion, including tabular and non-tabular calculations. The tabular workers compensation discount is calculated using a 3.5 percent interest rate and the 1979-81 Decennial Mortality Table. The non-tabular workers compensation discount is calculated separately for companies domiciled in New York and Pennsylvania, and follows the statutory regulations for each state. For New York companies, the discount is based on a five percent interest rate and the companies’ own payout patterns. For Pennsylvania companies, the statute has specified discount factors for accident years 2001 and prior, which are based on a six percent interest rate and an industry payout pattern. For accident years 2002 and subsequent, the discount is based on the yield of U.S. Treasury securities ranging from one to twenty years and the company’s own payout pattern, with the future expected payment for each year using the interest rate associated with the corresponding Treasury security yield for that time period. The discount is comprised of the following: $662 million - tabular discount for workers compensation in DBG; $1.27 billion - non-tabular discount for workers compensation in DBG; and, $330 million - non-tabular discount for other liability occurrence and products liability occurrence in AIRCO. The total undiscounted workers compensation loss reserve carried by DBG is approximately $11.5 billion as of year-end 2006. The other liability occurrence and products liability occurrence business in AIRCO that is assumed from DBG is discounted based on the yield of U.S. Treasury securities ranging from one to twenty years and the DBG payout pattern for this business. The undiscounted reserves assumed by AIRCO from DBG totaled approximately $3.66 billion at December 31, 2006.
The following table presents the reconciliation of net loss reserves for 2006, 2005 and 2004 as follows:
The loss ratios recorded by AIG for 2006 took into account the results of the comprehensive reserve reviews that were completed in the fourth quarter of 2005. AIG’s year-end 2005 reserve review reflected careful consideration of the reserve analyses prepared by AIG’s internal actuarial staff with the assistance of third party actuaries. In determining the appropriate loss ratios for accident year 2006 for each class of business, AIG gave consideration to the loss ratios resulting from the 2005 reserve analyses as well as all other relevant information including rate changes, expected changes in loss costs, changes in coverage, reinsurance or mix of business, and other factors that may affect the loss ratios.
In 2006, AIG enhanced its process of determining the quarterly loss development from prior accident years. In the first quarter of 2006, AIG began conducting additional analyses to determine the change in estimated ultimate loss for each accident year for each profit center. For example, if loss emergence for a profit center is different than expected for certain accident years, the actuaries now take additional steps to examine the indicated effect such emergence would have on the reserves of that profit center. In some cases, the higher or lower than expected emergence may result in no clear change in the ultimate loss estimate for the accident years in question, and no adjustment would be made to the profit center’s reserves for prior accident years. In other cases, the higher or lower than expected emergence may result in a larger change, either favorable or unfavorable, than the difference between the actual and expected loss emergence. Such additional analyses were conducted for each profit center, as appropriate, in the first, second and third quarters of 2006 to determine the loss development from prior accident years for the first, second and third quarters of 2006. As part of its quarterly reserving process, AIG also considers notices of claims received with respect to emerging issues, such as those related to stock option backdating. In the fourth quarter of 2006, a comprehensive loss reserve review was completed for each AIG general insurance subsidiary. The prior accident year loss reserve development shown in the tables above for 2006 reflects the results of these comprehensive reviews, including the effect of actual loss emergence in the fourth quarter of 2006.
In 2006, net loss development from prior accident years was favorable by approximately $53 million, including approximately $198 million in net adverse development from asbestos and environmental reserves resulting from the updated ground up analysis of these exposures in the fourth quarter of 2006; approximately $103 million of adverse development pertaining to the major hurricanes in 2004 and 2005; and $181 million of adverse development from the general reinsurance operations of Transatlantic; and excluding approximately $300 million from accretion of loss reserve discount. Excluding the fourth quarter asbestos and environmental reserve increase, catastrophes and Transatlantic, as well as accretion of discount, net loss development in 2006 from prior accident years was favorable by approximately $535 million. The overall favorable development of $53 million consisted of approximately $2.30 billion of favorable development from accident years 2003 through 2005, partially offset by approximately $2.25 billion of adverse development from accident years 2002 and prior. For 2006, most classes of AIG’s business continued to experience favorable development for accident years 2003 through 2005. The adverse development from accident years 2002 and prior reflected development from excess casualty, workers compensation, excess workers compensation, and post-1986 environmental liability classes of business, all within DBG, from asbestos reserves within DBG and Foreign General, and from Transatlantic.
For 2005, net loss development from prior accident years was adverse by approximately $4.68 billion, including approximately $269 million from the general reinsurance operations of Transatlantic. This $4.68 billion adverse development in 2005 was comprised of approximately $8.60 billion for the 2002 and prior accident years, partially offset by favorable development for accident years 2003 and 2004 for most classes of business, with the notable exception of D&O. The adverse loss development for 2002 and prior accident years was attributable to approximately $4.0 billion of development from the D&O and related management liability classes of business, excess casualty, and excess workers compensation, and to approximately $900 million of adverse development from asbestos and environmental claims. The remaining portion of the adverse development from 2002 and
For 2004, AIG’s overall net loss reserve development from prior accident years was an increase of approximately $3.19 billion, including approximately $317 million from the general reinsurance operations of Transatlantic and excluding approximately $377 million from accretion of loss reserve discount. This $3.19 billion adverse development in 2004 was comprised of approximately $4.67 billion of adverse development for the 2002 and prior accident years, partially offset by approximately $1.48 billion of favorable development for accident year 2003. The adverse development for the 2002 and prior accident years was primarily attributable to excess casualty, D&O and related management liability classes, and asbestos and environmental reserves, all within DBG, and also to Transatlantic. Most classes of business throughout AIG produced favorable development for accident year 2003.
The following is a discussion of the primary reasons for the development in 2006, 2005 and 2004 for those classes of business that experienced significant prior accident year developments during the three-year period. See Asbestos and Environmental Reserves below for a further discussion of asbestos and environmental reserves and developments.
In the year-end 2004 loss reserve review, AIG’s actuaries responded to the adverse development for excess casualty by increasing the loss development factor assumptions. In the year-end 2004 reserve study, the development factors applicable to accident years 1998 and subsequent were increased by approximately 12 percent. In addition, the expected loss ratios for accident years 2002 and subsequent were increased to take into account the higher ultimate loss ratios for accident years 2001 and prior.
Loss reserves pertaining to the excess casualty class of business are generally included in the Other liability occurrence line of business, with a small portion of the excess casualty reserves included in the Other liability claims made line of business, as presented in the table on page 37.
In the year-end 2004 loss reserve review, AIG’s actuaries responded to the adverse development for D&O and related management liability classes by increasing the loss development factor assumptions. The development factors applicable to accident years 1997 and subsequent were increased by approximately 5 percent in the year-end 2004 reserve study. In addition, the expected loss ratios for accident years 2002 and subsequent were increased to take into account the higher ultimate loss ratios for accident years 2001 and prior. The loss ratios for the older accident years increased due to the combination of higher than expected loss development in the year and the increase in the loss development factor assumptions.
For the year-end 2006 loss reserve review, AIG claims staff updated the claim-by-claim projection for each open claim for accident years 1999 and prior. These updated claims projections were utilized by the actuaries as a benchmark for loss development factors in the year-end 2006 study. AIG’s actuaries determined that no significant changes in the assumptions were required. Prior accident year development in 2006 was adverse by approximately $70 million, a relatively minor amount for this class.
AIG’s carried net long-tail loss reserves are tested using loss trend factors that AIG considers appropriate for each class of business. A variety of actuarial methods and assumptions is normally employed to estimate net losses for long-tail casualty classes of businesses. These methods ordinarily involve the use of loss trend factors intended to reflect the annual growth in loss costs from one accident year to the next. For the majority of long-tail casualty classes of business, net loss trend factors approximated five percent. Loss trend factors reflect many items
In testing the reserves for each class of business, a determination is made by AIG’s actuaries as to the most appropriate actuarial methods. This determination is based on a variety of factors including the nature of the claims associated with the class of business, such as frequency or severity. Other factors considered include the loss development characteristics associated with the claims, the volume of claim data available for the applicable class, and the applicability of various actuarial methods to the class. In addition to determining the actuarial methods, the actuaries determine the appropriate loss reserve groupings of data. For example, AIG writes a great number of unique subclasses of professional liability. For pricing or other purposes, it is appropriate to evaluate the profitability of each subclass individually. However, for purposes of estimating the loss reserves for professional liability, it is appropriate to combine the subclasses
into larger groups. The greater degree of credibility in the claims experience of the larger groups may outweigh the greater degree of homogeneity of the individual subclasses. This determination of data segmentation and actuarial methods is carefully considered for each class of business. The segmentation and actuarial methods chosen are those which together are expected to produce the most accurate estimate of the loss reserves.
Actuarial methods used by AIG for most long-tail casualty classes of business include loss development methods and expected loss ratio methods, including “Bornhuetter Ferguson” methods described below. Other methods considered include frequency/severity methods, although these are generally used by AIG more for pricing analysis than for loss reserve analysis. Loss development methods utilize the actual loss development patterns from prior accident years to project the reported losses to an ultimate basis for subsequent accident years. Loss development methods generally are most appropriate for classes of business which exhibit a stable pattern of loss development from one accident year to the next, and for which the components of the classes have similar development characteristics. For example, property exposures would generally not be combined into the same class as casualty exposures, and primary casualty exposures would generally not be combined into the same class as excess casualty exposures. Expected loss ratio methods are generally utilized by AIG where the reported loss data lacks sufficient credibility to utilize loss development methods, such as for new classes of business or for long-tail classes at early stages of loss development.
Expected loss ratio methods rely on the application of an expected loss ratio to the earned premium for the class of business to determine the loss reserves. For example, an expected loss ratio of 70 percent applied to an earned premium base of $10 million for a class of business would generate an ultimate loss estimate of $7 million. Subtracting any reported paid losses and loss expense would result in the indicated loss reserve for this class. “Bornhuetter Ferguson” methods are expected loss ratio methods for which the expected loss ratio is applied only to the expected unreported portion of the losses. For example, for a long-tail class of business for which only 10 percent of the losses are expected to be reported at the end of the accident year, the expected loss ratio would be applied to the 90 percent of the losses still unreported. The actual reported losses at the end of the accident year would be added to determine the total ultimate loss estimate for the accident year. Subtracting the reported paid losses and loss expenses would result in the indicated loss reserve. In the example above, the expected loss ratio of 70 percent would be multiplied by 90 percent. The result of 63 percent would be applied to the earned premium of $10 million resulting in an estimated unreported loss of $6.3 million. Actual reported losses would be added to arrive at the total ultimate losses. If the reported losses were $1 million, the ultimate loss estimate under the “Bornhuetter Ferguson” method would be $7.3 million versus the $7 million amount under the expected loss ratio method described above. Thus, the “Bornhuetter Ferguson” method gives partial credibility to the actual loss experience to date for the class of business. Loss development methods generally give full credibility to the reported loss experience to date. In the example above, loss development methods would typically indicate an ultimate loss estimate of $10 million, as the reported losses of $1 million would be estimated to reflect only 10 percent of the ultimate losses.
class of business must consist of homogeneous types of claims for which loss severity trends from one year to the next are reasonably consistent. Generally these methods work best for high frequency, low severity classes of business such as personal auto. AIG utilizes these methods in pricing subclasses of professional liability. However, AIG does not generally utilize frequency/severity methods to test loss reserves, due to the general nature of AIG’s reserves being applicable to lower frequency, higher severity commercial classes of business where average claim severity is volatile.
Excess Casualty: AIG generally uses a combination of loss development methods and expected loss ratio methods for excess casualty classes. Expected loss ratio methods are generally utilized for at least the three latest accident years, due to the relatively low credibility of the reported losses. The loss experience is generally reviewed separately for lead umbrella classes and for other excess classes, due to the relatively shorter tail for lead umbrella business. Automobile-related claims are generally reviewed separately from non-auto claims, due to the shorter tail nature of the automobile related claims. The expected loss ratios utilized for recent accident years are based on the projected ultimate loss ratios of prior years, adjusted for rate changes, estimated loss cost trends and all other changes that can be quantified. The estimated loss cost trend utilized in the year-end 2006 reviews averaged approximately 6 percent for excess casualty classes. Frequency/severity methods are generally not utilized as the vast majority of reported claims do not result in a claim payment. In addition, the average severity varies significantly from accident year to accident year due to large losses which characterize this class of business, as well as changing proportions of claims which do not result in a claim payment.
General Liability: AIG generally uses a combination of loss development methods and expected loss ratio methods for primary general liability or products liability classes. For certain classes of business with sufficient loss volume, loss development methods may be given significant weight for all but the most recent one or two accident years, whereas for smaller or more volatile classes of business, loss development methods may be given limited weight for the five or more most recent accident years. Expected loss ratio methods would be utilized for the more recent accident years for these classes. The loss experience for primary general liability business is generally reviewed at a level that is believed to provide the most appropriate data for reserve analysis. For example, primary claims made business is generally segregated from business written on an occurrence policy form. Additionally, certain subclasses, such as construction, are generally reviewed separately from business in other subclasses. Due to the fairly long-tail nature of general liability business, and the many subclasses that are reviewed individually, there is less credibility in the reported losses and increased reliance on expected loss ratio methods. AIG’s actuaries generally do not
Professional Liability: AIG generally uses a combination of loss development methods and expected loss ratio methods for professional liability classes of business. Loss development methods are used for the more mature accident years. Greater weight is given to expected loss ratio methods in the more recent accident years. Reserves are tested separately for claims made classes and classes written on occurrence policy forms. Further segmentations are made in a manner believed to provide the most appropriate balance between credibility and homogeneity of the data. Frequency/severity methods are used in pricing and profitability analyses for some classes of professional liability; however, for loss reserve testing, the need to enhance credibility generally results in classes that are not sufficiently homogenous to utilize frequency/severity methods.
Mortgage Guaranty: AIG tests mortgage guaranty reserves using loss development methods, supplemented by an internal claim analysis by actuaries and staff who specialize in the mortgage guaranty business. The claim analysis projects ultimate losses for claims within each of several categories of default based on actual historical experience and is essentially a frequency/severity analysis for each category of default.
As described above, AIG uses numerous assumptions in determining its best estimate of reserves for each class of business. The importance of any specific assumption can vary by both class of business and accident year. If actual experience differs from key assumptions used in establishing reserves, there is potential for significant variation in the development of loss reserves, particularly for long-tail casualty classes of business such as excess casualty, D&O or workers compensation. Set forth below is a sensitivity analysis that estimates the effect on the loss reserve position of using alternative loss trend or loss development factor assumptions rather than those actually used in determining AIG’s best estimates in the year-end loss reserve analyses for 2006. The analysis addresses each major class of business for which a material deviation to AIG’s overall reserve position is believed reasonably possible, and uses what AIG believes is a reasonably likely range of potential deviation for each class. There can be no assurance, however, that actual reserve development will be consistent with either the original or the adjusted loss trend or loss development factor assumptions, or that other assumptions made in the reserving process will not materially affect reserve development for a particular class of business.
D&O and Related Management Liability Classes of Business: For D&O and related management liability classes of business, the assumed loss cost trend was approximately four percent. After evaluating the historical loss cost trends from prior accident years since the early 1990s, in AIG’s judgment, it is reasonably likely that actual loss cost trends applicable to the year-end 2006 loss reserve review for these classes will range from negative 11 percent to positive 19 percent, or approximately 15 percent lower or higher than the assumption actually utilized in the year-end 2006 reserve review. A 15 percent change in the assumed loss cost trend for these classes would cause approximately a $625 million increase or a $550 million decrease in the net loss and loss expense reserves for these classes of business. It should be emphasized that the 15 percent deviations are not considered the highest possible deviations that might be expected, but rather what is considered by AIG to reflect a reasonably likely range of potential deviation. Actual loss cost trends for these classes in the early 1990s were negative for several years, including amounts below the negative 11 percent cited above, whereas actual loss cost trends in the late 1990s ran at nearly 50 percent per year for several years, vastly exceeding the 19 percent figure cited above. Because the D&O class of business has exhibited highly volatile loss trends from one accident year to the next, there is the possibility of an exceptionally high deviation.
For excess workers compensation business, the assumed loss development factors are a critical assumption. Excess workers compensation is an extremely long-tail class of business, with a much greater than normal uncertainty as to the appropriate loss development factors for the tail of the loss development. After evaluating the historical loss development factors for prior accident years since the 1980s, in AIG’s judgment, it is reasonably likely that actual loss development factors will range approximately 15 percent lower or higher than those factors actually utilized in the year-end 2006 loss reserve review for excess workers compensation. If the loss development factor assumptions were changed by 15 percent, the net loss reserves for excess workers compensation would increase or decrease by approximately $600 million. Given the exceptionally long-tail for this class of business, there is the potential for actual deviations in the loss development tail to exceed the deviations assumed, perhaps materially.
Primary Workers Compensation: For primary workers compensation, the loss cost trend assumption is not believed to be material with respect to AIG’s loss reserves. This is primarily because AIG’s actuaries are generally able to use loss development projections for all but the most recent accident year’s reserves, so there is limited need to rely on loss cost trend assumptions for primary workers compensation business.
However, for primary workers compensation business the loss development factor assumptions are important. Generally, AIG’s actual historical workers compensation loss development factors would be expected to provide a reasonably accurate predictor of future loss development. However, workers compensation is a long-tail class of business, and AIG’s business reflects a very significant volume of losses particularly in recent accident years due to growth of the business. After evaluating the actual historical loss developments since the 1980s for this business, in AIG’s judgment, it is reasonably likely that actual loss development factors will fall within the range of approximately 2.75 percent below to 7.5 percent above those actually utilized in the year-end 2006 loss reserve review. If the loss development factor assumptions were changed by 2.75 percent and 7.5 percent, respectively, the net loss reserves for workers compensation would decrease or increase by approximately $525 million and $1.5 billion, respectively. It should be noted that loss emergence in 2006 for this class was higher than historical averages, resulting in an increase in loss reserves for prior accident years. However, it is too soon to ascertain if this increased emergence represents a new trend in the pattern of loss development. For this class of business, there can be no assurance that actual deviations from the expected loss development factors will not exceed the deviations assumed, perhaps materially.
Due to this uncertainty, it is not possible to determine the future development of asbestos and environmental claims with the same degree of reliability as with other types of claims. Such future development will be affected by the extent to which courts continue to expand the intent of the policies and the scope of the coverage, as they have in the past, as well as by the changes in Superfund and waste dump site coverage and liability issues. If the asbestos and environmental reserves develop deficiently, such deficiency would have an adverse effect on AIG’s future results of operations.
holder-specific and claim-specific information that has been gathered over many years from a variety of sources. Ground-up studies can thus more accurately assess the exposure to AIG’s layers of coverage for each policyholder, and hence for all policyholders in the aggregate, provided a sufficient sample of the policyholders can be modeled in this manner.
In order to ensure its ground-up analyses were comprehensive, AIG staff produced in the 2006 analyses the information required at policy and claim level detail for over 1,000 asbestos defendants and nearly 1,000 environmental defendants. This represented over 95 percent of all accounts for which AIG had received any claim notice of any amount pertaining to asbestos or environmental exposure. AIG did not set any minimum thresholds, such as amount of case reserve outstanding, or paid losses to date, that would have served to reduce the sample size and hence the comprehensiveness of the ground-up analysis. The results of the ground-up analysis for each significant account were examined by AIG’s claims staff for reasonableness, for consistency with policy coverage terms, and any claim settlement terms applicable. Adjustments were incorporated accordingly. The results from the universe of modeled accounts, which as noted above reflects the vast majority of AIG’s known exposures, were then utilized to estimate the ultimate losses from accounts or exposures that could not be modeled and to determine the appropriate provision for all unreported claims.
AIG conducted a comprehensive analysis of reinsurance recoverability to establish the appropriate asbestos and environmental reserve net of reinsurance. AIG determined the amount of reinsurance that would be ceded to insolvent reinsurers or to commuted reinsurance contracts for both reported claims and for IBNR. These amounts were then deducted from the indicated amount of reinsurance recoverable. The year-end 2006 analysis reflected an update to the comprehensive analysis of reinsurance recoverability that was first completed in 2005. All asbestos accounts for which there was a significant change in estimated losses in the 2006 review were analyzed to determine the appropriate reserve net of reinsurance.
For asbestos, these tests project the expected losses to be reported over the next twenty years, i.e., from 2007 through 2026, based on the actual losses reported through 2006 and the expected future loss emergence for these claims. Three scenarios were tested, with a series of assumptions ranging from more optimistic to more conservative. In the first scenario, all carried asbestos case reserves are assumed to be within ten percent of their ultimate settlement value. The second scenario relies on an actuarial projection of report year development for asbestos claims reported from 1993 to the present to estimate case reserve adequacy as of year-end 2006. The third scenario relies on an actuarial projection of report year claims for asbestos but reflects claims reported from 1989 to the present to estimate case reserve adequacy as of year-end 2006. Based on the results of the prior report years for each of the three scenarios described above, the report year approach then projects forward to the year 2026 the expected future report year losses, based on AIG’s estimate of reasonable loss trend assumptions. These calculations are performed on losses gross of reinsurance. The IBNR (including a provision for development of reported claims) on a net basis is based on applying a factor reflecting the expected ratio of net losses to gross losses for future loss emergence.
The number of insureds seeking bankruptcy protection and the effect of prepackaged bankruptcies;
A summary of reserve activity, including estimates for applicable IBNR, relating to asbestos and environmental claims separately and combined at December 31, 2006, 2005 and 2004 appears in the table below. The vast majority of such claims arise from policies written in 1984 and prior years. The current environmental policies that AIG underwrites on a claims-made basis have been excluded from the table below.
As indicated in the table above, asbestos loss payments increased significantly in 2006 compared to the prior years, primarily as a result of payments pertaining to settlements that had been negotiated in earlier periods.
The gross and net IBNR included in the reserve for losses and loss expenses, relating to asbestos and environmental claims separately and combined, at December 31, 2006, 2005 and 2004 were estimated as follows:
The opened claims count increased substantially during 2005 compared to 2004 because a court ruling led AIG to report separate opened claims for previously pending cases relating to alleged MTBE exposures that AIG previously had counted in the aggregate as only a single claim on the assumption that the cases would be consolidated into a single federal court proceeding.
The following table presents AIG’s survival ratios for asbestos and environmental claims for year-end 2006, 2005 and 2004. The survival ratio is derived by dividing the year end carried loss reserve by the average payments for the three most recent calendar years for these claims. Therefore, the survival ratio is a simplistic measure estimating the number of years it would be before the current ending loss reserves for these claims would be paid off using recent year average payments. The December 31, 2006 survival ratio is lower than the ratio at December 31, 2005 because the more recent periods included in the rolling average reflect higher claims payments. Many factors, such as aggressive settlement procedures, mix of business and level of coverage provided, have a significant effect on the amount of asbestos and environmental reserves and payments and the resultant survival ratio. Thus, caution should be exercised in attempting to determine reserve adequacy for these claims based simply on this survival ratio.
Overseas, AIG’s Life Insurance & Retirement Services operations include insurance and investment-oriented products such as whole and term life, investment linked, universal life and endowments, personal accident and health products, group products including pension, life and health, and fixed and variable annuities.
AIG’s Life Insurance & Retirement Services subsidiaries report their operations through the following major internal reporting units and business units:
Life Insurance & Retirement Services results for 2006, 2005 and 2004 were as follows:
The following table presents the Insurance In-force for Life Insurance & Retirement Services for the years ended December 31, 2006, 2005 and 2004:
Life Insurance & Retirement Service revenues increased $2.8 billion in 2006, to $50.2 billion. The increased revenues reflect growth in the underlying global Life Insurance & Retirement Services businesses. Revenues include the positive effect of out of period adjustments related to the accounting for certain interests in unit investment trusts totaling $240 million in 2006. Operating income grew by $1.1 billion from 2005, to $10.0 billion, reflecting higher revenues and out of period reductions of policy benefits expense of $163 million resulting from corrections of par policyholder dividend reserves and allocations between participating and non-participating accounts, both of which were related to remediation efforts. Net investment income increased $1.3 billion, reflecting growth in the underlying global business and the related increased level of invested assets. Realized capital gains increased $246 million in 2006 compared to 2005. In addition, operating income in 2006 includes charges of $125 million for the adverse Superior National arbitration ruling (see Note 12(c) of Notes to Consolidated Financial Statements) and $66 million related to the exiting of the domestic financial institutions credit life business.
Life Insurance & Retirement Services revenues, including realized capital losses of $158 million, grew $4.0 billion to $47.4 billion. The increase in revenues reflects growth in the underlying global Life Insurance & Retirement Services businesses. Operating income grew $979 million in 2005, reflecting growth in both domestic and overseas operations. In 2005, the Domestic Life Insurance reporting unit performed well in its life insurance and payout annuities businesses, but results were offset by restructuring efforts in both home services and group life/health. The Domestic Retirement Services reporting unit faced a challenging environment in 2005, resulting in lower deposits and increased surrender rates. The Foreign Life Insurance & Retirement Services reporting unit had improved operating income in 2005 helped by higher net investment income, lower acquisition and operating expenses in life insurance and strong growth in annuities, partially offset by lower realized capital gains and higher incurred policy benefit costs.
Foreign Life Insurance & Retirement Services results for 2006, 2005 and 2004 were as follows:
Includes the effect of out of period adjustments related to the accounting for certain interests in unit investment trusts. For 2006, the effect was an increase of $208 million and $137 million in net investment income and operating income, respectively. Operating income also includes an out of period reduction in participating policyholder dividend reserves of $163 million, primarily as a result of tax remediation adjustments.
Revenues include approximately $640 million of premiums from a single reinsurance transaction involving terminal funding business, which is offset by a similar increase of benefit reserves.
In 2005, total revenues for the Japan and Other reporting unit grew $3.1 billion to $15.3 billion, including policyholder trading gains of $1.3 billion. Operating income grew $566 million to $3.0 billion. Compared to 2004, results reported in U.S. dollars were negatively affected by foreign exchange, particularly the weakening of the Japanese Yen to the U.S. dollar. In addition, Japan and Other operating income was negatively affected by the runoff of older higher margin in-force business of AIG Star Life and AIG Edison Life. Life insurance operating income grew primarily due to lower realized capital losses and higher GAAP premiums. Personal accident operating income continued to report stable profit margins and grew $119 million to $1.05 billion. Group operating income grew to $191 million on strong growth in ALICO operations outside of Japan. Individual fixed annuities operating income grew to $390 million, primarily from strong growth of net flows that increased underlying reserves in Japan. Individual fixed annuity operating income for 2005 included a charge of $47 million related to the unwinding of certain businesses in Chile that were sold in 2006. Individual variable annuities operating income grew to $47 million on higher average reserves. Net investment income for individual variable annuities grew to $767 million in 2005 and represents policyholder trading gains (losses) that are offset by an equal amount in incurred policy losses and benefits.
Revenues for Asia grew $1.9 billion in 2006 to $17.9 billion. Operating income grew $774 million, to $3.1 billion, including realized capital gains of $301 million. Revenues and operating income in 2006 include $208 million and $137 million, respectively, from out of period adjustments related to certain investments in unit trusts. GAAP premiums grew 4 percent in 2006 compared to 2005. The GAAP premium growth rate was negatively affected by the continuing trend towards investment-oriented products in Asia as only a portion of policy charges collected from the customers are reported as GAAP premiums. AIG’s Life Insurance operations in Asia have responded to this trend by offering a wide array of investment linked products, with multiple fund choices but with minimal investment guarantees.
Operating income benefited in 2006 from an out of period reduction in participating policyholder dividend reserves of $163 million, primarily as a result of tax remediation adjustments and a correction to expense allocations between participating and non-participating accounts. Certain participating policyholder dividend reserves are determined on an after tax basis and as a result any change in the local tax provision will have a partially offsetting, but not equal, effect on participating policyholder dividend reserves. The amount of the offsetting effect depends on the level of participation required by law or regulation in that specific country or by the participation level provided for in the underlying contracts. In 2005, operating income for Asia included a charge of $137 million related to an increase in participating policyholder dividends as a result of the settlement of a tax dispute in Singapore. Life insurance revenues grew $1.4 billion to $15.4 billion in 2006, including realized capital gains of $258 million and policyholder trading gains of $552 million, helped by strong growth in investment linked products throughout Asia. Operating income grew $609 million, including adjustments in 2006 and 2005 for participating policyholder dividend reserves mentioned above. Operating income includes the Life Insurance & Retirement Services segment’s equal share of the results of AIG Credit Card Company (Taiwan), which amounted to a loss of $47 million in 2006 compared to a gain of $26 million in 2005. Personal accident revenues grew 28 percent to $1.7 billion, reflecting increased focus on risk based accident and health products. The growth in revenues resulted in operating income of $337 million for the year, an increase of 40 percent over 2005. Group products revenues increased $72 million from 2005, to $627 million, resulting in operating income growth of $47 million to $178 million.
In 2005, revenues were essentially unchanged at $16.0 billion on lower realized capital gains that declined $372 million, due to lower gains on derivatives that did not qualify for hedge accounting. Operating income declined in 2005 by $169 million due to the decrease in realized capital gains and an increase in liabilities for participating policyholder dividends of $137 million as a result of the settlement of a tax dispute in Singapore. Life insurance GAAP premiums grew $310 million to $10.8 billion. Life insurance operating income did not grow in 2005 due to the effect of the additional par policy dividend reserves previously noted and
Effective January 1, 2006, the broker-dealer operations of the Domestic Life Insurance companies are being reported and managed within the Asset Management segment. Included in GAAP premiums and Total Revenues were revenues of $102 million and $96 million, respectively, for 2005 and 2004.
Domestic Life Insurance operating income of $917 million declined by 39 percent in 2006 compared to 2005 due to several significant transactions, including a $125 million charge resulting from the loss of the Superior National arbitration. For a further discussion of the Superior National arbitration see Note 12(c) of Notes to Consolidated Financial Statements. In addition, Domestic Life operating income was negatively affected by a $55 million accrual related to other litigation and a $66 million loss related to exiting the financial institutions credit business.
The Domestic Life Insurance operations in 2005 had continued growth in term and universal life sales with good performance from the independent distribution channels. GAAP premiums for life insurance grew 12 percent in 2005 reflecting consistently strong sales from the independent distribution platform. Payout annuities declined slightly due to the low interest rate environment and the competitive market conditions for structured settlement and single premiums individual annuity business. Home service GAAP premiums were essentially flat in this slow growth business. The group life/health GAAP premiums declined by $116 million, or 10 percent, primarily due to the non-renewal of several accounts where pricing was unacceptable and loss experience was higher than anticipated.
Domestic Life Insurance operating income of $1.5 billion increased 46 percent in 2005 resulting from increased realized capital gains, higher partnership income and growth in the underlying business compared to 2004. Life insurance operating income was up 43 percent in 2005 compared to 2004 due in part to growth in the underlying business, improved mortality results and higher realized capital gains, offset by higher losses from partnership investments in synthetic fuel production facilities. Home service operating income declined as a result of a reduction in premiums in-force and higher insurance and acquisitions expenses, combined with an increase in losses related to hurricanes. Group life/health operating income was affected by the non-renewal of cases where acceptable margins could not be achieved. Operating income in 2004 includes a $178 million charge related to a workers compensation quota share reinsurance agreement with Superior National. In addition, in 2004, as part of the business review of group life/health, approximately $68 million was incurred for reserve strengthening and allowances for receivables. Payout annuities operating income increased 3 percent as growth in the business base was offset by higher realized capital losses. Individual annuities runoff operating income increased in 2005 primarily as a result of lower operating expenses offset by higher realized capital losses when compared to 2004.
Domestic Retirement Services results, presented on a sub-product basis for 2006, 2005 and 2004 were as follows:
A further increase in the level of surrenders in any of these businesses or in the individual fixed annuities runoff block could accelerate the amortization of DAC and negatively affect fee income earned on assets under management.
The following table presents the net flows by line of business for 2006, 2005 and 2004:
The combination of lower deposits and higher surrenders in the individual fixed annuity and individual fixed annuity-runoff blocks, which include closed blocks of business from acquired companies or terminated distribution relationships, resulted in negative net flows for 2006. The continuation of the current interest rate and competitive environment could prolong this trend.
The following table summarizes the components of net investment income for 2006, 2005 and 2004:
Other net investment income includes real estate income, income on non-partnership invested assets, securities lending and Life Insurance & Retirement Services’ equal share of the results of AIG Credit Card Company (Taiwan).
Includes the effect of out of period adjustments relating to the accounting for certain interests in unit investment trusts. For 2006, the effect was an increase of $240 million.
AIG generates income tax credits as a result of investing in synthetic fuel production (synfuels) related to the investment loss shown in the above table and records those benefits in its provision for income taxes. The amounts of those income tax credits were $127 million, $203 million and $160 million for 2006, 2005 and 2004, respectively. For a further discussion of the effect of fluctuating domestic crude oil prices on synfuel tax credits, see Note 12(c) of Notes to Consolidated Financial Statements.
The following table summarizes realized capital gains (losses) by major category for 2006, 2005 and 2004:
DAC for Life Insurance & Retirement Services products arises from the deferral of those costs that vary with, and are directly related to, the acquisition of new or renewal business. Policy acquisition costs for life insurance products are generally deferred and amortized over the premium paying period of the policy. Policy acquisition costs that relate to universal life and investment-type products, including variable and fixed annuities (investment-oriented products), are deferred and amortized, with interest, as appropriate, in relation to the historical and future incidence of estimated gross profits to be realized over the estimated lives of the contracts. Total acquisition costs deferred increased $310 million over 2005 and were generally in line with growth in new business. Total DAC amortization expense, excluding VOBA, grew $432 million over 2005 with each year’s amortization expense level at approximately 14 percent of the opening DAC balance. Amortization expense includes the effects of current period realized capital gains and losses for investment type products. With respect to investment-oriented products, AIG’s policy is to adjust amortization assumptions for DAC when estimates of current or future gross profits to be realized from these contracts are revised. With respect to variable annuities sold domestically (representing the vast majority of AIG’s variable annuity business), the assumption for the long-term annual net growth rate of the equity markets used in the determination of DAC amortization is approximately ten percent. A methodology referred to as “reversion to the mean” is used to maintain this long-term net growth rate assumption, while giving consideration to short-term variations in equity markets. Estimated gross profits include investment income and gains and losses less interest required on policyholder reserves, as well as other charges in the contract less actual mortality and expenses. Current experience and changes in the expected future gross profits are analyzed to determine the effect on the amortization of DAC. The projection of estimated gross profits requires significant management judgment. The assumptions with respect to the current and projected gross profits are reviewed and analyzed quarterly and are adjusted accordingly.
In 2006, all other amortization for Domestic Life Insurance & Retirement Services includes $136 million of negative amortization related to changes in estimates from conversion of actuarial systems, which is substantially offset by related adjustments in incurred policy losses and benefits in the consolidated statement of income.
AIG’s variable annuity earnings will be affected by changes in market returns because separate account revenues, primarily composed of mortality and expense charges and asset management fees, are a function of asset values.
DAC for both insurance-oriented and investment-oriented products as well as retirement services products is reviewed for recoverability, which involves estimating the future profitability of current business. This review also involves significant management judgment. If the actual emergence of future profitability were to be substantially lower than estimated, AIG’s results of operations could be significantly affected in future periods.
Financial Services results for 2006, 2005 and 2004 were as follows:
Includes the effect of hedging activities that did not qualify for hedge accounting treatment under FAS 133, including the related foreign exchange gains and losses. For 2006, 2005 and 2004, respectively, the effect was $(1.8) billion, $2.0 billion and $(122) million in both revenues and operating income for Capital Markets. These amounts result primarily from interest rate and foreign currency derivatives that are economically hedging available for sale securities and borrowings. For 2004, the effect was $(27) million in operating income for Aircraft Leasing. During 2006 and 2005, Aircraft Leasing derivative gains and losses were reported as part of AIG’s Other category, and were not reported in Aircraft Leasing operating income.
AIG’s Aircraft Leasing operations represent the operations of ILFC, which generates its revenues primarily from leasing new and used commercial jet aircraft to foreign and domestic airlines. Revenues also result from the remarketing of commercial jets for ILFC’s own account, and remarketing and fleet management services for airlines and financial institutions. ILFC finances its purchases of aircraft primarily through the issuance of a variety of debt instruments. The composite borrowing rates at December 31, 2006 and 2005 were 5.17 percent and 4.61 percent, respectively. The composite borrowing rates did not reflect the benefit of economically hedging ILFC’s floating rate and foreign currency denominated debt using interest rate and foreign currency derivatives. These derivatives are effective economic hedges; however, since hedge accounting under FAS 133 was not applied, the benefits of using derivatives to hedge these exposures were not reflected in ILFC’s borrowing rates.
ILFC typically contracts to re-lease aircraft before the end of the existing lease term. For aircraft returned before the end of the lease term, ILFC has generally been able to re-lease such aircraft within two to six months of its return. As a lessor, ILFC considers an aircraft “idle” or “off lease” when the aircraft is not subject to a signed lease agreement or signed letter of intent. ILFC had one aircraft off lease at December 31, 2006, and all new aircraft scheduled for delivery through 2007 have been leased.
Capital Markets represents the operations of AIGFP, which engages as principal in a wide variety of financial transactions, including standard and customized financial products involving commodities, credit, currencies, energy, equities and rates. AIGFP also invests in a diversified portfolio of securities and principal investments and engages in borrowing activities involving issuing standard and structured notes and other securities, and entering into GIAs.
Spread income on investments and borrowings is recorded on an accrual basis over the life of the transaction. Investments are classified as securities available for sale and are carried at fair value with the resulting unrealized gains or losses reflected in accumulated other comprehensive income. U.S. dollar denominated borrowings are carried at cost, while borrowings in any currency other than the U.S. dollar result in unrealized foreign
Financial market conditions in 2006 were characterized by a general flattening of interest rate yield curves across fixed income markets globally, tightening of credit spreads, higher equity valuations and a weaker U.S. dollar.
The most significant component of Capital Markets operating expenses is compensation, which was approximately $544 million, $481 million and $497 million in 2006, 2005 and 2004, respectively. The amount of compensation was not affected by gains and losses arising from derivatives not qualifying for hedge accounting treatment under FAS 133.
AIG’s consumer finance operations in North America are principally conducted through AGF. Effective January 2, 2007, AGF expanded its operations into the United Kingdom through the acquisition of Ocean Finance and Mortgages Limited, a finance broker for home owner loans in the United Kingdom. AGF derives a substantial portion of its revenues from finance charges assessed on outstanding real estate loans, secured and unsecured non-real estate loans and retail sales finance receivables. The real estate loans are comprised principally of first lien and some second lien mortgages on residential real estate generally having a maximum term of 360 months, and are considered non-conforming. The real estate loans may be closed-end accounts or open-end home equity lines of credit and may be fixed rate or adjustable rate products. AGF does not offer mortgage products
Domestically, the U.S. housing market deteriorated throughout 2006 and ended the year fairly weak compared to recent years. As a result, the real estate loan portfolio decreased slightly during 2006 due to lower refinancing activity. This lower refinancing activity also caused a significant decrease in originations and whole loan sales in AGF’s mortgage banking operation, which resulted in a substantial reduction of revenue and operating income compared to the prior year. However, softening home prices (reducing the equity customers are able to extract from their homes when refinancing) and higher mortgage rates contributed to customers utilizing non-real estate loans, which increased 10 percent compared to 2005. Retail sales finance receivables also increased 23 percent due to increased marketing efforts and customer demand. Higher revenue resulting from portfolio growth was more than offset by higher interest expense. AGF’s short-term borrowing rates were 5.14 percent in 2006 compared to 3.58 percent in 2005. AGF’s long-term borrowing rates were 5.05 percent in 2006 compared to 4.41 percent in 2005. AGF’s net charge-off ratio improved to 0.95 percent in 2006 from 1.19 percent in 2005. The improvement in the net charge-off ratio in 2006 was primarily due to positive economic fundamentals. The U.S. economy continued to expand during the year, and the unemployment rate remained low, which improved the credit quality of AGF’s portfolio. AGF’s delinquency ratio remained relatively low, although it increased to 2.06 percent at December 31, 2006 from 1.93 percent at December 31, 2005. AGF reduced the hurricane Katrina portion of its allowance for finance receivable losses to $15 million at December 31, 2006 after the reevaluation of its remaining estimated losses. AGF’s allowance ratio was 2.01 percent at December 31, 2006 compared to 2.20 percent at December 31, 2005.
Revenues from the foreign consumer finance operations increased by approximately 19 percent in 2006 compared to 2005. Loan growth, particularly in Poland and Argentina, was the primary driver behind the higher revenues. Higher revenues were more than offset, however, by AIGCFG’s $47 million share of the allowance for losses related to industry-wide credit deterioration in the Taiwan credit card market, increased cost of funds, and higher operating expenses in connection with expansion into new markets and distribution channels and new product promotions, resulting in lower operating income for 2006 compared to 2005.
Revenues and operating income from the Consumer Finance operations improved in 2005, both domestically and internationally.
Foreign consumer finance operations performed well, as the operations in Poland and Argentina recorded improved growth in operating income. The Hong Kong businesses experienced improved loan and earnings growth in a strengthening economy.
AIG’s Asset Management operations comprise a wide variety of investment-related services and investment products. Such services and products are offered to individuals and institutions both domestically and overseas, and are primarily comprised of Spread-Based Investment Businesses, Institutional Asset Management and Brokerage Services and Mutual Funds.
In prior years, the sale of GICs to investors, both domestically and overseas, was AIG’s primary institutional Spread-Based Investment Business. During 2005, AIG launched its MIP and its asset management subsidiaries, primarily SunAmerica Life, ceased writing new GIC business. The GIC business will continue to run off for the foreseeable future while the MIP business is expected to grow.
AIG’s Institutional Asset Management business provides an array of investment products and services globally to institutional investors, AIG subsidiaries and affiliates and high net worth investors. These products and services include traditional equity and fixed income investment management and a full range of alternative asset classes. Delivery of AIG’s Institutional Asset Management products and services is accomplished via a global network of operating subsidiaries comprising AIGGIG. The primary operating entities within this group are AIG Global Investment Corp., AIG Global Real Estate Investment Corp. and AIG Private Bank. AIG Private Bank offers banking, trading and investment management services to private client and high net worth individuals and institutions globally.
AIG’s Brokerage Services and Mutual Funds business provides mutual fund and broker-dealer related services to retail investors, group trusts and corporate accounts through an independent network of financial advisors. The AIG Advisor Group, Inc., a subsidiary of AIG Retirement Services, Inc., is comprised of several broker-dealer entities that provide these services to clients primarily in the U.S. marketplace. SAAMCo manages, advises and/or administers retail mutual funds, as well as the underlying assets of variable annuities sold by AIG SunAmerica and VALIC to individuals and groups throughout the United States.
Included in the Other category for Asset Management is income or loss from partnerships. Partnership assets consist of investments in a diversified portfolio of private equity funds, affordable housing partnerships and hedge fund investments.
Includes the full results of certain AIG managed private equity and real estate funds that are consolidated pursuant to FIN 46(R), “Consolidation of Variable Interest Entities”. Also includes $346 million, $261 million and $195 million for 2006, 2005 and 2004, respectively, of third-party limited partner earnings offset in minority interest expense on the consolidated statement of income which is not a component of operating income.
Includes the full results of certain AIG managed partnerships that are consolidated effective January 1, 2006 pursuant to EITF 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights”. For 2006, operating income includes $252 million of third-party limited partner earnings offset in minority interest expense which is not a component of operating income.
During 2005, the MIP replaced the GIC program as AIG’s principal spread-based investment activity. While the MIP showed strong growth in operating income, AIG does not expect that the income growth in the MIP will offset the runoff in the GIC portfolio for the foreseeable future, because the asset mix under the MIP does not include the alternative investments utilized in the GIC program.
The MIP was initially launched in the Euromarkets in September 2005 through AIG’s $10 billion Euro medium term note program. Through December 31, 2006, AIG has issued the equivalent of $5.3 billion for the MIP in the Euromarkets and the U.S. public and private markets.
Operating income related to Institutional Asset Management increased 50 percent in 2006 to $1.0 billion compared to 2005, primarily due to an increase of $337 million in gains on certain VIEs and partnerships. These gains are offset in minority interest expense, which is not a component of operating income. AIG’s unaffiliated client assets under management, including both retail mutual funds and institutional accounts, increased 21 percent from year-end 2005 to $75 billion, resulting in higher management fee income. Increased realized capital gains on real estate investments from 2005 also contributed to the increase in operating income. The growth in Institutional Asset Management revenues and operating income were driven by contributions from all asset classes globally. Partially offsetting this growth were lower performance-based fees on private equity investments, and higher expenses related to the planned expansion of marketing and distribution capabilities, combined with technology and operational infrastructure-related enhancements.
Includes borrowings under Export Credit Facility of $2.7 billion and $2.6 billion, at December 31, 2006 and 2005, respectively.
AIG also maintains a Euro medium term note program under which an aggregate nominal amount of up to $10.0 billion of notes may be outstanding at any one time. The program provides that additional notes may be issued to replace matured or redeemed notes. As of December 31, 2006, the equivalent of $5.7 billion of notes were outstanding under the program, of which $3.7 billion were used to fund the MIP and the remainder was used for AIG’s general corporate purposes. The aggregate amount outstanding includes $249 million resulting from foreign exchange translation into U.S. dollars, of which $151 million relates to notes issued by AIG for general corporate purposes and $98 million relates to notes issued to fund the MIP. AIG has hedged the currency exposure arising from foreign currency denominated notes by effectively economically hedging that exposure, although such hedges did not qualify for hedge accounting treatment under FAS 133. In 2007, through February 15, AIG issued the equivalent of $194 million under the Euro program to fund the MIP.
In 2006, AIG issued in Rule 144A/Regulation S offerings $3 billion principal amount of senior notes, of which $1.0 billion was exchanged by AIG for substantially identical notes that are registered under the Securities Act. The proceeds from the sale of $2.25 billion of these notes were used for AIG’s general corporate purposes and $750 million was used to fund the MIP. In 2007, through February 15, AIG issued in Rule 144A offerings an aggregate of $750 million principal amount of senior notes, of which $500 million was used to fund the MIP and $250 million was used for AIG’s general corporate purposes.
In November 2006, AIG filed a shelf registration statement in Japan, providing for the issuance of up to Japanese Yen 300 billion principal amount of senior notes. In December 2006, AIG issued the equivalent of $429 million under the Japanese shelf registration statement, the proceeds of which were used for AIG’s general corporate purposes.
In March 2006, AIG borrowed a total of $1.3 billion on an unsecured basis pursuant to loan agreements with third-party banks, of which $700 million remained outstanding on Decem-
ber 31, 2006; $500 million was repaid in February 2007, and the balance matures in March 2007.
In June 2006, AIGFP sold an aggregate of $2.0 billion principal amount of senior, floating rate notes in Rule 144A offerings, of which $1.0 billion matures in 2007 and $1.0 billion matures in 2008. AIGFP also has a Euro medium term note program under which an aggregate nominal amount of up to $10.0 billion of notes may be outstanding at any one time. The program provides that additional notes may be issued to replace matured or redeemed notes. As of December 31, 2006, $5.66 billion of notes were outstanding under the program, including $575 million resulting from foreign exchange translation into U.S. dollars. AIGFP’s Rule 144A Notes and the notes issued under this program are guaranteed by AIG and are included in AIGFP’s Notes and Bonds Payable in the preceding table of borrowings.
AIG Funding, Inc. (AIG Funding), issues commercial paper that is guaranteed by AIG in order to help fulfill the short-term cash requirements of AIG and its subsidiaries. The issuance of AIG Funding’s commercial paper, including the guarantee by AIG, is subject to the approval of AIG’s Board of Directors or the Finance Committee of the Board if it exceeds certain pre-approved limits.
In May 2004, ILFC entered into a similarly structured Export Credit Facility for up to a maximum of $2.64 billion for Airbus aircraft to be delivered through May 31, 2005. The facility was subsequently increased to $3.64 billion and extended to include aircraft to be delivered through May 31, 2007. The facility becomes available as the various European Export Credit Agencies provide their guarantees for aircraft based on a six-month forward-looking calendar, and the interest rate is determined through a bid process. At December 31, 2006, ILFC had $1.7 billion outstanding under this facility. Borrowings with respect to these facilities are included in ILFC’s Notes and bonds payable in the preceding table of borrowings.
From time to time, ILFC enters into funded financing agreements. As of December 31, 2006, ILFC had a total of $1.2 billion outstanding, which has varying maturities through February 2012. The interest rates are LIBOR-based, with spreads ranging from 0.30 percent to 1.625 percent.
In December of 2005, ILFC issued two tranches of junior subordinated debt totaling $1.0 billion to underlie trust preferred securities issued by a trust sponsored by ILFC. Both tranches mature on December 21, 2065, but each tranche has a different call option. The $600 million tranche has a call date of December 21, 2010 and the $400 million tranche has a call date of December 21, 2015. The tranche with the 2010 call date has a fixed interest rate of 5.90 percent for the first five years. The tranche with the 2015 call date has a fixed interest rate of 6.25 percent for the first ten years.
Both tranches have interest rate adjustments if the call option is not exercised. If the call option is not exercised, the new interest rate will be a floating quarterly reset rate based on the initial credit spread plus the highest of (i) 3-month LIBOR, (ii) 10-year constant maturity treasury and (iii) 30-year constant maturity treasury.
AGF issued $3.62 billion during 2006 and $5.51 billion during 2005 of notes and bonds ranging in maturities from two to 25 years. As of December 31, 2006, notes and bonds aggregating $19.59 billion were outstanding with maturity dates ranging from 2007 to 2031 at interest rates ranging from 1.94 percent to 8.45 percent. To the extent deemed appropriate, AGF may enter into swap transactions to manage its effective borrowing with respect to these notes and bonds. As a well-known seasoned issuer, AGF has filed an automatic shelf registration statement with the SEC allowing AGF immediate access to the U.S. public debt markets. At December 31, 2006, AGF had the corporate authority to issue up to $13.4 billion of debt securities under its shelf registration statements.
In January 2007, AGF issued junior subordinated debentures in an aggregate principal amount of $350 million that mature in January 2067. The debentures underlie a series of trust preferred securities sold by a trust sponsored by AGF in a Rule 144A/Regulation S offering. AGF can redeem the debentures at par beginning in January 2017 and until that time will pay a fixed rate of interest. If AGF does not redeem the debentures in January 2017, the interest rate changes to a floating rate, which will reset based on 3-month LIBOR.
AIGCFG has a variety of funding mechanisms for its various markets, including: retail and wholesale deposits; short-term and long-term bank loans and intercompany subordinated debt. AIG Credit Card Company (Taiwan), a consumer finance business in Taiwan, has issued commercial paper for the funding of its own operations. AIG does not guarantee any borrowings for AIGCFG businesses, including this commercial paper.
American General Finance, Inc. is an eligible borrower for up to $400 million only.
Standard & Poor’s, a division of the McGraw-Hill Companies (S&P). S&P ratings may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories.
Fitch Ratings (Fitch). Fitch ratings may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories.
Negative rating outlook. A negative outlook by S&P indicates that a rating may be lowered, but is not necessarily a precursor of a ratings change. The outlook on all other credit ratings in the table is stable.
These credit ratings are current opinions of the rating agencies. As such, 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 AIG management’s request. This discussion of ratings is not a complete list of ratings of AIG and its subsidiaries. See Item 1A. Risk Factors for more information regarding the credit ratings of AIG and its subsidiaries and certain risks related thereto.
It is estimated that, as of the close of business on February 15, 2007, based on AIGFP’s outstanding municipal GIAs and financial derivatives transactions as of such date, a downgrade of AIG’s long-term senior debt ratings to ‘Aa3’ by Moody’s or ‘AA-’ by S&P would permit counterparties to call for approximately $864 million of collateral. Further, additional downgrades could result in requirements for substantial additional collateral, which could have a material effect on how AIGFP manages its liquidity. The actual amount of additional collateral that AIGFP would be required to post to counterparties in the event of such downgrades depends on market conditions, the fair value of the outstanding affected transactions and other factors prevailing at the time of the downgrade. Additional obligations to post collateral would increase the demand on AIGFP’s liquidity.
Represents future loss and loss adjustment expense payments estimated based on historical loss development payment patterns.
Insurance and investment contract liabilities include various investment-type products with contractually scheduled maturities, including periodic payments of a term certain nature. Insurance and investment contract liabilities also include benefit and claim liabilities, of which a significant portion represents policies and contracts that do not have stated contractual maturity dates and may not result in any future payment obligations. For these policies and contracts (i) AIG is currently not making payments until the occurrence of an insurable event, such as death or disability, (ii) payments are conditional on survivorship, or (iii) the occurrence of a payment due to a surrender or other non-scheduled event out of AIG’s control. AIG has made significant assumptions to determine the estimated undiscounted cash flows of these contractual policy benefits which include mortality, morbidity, future lapse rates, expenses, investment returns and interest crediting rates, offset by expected future deposits and premium on in-force policies. Due to the significance of the assumptions used, the amounts presented could be materially different from actual required payments. The amounts presented in this table are undiscounted and therefore exceed the future policy benefits and policyholder contract deposits included in the balance sheet.
The maturity schedule of other commercial commitments of AIG and its consolidated subsidiaries at December 31, 2006 was as follows:
Represents reimbursement obligations under letters of credit issued by commercial banks.
Excludes commitments with respect to pension plans. The annual pension contribution for 2007 is expected to be approximately $95 million for U.S. and non-U.S. plans. See also Note 15 of Notes to Consolidated Financial Statements.
AIG has guidelines with respect to the formation of and investment in SPVs and off balance sheet arrangements. In addition, AIG has expanded the responsibility of its Complex Structured Financial Transaction Committee (CSFT) to include the review of any transaction that could subject AIG to heightened legal, reputational, regulatory, accounting or other risk. See Item 9A. Controls and Procedures - Management’s Report on Internal Control Over Financial Reporting for a further discussion of the CSFT.
AIG has in the past reinvested most of its unrestricted earnings in its operations and believes such continued reinvestment in the future will be adequate to meet any foreseeable capital needs. However, AIG may choose from time to time to raise additional funds through the issuance of additional securities.
Payments of dividends to AIG by its insurance subsidiaries are subject to certain restrictions imposed by regulatory authorities. With respect to AIG’s domestic insurance subsidiaries, the payment of any dividend requires formal notice to the insurance department in which the particular insurance subsidiary is domiciled. Under the laws of many states, an insurer may pay a dividend without prior approval of the insurance regulator when the amount of the dividend is below certain regulatory thresholds. Other foreign jurisdictions may restrict the ability of AIG’s foreign insurance subsidiaries to pay dividends. The most significant foreign insurance regulatory jurisdictions include Bermuda, Japan, Hong Kong, Taiwan, the United Kingdom, Thailand and Singapore. Largely as a result of the restrictions, approximately 90 percent of consolidated shareholders’ equity was restricted from immediate transfer to AIG parent at December 31, 2006. See Regulation and Supervision herein. AIG cannot predict how recent regulatory investigations may affect the ability of its regulated subsidiaries to pay dividends. To AIG’s knowledge, no AIG company is currently on any regulatory or similar “watch list” with regard to solvency. See also Liquidity herein, Note 12 of Notes to Consolidated Financial Statements and Item 1A. Risk Factors - Liquidity.
In preparing both its 2004 and 2005 audited statutory financial statements for its Domestic General Insurance companies, AIG agreed with the relevant state regulatory authorities on the statutory accounting treatment of the various items requiring adjustment or restatement. With respect to the 2004 audited statutory financial statements, these adjustments and restatements reduced previously reported General Insurance statutory surplus at December 31, 2004 by approximately $3.5 billion, to approximately $20.6 billion. With respect to the 2005 audited statutory financial statements, the state regulators permitted the Domestic General Insurance companies to record a $724 million reduction to opening statutory surplus as of January 1, 2005.
AIG’s insurance subsidiaries file financial statements prepared in accordance with statutory accounting practices prescribed or
permitted by domestic and foreign insurance regulatory authorities. The principal differences between statutory financial statements and financial statements prepared in accordance with U.S. GAAP for domestic companies are that statutory financial statements do not reflect DAC, some bond portfolios may be carried at amortized cost, assets and liabilities are presented net of reinsurance, policyholder liabilities are valued using more conservative assumptions and certain assets are non-admitted.
Statutory capital of each company continued to exceed minimum company action level requirements following the adjustments, but AIG nonetheless contributed an additional $750 million of capital into American Home effective September 30, 2005 and contributed a further $2.25 billion of capital in February 2006 for a total of approximately $3 billion of capital into Domestic General Insurance subsidiaries effective December 31, 2005. To enhance their current capital positions, AIG suspended dividends from the DBG companies from the fourth quarter 2005 through 2006, but AIG expects dividend payments will resume in the first quarter of 2007. AIG believes it has the capital resources and liquidity to fund any necessary statutory capital contributions.
As discussed above, various regulators have commenced investigations into certain insurance business practices. In addition, the OTS and other regulators routinely conduct examinations of AIG and its subsidiaries, including AIG’s consumer finance operations. AIG cannot predict the ultimate effect that these investigations and examinations, or any additional regulation arising therefrom, might have on its business. Federal, state or local legislation may affect AIG’s ability to operate and expand its various financial services businesses, and changes in the current laws, regulations or interpretations thereof may have a material adverse effect on these businesses.
AIG’s U.S. operations are negatively affected under guarantee fund assessment laws which exist in most states. As a result of operating in a state which has guarantee fund assessment laws, a solvent insurance company may be assessed for certain obligations arising from the insolvencies of other insurance companies which operated in that state. AIG generally records these assessments upon notice. Additionally, certain states permit at least a portion of the assessed amount to be used as a credit against a company’s future premium tax liabilities. Therefore, the ultimate net assessment cannot reasonably be estimated. The guarantee fund assessments net of credits for 2006, 2005 and 2004, respectively, were $97 million, $124 million and $118 million.
AIG manages liquidity at both the subsidiary and parent company levels. At December 31, 2006, AIG’s consolidated invested assets, primarily held by its subsidiaries, included $26.8 billion in cash and short-term investments. Consolidated net cash provided from operating activities in 2006 amounted to $6.8 billion. At the parent company level, liquidity management activities are conducted in a manner to preserve and enhance funding stability, flexibility, and diversity through the full range of potential operating environments and market conditions. AIG’s primary sources of cash flow are dividends and other payments from its regulated and unregulated subsidiaries, as well as issuances of debt securities. Primary uses of cash flow are for debt service, subsidiary funding and shareholder dividend payments. Management believes that AIG’s liquid assets, cash provided by operations and access to the capital markets will enable it to meet its anticipated cash requirements, including the funding of increased
The liquidity of the combined insurance operations is derived both domestically and abroad. The combined insurance operating cash flow is derived from two sources, underwriting operations and investment operations. Cash flow from underwriting operations includes periodic premium collections, including policyholders’ contract deposits, and paid loss recoveries, less reinsurance premiums, losses, benefits, and acquisition and operating expenses. Generally, there is a time lag from when premiums are collected and, when as a result of the occurrence of events specified in the policy, the losses and benefits are paid. Investment cash flow is primarily derived from interest and dividends received and includes realized capital gains net of realized capital losses.
Asset Management operating cash flow is derived primarily from investment income in connection with domestic and foreign GICs and from the collection of various forms of investment management fees, brokerage commissions and custody fees earned from affiliated and unaffiliated clients. Investment management fees are typically asset-based fees collected on a periodic basis, while brokerage commissions and custody fees are more transaction driven and received on a continual basis. Asset Management also derives cash from the realization of gains earned through its investment partnership holdings and collects various forms of incentive management fees. These incentive management fees, which are typically based on the appreciation and/or realization of gains on managed assets, are generally received in the form of carried interest earned from sponsored funds managed on behalf of clients. Asset Management’s spread-based investment business derives cash from the investment income and the sale of invested assets backing these contract liabilities.
AIGGIG incurs expenses with associated cash outflows from the operation of its business, including costs related to portfolio management and related back and middle office costs. In addition, cash is used in association with investment warehousing activities wherein AIGGIG funds and holds an investment for the benefit of a future investment vehicle.
Cash needs for the spread-based investment business are principally the result of GIC maturities. Significant blocks of the GIC portfolio will mature over the next five years. AIG utilizes asset liability matching to control liquidity risks associated with
this business. In addition, AIG believes that its products incorporate certain restrictions which encourage persistency, limiting the magnitude of unforeseen surrenders in the GIC portfolio.
Liquidity for Asset Management operations can be affected by significant credit or geopolitical events that might cause a delay in fund closings, securitizations or an inability of AIG’s clients to fund their capital commitments. AIGGIG has relied upon AIG from time to time in order to fund certain liquidity requirements associated with investment warehousing. In addition, AIG Global Real Estate maintains several external credit lines in order to fund its ongoing property development and construction related activities.
The liquidity of the parent company is principally derived from its subsidiaries. The primary sources of cash flow are dividends and other payments from its regulated and unregulated subsidiaries, as well as issuance of debt securities. Primary uses of cash flow are for debt service, subsidiary funding, shareholder dividend payments and purchases of outstanding shares of common stock. In 2006, AIG Parent collected $2.1 billion in dividends and other payments from subsidiaries and issued $6.6 billion in debt securities excluding MIP and Series AIGFP debt. AIG Parent also made interest payments totaling $232 million, made $2.9 billion in capital contributions to subsidiaries (principally $2.3 billion to DBG), and paid $1.6 billion in dividends to shareholders in 2006. No share repurchases were made by AIG Parent in 2006.
At the parent company level, liquidity management activities are conducted in a manner intended to preserve and enhance funding stability, flexibility, and diversity through the full range of potential operating environments and market conditions. Assessing liquidity risk involves forecasting of cash inflows/outflows on both a short- and long-term basis. Corporate Treasury is responsible for formulating the parent company’s liquidity and contingency planning efforts, as well as for execution of AIG’s specific funding activities. Through active liquidity management, AIG seeks to retain stable, reliable and cost-effective funding sources. In addition to current liquidity requirements, factors which affect funding decisions include market conditions, prevailing interest rates and the desired maturity profile of liabilities. The objectives of contingency planning are to ensure maintenance of appropriate liquidity during normal and stress periods, to measure and project funding requirements during periods of stress, and to manage access to funding sources. Diversification of funding sources is an important element of AIG’s liquidity risk management approach.
AIG’s investment strategy is to invest primarily in high quality securities while maintaining diversification to avoid significant exposure to issuer, industry and/or country concentrations.
Fixed income holdings of the Domestic General Insurance companies are comprised primarily of tax-exempt securities, which provide attractive risk-adjusted after-tax returns. These high quality municipal investments have an average rating of high AA.
While reserves are invested in conventional fixed income securities in Domestic General Insurance, a modest portion of surplus is allocated to large capitalization, high-dividend, public equity strategies and to alternative investments, including private equity and hedge funds. These investments have provided a combination of added diversification and attractive long-term returns.
With respect to Life Insurance & Retirement Services, AIG’s investment strategy is to produce cash flows greater than maturing insurance liabilities. AIG actively manages the asset-liability relationship in its foreign operations, as it has been doing throughout AIG’s history, even though certain territories lack qualified long-term investments or certain local regulatory authorities may impose investment restrictions. For example, in several Southeast Asian countries, the duration of investments is shorter than the effective maturity of the related policy liabilities. Therefore, there is risk that the reinvestment of the proceeds at
In 2006, new money investment rates generally increased in the U.S., Japan and Taiwan, and were generally unchanged in Thailand. In regard to in-force business, management focus is required in both the investment and product management process to maintain an adequate yield to match the interest necessary to support future policy liabilities. Business strategies continue to evolve to maintain profitability of the overall business. In some countries, new products are being introduced with minimal investment guarantees resulting in a shift toward investment linked savings products and away from traditional savings products with higher guarantees.
The investment of insurance cash flows and reinvestment of the proceeds of matured securities and coupons requires active management of investment yields while maintaining satisfactory investment quality and liquidity.
A number of guaranteed benefits, such as living benefits or guaranteed minimum death benefits, are offered on certain variable life and variable annuity products. AIG manages its exposure resulting from these long-term guarantees through reinsurance or capital market hedging instruments.
ordered, and it must arrange financing for portions of the purchase price of such equipment. ILFC has been successful to date both in placing its new aircraft on lease or under sales contract and obtaining adequate financing, but there can be no assurance that such success will continue in future environments.
AIGFP uses the proceeds from the issuance of notes and bonds and GIAs to invest in a diversified portfolio of securities, including securities available for sale, at market, and derivative transactions. The funds may also be invested in securities purchased under agreements to resell. The proceeds from the disposal of the aforementioned securities available for sale and securities purchased under agreements to resell are used to fund the maturing GIAs or other AIGFP financings, or invest in new assets. For a further discussion of AIGFP’s borrowings, see Capital Resources - Borrowings herein.
Trading securities, at fair value, and securities and spot commodities sold but not yet purchased, at fair value, are marked to market daily with the unrealized gain or loss being recognized in income at that time. These trading securities are purchased and sold as necessary to meet the risk management objectives of Capital Markets operations.
Asset Management invested assets grew by $14.3 billion, or 20 percent during 2006, although aggregate Asset Management fixed income investments remained essentially flat at $37.7 billion. The growth in invested assets was primarily attributable to increases in short-term investments, securities lending collateral and real estate investments. These increases were primarily driven by continued growth of the MIP and AIG’s foreign spread-based business, and the growth of AIG’s institutional Asset Management business. These increases were partially offset by the decrease in assets associated with the runoff of the domestic GIC program.
Hedge funds and limited partnerships in which AIG holds in the aggregate less than a five percent interest are carried at fair value. The change in fair value is recognized as a component of Accumulated other comprehensive income, net of tax.
AIG periodically evaluates its securities for other-than-temporary impairments in valuation. As a matter of policy, the determination that a security has incurred an other-than-temporary decline in value and the amount of any loss recognition requires the judgment of AIG’s management and a continual review of its investments. See Note 1(e) of Notes to Consolidated Financial Statements for further information on AIG’s policy.
As more fully described above, upon realization, certain realized losses will be charged to participating policyholder accounts, or realization will result in a current decrease in the amortization of DAC.
At December 31, 2006, the fair value of AIG’s fixed maturities and equity securities aggregated $496.0 billion. At December 31, 2006, aggregate unrealized gains after taxes for fixed maturity and equity securities were $11.4 billion. At December 31, 2006, the aggregate unrealized losses after taxes of fixed maturity and equity securities were approximately $2.5 billion.
At December 31, 2006, unrealized losses for fixed maturity securities and equity securities did not reflect any significant industry concentrations.
The amortized cost of fixed maturities available for sale in an unrealized loss position at December 31, 2006, by contractual maturity, is shown below:
AIG senior management establishes the framework, principles and guidelines for risk management. The business executives are responsible for establishing and implementing risk management processes and responding to the individual needs and issues within their business, including risk concentrations within their business segments.
The Credit Risk Committee (CRC) is responsible for (i) approving credit risk policies and procedures for use throughout AIG; (ii) delegating credit authority to business unit credit officers and select business unit managers; (iii) approving transaction requests and limits for corporate, sovereign and cross-border credit exposures that exceed the delegated authorities; (iv) establishing and maintaining AIG’s risk rating process for corporate, financial and sovereign obligors; and (v) regular reviews of credit risk exposures in the portfolios of all credit-incurring business units.
The Financial Risk Committee (FRC) oversees AIG’s market risk exposures to interest rates, foreign exchange and equity prices and provides strategic direction for AIG’s asset-liability management. The FRC meets monthly and acts as a central mechanism for AIG senior management to review comprehensive information on AIG’s financial exposures and to exercise broad control over these exposures.
The Derivatives Review Committee (DRC) provides an independent review of any proposed derivative transaction or program not otherwise managed by AIGFP. The DRC examines, among other things, the nature and purpose of the derivative transaction, its potential credit exposure, if any, and the estimated benefits.
The Complex Structured Finance Transaction Committee (CSFTC) has the authority and responsibility to review and approve proposed transactions that could subject AIG to heightened legal, reputational, accounting, or regulatory risk (CSFTs). The CSFTC provides guidance to and monitors the activities of transaction review committees (TRCs) which have been established in all major business units. TRCs have the responsibility to identify, review and refer CSFTs to the CSFTC.
Credit risk is one of AIG’s largest single business risks and AIG devotes considerable resources, expertise and controls to managing its credit exposures. Credit risk is defined as the risk that AIG’s customers or counterparties are unable or unwilling to repay their contractual obligations when they come due. Credit risk may also be manifested: (i) through the downgrading of credit ratings of counterparties whose credit instruments AIG may be holding, or, in some cases, insuring, causing the value of the assets to decline or insured risks to rise and (ii) as cross-border risk where a country (sovereign government risk) or one or more non-sovereign obligors within a country are unable to repay an obligation or are unable to provide foreign exchange to service a credit or equity exposure incurred by another AIG business unit located outside that country.
AIG’s credit risks are managed at the corporate level by the Credit Risk Management Department (CRM) whose primary role is to support and supplement the work of the CRC. CRM is headed by AIG’s Chief Credit Officer (CCO), who reports to AIG’s CRO. AIG’s CCO is primarily responsible for the development and maintenance of credit risk policies and procedures approved by the CRC. In discharging this function CRM has the following responsibilities:
Approve delegated credit authorities to CRM credit executives and business unit credit officers.
Develop methodologies for quantification and assessment of credit risks, including the establishment and maintenance of AIG’s internal risk rating process.
Approve appropriate credit reserves and methodologies at the business unit and enterprise levels.
AIG closely monitors and controls its company-wide credit risk concentrations and attempts to avoid unwanted or excessive risk accumulations, whether funded or unfunded. To minimize the level of credit risk in certain circumstances, AIG may require collateral, guarantees and/or reinsurance support such as letters of credit.
AIG defines its aggregate credit exposures to a counterparty as the sum of its fixed maturities, loans, derivatives (mark to market), deposits (in the case of financial institutions) and the specified credit equivalent exposure to certain insurance products which embody credit risk.
The following table presents AIG’s largest credit exposures at December 31, 2006 as a percentage of total shareholders’ equity.
Six are highly-rated financial institutions and three are investment-grade rated sovereigns; none is rated lower than BBB+ or its equivalent.
Several of AIG’s Foreign Life subsidiaries operate in developing markets where maturities on longer-term life insurance liabilities exceed the maximum maturities of available local currency assets.
AIG calculated the VaR with respect to net fair values as of December 31, 2006 and 2005. The VaR number represents the maximum potential loss as of those dates that could be incurred with a 95 percent confidence (i.e., only five percent of historical scenarios show losses greater than the VaR figure) within a one-month holding period. AIG uses the historical simulation methodology that entails repricing all assets and liabilities under explicit changes in market rates within a specific historical time period. AIG uses the most recent three years of historical market information for interest rates, foreign exchange rates, and equity index prices. For each scenario, each transaction was repriced. Segment and AIG-wide scenario values are then calculated by netting the values of all the underlying assets and liabilities.
The following table presents the year-end, average, high and low VaRs on a diversified basis and of each component of market risk for each of AIG’s non-trading investments as of December 31, 2006 and 2005. The diversified VaR is usually smaller than the sum of its components due to correlation effects.
AIG’s total VaR declined from $5.2 billion at the end of 2005 to $5.1 billion at the end of 2006, even as the diversified VaR in each of the Insurance segments grew modestly. Two factors contributed to the decline in total VaR. A reduction in interest rate volatility in many currencies moderated AIG’s interest rate risk profile, and higher correlations between the long asset duration exposure in U.S. fixed income and long liability duration exposures in many emerging markets provided a greater diversification benefit during 2006. Lower VaR figures in both the Financial Services and Asset Management segments during 2006 were the result of a combination of closer duration matching and a reduction of interest rate volatility.
AIG has established a corporate-level Operational Risk Management Department (ORM) to oversee AIG’s operational risk management practices. The Director of ORM reports to the CRO. ORM is responsible for establishing the framework, principles and guidelines for operational risk management. This framework also utilizes the risk management efforts of AIG’s compliance, legal and regulatory and internal audit functions. ORM also manages compliance with the requirements of the Sarbanes-Oxley Act of 2002.
Each business is responsible for implementing the components of AIG’s operational risk management program to ensure that effective operational risk management practices are utilized throughout AIG. These components include governance, risk and control self assessment, risk event data analysis, and key risk indicators. The program currently incorporates the following:
AIG uses reinsurance programs for its general insurance risks as follows: (i) facultative to cover large individual exposures; (ii) quota share treaties to cover specific books of business; (iii) excess of loss treaties to cover large losses; and (iv) catastrophe treaties to cover certain catastrophes including earthquake, flood, wind and terror. AIG’s Reinsurance Security Department conducts periodic detailed assessments of the reinsurance markets and current and potential reinsurers, both foreign and domestic. Such assessments may include, but are not limited to, identifying if a reinsurer is appropriately licensed and has sufficient financial capacity, and evaluating the local economic environment in which a foreign reinsurer operates.
The Reinsurance Security Department reviews the nature of the risks ceded to reinsurers and the requirements for credit risk mitigants. For example, in AIG’s treaty reinsurance contracts, AIG frequently includes provisions that require a reinsurer to post collateral when a referenced event occurs. Furthermore, AIG limits its unsecured exposure to reinsurers through the use of credit triggers, which include, but are not limited to, insurer financial strength rating downgrades, declines in policyholders surplus below predetermined levels or reaching maximum limits of reinsurance recoverable. In addition, AIG’s CRC reviews all reinsurer exposures and credit limits and approves most large reinsurer credit limits that represent actual or potential credit concentrations. AIG believes that no exposure to a single reinsurer represents an inappropriate concentration of risk to AIG, nor is AIG’s business substantially dependent upon any single reinsurance contract.
The following table provides information for each reinsurer representing in excess of five percent of AIG’s general reinsurance assets at December 31, 2006.
General Insurance - risks covered include property, casualty, fidelity/surety, management liability and mortgage insurance. Risks in the general insurance segment are managed through aggregations and limitations of concentrations at multiple levels: policy, line of business, correlation and catastrophic risk events.
writing authority, the use of sound underwriting practices, pricing procedures and the use of actuarial analysis as part of the determination of overall adequacy of provisions for insurance contract liabilities.
The nature of AIG’s business exposes it to various catastrophic risk events in which multiple losses across multiple lines of business can occur in any calendar year. In order to control this exposure, AIG uses a combination of techniques, including setting aggregate limits in key business units, monitoring and modeling accumulated exposures and purchasing catastrophe reinsurance to supplement its other reinsurance protections.
AIG evaluates catastrophic events and assesses the probability of occurrence and magnitude of catastrophic events through the use of state-of-the-art industry recognized models, among other techniques. AIG supplements these models by periodically monitoring the risk exposure of AIG’s worldwide General Insurance operations and adjusting such models accordingly. Following is an overview of modeled losses associated with the more significant natural perils, which includes exposures for DBG, Personal Lines, Foreign General (other than Ascot), HSB and 21st Century. Transatlantic and Ascot utilize a different model, and their combined results are presented separately below. The modeled results assume that all reinsurers fulfill their obligations to AIG in accordance with their terms.
Single event modeled property and workers compensation losses to AIG’s worldwide portfolio of risk for key geographic areas. Gross values represent AIG’s liability after the application of policy limits and deductibles, and net values represent losses after all reinsurance is applied.
The specific international RDS events do not necessarily correspond to AIG’s international exposures. As a result, AIG runs its own simulations where statistical return period losses associated with the written exposure specific to AIG provide the basis for monitoring risk. Based on these simulations, the 100-year return period for Japanese Earthquake is $296 million gross, and $120 million net, the 100-year return period for European Windstorm is $269 million gross, and $80 million net, and the 100-year return period for Japanese Typhoon is $306 million gross, and $252 million net.
Terrorism risk is monitored to manage AIG’s exposure. AIG shares its exposures to terrorism risks under the Terrorism Risk Insurance Act (TRIA). During 2006, AIG’s deductible under TRIA was approximately $3.3 billion, with a 10 percent share of certified terrorism losses in excess of the deductible. As of January 1, 2007, the deductible increased to approximately $4.0 billion, with a 15 percent share of certified terrorism losses in excess of the deductible. Without an extension by Congress, TRIA will sunset at December 31, 2007. Should TRIA not be renewed, AIG would expect to reassess and modify its underwriting guidelines and retention levels as appropriate.
AIG’s Foreign Life Insurance & Retirement Services companies generally limit their maximum underwriting exposure on life insurance of a single life to approximately $1.7 million of coverage. AIG’s Domestic Life Insurance & Retirement Services companies limit their maximum underwriting exposure on life insurance of a single life to $10 million of coverage in certain circumstances by using yearly renewable term reinsurance. In Life Insurance & Retirement Services, the reinsurance programs provide risk mitigation per policy, per individual life and group covers and for catastrophic risk events.
The potential for a pandemic influenza outbreak has received much recent attention. While outbreaks of the Avian Flu continue to occur among poultry or wild birds in a number of countries in Asia, Europe, including the U.K., and Africa, transmission to humans has been rare to date. If the virus mutates to a form that can be transmitted from human to human, it has the potential to spread rapidly worldwide. If such an outbreak were to take place, early quarantine and vaccination could be critical to containment.
AIG’s fixed maturity investments totaled $417.9 billion at December 31, 2006, compared to $385.7 billion at December 31, 2005. AIG’s investment strategies are tailored to the specific business needs of each operating unit based on considerations that include the local market, liability duration and cash flow characteristics, rating agency and regulatory capital considerations, legal investment limitations, tax optimization, diversification and credit limits. These strategies are intended to produce a reasonably stable and predictable return throughout the economic cycle, without undue risk or volatility.
The credit ratings of fixed maturity investments, other than those of AIGFP, at December 31, 2006 were:
AIG uses asset-liability matching as a management tool worldwide in the life insurance business to determine the composition of the invested assets and appropriate marketing strategies. AIG’s objective is to maintain a matched asset-liability structure. However, in certain markets, the absence of long-dated fixed income instruments may preclude a matched asset-liability position in those markets. In addition, AIG may occasionally determine that it is economically advantageous to be temporarily in an unmatched position.
AIG’s Financial Services subsidiaries engage in diversified activities including aircraft and equipment leasing, capital markets, consumer finance and insurance premium finance.
AIG’s Aircraft Leasing operations represent the operations of ILFC, which generates its revenues primarily from leasing new and used commercial jet aircraft to scheduled and charter airlines and companies associated with the airline industry. Risks inherent in this business, and which are managed at the business unit level, include: (i) the risk that there will be no market for the aircraft acquired; (ii) the risk that aircraft cannot be placed with lessees; (iii) the risk of nonperformance by lessees; and (iv) the risk that aircraft and related assets cannot be disposed of at the time and in a manner desired.
In certain cases, the credit risk associated with a designated portfolio is tranched into different layers of risk, which are then analyzed and rated by the credit rating agencies. Typically, there
AIGFP continually monitors the underlying portfolios to determine whether the credit loss experience for any particular portfolio has caused the likelihood of AIGFP having a payment obligation under the transaction to be greater than super senior risk. AIGFP maintains the ability opportunistically to economically hedge specific securities in a portfolio and thereby further limit its exposure to loss and has hedged outstanding transactions in this manner on occasion. At December 31, 2006, the notional amount with respect to the Capital Markets credit derivative portfolio (including the super senior transactions) was $483.6 billion.
AIGFP’s management objective is to minimize interest rate, currency, commodity and equity risks associated with its securities available for sale. That is, when AIGFP purchases a security for its securities available for sale investment portfolio, it simultaneously enters into an offsetting internal hedge such that the payment terms of the hedging transaction offset the payment terms of the investment security, which achieves the economic result of converting the return on the underlying security to U.S. dollar LIBOR plus or minus a spread based on the underlying profit on each security on the initial trade date. The market risk associated with such internal hedges is managed on a portfolio basis, with third-party hedging transactions executed as necessary. These hedging activities did not qualify for hedge accounting treatment under FAS 133.
At December 31, 2006 and 2005, the distribution by counterparty credit quality with respect to the fair value of Capital Markets derivatives portfolios was as follows:
AIGFP’s minimal reliance on market risk driven revenue is reflected in its VaR. AIGFP’s VaR calculation is based on the interest rate, equity, commodity and foreign exchange risk arising from its portfolio. Because the market risk with respect to securities available for sale, at market, is substantially hedged, segregation of the financial instruments into trading and other than trading was not deemed necessary.
In 2006, VaR calculations were changed from a 30-day holding period to a one-day holding period. Accordingly, the 2005 VaR amounts have been restated to reflect this change.
AIG’s Consumer Finance operations provide a wide variety of consumer finance products, including real estate and other consumer loans, credit card loans, retail sales finance and credit-related insurance to customers both domestically and overseas, particularly in emerging markets. Consumer Finance operations include AGF as well as AIGCFG. AGF provides a wide variety of consumer finance products, including real estate loans, non-real estate loans, retail sales finance and credit-related insurance to customers in the United States, Puerto Rico and the U.S. Virgin Islands. AIGCFG, through its subsidiaries, is engaged in developing a multi-product consumer finance business with an emphasis on emerging markets.
Many of AGF’s borrowers are non-prime or sub-prime. Current economic conditions, such as interest rate and employment levels, can have a direct effect on the borrowers’ ability to repay these loans. AGF manages the credit risk inherent in its portfolio by using credit scoring models at the time of credit applications, established underwriting criteria, and, in certain cases, individual loan reviews. AGF monitors the quality of the finance receivables portfolio and determines the appropriate level of the allowance for losses through its Credit Strategy and Policy Committee. This Committee bases its conclusions on quantitative analyses, qualitative factors, current economic conditions and trends, and each Committee member’s experience in the consumer finance industry. Through 2006, the credit quality of AGF’s finance receivables continued to be strong. However, declines in the strength of the U.S. housing market or economy may adversely affect the future credit quality of these receivables.
AIGCFG monitors the quality of its finance receivable portfolio and determines the appropriate level of the allowance for losses through several internal committees. These committees base their
conclusions on quantitative analysis, qualitative factors, current economic conditions and trends, political and regulatory implications, competition and the judgment of the committees’ members.
AIG’s Asset Management operations are exposed to various forms of credit, market and operational risks. Asset Management complies with AIG’s corporate risk management guidelines and framework and is subject to periodic reviews by the CRC. In addition, transactions are referred to the Asset Management investment committees for approval of investment decisions.
In the spread-based investment businesses, GIC and MIP, the primary risk is investment risk, which represents the exposure to loss resulting from the cash flows from the invested assets being less than the cash flows required to meet the obligations of the liabilities and the necessary return on investments. Credit risk is also a significant component of the investment strategy for these businesses. Market risk is taken in the form of duration and convexity risk. While AIG generally maintains a matched asset-liability relationship, it may occasionally determine that it is economically advantageous to be in an unmatched duration position. The risks in the spread-based businesses are managed through exposure limitations, active management of the investment portfolios and close oversight of the asset-liability relationship.
During 2006, AIG developed a methodology framework that incorporates financial services industry best practices, maintains consistency with regulatory frameworks and reflects AIG’s distinct global business and management strategies. By utilizing stochastic simulation techniques, where appropriate, AIG enhanced existing models or developed new ones through a collaborative effort among business executives, actuaries, finance specialists and risk professionals. Initial assessments of Economic Capital were made and AIG began reviewing its economic capital model methodology with the rating agencies.
The initial assessments have provided useful insight into the overall capital strength of the corporation and its segments and, to date, the initiative has introduced guidance concerning processes to assess economic risk and returns for selected issues, including funding and investment strategies for the MIP, product development, pricing, hedging for living benefits in the variable annuity business and asset-liability management strategies for life insurance products, particularly in Asian markets.
On June 29, 2005, the FASB issued Statement 133 Implementation Issues No. B38, “Embedded Derivatives: Evaluation of Net Settlement with Respect to the Settlement of a Debt Instrument through Exercise of an Embedded Put Option or Call Option” and No. B39, “Application of Paragraph 13(b) to Call Options That are Exercisable Only by the Debtor.”
On March 27, 2006, the FASB issued FASB FTB 85-4-1, “Accounting for Life Settlement Contracts by Third-Party Investors” (FSP 85-4-1), an amendment of FTB 85-4, “Accounting for Purchases of Life Insurance.”
On April 13, 2006, the FASB issued FSP FIN 46(R)-6, “Determining the Variability to be Considered in Applying FASB Interpretation No. 46(R).”
In September 2006, the FASB issued FAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (FAS 158).
In February 2007, the FASB issued FAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (FAS 159).
As described in Notes 1, 14 and 15 to the consolidated financial statements, AIG changed its accounting for certain hybrid financial instruments, life settlement contracts and share based compensation as of January 1, 2006, and certain employee benefit plans as of December 31, 2006.
This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2006 consolidated financial statements, and our opinion regarding the effectiveness of AIG’s internal control over financial reporting does not affect our opinion on those consolidated financial statements.
In our opinion, management’s assessment that AIG did not maintain effective internal control over financial reporting as of December 31, 2006 is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the COSO. Also, in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, AIG has not maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the COSO.
Certain of AIG’s foreign subsidiaries included in the consolidated financial statements report on a fiscal year ending November 30. The effect on AIG’s consolidated financial condition and results of operations of all material events occurring after November 30 and prior to the applicable balance sheet date has been recorded.
AIG considers its most critical accounting estimates to be those with respect to reserves for losses and loss expenses, future policy benefits for life and accident and health contracts, recoverability of deferred policy acquisition costs (DAC), estimated gross profits for investment-oriented products, fair value determinations for certain Capital Markets assets and liabilities, other-than-temporary declines in the value of investments and flight equipment recoverability.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ, possibly materially, from those estimates.
Certain reclassifications and format changes have been made to prior year amounts to conform to the current year presentation.
Net Investment Income: Net investment income represents income primarily from the following sources in AIG’s insurance operations:
Accrued interest income, as well as amortization and accretion of premiums and discounts on bonds.
Realized Capital Gains (Losses): Realized capital gains and losses are determined principally by specific identification. The realized capital gains and losses are generated primarily from the following sources (in AIG’s insurance operations and Other category):
Reductions to the cost basis of fixed maturities, equity securities and other invested assets for other-than-temporary impairments.
Other Income: Other income includes income from flight equipment, finance charges on consumer loans and income generated from asset management activities and from the operations of AIGFP.
Income generated with respect to asset management operations is generally recognized as revenues as services are performed. Certain costs incurred in the sale of mutual funds are deferred and subsequently amortized.
Accrued interest income and expense, as well as amortization and accretion of premiums and discounts on bonds.
Changes in the fair value of derivatives. In certain instances, no initial gain or loss is recognized in accordance with Emerging Issues Task Force Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities” (EITF 02-3). The initial gain or loss is recognized over the life of the transactions and as observable market data becomes available.
Unrealized gains and losses from trading securities, commodities sold, but not yet purchased, futures and hybrid financial instruments.
Incurred policy losses and benefits: Incurred policy losses for short duration insurance contracts consist of the estimated ultimate cost of settling claims incurred within the reporting period, including incurred but not reported claims, plus the changes in estimates of current and prior period losses resulting from the continuous review process. Benefits for long duration insurance contracts consist of benefits paid and changes in future policy benefits liabilities. Benefits for universal life and investment-type products primarily consists of interest credited to policy account balances and benefit payments made in excess of policy account balances.
(c) Income Taxes: Deferred tax assets and liabilities are recorded for the effects of temporary differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements. AIG assesses its ability to realize deferred tax assets primarily based on the earnings history, future earnings potential, the reversal of taxable temporary differences, and the tax planning strategies available to the legal entities recognizing deferred tax assets, in accordance with FAS 109, “Accounting for Income Taxes.” See Note 3 herein for a further discussion of income taxes.
Unrealized gains and losses from available for sale investments in equity and fixed maturity securities are reflected as a separate component of other comprehensive income, net of deferred income taxes currently. Unrealized gains and losses from investments in trading securities are reflected in income currently. Investments in fixed maturities and equity securities are recorded on a trade date basis.
AIG evaluates its investments for impairment. As a matter of policy, the determination that a security has incurred an other-than-temporary decline in value and the amount of any loss recognition requires the judgment of AIG’s management and a continual review of its investments.
At each balance sheet date, AIG evaluates its securities holdings in an unrealized loss position. Where AIG does not intend to hold such securities until they have fully recovered their carrying value, based on the circumstances present at the date of evaluation, AIG records the unrealized loss in income. If events or circumstances change, such as unexpected changes in the creditworthiness of the obligor, unanticipated changes in interest rates, tax laws, statutory capital positions and liquidity events, among others, AIG revisits its intent. Further, if a loss is recognized from a sale subsequent to a balance sheet date pursuant to these unexpected changes in circumstances, the loss is recognized in the period in which the intent to hold the securities to recovery no longer existed.
In periods subsequent to the recognition of an other-than-temporary impairment loss for debt securities, AIG generally amortizes the discount or reduced premium over the remaining life of the security in a prospective manner based on the amount and timing of future estimated cash flows.
(h) Financial Services - Securities Available for Sale, at fair value: These securities are held to meet long-term investment objectives and are accounted for as available for sale, carried at current fair values and recorded on a trade-date basis. This portfolio is hedged using interest rate, foreign exchange, commodity and equity derivatives. The market risk associated with such hedges is managed on a portfolio basis, with third party hedging transactions executed as necessary. As hedge accounting treatment is not achieved in accordance with FAS 133, “Accounting for Derivative Instruments and Hedging Activities” (FAS 133), the unrealized gains and losses on these securities resulting from changes in interest rates, currency rates and equity prices are recorded in Other comprehensive income in consolidated shareholders’ equity while the unrealized gains and losses on the related economic hedges are reflected in Other income.
(i) Financial Services - Trading Securities, at fair value: Trading securities are held to meet short-term investment objectives, including hedging securities. These securities are recorded on a trade-date basis and carried at current fair values. Unrealized gains and losses are reflected in Other income currently.
(k) Financial Services - Unrealized Gain and Unrealized Loss on Swaps, Options and Forward Transactions: Interest rate, currency, equity and commodity swaps, swaptions, options and forward transactions are accounted for as derivatives recorded on a trade-date basis and are carried at current market values or estimated fair values when market prices are not available. Unrealized gains and losses are reflected in income currently, where appropriate. In certain instances, when income is not recognized at inception of the contract under EITF 02-03, income is recognized over the life of the contract and as observable market data becomes available. Estimated fair values are based on the use of valuation models that utilize, among other things, current interest, foreign exchange, equity, commodity and volatility rates. AIG attempts to secure reliable and independent current market prices, such as published exchange prices, external subscription services’ prices such as Bloomberg or Reuters or third-party broker quotes for use in its models. When such prices are not available, AIG uses an internal methodology which includes interpolation and extrapolation from observable and verifiable prices nearest to the dates of the transactions. These valuations represent an assessment of the present values of expected future cash flows of these transactions and reflect market and credit risk. The portfolio’s discounted cash flows are evaluated with reference to current market conditions, maturities within the portfolio, and other relevant factors. Based upon this evaluation, it is determined what offsetting transactions, if any, are necessary to reduce the market risk of the portfolio. AIG manages its market risk with a variety of transactions, including swaps, trading securities, futures and forward contracts and other transactions as appropriate. Because of the limited liquidity of some of these instruments, the recorded values of these transactions may be different from the values that might be realized if AIG were to sell or close out the transactions prior to maturity. AIG believes that such differences are not significant to its financial condition or liquidity. Such differences would be immediately recognized in income when the transactions were sold or closed out prior to maturity.
Direct costs of originating loans, net of nonrefundable points and fees, are deferred and included in the carrying amount of the related loans. The amount deferred is recognized as an adjustment to finance charge revenues, using the interest method.
Hedge funds and limited partnerships in which AIG holds in the aggregate less than a five percent interest are reported at fair value. The change in fair value is recognized as a component of Other comprehensive income.
AIG obtains the fair values of its investments in limited partnerships and hedge funds from information provided by the general partner or manager of each of these investments, the accounts of which generally are audited on an annual basis.
(r) Cash: Cash represents cash on hand and non-interest bearing demand deposits.
General Insurance: Acquisition costs represent those costs, including commissions, premium taxes and other underwriting expenses, that vary with and are primarily related to the acquisition of new business. These costs are deferred and amortized over the period in which the related premiums written are earned. 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 profitability of the underlying insurance contracts. Investment income is not anticipated in the recoverability of deferred policy acquisition costs.
Life Insurance & Retirement Services: Acquisition costs represent those costs, including commissions, underwriting and marketing expenses, that vary with, and are primarily related to, the acquisition of new business. Policy acquisition costs for traditional life insurance products are generally deferred and amortized over the premium paying period in accordance with FAS 60, “Accounting and Reporting by Insurance Enterprises” (FAS 60). Policy acquisition costs and policy issuance costs related to universal life, participating life, and investment-type products (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 in accordance with FAS 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments” (FAS 97). Estimated gross profits are composed of net interest income, net realized investment gains and losses, fees, surrender charges, expenses, and mortality and morbidity gains and losses. If estimated gross profits change significantly, DAC is recalculated using the new assumptions. Any resulting adjustment is included in current earnings as an adjustment to DAC. 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 profitability (both current and projected future) of the underlying insurance contracts.
securities available for sale that is credited or charged directly to other comprehensive income. DAC has been decreased by $720 million at December 31, 2006 and decreased by $1.14 billion at December 31, 2005 for this adjustment. See also Note 4 herein.
Value of Business Acquired (VOBA) is determined at the time of acquisition and is reported on the consolidated balance sheet with DAC. This value is based on present value of future pre-tax profits discounted at current yields applicable at time of purchase. For products accounted under FAS 60, VOBA is amortized over the life of the business similar to that for DAC based on the assumptions at purchase. For FAS 97 products, VOBA is amortized in relation to the estimated gross profits to date for each period. As of December 31, 2006, there have been no impairments of VOBA.
AIG periodically assesses the carrying value of its real estate for purposes of determining any asset impairment.
(x) Goodwill and Intangible Assets: Goodwill is the excess of cost over the fair value of net assets acquired. Goodwill is reviewed for impairment on an annual basis, or more frequently if circumstances indicate that a possible impairment has occurred. The assessment of impairment involves a two-step process whereby an initial assessment for potential impairment is performed, followed by a measurement of the amount of impairment, if any. Impairment testing is performed using the fair value approach, which requires the use of estimates and judgment, at the “reporting unit” level. A reporting unit is the operating segment, or a business that is one level below the operating segment if discrete financial information is prepared and regularly reviewed by management at that level. The determination of a reporting unit’s fair value is based on management’s best estimate, which generally considers the unit’s market-based earning multiples of peer companies and expected future earnings. If the carrying value of a reporting unit’s goodwill exceeds its fair value, the excess is recognized as an impairment and recorded as a charge against net income. No impairment has been recorded by AIG in 2006, 2005 or 2004. Changes in the carrying amount of goodwill result from foreign currency translation adjustments and other purchase price adjustments.
(z) Reserve for Losses and Loss Expenses: Losses and loss expenses are charged to income as incurred. The reserve for losses and loss expenses represents the accumulation of estimates for unpaid reported losses and includes provisions for losses incurred but not reported. The methods of determining such estimates and establishing resulting reserves, including amounts relating to allowances for estimated unrecoverable reinsurance, are reviewed and updated. If the estimate of reserves is determined to be inadequate or redundant, the increase or decrease is reflected in income. AIG discounts its loss reserves relating to workers compensation business written by its U.S. domiciled subsidiaries as permitted by the domiciliary statutory regulatory authorities.
(aa) Future Policy Benefits for Life and Accident and Health Contracts: The liabilities for future policy benefits and policyholders’ contract deposits are established using assumptions described in Note 6 herein.
(bb) Other Policyholders’ Funds: Other policyholders’ funds are reported at cost and include any policyholders’ funds on deposit which encompasses premium deposits and similar items.
(gg) Preferred Shareholders’ Equity in Subsidiary Companies: Preferred shareholders’ equity in subsidiary companies relates principally to outstanding preferred stock or interest of ILFC, a wholly owned subsidiary of AIG. Cash distributions on such preferred stock or interest are accounted for as interest expense.
For its service-based awards under the 1999 Stock Option Plan, 2002 Stock Incentive Plan and 1996 Employee Stock Purchase Plan, AIG recognizes compensation on a straight-line basis over the scheduled vesting period. Unrecognized unvested compensation expense for stock option awards granted under APB 25 (i.e., before January 1, 2003) will be recognized from January 1, 2006 to the vesting date. However, for the SICO Plans, the AIG Deferred Compensation Profit Participant Plan (AIG DCPPP) and the AIG Partners Plan, which contain both performance and service conditions, AIG recognizes compensation utilizing a graded vesting expense attribution method. The effect of this approach is to recognize compensation cost over the requisite service period for each separately vesting tranche of the award.
granted after January 1, 2006, compensation expense is recognized ratably from the date of grant through the shorter of age 65 or the vesting period. This change did not have a material effect on AIG’s consolidated financial position or results of operations. Awards granted prior to January 1, 2006 will continue to be recognized over the vesting period with accelerated expense recognition upon an actual retirement. Starr International Company, Inc. (SICO) compensation expense for participants retiring after age 65 had been reflected in prior years’ results consistent with vested status under the SICO Plans.
The effective date of the implementation guidance is January 1, 2007. Upon implementation, AIG expects to record a decrease to opening retained earnings of approximately $100 million, net of tax, to reflect changes in unamortized DAC, VOBA, unearned revenue liabilities and deferred sales inducement assets. This adjustment will reflect changes including the cumulative effect of a shorter expected amortization period for deferred items related to certain group life and health insurance contracts and the effect on the estimated gross profits of investment-oriented products related to previously anticipated future internal replacements. AIG does not expect the implementation of SOP 05-1 to have a material effect on its consolidated financial condition or its consolidated results of operations, although operating income for the Life Insurance & Retirement Services segment will be negatively affected.
On July 13, 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (FIN 48), which clarifies the accounting for uncertainty in income tax positions. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of an income tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, and additional disclosures. The effective date of this implementation guidance is January 1, 2007, with the cumulative effect of the change in accounting principles recorded as an adjustment to opening retained earnings. AIG does not expect the implementation of FIN 48 to be material to its consolidated financial condition.
In February 2007, the FASB issued FAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (FAS 159). FAS 159 permits entities to choose to measure at fair value many financial instruments and certain other items that are not currently required to be measured at fair value. Subsequent changes in fair value for designated items will be required to be reported in earnings in the current period. FAS 159 also establishes presentation and disclosure requirements for similar types of assets and liabilities measured at fair value. FAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. AIG is currently assessing the effect of implementing this guidance, which depends on the nature and extent of items elected to be measured at fair value, upon initial application of the standard on January 1, 2008.
AIG identifies its reportable segments by product line consistent with its management structure. These segments and their respective operations are as follows:
General Insurance: AIG’s General Insurance subsidiaries are multiple line companies writing substantially all lines of commercial property and casualty insurance and various personal lines both domestically and abroad. AIG’s principal General Insurance operations are as follows:
Each of the General Insurance sub-segments is comprised of groupings of major products and services as follows: DBG is comprised of domestic commercial insurance products and services; Transatlantic is comprised of reinsurance products and services sold to other general insurance companies; Personal Lines are comprised of general insurance products and services sold to individuals; Mortgage Guaranty is comprised of products insuring against losses arising under certain loan agreements; and Foreign General is comprised of general insurance products sold overseas.
Life Insurance & Retirement Services: AIG’s Life Insurance & Retirement Services subsidiaries offer a wide range of insurance and retirement savings products both domestically and abroad. Insurance-oriented products consist of individual and group life, payout annuities (including structured settlements), endowment and accident and health policies. Retirement savings products consist generally of fixed and variable annuities.
AIG’s principal overseas Life Insurance & Retirement Services operations are American Life Insurance Company (ALICO), American International Assurance Company, Limited, together with American International Assurance Company (Bermuda) Limited (AIA), Nan Shan Life Insurance Company, Ltd. (Nan Shan), The Philippine American Life and General Insurance Company (PhilamLife), AIG Edison Life Insurance Company (AIG Edison Life) and AIG Star Life Insurance Co. Ltd. (AIG Star Life). In 2006, the major internal reporting units for the Foreign Life operations were realigned to better reflect the current management structure. PhilamLife and other Life operations were classified as a reporting unit in 2005. In 2006, PhilamLife is included with AIA, AIRCO and Nan Shan in the Asia internal reporting unit and other operations are included with ALICO, AIG Star Life and AIG Edison Life in the Japan and Other reporting unit. Prior period amounts have been reclassified to conform to the current period presentation.
American International Reinsurance Company (AIRCO) acts primarily as an internal reinsurance company for AIG’s insurance operations.
Financial Services: AIG’s Financial Services subsidiaries engage in diversified financial products and services including aircraft and equipment leasing, capital markets transactions, consumer finance and insurance premium finance.
AIG’s Aircraft Leasing operations represent the operations of International Lease Finance Corporation (ILFC), which generates its revenues primarily from leasing new and used commercial jet aircraft to domestic and foreign airlines. Revenues also result from the remarketing of commercial jets for its own account, and remarketing and fleet management services for airlines and for financial institutions.
The following table summarizes the operations by major operating segment for the years ended December 31, 2006, 2005 and 2004:
Includes AIG Parent and other operations which are not required to be reported separately. The following table presents the operating loss for AIG’s Other category for the years ended December 31, 2006, 2005 and 2004:
Includes current year catastrophe-related losses from unconsolidated entities of $312 million and $96 million for 2005 and 2004, respectively. There were no significant catastrophe-related losses in 2006.
Represents the sum of General Insurance net premiums earned, Life Insurance & Retirement Services GAAP premiums, net investment income, Financial Services interest, lease and finance charges, Asset Management net investment income from spread-based products and advisory and management fees, and realized capital gains (losses).
Includes additional losses incurred and net reinstatement premiums related to prior year catastrophes of $199 million and $277 million in 2006 and 2005, respectively.
Revenues in 2004 include approximately $640 million of premium from a single reinsurance transaction involving terminal funding pension business, which is offset by a similar increase in benefit reserves. Revenues and operating income include realized capital gains (losses) of $301 million, $156 million and $528 million for 2006, 2005 and 2004, respectively. Includes the effect of hedging activities that did not qualify for hedge accounting treatment under FAS 133 and the application of FAS 52, which were $191 million, $(97) million and $166 million for 2006, 2005 and 2004, respectively.
Includes the effect of out of period adjustments related to the accounting for certain interests in unit investment trusts. For 2006 the effect was an increase of $240 million in revenues and $169 million in operating income.
The following table summarizes AIG’s Financial Services operations by major internal reporting unit for the years ended December 31, 2006, 2005 and 2004:
Certain transactions entered into by AIGFP generate tax credits and benefits which are included in income taxes in the consolidated statement of income. The amount of such tax credits and benefits for the years ended December 31, 2006, 2005 and 2004 were $50 million, $67 million, and $107 million, respectively.
Operating loss in 2006 includes specific reserves of $42 million related to two commercial lending transactions.
Interest expense for the Capital Markets business is included in Revenues above and in Other income on the Consolidated Statement of Income.
Includes the effect of hedging activities that did not qualify for hedge accounting treatment under FAS 133, including the related foreign exchange gains and losses. For 2006, 2005 and 2004, respectively, the effect was $(1.82) billion, $2.01 billion and $(122) million in both revenues and operating income for Capital Markets. These amounts result primarily from interest rate and foreign currency derivatives that are economically hedging available for sale securities and borrowings. For 2004, the effect was $(27) million in operating income for Aircraft Leasing. During 2006 and 2005, Aircraft Leasing derivative gains and losses were reported as part of AIG’s Other category, and were not reported in Aircraft Leasing’s operating income.
AIG and its eligible U.S. subsidiaries file a consolidated U.S. federal income tax return. Life Insurance subsidiaries of American General Corporation (AGC) also file a consolidated U.S. federal income tax return and will not be included in AIG’s consolidated federal income tax return until 2007. Other U.S. entities included in the consolidated financial statements also file separate U.S. federal income tax returns. Subsidiaries operating outside the U.S. are taxed, and income tax expense is recorded, based on applicable U.S. and foreign statutes.
It is management’s belief that there are substantial arguments in support of the positions taken by AIG, AIG Retirement Services Inc., and SunAmerica Life in their Letters of Protest and Tax Court litigation. Although the final outcome of any issues raised in connection with these years is uncertain, AIG believes that any tax obligation, including interest thereon, would not be material to AIG’s consolidated financial condition, results of operations or liquidity.
AGC’s tax years through 1999 have been audited and settled with the IRS. Although a Revenue Agent’s Report has not yet been issued to AGC for years ended December 31, 2000, 2001 and 2002, AIG has received a notice of proposed adjustment for certain items during that period from the IRS.
The pretax components of U.S. and foreign income reflect the locations in which such pretax income was generated. The pretax U.S. and foreign income was as follows for the years ended December 31, 2006, 2005 and 2004:
The components of the net deferred tax liability as of December 31, 2006 and 2005 were as follows:
The following reflects the policy acquisition costs deferred for amortization against future income and the related amortization charged to income for General Insurance and Life Insurance & Retirement Services operations:
There were no impairments of DAC or VOBA for the years ended December 31, 2006, 2005 and 2004.
General Reinsurance: General reinsurance is effected under reinsurance treaties and by negotiation on individual risks. Certain of these reinsurance arrangements consist of excess of loss contracts which protect AIG against losses over stipulated amounts. Ceded premiums are considered prepaid reinsurance premiums and are recognized as a reduction of premiums earned over the contract period in proportion to the protection received. Amounts recoverable from general reinsurers are estimated in a manner consistent with the claims liabilities associated with the reinsurance and presented as a component of reinsurance assets. Assumed reinsurance premiums are earned primarily on a pro-rata basis over the terms of the reinsurance contracts.
Life Insurance recoveries, which reduced death and other benefits, approximated $806 million, $770 million and $779 million, respectively, for the years ended December 31, 2006, 2005 and 2004.
Supplemental information for gross loss and benefit reserves net of ceded reinsurance at December 31, 2006 and 2005 follows:
AIG’s Domestic Life Insurance & Retirement Services operations utilize internal and third-party reinsurance relationships to
manage insurance risks and to facilitate capital management strategies. Pools of highly-rated third-party reinsurers are utilized to manage net amounts at risk in excess of retention limits. AIG’s Domestic Life Insurance companies also cede excess, non-economic reserves carried on a statutory-basis only on certain term and universal life insurance policies and certain fixed annuities to an offshore affiliate.
AIG generally obtains letters of credit in order to obtain statutory recognition of its intercompany reinsurance transactions. For this purpose, AIG has a $2.5 billion syndicated letter of credit facility outstanding as of December 31, 2006, all of which relates to life intercompany reinsurance transactions.
Reflects the opening balance with respect to the acquisition of the Central Insurance Co., Ltd. in the third quarter of 2006.
Includes fourth quarter charge of $1.8 billion resulting from the annual review of General Insurance loss and loss adjustment reserves.
Includes fourth quarter charge of $850 million attributable to the change in estimate for asbestos and environmental exposures.
The analysis of the future policy benefits and policyholders’ contract deposits liabilities follows:
Long duration contract liabilities included in future policy benefits, as presented in the preceding table, result from life products. Short duration contract liabilities are primarily accident and health products. The liability for future life policy benefits has been established based upon the following assumptions:
Participating life business represented approximately 19 percent of the gross insurance in force at December 31, 2006 and 34 percent of gross GAAP premiums in 2006. The amount of annual dividends to be paid is determined locally by the boards of directors. Provisions for future dividend payments are computed by jurisdiction, reflecting local regulations.
The liability for policyholders’ contract deposits has been established based on the following assumptions:
Interest rates credited on deferred annuities, which vary by territory and year of issuance, range from 1.2 percent to, including bonuses, 12.0 percent. Less than 1.0 percent of the liabilities are credited at a rate greater than 9.0 percent. Current declared interest rates are generally guaranteed to remain in effect for a period of one year though some are guaranteed for longer periods. Withdrawal charges generally range from zero percent to 20.0 percent grading to zero over a period of zero to 19 years.
Statutory surplus and net income with respect to foreign operations are estimated as of November 30. The basis of presentation for branches of AIA is the Hong Kong statutory filing basis. The basis of presentation for branches of ALICO is the U.S. statutory filing basis. AIG Star Life, AIG Edison Life, Nan Shan and Philamlife are estimated based on their respective local country filing basis.
(b) Net Investment Income: An analysis of net investment income follows:
The realized capital gains (losses) and increase (decrease) in unrealized appreciation of AIG’s consolidated available for sale investments were as follows:
The amortized cost and estimated fair value of securities available for sale and held to maturity for the Insurance and Asset Management segments at December 31, 2006 and December 31, 2005 follows:
In 2006, excludes hybrid financial instruments with an estimated fair value of $522 million at December 31, 2006.
The following table presents the amortized cost and estimated fair values of fixed maturity securities available for sale and held to maturity at December 31, 2006, by contractual maturity. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
(e) Non-Income Producing Invested Assets: At December 31, 2006, non-income producing invested assets were insignificant.
The following table summarizes the gross unrealized losses and cost basis on securities available for sale, aggregated by major investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2006 and 2005.
AIG recorded other-than-temporary impairment losses of approximately $944 million, $598 million and $684 million in realized capital gains (losses) in 2006, 2005 and 2004, respectively. See Note 1(e) herein for AIG’s other-than-temporary impairment accounting policy.
As of December 31, 2006, the anticipated life insurance premiums required to keep the life settlement contracts in force, payable in the ensuing twelve months ending December 31, 2007 and the four succeeding years ending December 31, 2011 are $77 million, $81 million, $85 million, $86 million, and $87 million, respectively.
(i) Economic Hedging of Securities Available for Sale: AIGFP follows a policy of minimizing interest rate, currency, commodity, and equity risks associated with securities available for sale by entering into internal offsetting positions, on a security by security basis within its derivatives portfolio, thereby offsetting a significant portion of the unrealized appreciation and depreciation. In addition, to reduce its credit risk, AIGFP has entered into credit derivative transactions with respect to $128 million of securities available for sale to economically hedge its credit risk. As previously discussed, these economic offsets did not meet the hedge accounting requirements of FAS 133 and, therefore, are recorded in Other income in the Consolidated Statement of Income.
The following table summarizes the gross unrealized losses and cost basis on Capital Markets securities available for sale, aggregated by length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2006 and 2005.
At December 31, 2006, AIG’s net borrowings were $17.13 billion after reflecting amounts not guaranteed by AIG, amounts that were matched borrowings by AIG and AIGFP and liabilities connected to trust preferred stock. The following table summarizes borrowings outstanding at December 31, 2006 and 2005:
Total debt in 2006 includes commercial paper of $12.15 billion and $3.25 billion of debt related to VIEs required to be consolidated under the provisions of FIN 46R.
Total debt at December 31, 2006 is shown below with year of payment due in each of the next five years and thereafter.
Excludes $12.15 billion of commercial paper and $3.25 billion of debt related to VIEs required to be consolidated under the provisions of FIN 46R.
Represents structured notes issued by AIGFP that are accounted for under the fair value option.
At December 31, 2006, the commercial paper issued and outstanding was as follows:
At December 31, 2006, AIG did not guarantee the commercial paper of any of its subsidiaries other than AIG Funding.
In 2006, AIG issued in Rule 144A/Regulation S offerings $3 billion principal amount of senior notes, of which $1.0 billion was exchanged by AIG for substantially identical notes that are registered under the Securities Act of 1933 (Securities Act). The proceeds from the sale of $2.25 billion of these notes were used for AIG’s general corporate purposes and $750 million were used to fund the MIP.
(ii) Notes and bonds issued by SunAmerica Inc. (SAI): As of December 31, 2006, notes and bonds originally issued by SAI aggregating $435 million (net of unamortized discount of $40 million) were outstanding with maturity dates from 2007 to 2097 at interest rates ranging from 5.60 percent to 9.95 percent.
Funds received from GIA borrowings are invested in a diversified portfolio of securities and derivative transactions. At December 31, 2006, the fair value of securities pledged as collateral with respect to these obligations approximated $7.4 billion.
AIGFP economically hedges its notes and bonds. AIG guarantees all of AIGFP’s debt.
(d) AGC Borrowings: As of December 31, 2006, AGC notes aggregating $797 million were outstanding with maturity dates ranging from 2010 to 2029 at interest rates of up to 7.50 percent. AIG guarantees the notes and bonds of AGC.
(i) Notes and Bonds issued by ILFC: As of December 31, 2006, notes aggregating $22.8 billion were outstanding, consisting of $12.8 billion of term notes, $9.0 billion of medium-term notes with maturities ranging from 2007 to 2013 and interest rates ranging from 3.32 percent to 6.62 percent and $1.0 billion of junior subordinated debt as discussed below. Notes aggregating $5.1 billion are at floating interest rates and the remainder are at fixed rates. To the extent deemed appropriate, ILFC may enter into swap transactions to manage its effective borrowing rates with respect to these notes.
In May 2004, ILFC entered into a similarly structured ECA for up to a maximum of $2.64 billion for Airbus aircraft to be delivered through May 31, 2005. The facility was subsequently increased to $3.64 billion and extended to include aircraft to be delivered through May 31, 2007. The facility becomes available as the various European Export Credit Agencies provide their guarantees for aircraft based on a six-month forward-looking calendar, and the interest rate is determined through a bid process. At December 31, 2006, ILFC had $1.7 billion outstanding under this facility.
(iii) Bank Financings: From time to time, ILFC enters into various bank financings. As of December 31, 2006, the total funded amount was $1.2 billion. The financings mature through 2012.
1.94 percent to 8.45 percent. To the extent deemed appropriate, AGF may enter into swap transactions to manage its effective borrowing rates with respect to these notes.
As a well-known seasoned issuer, AGF has filed an automatic shelf registration statement with the SEC allowing AGF immediate access to the U.S. public debt markets. At December 31, 2006, AGF had the corporate authority to issue up to $13.4 billion of debt securities registered under the Securities Act using AGF’s effective shelf registration statements.
(h) Other Notes, Bonds, Loans and Mortgages Payable at December 31, 2006, consisted of the following:
(b) This facility can be drawn in the form of loans or letters of credit. All drawn amounts shown above are in the form of letters of credit.
(d) American General Finance, Inc. is an eligible borrower for up to $400 million only.
AIG parent depends on its subsidiaries for cash flow in the form of loans, advances, reimbursement for shared expenses, and dividends. AIG’s insurance subsidiaries are subject to regulatory restrictions on the amount of dividends which can be remitted to AIG parent. These restrictions vary by state. For example, unless permitted by the New York Superintendent of Insurance, general insurance companies domiciled in New York may not pay dividends to shareholders which in any twelve month period exceed the lesser of ten percent of the company’s statutory policyholders’ surplus or 100 percent of its “adjusted net investment income,” as defined. Generally, less severe restrictions applicable to both General and Life Insurance companies exist in most of the other states in which AIG’s insurance subsidiaries are domiciled. Certain foreign jurisdictions have restrictions which could delay or limit the remittance of dividends. There are also various local restrictions limiting cash loans and advances to AIG by its subsidiaries. Largely as a result of the restrictions, approximately 90 percent of consolidated shareholders’ equity was restricted from immediate transfer to AIG parent at December 31, 2006.
At December 31, 2006, there were 6,000,000 shares of AIG’s $5 par value serial preferred stock authorized, issuable in series, none of which were outstanding.
The computation of earnings per share for December 31, 2006, 2005 and 2004 was as follows:
Litigation Arising from Operations. AIG and its subsidiaries, in common with the insurance and financial services industries in general, are subject to litigation, including claims for punitive damages, in the normal course of their business. In AIG’s insurance operations, litigation arising from claims settlement activities is generally considered in the establishment of AIG’s reserve for losses and loss expenses. However, in certain circumstances, AIG provides disclosure because of the size or nature of the potential liability to AIG. The potential for increasing jury awards and settlements makes it difficult to assess the ultimate outcome of such litigation.
Litigation Arising from Insurance Operations - Caremark. AIG and certain of its subsidiaries have been named defendants in two putative class actions in state court in Alabama that arise out of the 1999 settlement of class and derivative litigation involving Caremark Rx, Inc. (Caremark). An excess policy issued by a subsidiary of AIG with respect to the 1999 litigation was expressly stated to be without limit of liability. In the current actions, plaintiffs allege that the judge approving the 1999 settlement was misled as to the extent of available insurance coverage and would not have approved the settlement had he known of the existence and/or unlimited nature of the excess policy. They further allege that AIG, its subsidiaries, and Caremark are liable for fraud and suppression for misrepresenting and/or concealing the nature and extent of coverage. In their complaint, plaintiffs request compensatory damages for the 1999 class in the amount of $3.2 billion, plus punitive damages. AIG and its subsidiaries deny the allegations of fraud and suppression and have asserted, inter alia, that information concerning the excess policy was publicly disclosed months prior to the approval of the settlement. AIG and its subsidiaries further assert that the current claims are barred by the statute of limitations and that plaintiffs’ assertions that the statute was tolled cannot stand against the public disclosure of the excess coverage. Plaintiffs, in turn, have asserted that the disclosure was insufficient to inform them of the nature of the coverage and did not start the running of the statute of limitations. The trial court is currently considering, under standards mandated by the Alabama Supreme Court, whether a class action can be certified. AIG cannot reasonably estimate either the likelihood of its prevailing in these actions or the potential damages in the event liability is determined.
2006 Regulatory Settlements. In February 2006, AIG reached a resolution of claims and matters under investigation with the United States Department of Justice (DOJ), SEC, the Office of the New York Attorney General (NYAG) and the New York State Department of Insurance (DOI). AIG recorded an after-tax charge of $1.15 billion relating to these settlements in the fourth quarter of 2005.
As a result of these settlements, AIG made payments or placed amounts in escrow in 2006 totaling approximately $1.64 billion, $225 million of which represented fines and penalties. Amounts held in escrow totaling $699 million, including interest thereon, are included in other assets at December 31, 2006. At that date, approximately $314 million of the funds were escrowed for settlement of claims resulting from the underpayment by AIG of its residual market assessments for workers compensation. The National Workers Compensation Reinsurance Pool on behalf of its participant members and various states have communicated to AIG that they may assert claims with respect to the underpayment of such assessments. AIG cannot currently estimate whether the amount ultimately required to settle these claims will exceed the funds escrowed for this purpose.
In addition to the escrowed funds, the $800 million was deposited into a fund under the supervision of the SEC as part of the settlements to be available to resolve claims asserted against AIG by investors including, the shareholder lawsuits described herein.
Securities Actions. Beginning in October 2004, a number of putative securities fraud class action suits were filed against AIG and consolidated as In re American International Group, Inc. Securities Litigation. Subsequently, a separate, though similar, securities fraud action was also brought against AIG by certain Florida pension funds. The lead plaintiff in the class action is a group of public retirement systems and pension funds benefiting Ohio state employees, suing on behalf of themselves and all purchasers of AIG’s publicly traded securities between October 28, 1999 and April 1, 2005. The named defendants are AIG and a number of present and former AIG officers and directors, as well as Starr, SICO, General Reinsurance Corporation, and PricewaterhouseCoopers LLP (PwC), among others. The lead plaintiff alleges, among other things, that AIG: (1) concealed that it engaged in anti-competitive conduct through alleged payment of contingent commissions to brokers and participation in illegal bid-rigging; (2) concealed that it used “income smoothing” products and other techniques to inflate its earnings; (3) concealed that it marketed and sold “income smoothing” insurance products to other companies; and (4) misled investors about the scope of government investigations. In addition, the lead plaintiff alleges that AIG’s former Chief Executive Officer manipulated AIG’s stock price. The lead plaintiff asserts claims for violations of Sections 11 and 15 of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5 promulgated thereunder, Section 20(a) of the Exchange Act, and Section 20A of the Exchange Act. In April 2006, the court denied the defendants’ motions to dismiss the second amended class action complaint and the Florida complaint. In December 2006, a third amended class action complaint was filed, which does not differ substantially from the prior complaint. Fact and class discovery is currently ongoing.
The plaintiffs in the Commercial Complaint are nineteen corporations, individuals and public entities that contracted with the broker defendants for the provision of insurance brokerage services for a variety of insurance needs. The broker defendants are alleged to have placed insurance coverage on the plaintiffs’ behalf with a number of insurance companies named as defendants, including AIG subsidiaries. The Commercial Complaint also named ten brokers and fourteen other insurers (one of which has since settled) as defendants. The Commercial Complaint alleges that defendants engaged in a widespread conspiracy to allocate customers through “bid-rigging” and “steering” practices. The Commercial Complaint also alleges that the insurer defendants permitted brokers to place business with AIG subsidiaries through wholesale intermediaries affiliated with or owned by those same brokers rather than placing the business with AIG subsidiaries directly. Finally, the Commercial Complaint alleges that the insurer defendants entered into agreements with broker defendants that tied insurance placements to reinsurance placements in order to provide additional compensation to each broker. Plaintiffs assert that the defendants violated the Sherman Antitrust Act, RICO, the antitrust laws of 48 states and the District of Columbia, and are liable under common law breach of fiduciary duty and unjust enrichment theories. Plaintiffs seek treble damages plus interest and attorneys’ fees as a result of the alleged RICO and Sherman Act violations.
The plaintiffs in the Employee Benefits Complaint are nine individual employees and corporate and municipal employers alleging claims on behalf of two separate nationwide purported classes: an employee class and an employer class that acquired insurance products from the defendants from August 26, 1994 to the date of any class certification. The Employee Benefits Complaint names AIG, as well as eleven brokers and five other insurers, as defendants. The activities alleged in the Employee Benefits Complaint, with certain exceptions, track the allegations of contingent commissions, bid-rigging and tying made in the Commercial Complaint.
On October 3, 2006, Judge Hochberg of the District of New Jersey reserved in part and denied in part motions filed by the insurer defendants and broker defendants to dismiss the multi-district litigation. The Court also ordered the plaintiffs in both actions to file supplemental statements of particularity to elaborate on the allegations in their complaints. Plaintiffs filed their supplemental statements on October 25, 2006, and the AIG defendants, along with other insurer and broker defendants in the two consolidated actions, filed renewed motions to dismiss on November 30, 2006. Briefing has been completed on the renewed motions to dismiss, as well as plaintiffs’ motion for class certification in both cases. On February 16, 2007, Chief Judge Brown of the District of New Jersey transferred the multi-district litigation to himself. Oral argument on the renewed motions to dismiss has been scheduled before Chief Judge Brown on March 1, 2007. Fact discovery in the multi-district litigation proceeding is ongoing.
SICO. In July, 2005, SICO filed a complaint against AIG in the Southern District of New York, claiming that AIG had refused to provide SICO access to certain artwork and asked the court to order AIG immediately to release the property to SICO. AIG filed an answer denying SICO’s allegations and setting forth defenses to SICO’s claims. In addition, AIG filed counterclaims asserting breach of contract, unjust enrichment, conversion, breach of fiduciary duty, a constructive trust and declaratory judgment, relating to SICO’s breach of its commitment to use its AIG shares only for the benefit of AIG and AIG employees. Fact and expert discovery has been substantially concluded and briefing on SICO’s motion for summary judgment is underway.
Minimum future rental income on noncancelable operating leases of flight equipment which have been delivered at December 31, 2006 was as follows:
Rent expense approximated $657 million, $597 million, and $568 million for the years ended December 31, 2006, 2005, and 2004, respectively.
Although AIG regularly reviews the adequacy of the established reserve for losses and loss expenses, there can be no assurance that AIG’s ultimate loss reserves will not develop adversely and materially exceed AIG’s current loss reserves. Estimation of ultimate net losses, loss expenses and loss reserves is a complex process for long-tail casualty lines of business, which include excess and umbrella liability, directors and officers liability (D&O), professional liability, medical malpractice, workers compensation, general liability, products liability and related classes, as well as for asbestos and environmental exposures. Generally, actual historical loss development factors are used to project
AIG and certain of its subsidiaries become parties to derivative financial instruments with market risk resulting from both dealer and end-user activities and to reduce currency, interest rate, equity and commodity exposures. These instruments are carried at their estimated fair values in the consolidated balance sheet. The vast majority of AIG’s derivative activity is transacted by AIGFP. See also Note 19 herein.
SAI Deferred Compensation Holdings, Inc., a wholly owned subsidiary of AIG, has established a deferred compensation plan for registered representatives of certain AIG subsidiaries, pursuant to which participants have the opportunity to invest deferred commissions and fees on a notional basis. The value of the deferred compensation fluctuates with the value of the deferred investment alternatives chosen. AIG has provided a full and unconditional guarantee of the obligations of SAI Deferred Compensation Holdings, Inc. to pay the deferred compensation under the plan.
Equity securities: Fair values were based on quoted market prices. Where market prices were not readily available, fair values were estimated using quoted market prices of comparable investments.
Trading assets and trading liabilities: Fair values approximate the carrying values.
The carrying values and fair values of AIG’s financial instruments at December 31, 2006 and 2005 were as follows:
(a) The carrying value of all other financial instruments approximates fair value.
The adoption of FAS 123R resulted in share-based compensation expense of approximately $17 million during 2006, related to awards which were accounted for under the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” FAS 123R also requires AIG to estimate forfeitures in calculating the expense relating to share-based compensation, rather than recognizing these forfeitures and corresponding reductions in expense as they occur. The pre-tax cumulative effect of adoption, recognized as a reduction in stock-based compensation of $46 million, was recorded as a cumulative effect of an accounting change, net of tax. FAS 123R requires AIG to reflect the cash savings resulting from excess tax benefits in its financial statements as cash flow from financing activities, rather than as cash flow from operating activities as in prior periods. The amount of this excess tax benefit for 2006 was $27.9 million.
Included in AIG’s consolidated statement of income for the year ended December 31, 2006 was pre-tax share-based compensation expense of $353 million ($326 million after tax).
If AIG had adopted the FAS 123 provisions for recognizing compensation expense commencing at the date of grant of the awards, the effect would not have been material to net income or basic or diluted earnings per share for 2005.
The 1999 Plan provides that options to purchase a maximum of 45,000,000 shares of common stock can be granted to certain key employees and members of the Board of Directors at prices not less than fair market value at the date of grant.
The 1999 Plan was approved by the shareholders at the 2000 Annual Meeting of Shareholders, with certain amendments approved at the 2003 Annual Meeting of Shareholders. The 1999 Plan superseded the 1991 Employee Stock Option Plan (the 1991 Plan), although outstanding options granted under the 1991 Plan continue in-force until exercise or expiration. The maximum number of shares that may be granted to any employee in any one year under the 1999 Plan is 900,000. Options granted under the 1999 Plan generally vest over four years (25 percent vesting per year) and expire 10 years from the date of grant.
At December 31, 2006, there were 19,615,911 shares reserved for future grants under the 1999 Plan and 28,021,943 shares reserved for issuance under the 1999 and 1991 Plans.
The dividend yield is based on the dividend yield over the twelve month period prior to the grant date.
In 2006, expected volatility is the average of historical volatility (based on seven years of daily stock price changes) and the implied volatility of actively traded options on AIG shares and in 2005, expected volatility is the historical volatility based on five years of daily stock price changes.
The interest rate curves used in the valuation model were the U.S. Treasury STRIP rates with terms from 3 months to 10 years.
The contractual term of the option is generally 10 years with an expected term of 7 years calculated based on an analysis of historical employee exercise behavior and employee turnover (post-vesting terminations). The early exercise rate is a function of time elapsed since the grant. Fifteen years of historical data were used to estimate the early exercise rate.
Additional information with respect to AIG’s stock option plans at December 31, 2006, and changes for the year then ended, were as follows:
Includes options with respect to 2,067,643 shares exercised with delivery deferred, resulting in obligations to issue 1,527,613 shares.
The following table presents information about stock options outstanding at December 31, 2006:
Vested and expected-to-vest options as of December 31, 2006, included in the table above, totaled 45,382,149, with a weighted average exercise price of $57.42, a weighted average contractual life of 4.33 years and an aggregate intrinsic value of $720 million.
The 2002 Plan was adopted at the 2002 Annual Meeting of shareholders and amended and restated by the AIG Board of Directors on September 18, 2002. The 2002 Plan provides that equity-based or equity-related awards with respect to shares of common stock can be issued to employees in any year up to a maximum of that number of shares equal to (a) 1,000,000 shares plus (b) the number of shares available but not issued in the prior calendar year. The maximum award that a grantee may receive under the 2002 Plan per year is rights with respect to 250,000 shares. During 2006 and 2005, 6,836,785 RSUs, including performance RSUs, and 3,055,835 RSUs, respectively, were granted by AIG. There were 4,488,458 shares reserved for issuance in connection with future awards at December 31, 2006. Substantially all RSUs granted to date under the 2002 Plan other than performance RSUs granted under the AIG DCPPP and the AIG Partners Plan vest on the fourth anniversary of the date of grant.
Although none of the costs of the various benefits provided under the SICO Plans have been paid by AIG, AIG has recorded compensation expense for the deferred compensation amounts paid to AIG employees by SICO, with an offsetting amount credited to additional paid-in capital reflecting amounts deemed contributed by SICO.
A significant portion of the awards under the SICO Plans vest upon retirement when or after the participant reaches age 65. The portion of the awards for which early payout is available vest on the applicable payout date.
The AIG DCPPP contingently allocates a fixed number of shares to each participant if AIG’s cumulative adjusted earnings per share, as determined by AIG’s Compensation Committee, for 2005 and 2006 exceed that for 2003 and 2004. The performance period is September 21, 2005 to December 31, 2006. At the end of the performance period, common shares are contingently allocated. The service period and related vesting consists of three pre-retirement tranches and a final retirement tranche at age 65.