We record quarterly changes in loss reserves for each product line of business. The overall change in our loss reserves is based on the sum of the changes for all product lines of business. For most long-tail product lines of business, the quarterly loss reserve changes are based on the estimated current loss ratio for each subset of coverage less any amounts paid. Also, any change in estimated ultimate losses from prior accident years deemed to be necessary based on the results of our latest detailed valuation reviews, large loss analyses, or other analytical techniques, either positive or negative, is reflected in the loss reserve and incurred losses for the current quarter. Differences between actual loss emergence in a given period and our expectations based on prior loss reserve estimates are used to monitor reserve adequacy between detailed valuation reviews and may also influence our judgment with respect to adjusting reserve estimates.
For the year ended December 31, 2018, recent changes in market conditions, including rising interest rates, impacted the unrealized tax gains and losses in the U.S. Non-Life Companies’ available for sale securities portfolio, resulting in a decrease to the deferred tax liability related to net unrealized tax capital gains. As of December 31, 2018, we continue to be in an overall unrealized tax gain position with respect to the U.S. Non-Life Companies’ available for sale securities portfolio and thus concluded no valuation allowance is necessary in the U.S. Non-Life Companies’ available for sale securities portfolio.
We formed Fortitude Group Holdings, LLC (Fortitude Holdings) to act as a holding company for Fortitude Re. On November 13, 2018, we completed the sale of a 19.9 percent ownership interest in Fortitude Holdings to TC Group Cayman Investment Holdings, L.P. (TCG), an affiliate of The Carlyle Group L.P. (Carlyle) (the Fortitude Re Closing). Fortitude Holdings owns 100 percent of the outstanding common shares of Fortitude Re and AIG has an 80.1 percent ownership interest in Fortitude Holdings. In connection with the sale, we agreed to certain investment commitment targets into various Carlyle strategies and to certain minimum investment management fee payments within thirty-six months following the closing. We also will be required to pay a proportionate amount of an agreed make-whole fee to the extent we fail to satisfy such investment commitment targets.
Additionally, sustained low interest rates on discounting of projected benefit cash flows for our pension plans may result in higher pension expense.
For additional information on our investment and asset-liability management strategies see Investments.
• higher general operating and other expenses due to the acquisition of Validus, business growth and continued investments in business platforms.
• lower losses incurred from General Insurance operations driven by significantly lower catastrophe losses and lower unfavorable prior year loss reserve development, partially offset by higher severe losses; and
The International General Insurance business is focused on underwriting profits and improved efficiency, further improving underwriting margins, and growing profitably in segments and geographies that support our growth strategy. This includes creating operating leverage by improving the expense ratio, a focus on new business sales in Japan, a strategic review of the use of reinsurance and leveraging Talbot, International’s newly acquired Lloyd’s of London insurance syndicate.
Adjusted pre-tax loss decreased primarily due to significantly lower unfavorable prior year loss reserve development.
As life insurance ownership remains at historical lows in the U.S. and the U.K., efforts to expand the reach and increase the affordability of life insurance are critical. The industry is investing in consumer-centric efforts to reduce traditional barriers to securing life protection by simplifying the sales and service experience. Digitally enabled processes and tools provide a fast, friendly and simple path to life insurance protection.
· increases in reserves primarily due to additional reserves for guaranteed benefits in 2017 compared to a reduction in 2016;
• higher net investment income, primarily from the receipt of non-recurring payments on structured securities and higher commercial mortgage loan prepayments, partially offset by lower gains on fixed maturity securities for which the fair value option was elected when compared to 2017 where returns were higher as a result of significant spread tightening that occurred.
Premiums and deposits decreased in 2018 compared to 2017 due to lower sales in pension risk transfer and structured settlements, partially offset by $1.4 billion in FHLB funding agreements. Premiums and deposits increased in 2017 compared to 2016 primarily driven by higher pension risk transfer business, partially offset by lower structured settlement sales.
lower Legacy General Insurance earnings compared to 2017 due to lower net investment income, Japanese catastrophe losses in 2018 and a change in premium earning patterns on certain environmental business in 2018; and
(b) The weighted average expected life was seven years at December 31, 2018 and six years at December 31, 2017.
Our underwriting practices for investing in RMBS, other asset-backed securities (ABS) and CDOs take into consideration the quality of the originator, the manager, the servicer, security credit ratings, underlying characteristics of the mortgages, borrower characteristics, and the level of credit enhancement in the transaction.
• we decreased our reversion to the mean rates (gross of fees) to 2.92 percent from 3.74 percent for the Variable Annuity product line in Individual Retirement and to 1.90 percent from 3.78 percent for the Variable Annuity product line in Group Retirement. Our separate account long-term asset growth rate assumption related to equity market performance remained unchanged at 7.0 percent; and
The decrease in the economic hedge target liability in 2018 was primarily due to higher interest rates and widening of credit spreads, offset by lower equity markets. The decrease in the economic hedge target liability in 2017 was primarily due to positive equity markets, partially offset by tighter credit spreads and lower equity volatility.
• Changes in the fair value of interest rate derivative contracts, which included swaps, swaptions and futures, resulted in net losses driven by higher interest rates in 2018. The small net loss in 2017 reflected increases in rates in the latter half of 2017, partially offset by the impact of interest rate declines in the first half of 2017. The net losses in 2016 reflected increases in rates in the fourth quarter of 2016, which more than offset the impact of interest rate declines in the first nine months of 2016.
In October 2018, our subsidiary Validus Reinsurance, Ltd. redeemed its outstanding Floating Rate Deferrable Interest Junior Subordinated Notes due July 30, 2037 at a redemption price of 100 percent of the principal amount, plus accrued and unpaid interest, for a net amount of approximately $90 million. In December 2018, Validus Reinsurance, Ltd. redeemed its outstanding (i) U.S. dollar-denominated Floating Rate Deferrable Interest Subordinated Notes due September 15, 2036, (ii) euro-denominated Floating Rate Deferrable Interest Subordinated Notes due September 15, 2036 and (iii) Floating Rate Deferrable Interest Subordinated Notes due September 15, 2037, each at a redemption price of 100 percent of the principal amount, plus accrued and unpaid interest, for an aggregate amount of approximately $162 million. In addition, in December 2018, Validus redeemed its outstanding (i) Junior Subordinated Deferrable Interest Debentures due June 15, 2036 and (ii) Junior Subordinated Deferrable Interest Debentures due June 15, 2037, each at a redemption price of 100 percent of the principal amount, plus accrued and unpaid interest, for an aggregate net amount of approximately $295 million.
(b) S&P ratings may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories.
We monitor and control our company-wide credit risk concentrations and attempt to avoid unwanted or excessive risk accumulations, whether funded or unfunded. To minimize the level of credit risk in some circumstances, we may require mitigants, such as third-party guarantees, reinsurance or collateral, including commercial bank-issued letters of credit and trust collateral accounts. We treat these guarantees, reinsurance recoverables, and letters of credit as credit exposure and include them in our risk concentration exposure data. We also monitor closely the quality of any trust collateral accounts.
We are exposed to changes in equity market prices affecting a variety of instruments. Changes in equity prices can affect the valuation of publicly traded equity shares, investments in private equity, hedge funds, mutual funds, exchange-traded funds, and other equity-linked capital market instruments as well as equity-linked insurance products, including but not limited to index annuities, variable annuities, indexed universal life insurance and variable universal life insurance.
Changes in commodity prices (the value of commodities) can affect the valuation of publicly-traded commodities, commodity indices and derivatives on commodities and commodity indices. We are exposed to commodity prices primarily through their impact on the prices and credit quality of commodity producers’ debt and equity securities in our investment portfolio.
Our foreign currency-denominated net asset position at December 31, 2018, decreased by $1.2 billion compared to December 31, 2017. The decrease was primarily due to a $669 million decrease in our Japanese yen position and a $264 million decrease in our Canadian dollar position, each due to an increase in loss reserves.
• a 10 percent depreciation of foreign currency exchange rates is consistent with a one standard deviation movement in the U.S. dollar (USD)/Japanese yen (JPY) exchange rate.
Experience studies. Ongoing assessment of mortality, longevity, morbidity and policyholder behavior experience relative to that assumed in pricing and valuation and that experienced in the general market.
Common and preferred stock available for sale, at fair value (cost: 2017 - $1,305)
(portion measured at fair value: 2018 - $3,015; 2017 - $2,615)
Premiums and other receivables - net of allowance include premium balances receivable, amounts due from agents and brokers and policyholders, trade receivables for the Direct Investment book (DIB) and Global Capital Markets (GCM) and other receivables. Trade receivables for GCM include cash collateral posted to derivative counterparties that is not eligible to be netted against derivative liabilities. The allowance for doubtful accounts on premiums and other receivables was $216 million and $236 million at December 31, 2018 and 2017, respectively.
We adopted this standard on its effective date of January 1, 2018. The standard primarily addresses the presentation of the service cost component of net periodic benefit costs in the income statement. AIG’s U.S. pension plans are frozen and no longer accrue benefits, which are reflected as service costs. Therefore, the standard did not have a material impact on our reported consolidated financial condition, results of operations, cash flows or required disclosures.
· North America - consists of insurance businesses in the United States, Canada and Bermuda. This also includes the results of Validus Reinsurance, Ltd. and Western World Insurance Group, Inc. as of the acquisition date.
· Individual Retirement - consists of fixed annuities, fixed index annuities, variable annuities and retail mutual funds.
· Blackboard - a subsidiary focused on delivering commercial insurance solutions using digital technology, data analytics and automation.
As part of the purchase, we guaranteed 6,000 issued and outstanding 5.875% Non-Cumulative Preference Shares, Series A (the Series A Preference Shares) and 10,000 issued and outstanding 5.800% Non-Cumulative Preference Shares, Series B (together with the Series A Preference Shares, the Preference Shares). On October 30, 2018, Validus redeemed all of its outstanding Preference Shares at a redemption price of $26,000 per Preference Share for approximately $416 million in the aggregate.
• Our Own Credit Risk. Fair value measurements for certain liabilities incorporate our own credit risk by determining the explicit cost for each counterparty to protect against its net credit exposure to us at the balance sheet date by reference to observable AIG CDS or cash bond spreads. We calculate the effect of credit spread changes using discounted cash flow techniques that incorporate current market interest rates. A derivative counterparty’s net credit exposure to us is determined based on master netting agreements, when applicable, which take into consideration all derivative positions with us, as well as collateral we post with the counterparty at the balance sheet date. For a description of how we incorporate our own credit risk in the valuation of embedded derivatives related to certain annuity and life insurance products see Embedded Derivatives within Policyholder Contract Deposits below.
(a) There were no issuances during the years ended December 31, 2018 and 2017.
• Option budget estimates the expected long-term cost of options used to hedge exposures associated with equity price changes. The level of option budgets determines future costs of the options, which impacts the growth in account value and the valuation of embedded derivatives.
* Includes $178 million and $251 million of U.S. government agency backed ABS at December 31, 2018 and 2017, respectively.
On January 1, 2018, AIG adopted the Financial Instruments Recognition and Measurement standard for equity securities. The new standard requires equity securities to be measured at fair value with changes in fair value recognized in earnings each reporting period. As a result of the new standard, equity securities with readily determinable fair values are no longer required to be evaluated for other-than-temporary-impairment.
Prior to the adoption of the Recognition and Measurement standard on January 1, 2018, we evaluated our available for sale equity securities for impairment by considering such securities as candidates for other-than-temporary impairment if they meet any of the following criteria:
Our investments in life settlements were monitored for impairment on a contract-by-contract basis quarterly. An investment in life settlements was considered impaired if the undiscounted cash flows resulting from the expected proceeds would not be sufficient to recover our estimated future carrying amount, which was the current carrying amount for the investment in life settlements plus anticipated undiscounted future premiums and other capitalizable future costs, if any. Impaired investments in life settlements were written down to their estimated fair value which was determined on a discounted cash flow basis, incorporating current market mortality assumptions and market yields or by repricing to the anticipated sale price as appropriate.
At December 31, 2018 and December 31, 2017, amounts loaned under reverse repurchase agreements totaled $426 million and $2.2 billion, respectively.
(d) At December 31, 2018 and 2017, off-balance sheet exposure primarily consisting of commitments to real estate and investment entities was $1.4 billion and $86 million, respectively.
(e) At December 31, 2018 and 2017, $16.0 billion and $17.6 billion, respectively, of the total assets of consolidated securitization vehicles were owed to AIG Parent or its subsidiaries.
The following table presents the changes in other intangible assets and the value of distribution network acquired by operating segment:
· Bornhuetter-Ferguson method: The Bornhuetter-Ferguson method using premiums and paid losses is a combination of the Paid Development method and the Expected Loss Ratio method where the weight given to each method is the reciprocal of the loss development factor. This method normally determines expected loss ratios similar to the method used for the Expected Loss Ratio method. The Bornhuetter-Ferguson method using premiums and incurred losses is similar to the Bornhuetter-Ferguson method using premiums and paid losses except that it uses case-incurred losses.
During 2017 we recognized $507 million of unfavorable prior year development in UK/Europe casualty and Financial Lines. We observed a significant increase in large claims activity across multiple segments, notably excess casualty business and D&O and professional liability coverages for financial institutions. This experience was spread across multiple accident years but had the largest impact on accident year 2016 and accident years 2008 and prior. We increased loss development assumptions for Financial Lines business in consideration of the increased loss activity experienced in older accident years and increased expected loss ratios for more recent accident years. For Casualty lines, we increased loadings for large losses, particularly in the more recent accident years. In addition, we increased our loss reserves as a result of the decision made by the U.K. Ministry of Justice to reduce the discount rate applied to lump-sum bodily injury payouts, known as the Ogden rate.
On July 11, 2013, the AIGLH junior subordinated debentures were distributed to holders of the capital securities, the capital securities were cancelled and the trusts were dissolved. At December 31, 2018, the junior subordinated debentures outstanding consisted of $113 million of 8.5 percent junior subordinated debentures due July 2030, $211 million of 8.125 percent junior subordinated debentures due March 2046 and $37 million of 7.57 percent junior subordinated debentures due December 2045, each guaranteed by AIG Parent.
The following table presents the other comprehensive income (loss) reclassification adjustments for the years ended December 31, 2018, 2017 and 2016:
Our non-employee directors, who serve on our Board of Directors, receive share-based compensation in the form of fully vested DSUs with delivery deferred until retirement from the Board. DSUs granted in 2018, 2017 and 2016 accrue DEUs equal to the amount of any regular quarterly dividend that would have been paid by AIG if the shares of AIG Common Stock underlying the DSUs had been outstanding. In 2018, 2017 and 2016, we granted to non-employee directors 39,092, 32,067 and 41,974 DSUs, respectively, under the 2013 Plan, and recognized expense of $2.1 million, $2.0 million and $2.4 million, respectively.
The following table presents the net deferred tax assets (liabilities) at December 31, 2018 and 2017 on a U.S. GAAP basis: