SEC Filing | American International Group, Inc.

1 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------------- FORM 10-Q [ X ] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO FOR QUARTER ENDED SEPTEMBER 30, 1998 COMMISSION FILE NUMBER 1-8787 --------------------- AMERICAN INTERNATIONAL GROUP, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 13-2592361 (STATE OR OTHER JURISDICTION OF INCORPORATION (I.R.S. EMPLOYER IDENTIFICATION NUMBER) OR ORGANIZATION) 70 PINE STREET, NEW YORK, NEW YORK 10270 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE (212) 770-7000 NONE FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE LAST REPORT.

--------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [ X ] NO [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of September 30, 1998: 1,049,959,401. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 2 AMERICAN INTERNATIONAL GROUP, INC. CONSOLIDATED BALANCE SHEET (IN THOUSANDS)
SEPTEMBER 30, DECEMBER 31, 1998 1997 ------------- ------------ (UNAUDITED) ASSETS: Investments and cash: Fixed maturities: Bonds available for sale, at market value (amortized cost: 1998 -- $42,796,372; 1997 -- $36,568,360)... $ 44,477,805 $ 38,077,792 Bonds held to maturity, at amortized cost (market value: 1998 -- $14,048,353; 1997 -- $13,365,703).............................. 13,021,715 12,530,315 Bonds trading securities, at market value (cost: 1998 -- $939,192; 1997 -- $699,614)............... 989,374 718,548 Preferred stocks, at amortized cost (market value: 1998 -- $2,718; 1997 -- $530,705)................. 2,963 239,331 Equity securities: Common stocks (cost: 1998 -- $4,493,060; 1997 -- $4,625,433)............................... 4,236,211 5,209,274 Non-redeemable preferred stocks (cost: 1998 -- $283,687; 1997 -- $138,412)............... 271,180 138,745 Mortgage loans on real estate, policy and collateral loans -- net......................................... 8,550,672 7,919,764 Financial services assets: Flight equipment primarily under operating leases, net of accumulated depreciation (1998 -- $1,957,204; 1997 -- $1,657,313).......... 16,035,558 14,438,074 Securities available for sale, at market value (cost: 1998 -- $9,294,249; 1997 -- $9,145,244)........... 9,300,161 9,145,317 Trading securities, at market value.................. 6,378,719 3,974,561 Spot commodities, at market value.................... 459,304 459,517 Unrealized gain on interest rate and currency swaps, options and forward transactions.................. 9,779,517 7,422,290 Trading assets....................................... 5,730,990 6,715,486 Securities purchased under agreements to resell, at contract value................................. 4,969,860 4,551,191 Other invested assets.................................. 6,587,413 4,681,423 Short-term investments, at cost (approximates market value)............................................... 3,257,420 3,332,542 Cash................................................... 209,959 86,917 ------------ ------------ Total investments and cash...................... 134,258,821 119,641,087 Investment income due and accrued......................... 1,814,046 1,368,404 Premiums and insurance balances receivable -- net......... 11,837,467 10,282,987 Reinsurance assets........................................ 17,117,550 16,110,521 Deferred policy acquisition costs......................... 6,914,113 6,592,506 Investments in partially-owned companies.................. 440,560 1,121,173 Real estate and other fixed assets, net of accumulated depreciation (1998 -- $1,690,106; 1997 -- $1,512,617).................................... 2,419,083 2,342,187 Separate and variable accounts............................ 5,578,226 3,993,971 Other assets.............................................. 3,542,955 2,517,851 ------------ ------------ Total assets.................................... $183,922,821 $163,970,687 ============ ============
See Accompanying Notes to Financial Statements. 1 3 AMERICAN INTERNATIONAL GROUP, INC. CONSOLIDATED BALANCE SHEET -- (CONTINUED) (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
SEPTEMBER 30, DECEMBER 31, 1998 1997 ------------- ------------ (UNAUDITED) LIABILITIES: Reserve for losses and loss expenses...................... $ 37,651,600 $ 33,400,160 Reserve for unearned premiums............................. 9,909,524 8,739,006 Future policy benefits for life and accident and health insurance contracts.................................... 26,111,933 24,502,005 Policyholders' contract deposits.......................... 11,862,084 10,323,112 Other policyholders' funds................................ 2,408,809 2,352,514 Reserve for commissions, expenses and taxes............... 2,050,559 1,739,945 Insurance balances payable................................ 1,954,531 1,702,578 Funds held by companies under reinsurance treaties........ 437,384 336,585 Income taxes payable: Current................................................ 701,063 585,375 Deferred............................................... 183,711 470,706 Financial services liabilities: Borrowings under obligations of guaranteed investment agreements........................................... 8,411,947 8,000,326 Securities sold under agreements to repurchase, at contract value....................................... 3,758,854 2,706,310 Trading liabilities.................................... 5,077,895 5,366,421 Securities and spot commodities sold but not yet purchased, at market value........................... 4,837,810 5,171,680 Unrealized loss on interest rate and currency swaps, options and forward transactions..................... 7,135,097 5,979,571 Deposits due to banks and other depositors............. 1,038,864 972,423 Commercial paper....................................... 3,281,821 2,208,167 Notes, bonds and loans payable......................... 15,079,028 12,608,891 Commercial paper.......................................... 1,007,867 1,166,740 Notes, bonds, loans and mortgages payable................. 1,582,927 1,276,521 Separate and variable accounts............................ 5,578,226 3,993,971 Other liabilities......................................... 7,630,561 5,966,553 ------------ ------------ Total liabilities............................... 157,692,095 139,569,560 ------------ ------------ Preferred shareholders' equity in subsidiary company...... 400,000 400,000 ------------ ------------ CAPITAL FUNDS: Common stock, $2.50 par value: 2,000,000,000 shares authorized; shares issued 1998 -- 1,138,658,328; 1997 -- 759,121,505.................................... 2,846,646 1,897,804 Additional paid-in capital................................ 87,416 105,689 Retained earnings......................................... 24,566,129 22,920,991 Accumulated other comprehensive income.................... (588,923) 172,141 Treasury stock, at cost; 1998 -- 88,698,927; 1997 -- 59,603,224 shares of common stock.............. (1,080,542) (1,095,498) ------------ ------------ Total capital funds............................. 25,830,726 24,001,127 ------------ ------------ Total liabilities and capital funds............. $183,922,821 $163,970,687 ============ ============
See Accompanying Notes to Financial Statements. 2 4 AMERICAN INTERNATIONAL GROUP, INC. CONSOLIDATED STATEMENT OF INCOME (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED)
NINE MONTHS THREE MONTHS ENDED SEPTEMBER 30, ENDED SEPTEMBER 30, -------------------------- ------------------------ 1998 1997 1998 1997 ----------- ----------- ---------- ---------- General insurance operations: Net premiums written.................... $10,758,856 $10,286,766 $3,760,223 $3,429,877 Change in unearned premium reserve...... (439,628) (989,410) (61,108) (340,613) ----------- ----------- ---------- ---------- Net premiums earned..................... 10,319,228 9,297,356 3,699,115 3,089,264 Net investment income................... 1,587,337 1,366,275 584,588 463,324 Realized capital gains.................. 169,351 106,787 72,995 28,188 ----------- ----------- ---------- ---------- 12,075,916 10,770,418 4,356,698 3,580,776 ----------- ----------- ---------- ---------- Losses and loss expenses incurred....... 7,841,503 7,042,283 2,801,556 2,300,428 Underwriting expenses................... 2,072,805 1,883,499 773,514 670,555 ----------- ----------- ---------- ---------- 9,914,308 8,925,782 3,575,070 2,970,983 ----------- ----------- ---------- ---------- Operating income........................ 2,161,608 1,844,636 781,628 609,793 ----------- ----------- ---------- ---------- Life insurance operations: Premium income.......................... 7,389,556 7,329,233 2,407,129 2,480,443 Net investment income................... 2,335,041 2,147,593 774,978 742,483 Realized capital gains (losses)......... (29,412) 12,789 (14,917) 6,540 ----------- ----------- ---------- ---------- 9,695,185 9,489,615 3,167,190 3,229,466 ----------- ----------- ---------- ---------- Death and other benefits................ 3,182,774 2,964,978 1,090,675 1,033,619 Increase in future policy benefits...... 3,308,805 3,521,732 985,058 1,153,378 Acquisition and insurance expenses...... 1,904,189 1,855,616 645,884 636,499 ----------- ----------- ---------- ---------- 8,395,768 8,342,326 2,721,617 2,823,496 ----------- ----------- ---------- ---------- Operating income........................ 1,299,417 1,147,289 445,573 405,970 ----------- ----------- ---------- ---------- Financial services operating income..... 640,065 487,434 234,229 180,485 Equity in income of minority-owned insurance operations.................. 57,127 84,593 0 26,804 Other realized capital losses........... (10,731) (20,602) (7,636) (10,466) Other income (deductions) -- net........ (109,476) (66,612) (39,265) (22,761) ----------- ----------- ---------- ---------- Income before income taxes and minority interest.............................. 4,038,010 3,476,738 1,414,529 1,189,825 ----------- ----------- ---------- ---------- Income taxes -- Current................. 908,178 923,154 276,734 314,746 -- Deferred............... 269,251 80,343 138,738 29,510 ----------- ----------- ---------- ---------- 1,177,429 1,003,497 415,472 344,256 ----------- ----------- ---------- ---------- Income before minority interest......... 2,860,581 2,473,241 999,057 845,569 Minority interest....................... (100,968) (25,493) (67,987) (5,251) ----------- ----------- ---------- ---------- Net income............................ $ 2,759,613 $ 2,447,748 $ 931,070 $ 840,318 =========== =========== ========== ========== Earnings per common share* Basic................................. $ 2.63 $ 2.32 $ 0.89 $ 0.80 =========== =========== ========== ========== Diluted............................... $ 2.62 $ 2.31 $ 0.89 $ 0.79 =========== =========== ========== ========== Cash dividends per common share*........ $ 0.156 $ 0.139 $ 0.056 $ 0.050 =========== =========== ========== ========== Average shares outstanding* Basic................................. 1,049,678 1,053,860 1,049,992 1,052,078 ----------- ----------- ---------- ---------- Diluted............................... 1,054,704 1,058,682 1,055,112 1,056,896 ----------- ----------- ---------- ----------
- --------------- * Share information reflects a common stock split in the form of a 50 percent common stock dividend paid July 31, 1998. See Accompanying Notes to Financial Statements. 3 5 AMERICAN INTERNATIONAL GROUP, INC. CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (IN THOUSANDS) (UNAUDITED)
NINE MONTHS THREE MONTHS ENDED SEPTEMBER 30, ENDED SEPTEMBER 30, ------------------------ ------------------------ 1998 1997 1998 1997 ---------- ---------- ----------- --------- Net income............................... $2,759,613 $2,447,748 $ 931,070 $ 840,318 Other comprehensive income: Unrealized appreciation (depreciation) of investments -- net of reclassification adjustments*...................... (980,785) 277,348 (1,118,462) 490,924 Deferred income tax (expense) benefit on changes................ 366,136 (109,813) 389,576 (152,395) Foreign currency translation adjustments......................... (159,671) (458,174) (28,080) (310,430) Applicable income tax (expense) benefit on changes................ 13,256 54,182 (5,344) 18,179 ---------- ---------- ----------- --------- Other comprehensive income............... (761,064) (236,457) (762,310) 46,278 ---------- ---------- ----------- --------- Comprehensive Income..................... $1,998,549 $2,211,291 $ 168,760 $ 886,596 ========== ========== =========== =========
- --------------- * A significant portion of the unrealized depreciation of investments for the three months ended September 30, 1998 relates to American International Group, Inc. (AIG) becoming a majority shareholder of 20th Century Industries (20th Century). Previously, the appreciation of AIG's investment in 20th Century over its cost basis was reflected as a component of unrealized appreciation (depreciation) of investments. As a result of the consolidation of the results of operations and the statement of condition of 20th Century for the third quarter, such unrealized appreciation with respect to 20th Century was eliminated. See Accompanying Notes to Financial Statements. 4 6 AMERICAN INTERNATIONAL GROUP, INC. CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30, ---------------------------- 1998 1997 ------------ ------------ Cash Flows From Operating Activities: Net Income.................................................. $ 2,759,613 $ 2,447,748 ------------ ------------ Adjustments to reconcile net income to net cash provided by operating activities: Non-cash revenues, expenses, gains and losses included in income: Change in: General and life insurance reserves..................... 3,055,362 3,504,897 Premiums and insurance balances receivable and payable -- net........................................ (1,219,067) (421,135) Reinsurance assets...................................... (345,301) (784,565) Deferred policy acquisition costs....................... (244,793) (262,862) Investment income due and accrued....................... (353,377) (166,218) Funds held under reinsurance treaties................... (30,312) (44,793) Other policyholders' funds.............................. 56,295 55,921 Current and deferred income taxes -- net................ 371,280 517,215 Reserve for commissions, expenses and taxes............. 280,533 363,824 Other assets and liabilities -- net..................... (682,833) 199,004 Trading assets and liabilities -- net................... 695,970 (677,204) Trading securities, at market value..................... (2,404,158) 18,396 Spot commodities, at market value....................... 213 (266,448) Net unrealized gain on interest rate and currency swaps, options and forward transactions...................... (1,201,701) (1,215,474) Securities purchased under agreements to resell......... (418,669) (422,806) Securities sold under agreements to repurchase.......... 1,052,544 (2,431,765) Securities and spot commodities sold but not yet purchased, at market value............................ (333,870) 2,432,614 Realized capital gains.................................... (129,208) (98,974) Equity in income of partially-owned companies and other invested assets......................................... (152,190) (116,209) Depreciation expenses, principally flight equipment....... 677,818 650,186 Change in cumulative translation adjustments.............. (159,671) (458,174) Other -- net.............................................. 197,851 (82,523) ------------ ------------ Total adjustments......................................... (1,287,284) 292,907 ------------ ------------ Net cash provided by operating activities................... $ 1,472,329 $ 2,740,655 ------------ ------------
See Accompanying Notes to Financial Statements. 5 7 AMERICAN INTERNATIONAL GROUP, INC CONSOLIDATED STATEMENT OF CASH FLOWS -- (CONTINUED) (IN THOUSANDS) (UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30, ---------------------------- 1998 1997 ------------ ------------ Cash Flows From Investing Activities: Cost of fixed maturities, at amortized cost matured or redeemed................................................ $ 1,083,041 $ 993,917 Cost of bonds, at market sold............................. 7,740,764 7,360,382 Cost of bonds, at market matured or redeemed.............. 3,300,677 2,151,855 Cost of equity securities sold............................ 2,118,097 1,773,257 Realized capital gains.................................... 129,208 98,974 Purchases of fixed maturities............................. (14,448,893) (13,342,852) Purchases of equity securities............................ (1,938,796) (1,735,493) Acquisition of 20th Century Industries, net of cash acquired................................................ (482,418) -- Mortgage, policy and collateral loans granted............. (1,781,309) (1,662,318) Repayments of mortgage, policy and collateral loans....... 1,150,401 1,341,579 Sales of securities available for sale.................... 2,274,537 2,946,116 Maturities of securities available for sale............... 1,896,821 3,183,803 Purchases of securities available for sale................ (4,344,063) (4,116,709) Sales of flight equipment................................. 523,031 974,249 Purchases of flight equipment............................. (2,549,130) (2,795,624) Net additions to real estate and other fixed assets....... (289,798) (354,410) Sales or distributions of other invested assets........... 1,038,734 5,653,523 Investments in other invested assets...................... (2,393,956) (6,113,935) Change in short-term investments.......................... 262,047 (162,251) Investments in partially-owned companies.................. (34,896) (28,654) ------------ ------------ Net cash used in investing activities....................... (6,745,901) (3,834,591) ------------ ------------ Cash Flows From Financing Activities: Change in policyholders' contract deposits................ 1,538,972 627,363 Change in deposits due to banks and other depositors...... 66,441 (36,867) Change in commercial paper................................ 914,781 (595,297) Proceeds from notes, bonds, loans and mortgages payable... 5,974,967 5,461,763 Repayments on notes, bonds, loans and mortgages payable... (3,341,218) (5,403,645) Liquidation of zero coupon notes payable.................. -- (12,235) Proceeds from guaranteed investment agreements............ 3,860,098 3,407,703 Maturities of guaranteed investment agreements............ (3,448,477) (1,851,811) Proceeds from common stock issued......................... 27,998 27,375 Cash dividends to shareholders............................ (165,633) (146,787) Acquisition of treasury stock............................. (38,324) (274,448) Other -- net.............................................. 7,009 5,305 ------------ ------------ Net cash provided by financing activities................... 5,396,614 1,208,419 ------------ ------------ Change in cash.............................................. 123,042 114,483 Cash at beginning of period................................. 86,917 58,740 ------------ ------------ Cash at end of period....................................... $ 209,959 $ 173,223 ============ ============
See Accompanying Notes to Financial Statements. 6 8 AMERICAN INTERNATIONAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1998 a) These statements are unaudited. In the opinion of management, all adjustments consisting of normal recurring accruals have been made for a fair presentation of the results shown. b) Earnings per share of American International Group, Inc. (AIG) are based on the weighted average number of common shares outstanding during the period, retroactively adjusted to reflect all stock splits. Cash dividends per common share reflect the adjustment for a common stock split in the form of a 50 percent common stock dividend paid July 31, 1998. The quarterly dividend rate per common share, commencing with the dividend paid September 18, 1998 is $0.056. c) Supplemental cash flow information for the nine month periods ended September 30, 1998 and 1997 is as follows:
1998 1997 ---------- ---------- (i) (IN THOUSANDS) ~~Income taxes paid.................................. $ 764,300 $ 408,000 Interest paid...................................... $1,255,300 $1,256,000~~
(ii) Preferred stock with a cost of $229,255,000 and warrants with a cost of $16,000,000 were converted to common stock in connection with the acquisition of 20th Century Industries. d) Statement of Accounting Standards No. 130 "Comprehensive Income" (FASB 130) was adopted by AIG effective January 1, 1998. FASB 130 establishes standards for reporting comprehensive income and its components as part of capital funds. Such statement is presented herein. The reclassification adjustments with respect to available for sale securities were $50.4 million and $129.2 million for the third quarter and first nine months of 1998, respectively. e) Derivatives Accounting Policy: AIG Financial Products Corp. and its subsidiaries (AIGFP) and AIG Trading Group Inc. and its subsidiaries (AIGTG) enter into future, forward, swap and option derivative transactions. These transactions are marked to market. With the exception of the derivatives used in market hedging activities with respect to securities available for sale, at market, the marks to market on all such other derivative transactions are recognized in income currently. The mark to market with respect to derivatives which hedge the market movements of securities available for sale, at market is recognized as a component of unrealized appreciation of investments, net of taxes. When the underlying security is sold, the loss or gain resulting from the hedging derivative transaction is recognized as income in that same period. f) In June 1998, FASB issued Statement of Financial Accounting Standards No. 133 "Accounting for Derivative Instruments and Hedging Activities" (FASB 133). This statement requires AIG to recognize all derivatives in the consolidated balance sheet measuring these derivatives at fair value. The recognition of the changes in the fair value of a derivative depends on a number of factors, including the intended use of the derivative. AIGTG and AIGFP account for derivatives as described above. AIG is evaluating the impact of FASB 133 with respect to derivative transactions entered into by other AIG operations. AIG believes that the impact of FASB 133 on its results of operations, financial condition or liquidity will not be significant. FASB 133 is effective for the year commencing January 1, 2000. g) For further information, refer to the Annual Report on Form 10-K of AIG for the year ended December 31, 1997. 7 9 AMERICAN INTERNATIONAL GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OPERATIONAL REVIEW General Insurance Operations General insurance operations for the nine month periods ending September 30, 1998, and 1997 were as follows: (in thousands) - ------------------------------------------------------
1998 1997 - -------------------------------------------------------- Net premiums written: Domestic $ 7,223,956 $ 6,944,434 Foreign 3,534,900 3,342,332 - -------------------------------------------------------- Total $10,758,856 $10,286,766 - -------------------------------------------------------- Net premiums earned: Domestic $ 6,984,066 $ 6,291,014 Foreign 3,335,162 3,006,342 - -------------------------------------------------------- Total $10,319,228 $ 9,297,356 - -------------------------------------------------------- Adjusted underwriting profit: Domestic $ 15,883 $ 3,085 Foreign 389,037 368,489 - -------------------------------------------------------- Total $ 404,920 $ 371,574 - -------------------------------------------------------- Net investment income: Domestic $ 1,265,097 $ 1,095,993 Foreign 322,240 270,282 - -------------------------------------------------------- Total $ 1,587,337 $ 1,366,275 - -------------------------------------------------------- Operating income before realized capital gains: Domestic $ 1,280,980 $ 1,099,078 Foreign 711,277 638,771 - -------------------------------------------------------- Total 1,992,257 1,737,849 Realized capital gains 169,351 106,787 - -------------------------------------------------------- Operating income $ 2,161,608 $ 1,844,636 - --------------------------------------------------------
Commencing with the third quarter 1998, the results of operations and the statements of condition of Transatlantic Holdings, Inc. (Transatlantic) and 20th Century Industries (20th Century) were consolidated into AIG's results of operations and statement of condition as components of general insurance operations. During the first nine months of 1998, the net premiums written and net premiums earned in AIG's general insurance operations increased 4.6 percent and 11.0 percent, respectively, from those of 1997. Although the commercial insurance market remains highly competitive and excessively capitalized, AIG has been able to sustain growth in various specialty markets. Foreign general insurance operations produced 32.9 percent of the general insurance net premiums written in the first nine months of 1998 and 32.5 percent in the same period of 1997. In comparing the foreign currency exchange rates used to translate the results of AIG's foreign general operations during the first nine months of 1998 to those foreign currency exchange rates used to translate AIG's foreign general results during the same period of 1997, the U.S. dollar strengthened in value in relation to most major foreign currencies in which AIG transacts business. Accordingly, when foreign net premiums written were translated into U.S. dollars for the purposes of the preparation of the consolidated financial statements, total general insurance net premiums written were approximately 2.9 percentage points less than they would have been if translated utilizing those foreign currency exchange rates which prevailed during that same period of 1997. Net premiums written are initially deferred and earned based upon the terms of the underlying policies. The net unearned premium reserve constitutes deferred revenues which are generally earned ratably over the policy period. Thus, the net unearned premium reserve is not fully recognized as net premiums earned until the end of the policy period. The statutory general insurance ratios were as follows: ------------------------------------------------------
1998 1997 - ------------------------------------------------------- Domestic: Loss Ratio 84.63 84.65 Expense Ratio 15.35 15.48 - ------------------------------------------------------- Combined Ratio 99.98 100.13 - ------------------------------------------------------- Foreign: Loss Ratio 57.90 57.11 Expense Ratio 30.32 30.67 - ------------------------------------------------------- Combined Ratio 88.22 87.78 - ------------------------------------------------------- Consolidated: Loss Ratio 75.99 75.75 Expense Ratio 20.27 20.42 - ------------------------------------------------------- Combined Ratio 96.26 96.17 - -------------------------------------------------------
Adjusted underwriting profit (operating income less net investment income and realized capital gains) represents statutory underwriting profit adjusted primarily for changes in deferred acquisition costs. The adjusted underwriting profits were $404.9 million in the first nine months of 1998 and $371.6 million in the same period of 1997. 8 10 AIG's results reflect the net impact of incurred losses from catastrophes approximating $83 million and $16 million in 1998 and 1997, respectively. AIG's gross incurred losses from catastrophes approximated $400 million and $22 million in 1998 and 1997, respectively. If catastrophes were excluded from the losses incurred in each period, the pro forma consolidated statutory general insurance ratios would be as follows: - ------------------------------------------------------
1998 1997 - ------------------------------------------------------- Loss Ratio 75.18 75.57 Expense Ratio 20.27 20.42 - ------------------------------------------------------- Combined Ratio 95.45 95.99 - -------------------------------------------------------
AIG's ability to maintain its combined ratio below 100 is primarily attributable to the profitability of AIG's foreign general insurance operations and AIG's emphasis on maintaining its disciplined underwriting, especially in the domestic specialty markets. In addition, AIG does not seek net premium growth where rates do not adequately reflect its assessment of exposures. General insurance net investment income in the first nine months of 1998 increased 16.2 percent when compared to the same period of 1997. The growth in net investment income in 1998 was attributable to new cash flow for investment and the compounding of previously earned and reinvested net investment income. (See also the discussion under "Liquidity" herein.) General insurance realized capital gains were $169.4 million in the first nine months of 1998 and $106.8 million in 1997. These realized gains resulted from the ongoing management of the general insurance investment portfolios within the overall objectives of the general insurance operations and arose primarily from the disposition of equity securities and available for sale fixed maturities as well as redemptions of fixed maturities. General insurance operating income in the first nine months of 1998 increased 17.2 percent when compared to the same period of 1997. The contribution of general insurance operating income to income before income taxes and minority interest was 53.5 percent in 1998 compared to 53.1 percent in 1997. AIG is a major purchaser of reinsurance for its general insurance operations. AIG is cognizant of the need to exercise good judgment in the selection and approval of both domestic and foreign companies participating in its reinsurance programs. AIG insures risks in over 100 countries and its reinsurance programs must be coordinated in order to provide AIG the level of reinsurance protection that AIG desires. These reinsurance arrangements do not relieve AIG from its direct obligations to its insureds. AIG's general reinsurance assets amounted to $17.00 billion and resulted from AIG's reinsurance arrangements. Thus, a credit exposure existed at September 30, 1998 with respect to reinsurance recoverable to the extent that any reinsurer may not be able to reimburse AIG under the terms of these reinsurance arrangements. AIG manages its credit risk in its reinsurance relationships by transacting with reinsurers that it considers financially sound and, when necessary, AIG holds substantial collateral in the form of funds, securities and/or irrevocable letters of credit. This collateral can be drawn on for amounts that remain unpaid beyond specified time periods on an individual reinsurer basis. At December 31, 1997, approximately 50 percent of the general reinsurance assets were from unauthorized reinsurers. In order to obtain statutory recognition, nearly all of these balances were collateralized. The remaining 50 percent of the general reinsurance assets were from authorized reinsurers and over 94 percent of such balances are from reinsurers rated A- (excellent) or better, as rated by A.M. Best. This rating is a measure of financial strength. The terms authorized and unauthorized pertain to regulatory categories, not creditworthiness. Through September 30, 1998, these distribution percentages have not significantly changed. AIG's provision for estimated unrecoverable reinsurance has not changed significantly from December 31, 1997 when AIG had allowances for unrecoverable reinsurance approximating $120 million. At that date, and prior to this allowance, AIG had no significant reinsurance recoverables from any individual reinsurer which is financially troubled (e.g., liquidated, insolvent, in receivership or otherwise subject to formal or informal regulatory restriction). AIG's Reinsurance Security Department conducts ongoing detailed assessments of the reinsurance markets and current and potential reinsurers both foreign and domestic. Such assessments include, but are not limited to, identifying if a reinsurer is appropriately licensed, and has sufficient financial capacity, and the local economic environment in which a foreign reinsurer operates. This department also reviews the nature of the risks 9 11 ceded and the need for collateral. In addition, AIG's Credit Risk Committee reviews the credit limits for and concentrations with any one reinsurer. AIG enters into certain intercompany reinsurance transactions for 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. At September 30, 1998, the consolidated general reinsurance assets of $17.00 billion included reinsurance recoverables for paid losses and loss expenses of $1.64 billion and $13.11 billion with respect to the ceded reserve for losses and loss expenses, including ceded losses incurred but not reported (IBNR) (ceded reserves). The ceded reserves represent the accumulation of estimates of ultimate ceded losses including provisions for ceded IBNR and loss expenses. The methods used to determine such estimates and to establish the resulting ceded reserves are continually reviewed and updated. Any adjustments therefrom are reflected in income currently. It is AIG's belief that the ceded reserves at September 30, 1998 were representative of the ultimate losses recoverable. In the future, as the ceded reserves continue to develop to ultimate amounts, the ultimate loss recoverable may be greater or less than the reserves currently ceded. At September 30, 1998, general insurance reserves for losses and loss expenses (loss reserves) amounted to $37.65 billion. Excluding the consolidation of the loss reserves of Transatlantic and 20th Century, the loss reserves amounted to $34.09 billion, an increase of $688.9 million or 2.1 percent from the prior year end. These loss reserves represent the accumulation of estimates of ultimate losses, including IBNR, and loss expenses and minor amounts of discounting related to certain workers' compensation claims. At September 30, 1998, general insurance net loss reserves increased $477.8 million to $24.55 billion. Excluding the consolidation of the net loss reserves of Transatlantic and 20th Century, the net loss reserves amounted to $21.61 billion, an increase of $436.7 million, or 2.1 percent from the prior year end. These loss reserves represent loss reserves reduced by reinsurance recoverable, net of an allowance for unrecoverable reinsurance. The methods used to determine such estimates and to establish the resulting reserves are continually reviewed and updated. Any adjustments resulting therefrom are reflected in operating income currently. It is management's belief that the general insurance net loss reserves are adequate to cover all general insurance net losses and loss expenses as at September 30, 1998. In the future, if the general insurance net loss reserves develop deficiently, such deficiency would have an adverse impact on such future results of operations. In a very broad sense, the general loss reserves can be categorized into two distinct groups: one group being long tail casualty lines of business; the other being short tail lines of business consisting principally of property lines and including certain classes of casualty lines. Estimation of ultimate net losses and loss expenses (net losses) for long tail casualty lines of business is a complex process and depends on a number of factors, including the line and volume of the business involved. In the more recent accident years of long tail casualty lines there is limited statistical credibility in reported net losses. That is, a relatively low proportion of net losses would be reported claims and expenses and an even smaller proportion would be net losses paid. A relatively high proportion of net losses would therefore be IBNR. 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. For the majority of long tail casualty lines, net loss trend factors approximated six percent. Loss trend factors reflect many items including changes in claims handling, exposure and policy forms and current and future estimates of monetary 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 vary slightly, depending on the particular class and nature of the business involved. These factors are periodically reviewed and subsequently adjusted, as appropriate, to reflect emerging trends which are based upon past loss experience. Estimation of net losses for short tail business is less complex than for long tail casualty lines. Loss cost trends for many property lines can generally be assumed to be similar to the growth in exposure of such lines. For example, if the fire insurance coverage remained proportional to the actual value of the 10 12 property, the growth in property's exposure to fire loss can be approximated by the amount of insurance purchased. For other property and short tail casualty lines, the loss trend is implicitly assumed to grow at the rate that reported net losses grow from one year to the next. The concerns noted above for longer tail casualty lines with respect to the limited statistical credibility of reported net losses generally do not apply to shorter tail lines. AIG continues to receive claims asserting injuries from toxic waste, hazardous substances, and other environmental pollutants and alleged damages to cover the cleanup costs of hazardous waste dump sites (hereinafter referred to collectively as environmental claims) and indemnity claims asserting injuries from asbestos. The vast majority of these asbestos and environmental claims emanate from policies written in 1984 and prior years. AIG has established a specialized claims unit which investigates and adjusts all such asbestos and environmental claims. Commencing in 1985, standard policies contained an absolute exclusion for pollution related damage. However, AIG currently underwrites pollution impairment liability insurance on a claims made basis and excluded such claims from the analyses included herein. Estimation of asbestos and environmental claims loss reserves is a difficult process. These asbestos and environmental claims cannot be estimated by conventional reserving techniques as previously described. Quantitative techniques frequently have to be supplemented by subjective considerations including managerial judgment. Significant factors which affect the trends which influence the development of asbestos and environmental claims are the inconsistent court resolutions and judicial interpretations which broaden the intent of the policies and scope of coverage. The current case law can be characterized as still evolving and there is little likelihood that any firm direction will develop in the near future. Additionally, the exposure for cleanup costs of hazardous waste dump sites involves issues such as allocation of responsibility among potentially responsible parties and the government's refusal to release parties. The cleanup cost exposure may significantly change if the Congressional reauthorization of Superfund dramatically changes, thereby reducing or increasing litigation and cleanup costs. In the interim, AIG and other industry members have and will continue to litigate the broadening judicial interpretation of the policy coverage and the liability issues. At the current time, it is not possible to determine the future development of asbestos and environmental claims with the same degree of reliability as is the case for other types of claims. Such development will be affected by the extent to which courts continue to expand the intent of the policies and the scope of the coverage, as they have in the past, as well as by changes in Superfund and waste dump site coverage issues. Although the estimated liabilities for these claims are subject to a significantly greater margin of error than for other claims, the reserves carried for these claims at September 30, 1998 are believed to be adequate as these reserves are based on the known facts and current law. Furthermore, as AIG's net exposure retained relative to the gross exposure written was lower in 1984 and prior years, the potential impact of these claims is much smaller on the net loss reserves than on the gross loss reserves. (See the previous discussion on reinsurance collectibility herein.) The majority of AIG's exposures for asbestos and environmental claims are excess casualty coverages, not primary coverages. Thus, the litigation costs are treated in the same manner as indemnity reserves. That is, litigation expenses are included within the limits of the liability AIG incurs. Individual significant claim liabilities, where future litigation costs are reasonably determinable, are established on a case basis. A summary of reserve activity, including estimates for applicable IBNR, relating to asbestos and 11 13 environmental claims separately and combined at September 30, 1998 and 1997 was as follows:
(in millions) - -------------------------------------------------------------- 1998 1997 ------------------ ----------------- GROSS Net Gross Net - -------------------------------------------------------------- Asbestos: Reserve for losses and loss expenses at beginning of year $ 842.1 $ 195.1 $ 875.9 $172.3 Losses and loss expenses incurred 258.8 74.5 219.6 61.5 Losses and loss expenses paid (193.6) (36.9) (244.7) (41.7) - -------------------------------------------------------------- Reserve for losses and loss expenses at end of period $ 907.3 $ 232.7 $ 850.8 $192.1 - -------------------------------------------------------------- Environmental: Reserve for losses and loss expenses at beginning of year $1,467.1 $ 592.2 $1,427.4 $570.6 Losses and loss expenses incurred 129.8 60.8 173.8 86.3 Losses and loss expenses paid (170.6) (69.6) (117.6) (40.0) - -------------------------------------------------------------- Reserve for losses and loss expenses at end of period $1,426.3 $ 583.4 $1,483.6 $616.9 - -------------------------------------------------------------- Combined: Reserve for losses and loss expenses at beginning of year $2,309.2 $ 787.3 $2,303.3 $742.9 Losses and loss expenses incurred 388.6 135.3 393.4 147.8 Losses and loss expenses paid (364.2) (106.5) (362.3) (81.7) - -------------------------------------------------------------- Reserve for losses and loss expenses at end of period $2,333.6 $ 816.1 $2,334.4 $809.0 - --------------------------------------------------------------
The gross and net IBNR included in the reserve for losses and loss expenses at September 30, 1998 and December 31, 1997 were estimated as follows: (in thousands) - ------------------------------------------------------
1998 1997 ------------------- --------------------- GROSS Net Gross Net - ------------------------------------------------------------------ ~~Combined $949,000 $362,990 $1,004,000 $393,900 - ------------------------------------------------------------------~~
A summary of asbestos and environmental claims count activity for the nine month periods ended September 30, 1998 and 1997 was as follows:
- --------------------------------------------------------------------------------------------------------------------- 1998 1997 ----------------------------------- ----------------------------------- ASBESTOS ENVIRONMENTAL Combined Asbestos Environmental Combined - --------------------------------------------------------------------------------------------------------------------- Claims at beginning of year 6,150 17,422 23,572 5,668 17,395 23,063 Claims during period: Opened 652 2,405 3,057 865 2,716 3,581 Settled (51) (460) (511) (105) (315) (420) Dismissed or otherwise resolved (482) (2,780) (3,262) (303) (1,803) (2,106) - --------------------------------------------------------------------------------------------------------------------- Claims at end of period 6,269 16,587 22,856 6,125 17,993 24,118 - ---------------------------------------------------------------------------------------------------------------------
The average cost per claim settled, dismissed or otherwise resolved for the nine month periods ended September 30, 1998 and 1997 was as follows: - ------------------------------------------------------
1998 1997 ------------------ ------------------- GROSS Net Gross Net - ---------------------------------------------------------------- Asbestos $363,200 $69,200 $599,800 $102,200 Environmental 52,700 21,500 55,500 18,900 Combined 96,500 28,200 143,400 32,300 - ----------------------------------------------------------------
An insurance rating agency has developed a survival ratio to measure the number of years it would take a company to exhaust both its asbestos and environmental reserves for losses and loss expenses based on that company's current level of asbestos and environmental claims payments. The higher the ratio, the more years the reserves for losses and loss expenses cover these claims payments. These ratios are computed based on the ending reserves for losses and loss expenses over the respective claims settlements during the fiscal year. Such payments include indemnity payments and legal and loss adjustment payments. It should be noted, however, that this is an extremely simplistic approach to measuring asbestos and environmental reserve levels. Many factors, such as aggressive settlement procedures, mix of business and level of coverage provided, have significant impact on the amount of asbestos and environmental losses and loss expense reserves, ultimate payments thereof and the resultant ratio. The developed survival ratios include both involuntary and voluntary indemnity payments. Involuntary payments include court judgments, court orders, covered claims with no coverage de- 12 14 fenses, state mandated cleanup costs, claims where AIG's coverage defenses are minimal, and settlements made less than six months before the first trial setting. Also, AIG considers all legal and loss adjustment payments as involuntary. AIG believes voluntary indemnity payments should be excluded from the survival ratio. The special asbestos and environmental claims unit actively manages AIG's asbestos and environmental claims and proactively pursues early settlement of environmental claims for all known and unknown sites. As a result, AIG reduces its exposure to future environmental loss contingencies. AIG's survival ratios for involuntary asbestos and environmental claims, separately and combined, were based upon a three year average payment. These ratios at September 30, 1998 and 1997 were as follows: - ------------------------------------------------------
1998 1997 -------------- -------------- GROSS Net Gross Net - --------------------------------------------------------- Involuntary survival ratios: Asbestos 3.2 4.2 3.6 4.2 Environmental 16.3 17.5 15.8 19.1 Combined 7.0 9.9 7.7 11.0 - ---------------------------------------------------------
AIG's operations are negatively impacted under guarantee fund assessment laws which exist in most states. As a result of operating in a state which has guarantee fund assessment laws, a solvent insurance company may be assessed for certain obligations arising from the insolvencies of other insurance companies which operated in that state. AIG generally records these assessments upon notice. Additionally, certain states permit at least a portion of the assessed amount to be used as a credit against a company's future premium tax liabilities. Therefore, the ultimate net assessment cannot reasonably be estimated. The guarantee fund assessments net of credits for 1997 was $15.4 million. Based upon current information, AIG does not anticipate that its net assessment will be significantly different in 1998. AIG is also required to participate in various involuntary pools (principally workers' compensation business) which provide insurance coverage for those not able to obtain such coverage in the voluntary markets. This participation is also recorded upon notification, as these amounts cannot reasonably be estimated. Life Insurance Operations Life insurance operations for the nine month periods ending September 30, 1998 and 1997 were as follows: (in thousands) - ------------------------------------------------------
1998 1997 - --------------------------------------------------------- Premium income: Domestic $ 555,178 $ 403,507 Foreign 6,834,378 6,925,726 - --------------------------------------------------------- Total $ 7,389,556 $ 7,329,233 - --------------------------------------------------------- Net investment income: Domestic $ 693,902 $ 620,219 Foreign 1,641,139 1,527,374 - --------------------------------------------------------- Total $ 2,335,041 $ 2,147,593 - --------------------------------------------------------- Operating income before realized capital gains (losses): Domestic $ 111,522 $ 93,337 Foreign 1,217,307 1,041,163 - --------------------------------------------------------- Total 1,328,829 1,134,500 Realized capital gains (losses) (29,412) 12,789 - --------------------------------------------------------- Operating income $ 1,299,417 $ 1,147,289 - --------------------------------------------------------- Life insurance in-force:* Domestic $ 62,869,221 $ 59,516,720 Foreign 396,203,509 377,056,403 - --------------------------------------------------------- Total $459,072,730 $436,573,123 - ---------------------------------------------------------
* Amounts presented were as at September 30, 1998 and December 31, 1997, respectively. AIG's life insurance operations, demonstrating the strength of its franchise, continued to show growth in local currency. AIG's life premium income during the first nine months of 1998 represented a 0.8 percent increase in U.S. dollars from the same period in 1997. Foreign life operations produced 92.5 percent and 94.5 percent of the life premium income in 1998 and 1997, respectively. As previously discussed, the U.S. dollar strengthened in value in relation to most major foreign currencies in which AIG transacts business. Accordingly, for the first nine months of 1998, when foreign life premium income was translated into U.S. dollars for purposes of the preparation of the consolidated financial statements, total life premium income was approximately 15.6 percentage points less than it would have been if translated utilizing exchange rates prevailing in 1997. Life insurance net investment income increased 8.7 percent during the first nine months of 1998. The growth in net investment income was primarily attributable to foreign new cash flow for investment. The new cash flow was generated from life insurance operations and included the com- 13 15 pounding of previously earned and reinvested net investment income. (See also the discussion under "Liquidity" herein.) The traditional life products, such as whole and term life and endowments, were the major contributors to the growth in investment income as well as local currency premium income. A mixture of traditional, accident and health and financial products are being sold in Japan. Life insurance realized capital losses were $29.4 million in 1998 compared to realized capital gains of $12.8 million in 1997. These realized capital gains and losses resulted from the ongoing management of the life insurance investment portfolios within the overall objectives of the life insurance operations and arose primarily from the disposition of equity securities and available for sale fixed maturities as well as redemptions of fixed maturities. Life insurance operating income during the first nine months of 1998 increased 13.3 percent to $1.30 billion. Excluding realized capital gains and losses from life insurance operating income, the increase would be 17.1 percent. The contribution of life insurance operating income to income before income taxes and minority interest amounted to 32.2 percent during the first nine months of 1998 compared to 33.0 percent in the same period of 1997. The risks associated with the traditional life and accident and health products are underwriting risk and investment risk. The risk associated with the financial and investment contract products is investment risk. Underwriting risk represents the exposure to loss resulting from the actual policy experience adversely emerging in comparison to the assumptions made in the product pricing associated with mortality, morbidity, termination and expenses. AIG's life companies limit their maximum underwriting exposure on traditional life insurance of a single life to approximately one million dollars of coverage by using yearly renewable term reinsurance. The life insurance operations have not entered into assumption reinsurance transactions or surplus relief transactions during the two year period ended September 30, 1998. The investment risk represents the exposure to loss resulting from the cash flows from the invested assets, primarily long-term fixed rate investments, being less than the cash flows required to meet the obligations of the expected policy and contract liabilities and the necessary return on investments. 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 assess whether there is a liquidity excess or deficit. 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.) The asset-liability relationship is appropriately managed in AIG's foreign operations, as it has been throughout AIG's history, even though certain territories lack qualified long-term investments or there are investment restrictions imposed by the local regulatory authorities. For example, in Japan and several Southeast Asia territories, the duration of the investments is often for a shorter period than the effective maturity of such policy liabilities. Therefore, there is a risk that the reinvestment of the proceeds at the maturity of the investments may be at a yield below that of the interest required for the accretion of the policy liabilities. At December 31, 1997, the average duration of the investment portfolio in Japan was 5.7 years, while the related policy liabilities were estimated to be 13.7 years. These durations have not changed significantly during 1998. To maintain an adequate yield to match the interest required over the duration of the liabilities, constant management focus is required to reinvest the proceeds of the maturing securities without sacrificing investment quality. To the extent permitted under local regulation, AIG may invest in qualified longer-term securities outside Japan to achieve a closer matching in both duration and the required yield. AIG is able to manage any asset-liability duration difference through maintenance of sufficient global liquidity and to support any operational shortfall through its international financial network. Domestically, active monitoring assures appropriate asset-liability matching as there are investments available to match the duration and the required yield. (See also the discussion under "Liquidity" herein.) AIG uses asset-liability matching as a management tool to determine the composition of the invested assets and marketing strategies. As a part of these strategies, AIG may determine that it is economically advantageous to be temporarily in an 14 16 unmatched position due to anticipated interest rate or other economic changes. Financial Services Operations Financial services operations for the nine month periods ending September 30, 1998 and 1997 were as follows: (in thousands) - ------------------------------------------------------
1998 1997 - --------------------------------------------------------- Revenues: International Lease Finance Corp. $1,474,242 $1,369,091 AIG Financial Products Corp.* 353,782 294,513 AIG Trading Group Inc.* 316,009 365,052 Other 269,384 299,020 - --------------------------------------------------------- Total $2,413,417 $2,327,676 - --------------------------------------------------------- Operating income: International Lease Finance Corp. $ 353,304 $ 287,151 AIG Financial Products Corp. 201,936 151,119 AIG Trading Group Inc. 104,542 83,431 Other, including intercompany adjustments (19,717) (34,267) - --------------------------------------------------------- Total $ 640,065 $ 487,434 - ---------------------------------------------------------
* Represents net trading revenues. Financial services operating income increased 31.3 percent in the first nine months of 1998 over 1997. Financial services operating income represented 15.9 percent of AIG's income before income taxes and minority interest in the first nine months of 1998. This compares to 14.0 percent in the same period of 1997. International Lease Finance Corporation (ILFC) generates its revenues primarily from leasing new and used commercial jet aircraft to domestic and foreign airlines. Revenues also result from the remarketing of commercial jets for its own account, for airlines and for financial institutions. Revenues in the first nine months of 1998 increased 7.7 percent from 1997. The revenue growth resulted primarily from the growth in the relative cost of the fleet and the increase in the number of aircraft sold. Approximately 20 percent of ILFC's operating lease revenues are derived from U.S. and Canadian airlines. During the first nine months of 1998, operating income increased 23.0 percent from 1997. The composite borrowing rates at the end of the first nine months of 1998 and 1997 were 6.18 percent and 6.34 percent, respectively. (See also the discussions under "Capital Resources" and "Liquidity" herein.) ILFC is exposed to loss through non-performance of aircraft lessees, through owning aircraft which it would be unable to sell or re-lease at acceptable rates at lease expiration and through 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 September 30, 1998, there were 325 aircraft subject to operating leases and there were no aircraft off lease. (See also the discussions under "Capital Resources" and "Liquidity" herein.) AIG Financial Products Corp. and its subsidiaries (AIGFP) participate in the derivatives dealer market conducting, primarily as principal, an interest rate, currency, equity and credit derivative products business. AIGFP also enters into structured transactions including long-dated forward foreign exchange contracts, option transactions, liquidity facilities and investment agreements and invests in a diversified portfolio of securities. AIGFP derives substantially all its revenues from proprietary positions entered in connection with counterparty transactions rather than from speculative transactions. Revenues in the first nine months of 1998 increased 20.1 percent from the same period of 1997. During the first nine months of 1998, operating income increased 33.6 percent from the same period of 1997. As AIGFP is a transaction-oriented operation, current and past revenues and operating results may not provide a basis for predicting future performance. (See also the discussions under "Capital Resources," "Liquidity" and "Derivatives" herein.) AIG Trading Group Inc. and its subsidiaries (AIGTG) derive a substantial portion of their revenues from market making and trading activities, as principals, in foreign exchange, interest rates and precious and base metals. Revenues in the first nine months of 1998 decreased 13.4 percent from the same period of 1997. During the first nine months of 1998, operating income increased 25.3 percent from the same period of 1997. As AIGTG is a transaction-oriented operation, current and past revenues and operating results may not provide a basis for predicting future performance. (See also the discussions under "Capital Resources," "Liquidity" and "Derivatives" herein.) OTHER OPERATIONS In the first nine months of 1998, AIG's equity in income of minority-owned insurance operations 15 17 was $57.1 million compared to $84.6 million in the same period of 1997. In the first nine months of 1998, the equity interest in insurance companies represented 1.4 percent of income before income taxes and minority interest compared to 2.4 percent in the same period of 1997. As previously mentioned, Transatlantic was consolidated as a component of general insurance operations for the first time this quarter. SELIC Holdings, Ltd. was consolidated earlier this year. IPC Holdings, Ltd., the remaining operation included in Equity in income of minority-owned insurance operations in previous periods is now reported as a component of Other income (deductions) -- net. Other realized capital losses amounted to $10.7 million and $20.6 million in the first nine months of 1998 and 1997, respectively. Other income (deductions) -- net includes AIG's equity in certain minor majority-owned subsidiaries and certain partially-owned companies, realized foreign exchange transaction gains and losses in substantially all currencies and unrealized gains and losses in hyperinflationary currencies, as well as the income and expenses of the parent holding company and other miscellaneous income and expenses. In the first nine months of 1998, net deductions amounted to $109.5 million. In the same period of 1997, net deductions amounted to $66.6 million. Income before income taxes and minority interest amounted to $4.04 billion in the first nine months of 1998, and $3.48 billion in the same period of 1997. In the first nine months of 1998, AIG recorded a provision for income taxes of $1.18 billion compared to the provision of $1.00 billion in the same period of 1997. These provisions represent effective tax rates of 29.2 percent in the first nine months of 1998, and 28.9 percent in the same period of 1997. Minority interest represents minority shareholders' equity in operating income and capital gains of certain consolidated subsidiaries. In the first nine months of 1998, minority interest amounted to $101.0 million. In the first nine months of 1997, minority interest amounted to $25.5 million. Net income amounted to $2.76 billion in the first nine months of 1998, and $2.45 billion in the same period of 1997. The increases in net income over the periods resulted from those factors described above. CAPITAL RESOURCES At September 30, 1998, AIG had total capital funds of $25.83 billion and total borrowings of $29.36 billion. At that date, $26.95 billion of such borrowings were either not guaranteed by AIG or were matched borrowings under obligations of guaranteed investment agreements (GIAs) or matched notes and bonds payable. Total borrowings and borrowings not guaranteed or matched at September 30, 1998 and December 31, 1997 were as follows: (in thousands) - ------------------------------------------------------
1998 1997 - --------------------------------------------------------- GIAs -- AIGFP $ 8,411,947 $ 8,000,326 - --------------------------------------------------------- Commercial Paper: Funding 196,764 307,997 ILFC(a) 3,281,821 2,208,167 AICCO 760,467 833,647 Universal Finance Company (UFC)(a) 50,636 25,096 - --------------------------------------------------------- Total 4,289,688 3,374,907 - --------------------------------------------------------- Medium Term Notes: ILFC(a) 3,216,750 2,896,865 AIG 230,565 248,225 - --------------------------------------------------------- Total 3,447,315 3,145,090 - --------------------------------------------------------- Notes and Bonds Payable: ILFC(a) 4,025,000 3,950,000 AIGFP 6,996,510 4,858,706 AIG: Lire bonds 159,067 159,067 Zero coupon notes 98,972 91,179 - --------------------------------------------------------- Total 11,279,549 9,058,952 - --------------------------------------------------------- Loans and Mortgages Payable: ILFC(a)(b) 840,768 903,320 SPC Credit Limited (SPC)(a) 528,660 538,988 Consumer Finance(a) 234,836 -- AIG 330,827 239,062 - --------------------------------------------------------- Total 1,935,091 1,681,370 - --------------------------------------------------------- Total Borrowings 29,363,590 25,260,645 - --------------------------------------------------------- Borrowings not guaranteed by AIG 12,178,471 10,522,436 Matched GIA borrowings 8,411,947 8,000,326 Matched notes and bonds payable -- AIGFP 6,357,274 3,754,420 - --------------------------------------------------------- 26,947,692 22,277,182 - --------------------------------------------------------- Remaining borrowings of AIG $ 2,415,898 $ 2,983,463 - ---------------------------------------------------------
(a)AIG does not guarantee or support these borrowings. (b)Capital lease obligations. During the first nine months of 1998, AIGFP increased the aggregate principal amount outstanding of its notes and bonds payable to $7.0 billion, a net increase of $2.14 billion and increased its net GIA borrowings by $411.6 million. AIGFP uses the proceeds from the issuance of notes and bonds to invest in a segregated portfolio of securities availa- 16 18 ble for sale, although these funds may be temporarily invested in securities purchased under agreements to resell. Funds received from GIA borrowings are invested in a diversified portfolio of securities and derivative transactions. (See also the discussions under "Operational Review," "Liquidity" and "Derivatives" herein.) AIG Funding, Inc. (Funding), through the issuance of commercial paper, fulfills the short-term cash requirements of AIG and its non-insurance subsidiaries. Funding intends to continue to meet AIG's funding requirements through the issuance of commercial paper guaranteed by AIG. This issuance of Funding's commercial paper is subject to the approval of AIG's Board of Directors. ILFC, A.I. Credit Corp. (AICCO) and UFC, a consumer finance subsidiary in Taiwan, issue commercial paper for the funding of their own operations. AIG does not guarantee AICCO's, ILFC's or UFC's commercial paper. However, AIG has entered into an agreement in support of AICCO's commercial paper. From time to time, AIGFP may issue commercial paper, which AIG guarantees, to fund its operations. At September 30, 1998, AIGFP had no commercial paper outstanding. (See also the discussion under "Derivatives" herein.) AIG and Funding have entered into two syndicated revolving credit facilities (the Facilities) aggregating $1 billion. The Facilities consist of a $500 million 364 day revolving credit facility and a $500 million five year revolving credit facility. The Facilities can be used for general corporate purposes and also provide backup for AIG's commercial paper programs administered by Funding. There are currently no borrowings outstanding under either of the Facilities, nor were any borrowings outstanding as of September 30, 1998. At September 30, 1998, ILFC had increased the aggregate principal amount outstanding of its medium term and term notes to $7.24 billion, a net increase of $394.9 million, and recorded a net decline in its capital lease obligations of $62.6 million and a net increase in its commercial paper of $1.07 billion. At September 30, 1998, ILFC had $880 million in aggregate principal amount of debt securities registered for issuance from time to time. The proceeds of ILFC's debt financing are primarily used to purchase flight equipment, including progress payments during the construction phase. The primary sources for the repayment of this debt and the interest expense thereon are the cash flow from operations, proceeds from the sale of flight equipment and the rollover and refinancing of the prior debt. (See also the discussions under "Operational Review" and "Liquidity" herein.) During the first nine months of 1998, AIG issued $22.3 million principal amount of Medium Term Notes and $40.0 million of previously issued notes matured. At September 30, 1998 AIG had $516.5 million in aggregate principal amount of debt securities registered for issuance from time to time. AIG's capital funds increased $1.83 billion during the first nine months of 1998. Unrealized appreciation of investments, net of taxes decreased $614.6 million. During the first nine months of 1998, the cumulative translation adjustment loss, net of taxes, increased $146.4 million. The changes from period to period with respect to the unrealized appreciation of investments, net of taxes and the cumulative translation adjustment loss, net of taxes were primarily impacted by the economic situation in Japan and Southeast Asia and the general strength of the U.S. dollar against most currencies in which AIG conducts operations. Additionally, the unrealized appreciation of investments, net of taxes declined as a result of the consolidation of 20th Century which was previously carried as an investment presented at market value. (See also the discussion under "Operational Review" and "Liquidity" herein.) Retained earnings increased $1.65 billion, resulting from net income less dividends. During the period from January 1, 1998 through October 30, 1998, AIG repurchased 1,044,750 shares of its common stock in the open market at a cost of $77.5 million. AIG intends to continue to buy its common shares in the open market to satisfy its obligations under various employee benefit plans and, depending on market conditions, for other corporate purposes. Payments of dividends to AIG by its insurance subsidiaries are subject to certain restrictions imposed by regulatory authorities. AIG has in the past reinvested most of its unrestricted earnings in its operations and believes such continued reinvestment in the future will be adequate to meet any foreseeable capital needs. However, AIG may choose from time to time to raise additional funds through the issuance of additional securities. At September 30, 1998, there were no significant statu- 17 19 tory or regulatory issues which would impair AIG's financial condition, results of operations or liquidity. To AIG's knowledge, no AIG company is on any regulatory or similar "watch list." (See also the discussion under "Liquidity" herein.) The National Association of Insurance Commissioners (NAIC) has developed Risk-Based Capital (RBC) requirements. RBC relates an individual insurance company's statutory surplus to the risk inherent in its overall operations. At December 31, 1997, the adjusted capital of each of AIG's domestic general companies and of each of AIG's domestic life companies exceeded each of their RBC standards by considerable margins. There has been no significant change through September 30, 1998. A substantial portion of AIG's general insurance business and a majority of its life insurance business are conducted in foreign countries. The degree of regulation and supervision in foreign jurisdictions varies from minimal in some to stringent in others. Generally, AIG, as well as the underwriting companies operating in such jurisdictions, must satisfy local regulatory requirements. LIQUIDITY AIG's liquidity is primarily derived from the operating cash flows of its general and life insurance operations. At September 30, 1998, AIG's consolidated invested assets included approximately $3.47 billion of cash and short-term investments. Consolidated net cash provided from operating activities in the first nine months of 1998 amounted to $1.47 billion. Sources of funds considered in meeting the objectives of AIG's financial services' operations include guaranteed investment agreements, issuance of long and short-term debt, maturities and sales of securities available for sale, securities sold under repurchase agreements, trading liabilities, securities and spot commodities sold but not yet purchased, issuance of equity, and cash provided from such operations. AIG's strong capital position is integral to managing this liquidity, as it enables AIG to raise funds in diverse markets worldwide. (See also the discussions under "Capital Resources" herein.) Management believes that AIG's liquid assets, its net cash provided by operations, and access to the capital markets will enable it to meet any foreseeable cash requirements. The liquidity of the combined insurance operations is derived both domestically and abroad. The combined insurance operating cash flow is derived from two sources, underwriting operations and investment operations. In the aggregate, AIG's insurance operations generated over $5.5 billion in pre-tax cash flow during the first nine months of 1998. Cash flow includes periodic premium collections, including policyholders' contract deposits, paid loss recoveries less reinsurance premiums, losses, benefits, acquisition and operating expenses. Generally, there is a time lag from when premiums are collected and, when as a result of the occurrence of events specified in the policy, the losses and benefits are paid. AIG's insurance investment operations generated approximately $3.7 billion in investment income cash flow during the first nine months of 1998. Investment income cash flow is primarily derived from interest and dividends received and includes realized capital gains. The combined insurance pre-tax operating cash flow coupled with the cash and short-term investments of $3.2 billion provided the insurance operations with a significant amount of liquidity during the first nine months of 1998. This liquidity is available to purchase high quality and diversified fixed income securities and to a lesser extent marketable equity securities and to provide mortgage loans on real estate, policy loans and collateral loans. This liquidity coupled with proceeds approximating $14 billion from the maturities, sales and redemptions of fixed income securities and from the sale of equity securities was used to purchase nearly $16 billion of fixed income securities and marketable equity securities during the first nine months of 1998. 18 20 The following table is a summary of AIG's invested assets by significant segment, including investment income due and accrued and real estate, at September 30, 1998 and December 31, 1997: (dollars in thousands) - --------------------------------------------------------------------------------
September 30, 1998 December 31, 1997 --------------------------- --------------------------- INVESTED Percent Invested Percent ASSETS of Total Assets of Total - ------------------------------------------------------------------------------------------------------------------------ General insurance $ 37,936,805 27.6% $ 31,844,084 26.0% Life insurance 43,624,514 31.7 41,046,969 33.5 Financial services 55,230,856 40.2 48,899,127 39.9 Other 673,609 0.5 661,701 0.6 - ------------------------------------------------------------------------------------------------------------------------ Total $137,465,784 100.0% $122,451,881 100.0% - ------------------------------------------------------------------------------------------------------------------------
INSURANCE INVESTED ASSETS The following tables summarize the composition of AIG's insurance invested assets by insurance seg- ment, including investment income due and accrued and real estate, at September 30, 1998 and December 31, 1997: (dollars in thousands) - --------------------------------------------------------------------------------
PERCENT DISTRIBUTION PERCENT --------------------- SEPTEMBER 30, 1998 GENERAL LIFE TOTAL OF TOTAL DOMESTIC FOREIGN - ------------------------------------------------------------------------------------------------------------------------ Fixed Maturities: Available for sale, at market value(a) $15,544,237 $29,777,464 $45,321,701 55.5% 43.7% 56.3% Held to maturity, at amortized cost(b) 13,024,678 -- 13,024,678 16.0 100.0 -- Equity securities, at market value(c) 3,050,931 1,230,325 4,281,256 5.2 49.3 50.7 Mortgage loans on real estate, policy and collateral loans 50,743 6,618,103 6,668,846 8.2 38.8 61.2 Short-term investments, including time deposits, and cash 626,748 2,547,409 3,174,157 3.9 14.4 85.6 Real estate 385,955 931,375 1,317,330 1.6 17.3 82.7 Investment income due and accrued 642,132 1,051,457 1,693,589 2.1 43.1 56.9 Other invested assets 4,611,381 1,468,381 6,079,762 7.5 82.1 17.9 - ------------------------------------------------------------------------------------------------------------------------ Total $37,936,805 $43,624,514 $81,561,319 100.0% 53.8% 46.2% - ------------------------------------------------------------------------------------------------------------------------
(a)Includes $989,374 of bonds trading securities, at market value. (b)Includes $2,963 of preferred stock, at amortized cost. (c)Includes $244,045 of preferred stock, at market value. (dollars in thousands) - --------------------------------------------------------------------------------
Percent Distribution Percent --------------------- December 31, 1997 General Life Total of Total Domestic Foreign - ------------------------------------------------------------------------------------------------------------------------ Fixed Maturities: Available for sale, at market value(a) $11,326,246 $27,340,210 $38,666,456 53.0% 37.8% 62.2% Held to maturity, at amortized cost(b) 12,769,646 -- 12,769,646 17.5 100.0 -- Equity securities, at market value(c) 3,314,603 1,815,849 5,130,452 7.0 43.5 56.5 Mortgage loans on real estate, policy and collateral loans 50,297 6,147,606 6,197,903 8.5 39.0 61.0 Short-term investments, including time deposits, and cash 616,683 2,409,353 3,026,036 4.2 33.1 66.9 Real estate 401,995 979,543 1,381,538 1.9 16.8 83.2 Investment income due and accrued 528,164 817,348 1,345,512 1.9 39.7 60.3 Other invested assets 2,836,450 1,537,060 4,373,510 6.0 76.7 23.3 - ------------------------------------------------------------------------------------------------------------------------ Total $31,844,084 $41,046,969 $72,891,053 100.0% 51.0% 49.0% - ------------------------------------------------------------------------------------------------------------------------
(a)Includes $718,548 of bonds trading securities, at market value. (b)Includes $239,331 of preferred stock, at amortized cost. (c)Includes $111,609 of preferred stock, at market value. Generally, insurance regulations restrict the types of assets in which an insurance company may invest. With respect to fixed maturities, AIG's general strategy is to invest in high quality securities while maintaining diversification to avoid significant exposure to issuer, industry and/or country concentra- 19 21 tions. With respect to general insurance, AIG's strategy is to invest in longer duration fixed maturities to maximize the yields at the date of purchase. With respect to life insurance, AIG's strategy is to produce cash flows required to meet maturing insurance liabilities (See also the discussion under "Operational Review: Life Insurance Operations" herein.) The fixed maturity available for sale portfolio is subject to decline in fair value as interest rates rise. Such declines in fair value are presented as a component of capital funds in unrealized appreciation of investments, net of taxes. The fixed maturities held to maturity portfolio is exposed to adverse interest rate fluctuations. However, AIG has the ability and intent to hold such securities to maturity. Therefore, there would be no detrimental impact to AIG's results of operations or financial condition as a result of such fluctuations. At September 30, 1998, approximately 56.2 percent of the fixed maturities investments were domestic securities. Approximately 40 percent of such domestic securities were rated AAA. Approximately 11 percent were below investment grade or not rated. A significant portion of the foreign insurance fixed income portfolio is rated by Moody's, Standard & Poor's (S&P) or similar foreign services. Similar credit quality rating services are not available in all overseas locations. AIG annually reviews the credit quality of the foreign portfolio nonrated fixed income investments, including mortgages. At September 30, 1998, approximately 18 percent of the foreign fixed income investments were either rated AAA or, on the basis of AIG's internal analysis, were equivalent from a credit standpoint to securities so rated. Approximately 16 percent were below investment grade or not rated at that date. At September 30, 1998, approximately four percent of the fixed maturities portfolio was Collateralized Mortgage Obligations (CMOs), including minor amounts with respect to Commercial Mortgage Backed Securities. All of the CMOs were investment grade and approximately 54 percent of the CMOs were backed by various U.S. government agencies. CMOs are exposed to interest rate risk as the duration and ultimate realized yield would be affected by the accelerated prepayments of the underlying mortgages. There were no interest only or principal only CMOs at September 30, 1998. Any fixed income security may be subject to downgrade for a variety of reasons subsequent to any balance sheet date. There have been no significant downgrades as of November 1, 1998. AIG invests in equities for reasons including diversifying its overall exposure to interest rate risk. Equity securities are subject to declines in fair value. Such declines in fair value are presented as components of capital funds in unrealized appreciation of investments, net of taxes. Mortgage loans on real estate, policy and collateral loans comprised 8.2 percent of AIG's insurance invested assets at September 30, 1998. AIG's insurance operations' holdings of real estate mortgages amounted to $2.74 billion of which 37.9 percent was domestic. At September 30, 1998, no domestic mortgages and only a nominal amount of foreign mortgages were in default. It is AIG's practice to maintain a maximum loan to value ratio of 75 percent at loan origination. At September 30, 1998, AIG's insurance holdings of collateral loans amounted to $1.07 billion, all of which were foreign. It is AIG's strategy to enter into mortgage and collateral loans as an adjunct primarily to life insurance fixed maturity investments. AIG's policy loans increased from $2.67 billion at December 31, 1997 to $2.86 billion at September 30, 1998. Short-term investments represent amounts invested in various internal and external money market funds, time deposits and cash held. AIG's real estate investment properties are primarily occupied by AIG's various operations. The current market value of these properties considerably exceeds their carrying value. Other invested assets were primarily comprised of both foreign and domestic private placements, limited partnerships and outside managed funds. When permitted by regulatory authorities and when deemed necessary to protect insurance assets, including invested assets, from adverse movements in foreign currency exchange rates, interest rates and equity prices, AIG and its insurance subsidiaries may enter into derivative transactions as end users. To date, such activities have not been significant. (See also the discussion under "Derivatives" herein.) In certain jurisdictions, significant regulatory and/or foreign governmental barriers exist which may not permit the immediate free flow of funds 20 22 between insurance subsidiaries or from the insurance subsidiaries to AIG parent. These barriers generally cause only minor delays in the outward remittance of the funds. AIG's insurance operations are exposed to market risk. Market risk is the risk of loss of fair value resulting from adverse fluctuations in interest and foreign currency exchange rates and equity prices. Measuring potential losses in fair values has recently become the focus of risk management efforts by many companies. Such measurements are performed through the application of various statistical techniques. One such technique is Value at Risk (VaR). VaR is a summary statistical measure that uses historical interest and foreign currency exchange rates and equity prices and estimates the volatility and correlation of each of these rates and prices to calculate the maximum loss that could occur over a defined period of time given a certain probability. AIG believes that statistical models alone do not provide a reliable method of monitoring and controlling market risk. While VaR models are relatively sophisticated, the quantitative market risk information generated is limited by the assumptions and parameters established in creating the related models. Therefore, such models are tools and do not substitute for the experience or judgment of senior management. AIG has performed a VaR analysis to estimate the maximum potential loss of fair value for each of AIG's insurance segments and for each market risk within each insurance segment. In this analysis, financial instrument assets include the domestic and foreign invested assets excluding real estate and investment income due and accrued. Financial instrument liabilities include reserve for losses and loss expenses, reserve for unearned premiums, future policy benefits for life and accident and health insurance contracts and policyholders' funds. Due to the nature of each insurance segment, AIG manages the general and life insurance operations separately. As a result, AIG manages separately the invested assets of each. Accordingly, the VaR analysis was separately performed for the general and the life insurance operations. AIG calculated the VaR with respect to the net fair value of each of AIG's insurance segments as of December 31, 1997. Through September 30, 1998, the economic facts and circumstances have not significantly changed. Therefore, the VaR at December 31, 1997 was representative of a VaR at September 30, 1998. This calculation used the variance-covariance (delta-normal) methodology. The calculation also used daily historical interest and foreign currency exchange rates and equity prices in the two years ending December 31, 1997. The VaR model estimated the volatility of each of these rates and equity prices and the correlation among them. For interest rates, each country's yield curve was constructed using eleven separate points on this curve to model possible curve movements. Inter-country correlations were also used. The redemption experience of municipal and corporate fixed maturities and mortgage securities was taken into account as well as the use of financial modeling. Thus, the VaR measured the sensitivity of the asset and the liability portfolios to each of the aforementioned market risk exposures. Each sensitivity was estimated separately to capture the market exposures within each insurance segment. These sensitivities were then applied to a data base which contained both historical ranges of movements in all market factors and the correlations among them. The results were aggregated to provide a single amount that depicts the maximum potential loss in fair value at a confidence level of 95 percent for a time period of one month. At December 31, 1997 the VaR of AIG's insurance segments was approximately $520 million for general insurance and $799 million for life insurance. The following table presents the VaR of each component of market risk for each of AIG's insurance segments as of December 31, 1997. VaR with respect to combined operations cannot be derived by aggregating the individual risk or segment amounts presented herein. (in millions) - --------------------------------------------------------------------------------
MARKET RISK GENERAL INSURANCE LIFE INSURANCE - ------------------------------------------------------------------------------------------------- Interest rate $235.6 $779.3 Currency 25.9 84.9 Equity 354.5 120.1 - -------------------------------------------------------------------------------------------------
21 23 FINANCIAL SERVICES INVESTED ASSETS The following table is a summary of the composition of AIG's financial services invested assets at September 30, 1998 and December 31, 1997. (See also the discussions under "Operational Review: Financial Services Operations," "Capital Resources" and "Derivatives" herein.) (dollars in thousands) - --------------------------------------------------------------------------------
1998 1997 ------------------------- ------------------------- INVESTED Percent Invested Percent ASSETS of Total Assets of Total - -------------------------------------------------------------------------------------------------------------------- Flight equipment primarily under operating leases, net of accumulated depreciation $16,035,558 29.1% $14,438,074 29.5% Unrealized gain on interest rate and currency swaps, options and forward transactions 9,779,517 17.7 7,422,290 15.2 Securities available for sale, at market value 9,300,161 16.8 9,145,317 18.7 Trading securities, at market value 6,378,719 11.5 3,974,561 8.1 Securities purchased under agreements to resell, at contract value 4,969,860 9.0 4,551,191 9.3 Trading assets 5,730,990 10.4 6,715,486 13.8 Spot commodities, at market value 459,304 0.8 459,517 0.9 Other, including short-term investments 2,576,747 4.7 2,192,691 4.5 - -------------------------------------------------------------------------------------------------------------------- Total $55,230,856 100.0% $48,899,127 100.0% - --------------------------------------------------------------------------------------------------------------------
As previously discussed, the cash used for the purchase of flight equipment is derived primarily from the proceeds of ILFC's debt financings. The primary sources for the repayment of this debt and the interest expense thereon are the cash flow from operations, proceeds from the sale of flight equipment and the rollover and refinancing of the prior debt. During the first nine months of 1998, ILFC acquired flight equipment costing $2.55 billion. AIGFP's derivative transactions are carried at market value or at estimated fair value when market prices are not readily available. AIGFP reduces its economic risk exposure through similarly valued offsetting transactions including swaps, trading securities, options, forwards and futures. The estimated fair values of these transactions represent assessments of the present value of expected future cash flows. These transactions are exposed to liquidity risk if AIGFP were to sell or close out the transactions prior to maturity. AIG believes that the impact of any such limited liquidity would not be significant to AIG's financial condition or its overall liquidity. (See also the discussion under "Operational Review: Financial Services Operations" and "Derivatives" herein.) Securities available for sale, at market value and securities purchased under agreements to resell are purchased with the proceeds of AIGFP's GIA financings and other long and short term borrowings. The proceeds from the disposal of securities available for sale and securities purchased under agreements to resell have been used to fund the maturing GIAs or other AIGFP financing. (See also the discussion under "Capital Resources" herein.) Securities available for sale is mainly a portfolio of debt securities, where the individual securities have varying degrees of credit risk. At September 30, 1998, the average credit rating of this portfolio was AA or the equivalent thereto as determined through rating agencies or internal review. AIGFP has also entered into credit derivative transactions to hedge its credit risk associated with $397.3 million of these securities. There were no securities deemed below investment grade at September 30, 1998. There have been no significant downgrades through November 1, 1998. Securities purchased under agreements to resell are treated as collateralized transactions. AIGFP takes possession of or obtains a security interest in securities purchased under agreements to resell. AIGFP further minimizes its credit risk by monitoring counterparty credit exposure and, when AIGFP deems necessary, it requires additional collateral to be deposited. Trading securities, at market value are marked to market daily and are held to meet the short-term risk management objectives of AIGFP. AIGTG conducts, as principal, market making and trading activities in foreign exchange, interest rates and precious and base metals. AIGTG owns inventories in the commodities in which it trades and may reduce the exposure to market risk through the use of swaps, forwards, futures and option contracts. AIGTG uses derivatives to manage the economic exposure of its various trading positions and transactions from adverse movements of interest 22 24 rates, foreign currency exchange rates and commodity prices. AIGTG supports its trading activities largely through trading liabilities, unrealized losses on swaps, short-term borrowings, securities sold under agreements to repurchase and securities and commodities sold but not yet purchased. (See also the discussions under "Capital Resources" and "Derivatives" herein.) The gross unrealized gains and gross unrealized losses of AIGFP and AIGTG included in the financial services assets and liabilities at September 30, 1998 were as follows: (in thousands) - --------------------------------------------------------------------------------
GROSS GROSS UNREALIZED UNREALIZED GAINS LOSSES - -------------------------------------------------------------------------------------- Securities available for sale, at market value $ 456,154 $ 450,242 Unrealized gain/loss on interest rate and currency swaps, options and forward transactions(a)(b) 9,779,517 7,135,097 Trading assets 7,119,518 4,673,017 Spot commodities, at market value -- 81,788 Trading liabilities -- 3,157,557 Securities and spot commodities sold but not yet purchased, at market value 397,381 -- - --------------------------------------------------------------------------------------
(a)These amounts are also presented as the respective balance sheet amounts. (b)At September 30, 1998, AIGTG's replacement values with respect to interest rate and currency swaps were $856.1 million. AIGFP's interest rate risk on securities available for sale, at market, is managed by taking offsetting positions on a security by security basis, thereby offsetting a significant portion of the unrealized appreciation or depreciation. At September 30, 1998, the unrealized gains and losses remaining after the benefit of the offsets were $11.6 million and $5.7 million, respectively. Trading securities and spot commodities, at market value, and securities and spot commodities sold but not yet purchased, at market value are marked to market daily with the unrealized gain or loss being recognized in income at that time. These securities and spot commodities are held to meet the short-term risk management objectives of AIGFP and AIGTG. The senior management of AIG defines the policies and establishes general operating parameters for AIGFP and AIGTG. AIG's senior management has established various oversight committees to review the various financial market, operational and credit issues of AIGFP and AIGTG. The senior managements of AIGFP and AIGTG report the results of their respective operations to and review future strategies with AIG's senior management. AIG actively manages the exposures to limit potential losses, while maximizing the rewards afforded by these business opportunities. In doing so, AIG must manage a variety of exposures including credit, market, liquidity, operational and legal risks. Market risk arises principally from the uncertainty that future earnings are exposed to potential changes in volatility, interest rates, foreign currency exchange rates, and equity and commodity prices. AIG generally controls its exposure to market risk by taking offsetting positions. AIG's philosophy with respect to its financial services operations is to minimize or set limits for open or uncovered positions that are to be carried. Credit risk exposure is separately managed. (See the discussion on the management of credit risk below.) AIG's Market Risk Management Department provides detailed independent review of AIG's market exposures, particularly those market exposures of AIGFP and AIGTG. This department determines whether AIG's market risks, as well as those market risks of individual subsidiaries, are within the parameters established by AIG's senior management. Well established market risk management techniques such as sensitivity analysis are used. Additionally, this department verifies that specific market risks of each of certain subsidiaries are managed and hedged by that subsidiary. AIGFP is exposed to market risk due to changes in the level and volatility of interest rates and the shape and slope of the yield curve. AIGFP hedges its exposure to interest rate risk by entering into transactions such as interest rate swaps and options and purchasing U.S. and foreign government obligations. AIGFP is exposed to market risk due to changes in and volatility of foreign currency exchange rates. AIGFP hedges its foreign currency 23 25 exchange risk primarily through the use of currency swaps, options, forwards and futures. AIGFP is exposed to market risk due to changes in the level and volatility of equity prices which affect the value of securities or instruments that derive their value from a particular stock, a basket of stocks or a stock index. AIGFP reduces the risk of loss inherent in its inventory in equity securities by entering into hedging transactions, including equity swaps and options and purchasing U.S. and foreign government obligations. AIGFP does not seek to manage the market risk of each of its transactions through an individual offsetting transaction. Rather, AIGFP takes a portfolio approach to the management of its market risk exposure. AIGFP values its portfolio at market value or estimated fair value when market values are not readily available. These valuations represent an assessment of the present values of expected future cash flows of AIGFP's transactions and may include reserves for such risks as are deemed appropriate by AIGFP's and AIG's management. AIGFP evaluates the portfolio's discounted cash flows with reference to current market conditions, maturities within the portfolio and other relevant factors. Based upon this evaluation, AIGFP determines what, if any, offsetting transactions are necessary to reduce the market risk exposure of the portfolio. The aforementioned estimated fair values are based upon the use of valuation models. These models utilize, among other things, current interest, foreign exchange and volatility rates. These valuation models are integrated into the evaluation of the portfolio, as described above, in order to provide timely information for the market risk management of the portfolio. Additionally, depending upon the changes in interest rates and other market movements during the day, the system will produce reports for management's consideration for intra-day offsetting positions. Overnight, the system generates reports which recommend the types of offsets management should consider for the following day. Additionally, AIGFP operates in major business centers overseas and is essentially open for business 24 hours a day. Thus, the market exposure and offset strategies are monitored, reviewed and coordinated around the clock. Therefore, offsetting adjustments can be made as and when necessary from any AIGFP office in the world. As part of its monitoring and controlling of its exposure to market risk, AIGFP applies various testing techniques which reflect potential market movements. These techniques vary by currency and are regularly changed to reflect factors affecting the derivatives portfolio. In addition to the daily monitoring, AIGFP's senior management and local risk managers conduct a weekly review of the derivatives portfolio and existing hedges. This review includes an examination of the portfolio's risk measures, such as aggregate option sensitivity to movements in market variables. AIGFP's management may change these measures to reflect their judgment and evaluation of the dynamics of the markets. This management group will also determine whether additional or alternative action is required in order to manage the portfolio. AIG utilizes an outside consultant to provide the managements of AIG and AIGFP with comfort that the system produces representative values. All of AIGTG's market risk sensitive instruments are entered into for trading purposes. The fair values of AIGTG's financial instruments are exposed to market risk as a result of adverse market changes in interest rates, foreign currency exchange rates, commodity prices and adverse changes in the liquidity of the markets in which AIGTG trades. AIGTG's approach to managing market risk is to establish an appropriate offsetting position to a particular transaction or group of transactions depending upon the extent of market risk AIGTG expects to reduce. AIGTG's senior management has established positions and stop-loss limits for each line of business. AIGTG's traders are required to maintain positions within these limits. These positions are monitored during the day either manually and/or through on-line computer systems. In addition, these positions are reviewed by AIGTG's management. Reports which present each trading books position and the prior day's profit and loss are reviewed by traders, head traders and AIGTG's senior management. Based upon these and other reports, AIGTG's senior management may determine to adjust AIGTG's risk profile. AIGTG attempts to secure reliable current market prices, such as published prices or third party quotes, to value its derivatives. Where such prices are not available, AIGTG uses an internal methodology which includes interpolation or extrapolation from verifiable prices nearest to the dates 24 26 of the transactions. The methodology may reflect interest and exchange rates, commodity prices, volatility rates and other relevant factors. A significant portion of AIGTG's business is transacted in liquid markets. Certain of AIGTG's derivative product exposures are evaluated using simulation techniques which consider such factors as changes in currency and commodity prices, interest rates, volatility levels and the effect of time. Though not indicative of the future, past volatile market scenarios have represented profit opportunities for AIGTG. AIGFP and AIGTG are both exposed to the risk of loss of fair value. Sensitivity analysis is the statistical technique utilized to measure this exposure. Such analysis is performed and presented separately for AIGFP and AIGTG as AIG manages these operations separately. AIGFP and AIGTG used the sensitivity analysis model to measure the potential loss in fair value of market risk sensitive instruments of each of their respective portfolios. This potential loss in fair value results from selected hypothetical changes in interest and foreign currency exchange rates, equity prices and/or other market rates or prices over time. The portfolios for which this analysis was performed included market risk sensitive transactions entered into by AIGFP and AIGTG. This includes over the counter and exchange traded investments, derivative transactions, borrowings and hedged securities and commodities. As the market risk with respect to securities available for sale, at market is substantially hedged, segregation of market sensitive instruments into trading and other than hedging was not done. In each of these models, the market risks of AIGFP and AIGTG have been classified as changes in the level of interest rates, foreign currency exchange rates, equity prices or commodity prices and the respective volatility of each. For each risk, four sensitivities were calculated under four scenarios with respect to the fair values of the portfolios at September 30, 1998. The four scenarios consisted of uniformly increasing or decreasing the relevant market rates or prices by 10 percent; and uniformly increasing or decreasing the relevant market volatility by 10 percent. For a given risk, the sensitivity presented herein was the largest potential loss in fair value assuming trade settlement under the most adverse of the four scenarios that could result in one day. Not all market risk exposures that are managed by AIGFP and AIGTG are quantified by this analysis. In almost all currencies, changes in the slope and shape of the yield curve or changes in the relative value between certain types of financial instruments or between the same type of instruments in different currencies could affect the results of this analysis. Additionally, the following quantitative information does not take into account anticipated management reaction to breaches of counterparty credit limitations caused by the shocks within a given risk category. The actual results could differ from the results of this analysis because market movements could be different from the scenarios that were considered or because the composition of the portfolio could change substantially with time. AIGFP is also exposed to uncertainty on the amount of dividends paid or the cost of borrowing certain equities. The following table presents the one day exposure to the potential loss in fair value of each component of AIGFP's market risk as of September 30, 1998 under the most adverse scenario as mentioned above: (in millions) - ------------------------------------------------------
MARKET RISK - ------------------------------------------------------ Interest rate $ 25.1 Currency 25.1 Equity 12.8 - ------------------------------------------------------
The following table presents the one day exposure to potential loss in fair value of each component of AIGTG's market risk as of September 30, 1998 under the most adverse scenario as discussed above: (in millions) - ------------------------------------------------------
MARKET RISK - ------------------------------------------------------ Interest rate $5.7 Currency 5.2 Commodity 0 - ------------------------------------------------------
DERIVATIVES Derivatives are financial arrangements among two or more parties whose returns are linked to or "derived" from some underlying equity, debt, commodity or other asset, liability, or index. Derivatives payments may be based on interest rates and exchange rates and/or prices of certain securities, 25 27 certain commodities, or financial or commodity indices. The more significant types of derivative arrangements in which AIG transacts are swaps, forwards, futures, options and related instruments. The most commonly used swaps are interest rate and currency swaps. An interest rate swap is a contract between two parties to exchange interest rate payments (typically a fixed interest rate versus a variable interest rate) calculated on a notional principal amount for a specified period of time. The notional amount is not exchanged. A currency swap is similar but the notional amounts are different currencies which are typically exchanged at the commencement and termination of the swap based upon negotiated exchange rates. A futures or forward contract is a legal contract between two parties to purchase or sell at a specified future date a specified quantity of a commodity, security, currency, financial index or other instrument, at a specified price. A futures contract is traded on an exchange, while a forward contract is executed over the counter. Over the counter derivatives are not transacted in an exchange traded environment. The futures exchanges maintain considerable financial requirements and surveillance to ensure the integrity of exchange traded futures and options. An option contract generally provides the option purchaser with the right but not the obligation to buy or sell during a period of time or at a specified date the underlying instrument at a set price. The option writer is obligated to sell or buy the underlying item if the option purchaser chooses to exercise his right. The option writer receives a nonrefundable fee or premium paid by the option purchaser. Derivatives are generally either negotiated over the counter contracts or standardized contracts executed on an exchange. Standardized exchange traded derivatives include futures and options which can be readily bought or sold over recognized security or commodity exchanges and settled daily through such clearing houses. Negotiated over the counter derivatives include forwards, swaps and options. Over the counter derivatives are generally not traded like exchange traded securities. However, in the normal course of business, with the agreement of the original counterparty, these contracts may be terminated early or assigned to another counterparty. All significant derivatives activities are conducted through AIGFP and AIGTG permitting AIG to participate in the derivatives dealer market acting primarily as principal. In these derivative operations, AIG structures agreements which generally allow its counterparties to enter into transactions with respect to changes in interest and exchange rates, securities' prices and certain commodities and financial or commodity indices. Generally, derivatives are used by AIG's customers such as corporations, financial institutions, multinational organizations, sovereign entities, government agencies and municipalities. For example, a futures, forward or option contract can be used to protect the customers' assets or liabilities against price fluctuations. A counterparty may default on any obligation to AIG, including a derivative contract. Credit risk is a consequence of extending credit and/or carrying trading and investment positions. Credit risk exists for a derivative contract when that contract has an estimated positive fair value. To help manage this risk, the credit departments of AIGFP and AIGTG operate within the guidelines of the AIG Credit Risk Committee, which sets credit policy and limits for counterparties and provides limits for derivative transactions with counterparties having different credit ratings. In addition to credit ratings, this committee takes into account other factors, including the industry and country of the counterparty. Transactions which fall outside these pre-established guidelines require the approval of the AIG Credit Risk Committee. It is also AIG's policy to establish reserves for potential credit impairment when necessary. AIGFP and AIGTG determine the credit quality of each of their counterparties taking into account credit ratings assigned by recognized statistical rating organizations. If it is determined that a counterparty requires credit enhancement, then one or more enhancement techniques will be used. Examples of such enhancement techniques include letters of credit, guarantees, collateral credit triggers and credit derivatives and margin agreements. A significant majority of AIGFP's transactions are contracted and documented under ISDA Master Agreements that provide for legally enforceable set-off and close out netting of exposures in the event of default. Under such agreements, in connection with the early termination of a transaction, AIGFP is permitted to set-off its receivables from a 26 28 counterparty against AIGFP's payables to that same counterparty arising out of all included transactions. Excluding regulated exchange transactions, AIGTG, whenever possible, enters into netting agreements with its counterparties which are similar in effect to those discussed above. The following tables provide the notional and contractual amounts of AIGFP's and AIGTG's derivatives transactions at September 30, 1998 and December 31, 1997. The notional amounts used to express the extent of AIGFP's and AIGTG's involvement in swap transactions represent a standard of measurement of the volume of AIGFP's and AIGTG's swaps business. Notional amount is not a quantification of market risk or credit risk and it may not necessarily be recorded on the balance sheet. Notional amounts represent those amounts used to calculate contractual cash flows to be exchanged and are not paid or received, except for certain contracts such as currency swaps. The timing and the amount of cash flows relating to AIGFP's and AIGTG's foreign exchange forwards and exchange traded futures and options contracts are determined by each of the respective contractual agreements. The net replacement value most closely represents the net credit risk to AIGFP or the maximum amount exposed to potential loss after the application of the aforementioned strategies, ISDA Master Agreements and collateral held. The following table presents AIGFP's derivatives portfolio by maturity and type of derivative at September 30, 1998 and December 31, 1997: (in thousands) - --------------------------------------------------------------------------------
REMAINING LIFE ---------------------------------------------------------------------------------------- ONE TWO THROUGH SIX THROUGH AFTER TEN TOTAL TOTAL YEAR FIVE YEARS TEN YEARS YEARS 1998 1997 - ----------------------------------------------------------------------------------------------------------------------- Interest rate, currency and equity/commodity swaps and swaptions: Notional amount: Interest rate swaps $ 77,684,000 $97,938,000 $46,869,000 $ 7,240,000 $229,731,000 $200,491,000 Currency swaps 22,239,000 21,569,000 15,088,000 3,494,000 62,390,000 54,748,000 Swaptions and equity swaps 7,644,000 5,755,000 5,629,000 1,245,000 20,273,000 11,217,000 - ----------------------------------------------------------------------------------------------------------------------- Total $107,567,000 $125,262,000 $67,586,000 $11,979,000 $312,394,000 $266,456,000 - ----------------------------------------------------------------------------------------------------------------------- Futures and forward contracts: Exchange traded futures contracts contractual amount $ 4,882,000 -- -- -- $ 4,882,000 $ 4,411,000 Over the counter forward contracts contractual amount $ 38,579,000 $ 85,000 -- -- $ 38,664,000 $ 13,271,000 - -----------------------------------------------------------------------------------------------------------------------
AIGFP determines counterparty credit quality by reference to ratings from independent rating agencies or internal analysis. At September 30, 1998 and December 31, 1997, the counterparty credit quality by derivative product with respect to the net replacement value of AIGFP's derivatives portfolio was as follows: (in thousands) - --------------------------------------------------------------------------------
NET REPLACEMENT VALUE ------------------------------- SWAPS AND FUTURES AND TOTAL TOTAL SWAPTIONS FORWARD CONTRACTS 1998 1997 - ---------------------------------------------------------------------------------------------------------------------- Counterparty credit quality: AAA $2,334,687 $ 4,076 $2,338,763 $2,326,502 AA 3,614,631 12,323 3,626,954 2,311,104 A 1,619,231 6,200 1,625,431 1,165,410 BBB 1,045,586 169 1,045,755 608,495 Below investment grade 258,663 -- 258,663 289,563 - ---------------------------------------------------------------------------------------------------------------------- Total $8,872,798 $22,768 $8,895,566 $6,701,074 - ----------------------------------------------------------------------------------------------------------------------
27 29 At September 30, 1998 and December 31, 1997, the counterparty breakdown by industry with respect to the net replacement value of AIGFP's derivatives portfolio was as follows: (in thousands) - --------------------------------------------------------------------------------
NET REPLACEMENT VALUE ------------------------------- SWAPS AND FUTURES AND TOTAL TOTAL SWAPTIONS FORWARD CONTRACTS 1998 1997 - ---------------------------------------------------------------------------------------------------------------------- Non-U.S. banks $2,912,369 $16,725 $2,929,094 $2,263,305 Insured municipalities 946,438 -- 946,438 757,514 U.S. industrials 1,046,843 4,449 1,051,292 514,041 Governmental 666,539 -- 666,539 677,230 Non-U.S. financial service companies 233,865 -- 233,865 64,787 Non-U.S. industrials 1,200,108 -- 1,200,108 1,034,792 Special purpose 176,996 -- 176,996 163,109 U.S. banks 634,332 -- 634,332 584,915 U.S. financial service companies 862,490 1,594 864,084 433,710 Supranationals 192,818 -- 192,818 207,671 - ---------------------------------------------------------------------------------------------------------------------- Total $8,872,798 $22,768 $8,895,566 $6,701,074 - ----------------------------------------------------------------------------------------------------------------------
The following tables provide the contractual and notional amounts of AIGTG's derivatives portfolio at September 30, 1998 and December 31, 1997. In addition, the estimated positive fair values associated with the derivatives portfolio are also provided and include a maturity profile for the September 30, 1998 balances based upon the expected timing of the future cash flows. The gross replacement values presented represent the sum of the estimated positive fair values of all of AIGTG's derivatives contracts at September 30, 1998 and December 31, 1997. These values do not represent the credit risk to AIGTG. Net replacement values presented represent the net sum of estimated positive fair values after the application of legally enforceable master closeout netting agreements and collateral held. The net replacement values most closely represent the net credit risk to AIGTG or the maximum amount exposed to potential loss. 28 30 The following tables present AIGTG's derivatives portfolio and the associated credit exposure, if applicable, by maturity and type of derivative at September 30, 1998 and December 31, 1997: (in thousands) - --------------------------------------------------------------------------------
REMAINING LIFE ----------------------------------------------------- ONE TWO THROUGH SIX THROUGH AFTER TEN TOTAL TOTAL YEAR FIVE YEARS TEN YEARS YEARS 1998 1997 - ---------------------------------------------------------------------------------------------------------------------- Contractual amount of futures, forwards and options: Exchange traded futures and options $ 18,529,188 $1,230,515 $ 77,545 $ -- $ 19,837,248 $ 24,579,298 - ---------------------------------------------------------------------------------------------------------------------- Forwards $312,099,359 $17,939,515 $1,629,184 $ -- $331,668,058 $267,959,285 - ---------------------------------------------------------------------------------------------------------------------- Over the counter purchased options $ 53,438,716 $18,646,124 $5,325,340 $1,240,695 $ 78,650,875 $ 60,273,754 - ---------------------------------------------------------------------------------------------------------------------- Over the counter sold options(a) $ 53,266,013 $14,748,012 $5,033,565 $1,162,137 $ 74,209,727 $ 58,189,846 - ---------------------------------------------------------------------------------------------------------------------- Notional amount: Interest rate swaps and forward rate agreements $ 95,161,410 $23,614,760 $5,705,350 $ 668,133 $125,149,653 $ 77,502,650 Currency swaps 1,203,155 4,872,841 1,259,989 -- 7,335,985 6,489,333 Swaptions 172,838 1,528,401 1,130,980 1,358,815 4,191,034 1,633,988 - ---------------------------------------------------------------------------------------------------------------------- Total $ 96,537,403 $30,016,002 $8,096,319 $2,026,948 $136,676,672 $ 85,625,971 - ---------------------------------------------------------------------------------------------------------------------- Credit exposure: Futures, forwards, swaptions and purchased options contracts and interest rate and currency swaps: Gross replacement value $ 7,654,891 $1,727,021 $ 625,607 $ 127,559 $ 10,135,078 $ 11,019,717 Master netting arrangements (4,799,011) (738,235) (329,803) (71,340) (5,938,389) (5,798,311) Collateral (365,130) (37,020) (19,882) (8,143) (430,175) (224,678) - ---------------------------------------------------------------------------------------------------------------------- Net replacement value(b) $ 2,490,750 $ 951,766 $ 275,922 $ 48,076 $ 3,766,514 $ 4,996,728 - ----------------------------------------------------------------------------------------------------------------------
(a) Sold options obligate AIGTG to buy or sell the underlying item if the option purchaser chooses to exercise. The amounts do not represent credit exposure. (b) The net replacement values with respect to exchange traded futures and options, forward contracts, swaptions and purchased over the counter options are presented as a component of trading assets in the accompanying balance sheet. The net replacement values with respect to interest rate and currency swaps are presented as a component of unrealized gain on interest rate and currency swaps, options and forward transactions in the accompanying balance sheet. 29 31 AIGTG determines counterparty credit quality by reference to ratings from independent rating agencies or internal analysis. At September 30, 1998 and December 31, 1997, the counterparty credit quality and counterparty breakdown by industry with respect to the net replacement value of AIGTG's derivatives portfolio was as follows: (in thousands) - --------------------------------------------------------------------------------
NET REPLACEMENT VALUE ---------------------------- 1998 1997 - -------------------------------------------------------------------------------------------- Counterparty credit quality: AAA $ 486,330 $ 752,741 AA 1,735,492 2,503,289 A 918,312 1,023,650 BBB 341,714 342,695 Below investment grade 71,873 98,425 Not externally rated, including exchange traded futures and options* 212,793 275,928 - -------------------------------------------------------------------------------------------- Total $3,766,514 $4,996,728 - -------------------------------------------------------------------------------------------- Counterparty breakdown by industry: Non-U.S. banks $1,370,884 $2,685,998 U.S. industrials 238,733 163,484 Governmental 166,693 135,269 Non-U.S. financial service companies 492,012 260,412 Non-U.S. industrials 125,339 167,835 U.S. banks 467,307 560,388 U.S. financial service companies 692,753 747,414 Exchanges* 212,793 275,928 - -------------------------------------------------------------------------------------------- Total $3,766,514 $4,996,728 - --------------------------------------------------------------------------------------------
* Exchange traded futures and options are not deemed to have significant credit exposure as the exchanges guarantee that every contract will be properly settled on a daily basis. Generally, AIG manages and operates its businesses in the currencies of the local operating environment. Thus, exchange gains or losses occur when AIG's foreign currency net investment is affected by changes in the foreign exchange rates relative to the U.S. dollar from one reporting period to the next. As an end user, AIG and its subsidiaries, including its insurance subsidiaries, use derivatives to aid in managing AIG's foreign exchange translation exposure. Derivatives may also be used to minimize certain exposures with respect to AIG's debt financing and insurance operations; to date, such activities have not been significant. AIG, through its Foreign Exchange Operating Committee, evaluates each of its worldwide consolidated foreign currency net asset or liability positions and manages AIG's translation exposure to adverse movement in currency exchange rates. AIG may use forward exchange contracts and purchase options where the cost of such is reasonable and markets are liquid to reduce these exchange translation exposures. The exchange gain or loss with respect to these hedging instruments is recorded on an accrual basis as a component of the cumulative translation adjustment account in capital funds. Legal risk arises from the uncertainty of the enforceability, through legal or judicial processes, of the obligations of AIG's clients and counterparties, including contractual provisions intended to reduce credit exposure by providing for the netting of mutual obligations. (See also the discussion on master netting agreements above.) AIG seeks to eliminate or minimize such uncertainty through continuous consultation with internal and external legal advisors, both domestically and abroad, in order to understand the nature of legal risk, to improve documentation and to strengthen transaction structure. ACCOUNTING STANDARDS In February 1997, FASB issued Statement of Financial Accounting Standards No. 128 "Earnings per Share" (FASB 128). This statement simplifies the existing computational guidelines, revises the disclosure requirements and increases earnings per share comparability on an international basis. AIG adopted all requirements of FASB 128 at December 31, 1997 and all prior period information has been restated. In June 1997, FASB issued Statement of Financial Accounting Standards No. 130 "Reporting Comprehensive Income" (FASB 130) and State- 30 32 ment of Financial Accounting Standards No. 131 "Disclosure about Segments of an Enterprise and Related Information" (FASB 131). FASB 130 establishes standards for reporting comprehensive income and its components in a full set of general purpose financial statements. FASB 130 is effective for AIG as of January 1, 1998 and has been adopted herein. FASB 130 had no impact on AIG's results of operations, financial condition or liquidity. FASB 131 establishes standards for the way AIG is required to disclose certain information about its operating segments in its annual financial statements and certain selected information in its interim financial statements. FASB 131 establishes, where practicable, standards with respect to geographic areas, among other things. Certain descriptive information is also required. FASB 131 is effective for the year ended December 31, 1998. In February 1998, FASB issued Statement of Financial Accounting Standards No. 132 "Employers' Disclosures about Pensions and Other Postretirement Benefits" (FASB 132). This statement requires AIG to revise its disclosures about pension and other postretirement benefit plans and does not change the measurement or recognition of these plans. Also, FASB 132 requires additional information on changes in the benefit obligations and fair values of plan assets. FASB 132 is effective for the year ended December 31, 1998. In June 1998, FASB issued Statement of Financial Accounting Standards No. 133 "Accounting for Derivative Instruments and Hedging Activities" (FASB 133). This statement requires AIG to recognize all derivatives in the consolidated balance sheet measuring these derivatives at fair value. The recognition of the change in the fair value of a derivative depends on a number of factors, including the intended use of the derivative. Currently, AIGTG and AIGFP present, in all material respects, the changes in fair value of their derivative transactions as a component of AIG's operating income. AIG is evaluating the impact of FASB 133 with respect to derivative transactions entered into by other AIG operations. AIG believes that the impact of FASB 133 on its results of operations, financial condition or liquidity will not be significant. FASB 133 is effective for the year commencing January 1, 2000. RECENT DEVELOPMENTS The Year 2000 issue arises from computer programs being written using two digits rather than four digits to define the applicable year. This could result in a failure of the information technology systems (IT systems) and other equipment containing imbedded technology (non-IT systems) in the year 2000, causing disruption of operations of AIG, its lessees, vendors, or business partners. AIG has developed a plan to address the Year 2000 issue as it affects AIG's internal IT and non-IT systems, and to assess Year 2000 issues relating to third parties with whom AIG has critical relationships. The plan for addressing internal systems includes an assessment of internal IT and non-IT systems and equipment affected by the Year 2000 issue; definition of strategies to address affected systems and equipment; remediation of identified affected systems and equipment; and internal certification that each internal system is Year 2000 compliant. AIG has remediated, tested and returned to production substantially all of its internal IT systems. AIG continues to remediate and test internal non-IT systems and expects to complete remediation by mid-1999. AIG has also initiated formal communications with respect to the Year 2000 issue to those third parties which have significant interaction with AIG. Currently, AIG is unable to ascertain whether all such third parties will successfully address the Year 2000 issue, particularly those third parties outside the United States where it is believed that remediation efforts relating to the Year 2000 issue may be less advanced. While AIG expects to have no interruption of operations as a result of internal IT and non-IT systems, significant uncertainties remain about the effect on AIG of third parties who are not Year 2000 compliant. AIG will continue to monitor third party Year 2000 issue readiness to determine whether additional or alternative measures may be necessary. Such measures may include the selection of alternate third parties or other actions designed to mitigate the effects of a third party's lack of preparedness. There can be no assurance that unresolved Year 2000 issues of third parties will not have a material adverse impact on AIG's results of operations, financial condition or liquidity. AIG is considering the effects of Year 2000 related failures on its business and, as the most reasonably likely 31 33 worst case scenarios become more clearly identified, AIG will develop appropriate contingency plans. The costs associated with addressing the Year 2000 issue, including developing and implementing the above stated plans and remediating affected systems and equipment, has approximated $80 million and has been expensed as incurred. On January 1, 1999, certain of the member nations of the European Economic and Monetary Union (EMU) will adopt a common currency, the Euro. Once the national currencies are phased out, the Euro will be the sole legal tender of each of these nations. During the transition period, commerce of these nations will be transacted in the Euro or in the currently existing national currency. AIG has identified the significant issues and will be prepared with respect to the phase in of and ultimate redenomination to the Euro. Any costs associated with the adoption of the Euro are expensed as incurred and are not material to AIG's results of operations, financial condition or liquidity. Any statements contained in this section that are not historical facts, or that might be considered an opinion or projection, whether expressed or implied, is meant as, and should be considered, a forward-looking statement as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on assumptions and opinions concerning a variety of known and unknown risks, including those risks related to the Year 2000 issue. If any assumptions or opinions prove incorrect, any forward-looking statements made on that basis may also prove materially incorrect. On August 20, 1998, AIG and SunAmerica Inc. (SunAmerica) announced that they have entered into a definitive agreement whereby AIG will acquire 100 percent of the outstanding common stock of SunAmerica. The merger transaction has been approved by the Board of Directors of both companies, and is subject to various regulatory approvals and other customary conditions, as well as the approval of AIG and SunAmerica shareholders at special meetings scheduled to be held November 18, 1998. 32 34 PART II -- OTHER INFORMATION ITEM 6 -- EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits See accompanying Exhibit Index. (b) Reports on Form 8-K. During the three months ended September 30, 1998, there were three current reports filed on Form 8-K: (1) Current Report on Form 8-K, August 20, 1998: Press Release dated August 20, 1998 announcing that SunAmerica Inc. will merge into AIG (2) Current Report on Form 8-K, August 24, 1998 to report the definitive Agreement and Plan of Merger between SunAmerica Inc. and American International Group, Inc., dated as of August 19, 1998 (3) Current Report on Form 8-K, October 22, 1998: Press Release dated October 22, 1998 reporting the earnings of AIG for the quarter and the nine months ended September 30, 1998 33 35 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. AMERICAN INTERNATIONAL GROUP, INC. -------------------------------------- (Registrant) /s/ HOWARD I. SMITH -------------------------------------- Howard I. Smith Executive Vice President, Chief Financial Officer and Comptroller Dated: November 13, 1998 34 36 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION LOCATION - ------- ----------- -------- 2 Plan of acquisition, reorganization, arrangement, liquidation or succession (a) Agreement and Plan of Merger between SunAmerica Inc. and American International Group, Inc., dated as of August 19, 1998............................................... Filed as an Exhibit to AIG's Current Report on Form 8-K, August 24, 1998 (File No. 1-8787) 4 Instruments defining the rights of security holders, including indentures........................................ Not required to be filed. 10 Material contracts.......................................... None 11 Statement re computation of per share earnings.............. Filed herewith. 12 Statement re computation of ratios.......................... Filed herewith. 15 Letter re unaudited interim financial information........... None 18 Letter re change in accounting principles................... None 19 Report furnished to security holders........................ None 22 Published report regarding matters submitted to vote of security holders............................................ None 23 Consents of experts and counsel............................. None 24 Power of attorney........................................... None 27 Financial Data Schedule..................................... Provided herewith. 99 Additional exhibits......................................... None
35

1 EXHIBIT 11 AMERICAN INTERNATIONAL GROUP, INC. COMPUTATION OF EARNINGS PER SHARE (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
NINE MONTHS THREE MONTHS ENDED SEPTEMBER 30, ENDED SEPTEMBER 30, ------------------------ ------------------------ 1998(a) 1997 1998 1997 ---------- ---------- ---------- ---------- SHARE INFORMATION REFLECTS AN ADJUSTMENT FOR A COMMON STOCK SPLIT IN THE FORM OF A 50 PERCENT COMMON STOCK DIVIDEND PAID JULY 31, 1998. Numerator: Net income (applicable to common stock)... $2,759,613 $2,447,748 $ 931,070 $ 840,318 ========== ========== ========== ========== Denominator: Average outstanding shares used in the computation of per share earnings: Common Stock............................ 1,138,675 1,138,687 1,138,664 1,138,684 Common stock in treasury................ (88,997) (84,827) (88,672) (86,606) ---------- ---------- ---------- ---------- Average outstanding shares -- basic....... 1,049,678 1,053,860 1,049,992 1,052,078 ---------- ---------- ---------- ---------- Stock options (treasury stock method)..... 4,957 4,761 5,037 4,749 Stock purchase plan....................... 69 61 83 69 ---------- ---------- ---------- ---------- Average outstanding shares -- diluted..... 1,054,704 1,058,682 1,055,112 1,056,896 ---------- ---------- ---------- ---------- Net income per share: Basic................................... $ 2.63 $ 2.32 $ 0.89 $ 0.80 ---------- ---------- ---------- ---------- Diluted................................. $ 2.62 $ 2.31 $ 0.89 $ 0.79 ---------- ---------- ---------- ----------
- --------------- (a) The number of common shares outstanding as of September 30, 1998 was 1,049,959,401. The number of common shares that would have been outstanding as of September 30, 1998 assuming the exercise or issuance of all potentially dilutive common shares is 1,054,754,786.

1 EXHIBIT 12 AMERICAN INTERNATIONAL GROUP, INC. COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES (IN THOUSANDS, EXCEPT RATIOS)
NINE MONTHS THREE MONTHS ENDED SEPTEMBER 30, ENDED SEPTEMBER 30, ------------------------ ------------------------ 1998 1997 1998 1997 ---------- ---------- ---------- ---------- Income before income taxes and minority interest................................ $4,038,010 $3,476,738 $1,414,529 $1,189,825 Less -- Equity income of less than 50% owned persons........................... 83,193 89,193 10,132 23,046 Add -- Dividend from less than 50% owned persons................................. 19,225 20,247 1,937 3,682 ---------- ---------- ---------- ---------- 3,974,042 3,407,792 1,406,334 1,170,461 Add -- Fixed charges........................... 1,476,387 1,340,101 468,542 446,820 Less -- Capitalized interest.................... 47,062 35,586 15,175 11,808 ---------- ---------- ---------- ---------- Income before income taxes, minority interest and fixed charges.............. $5,403,367 $4,712,307 $1,859,701 $1,605,473 ========== ========== ========== ========== Fixed charges: Interest costs.......................... $1,410,336 $1,284,448 $ 446,525 $ 428,269 Rent expense*........................... 66,051 55,653 22,017 18,551 ---------- ---------- ---------- ---------- Total fixed charges............. $1,476,387 $1,340,101 $ 468,542 $ 446,820 ========== ========== ========== ========== Ratio of earnings to fixed charges........ 3.66 3.52 3.97 3.59
- --------------- * The proportion deemed representative of the interest factor. The ratio shown is significantly affected as a result of the inclusion of the fixed charges and operating results of AIG Financial Products Corp. and its subsidiaries (AIGFP). AIGFP structures borrowings through guaranteed investment agreements and engages in other complex financial transactions, including interest rate and currency swaps. In the course of its business, AIGFP enters into borrowings that are primarily used to purchase assets that yield rates greater than the rates on the borrowings with the intent of earning a profit on the spread and to finance the acquisition of securities utilized to hedge certain transactions. The pro forma ratios of earnings to fixed charges, which exclude the effects of the operating results of AIGFP, are 5.95 and 5.56 for the third quarter and 5.86 and 5.46 for the first nine months of 1998 and 1997, respectively. As AIGFP will continue to be a subsidiary, AIG expects that these ratios will continue to be lower than they would be if the fixed charges and operating results of AIGFP were not included therein.

7 1,000 US DOLLARS 9-MOS DEC-31-1998 JAN-01-1998 SEP-30-1998 1 44,477,805 13,021,715 14,048,353 4,507,391 3,260,127 1,392,917 134,048,862 209,959 17,117,550 6,914,113 183,922,821 63,763,533 9,909,524 0 14,270,893 20,951,643 0 0 2,846,646 22,984,080 183,922,821 17,708,784 3,922,378 129,208 (109,476) 14,333,082 1,459,159 2,517,835 4,038,010 1,177,429 2,759,613 0 0 0 2,759,613 2.63 2.62 21,171,500 7,841,500 0 2,550,800 4,813,000 24,545,100 0 EARNINGS PER SHARE INFORMATION REFLECTS A COMMON STOCK SPLIT IN THE FORM OF A 50 PERCENT COMMON STOCK DIVIDEND PAID JULY 31, 1998. PRIOR PERIOD FINANCIAL DATA SCHEDULES HAVE NOT BEEN RESTATED FOR THIS STOCK SPLIT.