The commercial property and casualty insurance industry has historically experienced cycles of price erosion followed by rate strengthening as a result of catastrophe or other significant losses that affect the overall capacity of the industry to provide coverage. Despite industry price erosion in commercial lines, AIG expects to continue to identify profitable opportunities and build attractive new general insurance businesses as a result of AIG’s broad product line and extensive distribution networks in the U.S. and abroad. Workers compensation remains under considerable pricing pressure, as statutory rates continue to decline. Rates for D&O insurance also continue to decline due to competitive pressures. There can be no assurance that price erosion will not become more widespread or that AIG’s profitability will not deteriorate from current levels in major commercial lines, as well as in personal lines and specialty coverages, such as mortgage guaranty, where the loss ratio has increased due to softening in the U.S. housing market and the weakening performance of non-traditional mortgage products. In Foreign General, opportunities for growth exist in the consumer lines due to increased demand in emerging markets and the trend toward privatization of health insurance. Growth in the Personal Lines marketplace remains challenged from flat renewal pricing, consumer price shopping and increased advertising spending by market leaders. However, the high net worth market continues to provide opportunities for growth as a result of AIG’s innovative products and services specifically designed for that market. AIG expects that the acquisition of the remaining interest in 21st Century will enhance AIG’s ability to grow the Personal Lines business while gaining efficiencies of scale.
AIG is a leader in direct marketing through sponsors and in the broad market in Japan and Korea, and AIG is investing in expanding distribution channels in India, Korea and Vietnam.
AIG’s Asset Management operations include institutional and retail asset management, broker-dealer services and institutional spread-based investment businesses. The MIP has replaced the GIC program as AIG’s principal spread-based investment activity.
Expected loss ratios for the latest accident year: in this case, accident year 2006 for the year end 2006 loss reserve analysis. For low-frequency, high-severity classes such as excess casualty, expected loss ratios generally are utilized for at least the three most recent accident years.
Statutory underwriting profit (loss) is a measure that U.S. domiciled insurance companies are required to report to their regulatory authorities. The following table reconciles statutory underwriting profit (loss) to operating income for General Insurance for the years ended December 31, 2006, 2005 and 2004:
Transatlantic’s net premiums written and net premiums earned increased in 2006 by 5 percent and 6 percent, respectively, compared to 2005 due primarily to increased writings in domestic operations. Operating income increased in 2006 compared to 2005 due largely to lower catastrophe losses and net ceded reinstatement premiums, and increased net investment income.
The following table presents the components of the General Insurance gross reserve for losses and loss expenses (loss reserves) as of December 31, 2006 and 2005 by major lines of business on a statutory Annual Statement basis*:
The following table classifies the components of the General Insurance net loss reserves by business unit as of December 31, 2006 and 2005.
Management believes that the General Insurance net loss reserves are adequate to cover General Insurance net losses and loss expenses as of December 31, 2006. While AIG regularly reviews the adequacy of established loss reserves, there can be no assurance that AIG’s ultimate loss reserves will not develop adversely and materially exceed AIG’s loss reserves as of December 31, 2006. In the opinion of management, such adverse development and resulting increase in reserves is not likely to have a material adverse effect on AIG’s consolidated financial condition, although it could have a material adverse effect on AIG’s consolidated results of operations for an individual reporting period. See also Item 1A. Risk Factors - Casualty Insurance and Underwriting Reserves.
prior accident years included approximately $520 million related to Transatlantic with the balance spread across many other classes of business. Most classes of business produced favorable development for accident years 2003 and 2004, and adverse development for accident years 2001 and prior.
Workers Compensation: AIG generally utilizes loss development methods for all but the most recent accident year. 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. AIG is a leading writer of workers compensation, and thus has sufficient volume of claims experience to utilize development methods. AIG does not believe frequency/severity methods are as appropriate, due to significant growth and changes in AIG’s workers compensation business over the years. AIG generally segregates California business from other business in evaluating workers compensation reserves. Certain classes of workers compensation, such as construction, are also evaluated separately. Additionally, AIG writes a number of very large accounts which include workers compensation coverage. These accounts are generally priced by AIG actuaries, and to the extent appropriate, the indicated losses based on the pricing analysis may be utilized to record the initial estimated loss reserves for these accounts.
Excess Casualty: For the excess casualty class of business, the assumed loss cost trend was approximately six percent. After evaluating the historical loss cost trends from prior accident years since the early 1990s, in AIG’s judgment, it is reasonably likely that actual loss cost trends applicable to the year-end 2006 loss reserve review for excess casualty will range from negative four percent to positive 16 percent, or approximately ten percent lower or higher than the assumption actually utilized in the year-end 2006 reserve review. A ten percent change in the assumed loss cost trend for excess casualty would cause approximately a $1.7 billion increase or a $1.2 billion decrease in the net loss and loss expense reserve for this class of business. It should be emphasized that the ten percent deviations are not considered the highest possible deviations that might be expected, but rather what is considered by AIG to reflect a reasonably likely range of potential deviation. Actual loss cost trends in the early 1990s were negative for several years, including amounts below the negative four percent cited above, whereas actual loss cost trends in the late 1990s ran well into the double digits for several years, including amounts greater than the 16 percent cited above. Thus, there can be no assurance that loss trends will not deviate by more than ten percent. The loss cost trend assumption is critical for the excess casualty class of business due the long-tail nature of the claims and therefore is applied across many accident years.
With respect to asbestos claims handling, AIG’s specialized claims staff operates to mitigate losses through proactive handling, supervision and resolution of asbestos cases. Thus, while AIG has resolved all claims with respect to miners and major manufacturers (Tier One), its claims staff continues to operate under the same proactive philosophy to resolve claims involving accounts with products containing asbestos (Tier Two), products containing small amounts of asbestos, companies in the distribution process, and parties with remote, ill-defined involvement in asbestos (Tiers Three and Four). Through its commitment to appropriate staffing, training, and management oversight of asbestos cases, AIG mitigates to the extent possible its exposure to these claims.
Includes increases to gross losses and loss expense reserves of $2.0 billion and $1.5 billion in the fourth quarter of 2005 and 2004, respectively, and increases to net losses and loss expense reserves of $873 million and $850 million for the fourth quarter of 2005 and 2004, respectively.
Net flows are defined as deposits received less benefits, surrenders, withdrawals and death benefits.
Includes catastrophe-related losses of $62 million recorded in the third quarter of 2005 resulting from hurricane Katrina, which were reduced by $35 million in 2006 due to the reevaluation of the remaining estimated losses.
Consumer Finance operating income decreased to $761 million, or 13 percent, in 2006 compared to 2005. Operating income from domestic consumer finance operations declined as a result of decreased originations and purchases of real estate loans and margin compression resulting from increased interest rates and flattened yield curves. The foreign operations operating income decreased primarily due to the credit deterioration in the Taiwan credit card market.
Within the alternative investment asset class, AIGGIG offers hedge and private equity fund-of-funds, direct investments and distressed debt investments. Within the structured fixed income and equity product asset class, AIGGIG offers various forms of structured and credit linked notes, various forms of collateralized debt obligations and other investment strategies aimed at achieving superior returns or capital preservation. In addition, Institutional Asset Management’s product offerings include various forms of principal protected and liability management structures.
The debt activity, excluding commercial paper of $12.15 billion and VIE debt of $3.25 billion, for the year ended December 31, 2006 was as follows:
AIGFP uses the proceeds from the issuance of notes and bonds and GIA borrowings to invest in a diversified portfolio of securities and derivative transactions. The borrowings may also be temporarily invested in securities purchased under agreements to resell. AIGFP’s notes and bonds include structured debt instruments whose payment terms are linked to one or more financial or other indices (such as an equity index or commodity index or another measure that is not considered to be clearly and closely related to the debt instrument). These notes contain embedded derivatives that otherwise would be required to be accounted for separately under FAS 133. Upon AIG’s early adoption of FAS 155, AIGFP elected the fair value option for these notes. The notes that are accounted for using the fair value option are reported separately under hybrid financial instrument liabilities. AIG guarantees the obligations of AIGFP under AIGFP’s notes and bonds and GIA borrowings. See Operating Review - Financial Services Operations, Liquidity and Derivatives herein.
For additional information related to AIG’s activities with respect to VIEs and certain guarantees, see Notes 1 and 18 of Notes to Consolidated Financial Statements.
A substantial portion of AIG’s General Insurance business and a majority of its Life Insurance & Retirement Services business are conducted in foreign countries. The degree of regulation and supervision in foreign jurisdictions varies. Generally, AIG, as well as the underwriting companies operating in such jurisdictions, must satisfy local regulatory requirements. Licenses issued by foreign authorities to AIG subsidiaries are subject to modification and revocation. Thus, AIG’s insurance subsidiaries could be prevented from conducting future business in certain of the jurisdictions where they currently operate. AIG’s international operations include operations in various developing nations. Both current and future foreign operations could be adversely affected by unfavorable political developments up to and including nationalization of AIG’s operations without compensation. Adverse effects resulting from any one country may affect AIG’s results of operations, liquidity and financial condition depending on the magnitude of the event and AIG’s net financial exposure at that time in that country.
Life Insurance & Retirement Services invested assets grew by $37.0 billion, or 10 percent, during 2006 as bond holdings grew by $15.1 billion, or 6 percent, and listed equity holdings grew by $6.7 billion, or 41 percent. For a discussion of credit risk exposures, see Risk Management - Credit Risk Management herein.
At December 31, 2006, ILFC had committed to purchase 254 new aircraft deliverable from 2007 through 2015 for an estimated aggregate purchase price of $19.0 billion. As of February 22, 2007, ILFC has entered into leases for all of the new aircraft to be delivered in 2007, and 64 of 171 of the new aircraft to be delivered subsequent to 2007. ILFC will be required to find customers for any aircraft currently on order and any aircraft to be
AIGFP owns inventories in certain commodities in which it trades, and may reduce the exposure to market risk through the use of swaps, forwards, futures, and option contracts. Physical commodities held in AIGFP’s wholly owned broker-dealer subsidiary are recorded at fair value. All other commodities are recorded at the lower of cost or market value.
The senior management of AIG defines the policies and establishes general operating parameters for Capital Markets operations. AIG’s senior management has established various oversight committees to monitor on an ongoing basis the various financial market, operational and credit risks attendant to the Capital Markets operations. The senior management of AIGFP reports the results of its operations to and reviews future strategies with AIG’s senior management.
nities. In doing so, AIGFP must continually manage a variety of exposures, including credit, market, liquidity, operational and legal risks.
With respect to hedge funds and limited partnerships in which AIG holds in the aggregate a five percent or greater interest, or less than a five percent interest but where AIG has more than a minor influence over the operations of the investee, AIG accounts for these investments using the equity method. The changes in such net asset values are included in operating income.
AIG believes that strong risk management practices and a sound internal control environment are fundamental to its continued success and profitable growth. Failure to manage risk properly could expose AIG to significant losses, regulatory issues and a damaged reputation.
Aggregate globally all credit exposure data by counterparty, country and industry and report risk concentrations regularly to the CRC.
The CRC reviews quarterly concentration reports in all categories listed above as well as credit trends by risk ratings. The CRC may adjust limits to provide reasonable assurance that AIG does not incur excessive levels of credit risk and that AIG’s credit risk profile is properly calibrated across business units.
Much of AIG’s domestic capital is invested in fixed income or equity securities, leading to exposures to U.S. yields and equity markets.
At December 31, 2006, consolidated general reinsurance assets of $21.8 billion include reinsurance recoverables for paid losses and loss expenses of $1.0 billion and $17.3 billion with respect to the ceded reserve for losses and loss expenses, including ceded losses IBNR (ceded reserves) and $3.5 billion of ceded reserve for unearned premiums. The ceded reserve for losses and loss expenses represent the accumulation of estimates of ultimate ceded losses including provisions for ceded IBNR and loss expenses. The methods used to determine such estimates and to establish the resulting ceded reserves involve significant judgment in projecting the frequency and severity of losses over multiple years and are continually reviewed and updated by management. Any adjustments thereto are reflected in income currently. It is AIG’s belief that the ceded reserves for losses and loss expenses at December 31, 2006 were representative of the ultimate losses recoverable. In the future, as the ceded reserves continue to develop to ultimate amounts, the ultimate loss recoverable may be greater or less than the reserves currently ceded.
AIG maintains an allowance for estimated unrecoverable reinsurance of $536 million. The allowance was reduced substantially during 2006, as uncollectible amounts due from individual reinsurers were charged off against the allowance, primarily as a result of the balance sheet reconciliation remediation process; in addition, a portion of the allowance was reclassified to align it with the related receivable. The reduction for charge offs was partially offset by additional provisions totaling $147 million during 2006. At December 31, 2006, AIG had no significant reinsurance recoverables due from any individual reinsurer that was financially troubled (i.e., liquidated, insolvent, in receivership or otherwise subject to formal or informal regulatory restriction).
Catastrophic risk from the earthquake and hurricane perils is proactively managed through reinsurance programs, and aggregate accumulation monitoring. Catastrophe reinsurance is purchased by AIG from financially sound reinsurers. Recoveries under this program, along with other non-catastrophic reinsurance protections, are reflected in the net values provided in the tables above. In addition to catastrophic reinsurance programs, hurricane and earthquake exposures are controlled by periodically monitoring aggregate exposures. The aggregate exposures are calculated by compiling total liability within AIG defined hurricane and earthquake catastrophe risk zones and therefore represent the maximum that could be lost in any individual zone. These aggregate accumulations are tracked over time in order to monitor both long and short term trends. AIG’s major property writers, Lexington and AIG private client group, have also implemented catastrophe-related underwriting procedures and manage their books at an account level. Lexington individually models most accounts prior to binding in order to specifically quantify catastrophic risk for each account.
At the June 2005 meeting, the EITF reached a consensus with respect to Issue No. 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners have Certain Rights.”
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, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 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. These financial statements and financial statement schedules are the responsibility of AIG’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes 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. We believe that our audits provide a reasonable basis for our opinion.
Impairment of mortgage loans on real estate and collateral loans is based upon certain risk factors and when collection of all amounts due under the contractual term is not probable. This impairment is generally measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate subject to the fair value of underlying collateral if the loan is collateral dependent. Interest income on such impaired loans is recognized as cash is received.
(dd) Short- and Long-Term Borrowings: AIG’s funding is principally obtained from medium term and long-term borrowings and commercial paper. Commercial paper, when issued at a discount, is recorded at the proceeds received and accreted to its par value. Long-term borrowings are carried at the principal amount borrowed, net of unamortized discounts or premiums. See Note 9 herein for additional information.
In September 2006, the FASB issued FAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (FAS 158). FAS 158 requires AIG to prospectively recognize the over funded or under funded status of defined benefit postretirement plans as an asset or liability in AIG’s consolidated balance sheet and to recognize changes in that funded status in the year in which the changes occur through Other Comprehensive Income. FAS 158 also requires AIG to measure the funded status of plans as of the date of its year-end balance sheet, with limited exceptions. AIG adopted FAS 158 for the year ending December 31, 2006. The cumulative effect, net of deferred income taxes, on AIG’s consolidated balance sheet at December 31, 2006 was a net reduction in shareholders’ equity through a charge to Accumulated other comprehensive income of $532 million, with a corresponding net decrease of $538 million in total assets, and a net decrease of $6 million in total liabilities. See Note 15 herein for additional information on the adoption of FAS 158.
Includes the life operations of AIG Life Insurance Company and American International Life Assurance Company of New York. Operating income in 2006 included charges of $125 million resulting from the adverse Superior National arbitration ruling and $66 million related to the exiting of the domestic financial institutions credit life business. Operating income in 2004 included a $178 million charge related to a workers compensation quota share reinsurance agreement with Superior National. See Note 12(c) herein for additional information. In addition, in 2004, as part of the business review of group life/health, approximately $68 million was incurred for reserve strengthening and allowances for receivables. Revenues and operating income include realized capital gains (losses) of $(215) million, $35 million and $(120) million for 2006, 2005 and 2004, respectively. Includes the effect of hedging activities that did not qualify for hedge accounting treatment under FAS 133 and the application of FAS 52, which were $19 million, $76 million and $8 million for 2006, 2005 and 2004, respectively.
Represents the sum of Life Insurance & Retirement Services GAAP premiums, net investment income and realized capital gains (losses).
U.S. federal income taxes have not been provided on $1.3 billion of undistributed earnings of certain U.S. subsidiaries that are not included in the consolidated AIG U.S. federal income tax return because tax planning strategies are available, and would be utilized, to eliminate the tax liability related to these earnings. U.S. federal income taxes have not been provided on the undistributed earnings of certain non-U.S. subsidiaries to the extent that such earnings have been reinvested abroad for an indefinite period of time. At December 31, 2006, the cumulative amount of undistributed earnings in these subsidiaries approximated $17.6 billion. Determining the deferred tax liability that would arise if these earnings were not permanently reinvested abroad is not practicable.
A Revenue Agent’s Report proposing to assess additional taxes for the years 1997 to 1999 has been issued to AIG and a Letter of Protest contesting the proposed assessments has been filed with the Internal Revenue Service (IRS). A draft settlement agreed to in substance has been received from the IRS for years 1997 to 1999. Settlement has been reached with the IRS for years prior to 1997 although AIG has reserved the right to timely claim refunds for items related to the restatements of AIG’s 2004 and prior financial statements during 2005.
The following analysis provides a reconciliation of the activity in the reserve for losses and loss expenses:
Domestically, guaranteed investment contracts (GICs) have market value withdrawal provisions for any funds withdrawn other than benefit responsive payments. Interest rates credited generally range from 2.6 percent to 9.0 percent. The vast majority of these GICs mature within five years. Overseas, interest rates credited on GICs generally range from 1.2 percent to 5.2 percent and maturities range from one to five years.
For variable products and investment contracts, policy values are expressed in terms of investment units. Each unit is linked to an asset portfolio. The value of a unit increases or decreases based on the value of the linked asset portfolio. The current liability at any time is the sum of the current unit value of all investment units plus any liability for guaranteed minimum death or withdrawal benefits. A portion of these liabilities are classified in the Spread-Based Investment Business for segment reporting purposes.
Statutory surplus and net income for General Insurance, Life Insurance & Retirement Services operations in accordance with regulatory accounting practices were as follows:
Other invested assets at December 31, 2006, also includes approximately $1.8 billion of aircraft asset investments held by non-financial services subsidiaries.
(ii) Export credit facility: ILFC had a $4.3 billion Export Credit Facility (ECA) for use in connection with the purchase of approximately 75 aircraft delivered through 2001. This facility was guaranteed by various European Export Credit Agencies. The interest rate varies from 5.75 percent to 5.90 percent on these amortizing ten-year borrowings depending on the delivery date of the aircraft. At December 31, 2006, ILFC had $1.0 billion outstanding under this facility. The debt is collateralized by a pledge of the shares of a subsidiary of ILFC, which holds title to the aircraft financed under the facility.
AIG does not guarantee any of the debt obligations of ILFC.
Derivative Actions - Delaware Chancery Court. From October 2004 to April 2005, AIG shareholders filed five derivative complaints in the Delaware Chancery Court. All of these derivative lawsuits have been consolidated into a single action. The amended consolidated complaint names 43 defendants (not including nominal defendant AIG) who, like the New York consolidated derivative litigation, are current and former officers and directors of AIG, as well as other entities and certain of their current and former employees and directors. The factual allegations, legal claims and relief sought in Delaware action are similar to those alleged in the New York derivative actions, except that plaintiffs in the Delaware derivative action assert claims only under state law. The court has approved agreements staying the derivative case pending in the Delaware Chancery Court while the special committee performs its work. The current stay extends until March 14, 2007.
Litigation Relating to 21st Century. Shortly after the announcement in late January 2007 of AIG’s offer to acquire the outstanding shares of 21st Century not already owned by AIG and its subsidiaries, two related class actions were filed in the Superior Court of California, Los Angeles County, against AIG, 21st Century, and the individual members of 21st Century’s Board of Directors, two of whom are current executive officers of AIG. The actions were filed purportedly on behalf of the minority shareholders of 21st Century and assert breaches of fiduciary duty in connection with the AIG proposal. The complaints allege that the proposed per share price is unfair and seek preliminary
At December 31, 2006, AIG’s non-employee directors received stock-based compensation in two forms, options granted pursuant to the 1999 Plan and grants of AIG common stock with delivery deferred until retirement from the Board, pursuant to the AIG Director Stock Plan, which was approved by the shareholders at the 2004 Annual Meeting of Shareholders.
At December 31, 2006, AIG was obligated to issue 8,382,632 shares in connection with previous exercises of options with delivery deferred.
As of December 31, 2006, total unrecognized compensation cost (net of expected forfeitures) was $133 million and $3 million related to non-vested share-based compensation awards granted under the 1999 Plan and the 1996 Plan, respectively, with blended weighted average periods of 1.44 years and 0.41 years, respectively. The cost of awards outstanding under these plans at December 31, 2006 is expected to be recognized over approximately three years and one year, respectively, for the 1999 Plan and the 1996 Plan.
The intrinsic value of options exercised during 2006 was approximately $215 million. The fair value of options vesting during 2006 was approximately $97 million. AIG received $104 million and $65 million in cash during 2006 and 2005, respectively, from the exercise of stock options. The tax benefits realized as a result of stock option exercises were $35 million and $20 million for 2006 and 2005, respectively.
(a) Pension Plans: Employees of AIG, its subsidiaries and certain affiliated companies, including employees in foreign countries, are generally covered under various funded, unfunded and insured pension plans. Eligibility for participation in the various plans is based on either completion of a specified period of continuous service or date of hire, subject to age limitations. Some AIG subsidiaries provide retirement benefits through defined benefit plans, others employ defined contribution plans and some use both.
The mortality assumption used to determine the obligations for the U.S. plans as of December 31, 2006 and December 31, 2005 was based on the RP2000 White Collar Combined Mortality Table projected to 2006. The mortality assumptions for AIG’s non-U.S. plans vary by country. There was a change in the mortality table assumption for Ireland, Japan, Taiwan and United Kingdom as of December 31, 2006 (November 30, 2006 for non-U.S. plans of sponsoring companies with a fiscal year-end date of November 30, 2006). The assumptions used are expected to reasonably anticipate future mortality experience. No other significant changes have been made for the December 31, 2006 obligations (November 30, 2006 obligations for non-U.S. plans of sponsoring companies with a fiscal year-end date of November 30, 2006).
expected returns within each asset category. The return with respect to each asset class considers both historical returns and the future expectations for such returns.
Entities for which AIG is the primary beneficiary and consolidates or where AIG has a significant variable interest are as follows:
As part of its investment activities, AIG’s insurance operations invest in obligations which include debt and equity securities and interests issued by VIEs. These investments include investments in AIG sponsored and non-sponsored investment funds, hedge funds, private equity funds, and structured financing arrangements. The investments in these VIEs allow AIG’s insurance entities to purchase assets permitted by insurance regulations while maximizing their return on these assets. AIG’s insurance operations typically are not involved in the design or establishment of the VIE, nor do they actively participate in the management of the VIE.
The vast majority of AIG’s exposure on guarantees made to variable contract holders arises from GMDB. Details concerning AIG’s GMDB exposures as of December 31, 2006 and 2005 are as follows: