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DERIVATIVES AND HEDGE ACCOUNTING
 3 Months Ended
Mar. 31, 2014
DERIVATIVES AND HEDGE ACCOUNTING  
DERIVATIVES AND HEDGE ACCOUNTING

9. DERIVATIVES AND HEDGE ACCOUNTING

We use derivatives and other financial instruments as part of our financial risk management programs and as part of our investment operations. See Note 11 to the Consolidated Financial Statements in the 2013 Annual Report for a discussion of our accounting policies and procedures regarding derivatives and hedge accounting.

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

March 31, 2014December 31, 2013
Gross Derivative AssetsGross Derivative LiabilitiesGross Derivative AssetsGross Derivative Liabilities
NotionalFairNotionalFairNotionalFairNotionalFair
(in millions)AmountValue(a)AmountValue(a)AmountValue(a)AmountValue(a)
Derivatives designated as
hedging instruments:
Interest rate contracts(b)$ -$ -$ 114$ 13$ -$ -$ 112$ 15
Foreign exchange contracts 210 2 1,752 153 - - 1,857 190
Equity contracts(c) 80 4 25 - - - - -
Derivatives not designated
as hedging instruments:
Interest rate contracts(b) 54,735 3,797 58,374 4,399 50,897 3,771 59,585 3,849
Foreign exchange contracts 2,091 35 3,840 101 1,774 52 3,789 129
Equity contracts(c) 4,106 203 32,531 875 29,296 413 9,840 524
Commodity contracts 17 1 13 4 17 1 13 5
Credit contracts 60 41 15,252 1,226 70 55 15,459 1,335
Other contracts(d) 33,396 36 1,325 171 32,440 34 1,408 167
Total derivatives not
designated as hedging
instruments 94,405 4,113 111,335 6,776 114,494 4,326 90,094 6,009
Total derivatives, gross$ 94,695$ 4,119$ 113,226$ 6,942$ 114,494$ 4,326$ 92,063$ 6,214

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

(b) Includes cross-currency swaps.

(c) Notional amount of derivative assets and fair value of derivative assets were both zero at March 31, 2014 and were $23.2 billion and $107 million at December 31, 2013, respectively, related to bifurcated embedded derivatives. Notional amount of derivative liabilities and fair value of derivative liabilities include $32 billion and $782 million, respectively, at March 31, 2014, and $6.7 billion and $424 million, respectively, at December 31, 2013, related to bifurcated embedded derivatives. A bifurcated embedded derivative is generally presented with the host contract in the Condensed Consolidated Balance Sheets.

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

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

March 31, 2014December 31, 2013
Derivative AssetsDerivative LiabilitiesDerivative AssetsDerivative Liabilities
NotionalFairNotionalFairNotionalFairNotionalFair
(in millions)AmountValueAmountValueAmountValueAmountValue
Global Capital Markets derivatives:
AIG Financial Products$ 41,629$ 2,470$ 52,643$ 3,850$ 41,942$ 2,567$ 52,679$ 3,506
AIG Markets 14,986 1,016 19,263 1,499 12,531 964 23,716 1,506
Total Global Capital Markets derivatives 56,615 3,486 71,906 5,349 54,473 3,531 76,395 5,012
Non-Global Capital Markets derivatives(a) 38,080 633 41,320 1,593 60,021 795 15,668 1,202
Total derivatives, gross$ 94,695 4,119$ 113,226 6,942$ 114,494 4,326$ 92,063 6,214
Counterparty netting(b) (1,680) (1,680) (1,734) (1,734)
Cash collateral(c) (838) (1,375) (820) (1,484)
Total derivatives, net 1,601 3,887 1,772 2,996
Less: Bifurcated embedded derivatives - 848 107 485
Total derivatives on consolidated
balance sheet$ 1,601$ 3,039$ 1,665$ 2,511

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

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

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

Collateral

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

Collateral posted by us to third parties for derivative transactions was $3.0 billion and $3.2 billion at March 31, 2014 and December 31, 2013, respectively. In the case of collateral posted under derivative transactions that are not subject to clearing, this collateral can generally be repledged or resold by the counterparties. Collateral provided to us from third parties for derivative transactions was $1.1 billion and $1.0 billion at March 31, 2014 and December 31, 2013, respectively. We generally can repledge or resell this collateral.

Offsetting

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

Hedge Accounting

We designated certain derivatives entered into by Global Capital Markets (GCM) with third parties as fair value hedges of available-for-sale investment securities held by our insurance subsidiaries. The fair value hedges include foreign currency forwards designated as hedges of the change in fair value of foreign currency denominated available-for-sale securities attributable to changes in foreign exchange rates. We also designated certain cross-currency interest rate swaps as hedges of the change in fair values of fixed-rate GICs attributable to changes in benchmark interest rates and foreign exchange rates.

We use foreign currency denominated debt and cross-currency swaps as hedging instruments in net investment hedge relationships to mitigate the foreign exchange risk associated with our non-U.S. dollar functional currency foreign subsidiaries. We assess the hedge effectiveness and measure the amount of ineffectiveness for these hedge relationships based on changes in spot exchange rates. For the three month periods ended March 31, 2014 and 2013, we recognized gains of $3 million and $130 million, respectively, included in Change in foreign currency translation adjustment in Other comprehensive income related to the net investment hedge relationships.

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

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

Three Months Ended March 31,
(in millions)20142013
Interest rate contracts:
Gain recognized in earnings on derivatives(b)$ 2$ -
Gain recognized in earnings on hedged items(c) 65 30
Foreign exchange contracts:(d)
Gain (loss) recognized in earnings on derivatives 24 (5)
Gain (loss) recognized in earnings on hedged items (32) 4
Loss recognized in earnings for amounts excluded from effectiveness testing (8) (1)

(a) Excludes immaterial amounts related to equity forwards used to hedge the change in fair value of available-for-sale common stock.

(b) Includes gains of $1 million recorded in Interest credited to policyholder account balances and $1 million recorded in Net realized capital gains (losses) for the three month period ending March 31, 2014.

(c) Includes gains of $18 million and $30 million for the three month periods ended March 31, 2014 and 2013, respectively, representing the amortization of debt basis adjustment recorded in Other income and Net realized capital gains (losses) following the discontinuation of hedge accounting. Also includes gains of $50 million for the three month period ended March 31, 2014, recorded in Loss on extinguishment of debt, representing the release of debt basis following the repurchase of issued debt that was part of previously discontinued hedge accounting relationships.

(d) Gains and losses recognized in earnings for the ineffective portion and amounts excluded from effectiveness testing, if any, are recorded in Net realized capital gains (losses).

Derivatives Not Designated as Hedging Instruments

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

Gains (Losses)
Three Months Ended March 31,Recognized in Earnings
(in millions)20142013
By Derivative Type:
Interest rate contracts(a)$ 139$ (216)
Foreign exchange contracts (14) 155
Equity contracts(b) (422) 44
Commodity contracts 1 -
Credit contracts 80 175
Other contracts 15 44
Total$ (201)$ 202
By Classification:
Policy fees$ 68$ 45
Net investment income 14 24
Net realized capital losses (337) (276)
Other income 49 412
Policyholder benefits and claims incurred 5 (3)
Total$ (201)$ 202

(a) Includes cross currency swaps.

(b) Includes embedded derivative gains (losses) of $(389) million and $256 million for the three month periods ended March 31, 2014 and 2013, respectively.

Global Capital Markets Derivatives

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

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

Super Senior Credit Default Swaps

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

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

Fair Value ofUnrealized Market Valuation
Net Notional Amount atDerivative Liability atThree Months Ended
March 31,December 31,March 31,December 31,March 31,March 31,
(in millions) 201420132014201320142013
Arbitrage:
Multi-sector CDOs(a) 3,166 3,257 1,151 1,249 72 155
Corporate debt/CLOs(b) 11,821 11,832 25 28 3 16
Total$ 14,987$ 15,089$ 1,176$ 1,277$ 75$ 171

(a) During the three month period ended March 31, 2014, we paid $26 million to counterparties with respect to multi-sector CDOs, which was previously included in the fair value of the derivative liability as an unrealized market valuation loss. Collateral postings with regards to multi-sector CDOs were $1.0 billion and $1.1 billion at March 31, 2014 and December 31, 2013, respectively.

(b) Corporate debt/Collateralized Loan Obligations (CLOs) include $1.0 billion in net notional amount of credit default swaps written on the super senior tranches of CLOs at both March 31, 2014 and December 31, 2013. Collateral postings with regards to corporate debt/CLOs were $352 million and $353 million at March 31, 2014 and December 31, 2013, respectively.

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

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

Written Single Name Credit Default Swaps

We have legacy credit default swap contracts referencing single-name exposures written on corporate, index and asset-backed credits with the intention of earning spread income on credit exposure. Some of these transactions were entered into as part of a long-short strategy to earn the net spread between CDSs written and purchased. At March 31, 2014 and December 31, 2013, the net notional amounts of these written CDS contracts were $302 million and $373 million, respectively, including ABS CDS transactions purchased from a liquidated multi-sector super senior CDS transaction. These exposures were partially hedged by purchasing offsetting CDS contracts of $50 million in net notional amounts at both March 31, 2014 and December 31, 2013. The net unhedged positions of $252 million and $323 million at March 31, 2014 and December 31, 2013, respectively, represent the maximum exposure to loss on these CDS contracts. The average maturity of the written CDS contracts was three years at both March 31, 2014 and December 31, 2013. At March 31, 2014 and December 31, 2013, the fair values of derivative liabilities (which represents the carrying value) of the portfolio of CDS were $29 million and $32 million, respectively.

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

These CDS contracts were written under ISDA Master Agreements. The majority of these ISDA Master Agreements include credit support annexes (CSAs) that provide for collateral postings that may vary at various ratings and threshold levels. At March 31, 2014 and December 31, 2013, net collateral posted by us under these contracts was $34 million and $38 million, respectively, prior to offsets for other transactions.

All Other Derivatives

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

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

Credit Risk-Related Contingent Features

The aggregate fair value of our derivative instruments that contain credit risk-related contingent features that were in a net liability position at March 31, 2014 and December 31, 2013, was approximately $2.9 billion and $2.6 billion, respectively. The aggregate fair value of assets posted as collateral under these contracts at March 31, 2014 and December 31, 2013, was $3.0 billion and $3.1 billion, respectively.

We estimate that at March 31, 2014, based on our outstanding financial derivative transactions, a one-notch downgrade of our long-term senior debt ratings to BBB+ by Standard & Poor’s Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. (S&P), would permit counterparties to make additional collateral calls and permit certain counterparties to elect early termination of contracts, resulting in a negligible amount of corresponding collateral postings and termination payments; a one-notch downgrade to Baa2 by Moody’s Investors’ Service, Inc. (Moody’s) and an additional one-notch downgrade to BBB by S&P would result in approximately $61 million in additional collateral postings and termination payments, and a further one-notch downgrade to Baa3 by Moody’s and BBB- by S&P would result in approximately $139 million in additional collateral postings and termination payments.

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

Hybrid Securities with Embedded Credit Derivatives

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

We elect to account for our investments in these hybrid securities with embedded written credit derivatives at fair value, with changes in fair value recognized in Net investment income and Other income. Our investments in these hybrid securities are reported as Other bond securities in the Consolidated Balance Sheets. The fair values of these hybrid securities were $6.3 billion and $6.4 billion at March 31, 2014 and December 31, 2013, respectively. These securities have par amounts of $13.1 billion and $13.4 billion at March 31, 2014 and December 31, 2013, respectively, and have remaining stated maturity dates that extend to 2052.