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DERIVATIVES AND HEDGE ACCOUNTING
 12 Months Ended
Dec. 31, 2014
DERIVATIVES AND HEDGE ACCOUNTING  
DERIVATIVES AND HEDGE ACCOUNTING

11. DERIVATIVES AND HEDGE ACCOUNTING

We use derivatives and other financial instruments as part of our financial risk management programs and as part of our investment operations. Interest rate, currency, equity and commodity swaps, credit contracts (including the super senior credit default swap portfolio), swaptions, options and forward transactions are accounted for as derivatives, recorded on a trade-date basis and carried at fair value. Unrealized gains and losses are reflected in income, when appropriate. In certain instances, a contract’s transaction price is the best indication of initial fair value. Aggregate asset or liability positions are netted on the Consolidated Balance Sheets only to the extent permitted by qualifying master netting arrangements in place with each respective counterparty. Cash collateral posted with counterparties in conjunction with transactions supported by qualifying master netting arrangements is reported as a reduction of the corresponding net derivative liability, while cash collateral received in conjunction with transactions supported by qualifying master netting arrangements is reported as a reduction of the corresponding net derivative asset.

Derivatives, with the exception of bifurcated embedded derivatives, are reflected in the Consolidated Balance Sheets in Derivative assets, at fair value and Derivative liabilities, at fair value. A bifurcated embedded derivative is measured at fair value and accounted for in the same manner as a free standing derivative contract. The corresponding host contract is accounted for according to the accounting guidance applicable for that instrument. A bifurcated embedded derivative is generally presented with the host contract in the Consolidated Balance Sheets. See Notes 5 and 14 herein for additional information on embedded policy derivatives.

Effective April 1, 2014, we reclassified cross-currency swaps from Interest rate contracts to Foreign exchange contracts. This change was applied prospectively.

The following table presents the notional amounts and fair values of our derivative instruments:

December 31, 2014December 31, 2013
Gross Derivative AssetsGross Derivative LiabilitiesGross Derivative AssetsGross Derivative Liabilities
NotionalFairNotionalFairNotionalFairNotionalFair
(in millions)AmountValue(a)AmountValue(a)AmountValue(a)AmountValue(a)
Derivatives designated as
hedging instruments:
Interest rate contracts$155$-$25$2$-$-$112$15
Foreign exchange contracts611251,794239--1,857190
Equity contracts7110413----
Derivatives not designated
as hedging instruments:
Interest rate contracts65,0703,74345,2513,18350,8973,77159,5853,849
Foreign exchange contracts13,6678158,5161,2511,774523,789129
Equity contracts(b)7,56520642,3871,61529,2964139,840524
Commodity contracts15-116171135
Credit contracts545,288982705515,4591,335
Other contracts(c)36,155315389032,440341,408167
Total derivatives not
designated as hedging
instruments122,4774,799101,9917,127114,4944,32690,0946,009
Total derivatives, gross$123,250$4,825$103,914$7,381$114,494$4,326$92,063$6,214

(a) Fair value amounts are shown before the effects of counterparty netting adjustments and offsetting cash collateral.

(b) There were no derivative assets or notionals related to bifurcated embedded derivatives at December 31, 2014. Notional amount of derivative assets and fair value of derivative assets include $23.2 billion and $107 million at December 31, 2013 related to bifurcated embedded derivatives. Notional amount of derivative liabilities and fair values of derivative liabilities include $39.3 billion and $1.5 billion, respectively, at December 31, 2014 and $6.7 billion and $424 million, respectively at December 31, 2013 related to bifurcated embedded derivatives. A bifurcated embedded derivative is generally presented with the host contract in the Consolidated Balance Sheets.

(c) Consists primarily of contracts with multiple underlying exposures.

The following table presents the fair values of derivative assets and liabilities in the Consolidated Balance Sheets:

December 31, 2014December 31, 2013
Derivative AssetsDerivative LiabilitiesDerivative AssetsDerivative Liabilities
NotionalFairNotionalFairNotionalFairNotionalFair
(in millions)AmountValueAmountValueAmountValueAmountValue
Global Capital Markets derivatives:
AIG Financial Products$23,153$2,445$27,719$3,019$41,942$2,567$52,679$3,506
AIG Markets55,0051,93529,2512,13612,53196423,7161,506
Total Global Capital Markets derivatives78,1584,38056,9705,15554,4733,53176,3955,012
Non-Global Capital Markets derivatives(a)45,09244546,9442,22660,02179515,6681,202
Total derivatives, gross$123,2504,825$103,9147,381$114,4944,326$92,0636,214
Counterparty netting(b)(2,102)(2,102)(1,734)(1,734)
Cash collateral(c)(1,119)(1,429)(820)(1,484)
Total derivatives, net1,6043,8501,7722,996
Less: Bifurcated embedded derivatives-1,577107485
Total derivatives on consolidated
balance sheet$1,604$2,273$1,665$2,511

(a) Represents derivatives used to hedge the foreign currency and interest rate risk associated with insurance as well as embedded derivatives included in insurance contracts. Assets and liabilities include bifurcated embedded derivatives, which are recorded in Policyholder contract deposits.

(b) Represents netting of derivative exposures covered by a qualifying master netting agreement.

(c) Represents cash collateral posted and received that is eligible for netting.

Collateral

We engage in derivative transactions that are not subject to a clearing requirement directly with unaffiliated third parties, in most cases, under International Swaps and Derivatives Association, Inc. (ISDA) agreements. Many of the ISDA agreements also include Credit Support Annex (CSA) provisions, which provide for collateral postings that may vary at various ratings and threshold levels. We attempt to reduce our risk with certain counterparties by entering into agreements that enable collateral to be obtained from a counterparty on an upfront or contingent basis. We minimize the risk that counterparties to transactions might be unable to fulfill their contractual obligations by monitoring counterparty credit exposure and collateral value and may require additional collateral to be posted upon the occurrence of certain events or circumstances. In addition, certain derivative transactions have provisions that require collateral to be posted upon a downgrade of our long-term debt ratings or give the counterparty the right to terminate the transaction. In the case of some of the derivative transactions, upon a downgrade of our long-term debt ratings, as an alternative to posting collateral and subject to certain conditions, we may assign the transaction to an obligor with higher debt ratings or arrange for a substitute guarantee of our obligations by an obligor with higher debt ratings or take other similar action. The actual amount of collateral required to be posted to counterparties in the event of such downgrades, or the aggregate amount of payments that we could be required to make, depends on market conditions, the fair value of outstanding affected transactions and other factors prevailing at and after the time of the downgrade.

Collateral posted by us to third parties for derivative transactions was $3.3 billion and $3.2 billion at December 31, 2014 and 2013, respectively. In the case of collateral posted under derivative transactions that are not subject to clearing, this collateral can generally be repledged or resold by the counterparties. Collateral provided to us from third parties for derivative transactions was $1.3 billion and $1.0 billion at December 31, 2014 and 2013, respectively. We generally can repledge or resell collateral posted under derivative transactions that are not subject to clearing.

Offsetting

We have elected to present all derivative receivables and derivative payables, and the related cash collateral received and paid, on a net basis on our Consolidated Balance Sheets when a legally enforceable ISDA Master Agreement exists between us and our derivative counterparty. An ISDA Master Agreement is an agreement between two counterparties, which may have multiple derivative transactions with each other governed by such agreement, and such ISDA Master Agreement generally provides for the net settlement of all or a specified group of these derivative transactions, as well as pledged collateral, through a single payment, in a single currency, in the event of a default on, or affecting any, one derivative transaction or a termination event affecting all, or a specified group of, derivative transactions.

Hedge Accounting

We designated certain derivatives entered into by GCM with third parties as fair value hedges of available-for-sale investment securities held by our insurance subsidiaries. The fair value hedges include foreign currency forwards designated as hedges of the change in fair value of foreign currency denominated available-for-sale securities attributable to changes in foreign exchange rates. We previously designated certain interest rate swaps entered into by GCM with third parties as cash flow hedges of certain floating rate debt issued by ILFC, specifically to hedge the changes in cash flows on floating rate debt attributable to changes in the benchmark interest rate. We de-designated such derivatives as cash flow hedges in December 2012 in connection with ILFC being classified as held-for-sale.

We use foreign currency denominated debt and cross-currency swaps as hedging instruments in net investment hedge relationships to mitigate the foreign exchange risk associated with our non-U.S. dollar functional currency foreign subsidiaries. We assess the hedge effectiveness and measure the amount of ineffectiveness for these hedge relationships based on changes in spot exchange rates. For the years ended December 31, 2014, 2013, and 2012 we recognized gain of $156 million, and losses of $38 million and $74 million, respectively, included in Change in foreign currency translation adjustments in Other comprehensive income related to the net investment hedge relationships.

A qualitative methodology is utilized to assess hedge effectiveness for net investment hedges, while regression analysis is employed for all other hedges.

The following table presents the gain (loss) recognized in earnings on our derivative instruments in fair value hedging relationships in the Consolidated Statements of Income:

Gains/(Losses) Recognized in Earnings for:Including Gains/(Losses) Attributable to:
HedgingHedgedHedgeExcluded
(in millions)Derivatives(a)ItemsIneffectivenessComponentsOther(b)
Year ended December 31, 2014
Interest rate contracts:
Realized capital gains/(losses)$1$(2)$-$-$(1)
Interest credited to policyholder
account balances-(1)--(1)
Other income-43--43
Gain/(Loss) on extinguishment of debt-164--164
Foreign exchange contracts:
Realized capital gains/(losses)(129)147-810
Interest credited to policyholder
account balances-(3)--(3)
Other income-23--23
Gain/(Loss) on extinguishment of debt-2--2
Equity contracts:
Realized capital gains/(losses)(23)22-(1)-
Year ended December 31, 2013
Interest rate contracts:
Realized capital gains/(losses)$(5)$5$-$-$-
Interest credited to policyholder
account balances-(2)--(2)
Other income-99--99
Foreign exchange contracts:
Realized capital gains/(losses)(187)204-17-
Policyholder benefits-----
Other income-----
Year ended December 31, 2012
Interest rate contracts:
Other income$-$124$-$-$124
Foreign exchange contracts:
Realized capital gains/(losses)(2)2---

(a) The amounts presented do not include the periodic net coupon settlements of the derivative contract or the coupon income (expense) related to the hedged item.

(b) Represents accretion/amortization of opening fair value of the hedged item at inception of hedge relationship, amortization of basis adjustment on hedged item following the discontinuation of hedge accounting, and the release of debt basis adjustment following the repurchase of issued debt that was part of previously-discontinued fair value hedge relationship.

The following table presents the effect of our derivative instruments in cash flow hedging relationships in the Consolidated Statements of Income:

Years Ended December 31,
(in millions)201420132012
Interest rate contracts(a):
Loss recognized in Other comprehensive income on derivatives$-$-$(2)
Loss reclassified from Accumulated other comprehensive income into earnings(b)--(35)

(a) Hedge accounting was discontinued in December 2012 in connection with ILFC being classified as held-for-sale. Gains and losses recognized in earnings are recorded in Income from continuing operations. Previously the effective portion of the change in fair value of a derivative qualifying as a cash flow hedge was recorded in Accumulated other comprehensive income until earnings were affected by the variability of cash flows in the hedged item. Gains and losses reclassified from Accumulated other comprehensive income were previously recorded in Other income. Gains or losses recognized in earnings on derivatives for the ineffective portion were previously recorded in Net realized capital gains (losses).

(b) Includes $19 million for the year ended December 2012, representing the reclassification from Accumulated other comprehensive income into earnings following the discontinuation of cash flow hedges of ILFC debt.

Derivatives Not Designated as Hedging Instruments

The following table presents the effect of our derivative instruments not designated as hedging instruments in the Consolidated Statements of Income:

Gains (Losses)
Years Ended December 31,Recognized in Earnings
(in millions)201420132012
By Derivative Type:
Interest rate contracts(a)$847$(331)$(241)
Foreign exchange contracts3094196
Equity contracts(b)(1,111)664(644)
Commodity contracts(1)(4)(1)
Credit contracts263567641
Other contracts192856
Total$499$1,022$(143)
By Classification:
Net investment income102285
Net realized capital gains (losses)(219)257(516)
Other income599750368
Policyholder benefits and losses incurred17(13)-
Total$499$1,022$(143)

(a) Includes cross currency swaps.

(b) Includes embedded derivative gains (losses) of $(837) million, $1.2 billion and $(170) million for the years ended December 31, 2014, 2013 and 2012, respectively.

Global Capital Markets Derivatives

Derivative transactions between AIG and its subsidiaries and third parties are generally centralized through GCM, specifically AIG Markets. The derivatives portfolio of AIG Markets consists primarily of interest rate and currency derivatives and also includes legacy credit derivatives that have been novated from AIGFP. AIGFP also enters into derivatives to mitigate market risk in its exposures (interest rates, currencies, credit, commodities and equities) arising from its portfolio of remaining transactions.

GCM follows a policy of minimizing interest rate, currency, commodity, and equity risks associated with investment securities by entering into offsetting positions, thereby offsetting a significant portion of the unrealized appreciation and depreciation.

Super Senior Credit Default Swaps

Credit default swap transactions were entered into by AIGFP with the intention of earning revenue on credit exposure. In the majority of these transactions, we sold credit protection on a designated portfolio of loans or debt securities. Generally, such credit protection was provided on a “second loss” basis, meaning we would incur credit losses only after a shortfall of principal and/or interest, or other credit events, in respect of the protected loans and debt securities, exceeded a specified threshold amount or level of “first losses.”

The following table presents the net notional amount (net of all structural subordination below the covered tranches), fair value of derivative liability before the effects of counterparty netting adjustments and offsetting cash collateral and unrealized market valuation gain of the super senior credit default swap portfolio by asset class:

Fair Value ofUnrealized Market Valuation
Net Notional Amount atDerivative Liability atGain for the Years Ended
December 31,December 31,December 31,December 31,December 31,December 31,
(in millions) 201420132014201320142013
Arbitrage:
Multi-sector CDOs(a)$2,619$3,257$947$1,249$235$518
Corporate debt/CLOs(b)(c)2,48011,8327282132
Total$5,099$15,089$954$1,277$256$550

(a) During 2014, we paid $67 million to counterparties with respect to multi-sector CDOs, which was previously included in the fair value of the derivative liability as an unrealized market valuation loss. Collateral postings with regards to multi-sector CDOs were $852 million and $1.1 billion at December 31, 2014 and 2013, respectively.

(b) Corporate debt/Collateralized Loan Obligations (CLOs) include $555 million and $1.0 billion in net notional amount of credit default swaps written on the super senior tranches of CLOs at December 31, 2014 and 2013, respectively. Collateral postings with regards to corporate debt/CLOs were $147 million and $353 million at December 31, 2014 and 2013, respectively.

(c) On July 17, 2014, AIGFP terminated Corporate Debt Super Senior CDSs with a notional amount of $8.8 billion.

The expected weighted average maturity of the super senior credit derivative portfolios as of December 31, 2014 was five years for the multi-sector CDO arbitrage portfolio and three years for the corporate debt/CLO portfolio.

Because of long-term maturities of the CDSs in the arbitrage portfolio, we are unable to make reasonable estimates of the periods during which any payments would be made. However, the net notional amount represents the maximum exposure to loss on the super senior credit default swap portfolio.

Written Single Name Credit Default Swaps

We have legacy credit default swap contracts referencing single-name exposures written on corporate, index and asset-backed credits with the intention of earning spread income on credit exposure. Some of these transactions were entered into as part of a long-short strategy to earn the net spread between CDSs written and purchased. At December 31, 2014 and 2013, the net notional amounts of these written CDS contracts were $190 million and $373 million, respectively, including ABS CDS transactions purchased from a liquidated multi-sector super senior CDS transaction. These exposures were partially hedged by purchasing offsetting CDS contracts of $5 million and $50 million in net notional amounts at December 31, 2014 and 2013, respectively. The net unhedged positions of $185 million and $323 million at December 31, 2014 and 2013, respectively, represent the maximum exposure to loss on these CDS contracts. The average maturity of the written CDS contracts was two years and three years at December 31, 2014 and 2013, respectively. At December 31, 2014 and 2013, the fair values of derivative liabilities (which represents the carrying amount) of the portfolio of CDS was $25 million and $32 million, respectively.

Upon a triggering event (e.g., a default) with respect to the underlying reference obligations, settlement is generally effected through the payment of the notional amount of the contract to the counterparty in exchange for the related principal amount of securities issued by the underlying credit obligor (physical settlement) or, in some cases, payment of an amount associated with the value of the notional amount of the reference obligations through a market quotation process (cash settlement).

These CDS contracts were written under ISDA Master Agreements. The majority of these ISDA Master Agreements include credit support annexes (CSAs) that provide for collateral postings that may vary at various ratings and threshold levels. At December 31, 2014 and 2013, net collateral posted by us under these contracts was $30 million and $38 million, respectively, prior to offsets for other transactions.

All Other Derivatives

Our businesses, other than GCM, also use derivatives and other instruments as part of their financial risk management. Interest rate derivatives (such as interest rate swaps) are used to manage interest rate risk associated with embedded derivatives contained in insurance contract liabilities, fixed maturity securities, outstanding medium- and long-term notes as well as other interest rate sensitive assets and liabilities. Foreign exchange derivatives (principally foreign exchange forwards and options) are used to economically mitigate risk associated with non-U.S. dollar denominated debt, net capital exposures, and foreign currency transactions. Equity derivatives are used to mitigate financial risk embedded in certain insurance liabilities. The derivatives are effective economic hedges of the exposures that they are meant to offset.

In addition to hedging activities, we also enter into derivative instruments with respect to investment operations, which include, among other things, credit default swaps and purchasing investments with embedded derivatives, such as equity-linked notes and convertible bonds.

Credit Risk-Related Contingent Features

The aggregate fair value of our derivative instruments that contain credit risk-related contingent features that were in a net liability position at December 31, 2014 and 2013, was approximately $2.5 billion and $2.6 billion, respectively. The aggregate fair value of assets posted as collateral under these contracts at December 31, 2014 and 2013, was $2.7 billion and $3.1 billion, respectively.

We estimate that at December 31, 2014, based on our outstanding financial derivative transactions, a one-notch downgrade of our long-term senior debt ratings to BBB+ by Standard & Poor’s Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. (S&P), would permit counterparties to make additional collateral calls and permit certain counterparties to elect early termination of contracts, resulting in a negligible amount of corresponding collateral postings and termination payments; a one-notch downgrade to Baa2 by Moody’s Investors’ Service, Inc. (Moody’s) and an additional one-notch downgrade to BBB by S&P would result in approximately $46 million in additional collateral postings and termination payments, and a further one-notch downgrade to Baa3 by Moody’s and BBB- by S&P would result in approximately $153 million in additional collateral postings and termination payments.

Additional collateral postings upon downgrade are estimated based on the factors in the individual collateral posting provisions of the CSA with each counterparty and current exposure as of December 31, 2014. Factors considered in estimating the termination payments upon downgrade include current market conditions, the complexity of the derivative transactions, historical termination experience and other observable market events such as bankruptcy and downgrade events that have occurred at other companies. Our estimates are also based on the assumption that counterparties will terminate based on their net exposure to us. The actual termination payments could significantly differ from our estimates given market conditions at the time of downgrade and the level of uncertainty in estimating both the number of counterparties who may elect to exercise their right to terminate and the payment that may be triggered in connection with any such exercise.

Hybrid Securities with Embedded Credit Derivatives

We invest in hybrid securities (such as credit-linked notes) with the intent of generating income, and not specifically to acquire exposure to embedded derivative risk. As is the case with our other investments in RMBS, CMBS, CDOs and ABS, our investments in these hybrid securities are exposed to losses only up to the amount of our initial investment in the hybrid security. Other than our initial investment in the hybrid securities, we have no further obligation to make payments on the embedded credit derivatives in the related hybrid securities.

We elect to account for our investments in these hybrid securities with embedded written credit derivatives at fair value, with changes in fair value recognized in Net investment income and Other income. Our investments in these hybrid securities are reported as Other bond securities in the Consolidated Balance Sheets. The fair values of these hybrid securities were $6.1 billion and $6.4 billion at December 31, 2014 and 2013, respectively. These securities have par amounts of $12.3 billion and $13.4 billion at December 31, 2014 and 2013, respectively, and both have remaining stated maturity dates that extend to 2052.