DERIVATIVES AND HEDGE ACCOUNTING

9 Months Ended

Sep. 30, 2012

DERIVATIVES AND HEDGE ACCOUNTING

DERIVATIVES AND HEDGE ACCOUNTING

8. DERIVATIVES AND HEDGE ACCOUNTING

AIG uses derivatives and other financial instruments as part of its financial risk management programs and as part of its investment operations. AIGFP had also transacted in derivatives as a dealer and had acted as an intermediary between the relevant AIG subsidiary and the counterparty. AIG Markets, Inc. (AIG Markets) has largely replaced AIGFP in acting as an intermediary between AIG subsidiaries and the external counterparties. Global Capital Markets (GCM), included in AIG's Other operations, consists of the operations of AIG Markets and the remaining derivatives portfolio of AIGFP.

The following table presents the notional amounts and fair values of AIG's derivative instruments:

	September 30, 2012								December 31, 2011
	Gross Derivative Assets				Gross Derivative Liabilities				Gross Derivative Assets				Gross Derivative Liabilities
(in millions)	Notional Amount		Fair Value(a)		Notional Amount		Fair Value(a)		Notional Amount		Fair Value(a)		Notional Amount		Fair Value(a)
Derivatives designated as hedging instruments:
Interest rate contracts(b)	$	–	$	–	$	366	$	24	$	–	$	–	$	481	$	38
Foreign exchange contracts		–		–		–		–		–		–		180		1
Derivatives not designated as hedging instruments:
Interest rate contracts(b)		66,896		7,285		68,939		6,522		72,660		8,286		73,248		6,870
Foreign exchange contracts		5,080		53		2,969		166		3,278		145		3,399		178
Equity contracts(c)		5,546		264		22,714		1,479		4,748		263		18,911		1,126
Commodity contracts		633		142		626		143		691		136		861		146
Credit contracts		167		60		17,618		2,349		407		89		25,857		3,366
Other contracts(d)		19,092		68		1,610		276		24,305		741		2,125		372
Total derivatives not designated as hedging instruments		97,414		7,872		114,476		10,935		106,089		9,660		124,401		12,058
Total derivatives	$	97,414	$	7,872	$	114,842	$	10,959	$	106,089	$	9,660	$	125,062	$	12,097

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

(b)     Includes cross currency swaps.

(c)     Notional amount of derivative liabilities and fair values of derivative liabilities include $22 billion and $1.3 billion, respectively, at September 30, 2012, and $18.3 billion and $0.9 billion, respectively, at December 31, 2011, related to bifurcated embedded derivatives. A bifurcated embedded derivative is generally presented with the host contract in the Consolidated Balance Sheet.

(d)     Consist primarily of contracts with multiple underlying exposures.

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

	September 30, 2012										December 31, 2011
	Derivative Assets					Derivative Liabilities					Derivative Assets					Derivative Liabilities
(in millions)	Notional Amount		Fair Value			Notional Amount		Fair Value			Notional Amount		Fair Value			Notional Amount		Fair Value
Global Capital Markets derivatives	$	87,274	$	6,827		$	85,934	$	8,428		$	94,036	$	8,472		$	98,442	$	10,021
All other derivatives(a)		10,140		1,045			28,908		2,531			12,053		1,188			26,620		2,076
Total derivatives, gross	$	97,414		7,872		$	114,842		10,959		$	106,089		9,660		$	125,062		12,097
Counterparty netting(b)				(3,219	)				(3,219	)				(3,660	)				(3,660	)
Cash collateral(c)				(1,197	)				(2,118	)				(1,501	)				(2,786	)
Total derivatives, net				3,456					5,622					4,499					5,651
Less: Bifurcated embedded derivatives				–					1,308					–					918
Total derivatives on consolidated balance sheet			$	3,456				$	4,314				$	4,499				$	4,733

(a)     Represents derivatives used to hedge the foreign currency and interest rate risk associated with insurance and ILFC operations, as well as embedded derivatives included in insurance contracts. 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.

Collateral

AIG engages in derivative transactions directly with unaffiliated third parties in most cases under International Swaps and Derivatives Association, Inc. (ISDA) agreements (ISDA Master Agreements). Many of the ISDA Master Agreements also include Credit Support Annex (CSA) provisions, which generally provide for collateral postings at various ratings and threshold levels.

Collateral posted by AIG to third parties for derivative transactions was $4.6 billion and $4.7 billion at September 30, 2012 and December 31, 2011, respectively. This collateral can generally be repledged or resold by the counterparties. Collateral obtained by AIG from third parties for derivative transactions was $1.5 billion and $1.6 billion at September 30, 2012 and December 31, 2011, respectively. This collateral can generally be repledged or resold by AIG.

Hedge Accounting

AIG designated certain derivatives entered into by GCM with third parties as cash flow hedges of certain debt issued by ILFC and designated certain derivatives entered into by AIG's insurance subsidiaries with third parties as fair value hedges of available-for-sale investment securities held by such 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. With respect to the cash flow hedges, interest rate swaps were designated as hedges of the changes in cash flows on floating rate debt attributable to changes in the benchmark interest rate.

AIG uses foreign currency denominated debt as hedging instruments in net investment hedge relationships to mitigate the foreign exchange risk associated with AIG's non-U.S. dollar functional currency foreign subsidiaries. AIG assesses the hedge effectiveness and measures the amount of ineffectiveness for these hedge relationships based on changes in spot exchange rates. For the three- and nine-month periods ended September 30, 2012, AIG recognized losses of $70 million and $13 million, respectively, and for the three- and nine-month periods ended September 30, 2011, AIG recognized losses of $1 million and $36 million, respectively, included in Foreign currency translation adjustment in Accumulated 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 effect of AIG's derivative instruments in fair value hedging relationships in the Consolidated Statement of Operations:

	Three Months Ended September 30,				Nine Months Ended September 30,
(in millions)	2012		2011		2012			2011
Interest rate contracts(a):
Loss recognized in earnings on derivatives	$	–	$	–	$	(2	)	$	(3	)
Gain recognized in earnings on hedged items(b)		19		39		99			127
Loss recognized in earnings for ineffective portion and amount excluded from effectiveness testing		–		–		–			(1	)

(a)     Gains and losses recognized in earnings for the ineffective portion and amounts excluded from effectiveness testing are recorded in Net realized capital gains (losses). Includes immaterial amounts related to foreign exchange contracts.

(b)     Includes $18 million and 39 million, for the three-month periods ended September 30, 2012 and 2011, respectively, and $97 million and $125 million, for the nine-month periods ended September 30, 2012 and 2011, respectively, representing the amortization of debt basis adjustment following the discontinuation of hedge accounting recorded in Other income and Net realized capital gains (losses).

The following table presents the effect of AIG's derivative instruments in cash flow hedging relationships in the Consolidated Statement of Operations:

	Three Months Ended September 30,						Nine Months Ended September 30,
(in millions)	2012			2011			2012			2011
Interest rate contracts(a):
Loss recognized in OCI on derivatives	$	(1	)	$	(2	)	$	(2	)	$	(5	)
Loss reclassified from Accumulated OCI into earnings(b)		(4	)		(15	)		(13	)		(49	)

(a)     Gains and losses reclassified from Accumulated other comprehensive income are recorded in Other income. Gains or losses recognized in earnings on derivatives for the ineffective portion are recorded in Net realized capital gains (losses).

(b)     The effective portion of the change in fair value of a derivative qualifying as a cash flow hedge is recorded in Accumulated other comprehensive income until earnings are affected by the variability of cash flows in the hedged item. At September 30, 2012, $15 million of the deferred net loss in Accumulated other comprehensive income is expected to be recognized in earnings during the next 12 months.

Derivatives Not Designated as Hedging Instruments

The following table presents the effect of AIG's derivative instruments not designated as hedging instruments in the Consolidated Statement of Operations:

	Gains (Losses) Recognized in Earnings
	Three Months Ended September 30,						Nine Months Ended September 30,
(in millions)	2012			2011			2012			2011
By Derivative Type:
Interest rate contracts(a)	$	(220	)	$	523		$	(208	)	$	270
Foreign exchange contracts		(93	)		84			(3	)		80
Equity contracts(b)		(206	)		416			(601	)		379
Commodity contracts		2			(1	)		–			6
Credit contracts		200			(83	)		414			218
Other contracts		(4	)		(741	)		(56	)		(741	)
Total	$	(321	)	$	198		$	(454	)	$	212
By Classification:
Policy fees	$	42		$	29		$	115		$	80
Net investment income		–			2			1			6
Net realized capital gains (losses)		(183	)		(163	)		(843	)		13
Other income (losses)		(180	)		330			273			113
Total	$	(321	)	$	198		$	(454	)	$	212

(a)     Includes cross currency swaps.

(b)     Includes embedded derivative losses of $75 million and $812 million for the three-month periods ended September 30, 2012 and 2011, respectively, and embedded derivatives losses of $268 million and $807 million, for the nine-month periods ended September 30, 2012 and 2011, respectively.

Global Capital Markets Derivatives

GCM enters into derivatives to mitigate market risk in its exposures (interest rates, currencies, commodities, credit and equities) arising from its transactions. At September 30, 2012, GCM has entered into credit derivative transactions with respect to $81 million of securities to economically hedge its credit risk. In most cases, GCM has not hedged its exposures related to the credit default swaps it has written.

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 with the intention of earning revenue on credit exposure. In the majority of these transactions, credit protection was sold on a designated portfolio of loans or debt securities. Generally, such credit protection was provided on a "second loss" basis, meaning that credit losses would be incurred only after a shortfall of principal and/or interest, or other credit events, in respect of the protected loans and debt securities, exceeds a specified threshold amount or level of "first losses."

The following table presents the net notional amount, fair value of derivative (asset) liability and unrealized market valuation gain (loss) of the super senior credit default swap portfolio, including credit default swaps written on mezzanine tranches of certain regulatory capital relief transactions, by asset class:

									Unrealized Market Valuation Gain (Loss)(c)
					Fair Value of Derivative (Asset) Liability at(b)(c)
	Net Notional Amount(a)								Three Months Ended September 30,					Nine Months Ended September 30,
	September 30, 2012		December 31, 2011		September 30, 2012		December 31, 2011
(in millions)									2012		2011			2012		2011
Regulatory Capital:
Corporate loans	$	898	$	1,830	$	–	$	–	$	–	$	–		$	–	$	–
Prime residential mortgages		139		3,653		–		–		–		–			–		6
Other		–		887		–		9		6		(10	)		9		–
Total		1,037		6,370		–		9		6		(10	)		9		6
Arbitrage:
Multi-sector CDOs(d)		4,363		5,476		2,183		3,077		142		47			336		230
Corporate debt/CLOs(e)		11,707		11,784		74		127		42		(33	)		53		11
Total		16,070		17,260		2,257		3,204		184		14			389		241
Mezzanine tranches		–		989		–		10		14		(1	)		3		(15	)
Total	$	17,107	$	24,619	$	2,257	$	3,223	$	204	$	3		$	401	$	232

(a)     Net notional amounts presented are net of all structural subordination below the covered tranches.

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

(c)     Includes credit valuation adjustment gains (losses) of $(12) million and $25 million in the three-month periods ended September 30, 2012 and 2011, respectively, and $(36) million and $27 million in the nine-month periods ended September 30, 2012 and 2011, respectively, representing the effect of changes in AIG's credit spreads on the valuation of the derivatives liabilities.

(d)     During the nine-month period ended September 30, 2012, a super senior CDS transaction with a net notional amount of $470 million was terminated at approximately its fair value at the time of termination. As a result, a $416 million loss, which was previously included in the fair value derivative liability as an unrealized market valuation loss, was realized. During the nine-month period ended September 30, 2012, $142 million was paid to counterparties with respect to multi-sector CDOs. Upon payment, a $142 million loss, which was previously included in the fair value of the derivative liability as an unrealized market valuation loss, was realized. Multi-sector CDOs also include $3.7 billion and $4.6 billion in net notional amount of credit default swaps written with cash settlement provisions at September 30, 2012 and December 31, 2011, respectively.

(e)     Corporate debt/CLOs include $1.2 billion in net notional amount of credit default swaps written on the super senior tranches of CLOs at both September 30, 2012 and December 31, 2011.

The expected weighted average maturity of the super senior credit derivative portfolios as of September 30, 2012 was less than one year for both the regulatory capital corporate loan portfolio and the regulatory capital prime residential mortgage portfolio, 5.8 years for the multi-sector CDO arbitrage portfolio and 3.4 years for the corporate debt/CLO portfolio.

Given the current performance of the underlying portfolios, the level of subordination of the credit protection written and the assessment of the credit quality of the underlying portfolio, as well as the risk mitigants inherent in the transaction structures, AIG does not expect that it will be required to make payments pursuant to the contractual terms of those transactions providing regulatory relief.

Because of long-term maturities of the CDS in the arbitrage portfolio, AIG is 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

Credit default swap contracts referencing single-name exposures written on corporate, index and asset-backed credits have also been entered into 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 CDS written and purchased. At September 30, 2012, the net notional amount of these written CDS contracts was $633 million, including ABS CDS transactions purchased from a liquidated multi-sector super senior CDS transaction. These exposures have been partially hedged by purchasing offsetting CDS contracts of $52 million in net notional amount. The net unhedged position of $581 million represents the maximum exposure to loss on these CDS contracts. The average maturity of the written CDS contracts is 3.0 years. At September 30, 2012, the fair value of derivative liability (which represents the carrying value) of the portfolio of CDS was $72 million.

Upon a triggering event (e.g., a default) with respect to the underlying credit, the option would normally exist to either settle the position through an auction process (cash settlement) or pay the notional amount of the contract to the counterparty in exchange for a bond issued by the underlying credit obligor (physical settlement).

These CDS contracts were written under ISDA Master Agreements. The majority of these ISDA Master Agreements include CSAs that provide for collateral postings at various ratings and threshold levels. At September 30, 2012, collateral posted by AIG under these contracts was $85 million prior to offsets for other transactions.

All Other Derivatives

AIG's 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, AIG also enters 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 AIG's derivative instruments that contain credit risk-related contingent features that were in a net liability position at September 30, 2012, was approximately $4.0 billion. The aggregate fair value of assets posted as collateral under these contracts at September 30, 2012, was $4.4 billion.

AIG estimates that at September 30, 2012, based on AIG's outstanding financial derivative transactions a one-notch downgrade of AIG's 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 the 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' Services, Inc. (Moody's) and an additional one-notch downgrade to BBB by S&P would result in approximately $125 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 $165 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 September 30, 2012. 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. Management's estimates are also based on the assumption that counterparties will terminate based on their net exposure to AIG. The actual termination payments could significantly differ from management's 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

AIG invests in hybrid securities (such as credit-linked notes) with the intent of generating income, and not specifically to acquire exposure to embedded derivative risk. Similar to AIG's other investments in RMBS, CMBS, CDOs and ABS, AIG's investments in these hybrid securities are exposed to losses only up to the amount of AIG's initial investment in the hybrid security. Other than AIG's initial investment in the hybrid securities, AIG has no further obligation to make payments on the embedded credit derivatives in the related hybrid securities.

AIG elects to account for its 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. AIG's investments in these hybrid securities are reported as Bond trading securities in the Consolidated Balance Sheet. The fair value of these hybrid securities was $7.0 billion at September 30, 2012. These securities have a current par amount of $15.4 billion and have remaining stated maturity dates that extend to 2052.