The gross and net impacts of the catastrophe losses during 1993 were approximately $134 million and $70 million, respectively. This was significantly below the approximately $567 million and $192 million in gross and net catastrophe losses, respectively, recorded in 1992, which included the three major storms Andrew, Iniki and Omar. Losses of $99 million and $68 million, respectively, were recorded in 1991. If the catastrophes were excluded from the losses incurred in each period, the pro forma statutory general insurance ratios would be as follows:
AIG enters into certain intercompany reinsurance transactions for both its general and life operations. AIG enters these transactions as a sound and prudent business practice in order to maintain underwriting control and spread insurance risk among various legal entities. These reinsurance agreements have been approved by the appropriate regulatory authorities. All material intercompany transactions have been eliminated in consolidation.
A variety of actuarial methods and assumptions are normally employed to estimate net losses for long tail casualty lines. These methods ordinarily involve the use of loss trend factors intended to reflect the estimated annual growth in loss costs from one accident year to the next. Loss trend factors reflect many items including changes in claims handling, exposure and policy forms and current and future estimates of inflation and social inflation. Thus, many factors are implicitly considered in estimating the year to year growth in loss costs. Therefore, AIG's carried net long tail loss reserves are judgmentally set as well as tested for reasonableness using the most appropriate loss trend factors for each class of business. In the evaluation of AIG's net loss reserves, loss trend factors have ranged from 7 percent to 22 percent of average loss costs, depending on the particular class and nature of the business involved. For the majority of long tail casualty lines, net loss trend factors approximating 10 percent were employed. These factors are periodically reviewed and subsequently adjusted, as appropriate, to reflect emerging trends which are based upon past loss experience.
The risks associated with the traditional and accident and health products are underwriting risk and investment risk. The risk associated with the financial and investment contract products is investment risk.
To minimize its exposure to investment risk, AIG tests the cash flows from the invested assets and the policy and contract liabilities using various interest rate scenarios to determine if a liquidity excess or deficit is perceived to exist. If a rebalancing of the invested assets to the policy and contract claims became necessary and did not occur, a demand could be placed upon liquidity. (See also the discussion under "Liquidity" herein.)
Life insurance net investment income increased 14.1 percent to $1.50 billion in 1993 compared to increases of 15.3 percent and 16.6 percent in 1992 and 1991, respectively. The growth in net investment income in each of the three years was primarily attributable to new cash flow for investment. The new cash flow was generated from net life insurance operating cash flow and included the compounding of previously earned and reinvested net investment income. The decline in the rate of growth is a reflection of the general worldwide downward trend in interest rates. (See also the discussion under "Liquidity" herein.)
Through AIGFP and AIGTG, AIG participates in the derivatives market, which has expanded significantly during the past several years. Derivative products typically take the form of futures, forward, swap and option contracts and derive their values from underlying interest rate, foreign exchange, equity or commodity instruments. End users find derivatives to be a cost effective approach to managing market risks associated with traditional on-balance sheet financial instruments. As a dealer of derivative contracts, AIG typically acts as a counterparty to end users or other dealers. Consequently, AIG may build up substantial positions in derivatives which are managed by taking offsetting positions in other derivatives, commodities or financial instruments. AIG's counterparties include financial services companies, governmental units, banks and industrial companies. In considering AIG's derivative activities, it is also important to note that all significant derivative activities are conducted through AIGFP and AIGTG and that AIG's other units, including its insurance subsidiaries, are not significant end users of derivative products.
AIGFP monitors and controls its risk exposure on a daily basis through financial, credit and legal reporting systems and, accordingly, has in place effective procedures for evaluating and limiting the credit and market risks to which it is subject. Management is not aware of any potential counterparty defaults as of December 31, 1993.
ILFC primarily engages in the acquisition of new and used commercial jet aircraft and the leasing and sale of such aircraft to airlines around the world. In addition, ILFC is engaged in the remarketing of commercial jets for airlines and financial institutions. ILFC is exposed to loss through non-performance of aircraft lessees and through owning and committing to purchase aircraft which it would be unable to lease. ILFC manages its lessee non-performance exposure through credit reviews and security deposit requirements. At December 31, 1993, only one of 230 aircraft owned was not leased. This aircraft is being converted for freighter service. Currently, 76.5 percent of the fleet is leased to foreign carriers.
ILFC sold $100 million of Market Auction Preferred Stock in each of November 1993 and December 1992.
(I) NET UNREALIZED GAIN ON INTEREST RATE AND CURRENCY SWAPS, OPTIONS AND FORWARD TRANSACTIONS: Swaps, options and forward transactions are accounted for as contractual commitments recorded on a trade date basis and are carried at estimated fair value based on the use of valuation models that utilize, among other things, current interest, foreign exchange and volatility rates, as applicable, with the resulting unrealized gains or losses reflected in the current period's income. These values are also reviewed by reference to the market levels at which AIG hedges its transactions, and are adjusted, as deemed appropriate by management. The recorded values may be different than the values that might be realized if AIG were to sell or close out the transactions because of limited liquidity for these instruments. AIGmanages its economic risk with a variety of transactions, including swaps, options, bonds, forwards or futures contracts and other transactions as appropriate.
(J) RECEIVABLES FROM AND PAYABLES TO SECURITIES BROKERS AND DEALERS: Receivables from and payables to securities brokers and dealers include balances due from and due to clearing brokers and exchanges and receivables from and payables to counterparties which relate to unrealized gains and losses on open forward settlement contracts and next day settlements on securities and swap payments.
(a) AIG and its domestic subsidiaries file a consolidated U.S. Federal income tax return. Revenue Agent's Reports assessing additional taxes for the years 1985 and 1986 have been issued and Letters of Protest contesting the assessments have been filed with the Internal Revenue Service. It is management's belief that there are substantial arguments in support of the positions taken by AIG in its Letters of Protest. Management also believes that the final result of these examinations will be immaterial to the financial statements.
AIG's reinsurance arrangements do not relieve AIG from its direct obligation to its insureds. Thus, a contingent liability exists with respect to both general and life reinsurance ceded to the extent that any reinsurer is unable to meet the obligations
(B) NET INVESTMENT INCOME: An analysis of the net investment income from the general and life insurance operations follows:
The amortized cost and estimated market values of fixed maturities held to maturity and of fixed maturities available for sale at December 31, 1993, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
At December 31, 1993, the maturity schedule for ILFC's outstanding Medium Term Notes was as follows:
(ii) Italian Lire Bonds: In December, 1991, AIG issued unsecured bonds denominated in Italian Lire. The principal amount of Italian Lire 200 billion matures December 4, 2001 and accrues interest at a rate of 11.7 percent which is paid annually. These bonds are not redeemable prior to maturity, except in the event of certain changes involving taxation in the United States or the imposition of certain certification, identification or reporting requirements.
Forward and futures contracts are contracts for delivery of foreign currencies or money market instruments in which the seller/purchaser agrees to make/take delivery at a specified future date of a specified instrument at a specified price or yield. Risks arise as a result of movements in current markets from contracted levels and the potential inability of counterparties to meet the terms of their contracts. At December 31, 1993, the notional principal amount of open purchase and sale forward and futures contracts of AIGTG approximated $101 billion. The notional or contractual amounts used to summarize the volume of financial instruments do not represent the amount of financial instruments subject to off-balance sheet risks. Assuming simultaneous nonperformance by all counterparties on all contracts of AIGTG potentially subject to loss, the maximum potential loss, based on the cost of replacement at market rates prevailing at December 31, 1993, approximated $800 million.