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 12 to the Consolidated Financial Statements in the 2012 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 AIG's derivative instruments:




	June 30, 2013								December 31, 2012
	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:
Foreign exchange contracts	$	226	$	2	$	971	$	57	$	–	$	–	$	–	$	–
Derivatives not designated as hedging instruments:
Interest rate contracts^(b)		56,436		5,078		61,714		4,596		63,463		6,479		63,482		5,806
Foreign exchange contracts		4,259		115		2,279		98		8,325		104		10,168		174
Equity contracts^(c)		5,606		265		28,294		708		4,990		221		25,626		1,377
Commodity contracts		615		124		610		127		625		145		622		146
Credit contracts		70		56		15,526		1,650		70		60		16,244		2,051
Other contracts^(d)		22,256		37		1,317		167		20,449		38		1,488		206

Total derivatives not designated as hedging instruments		89,242		5,675		109,740		7,346		97,922		7,047		117,630		9,760

Total derivatives, gross	$	89,468	$	5,677	$	110,711	$	7,403	$	97,922	$	7,047	$	117,630	$	9,760

(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 value of derivative liabilities include $25.9 billion and $.6 billion, respectively, at June 30, 2013, and $23 billion and $1.3 billion, respectively, at December 31, 2012, 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:




	June 30, 2013										December 31, 2012
	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:
AIG Financial Products	$	54,970	$	3,982		$	60,806	$	4,204		$	59,854	$	4,725		$	66,717	$	5,506
AIG Markets		8,051		853			15,642		1,576			14,028		1,308			18,774		1,818

Total Global Capital Markets derivatives		63,021		4,835			76,448		5,780			73,882		6,033			85,491		7,324
Non-Global Capital Markets derivatives^(a)		26,447		842			34,263		1,623			24,040		1,014			32,139		2,436

Total derivatives, gross	$	89,468		5,677		$	110,711		7,403		$	97,922		7,047		$	117,630		9,760

Counterparty netting^(b)				(2,011	)				(2,011	)				(2,467	)				(2,467	)
Cash collateral^(c)				(861	)				(1,612	)				(909	)				(1,976	)

Total derivatives, net				2,805					3,780					3,671					5,317

Less: Bifurcated embedded derivatives				–					656					–					1,256

Total derivatives on consolidated balance sheet			$	2,805				$	3,124				$	3,671				$	4,061

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

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

Collateral

We engage in derivative transactions directly with unaffiliated third parties, which generally provide for collateral postings to such unaffiliated third parties or (in the case of derivative transactions subject to clearing) centralized clearing organizations at various ratings and threshold levels. The collateral posting provisions are generally contained in Credit Support Annexes (CSAs) included in International Swaps and Derivatives Association, Inc. (ISDA) agreements or (in the case of derivative transactions subject to clearing) clearing agreements with futures commission merchants.

Collateral posted by us to third parties for derivative transactions was $3.5 billion and $4.5 billion at June 30, 2013 and December 31, 2012, 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 $1.4 billion at June 30, 2013 and December 31, 2012, respectively. We generally can repledge or resell this collateral to the extent it is posted under derivative transactions that are not subject to clearing.

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 master netting agreement exists between us and our derivative counterparty. A master netting agreement is an agreement between two counterparties who have multiple derivative contracts with each other that provides for the net settlement of all contracts, as well as cash collateral, through a single payment, in a single currency, in the event of default on or upon termination of any one contract.

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 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- and six-month periods ended June 30, 2013, we recognized gains (losses) of $(35) million and $95 million, respectively, and for the three- and six-month periods ended June 30, 2012, we recognized gains of $147 million and $56 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 gain (loss) recognized in earnings on our derivative instruments in fair value hedging relationships in the Condensed Consolidated Statements of Income:




	Three Months Ended June 30,					Six Months Ended June 30,
(in millions)	2013			2012		2013			2012

Interest rate contracts:^(a)
Loss recognized in earnings on derivatives	$	–		$	–	$	–		$	(2	)
Hedged items^(b)		23			48		53			80
Foreign exchange contracts:^(a)
Derivatives		(35	)		–		(40	)		–
Hedged items		43			–		47			–
Amount excluded from effectiveness testing		8			–		7			–

(a) 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.

(b) Represents the amortization of debt basis adjustment recorded in Other income and Net realized capital gains (losses) following the discontinuation of hedge accounting.

Derivatives Not Designated as Hedging Instruments

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




	Gains (Losses) Recognized in Earnings
	Gains (Losses) Recognized in Earnings						Gains (Losses) Recognized in Earnings
	Three Months Ended June 30,						Gains (Losses) Recognized in Earnings
	Three Months Ended June 30,						Six Months Ended June 30,
(in millions)	2013			2012			2013			2012

By Derivative Type:
Interest rate contracts^(a)	$	(69	)	$	598		$	(285	)	$	12
Foreign exchange contracts		(8	)		21			147			90
Equity contracts^(b)		468			(207	)		512			(395	)
Commodity contracts		(2	)		(1	)		(2	)		(2	)
Credit contracts		138			63			313			214
Other contracts		16			(81	)		60			(52	)

Total	$	543		$	393		$	745		$	(133	)

By Classification:
Policy fees	$	48		$	37		$	93		$	73
Net investment income		5			–			29			1
Net realized capital gains (losses)		276			(423	)		–			(660	)
Other income		219			779			631			453
Policyholder benefits and claims incurred		(5	)		–			(8	)		–

Total	$	543		$	393		$	745		$	(133	)

(a) Includes cross currency swaps.

(b) Includes embedded derivative gains of $505 million and $760 million for the three- and six-month periods ended June 30, 2013, respectively, and embedded derivative losses of $368 million and $193 million for the three- and six-month periods ended June 30, 2012, respectively.

Global Capital Markets Derivatives

GCM enters into derivatives to mitigate market risk in its exposures (interest rates, currencies, commodities, credit and equities) arising from its transactions. At June 30, 2013, GCM has entered into credit derivative transactions with respect to $66 million of securities to economically hedge its credit risk. In most cases, GCM has not hedged its exposures related to the credit default swaps it has written.

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 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, we provided such credit protection 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, 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:




	Net Notional Amount at^(a)				Fair Value of Derivative Liability at^(b)				Unrealized Market Valuation Gain^(c)
	June 30,		December 31,		June 30,		December 31,		Three Months Ended June 30,					Six Months Ended June 30,
(in millions)	2013		2012		2013		2012		2013		2012			2013		2012

Regulatory Capital:
Prime residential mortgages	$	11	$	97	$	–	$	–	$	–	$	–		$	–	$	–
Other		–		–		–		–		–		(3	)		–		3

Total		11		97		–		–		–		(3	)		–		3

Arbitrage:
Multi-sector CDOs^(d)		3,575		3,944		1,547		1,910		126		68			281		194
Corporate debt/CLOs^(e)		11,590		11,832		39		60		5		(6	)		21		11

Total		15,165		15,776		1,586		1,970		131		62			302		205

Mezzanine tranches		–		–		–		–		–		(2	)		–		(11	)

Total	$	15,176	$	15,873	$	1,586	$	1,970	$	131	$	57		$	302	$	197

(a) Net notional amounts presented are net of all structural subordination below the covered tranches. The decrease in the total net notional amount from December 31, 2012 to June 30, 2013 was primarily due to amortization of $523 million, foreign exchange rate movement of $110 million and a combination of terminations and maturities of $64 million.

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

(c) Includes credit valuation adjustment gains of $1 million and $2 million for the three-month periods ended June 30, 2013 and 2012, respectively, and losses of $1 million and $24 million for the six-month periods ended June 30, 2013 and 2012, 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, 2013, we paid $82 million to counterparties with respect to multi-sector CDOs. Upon payment, a $82 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 $3.1 billion and $3.4 billion in net notional amount of credit default swaps written with cash settlement provisions at June 30, 2013 and December 31, 2012, respectively. Collateral postings with regards to multi-sector CDOs were $1.3 billion and $1.6 billion at June 30, 2013 and December 31, 2012, respectively.

(e) Corporate debt/Collateralized Loan Obligations (CLOs) include $1.0 billion and $1.2 billion in net notional amount of credit default swaps written on the super senior tranches of CLOs at June 30, 2013 and December 31, 2012, respectively. Collateral postings with regards to corporate debt/CLOs were $383 million and $420 million at June 30, 2013 and December 31, 2012, respectively.

The expected weighted average maturity of the super senior credit derivative portfolios as of June 30, 2013 was less than one year for the regulatory capital prime residential mortgage portfolio, 6 years for the multi-sector CDO arbitrage portfolio and 3 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, we do not expect that we 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, 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 also entered into 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 CDS written and purchased. At June 30, 2013, the net notional amount of these written CDS contracts was $389 million, 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 $50 million in net notional amount. The net unhedged position of $339 million represents the maximum exposure to loss on these CDS contracts. The average maturity of the written CDS contracts is 4 years. At June 30, 2013, the fair value of the derivative liability (which represents the carrying value) of the portfolio of CDS was $36 million.

Upon a triggering event (e.g., a default) with respect to the underlying credit, we would have the option 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, 2013, collateral posted by us under these contracts was $57 million 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 June 30, 2013, was approximately $3 billion. The aggregate fair value of assets posted as collateral under these contracts at June 30, 2013, was $3.4 billion.

We estimate that at June 30, 2013, 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 $78 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 $121 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, 2013. 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 Bond trading securities in the Condensed Consolidated Balance Sheets. The fair value of these hybrid securities was $6.6 billion at June 30, 2013. These securities have a current par amount of $14.1 billion and have remaining stated maturity dates that extend to 2052.