12. LIABILITY FOR UNPAID CLAIMS AND CLAIMS ADJUSTMENT EXPENSE, FUTURE POLICY BENEFITS FOR LIFE AND ACCIDENT AND HEALTH INSURANCE CONTRACTS, AND POLICYHOLDER CONTRACT DEPOSITS

Liability for Unpaid Claims and Claims Adjustment Expense

The liability for unpaid claims and claims adjustment expense represents the accumulation of estimates of unpaid claims, including estimates for claims incurred but not reported and claim adjustments expenses, less applicable discount for future investment income. We continually review and update the methods used to determine loss reserve estimates and to establish the resulting reserves. Any adjustments resulting from this review are reflected currently in pre-tax income. Because these estimates are subject to the outcome of future events, changes in estimates are common given that loss trends vary and time is often required for changes in trends to be recognized and confirmed. Reserve changes that increase previous estimates of ultimate cost are referred to as unfavorable or adverse development or reserve strengthening. Reserve changes that decrease previous estimates of ultimate cost are referred to as favorable development.

Our gross loss reserves before reinsurance and discount are net of contractual deductible recoverable amounts due from policyholders of approximately $12.0 billion and $11.7 billion at December 31, 2013 and 2012, respectively. These recoverable amounts are related to certain policies with high deductibles (primarily for U.S. commercial casualty business) where we manage and pay the entire claim on behalf of the insured and are reimbursed by the insured for the deductible portion of the claim. At December 31, 2013 and 2012, we held collateral totaling $9.0 billion and $8.3 billion, respectively, for these deductible recoverable amounts, consisting primarily of letters of credit and trust agreements.

The following table presents the reconciliation of activity in the Liability for unpaid claims and claims adjustment expense:




Years Ended December 31, (in millions)	2013			2012			2011

Liability for unpaid claims and claims adjustment expense, beginning of year	$	87,991		$	91,145		$	91,151
Reinsurance recoverable		(19,209	)		(20,320	)		(19,644	)

Net liability for unpaid claims and claims adjustment expense, beginning of year		68,782			70,825			71,507

Foreign exchange effect^(a)		(617	)		(90	)		353
Dispositions		(79	)		(11	)		–
Changes in net loss reserves due to retroactive asbestos reinsurance transaction		22			90			(1,703	)

Total		68,108			70,814			70,157

Losses and loss expenses incurred:
Current year		22,171			25,385			27,931
Prior years, other than accretion of discount^(b)		557			421			195
Prior years, accretion of discount		(309	)		(63	)		34

Total		22,419			25,743			28,160

Losses and loss expenses paid^(c):
Current year		7,431			8,450			11,534
Prior years		18,780			19,325			15,958

Total		26,211			27,775			27,492

Balance, end of year:
Net liability for unpaid claims and claims adjustment expense		64,316			68,782			70,825
Reinsurance recoverable		17,231			19,209			20,320

Total	$	81,547		$	87,991		$	91,145

(a) For the 2012 amounts, $847 million was reclassified from "Foreign exchange effect" to "Losses and loss expenses paid (current year)". The impact of this reclassification was a decrease of $847 million for foreign exchange and loss expenses paid (current year), with no income statement or balance sheet impact.

(b) In 2013, includes $144 million, $269 million, $498 million and $54 million related to excess casualty, environmental and pollution, primary casualty and healthcare, respectively. In 2012, includes $157 million, $200 million, $531 million and $68 million related to excess casualty, environmental and pollution, primary casualty and healthcare, respectively. In 2011, includes $(588) million, $385 million, $686 million and $45 million related to excess casualty, environmental and pollution, primary casualty and healthcare, respectively

The net adverse development includes loss-sensitive business, for which we recognized $89 million, $54 million and $172 million loss-sensitive premium adjustments for the years ended December 31, 2013, 2012 and 2011, respectively.

Discounting of Reserves

At December 31, 2013, the liability for unpaid claims and claims adjustment expense reflects a net loss reserve discount of $3.6 billion, including tabular and non-tabular calculations based upon the following assumptions:

•: Certain asbestos business that was written by AIG Property Casualty is discounted, when allowed by the regulator and when payments are fixed and determinable, based on the investment yields of the companies and the payout pattern for this business.
•: The tabular workers' compensation discount is calculated using a 3.5 percent interest rate and the 1979 – 81 Decennial Mortality Table.
•: The non-tabular workers' compensation discount is calculated separately for companies domiciled in New York and Pennsylvania, and follows the statutory regulations (prescribed or approved) for each state. For New York companies, the discount is based on a five percent interest rate and the companies' own payout patterns. In 2012, for Pennsylvania companies, the statute has specified discount factors for accident years 2001 and prior, which are based on a six percent interest rate and an industry payout pattern. For accident years 2002 and subsequent, the discount is based on the payout patterns and investment yields of the companies.
•: Effective for the fourth quarter of 2013, our Pennsylvania regulator approved use of a consistent discount rate (U.S. Treasury rate plus a liquidity premium) to all of our workers' compensation reserves in our Pennsylvania-domiciled companies, as well as our use of updated payout patterns specific to our primary and excess workers' compensation portfolios. Prior to this change, workers' compensation reserves held by a Pennsylvania-domiciled insurer were discounted as follows: i) For loss reserves associated with accident year 2001 and prior accident years, a prescribed discount factor based on a rate of 6 percent and industry payout patterns, were applied, ii) For loss reserves associated with accident year 2002 and subsequent accident years, a rate of 4.25 percent and our own payout patterns were applied; and iii) For a portion of loss reserves comprising excess workers' compensation reserves that were assumed into a Pennsylvania-domiciled insurer from New York-domiciled insurers during 2011, we applied New York discounting rules, which include a prescribed rate of 5 percent on case reserves only (no discounting of IBNR reserves). As a result of these changes, the total net discount increased by $427 million.

The discount consists of the following: $798 million of tabular discount for workers' compensation in the domestic operations of AIG Property Casualty and $2.7 billion of non-tabular discount for workers' compensation in the domestic operations of AIG Property Casualty; and $33 million — non-tabular discount for asbestos for AIG Property Casualty.

Future Policy Benefits

Future policy benefits primarily include reserves for traditional life and annuity payout contracts, which represent an estimate of the present value of future benefits less the present value of future net premiums. Included in Future policy benefits are liabilities for annuities issued in structured settlement arrangements whereby a claimant has agreed to settle a general insurance claim in exchange for fixed payments over a fixed determinable period of time with a life contingency feature. Future policy benefits also include certain guaranteed benefits of variable annuity products that are not considered embedded derivatives, primarily guaranteed minimum death benefits. See Note 13 for additional information on liabilities for guaranteed benefits included in Future policy benefits.

The liability for long duration future policy benefits has been established on the basis of the following assumptions:

•: Interest rates (exclusive of immediate/terminal funding annuities), which vary by year of issuance and products, range from 3.0 percent to 10.0 percent within the first 20 years. Interest rates on immediate/terminal funding annuities are at a maximum of 13.5 percent and grade to not less than zero percent.
•: Mortality and surrender rates are generally based on actual experience when the liability is established.

Policyholder Contract Deposits

The liability for Policyholder contract deposits is primarily recorded at accumulated value (deposits received and net transfers from separate accounts, plus accrued interest, less withdrawals and assessed fees). Deposits collected on investment-oriented products are not reflected as revenues, because they are recorded directly to Policyholder contract deposits upon receipt. Policyholder contract deposits also include our liability for (a) certain guaranteed benefits and indexed features accounted for as embedded derivatives at fair value, (b) annuities issued in a structured settlement arrangement with no life contingency and (c) certain contracts we have elected to account for at fair value. See Note 13 herein for additional information on guaranteed benefits accounted for as embedded derivatives.

The following table presents Policyholder contract deposits by product type:




At December 31, (in millions)	2013		2012

Policyholder contract deposits:
Life Insurance and A&H	$	13,081	$	12,201
Fixed Annuities		54,515		55,985
Retirement Income Solutions		6,729		5,451
Group Retirement		37,694		36,778
Institutional Markets		9,433		12,056
All other Institutional		564		509

Total Policyholder contract deposits	$	122,016	$	122,980

The products for which reserves are included in Policyholder contract deposits at December 31, 2013 had the following characteristics:

•: Interest rates credited on deferred annuities, which vary by year of issuance, range from 1.0 percent to, including bonuses, 8.4 percent. Current declared interest rates are generally guaranteed to remain in effect for a period of one year though some are guaranteed for longer periods. Withdrawal charges generally range from zero percent to 15 percent grading to zero over a period of zero to 20 years.
•: Guaranteed investment contracts (GICs) have market value withdrawal provisions for any funds withdrawn other than benefit responsive payments. Interest rates credited generally range from 0.3 percent to 8.3 percent. The majority of these GICs mature within seven years.
•: Interest rates on corporate life insurance products are guaranteed at 3.0 percent and the weighted average rate credited in 2013 was 4.4 percent.
•: The universal life products have credited interest rates of 1.0 percent to 8.0 percent and guarantees ranging from 1.0 percent to 5.5 percent depending on the year of issue. Additionally, universal life funds are subject to surrender charges that amount to 8.7 percent of the aggregate fund balance grading to zero over a period not longer than 20 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 liabilities for guaranteed minimum death or guaranteed minimum withdrawal benefits.

Other Policyholder Funds

Other policyholder funds include provisions for future dividends to participating policyholders, accrued in accordance with all applicable regulatory or contractual provisions. Participating life business represented approximately 2.1 percent of the gross insurance in force at December 31, 2013 and 3.7 percent of gross Premiums and other considerations in 2013. The amount of annual dividends to be paid is approved locally by the boards of directors of the insurance companies. Provisions for future dividend payments are computed by jurisdiction, reflecting local regulations. The portions of current and prior net income and of current unrealized appreciation of investments that can inure to our benefit are restricted in some cases by the insurance contracts and by the local insurance regulations of the jurisdictions in which the policies are in force.

Certain products are subject to experience adjustments. These include group life and group medical products, credit life contracts, accident and health insurance contracts/riders attached to life policies and, to a limited extent, reinsurance agreements with other direct insurers. Ultimate premiums from these contracts are estimated and recognized as revenue, and the unearned portions of the premiums recorded as liabilities. Experience adjustments vary according to the type of contract and the territory in which the policy is in force and are subject to local regulatory guidance.