e10vk
 

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-K
     
(Mark One)
   
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 
    For the fiscal year ended December 31, 2005
 
or
 
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
 
    For the transition period from                 to
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 or organization)
  (I.R.S. Employer
Identification No.)
70 Pine Street, New York, New York
(Address of principal executive offices)
  10270
(Zip Code)
Registrant’s telephone number, including area code (212) 770-7000
 
Securities registered pursuant to Section 12(b) of the Act:
     
    Name of each exchange
Title of each class   on which registered
     
Common Stock, Par Value $2.50 Per Share
  New York Stock Exchange, Inc.
Securities registered pursuant to Section 12(g) of the Act:
     
Title of each class    
     
None
   
 
    Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes o         No þ
    Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes o         No þ
    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 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 þ         No o
    Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o
    Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
    Large Accelerated Filer þ         Accelerated Filer o         Non-Accelerated Filer o
    Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o                  No þ
    The aggregate market value of the voting and nonvoting common equity held by nonaffiliates of the registrant computed by reference to the price at which the common equity was last sold as of June 30, 2005 (the last business day of the registrant’s most recently completed second fiscal quarter), was approximately $127,330,500,000.
    As of January 31, 2006, there were outstanding 2,596,987,248 shares of Common Stock, $2.50 par value per share, of the registrant.
Documents Incorporated by Reference:
    The registrant’s definitive proxy statement filed or to be filed with the Securities and Exchange Commission pursuant to Regulation 14A involving the election of Directors at the Annual Meeting of Shareholders of the registrant scheduled to be held on May 17, 2006 is incorporated by reference in Part III of this Form 10-K.
 
 
AIG  -  Form 10-K
1


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
Table of Contents
 
               
Index   Page
 
PART I
 
Item 1.
  Business     3  
 
Item 1A.
  Risk Factors     14  
 
Item 1B.
  Unresolved Staff Comments     17  
 
Item 2.
  Properties     17  
 
Item 3.
  Legal Proceedings     17  
 
Item 4.
  Submission of Matters to a Vote of Security Holders     21  
PART II
 
Item 5.
  Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities     23  
 
Item 6.
  Selected Financial Data     24  
 
Item 7.
  Management’s Discussion and Analysis of Financial Condition and Results of Operations     25  
 
Item 7A.
  Quantitative and Qualitative Disclosures About Market Risk     69  
 
Item 8.
  Financial Statements and Supplementary Data     69  
 
Item 9.
  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure     140  
 
Item 9A.
  Controls and Procedures     140  
 
Item 9B.
  Other Information     143  
PART III
 
Item 10.
  Directors and Executive Officers of the Registrant     144  
 
Item 11.
  Executive Compensation     144  
 
Item 12.
  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters     144  
 
Item 13.
  Certain Relationships and Related Transactions     144  
 
Item 14.
  Principal Accountant Fees and Services     145  
PART IV
 
Item 15.
  Exhibits and Financial Statement Schedules     144  
SIGNATURES
        145  
 
2
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
Part I
 
ITEM 1.
Business
American International Group, Inc. (AIG), a Delaware corporation, is a holding company which, through its subsidiaries, is engaged in a broad range of insurance and insurance-related activities in the United States and abroad. AIG’s primary activities include both General Insurance and Life Insurance & Retirement Services operations. Other significant activities include Financial Services and Asset Management. The principal General Insurance company subsidiaries are American Home Assurance Company (American Home), National Union Fire Insurance Company of Pittsburgh, Pa. (National Union), New Hampshire Insurance Company (New Hampshire), Lexington Insurance Company (Lexington), The Hartford Steam Boiler Inspection and Insurance Company (HSB), Transatlantic Reinsurance Company, American International Underwriters Overseas, Ltd. (AIUO) and United Guaranty Residential Insurance Company. Significant Life Insurance & Retirement Services operations include those conducted through American Life Insurance Company (ALICO), American International Reinsurance Company, Ltd. (AIRCO), American International Assurance Company, Limited together with American International Assurance Company (Bermuda) Limited (AIA), Nan Shan Life Insurance Company, Ltd. (Nan Shan), The Philippine American Life and General Insurance Company (Philamlife), AIG Star Life Insurance Co., Ltd. (AIG Star Life), AIG Edison Life Insurance Company (AIG Edison Life), AIG Annuity Insurance Company (AIG Annuity), the AIG American General Life Companies (AIG American General), American General Life and Accident Insurance Company (AGLA), The United States Life Insurance Company in the City of New York (USLIFE), The Variable Annuity Life Insurance Company (VALIC), SunAmerica Life Insurance Company (SunAmerica Life) and AIG SunAmerica Life Assurance Company. AIG’s Financial Services operations are conducted primarily through International Lease Finance Corporation (ILFC), AIG Financial Products Corp. and AIG Trading Group Inc. (AIGTG) and their respective subsidiaries (collectively referred to as AIGFP), and American General Finance, Inc. and its subsidiaries (AGF). AIG’s Asset Management operations include AIG SunAmerica Asset Management Corp. (SAAMCo) and AIG Global Asset Management Holdings Corp. (formerly known as AIG Global Investment Group, Inc.) and its subsidiaries and affiliated companies (AIG Global Investment Group). For information on AIG’s business segments, see Note 2 of Notes to Consolidated Financial Statements.
    At December 31, 2005, AIG and its subsidiaries had approximately 97,000 employees.
    AIG’s Internet address for its corporate website is www.aigcorporate.com. AIG makes available free of charge, through the Investor Information section of AIG’s corporate website, Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the Exchange Act) as soon as reasonably practicable after such materials are electronically filed with, or furnished to, the Securities and Exchange Commission (SEC). AIG also makes available on its corporate website copies of its charters for its Audit, Nominating and Corporate Governance and Compensation Committees, as well as its Corporate Governance Guidelines (which includes Director Independence Standards) and Director, Executive Officer and Senior Financial Officer Code of Business Conduct and Ethics.
    Throughout this Annual Report on Form 10-K, AIG presents its operations in the way it believes will be most meaningful, as well as most transparent. Certain of the measurements used by AIG management are “non-GAAP financial measures” under SEC rules and regulations. Statutory underwriting profit (loss) and combined ratios are determined in accordance with accounting principles prescribed by insurance regulatory authorities. For an explanation of why AIG management considers these “non-GAAP measures” useful to investors, see Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The Restatements
    AIG has completed two restatements of its financial statements (the Restatements). In connection with the first restatement (the First Restatement), AIG restated its consolidated financial statements and financial statement schedules for the years ended December 31, 2003, 2002, 2001 and 2000, the quarters ended March 31, June 30 and September 30, 2004 and 2003 and the quarter ended December 31, 2003. In the second restatement (the Second Restatement), AIG restated its consolidated financial statements and financial statement schedules for the years ended December 31, 2004, 2003 and 2002, along with 2001 and 2000 for purposes of preparation of the Consolidated Financial Data for 2001 and 2000, the quarterly financial information for 2004 and 2003 and the first three quarters of 2005. AIG, however, did not amend its quarterly report on Form 10-Q for the quarter ended September 30, 2005 because the adjustments to the financial statements included therein were not material to those financial statements. All financial information included in this Annual Report on Form 10-K reflects the Restatements.
AIG  -  Form 10-K
3


 

 
The following table shows the general development of the business of AIG on a consolidated basis, the contributions made to AIG’s consolidated revenues and operating income and the assets held, in the periods indicated, by its General Insurance, Life Insurance & Retirement Services, Financial Services and Asset Management operations and other realized capital gains (losses). For additional information, see Selected Financial Data, Management’s Discussion and Analysis of Financial Condition and Results of Operations and Notes 1 and 2 of Notes to Consolidated Financial Statements.
                                           
 
Years Ended December 31,
(in millions)   2005   2004   2003   2002   2001
 
General Insurance operations:
                                       
 
Gross premiums written
  $ 52,725     $ 52,046     $ 46,938     $ 36,678     $ 28,341  
 
Net premiums written
    41,872       40,623       35,031       26,718       19,793  
 
Net premiums earned
    40,809       38,537       31,306       23,595       18,661  
 
Underwriting profit (loss)(a)
    (2,050 )     (247 )     1,975       (1,082 )(c)     (777 )(d)
 
Net investment income
    4,031       3,196       2,566       2,350       2,551  
 
Realized capital gains (losses)
    334       228       (39 )     (345 )     (189 )
 
Operating income
    2,315       3,177       4,502       923 (c)     1,585 (d)
 
Identifiable assets
    150,667       131,658       117,511       105,891       88,250  
 
 
Loss ratio
    81.1       78.8       73.1       83.1       79.3  
 
Expense ratio
    23.6       21.5       19.6       21.8       24.3  
 
 
Combined ratio(b)
    104.7       100.3       92.7       104.9 (c)     103.6 (d)
 
Life Insurance & Retirement Services operations:
                                       
 
GAAP premiums
    29,400       28,088       23,496       20,694       19,600  
 
Net investment income
    18,134       15,269       12,942       11,243       10,451  
 
Realized capital gains (losses)(e)
    (218 )     43       240       (372 )     (400 )
 
Operating income
    8,844       7,923       6,807       5,181       4,633 (f)
 
Identifiable assets
    480,622       447,841       372,126       289,914       256,767  
 
Insurance in-force at end of year(g)
    1,852,833       1,858,094       1,583,031       1,298,592       1,228,501  
Financial Services operations:
                                       
 
Interest, lease and finance charges (h)
    10,525       7,495       6,242       6,822       6,321  
 
Operating income(g)
    4,276       2,180       1,182       2,125       1,769  
 
Identifiable assets
    166,488       165,995       141,667       128,104       107,719  
Asset Management operations:
                                       
 
Advisory and management fees and net investment income from GICs
    5,325       4,714       3,651       3,467       3,565  
 
Operating income
    2,253       2,125       1,316       1,125       1,019  
 
Identifiable assets
    81,080       80,075       64,047       53,732       42,961  
Other realized capital gains (losses)
    225       (227 )     (643 )     (936 )     (321 )
Revenues(i)
    108,905       97,666       79,421       66,171       59,958  
Total operating income(j)
    15,213       14,845       11,907       7,808       5,917  
Total assets
    853,370       801,145       675,602       561,598       490,614  
 
(a) Underwriting profit (loss), a Generally Accepted Accounting Principles (GAAP) measure, is statutory underwriting profit (loss) adjusted primarily for changes in the deferral of policy acquisition costs. This adjustment is necessary to present the financial statements in accordance with GAAP.
 
(b) Calculated on a statutory basis, includes catastrophe losses of $2.63 billion, $1.05 billion, $83 million, $61 million and $867 million (including World Trade Center and related losses (WTC losses) of $769 million) in 2005, 2004, 2003, 2002 and 2001, respectively.
 
(c) In the fourth quarter of 2002, after completion of its annual review of General Insurance loss and loss adjustment expense reserves, AIG increased its net loss reserves relating to accident years 1997 through 2001 by $2.1 billion.
(d) Includes $867 million of catastrophe losses.
(e) Includes the effect of hedging activities that do not qualify for hedge accounting treatment under FAS 133 and the application of FAS 52. For 2005, 2004, 2003, 2002, and 2001, respectively, the amounts included are $(437) million, $(140) million, $78 million, $(91) million and $(219) million.
(f) Includes $100 million in WTC losses.
(g) 2005 includes the effect of the non-renewal of a single large group life case of $36 billion. Also, the foreign in-force is translated to U.S. dollars at the appropriate balance sheet exchange rate in each period.
 
(h) Includes the effect of hedging activities that do not qualify for hedge accounting treatment under FAS 133, including the related foreign exchange gains and losses. For 2005, 2004, 2003, 2002 and 2001, respectively, the amounts included in interest, lease and finance charges are $2.01 billion, $(122) million, $(1.01) billion, $220 million and $56 million, and the amounts included in Financial Services operating income are $1.98 billion, $(149) million, $(964) million, $240 million and $75 million.
 
(i) Represents the sum of General Insurance net premiums earned, Life Insurance & Retirement Services GAAP premiums, net investment income, Financial Services interest, lease and finance charges, Asset Management advisory and management fees and net investment income from Guaranteed Investment Contracts (GICs), and realized capital gains (losses).
 
(j) Represents income before income taxes, minority interest and cumulative effect of accounting changes. Includes segment operating income and other realized capital gains (losses) presented above, as well as AIG Parent and other operations of $(2.70) billion, $(333) million, $(1.26) billion, $(610) million and $(751) million in 2005, 2004, 2003, 2002 and 2001, respectively, and acquisition, restructuring and related charges of $(2.02) billion in 2001.
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AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
General Insurance Operations
AIG’s General Insurance subsidiaries are multiple line companies writing substantially all lines of property and casualty insurance both domestically and abroad. Domestic General Insurance operations are comprised of the Domestic Brokerage Group (DBG), which includes the operations of HSB; Transatlantic Holdings, Inc. (Transatlantic); Personal Lines, including 21st Century Insurance Group (21st Century); and United Guaranty Corporation (UGC).
    AIG’s primary domestic division is DBG. DBG’s business in the United States and Canada is conducted through its General Insurance subsidiaries including American Home, National Union, Lexington and certain other General Insurance company subsidiaries of AIG.
    DBG writes substantially all classes of business insurance, accepting such business mainly from insurance brokers. This provides DBG the opportunity to select specialized markets and retain underwriting control. Any licensed broker is able to submit business to DBG without the traditional agent-company contractual relationship, but such broker usually has no authority to commit DBG to accept a risk.
    In addition to writing substantially all classes of business insurance, including large commercial or industrial property insurance, excess liability, inland marine, environmental, workers compensation and excess and umbrella coverages, DBG offers many specialized forms of insurance such as aviation, accident and health, equipment breakdown, directors and officers liability (D&O), difference-in-conditions, kidnap-ransom, export credit and political risk, and various types of professional errors and omissions coverages. The AIG Risk Management operation provides insurance and risk management programs for large corporate customers. The AIG Risk Finance operation is a leading provider of customized structured insurance products. Also included in DBG are the operations of AIG Environmental, which focuses specifically on providing specialty products to clients with environmental exposures. Lexington writes surplus lines, those risks for which conventional insurance companies do not readily provide insurance coverage, either because of complexity or because the coverage does not lend itself to conventional contracts.
    Certain of the products of the DBG companies include funding components or have been structured in a manner such that little or no insurance risk is actually transferred. Funds received in connection with these products are recorded as deposits, included in other liabilities, rather than premiums and incurred losses.
    The AIG Worldsource Division introduces and coordinates AIG’s products and services to U.S.-based multinational clients and foreign corporations doing business in the U.S.
    Transatlantic subsidiaries offer reinsurance capacity on both a treaty and facultative basis both in the U.S. and abroad. Transatlantic structures programs for a full range of property and casualty products with an emphasis on specialty risk.
    AIG’s Personal Lines operations provide automobile insurance through AIG Direct, the mass marketing operation of AIG, Agency Auto Division and 21st Century, as well as a broad range of coverages for high net-worth individuals through the AIG Private Client Group.
    The main business of the UGC subsidiaries is the issuance of residential mortgage guaranty insurance on conventional first lien mortgages for the purchase or refinance of 1-4 family residences. This type of insurance protects lenders in both domestic and international markets against loss if borrowers default. Other UGC subsidiaries write second lien and private student loan guaranty insurance. The second lien coverage protects lenders against loss from default on home equity and closed-end second mortgages used to finance home improvements, repairs or other expenses not directly related to the purchase of a borrower’s home. Private student loan guaranty insurance protects lenders against loss if the student, or in many cases the student’s parent, defaults on their education loan. UGC had approximately $23 billion of guaranty risk in force at December 31, 2005.
    AIG’s Foreign General Insurance group accepts risks primarily underwritten through American International Underwriters (AIU), a marketing unit consisting of wholly owned agencies and insurance companies. The Foreign General Insurance group also includes business written by AIG’s foreign-based insurance subsidiaries. The Foreign General group uses various marketing methods and multiple distribution channels to write both commercial and consumer lines insurance with certain refinements for local laws, customs and needs. AIU operates in Asia, the Pacific Rim, the United Kingdom, Europe, Africa, the Middle East and Latin America. See also Note 2 of Notes to Consolidated Financial Statements.
    During 2005, DBG and the Foreign General Insurance group accounted for 55 percent and 24 percent, respectively, of AIG’s General Insurance net premiums written.
    AIG’s General Insurance company subsidiaries worldwide operate primarily by underwriting and accepting risks for their direct account and securing reinsurance on that portion of the risk in excess of the limit which they wish to retain. This operating policy differs from that of many insurance companies that will underwrite only up to their net retention limit, thereby requiring the broker or agent to secure commitments from other underwriters for the remainder of the gross risk amount.
    Certain of DBG’s commercial insurance is reinsured on a quota share basis by AIRCO. Various AIG profit centers, including AIU, AIG Reinsurance Advisors, Inc. and AIG Risk Finance, use AIRCO as a reinsurer for certain of their businesses, and AIRCO also receives premiums from offshore fronting arrangements for clients of AIG subsidiaries. In accordance with permitted accounting practices in Bermuda, AIRCO discounts reserves attributable to certain classes of business assumed from other AIG subsidiaries. See Management’s Discussion and Analysis of Financial Condition and Results of Operations – “Operating Review – Reserve for Losses and Loss Expenses.”
AIG  -  Form 10-K
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    The utilization of reinsurance is closely monitored by senior management and AIG’s Credit Risk Committee. AIG believes that no exposure to a single reinsurer represents an inappropriate concentration of risk to AIG, nor is AIG’s business substantially dependent upon any reinsurance contract. See also Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 5 of Notes to Consolidated Financial Statements.
    AIG is diversified both in terms of classes of business and geographic locations. In General Insurance, approximately 15 percent of net premiums written for the year ended December 31, 2005 represented workers compensation business. During 2005, of the direct General Insurance premiums written (gross premiums less return premiums and cancellations, excluding reinsurance assumed and before deducting reinsurance ceded), 11 percent and 7 percent were written in California and New York, respectively. No other state accounted for more than five percent of such premiums.
    The majority of AIG’s General Insurance business is in the casualty classes, which tend to involve longer periods of time for the reporting and settling of claims. This may increase the risk and uncertainty with respect to AIG’s loss reserve development. See also the Discussion and Analysis of Consolidated Net Losses and Loss Expense Reserve Development in this Item 1. Business and Management’s Discussion and Analysis of Financial Condition and Results of Operations.
    A significant portion of AIG’s General Insurance operating revenue is derived from AIG’s insurance investment operations. For a table summarizing the investment results of General Insurance see “Insurance Investments Operations” below. See also Management’s Discussion and Analysis of Financial Conditions and Results of Operations and Notes 1, 2 and 8 of Notes to Consolidated Financial Statements.
Discussion and Analysis of Consolidated Net Losses and Loss Expense Reserve Development
The reserve for net losses and loss expenses represents the accumulation of estimates for reported losses (case basis reserves) and provisions for losses incurred but not reported (IBNR), both reduced by applicable reinsurance recoverable and the discount for future investment income. Losses and loss expenses are charged to income as incurred.
    Loss reserves established with respect to foreign business are set and monitored in terms of the respective local or functional currency. Therefore, no assumption is included for changes in currency rates. See also Note 1(bb) of Notes to Consolidated Financial Statements.
    Management reviews the adequacy of established loss reserves through the utilization of a number of analytical reserve development techniques. Through the use of these techniques, management is able to monitor the adequacy of AIG’s established reserves and determine appropriate assumptions for inflation. Also, analysis of emerging specific development patterns, such as case reserve redundancies or deficiencies and IBNR emergence, allows management to determine any required adjustments. See also Management’s Discussion and Analysis of Financial Condition and Results of Operations.
    The “Analysis of Consolidated Net Losses and Loss Expense Reserve Development” table presents the development of net losses and loss expense reserves for calendar years 1995 through 2005. Immediately following this table is a second table that presents all data on a basis that excludes asbestos and environmental net losses and loss expense reserve development. The opening reserves held are shown at the top of the table for each year end date. The amount of loss reserve discount included in the opening reserve at each date is shown immediately below the reserves held for each year. The undiscounted reserve at each date is thus the sum of the discount and the reserve held. The upper half of the table shows the cumulative amounts paid during successive years related to the undiscounted opening loss reserves. For example, in the table that excludes asbestos and environmental losses, with respect to the net losses and loss expense reserve of $24.55 billion as of December 31, 1998, by the end of 2005 (seven years later) $24.75 billion had actually been paid in settlement of these net loss reserves. In addition, as reflected in the lower section of the table, the original reserve of $25.45 billion was reestimated to be $30.64 billion at December 31, 2005. This increase from the original estimate would generally result from a combination of a number of factors, including reserves being settled for larger amounts than originally estimated. The original estimates will also be increased or decreased as more information becomes known about the individual claims and overall claim frequency and severity patterns. The redundancy (deficiency) depicted in the table, for any particular calendar year, shows the aggregate change in estimates over the period of years subsequent to the calendar year reflected at the top of the respective column heading. For example, the deficiency of $3.75 billion at December 31, 2005 related to December 31, 2004 net losses and loss expense reserves of $47.30 billion represents the cumulative amount by which reserves for 2004 and prior years have developed deficiently during 2005. The deficiency that has emerged in the last year can be attributed primarily to the excess casualty, excess workers compensation, and D&O and related management liability classes of business. These classes in total produced approximately $4 billion of adverse development in 2005, primarily related to claims from accident years 2002 and prior. For most other classes, accident years 2002 and prior generally produced adverse development in 2005, whereas accident year 2004 generally produced favorable development. In total, the favorable development for all classes of business for accident year 2004 was approximately $3.85 billion. The accident year emergence can be seen by comparing the respective development in 2005 for each column’s loss reserve in the table that follows. Loss development patterns utilized to test the reserves generally rely on the actual historical loss development patterns of prior accident years for each class of business. See also Management’s Discussion and Analysis of Financial Condition and Results of Operations for further discussion of loss development in 2005.
6
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
    The bottom of each table below shows the remaining undiscounted and discounted net loss reserve for each year. For example, in the table that excludes asbestos and environmental losses, for the 2000 year-end, the remaining undiscounted reserves held as of December 31, 2005 are $10.01 billion, with a corresponding discounted net reserve of $9.32 billion.
    The reserves for net losses and loss expenses with respect to Transatlantic and 21st Century are included only in consolidated net losses and loss expenses commencing with the year ended December 31, 1998, the year they were first consolidated in AIG’s financial statements. Reserve development for these operations is included only for 1998 and subsequent periods. Thus, the presentation for 1997 and prior year ends is not fully comparable to that for 1998 and subsequent years in the tables below.
AIG  -  Form 10-K
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Analysis of Consolidated Losses and Loss Expense Reserve Development
The following table presents for each calendar year the losses and loss expense reserves and the development thereof including those with respect to asbestos and environmental claims. See also Management’s Discussion and Analysis of Financial Condition and Results of Operations.
                                                                                           
 
(in millions)   1995   1996   1997   1998   1999   2000   2001   2002   2003   2004   2005
 
Net Reserves Held
  $ 19,755     $ 20,496     $ 20,901     $ 25,418     $ 25,636     $ 25,684     $ 26,005     $ 29,347     $ 36,228     $ 47,254     $ 57,476  
Discount (in Reserves Held)
    217       393       619       897       1,075       1,287       1,423       1,499       1,516       1,553       2,110  
Net Reserves Held (Undiscounted)
    19,972       20,889       21,520       26,315       26,711       26,971       27,428       30,846       37,744       48,807       59,586  
Paid (Cumulative) as of:
                                                                                       
 
One year later
    5,416       5,712       5,607       7,205       8,266       9,709       11,007       10,775       12,163       14,910          
 
Two years later
    8,982       9,244       9,754       12,382       14,640       17,149       18,091       18,589       21,773                  
 
Three years later
    11,363       11,943       12,939       16,599       19,901       21,930       23,881       25,513                          
 
Four years later
    13,108       14,152       15,484       20,263       23,074       26,090       28,717                                  
 
Five years later
    14,667       16,077       17,637       22,303       25,829       29,473                                          
 
Six years later
    16,120       17,551       18,806       24,114       28,165                                                  
 
Seven years later
    17,212       18,415       19,919       25,770                                                          
 
Eight years later
    17,792       19,200       21,089                                                                  
 
Nine years later
    18,379       20,105                                                                          
 
Ten years later
    19,155                                                                                  
 
                                                                                           
 
(in millions)   1995   1996   1997   1998   1999   2000   2001   2002   2003   2004   2005
 
Net Reserves Held (undiscounted)
  $ 19,972     $ 20,889     $ 21,520     $ 26,315     $ 26,711     $ 26,971     $ 27,428     $ 30,846     $ 37,744     $ 48,807     $ 59,586  
Undiscounted Liability as of:
                                                                                       
 
One year later
    19,782       20,795       21,563       25,897       26,358       26,979       31,112       32,913       40,931       53,486          
 
Two years later
    19,866       20,877       21,500       25,638       27,023       30,696       33,363       37,583       49,463                  
 
Three years later
    19,865       20,994       21,264       26,169       29,994       32,732       37,964       46,179                          
 
Four years later
    20,143       20,776       21,485       28,021       31,192       36,210       45,203                                  
 
Five years later
    19,991       20,917       22,405       28,607       33,910       41,699                                          
 
Six years later
    19,950       21,469       22,720       30,632       38,087                                                  
 
Seven years later
    20,335       21,671       24,209       33,861                                                          
 
Eight years later
    20,558       22,986       26,747                                                                  
 
Nine years later
    21,736       25,264                                                                          
 
Ten years later
    23,878                                                                                  
Net Redundancy/(Deficiency)
    (3,906 )     (4,375 )     (5,227 )     (7,546 )     (11,376 )     (14,728 )     (17,775 )     (15,333 )     (11,719 )     (4,679 )        
Remaining Reserves (Undiscounted)
    4,724       5,158       5,658       8,091       9,922       12,226       16,486       20,666       27,690       38,576          
Remaining Discount
    252       299       358       459       568       690       846       999       1,212       1,568          
Remaining Reserves
    4,472       4,859       5,300       7,632       9,354       11,536       15,640       19,667       26,478       37,008          
 
The table below shows the gross liability (before discount), reinsurance recoverable and net liability recorded at each year-end and the reestimation of these amounts as of December 31, 2005.
                                                                                         
 
(in millions)   1995   1996   1997   1998   1999   2000   2001   2002   2003   2004   2005
 
Gross Liability, End of Year
  $ 32,298     $ 32,605     $ 32,049     $ 36,973     $ 37,278     $ 39,222     $ 42,629     $ 48,173     $ 53,387     $ 63,431     $ 79,279  
Reinsurance Recoverable,
End of Year
    12,326       11,716       10,529       10,658       10,567       12,251       15,201       17,327       15,643       14,624       19,693  
Net Liability, End of Year
    19,972       20,889       21,520       26,315       26,711       26,971       27,428       30,846       37,744       48,807       59,586  
Reestimated Gross Liability
    40,012       40,817       42,937       51,847       56,864       61,991       65,704       66,398       66,967       69,327          
Reestimated Reinsurance Recoverable
    16,134       15,553       16,190       17,986       18,777       20,292       20,501       20,219       17,504       15,841          
Reestimated Net Liability
    23,878       25,264       26,747       33,861       38,087       41,699       45,203       46,179       49,463       53,486          
Cumulative Gross Redundancy/(Deficiency)
    (7,713 )     (8,212 )     (10,888 )     (14,874 )     (19,586 )     (22,769 )     (23,075 )     (18,225 )     (13,580 )     (5,896 )        
 
8
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
Analysis of Consolidated Losses and Loss Expense Reserve Development Excluding Asbestos and Environmental Losses and Loss Expense Reserve Development
The following table presents for each calendar year the losses and loss expense reserves and the development thereof excluding those with respect to asbestos and environmental claims. See also Management’s Discussion and Analysis of Financial Condition and Results of Operations.
                                                                                           
 
(in millions)   1995   1996   1997   1998   1999   2000   2001   2002   2003   2004   2005
 
Net Reserves Held
  $ 19,247     $ 19,753     $ 20,113     $ 24,554     $ 24,745     $ 24,829     $ 25,286     $ 28,650     $ 35,559     $ 45,742     $ 55,227  
Discount (in Reserves Held)
    217       393       619       897       1,075       1,287       1,423       1,499       1,516       1,553       2,110  
Net Reserves Held (Undiscounted)
    19,464       20,146       20,732       25,451       25,820       26,116       26,709       30,149       37,075       47,295       57,336  
Paid (Cumulative) as of:
                                                                                       
 
One year later
    5,309       5,603       5,467       7,084       8,195       9,515       10,861       10,632       11,999       14,718          
 
Two years later
    8,771       8,996       9,500       12,190       14,376       16,808       17,801       18,283       21,419                  
 
Three years later
    11,013       11,582       12,618       16,214       19,490       21,447       23,430       25,021                          
 
Four years later
    12,645       13,724       14,972       19,732       22,521       25,445       28,080                                  
 
Five years later
    14,139       15,460       16,983       21,630       25,116       28,643                                          
 
Six years later
    15,404       16,792       18,014       23,282       27,266                                                  
 
Seven years later
    16,355       17,519       18,972       24,753                                                          
 
Eight years later
    16,798       18,149       19,960                                                                  
 
Nine years later
    17,230       18,873                                                                          
 
Ten years later
    17,826                                                                                  
 
                                                                                           
 
(in millions)   1995   1996   1997   1998   1999   2000   2001   2002   2003   2004   2005
 
Net Reserves Held (undiscounted)
  $ 19,464     $ 20,146     $ 20,732     $ 25,451     $ 25,820     $ 26,116     $ 26,709     $ 30,149     $ 37,075     $ 47,295     $ 57,336  
Undiscounted Liability as of:
                                                                                       
 
One year later
    18,937       19,904       20,576       24,890       25,437       26,071       30,274       32,129       39,261       51,048          
 
Two years later
    18,883       19,788       20,385       24,602       26,053       29,670       32,438       35,803       46,865                  
 
Three years later
    18,680       19,777       20,120       25,084       28,902       31,619       36,043       43,467                          
 
Four years later
    18,830       19,530       20,301       26,813       30,014       34,102       42,348                                  
 
Five years later
    18,651       19,633       21,104       27,314       31,738       38,655                                          
 
Six years later
    18,574       20,070       21,336       28,345       34,978                                                  
 
Seven years later
    18,844       20,188       21,836       30,636                                                          
 
Eight years later
    18,984       20,515       23,441                                                                  
 
Nine years later
    19,173       21,858                                                                          
 
Ten years later
    20,379                                                                                  
Net Redundancy/(Deficiency)
    (915 )     (1,712 )     (2,709 )     (5,185 )     (9,158 )     (12,539 )     (15,639 )     (13,318 )     (9,790 )     (3,753 )        
Remaining Reserves (undiscounted)
    2,553       2,985       3,482       5,883       7,712       10,012       14,269       18,446       25,447       36,330          
Remaining Discount
    252       299       358       459       568       690       846       999       1,212       1,568          
Remaining Reserves
    2,301       2,686       3,124       5,424       7,144       9,322       13,423       17,447       24,235       34,762          
 
The table below shows the gross liability (before discount), reinsurance recoverable and net liability recorded at each year-end and the reestimation of these amounts as of December 31, 2005.
                                                                                         
 
(in millions)   1995   1996   1997   1998   1999   2000   2001   2002   2003   2004   2005
 
Gross Liability, End of Year
  $ 30,356     $ 30,302     $ 29,740     $ 34,474     $ 34,666     $ 36,777     $ 40,400     $ 46,036     $ 51,363     $ 59,897     $ 73,912  
Reinsurance Recoverable,
End of Year
    10,892       10,156       9,008       9,023       8,846       10,661       13,691       15,887       14,288       12,602       16,576  
Net Liability, End of Year
    19,464       20,146       20,732       25,451       25,820       26,116       26,709       30,149       37,075       47,295       57,336  
Reestimated Gross Liability
    30,452       31,660       34,226       43,461       48,886       54,534       58,776       59,813       60,788       63,544          
Reestimated Reinsurance Recoverable
    10,073       9,802       10,785       12,825       13,908       15,879       16,428       16,346       13,923       12,496          
Reestimated Net Liability
    20,379       21,858       23,441       30,636       34,978       38,655       42,348       43,467       46,865       51,048          
Cumulative Gross Redundancy/(Deficiency)
    (96 )     (1,358 )     (4,486 )     (8,987 )     (14,220 )     (17,757 )     (18,376 )     (13,777 )     (9,425 )     (3,647 )        
 
AIG  -  Form 10-K
9


 

 
Reconciliation of Net Reserves for Losses and Loss Expenses
 
                           
(in millions)   2005   2004   2003
 
Net reserve for losses and loss
expenses at beginning of year
  $ 47,254     $ 36,228     $ 29,347  
Foreign exchange effect
    (628 )     524       580  
Acquisition
                391 (a)
 
Losses and loss expenses incurred:
                       
 
Current year
    28,426       26,793       20,509  
 
Prior years(b)
    4,665       3,564       2,363  
 
      33,091       30,357       22,872  
 
Losses and loss expenses paid:
                       
 
Current year
    7,331       7,692       6,187  
 
Prior years
    14,910       12,163       10,775  
 
      22,241       19,855       16,962  
 
Net reserve for losses and loss
expenses at end of year(c)
  $ 57,476     $ 47,254     $ 36,228  
 
(a) Reflects the opening balances with respect to the GE U.S.-based auto and home insurance business acquired in 2003.
 
(b) Includes accretion of discount of $(15) million in 2005, including an increase of $375 million in the discount recorded in 2005; $377 million in 2004 and $296 million in 2003. Additionally, includes $269 million in 2005, $317 million in 2004 and $323 million in 2003 for the general reinsurance operations of Transatlantic, and $197 million of additional losses incurred in 2005 resulting from increased labor and material costs related to the 2004 Florida hurricanes.
 
(c) See also Note 6(a) of Notes to Consolidated Financial Statements.
    The reserve for losses and loss expenses as reported in AIG’s Consolidated Balance Sheet at December 31, 2005 differs from the total reserve reported in the Annual Statements filed with state insurance departments and, where appropriate, with foreign regulatory authorities. The differences at December 31, 2005 relate primarily to reserves for certain foreign operations not required to be reported in the United States for statutory reporting purposes.
    The reserve for gross losses and loss expenses is prior to reinsurance and represents the accumulation for reported losses and IBNR. Management reviews the adequacy of established gross loss reserves in the manner previously described for net loss reserves.
    For further discussion regarding net reserves for losses and loss expenses, see Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Life Insurance & Retirement Services Operations
AIG’s Life Insurance & Retirement Services subsidiaries offer a wide range of insurance and retirement savings products both domestically and abroad. Insurance-oriented products consist of individual and group life, payout annuities, endowment and accident and health policies. Retirement savings products consist generally of fixed and variable annuities. See also Management’s Discussion and Analysis of Financial Condition and Results of Operations.
    Life Insurance & Retirement Services operations in foreign countries comprised 78 percent of Life Insurance & Retirement Services GAAP premiums and 59 percent of Life Insurance & Retirement Services operating income in 2005. AIG operates overseas principally through ALICO, AIA, Nan Shan, Philamlife, AIG Star Life, and AIG Edison Life. ALICO is incorporated in Delaware and all of its business is written outside of the United States. ALICO has operations either directly or through subsidiaries in Europe, Latin America, the Caribbean, the Middle East, South Asia and the Far East, with Japan being the largest territory. AIG added significantly to its presence in Japan with the acquisition of GE Edison Life Insurance Company (now AIG Edison Life), which was consolidated beginning with the fourth quarter of 2003. AIA operates primarily in China (including Hong Kong), Singapore, Malaysia, Thailand, Korea, Australia, New Zealand, Vietnam, and India. The operations in India are conducted through a joint venture, Tata AIG Life Insurance Company Limited. Nan Shan operates in Taiwan. Philamlife is the largest life insurer in the Philippines. AIG Star Life operates in Japan. See also Note 2 of Notes to Consolidated Financial Statements.
    AIRCO acts primarily as an internal reinsurance company for AIG’s foreign life operations. This facilitates insurance risk management (retention, volatility, concentrations) and capital planning locally (branch and subsidiary). It also allows AIG to pool its insurance risks and purchase reinsurance more efficiently at a consolidated level, manage global counterparty risk and relationships and manage global life catastrophe risks.
    AIG’s principal domestic Life Insurance & Retirement Services operations include AGLA, AIG American General, AIG Annuity, USLIFE, VALIC and SunAmerica Life. These companies utilize multiple distribution channels including independent producers, brokerage, career agents and banks to offer life insurance, annuity and accident and health products and services, as well as financial and other investment products. The domestic Life Insurance & Retirement Services operations comprised 22 percent of total Life Insurance & Retirement Services GAAP premiums and 41 percent of Life Insurance & Retirement Services operating income in 2005.
    There was no significant adverse effect on AIG’s Life Insurance & Retirement Services results of operations from
10
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
economic conditions in any one state, country or geographic region for the year ended December 31, 2005. See also Management’s Discussion and Analysis of Financial Condition and Results of Operations.
    Life insurance products such as whole life and endowment continue to be significant in the overseas companies, especially in Southeast Asia, while a mixture of life insurance, accident and health and retirement services products are sold in Japan.
    In addition to the above, AIG also has subsidiary operations in Canada, Egypt, Mexico, Poland, Switzerland and Puerto Rico, and conducts life insurance business through a joint venture in Brazil and through an AIUO subsidiary company in Russia, and in certain countries in Central and South America.
    The Foreign Life Insurance & Retirement Services companies have over 270,000 full and part-time agents, as well as independent producers, and sell their products largely to indigenous persons in local and foreign currencies. In addition to the agency outlets, these companies also distribute their products through direct marketing channels, such as mass marketing, and through brokers and other distribution outlets, such as financial institutions.
Insurance Investment Operations
A significant portion of AIG’s General Insurance and Life Insurance & Retirement Services operating revenues are derived from AIG’s insurance investment operations. See also Management’s Discussion and Analysis of Financial Condition and Results of Operations and Notes 1, 2 and 8 of Notes to Consolidated Financial Statements.
The following table summarizes the investment results of the General Insurance operations. See also Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 8 of Notes to Consolidated Financial Statements.
 
                                         
    Annual Average Cash and Invested Assets         
             
    Cash            
    (including       Return on   Return on
Years Ended December 31,   short-term   Invested       Average Cash   Average
(in millions)   investments)   Assets(a)   Total   and Assets(b)   Assets(c)
 
2005
  $ 2,450     $ 86,211     $ 88,661       4.5 %     4.7 %
2004
    2,012       73,338       75,350       4.2       4.4  
2003
    1,818       59,855       61,673       4.2       4.3  
2002
    1,537       47,477       49,014       4.8       5.0  
2001
    1,338       41,481       42,819       6.0       6.2  
 
(a) Including investment income due and accrued, and real estate.
 
(b) Net investment income divided by the annual average sum of cash and invested assets.
 
(c) Net investment income divided by the annual average invested assets.
The following table summarizes the investment results of the Life Insurance & Retirement Services operations. See also Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 8 of Notes to Consolidated Financial Statements.
 
                                         
    Annual Average Cash and Invested Assets        
             
    Cash            
    (including       Return on   Return on
Years Ended December 31,   short-term   Invested       Average Cash   Average
(in millions)   investments)   Assets(a)   Total   and Assets(b)   Assets(c)
 
2005
  $ 6,180     $ 352,250     $ 358,430       5.1 %     5.1 %
2004
    5,089       307,659       312,748       4.9       5.0  
2003
    4,680       247,608       252,288       5.1       5.2  
2002
    3,919       199,750       203,669       5.5       5.6  
2001
    3,615       162,708       166,323       6.3       6.4  
 
(a) Including investment income due and accrued, and real estate.
 
(b) Net investment income divided by the annual average sum of cash and invested assets.
 
(c) Net investment income divided by the annual average invested assets.
    AIG’s worldwide insurance investment policy places primary emphasis on investments in government and other high quality, fixed income securities in all of its portfolios and, to a lesser extent, investments in high yield bonds, common stocks, real estate, hedge funds and partnerships, in order to enhance returns on policyholders’ funds and generate net investment income. The ability to implement this policy is somewhat limited in certain territories as there may be a lack of adequate long-term investments or investment restrictions may be imposed by the local regulatory authorities. See also Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Financial Services Operations
AIG’s Financial Services subsidiaries engage in diversified activities including aircraft and equipment leasing, capital markets transactions, consumer finance and insurance premium financing.
AIG  -  Form 10-K
11


 

 
    AIG’s Aircraft Finance operations represent the operations of ILFC, which 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. See also Note 2 of Notes to Consolidated Financial Statements.
    The Capital Markets operations of AIG are conducted primarily through AIGFP, which engages as principal in standard and customized interest rate, currency, equity, commodity, energy and credit products with top-tier corporations, financial institutions, governments, agencies, institutional investors, and high-net-worth individuals throughout the world. AIGFP also raises funds through municipal reinvestment contracts and other private and public security offerings, investing the proceeds in a diversified portfolio of high grade securities and derivative transactions. See also Note 2 of Notes to Consolidated Financial Statements.
    Consumer Finance operations include AGF as well as AIG Consumer Finance Group, Inc. (AIGCFG). AGF provides a wide variety of consumer finance products, including real estate mortgages, consumer loans, retail sales finance and credit-related insurance to customers in the United States. AIGCFG, through its subsidiaries, is engaged in developing a multi-product consumer finance business with an emphasis on emerging markets. See also Note 2 of Notes to Consolidated Financial Statements.
    Together, the Aircraft Finance, Capital Markets and Consumer Finance operations generate the vast majority of the revenues produced by AIG’s consolidated Financial Services operations.
    Imperial A.I. Credit Companies also contribute to Financial Services income. This operation engages principally in insurance premium financing for both AIG’s customers and those of other insurers. See Note 1 of Notes to Consolidated Financial Statements.
Asset Management Operations
AIG’s Asset Management operations comprise a wide variety of investment-related services and investment products, including institutional and retail asset management, broker dealer services and spread-based investment business from the sale of guaranteed investment contracts, also known as funding agreements (GICs). Such products and services are offered to individuals and institutions both domestically and overseas.
    AIG’s principal Asset Management operations are conducted through certain subsidiaries of AIG Retirement Services, Inc. (AIG SunAmerica), including SAAMCo and the AIG Advisor Group broker dealers and AIG Global Investment Group. AIG SunAmerica sells and manages mutual funds and provides financial advisory services through independent-contractor registered representatives. AIG Global Investment Group manages invested assets on a global basis for third-party institutional, retail, private equity and real estate investment funds, provides securities lending and custodial services and organizes and manages the invested assets of institutional private equity investment funds. Each of these subsidiary operations receives fees for investment products and services provided. See also Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 2 of Notes to Consolidated Financial Statements.
Other Operations
Certain other AIG subsidiaries provide insurance-related services such as adjusting claims and marketing specialized products. Several wholly owned foreign subsidiaries of AIG operating in countries or jurisdictions such as Ireland, Bermuda, Barbados and Gibraltar provide insurance and related administrative and back office services to a variety of insurance and reinsurance companies. These companies include captive insurance companies unaffiliated with AIG, subsidiaries of AIG and the subsidiaries of holding companies in which AIG holds an interest, such as IPC Holdings, Ltd (IPC) and Allied World Assurance Holdings, Ltd. (AWAC). AIG also has several other subsidiaries which engage in various businesses. Mt. Mansfield Company, Inc. owns and operates the ski slopes, lifts, school and an inn located at Stowe, Vermont. Also included in other operations are unallocated corporate expenses, including the settlement costs more fully described in Item 3. Legal Proceedings and Note 12(i) of Notes to Consolidated Financial Statements.
Additional Investments
AIG holds a 24.3 percent interest in IPC, a reinsurance holding company, a 23.4 percent interest in AWAC, a property-casualty insurance holding company, and a 24.5 percent interest in The Fuji Fire and Marine Insurance Co., Ltd., a general insurance company. See also Note 1(s) of Notes to Consolidated Financial Statements.
Locations of Certain Assets
As of December 31, 2005, approximately 34 percent of the consolidated assets of AIG were located in foreign countries (other than Canada), including $4.4 billion of cash and securities on deposit with foreign regulatory authorities. Foreign operations and assets held abroad may be adversely affected by political developments in foreign countries, including such possibilities as tax changes, nationalization, and changes in regulatory policy, as well as by consequence of hostilities and unrest. The risks of such occurrences and their overall effect upon AIG vary from country to country and cannot easily be predicted. If expropriation or nationalization does occur, AIG’s policy is to take all appropriate measures to seek recovery of such assets. Certain of the countries in which AIG’s business is conducted have currency restrictions which generally cause a delay in a company’s ability to repatriate assets and profits. See also Notes 1 and 2 of Notes to Consolidated Financial Statements and “Risk Factors — Foreign Operations” in Item 1A. Risk Factors.
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AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
Regulation
AIG’s operations around the world are subject to regulation by many different types of regulatory authorities, including insurance, securities, investment advisory, banking and thrift regulators in the United States and abroad. The regulatory environment can have a significant effect on AIG and its business. AIG’s operations have become more diverse and consumer-oriented, increasing the scope of regulatory supervision and the possibility of intervention. In addition, the investigations into financial accounting practices that led to the Restatements of AIG’s financial statements have heightened regulatory scrutiny of AIG worldwide.
    Certain states require registration and periodic reporting by insurance companies that are licensed in such states and are controlled by other corporations. Applicable legislation typically requires periodic disclosure concerning the corporation that controls the registered insurer and the other companies in the holding company system and prior approval of intercorporate services and transfers of assets (including in some instances payment of dividends by the insurance subsidiary) within the holding company system. AIG’s subsidiaries are registered under such legislation in those states that have such requirements. See also Note 11 of Notes to Consolidated Financial Statements.
    AIG’s insurance subsidiaries, in common with other insurers, are subject to regulation and supervision by the states and by other jurisdictions in which they do business. Within the United States, the method of such regulation varies but generally has its source in statutes that delegate regulatory and supervisory powers to an insurance official. The regulation and supervision relate primarily to approval of policy forms and rates, the standards of solvency that must be met and maintained, including risk-based capital measurements, the licensing of insurers and their agents, the nature of and limitations on investments, restrictions on the size of risks that may be insured under a single policy, deposits of securities for the benefit of policyholders, requirements for acceptability of reinsurers, periodic examinations of the affairs of insurance companies, the form and content of reports of financial condition required to be filed, and reserves for unearned premiums, losses and other purposes. In general, such regulation is for the protection of policyholders rather than the equity owners of these companies. See also Management’s Discussion and Analysis of Financial Condition and Results of Operations.
    In connection with the Restatements, AIG undertook to examine and evaluate each of the items that have been restated or adjusted in its consolidated GAAP financial statements to determine whether restatement of the previously filed statutory financial statements of its insurance company subsidiaries would be required. AIG completed its 2004 audited statutory financial statements for all of the Domestic General Insurance companies in late 2005. The statutory accounting treatment of the various items requiring adjustment or restatement were reviewed and agreed to with the relevant state insurance regulators in advance of the filings. Adjustments necessary to reflect the cumulative effect on statutory surplus of adjustments relating to years prior to 2004 were made to 2004 opening surplus, and 2004 statutory net income was restated accordingly. Previously reported General Insurance statutory surplus at December 31, 2004 was reduced by approximately $3.5 billion to approximately $20.6 billion.
    AIG also recently completed its 2005 unaudited statutory financial statements for all of the Domestic General Insurance companies, again after reviewing and agreeing with the relevant state insurance regulators the statutory accounting treatment of various items. The state regulators have permitted the Domestic General Insurance companies to record a $724 million reduction to opening statutory surplus as of January 1, 2005, to reflect the effects of the Second Restatement. See also Management’s Discussion and Analysis of Financial Condition and Results of Operations — “Capital Resources — Regulation and Supervision” herein.
    AIG has taken various steps to enhance the capital positions of the Domestic General Insurance companies. AIG entered into capital maintenance agreements with the Domestic General Insurance companies that set forth procedures through which AIG will provide ongoing capital support. Dividends from the Domestic General Insurance companies were suspended in the fourth quarter of 2005. AIG contributed an additional $750 million of capital into American Home effective September 30, 2005, and contributed a further $2.25 billion of capital in February 2006 for a total of approximately $3 billion of capital into Domestic General Insurance subsidiaries effective December 31, 2005. Furthermore, in order to allow the Domestic General Insurance companies to record as an admitted asset at December 31, 2005 certain reinsurance ceded to non-U.S. reinsurers (which has the effect of increasing the statutory surplus of such Domestic General Insurance companies), AIG has obtained, and entered into reimbursement agreements for $1.5 billion of letters of credit issued by several commercial banks in favor of certain Domestic General Insurance companies.
    AIG’s insurance operations are currently under review by various state regulatory agencies. See Item 3. Legal Proceedings for a further description of these investigations and see “Risk Factors – Regulatory Investigations” in Item 1A. Risk Factors for more information on their application to AIG’s insurance businesses.
    Risk-Based Capital (RBC) is designed to measure the adequacy of an insurer’s statutory surplus in relation to the risks inherent in its business. Thus, inadequately capitalized general and life insurance companies may be identified.
    The RBC formula develops a risk adjusted target level of statutory surplus by applying certain factors to various asset, premium and reserve items. Higher factors are applied to more risky items and lower factors are applied to less risky items. Thus, the target level of statutory surplus varies not only as a result of the insurer’s size, but also on the risk profile of the insurer’s operations.
    The RBC Model Law provides for four incremental levels of regulatory attention for insurers whose surplus is below the calculated RBC target. These levels of attention range in severity from requiring the insurer to submit a plan for
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corrective action to placing the insurer under regulatory control.
    The statutory surplus of each of AIG’s domestic general and life insurance subsidiaries exceeded their RBC standards as of December 31, 2005.
    To the extent that any of AIG’s insurance entities would fall below prescribed levels of surplus, it would be AIG’s intention to infuse necessary capital to support that entity.
    A substantial portion of AIG’s General Insurance business and a majority of its Life Insurance business is carried on in foreign countries. The degree of regulation and supervision in foreign jurisdictions varies. Generally, AIG, as well as the underwriting companies operating in such jurisdictions, must satisfy local regulatory requirements. Licenses issued by foreign authorities to AIG subsidiaries are subject to modification or revocation by such authorities, and AIU or other AIG subsidiaries could be prevented from conducting business in certain of the jurisdictions where they currently operate. In the past, AIU has been allowed to modify its operations to conform with new licensing requirements in most jurisdictions.
    In addition to licensing requirements, AIG’s foreign operations are also regulated in various jurisdictions with respect to currency, policy language and terms, amount and type of security deposits, amount and type of reserves, amount and type of local investment and the share of profits to be returned to policyholders on participating policies. Some foreign countries regulate rates on various types of policies. Certain countries have established reinsurance institutions, wholly or partially owned by the state, to which admitted insurers are obligated to cede a portion of their business on terms which may not always allow foreign insurers, including AIG, full compensation. In some countries, regulations governing constitution of technical reserves and remittance balances may hinder remittance of profits and repatriation of assets.
    In 1999, AIG became a unitary thrift holding company when the Office of Thrift Supervision (OTS) granted AIG approval to organize AIG Federal Savings Bank. Annually, the OTS conducts an examination of AIG. The OTS examination involves assessing the organization’s overall risk profile.
Competition
AIG’s Insurance, Financial Services and Asset Management businesses operate in a highly competitive environment, both domestically and overseas. Principal sources of competition are insurance companies, banks, investment banks and other non-bank financial institutions.
    The insurance industry in particular is highly competitive. Within the United States, AIG’s General Insurance subsidiaries compete with approximately 3,100 other stock companies, specialty insurance organizations, mutual companies and other underwriting organizations. AIG’s subsidiaries offering Life Insurance and Retirement Services compete in the United States with approximately 2,000 life insurance companies and other participants in related financial services fields. Overseas, AIG subsidiaries compete for business with foreign insurance operations of the larger U.S. insurers, global insurance groups, and local companies in particular areas in which they are active.
    AIG’s strong ratings have historically provided a competitive advantage. The effect on the business of AIG of recent regulatory investigations, the Restatements, and subsequent ratings actions is currently unknown, but these developments may adversely affect the competitive position of AIG and its subsidiaries. See “Risk Factors — AIG Credit Ratings” in Item 1A. Risk Factors.
ITEM 1A.
Risk Factors
AIG’s Credit Ratings
The downgrades in AIG’s credit ratings will increase AIG’s borrowing costs, may lessen AIG’s ability to compete in certain businesses and will require AIG to post additional collateral.
    From March through June of 2005, the major rating agencies downgraded AIG’s ratings in a series of actions. Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. (S&P), lowered the long-term senior debt and counterparty ratings of AIG from ‘AAA’ to ‘AA’ and changed the rating outlook to negative. Moody’s Investors Service (Moody’s) lowered AIG’s long-term senior debt rating from ‘Aaa’ to ‘Aa2’ and changed the outlook to stable. Fitch Ratings (Fitch) downgraded the long-term senior debt ratings of AIG from ‘AAA’ to ‘AA’ and placed the ratings on Rating Watch Negative.
    The agencies also took rating actions on AIG’s insurance subsidiaries. S&P and Fitch lowered to ‘AA+’ the insurance financial strength ratings of most of AIG’s insurance companies. Moody’s lowered the insurance financial strength ratings generally to either ‘Aa1’ or ‘Aa2’. A.M. Best downgraded the financial strength ratings for most of AIG’s insurance subsidiaries from ‘A++’ to ‘A+’ and the issuer credit ratings from ‘aa+’ to ‘aa-’. Many of these companies’ ratings remain on a negative watch.
    In addition, S&P changed the outlook on ILFC’s ‘AA-’ long-term senior debt rating to negative. Moody’s affirmed ILFC’s long-term and short-term senior debt ratings (‘A1’/‘P-1’). Fitch downgraded ILFC’s long-term senior debt rating from ‘AA-’ to ‘A+’ and placed the rating on Rating Watch Negative and downgraded ILFC’s short-term debt rating from ‘F1+’ to ‘F1’. Fitch also placed the ‘A+’ long-term senior debt ratings of American General Finance Corporation and American General Finance, Inc. on Rating Watch Negative. S&P and Moody’s affirmed the long-term and short-term senior debt ratings of American General Finance Corporation at ‘A+’/‘A-1’ and ‘A1’/‘P-1’, respectively.
    These debt and financial strength ratings are current opinions of the rating agencies. As such, they may be changed, suspended or withdrawn at any time by the rating agencies as a result of changes in, or unavailability of, information or based on other circumstances. Ratings may also be withdrawn at AIG management’s request. This discussion of ratings is not a complete list of ratings of AIG and its subsidiaries.
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AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
    These ratings actions have affected and will continue to affect AIG’s business and results of operations in a number of ways.
-   Downgrades in AIG’s debt ratings will adversely affect AIG’s results of operations. AIG relies on external sources of financing to fund several of its operations. The cost and availability of unsecured financing are generally dependent on the issuer’s long-term and short-term debt ratings. These downgrades and any future downgrades in AIG’s debt ratings may adversely affect AIG’s borrowing costs and therefore adversely affect AIG’s results of operations.
-   The downgrade in AIG’s long-term senior debt ratings will adversely affect AIGFP’s ability to compete for certain businesses. Credit ratings are very important to the ability of financial institutions to compete in the derivative and structured transaction marketplaces. Historically, AIG’s triple-A ratings provided AIGFP a competitive advantage. The downgrades have reduced this advantage and, for specialized financial transactions that generally are conducted only by triple-A rated financial institutions, counterparties may be unwilling to transact business with AIGFP except on a secured basis. This could require AIGFP to post more collateral to counterparties in the future. See below for a further discussion of the effect that posting collateral may have on AIG’s liquidity.
-   Although the financial strength ratings of AIG’s insurance company subsidiaries remain high compared to many of their competitors, the downgrades have reduced the previous ratings differential. The competitive advantage of the ratings to AIG’s insurance company subsidiaries may be lessened accordingly.
-   As a result of the downgrades of AIG’s long-term senior debt ratings, AIG was required to post approximately $1.16 billion of collateral with counterparties to municipal guaranteed investment contracts and financial derivatives transactions. In the event of a further downgrade, AIG will be required to post additional collateral. It is estimated that, as of the close of business on February 28, 2006 based on AIG’s outstanding municipal guaranteed investment agreements and financial derivatives transactions as of such date, a further downgrade of AIG’s long-term senior debt ratings to ‘Aa3’ by Moody’s or ‘AA-’ by S&P would permit counterparties to call for approximately $962 million of additional collateral. Further, additional downgrades could result in requirements for substantial additional collateral, which could have a material effect on how AIG manages its liquidity. The actual amount of additional collateral that AIG would be required to post to counterparties in the event of such downgrades depends on market conditions, the market value of the outstanding affected transactions and other factors prevailing at the time of the downgrade. Any additional obligations to post collateral will increase the demand on AIG’s liquidity.
Regulatory Investigations
Significant legal proceedings have adversely affected AIG’s results of operations for 2005. As a result of the settlements discussed below under Item 3. Legal Proceedings, AIG recorded an after-tax charge of approximately $1.15 billion in the fourth quarter of 2005. AIG is party to numerous other legal proceedings and regulatory investigations. It is possible that the effect of the unresolved matters could be material to AIG’s consolidated results of operations for an individual reporting period. For a discussion of these unresolved matters, see Item 3. Legal Proceedings.
Significant investigations into AIG’s business are continuing and the commencement of additional investigations is possible. Broad-ranging investigations into AIG’s business practices continue. These investigations are being conducted by a number of regulators, and related actions by regulators both within and outside the United States may be undertaken in response. The review of large amounts of information by various regulatory authorities may result in the commencement of new areas of inquiry and, possibly, new significant legal proceedings.
The Relationships Between AIG and Starr and SICO
The relationships between AIG and Starr and SICO may take an extended period of time to unwind and/or resolve, and the consequences of such resolution are uncertain. Although AIG is currently working on unwinding and resolving its relationships with C.V. Starr & Co, Inc. (Starr) and Starr International Company, Inc. (SICO), AIG cannot predict what its future relationship with Starr and SICO will be. AIG subsidiaries are in the process of terminating their agency relationships with the Starr agencies and are beginning to write the business previously produced by those agencies on a direct basis. AIG also continues to address the issues posed by compensation plans and programs previously provided to AIG executives by Starr and SICO, as AIG is providing compensation programs that recognize those plans and programs. In January 2006, Starr announced that it had completed its tender offers to purchase interests in Starr and that all eligible shareholders had tendered their shares. As a result of completion of the tender offers, no AIG executive currently holds any Starr interest. AIG has entered into agreements pursuant to which AIG agrees, subject to certain conditions, to assure AIG’s current employees that all payments are made under a series of two-year Deferred Compensation Profit Participation Plans provided by SICO (SICO Plans). See Note 12(f) and Note 16 of Notes to Consolidated Financial Statements. Nevertheless, there can be no assurance that AIG will be able to effectively address the consequences for its executives of the unwinding of their participation in the Starr and SICO plans and programs. Nor can there be any assurance that AIG will compete successfully for the business previously produced by the Starr agencies.
    Finally, litigation between AIG and Starr and SICO remains pending, and the timing and terms of any resolution cannot currently be predicted. As a result of the foregoing, there can be no assurance that the ultimate resolution of AIG’s relationships with Starr and SICO will not be adverse to AIG. For further information about litigation between AIG and Starr and SICO, see Item 3. Legal Proceedings.
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Certain Material Weaknesses
Management identified three remaining material weaknesses in AIG’s internal control over financial reporting. Remediation of these material weaknesses is ongoing. Until these weaknesses are remediated, the weaknesses could affect the accuracy or timing of future filings with the SEC and other regulatory authorities. A discussion of these material weaknesses and AIG’s remediation efforts can be found in Item 9A of Part II of this Annual Report on Form 10-K.
Access to Capital Markets
AIG’s access to the U.S. public capital markets may be delayed by the SEC registration process. Although AIG is able to access the Rule 144A and Euro markets, AIG will be unable to access the U.S. public securities markets until it has filed and the SEC has declared effective a new registration statement under the Securities Act of 1933. Depending upon the SEC’s review of these filings, this process may take several months or more.
Unless relief is granted by the SEC, AIG will not be able to avail itself of certain favorable provisions of the Securities Act. AIG will not, for a period of three years, be a “well-known seasoned issuer”. During this period, AIG’s ability to communicate with respect to new product offerings and to structure client products will be more limited than they otherwise would. In addition, during this period, AIG will not be able to avail itself of provisions that allow for an automatically effective shelf registration statement or rely on the “forward-looking statements” safe harbor under the securities laws in providing forward-looking information to investors.
Foreign Operations
Foreign operations expose AIG to risks that may affect its operations, liquidity and financial conditions. AIG provides insurance and investment products and services to both businesses and individuals in more than 130 countries and jurisdictions. A substantial portion of AIG’s General Insurance business and a majority of its Life Insurance & Retirement Services businesses are conducted outside the United States. Operations outside of the United States may be affected by regional economic downturns, political upheaval, nationalization and other restrictive government actions, which could also affect other AIG operations.
    The degree of regulation and supervision in foreign jurisdictions varies. Generally, AIG, as well as the underwriting companies operating in such jurisdictions, must satisfy local regulatory requirements. Licenses issued by foreign authorities to AIG subsidiaries are subject to modification and revocation. Thus, AIG’s insurance subsidiaries could be prevented from conducting future business in certain of the jurisdictions where they currently operate. AIG’s international operations include operations in various developing nations. Both current and future foreign operations could be adversely affected by unfavorable political developments including tax changes, regulatory restrictions and nationalization of AIG’s operations without compensation. Adverse affects resulting from any one country may affect AIG’s results of operations, liquidity and financial condition depending on the magnitude of the event and AIG’s net financial exposure at that time in that country.
Liquidity
Payments from subsidiaries may be limited by regulators. AIG depends on dividends, distributions and other payments from AIG’s subsidiaries to fund dividend payments and to fund payments on AIG’s obligations, including debt obligations. Regulatory and other legal restrictions may limit AIG’s ability to transfer funds freely, either to or from AIG’s subsidiaries. In particular, many of AIG’s subsidiaries, including AIG’s insurance subsidiaries, are subject to laws and regulations that authorize regulatory bodies to block or reduce the flow of funds to the parent holding company, or that prohibit such transfer altogether in certain circumstances. These laws and regulations may hinder AIG’s ability to access funds that AIG may need to make payments on AIG’s obligations.
Regulation
AIG is subject to extensive regulation in the jurisdictions in which it conducts its businesses. AIG’s operations around the world are subject to regulation by different types of regulatory authorities, including insurance, securities, investment advisory, banking and thrift regulators in the United States and abroad. AIG’s operations have become more diverse and consumer-oriented, increasing the scope of regulatory supervision and the possibility of intervention. In particular, AIG’s consumer lending business is subject to a broad array of laws and regulations governing lending practices and permissible loan terms, and AIG would expect increased regulatory oversight relating to this business.
    The regulatory environment could have a significant effect on AIG and its businesses. Among other things, AIG could be fined, prohibited from engaging in some of its business activities or subject to limitations or conditions on its business activities. Significant regulatory action against AIG could have material adverse financial effects, cause significant reputational harm, or harm business prospects. New laws or regulations or changes in the enforcement of existing laws or regulations applicable to clients may also adversely affect AIG and its businesses. See Item 1. Business — “Regulation.”
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AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
Casualty Insurance Underwriting and Reserves
Casualty insurance liabilities are difficult to predict and may exceed the related reserves for losses and loss expenses. Although AIG annually reviews the adequacy of the established reserve for losses and loss expenses, there can be no assurance that AIG’s ultimate loss reserves will not develop adversely and materially exceed AIG’s current loss reserves. Estimation of ultimate net losses, loss expenses and loss reserves is a complex process for long-tail casualty lines of business, which include excess and umbrella liability, D&O, professional liability, medical malpractice, workers compensation, general liability, products liability and related classes, as well as for asbestos and environmental exposures. Generally, actual historical loss development factors are used to project future loss development. However, there can be no assurance that future loss development patterns will be the same as in the past. Moreover, any deviation in loss cost trends or in loss development factors might not be discernible for an extended period of time subsequent to the recording of the initial loss reserve estimates for any accident year. Thus, there is the potential for reserves with respect to a number of years to be significantly affected by changes in loss cost trends or loss development factors that were relied upon in setting the reserves. These changes in loss trends or loss development factors could be attributable to changes in inflation in labor and material costs or in the judicial environment, or in other social or economic phenomena affecting claims. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Operating Review — Reserve for Losses and Loss Expenses.”
Natural Disasters and Pandemic Diseases
Natural disasters and pandemic disease could adversely affect AIG’s operating results. Natural disasters such as hurricanes, earthquakes and other catastrophes have the potential to adversely affect AIG’s operating results. Other risks, such as an outbreak of a pandemic disease, such as the Avian Influenza A Virus (H5N1), could adversely affect AIG’s business and operating results to an extent that may be only minimally offset by reinsurance programs.
    While to date outbreaks of the Avian Flu continue to occur among poultry or wild birds in a number of countries in Asia, parts of Europe, and recently in Africa, transmission to humans has been rare. If the virus mutates to a form that can be transmitted from human to human, it has the potential to spread rapidly worldwide. If such an outbreak were to take place, early quarantine and vaccination could be critical to containment.
    Both the contagion and mortality rate of any mutated H5N1 virus that can be transmitted from human to human are highly speculative. AIG continues to monitor the developing facts. A significant global outbreak could have a material adverse effect on AIG’s life insurance business operating results and liquidity from increased mortality and morbidity rates.
ITEM 1B.
Unresolved Staff Comments
There are no material unresolved written comments that were received from the SEC staff 180 days or more before the end of AIG’s fiscal year relating to AIG’s periodic or current reports under the Securities Exchange Act of 1934 (Exchange Act).
ITEM 2.
Properties
AIG and its subsidiaries operate from approximately 2,200 offices in the United States, 8 offices in Canada and numerous offices in approximately 100 foreign countries. The offices in Montgomery, Alabama; Greensboro, North Carolina; Springfield, Illinois; Amarillo, Ft. Worth and Houston, Texas; Wilmington, Delaware; San Juan, Puerto Rico; Tampa, Florida; Livingston, New Jersey; Evansville, Indiana; Nashville, Tennessee; 70 Pine Street, 72 Wall Street and 175 Water Street in New York City; and offices in more than 30 foreign countries and jurisdictions including Bermuda, Chile, Hong Kong, the Philippines, Japan, United Kingdom, Singapore, Switzerland, Taiwan and Thailand are located in buildings owned by AIG and its subsidiaries. The remainder of the office space utilized by AIG subsidiaries is leased.
ITEM 3.
Legal Proceedings
General
AIG and its subsidiaries, in common with the insurance industry in general, are subject to litigation, including claims for punitive damages, in the normal course of their business. See Notes 12(d), 12(g), 12(h) and 12(i) of Notes to Consolidated Financial Statements, as well as the Discussion and Analysis of Consolidated Net Losses and Loss Expense Reserve Development and Management’s Discussion and Analysis of Financial Condition and Results of Operations.
2006 Regulatory Settlements
In February 2006, AIG reached a final settlement with the SEC, the United States Department of Justice (DOJ), the Office of the New York Attorney General (NYAG) and the New York State Department of Insurance (DOI). The settlements resolved outstanding litigation filed by the SEC, NYAG and DOI against AIG and concluded negotiations with these authorities and the DOJ in connection with the accounting, financial reporting and insurance brokerage practices of AIG and its subsidiaries, as well as claims relating to the underpayment of certain workers compensation premium taxes and other assessments. The 2005 financial statements included in this Annual Report on Form 10-K include a fourth quarter after-tax charge of $1.15 billion recording the settlements.
    As part of the settlement with the SEC, the SEC filed a civil complaint, alleging that from 2000 until 2005, AIG materially falsified its financial statements through a variety of transactions and entities in order to strengthen the appearance of its financial results to analysts and investors.
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    AIG, without admitting or denying the allegations in the SEC complaint, consented to the issuance of a final judgment on February 9, 2006: (a) permanently restraining and enjoining AIG from violating Section 17(a) of the Securities Act of 1933 (Securities Act) and Sections 10(b), 13(a), 13(b)(2) and 13(b)(5) and Rules 10b-5, 12b-20, 13a-1, 13a-13 and 13b2-1 of the Exchange Act; (b) ordering AIG to pay disgorgement in the amount of $700 million; and (c) ordering AIG to pay a civil penalty in the amount of $100 million. These amounts have been paid into a fund under the supervision of the SEC to be available to resolve claims asserted in various civil proceedings, including shareholder lawsuits.
    In February 2006, AIG and the DOJ entered into a letter agreement. In the letter agreement, the DOJ notified AIG that in its view, AIG, acting through some of its employees, violated federal criminal law in connection with misstatements in periodic financial reports that AIG filed with the SEC between 2000 and 2004 relating to certain transactions. The settlement with the DOJ consists of, among other things, AIG’s cooperating with the DOJ in the DOJ’s ongoing criminal investigation, accepting responsibility for certain of its actions and those of its employees relating to these transactions and paying $25 million.
    Effective February 9, 2006, AIG entered into agreements with the NYAG and the DOI, settling claims under New York’s Martin Act and insurance laws, among other provisions, which were originally brought by the NYAG and the DOI in a civil complaint filed on May 26, 2005. Under the agreements, $375 million was paid into a fund under the supervision of the NYAG and the DOI to be available principally to pay certain AIG insureds who purchased excess casualty policies through Marsh & McLennan Companies, Inc. or Marsh Inc. In addition, approximately $343 million will be used to compensate participating state funds in connection with the underpayment of certain workers compensation premium taxes and other assessments. In addition, AIG paid $100 million as a fine to the State of New York.
    As part of these settlements, AIG has agreed to retain for a period of three years an independent consultant who will conduct a review that will include the adequacy of AIG’s internal controls over financial reporting and the remediation plan that AIG has implemented as a result of its own internal review.
PNC Settlement
In November 2004, AIG and AIGFP reached a final settlement with the SEC, the Fraud Section of the DOJ and the United States Attorney for the Southern District of Indiana with respect to issues arising from certain structured transactions entered into with Brightpoint, Inc. and The PNC Financial Services Group, Inc. (PNC), the marketing of transactions similar to the PNC transactions and related matters.
    As part of the settlement, the SEC filed against AIG a civil complaint, based on the conduct of AIG primarily through AIGFP, alleging violations of certain antifraud provisions of the federal securities laws and for aiding and abetting violations of reporting and record keeping provisions of those laws. AIG, without admitting or denying the allegations in the SEC complaint, consented to the issuance of a final judgment permanently enjoining it and its employees and related persons from violating certain provisions of the Exchange Act, Exchange Act Rules and the Securities Act, ordering disgorgement of fees it received in the PNC transactions and providing for AIG to establish a transaction review committee to review the appropriateness of certain future transactions and to retain an independent consultant to examine certain transactions entered into between 2000 and 2004 and review the policies and procedures of the transaction review committee. The independent consultant has a broad mandate to review transactions entered into by AIG during this period. The review of the independent consultant is now ongoing and AIG cannot at this time predict the outcome of this review.
    The DOJ filed against AIGFP PAGIC Equity Holding Corp. (AIGFP PAGIC), a wholly-owned subsidiary of AIGFP, a criminal complaint alleging that AIGFP PAGIC violated federal securities laws by aiding and abetting securities law violations by PNC, in connection with a transaction entered into in 2001 with PNC that was intended to enable PNC to remove certain assets from its balance sheet.
    The settlement with the DOJ consists of separate agreements with AIG and AIGFP and a complaint filed against, and deferred prosecution agreement with, AIGFP PAGIC. Under the terms of the settlement, AIGFP paid a monetary penalty of $80 million. On January 17, 2006, the court approved an order dismissing the complaint with prejudice. The obligations of AIG, AIGFP and AIGFP PAGIC under the DOJ agreements relate principally to cooperating with the DOJ and other federal agencies in connection with their related investigations.
Investigations of Insurance Practices
Regulators from several states have commenced investigations into insurance brokerage practices related to contingent commissions and other broker-related conduct, such as alleged bid rigging. Various parties, including insureds and shareholders, have also asserted putative class action and other claims against AIG or its subsidiaries alleging, among other things, violations of the antitrust and federal securities laws, and AIG expects that additional claims may be made. Pursuant to the settlements with the NYAG and the DOI, $375 million was paid into a fund under the supervision of the NYAG and the DOI to be available principally to pay certain AIG insureds who purchased excess casualty policies through Marsh Inc. In addition, approximately $343 million will be used to compensate participating states in connection with the underpayment of certain workers compensation premium taxes and other assessments. It is likely that many of the claims arising from state investigations, as well as claims made by insureds, will be settled using these funds.
    Various federal and state regulatory agencies are reviewing certain other transactions and practices of AIG and its subsidiaries in connection with industry-wide and other inquiries. AIG has cooperated, and will continue to cooperate, with all these investigations, including by producing documents and other information in response to the subpoenas.
18
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
Pending Litigation
A number of lawsuits have been filed regarding the subject matter of the investigations of insurance brokerage practices, including derivative actions, individual actions and class actions under the federal securities laws, Racketeering Influenced and Corrupt Organizations Act (RICO), Employee Retirement Income Security Act (ERISA) and state common and corporate laws in both federal and state courts, including the federal district court in the United States District Court for the Southern District of New York (Southern District of New York), in the Commonwealth of Massachusetts Superior Court and in the Delaware Chancery Court. All of these actions generally allege that AIG and its subsidiaries violated the law by allegedly concealing a scheme to “rig bids” and “steer” business between insurance companies and insurance brokers.
    Since October 19, 2004, AIG or its subsidiaries have been named as a defendant in fifteen complaints that were filed in federal court and two that were originally filed in state court (Massachusetts and Florida) and removed to federal court. These cases generally allege that AIG and its subsidiaries violated federal and various state antitrust laws, as well as federal RICO laws, various state deceptive and unfair practice laws and certain state laws governing fiduciary duties. The alleged basis of these claims is that there was a conspiracy between insurance companies and insurance brokers with regard to the use of contingent commission agreements, bidding practices, and other broker-related conduct concerning coverage in certain sectors of the insurance industry. The Judicial Panel on Multidistrict Litigation entered an order on February 17, 2005, consolidating most of these cases and transferring them to the United States District Court for the District of New Jersey (District of New Jersey). The remainder of these cases have been transferred to the District of New Jersey. On August 15, 2005, the plaintiffs in the multidistrict litigation filed a Corrected First Consolidated Amended Commercial Class Action Complaint, which, in addition to the previously named AIG defendants, names new AIG subsidiaries as defendants. Also on August 15, 2005, AIG and two subsidiaries were named as defendants in a Corrected First Consolidated Amended Employee Benefits Class Action Complaint filed in the District Court of New Jersey, which asserts similar claims with respect to employee benefits insurance and a claim under ERISA on behalf of putative classes of employers and employees. On November 29, 2005, the AIG defendants, along with other insurer defendants and the broker defendants filed motions to dismiss both the Commercial and Employee Benefits Complaints. Plaintiffs have filed a motion for class certification in the consolidated action. In addition, complaints were filed against AIG and several of its subsidiaries in Massachusetts and Florida state courts, which have both been stayed. In the Florida action, the plaintiff has filed a petition for a writ of certiorari with the District Court of Appeals of the State of Florida, Fourth District with respect to the stay order. On February 9, 2006, a complaint against AIG and several of its subsidiaries was filed in Texas state court, making claims similar to those in the federal cases above.
    In April and May 2005, amended complaints were filed in the consolidated derivative and securities cases, as well as in one of the ERISA lawsuits, pending in the Southern District of New York adding allegations concerning AIG’s accounting treatment for non-traditional insurance products. In September 2005, a second amended complaint was filed in the consolidated securities cases adding allegations concerning AIG’s First Restatement. Also in September 2005, a new securities action complaint was filed in the Southern District of New York, asserting claims premised on the same allegations made in the consolidated cases. Motions to dismiss have been filed in the securities actions. In September 2005, a consolidated complaint was filed in the ERISA case pending in the Southern District of New York. Motions to dismiss have been filed in that ERISA case. Also in April 2005, new derivative actions were filed in the Delaware Chancery Court, and in July and August 2005, two new derivative actions were filed in the Southern District of New York asserting claims duplicative of the claims made in the consolidated derivative action.
    In July 2005, a second amended complaint was filed in the consolidated derivative case in the Southern District of New York, expanding upon accounting-related allegations based upon AIG’s First Restatement and, in August 2005, an amended consolidated complaint was filed. In June 2005, the derivative cases in Delaware were consolidated. AIG’s Board of Directors has appointed a special committee of independent directors to review the matters asserted in the derivative complaints. The courts have approved agreements staying the derivative cases pending in the Southern District of New York and in the Delaware Chancery Court while the special committee of independent directors performs its work. In September 2005, a shareholder filed suit in Delaware Chancery Court seeking documents relating to some of the allegations made in the derivative suits. AIG filed a motion to dismiss in October 2005.
    In late 2002, a derivative action was filed in the Delaware Chancery Court in connection with AIG’s transactions with certain entities affiliated with Starr and SICO. In May 2005, the plaintiff filed an amended complaint which adds additional claims premised on allegations relating to insurance brokerage practices and AIG’s non-traditional insurance products. Plaintiffs in that case have agreed to dismiss newly added allegations unrelated to transactions with entities affiliated with Starr and SICO without prejudice to pursuit of these claims in the separate derivative actions described above. On February 16, 2006, the Delaware Chancery Court entered an order dismissing the litigation with prejudice with respect to AIG’s outside directors and dismissing the claims against the remaining AIG defendants without prejudice.
    On July 8, 2005, SICO filed a complaint against AIG in the Southern District of New York. The complaint alleges that AIG is in the possession of items, including artwork, which SICO claims it owns, and seeks an order causing AIG to release those items as well as actual, consequential, punitive and exemplary damages. On September 27, 2005, AIG filed its answer to SICO’s complaint denying SICO’s allegations and asserting counter-claims for breach of contract, unjust enrichment, conversion and breach of fiduciary duty relating to
AIG  -  Form 10-K
19


 

 
SICO’s breach of its commitment to use its AIG shares for the benefit of AIG and its employees. On October 17, 2005, SICO replied to AIG’s counter-claims and additionally sought a judgment declaring that SICO is neither a control person nor an affiliate of AIG for the purposes of Schedule 13D under the Exchange Act, and Rule 144 under the Securities Act, respectively. AIG responded to the SICO claims on November 7, 2005.
Effect on AIG
In the opinion of AIG management, AIG’s ultimate liability for the unresolved matters referred to above is not likely to have a material adverse effect on AIG’s consolidated financial condition, although it is possible that the effect would be material to AIG’s consolidated results of operations for an individual reporting period.
20
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
ITEM 4.
Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders during the fourth quarter of 2005.
Directors and Executive Officers of the Registrant
Set forth below is information concerning the directors and executive officers of AIG. All directors are elected for one-year terms at the annual meeting of shareholders. All officers serve at the pleasure of the Board of Directors, but subject to the foregoing, are elected to one-year terms.
    Except as hereinafter noted, each of the executive officers has, for more than five years, occupied an executive position with AIG or companies that are now its subsidiaries. There are no other arrangements or understandings between any officer and any other person pursuant to which the officer was elected to such position. From January 2000 until joining AIG in May 2004, Mr. Frenkel served as Chairman of Merrill Lynch International, Inc. Between 1991 and 2001, Mr. Frenkel served for two consecutive terms as the Governor of the Bank of Israel. Prior to joining AIG in September 2002, Mr. Bensinger was Executive Vice President and Chief Financial Officer of Combined Specialty Group, Inc. (a division of Aon Corporation) commencing in March 2002, and served as Executive Vice President of Trenwick Group, Ltd. from October 1999 through December 2001. Prior to joining AIG in February 2005, Mr. Winans was a Vice President at Lehman Brothers Equity Research covering property-casualty insurers. Prior to joining Lehman Brothers in June 2003, he held a similar position at Williams Capital, following three years as an equity analyst covering the property-casualty sector at Morgan Stanley and previously at Paine Webber, which he joined in late 1999. From May 1985 until joining AIG, Mr. Roemer was employed by JPMorgan Chase, most recently as Senior Vice President – Internal Audit.
             
 
    Served as
    Director or
Name   Title   Age   Officer Since
 
M. Bernard Aidinoff
  Director   77   1984
Pei-yuan Chia
  Director   67   1996
Marshall A. Cohen
  Director   70   1992
William S. Cohen
  Director   65   2004
Martin S. Feldstein
  Director   66   1987
Ellen V. Futter
  Director   56   1999
Stephen L. Hammerman
  Director   67   2005
Carla A. Hills
  Director   72   1993
Richard C. Holbrooke
  Director   64   2001
Fred H. Langhammer
  Director   62   2006
George L. Miles, Jr.
  Director   64   2005
Morris W. Offit
  Director   69   2005
Martin J. Sullivan
  Director, President and Chief Executive Officer   51   2002
Michael H. Sutton
  Director   65   2005
Edmund S. W. Tse
  Director, Senior Vice Chairman – Life Insurance   68   1996
Robert B. Willumstad
  Director   60   2006
Frank G. Zarb
  Director and Chairman   71   2001
Thomas R. Tizzio
  Senior Vice Chairman – General Insurance   68   1982
Jacob A. Frenkel
  Vice Chairman – Global Economic Strategies   62   2004
Frank G. Wisner
  Vice Chairman – External Affairs   67   1997
Steven J. Bensinger
  Executive Vice President and Chief Financial Officer   51   2002
Rodney O. Martin, Jr.
  Executive Vice President – Life Insurance   53   2002
Kristian P. Moor
  Executive Vice President – Domestic General Insurance   46   1998
Win J. Neuger
  Executive Vice President and Chief Investment Officer   56   1995
R. Kendall Nottingham
  Executive Vice President – Life Insurance   67   1998
Robert M. Sandler
  Executive Vice President – Domestic Personal Lines   63   1980
Nicholas C. Walsh
  Executive Vice President – Foreign General Insurance   55   2005
Jay S. Wintrob
  Executive Vice President – Retirement Services   48   1999
William N. Dooley
  Senior Vice President – Financial Services   53   1992
Axel I. Freudmann
  Senior Vice President – Human Resources   59   1986
David L. Herzog
  Senior Vice President and Comptroller   46   2005
Robert E. Lewis
  Senior Vice President and Chief Risk Officer   54   1993
Ernest T. Patrikis
  Senior Vice President and General Counsel   61   1998
Michael E. Roemer
  Senior Vice President and Director of Internal Audit   43   2005
Brian T. Schreiber
  Senior Vice President – Strategic Planning   40   2002
Richard W. Scott
  Senior Vice President – Investments   52   2002
Kathleen E. Shannon
  Senior Vice President and Secretary   56   1986
Keith L. Duckett
  Vice President – Administration   45   2001
Robert A. Gender
  Vice President and Treasurer   48   2005
Charlene M. Hamrah
  Vice President and Director of Investor Relations   58   2004
AIG  -  Form 10-K
21


 

 
             
            Served as
            Director or
Name   Title   Age   Officer Since
 
Peter K. Lathrop
  Vice President and Director of Taxes   63   2001
Eric N. Litzky
  Vice President – Corporate Governance   44   2005
Christopher D. Winans
  Vice President – Media Relations   55   2005
 
22
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
Part II
 
ITEM 5.
Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
(a)  AIG’s common stock is listed in the U.S. on the New York Stock Exchange, as well as the stock exchanges in London, Paris, Switzerland and Tokyo.
The table below shows the high and low closing sales prices per share of AIG’s common stock on the New York Stock Exchange Composite Tape, for each quarter of 2005 and 2004.
                                 
    2005   2004
 
    High   Low   High   Low
 
First quarter
  $ 73.46     $ 54.18     $ 75.12     $ 66.79  
Second quarter
    58.94       49.91       76.77       69.39  
Third quarter
    63.73       56.00       72.66       66.48  
Fourth quarter
    64.40       60.43       68.72       54.70  
 
(b)  In 2005, AIG paid a quarterly dividend of 12.5 cents in March and June and 15.0 cents in September and December for a total cash payment of 55.0 cents per share of common stock. In 2004, AIG paid a quarterly dividend of 6.5 cents in March and June and 7.5 cents in September and December for a total cash payment of 28.0 cents per share of common stock. Subject to the dividend preference of any of AIG’s serial preferred stock which may be outstanding, the holders of shares of common stock are entitled to receive such dividends as may be declared by the Board of Directors from funds legally available therefor.
See Note 11(a) of Notes to Financial Consolidated Statements for a discussion of certain restrictions on the payment of dividends to AIG by some of its insurance subsidiaries.
(c)  The approximate number of holders of common stock as of January 31, 2006, based upon the number of record holders, was 56,000.
(d)  The following table summarizes AIG’s stock repurchases for the three month period ended December 31, 2005:
                                 
 
    Maximum
    Number of
    Total   Shares
    Number of   that May
    Shares   Yet Be
    Purchased   Purchased
    Average   as Part of   Under the
    Price   Publicly   Plans or
    Total Number   Paid   Announced   Programs
    of Shares   per   Plans or   at End of
Period   Purchased(a)(b)   Share   Programs   Month(b)
 
October 1 - 31, 2005
        $             36,542,700  
November 1 - 30, 2005
                      36,542,700  
December 1 - 31, 2005
                      36,542,700  
 
Total
        $                
 
(a) Does not include 76,829 shares delivered or attested to in satisfaction of the exercise price by holders of AIG employee stock options exercised during the three months ended December 31, 2005.
 
(b) On July 19, 2002, AIG announced that its Board of Directors had authorized the open market purchase of up to 10 million shares of common stock. On February 13, 2003, AIG announced that the Board had expanded the existing program through the authorization of an additional 50 million shares. The purchase program has no set expiration or termination date.
AIG  -  Form 10-K
23


 

 
ITEM 6.
Selected Financial Data
AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
SELECTED CONSOLIDATED FINANCIAL DATA
The Selected Consolidated Financial Data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and accompanying notes included elsewhere herein.
 
                                           
Years Ended December 31,                    
(in millions, except per share data)   2005   2004   2003   2002   2001
 
Revenues(a):
                                       
 
Premiums and other considerations
  $ 70,209     $ 66,625     $ 54,802     $ 44,289     $ 38,261  
 
Net investment income
    22,165       18,465       15,508       13,593       13,002  
 
Realized capital gains (losses)
    341       44       (442 )     (1,653 )     (910 )
 
Other revenues(b)
    16,190       12,532       9,553       9,942       9,605  
Total revenues
    108,905       97,666       79,421       66,171       59,958  
Benefits and expenses:
                                       
 
Incurred policy losses and benefits
    63,711       58,360       46,034       40,005       33,984  
 
Insurance acquisition and other operating expenses
    29,981       24,461       21,480       18,358       18,040  
 
Acquisition, restructuring and related charges
                            2,017  
Total benefits and expenses
    93,692       82,821       67,514       58,363       54,041  
Income before income taxes, minority interest and cumulative effect of accounting changes (c)
    15,213       14,845       11,907       7,808       5,917  
Income taxes
    4,258       4,407       3,556       1,919       1,594  
Income before minority interest and cumulative effect of accounting changes
    10,955       10,438       8,351       5,889       4,323  
Minority interest
    (478 )     (455 )     (252 )     (160 )     (101 )
Income before cumulative effect of accounting changes
    10,477       9,983       8,099       5,729       4,222  
Cumulative effect of accounting changes, net of tax
          (144 )     9             (136 )
Net income
    10,477       9,839       8,108       5,729       4,086  
Earnings per common share:
                                       
 
Basic
                                       
 
  Income before cumulative effect of accounting changes
    4.03       3.83       3.10       2.20       1.61  
 
  Cumulative effect of accounting changes, net of tax
          (0.06 )                 (0.05 )
 
  Net income
    4.03       3.77       3.10       2.20       1.56  
 
Diluted(d)
                                       
 
  Income before cumulative effect of accounting changes
    3.99       3.79       3.07       2.17       1.59  
 
  Cumulative effect of accounting changes, net of tax
          (0.06 )                 (0.05 )
 
  Net income
    3.99       3.73       3.07       2.17       1.54  
Dividends per common share(e)
    0.63       0.29       0.24       0.18       0.16  
Total assets
    853,370       801,145       675,602       561,598       490,614  
Long-term debt and commercial paper(f)
                                       
 
Guaranteed by AIG
    10,425       8,498       7,469       7,144       8,141  
 
Liabilities connected to trust preferred stock
    1,391       1,489       1,682              
 
Matched/not guaranteed by AIG
    98,033       86,912       71,198       63,866       56,073  
Total Liabilities(g)
    766,867       721,273       606,180       501,163       438,551  
Shareholders’ equity
  $ 86,317     $ 79,673     $ 69,230     $ 58,303     $ 49,881  
 
(a) Represents the sum of General Insurance net premiums earned, Life Insurance & Retirement Services GAAP premiums, net investment income, Financial Services interest, lease and finance charges, Asset Management advisory and management fees and net investment income from guaranteed investment contracts, and realized capital gains (losses).
 
(b) Includes the effect of hedging activities that do not qualify for hedge accounting treatment under FAS 133, including the related foreign exchange gains and losses. For 2005, 2004, 2003, 2002 and 2001, respectively, the amounts included are $2.01 billion, $(122) million, $(1.01) billion, $220 million and $56 million.
(c) Includes catastrophe losses of $3.28 billion in 2005, $1.16 billion in 2004, $83 million in 2003, $61 million in 2002 and World Trade Center losses of $900 million in 2001.
(d) Assumes conversion of contingently convertible bonds due to the adoption of EITF Issue No. 04-8 “Accounting Issues Related to Certain Features of Contingently Convertible Debt and the Effect on Diluted Earnings per Share.”
(e) Dividends have not been restated to reflect dividends paid by AGC which was acquired by AIG on August 29, 2001.
(f) Including that portion of long-term debt maturing in less than one year. See also Note 9 of Notes to Consolidated Financial Statements.
(g) Includes $2.1 billion and $2.2 billion for the years ended 2002 and 2001, respectively, of other liabilities connected to the consolidation of the Muni Tender Option Bond Program trusts.
24
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
Management’s Discussion and Analysis of
Financial Condition and Results of Operations
 
ITEM 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations, AIG presents its operations in the way it believes will be most meaningful. Statutory underwriting profit (loss) and combined ratios are presented in accordance with accounting principles prescribed by insurance regulatory authorities because these are standard measures of performance used in the insurance industry and thus allow more meaningful comparisons with AIG’s insurance competitors. AIG has also incorporated into this discussion a number of cross-references to additional information included throughout this Annual Report on Form 10-K to assist readers seeking related information on a particular subject.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Management’s Discussion and Analysis of Financial Condition and Results of Operations is designed to provide the reader a narrative with respect to AIG’s operations, financial condition and liquidity and certain other significant matters.
 
 
           
Index   Page
 
Cautionary Statement Regarding
Projections and Other Information About Future Events
    25  
Overview of Operations and Business Results
    26  
Consolidated Results
    26  
Critical Accounting Estimates
    29  
Operating Review
    30  
General Insurance Operations
    30  
 
General Insurance Results
    31  
 
Reinsurance
    33  
 
Reserve for Losses and Loss Expenses
    34  
 
Asbestos and Environmental Reserves
    40  
Life Insurance & Retirement Services Operations
    43  
 
Life Insurance & Retirement Services Results
    44  
 
Underwriting and Investment Risk
    47  
Insurance and Asset Management Invested Assets
    48  
 
Credit Quality
    49  
 
Valuation of Invested Assets
    49  
Financial Services Operations
    51  
 
Financial Services Results
    54  
 
Financial Services Invested Assets
    55  
Asset Management Operations
    56  
 
Asset Management Results
    57  
Other Operations
    57  
Capital Resources
    58  
Borrowings
    58  
Contractual Obligations and Other Commercial Commitments
    61  
Shareholders’ Equity
    62  
Stock Purchase
    62  
Dividends from Insurance Subsidiaries
    62  
Regulation and Supervision
    62  
Liquidity
    63  
Special Purpose Vehicles and Off Balance Sheet Arrangements
    64  
Derivatives
    65  
Managing Market Risk
    65  
Insurance
    65  
Financial Services
    66  
Recent Accounting Standards
    67  
 



Cautionary Statement Regarding Projections and Other Information About Future Events
This Annual Report on Form 10-K and other publicly available documents may include, and AIG’s officers and representatives may from time to time make, projections concerning financial information and statements concerning future economic performance and events, plans and objectives relating to management, operations, products and services, and assumptions underlying these projections and statements. These projections and statements are not historical facts but instead represent only AIG’s belief regarding future events, many of which, by their nature, are inherently uncertain and outside AIG’s control. These projections and statements may address, among other things, the status and potential future outcome of the current regulatory and civil proceedings against AIG and their potential effect on AIG’s businesses, financial position, results of operations, cash flows and liquidity, the effect of the credit rating downgrades on AIG’s businesses and competitive position, the unwinding and resolving of various relationships between AIG and Starr and SICO and AIG’s strategy for growth, product development, market position, financial results and reserves. It is possible that AIG’s actual results and financial condition may differ, possibly materially, from the anticipated results and financial condition indicated in these projections and statements. Factors that could cause AIG’s actual results to differ, possibly materially, from those in the specific projections and statements are discussed throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations and in “Risk Factors” in Item 1A, Part I of this Annual Report on Form 10-K. AIG is not under any obligation (and expressly disclaims any such obligations) to update or alter any projection or other statement, whether written or oral, that may be made from time to time, whether as a result of new information, future events or otherwise.
AIG  -  Form 10-K
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Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
 
Overview of Operations and Business Results
In 2003 and prior years, AIG’s operations were conducted by its subsidiaries principally through four operating segments: General Insurance, Life Insurance, Financial Services and Retirement Services & Asset Management. Beginning with the first quarter of 2004, AIG reports Retirement Services results in the same segment as Life Insurance, reflecting the convergence of protective financial and retirement products and AIG’s current management of these operations. All financial information herein gives effect to the Restatements described in “The Restatements” under Item 1. Business. Information for years prior to 2005 included herein has been reclassified to show AIG’s results of operations and financial position on a comparable basis with the 2005 presentation.
    Through these segments, AIG provides insurance and investment products and services to both businesses and individuals in more than 130 countries and jurisdictions. This geographic, product and service diversification is one of AIG’s major strengths and sets it apart from its competitors. The importance of this diversification was especially evident in 2005, when record catastrophe losses, settlements of legal proceedings and charges for increases in reserves for loss and loss expenses, were more than offset by profitability in other segments and product lines. Although regional economic downturns or political upheaval could negatively affect parts of AIG’s operations, AIG believes that its diversification makes it unlikely that regional difficulties would have a material effect on its operating results, financial condition or liquidity.
    AIG’s subsidiaries serve commercial, institutional and individual customers through an extensive property-casualty and life insurance and retirement services network. In the United States, AIG companies are the largest underwriters of commercial and industrial insurance and one of the largest life insurance and retirement services operations as well. AIG’s Financial Services businesses include commercial aircraft and equipment leasing, capital markets operations and consumer finance, both in the United States and abroad. AIG also provides asset management services and offers guaranteed investment contracts (GICs) to institutions and individuals.
    A primary goal of AIG in managing its General Insurance operations is to achieve an underwriting profit. To achieve this goal, AIG must be disciplined in its risk selection and premiums must be adequate and terms and conditions appropriate to cover the risk accepted. AIG believes in strict control of expenses.
    AIG’s 2005 operating performance reflects continuing implementation of various long-term strategies in its various operating segments.
    A central focus of AIG operations in recent years is the development and expansion of new distribution channels. In 2005, AIG continued to expand its distribution channels in many Asian countries, which now include banks, credit card companies and television-media home shopping. In late 2003, AIG entered into an agreement with PICC Property and Casualty Company, Limited (PICC), which will enable the marketing of accident and health products throughout China through PICC’s branch networks and agency system. AIG participates in the underwriting results through a reinsurance agreement and also holds a 9.9 percent ownership interest in PICC. Other examples of new distribution channels used both domestically and overseas include banks, affinity groups, direct response and e-commerce.
    AIG patiently builds relationships in markets around the world where it sees long-term growth opportunities. For example, the fact that AIG has the only wholly-owned foreign life insurance operations in eight cities in China is the result of relationships developed over nearly 30 years. AIG’s more recent expansion of operations into India, Vietnam, Russia and other emerging markets reflect the same growth strategy. Moreover, AIG believes in investing in the economies and infrastructures of these countries and growing with them. When AIG companies enter a new jurisdiction, they typically offer both basic protection and savings products. As the economies evolve, AIG’s products evolve with them, to more complex and investment-oriented models.
    Growth for AIG may be generated both internally and through acquisitions which both fulfill strategic goals and offer adequate return on investment. In recent years, the acquisitions of AIG Star Life and AIG Edison Life have broadened AIG’s penetration of the Japanese market through new distribution channels and will result in operating efficiencies as they are integrated into AIG’s previously existing companies operating in Japan.
    AIG provides leadership on issues of concern to the global and local economies as well as the insurance and financial services industries. In recent years, efforts to reform the tort system and class action litigation procedures, legislation to deal with the asbestos problem and the renewal of the Terrorism Risk Insurance Act have been key issues, while in prior years trade legislation and Superfund had been issues of concern.
The following table summarizes AIG’s revenues, income before income taxes, minority interest and cumulative effect of accounting changes and net income for the twelve months ended December 31, 2005, 2004 and 2003:
 
                         
Years Ended December 31,            
(in millions)   2005   2004   2003
 
Total revenues
  $ 108,905     $ 97,666     $ 79,421  
 
Income before income taxes, minority interest and cumulative effect of accounting changes
    15,213       14,845       11,907  
 
Net income
  $ 10,477     $ 9,839     $ 8,108  
 
Consolidated Results
The 12 percent growth in revenues in 2005 and 23 percent growth in revenues in 2004 were primarily attributable to the growth in net premiums earned from global General Insurance operations as well as growth in both General Insurance and Life Insurance & Retirement Services net investment income and Life Insurance & Retirement Services GAAP premiums. An additional factor was the capital gains realized in 2004 rather than the capital losses realized in 2003.
26
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
    AIG’s income before income taxes, minority interest and cumulative effect of accounting changes increased 2 percent in 2005 when compared to 2004 and 25 percent in 2004 when compared to 2003. Life Insurance & Retirement Services, Financial Services and Asset Management operating income gains accounted for the increase over 2004 and 2003 in both pretax income and net income. Somewhat offsetting these gains in 2005 was the effect of the charges related to regulatory settlements, as described in Item 3. Legal Proceedings.
The following table summarizes the net effect of catastrophe losses for December 31, 2005, 2004 and 2003.
 
                         
(in millions)   2005   2004   2003
 
Pretax(*)
  $ 3,280     $ 1,155     $ 83  
 
Net of tax and minority interest
    2,109       729       53  
 
(*) Includes $312 million and $96 million in catastrophe losses from partially owned companies in 2005 and 2004, respectively.
The following table summarizes the operations of each principal segment for the twelve months ended December 31, 2005, 2004 and 2003. See also Note 2 of Notes to Consolidated Financial Statements.
 
                           
(in millions)   2005   2004   2003
 
Revenues(a):
                       
 
General Insurance(b)
  $ 45,174     $ 41,961     $ 33,833  
 
Life Insurance & Retirement Services(c)
    47,316       43,400       36,678  
 
Financial Services(d)
    10,525       7,495       6,242  
 
Asset Management(e)
    5,325       4,714       3,651  
 
Other
    565       96       (983 )
 
Total
  $ 108,905     $ 97,666     $ 79,421  
 
Operating Income(a)(f)(g):
                       
 
General Insurance
  $ 2,315     $ 3,177     $ 4,502  
 
Life Insurance & Retirement Services
    8,844       7,923       6,807  
 
Financial Services
    4,276       2,180       1,182  
 
Asset Management
    2,253       2,125       1,316  
 
Other(h)(i)
    (2,475 )     (560 )     (1,900 )
 
Total
  $ 15,213     $ 14,845     $ 11,907  
 
(a) Includes the effect of hedging activities that do not qualify for hedge accounting treatment under FAS 133, including the related foreign exchange gains and losses. For 2005, 2004 and 2003, the effect was $(34) million, $(27) million and $49 million, respectively, in operating income for Aircraft Finance and $2.01 billion, $(122) million and $(1.01) billion in revenues and operating income, respectively, for Capital Markets (AIGFP).
 
(b) Represents the sum of General Insurance net premiums earned, net investment income and realized capital gains (losses).
(c) Represents the sum of Life Insurance & Retirement Services GAAP premiums, net investment income and realized capital gains (losses). Included in realized capital gains (losses) is the effect of hedging activities that do not qualify for hedge accounting treatment under FAS 133 and the application of FAS 52 of $(437) million, $(140) million and $78 million.
(d) Represents interest, lease and finance charges.
(e) Represents management and advisory fees, and net investment income with respect to GICs.
 
(f) Represents income before income taxes, minority interest, and cumulative effect of accounting changes.
(g) Catastrophe losses were $3.28 billion, $1.16 billion and $83 million in 2005, 2004 and 2003, respectively.
 
(h) Represents unallocated corporate expenses and other realized capital gains (losses) and includes the NYAG, DOI, SEC and DOJ settlement costs in 2005.
(i) Includes $312 million and $96 million in catastrophe related losses from partially owned companies in 2005 and 2004, respectively, and approximately $1.6 billion of regulatory settlement charges in 2005.
General Insurance
AIG’s General Insurance operations provide property and casualty products and services throughout the world. The decrease in General Insurance operating income in 2005 compared to 2004 was primarily attributable to catastrophe related losses, increases in the reserve for losses and loss expenses and changes in estimates related to the remediation of AIG’s material weakness in control over certain balance sheet reconciliations, partially offset by profitable growth in Foreign General’s underwriting results and DBG’s and Foreign General’s net investment income. In addition, realized capital gains increased in 2005 compared to 2004. General Insurance operating income includes $2.89 billion, $1.05 billion and $83 million in catastrophe related losses in 2005, 2004 and 2003, respectively. DBG’s operating income included $197 million of additional losses in 2005 resulting from increased labor and material costs related to the 2004 Florida hurricanes.
Life Insurance & Retirement Services
AIG’s Life Insurance & Retirement Services operations provide insurance, financial and investment products throughout the world. Foreign operations provided approximately 59 percent and 61 percent of AIG’s Life Insurance & Retirement Services operating income in 2005 and 2004, respectively.
    Life Insurance & Retirement Services operating income increased 12 percent in 2005 and 16 percent in 2004 when compared to 2003. Foreign Life Insurance & Retirement Services operating income grew 8 percent in 2005. Realized capital gains included in operating income was $84 million in 2005 compared to $372 million in 2004 and $486 million in 2003. The decline in realized capital gains in 2005 includes the effect of hedging activities that do not qualify for hedge accounting under FAS 133, including the related foreign exchange gains and losses under FAS 52. For 2005, the foreign Life & Retirement Service segment also incurred higher policy benefit costs for contributions to the participating policyholder fund in Singapore, totaling $137 million related to the settlement of a long disputed local tax issue. The domestic Life Insurance & Retirement Services segment operating income grew by 17 percent in 2005. Realized capital losses included in operating income was $(302) million in 2005 compared to $(329) million in 2004 and $(246) million in 2003. The 2004 results include increased policy benefits of $178 million associated with the workers compensation arbitration with Superior National. The domestic Life Insurance & Retirement
AIG  -  Form 10-K
27


 

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
 
Services segment also includes $12 million and $5 million in catastrophe related losses in 2005 and 2004, respectively.
Financial Services
AIG’s Financial Services subsidiaries engage in diversified activities including aircraft and equipment leasing, capital markets transactions, consumer finance and insurance premium financing.
    Financial Services operating income increased significantly in 2005 compared to 2004 and in 2004 compared to 2003, primarily due to the fluctuation in earnings resulting from not qualifying for hedge accounting treatment under FAS 133. Offsetting this increase in 2004 when compared to 2003 is the effect of ILFC’s disposition of approximately $2 billion in aircraft through securitizations in the third quarter of 2003 and the first quarter of 2004. Fluctuations in revenues and operating income from quarter to quarter are not unusual because of the transaction-oriented nature of Capital Markets operations and the effect of not qualifying for hedge accounting treatment under FAS 133 for hedges on securities available for sale and borrowings. The increase in 2005 when compared to 2004 was partially offset by $62 million in catastrophe related losses in the Consumer Finance operations in 2005. The charge relating to the PNC settlement, see Item 3. Legal Proceedings, had a significant negative effect on results in 2004. Consumer Finance operations increased revenues and operating income, both domestically and internationally.
Asset Management
AIG’s Asset Management operations include institutional and retail asset management and broker dealer services and spread-based investment business from the sale of GICs. These products and services are offered to individuals and institutions, both domestically and overseas.
    Asset Management operating income increased 6 percent in 2005 when compared to 2004 as a result of the upturn in worldwide financial markets and a strong global product portfolio; operating income also increased 61 percent in 2004 when compared to 2003 as a result of the same factors.
Capital Resources
At December 31, 2005, AIG had total consolidated shareholders’ equity of $86.32 billion and total consolidated borrowings of $109.85 billion. At that date, $99.42 billion of such borrowings were either not guaranteed by AIG or were matched borrowings under obligations of guaranteed investment agreements (GIAs), liabilities connected to trust preferred stock, or matched notes and bonds payable.
    During 2005, AIG repurchased in the open market 2,477,100 shares of its common stock.
Liquidity
At December 31, 2005, AIG’s consolidated invested assets included $17.24 billion in cash and short-term investments. Consolidated net cash provided from operating activities in 2005 amounted to $25.14 billion. AIG believes that its liquid assets, cash provided by operations and access to short term funding through commercial paper and bank credit facilities will enable it to meet any anticipated cash requirements.
Outlook
From March through June of 2005, the major rating agencies downgraded AIG’s ratings in a series of actions. S&P lowered the long-term senior debt and counterparty ratings of AIG from ‘AAA’ to ‘AA’ and changed the rating outlook to negative. Moody’s lowered AIG’s long-term senior debt rating from ‘Aaa’ to ‘Aa2’ and changed the outlook to stable. Fitch downgraded the long-term senior debt ratings of AIG from ‘AAA’ to ‘AA’ and placed the ratings on Rating Watch Negative.
    The agencies also took rating actions on AIG’s insurance subsidiaries. S&P and Fitch lowered to ‘AA+’ the insurance financial strength ratings of most of AIG’s insurance companies. Moody’s lowered the insurance financial strength ratings generally to either ‘Aa1’ or ‘Aa2’. A.M. Best downgraded the financial strength ratings for most of AIG’s insurance subsidiaries from ‘A++’ to ‘A+’ and the issuer credit ratings from ‘aa+’ to ‘aa-’. Many of these companies’ ratings remain on a negative watch.
    In addition, S&P changed the outlook on ILFC’s ‘AA-’ long-term senior debt rating to negative. Moody’s affirmed ILFC’s long-term and short-term senior debt ratings (‘A1’/‘P-1’). Fitch downgraded ILFC’s long-term senior debt rating from ‘AA-’ to ‘A+’ and placed the rating on Rating Watch Negative and downgraded ILFC’s short-term debt rating from ‘F1+’ to ‘F1’. Fitch also placed the ‘A+’ long-term senior debt ratings of American General Finance Corporation and American General Finance, Inc. on Rating Watch Negative. S&P and Moody’s affirmed the long-term and short-term senior debt ratings of American General Finance Corporation at ‘A+’/‘A-1’ and ‘A1’/‘P-1’, respectively.
    These debt and financial strength ratings are current opinions of the rating agencies. As such, they may be changed, suspended or withdrawn at any time by the rating agencies as a result of changes in, or unavailability of, information or based on other circumstances. Ratings may also be withdrawn at AIG management’s request. This discussion of ratings is not a complete list of ratings of AIG and its subsidiaries. For a discussion of the effect of these ratings downgrades on AIG’s businesses, see “Risk Factors — AIG’s Credit Ratings” in Item 1A. Risk Factors.
    Despite industry price erosion in some classes of general insurance, AIG expects to continue to identify profitable opportunities and build attractive new General Insurance businesses as a result of AIG’s broad product line and extensive distribution networks. In December 2005, AIUO received a license from the government of Vietnam to operate a wholly owned general insurance company in Vietnam. This license, the first general insurance license granted by Vietnam to a U.S.-based insurance organization, permits AIG to operate a general insurance company throughout Vietnam. In early 2006, AIG announced plans to acquire a leading general insurance company in Taiwan.
28
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
    In China, AIG has wholly-owned life insurance operations in eight cities. These operations should benefit from China’s rapid rate of economic growth and growing middle class, a segment that is a prime market for life insurance. AIG believes that it may also have opportunities in the future to grow by entering the group insurance business. However, in March 2005 it withdrew its application to serve the group insurance market until certain regulatory issues are resolved. Among the regulatory issues to be addressed is the response to AIG’s acknowledgment that certain of its Hong Kong based agents sold life insurance to customers on the Chinese mainland in contravention of applicable regulations.
    AIG Edison Life, acquired in August 2003, adds to the current agency force in Japan, and provides alternative distribution channels including banks, financial advisers, and corporate and government employee relationships. In January 2005, AIG Star Life entered into an agreement with the Bank of Tokyo Mitsubishi, one of Japan’s largest banks, to market a multi-currency fixed annuity. Through ALICO, AIG Star Life and AIG Edison, AIG has developed a leadership position in the distribution of annuities through banks. AIG is also a leader in the direct marketing of insurance products through sponsors and in the broad market. AIG also expects continued growth in India, Korea and Vietnam.
    Domestically, AIG anticipates continued operating growth in 2006 as distribution channels are expanded and new products are introduced. The home service operation has not met business objectives, although its cash flow has been strong, and domestic group life/health continues to be weak. The home service operation is expected to be a slow growth business. AIG American General’s current ratings remain equal to or higher than many of its principal competitors. AIG American General competes with a variety of companies based on services and products, in addition to ratings. The recent rating actions appear to be having no negative long term effect on independent producer relationships or customer surrender activity.
    In the airline industry, changes in market conditions are not immediately apparent in operating results. Lease rates have firmed considerably, as a result of strong demand spurred by the recovering global commercial aviation market, especially in Asia. Sales have begun to increase, and AIG expects an increasing level of interest from a variety of purchasers. AIG also expects increased contributions to Financial Services revenues and income from its consumer finance operations overseas. However, the downgrades of AIG’s credit ratings may adversely affect funding costs for AIG and its subsidiaries and AIGFP’s ability to engage in derivative transactions and certain structured products. See “Risk Factors – AIG’s Credit Ratings” in Item 1A. Risk Factors.
    GICs, which are sold domestically and abroad to both institutions and individuals, are written on an opportunistic basis when market conditions are favorable. In September 2005, AIG launched a $10 billion matched investment program in the Euromarkets under which AIG debt securities will be issued. AIG also expects to launch a matched investment program in the domestic market which, along with the Euro program, will become AIG’s principal spread-based investment activity. However, the timing of the launch of the domestic program is uncertain. Because AIG’s credit spreads in the capital markets have widened following the ratings declines, there may be a reduction in the earnings on new business in AIG’s spread based funding businesses.
    AIG has many promising growth initiatives underway around the world. Cooperative agreements such as those with PICC and various banks in the U.S., Japan and Korea are expected to expand distribution networks for AIG’s products and provide models for future growth.
    For a description of the risk factors that may affect these operations and initiatives, see Item 1A. Risk Factors.
Critical Accounting Estimates
AIG considers its most critical accounting estimates those with respect to reserves for losses and loss expenses, future policy benefits for life and accident and health contracts, deferred policy acquisition costs, estimated gross profits for investment-oriented products, fair value determinations for certain Capital Markets assets and liabilities, other-than-temporary declines in the value of investments and flight equipment recoverability. These accounting estimates require the use of assumptions about matters, some of which are highly uncertain at the time of estimation. To the extent actual experience differs from the assumptions used, AIG’s results of operations would be directly affected.
    Throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations, AIG’s critical accounting estimates are discussed in detail. The major categories for which assumptions are developed and used to establish each critical accounting estimate are highlighted below.
RESERVES FOR LOSSES AND LOSS EXPENSES (GENERAL INSURANCE):
-   Loss trend factors: used to establish expected loss ratios for subsequent accident years based on premium rate adequacy and the projected loss ratio with respect to prior accident years.
-   Expected loss ratios for the latest accident year: in this case, accident year 2005 for the year end 2005 loss reserve analysis. For low-frequency, high-severity classes such as excess casualty and D&O, expected loss ratios generally are utilized for at least the three most recent accident years.
-   Loss development factors: used to project the reported losses for each accident year to an ultimate amount.
FUTURE POLICY BENEFITS FOR LIFE AND ACCIDENT AND HEALTH CONTRACTS (LIFE INSURANCE & RETIREMENT SERVICES):
-   Interest rates: which vary by geographical region, year of issuance and products.
-   Mortality, morbidity and surrender rates: based upon actual experience by geographical region modified to allow for variation in policy form.
AIG  -  Form 10-K
29


 

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
 
ESTIMATED GROSS PROFITS (LIFE INSURANCE & RETIREMENT SERVICES):
    Estimated gross profits to be realized over the estimated duration of the contracts (investment-oriented products) affect the carrying value of deferred policy acquisition costs under FAS 97. Estimated gross profits include investment income and gains and losses on investments less required interest, actual mortality and other expenses.
DEFERRED POLICY ACQUISITION COSTS (LIFE INSURANCE & RETIREMENT SERVICES):
-   Recoverability based on current and future expected profitability, which is affected by interest rates, foreign exchange rates, mortality experience, and policy persistency.
DEFERRED POLICY ACQUISITION COSTS (GENERAL INSURANCE):
-   Recoverability and eligibility based upon the current terms and profitability of the underlying insurance contracts.
FAIR VALUE DETERMINATIONS OF CERTAIN ASSETS AND LIABILITIES (FINANCIAL SERVICES):
-   Valuation models: utilizing factors, such as market liquidity and current interest, foreign exchange and volatility rates.
-   Pricing data: AIG attempts to secure reliable and independent current market price data, such as published exchange rates from external subscription services such as Bloomberg or Reuters or third-party broker quotes for use in its models. When such prices are not available, AIG uses an internal methodology, which includes interpolation and extrapolation from verifiable prices from trades occurring on dates nearest to the dates of the transactions.
OTHER-THAN-TEMPORARY DECLINES IN THE VALUE OF INVESTMENTS:
Securities are considered a candidate for other-than-temporary impairment based upon the following criteria:
-   Trading at a significant (25 percent or more) discount to par or amortized cost (if lower) for an extended period of time (nine months or longer).
-   The occurrence of a discrete credit event resulting in the debtor defaulting or seeking bankruptcy or insolvency protection or voluntary reorganization.
-   The probability of non-realization of a full recovery on its investment, irrespective of the occurrence of one of the foregoing events.
FLIGHT EQUIPMENT — RECOVERABILITY (FINANCIAL SERVICES)
-   Expected undiscounted future net cash flows: based upon current lease rates, projected future lease rates and estimated terminal values of each aircraft based on third party information.
Operating Review
General Insurance Operations
AIG’s General Insurance subsidiaries are multiple line companies writing substantially all lines of property and casualty insurance both domestically and abroad. See “General Insurance Operations” in Item 1. Business for more information relating to General Insurance subsidiaries.
    As previously noted, AIG believes it should present and discuss its financial information in a manner most meaningful to its investors. Accordingly, in its General Insurance business, AIG uses certain non-GAAP measures, where AIG has determined these measurements to be useful and meaningful.
    A critical discipline of a successful general insurance business is the objective to produce operating income from underwriting exclusive of investment-related income. When underwriting is not profitable, premiums are inadequate to pay for insured losses and underwriting related expenses. In these situations, the addition of general insurance related investment income and realized capital gains may, however, enable a general insurance business to produce operating income. For these reasons, AIG views underwriting profit to be critical in the overall evaluation of performance. Although in and of itself not a GAAP measurement, AIG believes that underwriting profit is a useful and meaningful disclosure. See also the discussion under “Liquidity” herein.
    Underwriting profit is measured in two ways: statutory underwriting profit and GAAP underwriting profit.
    Statutory underwriting profit is derived by reducing net premiums earned by net losses and loss expenses incurred and net expenses incurred. Statutory accounting generally requires immediate expense recognition and ignores the matching of revenues and expenses as required by GAAP. That is, for statutory purposes, expenses are recognized immediately, not over the same period that the revenues are earned.
    GAAP accounting requires the recognition of expenses at the same time revenues are earned, the accounting principle of matching. Therefore, to convert underwriting results to a GAAP basis, acquisition expenses are deferred (deferred policy acquisition costs (DAC)) and amortized over the period the related net premiums written are earned. Accordingly, the statutory underwriting profit has been adjusted as a result of acquisition expenses being deferred as required by GAAP. DAC is reviewed for recoverability, and such review requires management judgment. See also “Critical Accounting Estimates” herein and Notes 1 and 4 of Notes to Consolidated Financial Statements.
    AIG, along with most General Insurance companies, uses the loss ratio, the expense ratio and the combined ratio as measures of underwriting performance. The loss ratio is the sum of losses and loss expenses incurred divided by net premiums earned. The expense ratio is statutory underwriting expenses divided by net premiums written. The combined ratio is the sum of the loss ratio and the expense ratio. These ratios are relative measurements that describe, for every $100 of net premiums earned or written, the cost of losses and statutory expenses, respectively. The combined ratio presents the total
30
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
cost per $100 of premium production. A combined ratio below 100 demonstrates underwriting profit; a combined ratio above 100 demonstrates underwriting loss.
    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 in income as net premiums earned until the end of the policy period.
    The underwriting environment varies from country to country, as does the degree of litigation activity. Regulation, product type and competition have a direct effect on pricing and consequently on profitability as reflected in underwriting profit and statutory general insurance ratios.
General Insurance operating income is comprised of underwriting profit (loss), net investment income and realized capital gains and losses. These components, as well as net premiums written, net premiums earned and statutory ratios for 2005, 2004 and 2003 were as follows:
                             
 
(in millions, except ratios)   2005   2004   2003
 
Net premiums written:
                       
 
Domestic General
                       
   
DBG
  $ 23,128     $ 22,506     $ 19,563  
   
Transatlantic
    3,466       3,749       3,341  
   
Personal Lines
    4,653       4,354       3,732  
   
Mortgage Guaranty
    628       607       531  
 
Foreign General
    9,997       9,407       7,864  
 
Total
  $ 41,872     $ 40,623     $ 35,031  
 
Net premiums earned:
                       
 
Domestic General
                       
   
DBG
  $ 22,602     $ 21,215     $ 16,704  
   
Transatlantic
    3,385       3,661       3,171  
   
Personal Lines
    4,634       4,291       3,678  
   
Mortgage Guaranty
    533       539       496  
 
Foreign General(f)
    9,655       8,831       7,257  
 
Total
  $ 40,809     $ 38,537     $ 31,306  
 
Underwriting profit (loss)(a):
                       
 
Domestic General
                       
   
DBG
  $ (3,250 ) (b)(c)   $ (1,340 )   $ 387  
   
Transatlantic
    (420 )     (47 )     109  
   
Personal Lines
    (19 )     160       183  
   
Mortgage Guaranty
    241       278       264  
 
Foreign General(e)(f)
    1,398       702       1,032  
 
Total
  $ (2,050 ) (d)   $ (247 )   $ 1,975  
 
Net investment income:
                       
 
Domestic General
                       
   
DBG
  $ 2,403     $ 1,965     $ 1,433  
   
Transatlantic
    343       307       271  
   
Personal Lines
    217       186       152  
   
Mortgage Guaranty
    123       120       142  
   
Intercompany adjustments and eliminations – net
    1             7  
 
Foreign General
    944       618       561  
 
Total
  $ 4,031     $ 3,196     $ 2,566  
 
Realized capital gains (losses)
    334       228       (39 )
 
Operating income(a)
  $ 2,315 (b)(c)(d)   $ 3,177     $ 4,502  
 
Domestic General:
                       
 
Loss ratio
    89.59       83.88       78.35  
 
Expense ratio
    21.00       19.21       17.25  
 
Combined ratio
    110.59       103.09       95.60  
 
Foreign General:
                       
 
Loss ratio
    53.66       61.61       55.52  
 
Expense ratio(e)
    31.90       29.20       27.82  
 
Combined ratio(f)
    85.56       90.81       83.34  
 
Consolidated:
                       
 
Loss ratio
    81.09       78.78       73.06  
 
Expense ratio
    23.60       21.52       19.62  
 
Combined ratio(a)
    104.69       100.30       92.68  
 
(a) The effect of catastrophe related losses on the consolidated General Insurance combined ratio for 2005, 2004 and 2003 was 7.06, 2.74 and 0.27, respectively. Catastrophe related losses for 2005, 2004 and 2003 by reporting unit were as follows:
                                 
 
(in millions)   2005   2004   2003
 
    Insurance   Net   Insurance   Insurance
    Related   Reinstatement   Related   Related
Reporting Unit   Losses   Premium Cost   Losses   Losses
 
DBG
  $ 1,747     $ 122     $ 582     $ 48  
Transatlantic
    463       45       215       4  
Personal Lines
    112       2       25       5  
Mortgage Guaranty
    10                    
Foreign General
    293       94       232       26  
 
Total
  $ 2,625     $ 263     $ 1,054     $ 83  
 
(b) Includes $197 million of additional losses incurred resulting from increased labor and material costs related to the 2004 Florida hurricanes.
 
(c) The 2005 operating loss for DBG includes $291 million of expenses related to changes in estimates for uncollectible reinsurance and other premium balances and $100 million of accrued expenses in connection with certain workers compensation insurance policies written between 1985 and 1996. See Note 12(i) of Notes to Consolidated Financial Statements.
 
(d) Includes the fourth quarter 2005 increase in net reserves of approximately $1.8 billion.
(e) Includes the results of wholly owned AIU agencies.
(f) Income statement accounts expressed in non-functional currencies are translated into U.S. dollars using average exchange rates.
General Insurance Results
General Insurance operating income in 2005 decreased after accounting for catastrophe related losses, the fourth quarter increase in reserves and changes in estimates related to remediation of the material weakness in reconciliation of balance sheet accounts. This decrease was partially offset by strong profitable growth in Foreign General’s underwriting results and DBG’s and Foreign General’s net investment income. DBG’s underwriting results also included additional losses incurred resulting from increased labor and material costs related to the 2004 Florida hurricanes. General Insurance operating income in 2004 showed positive results, even after accounting for catastrophe losses, the charge for asbestos and environmental exposures and the $232 million charge reflecting a change in estimate for salvage and subrogation recoveries. Net investment income and the capital gains realized in 2004 rather than the capital losses realized in 2003 also benefited General Insurance results.
AIG  -  Form 10-K
31


 

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
 
    DBG’s net premiums written increased modestly in 2005 when compared to 2004, reflecting generally improving renewal retention rates and a modest change in the mix of business towards smaller accounts for which DBG purchases less reinsurance. DBG also continued to expand its relationships with a larger number and broader range of brokers. Recently, DBG has seen improvement in domestic property rates as well as increases in submission activity in the aftermath of the 2005 hurricanes. DBG attributes the increase in submissions to its overall financial strength in comparison to many insurers that experienced significant losses and reductions of surplus as a result of the hurricanes.
    The DBG loss ratio increased in 2005 from 2004 principally as a result of adverse loss development, the third and fourth quarter 2005 catastrophe related losses and the $197 million of additional losses resulting from increased labor and material costs related to the 2004 hurricanes.
    The DBG expense ratio increased in 2005 from 2004 principally due to an increase in net commissions resulting from the replacement of certain ceded quota share reinsurance, for which DBG earns a ceding commission, with excess-of-loss reinsurance, which generally does not include a ceding commission. Increases in other underwriting expenses at DBG relate to the changes in estimates noted above, as well as unusually high expenses for Personal Lines. The Foreign General expense ratio increased in 2005 from 2004 principally because consumer lines of business, which have higher acquisition costs, have become more significant.
    Transatlantic’s net premiums written and net premiums earned for 2005 decreased compared to 2004, principally due to competitive market conditions and increased ceding company retentions in certain classes of business. The great majority of the premium decrease relates to Transatlantic’s domestic operations. Operating income decreased principally as a result of the increased level of catastrophe losses.
    Personal Lines net premiums written and net premiums earned for 2005 increased when compared to 2004 as a result of strong growth in the Private Client Group and Agency Auto divisions due to increased agent/broker appointments, greater penetration and enhanced product offerings. AIG direct premiums are down slightly from 2004 due to aggressive re-underwriting of the previously acquired GE business and the discontinuation of underwriting homeowners business. Involuntary auto premiums were down in 2005 due to the decline in the assigned risk marketplace. Underwriting profit declined in 2005 as a result of hurricane losses and related expenses, reserve strengthening, an increase in Agency Auto’s current accident year physical damage loss ratio, and expenses incurred related to terminating AIG’s relationship with The Robert Plan effective December 31, 2005.
    Mortgage Guaranty net premiums written were up slightly for 2005 when compared to 2004, reflecting growth in the second liens and international businesses offset by higher ceded premiums. Higher acquisition costs and lower earned premiums from certain single premium product lines resulted in lower underwriting profit in 2005 compared to 2004. UGC continued to achieve expansion of its international business in 2005.
    Foreign General Insurance had strong results in 2005. Growth in net premiums written for 2005 was achieved from new business as well as new distribution channels. In Japan, the purchase in February 2005 of the insurance portfolio of the Royal & SunAlliance branch operations opened new distribution channels. In the Far East, personal accident business exhibited strong growth and had excellent results for 2005. Commercial lines in Europe exhibited healthy growth and had positive results for 2005, partially offset by rate decreases in Australia and the United Kingdom. Personal lines operations in Brazil and Latin America continue to exhibit strong growth, which translated into improved underwriting results for 2005. The Lloyd’s Ascot syndicate continues to grow; however, insurance losses and reinstatement premium costs relating to the hurricanes caused a significant reduction in 2005 underwriting results. Foreign General Insurance also benefited from a decrease in the fourth quarter of 2005 in net reserves for loss and loss expense for non-asbestos and environmental reserves. Approximately half of the Foreign General Insurance net premiums written is derived from commercial insurance and the remainder from consumer lines.
AIG transacts business in most major foreign currencies. The following table summarizes the effect of changes in foreign currency exchange rates on the growth of General Insurance net premiums written.
         
    2005
 
Growth in original currency
    2.6 %
Foreign exchange effect
    0.5  
Growth as reported in U.S. dollars
    3.1 %
 
    AIG’s General Insurance results reflect the effects of catastrophe related losses of $2.89 billion, $1.05 billion and $83 million in 2005, 2004 and 2003, respectively. Losses caused by catastrophes can fluctuate widely from year to year, making comparisons of recurring type business more difficult. With respect to catastrophe losses, AIG believes that it has taken appropriate steps, such as careful exposure selection and obtaining reinsurance coverage, to reduce the effect of the magnitude of possible future losses. The occurrence of one or more catastrophic events of unanticipated frequency or severity, such as a terrorist attack, earthquake or hurricane, that causes insured losses, however, could have a material adverse effect on AIG’s results of operations, liquidity or financial condition.
    General Insurance net investment income grew in 2005 when compared to 2004. AIG is benefiting from strong cash flow, higher interest rates and increased partnership income. Cash flow for Foreign General was lower in 2005 when compared to 2004 due to payments for catastrophe related losses incurred in 2005 and 2004 and for the purchase of the Royal & SunAlliance branch operations. Partnership income was particularly strong for Foreign General due to increases in market valuations of infrastructure fund investments in Africa, Asia, China, Eastern Europe and India. Additionally, net investment income was positively affected by the compounding of previously earned and reinvested net investment income. In
32
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AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
2004, net investment income increased when compared to 2003. See also the discussion under “Liquidity” herein and Note 8 of Notes to Consolidated Financial Statements.
    Realized capital gains and losses resulted from the ongoing investment management of the General Insurance portfolios within the overall objectives of the General Insurance operations. See the discussion on “Valuation of Invested Assets” herein.
    The contribution of General Insurance operating income to AIG’s consolidated income before income taxes, minority interest and cumulative effect of accounting changes was 15 percent in 2005, compared to 21 percent in 2004 and 38 percent in 2003. The decrease in contribution percentages in both 2005 and 2004 was largely the result of reserve increases and the effects of catastrophe losses.
Reinsurance
AIG is a major purchaser of reinsurance for its General Insurance operations. AIG insures risks globally, and its reinsurance programs must be coordinated in order to provide AIG the level of reinsurance protection that AIG desires. Reinsurance is an important risk management tool to manage transaction and insurance line risk retention at prudent levels set by management. AIG also purchases reinsurance to mitigate its catastrophic exposure. 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 because one or more catastrophe losses could negatively affect AIG’s reinsurers and result in an inability of AIG to collect reinsurance recoverables. AIG’s reinsurance department evaluates catastrophic events and assesses the probability of occurrence and magnitude of catastrophic events through the use of state-of-the-art industry recognized program models among other techniques. AIG supplements these models through continually monitoring the risk exposure of AIG’s worldwide General Insurance operations and adjusting such models accordingly. Although reinsurance arrangements do not relieve AIG from its direct obligations to its insureds, an efficient and effective reinsurance program substantially limits AIG’s exposure to potentially significant losses. With respect to its property business, AIG has either renewed existing coverage or purchased new coverage that, in the opinion of management, is adequate to limit AIG’s exposures.
    AIG’s consolidated general reinsurance assets amounted to $23.59 billion at December 31, 2005 and resulted from AIG’s reinsurance arrangements. Thus, a credit exposure existed at December 31, 2005 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, 2005, approximately 48 percent of the general reinsurance assets were from unauthorized reinsurers. Many of these balances were collateralized, permitting statutory recognition. Additionally, with the approval of its domiciliary insurance regulators, AIG posted approximately $1.5 billion of letters of credit issued by several commercial banks in favor of certain Domestic General Insurance companies to permit statutory recognition of balances otherwise uncollateralized at December 31, 2005. The remaining 52 percent of the general reinsurance assets were from authorized reinsurers. The terms authorized and unauthorized pertain to regulatory categories, not creditworthiness. At December 31, 2005, approximately 88 percent of the balances with respect to authorized reinsurers are from reinsurers rated A (excellent) or better, as rated by A.M. Best, or A (strong) or better, as rated by S&P. These ratings are measures of financial strength.
    AIG maintains a reserve for estimated unrecoverable reinsurance. While AIG has been largely successful in its previous recovery efforts, at December 31, 2005, AIG had a reserve for unrecoverable reinsurance approximating $992 million. At that date, AIG had no significant reinsurance recoverables due from any individual reinsurer that was 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 evaluating the local economic environment in which a foreign reinsurer operates. This department also reviews the nature of the risks ceded and the requirements for credit risk mitigants. For example, in AIG’s treaty reinsurance contracts, AIG includes provisions that frequently require a reinsurer to post collateral when a referenced event occurs. Furthermore, AIG limits its unsecured exposure to reinsurers through the use of credit triggers, which include, but are not limited to, insurer financial strength rating downgrades, policyholder surplus declines at or below a certain predetermined level or a certain predetermined level of a reinsurance recoverable being reached. In addition, AIG’s Credit Risk Committee reviews the credit limits for and concentrations with any one reinsurer.
    AIG enters into intercompany reinsurance transactions, primarily through AIRCO, for its General Insurance and Life Insurance operations. AIG enters into these transactions as a sound and prudent business practice in order to maintain underwriting control and spread insurance risk among AIG’s various legal entities. These reinsurance agreements have been approved by the appropriate regulatory authorities. All material intercompany transactions have been eliminated in consolidation. AIG generally obtains letters of credit in order to obtain statutory recognition of these intercompany reinsurance transactions. At December 31, 2005, approximately $3.6 billion of letters of credit were outstanding to cover intercompany reinsurance transactions with AIRCO or other General Insurance subsidiaries.
    At December 31, 2005, the consolidated general reinsurance assets of $23.59 billion include reinsurance recoverables for paid losses and loss expenses of $829 million and $19.69 bil-
AIG  -  Form 10-K
33


 

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
 
lion with respect to the ceded reserve for losses and loss expenses, including ceded losses incurred but not reported (IBNR) (ceded reserves) and $3.07 billion of ceded reserve for unearned premiums. The ceded reserve for losses and loss expenses 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 by management. Any adjustments thereto are reflected in income currently. It is AIG’s belief that the ceded reserve for losses and loss expenses at December 31, 2005 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.
Reserve for Losses and Loss Expenses
The table below classifies as of December 31, 2005 the components of the General Insurance gross reserve for losses and loss expenses (loss reserves) by major lines of business on a statutory Annual Statement basis*:
         
 
(in millions)    
 
Other liability occurrence
  $ 18,116  
Other liability claims made
    12,447  
Workers compensation
    11,630  
Auto liability
    6,569  
Property
    7,217  
International
    4,939  
Reinsurance
    2,886  
Medical malpractice
    2,363  
Aircraft
    1,844  
Products liability
    1,937  
Commercial multiple peril
    1,359  
Accident and health
    1,678  
Fidelity/ surety
    1,072  
Other
    3,112  
 
Total
  $ 77,169  
 
Presented by lines of business pursuant to statutory reporting requirements as prescribed by the National Association of Insurance Commissioners.
    AIG’s reserve for losses and loss expenses represents the accumulation of estimates of ultimate losses, including IBNR and loss expenses. The methods used to determine loss reserve estimates and to establish the resulting reserves are continually reviewed and updated by management. Any adjustments resulting therefrom are reflected in operating income currently. Because loss reserve estimates are subject to the outcome of future events, changes in estimates are unavoidable given that loss trends vary and time is often required for changes in trends to be recognized and confirmed. Reserve changes that increase previous estimates of ultimate cost are referred to as unfavorable or adverse development or reserve strengthening. Reserve changes that decrease previous estimates of ultimate cost are referred to as favorable development.
    At December 31, 2005, General Insurance net loss reserves were $57.5 billion, an increase of $10.22 billion from the prior year-end. The net loss reserve increase includes the fourth quarter 2005 increase in net reserves of approximately $1.8 billion, comprised of $960 million for non-asbestos and environmental exposures, and $873 million for asbestos and environmental exposures. The increase in non-asbestos and environmental reserves includes an increase of $1.44 billion for DBG and decreases of $455 million for Foreign General Insurance and $29 million for Mortgage Guaranty. The DBG increase of $1.44 billion is $140 million greater than the amount previously announced in AIG’s press release of February 9, 2006 as a result of an additional change in estimate related to a commuted reinsurance agreement. The aggregate increase in asbestos and environmental reserves includes increases of $706 million and $167 million, respectively, for DBG and Foreign General Insurance.
    As discussed in more detail below, the fourth quarter 2005 reserve increase was attributable to adverse development primarily related to 2002 and prior accident years, partially offset by favorable development for accident years 2003 through 2005. This reserve action reflects the completion of both the Milliman, Inc. (Milliman) review and AIG’s own actuarial studies in the fourth quarter of 2005.
    The net loss reserves represent loss reserves reduced by reinsurance recoverables, net of an allowance for unrecoverable reinsurance and applicable discount for future investment income. The table below classifies the components of the General Insurance net loss reserves by business unit as of December 31, 2005.
         
 
(in millions)    
 
DBG(a)
  $ 40,782  
Personal Lines(b)
    2,578  
Transatlantic
    5,690  
Mortgage Guaranty
    340  
Foreign General(c)
    8,086  
 
Total Net Loss Reserve
  $ 57,476  
 
(a)  DBG loss reserves include approximately $3.77 billion ($4.26 billion before discount) related to business written by DBG but ceded to AIRCO and reported in AIRCO’s statutory filings. DBG loss reserves also include approximately $407 million related to business included in AIUO’s statutory filings.
 
(b)  Personal Lines loss reserves include $878 million related to business ceded to DBG and reported in DBG’s statutory filings.
(c)  Foreign General loss reserves include approximately $2.15 billion related to business reported in DBG’s statutory filings.
    The DBG net loss reserve of $40.78 billion is comprised principally of the business of AIG subsidiaries participating in the American Home/ National Union pool (11 companies) and the surplus lines pool (Lexington, Starr Excess Liability Insurance Company and Landmark Insurance Company).
    Beginning in 1998, DBG ceded a quota share percentage of its other liability occurrence and products liability occurrence business to AIRCO. The quota share percentage ceded was 40 percent in 1998, 65 percent in 1999, 75 percent in 2000 and 2001, 50 percent in 2002 and 2003, 40 percent in 2004 and 35 percent in 2005 and covered all business written in these years for these lines by participants in the American Home/National Union pool. In 1998 the cession reflected only the other liability occurrence business, but in 1999 and
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AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
subsequent years included products liability occurrence. AIRCO’s loss reserves relating to these quota share cessions from DBG are recorded on a discounted basis. As of year-end 2005, AIRCO carried a discount of approximately $490 million applicable to the $4.26 billion in undiscounted reserves it assumed from the American Home/National Union pool via this quota share cession. AIRCO also carries approximately $440 million in net loss reserves relating to Foreign General insurance business. These reserves are carried on an undiscounted basis.
    Beginning in 1997, the Personal Lines division ceded a percentage of all business written by the companies participating in the personal lines pool to the American Home/National Union pool. As noted above, the total reserves carried by participants in the American Home/National Union pool relating to this cession amounted to $878 million as of year-end 2005.
    The companies participating in the American Home/National Union pool have maintained a participation in the business written by AIU for decades. As of year-end 2005, these AIU reserves carried by participants in the American Home/National Union pool amounted to approximately $2.15 billion. The remaining Foreign General reserves are carried by AIUO, AIRCO, and other smaller AIG subsidiaries domiciled outside the United States. Statutory filings in the U.S. by AIG companies reflect all the business written by U.S. domiciled entities only, and therefore exclude business written by AIUO, AIRCO, and all other internationally domiciled subsidiaries. The total reserves carried at year-end 2005 by AIUO and AIRCO were approximately $3.72 billion and $4.21 billion, respectively. AIRCO’s $4.21 billion in total general insurance reserves consist of approximately $3.77 billion from business assumed from the American Home/National Union pool and an additional $440 million relating to Foreign General Insurance business.
Discounting of Reserves
At December 31, 2005, AIG’s overall General Insurance net loss reserves reflects a loss reserve discount of $2.11 billion, including tabular and non-tabular calculations. The tabular workers compensation discount is calculated using a 3.5 percent interest rate and the 1979-81 Decennial Mortality Table. The non-tabular workers compensation discount is calculated separately for companies domiciled in New York and Pennsylvania, and follows the statutory regulations for each state. For New York companies, the discount is based on a five percent interest rate and the companies’ own payout patterns. For Pennsylvania companies, the statute has specified discount factors for accident years 2001 and prior, which are based on a six percent interest rate and an industry payout pattern. For accident years 2002 and subsequent, the discount is based on the yield of U.S. Treasury securities ranging from one to twenty years and the company’s own payout pattern, with the future expected payment for each year using the interest rate associated with the corresponding Treasury security yield for that time period. The discount is comprised of the following: $512 million — tabular discount for workers compensation in DBG; $1.11 billion — non-tabular discount for workers compensation in DBG; and, $490 million — non-tabular discount for other liability occurrence and products liability occurrence in AIRCO. The total undiscounted workers compensation loss reserve carried by DBG is approximately $9.5 billion as of year-end 2005. The other liability occurrence and products liability occurrence business in AIRCO that is assumed from DBG is discounted based on the yield of U.S. Treasury securities ranging from one to twenty years and the DBG payout pattern for this business. The undiscounted reserves assumed by AIRCO from DBG totaled approximately $4.26 billion at December 31, 2005.
Results of 2005 Reserving Process
It is management’s belief that the General Insurance net loss reserves are adequate to cover General Insurance net losses and loss expenses as of December 31, 2005. While AIG annually reviews the adequacy of established loss reserves, there can be no assurance that AIG’s ultimate loss reserves will not develop adversely and materially exceed AIG’s loss reserves as of December 31, 2005. In the opinion of management, such adverse development and resulting increase in reserves is not likely to have a material adverse effect on AIG’s consolidated financial position, although it could have a material adverse effect on AIG’s consolidated results of operations for an individual reporting period. See “Risk Factors — Casualty Insurance and Underwriting Reserves” in Item 1A. Risk Factors.
    As part of the 2005 year-end actuarial loss reserve analysis, AIG expanded its review processes and conducted additional studies. In addition, in August 2005, AIG commissioned Milliman to provide an independent, comprehensive review of the loss reserves of AIG’s principal property-casualty insurance operations, including an independent ground up study of AIG’s asbestos and environmental exposures. The Milliman review encompassed nearly all of AIG’s carried loss reserves, other than those pertaining to the operations of Transatlantic and 21st Century. AIG’s management carefully considered the analyses provided by its actuarial staff and by Milliman for each class of business in determining AIG’s best estimate of its loss reserves.
AIG  -  Form 10-K
35


 

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
 
The table below presents the reconciliation of net loss reserves for 2005, 2004 and 2003 as follows:
                         
 
(in millions)   2005   2004   2003
 
Net reserve for losses and loss expenses at beginning of year
  $ 47,254     $ 36,228     $ 29,347  
Foreign exchange effect
    (628 )     524       580  
Acquisition
                391 (a)
 
Losses and loss expenses incurred:
                       
Current year
    28,426       26,793       20,509  
Prior years(b)
    4,665 (c)     3,564 (d)     2,363  
 
Losses and loss expenses incurred
    33,091       30,357       22,872  
 
Losses and loss expenses paid:
                       
Current year
    7,331       7,692       6,187  
Prior years
    14,910       12,163       10,775  
 
Losses and loss expenses paid
    22,241       19,855       16,962  
 
Net reserve for losses and loss expenses at end of year
  $ 57,476     $ 47,254     $ 36,228  
 
(a) Reflects the opening balances with respect to the GE U.S.-based auto and home insurance business acquired in 2003.
 
(b) Includes accretion of discount of $(15) million in 2005, including an increase of $375 million in the discount recorded in 2005; $377 million in 2004 and $296 million in 2003. Additionally, includes $269 million in 2005, $317 million in 2004 and $323 million in 2003 for the general reinsurance operations of Transatlantic, and $197 million of additional losses incurred in 2005 resulting from increased labor and material costs related to the 2004 Florida hurricanes.
 
(c) Includes fourth quarter charge of $1.8 billion.
 
(d) Includes fourth quarter charge of $850 million attributable to the change in estimate for asbestos and environmental exposures.
    For 2005, AIG’s overall net loss reserve development from prior accident years was an increase of approximately $4.67 billion, including approximately $269 million from the general reinsurance operations of Transatlantic. This $4.67 billion adverse development in 2005 was comprised of approximately $8.60 billion for 2002 and prior accident years, partially offset by favorable development for accident years 2003 and 2004 for most lines of business, with the notable exception being D&O. The adverse loss development for 2002 and prior accident years is attributable to approximately $4.0 billion of development from D&O and related management liability classes of business, excess casualty, and excess workers compensation, and to approximately $873 million of development from asbestos and environmental claims. The remaining portion of the adverse development for 2002 and prior accident years includes approximately $520 million related to Transatlantic with the balance spread across many other lines of business.
    The largest contributors to the $4.67 billion net adverse loss development were:
D&O and related management liability classes of business: The adverse development for 2002 and prior accident years totalled approximately $1.7 billion, principally related to 2002 and prior accident years. This adverse development resulted from significant loss cost escalation due to a variety of factors, including the following: the increase in frequency and severity of corporate bankruptcies; the increase in frequency of financial statement restatements; the sharp rise in market capitalization of publicly traded companies and the increase in the number of initial public offerings, which led to an unprecedented number of IPO allocation/laddering suits in 2001. In addition, the extensive utilization of multi-year policies during this period limited AIG’s ability to respond to emerging trends as rapidly as would otherwise be the case.
    AIG has experienced significant adverse loss development since 2002 as a result of these issues. AIG has taken numerous actions in response to this development, including rate increases and policy form and coverage changes to better contain future loss costs in this class of business. AIG’s 2005 year-end actuarial reserve analyses for DBG exposures reflected several other noteworthy additional considerations and studies. AIG’s claims staff conducted a series of ground-up claim projections covering all open claims for this class of business through accident year 2004. Given the adverse development observed for this class of business in recent years, for year-end 2005 AIG believed its reserves for this class were better estimated by benchmarking the actuarial indications to these claim projections.
Excess Casualty: The adverse development for prior years was approximately $1.3 billion related to 2001 and prior accident years. This adverse development resulted from significant loss cost increases due to both frequency and severity of claims. The primary drivers of the increasing loss costs were medical inflation, which increased the economic loss component of tort claims; advances in medical care, which extended the life span of severely injured workers; and larger jury verdicts, which increased the value of severe tort claims. An additional factor affecting AIG’s excess casualty experience in recent years has been the accelerated exhaustion of underlying primary policies for homebuilders. This has led to increasing construction defect related claim activity on AIG’s excess policies. As noted above for D&O, many excess casualty policies were written on a multi-year basis in the late 1990s, which limited AIG’s ability to respond to emerging trends as rapidly as would otherwise be the case. AIG responded to these emerging trends by increasing rates and effecting numerous policy form and coverage changes. This led to a significant improvement in experience beginning with accident year 2001. In response to the continuing loss development, AIG increased further the loss development factors for this class of business in its 2005 year-end actuarial reserve analysis. In addition, to more accurately estimate losses for construction defects, a separate review was performed by AIG claims staff for accounts with significant exposure to these claims.
Excess Workers Compensation: The adverse development for prior years was approximately $1 billion related to 2002 and prior accident years. This adverse development resulted from significant loss cost increases, primarily attributable to rapidly increasing medical inflation and advances in medical care, which increased the cost of covered medical care and extended the life span of severely injured workers. The effect of these factors on excess workers compensation claims experience is leveraged, as frequency is increased by the rising number of claims that reach the excess layers.
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AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
    In response to the continuing loss development, an additional study was conducted for the 2005 year-end actuarial reserve analysis for DBG pertaining to the selection of loss development factors for this class of business. Claims for excess workers compensation exhibit an exceptionally long tail of loss development, running for decades from the date the loss is incurred. Thus, the adequacy of loss reserves for this class is sensitive to the estimated loss development factors, as such factors may be applied to many years of loss experience. In order to better estimate the tail development for this class, AIG claims staff conducted a claim by claim projection of the expected ultimate paid loss for each open claim for 1998 and prior accident years as these are the primary years that drive the tail factors. The objective of the study was to provide a benchmark against which loss development factors in the tail could be evaluated.
    For a discussion of the adverse development in asbestos and environmental exposures, see “Asbestos and Environmental Reserves” below.
    The favorable development in 2005 referred to above was principally the result of the following: Most classes of business, with the notable exception of D&O, experienced favorable loss development for accident year 2003, and nearly all classes experienced favorable development for accident year 2004. These accident years are benefiting from the actions AIG has taken in response to the significant improvement in market conditions that occurred beginning in 2001 and that accelerated thereafter. Rates increased sharply for most classes of business, and policy terms and conditions were also improved significantly. In connection with AIG’s 2005 year-end actuarial reserve analysis and after considering the results of the Milliman review, AIG has recognized the improving results to the extent they are credible, evidenced by up to five years of favorable loss experience across many lines of business since the market conditions improved. In addition, AIG has taken this information into consideration in determining the expected loss ratios for the 2005 accident year.
Overview of Loss Reserving Process
    The General Insurance loss reserves can generally be categorized into two distinct groups. One group is long-tail casualty lines of business which include excess and umbrella liability, D&O, professional liability, medical malpractice, workers compensation, general liability, products liability, and related classes. The other group is short-tail lines of business consisting principally of property lines, personal lines and certain classes of casualty lines.
Short-Tail Reserves
    For operations writing short-tail coverages, such as property coverages, the process of recording quarterly loss reserve changes is geared toward maintaining an appropriate reserve level for the outstanding exposure, rather than determining an expected loss ratio for current business. For example, the IBNR reserve required for a class of property business might be expected to approximate 20 percent of the latest year’s earned premiums, and this level of reserve would generally be maintained regardless of the loss ratio emerging in the current quarter. The 20 percent factor is adjusted to reflect changes in rate levels, loss reporting patterns, known exposures to large unreported losses, or other factors affecting the particular class of business.
Long-Tail Reserves
    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. Experience in the more recent accident years of long-tail casualty lines shows limited statistical credibility in reported net losses because a relatively low proportion of net losses would be reported claims and expenses and an even smaller proportion would be net losses paid. Therefore, IBNR would constitute a relatively high proportion of net losses.
    AIG’s carried net long-tail loss reserves are tested using loss trend factors that AIG considers most appropriate for each class of business. A variety of actuarial methods and assumptions is 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 five percent. Loss trend factors reflect many items including changes in claims handling, exposure and policy forms; current and future estimates of monetary inflation and social inflation and increases in litigation and awards. These factors are periodically reviewed and subsequently adjusted, as appropriate, to reflect emerging trends which are based upon past loss experience. Thus, many factors are implicitly considered in estimating the year to year growth in loss costs recognized.
    A number of actuarial assumptions are made in the review of reserves for each line of business. For longer tail lines of business, actuarial assumptions generally are made with respect to the following:
-   Loss trend factors which are used to establish expected loss ratios for subsequent accident years based on the projected loss ratio for prior accident years.
-   Expected loss ratios for the latest accident year (i.e., accident year 2005 for the year end 2005 loss reserve analysis) and, in some cases, for accident years prior to the latest accident year. The expected loss ratio generally reflects the projected loss ratio from prior accident years, adjusted for the loss trend (see above) and the effect of rate changes and other quantifiable factors. For low-frequency, high-severity classes such as excess casualty and D&O, expected loss ratios generally are utilized for at least the three most recent accident years.
-   Loss development factors which are used to project the reported losses for each accident year to an ultimate basis.
    AIG records quarterly changes in loss reserves for each of its many General Insurance profit centers. The overall change in AIG’s loss reserves is based on the sum of these profit center level changes. For most profit centers which write longer tail classes of casualty coverage, the process of recording quarterly loss reserve changes involves determining the estimated current loss ratio for each class of coverage. This loss ratio is multiplied by the current quarter’s net earned premium for that
AIG  -  Form 10-K
37


 

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
 
class of coverage to determine the quarter’s total estimated net incurred loss and loss expense. The change in loss reserves for the quarter for each class is thus the difference between the net incurred loss and loss expense, estimated as described above, and the net paid losses and loss expenses in the quarter.
Details of the Loss Reserving Process
    The process of determining the current loss ratio for each class or business segment is based on a variety of factors. These include, but are not limited to, the following considerations: prior accident year and policy year loss ratios; actual and anticipated rate changes; actual and anticipated changes in coverage, reinsurance, or mix of business; actual and anticipated changes in external factors affecting results, such as trends in loss costs or in the legal and claims environment. Each profit center’s current loss ratio reflects input from actuarial, profit center and claims staff and is intended to represent management’s best estimate of the current loss ratio after reflecting all of the factors described above. At the close of each quarter, the assumptions underlying the loss ratios are reviewed to determine if the loss ratios based thereon remain appropriate. This process includes a review of the actual claims experience in the quarter, actual rate changes achieved, actual changes in coverage, reinsurance or mix of business, and changes in certain other factors that may affect the loss ratio. When this review suggests that the initially determined loss ratio is no longer appropriate, the loss ratio for current business would be changed to reflect the revised assumptions.
    A comprehensive annual loss reserve review is conducted in the fourth quarter of each year for each AIG General Insurance subsidiary. These reviews are conducted in full detail for each class or line of business for each subsidiary, and thus consist of literally hundreds of individual analyses. The purpose of these reviews is to confirm the appropriateness of the reserves carried by each of the individual subsidiaries, and thereby of AIG’s overall carried reserves. The reserve analysis for each business class is performed by the actuarial personnel who are most familiar with that class of business. In completing these detailed actuarial reserve analyses, the actuaries are required to make numerous assumptions, including for example the selection of loss development factors and loss cost trend factors. They are also required to determine and select the most appropriate actuarial method(s) to employ for each business class. Additionally, they must determine the appropriate segmentation of data or segments from which the adequacy of the reserves can be most accurately tested. In the course of these detailed reserve reviews for each business segment, a point estimate of the loss reserve is generally determined. The sum of these point estimates for each of the individual business classes for each subsidiary provides an overall actuarial point estimate of the loss reserve for that subsidiary. The ultimate process by which the actual carried reserves are determined considers not only the actuarial point estimate but a myriad of other factors. Other crucial internal and external factors considered include a qualitative assessment of inflation and other economic conditions in the United States and abroad, changes in the legal, regulatory, judicial and social environments, underlying policy pricing, terms and conditions, and claims handling. Loss reserve development can also be affected by commutations of assumed and ceded reinsurance agreements.
    AIG’s annual loss reserve review does not calculate a range of loss reserve estimates. Because a large portion of the loss reserves from AIG’s General Insurance business relates to long-tail casualty lines driven by severity rather than frequency of claims, such as excess casualty and D&O, developing a range around loss reserve estimates would not be meaningful. An estimate is calculated which AIG’s actuaries believe provides a reasonable estimate of the required reserve. This amount is then evaluated against actual carried reserves.
Volatility of Reserve Estimates and Sensitivity Analyses
    There is potential for significant variation in the development of loss reserves, particularly for long-tail casualty classes of business such as excess casualty, when actual costs differ from the assumptions used to test the reserves. Such assumptions include those made for loss trend factors and loss development factors, as described earlier. Set forth below is a sensitivity analysis demonstrating the estimated effect on the loss reserve position of alternative loss trend or loss development factor assumptions as compared to those actually used to test the carried reserves.
    For the excess casualty class of business the assumed loss cost trend was approximately six percent. A five percent change in the assumed loss cost trend from each accident year to the next would cause approximately a $600 million change (either positively or negatively) to the net loss and loss expense reserve for this business. For the D&O and related management liability classes of business the assumed loss cost trend was four percent. A five percent change in this assumed loss cost trend would cause approximately a $300 million change (either positively or negatively) to the net loss and loss expense reserve for such business. The effect of the loss trend assumption for the D&O class decreased in 2005 as a result of AIG’s change in methodology, as described above, whereby claim projections through accident year 2004 are utilized as a benchmark for the actuarial indications. For the excess workers compensation class of business, loss costs were trended at six percent per annum. A five percent change in the assumed loss cost trend would cause approximately a $250 million change (either positively or negatively) to the loss and loss expense reserve for this class. Actual loss cost trends in the early 1990’s were negative for these classes, whereas in the late 1990’s loss costs trends ran well into the double digits for each of these three classes. The sharp increase in loss costs in the late 1990’s was thus much greater than the five percent changes cited above, and caused significant increases in the overall loss reserve needs for these classes. While changes in the loss cost trend assumptions can have a significant effect on the reserve needs for other smaller classes of liability business, the potential effect of these changes on AIG’s overall carried reserves would be much less than for the classes noted above.
    For the excess casualty class, if future loss development factors differed by five percent from those utilized in the year-end 2005 loss reserve review, there would be approximately a
38
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
$400 million change (either positively or negatively) to the overall AIG loss reserve position. The comparable effect on the D&O and related management liability classes would be approximately $200 million (either positively or negatively) if future loss development factors differed by five percent from those utilized in the year-end 2005 loss reserve review. For the excess workers compensation class, the effect would be approximately $150 million (either positively or negatively). For workers compensation reserves, other than excess workers compensation reserves, the effect of a five percent deviation from the loss development factors utilized in the year-end 2005 reserve reviews would be approximately $1.0 billion (either positively or negatively). Because loss development factors for this class have shown less volatility than higher severity classes such as excess casualty, however, actual changes in loss development factors are expected to be less than five percent. There is some degree of volatility in loss development patterns for other longer tail liability classes as well. However, the potential effect on AIG’s reserves would be much less than for the classes cited above.
    The calculations of the effect of the five percent change in loss development factors are made by selecting the stage of accident year development where it is believed reasonable for such a deviation to occur. For example, for workers compensation, the $1.0 billion amount is calculated by assuming that each of the most recent eight accident years develop five percent higher than estimated by the current loss development factors utilized in the reserve study, i.e. the factor 1.05 is multiplied by the incurred losses (including IBNR and loss expenses) for these accident years.
    AIG management believes that using a five percent change in the assumptions for loss cost trends and loss development factors provides a reasonable benchmark for a sensitivity analysis of the reserves of AIG’s most significant lines of general insurance business. For excess casualty business, both the loss cost trend and the loss development factor assumptions are critical. Generally, actual historical loss development factors are used to project future loss development. However, there can be no assurance that future loss development patterns will be the same as in the past. Moreover, as excess casualty is a long-tail class of business, any deviation in loss cost trends or in loss development factors might not be discernible for an extended period of time subsequent to the recording of the initial loss reserve estimates for any accident year. Thus, there is the potential for the reserves with respect to a number of accident years to be significantly affected by changes in the loss cost trends or loss development factors that were initially relied upon in setting the reserves. These changes in loss trends or loss development factors could be attributable to changes in inflation or in the judicial environment, or in other social or economic phenomena affecting claims. For example, during the lengthy periods during which losses develop for excess casualty, actual changes in loss costs from one accident year to the next have ranged from negative values to double-digit amounts. Thus, there is the potential for significant volatility in loss costs for excess casualty and, although five percent is considered a reasonable benchmark for sensitivity analysis for this business, there is the potential for variations far greater than this amount (either positively or negatively). Likewise, in the judgment of AIG’s actuaries, five percent is considered an appropriate benchmark for sensitivity analysis with respect to the loss development factor assumptions used to test the reserves.
    For D&O and related management liability classes of business, the loss cost trend assumption has been critical in past analyses, however, because of the utilization of claim projections for all claims through accident year 2004, as described above, the sensitivity of the reserves to this assumption has been reduced in 2005. The loss development factor assumption is important but less critical than for excess casualty. As this coverage is written on a claims-made basis, claims for a given accident year are all reported within that year. Actual changes in loss costs from one accident year to the next in the 1990s ranged from double digit negative values for several accident years in the early 1990s to nearly 50 percent per year for the period from accident year 1996 to accident year 1999. Thus, there is the potential for extreme volatility in loss costs for this business and, although five percent is considered a reasonable benchmark for sensitivity analysis, there is the potential for variations far greater than this amount (either positively or negatively). Five percent is also considered an appropriate benchmark for sensitivity analysis with respect to the loss development factor assumptions used to test the reserves for these classes. However, as noted above, the effect of such a deviation is less than that of a similar deviation in loss cost trends. For the excess workers compensation class, the loss development factor assumptions are critical and the loss trend assumption is important but not as critical. Excess workers compensation is an extremely long tail class of business, hence there is a much greater than normal uncertainty as to the appropriate loss development factors for the tail of the loss development. As noted above, the effect of a five percent change in the loss development factor is approximately $150 million. It would not be uncommon for the loss development factors to deviate by greater than five percent for this class of business.
    For workers compensation, the loss development factor assumptions are important. Generally, AIG’s actual historical workers compensation loss development would be expected to provide a reasonably accurate predictor of future loss development. A five percent sensitivity indicator for workers compensation would thus be considered to be toward the high end of potential deviations for this class of business. The loss cost trend assumption for workers compensation is not believed to be material with respect to AIG’s loss reserves. This is primarily because AIG’s actuaries are generally able to use loss development projections for all but the most recent accident year’s reserves, so there is limited need to rely on loss cost trend assumptions for workers compensation business.
    For casualty business other than the classes noted above, there is generally some potential for deviation in both the loss cost trend and loss development factor selections. However, the effect of such deviations would not be material when compared to the effect on the classes cited above.
AIG  -  Form 10-K
39


 

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
 
Asbestos and Environmental Reserves
The estimation of loss reserves relating to asbestos and environmental claims on insurance policies written many years ago is subject to greater uncertainty than other types of claims due to inconsistent court decisions as well as judicial interpretations and legislative actions that in some cases have tended to broaden coverage beyond the original intent of such policies and in others have expanded theories of liability. The insurance industry as a whole is engaged in extensive litigation over these coverage and liability issues and is thus confronted with a continuing uncertainty in its efforts to quantify these exposures.
    AIG continues to receive claims asserting injuries and damages from toxic waste, hazardous substances, and other environmental pollutants and alleged claims to cover the cleanup costs of hazardous waste dump sites, 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. Commencing in 1985, standard policies contained an absolute exclusion for pollution related damage and an absolute asbestos exclusion was also implemented. However, AIG currently underwrites environmental impairment liability insurance on a claims-made basis and has excluded such claims from the analysis 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 amounts. 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.
    Estimation of asbestos and environmental claims loss reserves is a subjective process and reserves for asbestos and environmental claims cannot be estimated using conventional reserving techniques such as those that rely on historical accident year loss development factors.
    Significant factors which affect the trends that influence the asbestos and environmental claims estimation process 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 exposures for cleanup costs of hazardous waste dump sites involve issues such as allocation of responsibility among potentially responsible parties and the government’s refusal to release parties.
    Due to this uncertainty, it is not possible to determine the future development of asbestos and environmental claims with the same degree of reliability as with other types of claims. Such future 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 the changes in Superfund and waste dump site coverage and liability issues. If the asbestos and environmental reserves develop deficiently, such deficiency would have an adverse effect on AIG’s future results of operations. AIG does not discount asbestos and environmental reserves.
    With respect to known asbestos and environmental claims, AIG established over a decade ago specialized toxic tort and environmental claims units, which investigate and adjust all such asbestos and environmental claims. These units evaluate these asbestos and environmental claims utilizing a claim-by-claim approach that involves a detailed review of individual policy terms and exposures. Because each policyholder presents different liability and coverage issues, AIG generally evaluates exposure on a policy-by-policy basis, considering a variety of factors such as known facts, current law, jurisdiction, policy language and other factors that are unique to each policy. Quantitative techniques have to be supplemented by subjective considerations including management judgment. Each claim is reviewed at least semi-annually utilizing the aforementioned approach and adjusted as necessary to reflect the current information.
    In both the specialized and dedicated asbestos and environmental claims units, AIG actively manages and pursues early resolution with respect to these claims in an attempt to mitigate its exposure to the unpredictable development of these claims. AIG attempts to mitigate its known long-tail environmental exposures by utilizing a combination of proactive claim-resolution techniques including policy buybacks, complete environmental releases, compromise settlements, and, where indicated, litigation.
    With respect to asbestos claims handling, AIG’s specialized claims staff operates to mitigate losses through proactive handling, supervision and resolution of asbestos cases. Thus, while AIG has resolved all claims with respect to miners and major manufacturers (Tier One), its claims staff continues to operate under the same proactive philosophy to resolve claims involving accounts with products containing asbestos (Tier Two), products containing small amounts of asbestos, companies in the distribution process, and parties with remote, ill defined involvement in asbestos (Tiers Three and Four). Through its commitment to appropriate staffing, training, and management oversight of asbestos cases, AIG mitigates to the extent possible its exposure to these claims.
    To determine the appropriate loss reserve as of December 31, 2005 for its asbestos and environmental exposures, AIG performed a series of top-down and ground-up reserve analyses. In order to ensure it had the most comprehensive analysis possible, AIG engaged Milliman to provide an analysis of these exposures including ground-up estimates for both asbestos reserves and environmental reserves. Prior to 2005, AIG’s reserve analyses for asbestos and environmental exposures was focused around a report year projection of aggregate losses for both asbestos and environmental reserves. Additional tests such as market share analyses were also performed. Ground-up analyses such as those provided by Milliman take into account policyholder-specific and claim-specific information that has been gathered over many years from a variety of sources. Ground-up studies can thus more accurately assess the exposure to AIG’s layers of coverage for each policyholder, and hence
40
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
for all policyholders in the aggregate provided a sufficient sample of the policyholders can be modeled in this manner.
    In order to ensure its ground-up analysis was as comprehensive as possible, AIG staff produced the information required at policy and claim level detail for nearly 1,000 asbestos defendants and over 1,100 environmental defendants. This represented nearly 90 percent of all accounts for which AIG had received any claim notice of any amount pertaining to asbestos or environmental exposure. AIG did not set any minimum thresholds such as amount of case reserve outstanding, or paid losses to date, that would have served to reduce the sample size and hence the comprehensiveness of the ground-up analysis. The results of the ground-up analysis for each significant account were examined by AIG’s claims staff for reasonableness, for consistency with policy coverage terms, and any claim settlement terms applicable. Adjustments were incorporated accordingly. The results from the universe of modeled accounts, which as noted above reflects the vast majority of AIG’s known exposures, were then utilized to estimate the ultimate losses from accounts that could not be modeled and to determine the appropriate provision for all unreported claims.
    AIG conducted a comprehensive analysis of reinsurance recoverability to establish the appropriate asbestos and environmental reserve net of reinsurance. AIG determined the amount of reinsurance that would be ceded to insolvent reinsurers or to commuted reinsurance contracts for both reported claims and for IBNR. These amounts were then deducted from the indicated amount of reinsurance recoverable.
    AIG also completed a top-down report year projection of its indicated asbestos and environmental loss reserves. These projections consist of a series of tests performed separately for asbestos and for environmental exposures.
    For asbestos, these tests project the expected losses to be reported over the next twenty years, i.e., from 2006 through 2025, based on the actual losses reported through 2005 and the expected future loss emergence for these claims. Three scenarios were tested, with a series of assumptions ranging from more optimistic to more conservative. In the first scenario, all carried asbestos case reserves are assumed to be within ten percent of their ultimate settlement value. The second scenario relies on an actuarial projection of report year development for asbestos claims reported from 1993 to the present to estimate case reserve adequacy as of year-end 2005. The third scenario relies on an actuarial projection of report year claims for asbestos but reflects claims reported from 1989 to the present to estimate case reserve adequacy as of year-end 2005. Based on the results of the prior report years for each of the three scenarios described above, the report year approach then projects forward to the year 2025 the expected future report year losses, based on AIG’s estimate of reasonable loss trend assumptions. These calculations are performed on losses gross of reinsurance. The IBNR (including a provision for development of reported claims) on a net basis is based on applying a factor reflecting the expected ratio of net losses to gross losses for future loss emergence.
    For environmental claims, an analogous series of frequency/ severity tests are produced. Environmental claims from future report years, (i.e., IBNR) are projected out ten years, i.e., through the year 2015.
    At year-end 2005, AIG considered a number of factors and recent experience, in addition to the results of the respective top-down and ground-up analyses performed for asbestos and environmental reserves. Among the factors considered by AIG was the continued deterioration in its asbestos report year experience. The indication from the third scenario as described above for asbestos was approximately $265 million greater than AIG’s carried net asbestos reserve, prior to its increase in the fourth quarter of 2005. This marks a continuation of the trend of adverse report year development for asbestos that has been observed for the past several years. AIG also noted its asbestos paid losses in 2005 increased from 2004’s levels. AIG considered the significant uncertainty that remains as to AIG’s ultimate liability relating to asbestos and environmental claims. This uncertainty is due to several factors including:
-   The long latency period between asbestos exposure and disease manifestation and the resulting potential for involvement of multiple policy periods for individual claims;
-   The increase in the volume of claims by currently unimpaired plaintiffs;
-   Claims filed under the non-aggregate premises or operations section of general liability policies;
-   The number of insureds seeking bankruptcy protection and the effect of prepackaged bankruptcies;
-   Diverging legal interpretations; and
-   With respect to environmental claims, the difficulty in estimating the allocation of remediation cost among various parties.
    After carefully considering the results of the ground-up analysis, which AIG now plans to update on an annual basis, as well as all of the above factors including the recent report year experience, AIG determined its best estimate was to recognize an increase of $843 million in its carried net asbestos reserves, and an increase of $30 million in its carried net environmental reserves at December 31, 2005. The corresponding increases in gross reserves were approximately $1.97 billion for asbestos and $56 million for environmental.
AIG  -  Form 10-K
41


 

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
 
A summary of reserve activity, including estimates for applicable IBNR, relating to asbestos and environmental claims separately and combined at December 31, 2005, 2004 and 2003 follows:
                                                   
 
    2005   2004   2003
             
(in millions)   Gross   Net   Gross   Net   Gross   Net
 
Asbestos:
                                               
 
Reserve for losses and loss expenses at beginning of year
  $ 2,559     $ 1,060     $ 1,235     $ 386     $ 1,304     $ 400  
 
Losses and loss expenses incurred*
    2,207 (a)     903 (a)     1,595 (a)     772 (a)     175       43  
 
Losses and loss expenses paid*
    (325 )     (123 )     (271 )     (98 )     (244 )     (57 )
 
Reserve for losses and loss expenses at end of year
  $ 4,441     $ 1,840     $ 2,559     $ 1,060     $ 1,235     $ 386  
 
Environmental:
                                               
 
Reserve for losses and loss expenses at beginning of year
  $ 974     $ 451     $ 789     $ 283     $ 832     $ 296  
 
Losses and loss expenses incurred*
    47 (b)     27 (b)     314 (b)     234 (b)     133       52  
 
Losses and loss expenses paid*
    (95 )     (68 )     (129 )     (66 )     (176 )     (65 )
 
Reserve for losses and loss expenses at end of year
  $ 926     $ 410     $ 974     $ 451     $ 789     $ 283  
 
Combined:
                                               
 
Reserve for losses and loss expenses at beginning of year
  $ 3,533     $ 1,511     $ 2,024     $ 669     $ 2,136     $ 696  
 
Losses and loss expenses incurred*
    2,254 (c)     930 (c)     1,909 (c)     1,006 (c)     308       95  
 
Losses and loss expenses paid*
    (420 )     (191 )     (400 )     (164 )     (420 )     (122 )
 
Reserve for losses and loss expenses at end of year
  $ 5,367     $ 2,250     $ 3,533     $ 1,511     $ 2,024     $ 669  
 
* All amounts pertain to policies underwritten in prior years.
 
(a) Includes increases to gross losses and loss expense reserves of $2.0 billion and $1.2 billion in the fourth quarter of 2005 and 2004, respectively, and increases to net losses and loss expense reserves of $843 million and $650 million for the fourth quarter of 2005 and 2004, respectively.
 
(b) Includes increases to gross losses and loss expense reserves of $56 million and $250 million in the fourth quarter of 2005 and 2004, respectively, and increases to net losses and loss expense reserves of $30 million and $200 million for the fourth quarter of 2005 and 2004, respectively.
 
(c) Includes increases to gross losses and loss expense reserves of $2.0 billion and $1.5 billion in the fourth quarter of 2005 and 2004, respectively, and increases to net losses and loss expense reserves of $873 million and $850 million for the fourth quarter of 2005 and 2004, respectively.
The gross and net IBNR included in the reserve for losses and loss expenses, relating to asbestos and environmental claims separately and combined, at December 31, 2005, 2004 and 2003 were estimated as follows:
                                                 
 
    2005   2004   2003
             
(in millions)   Gross   Net   Gross   Net   Gross   Net
 
Asbestos
  $ 3,401     $ 1,465     $ 2,033     $ 876     $ 695     $ 200  
Environmental
    586       266       606       284       347       80  
 
Combined
  $ 3,987     $ 1,731     $ 2,639     $ 1,160     $ 1,042     $ 280  
 
A summary of asbestos and environmental claims count activity for the years ended December 31, 2005, 2004 and 2003 was as follows:
                                                                           
 
    2005   2004   2003
             
    Asbestos   Environmental   Combined   Asbestos   Environmental   Combined   Asbestos   Environmental   Combined
 
Claims at beginning of year
    7,575       8,216       15,791       7,474       8,852       16,326       7,085       8,995       16,080  
Claims during year:
                                                                       
 
Opened
    854       5,253 *     6,107       909       2,592       3,501       669       2,106       2,775  
 
Settled
    (67 )     (219 )     (286 )     (100 )     (279 )     (379 )     (86 )     (244 )     (330 )
 
Dismissed or otherwise resolved
    (1,069 )     (3,377 )     (4,446 )     (708 )     (2,949 )     (3,657 )     (194 )     (2,005 )     (2,199 )
 
Claims at end of year
    7,293       9,873       17,166       7,575       8,216       15,791       7,474       8,852       16,326  
 
* The opened claims count increased substantially during 2005 because a court ruling led AIG to report separate opened claims for previously pending cases relating to alleged MTBE exposures that AIG previously had counted in the aggregate as only a single claim on the assumption that the cases would be consolidated into a single federal court proceeding.
   
    The table below presents AIG’s survival ratios for asbestos and environmental claims for year end 2005, 2004 and 2003. The survival ratio is derived by dividing the year end carried loss reserve by the average payments for the three most recent calendar years for these claims. Therefore the survival ratio is a simplistic measure estimating the number of years it would be before the current ending loss reserves for these claims would be paid off using recent year average payments. Many factors, such as aggressive settlement procedures, mix of business and level of coverage provided, have a significant effect on the amount of asbestos and environmental reserves and payments and the resultant survival ratio. Thus, caution should be
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AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
exercised in attempting to determine reserve adequacy for these claims based simply on this survival ratio.
AIG’s survival ratios for asbestos and environmental claims, separately and combined were based upon a three-year average payment. These ratios for the years ended December 31, 2005, 2004 and 2003 were as follows:
                   
 
    Gross   Net
 
2005
               
Survival ratios:
               
 
Asbestos
    15.9       19.8  
 
Environmental
    6.9       6.2  
 
Combined
    13.0       14.2  
 
2004
               
Survival ratios:
               
 
Asbestos
    10.7       13.5  
 
Environmental
    6.5       6.8  
 
Combined
    9.1       10.5  
 
2003
               
Survival ratios:
               
 
Asbestos
    4.7       4.5  
 
Environmental
    4.7       4.1  
 
Combined
    4.7       4.3  
 
Life Insurance & Retirement Services Operations
AIG’s Life Insurance & Retirement Services subsidiaries offer a wide range of insurance and retirement savings products both domestically and abroad. Insurance-oriented products consist of individual and group life, payout annuities, endowment and accident and health policies. Retirement savings products consist generally of fixed and variable annuities. See also Note 2 of Notes to Consolidated Financial Statements.
    Domestically, AIG’s Life Insurance & Retirement Services operations offer a broad range of protection products, including life insurance, group life and health products, including disability income products and payout annuities, which include single premium immediate annuities, structured settlements and terminal funding annuities. Home service operations include an array of life insurance, accident and health and annuity products sold through career agents. In addition, home service includes a small block of run-off property and casualty coverage. Retirement services include group retirement products, individual fixed and variable annuities sold through banks, broker dealers and exclusive sales representatives, and annuity runoff operations which include previously-acquired “closed blocks” and other fixed and variable annuities largely sold through distribution relationships that have been discontinued.
    Overseas, AIG’s Life Insurance & Retirement Services operations include insurance and investment-oriented products such as whole and term life, investment linked, universal life and endowments, personal accident and health products, group products including pension, life and health, and fixed and variable annuities.
Life Insurance & Retirement Services operations presented on a major product basis for 2005, 2004 and 2003 were as follows:
                           
 
(in millions)   2005   2004(a)   2003(a)
 
GAAP Premiums:
                       
Domestic Life:
                       
 
Life insurance
  $ 2,108     $ 1,888     $ 1,751  
 
Home service
    801       812       834  
 
Group life/health
    1,012       1,128       1,046  
 
Payout annuities(b)
    1,473       1,484       1,272  
 
 
Total
    5,394       5,312       4,903  
 
Domestic Retirement Services:                
 
Group retirement products
    351       313       250  
 
Individual fixed annuities
    100       59       53  
 
Individual variable annuities
    467       407       331  
 
Individual fixed annuities — runoff(c)
    72       80       86  
 
 
Total
    990       859       720  
 
Total Domestic
    6,384       6,171       5,623  
 
Foreign Life:
                       
 
Life insurance
    15,631       14,938       13,204  
 
Personal accident & health
    5,002       4,301       3,126  
 
Group products(d)
    1,925       2,215       1,267  
 
 
Total
    22,558       21,454       17,597  
 
Foreign Retirement Services:
                       
 
Individual fixed annuities
    361       395       255  
 
Individual variable annuities
    97       68       21  
 
 
Total
    458       463       276  
 
Total Foreign
    23,016       21,917       17,873  
 
Total GAAP Premiums
  $ 29,400     $ 28,088     $ 23,496  
 
Net investment income:
                       
Domestic Life:
                       
 
Life insurance
  $ 1,411     $ 1,287     $ 1,179  
 
Home service
    605       608       616  
 
Group life/health
    142       123       121  
 
Payout annuities
    912       801       699  
 
 
Total
    3,070       2,819       2,615  
 
Domestic Retirement Services:                
 
Group retirement products
    2,233       2,201       2,055  
 
Individual fixed annuities
    3,393       3,100       2,567  
 
Individual variable annuities
    217       239       239  
 
Individual fixed annuities — runoff(c)
    1,046       1,076       1,266  
 
 
Total
    6,889       6,616       6,127  
 
Total Domestic
    9,959       9,435       8,742  
 
                         
(continued)
AIG  -  Form 10-K
43


 

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
 
 
                           
(in millions)   2005   2004(a)   2003(a)
 
Foreign Life:
                       
 
Life insurance
    4,844       4,065       3,356  
 
Personal accident & health
    255       179       161  
 
Group products
    613       431       326  
 
Intercompany adjustments
    (36 )     (18 )     (15 )
 
 
Total
    5,676       4,657       3,828  
 
Foreign Retirement Services:
                       
 
Individual fixed annuities
    1,728       1,034       368  
 
Individual variable annuities
    771       143       4  
 
 
Total
    2,499       1,177       372  
 
 
Total Foreign
    8,175       5,834       4,200  
 
Total net investment income
  $ 18,134     $ 15,269     $ 12,942  
 
Realized capital gains (losses):
                       
Domestic realized capital gains (losses)(e)
  $ (302 )   $ (329 )   $ (246 )
 
Foreign realized capital gains (losses)(f)
    (260 )     147       330  
Pricing net investment gains(g)
    344       225       156  
 
Total Foreign
    84       372       486  
 
Total realized capital gains (losses)
  $ (218 )   $ 43     $ 240  
 
Operating Income:
                       
 
Domestic(h)
    3,599       3,075       2,765  
 
Foreign
    5,245       4,848       4,042  
 
Total operating income
  $ 8,844     $ 7,923     $ 6,807  
 
Life insurance in–force:
                       
 
Domestic
  $ 825,151 (i)   $ 772,251     $ 645,606  
 
Foreign
    1,027,682       1,085,843       937,425  
 
Total
  $ 1,852,833     $ 1,858,094     $ 1,583,031  
 
(a) Adjusted to conform to 2005 presentation.
 
(b) Includes structured settlements, single premium immediate annuities and terminal funding annuities.
 
(c) Primarily represents runoff annuity business sold through discontinued distribution relationships.
 
(d) Revenues in 2004 includes approximately $640 million of single premium from a reinsurance transaction involving terminal funding business, which is offset by a similar increase of benefit reserves.
 
(e) Includes the effect of hedging activities that do not qualify for hedge accounting treatment under FAS 133 and the application of FAS 52. For 2005, 2004, and 2003, respectively, the amounts included are $63 million, $(6) million, and $19 million.
 
(f) Includes the effect of hedging activities that do not qualify for hedge accounting treatment under FAS 133 and the application of FAS 52. For 2005, 2004, and 2003, respectively, the amounts included are $(500) million, $(134) million, and $59 million.
 
(g) For purposes of this presentation, pricing net investment gains are segregated as a component of total realized gains (losses). They represent certain amounts of realized capital gains where gains are an inherent element in pricing certain life products in some foreign countries.
 
(h) Operating income includes the effect on deferred policy acquisition cost amortization for FAS 97 products related to realized capital gains (losses) and has reduced amortization costs totaling $59 million, $44 million and $54 million for 2005, 2004 and 2003, respectively.
 
(i) Domestic in-force for 2005 includes the effect of the non-renewal of a single large group life case of $36 billion.
    AIG’s Life Insurance & Retirement Services subsidiaries report their operations through the following operating units: Domestic Life — AIG American General, including American General Life Insurance Company (AG Life), USLIFE and AGLA; Domestic Retirement Services — VALIC, AIG Annuity and AIG SunAmerica; Foreign Life — ALICO, AIRCO, AIG Edison Life, AIG Star Life, AIA, Nan Shan and Philamlife.
Life Insurance & Retirement Services Results
The increase in operating income in 2005 compared to 2004 was caused by growth in both domestic and overseas operations. Similarly, the increase in operating income in 2004 compared to 2003 was due to strong growth, particularly overseas.
    Life Insurance & Retirement Services GAAP premiums grew in 2005 when compared with 2004 as well as 2004 when compared with 2003. AIG’s Domestic Life operations had continued growth in term and universal life sales with good performance from the independent distribution channels. GAAP premiums for life insurance grew 12 percent in 2005 reflecting consistently strong sales from the independent distribution channels. Retail periodic life sales increased 18 percent in 2005, representing a compound rate of growth of 16 percent since 2001, compared to modest growth in the industry. Profit margins have been maintained through strict underwriting discipline and low cost. In addition, increases in product prices and retention have offset price increases by reinsurers. Payout annuities declined slightly due to the low interest rate environment and the competitive market conditions for structured settlement and single premium individual annuity business. The domestic group business is below AIG’s growth standards, largely because several accounts where pricing was unacceptable were not renewed and loss experience was higher than anticipated. Restructuring efforts in this business are focused on new product introductions, cross selling and other growth strategies. AGLA, the home service business, is diversifying product offerings, enhancing the capabilities and quality of the sales force, and broadening the markets served beyond those historically serviced in an effort to accelerate growth, although it is expected to remain a slow growth business.
    Domestic Retirement Services businesses faced a challenging environment in 2005 and 2004, as deposits declined approximately 17 percent for 2005 compared to 2004 and 1 percent for 2004 compared to 2003. The decrease in AIG’s individual variable annuity product sales in 2005 was largely attributable to significant variable annuity sales declines at several of AIG’s largest distribution firms due to lackluster equity markets, more
44
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
intense industry competition with regard to living benefit product features and heightened compliance procedures over selling practices. AIG’s introduction of more competitive guaranteed minimum withdrawal features was delayed until late in the fourth quarter due to filing delays associated with the Restatements. During 2005, the interest yield curve flattened and, as a result, competing bank products such as certificates of deposit and other money market instruments with shorter durations than AIG’s individual fixed annuity products became more attractive. The following table reflects deposit amounts for Domestic Retirement Services:
                         
Domestic Retirement Services — Deposits            
 
December 31,
(in millions)   2005   2004   2003
 
Group retirement products*
  $ 6,436     $ 6,502     $ 5,918  
Individual fixed annuities
    7,337       9,947       11,384  
Individual variable annuities
    3,319       4,126       3,412  
Individual fixed annuities - runoff
    200       253       350  
 
  Total
  $ 17,292     $ 20,828     $ 21,064  
 
* Includes mutual funds.
    In 2005, AIG experienced a significant increase in surrender rates in all product lines. Group retirement products experienced higher surrenders as the average participant age increased and a greater percentage of these participants are near retirement age and/or termination of service from their employers. Individual fixed annuities surrender rates are higher in 2005 primarily due to the shape of the interest yield curve and the general aging of the in-force reserves. However, less than 20 percent of the individual fixed annuity reserves are available to surrender without charge. The increase in individual variable annuity surrender rates primarily reflects the higher shock-lapse that occurred following expiration of the surrender charge period on certain 3-year and 7-year contracts (including a large closed block of acquired business). Reflecting a widespread industry phenomenon, this lapse rate, much of which was anticipated when the products were issued, has recently been affected by investor demand to exchange existing policies for new-generation contracts with living benefits or lower fees. In addition, partial withdrawals on certain variable annuity products have increased as AIG has introduced features designed to generate a stream of income to the participants. The following chart shows the amount of reserves by surrender charge category as of December 31, 2005.
                     
Domestic Retirement Services            
Reserves Subject to Surrender Charges            
 
    Group   Individual   Individual
    Retirement   Fixed   Variable
(in millions)   Products*   Annuities   Annuities
 
Zero or no surrender charge
  $39,831   $ 9,324     $ 9,765  
Greater than 0% - 4%
  11,248     10,815       8,386  
Greater than 4%
  2,648     31,183       10,035  
Non-Surrenderable
  892     3,148       81  
 
  Total
  $54,619   $ 54,470     $ 28,267  
 
* Excludes mutual funds.
    A continued increase in the level of surrenders in any of these businesses could increase the amortization of deferred acquisition costs in future years and will negatively affect fee income earned on assets under management. The combination of reduced sales and increased surrenders and withdrawals resulted in significantly lower net flows for total domestic Retirement Services than in the prior year. AIG expects that net flows will remain lower than in prior years as long as an environment of lackluster equity market performance persists and the yield curve remains flat. The following table reflects the net flows for Domestic Retirement Services:
                         
Domestic Retirement Services — Net Flows(a)    
 
December 31,
(in millions)   2005   2004   2003
 
Group retirement products(b)
  $ 628     $ 1,706     $ 2,756  
Individual fixed annuities
    1,759       6,169       8,679  
Individual variable annuities
    (336 )     1,145       927  
Individual fixed annuities - runoff
    (2,508 )     (2,084 )     (1,967 )
 
  Total
  $ (457 )   $ 6,936     $ 10,395  
 
(a) Net flows are defined as deposits received, less benefits, surrenders, withdrawals and death benefits.
(b) Includes mutual funds.
    The majority of the growth in Life Insurance & Retirement Services GAAP premiums in Foreign Life operations was attributable to the life insurance and personal accident & health lines of business. Globally, AIG’s deep and diverse distribution, which includes bancassurance, worksite marketing, direct marketing, and strong agency organizations, provides a powerful platform for growth. This growth was most significant in Japan, where AIG has benefited from a flight to quality and development of multiple distribution channels. In Southeast Asia, AIG maintains significant market share by offering an attractive and diverse product line, distributed by its strong agency force. There has been a continuing trend in Southeast Asia, as the insurance market continues to develop, for clients to purchase investment-oriented products at the expense of traditional term or whole life products. For GAAP reporting purposes, only revenues from policy charges for insurance, administration, and surrender charges are reported as GAAP premiums. This product mix shift contributed to the single digit growth rate in Foreign Life Insurance & Retirement Services GAAP premiums.
    Also in Japan, AIG Edison Life has improved the quality and productivity of its sales force resulting in higher sales and improved new business persistency. AIG Star Life is growing first year premiums as a result of new product introductions and an expanded agency force, and is benefiting from growth in the bank annuity market.
    However, in March of 2006, Japanese tax authorities are expected to announce a reduction in the amount of premium policyholders may deduct from their Japanese tax returns for certain accident and health products. These products are generally sold by independent agents to corporate clients and thus represent a specific niche market segment and not the mainstream accident and health products sold by AIG in Japan. A reduction in the amount of tax deduction related to these products will make them less attractive to the market and will reduce the level of future sales. In addition, a portion of existing policies may be canceled, and depending on the duration of those policies and other factors, could result in a write-off of deferred acquisition costs. At the current time, management does not believe that such losses, should they
AIG  -  Form 10-K
45


 

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
 
occur, would be material to AIG’s consolidated financial condition, results of operations or liquidity.
    The Foreign Retirement Services business continues its strong growth based upon its success in Japan and Korea by expanding its extensive distribution network and leveraging AIG’s product expertise. Somewhat offsetting this growth were the negative effects on customer demand for certain multi-currency fixed annuity products in Japan stemming from currency exchange rate fluctuations. AIG is introducing annuity products in new markets. In January 2005, AIG Star Life entered into an agreement with the Bank of Tokyo Mitsubishi, one of Japan’s largest banks, to market a multi-currency fixed annuity.
    Foreign Life Insurance & Retirement Services operations produced 78 percent, 78 percent and 76 percent of Life Insurance & Retirement Services GAAP premiums in 2005, 2004 and 2003, respectively.
AIG transacts business in most major foreign currencies. The following table summarizes the effect of changes in foreign currency exchange rates on the growth of Life Insurance & Retirement Services GAAP premiums.
         
 
    2005
 
Growth in original currency
    2.7 %
Foreign exchange effect
    2.0  
Growth as reported in U.S. dollars
    4.7 %
 
    The growth in net investment income in 2005 and 2004 parallels the growth in general account reserves and surplus for both Foreign and Domestic Life Insurance & Retirement Services companies. Also, net investment income was positively affected by the compounding of previously earned and reinvested net investment income along with the addition of new cash flow from operations available for investment. The global flattening of the yield curve put additional pressure on yields and spreads, which was partially offset with income generated from other investment sources, including income from partnerships. Partnership income was $273 million and $192 million for 2005 and 2004, respectively. As of first quarter 2004, foreign separate accounts were transferred to the general account per Statement of Position 03-1, resulting in increased net investment income volatility. The positive effect of Statement of Position 03-1 on Foreign Life Insurance & Retirement Services net investment income was $1.34 billion and $271 million for 2005 and 2004, respectively. These amounts do not affect operating income as they are offset in incurred policy benefits.
    AIG’s domestic subsidiaries invest in certain limited liability companies that invest in synthetic fuel production facilities as a means of generating income tax credits. Net investment income includes operating losses of approximately $143 million, $121 million and $108 million, respectively, for 2005, 2004 and 2003 and income taxes includes tax credits and benefits of approximately $203 million, $160 million and $155 million, respectively, for 2005, 2004 and 2003 from these investments. See also Note 12(k) of Notes to Consolidated Financial Statements “Commitments and Contingent Liabilities.”
    Life Insurance & Retirement Services operating income grew by 12 percent in 2005. Operating income for the AIG Domestic Life insurance line of business was up 8 percent and in line with the growth in GAAP premiums for the current year, due in part to growth in the business base and improved mortality results, offset by higher losses recorded in 2005 from limited partnership investments in synthetic fuel production facilities. Operating income for the home service line of business declined as a result of the continued decline in premiums in force and higher insurance and acquisition expenses, combined with an increase in property casualty losses related to hurricanes. The group life/health business and operating income were affected by non-renewal of cases where acceptable margins could not be achieved. In addition, 2005 results were affected by reserve strengthening related to disability income products totaling $12 million compared to reserve strengthening of $178 million for Superior National and $68 million for all other items in 2004. Operating income for the payout annuities line of business increased 22 percent in line with the growth in policy benefit reserves. The group retirement products business recorded a modest increase in operating income due primarily to higher variable annuity fee income and growth in average reserves. Individual fixed annuity results are higher than last year due primarily to 13 percent growth in average reserves, higher surrender charges and reductions in acquisition cost amortization expense resulting from increased capital losses realized on bonds. Individual variable annuity earnings are lower in 2005 when compared to 2004 principally due to favorable deferred acquisition cost amortization variances attributable to changes in assumptions and realized capital loss activity in 2004.
    Foreign Life Insurance & Retirement Services operating income of $5.25 billion for 2005 included $84 million of realized capital gains, and for 2004, operating income of $4.85 billion included $372 million of realized capital gains. Underwriting and investment results before the effects of realized capital gains (losses) increased for all lines of business. On this basis, the life insurance line of business benefited in part from lower amortization of acquisition costs for FAS 97 products, reflective of the increasing investment yields for those portfolios, particularly in Japan. In Southeast Asia, operating income growth attributable to life insurance and deposit-based businesses was partially offset by higher incurred policy benefit costs for contributions to the participating policyholder fund in Singapore, totaling $137 million, related to the settlement of a long disputed local tax issue. Growth in the personal accident & health line of business is generally in line with the growth in premiums and reflects stable profit margins. The group products business grew across all segments and maintained profit margins. The largest contributor to the growth in group products is the pension profit center which enjoyed higher fee income emanating from higher assets under management in Brazil and Southeast Asia. Growth in individual fixed annuities, emanating primarily from Japan, is generally in line with the growth in reserves and net spread rates were maintained. The individual variable annuity line of business also grew in line with the growth in reserves.
46
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
    The contribution of Life Insurance & Retirement Services operating income to AIG’s consolidated income before income taxes, minority interest and cumulative effect of accounting changes amounted to 58 percent in 2005, compared to 53 percent in 2004 and 57 percent in 2003.
Underwriting and Investment Risk
The risks associated with the life and accident & health products are underwriting risk and investment risk. The risk associated with the financial and investment contract products is primarily 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. The emergence of significant adverse experience would require an adjustment to DAC and benefit reserves that could have a substantial effect on AIG’s results of operations.
    Natural disasters such as hurricanes, earthquakes and other catastrophes have the potential to adversely affect AIG’s operating results. Other risks, such as an outbreak of a pandemic disease, such as the Avian Influenza A Virus (H5N1), could adversely affect AIG’s business and operating results to an extent that may be only minimally offset by reinsurance programs.
    While to date, outbreaks of the Avian Flu continue to occur among poultry or wild birds in a number of countries in Asia, parts of Europe, and recently in Africa, transmission to humans has been rare. If the virus mutates to a form that can be transmitted from human to human, it has the potential to spread rapidly worldwide. If such an outbreak were to take place, early quarantine and vaccination could be critical to containment.
    Both the contagion and mortality rate of any mutated H5N1 virus that can be transmitted from human to human are highly speculative. AIG continues to monitor the developing facts. A significant global outbreak could have a material adverse effect on Life Insurance & Retirement Services operating results and liquidity from increased mortality and morbidity rates.
    AIG’s Foreign Life Insurance & Retirement Services companies generally limit their maximum underwriting exposure on life insurance of a single life to approximately $1.7 million of coverage. AIG’s Domestic Life Insurance & Retirement Services companies limit their maximum underwriting exposure on life insurance of a single life to $10 million of coverage in certain circumstances by using yearly renewable term reinsurance. See the discussion under “Liquidity” herein and Note 6 of Notes to Consolidated Financial Statements.
    AIRCO acts primarily as an internal reinsurance company for AIG’s foreign life operations. This facilitates insurance risk management (retention, volatility, concentrations) and capital planning locally (branch and subsidiary). It also allows AIG to pool its insurance risks and purchase reinsurance more efficiently at a consolidated level, manage global counterparty risk and relationships and manage global life catastrophe risks.
    AIG’s domestic Life Insurance & Retirement Services operations utilize internal and third-party reinsurance relationships to manage insurance risks and to facilitate capital management strategies. Pools of highly-rated third-party reinsurers are utilized to manage net amounts at risk in excess of retention limits. AIG’s domestic life insurance companies also cede excess, non-economic reserves carried on a statutory-basis only on certain term and universal life insurance policies and certain fixed annuities to AIG Life of Bermuda Ltd., a wholly owned Bermuda reinsurer.
    AIG generally obtains letters of credit in order to obtain statutory recognition of these intercompany reinsurance transactions. For this purpose, AIG entered into a $2.5 billion syndicated letter of credit facility in December 2004. Letters of credit totaling $2.17 billion were outstanding as of December 31, 2004, and letters of credit for all $2.5 billion were outstanding as of December 31, 2005, all of which relate to life intercompany reinsurance transactions. The letter of credit facility has a ten-year term, but the facility can be reduced or terminated by the lenders beginning after seven years.
    In November 2005, AIG entered into a revolving credit facility for an aggregate amount of $3 billion. The facility can be drawn in the form of letters of credit with terms of up to ten years. As of December 31, 2005 and as of the date hereof, $1.86 billion principal amount of letters of credit are outstanding under this facility, of which approximately $494 million relates to life intercompany reinsurance transactions. AIG also obtained approximately $212 million letters of credit on a bilateral basis.
    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. See also the discussion under “Liquidity” herein.
    To minimize its exposure to investment risk, AIG tests the cash flows from invested assets and policy and contract liabilities using various interest rate scenarios to evaluate investment risk and to confirm that assets are sufficient to pay these liabilities.
    AIG actively manages the asset-liability relationship in its foreign operations, as it has been doing throughout AIG’s history, even though certain territories lack qualified long-term investments or certain local regulatory authorities may impose investment restrictions. For example, in several Asian countries, the duration of the investments is shorter than the effective maturity of the related policy liabilities. Therefore, there is a risk that the reinvestment of the proceeds at the maturity of the initial investments may be at a yield below that of the interest required for the accretion of the policy liabilities. Additionally, there exists a future investment risk associated with certain policies currently in force which will have premium receipts in the future. That is, the investment of these future premium receipts may be at a yield below that required to meet future policy liabilities.
    In 2005, new money investment yields increased in some markets and continued to decrease in others, leading to more frequent adjustments in new business premium rates, credited
AIG  -  Form 10-K
47


 

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
 
rates, and discontinuance of some products. In regard to the inforce business, to maintain an adequate yield to match the interest necessary to support future policy liabilities, management focus is required in both the investment and product management process. Business strategies continue to evolve to maintain profitability of the overall business. As such, in some countries, sales growth may slow for some product lines and accelerate for others.
    The investment of insurance cash flows and reinvestment of the proceeds of matured securities and coupons requires active management of investment yields while maintaining satisfactory investment quality and liquidity.
    AIG may use alternative investments in certain foreign jurisdictions where interest rates remain low and there are limited long-dated bond markets, including equities, real estate and foreign currency denominated fixed income instruments to extend the duration or increase the yield of the investment portfolio to more closely match the requirements of the policyholder liabilities and DAC recoverability. This strategy has been effectively used in Japan and more recently by Nan Shan in Taiwan. Foreign assets comprised approximately 33 percent of Nan Shan’s invested assets at December 31, 2005, slightly below the maximum allowable percentage under current regulation. In response to continued declining interest rates and the volatile exchange rate of the NT dollar, Nan Shan is emphasizing new products with lower implied guarantees, including participating endowments and variable universal life. Although the risks of a continued low interest rate environment coupled with a volatile NT dollar could increase net liabilities and require additional capital to maintain adequate local solvency margins, Nan Shan currently believes it has adequate resources to meet all future policy obligations.
    AIG actively manages the asset-liability relationship in its domestic operations. This relationship is more easily managed through the ample supply of appropriate long-term investments.
    AIG uses asset-liability matching as a management tool worldwide to determine the composition of the invested assets and appropriate marketing strategies. As a part of these strategies, AIG may determine that it is economically advantageous to be temporarily in an unmatched position due to anticipated interest rate or other economic changes. In addition, the absence of long-dated fixed income instruments in certain markets may preclude a matched asset-liability position in those markets.
    A number of guaranteed benefits, such as living benefits or guaranteed minimum death benefits, are offered on certain variable life and variable annuity products. AIG manages its exposure resulting from these long-term guarantees through reinsurance or capital market hedging instruments. See Note 21 of Notes to Consolidated Financial Statements for a discussion of new accounting guidance for these benefits.
    DAC for Life Insurance & Retirement Services products arises from the deferral of those costs that vary with, and are directly related to, the acquisition of new or renewal business. Policy acquisition costs for life insurance products are generally deferred and amortized over the premium paying period of the policy. Policy acquisition costs which relate to universal life and investment-type products, including variable and fixed annuities (investment-oriented products) are deferred and amortized, with interest, as appropriate, in relation to the historical and future incidence of estimated gross profits to be realized over the estimated lives of the contracts. Amortization expense includes the effects of current period realized capital gains and losses. With respect to universal life and investment-oriented products, AIG’s policy, as appropriate, has been to adjust amortization assumptions for DAC when estimates of current or future gross profits to be realized from these contracts are revised. With respect to variable annuities sold domestically (representing the vast majority of AIG’s variable annuity business), the assumption for the long-term annual net growth rate of the equity markets used in the determination of DAC amortization is approximately ten percent. A methodology referred to as “reversion to the mean” is used to maintain this long-term net growth rate assumption, while giving consideration to short-term variations in equity markets. Estimated gross profits include investment income and gains and losses on investments less interest required as well as other charges in the contract less actual mortality and expenses. Current experience and changes in the expected future gross profits are analyzed to determine the effect on the amortization of DAC. The estimation of projected gross profits requires significant management judgment. The elements with respect to the current and projected gross profits are reviewed and analyzed quarterly and are adjusted accordingly.
    AIG’s variable annuity earnings will be affected by changes in market returns because separate account revenues, primarily composed of mortality and expense charges and asset management fees, are a function of asset values.
    DAC for both insurance-oriented and investment-oriented products as well as retirement services products are reviewed for recoverability, which involve estimating the future profitability of current business. This review also involves significant management judgment. If the actual emergence of future profitability were to be substantially different than that estimated, AIG’s results of operations could be significantly affected in future periods. See also Note 4 of Notes to Consolidated Financial Statements.
Insurance and Asset Management Invested Assets
AIG’s investment strategy is to invest primarily in high quality securities while maintaining diversification to avoid significant exposure to issuer, industry and/or country concentrations. With respect to Domestic General Insurance, AIG’s strategy is to invest in longer duration fixed maturity investments to maximize the yields at the date of purchase. With respect to Life Insurance & Retirement Services, AIG’s strategy is to produce cash flows required to meet maturing insurance liabilities. See also the discussion under “Operating Review: Life Insurance & Retirement Services Operations” herein. AIG invests in equities for various reasons, including diversifying its overall exposure to interest rate risk. Available for sale bonds and equity securities are subject to declines in fair value. Such changes in fair value are presented in unrealized appreciation or depreciation of investments, net of taxes, as a component of accumulated other comprehensive income. Generally, insurance
48
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
regulations restrict the types of assets in which an insurance company may invest. 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. 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 between insurance subsidiaries or from the insurance subsidiaries to AIG parent.
The following tables summarize the composition of AIG’s insurance and asset management invested assets by segment, at December 31, 2005 and 2004:
                                                           
 
    Life       Percent
    Insurance &       Distribution
    General   Retirement   Asset       Percent    
(dollars in millions)   Insurance   Services   Management   Total   of Total   Domestic   Foreign
 
2005
                                                       
Fixed maturities:
                                                       
 
Available for sale, at market value
  $ 50,870     $ 273,165     $ 34,174     $ 358,209       66.2 %     59.2 %     40.8 %
 
Held to maturity, at amortized cost
    21,528                   21,528       4.0       100.0        
 
Trading securities, at market value
          1,073       3,563       4,636       0.9       3.3       96.7  
Equity securities:
                                                       
 
Common stocks, at market value
    4,930       15,558       639       21,127       3.9       18.6       81.4  
 
Preferred stocks, at market value
    1,632       760             2,392       0.4       88.8       11.2  
Mortgage loans on real estate, policy and collateral loans
    19       18,406       4,594       23,019       4.3       65.5       34.5  
Short-term investments, including time deposits, and cash
    2,787       6,844       5,815       15,446       2.8       26.1       73.9  
Real estate
    603       2,729       1,710       5,042       0.9       45.2       54.8  
Investment income due and accrued
    1,232       4,073       402       5,707       1.1       56.9       43.1  
Securities lending collateral
    4,931       42,991       11,549       59,471       11.0       87.3       12.7  
Other invested assets
    6,272       7,805       10,459       24,536       4.5       85.7       14.3  
 
Total
  $ 94,804     $ 373,404     $ 72,905     $ 541,113       100.0 %     62.3 %     37.7 %
 
                                                           
2004
                                                       
Fixed maturities:
                                                       
 
Available for sale, at market value
  $ 44,376     $ 259,602     $ 39,077     $ 343,055       68.5 %     61.2 %     38.8 %
 
Held to maturity, at amortized cost
    18,294                   18,294       3.7       100.0        
 
Trading securities, at market value
          600       2,384       2,984       0.6       1.2       98.8  
Equity securities:
                                                       
 
Common stocks, at market value
    4,165       11,280       177       15,622       3.1       21.9       78.1  
 
Preferred stocks, at market value
    1,466       565             2,031       0.4       91.9       8.1  
Mortgage loans on real estate, policy and collateral loans
    22       16,858       5,093       21,973       4.4       65.6       34.4  
Short-term investments, including time deposits, and cash
    2,113       5,515       9,679       17,307       3.4       37.1       62.9  
Real estate
    592       3,007       326       3,925       0.8       22.8       77.2  
Investment income due and accrued
    997       4,035       461       5,493       1.1       57.3       42.7  
Securities lending collateral
    4,889       34,923       9,357       49,169       9.8       86.7       13.3  
Other invested assets
    5,604       7,072       8,316       20,992       4.2       86.7       13.3  
 
Total
  $ 82,518     $ 343,457     $ 74,870     $ 500,845       100.0 %     63.8 %     36.2 %
 
Credit Quality
At December 31, 2005, approximately 61 percent of the fixed maturities investments were domestic securities. Approximately 35 percent of such domestic securities were rated AAA by one or more of the principal rating agencies. Approximately six percent were below investment grade or not rated.
    A significant portion of the foreign fixed income portfolio is rated by Moody’s, S&P or similar foreign services. Similar credit quality rating services are not available in all overseas locations. AIG reviews the credit quality of the foreign portfolio nonrated fixed income investments, including mortgages. At December 31, 2005, approximately 19 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 five percent were below investment grade or not rated at that date. A large portion of the foreign fixed income portfolio are sovereign fixed maturity securities supporting the policy liabilities in the country of issuance.
    Any fixed income security may be subject to downgrade for a variety of reasons subsequent to any balance sheet date.
Valuation of Invested Assets
AIG has the ability to hold any fixed maturity security to its stated maturity, including those fixed maturity securities classified as available for sale. Therefore, the decision to sell
AIG  -  Form 10-K
49


 

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
 
any such fixed maturity security classified as available for sale reflects the judgment of AIG’s management that the security sold is unlikely to provide, on a relative value basis, as attractive a return in the future as alternative securities entailing comparable risks. With respect to distressed securities, the sale decision reflects management’s judgment that the risk-discounted anticipated ultimate recovery is less than the value achievable on sale.
    The valuation of invested assets involves obtaining a market value for each security. The source for the market value is generally from market exchanges or dealer quotations, with the exception of nontraded securities.
    If AIG chooses to hold a security, it evaluates the security for an other-than-temporary impairment in valuation. As a matter of policy, the determination that a security has incurred an other-than-temporary decline in value and the amount of any loss recognition requires the judgment of AIG’s management and a continual review of its investments.
    In general, a security is considered a candidate for other-than-temporary impairment if it meets any of the following criteria:
-   Trading at a significant (25 percent or more) discount to par or amortized cost (if lower) for an extended period of time (nine months or longer);
-   The occurrence of a discrete credit event resulting in (i) the issuer defaulting on a material outstanding obligation; or (ii) the issuer seeking protection from creditors under the bankruptcy laws or any similar laws intended for the court supervised reorganization of insolvent enterprises; or (iii) the issuer proposing a voluntary reorganization pursuant to which creditors are asked to exchange their claims for cash or securities having a fair value substantially lower than par value of their claims; or
-   In the opinion of AIG’s management, it is probable that AIG may not realize a full recovery on its investment, irrespective of the occurrence of one of the foregoing events.
    Once a security has been identified as other-than-temporarily impaired, the amount of such impairment is determined by reference to that security’s contemporaneous market price and recorded as a charge to earnings.
    As a result of these policies, AIG recorded other-than-temporary impairment losses net of taxes of approximately $389 million, $369 million and $1.0 billion in 2005, 2004 and 2003, respectively.
    No impairment charge with respect to any one single credit was significant to AIG’s consolidated financial condition or results of operations, and no individual impairment loss exceeded 1.0 percent of consolidated net income for 2005.
    Excluding the other-than-temporary impairments noted above, the changes in market value for AIG’s available for sale portfolio, which constitutes the vast majority of AIG’s investments, were recorded in accumulated other comprehensive income as unrealized gains or losses, net of tax.
    At December 31, 2005, the fair value of AIG’s fixed maturities and equity securities aggregated to $409.8 billion. At December 31, 2005, aggregate unrealized gains after taxes for fixed maturity and equity securities were $10.5 billion. At December 31, 2005, the aggregate unrealized losses after taxes of fixed maturity and equity securities were approximately $2.6 billion.
    The effect on net income of unrealized losses after taxes will be further mitigated upon realization, because certain realized losses will be charged to participating policyholder accounts, or realization will result in current decreases in the amortization of certain deferred policy acquisition costs.
    At December 31, 2005, unrealized losses for fixed maturity securities and equity securities did not reflect any significant industry concentrations.
The amortized cost of fixed maturities available for sale in an unrealized loss position at December 31, 2005, by contractual maturity, is shown below:
         
 
(in millions)   Amortized Cost
 
Due in one year or less
  $ 3,882  
Due after one year through five years
    25,919  
Due after five years through ten years
    56,204  
Due after ten years
    56,786  
 
Total
  $ 142,791  
 
    In the twelve months ended December 31, 2005, the pretax realized losses incurred with respect to the sale of fixed maturities and equity securities were $1.6 billion. The aggregate fair value of securities sold was $51.7 billion, which was approximately 97 percent of amortized cost. The average period of time that securities sold at a loss during the twelve months ended December 31, 2005 were trading continuously at a price below book value was approximately three months.
50
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
At December 31, 2005, aggregate pretax unrealized gains were $16.1 billion, while the pretax unrealized losses with respect to investment grade bonds, below investment grade bonds and equity securities were $3.3 billion, $404 million and $257 million, respectively. Aging of the pretax unrealized losses with respect to these securities, distributed as a percentage of cost relative to unrealized loss (the extent by which the market value is less than amortized cost or cost), including the number of respective items, was as follows:
                                                                                                   
 
    Less than or equal to   Greater than 20% to   Greater than 50%    
    20% of Cost(a)   50% of Cost(a)   of Cost(a)   Total
                 
Aging   Unrealized   Unrealized   Unrealized   Unrealized
(dollars in millions)   Cost(a)   Loss   Items   Cost(a)   Loss   Items   Cost(a)   Loss   Items   Cost(a)   Loss(b)   Items
 
Investment grade bonds
                                                                                               
 
0-6 months
  $ 101,885     $ 1,984       12,264     $ 36     $ 9       11     $     $           $ 101,921     $ 1,993       12,275  
 
7-12 months
    14,271       426       1,749       1             1                         14,272       426       1,750  
 
>12 months
    19,502       791       2,722       450       107       17       5       3       8       19,957       901       2,747  
 
Total
  $ 135,658     $ 3,201       16,735     $ 487     $ 116       29     $ 5     $ 3       8     $ 136,150     $ 3,320       16,772  
 
Below investment grade bonds
                                                                                               
 
0-6 months
  $ 3,651     $ 129       852     $ 111     $ 29       24     $ 11     $ 6       14     $ 3,773     $ 164       890  
 
7-12 months
    1,524       93       338       139       38       34       2       1       15       1,665       132       387  
 
>12 months
    1,113       84       225       90       24       23                   11       1,203       108       259  
 
Total
  $ 6,288     $ 306       1,415     $ 340     $ 91       81     $ 13     $ 7       40     $ 6,641     $ 404       1,536  
 
Total bonds
                                                                                               
 
0-6 months
  $ 105,536     $ 2,113       13,116     $ 147     $ 38       35     $ 11     $ 6       14     $ 105,694     $ 2,157       13,165  
 
7-12 months
    15,795       519       2,087       140       38       35       2       1       15       15,937       558       2,137  
 
>12 months
    20,615       875       2,947       540       131       40       5       3       19       21,160       1,009       3,006  
 
Total
  $ 141,946     $ 3,507       18,150     $ 827     $ 207       110     $ 18     $ 10       48     $ 142,791     $ 3,724       18,308  
 
Equity securities
                                                                                               
 
0-6 months
  $ 3,041     $ 113       1,109     $ 75     $ 23       71     $ 30     $ 20       42     $ 3,146     $ 156       1,222  
 
7-12 months
    573       41       122       169       45       68       6       4       23       748       90       213  
 
>12 months
    66       4       26       30       6       13       1       1       29       97       11       68  
 
Total
  $ 3,680     $ 158       1,257     $ 274     $ 74       152     $ 37     $ 25       94     $ 3,991     $ 257       1,503  
 
(a) For bonds, represents amortized cost.
 
(b) As more fully described above, upon realization, certain realized losses will be charged to participating policyholder accounts, or realization will result in a current decrease in the amortization of certain deferred policy acquisition costs.
    As stated previously, the valuation for AIG’s investment portfolio comes from market exchanges or dealer quotations, with the exception of nontraded securities. AIG considers nontraded securities to mean certain fixed income investments, certain structured securities, direct private equities, limited partnerships, and hedge funds. The aggregate carrying value of these securities at December 31, 2005 was approximately $62 billion.
    The methodology used to estimate fair value of nontraded fixed income investments is by reference to traded securities with similar attributes and using a matrix pricing methodology. This technique takes into account such factors as the industry, the security’s rating and tenor, its coupon rate, its position in the capital structure of the issuer, and other relevant factors. The change in fair value is recognized as a component of accumulated other comprehensive income, net of tax.
    For certain structured securities, the carrying value is based on an estimate of the security’s future cash flows pursuant to the requirements of Emerging Issues Task Force Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets.” The change in carrying value is recognized in income.
    Hedge funds and limited partnerships in which AIG holds in the aggregate less than a five percent interest are carried at fair value. The change in fair value is recognized as a component of accumulated other comprehensive income, net of tax.
    With respect to hedge funds and limited partnerships in which AIG holds in the aggregate a five percent or greater interest, AIG uses the equity method to record these investments. The changes in such net asset values are recorded in income.
    AIG obtains the fair value of its investments in limited partnerships and hedge funds from information provided by the general partner or manager of each of these investments, the accounts of which are generally audited on an annual basis.
    Each of these investment categories is tested to determine if impairment in value exists. Various valuation techniques are used with respect to each category in this determination.
Financial Services Operations
AIG’s Financial Services subsidiaries engage in diversified activities including aircraft and equipment leasing, capital markets transactions, consumer finance and insurance premium financing. See also Note 2 of Notes to Consolidated Financial Statements.
AIG  -  Form 10-K
51


 

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
 
Aircraft Finance
AIG’s Aircraft Finance operations represent the operations of ILFC, which 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.
    ILFC finances its purchases of aircraft primarily through the issuance of a variety of debt instruments. The composite borrowing rates at December 31, 2005, 2004 and 2003 were 5.00 percent, 4.34 percent and 4.53 percent, respectively. See also the discussions under “Capital Resources” and “Liquidity” herein and Notes 2 and 9 of Notes to Consolidated Financial Statements.
    ILFC’s sources of revenue are principally from scheduled and charter airlines and companies associated with the airline industry. The airline industry is sensitive to changes in economic conditions, cyclical and highly competitive. Airlines and related companies may be affected by political or economic instability, terrorist activities, changes in national policy, competitive pressures on certain air carriers, fuel prices and shortages, labor stoppages, insurance costs, recessions, and other political or economic events adversely affecting world or regional trading markets. ILFC’s revenues and income will be affected by its customers’ ability to react and cope with the volatile competitive environment in which they operate, as well as ILFC’s own competitive environment.
    ILFC is exposed to operating loss and liquidity strain through nonperformance of aircraft lessees, through owning aircraft which it would be unable to sell or re-lease at acceptable rates at lease expiration and, in part, through committing to purchase aircraft which it would be unable to lease.
    ILFC manages the risk of nonperformance by its lessees with security deposit requirements, through repossession rights, overhaul requirements, and closely monitoring industry conditions through its marketing force. However, there can be no assurance that ILFC would be able to successfully manage the risks relating to the effect of possible future deterioration in the airline industry. Approximately 90 percent of ILFC’s fleet is leased to non-U.S. carriers, and this fleet, comprised of the most efficient aircraft in the airline industry, continues to be in high demand from such carriers.
    ILFC typically contracts to re-lease aircraft before the end of the existing lease term. For aircraft returned before the end of the lease term, ILFC has generally been able to re-lease such aircraft within two to six months of its return. As a lessor, ILFC considers an aircraft “idle” or “off lease” when the aircraft is not subject to a signed lease agreement or signed letter of intent. ILFC had no aircraft off lease at December 31, 2005. As of March 10, 2006, all new aircraft deliveries in 2006 have been leased, and 76 percent of 2007 new aircraft deliveries have been leased. See also the discussions under “Capital Resources” and “Liquidity” herein.
    ILFC sold two portfolios consisting of 34 and 37 aircraft in 2004 and 2003, respectively, to two trusts connected to securitization transactions. Certain of AIG’s Life Insurance & Retirement Services businesses purchased a large share of the securities issued in connection with these securitizations, which included both debt and equity securities.
    Management formally reviews regularly, and no less frequently than quarterly, issues affecting ILFC’s fleet, including events and circumstances that may cause impairment of aircraft values. Management evaluates aircraft in the fleet as necessary, based on these events and circumstances in accordance with Statement of Financial Accounting Standards No. 144 — “Accounting for the Impairment or Disposal of Long-Lived Assets” (FAS 144). ILFC has not recognized any impairment related to its fleet, as the existing service potential of the aircraft in ILFC’s portfolio has not been diminished. Further, ILFC has been able to re-lease the aircraft without diminution in lease rates to an extent that would require an impairment write-down. See also the discussions under “Liquidity” herein.
Capital Markets
Capital Markets represents the operations of AIGFP, which engages in a wide variety of financial transactions, including standard and customized interest rate, currency, equity, commodity and credit products and structured borrowings through notes, bonds and guaranteed investment agreements. AIGFP also engages in various commodity and foreign exchange trading, and market-making activities.
    As Capital Markets is a transaction-oriented operation, current and past revenues and operating results may not provide a basis for predicting future performance. Also, AIG’s Capital Markets operations may be adversely affected by the downgrades in AIG’s credit ratings. See “Risk Factors — AIG’s Credit Ratings,” in Item 1A. Risk Factors for a further discussion of the potential effect of the rating downgrades on AIG’s Capital Markets businesses.
    AIG’s Capital Markets operations derive substantially all their revenues from hedged financial positions entered in connection with counterparty transactions rather than from speculative transactions. AIGFP participates in the derivatives and financial transactions dealer markets conducting, primarily as principal, an interest rate, currency, equity, commodity, energy and credit products business.
    As a dealer in financial derivatives, AIGFP marks all derivative and trading transactions to fair value daily. Thus, a gain or loss on each transaction is recognized daily. Under GAAP, in certain instances, gains and losses are required to be recorded in earnings immediately, whereas in other instances, they are required to be recognized over the life of the underlying instruments. AIGFP economically hedges the market risks arising from its transactions, although hedge accounting is not currently being applied to any of the derivatives and related assets and liabilities. Accordingly, revenues and operating income are exposed to volatility resulting from differences in the timing of revenue recognition between the derivatives and the hedged assets and liabilities. Revenues and operating income of the Capital Markets operations and the percentage change in these amounts for any given period are also significantly affected by the number, size and profitability of transactions entered into by these subsidiaries during that
52
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
period relative to those entered into during the prior period. Generally, the realization of trading revenues as measured by the receipt of funds is not a significant reporting event as the gain or loss on AIGFP’s trading transactions is currently reflected in operating income as the fair values change from period to period.
    Derivative transactions are entered into in the ordinary course of Capital Markets operations. Therefore, income on interest rate, currency, equity, commodity, energy and credit derivatives is recorded at fair value, determined by reference to the mark to market value of the derivative or their estimated fair value where market prices are not readily available. The resulting aggregate unrealized gains or losses from the derivative are reflected in the income statement in the current year. Where Capital Markets cannot verify significant model inputs to observable market data and verify the model value to market transactions, Capital Markets values the contract at the transaction price at inception and, consequently, records no initial gain or loss in accordance with Emerging Issues Task Force Issue No. 02-03, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities” (EITF 02-03). Such initial gain or loss is recognized over the life of the transaction. Capital Markets periodically reevaluates its revenue recognition under EITF 02-03 based on the observability of market parameters. The mark to fair value of derivative transactions is reflected in the balance sheet in the captions “Unrealized gain on swaps, options and forward transactions,” “Unrealized loss on swaps, options and forward transactions,” “Trading assets” and “Trading liabilities.” Unrealized gains represent the present value of the aggregate of each net receivable by counterparty, and the unrealized losses represent the present value of the aggregate of each net payable by counterparty as of December 31, 2005. These amounts will change from one period to the next due to changes in interest rates, currency rates, equity and commodity prices and other market variables, as well as cash movements, execution of new transactions and the maturing of existing transactions. See also the discussion under “Derivatives” herein and Note 20 of Notes to Consolidated Financial Statements.
    Spread income on investments and borrowings is recorded on an accrual basis over the life of the transaction. Investments are classified as securities available for sale and are marked to market with the resulting unrealized gains or losses reflected in accumulated other comprehensive income. U.S. dollar denominated borrowings are carried at cost, while borrowings in any currency other than the U.S. dollar result in unrealized foreign exchange gains or losses reported in income. AIGFP hedges the economic exposure on its investments and borrowings through its derivatives portfolio. The requirements under FAS 133 hedge accounting were not met for these hedge transactions for the years ending December 31, 2005, 2004 and 2003. Thus, these hedges are marked to fair value with the unrealized gains or losses reported in income.
Consumer Finance
Domestically, AIG’s Consumer Finance operations are principally conducted through AGF. AGF derives a substantial portion of its revenues from finance charges assessed on outstanding mortgages, home equity loans, secured and unsecured consumer loans and retail merchant financing. The real estate loans include first or second mortgages on residential real estate generally having a maximum term of 360 months, and are considered non-conforming. These loans may be closed-end accounts or open-end home equity lines of credit and may be fixed-rate or adjustable rate products. The secured consumer loans are secured by consumer goods, automobiles, or other personal property. Both secured and unsecured consumer loans generally have a maximum term of 60 months. The core of AGF’s originations are sourced through its branches. However, a significant volume of real estate loans are also originated through broker relationships, and to lesser extents, through correspondent relationships and direct mail solicitations.
    Many of AGF’s borrowers are non-conforming, non-prime or sub-prime. Current economic conditions, such as interest rate and employment, have a direct effect on the borrowers’ ability to repay these loans. AGF manages the credit risk inherent in its portfolio by using credit scoring models at the time of credit applications, established underwriting criteria, and in certain cases, individual loan reviews. AGF’s Credit Strategy and Policy Committee monitors the quality of the finance receivables portfolio on a monthly basis when determining the appropriate level of the allowance for finance receivable losses. The Credit Strategy and Policy Committee bases its conclusions on quantitative analyses, qualitative factors, current economic conditions and trends, and each committee member’s experience in the consumer finance industry. Through 2005, the credit quality of AGF’s finance receivables continues to be strong.
    Overseas operations, particularly those in emerging markets, provide credit cards, personal and auto loans, term deposits, savings accounts, sales finance and mortgages.
    Consumer Finance operations are exposed to loss when contractual payments are not received. Credit loss exposure is managed through tight underwriting controls, mix of loans, collateral, and collection efficiency.
AIG  -  Form 10-K
53


 

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
 
Financial Services operations for 2005, 2004 and 2003 were as follows:
                           
 
(in millions)   2005   2004   2003
 
Revenues(a):
                       
 
Aircraft Finance(b)
  $ 3,578     $ 3,136     $ 2,897  
 
Capital Markets(c)(d)
    3,260       1,278       595  
 
Consumer Finance(e)
    3,613       2,978       2,642  
 
Other
    74       103       108  
 
Total
  $ 10,525     $ 7,495     $ 6,242  
 
Operating income (loss)(a):
                       
 
Aircraft Finance
  $ 679     $ 642     $ 672  
 
Capital Markets(d)
    2,661       662       (188 )
 
Consumer Finance(f)
    901       808       623  
 
Other, including intercompany adjustments
    35       68       75  
 
Total
  $ 4,276     $ 2,180     $ 1,182  
 
(a) Includes the effect of hedging activities that do not qualify for hedge accounting treatment under FAS 133, including the related foreign exchange gains and losses. For 2005, 2004 and 2003, the effect was $(34) million, $(27) million and $49 million, respectively, in operating income for Aircraft Finance and $2.01 billion, $(122) million and $(1.01) billion in both revenues and operating income for Capital Markets.
 
(b) Revenues are primarily from ILFC aircraft lease rentals.
(c) Revenues, shown net of interest expense, are primarily from hedged financial positions entered into in connection with counterparty transactions and the effect of hedging activities that do not qualify for hedge accounting treatment under FAS 133 described in (a) above.
(d) Certain transactions entered into by AIGFP generate tax credits and benefits which are included in income taxes in the consolidated statement of income. The amount of such tax credits and benefits for the years ended December 31, 2005, 2004 and 2003 are $67 million, $107 million and $123 million, respectively.
(e) Revenues are primarily finance charges.
 
(f) Includes $62 million of catastrophe related losses for 2005.
Financial Services Results
Financial Services operating income increased in 2005 compared to 2004 as well as 2004 compared to 2003. Fluctuations in revenues and operating income from quarter to quarter are not unusual because of the transaction-oriented nature of Capital Markets operations and the effect of hedging activities that do not qualify for hedge accounting under FAS 133. Capital Markets operating income was also negatively affected in 2004 by the costs of the PNC settlement. See Item 3. Legal Proceedings.
    To the extent the Financial Services subsidiaries, other than AIGFP, use derivatives to economically hedge their assets or liabilities with respect to their future cash flows, and such hedges do not qualify for hedge accounting treatment under FAS 133, the changes in fair value of such derivatives are recorded in realized capital gains (losses) or other revenues.
    Financial market conditions in 2005 compared with 2004 were characterized by a general flattening of interest rate yield curves across fixed income markets globally, some tightening of credit spreads and equity valuations that were slightly higher. AIGFP’s 2005 results were adversely affected by customer uncertainty surrounding the negative actions of the rating agencies and the ongoing investigations, as well as the negative effect on its structured notes business of AIG being unable to fully access the capital markets during 2005.
    Financial market conditions in 2004 compared with 2003 were characterized by interest rates which were broadly unchanged across fixed income markets globally, a tightening of credit spreads and higher equity valuations. Capital Markets results in 2004 compared with 2003 reflected a shift in product activity to respond to these conditions.
    The most significant component of Capital Markets operating expenses is compensation, which was approximately $481 million, $497 million and $616 million in 2005, 2004 and 2003, respectively. The amount of compensation was not affected by gains and losses not qualifying for hedge accounting treatment under FAS 133.
    ILFC continued to see net improvements in lease rates, an increase in demand for the newer, modern, fuel efficient aircraft comprising the bulk of ILFC’s fleet, and an increasing level of interest from traditional buyers, third-party investors and debt providers for the purchase of aircraft from ILFC’s extensive lease portfolio. During 2005, ILFC’s revenues and operating income also increased as a result of adding more aircraft to its fleet and earning higher revenues on existing aircraft. However, these increases were offset by increasing interest rates, fewer aircraft sales, and leasing related and other reserves.
    During the fourth quarter of 2004, ATA Airlines and related entities (ATA) filed for protection under Chapter 11 of the U.S. Bankruptcy Code. On the basis of estimates of the probable outcome of the ATA bankruptcy, ILFC recorded pre-tax charges aggregating $54 million in the fourth quarter of 2004 to write down the value of the ATA securities and guarantees.
    Consumer Finance operations, both domestically and internationally, did very well with increased revenues and operating income. Domestically, the Consumer Finance operations had a record year in 2005. The relatively low interest rate environment contributed to a high level of mortgage refinancing activity. Real estate finance receivables increased 21 percent during 2005. Despite high energy costs, the U.S. economy continued to expand during the year improving consumer credit quality. Both AGF’s charge-off ratio and delinquency ratio improved over prior years. However, AGF incurred charges of approximately $62 million for the estimated effect of Hurricane Katrina on customers in the Gulf Coast areas affected by the storm. A new bankruptcy law went into effect in October 2005. Consumers, including some of AGF’s customers, filed for personal bankruptcy protection under the old law in record numbers in third quarter 2005 ahead of the new law’s effective date. AGF does not anticipate a significant effect on its earnings from this new law because 80 percent of its finance receivables are real estate loans with adequate collateral and conservative loan-to-value ratios.
    Foreign Consumer Finance operations performed well, as the operations in Poland, Argentina and AIG Federal Savings Bank recorded strong earnings growth. The Hong Kong
54
AIG  -  Form 10-K


 

AMERICAN INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
 
businesses experienced solid loan and earnings growth in a strengthening economy.
    Financial Services operating income represented 28 percent of AIG’s consolidated income before income taxes, minority interest and cumulative effect of accounting changes in 2005. This compares to 15 percent and 10 percent in 2004 and 2003, respectively. The increase in contribution percentage in 2005 compared to 2004 and 2003 was primarily due to the fluctuation in earnings resulting from derivatives that did not qualify for hedge accounting under FAS 133 and the reduction in General Insurance operating income in 2005.
Financial Services Invested Assets
The following table is a summary of the composition of AIG’s Financial Services invested assets at December 31, 2005 and 2004. See also the discussions under “Operating Review — Financial Services Operations”, “Capital Resources” and “Derivatives” herein.
                                 
 
    2005   2004
         
    Invested   Percent of   Invested   Percent of
(dollars in millions)   Assets   Total   Assets   Total
 
Flight equipment primarily under operating leases, net of accumulated depreciation
  $ 36,245       24.1 %   $ 32,130       21.6 %
Finance receivables, net of allowance
    27,995       18.6       23,574       15.9  
Unrealized gain on swaps, options and forward transactions
    18,695       12.4       22,670       15.3  
Securities available for sale, at market value
    37,511       24.9       31,225       21.0  
Trading securities, at market value
    6,499       4.3       2,746       1.8  
Securities purchased under agreements to resell, at contract value
    14,519       9.7       26,272       17.7  
Trading assets
    1,204       0.8       3,433       2.3  
Spot commodities
    92       0.1       534       0.4  
Other, including short-term investments
    7,615       5.1       5,982       4.0  
 
Total
  $ 150,375       100.0 %   $ 148,566       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 2005, ILFC acquired flight equipment costing $6.19 billion. See also the discussion under “Operating Review — Financial Services Operations” and “Capital Resources” herein.
    At December 31, 2005, ILFC had committed to purchase 338 new and used aircraft deliverable from 2006 through 2015 at an estimated aggregate purchase price of $23.3 billion and had options to purchase 16 new aircraft at an estimated aggregate purchase price of $1.5 billion. As of March 10, 2006, ILFC has entered into leases for all of the new aircraft to be delivered in 2006, 65 of 85 of the new aircraft to be delivered in 2007 and 11 of 155 of the new aircraft to be delivered subsequent to 2007. ILFC will be required to find customers for any aircraft currently on order and any aircraft to be ordered, and it must arrange financing for portions of the purchase price of such equipment. ILFC has been successful to date both in placing its new aircraft on lease or under sales contract and obtaining adequate financing, but there can be no assurance that such success will continue in future environments.
    AIG’s Consumer Finance operations provide a wide variety of consumer finance products, including real estate mortgages, credit cards, consumer loans, retail sales finance and credit-related insurance to customers both domestically and overseas, particularly in emerging markets. These products are funded through a combination of deposits and various borrowings including commercial paper and medium term notes. AIG’s Consumer Finance operations are exposed to credit risk and risk of loss resulting from adverse fluctuations in interest rates. Over half of the loan balance is related to real estate loans which are substantially collateralized by the related properties.
    With respect to credit losses, the allowance for finance receivable losses is maintained at a level considered adequate to absorb anticipated credit losses existing in that portfolio.
    Capital Markets 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 required to sell or close out the transactions prior to maturity. AIG believes that the effect of any such event would not be significant to AIG’s financial condition or its overall liquidity. See also the discussion under “Operating Review — Financial Services Operations” and “Derivatives” herein.
    AIGFP uses the proceeds from the issuance of notes, bonds and GIA borrowings to invest in a diversified portfolio of securities, including securities available for sale, at market, and derivative transactions. The funds may also be temporarily invested in securities purchased under agreements to resell. The proceeds from the disposal of the aforementioned securities available for sale and securities purchased under agreements to resell have been used to fund the maturing GIAs or other AIGFP financings, or invest in new assets. See also the discussion under “Capital Resources” herein.
    Securities available for sale is predominately a portfolio of fixed income securities, where the individual securities have
AIG  -  Form 10-K
55


 

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
 
varying degrees of credit risk. At December 31, 2005, 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 economically hedge its credit risk associated with $125 million of these securities. Securities deemed below investment grade at December 31, 2005 amounted to approximately $166 million in fair value representing 0.4 percent of the total AIGFP securities available for sale. There have been no significant downgrades through March 1, 2006. If its securities available for sale portfolio were to suffer significant default and the collateral held declined significantly in value with no replacement or the credit default swap counterparty failed to perform, AIGFP could have a liquidity strain. AIG guarantees AIGFP’s payment obligations, including its debt obligations.
    AIGFP’s risk management objective is to minimize interest rate, currency, commodity and equity risks associated with its securities available for sale. That is, when AIGFP purchases a security for its securities available for sale investment portfolio, it simultaneously enters into an offsetting internal hedge such that the payment terms of the hedging transaction offset the payment terms of the investment security, which achieves the economic result of converting the return on the underlying security to U.S. dollar LIBOR plus or minus a spread based on the underlying profit on each security on the initial trade date. The market risk associated with such internal hedges is managed on a portfolio basis, with third-party hedging transactions executed as necessary. As hedge accounting treatment is not achieved in accordance with FAS 133, the unrealized gains and losses on the securities related economic hedges are reflected in operating income, whereas the unrealized gains and losses on the underlying securities resulting from changes in interest rates, currency rates, commodity and equity prices, are recorded in accumulated other comprehensive income. When a security is sold, the related hedging transaction is terminated, and the realized gain or loss with respect to this security is then recorded in operating income.
    Securities purchased under agreements to resell are treated as collateralized financing 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 it deems necessary, it requires additional collateral to be deposited.
    AIGFP also conducts, as principal, trading activities in foreign exchange, and commodities, primarily precious metals. AIGFP owns inventories in the commodities, which it records at the lower of cost or market, in which it trades and may reduce the exposure to market risk through the use of swaps, forwards, futures, and option contracts. AIGFP uses derivatives to manage the economic exposure of its various trading positions and transactions from adverse movements of interest rates, foreign currency exchange rates and commodity prices. AIGFP 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” herein and Note 20 of Notes to Consolidated Financial Statements.