DERIVATIVES AND HEDGE ACCOUNTING

6 Months Ended

Jun. 30, 2012

DERIVATIVES AND HEDGE ACCOUNTING

DERIVATIVES AND HEDGE ACCOUNTING

8. DERIVATIVES AND HEDGE ACCOUNTING

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

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

	June 30, 2012								December 31, 2011
	Gross Derivative Assets				Gross Derivative Liabilities				Gross Derivative Assets				Gross Derivative Liabilities
(in millions)	Notional Amount		Fair Value(a)		Notional Amount		Fair Value(a)		Notional Amount		Fair Value(a)		Notional Amount		Fair Value(a)
Derivatives designated as hedging instruments:
Interest rate contracts(b)	$	-	$	-	$	409	$	29	$	-	$	-	$	481	$	38
Foreign exchange contracts		-		-		-		-		-		-		180		1
Derivatives not designated as hedging instruments:
Interest rate contracts(b)		72,634		7,667		69,122		6,879		72,660		8,286		73,248		6,870
Foreign exchange contracts		2,469		53		6,328		171		3,278		145		3,399		178
Equity contracts(c)		5,581		261		21,632		1,434		4,748		263		18,911		1,126
Commodity contracts		671		183		635		185		691		136		861		146
Credit contracts		310		64		20,842		2,656		407		89		25,857		3,366
Other contracts(d)		21,835		232		2,033		287		24,305		741		2,125		372
Total derivatives not designated as hedging instruments		103,500		8,460		120,592		11,612		106,089		9,660		124,401		12,058
Total derivatives	$	103,500	$	8,460	$	121,001	$	11,641	$	106,089	$	9,660	$	125,062	$	12,097

(a)

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

(b)

Includes cross currency swaps.

(c)

Notional amount of derivative liabilities and fair values of derivative liabilities include $20.9 billion and $1.2 billion, respectively, at June 30, 2012, and $18.3 billion and $0.9 billion, respectively, at December 31, 2011, related to bifurcated embedded derivatives. A bifurcated embedded derivative is generally presented with the host contract in the Consolidated Balance Sheet.

(d)

Consist primarily of contracts with multiple underlying exposures.

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

	June 30, 2012										December 31, 2011
	Derivative Assets					Derivative Liabilities					Derivative Assets					Derivative Liabilities
(in millions)	Notional Amount		Fair Value			Notional Amount		Fair Value			Notional Amount		Fair Value			Notional Amount		Fair Value
Global Capital Markets derivatives	$	91,350	$	7,396		$	93,518	$	9,300		$	94,036	$	8,472		$	98,442	$	10,021
All other derivatives(a)		12,150		1,064			27,483		2,341			12,053		1,188			26,620		2,076
Total derivatives, gross	$	103,500		8,460		$	121,001		11,641		$	106,089		9,660		$	125,062		12,097
Counterparty netting(b)				(3,716	)				(3,716	)				(3,660	)				(3,660	)
Cash collateral(c)				(991	)				(2,599	)				(1,501	)				(2,786	)
Total derivatives, net				3,753					5,326					4,499					5,651
Less: Bifurcated embedded derivatives				-					1,188					-					918
Total derivatives on consolidated balance sheet			$	3,753				$	4,138				$	4,499				$	4,733

(a)

Represents derivatives used to hedge the foreign currency and interest rate risk associated with insurance and ILFC operations, as well as embedded derivatives included in insurance contracts. Liabilities include bifurcated embedded derivatives, which are recorded in Policyholder contract deposits.

(b)

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

(c)

Represents cash collateral posted and received.

COLLATERAL

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

    Collateral posted by AIG to third parties for derivative transactions was $5.0 billion and $4.7 billion at June 30, 2012 and December 31, 2011, respectively. This collateral can generally be repledged or resold by the counterparties. Collateral obtained by AIG from third parties for derivative transactions was $1.1 billion and $1.6 billion at June 30, 2012 and December 31, 2011, respectively. This collateral can generally be repledged or resold by AIG.

HEDGE ACCOUNTING

    AIG designated certain derivatives entered into by Global Capital Markets with third parties as cash flow hedges of certain debt issued by ILFC and designated certain derivatives entered into by AIG's insurance subsidiaries with third parties as fair value hedges of available-for-sale investment securities held by such subsidiaries. The fair value hedges include foreign currency forwards designated as hedges of the change in fair value of foreign currency denominated available-for-sale securities attributable to changes in foreign exchange rates. With respect to the cash flow hedges, interest rate swaps were designated as hedges of the changes in cash flows on floating rate debt attributable to changes in the benchmark interest rate.

    AIG uses foreign currency denominated debt as hedging instruments in net investment hedge relationships to mitigate the foreign exchange risk associated with AIG's non-U.S. dollar functional currency foreign subsidiaries. AIG assesses the hedge effectiveness and measures the amount of ineffectiveness for these hedge relationships based on changes in spot exchange rates. For the three- and six-month periods ended June 30, 2012, AIG recognized gains of $147 million and $56 million, respectively, and for the three- and six-month periods ended June 30, 2011, AIG recognized losses of $11 million and $35 million, respectively, included in Foreign currency translation adjustment in Accumulated other comprehensive income related to the net investment hedge relationships.

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

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

	Three Months Ended June 30,				Six Months Ended June 30,
(in millions)	2012		2011		2012			2011
Interest rate contracts(a):
Gain (loss) recognized in earnings on derivatives	$	-	$	4	$	(2	)	$	(3	)
Gain recognized in earnings on hedged items(b)		48		40		80			88
Gain (loss) recognized in earnings for ineffective portion and amount excluded from effectiveness testing		-		-		-			(1	)

(a)

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

(b)

Includes $49 million and $44 million, for the three-month periods ended June 30, 2012 and 2011, respectively, and $79 million and $86 million, for the six-month periods ended June 30, 2012 and 2011, respectively, representing the amortization of debt basis adjustment following the discontinuation of hedge accounting recorded in Other income and Net realized capital gains (losses).

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

	Three Months Ended June 30,						Six Months Ended June 30,
(in millions)	2012			2011			2012			2011
Interest rate contracts(a):
Loss recognized in OCI on derivatives	$	-		$	(3	)	$	(1	)	$	(3	)
Loss reclassified from Accumulated OCI into earnings(b)		(4	)		(16	)		(9	)		(34	)

(a)

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

(b)

The effective portion of the change in fair value of a derivative qualifying as a cash flow hedge is recorded in Accumulated other comprehensive income until earnings are affected by the variability of cash flows in the hedged item. At June 30, 2012, $16 million of the deferred net loss in Accumulated other comprehensive income is expected to be recognized in earnings during the next 12 months.

DERIVATIVES NOT DESIGNATED AS HEDGING INSTRUMENTS

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

	Gains (Losses) Recognized in Earnings
	Three Months Ended June 30,						Six Months Ended June 30,
(in millions)	2012			2011			2012			2011
By Derivative Type:
Interest rate contracts(a)	$	598		$	21		$	12		$	(253	)
Foreign exchange contracts		21			(24	)		90			(4	)
Equity contracts(b)		(207	)		67			(395	)		(37	)
Commodity contracts		(1	)		2			(2	)		7
Credit contracts		63			(46	)		214			301
Other contracts		(81	)		18			(52	)		-
Total	$	393		$	38		$	(133	)	$	14
By Classification:
Premiums	$	37		$	26		$	73		$	51
Net investment income		-			2			1			4
Net realized capital gains (losses)		(423	)		231			(660	)		176
Other income (losses)		779			(221	)		453			(217	)
Total	$	393		$	38		$	(133	)	$	14

(a)

Includes cross currency swaps.

(b)

Includes embedded derivative losses of $368 million and $5 million for the three-month periods ended June 30, 2012 and 2011, respectively, and embedded derivatives gains (losses) of $(193) million and $102 million, for the six-month periods ended June 30, 2012 and 2011, respectively.

GLOBAL CAPITAL MARKETS DERIVATIVES

    Global Capital Markets enters into derivatives to mitigate market risk in its exposures (interest rates, currencies, commodities, credit and equities) arising from its transactions. In most cases, Global Capital Markets does not hedge its exposures related to the credit default swaps it has written.

    Global Capital Markets 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. In addition, at June 30, 2012, Global Capital Markets has entered into credit derivative transactions with respect to $130 million of securities to economically hedge its credit risk.

Super Senior Credit Default Swaps

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

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

									Unrealized Market Valuation Gain (Loss)
					Fair Value of Derivative (Asset) Liability at
	Net Notional Amount								Three Months Ended June 30,						Six Months Ended June 30,
	June 30, 2012(a)		December 31, 2011(a)		June 30, 2012(b)(c)		December 31, 2011(b)(c)
(in millions)									2012(c)			2011(c)			2012(c)			2011(c)
Regulatory Capital:
Corporate loans	$	1,148	$	1,830	$	-	$	-	$	-		$	-		$	-		$	-
Prime residential mortgages		648		3,653		-		-		-			-			-			6
Other		754		887		6		9		(3	)		1			3			10
Total		2,550		6,370		6		9		(3	)		1			3			16
Arbitrage:
Multi-sector CDOs(d)		4,602		5,476		2,386		3,077		68			(90	)		194			183
Corporate debt/CLOs(e)		11,630		11,784		116		127		(6	)		7			11			44
Total		16,232		17,260		2,502		3,204		62			(83	)		205			227
Mezzanine tranches		985		989		21		10		(2	)		(12	)		(11	)		(14	)
Total	$	19,767	$	24,619	$	2,529	$	3,223	$	57		$	(94	)	$	197		$	229

(a)

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

(b)

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

(c)

Includes credit valuation adjustment gains (losses) of $2 million and $8 million in the three-month periods ended June 30, 2012 and 2011, respectively, and $(24) million and $2 million in the six-month periods ended June 30, 2012 and 2011, respectively, representing the effect of changes in AIG's credit spreads on the valuation of the derivatives liabilities.

(d)

During the six-month period ended June 30, 2012, a super senior CDS transaction with a net notional amount of $470 million was terminated at approximately its fair value at the time of termination. As a result, a $416 million loss, which was previously included in the fair value derivative liability as an unrealized market valuation loss, was realized. During the six-month period ended June 30, 2012, $81 million was paid to counterparties with respect to multi-sector CDOs. Upon payment, an $81 million loss, which was previously included in the fair value of the derivative liability as an unrealized market valuation loss, was realized. Multi-sector CDOs also include $3.9 billion and $4.6 billion in net notional amount of credit default swaps written with cash settlement provisions at June 30, 2012 and December 31, 2011, respectively.

(e)

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

    The expected weighted average maturity of the super senior credit derivative portfolios as of June 30, 2012 was 0.2 years for the regulatory capital corporate loan portfolio, 0.6 years for the regulatory capital prime residential mortgage portfolio, 3.3 years for the regulatory capital other portfolio, 6.1 years for the multi-sector CDO arbitrage portfolio and 3.7 years for the corporate debt/CLO portfolio.

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

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

Written Single Name Credit Default Swaps

    Credit default swap contracts referencing single-name exposures written on corporate, index and asset-backed credits have also been entered into with the intention of earning spread income on credit exposure. Some of these transactions were entered into as part of a long-short strategy to earn the net spread between CDS written and purchased. At June 30, 2012, the net notional amount of these written CDS contracts was $1.3 billion, including ABS CDS transactions purchased from a liquidated multi-sector super senior CDS transaction. These exposures have been partially hedged by purchasing offsetting CDS contracts of $66 million in net notional amount. The net unhedged position of $1.2 billion represents the maximum exposure to loss on these CDS contracts. The average maturity of the written CDS contracts is 6.3 years. At June 30, 2012, the fair value of derivative liability (which represents the carrying value) of the portfolio of CDS was $85 million.

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

    These CDS contracts were written under ISDA Master Agreements. The majority of these ISDA Master Agreements include CSAs that provide for collateral postings at various ratings and threshold levels. At June 30, 2012, collateral posted by AIG under these contracts was $99 million prior to offsets for other transactions.

ALL OTHER DERIVATIVES

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

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

CREDIT RISK-RELATED CONTINGENT FEATURES

    The aggregate fair value of AIG's derivative instruments that contain credit risk-related contingent features that were in a net liability position at June 30, 2012, was approximately $3.8 billion. The aggregate fair value of assets posted as collateral under these contracts at June 30, 2012, was $4.1 billion.

    AIG estimates that at June 30, 2012, based on AIG's outstanding financial derivative transactions a one-notch downgrade of AIG's long-term senior debt ratings to BBB+ by Standard & Poor's Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. (S&P), would permit counterparties to make additional collateral calls and permit the counterparties to elect early termination of contracts, resulting in a negligible amount of corresponding collateral postings and termination payments; a one-notch downgrade to Baa2 by Moody's Investors' Services, Inc. (Moody's) and an additional one-notch downgrade to BBB by S&P would result in approximately $120 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 $230 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 June 30, 2012. Factors considered in estimating the termination payments upon downgrade include current market conditions, the complexity of the derivative transactions, historical termination experience and other observable market events such as bankruptcy and downgrade events that have occurred at other companies. Management's estimates are also based on the assumption that counterparties will terminate based on their net exposure to AIG. The actual termination payments could significantly differ from management's estimates given market conditions at the time of downgrade and the level of uncertainty in estimating both the number of counterparties who may elect to exercise their right to terminate and the payment that may be triggered in connection with any such exercise.

HYBRID SECURITIES WITH EMBEDDED CREDIT DERIVATIVES

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

    AIG elects to account for its investments in these hybrid securities with embedded written credit derivatives at fair value, with changes in fair value recognized in Net investment income and Other income. AIG's investments in these hybrid securities are reported as Bond trading securities in the Consolidated Balance Sheet. The fair value of these hybrid securities was $5 billion at June 30, 2012. These securities have a current par amount of $10 billion and have remaining stated maturity dates that extend to 2052.