(a) Comparability between 2010 and 2009 data is affected by the deconsolidation of AIA in the fourth quarter of 2010. Book value per share, excluding Accumulated other comprehensive income (loss) is a non-GAAP measure. See
MD&A - Results of Operations - AIG Property Casualty Operations for a reconciliation of the adjusted combined ratio.
Reflects changes from the adoption of the new accounting standard related to deferred acquisition costs for 2009 and 2008, as set out in further detail below. See Note 2 to the Consolidated Financial Statements for a description of the effect of the adoption of the new accounting standards on 2011 and 2010 periods, which is also reflected in the data presented above.
(b) Includes an adjustment to the loss accrual related to the sale of Nan Shan of $2.3 billion.
The following are significant developments that affected multiple periods and financial statement captions. Other items that affected comparability are included in the footnotes to the table presented immediately above.
In 2008, AIG also recognized unrealized market valuation losses representing the change in fair value of its super senior credit default swap portfolio, established a deferred tax valuation allowance and experienced an unprecedented strain on liquidity. This strain led to several transactions with the FRBNY and the Department of the Treasury. See Note 25 to the Consolidated Financial Statements for further discussion of these transactions and relationships.
The decline in interest expense in 2010 was due primarily to a reduced weighted-average interest rate on borrowings, a lower average outstanding balance and a decline in amortization of the prepaid commitment fee asset related to the partial repayment of the FRBNY Credit Facility. On January 14, 2011, AIG repaid the remaining $20.7 billion and terminated this facility, resulting in a net $3.3 billion pretax charge in the first quarter of 2011, representing primarily the accelerated amortization of the remaining prepaid commitment fee asset included in Net loss on extinguishment of debt. See Note 25 to the Consolidated Financial Statements for further discussion of the Recapitalization.
As a result of the closing of the Recapitalization on January 14, 2011, the preferred interests (the SPV Preferred Interests) in the special purpose vehicles that held remaining AIA shares and the proceeds of the AIA initial public offering and the ALICO sale (the SPVs) were transferred to the Department of the Treasury. After such closing, the SPV Preferred Interests were not considered permanent equity on AIG's Consolidated Balance Sheet and were classified as redeemable non-controlling interests.
On December 9, 2012, we announced the agreement to sell up to 90% of ILFC and executed multiple asset dispositions in 2010 and 2011, as further discussed in Note 4 to the Consolidated Financial Statements, including the completion of an initial public offering of AIA in 2010 for which AIG recognized an $18.1 billion gain.
Adjustment to Federal Deferred Tax Valuation Allowance in 2008, 2009, 2010, 2011 and 2012
As further discussed in Note 24 to the Consolidated Financial Statements, AIG concluded that $18.4 billion of the deferred tax asset valuation allowance for the U.S. consolidated income tax group should be released through the Consolidated Statement of Operations in 2011. The valuation allowance resulted primarily from losses subject to U.S. income taxes recorded from 2008 through 2010.
AIG's strategies to grow net investment income, efficiently manage capital and reduce expenses;
AIG's strategies for customer retention, growth, product development, market position, financial results and reserves; and
It is possible that AIG's actual results and financial condition will differ, possibly materially, from the results and financial condition indicated in these projections, goals, assumptions and statements. Factors that could cause AIG's actual results to differ, possibly materially, from those in the specific projections, goals, assumptions and statements include:
this Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A); and
Catastrophe losses are generally weather or seismic events having a net impact on AIG Property Casualty in excess of $10 million each.
Other Operations - Operating income (loss):income (loss) excluding certain legal reserves (settlements) related to legacy crisis matters described above, loss on extinguishment of debt, amortization of prepaid commitment fee asset, Net realized capital (gains) losses, net (gains) losses on sale of divested businesses and properties, and income from divested businesses. Results from discontinued operations are excluded from all of these measures.
AIG made solid progress toward many of its strategic objectives in 2012.
We improved our financial and operational performance, leading to a third consecutive year of profitability:
AIG Property Casualty reported improved operating income and the business also has continued to experience positive pricing trends.
Our financial flexibility was enhanced by $5.2 billion in cash distributions from subsidiaries.
We announced an agreement to sell ILFC, received final distributions on our interests in Maiden Lane II LLC (ML II) and ML III, and sold our remaining interest in AIA Group Limited (AIA), which will support our capital management initiatives, sharpen our business focus, and enable us to redeploy assets in a more productive manner.
* Comparability between 2011 and 2010 data is affected by the deconsolidation of AIA in the fourth quarter of 2010.
The following table presents a reconciliation of pre-tax income (loss) to operating income (loss) by operating segment and after-tax operating income (loss), which are non-GAAP measures. See Use of Non-GAAP Measures for additional information.
As discussed in Note 2 to the Consolidated Financial Statements, AIG retrospectively adopted an accounting standard on January 1, 2012 that amended the accounting for costs incurred by insurance companies that can be capitalized in connection with acquiring or renewing insurance contracts.
In the fourth quarter of 2012, to increase the focus on the drivers of the losses and proactively mitigate reserve development and legal costs, the management of certain environmental liability businesses written prior to 2004 was moved from Commercial Insurance to a separate claims organization. To align financial reporting with the internal management changes, this environmental (1987-2004) business is reported in the Other category. These revisions did not affect our total reportable segment results previously reported.
To align the presentation of changes in the fair value of derivatives with changes in the administration of AIG's derivatives portfolio, changes were made to the presentation within the Consolidated Statement of Operations and Consolidated Statement of Cash Flows. Specifically, amounts attributable to derivative activity where AIG Financial Products Corp. and AIG Trading Group Inc. and their respective subsidiaries (collectively AIGFP) is an intermediary for AIG subsidiaries have been reclassified from Other income to Net realized capital gains (losses).
Net investment income increased 38 percent to $20.3 billion in 2012 compared to 2011, primarily through our previous investments in ML III and AIA. The overall credit rating of our fixed maturity portfolio was largely unchanged, and other-than- temporary impairments declined compared to prior year levels.
•Our insurance operations achieved a $1.3 billion increase in net investment income in spite of the challenges presented by a continuing low rate environment. Net investment income improved due to the impact of yield enhancement initiatives and higher base yields. While corporate debt securities represented the core of new investment allocations, we continued to focus on risk weighted opportunistic investments in residential mortgage-backed (RMBS) and other structured securities to improve yields. These included purchases of assets sold in the ML II and ML III auctions by the FRBNY.
•The overall credit ratings of our fixed maturity investments were largely unchanged from last year, reflecting a continued focus on long term risk adjusted portfolio performance.
Our business is affected by industry and economic factors such as interest rates, credit and equity market conditions, regulation, tax policy, competition, and general economic, market and political conditions. In 2012, and continuing into 2013, we operated under difficult market conditions, characterized by factors such as low interest rates, instability in the global markets due to the European debt crisis, and slow growth in the U.S. economy.
The prevailing interest rate climate has a particularly significant effect on our industry. Investment returns have declined as the U.S. fixed income market remains in a low interest rate environment. In addition, current market conditions may not necessarily permit insurance companies to increase pricing across all our product lines.
The strategic outlook for each of our businesses and management initiatives to improve growth and performance in 2013 and over the longer term are described below.
We expect that the current low interest rate environment and ongoing uncertainty in global economic conditions will continue to challenge the growth of net investment income and limit growth in some markets through at least 2013. These conditions, coupled with overcapacity in the property casualty insurance industry business, are leading carriers to tighten terms and conditions, shed unprofitable business and develop advanced data analytics in order to improve profitability.
We expect that shifting our mix of business to higher value lines and geographies of opportunity will generate business with more favorable underwriting results. However, as a result of the business mix shift to consumer products, higher value commercial products, and the investment in growth economy nations, policy acquisition expenses, including direct marketing costs, are expected to continue to increase.
We expect to reduce loss costs by realizing greater efficiencies in servicing customer claims, introducing fraud detection tools and developing knowledge of the economic drivers of losses, which will proactively mitigate reserve development and legal costs, and establish effective pricing strategies.
Expand in attractive growth economies, specifically in Asia Pacific, the Middle East and Latin America.
Optimize the investment portfolio by aligning it with our risk appetite and tax objectives.
We plan to continue to execute capital management initiatives by enhancing broad-based risk tolerance guidelines for our operating units, implementing underwriting strategies to increase return on equity by line of business and reducing exposure to businesses with inadequate pricing and increased loss trends. In addition, we remain focused on enhancing our global reinsurance strategy to improve capital efficiency.
We continue to streamline our legal entity structure, to enhance transparency with regulators and optimize capital and tax efficiency. For the year ended December 31, 2012, we completed 41 legal entity and branch restructuring transactions. We completed the integration of our European operations into a single pan-European insurance company, AIG Europe Limited, and continued the restructuring activities in the Asia Pacific region, including focusing on the strategy to consolidate the Japan operations under one holding company. During 2012, our restructuring and capital management initiatives enabled certain subsidiaries in Europe and the Asia Pacific region to return $575 million of capital to be used for general corporate purposes. We continue to implement restructuring plans in each region and the overall end state structure is expected to be mostly completed by the end of 2014.
Opportunistic investments in structured securities and other yield-enhancement opportunities continue to be made with the objective of increasing net investment income. Overall base yields increased in 2012 due to the portfolio mix shift away from tax-exempt municipal bonds toward taxable instruments; overall investment purchases were made at expected yields higher than the weighted average yields of the existing portfolio.
AIG Life and Retirement plans to fully leverage its unified all-channel distribution organization to increase sales of profitable products across all channels. In addition, management will pursue select institutional market opportunities where AIG Life and Retirement's scale and capacity provides a competitive market advantage. AIG Life and Retirement is well positioned to capitalize on the growing demand for income solutions while certain competitors are scaling back in this market. AIG Life and Retirement will continue to manage the risks associated with variable annuity living benefits through innovative product designs and hedging strategies. Given the size and diversity of AIG Life and Retirement's overall product portfolio, variable annuity reserves are a relatively small portion of its total reserves compared to others in this market. As a result of a broad distribution network and a more favorable competitive environment, AIG Life and Retirement expects variable annuity sales to remain strong for 2013.
AIG Life and Retirement expects to leverage its streamlined legal entity structure to enhance financial strength and durability capital efficiency and ease of doing business. AIG Life and Retirement completed the merger of six life insurance operating legal entities into American General Life Insurance Company effective December 31, 2012. This merger will allow for more effective capital and dividend planning while creating operating efficiencies and making it easier for producers and customers to do business with AIG Life and Retirement. AIG Life and Retirement also plans to improve operational efficiencies and service through investments in technology, more productive use of existing resources and further use of lower-cost operations centers.
AIG Life and Retirement places primary emphasis on investments in fixed maturity securities issued by corporations, municipalities and other governmental agencies, structured securities collateralized by, among others, residential and commercial real estate, and to a lesser extent, commercial mortgage loans, private equity, hedge funds, other alternative investments, and common and preferred stock.
Our fundamental investment strategy is to maintain primarily a diversified, high quality portfolio of fixed maturity securities and, as nearly as is practicable, to match the duration characteristics of our liabilities with assets of comparable duration. In addition, AIG Life and Retirement enhances its returns through investments in a diversified portfolio of private equity funds, hedge funds and affordable housing partnerships. Although returns on these investments are more volatile than our base fixed maturity securities portfolio, they have historically achieved higher total returns and yields than the base portfolio yields. AIG Life and Retirement's expectation is that these alternative investments will continue to outperform the base portfolio yields over the long-term.
See Segment Results - AIG Life and Retirement Operations and Note 7 to the Consolidated Financial Statements for additional information.
Market developments - UGC is a market leader in the mortgage insurance industry with a differentiated risk-based pricing model that is designed to produce high quality new business. The withdrawal of certain competitors from the market during 2011 combined with UGC's investment grade rating and risk-based pricing has positioned UGC to take advantage of market opportunities. UGC plans to continue to execute this strategy during 2013 and to further enhance its market position. UGC will continue to review its new business pricing relative to changes in the market to ensure that the price of coverage is commensurate with the level of risk being underwritten.
Delinquent inventory review - During 2011 and 2012, UGC requested that lenders file claims, in accordance with the terms of the respective master policies, on approximately 21,000 accounts that had been delinquent approximately 24 months or more and were not expected to cure. Many of these delinquencies were the result of the foreclosure moratorium discussed below. Through December 31, 2012, UGC received responses to approximately 96 percent of these requests. While accelerating the payment of claims, these requests also impacted the cure rate of the delinquent inventory which in turn impacted UGC's estimate of reserve for loss and loss adjustment expenses. During 2013, reserve development may continue to have an impact on the business. UGC expects that newly reported delinquent loans will continue to decline during 2013 and that the delinquent inventory will decline further albeit at a slower rate than in 2012. However, the extent of the decline in delinquencies and the number of newly reported delinquencies is dependent on the prevailing macroeconomic conditions and the extent that the domestic economy does or does not improve. UGC will closely monitor these trends and the impact on its incurred loss and loss expenses in 2013.
The remaining derivatives portfolio of AIGFP consists primarily of hedges of the assets and liabilities of the DIB and a portion of the legacy hedges for AIG and its subsidiaries. Future hedging needs for AIG and its subsidiaries will be executed through AIG Markets. AIGFP's derivative portfolio consists primarily of interest rate, currency, credit, commodity and equity derivatives. Additionally, AIGFP has a credit default swap portfolio being managed for economic benefit and with limited risk. The AIGFP portfolio continues to be wound down and is managed consistent with our risk management objectives. Although the portfolio may experience periodic fair value volatility, it consists predominantly of transactions that we believe are of low complexity, low risk or currently not economically appropriate to unwind based on a cost versus benefit analysis.
The DIB portfolio is being wound down and is managed with the objective of ensuring that at all times it maintains the liquidity we believe is necessary to meet all its liabilities, as they come due, even under stress scenarios and to maximize return consistent with our risk management objectives. We are focused on meeting the DIB's liquidity needs, including the need for contingent liquidity arising from collateral posting for debt positions of the DIB without relying on resources beyond the DIB. As part of this program management, we may from time to time access the capital markets, subject to market conditions. In addition, we may seek to buy back debt or sell assets on an opportunistic basis, subject to market conditions.
Certain non-derivative assets and liabilities of the DIB are accounted for under the fair value option and thus operating results are subject to periodic market volatility. The overall hedging activity for the assets and liabilities of the DIB is executed by GCM. The value of hedges related to the non-derivative assets and liabilities of AIGFP in the DIB are included within the assets and liabilities and operating results of GCM and are not included within the DIB operating results, assets or liabilities.
increases in fair value of AIG's interest in AIA ordinary shares of $2.1 billion and $1.3 billion in 2012 and 2011, respectively. The increase in fair value in 2012 included a gain on sale of AIA ordinary shares of approximately $0.8 billion;
an increase in fair value of AIG's interest in ML III of $2.9 billion in 2012, compared to a decrease in fair value of $646 million in the same period of 2011;
an increase in estimated litigation liability of approximately $783 million for the year ended December 31, 2012 based on developments in several actions;
litigation settlement income of $210 million in 2012 from settlements with three financial institutions who participated in the creation, offering and sale of RMBS from which AIG and its subsidiaries suffered losses either for their own accounts or in connection with their participation in AIG's securities lending program; and
a $3.3 billion net loss, primarily consisting of the accelerated amortization of the remaining prepaid commitment fee asset resulting from the termination of the credit facility provided by the FRBNY (the FRBNY Credit Facility) in 2011. This was partially offset by a $484 million gain on extinguishment of debt in the fourth quarter of 2011 due to the exchange of subordinated debt.
For the third consecutive year we posted a full year profit.
Our total AIG Property Casualty accident year loss ratio, as adjusted, improved each year during the past three years.
Our investment portfolio performance improved due to the completion of the cash deployment in 2011.
After-tax operating income for 2012 was $6.6 billion compared to $2.1 billion for 2011.
Income from continuing operations before income taxes for 2011 and 2010 reflected the following:
•a reduction in realized capital losses in 2011 compared to 2010. As discussed above, AIG released $18.4 billion of the deferred tax asset valuation allowance for the U.S. consolidated income tax group in 2011.
In 2011, AIG recorded income from discontinued operations net of taxes of $1.8 billion, which included a pre-tax gain of $3.5 billion recorded in the first quarter of 2011 on the sale of AIG Star Life Insurance Co., Ltd. (AIG Star) and AIG Edison Life Insurance Company (AIG Edison). This compared to a net loss of $969 million in 2010, which included goodwill impairment charges of $4.6 billion associated with the sale of American Life Insurance Company (ALICO), AIG Star and AIG Edison.
For the year ended December 31, 2011, the effective tax rate on pre-tax operating income was (9.6) percent. The significant factors that contributed to the difference from the statutory rate included tax benefits resulting from tax exempt interest income, tax benefits associated with non-controlling interests, as well as discrete tax benefits recorded during the year.
For the year ended December 31, 2010, the effective tax rate on pre-tax operating income was 70.2 percent. The effective tax rate attributable to pre-tax operating income for the year ended December 31, 2010 differs from the statutory rate primarily due to tax benefits associated with divested businesses, which are excluded from after-tax operating income.
AIG reports the results of its operations through two reportable segments: AIG Property Casualty and AIG Life and Retirement. The Other operations category consists of businesses and items not allocated to our reportable segments.
AIG Life and Retirement - Pre-tax income increased in 2012 compared to 2011, principally due to efforts to actively manage net investment spreads. Results benefited from higher net investment income, lower interest credited, lower reserves for death claims and the impact of more favorable separate account performance on DAC amortization and policyholder benefit reserves. These items were partially offset by significant proceeds from a legal settlement in 2011, higher mortality costs and an increase in GIC reserves.
Other Operations - Other Operations recorded pre-tax income in 2012 compared to a pre-tax loss in 2011 due to fair value and realized gains in our interest in AIA ordinary shares, and in our interest in ML III, partially offset by an increase in estimated litigation liability, and a loss on extinguishment of debt of $3.3 billion in 2011 in connection with the termination of the FRBNY Credit Facility.
AIG Life and Retirement - Pre-tax income increased in 2011 compared to 2010 primarily due to net realized capital gains in 2011 compared to net realized capital losses in 2010 as a result of a decline in other-than-temporary impairments, partially offset by lower net investment income due to lower base yields and an increase in death claim reserves in conjunction with the use of the Social Security Death Master File (SSDMF) to identify potential claims not yet filed with its life insurance companies.
Net premiums written decreased for the year ended December 31, 2012 reflecting the continued execution of our strategic initiatives to improve business mix, pricing and loss performance. Declines within Commercial Insurance due to certain lines of business that did not meet internal operating objectives were partially offset by an increase in Consumer Insurance net premiums written.
The loss ratio improved by 4.4 points for the year ended December 31, 2012, due to a decrease in catastrophe losses, the benefit from positive pricing trends, the execution of our strategic initiatives and an increase in reserve discount. Catastrophe losses, adjusted for reinstatement premiums, were $2.7 billion in 2012, primarily as a result of Storm Sandy in the fourth quarter of 2012, compared to $3.3 billion in 2011. For the years ended December 31, 2012 and 2011, catastrophe losses contributed 7.5 and 9.2 points to the loss ratio, respectively. Net prior year adverse development, including related premium adjustments was $445 million and $39 million for the years ended December 31, 2012 and 2011, respectively.
Net investment income increased by 11.0 percent for the year ended December 31, 2012, due to asset diversification by reducing the concentration in tax-exempt municipal instruments and increasing investments in private placement debt and structured securities.
We paid cash and non-cash dividends of $2.5 billion to AIG in the year ended December 31, 2012. As a result of Storm Sandy catastrophe losses, AIG contributed $1.0 billion of capital in cash to its U.S. property casualty insurance subsidiaries in December 2012.
We will continue to assess the performance of our operating segments based on operating income (loss), loss ratio, acquisition ratio, general operating expense ratio and combined ratio.
We are developing new value-based metrics that provide management shorter-term measures to evaluate our performance across multiple lines and various countries. As an example, we have implemented a risk-adjusted profitability model as a business performance measure. Along with underwriting results, this risk-adjusted profitability model incorporates elements of capital allocations, costs of capital and net investment income. We believe that such performance measures will allow us to better assess the true economic returns of our business.
For the years ended December 31, 2012 and 2011, results reflect the effects of the full year of Fuji operations, while the corresponding 2010 period reflects the effects of Fuji for only two quarters, because we began consolidating Fuji's operating results on July 1, 2010, following its acquisition. Fuji operations primarily relate to Consumer Insurance.
Property net premiums written increased due to rate increases, primarily in the U.S., reduced catastrophe bond purchases in 2012, and the restructuring of the per-risk reinsurance program as part of our decision to retain more favorable risks while continuing to manage aggregate exposure. Catastrophe exposed business retained in the Americas and Asia Pacific region also benefitted from rate increases.
Financial lines net premiums written increased, reflecting strong business growth in all regions, despite targeted decreases where the business did not meet our risk selection and internal performance criteria. Financial lines net premiums written for year ended December 31, 2011 benefited from a multi-year Errors and Omissions policy in the Americas that produced net premiums written of $148 million.
A&H net premiums written increased, due to the growth of group personal accident business in the Americas and Asia Pacific, strong growth of new business sales in Fuji Life, travel insurance business, direct marketing programs in Japan and other Asia Pacific nations and growth in individual personal accident in other Asia Pacific nations. This was partially offset by the continuing strategies to reposition U.S. direct marketing operations, as well as pricing and underwriting actions in Europe.
Personal lines net premiums written increased primarily due to the execution of our strategic initiative to grow higher value lines of business in non-automobile products and rate increases in Japan automobile products. Growth in non-automobile net premiums written outpaced growth in automobile net premiums written, increasing its proportion to total net premiums written, due to our focus on diversifying the global product mix.
In 2011, net premiums written increased due to the effects of overall improvements in ratable exposures (i.e., asset values, payrolls and sales), general pricing improvement and retrospective premium adjustments on loss-sensitive contracts. We implemented certain initiatives designed to provide for a more effective use of capital, further growth in the strategic higher value lines of business and improvement in foreign exchange rates.
Property net premiums written increased due to particularly strong pricing trends in the U.S. and Japan, coupled with changes in the reinsurance strategy resulting in increased retentions. The catastrophe bond transactions in 2011 and 2010 reduced net premiums written by approximately $201 million and $208 million, respectively.
Financial lines net premiums written increased primarily due to a multi-year Errors and Omissions policy in the Americas that produced net premiums written of $148 million in 2011.
A&H net premiums written increased primarily due to the Fuji acquisition, direct marketing, group and individual accident, travel business, and the execution of new business strategies at Fuji Life. Excluding the Fuji acquisition, A&H net premiums written increased by approximately 7 percent, mainly attributable to favorable marketing programs and the benefits of rate increases implemented in 2010 in Japan and the effect of foreign exchange. Growth was also demonstrated in key geographic markets such as China, Continental Europe and Israel.
Asia Pacific net premiums written increased for the year ended December 31, 2012 primarily due to an increase in Consumer Insurance reflecting growth of personal property business, group personal accident insurance, and direct marketing business in Japan. The expansion in Asia Pacific countries outside Japan also continued in the year ended December 31, 2012, supported by growth in individual personal accident insurance, direct marketing and personal lines products. Commercial Insurance increased in the region primarily due to organic growth and rate increases in Property and moderate organic growth in Specialty and Financial lines.
EMEA net premiums written decreased primarily due to the impact of foreign exchange. The continued execution of underwriting discipline and the reduction in certain casualty lines that did not meet internal performance targets were offset by rate strengthening initiatives on new and renewal business for Commercial Insurance. Consumer Insurance experienced modest growth in travel, warranty, and specialty personal lines products while focused on re-building its direct marketing programs that it previously shared with American Life Insurance Company (ALICO).
Asia Pacific net premiums written increased as a result of the effect of the full year consolidation of Fuji. Excluding the effect of the Fuji acquisition, net premium written increased 13 percent. The increase in Commercial Insurance was due to rate increases in Property, primarily in Japan. Consumer Insurance business in Asia Pacific countries outside Japan also expanded, supported by growth in nearly all lines of business, particularly individual personal accident insurance, travel, and auto products.
Given the nature of the lines of business and the expenses included in Other, management has determined that the traditional underwriting measures of loss ratio, acquisition ratio, general operating expense ratio and combined ratio do not provide an appropriate measure of underwriting performance. Therefore, these ratios are not separately presented for Other.
The acquisition ratio increased by 2.0 points primarily due to our strategy of growing higher value lines, which typically incur higher acquisition costs, and the restructuring of our Casualty lines, especially the loss-sensitive
business in the U.S. In addition, ceding commissions decreased as a result of restructuring of the Property and Specialty reinsurance program as part of the strategic decision to retain more profitable business while continuing to manage aggregate exposures.
The acquisition ratio increased by 1.2 points primarily due to profit sharing arrangements in lines of business targeted for growth, direct marketing expenses and the reduction in VOBA benefit. Overall direct marketing costs increased by approximately 9 percent in 2012; total direct marketing spending outside the U.S. increased by approximately 18 percent in the same period. There was also a decrease of approximately $49 million in the benefit from the amortization of VOBA liabilities recognized at the time of the Fuji acquisition.
The Commercial Insurance accident year loss ratio, as adjusted, increased in 2011 due to increased losses for the Specialty Workers' Compensation and Excess Casualty business (in the Americas region) and the Primary Casualty and Professional Indemnity businesses (in the EMEA region). Severe losses were $296 million for the year ended December 31, 2011, compared to $135 million in the prior year. These increases were largely offset by rate strengthening and underwriting actions taken since 2010.
The general operating expense ratio decreased by 0.3 points, primarily due to the growth in the business offset by investments in strategic initiatives, including a consumer lines platform and the implementation of global finance and information systems totaling $16 million, an increase of approximately $9 million over the prior year.
We increased investments in a number of strategic initiatives during 2011, including the implementation of improved regional governance and risk management capabilities, the implementation of global accounting and claims systems, preparation for Solvency II and certain other legal entity restructuring initiatives. For the year ended December 31, 2011, such investments totaled $196 million, representing an increase of approximately $134 million over the prior year, and contributed approximately 0.5 points to the AIG Property Casualty general operating expense ratio.
(a) Events shown in the above table are catastrophic insured events having a net impact in excess of $10 million each. Severe losses are defined as non-catastrophe individual first party losses greater than $10 million, net of related reinsurance.
(b) On October 29, 2012 Storm Sandy, one of the largest Atlantic hurricanes on record, came ashore in the U.S. When the storm made landfall, it was categorized as an extratropical cyclone, not a hurricane. Storm Sandy is expected to be the second-costliest Atlantic hurricane in history, only surpassed by Hurricane Katrina in 2005. Storm Sandy caused widespread flooding and wind damage across the mid-Atlantic states.
Investment income is allocated to the Commercial Insurance and Consumer Insurance operating segments based on an internal investment income allocation model. The model estimates investable funds based primarily on loss reserves, unearned premium and a capital allocation for each segment. The investment income allocation is calculated based on the estimated investable funds and risk-free yields (plus an illiquidity premium) consistent with the approximate duration of the liabilities. The actual yields in excess of the allocated amounts and the investment
Net realized capital losses for the year ended December 31, 2012 were driven by other-than-temporary impairments and impairment charges on life settlement contracts offset by gains recognized on the sale of fixed maturity and equity securities. We recognized other-than-temporary impairment charges of $377 million primarily attributable to a decrease in recoverable values for structured securities, partnership investments and equity securities in an unrealized loss position for more than 12 months. During 2012, we recognized impairment charges on life settlement contracts in the amount of $309 million as a result of decreases in their estimated fair value as well as a change in management's intent about continuing to hold certain life settlement contracts. In addition, we recognized a loss of $43 million from derivatives used to economically hedge foreign currency positions. These decreases were offset by gains recognized on the sale of fixed maturity and equity securities in the amount of $675 million and a gain on the sale of a property in the amount of $55 million.
The following discussion of the consolidated liability for unpaid claims and claims adjustment expenses (loss reserves) presents loss reserves for AIG Property Casualty as well as the loss reserves pertaining to the Mortgage Guaranty reporting unit, which is reported in Other.
The following table presents the components of AIG's gross loss reserves by major lines of business on a U.S. statutory basis*:
(c) See tables below for details of prior year development by business unit, accident year and major class of business.
The following tables summarize development, (favorable) or unfavorable, of incurred losses and loss expenses for prior years, net of reinsurance:
In determining the loss development from prior accident years, we analyze and evaluate the change in estimated ultimate loss for each accident year by class of business. For example, if loss emergence for a class of business is different than expected for certain accident years, the actuaries examine the indicated effect such emergence would have on the reserves of that class of business. In some cases, the higher or lower than expected emergence may result in no clear change in the ultimate loss estimate for the accident years in question, and no adjustment would be made to the reserves for the class of business for prior accident years. In other cases, the higher or lower than expected emergence may result in a larger change, either favorable or unfavorable. As appropriate, we make adjustments for the difference between the actual and expected loss emergence. As part of our reserving process, we also consider notices of claims received with respect to emerging and/or evolving issues, such as those related to the U.S. mortgage and housing market.
During 2012, the excess casualty class of business experienced $262 million of adverse development based on worse than expected emergence in 2012, primarily from adverse outcomes relating to certain large claims from older accident years, from the legacy public entity excess casualty class of business and from a refined analysis applied to claims in excess of $10 million. This refined analysis considers the impact of changing attachment points (primarily impacting frequency of excess claims) and limit structures (primarily impacting severity of excess claims) throughout the loss development period.
Loss development was affected by an increase in loss costs in 2010, primarily due to medical inflation, which increased the economic loss component of tort claims; advances in medical care, which extended the life span of severely injured claimants; and larger jury verdicts, which increased the value of severe tort claims.
We experienced favorable development in 2012 and 2011. The favorable development over the two-year period related primarily to accident years 2005-2007, 2010, and, to a lesser extent, accident years 2001 and 2002. Development in 2010 was slightly negative.
During the 2012 loss reserve review, we augmented traditional reserve methodologies with an analysis of underlying claims cost drivers to inform our judgment of the ultimate loss costs for open reported claims from accident years 2003 and prior (representing approximately 95 percent of all open reported claims) and used the refined analysis to inform our judgment of the ultimate loss cost for claims that have not yet been reported using a frequency/severity approach for these accident years.
The refined analysis confirmed that significant uncertainty remains for this class of business, especially from unreported claims and from the propensity for future medical deterioration. Based on the more refined analysis we did not recognize any material development for accident years 2011 and prior.
AIG experienced significant adverse development of $825 million for this class in 2010. With the passage of the Affordable Care Act in March 2010, we concluded that there is increased vulnerability to the risk of further cost-shifting to the excess workers' compensation class of business. Settlement efforts can also be affected by changes to evaluation protocols implemented by the Centers for Medicare & Medicaid Services in 2009. These changes were expected to result in future prescription drug costs being borne by workers' compensation insurers to a significantly greater degree than in the past, and were assessed as being likely to lead to further deteriorating trends for the excess workers' compensation class of business.
reporting unit. Approximately 80 percent of the 2011 development was associated with accident years 2003 and prior.
•the difficulty in estimating the allocation of remediation cost among various parties with respect to environmental claims. As a result of the top-down and ground-up reserve analyses and the factors considered, asbestos reserves were strengthened by $3.3 billion gross and $1.5 billion net in 2010.
In 2011, we completed a top-down report year projection as well as a market share projection of our indicated asbestos and environmental loss reserves. These projections consisted of a series of tests performed separately for asbestos and for environmental exposures.
For asbestos, these tests project the losses expected to be reported through 2027. This projection was based on the actual losses reported through 2011 and the expected future loss emergence for these claims. Three scenarios were tested, with a series of assumptions ranging from more optimistic to more conservative.
For environmental claims, a comparable series of frequency/severity tests were produced. We updated the top-down report year projections in 2012. In this updated projection, environmental claims from future report years (i.e., IBNR) are projected out ten years, through the year 2022.
After we carefully considered the recent experience compared to the results of the 2010 ground-up analysis, as well as all of the above factors, no adjustment to gross and net asbestos reserves was recognized in 2012. Additionally in 2012, a moderate amount of incurred loss pertaining to the asbestos loss reserve discount is reflected in the table below and is related to the reserves not subject to the NICO reinsurance agreement.
* Net IBNR includes the reduction due to the NICO reinsurance transaction of $1,310 million and $1,414 million as of December 31, 2012 and 2011, respectively. A significant part of the reduction in IBNR in 2012 is due to the reclassification of estimated liabilities on a retained account from IBNR to case reserves.
•Disciplined spread management, primarily through the effect of reinvestment during 2011 of significant amounts of cash and short term investments and crediting rate changes, resulted in improvements in base net investment spreads for 2012. Private equity and hedge fund investment income increased $112 million in 2012 compared to 2011.
•Higher net realized capital gains from the sale of investments were reflected in 2012 in conjunction with a program to utilize capital loss tax carryforwards. The sales of securities in unrealized gain positions that support certain payout annuity products, and subsequent reinvestment of the proceeds at generally lower yields, triggered loss recognition accruals in 2012.
AIG Life and Retirement presents its business in two operating segments:
Operating income increased in 2012 principally due to our efforts to actively manage spread income. Results benefitted from higher net investment income, lower interest credited, lower reserve charges for death claims and the impact of favorable separate account performance on policyholder benefit expenses and DAC amortization. These items were partially offset by significant proceeds from legal settlements in 2011, higher mortality costs and a charge to increase GIC reserves.
Policy fees increased in 2012 as a result of growth in variable annuity assets under management from higher net flows and separate account performance, driven in large part by higher equity markets.
Amortization of deferred acquisition costs decreased in 2012 primarily as a result of updated assumptions related to fixed annuity surrender rates and the impact of favorable separate account performance.
Other acquisition and insurance expenses decreased in 2012 primarily due to the sharing of group benefit costs related to our strategic partnership with AIG Property Casualty.
Retirement Services operating income increased in 2012 due to improved net investment spreads (higher net investment income and lower interest credited), the impact of favorable separate account performance on DAC amortization and policyholder benefit expenses and lower DAC amortization due to updated assumptions for fixed annuity surrenders. These items were partially offset by significant proceeds from legal settlements in 2011 and an increase in GIC reserves in 2012.
Other income decreased due to the previously discussed legal settlement proceeds of $226 million in 2011 to resolve a litigation matter as discussed above.
Interest credited to policyholder account balances decreased in 2012 as a result of ongoing actions to actively manage interest crediting rates on new and renewal business including lower renewal credited rates, discipline on new business pricing and re-filing products to reduce minimum rate guarantees. As a result of a comprehensive review of reserves for the GIC portfolio, AIG Life and Retirement recorded an increase to such reserves through interest credited of $110 million for 2012, which partially offset the impact of crediting rate actions.
Amortization of deferred acquisition costs was lower in 2012 as a result of the favorable impact of updated assumptions for lower fixed annuity surrenders and the impact of higher separate account returns described above. For investment-type annuity products, policy acquisition and issuance costs are deferred and amortized, with interest, based on the estimated gross profits expected to be realized over the lives of the contracts. Estimated gross profits
include investment spreads, net realized investment gains and losses, fees, surrender charges, expenses and mortality gains and losses. Emerging actual gross profits are used to true up the amortization of DAC, VOBA and SIA each quarter. In addition, future assumptions are reviewed to determine whether they should be modified. If so, the DAC, VOBA and SIA assets may be recalculated and adjusted to reflect the updated assumptions. AIG Life and Retirement completed its comprehensive annual review of DAC assumptions in the fourth quarter of 2012 and adjusted the assumption for future fixed annuity surrender rates to be more consistent with recent experience that is expected to continue as long as interest rates remain relatively low.
Net investment income decreased in 2011 compared to 2010 reflecting lower base yields of 12 basis points as investment purchases in late 2010 and 2011 were made at yields lower than the weighted average yields of the existing base portfolio. Net investment income also decreased due to a $471 million decrease in fair value gains on ML II, $196 million lower call and tender income, $163 million of impairment charges on investments in leased commercial aircraft and a $121 million decrease in private equity and hedge funds income. The lower yields were partially offset by an increase in income from the reinvestment of significant amounts of cash and short term investments during 2011.
Policyholder benefits and claims incurred increased as a result of reserve charges for death claims not submitted to us in the normal course of business and higher reserves for guaranteed death benefits in our variable annuity products as a result of less favorable separate account performance in 2011 as compared to 2010.
Other acquisition and insurance expenses declined due to legal expense accruals and state guaranty fund assessments which were higher in 2010, as well as a reduction in the cost of letters of credit related to reinsurance.
Life Insurance operating income decreased in 2011 due to lower net investment income and an increase in death claim reserves, partially offset by lower DAC amortization due to updating actuarial assumptions in 2010 principally related to mortality and surrender rates.
Policyholder fees declined primarily as a result of updating certain assumptions in 2010 related to universal life and deferred annuity business, which resulted in a $58 million increase in fee income.
Policyholder benefits and claims incurred increased in 2011 reflecting an increase in reserves for death claims. AIG Life and Retirement recorded an increase of approximately $202 million in the estimated reserves for incurred but not reported death claims in 2011 in conjunction with the use of the Social Security Death Master File (SSDMF) to identify potential claims not yet filed with its life insurance companies.
Net investment income decreased in 2011 compared to 2010 reflecting lower base yields as investment purchases in late 2010 and 2011. Net investment income also decreased due to a $322 million decrease in fair value gains on ML II, $70 million lower call and tender income, $113 million of impairment charges on investments in leased commercial aircraft and a $127 million decrease in private equity and hedge fund income. The lower yields were partially offset by an increase in income from the reinvestment of significant amounts of cash and short term investments during 2011.
Changes in Fair Value of Fixed Maturity Securities Designated to Hedge Living Benefit Liabilities
AIG Life and Retirement has a dynamic hedging program designed to manage economic risk exposure associated with changes in equity markets, interest rates and volatilities related to embedded derivative liabilities contained in guaranteed benefit features of variable annuities. We substantially hedge our exposure to equity markets. However, due to regulatory capital considerations, a portion of our interest rate exposure is unhedged. In 2012, we began purchasing U.S. Treasury bonds as a capital-efficient strategy to reduce our interest rate risk exposure over time. As a result of decreases in interest rates on U.S. Treasury securities during 2012, the fair value of the U.S. Treasury securities used for hedging, net of financing costs, increased by $37 million. This was partially offset by embedded derivative losses related to the decline in interest rates, which are reported in net realized gains (losses).
In conjunction with a program to utilize capital loss tax carryforwards, we sold approximately $19.5 billion of investments in 2012. These and other sales with subsequent reinvestment at lower yields triggered loss recognition on certain long-term payout annuity contracts in the amount of $1.2 billion, which effectively transferred shadow loss recognition from unrealized (AOCI) to actual loss recognition (benefit expense) and, to a much lesser extent, transferred shadow DAC (AOCI) to DAC amortization expense in 2012. Assumptions related to investment yields, mortality experience and expenses will be reviewed periodically and updated as appropriate, which may result in additional loss recognition reserves. In addition, due to the reinvestment of the assets at lower yields, earnings related to this payout annuity block of business are expected to decline beginning in 2013.
Individual fixed annuity deposits declined due to the low interest rate environment as consumers are reluctant to purchase these products at the relatively low crediting rates currently offered. Group retirement product deposits (which include deposits into mutual funds and fixed options within variable annuities sold in group retirement markets) decreased modestly due to slightly lower levels of individual rollover deposits and periodic deposits in 2012, partially offset by higher mutual fund deposits. The low interest rate environment has affected group retirement deposits, resulting in lower levels of deposits into fixed options. Individual variable annuity deposits increased due to innovative product enhancements and expanded distribution as well as a more favorable competitive environment. Premiums from life insurance products increased in 2012, but were more than offset by declines in deferred annuities sold through life insurance distribution channels. Retail mutual fund sales growth was principally driven by SunAmerica Asset Management Corp.'s Focused Dividend Strategy product offering which continues to be a top long-term performer within its respective peer group.
AIG Life and Retirement's total life sales decreased 1 percent during 2012 compared to 2011. Overall retail universal life sales decreased 1 percent with sales of indexed products growing while sales of universal life products sensitive to low interest rates declined. Retail term insurance sales increased 1 percent in 2012 compared to 2011 because we continued our disciplined focus related to new business pricing and underwriting. Institutional life sales increased 4 percent in 2012 compared to 2011 from growth in single premium private placement universal life deposits.
Group retirement deposits increased primarily due to higher levels of individual rollover deposits in 2011. Individual fixed annuity deposits increased as certain bank distributors negotiated a lower commission in exchange for a higher rate offered to policyholders which made our individual fixed annuity products more attractive. However, fixed annuity deposits declined in the latter part of 2011 from the first six months of 2011 due to significant declines in interest rates. Variable annuity sales increased due to reinstatements of relationships at a number of key broker-dealers, and increased wholesaler productivity. Deposits from life insurance products increased in 2011, but were more than offset by declines in deferred annuities sold through life insurance distribution channels and a large private placement variable annuity sale in 2010. Retail mutual fund annual sales growth was driven by SunAmerica Asset Management Corp.'s Specialty Series product offerings (Alternative Strategies and Global Trends) and the Focused Dividend Strategy Portfolio.
AIG Life and Retirement grew new sales of mortality-based life insurance products during 2011 by strengthening the core retail independent distribution channel and continuing to focus on career agent and direct-to-consumer distribution. Retail life sales increased 17 percent during 2011 as we continued to re-engage independent distribution channels. Affiliated distribution channels grew 11 percent in 2011 as a result of an enhanced product suite appealing
to middle market consumers. AIG Direct, our direct-to-consumer platform, has proven highly effective for the distribution of term life and A&H products. The decline in institutional sales during 2011 reflected several large variable universal life sales during 2010.
The following table presents the account value rollforward for Retirement Services:
Net flows improved in 2011 due to both the significant increase in deposits and favorable surrender experience in group retirement and individual fixed annuities. However, individual fixed annuities net flows declined in the second half of the year due to lower deposits resulting from the low interest rate environment.
Surrender rates for individual fixed annuities also decreased in 2011 due to the low interest rate environment and the relative competitiveness of interest credited rates on the existing block of fixed annuities versus interest rates on alternative investment options available in the marketplace. AIG Life and Retirement returned to a more normal level of group surrender activity that no longer reflects the negative AIG publicity associated with the events of 2008 and 2009. Individual variable annuities net flows improved from 2010 levels due primarily to higher deposits throughout 2011 and turned positive in the fourth quarter of 2011.
There are a variety of factors that impact AIG Life and Retirement's businesses, and the life insurance and annuity industry in general, during a prolonged low interest rate environment. Declining interest rates result in higher fair values of assets backing insurance and annuity liabilities and may result in improved persistency of certain lines of business. A sustained low interest rate environment may also result in lower sales of fixed annuities and other products and lower net investment spreads as portfolio cash flows are reinvested at lower rates (spread compression). There are a number of management actions we may take to mitigate these impacts as discussed below.
AIG Life and Retirement is proactively addressing the impact of sustained low interest rates. During 2012, a number of actions were taken on both the asset and liability sides of our balance sheet:
Opportunistic investments in structured securities and re-deployment of cash in 2011 to increase yields
As a result of these actions, we estimate that the effect of interest rates remaining at or near current levels through the end of 2013 on pre-tax operating income would not be material, and would be modestly more significant with respect to 2014 results.
Disciplined New Business Pricing: New fixed annuity sales have declined in 2012 relative to 2011, due to the relatively low crediting rates offered as a result of our disciplined approach to new business. However, even in the current interest rate environment, we continue to pursue new sales of life and annuity products at targeted net investment spreads. New sales of fixed annuity products generally have minimum interest rate guarantees of 1 percent. Universal life insurance interest rate guarantees are generally 2 to 3 percent on new non-indexed products and 1 percent on new indexed products, and are designed to be sufficient to meet targeted net investment spreads. If the low interest rate environment continues, we expect our fixed annuities sales (including deposits into fixed options within variable annuities sold in group retirement markets) to remain weak into 2013.
Active Management of Renewal Credited Rates: The contractual provisions for renewal of crediting rates and guaranteed minimum crediting rates included in our products may have the effect, in a continued low interest rate environment, of reducing our spreads and thus reducing future profitability. Although we partially mitigate this interest rate risk through its asset-liability management process, product design elements and crediting rate strategies, a prolonged low interest rate environment may negatively affect future profitability. Our annuity and universal life products were designed with contractual provisions that allow crediting rates to be reset at pre-established intervals subject to minimum crediting rate guarantees. We have adjusted, and will continue to adjust, crediting rates in order to maintain targeted net investment spreads on both new business and in-force business where crediting rates are above minimum guarantees. In addition to annuity and universal life products discussed above, certain traditional long-duration products for which we do not have the ability to adjust interest rates, such as payout annuities, are exposed to reduced earnings and potential reserve increases in a prolonged low interest rate environment.
In December of 2012, we recorded litigation settlement income from settlements with three financial institutions who participated in the creation, offering and sale of RMBS as to which AIG and its subsidiaries suffered losses either directly on their own account or in connection with their participation in AIG's securities lending program.
Mortgage Guaranty recorded operating income in 2012 compared to an operating loss in 2011 primarily due to:
•a decline in first-lien earned premiums of $19 million reflecting higher premium refunds due to the rescissions arising from the claims requests sent to lenders during the fourth quarter of 2011 and continuing throughout 2012, as discussed in Outlook herein, in addition to the declining persistency on the 2008 and prior policy years;
•a $10 million increase in underwriting expenses driven primarily by an increase in underwriting, sales and product initiatives, all of which supported the increase in new insurance written for the year. New insurance written, which represents the original principal balance of the insured mortgages, was approximately $37 billion and $19 billion in 2012 and 2011, respectively. The increase in new insurance written is the result of the market acceptance by lenders of UGC's risk-based pricing model and withdrawal of certain competitors from the market during 2011. See Outlook - Other Operations - Mortgage Guaranty for further discussion.
•an increase in claims and claims adjustment expenses of $334 million, primarily in first-lien business. This reflected increased overturns of denied and rescinded claims and unfavorable first-lien loss development of $76 million in 2011, compared to favorable loss development of $385 million in 2010. These factors were partially offset by lower levels of newly reported delinquencies in the first-lien, second-lien and international products, and a reduction in reserves due to an agreement to resolve certain delinquencies with a major European lender that resulted in a $43 million benefit;
•the accrual of $22 million to pay for previously rescinded losses, certain legal fees and interest in connection with an adverse judgment. Mortgage Guaranty has appealed the court's decision. Partially offsetting these declines was a reduction in underwriting expenses compared to 2010 reflecting a $94 million accrual of estimated remedy losses in 2010. Remedy losses represent the indemnification for losses incurred by lenders arising from obligations contractually assumed by Mortgage Guaranty as a result of underwriting services provided to lenders during times of high loan origination activity. Mortgage Guaranty believes it has adequately accrued for these losses at December 31, 2011. Pre-tax income for 2010 also includes gains of approximately $150 million from legal settlements and reinsurance commutations.
GCM reported an operating loss in 2011 compared to operating income in 2010 primarily due to a decrease in unrealized market valuation gains related to the super senior CDS portfolio and losses in 2011 compared to gains in 2010 on the CDS contracts referencing single-name exposures written on corporate, index and asset-backed credits, which are not included in the super senior CDS portfolio. These items were partially offset by improvement in net credit valuation adjustments on derivative assets and liabilities. For 2011 and 2010, unrealized market valuation gains of $339 million and $598 million, respectively, were recognized on the super senior CDS portfolio. The decrease resulted primarily from CDS transactions written on multi-sector CDOs as a result of price declines of the underlying assets. For 2011, an unrealized market valuation loss of $23 million was recognized on CDS contracts referencing single-name exposures compared to a gain of $149 million in 2010 due to a decline in market conditions. For 2011 and 2010, net credit valuation adjustment losses of $53 million and $200 million, respectively, were recognized. The improvement resulted primarily from the narrowing of corporate spreads.
The DIB's operating income increased in 2012 compared to 2011 primarily due to improvement in net credit valuation adjustments on the DIB assets and liabilities for which the fair value option was elected and gains realized from unwinding certain transactions. For 2012 and 2011, net credit valuation adjustment gains of $789 million and $380 million, respectively, were recognized. The improvement resulted primarily from gains on assets due to the tightening of counterparty credit spreads, partially offset by losses on liabilities due to the tightening of AIG's credit spreads.
Change in Fair Value of AIA Securities Prior to Their Sale
The gain on ML III for 2010 was attributable to the shortening of its weighted average life. Additionally, fair value for 2010 was positively affected by a decrease in projected credit losses in the underlying collateral securities.
Corporate & Other reported lower operating losses in 2012 compared to 2011 primarily due to the effects of the following:
•reduction in expense of $211 million in 2012 resulting from settlements of the liability for the Department of the Treasury's underwriting fees for the sale of AIG Common Stock at amounts lower than had been estimated at the time the accrual was established, and AIG purchased a significant amount of shares for which no payment to the underwriters was required; and
•a decline in interest expense as a result of the repayment of the FRBNY Credit Facility and the exchange of outstanding junior subordinated debentures for senior unsecured notes in 2011. Real estate and other non-core businesses declined due to lower gains on real estate dispositions and higher equity losses on real estate investments in 2012 compared to 2011.
Corporate & Other reported lower operating losses in 2011 compared to 2010. This was primarily due to:
•improvement in real estate and other non-core businesses due to significantly lower levels of real estate investment impairment charges in 2011 compared to 2010.
•a gain on the sale of AIG Star and AIG Edison in 2011, a gain on the sale of ALICO in 2010, a loss on the sale of AGF in 2010 and a loss recognized in 2010 related to the sale of Nan Shan;
•impairments of goodwill in 2010 of $4.6 billion related to ALICO, AIG Star and AIG Edison.
The increase in 2012 was primarily attributable to appreciation in bonds available for sale due to lower interest rates and narrowing spreads for investment grade and high-yield securities. The ten year U.S. Treasury rate started the year at 1.88 percent, decreased to a historic low of 1.39 percent in the middle of the year, and ended the year at 1.76 percent. High yield and investment grade spreads were down approximately 200 basis points and 100 basis points, respectively, during the year, with the narrowing spreads being the major contributor to unrealized appreciation in bonds available for sale, which was almost double the amount recorded in 2011. Corporate bonds and structured securities were major beneficiaries from this continued low rate environment as prices on these assets increased significantly during the year. Non-agency securities provided the majority of the structured securities improvement as high yield securities generally benefited from the significant narrowing of spreads during the year. The significant majority of the unrealized appreciation occurred during the first three quarters of the year, as the fourth quarter experienced less rate and spread volatility.
The reclassification adjustments included in net income on unrealized appreciation of investments increased by $1.0 billion in 2012 compared to 2011 as a result of realized gains and losses recognized on sales of securities classified as available for sale.
We periodically evaluate the assumptions used to establish deferred acquisition costs and future policy benefits. These assumptions may be adjusted based on actual experience and judgment. Key assumptions include mortality, morbidity, persistency, maintenance expenses and investment returns.
The decline primarily reflects the gradual run-off of the cash flow hedge portfolio as well as the de-designations resulting from ILFC, partially offset by a decline in the interest rate environment.
The change attributable to divestitures and deconsolidations in 2011 primarily reflects the derecognition of all items in Accumulated other comprehensive income (loss) at the time of sale for AIG Star, AIG Edison and Nan Shan.
For the year ended December 31, 2011, the effective tax rate on pre-tax Other Comprehensive Loss was 9.1 percent. The effective tax rate differs from the statutory 35 percent rate primarily due to the effects of the Nan Shan disposition.
DAC amortization was reduced in 2011 and 2010 primarily as a result of increases in the unrealized appreciation of investments supporting interest-sensitive products. The declines also reflect the divestiture of multiple life insurance operations, including the sales of Nan Shan, AIG Star and AIG Edison in 2011, the deconsolidation of AIA in 2010 and sale of ALICO in 2010.
Change in Net Derivative Gains (Losses) Arising from Cash Flow Hedging Activities
The decline in 2011 compared to 2010 primarily reflects the gradual wind-down of the cash flow hedge portfolio, partially offset by a decline in the interest rate environment.
The decrease in 2011 was primarily due to the announced redesign and resulting remeasurement of the AIG Retirement and AIG Excess Plans, which was converted to cash balance plans effective April 1, 2012. AIG recognized a $590 million pre-tax reduction to Accumulated other comprehensive income in connection with the remeasurement in 2011, primarily due to a decrease in the discount rate since December 31, 2010. This decrease in Accumulated other comprehensive income was partially offset by the effect of the increase in the discount rate in the fourth quarter of 2011 in connection with the year end remeasurement.
As discussed above, for the year ended December 31, 2011, the effective tax rate differs from the statutory 35 percent rate primarily due to the effects of the Nan Shan disposition.
For the year ended December 31, 2010, the effective tax rate on pre-tax Other Comprehensive Income was 42.5 percent, primarily due to the effects of the AIA initial public offering, the ALICO disposition and changes in the estimated U.S. tax liability with respect to the potential sale of subsidiaries, including AIG Star and AIG Edison.
Capital refers to the long-term financial resources available to support the operation of our businesses, fund business growth, and cover financial and operational needs that arise from adverse circumstances. Our primary source of ongoing capital generation is the profitability of our insurance subsidiaries. We and our insurance subsidiaries must comply with numerous constraints on our minimum capital positions. These constraints drive the requirements for capital adequacy for both the consolidated company and the individual businesses and are based on internally-defined risk tolerances, regulatory requirements, rating agency and creditor expectations and business needs. Actual capital levels are monitored on a regular basis and using ERM's stress testing methodology, we evaluate the capital impact of potential macroeconomic, financial and insurance stresses in relation to the relevant capital constraints of both the consolidated company and our insurance subsidiaries.
Depending on market conditions, regulatory and rating agency considerations and other factors, we may take various liability and capital management actions. Liability management actions may include, but are not limited to repurchasing or redeeming outstanding debt, issuing new debt or engaging in debt exchange offers. Capital management actions may include, but are not limited to, paying dividends to our shareholders, share purchases and acquisitions.
Approximately $1.0 billion held in escrow to secure indemnifications provided to MetLife under the ALICO stock purchase agreement was released to AIG (see Note 16 to the Consolidated Financial Statements for additional information).
We paid down in full the remaining $8.6 billion liquidation preference of the Department of the Treasury's AIA SPV Preferred Interests and redeemed the Department of the Treasury's preferred participating return rights in the AIA SPV and the special purpose vehicle holding the proceeds from the sale of ALICO (ALICO SPV). The payment was funded using both existing funds and approximately $1.6 billion in proceeds to us from the FRBNY's final disposition of ML II securities, approximately $6.0 billion in proceeds from the sale of AIA ordinary shares and funds allocated to the MIP.
We repaid an aggregate total of $7.7 billion of debt, which includes repayments by AIG Parent of $3.2 billion.
On February 19, 2013, AIG commenced cash tender offers for (i) our 8.625% Series A-8 Junior Subordinated Debentures and 8.000% Series A-7 Junior Subordinated Debentures for a purchase price of up to $325 million, (ii) our 6.250% Series A-1 Junior Subordinated Debentures and 8.175% Series A-6 Junior Subordinated Debentures for a purchase price of up to $650 million and (iii) the 81/2% Capital Trust Pass-Through Securities of American General Capital II, the 7.57% Capital Securities, Series A of American General Institutional Capital A, the 81/8% Capital Securities, Series B of American General Institutional Capital B and the 5.60% Senior Debentures due July 2097 of SunAmerica Inc. assumed by AIG, for a purchase price of up to $275 million, in each case plus accrued interest or distributions through the settlement date. The offers are not cross-conditioned and AIG may complete all, some or none of the tender offers. The offers are scheduled to expire on March 18, 2013 with an early participation period through March 4, 2013, in each case subject to amendment and to extension in AIG's sole discretion. The purpose of the tender offers is to purchase certain outstanding debt issued or guaranteed by AIG and to reduce its level of indebtedness and its interest expense.
See Liquidity and Capital Resources of AIG Parent and Subsidiaries - AIG Parent - Sources and Uses of Liquidity and Capital Resources of AIG Parent herein for further discussion.
Cash provided by AIG Property Casualty operating activities was $1.1 billion in 2012 compared to $1.9 billion in 2011, primarily reflecting the decrease in net premiums written as a result of the continued execution of strategic initiatives to improve business mix and the timing of the cash flows used to pay claims and claims adjustment expenses and the related reinsurance recoveries.
Cash provided by operating activities by AIG Life and Retirement was $2.9 billion in 2012 compared to $2.4 billion in 2011, primarily reflecting efforts to actively manage spread income.
Net cash provided by operating activities declined in 2011 compared to 2010, principally due to the following:
•the cash payment by AIG Parent of $6.4 billion in accrued compounded interest and fees under the FRBNY Credit Facility. In prior periods, these payments were paid in-kind and did not affect operating cash flows;
Net cash provided by investing activities for 2012 includes the following items:
•approximately $2.1 billion of cash collateral received in connection with the securities lending program launched during 2012 by AIG Life and Retirement. Net cash provided by investing activities in 2011 was primarily attributable to:
•the utilization of $26.4 billion of restricted cash generated from the AIA IPO and ALICO sale in connection with the Recapitalization and $9.6 billion from the disposition of MetLife securities;
•net sales of short term investments and maturities of available for sale investments, primarily at AIG Property Casualty and AIG Life and Retirement, which were partially offset by purchases of available for sale investments. Net cash used in investing activities in 2010 primarily resulted from net purchases of fixed maturity securities, resulting from our investment of cash generated from operating activities, and the redeployment of liquidity that had been accumulated by the insurance companies in 2009.
•$8.6 billion pay down of the Department of the Treasury's AIA SPV Preferred Interests; and
(a) Includes reverse repurchase agreements totaling $8.9 billion, which are secured short term investments.
(c) For additional information relating to the contingent liquidity facility, see Contingent Liquidity Facilities below.
Sources and Uses of Liquidity and Capital Resources of AIG Parent
received approximately $8.5 billion in distributions from the FRBNY's dispositions of ML III assets;
approximately $2.9 billion in note repayments from AIG Life and Retirement subsidiaries funded by payments of dividends from subsidiaries of which $1.6 billion represented proceeds from the FRBNY's sale of ML II assets;
purchased an aggregate of approximately $13.0 billion of AIG Common Stock at the initial public offering price in four registered public offerings of AIG Common Stock completed by the Department of the Treasury, as the selling shareholder; we purchased approximately 421 million shares (see Note 17 to the Consolidated Financial Statements for additional information on these offerings);
retired $3.2 billion of debt, including $2.6 billion of MIP long-term debt, and made interest pay- ments totaling $2.1 billion;
utilized approximately $1.6 billion in proceeds from the distributions from ML II, approximately $6.0 billion in gross proceeds from the sale of AIA ordinary shares and existing funds from the MIP to pay down in full the liquidation preference of the AIA SPV Preferred Interests and redeem the Department of the Treasury's preferred participating return rights in the AIA SPV and the ALICO SPV; as a result, the following items, which had been held as security to support the repayment of the AIA SPV Preferred Interests, were released from that pledge:
made $1.2 billion in net capital contributions to subsidiaries, including a contribution of approximately $1.0 billion to AIG Property Casualty in the aftermath of Storm Sandy.
AIG Property Casualty paid cash and non-cash dividends totaling of $2.5 billion to AIG Parent in 2012, consisting of cash and municipal bonds, including $902 million of cash dividends in the fourth quarter of 2012.
AIG Parent could be required to provide additional funding to AIG Property Casualty subsidiaries to meet capital or liquidity needs under certain circumstances, including:
•large catastrophes that may require AIG to provide additional support to the affected operations;
•downgrades in AIG's credit ratings that could put pressure on the insurer financial strength ratings of AIG's subsidiaries which could result in non-renewals or cancellations by policyholders and adversely affect the subsidiary's ability to meet its own obligations;
•increases in market interest rates that may adversely affect the financial strength ratings of our subsidiaries, as rating agency capital models may reduce the amount of available capital relative to required capital; and
Among other things, the 2012 CMA provides that AIG Parent will maintain the total adjusted capital of the Fleet at or above the specified minimum percentage of the Fleet's projected total authorized control level RBC. As a result, the 2012 CMA provides that if the total adjusted capital of the Fleet falls below the specified minimum percentage of the Fleet's total authorized control level RBC, AIG Parent will contribute cash or other instruments admissible under applicable regulations to Chartis Inc., which will further contribute such funds to the AIG Property Casualty subsidiaries in the amount necessary to increase the Fleet's total adjusted capital to a level at least equal to such specified minimum percentage. Any required contribution under the 2012 CMA would generally be made during the second and fourth quarters of each year; however, AIG Parent may also make contributions in such amounts and at such times as it deems appropriate. In addition, the 2012 CMA provides that if the total adjusted capital of the Fleet exceeds that same specified minimum percentage of the Fleet's total authorized control level RBC, subject to board approval, the AIG Property Casualty insurance subsidiaries would declare and pay ordinary dividends to their respective equity holders up to an amount that is the lesser of:
(ii)the maximum amount of ordinary dividends permitted under applicable insurance law. The 2012 CMA does not prohibit, however, the payment of extraordinary dividends, subject to board or regulatory approval, to reduce the Fleet's projected or actual total adjusted capital to a level equal to or not materially greater than the specified minimum percentage. Any required dividend under the 2012 CMA would generally be made on a quarterly basis. As structured, the 2012 CMA contemplates that the specified minimum percentage would be reviewed and agreed upon at least annually.
For the years ended December 31, 2012 and 2011, AIG Parent received $2.3 billion and $1.3 billion, respectively, in dividends from Chartis Inc. that were made pursuant to the CMAs then in place, and AIG Parent was not required to make any capital contributions in either period pursuant to the CMAs then in place.
On February 20, 2013, the 2012 CMA was amended to exclude deferred tax assets from the calculation of total adjusted capital. As a result, effective February 20, 2013, the specified minimum percentage decreased from 350 percent to 325 percent.
In March 2012, the National Union Fire Insurance Company of Pittsburgh, Pa. (NUFI), an AIG Property Casualty company, became a member of the Federal Home Loan Bank (FHLB) of Pittsburgh. In August 2012, Chartis Specialty Insurance Company (CSI), an AIG Property Casualty company, became a member of the FHLB of Chicago. FHLB membership provides participants with access to various services, including access to low-cost advances through pledging of certain mortgage-backed securities, government and agency securities and other qualifying assets. These advances may be used to provide an additional source of liquidity for balance sheet management or contingency funding purposes. As of December 31, 2012, neither NUFI nor CSI had any advances outstanding under their respective FHLB facilities.
We believe that AIG Life and Retirement subsidiaries have liquidity sources adequate to satisfy future liquidity requirements and meet their obligations, including those arising from reasonably foreseeable contingencies or events, through cash from operations and, to the extent necessary, asset dispositions. The AIG Life and Retirement subsidiaries maintain liquidity in the form of cash and short-term investments, totaling $7.8 billion as of December 31, 2012. In 2012, AIG Life and Retirement provided $2.9 billion of liquidity to AIG Parent through note repayments funded by the payment of dividends from insurance subsidiaries. These payments included a $1.6 billion distribution relating to the liquidation of ML II and a distribution of $440 million in the form of a note repayment.
For the years ended December 31, 2012 and 2011, AIG Parent received a total of approximately $2.9 billion and $1.4 billion, respectively, in distributions from AIG Life and Retirement subsidiaries in the form of note repayments funded by the payment of dividends from these subsidiaries, which were made under the CMAs. AIG Parent was not required to make any capital contributions to AIG Life and Retirement subsidiaries in either period under the CMAs then in place.
We currently expect that our Mortgage Guaranty subsidiaries will be able to continue to satisfy future liquidity requirements and meet their obligations, including requirements arising out of reasonably foreseeable contingencies or events, through cash from operations and, to the extent necessary, asset dispositions. Mortgage Guaranty subsidiaries maintain substantial liquidity in the form of cash and short-term investments, totaling $699 million as of December 31, 2012. Mortgage Guaranty businesses also maintain significant levels of investment-grade fixed maturity securities, which could be monetized in the event liquidity levels are insufficient to meet obligations. These securities included substantial holdings in municipal and corporate bonds totaling $3.5 billion at December 31, 2012.
As of December 31, 2012 and December 31, 2011, respectively, GCM had total assets of $8.0 billion and $9.6 billion and total liabilities of $4.9 billion and $5.8 billion. GCM's assets consist primarily of cash, short-term investments, other receivables, net of allowance, and unrealized gains on swaps, options and forwards. GCM's liabilities consist primarily of trade payables and unrealized losses on swaps, options and forwards. Collateral posted included in GCM to third parties was $4.2 billion and $5.1 billion at December 31, 2012 and December 31, 2011, respectively. Collateral obtained included in GCM from third parties was $846 million and $1.2 billion at December 31, 2012 and December 31, 2011, respectively. The collateral amounts reflect counterparty netting adjustments available under master netting agreements and are inclusive of collateral that exceeded the fair value of derivatives as of the reporting date.
The DIB is managed so that it maintains the liquidity that we believe is necessary to meet all of the DIB liabilities as they come due, even under stress scenarios, without having to liquidate DIB assets or rely on additional liquidity from AIG Parent. If the DIB's risk target is breached, we expect to take appropriate actions to increase the DIB's liquidity sources or reduce liquidity requirements to maintain the risk target, although no assurance can be given that this can be achieved under then-prevailing market conditions. Any additional liquidity shortfalls would need to be funded by AIG Parent.
Collateral posted by operations included in the DIB to third parties was $4.3 billion and $5.1 billion at December 31, 2012 and December 31, 2011, respectively. This collateral primarily consists of securities of the U.S. government and government sponsored entities and generally cannot be repledged or resold by the counterparties.
The Four-Year Facility provides for $4.0 billion of unsecured revolving loans, which includes a $2.0 billion letter of credit sublimit. Our ability to borrow under the Four-Year Facility is not contingent on our credit ratings. However, our ability to borrow under the Four-Year Facility is conditioned on the satisfaction of certain legal, operating, administrative and financial covenants and other requirements contained in the Four-Year Facility. These include covenants relating to our maintenance of a specified total consolidated net worth and total consolidated debt to total consolidated capitalization. Failure to satisfy these and other requirements contained in the Four-Year Facility would restrict our access to the Four-Year Facility and could have a material adverse effect on our financial condition, results of operations and liquidity.
(d) Does not reflect unrecognized tax benefits of $4.4 billion ($4.1 billion excluding Aircraft Leasing), the timing of which is uncertain. In addition, the majority of our credit default swaps require us to provide credit protection on a designated portfolio of loans or debt securities. At December 31, 2012, the fair value derivative liability was $1.9 billion, relating to the super senior multi-sector CDO credit default swap portfolio. At December 31, 2012, collateral posted with respect to these swaps was $1.6 billion.
Insurance and investment contract liabilities, including GIC liabilities, relate to AIG Life and Retirement businesses. These liabilities include various investment-type products with contractually scheduled maturities, including periodic payments of a term certain nature. These 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) we are currently not making payments until the occurrence of an insurable event, such as death or disability, (ii) payments are conditional on survivorship or (iii) payment may occur due to a surrender or other non-scheduled event out of our control.
amounts presented in this table are undiscounted and exceed the future policy benefits and policyholder contract deposits included in the Consolidated Balance Sheet.
Our borrowings exclude those incurred by consolidated investments and include hybrid financial instrument liabilities recorded at fair value. We expect to repay the long-term debt maturities and interest accrued on borrowings by AIG and its subsidiaries through maturing investments and asset sales, future cash flows from operations, cash flows generated from invested assets, future debt issuance and other financing arrangements.
(c) Includes commitments to invest in private equity, hedge funds and mutual funds and commitments to purchase and develop real estate in the United States and abroad. The commitments to invest in private equity funds, hedge funds and other funds are called at the discretion of each fund, as needed for funding new investments or expenses of the fund. The expiration of these commitments is estimated in the table above based on the expected life cycle of the related fund, consistent with past trends of requirements for funding. Investors under these commitments are primarily insurance and real estate subsidiaries.
(d) Excludes commitments with respect to pension plans. The annual pension contribution for 2013 is expected to be approximately $100 million for U.S. and non-U.S. plans.
(e) Does not include guarantees, capital maintenance agreements or other support arrangements among AIG consolidated entities.
(f) Includes $340 million attributable to ILFC, which is reported as discontinued operations.
(b) AIG Parent guarantees all DIB debt, except for MIP notes payable and Series AIGFP matched notes and bonds payable, which are direct obligations of AIG Parent.
The following table summarizes maturing debt at December 31, 2012 of AIG and its subsidiaries for the next four quarters:
AIG borrowings supported by assets consisted of debt under the DIB. At December 31, 2012, all of the debt maturities in the DIB through December 31, 2013 are supported by short-term investments and maturing investments.
We are party to some agreements that contain "ratings triggers". Depending on the ratings maintained by one or more rating agencies, these triggers could result in (i) the termination or limitation of credit availability or require accelerated repayment, (ii) the termination of business contracts or (iii) requirement to post collateral for the benefit of counterparties.
In the event of adverse actions on our long-term debt ratings by the major rating agencies, AIGFP would be required to post additional collateral under some derivative transactions, or to permit termination of the transactions. Such transactions could adversely affect our business, our consolidated results of operations in a reporting period or our liquidity. In the event of a further downgrade of AIG's long-term senior debt ratings, AIGFP would be required to post additional collateral, and certain of AIGFP's counterparties would be permitted to terminate their contracts early.
We are currently regulated by the Board of Governors of the Federal Reserve System (FRB) and subject to its examination, supervision and enforcement authority and reporting requirements as a savings and loan holding company (SLHC). In addition, under Dodd-Frank we may separately become subject to the examination, enforcement and supervisory authority of the FRB. In October 2012, we received a notice that we are under consideration by the Financial Stability Oversight Council created by Dodd-Frank for a proposed determination that we are a systemically important financial institution (SIFI). Changes mandated by Dodd-Frank include directing the FRB to promulgate minimum capital requirements for both SLHCs and SIFIs. See Item 1. Business - Regulation and Item 1A. Risk Factors - Regulation for further information.
Our insurance subsidiaries are subject to regulation and supervision by the states and jurisdictions in which they do business. In the United States, the NAIC has developed RBC Model Law requirements. The RBC formula is designed to measure the adequacy of an insurer's statutory surplus in relation to the risks inherent in its business. The statutory surplus of each of our U.S.-based life and property and casualty insurance subsidiaries exceeded minimum required RBC levels as of December 31, 2012. Our foreign insurance operations are individually subject to local solvency margin requirements that require maintenance of adequate capitalization. We comply with these requirements in each country.
Payment of future dividends to our shareholders depends in part on the regulatory framework that will ultimately be applicable to us, including our status as an SLHC under Dodd-Frank and whether we are determined to be a SIFI. See Note 17 to the Consolidated Financial Statements for additional discussion of potential restrictions on dividend payments to common shareholders.
Dividend payments to AIG Parent by our insurance subsidiaries are subject to certain restrictions imposed by regulatory authorities. With respect to our domestic insurance subsidiaries, the payment of any dividend requires formal notice to the insurance department in which the particular insurance subsidiary is domiciled. Foreign jurisdictions may restrict the ability of our foreign insurance subsidiaries to pay dividends, which may also have unfavorable income tax consequences. There are also various local restrictions limiting cash loans and advances to AIG Parent by our subsidiaries. See Note 20 to the Consolidated Financial Statements for additional discussion of restrictions on payments of dividends by AIG and its subsidiaries.
•The U.S. dollar weakened during the year by 2 percent and 5 percent versus the Euro and British pound, respectively, and strengthened 13 percent versus the Yen.
At the local operating unit level, investment strategies are based on considerations that include the local market, general market conditions, liability duration and cash flow characteristics, rating agency and regulatory capital considerations, legal investment limitations, tax optimization and diversification.
•In the case of life insurance and retirement services companies, as well as in the DIB, our fundamental investment strategy is to match the duration characteristics of the liabilities with assets of comparable duration, to the extent practicable.
•Outside of the U.S., fixed maturity securities held by AIG Property Casualty companies consist primarily of intermediate duration high-grade securities generally denominated in the currencies of the countries in which we operate.
•Purchases of corporate debt securities continued to be the largest asset allocation of new investments.
•We purchased an aggregate of $7.1 billion of CDOs sold in the FRBNY auctions of ML III assets, and elected fair value option accounting treatment on those assets.
•Blended investment yields on new AIG Life and Retirement investments were lower than blended rates on investments that were sold, matured or called. Base yields at AIG Property Casualty benefited from blended yields on new investments that were higher than the yields on investments that were sold, matured or called.
•A continued low interest rate environment and narrowing spreads in many fixed income asset classes contributed to unrealized gains in the investment portfolio.
as taxable municipal bonds, government bonds and agency and corporate securities. The majority of these high quality investments are rated A or higher based on composite ratings.
Fixed income assets held in AIG Property Casualty foreign operations are of high quality and short to intermediate duration, averaging 3.5 years.
While invested assets backing reserves are invested in conventional fixed income securities in AIG Property Casualty domestic operations, a modest portion of surplus is allocated to alternative investments, including private equity and hedge funds. Notwithstanding the current environment, these investments have provided a combination of added diversification and attractive long-term returns over time.
With respect to AIG Life and Retirement, we use asset-liability management as a tool to determine the composition of the invested assets. Our objective is to maintain a matched asset-liability structure, although we may occasionally determine that it is economically advantageous to be temporarily in an unmatched position. To the extent that we have maintained a matched asset-liability structure, the economic effect of interest rate fluctuations is partially mitigated.
Our investment strategy for AIG Life and Retirement is to produce cash flows greater than maturing insurance liabilities. There exists a future investment risk associated with certain policies currently in-force which will have premium receipts in the future. That is, the investment of these future premium receipts may be at a yield below that required to meet future policy liabilities.
AIG Life and Retirement frequently reviews its interest rate assumptions and actively manages the crediting rates used for its new and in force business. Business strategies continue to evolve to maintain profitability of the overall business.
* At December 31, 2012 and December 31, 2011, bonds available for sale held by us that were below investment grade or not rated totaled $29.6 billion and $24.2 billion, respectively.
At December 31, 2012, the U.S. municipal bond portfolio was composed primarily of essential service revenue bonds and high-quality tax-backed bonds with 97 percent of the portfolio rated A or higher.
(a) Excludes certain university and not- for- profit entities that issue their bonds in the corporate debt market. Includes industrial revenue bonds.
* At December 31, 2012 and December 31, 2011, approximately 94 percent and 95 percent, respectively, of these investments were rated investment grade.
The following table presents our CMBS available for sale investments by year of vintage:
The following table presents our CMBS available for sale investments by credit rating:
The following table presents the percentage of our CMBS available for sale investments by geographic region based on amortized cost:
The following table presents the percentage of our CMBS available for sale investments by industry based on amortized cost:
See Note 7 to the Consolidated Financial Statements for further discussion.
(a) Impairments of investments in Life settlement contracts are recorded in Other realized losses.
(b) Impairments of investments in Real estate are recorded in Other income.
We recorded other-than-temporary impairment charges in the years ended December 31, 2012 and 2011 related to:
•securities for which we have changed our intent from hold to sell;
(b) Represents the percentage by which fair value is less than cost at December 31, 2012.
For 2012, net unrealized gains related to fixed maturity and equity securities increased by $10.4 billion primarily due to the decline in interest rates and narrowing of credit spreads.
See also Note 7 to the Consolidated Financial Statements for further discussion of our investment portfolio.
At AIG, risk management includes the identification and measurement of various forms of risk, the establishment of risk thresholds and the creation of processes intended to maintain risks within these thresholds while optimizing returns. We consider risk management an integral part of managing our core businesses and a key element of our approach to corporate governance.
Our risk governance fosters the development and maintenance of a risk and control culture that encompasses all significant risk categories. Accountability for the implementation and oversight of risk policies is aligned with individual corporate executives, with the risk committees receiving regular reports regarding compliance with each policy to support risk governance at our corporate level as well as in each business unit.
Our Board of Directors oversees the management of risk through its Finance and Risk Management Committee (the FRMC) and the Audit Committee. Those committees regularly interact with other committees of the Board. Our Executive Vice President (EVP) and Chief Risk Officer (CRO) reports to both the FRMC and AIG's Chief Executive Officer (CEO).
The Group Risk Committee (the GRC) is the senior management group charged with assessing all significant risk issues on a global basis in order to protect our financial strength, optimize our intrinsic value, and protect our reputation among key stakeholders. The GRC is chaired by our CRO. Its membership includes our CEO, EVP and Chief Financial Officer (CFO), EVP and General Counsel, and 12 other executives from across our corporate functions and business units. Our CRO reports periodically on behalf of the GRC to both the FRMC and the Audit Committee of the Board.
Financial Risk Group (FRG): The FRG is responsible for the oversight of financial risks taken by AIG and its subsidiaries. Its mandate includes overseeing our aggregate credit, market, interest rate, liquidity and model risks, as well as asset-liability management, derivatives activity, and foreign exchange transactions. Membership of the FRG includes our EVP - Investments, EVP and Treasurer, as well as our EVP and CFO, and other senior executives from Finance and ERM. Our CRO serves as Chair of the FRG.
Risk oversight activities also continue to be coordinated with discontinued operations, such as ILFC, until pending sale transactions are closed.
ERM has developed a company-wide Risk Appetite Statement (RAS), which will be updated on at least an annual basis. By formally defining our risk appetite, we seek to integrate stakeholder interests, business goals and available financial resources through taking measured risks that are intended to generate repeatable, sustainable earnings and produce long-term value and stability.
The stress testing framework assesses our aggregate exposure to our most significant financial and insurance risks, including the risk in each of our regulated subsidiaries in relation to its statutory capital needs under stress, risks inherent in our unregulated subsidiaries, and risks to AIG consolidated capital. Using our stress testing methodology, we evaluate the capital and earnings impact of potential stresses in relation to the relevant capital constraint of each business operation. We use this information to determine the liquidity resources AIG Parent needs to support insurance operations, contingent liquidity required from AIG Parent under stressed scenarios for non-insurance operations, and capital resources required to maintain consolidated company target capitalization levels.
We evaluate and manage risk in material topics as shown below. These topics are discussed in more detail in the following pages:
We devote considerable resources to managing our direct and indirect credit exposures. These exposures may arise from fixed income investments, equity securities, deposits, reverse repurchase agreements and repurchase agreements, commercial paper, corporate and consumer loans, leases, reinsurance recoverables, counterparty risk arising from derivatives activities, collateral extended to counterparties, insurance risk cessions to third parties, financial guarantees and letters of credit.
•administering regular portfolio credit reviews of investment, derivative and credit-incurring business units and recommending corrective actions where required;
The following table presents our aggregate (gross and net) credit exposures to non-U.S. governments:
•$80.6 billion, or 94 percent, of these global financial institution credit exposures were considered investment grade based on our internal ratings.
•$4.9 billion, or 6 percent, were considered non-investment grade. Most of the non-investment grade exposure was to financial institutions in countries that we believe are not of investment grade quality. Aggregate credit exposure to the ten largest below investment grade-rated financial institutions was $2.1 billion.
•Short-term bank deposit placements, reverse repurchase agreements, repurchase agreements and commercial paper issued by financial institutions (primarily commercial banks), operating account balances with banks and bank-issued commercial letters of credit supporting insurance credit exposures were $20.4 billion, or 24 percent of the total global financial institution credit exposure.
We actively monitor our European credit exposures, especially those exposures to issuers in the Euro-Zone periphery. We use various stress assumptions to identify issuers and securities warranting review by senior management and to determine the need for mitigating actions. As a mitigating action, we typically decide not to renew maturing exposures or, when the opportunity presents itself, to sell or to tender securities. To date, we have not actively used credit default protection. We periodically evaluate the financial condition of issuers and adjust internal risk ratings as warranted.
The following table presents our aggregate United Kingdom and European credit exposures (excluding ILFC) by major sector:
(a) Other represents mortgage guaranty insurance ($1.3 billion), primarily in Spain ($941 million) and Italy ($188 million).
Aggregate credit exposure to European governments totaled $6.0 billion at December 31, 2012, compared to $7.6 billion at December 31, 2011. Many of the European governments' ratings have been downgraded by one or more of the major rating agencies, occurring mostly in countries in the Euro-Zone periphery (Spain, Italy and Portugal) where our government credit exposures totaled $245 million at December 31, 2012. The downgrades primarily reflect large government budget deficits, rising government debt-to-GDP ratios and large financing requirements of these countries, which have led to difficult financing conditions. These credit exposures primarily included available-for-sale and trading securities (at fair value) issued by these governments. At December 31, 2012, we had no direct or guaranteed credit exposure to the governments of Greece or Ireland.
Our exposure to European financial institutions at December 31, 2012 included $20.2 billion of credit exposures to European banks, of which $18.7 billion were considered investment grade based on our internal ratings. Aggregate below investment grade rated credit exposures to European banks were $1.4 billion. Our credit exposures to banks domiciled in the Euro-Zone countries totaled $8.0 billion at December 31, 2012, of which $4.4 billion were fixed maturity securities. Credit exposures to banks based in the five countries of the Euro-Zone periphery (Spain, Italy, Ireland, Greece, and Portugal) totaled $993 million, of which $707 million were fixed maturity securities. These credit exposures were primarily to the largest banks in Spain and Italy. Credit exposures to banks based in France totaled $1.5 billion at December 31, 2012, of which $833 million were fixed maturity securities. Our credit exposures were predominantly to the largest banks in these countries.
The following table presents our aggregate United Kingdom and European credit exposures (excluding ILFC) by product type:
(a) Fixed maturity securities primarily includes available-for-sale and trading securities reported at fair value of $41.4 billion ($41.4 billion amortized cost), and $3.4 billion ($3.4 billion amortized cost), respectively.
(b) Cash and short-term investments include bank deposit placements ($3.8 billion), collateral posted to counterparties against structured products ($1.9 billion), securities purchased under agreements to resell ($187 million), and operating accounts ($115 million).
(c) Insurance Credit Exposures primarily consist of captive fronting management programs ($10.7 billion), trade credit insurance ($6.2 billion), and surety bonds ($2.1 billion) and commercial letters of credit supporting insurance credit exposures ($794 million).
We have a risk concentration in the residential mortgage sector in the form of non-agency RMBS, CDO of RMBS as well as our mortgage guaranty insurance business. See Investments - Available for Sale Investments herein for further details on RMBS and CDO investments. The net risk-in-force for UGC was $33.6 billion at December 31, 2012, of which exposure in the United States was $30.4 billion.
We regularly review concentration reports in the categories listed above as well as credit trends by risk ratings and credit spreads. We periodically adjust limits and review exposures for risk mitigation to provide reasonable assurance that we do not incur excessive levels of credit risk and that our credit risk profile is properly calibrated across business units.
Market risk is defined as the potential loss arising from adverse fluctuations in interest rates, foreign currencies, equity and commodity prices, and their levels of volatility. Market risk includes credit spread risk, the potential loss arising from adverse fluctuations in credit spreads of securities or counterparties.
Benchmark interest rates. Benchmark interest rates are also known as risk-free interest rates and are associated with either the government/treasury yield curve or the swap curve. The fair value of our significant fixed maturity securities portfolio changes as benchmark interest rates change.
Credit spread or risk premium. Credit spread risk is the potential for loss due to a change in an instrument's risk premium or yield relative to that of a comparable duration, default-free instrument.
Equity and alternative investment prices. We are exposed to equity and alternative investment prices affecting a variety of instruments. These include direct investments in common stock and mutual funds, minimum benefit guarantees embedded in the structure of certain variable annuity and variable life insurance products and other equity-like investments, such as hedge funds and private equity funds, private equity investments, commercial real estate and real estate funds.
Foreign currency exchange rates. We are a globally diversified enterprise with significant income, assets and liabilities denominated in, and significant capital deployed in, a variety of currencies.
Duration/key rate duration. Duration is the measure of the sensitivities of a fixed-income instrument to the changes in the benchmark yield curve. Key rate duration measures sensitivities to the movement at a given term point on the yield curve.
Scenario analysis. Scenario analysis uses historical, hypothetical, or forward-looking macroeconomic scenarios to assess and report exposures. Examples of hypothetical scenarios include a 100 basis point parallel shift in the yield curve or a 10 percent immediate and simultaneous decrease in world-wide equity markets.
$378 million and a net increase of Canadian-dollar exposure of $92 million due to unrealized investment appreciation and positive results from operations; Euro exposure as a result of a reduction in euro-denominated debt outstanding of $231 million, additional purchases of the AIRE real estate investment vehicle of $109 million as well as unrealized investment appreciation and positive results from operations at AIG Europe SA of $147 million; and a net increase across currencies of $258 million.
The sensitivity factors utilized for 2012 and presented above were selected based on historical data from 1992 to 2012, as follows (see the table below):
•a 20 percent drop for equity and alternative investments is broadly consistent with a one standard deviation movement in the S&P 500; and
Liquidity risk is defined as the risk that our financial condition will be adversely affected by the inability or perceived inability to meet our short-term cash, collateral or other financial obligations.
Sources of Liquidity risk can include, but are not limited to:
Each Business Unit is primarily responsible for managing its operational risks and implementing the components of the operational risk management program. In addition, certain control functions have been assigned accountability for enterprise-wide risk management oversight for their respective areas. These control functions include: Sarbanes-Oxley (SOX), Business Continuity Management (BCM), Information Technology Security Risk, Compliance, and Vendor Management. Senior business operational risk executives report to their respective business unit chief risk officer and to the Head of our ORM. This reporting structure enables a close alignment with the businesses while ensuring consistent implementation of operational risk management practices.
Operational risk management reporting to senior management and operational risk governance committees provides awareness of operational risk exposures, identifies key risks and facilitates management decision making. Reporting includes RCSA information such as operational risk events, self-assessment results and the status of issue resolution to senior management.
We manage insurance risks through risk review and selection processes, exposure limitations, exclusions, deductibles, self-insured retentions, coverage limits and reinsurance. This management is supported by sound underwriting practices, pricing procedures and the use of actuarial analysis to help determine overall adequacy of provisions for insurance. Underwriting practices and pricing procedures incorporate historical experience, current regulation and judicial decisions as well as proposed or anticipated regulatory changes.
For AIG Property Casualty, insurance risks primarily emanate from the following:
To control catastrophe exposure, we use a combination of techniques, including setting key business unit limits based on an aggregate PML, monitoring and modeling accumulated exposures, and purchasing catastrophe reinsurance to supplement our other reinsurance protections. The majority of policies exposed to catastrophic events are one-year contracts allowing us to quickly adjust our exposure to catastrophic events if climate changes or other events increase the frequency or severity of catastrophes.
AIG Property Casualty utilizes industry recognized catastrophe models. The use of different methodologies and assumptions could materially change the projected losses. Therefore, these modeled losses may not be comparable to estimates made by other companies. These estimates are inherently uncertain and may not reflect our maximum exposures to these events. It is highly likely that our losses will vary, perhaps significantly, from these estimates.
The modeled results provided in the table below were based on the Aggregate Exceedance Probability (AEP) losses which represent total property, workers' compensation, and A&H losses that may occur in any single year from one or more natural events. The values provided were based on 100-year return period losses, which have a one percent likelihood of being exceeded in any single year. The A&H data include exposures for United States and Japan earthquakes. These exposures represent the largest share of A&H exposures to earthquakes. A&H losses were modeled using April 2010 data. The property exposures were modeled with data as of September 2012. All reinsurance program structures, domestic and international, reflect the reinsurance programs in place as of January 1, 2013. Losses include loss adjustment expenses and the net values include reinstatement premiums.
Gross earthquake and tropical cyclone modeled losses decreased $926 million and $2.3 billion, respectively, compared to 2011, while net losses decreased $335 million and $1.7 billion, respectively, compared to 2011. Changes in both gross and net losses are primarily due to underwriting decisions to actively manage catastrophe exposure in the United States.
In addition to the aggregate return period loss, we evaluate potential single event earthquake and hurricane losses. The single events utilized are a subset of potential events identified and utilized by Lloyd's (see Lloyd's Realistic Disaster Scenarios, Scenario Specifications, January 2013) and referred to as Realistic Disaster Scenarios (RDS).
Single-event modeled property and workers' compensation losses and loss adjustment expenses to AIG's worldwide portfolio of risk for key geographic areas are shown below.
We also monitor key international property risks utilizing industry recognized natural catastrophe models. Based on the occurrence exceedance probabilities, the 100-year return period loss for Japanese Earthquake is $1.1 billion gross and $885 million net; the 100-year return period loss for European Windstorm is $575 million gross and $503 million net; and the 100-year return period loss for Japanese Typhoon is $1.7 billion gross and $842 million net.
We also share our exposures to terrorism risks under the Terrorism Risk Insurance Program Reauthorization Act of 2007 (TRIPRA). TRIPRA covers terrorist attacks in the United States only and excludes, as specified by applicable law, certain commercial lines of business as well as A&H, group life and personal lines. In 2012 and beginning January 1, 2013, our deductible under TRIPRA was approximately $3.0 billion and $2.8 billion, respectively, with a 15 percent coinsurance retention of certified terrorism losses in excess of the deductible for each period.
•Paid losses recoverable - balances due from reinsurers for losses and loss expenses paid by our subsidiaries and billed, but not yet collected.
At December 31, 2012, total reinsurance recoverable assets were $25.6 billion. These assets include general reinsurance paid losses recoverable of $1.3 billion, ceded loss reserves of $19.2 billion including reserves for incurred but not reported (IBNR) claims, and ceded reserves for unearned premiums of $3.6 billion, as well as life reinsurance recoverables of $1.5 billion. The methods used to estimate IBNR and to establish the resulting ultimate losses involve projecting the frequency and severity of losses over multiple years. These methods are continually reviewed and updated by management. Any adjustments are reflected in income. We believe that the amount recorded for ceded loss reserves at December 31, 2012 reflect a reasonable estimate of the ultimate losses recoverable. Actual losses may, however, differ from the reserves currently ceded.
The Reinsurance Credit Department (RCD) conducts periodic detailed assessments of the financial strength and condition of current and potential reinsurers, both foreign and domestic. The RCD monitors both the financial condition of reinsurers as well as the total reinsurance recoverable ceded to reinsurers, and set limits with regard to the amount and type or exposure we are willing to take with reinsurers. As part of these assessments, we attempt to identify whether a reinsurer is appropriately licensed, assess its financial capacity and liquidity; and evaluate the local economic and financial environment in which a foreign reinsurer operates. The RCD reviews the nature of the risks ceded and the need for measures, including collateral to mitigate credit risk. For example, in our treaty reinsurance contracts, we frequently include provisions that require a reinsurer to post collateral or use other measures to reduce exposure when a referenced event occurs. Furthermore, we limit our unsecured exposure to reinsurers through the use of credit triggers such as insurer financial strength rating downgrades, declines in regulatory capital, or relevant risk-based capital (RBC) ratios fall below certain levels. We also set maximum limits for reinsurance recoverable exposure, which in some cases is the recoverable amount plus an estimate of the maximum potential exposure from unexpected events for a reinsurer. In addition, credit executives within ERM review reinsurer exposures and credit limits and approve reinsurer credit limits above specified levels. Finally, even where we conclude that uncollateralized credit risk is acceptable, we require collateral from active reinsurance counterparties where it is necessary for our subsidiaries to recognize the reinsurance recoverable assets for statutory accounting purposes. At December 31, 2012, we held $8.6 billion of collateral, in the form of funds withheld, securities in reinsurance trust accounts and/or irrevocable letters of credit, in support of reinsurance recoverable assets from unaffiliated reinsurers. We believe that no exposure to a single reinsurer represents an inappropriate concentration of risk to AIG, nor is our business substantially dependent upon any single reinsurance contract.
•whether the reinsurer is financially troubled (i.e., liquidated, insolvent, in receivership or otherwise subject to formal or informal regulatory restriction);
For AIG Life and Retirement, the primary risks are the following:
Pricing risk - represents the potential exposure to loss if actual policy experience emerges adversely in comparison to the assumptions made in product pricing. These assumptions include investment results, mortality, morbidity, surrenders, other observed policyholder behavior and expenses;
AIG Life and Retirement companies generally limit their maximum underwriting exposure on life insurance of a single life to $15 million or less of coverage. In certain circumstances, this is achieved by using yearly renewable term reinsurance. For the AIG Life and Retirement companies, the reinsurance programs provide risk mitigation per life for individuals and group and for catastrophic risk events.
UGC's risk appetite statement establishes various concentration limits on the business UGC insures (for example, geography), and defines underwriting characteristics for which UGC will not insure loans.
GCM evaluates the counterparty credit quality by reference to ratings from rating agencies or, where such ratings are not available, by internal analysis consistent with the risk rating policies of the ERM. In addition, GCM's credit approval process involves pre-set counterparty and country credit exposure limits subject to approval by the ERM and, for particularly credit-intensive transactions, requires approval from the ERM.
income tax assets and liabilities, including recoverability of our net deferred tax asset and the predictability of future tax operating profitability of the character necessary to realize the net deferred tax asset;
We take a number of factors into account in order to reliably estimate future taxable income, so that we can determine the extent of our ability to realize net operating losses (NOLs), foreign tax credits (FTCs) and nonlife capital loss carryforwards. These factors include forecasts of future income for each of our businesses, actual and planned business and operational changes, which includes assumptions about future macroeconomic and AIG-specific conditions and events. We also subject the forecasts to stresses of key assumptions and evaluate the effect on tax attribute utilization. We also apply stresses to our assumptions about the effectiveness of relevant prudent and feasible tax planning strategies. Our income forecasts, coupled with our tax planning strategies and stressed scenarios, all resulted in sufficient taxable income to achieve realization of the tax attributes (other than life-insurance-business capital loss carryforwards) prior to their expiration.
Liability for Unpaid Claims and Claims Adjustment Expenses (AIG Property Casualty and Mortgage Guaranty)
The estimate of Unpaid Claims and Claims Adjustment Expenses consists of several key judgments:
Estimation of ultimate net losses and loss expenses (net losses) for long-tail casualty classes of business is a complex process and depends on a number of factors, including the class and volume of business, as well as estimates of the reinsurance recoverable. Experience in the more recent accident years shows limited statistical credibility in reported net losses on long-tail casualty classes of business. That is because a relatively low proportion of net incurred losses represent reported claims and expenses, and an even smaller percentage represent net losses paid. Therefore, IBNR constitutes a relatively high proportion of net losses.
Loss cost trend factors which are used to establish expected loss ratios for subsequent accident years based on the projected loss ratios for prior accident years.
Loss development factors which are used to project the reported losses for each accident year to an ultimate basis. Generally, the actual loss development factors observed from prior accident years would be used as a basis to determine the loss development factors for the subsequent accident years.
We conduct a comprehensive loss reserve review at least annually for each AIG Property Casualty subsidiary and class of business. The reserve analysis for each class of business is performed by the actuarial personnel who are most familiar with that class of business. In this process, the actuaries are required to make numerous assumptions, including the selection of loss development factors and loss cost trend factors. They are also required to determine and select the most appropriate actuarial methods for each business class. Additionally, they must determine the segmentation of data that will enable the most suitable test of reserve adequacy. In the course of these detailed reserve reviews an actuarial central estimate of the loss reserve is determined. The sum of these central estimates for each class of business provides an overall actuarial central estimate of the loss reserve for that class.
third-party actuarial reserve reviews were generally limited to certain U.S. long-tail lines of business and were concentrated in the fourth quarter of 2010. These detailed reviews are conducted for each class of business for each subsidiary, and consist of hundreds of individual analyses.
third-party actuarial reviews that are periodically performed for key classes of business.
In testing the reserves for each class of business, our actuaries determine the most appropriate actuarial methods. This determination is based on a variety of factors including the nature of the claims associated with the class of business, such as the frequency or severity of the claims. Other 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, we write many unique subclasses of professional liability. For pricing or other purposes, it is appropriate to evaluate the profitability of each subclass individually. However, for purposes of estimating the loss reserves for professional liability, we believe it is appropriate to combine the subclasses into larger groups to produce a greater degree of credibility in the claims experience. This determination of data segmentation and actuarial methods is carefully considered for each class of business. The segmentation and actuarial methods chosen are those which together are expected to produce the most robust estimate of the loss reserves.
The actuarial methods we use for most long-tail casualty classes of business include loss development methods, expected loss ratio methods, including "Bornhuetter Ferguson" methods described below, and frequency/severity models. Loss development methods utilize the actual loss development patterns from prior accident years to project the reported losses to an ultimate basis for subsequent accident years. Loss development methods generally are most appropriate for classes of business which exhibit a stable pattern of loss development from one accident year to the next, and for which the components of the classes have similar development characteristics. For example, property exposures would generally not be combined into the same class as casualty exposures, and primary casualty exposures would generally not be combined into the same class as excess casualty exposures. We generally use expected loss ratio methods in cases where the reported loss data lacks sufficient credibility to utilize loss development methods, such as for new classes of business or for long-tail classes at early stages of loss development. Frequency/severity models may be used where sufficient frequency counts are available to apply such approaches.
Expected loss ratio methods rely on the application of an expected loss ratio to the earned premium for the class of business to determine the loss reserves. For example, an expected loss ratio of 70 percent applied to an earned premium base of $10 million for a class of business would generate an ultimate loss estimate of $7 million. Subtracting any reported paid losses and loss expense would result in the indicated loss reserve for this class. Under the "Bornhuetter Ferguson" methods, the expected loss ratio is applied only to the expected unreported portion of 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.
•Claim by claim reviews to determine the stability and likelihood of settling an injured worker's indemnity and medical benefits - the claim file review was facilitated by a third party expert experienced in workers' compensation claims;
We continue to receive claims asserting injuries and damages from toxic waste, hazardous substances, and other environmental pollutants and alleged claims to cover the cleanup costs of hazardous waste dump sites, referred to collectively as environmental claims, and indemnity claims asserting injuries from asbestos. The vast majority of these asbestos and environmental claims emanate from policies written in 1984 and prior years. Commencing in 1985, standard policies contained an absolute exclusion for pollution-related damage. An absolute asbestos exclusion was also implemented. The current AIG Property Casualty Environmental policies that we specifically price and underwrite for environmental risks on a claims-made basis have been excluded from the analysis.
We generally use a combination of loss development methods and expected loss ratio methods for excess casualty classes. Frequency/severity methods are generally not used in isolation to determine ultimate loss costs as the vast majority of reported claims do not result in claim payment. (However, frequency/severity methods assist in the regular monitoring of the adequacy of carried reserves to support incurred but not reported claims). 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. In order to gain more stability in the projection, the claims amenable to loss development methods are analyzed in two layers: the layer capped at $10 million and the layer above $10 million. The expected loss ratio for the layer above $10 million is derived from the expected relationship between the layers, reflecting the attachment point and limit by accident year.
Expected loss ratio methods are given more weight in the two most recent accident years, whereas loss development methods are given more weight in more mature accident years. For the year-end 2012 loss reserve review, claims projections for accident years 2011 and prior were used. These classes of business reflect claims made coverage, and losses are characterized by low frequency and high severity.
We generally use a combination of loss development methods and expected loss ratio methods for workers' compensation. We segment the data by state and industry class to the extent that meaningful differences are determined to exist.
Expected loss ratio methods generally are given significant weight only in the most recent accident year. Workers' compensation claims are generally characterized by high frequency, low severity, and relatively consistent loss development from one accident year to the next. We historically have been a leading writer of workers' compensation, and thus have sufficient volume of claims experience to use development methods. We generally segregate California business from other business in evaluating workers' compensation reserves. In 2012, we segmented out New York from the other states to reflect its different development pattern and changing percentage of the mix by state. We also revised our assumptions to reflect changes in our claims management activities. Certain classes of workers' compensation, such as construction, are also evaluated separately. Additionally, we write a number of very large accounts which include workers' compensation coverage. These accounts are generally priced by our actuaries, and to the extent appropriate, the indicated losses based on the pricing analysis may be used to record the initial estimated loss reserves for these accounts.
We historically have used a combination of loss development methods and expected loss ratio methods for excess workers' compensation. For the year-end 2012 loss reserve review, our actuaries supplemented the methods used historically by applying a structural drivers approach to inform their judgment of the ultimate loss costs for open reported claims from accident years 2003 and prior (representing approximately 95% of all open reported claims) and used the refined analysis to inform their judgment of the ultimate loss cost for claims that have not yet been reported using a frequency/severity approach for these accident years.
the assumed future rate of inflation and other economic conditions in the United States;
the cost of new and additional treatment specialties, such as "pain management";
Expected loss ratio methods are given the greater weight for the more recent accident years. For the year-end 2012 loss reserve review, the structural drivers approach which was applied to open reported claims from accident years 2003 and prior, was deemed to be most suitable for informing our judgment of the ultimate loss cost for injured workers whose medical conditions had largely stabilized (i.e., at least 9 to 10 years have elapsed since the date of injury). The reserve for unreported claims is approximately 41 percent of the total estimated reserve requirement for accident years 2003 and prior. The reserve for accident years 2004 and subsequent was determined using a Bornhuetter Ferguson expected loss ratio method and constitute approximately 13 percent of the total reserve requirements for this class of business.
We generally use a combination of loss development methods and expected loss ratio methods for primary general liability or products liability classes. We also supplement the standard actuarial techniques by using evaluations of the ultimate losses on unusual claims or claim accumulations by external experts on those classes of claims. The segmentation of the data reflects state differences, industry classes, deductible/non-deductible programs and type of claim.
We generally use a combination of loss development methods and expected loss ratio methods for healthcare classes of business. Frequency/severity methods are sometimes used for pricing certain healthcare accounts or business. However, in testing loss reserves the business is generally combined into larger groupings to enhance the credibility of the loss experience.
We also use claim department projections of the ultimate value of each reported claim to supplement and inform the standard actuarial approaches.
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 an appropriate balance between credibility and homogeneity of the data.
We use expected loss ratio methods for all accident years for catastrophic casualty business. This class of business consists of casualty or financial lines coverage that attach in excess of very high attachment points; thus the claims experience is marked by very low frequency and high severity. Because of the limited number of claims, loss development methods are not used.
The expected loss ratios and loss development assumptions used are based upon the results of prior accident years for this business as well as for similar classes of business written above lower attachment points. The business can be written on a claims-made or occurrence basis. We use ground-up claim projections provided by our claims staff to assist in developing the appropriate reserve.
We generally use frequency/severity methods and loss development methods for domestic personal auto classes.
We test mortgage guaranty reserves using loss development methods, supplemented by an internal claim analysis by actuaries and staff who specialize in the mortgage guaranty business.
Occurrences of fraudulent loans, underwriting violations, and other deviations from contractual terms, mostly related to the 2006 and 2007 blocks of business, have resulted in historically high levels of claim rescissions and denials (collectively referred to as rescissions) during 2011. As a result, many lenders have increased their rescission appeals activity as well as the success rate on those appeals by focusing additional resources on the process. The increased lender attention on tracking down missing loan documents along with the heightened focus on appeals of rescissions caused the estimated ultimate rescission rate (net of appeals) assumed in the loss reserves to be lower than the rescission level projected in 2011. If this trend continues it may unfavorably affect future results. We believe we have provided appropriate reserves for currently delinquent loans, consistent with industry practices.
We determine reserves for legal defense and cost containment loss adjustment expenses for each class of business by one or more actuarial or structural driver methods. The methods generally include development methods comparable to those described for loss development methods. The development could be based on either the paid loss adjustment expenses or the ratio of paid loss adjustment expenses to paid losses, or both. Other methods include the utilization of expected ultimate ratios of paid loss expense to paid losses, based on actual experience from prior accident years or from similar classes of business.
The effect of these deviations is expected to be less material compared to the effect on the classes noted below
After evaluating the historical loss development factors from prior accident years since the early 1990s, in our judgment, it is reasonably likely that actual loss development factors will range from approximately 3.3 percent below those actually utilized in the year-end 2012 reserve review to approximately 4.6 percent above those factors actually utilized. Excess casualty is a long-tail class of business and any deviation in loss development factors might not be discernible for an extended period of time subsequent to the recording of the initial loss reserve estimates for any accident year. Thus, there is the potential for the reserves with respect to a number of accident years to be significantly affected by changes in loss development factors that were initially relied upon in setting the reserves. These changes in loss development factors could be attributable to changes in inflation or in the judicial environment, or in other social or economic conditions affecting claims.
Generally, our 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 our business reflects a very significant volume of losses, particularly in recent accident years. After evaluating the actual historical loss development since the 1980s for this business, in our judgment, it is reasonably likely that actual loss development factors will fall within the range of approximately 3.1 percent below to 6.9 percent above those actually utilized in the year-end 2012 loss reserve review.
Loss costs were trended at six percent per annum. After reviewing actual industry loss trends for the past ten years, in our judgment, it is reasonably likely that actual loss cost trends applicable to the year-end 2012 loss reserve review for excess workers' compensation will range five percent lower or higher than this estimated loss trend.
The following sensitivity analysis table summarizes the effect on the loss reserve position of using certain alternative loss cost trend (for accident years where we use expected loss ratio methods) or loss development factor assumptions rather than the assumptions actually used in determining our estimates in the year-end loss reserve analyses in 2012.
Periodically, we evaluate estimates used in establishing liabilities for future policy benefits for life and accident and health insurance contracts, which include liabilities for certain payout annuities. We also evaluate estimates used in amortizing Deferred Policy Acquisition Costs (DAC), Value of Business Acquired (VOBA) and Sales Inducement Assets (SIA) for these products. We evaluate these estimates against actual experience and adjust them based on management judgment regarding mortality, morbidity, persistency, maintenance expenses, and investment returns.
For long duration traditional business, a "lock-in" principle applies. The assumptions used to calculate the benefit liabilities and DAC are set when a policy is issued and do not change with changes in actual experience, unless a loss recognition event occurs. These assumptions include margins for adverse deviation in the event that actual experience might deviate from these assumptions.
We also use these estimates to determine whether to adjust DAC and record additional liabilities when unrealized gains or losses on fixed maturity and equity securities available for sale are recognized through accumulated other comprehensive income. The determination is made at each balance sheet date, as if the securities had been sold at their stated aggregate fair value and the proceeds reinvested at current yields. Significant unrealized appreciation on investments in a prolonged low interest rate environment may cause DAC to be adjusted and additional future policy benefit liabilities to be recorded through a charge directly to accumulated other comprehensive income (ie. Shadow DAC). This is included, net of tax, with the change in net unrealized appreciation (depreciation) of investments.
The only way the GMWB contract holder can monetize the excess of the guaranteed amount over the account value of the contract is through a series of withdrawals that do not exceed a specific percentage per year of the guaranteed amount. If, after the series of withdrawals, the account value is exhausted, the contract holder will receive a series of annuity payments equal to the remaining guaranteed amount, and, for lifetime GWWB products, the annuity payments can continue beyond the guaranteed amount. The account value can also fluctuate with equity market returns on a daily basis resulting in increases or decreases in the excess of the guaranteed amount over account value.
The net impact of the change in the fair value of the embedded derivative liabilities, as well as the change in the fair value of the derivative instruments is included in Net Realized Capital Gains (Losses).
For a further discussion of the risks of AIG's unhedged exposures, see Item 1A. - Risk Factors - Business and Operations.
(c) Represents the net impact of a 10 basis point parallel shift in the yield curve. Does not represent interest rate spread compression.
For a discussion of goodwill impairment, see Note 2 to the Consolidated Financial Statements.
Assets and liabilities recorded at fair value in the Consolidated Balance Sheet are measured and classified in a hierarchy for disclosure purposes consisting of three "levels" based on the observability of inputs available in the marketplace used to measure the fair value. See Note 6 to the Consolidated Financial Statements for additional information.
We classify fair value measurements for certain assets and liabilities as Level 3 when they require significant unobservable inputs in their valuation, including contractual terms, prices and rates, yield curves, credit curves, measures of volatility, prepayment rates, default rates, mortality rates and correlations of such inputs.
AIG utilizes sensitivity analyses that estimate the effects of using alternative pricing and other key inputs on our calculation of the unrealized market valuation loss related to the super senior credit default swap portfolio. While we believe that the ranges used in these analyses are reasonable, we are unable to predict which of the scenarios is most likely to occur. As recent experience demonstrates, actual results in any period are likely to vary, perhaps materially, from the modeled scenarios, and there can be no assurance that the unrealized market valuation loss related to the super senior credit default swap portfolio will be consistent with any of the sensitivity analyses. On average, prices for CDOs increased during 2012. Further, it is difficult to extrapolate future experience based on current market conditions.
The following table presents key inputs used in the BET model, and the potential increase (decrease) to the fair value of the derivative liability by ABS category at December 31, 2012 corresponding to changes in these key inputs:
Accident year loss ratio, as adjusted the loss ratio excluding catastrophe losses and related reinstatement premiums, prior year development, net of premium adjustments and the impact of reserve discount. Catastrophe losses are generally weather or seismic events having a net impact on AIG Property Casualty in excess of $10 million each.
Admitted insurer A company licensed to transact insurance business within a state.
AIG Life and Retirement - Operating income (loss) Operating income (loss) is derived by excluding the following items from net income (loss): legal settlements related to legacy crisis matters, changes in fair values of fixed maturity securities designated to hedge living benefit liabilities, net realized capital (gains) losses, and changes in benefit reserves and DAC, VOBA, and SIA related to net realized capital (gains) losses.
AIG Property Casualty - Net premiums written represent the sales of an insurer, adjusted for reinsurance premiums assumed and ceded, during a given period. Net premiums earned are the revenue of an insurer for covering risk during a given period. Net premiums written are a measure of performance for a sales period while Net premiums earned are a measure of performance for a coverage period. From the period in which the premiums are written until the period in which they are earned, the amount is presented as Unearned premium reserves in the Consolidated Balance Sheet.
Cede, ceded reinsurance, ceding company An insurance company that reinsures its risk with another, is referred to as the ceding company.
Long-Tail Reserves Reserves for claims that may be reported or settled several years after the coverage period has expired for these classes of businesses. Long-tail casualty classes of business include excess and umbrella liability, D&O, professional liability, medical malpractice, workers' compensation, general liability, products liability and related classes.
Loss reserve development The increase or decrease in incurred claims and claim adjustment expenses as a result of the re-estimation of claims and claim adjustment expense reserves at successive valuation dates for a given group of claims.
Other Operations - Operating income (loss): income (loss) excluding certain legal reserves (settlements) related to legacy crisis matters, loss on extinguishment of debt, amortization of prepaid commitment fee asset, Net realized capital (gains) losses, net (gains) losses on sale of divested businesses and properties, and income from divested businesses.
Retained Interest Category within AIG's Other operations that includes the fair value gains or losses, prior to their sale, of the AIA ordinary shares retained following the AIA initial public offering and the MetLife, Inc. (MetLife) securities that were received as consideration from the sale of American Life Insurance Company (ALICO) and the fair value gains or losses, prior to the FRBNY liquidation of ML III assets, on the retained interest in ML III.
VaR Value-at-Risk A summary statistical measure that uses the estimated volatility and correlation of market factors to calculate the maximum loss that could occur over a defined period of time with a specified level of statistical confidence.
Consolidated Statement of Operations for the years ended December 31, 2012, 2011 and 2010
Consolidated Statement of Comprehensive Income (Loss) for the years ended December 31, 2012, 2011 and
Consolidated Statement of Equity for the years ended December 31, 2012, 2011 and 2010
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of American International Group, Inc. and its subsidiaries (AIG) at December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, AIG maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). AIG's management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management's Report on Internal Control Over Financial Reporting appearing under Item 9A in the 2012 Form 10-K. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on AIG's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
As discussed in Note 2 to the consolidated financial statements, as of January 1, 2012, AIG retrospectively adopted a new accounting standard that amends the accounting for costs incurred by insurance companies that can be capitalized in connection with acquiring or renewing insurance contracts.
See accompanying Notes to Consolidated Financial Statements, which include a summary of revisions to prior year balances in connection with a change in accounting principle.
See accompanying Notes to Consolidated Financial Statements, which include a summary of revisions to prior-year balances in connection with a change in accounting principle. In addition, changes were made to the presentation of the Consolidated Statement of Cash Flows to align presentation of changes in fair value of derivatives with changes in the administration of our derivatives portfolio.
Certain of our foreign subsidiaries included in the consolidated financial statements report on different annual fiscal period bases, in most cases ending November 30. The effect on our consolidated financial condition and results of operations of all material events occurring at these subsidiaries between such fiscal year end and December 31 for all periods presented has been recorded.
The preparation of financial statements in accordance with GAAP requires the application of accounting policies that often involve a significant degree of judgment. We consider the accounting policies that are most dependent on the application of estimates and assumptions to be those relating to items considered by management in the determination of:
•classification of International Lease Finance Corporation (ILFC) as held for sale;
•insurance liabilities, including property and casualty and mortgage guaranty unpaid claims and claims adjustment expenses and future policy benefits for life and accident and health contracts;
•income tax assets and liabilities, including recoverability of our net deferred tax asset and the predictability of future tax operating profitability of the character necessary to realize the net deferred tax asset;
•impairment charges, including other-than-temporary impairments of financial instruments and goodwill impairments;
•Reclassified approximately $1.3 billion of income taxes from Accumulated other comprehensive income to Additional paid in capital as of January 1, 2010 to correct the presentation of components of Shareholders' Equity. These income taxes related to the creation in 2009 of special purpose vehicles that held our interests in AIA Group Ltd. (AIA) and American Life Insurance Company (ALICO). There was no effect on Total AIG shareholders' equity or on Total equity as a result of this reclassification.
•Changes were made to the presentation within the Consolidated Statement of Operations to align the presentation of changes in the fair value of derivatives with changes in the administration of AIG's derivatives portfolio. Specifically, amounts attributable to derivative activity where AIG Financial Products Corp. and AIG Trading Group Inc. and their respective subsidiaries (collectively, AIGFP) executed transactions with third parties on behalf of AIG subsidiaries have been reclassified from Other income to Net realized capital gains (losses).
Premiums: Premiums for short duration contracts are recorded as written on the inception date of the policy. Premiums are earned primarily on a pro rata basis over the term of the related coverage. Sales of extended services contracts are reflected as premiums and earned on a pro rata basis over the term of the related coverage. The reserve for unearned premiums includes the portion of premiums written relating to the unexpired terms of coverage. Reinsurance premiums under a reinsurance contract are typically earned over the same period as the underlying policies, or risks, covered by the contracts. As a result, the earning pattern of a reinsurance contract may extend up to 24 months, reflecting the inception dates of the underlying policies throughout a year.
Other income: Other income includes unrealized gains and losses on derivatives, including unrealized market valuation gains and losses associated with the Global Capital Markets (GCM) super senior credit default swap (CDS) portfolio, as well as income from the Direct Investment book (DIB).
Other income from the operations of the DIB and our Other Operations category consists of the following:
•Changes in the fair value of trading securities and spot commodities sold but not yet purchased, futures, hybrid financial instruments, securities purchased under agreements to resell, and securities sold under agreements to repurchase for which the fair value option was elected.
contracts consist of benefits paid and changes in future policy benefits liabilities. Benefits for universal life and investment-type products primarily consist of benefit payments made in excess of policy account balances except for certain contracts for which the fair value option was elected, for which benefits represent the entire change in fair value (including derivative gains and losses on related economic hedges).
Interest credited to policyholder account balances: Represents interest on account-value-based policyholder deposits consisting of amounts credited on non-equity-indexed account values, accretion to the host contract for equity indexed products, and net amortization of sales inducements.
Amortization of deferred acquisition costs: For a discussion of our accounting policies on amortization of deferred policy acquisition costs, see Note 10 herein.
Other invested assets: For a discussion of our accounting policies on classification, measurement and other-than-temporary impairment of other invested assets, see Note 7 herein.
(d) Cash: Cash represents cash on hand and non-interest bearing demand deposits.
(e) Premiums and other receivables - net: Premiums and other receivables includes premium balances receivable, amounts due from agents and brokers and insureds, trade receivables for the DIB and GCM and other receivables. Trade receivables for GCM include cash collateral posted to derivative counterparties that are not eligible to be netted against derivative liabilities. The allowance for doubtful accounts on premiums and other receivables was $619 million and $484 million at December 31, 2012 and 2011, respectively.
(f) Reinsurance assets - net: For a discussion about our accounting policies on reinsurance assets - net, see Note 9 herein.
(g) Deferred policy acquisition costs (DAC): For discussion of our accounting policies on deferred policy acquisition costs, see Note 10 herein.
The cost of buildings and furniture and equipment is depreciated principally on a straight-line basis over their estimated useful lives (maximum of 40 years for buildings and 10 years for furniture and equipment). Expenditures for maintenance and repairs are charged to income as incurred; expenditures for improvements are capitalized and depreciated. We periodically assess the carrying value of our real estate for purposes of determining any asset impairment. Capitalized software costs, which represent costs directly related to obtaining, developing or upgrading internal use software, are capitalized and amortized using the straight-line method over a period generally not exceeding five years. Real estate, fixed assets and other long-lived assets are assessed for impairment when impairment indicators exist.
If we determine it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we estimate the fair value of each reporting unit and compare the estimated fair value with the carrying amount of the reporting unit, including allocated goodwill. The estimate of a reporting unit's fair value may be based on one or a combination of approaches including market-based earnings multiples of the unit's peer companies, discounted expected future cash flows, external appraisals or, in the case of reporting units being considered for sale, third-party indications of fair value, if available. We consider one or more of these estimates when determining the fair value of a reporting unit to be used in the impairment test.
In connection with the announcement of the ILFC sale, discussed in Note 4, and management's determination that the reporting unit met the held-for-sale criteria, management tested the remaining goodwill of the reporting unit for impairment. Based on the results of the goodwill impairment test, we determined that all of the goodwill allocated to the reporting unit should be impaired and, accordingly, recognized a goodwill impairment charge in the fourth quarter of 2012.
At December 31, 2012, we performed our annual goodwill impairment test. Based on the results of the goodwill impairment test, we concluded that the remaining goodwill was not impaired.
(k) Separate accounts: Separate accounts represent funds for which investment income and investment gains and losses accrue directly to the policyholders who bear the investment risk. Each account has specific investment objectives and the assets are carried at fair value. The assets of each account are legally segregated and are not subject to claims that arise from any of our other businesses. The liabilities for these accounts are equal to the account assets.
(n) Other policyholder funds: Other policyholder funds are reported at cost and include any policyholder funds on deposit that encompass premium deposits and similar items.
For further discussion of secured financing arrangements, see Note 7 herein.
(u) Earnings (loss) per share: For a discussion of our accounting policies on earnings (loss) per share, see Note 19 herein
In February 2013 the FASB issued guidance that clarifies the scope of transactions subject to disclosures about offsetting assets and liabilities. The guidance applies to derivatives, repurchase agreements and reverse purchase agreements, and securities borrowing and securities lending transactions that are offset either in accordance with specific criteria contained in FASB Accounting Standards Codification or subject to a master netting arrangement or similar agreement.
In February 2013 the FASB issued guidance on the presentation requirements for items reclassified out of accumulated other comprehensive income. We will be required to disclose the effect of significant items reclassified out of accumulated other comprehensive income on the respective line items of net income or provide a cross-reference to other disclosures currently required under U.S. GAAP for relevant items.
In October 2010, the FASB issued an accounting standard update that amends the accounting for costs incurred by insurance companies that can be capitalized in connection with acquiring or renewing insurance contracts. The standard clarifies how to determine whether the costs incurred in connection with the acquisition of new or renewal insurance contracts qualify as DAC. We adopted the standard retrospectively on January 1, 2012.
Deferred policy acquisition costs represent those costs that are incremental and directly related to the successful acquisition of new or renewal insurance contracts. We defer incremental costs that result directly from, and are essential to, the acquisition or renewal of an insurance contract. Such costs generally include agent or broker commissions and bonuses, premium taxes, and medical and inspection fees that would not have been incurred if the insurance contract had not been acquired or renewed. Each cost is analyzed to assess whether it is fully deferrable. We partially defer costs, including certain commissions, when we do not believe the entire cost is directly related to the acquisition or renewal of insurance contracts.
The adoption of the standard resulted in a reduction to beginning of period retained earnings for the earliest period presented and a decrease in the amount of capitalized costs in connection with the acquisition or renewal of insurance contracts. Accordingly, we revised our historical financial statements and accompanying notes to the consolidated financial statements for the changes in DAC and associated changes in acquisition expenses and income taxes for affected entities and segments, including divested entities presented in continuing and discontinued operations.
The following tables present amounts previously reported for the years ended December 31, 2011 and 2010 to reflect the effect of the change due to the retrospective adoption of the standard, and the adjusted amounts that are reflected in our Consolidated Statement of Operations and Consolidated Statement of Cash Flows.
(a) Includes $783 million in Total net realized capital gains attributable to the effect of the reclassification of certain derivative activity discussed in Note 1 herein. Also includes the effect of the reclassification of ILFC as discontinued operations.
The standard removes from the assessment of effective control the requirement that the transferor have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee. The removal of this requirement makes the level of collateral received by the transferor in a repurchase agreement or similar arrangement irrelevant in determining whether the transaction should be accounted for as a sale. As a consequence, more repurchase agreements, securities lending transactions and similar arrangements will be accounted for as secured borrowings.
The guidance in the standard was required to be applied prospectively to transactions or modifications of existing transactions that occur on or after January 1, 2012. There are no repurchase agreements that continue to be accounted for as sales as of December 31, 2012.
In May 2011, the FASB issued an accounting standard that amended certain aspects of the fair value measurement guidance in GAAP, primarily to achieve the FASB's objective of a converged definition of fair value and substantially converged measurement and disclosure guidance with International Financial Reporting Standards (IFRS). The measurement and disclosure requirements under GAAP and IFRS are now generally consistent, with certain exceptions including the accounting for day one gains and losses, measuring the fair value of alternative investments using net asset value and certain disclosure requirements.
The standard's fair value measurement and disclosure guidance applies to all companies that measure assets, liabilities, or instruments classified in shareholders' equity at fair value or provide fair value disclosures for items not recorded at fair value. The guidance clarifies existing guidance on the application of fair value measurements, changes certain principles or requirements for measuring fair value, and requires significant additional disclosures for
In April 2010, the FASB issued an accounting standard that clarifies that an insurance company should not combine any investments held in separate account interests with its interest in the same investment held in its general account when assessing the investment for consolidation. Separate accounts represent funds for which investment income and investment gains and losses accrue directly to the policyholders who bear the investment risk. The standard also provides guidance on how an insurer should consolidate an investment fund when the insurer concludes that consolidation of an investment is required and the insurer's interest is through its general account in addition to any separate accounts.
In April 2011, the FASB issued an accounting standard that amends the guidance for a creditor's evaluation of whether a restructuring is a troubled debt restructuring and requires additional disclosures about a creditor's troubled debt restructuring activities. The standard clarifies the two criteria used to determine whether a modification or restructuring is a troubled debt restructuring: (i) whether the creditor has granted a concession and (ii) whether the debtor is experiencing financial difficulties.
In March 2010, the FASB issued an accounting standard that amends the accounting for embedded credit derivative features in structured securities that redistribute credit risk in the form of subordination of one financial instrument to another. The standard clarifies how to determine whether embedded credit derivative features, including those in collateralized debt obligations (CDOs), credit-linked notes (CLNs), synthetic CDOs and CLNs and other synthetic
securities (e.g., commercial and residential mortgage-backed securities issued by securitization entities that wrote credit derivatives), are considered to be embedded derivatives that should be analyzed for potential bifurcation and separate accounting or, alternatively, for fair value accounting in connection with the application of the fair value option to the entire hybrid instrument.
AIG Property Casualty - The AIG Property Casualty segment is presented as two operating segments - Commercial Insurance and Consumer Insurance in addition to an AIG Property Casualty Other category.
During 2012, to align financial reporting with the manner in which AIG's chief operating decision makers review the AIG Property Casualty businesses to assess performance and make decisions about resources to be allocated, certain products previously reported in Commercial Insurance were reclassified to Consumer Insurance. Also, certain environmental liability businesses were moved from Commercial Insurance to run-off operations included in the AIG Property Casualty Other category. Accordingly, all periods have been restated from previously reported segment information to reflect this change. These revisions did not affect the total AIG Property Casualty reportable segment results previously reported.
AIG Life and Retirement offers a comprehensive suite of products and services to individuals and groups, including term life insurance, universal life insurance, accident and health (A&H) insurance, fixed and variable deferred annuities, fixed payout annuities, mutual funds and financial planning. AIG Life and Retirement offers its products and services through a diverse, multi-channel distribution network that includes banks, national, regional and independent broker-dealers, affiliated financial advisors, independent marketing organizations, independent and career insurance agents, structured settlement brokers, benefit consultants and direct-to-consumer platforms.
•Corporate & Other operations (after allocations to our business segments); and
The following table presents AIG Property Casualty operations by operating segment:
The following table presents AIG Life and Retirement operations by operating segment:
On October 29, 2010, we completed an initial public offering (IPO) of 8.08 billion ordinary shares of AIA for aggregate gross proceeds of approximately $20.5 billion. Upon completion of the IPO, we owned 33 percent of the outstanding AIA ordinary shares. Accordingly, we deconsolidated AIA and recorded a pre-tax gain of $18.1 billion in 2010. During 2012, we sold our remaining AIA ordinary shares for aggregate gross proceeds of approximately $14.5 billion. As a result of these sales, we no longer held an interest in AIA as of December 31, 2012. Prior to the disposition, we accounted for our investment in AIA under the fair value option with gains and losses recorded in Net investment income. At December 31, 2011, the fair value of our retained interest in AIA was approximately $12.4 billion, and was included in Other invested assets.
We report a business as held for sale when management has approved or received approval to sell the business and is committed to a formal plan, the business is available for immediate sale, the business is being actively marketed, the sale is anticipated to occur during the next 12 months and certain other specified criteria are met. A business classified as held for sale is recorded at the lower of its carrying amount or estimated fair value less cost to sell. If the carrying amount of the business exceeds its estimated fair value, a loss is recognized. Depreciation is not recorded on assets of a business after it is classified as held for sale. Assets and liabilities related to a business classified as held for sale are segregated in the Consolidated Balance Sheet in the period in which the business is classified as held for sale.
On August 10, 2010, we entered into a definitive agreement to sell an 80 percent economic interest (84 percent voting interest) in AGF for $125 million. The AGF sale closed on November 30, 2010. Our voting ownership interest in AGF was reduced to approximately 16 percent, and we do not otherwise have significant continuing involvement with or significant continuing cash flows from AGF. We are carrying our retained investment in AGF of approximately $30 million as a cost method investment in Other invested assets. As a result of this transaction, we recorded a pre-tax loss of $1.7 billion in 2010. The components of the $1.7 billion charge consisted of the difference between (i) the sum of the fair value of the agreed consideration and our retained 20 percent economic interest and (ii) the net book value of the assets.
As part of the Recapitalization, we used approximately $6.1 billion of the cash proceeds from the ALICO sale to pay down a portion of the liquidation preference of the SPV Preferred Interests.
Certain other sales completed during 2011 and 2010 were not classified as discontinued operations because we continued to generate significant direct revenue-producing or cost-generating cash flows from the businesses or because associated assets, liabilities and results of operations were not material, individually or in the aggregate, to our consolidated financial position or results of operations.
Interest expense allocated to discontinued operations gives effect to the provisions of the Recapitalization discussed in Note 25 for all periods presented. For this reason, an interest allocation to discontinued operations related to a portion of the ALICO and all the AGF proceeds was required.
The 2011 purchases were accounted for as equity transactions because we previously consolidated Fuji due to our controlling interest. Accordingly, the difference between the fair value of the total consideration paid of $560 million and the carrying value of the noncontrolling interest acquired of $489 million was recognized as a reduction of our equity in Fuji. There was no gain or loss recorded in the Consolidated Statement of Operations for the year ended December 31, 2011.
Assets and liabilities recorded at fair value in the Consolidated Balance Sheet are measured and classified in accordance with a fair value hierarchy consisting of three "levels" based on the observability of inputs available in the marketplace used to measure the fair values as discussed below:
Counterparty Credit Risk. Fair value measurements for freestanding derivatives incorporate counterparty credit by determining the explicit cost for us to protect against our net credit exposure to each counterparty at the balance sheet date by reference to observable counterparty CDS spreads, when available. When not available, other directly or indirectly observable credit spreads will be used to derive the best estimates of the counterparty spreads. Our net credit exposure to a counterparty is determined based on master netting agreements, which take into consideration all derivative positions with the counterparty, as well as collateral posted by the counterparty at the balance sheet date. Fair values for fixed maturity securities based on observable market prices for identical or similar instruments implicitly incorporate counterparty credit risk. Fair values for fixed maturity securities based on internal models incorporate counterparty credit risk by using discount rates that take into consideration cash issuance spreads for similar instruments or other observable information.
We employ independent third-party valuation service providers to gather, analyze, and interpret market information to derive fair value estimates for individual investments, based upon market-accepted methodologies and assumptions. The methodologies used by these independent third-party valuation services are reviewed and understood by management, through periodic discussion with and information provided by the valuation services. In addition, as discussed further below, control processes are applied to the fair values received from third-party valuation services to ensure the accuracy of these values.
When our third-party valuation service providers are unable to obtain sufficient market observable information upon which to estimate the fair value for a particular security, fair value is determined either by requesting brokers who are knowledgeable about these securities to provide a price quote, which is generally non-binding, or by employing widely accepted valuation models. Broker prices may be based on an income approach, which converts expected future cash flows to a single present value amount, with specific consideration of inputs relevant to particular security types. For structured securities, such inputs may include ratings, collateral types, geographic concentrations, underlying loan vintages, loan delinquencies, and weighted average coupons and maturities. When the volume or level of market activity for a security is limited, certain inputs used to determine fair value may not be observable in the market. Broker prices may also be based on a market approach that considers recent transactions involving identical or similar securities. Fair values provided by brokers are subject to similar control processes to those noted above for fair values from third party valuation services, including management reviews. For those corporate debt instruments (for example, private placements) that are not traded in active markets or that are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and non-transferability, and such adjustments generally are based on available market evidence. When observable price quotations are not available, fair value is determined based on discounted cash flow models using discount rates based on credit spreads, yields or price levels of comparable securities, adjusted for illiquidity and structure. Fair values determined internally are also subject to management review to ensure that valuation models and related inputs are reasonable.
The methodology above is relevant for all fixed maturity securities including residential mortgage-backed securities (RMBS), commercial mortgage backed securities (CMBS), CDOs, other asset-backed securities (ABS) and fixed maturity securities issued by government sponsored entities and corporate entities.
Equity Securities Traded in Active Markets - Trading and Available for Sale
Whenever available, we obtain quoted prices in active markets for identical assets at the balance sheet date to measure at fair value marketable equity securities in our trading and available for sale portfolios or in Other invested assets. Market price data is generally obtained from exchange or dealer markets.
We initially estimate the fair value of investments in certain hedge funds, private equity funds and other investment partnerships by reference to the transaction price. Subsequently, we generally obtain the fair value of these investments from net asset value information provided by the general partner or manager of the investments, the financial statements of which are generally audited annually. We consider observable market data and perform certain control procedures to validate the appropriateness of using the net asset value as a fair value measurement. The fair values of other investments carried at fair value, such as direct private equity holdings, are initially determined based on transaction price and are subsequently estimated based on available evidence such as market transactions in similar instruments and other financing transactions of the issuer, with adjustments made to reflect illiquidity as appropriate.
For short-term investments that are measured at fair value, the carrying values of these assets approximate fair values because of the relatively short period of time between origination and expected realization, and their limited exposure to credit risk. Securities purchased under agreements to resell (reverse repurchase agreements) are generally treated as collateralized receivables. We report certain receivables arising from securities purchased under agreements to resell as Short-term investments in the Consolidated Balance Sheet. We use market-observable
Derivative assets and liabilities can be exchange-traded or traded over-the-counter (OTC). We generally value exchange-traded derivatives such as futures and options using quoted prices in active markets for identical derivatives at the balance sheet date.
With respect to embedded policy derivatives in our variable annuity contracts, because of the dynamic and complex nature of the expected cash flows, risk neutral valuations are used. Estimating the underlying cash flows for these products involves judgments regarding expected market rates of return, market volatility, correlations of market index returns to funds, fund performance, discount rates and policyholder behavior. With respect to embedded policy derivatives in our equity-indexed annuity and life contracts, option pricing models are used to estimate fair value, taking into account assumptions for future equity index growth rates, volatility of the equity index, future interest
We value CDS transactions written on the super senior risk layers of designated pools of debt securities or loans using internal valuation models, third-party price estimates and market indices. The principal market was determined to be the market in which super senior credit default swaps of this type and size would be transacted, or have been transacted, with the greatest volume or level of activity. We have determined that the principal market participants, therefore, would consist of other large financial institutions who participate in sophisticated over-the-counter derivatives markets. The specific valuation methodologies vary based on the nature of the referenced obligations and availability of market prices.
The valuation of the super senior credit derivatives is challenging given the limitation on the availability of market observable information due to the lack of trading and price transparency in certain structured finance markets. These market conditions have increased the reliance on management estimates and judgments in arriving at an estimate of fair value for financial reporting purposes. Further, disparities in the valuation methodologies employed by market participants and the varying judgments reached by such participants when assessing volatile markets have increased the likelihood that the various parties to these instruments may arrive at significantly different estimates as to their fair values.
Regulatory capital portfolio: In the case of credit default swaps written to facilitate regulatory capital relief, we estimate the fair value of these derivatives by considering observable market transactions. The transactions with the most observability are the early terminations of these transactions by counterparties. We continue to reassess the expected maturity of the portfolio. There has been no requirement to make any payments as part of terminations of super senior regulatory capital CDSs initiated by counterparties. In assessing the fair value of the regulatory capital CDS transactions, we also consider other market data, to the extent relevant and available.
We have adapted the BET model to estimate the price of the super senior risk layer or tranche of the CDO. We modified the BET model to imply default probabilities from market prices for the underlying securities and not from rating agency assumptions. To generate the estimate, the model uses the price estimates for the securities comprising the portfolio of a CDO as an input and converts those estimates to credit spreads over current LIBOR-based interest rates. These credit spreads are used to determine implied probabilities of default and expected losses
on the underlying securities. This data is then aggregated and used to estimate the expected cash flows of the super senior tranche of the CDO.
In addition to calculating an estimate of the fair value of the super senior CDO security referenced in the credit default swaps using our internal model, we also consider the price estimates for the super senior CDO securities provided by third parties, including counterparties to these transactions, to validate the results of the model and to determine the best available estimate of fair value. In determining the fair value of the super senior CDO security referenced in the credit default swaps, we use a consistent process that considers all available pricing data points and eliminates the use of outlying data points. When pricing data points are within a reasonable range an averaging technique is applied.
•A risk margin that market participants would require for a market return and the uncertainty inherent in the model inputs. The change in fair value of these policyholder contract deposits is recorded as Policyholder benefits and claims incurred in the Consolidated Statement of Operations.
The fair value of non-structured liabilities is generally determined by using market prices from exchange or dealer markets, when available, or discounting expected cash flows using the appropriate discount rate for the applicable maturity. We determine the fair value of structured liabilities and hybrid financial instruments (where performance is linked to structured interest rates, inflation or currency risks) using the appropriate derivative valuation methodology (described above) given the nature of the embedded risk profile. In addition, adjustments are made to the valuations of both non-structured and structured liabilities to reflect our own creditworthiness based on the methodology described under the caption "Incorporation of Credit Risk in Fair Value Measurements - Our Own Credit Risk" above.
Borrowings under obligations of Guaranteed Investment Agreements (GIAs), which are guaranteed by us, are recorded at fair value using discounted cash flow calculations based on interest rates currently being offered for similar contracts and our current market observable implicit credit spread rates with maturities consistent with those remaining for the contracts being valued. Obligations may be called at various times prior to maturity at the option of the counterparty. Interest rates on these borrowings are primarily fixed, vary by maturity and range up to 9.8 percent.
Other liabilities measured at fair value include certain securities sold under agreements to repurchase and certain securities and spot commodities sold but not yet purchased. Liabilities arising from securities sold under agreements to repurchase are generally treated as collateralized borrowings. We estimate the fair value of liabilities arising under these agreements by using market-observable interest rates. This methodology considers such factors as the coupon rate, yield curves and other relevant factors. Fair values for securities sold but not yet purchased are based on current market prices. Fair values of spot commodities sold but not yet purchased are based on current market prices of reference spot futures contracts traded on exchanges.
(d) Level 3 Credit contracts included the fair value derivative liability on the super senior credit default swap portfolio of $2.0 billion and $3.2 billion at December 31, 2012 and 2011, respectively.
Our policy is to record transfers of assets and liabilities between Level 1 and Level 2 at their fair values as of the end of each reporting period, consistent with the date of the determination of fair value. Assets are transferred out of Level 1 when they are no longer transacted with sufficient frequency and volume in an active market. Conversely, assets are transferred from Level 2 to Level 1 when transaction volume and frequency are indicative of an active market. During the year ended December 31, 2012, we transferred $464 million of securities issued by Non-U.S. government entities from Level 1 to Level 2, as they are no longer considered actively traded. For similar reasons, during the year ended December 31, 2012, we transferred $888 million of securities issued by the U.S. government and government-sponsored entities from Level 1 to Level 2. We had no material transfers from Level 2 to Level 1 during the year ended December 31, 2012.
Both observable and unobservable inputs may be used to determine the fair values of positions classified in Level 3 in the tables above. As a result, the unrealized gains (losses) on instruments held at December 31, 2012 and 2011 may include changes in fair value that were attributable to both observable (e.g., changes in market interest rates) and unobservable inputs (e.g., changes in unobservable long-dated volatilities).
During the year ended December 31, 2012, transfers into Level 3 assets included certain RMBS, CMBS, CDO/ABS, private placement corporate debt and certain private equity funds and hedge funds. Transfers of certain RMBS and certain CDO/ABS into Level 3 assets were related to decreased observations of market transactions and price information for those securities. The transfers of investments in certain other RMBS and CMBS into Level 3 assets were due to a decrease in market transparency, downward credit migration and an overall increase in price disparity for certain individual security types. Transfers of private placement corporate debt and certain other ABS into Level 3 assets were primarily the result of limited market pricing information that required us to determine fair value for these securities based on inputs that are adjusted to better reflect our own assumptions regarding the characteristics of a specific security or associated market liquidity. Certain private equity fund and hedge fund investments were also transferred into Level 3 due to these investments being carried at fair value and no longer being accounted for using the equity method of accounting, consistent with the changes to our ownership and the lack of ability to exercise more than minor influence over the respective investments. Other hedge fund investments were transferred into Level 3 as a result of limited market activity due to fund-imposed redemption restrictions.
Assets are transferred out of Level 3 when circumstances change such that significant inputs can be corroborated with market observable data. This may be due to a significant increase in market activity for the asset, a specific event, one or more significant input(s) becoming observable or a long-term interest rate significant to a valuation becoming short-term and thus observable. In addition, transfers out of Level 3 assets also occur when investments are no longer carried at fair value as the result of a change in the applicable accounting methodology, given changes in the nature and extent of our ownership interest. During the year ended December 31, 2012, transfers out of Level 3 assets primarily related to certain RMBS, CMBS, ABS, investments in private placement corporate debt and private equity funds and hedge funds. Transfers of certain RMBS out of Level 3 assets were based on consideration of the market liquidity as well as related transparency of pricing and associated observable inputs for these investments. Transfers of investments in certain CMBS out of Level 3 were due to an increase in market transparency, positive credit migration and an overall improvement in price comparability for certain individual security types. Transfers of ABS and private placement corporate debt out of Level 3 assets were primarily the result of using observable pricing information that reflects the fair value of those securities without the need for adjustment based on our own assumptions regarding the characteristics of a specific security or the current liquidity in the market. The removal of fund-imposed redemption restrictions, as well as certain fund investments becoming subject to the equity method of accounting based on our level of influence over the respective investments, resulted in the transfer of certain hedge fund and private equity fund investments out of Level 3.
We use various hedging techniques to manage risks associated with certain positions, including those classified within Level 3. Such techniques may include the purchase or sale of financial instruments that are classified within Level 1 and/or Level 2. As a result, the realized and unrealized gains (losses) for assets and liabilities classified within Level 3 presented in the table above do not reflect the related realized or unrealized gains (losses) on hedging instruments that are classified within Level 1 and/or Level 2.
(a) The unobservable inputs and ranges for the constant prepayment rate, loss severity and constant default rate relate to each of the individual underlying mortgage loans that comprise the entire portfolio of securities in the RMBS and CDO securitization vehicles and not necessarily to the securitization vehicle bonds (tranches) purchased by us. The ranges of these inputs do not directly correlate to changes in the fair values of the tranches purchased by us because there are other factors relevant to the specific tranches owned by us including, but not limited to, purchase price, position in the waterfall, senior versus subordinated position and attachment points.
Corporate debt securities included in Level 3 are primarily private placement issuances that are not traded in active markets or that are subject to transfer restrictions. Fair value measurements consider illiquidity and non-transferability. When observable price quotations are not available, fair value is determined based on discounted cash flow models using discount rates based on credit spreads, yields or price levels of publicly-traded debt of the issuer or other comparable securities, considering illiquidity and structure. The significant unobservable input used in the fair value measurement of corporate debt is the yield. The yield is affected by the market movements in credit spreads and U.S. Treasury yields. In addition, the migration in credit quality of a given security generally has a corresponding effect on the fair value measurement of the securities. For example, a downward migration of credit quality would increase spreads. Holding U.S. Treasury rates constant, an increase in corporate credit spreads would decrease the fair value of corporate debt.
The significant unobservable inputs used for embedded derivatives in policyholder contract deposits measured at fair value, mainly guaranteed minimum withdrawal benefits (GMWB) for variable annuity products, are equity volatility, mortality rates, lapse rates and utilization rates. Mortality, lapse and utilization rates may vary significantly depending
upon age groups and duration. In general, increases in volatility and utilization rates will increase the fair value, while increases in lapse rates and mortality rates will decrease the fair value of the liability associated with the GMWB.
Private equity fund investments included above are not redeemable, as distributions from the funds will be received when underlying investments of the funds are liquidated. Private equity funds are generally expected to have 10-year lives at their inception, but these lives may be extended at the fund manager's discretion, typically in one or two-year increments. At December 31, 2012, assuming average original expected lives of 10 years for the funds, 41 percent of the total fair value using net asset value or its equivalent above would have expected remaining lives of less than three years, 56 percent between three and seven years and 3 percent between seven and 10 years.
At December 31, 2012, hedge fund investments included above are redeemable monthly (15 percent), quarterly (34 percent), semi-annually (28 percent) and annually (23 percent), with redemption notices ranging from one day to 180 days. More than 69 percent of these hedge fund investments require redemption notices of less than 90 days. Investments representing approximately 74 percent of the value of the hedge fund investments cannot be redeemed, either in whole or in part, because the investments include various restrictions. The majority of these restrictions have pre-defined end dates and are generally expected to be lifted by the end of 2015. The restrictions that do not have stated end dates were primarily put in place prior to 2009. The partial restrictions relate to certain hedge funds that hold at least one investment that the fund manager deems to be illiquid.