1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------------- FORM 10-Q [ X ] QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO FOR QUARTER ENDED SEPTEMBER 30, 1997 COMMISSION FILE NUMBER 1-8787 --------------------- AMERICAN INTERNATIONAL GROUP, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) <TABLE> <S> <C> DELAWARE 13-2592361 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NUMBER) INCORPORATION OR ORGANIZATION) 70 PINE STREET, NEW YORK, NEW YORK 10270 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE (212) 770-7000 NONE FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE LAST REPORT. </TABLE> --------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [ X ] NO [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of September 30, 1997 701,493,275. ================================================================================
2 AMERICAN INTERNATIONAL GROUP, INC. CONSOLIDATED BALANCE SHEET (IN THOUSANDS) <TABLE> <CAPTION> DECEMBER 31, 1996 SEPTEMBER ------------ 30, 1997 ------------ (UNAUDITED) <S> <C> <C> ASSETS: Investments and cash: Fixed maturities: Bonds held to maturity, at amortized cost (market value: 1997 -- $13,368,529; 1996 -- $12,865,357)............. $ 12,641,522 $ 12,258,978 Bonds available for sale, at market value (amortized cost: 1997 -- $36,721,927; 1996 -- $34,243,127)....... 38,063,454 35,524,932 Bonds trading securities, at market value (cost: 1997 -- $615,154; 1996 -- $357,023)................... 628,485 364,069 Preferred stocks, at amortized cost (market value: 1997 -- $528,962; 1996 -- $591,091)................... 239,663 477,247 Equity securities: Common stocks (cost: 1997 -- $4,943,910; 1996 -- $4,993,799)................................... 5,995,445 5,989,572 Non-redeemable preferred stocks (cost: 1997 -- $108,502; 1996 -- $64,705)...................................... 122,905 76,068 Mortgage loans on real estate, policy and collateral loans -- net............................................. 8,197,559 7,876,820 Financial services assets: Flight equipment primarily under operating leases, net of accumulated depreciation (1997 -- $1,774,072; 1996 -- $1,465,031)................................... 15,199,781 13,808,660 Securities available for sale, at market value (cost: 1997 -- $7,734,250; 1996 -- $9,775,705)............... 7,742,935 9,785,909 Trading securities, at market value...................... 2,339,416 2,357,812 Spot commodities, at market value........................ 471,153 204,705 Unrealized gain on interest rate and currency swaps, options and forward transactions...................... 7,853,575 6,906,012 Trading assets........................................... 6,044,710 3,793,433 Securities purchased under agreements to resell, at contract value..................................... 2,065,397 1,642,591 Other invested assets...................................... 3,462,480 2,915,302 Short-term investments, at cost which approximates market value.................................................... 2,170,374 2,008,123 Cash....................................................... 173,223 58,740 ------------ ------------ Total investments and cash.......................... 113,412,077 106,048,973 Investment income due and accrued............................. 1,364,566 1,198,348 Premiums and insurance balances receivable -- net............. 10,429,017 9,617,061 Reinsurance assets............................................ 17,311,131 16,526,566 Deferred policy acquisition costs............................. 6,734,219 6,471,357 Investments in partially-owned companies...................... 1,074,477 951,352 Real estate and other fixed assets, net of accumulated depreciation (1997 -- $1,495,947; 1996 -- $1,390,225)...... 2,257,241 2,122,762 Separate and variable accounts................................ 3,789,414 3,271,716 Other assets.................................................. 2,239,943 2,222,867 ------------ ------------ Total assets........................................ $158,612,085 $148,431,002 ============ ============ </TABLE> See Accompanying Notes to Financial Statements. 1
3 AMERICAN INTERNATIONAL GROUP, INC. CONSOLIDATED BALANCE SHEET -- (CONTINUED) (IN THOUSANDS, EXCEPT SHARE AMOUNTS) <TABLE> <CAPTION> DECEMBER 31, 1996 SEPTEMBER ------------ 30, 1997 ------------ (UNAUDITED) <S> <C> <C> LIABILITIES: Reserve for losses and loss expenses.......................... $ 34,467,122 $ 33,429,807 Reserve for unearned premiums................................. 8,717,407 7,598,928 Future policy benefits for life and accident and health insurance contracts........................................ 25,253,226 24,002,860 Policyholders' contract deposits.............................. 10,430,772 9,803,409 Other policyholders' funds.................................... 2,275,828 2,219,907 Reserve for commissions, expenses and taxes................... 1,874,946 1,511,122 Insurance balances payable.................................... 2,223,470 1,832,649 Funds held by companies under reinsurance treaties............ 338,513 383,306 Income taxes payable: Current.................................................... 638,850 201,978 Deferred................................................... 691,248 586,703 Financial services liabilities: Borrowings under obligations of guaranteed investment agreements............................................... 7,279,120 5,723,228 Securities sold under agreements to repurchase, at contract value.................................................... 607,658 3,039,423 Trading liabilities........................................ 4,887,581 3,313,508 Securities and spot commodities sold but not yet purchased, at market value.......................................... 4,001,156 1,568,542 Unrealized loss on interest rate and currency swaps, options and forward transactions......................... 5,146,522 5,414,433 Deposits due to banks and other depositors................. 1,169,507 1,206,374 Commercial paper........................................... 2,789,568 2,739,388 Notes, bonds and loans payable............................. 12,113,038 12,312,805 Commercial paper.............................................. 1,113,111 1,758,588 Notes, bonds, loans and mortgages payable..................... 1,239,389 986,505 Separate and variable accounts................................ 3,789,414 3,271,716 Other liabilities............................................. 3,297,679 3,081,599 ------------ ------------ Total liabilities................................... 134,345,125 125,986,778 ------------ ------------ Preferred shareholders' equity in subsidiary company.......... 400,000 400,000 CAPITAL FUNDS: Common stock, $2.50 par value: 1,000,000,000 shares authorized; shares issued 1997 -- 759,121,505; 1996 -- 506,084,172........................................ 1,897,804 1,265,210 Additional paid-in capital.................................... 116,386 127,415 Unrealized appreciation of investments, net of taxes.......... 1,545,853 1,378,318 Cumulative translation adjustments, net of taxes.............. (897,210) (493,218) Retained earnings............................................. 22,089,248 20,420,881 Treasury stock, at cost; 1997 -- 57,628,230; 1996 -- 36,643,026 shares of common stock.................. (885,121) (654,382) ------------ ------------ Total capital funds................................. 23,866,960 22,044,224 ------------ ------------ Total liabilities and capital funds................. $158,612,085 $148,431,002 ============ ============ </TABLE> See Accompanying Notes to Financial Statements. 2
4 AMERICAN INTERNATIONAL GROUP, INC. CONSOLIDATED STATEMENT OF INCOME (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED) <TABLE> <CAPTION> NINE MONTHS THREE MONTHS ENDED SEPTEMBER 30, ENDED SEPTEMBER 30, --------------------------- ------------------------- 1997 1996 1997 1996 ----------- ----------- ---------- ---------- <S> <C> <C> <C> <C> General insurance operations: Net premiums written.................... $10,286,766 $ 9,722,560 $3,429,877 $3,230,729 Change in unearned premium reserve...... (989,410) (958,655) (340,613) (194,142) ----------- ----------- ---------- ---------- Net premiums earned..................... 9,297,356 8,763,905 3,089,264 3,036,587 Net investment income................... 1,366,275 1,244,475 463,324 420,718 Realized capital gains.................. 106,787 50,697 28,188 5,644 ----------- ----------- ---------- ---------- 10,770,418 10,059,077 3,580,776 3,462,949 ----------- ----------- ---------- ---------- Losses and loss expenses incurred....... 7,042,283 6,665,489 2,300,428 2,271,984 Underwriting expenses................... 1,883,499 1,757,951 670,555 638,828 ----------- ----------- ---------- ---------- 8,925,782 8,423,440 2,970,983 2,910,812 ----------- ----------- ---------- ---------- Operating income........................ 1,844,636 1,635,637 609,793 552,137 ----------- ----------- ---------- ---------- Life insurance operations: Premium income.......................... 7,329,233 6,508,465 2,480,443 2,213,481 Net investment income................... 2,147,593 2,046,296 742,483 718,352 Realized capital gains.................. 12,789 22,600 6,540 16,750 ----------- ----------- ---------- ---------- 9,489,615 8,577,361 3,229,466 2,948,583 ----------- ----------- ---------- ---------- Death and other benefits................ 2,964,978 2,701,139 1,033,619 963,453 Increase in future policy benefits...... 3,521,732 3,209,509 1,153,378 1,053,878 Acquisition and insurance expenses...... 1,855,616 1,708,658 636,499 585,806 ----------- ----------- ---------- ---------- 8,342,326 7,619,306 2,823,496 2,603,137 ----------- ----------- ---------- ---------- Operating income........................ 1,147,289 958,055 405,970 345,446 ----------- ----------- ---------- ---------- Financial services operating income..... 487,434 374,761 180,485 133,938 Equity in income of minority-owned insurance operations.................. 84,593 74,322 26,804 26,273 Other realized capital gains (losses)... (20,602) (1,072) (10,466) 649 Minority interest....................... (25,493) (33,289) (5,251) (9,283) Other income (deductions) -- net........ (66,612) (64,564) (22,761) (31,089) ----------- ----------- ---------- ---------- Income before income taxes.............. 3,451,245 2,943,850 1,184,574 1,018,071 ----------- ----------- ---------- ---------- Income taxes (benefits) -- Current...... 923,154 803,291 314,746 289,579 -- Deferred.... 80,343 13,536 29,510 (2,945) ----------- ----------- ---------- ---------- 1,003,497 816,827 344,256 286,634 ----------- ----------- ---------- ---------- Net income.............................. $ 2,447,748 $ 2,127,023 $ 840,318 $ 731,437 =========== =========== ========== ========== Earnings per common share*.............. $ 3.48 $ 3.01 $ 1.19 $ 1.04 =========== =========== ========== ========== Cash dividends per common share*........ $ 0.208 $ 0.180 $ 0.075 $ 0.067 =========== =========== ========== ========== Average shares outstanding*............. 702,574 707,273 701,385 704,155 ----------- ----------- ---------- ---------- </TABLE> * Share information reflects a common stock split in the form of a 50 percent common stock dividend paid July 25, 1997. See Accompanying Notes to Financial Statements. 3
5 AMERICAN INTERNATIONAL GROUP, INC. CONSOLIDATED STATEMENT OF CASH FLOWS (DOLLARS IN THOUSANDS) (UNAUDITED) <TABLE> <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, ----------------------------- 1997 1996 ------------ ------------ <S> <C> <C> Cash Flows From Operating Activities: Net income.................................................... $ 2,447,748 $ 2,127,023 ------------ ------------ Adjustments to reconcile net income to net cash provided by operating activities: Non-cash revenues, expenses, gains and losses included in income: Change in: General and life insurance reserves...................... 3,504,897 4,336,394 Premiums and insurance balances receivable and payable -- net.................................................... (421,135) 256,037 Reinsurance assets....................................... (784,565) (996,834) Deferred policy acquisition costs........................ (262,862) (593,152) Investment income due and accrued........................ (166,218) (174,790) Funds held under reinsurance treaties.................... (44,793) 74,041 Other policyholders' funds............................... 55,921 136,406 Current and deferred income taxes -- net................. 517,215 98,945 Reserve for commissions, expenses and taxes.............. 363,824 271,808 Other assets and liabilities -- net...................... 199,004 (479,051) Trading assets and liabilities -- net.................... (677,204) 278,527 Trading securities, at market value...................... 18,396 503,992 Spot commodities, at market value........................ (266,448) 494,147 Net unrealized gain on interest rate and currency swaps, options and forward transactions....................... (1,215,474) (156,276) Securities purchased under agreements to resell.......... (422,806) (1,199,375) Securities sold under agreements to repurchase........... (2,431,765) 649,284 Securities and spot commodities sold but not yet purchased, at market value............................. 2,432,614 (519,301) Realized capital gains...................................... (98,974) (72,225) Equity in income of partially-owned companies and other invested assets.......................................... (116,209) (119,331) Depreciation expenses, principally flight equipment......... 650,186 603,882 Change in cumulative translation adjustments................ (458,174) (30,049) Other -- net................................................ (82,523) 4,957 ------------ ------------ Total adjustments........................................... 292,907 3,368,036 ------------ ------------ Net cash provided by operating activities..................... $ 2,740,655 $ 5,495,059 ------------ ------------ </TABLE> See Accompanying Notes to Financial Statements. 4
6 AMERICAN INTERNATIONAL GROUP, INC. CONSOLIDATED STATEMENT OF CASH FLOWS -- (CONTINUED) (DOLLARS IN THOUSANDS) (UNAUDITED) <TABLE> <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, ----------------------------- 1997 1996 ------------ ------------ <S> <C> <C> Cash Flows From Investing Activities: Cost of fixed maturities, at amortized cost matured or redeemed................................................. $ 993,917 $ 1,346,988 Cost of bonds, at market sold............................... 7,360,382 6,816,250 Cost of bonds, at market matured or redeemed................ 2,151,855 1,960,194 Cost of equity securities sold.............................. 1,773,257 2,136,119 Realized capital gains...................................... 98,974 72,225 Purchases of fixed maturities............................... (13,342,852) (14,369,425) Purchases of equity securities.............................. (1,735,493) (2,507,784) Mortgage, policy and collateral loans granted............... (1,662,318) (2,706,970) Repayments of mortgage, policy and collateral loans......... 1,341,579 490,414 Sales of securities available for sale...................... 2,946,116 1,628,718 Maturities of securities available for sale................. 13,670,025 105,473 Purchases of securities available for sale.................. (14,602,931) (3,489,696) Sales of flight equipment................................... 974,249 1,126,044 Purchases of flight equipment............................... (2,795,624) (2,514,622) Net additions to real estate and other fixed assets......... (354,410) (291,162) Sales or distributions of other invested assets............. 5,653,523 871,082 Investments in other invested assets........................ (6,113,935) (978,006) Change in short-term investments............................ (162,251) 358,630 Investments in partially-owned companies.................... (28,654) (36,668) ------------ ------------ Net cash used in investing activities......................... (3,834,591) (9,982,196) ------------ ------------ Cash Flows From Financing Activities: Change in policyholders' contract deposits.................. 627,363 2,026,717 Change in deposits due to banks and other depositors........ (36,867) 492,513 Change in commercial paper.................................. (595,297) 915,212 Proceeds from notes, bonds, loans and mortgages payable..... 5,461,763 3,190,940 Repayments on notes, bonds, loans and mortgages payable..... (5,403,645) (1,927,525) Liquidation of zero coupon notes payable.................... (12,235) -- Proceeds from guaranteed investment agreements.............. 3,407,703 3,041,772 Maturities of guaranteed investment agreements.............. (1,851,811) (2,622,182) Proceeds from subsidiary company preferred stock issued..... -- (98) Proceeds from common stock issued........................... 27,375 16,083 Cash dividends to shareholders.............................. (146,787) (127,161) Acquisition of treasury stock............................... (274,448) (474,034) Other - net................................................. 5,305 16,533 ------------ ------------ Net cash provided by financing activities..................... 1,208,419 4,548,770 ------------ ------------ Change in cash................................................ 114,483 61,633 Cash at beginning of period................................... 58,740 88,371 ------------ ------------ Cash at end of period......................................... $ 173,223 $ 150,004 =========== =========== </TABLE> See Accompanying Notes to Financial Statements. 5
7 AMERICAN INTERNATIONAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1997 a) These statements are unaudited. In the opinion of management, all adjustments consisting of normal recurring accruals have been made for a fair presentation of the results shown. b) Earnings per share of American International Group, Inc. (AIG) are based on the weighted average number of common shares outstanding during the period, retroactively adjusted to reflect all stock splits. Cash dividends per common share reflect the adjustment for a common stock split in the form of a 50 percent common stock dividend paid July 25, 1997. The quarterly dividend rate per common share, commencing with the dividend paid September 19, 1997 is $0.075. c) Supplemental cash flow information for the nine month periods ended September 30, 1997 and 1996 is as follows: <TABLE> <CAPTION> 1997 1996 ----------- ----------- (IN THOUSANDS) <S> <C> <C> Income taxes paid................................. $ 408,000 $ 699,500 Interest paid..................................... $ 1,256,000 $ 1,123,000 </TABLE> d) In February 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 128 "Earnings Per Share" (FASB 128). This statement simplifies the existing computational guidelines, revises the disclosure requirements and increases earnings per share comparability on an international basis. FASB 128 is effective for year end 1997. Earlier application is not permitted. The pro forma share and earnings per share amounts computed using FASB 128 and reflecting the common stock split in the form of a 50 percent common stock dividend paid July 25, 1997 for the first nine months ended September 30, 1997 and 1996 were as follows: <TABLE> <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, ----------------------- 1997 1996 ---------- ---------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) <S> <C> <C> Average outstanding shares used in the computation of per share earnings: Common stock issued................................................... 759,125 759,126 Common stock in treasury.............................................. (56,551) (51,853) ---------- ---------- Average outstanding shares -- basic................................... 702,574 707,273 ---------- ---------- Stock options (treasury stock method)................................. 3,556 2,946 Stock purchase plan................................................... 61 39 ---------- ---------- Average outstanding shares -- diluted................................... 706,191 710,258 ---------- ---------- Net income applicable to common stock................................... $2,447,748 $2,127,023 ---------- ---------- Net income per share: Basic................................................................. $3.48 $3.01 Diluted............................................................... $3.47 $3.00 </TABLE> e) Derivatives Accounting Policy: AIG Financial Products Corp. and its subsidiaries and AIG Trading Group Inc. and its subsidiaries enter into future, forward, swap and option derivative transactions. These transactions are marked to market. With the exception of the derivatives used in market hedging activities with respect to securities available for sale, at market, the mark to market on all such other derivative transactions are recognized in income currently. The mark to market with respect to derivatives which hedge the market movements of securities available for sale, at market is recognized as a component of unrealized appreciation of investments, net of taxes. When the underlying security is sold, the loss or gain resulting from the hedging derivative transaction is recognized as income in that same period. f) For further information, refer to the Annual Report on Form 10-K of AIG for the year ended December 31, 1996. 6
8 AMERICAN INTERNATIONAL GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OPERATIONAL REVIEW General Insurance Operations General insurance operations for the nine month periods ending September 30, 1997 and 1996 were as follows: (in thousands) - ------------------------------------------------------ <TABLE> <CAPTION> 1997 1996 - ------------------------------------------------------ <S> <C> <C> Net premiums written: Domestic $ 6,944,434 $6,386,214 Foreign 3,342,332 3,336,346 - ------------------------------------------------------ Total $10,286,766 $9,722,560 - ------------------------------------------------------ Net premiums earned: Domestic $ 6,291,014 $5,763,020 Foreign 3,006,342 3,000,885 - ------------------------------------------------------ Total $ 9,297,356 $8,763,905 - ------------------------------------------------------ Adjusted underwriting profit: Domestic $ 3,085 $ 27,154 Foreign 368,489 313,311 - ------------------------------------------------------ Total $ 371,574 $ 340,465 - ------------------------------------------------------ Net investment income: Domestic $ 1,095,993 $ 988,362 Foreign 270,282 256,113 - ------------------------------------------------------ Total $ 1,366,275 $1,244,475 - ------------------------------------------------------ Operating income before realized capital gains: Domestic $ 1,099,078 $1,015,516 Foreign 638,771 569,424 - ------------------------------------------------------ Total 1,737,849 1,584,940 Realized capital gains 106,787 50,697 - ------------------------------------------------------ Operating income $ 1,844,636 $1,635,637 - ------------------------------------------------------ </TABLE> During the first nine months of 1997, the net premiums written and net premiums earned in AIG's general insurance operations increased 5.8 percent and 6.1 percent, respectively, from those of 1996. The growth in net premiums written in the first nine months of 1997 resulted from a combination of several factors. Domestically, AIG continued to achieve volume growth in some specialty markets, mortgage guaranty insurance and in personal lines. Foreign general insurance operations produced 32.5 percent of the general insurance net premiums written in the first nine months of 1997 and 34.3 percent in the same period of 1996. In comparing the foreign exchange rates used to translate the results of AIG's foreign general operations during the first nine months of 1997 to those foreign exchange rates used to translate AIG's foreign general results during the same period of 1996, the U.S. dollar strengthened in value in relation to most major foreign currencies in which AIG transacts business. Accordingly, when foreign net premiums written were translated into U.S. dollars for the purposes of consolidation, total general insurance net premiums written were approximately 1.8 percentage points less than they would have been if translated utilizing those exchange rates which prevailed during that same period of 1996. Net premiums written are initially deferred and earned based upon the terms of the underlying policies. The net unearned premium reserve constitutes the deferred revenues which are generally earned ratably over the policy period. Thus, the net unearned premium reserve is not fully recognized as net premiums earned until the end of the policy period. The statutory general insurance ratios were as follows: ------------------------------------------------------ <TABLE> <CAPTION> 1997 1996 - ------------------------------------------------------ <S> <C> <C> Domestic: Loss Ratio 84.65 85.54 Expense Ratio 15.48 14.51 - ------------------------------------------------------ Combined Ratio 100.13 100.05 - ------------------------------------------------------ Foreign: Loss Ratio 57.11 57.83 Expense Ratio 30.67 31.10 - ------------------------------------------------------ Combined Ratio 87.78 88.93 - ------------------------------------------------------ Consolidated: Loss Ratio 75.75 76.06 Expense Ratio 20.42 20.20 - ------------------------------------------------------ Combined Ratio 96.17 96.26 - ------------------------------------------------------ </TABLE> Adjusted underwriting profit (operating income less net investment income and realized capital gains) represents statutory underwriting profit adjusted primarily for changes in deferred acquisition costs. The adjusted underwriting profits were $371.6 million in the first nine months of 1997 and $340.5 million in the same period of 1996. 7
9 AIG's results reflect the net impact of incurred losses from catastrophes approximating $16 million and $78 million in 1997 and 1996, respectively. AIG's gross incurred losses from catastrophes approximated $22 million and $240 million in 1997 and 1996, respectively. If catastrophes were excluded from the losses incurred in each period, the pro forma consolidated statutory general insurance ratios would be as follows: <TABLE> <CAPTION> - ------------------------------------------------------ 1997 1996 - ------------------------------------------------------ <S> <C> <C> Loss Ratio 75.57 75.17 Expense Ratio 20.42 20.20 - ------------------------------------------------------ Combined Ratio 95.99 95.37 - ------------------------------------------------------ </TABLE> AIG's ability to maintain its combined ratio below 100 is primarily attributable to the profitability of AIG's foreign general insurance operations and AIG's emphasis on maintaining its disciplined underwriting, especially in the domestic specialty markets. In addition, AIG does not seek net premium growth where rates do not adequately reflect its assessment of exposures. General insurance net investment income in the first nine months of 1997 increased 9.8 percent when compared to the same period of 1996. The growth in net investment income in 1997 was primarily attributable to new cash flow for investment. The new cash flow was generated from net general insurance operating cash flow and included the compounding of previously earned and reinvested net investment income. (See also the discussion under "Liquidity" herein.) General insurance realized capital gains were $106.8 million in the first nine months of 1997 and $50.7 million in 1996. These realized gains resulted from the ongoing management of the general insurance investment portfolios within the overall objectives of the general insurance operations and arose primarily from the disposition of equity securities and available for sale and trading fixed maturities as well as redemptions of fixed maturities. General insurance operating income in the first nine months of 1997 increased 12.8 percent when compared to the same period of 1996. The contribution of general insurance operating income to income before income taxes was 53.4 percent in 1997 compared to 55.6 percent in 1996. AIG is a major purchaser of reinsurance for its general insurance operations. AIG is cognizant of the need to exercise good judgment in the selection and approval of both domestic and foreign companies participating in its reinsurance programs. AIG insures risks in over 100 countries and its reinsurance programs must be coordinated in order to provide AIG the level of reinsurance protection that it desires. These reinsurance arrangements do not relieve AIG from its direct obligations to its insureds. AIG's general reinsurance assets amounted to $17.18 billion and resulted from AIG's reinsurance arrangements. Thus, a credit exposure existed at September 30, 1997, 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, 1996, approximately 50 percent of the general reinsurance assets were from unauthorized reinsurers. In order to obtain statutory recognition, nearly all of these balances were collateralized. The remaining 50 percent of the general reinsurance assets were from authorized reinsurers and over 97 percent of such balances were from reinsurers rated A- (excellent) or better, as rated by A.M. Best. This rating is a measure of financial strength. The terms authorized and unauthorized pertain to regulatory categories, not creditworthiness. Through September 30, 1997, these distribution percentages have not significantly changed. AIG's provision for estimated unrecoverable reinsurance has not changed significantly from December 31, 1996, when AIG had allowances for unrecoverable reinsurance approximating $125 million. At that date, and prior to this allowance, AIG had no significant reinsurance recoverables from any individual reinsurer which is financially troubled (e.g., liquidated, insolvent, in receivership or otherwise subject to formal or informal regulatory restriction). 8
10 AIG's Reinsurance Security Department conducts ongoing detailed assessments of the reinsurance markets and current and potential reinsurers both foreign and domestic. Such assessments include, but are not limited to, identifying if a reinsurer is appropriately licensed and has sufficient financial capacity, and the local economic environment in which a foreign reinsurer operates. This department also reviews the nature of the risks ceded and the need for collateral. In addition, AIG's Credit Risk Committee reviews the credit limits for and concentrations with any one reinsurer. AIG enters into certain intercompany reinsurance transactions for its general and life operations. AIG enters into these transactions as a sound and prudent business practice in order to maintain underwriting control and spread insurance risk among various legal entities. These reinsurance agreements have been approved by the appropriate regulatory authorities. All material intercompany transactions have been eliminated in consolidation. At September 30, 1997, the consolidated general reinsurance assets of $17.18 billion include reinsurance recoverables for paid losses and loss expenses of $2.01 billion and $13.43 billion with respect to the ceded reserve for losses and loss expenses, including ceded losses incurred but not reported (IBNR) (ceded reserves). The ceded reserves represent the accumulation of estimates of ultimate ceded losses including provisions for ceded IBNR and loss expenses. The methods used to determine such estimates and to establish the resulting ceded reserves are continually reviewed and updated. Any adjustments therefrom are reflected in income currently. It is AIG's belief that the ceded reserves at September 30, 1997 were representative of the ultimate losses recoverable. In the future, as the ceded reserves continue to develop to ultimate amounts, the ultimate loss recoverable may be greater or less than the reserves currently ceded. At September 30, 1997, general insurance reserves for losses and loss expenses (loss reserves) amounted to $34.47 billion, an increase of $1.04 billion or 3.1 percent over the prior year end and represent the accumulation of estimates of ultimate losses, including IBNR, and loss expenses and minor amounts of discounting related to certain workers' compensation claims. General insurance net loss reserves increased $633.2 million or 3.1 percent to $21.04 billion and represent loss reserves reduced by reinsurance recoverable, net of an allowance for unrecoverable reinsurance. The methods used to determine such estimates and to establish the resulting reserves are continually reviewed and updated. Any adjustments resulting therefrom are reflected in operating income currently. It is management's belief that the general insurance net loss reserves are adequate to cover all general insurance net losses and loss expenses as at September 30, 1997. In the future, if the general insurance net loss reserves develop deficiently, such deficiency would have an adverse impact on such future results of operations. In a very broad sense, the general loss reserves can be categorized into two distinct groups: one group being long tail casualty lines of business; the other being short tail lines of business consisting principally of property lines and including certain classes of casualty lines. Estimation of ultimate net losses and loss expenses (net losses) for long tail casualty lines of business is a complex process and depends on a number of factors, including the line and volume of the business involved. In the more recent accident years of long tail casualty lines there is limited statistical credibility in reported net losses. That is, a relatively low proportion of net losses would be reported claims and expenses and an even smaller proportion would be net losses paid. A relatively high proportion of net losses would therefore be IBNR. A variety of actuarial methods and assumptions are normally employed to estimate net losses for long tail casualty lines. These methods ordinarily involve the use of loss trend factors intended to reflect the estimated annual growth in loss costs from one accident year to the next. For the majority of long tail casualty lines, net loss trend factors approximated eight percent. Loss trend factors reflect many items including changes in claims handling, exposure and policy forms and current and future estimates of monetary inflation and social inflation. Thus, many factors are implicitly considered in estimating the year to year growth in loss costs. Therefore, AIG's carried net long tail loss reserves are judgmentally set as well as tested for 9
11 reasonableness using the most appropriate loss trend factors for each class of business. In the evaluation of AIG's net loss reserves, loss trend factors vary slightly, depending on the particular class and nature of the business involved. These factors are periodically reviewed and subsequently adjusted, as appropriate, to reflect emerging trends which are based upon past loss experience. Estimation of net losses for short tail business is less complex than for long tail casualty lines. Loss cost trends for many property lines can generally be assumed to be similar to the growth in exposure of such lines. For example, if the fire insurance coverage remained proportional to the actual value of the property, the growth in the property's exposure to fire loss can be approximated by the amount of insurance purchased. For other property and short tail casualty lines, the loss trend is implicitly assumed to grow at the rate that reported net losses grow from one year to the next. The concerns noted above for longer tail casualty lines with respect to the limited statistical credibility of reported net losses generally do not apply to shorter tail lines. AIG continues to receive indemnity claims asserting injuries from toxic waste, hazardous substances, and other environmental pollutants and alleged damages to cover the cleanup costs of hazardous waste dump sites (hereinafter collectively referred to as environmental claims) and indemnity claims asserting injuries from asbestos. The vast majority of these asbestos and environmental claims emanate from policies written in 1984 and prior years. AIG has established a specialized claims unit which investigates and adjusts all such asbestos and environmental claims. Commencing in 1985, standard policies contained an absolute exclusion for pollution related damage. However, AIG currently underwrites pollution impairment liability insurance on a claims made basis and excluded such claims from the analyses included herein. Estimation of asbestos and environmental claims loss reserves is a difficult process. These asbestos and environmental claims cannot be estimated by conventional reserving techniques as previously described. Quantitative techniques frequently have to be supplemented by subjective considerations including managerial judgment. Significant factors which affect the trends which influence the development of asbestos and environmental claims are the inconsistent court resolutions and judicial interpretations which broaden the intent of the policies and scope of coverage. The current case law can be characterized as still evolving and there is little likelihood of any firm direction in the near future. Additionally, the exposure for cleanup costs of hazardous waste dump sites involves issues such as allocation of responsibility among potentially responsible parties and the government's refusal to release parties. The cleanup cost exposure may significantly change if the Congressional reauthorization of Superfund dramatically changes, thereby reducing or increasing litigation and cleanup costs. In the interim, AIG and other industry members have and will continue to litigate the broadening judicial interpretation of the policy coverage and the liability issues. At the current time, it is not possible to determine the future development of asbestos and environmental claims. Such development will be affected by the extent to which courts continue to expand the intent of the policies and the scope of the coverage, as they have in the past, as well as by changes in Superfund and waste dump site coverage issues. Additional liabilities could emerge for amounts in excess of the current reserves held. Although this emergence cannot now be reasonably estimated, it could have a material adverse impact on AIG's future operating results. The reserves carried for these claims at September 30, 1997 are believed to be adequate as these reserves are based on the known facts and current law. Furthermore, as AIG's net exposure retained relative to the gross exposure written was lower in 1984 and prior years, the potential impact of these claims is much smaller on the net loss reserves than on the gross loss reserves. (See the previous discussion on reinsurance collectibility herein.) The majority of AIG's exposures for asbestos and environmental claims are excess casualty coverages, not primary coverages. Thus, the litigation costs are treated in the same manner as indemnity reserves. That is, litigation expenses are included within the limits of the liability AIG incurs. Individual significant claim liabilities, where future litigation costs are reasonably determinable, are established on a case basis. A summary of reserve activity, including estimates for applicable IBNR, relating to asbestos and 10
12 environmental claims separately and combined at September 30, 1997 and 1996 was as follows: (in millions) - ------------------------------------------------------ <TABLE> <CAPTION> 1997 1996 ------------- ------------- GROSS NET Gross Net - ------------------------------------------------------ <S> <C> <C> <C> <C> Asbestos: Reserve for losses and loss expenses at beginning of period $ 875.9 $172.3 $ 744.8 $127.9 Losses and loss expenses incurred 219.6 61.5 144.7 77.6 Losses and loss expenses paid (244.7) (41.7) (198.3) (45.6) - ------------------------------------------------------ Reserve for losses and loss expenses at end of period $ 850.8 $192.1 $ 691.2 $159.9 - ------------------------------------------------------ Environmental: Reserve for losses and loss expenses at beginning of period $1,427.4 $570.6 $1,197.9 $379.3 Losses and loss expenses incurred 173.8 86.3 197.9 125.8 Losses and loss expenses paid (117.6) (40.0) (114.4) (37.7) - ------------------------------------------------------ Reserve for losses and loss expenses at end of period $1,483.6 $616.9 $1,281.4 $467.4 - ------------------------------------------------------ Combined: Reserve for losses and loss expenses at beginning of period $2,303.3 $742.9 $1,942.7 $507.2 Losses and loss expenses incurred 393.4 147.8 342.6 203.4 Losses and loss expenses paid (362.3) (81.7) (312.7) (83.3) - ------------------------------------------------------ Reserve for losses and loss expenses at end of period $2,334.4 $809.0 $1,972.6 $627.3 - ------------------------------------------------------ </TABLE> The gross and net IBNR included in the aforementioned reserve for losses and loss expenses at September 30, 1997 and 1996 were estimated as follows: (in thousands) - ------------------------------------------------------ <TABLE> <CAPTION> 1997 1996 ----------------- ---------------- GROSS NET Gross Net - ------------------------------------------------------ <S> <C> <C> <C> <C> Combined $1,067,550 $432,052 $861,500 $306,200 - ------------------------------------------------------ </TABLE> A summary of asbestos and environmental claims count activity for the nine month periods ended September 30, 1997 and 1996 were as follows: <TABLE> <CAPTION> ------------------------------------------------------------------------------------------------------------------ 1997 1996 ---------------------------------- ---------------------------------- ASBESTOS ENVIRONMENTAL COMBINED Asbestos Environmental Combined - ------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> Claims at beginning of period 5,668 17,395 23,063 5,244 17,858 23,102 Claims during period: Opened 865 2,716 3,581 740 1,993 2,733 Settled (105) (315) (420) (94) (395) (489) Dismissed or otherwise resolved (303) (1,803) (2,106) (555) (2,485) (3,040) - ------------------------------------------------------------------------------------------------------------------ Claims at end of period 6,125 17,993 24,118 5,335 16,971 22,306 - ------------------------------------------------------------------------------------------------------------------ </TABLE> The average cost per claim settled, dismissed or otherwise resolved for the nine month periods ended September 30, 1997 and 1996 was as follows: - ------------------------------------------------------ <TABLE> <CAPTION> 1997 1996 ---------------- --------------- GROSS NET Gross Net - ------------------------------------------------------ <S> <C> <C> <C> <C> Asbestos $599,800 $102,200 $305,500 $70,300 Environmental 55,500 18,900 39,700 13,100 Combined 143,400 32,300 88,600 23,600 - ------------------------------------------------------ </TABLE> An insurance rating agency has developed a survival ratio to measure the number of years it would take a company to exhaust both its asbestos and environmental reserves for losses and loss expenses based on that company's current level of asbestos and environmental claims payments. The higher the ratio, the more years the reserves for losses and loss expenses cover these claims payments. These ratios are computed based on the respective ending reserves for losses and loss ex- 11
13 penses over the respective claims settlements during the fiscal year. Such payments include indemnity payments and legal and loss adjustment payments. It should be noted, however, that this is an extremely simplistic approach to measuring asbestos and environmental reserve levels. Many factors, such as aggressive settlement procedures, mix of business and level of coverage provided, have significant impact on the amount of asbestos and environmental losses and loss expense reserves, ultimate payments thereof and the resultant ratio. The developed survival ratios include both involuntary and voluntary indemnity payments. Involuntary payments include court judgments, court orders, covered claims with no coverage defenses, state mandated cleanup costs, claims where AIG's coverage defenses are minimal, and settlements made less than six months before the first trial setting. Also, AIG considers all legal and loss adjustment payments as involuntary. AIG believes voluntary indemnity payments should be excluded from the survival ratio. The special asbestos and environmental claims unit actively manages AIG's asbestos and environmental claims and proactively pursues early settlement of environmental claims for all known and unknown sites. As a result, AIG reduces its exposure to future environmental loss contingencies. AIG's survival ratios for involuntary asbestos and environmental claims, separately and combined, were based upon a three year average payment. These ratios at September 30, 1997 and 1996 were as follows: - ------------------------------------------------------ <TABLE> <CAPTION> 1997 1996 ------------- ------------- GROSS NET Gross Net - ------------------------------------------------------ <S> <C> <C> <C> <C> Involuntary survival ratios: Asbestos 3.6 4.2 4.2 4.2 Environmental 15.8 19.1 16.1 15.7 Combined 7.7 11.0 8.7 9.8 - ------------------------------------------------------ </TABLE> AIG's operations are negatively impacted under guarantee fund assessment laws which exist in most states. As a result of operating in a state which has guarantee fund assessment laws, a solvent insurance company may be assessed for certain obligations arising from the insolvencies of other insurance companies which operated in that state. AIG generally records these assessments upon notice. Additionally, certain states permit at least a portion of the assessed amount to be used as a credit against a company's future premium tax liabilities. Therefore, the ultimate net assessment cannot reasonably be estimated. The guarantee fund assessments, net of credits for 1996 was $18.8 million. Based upon current information, AIG does not anticipate that its net assessment will be significantly different in 1997. AIG is also required to participate in various involuntary pools (principally workers' compensation business) which provide insurance coverage for those not able to obtain such coverage in the voluntary markets. This participation is also recorded upon notification, as these amounts cannot reasonably be estimated. Life Insurance Operations Life insurance operations for the nine month periods ending September 30, 1997 and 1996 were as follows: (in thousands) - ------------------------------------------------------ <TABLE> <CAPTION> 1997 1996 - ------------------------------------------------------ <S> <C> <C> Premium income: Domestic $ 403,507 $ 383,075 Foreign 6,925,726 6,125,390 - ------------------------------------------------------ Total $ 7,329,233 $ 6,508,465 - ------------------------------------------------------ Net investment income: Domestic $ 620,219 $ 762,058 Foreign 1,527,374 1,284,238 - ------------------------------------------------------ Total $ 2,147,593 $ 2,046,296 - ------------------------------------------------------ Operating income before realized capital gains: Domestic $ 93,337 $ 76,341 Foreign 1,041,163 859,114 - ------------------------------------------------------ Total 1,134,500 935,455 Realized capital gains 12,789 22,600 - ------------------------------------------------------ Operating income $ 1,147,289 $ 958,055 - ------------------------------------------------------ Life insurance in-force:* Domestic $ 64,560,685 $ 60,419,342 Foreign 379,686,844 361,563,791 - ------------------------------------------------------ Total $ 444,247,529 $ 421,983,133 - ------------------------------------------------------ </TABLE> * Amounts presented were as at September 30, 1997 and December 31, 1996, respectively. AIG's life insurance operations, demonstrating the strength of its franchise, continued to show growth primarily as a result of overseas operations, particularly in Asia. AIG's life premium income during the first nine months of 1997 represented a 12.6 percent increase from the same period in 1996. Foreign life operations produced 94.5 percent and 94.1 percent of the life premium income in 1997 and 1996, respectively. As previously discussed, the U.S. dollar strengthened in value in relation to most major 12
14 foreign currencies in which AIG transacts business. Accordingly, for the first nine months of 1997, when foreign life premium income was translated into U.S. dollars for purposes of consolidation, total life premium income was approximately 5.2 percentage points less than it would have been if translated utilizing exchange rates prevailing in the same period of 1996. Life insurance net investment income increased 5.0 percent during the first nine months of 1997. The growth in net investment income was primarily attributable to foreign new cash flow for investment. The new cash flow was generated from life insurance operations and included the compounding of previously earned and reinvested net investment income. (See also the discussion under "Liquidity" herein.) The decline in domestic net investment income resulted from the redemption of corporate owned life insurance policies beginning in 1996 and continuing into 1997. Such redemptions had no significant effect on domestic operating income. The traditional life products, such as whole and term life and endowments, were the major contributors to the growth in foreign premium income and investment income, particularly in Asia, and continue to be the primary source of growth in the life segment. A mixture of traditional, accident and health and financial products are being sold in Japan. Life insurance realized capital gains were $12.8 million in 1997 and $22.6 million in 1996. These realized gains resulted from the ongoing management of the life insurance investment portfolios within the overall objectives of the life insurance operations and arose primarily from the disposition of equity securities and available for sale fixed maturities as well as redemptions of fixed maturities. Life insurance operating income during the first nine months of 1997 increased 19.8 percent to $1.15 billion. Excluding realized capital gains from life insurance operating income, the percent increase would be 21.3 percent during the first nine months of 1997. The contribution of life insurance operating income to income before income taxes amounted to 33.2 percent during the first nine months of 1997 compared to 32.5 percent in the same period of 1996. The risks associated with the traditional life and accident and health products are underwriting risk and investment risk. The risk associated with the financial and investment contract products is investment risk. Underwriting risk represents the exposure to loss resulting from the actual policy experience adversely emerging in comparison to the assumptions made in the product pricing associated with mortality, morbidity, termination and expenses. AIG's life companies limit their maximum underwriting exposure on traditional life insurance of a single life to approximately one million dollars of coverage by using yearly renewable term reinsurance. The life insurance operations have not entered into assumption reinsurance transactions or surplus relief transactions during the two year period ended September 30, 1997. The investment risk represents the exposure to loss resulting from the cash flows from the invested assets, primarily long-term fixed rate investments, being less than the cash flows required to meet the obligations of the expected policy and contract liabilities and the necessary return on investments. To minimize its exposure to investment risk, AIG tests the cash flows from the invested assets and the policy and contract liabilities using various interest rate scenarios to assess whether there is a liquidity excess or deficit. If a rebalancing of the invested assets to the policy and contract claims became necessary and did not occur, a demand could be placed upon liquidity. (See also the discussion under "Liquidity" herein.) The asset-liability relationship is appropriately managed in AIG's foreign operations, as it has been throughout AIG's history, even though certain territories lack qualified long-term investments or there are investment restrictions imposed by the local regulatory authorities. For example, in Japan and several Southeast Asia territories, the duration of the investments is often for a shorter period than the effective maturity of such policy liabilities. Therefore, there is a risk that the reinvestment of the proceeds at the maturity of the investments may be at a yield below that of the interest required for the accretion of the policy liabilities. At December 31, 1996, the average duration of the investment portfolio in Japan was 5.9 years, while the related policy liabilities were estimated to be 12.3 years. These durations have not changed significantly during 1997. To maintain an adequate yield to match the 13
15 interest required over the duration of the liabilities, constant management focus is required to reinvest the proceeds of the maturing securities without sacrificing investment quality. To the extent permitted under local regulation, AIG may invest in qualified longer-term securities outside Japan to achieve a closer matching in both duration and the required yield. AIG is able to manage any asset-liability duration difference through maintenance of sufficient global liquidity and to support any operational shortfall through its international financial network. Domestically, active monitoring assures appropriate asset-liability matching as there are investments available to match the duration and the required yield. (See also the discussion under "Liquidity" herein.) AIG uses asset-liability matching as a management tool to determine the composition of the invested assets and marketing strategies. As a part of these strategies, AIG may determine that it is economically advantageous to be temporarily in an unmatched position due to anticipated interest rate or other economic changes. Financial Services Operations Financial services operations for the nine month periods ending September 30, 1997 and 1996 were as follows: (in thousands) - ------------------------------------------------------ <TABLE> <CAPTION> 1997 1996 - ------------------------------------------------------ <S> <C> <C> Revenues: International Lease Finance Corp. $1,369,091 $1,148,310 AIG Financial Products Corp.* 294,513 286,995 AIG Trading Group Inc.* 365,052 209,407 Other 299,020 230,412 - ------------------------------------------------------ Total $2,327,676 $1,875,124 - ------------------------------------------------------ Operating income: International Lease Finance Corp. $ 287,151 $ 226,050 AIG Financial Products Corp. 151,119 129,824 AIG Trading Group Inc. 83,431 53,903 Other, including intercompany adjustments (34,267) (35,016) - ------------------------------------------------------ Total $ 487,434 $ 374,761 - ------------------------------------------------------ </TABLE> *Represents net trading revenues. Financial services operating income increased 30.1 percent in the first nine months of 1997 over 1996. International Lease Finance Corporation (ILFC) generates its revenues primarily from leasing new and used commercial jet aircraft to domestic and foreign airlines. Revenues also result from the remarketing of commercial jets for its own account, for airlines and for financial institutions. Revenues in the first nine months of 1997 increased 19.2 percent from 1996. The revenue increase resulted primarily from the growth both in the size and relative cost of the fleet. During the first nine months of 1997, operating income increased 27.0 percent from 1996. The composite borrowing rates during the first nine months of 1997 and 1996 were 6.34 percent and 6.28 percent, respectively. (See also the discussions under "Capital Resources" and "Liquidity" herein.) ILFC is exposed to loss through non-performance of aircraft lessees, through owning aircraft which it would be unable to lease or re-lease at acceptable rates or sell at lease expiration and through committing to purchase aircraft which it would be unable to lease. ILFC manages its lessee non-performance exposure through credit reviews and security deposit requirements. At September 30, 1997, ILFC's aircraft subject to operating leases totaled 325. In addition, two other aircraft were not leased. At September 30, 1997, approximately 80 percent of the fleet was leased to foreign airlines. (See also the discussions under "Capital Resources" and "Liquidity" herein.) AIG Financial Products Corp. and its subsidiaries (AIGFP) participate in the derivatives dealer market conducting, primarily as principal, an interest rate, currency and equity derivative products business. AIGFP also enters into structured transactions including long-dated forward foreign exchange contracts, option transactions, liquidity facilities and investment agreements and invests in a diversified portfolio of securities. AIGFP derives substantially all its revenues from proprietary positions entered in connection with counterparty transactions rather than for speculative transactions. Revenues in the first nine months of 1997 increased 2.6 percent from the same period of 1996. During the first nine months of 1997, operating income increased 16.4 percent from the same period of 1996. As AIGFP is a transaction-oriented operation, current and past revenues and operating results may not provide a basis for predicting future performance. (See also the discussions under "Capital Resources," "Liquidity" and "Derivatives" herein.) AIG Trading Group Inc. and its subsidiaries (AIGTG) derive a substantial portion of their revenues from market making and trading activities, as principals, in foreign exchange, interest rates, precious and base metals and natural gas and other 14
16 energy products. Revenues in the first nine months of 1997 increased 74.3 percent from the same period of 1996. During the first nine months of 1997, operating income increased 54.8 percent from the same period of 1996. A substantial portion of AIGTG's improvement during the first nine months of 1997 over the same period of 1996 was currency trading activity in volatile foreign exchange markets particularly during the second quarter of 1997. On August 6, 1997, AIGTG entered into an agreement to sell its energy operations. The transaction is expected to close prior to December 31, 1997. (See also the discussion under "Recent Developments" herein.) It is not anticipated that the sale of these operations will have any significant impact on AIG. As AIGTG is a transaction-oriented operation, current and past revenues and operating results may not provide a basis of predicting future performance. (See also the discussions under "Capital Resources," "Liquidity" and "Derivatives" herein.) Financial services operating income represented 14.1 percent of AIG's income before income taxes in the first nine months of 1997. This compares to 12.7 percent in the same period of 1996. Other Operations In the first nine months of 1997, AIG's equity in income of minority-owned insurance operations was $84.6 million compared to $74.3 million in the same period of 1996. In the first nine months of 1997 and 1996, the equity interest in insurance companies represented 2.5 percent of income before income taxes in each period. Other realized capital losses amounted to $20.6 million and $1.1 million in the first nine months of 1997 and 1996, respectively. Minority interest represents minority shareholders' equity in income of certain consolidated subsidiaries. In the first nine months of 1997, minority interest amounted to $25.5 million. In the first nine months of 1996, minority interest amounted to $33.3 million. Other income (deductions)--net includes AIG's equity in certain minor majority-owned subsidiaries and certain partially-owned companies, realized foreign exchange transaction gains and losses in substantially all currencies and unrealized gains and losses in hyperinflationary currencies, as well as the income and expenses of the parent holding company and other miscellaneous income and expenses. In the first nine months of 1997, net deductions amounted to $66.6 million. In the same period of 1996, net deductions amounted to $64.6 million. Income before income taxes amounted to $3.45 billion in the first nine months of 1997, and $2.94 billion in the same period of 1996. In the first nine months of 1997, AIG recorded a provision for income taxes of $1.00 billion compared to the provision of $816.8 million in the same period of 1996. These provisions represent effective tax rates of 29.1 percent in the first nine months of 1997, and 27.7 percent in the same period of 1996. The increase in the effective tax rate in 1997 over the prior period is primarily due to the increase in the domestic general operating income relative to income before income taxes. Net income amounted to $2.45 billion in the first nine months of 1997 and $2.13 billion in the same period of 1996. The increases in net income over the periods resulted from those factors described above. CAPITAL RESOURCES At September 30, 1997, AIG had total capital funds of $23.87 billion and total borrowings of $24.53 billion. At that date, $21.22 billion of such borrowings were either not guaranteed by AIG or were matched borrowings under obligations of guaranteed investment agreements (GIAs) or matched notes and bonds payable. 15
17 Total borrowings at September 30, 1997 and December 31, 1996 were as follows: (in thousands) - ------------------------------------------------------ <TABLE> <CAPTION> 1997 1996 - ------------------------------------------------------ <S> <C> <C> GIAs -- AIGFP $ 7,279,120 $ 5,723,228 - ------------------------------------------------------ Commercial Paper: Funding 232,492 1,018,510 ILFC(a) 2,789,568 2,739,388 AICCO 880,619 740,078 - ------------------------------------------------------ Total 3,902,679 4,497,976 - ------------------------------------------------------ Medium Term Notes: ILFC(a) 3,015,465 2,551,485 AIG 240,000 140,000 - ------------------------------------------------------ Total 3,255,465 2,691,485 - ------------------------------------------------------ Notes and Bonds Payable: ILFC(a) 4,050,000 3,500,000 AIGFP 4,114,253 5,243,042 AIGTG -- 10,442 AIG: Lire bonds 159,067 159,067 Zero coupon notes 88,724 81,761 - ------------------------------------------------------ Total 8,412,044 8,994,312 - ------------------------------------------------------ Loans and Mortgages Payable: ILFC(a)(b) 933,320 1,007,836 AIG 751,598 605,677 - ------------------------------------------------------ Total 1,684,918 1,613,513 - ------------------------------------------------------ Total Borrowings 24,534,226 23,520,514 - ------------------------------------------------------ Borrowings not guaranteed by AIG 10,788,353 9,798,709 Matched GIA borrowings 7,279,120 5,723,228 Matched notes and bonds payable -- AIGFP 3,147,785 4,576,900 - ------------------------------------------------------ 21,215,258 20,098,837 - ------------------------------------------------------ Remaining borrowings of AIG $ 3,318,968 $ 3,421,677 - ------------------------------------------------------ </TABLE> (a)AIG does not guarantee or support these borrowings. (b)Primarily capital lease obligations. During the first nine months of 1997, AIGFP decreased the aggregate principal amount outstanding of its notes and bonds payable to $4.11 billion, a net decrease of $1.13 billion and increased its net GIA borrowings by $1.56 billion. AIGFP uses the proceeds from the issuance of notes and bonds to invest in a segregated portfolio of securities available for sale. Funds received from GIA borrowings are invested in a diversified portfolio of securities and derivative transactions. (See also the discussions under "Operational Review", "Liquidity" and "Derivatives" herein.) AIG Funding, Inc. (Funding), through the issuance of commercial paper, fulfills the short-term cash requirements of AIG and its subsidiaries. Funding intends to continue to meet AIG's funding requirements through the issuance of commercial paper guaranteed by AIG. This issuance of Funding's commercial paper is subject to the approval of AIG's Board of Directors. ILFC and A.I. Credit Corp. (AICCO) issue commercial paper for the funding of their own operations. AIG does not guarantee AICCO's or ILFC's commercial paper. However, AIG has entered into an agreement in support of AICCO's commercial paper. From time to time, AIGFP may issue commercial paper, which AIG guarantees, to fund its operations. At September 30, 1997, AIGFP had no commercial paper outstanding. (See also the discussion under "Derivatives" herein.) AIG and Funding have entered into two syndicated revolving credit facilities (the Facilities) aggregating $1 billion. The Facilities consist of a $500 million 364 day revolving credit facility and a $500 million five year revolving credit facility. The Facilities can be used for general corporate purposes and also provide backup for AIG's commercial paper programs administered by Funding. There are currently no borrowings outstanding under either of the Facilities, nor were any borrowings outstanding as of September 30, 1997. ILFC increased the aggregate principal amount outstanding of its medium term and term notes to $7.07 billion at September 30, 1997, a net increase of $1.01 billion, and recorded a net decline in its capital lease obligations of $62.6 million and a net increase in its commercial paper of $50.2 million at that date. At October 31, 1997, ILFC had $610 million aggregate principal amount of debt securities registered for issuance from time to time. The cash used to purchase flight equipment, including progress payments during the construction phase, is primarily derived 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 of prior debt. (See also the discussions under "Operational Review" and "Liquidity" herein.) During the first nine months of 1997, AIG issued $100 million principal amount of Medium Term Notes, Series E (2 1/4% Cash Exchangeable Equity-Linked Notes Due July 30, 2004) and no previously issued notes matured. At September 30, 1997, AIG had $547 million aggregate principal amount of debt securities registered for issuance from time to time. AIG's capital funds have increased $1.82 bil- lion in the first nine months of 1997. Unrealized appreciation of investments, net of taxes increased $167.5 million, primarily as a result of the effect of declining interest rates on the market value of the bonds available for sale portfolio. During the first 16
18 nine months of 1997, the cumulative translation adjustment loss, net of taxes, increased $404.0 million and retained earnings increased $1.67 billion, resulting from net income less dividends. During the period from January 1, 1997 through October 31, 1997, AIG repurchased in the open market 4.59 million shares of its common stock at a cost of $387.1 million. AIG intends to continue to buy its common shares in the open market from time to time and to satisfy its obligations under various employee benefit plans through such purchases. Payments of dividends to AIG by its insurance subsidiaries are subject to certain restrictions imposed by statutory authorities. AIG has in the past reinvested most of its unrestricted earnings in its operations and believes such continued reinvestment in the future will be adequate to meet any foreseeable capital needs. However, AIG may choose from time to time to raise additional funds through the issuance of additional securities. At September 30, 1997, there were no significant statutory or regulatory issues which would impair AIG's financial condition, results of operations or liquidity. (See also the discussion under "Liquidity" herein.) In 1989, the National Association of Insurance Commissioners (NAIC) adopted the "NAIC Solvency Policing Agenda for 1990". Included in this agenda was the development of Risk-Based Capital (RBC) requirements. RBC relates an individual insurance company's statutory surplus to the risk inherent in its overall operations. At December 31, 1996, the adjusted capital of each of AIG's domestic general companies and of each of AIG's domestic life companies exceeded each of their RBC standards by considerable margins. There has been no significant change through September 30, 1997. 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 from minimal in some to stringent in others. Generally, AIG, as well as the underwriting companies operating in such jurisdictions, must satisfy local regulatory requirements. To AIG's knowledge, no AIG company is on any regulatory or similar "watch list". LIQUIDITY At September 30, 1997, AIG's consolidated invested assets included approximately $2.34 billion of cash and short-term investments. Consolidated net cash provided from operating activities in the first nine months of 1997 amounted to approximately $2.74 billion. Management believes that AIG's liquid assets, its net cash provided by operations, and access to the capital markets will enable it to meet any foreseeable cash requirements. AIG's liquidity is primarily derived from the operating cash flows of its general and life insurance operations. The liquidity of the combined insurance operations is derived both domestically and abroad. The combined insurance pre-tax operating cash flow is derived from two sources, underwriting operations and investment operations. In the aggregate, AIG's insurance operations generated over $5 billion in pre-tax cash flow during the first nine months of 1997. Cash flow includes periodic premium collections, including policyholders' contract deposits, paid loss recoveries less reinsurance premiums, losses, benefits, acquisition and operating expenses. Generally, there is a time lag from when premiums are collected and, when as a result of the occurrence of events specified in the policy, the losses and benefits are paid. AIG's insurance investment operations generated approximately $3.5 billion in investment income cash flow during the first nine months of 1997. Investment income cash flow is primarily derived from interest and dividends received and includes realized capital gains. The combined insurance pre-tax operating cash flow coupled with the cash and short-term investments of $1.86 billion provided the insurance operations with a significant amount of liquidity during the first nine months of 1997. This liquidity is available to purchase high quality and diversified fixed income securities and to a lesser extent marketable equity securities and to provide mortgage loans on real estate, policy loans and collateral loans. With this liquidity coupled with proceeds of approximately $12.3 billion from the maturities, sales and redemptions of fixed income securities and from the sale of equity securities, AIG purchased approximately $15.1 billion of fixed income securities and marketable equity securities during the first nine months of 1997. 17
19 The following table is a summary of AIG's invested assets by significant segment, including investment income due and accrued and real estate, at September 30, 1997 and December 31, 1996: (dollars in thousands) - -------------------------------------------------------------------------------- <TABLE> <CAPTION> SEPTEMBER 30, 1997 December 31, 1996 ------------------------ -------------------------- INVESTED PERCENT Invested Percent ASSETS OF TOTAL Assets of Total --------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> General insurance $ 30,896,047 26.6% $ 28,786,140 26.5% Life insurance 40,561,308 34.9 38,491,870 35.4 Financial services 44,048,373 37.9 40,938,871 37.7 Other 688,112 0.6 401,248 0.4 - ------------------------------------------------------------------------------------------------------------------------ Total $116,193,840 100.0% $108,618,129 100.0% - ------------------------------------------------------------------------------------------------------------------------ </TABLE> The following tables summarize the composition of AIG's insurance invested assets by insurance segment, including investment income due and accrued and real estate, at September 30, 1997 and December 31, 1996: (dollars in thousands) - -------------------------------------------------------------------------------- <TABLE> <CAPTION> PERCENT DISTRIBUTION PERCENT ------------------- SEPTEMBER 30, 1997 GENERAL LIFE TOTAL OF TOTAL DOMESTIC FOREIGN - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Fixed Maturities: Available for sale, at market value(a) $11,029,897 $27,535,984 $38,565,881 54.0% 36.4% 63.6% Held to maturity, at amortized cost(b) 12,881,185 -- 12,881,185 18.0 100.0 -- Equity securities, at market value(c) 3,377,536 2,550,767 5,928,303 8.3 37.1 62.9 Mortgage loans on real estate, policy and collateral loans 50,727 6,414,205 6,464,932 9.0 42.3 57.7 Short-term investments, including time deposits, and cash 579,002 1,279,301 1,858,303 2.6 13.3 86.7 Real estate 401,054 901,296 1,302,350 1.8 17.6 82.4 Investment income due and accrued 535,085 815,027 1,350,112 1.9 44.4 55.6 Other invested assets 2,041,561 1,064,728 3,106,289 4.4 57.9 42.1 - --------------------------------------------------------------------------------------------------------------------------- Total $30,896,047 $40,561,308 $71,457,355 100.0% 48.6% 51.4% - --------------------------------------------------------------------------------------------------------------------------- </TABLE> (a)Includes $628,485 of bonds trading securities, at market value. (b)Includes $239,663 of preferred stock, at amortized cost. (c)Includes $93,570 of preferred stock, at market value. (dollars in thousands) - -------------------------------------------------------------------------------- <TABLE> <CAPTION> Percent Distribution Percent ------------------ December 31, 1996 General Life Total of Total Domestic Foreign - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Fixed Maturities: Available for sale, at market value(a) $ 9,713,937 $26,058,027 $35,771,964 53.2% 34.6% 65.4% Held to maturity, at amortized cost(b) 12,736,225 -- 12,736,225 18.9 100.0 -- Equity securities, at market value(c) 3,265,756 2,608,309 5,874,065 8.7 33.9 66.1 Mortgage loans on real estate, policy and collateral loans 50,578 6,224,878 6,275,456 9.3 43.1 56.9 Short-term investments, including time deposits, and cash 605,363 1,002,060 1,607,423 2.4 19.3 80.7 Real estate 409,808 843,933 1,253,741 1.9 18.2 81.8 Investment income due and accrued 493,338 697,891 1,191,229 1.8 44.4 55.6 Other invested assets 1,511,135 1,056,772 2,567,907 3.8 51.6 48.4 - --------------------------------------------------------------------------------------------------------------------------- Total $28,786,140 $38,491,870 $67,278,010 100.0% 47.9% 52.1% - --------------------------------------------------------------------------------------------------------------------------- </TABLE> (a)Includes $364,069 of bonds trading securities, at market value. (b)Includes $477,247 of preferred stock, at amortized cost. (c)Includes $46,732 of preferred stock, at market value. With respect to fixed maturities, AIG's general strategy is to invest in high quality securities while maintaining diversification to avoid significant exposure to issuer, industry and/or country concentrations. At September 30, 1997, approximately 52.3 percent of the fixed maturity investments were domestic securities. Approximately 41 percent of such domestic securities were rated AAA. Approximately seven percent were below investment grade or not rated. A significant portion of the foreign insurance fixed income portfolio is rated by Moody's, Standard & Poor's (S&P) or similar foreign services. 18
20 Similar credit quality rating services are not available in all overseas locations. AIG annually reviews the credit quality of the foreign portfolio nonrated fixed income investments, including mortgages. At September 30, 1997, approximately 31 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 seven percent were below investment grade or not rated at that date. Although AIG's fixed income insurance portfolios contain only minor amounts of securities below investment grade, any fixed income security may be subject to downgrade for a variety of reasons subsequent to any balance sheet date. There have been no significant downgrades as at November 1, 1997. At September 30, 1997, approximately five percent of the fixed maturities portfolio was Collateralized Mortgage Obligations (CMOs), including minor amounts with respect to Commercial Mortgage Backed Securities. All of the CMOs were investment grade and approximately 63 percent of the CMOs were backed by various U.S. government agencies. Thus, credit risk was minimal. CMOs are exposed to interest rate risk as the duration and ultimate realized yield would be affected by the accelerated prepayments of the underlying mortgages. There were no interest only or principal only CMOs. When permitted by regulatory authorities and when deemed necessary to protect insurance assets, including invested assets, from currency risk and interest rate risk, AIG and its insurance subsidiaries enter into derivative transactions as end users. To date, such activities have been minor. (See also the discussion under "Derivatives" herein.) Mortgage loans on real estate, policy and collateral loans comprised 9.0 percent of AIG's insurance invested assets at September 30, 1997. AIG's insurance operations' holdings of real estate mortgages amounted to $2.58 billion of which 34.1 percent was domestic. At September 30, 1997, no domestic mortgages and only a nominal amount of foreign mortgages were in default. At September 30, 1997, AIG's insurance holdings of collateral loans amounted to $843.7 million, all of which were foreign. It is AIG's practice to maintain a maximum loan to value ratio of 75 percent at loan origination. AIG's policy loans increased from $3.00 billion at December 31, 1996 to $3.04 billion at September 30, 1997. Short-term investments represent amounts invested in various internal and external money market funds, time deposits and cash held. AIG's real estate investment properties are primarily occupied by AIG's various operations. The current market value of these properties considerably exceeds their carrying value. Other invested assets were primarily comprised of both foreign and domestic private placements, limited partnerships and outside managed funds. 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. These barriers generally cause only minor delays in the outward remittance of the funds. 19
21 The following table is a summary of the composition of AIG's financial services invested assets at September 30, 1997 and December 31, 1996. (See also the discussions under "Operational Review," "Capital Resources" and "Derivatives" herein.) (dollars in thousands) - -------------------------------------------------------------------------------- <TABLE> <CAPTION> 1997 1996 ------------------------- ------------------------- INVESTED PERCENT Invested Percent ASSETS OF TOTAL Assets of Total - ----------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Flight equipment primarily under operating leases, net of accumulated depreciation $15,199,781 34.5% $13,808,660 33.7% Unrealized gain on interest rate and currency swaps, options and forward transactions 7,853,575 17.8 6,906,012 16.9 Securities available for sale, at market value 7,742,935 17.6 9,785,909 23.9 Trading securities, at market value 2,339,416 5.3 2,357,812 5.7 Securities purchased under agreements to resell, at contract value 2,065,397 4.7 1,642,591 4.0 Trading assets 6,044,710 13.7 3,793,433 9.3 Spot commodities, at market value 471,153 1.1 204,705 0.5 Other, including short-term investments 2,331,406 5.3 2,439,749 6.0 - ----------------------------------------------------------------------------------------------------------------------- Total $44,048,373 100.0% $40,938,871 100.0% - ----------------------------------------------------------------------------------------------------------------------- </TABLE> As previously discussed, the cash used for the purchase of flight equipment is derived primarily from the proceeds of ILFC's debt financing. 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 of prior debt. During the first nine months of 1997, ILFC acquired flight equipment costing $2.80 billion. AIGFP's derivative transactions are carried at market value or at estimated fair value when market prices are not readily available. AIGFP reduces its economic risk exposure through similarly valued offsetting transactions including swaps, trading securities, options, forwards and futures. The estimated fair values of these transactions represent assessments of the present value of expected future cash flows. These transactions are exposed to liquidity risk if AIGFP were to sell or close out the transactions prior to maturity. AIG believes that the impact of any such limited liquidity would not be significant to AIG's financial condition or its overall liquidity. (See also the discussion under "Derivatives" herein.) Securities available for sale, at market value and securities purchased under agreements to resell are purchased with the proceeds of AIGFP's GIA financings and other long and short-term borrowings. The proceeds from the disposal of securities available for sale and securities purchased under agreements to resell have been used to fund the maturing GIAs or other AIGFP financing. (See also the discussion under "Capital Resources" herein.) Securities available for sale is mainly a portfolio of debt securities, where the individual securities have varying degrees of credit risk. At September 30, 1997, the average credit rating of this portfolio was AA or the equivalent thereto as determined through rating agencies or internal review. At that date, AIGFP has also entered into credit derivative transactions to hedge its credit risk associated with $279 million of these securities. There were no securities deemed below investment grade. There have been no significant downgrades through November 1, 1997. Securities purchased under agreements to resell are treated as collateralized transactions. AIGFP takes possession of or obtains a security interest in securities purchased under agreements to resell. AIGFP further minimizes its credit risk by monitoring counterparty credit exposure and, when AIGFP deems necessary, it requires additional collateral to be deposited. Trading securities, at market value are marked to market daily and are held to meet the short-term risk management objectives of AIGFP. AIGTG conducts, as principal, market making and trading activities in foreign exchange, interest rates, precious and base metals and natural gas and other energy products. AIGTG owns inventories in the commodities in which it trades and may reduce the exposure to market risk through the use of swaps, forwards, futures and option contracts. AIGTG uses derivatives to manage the economic exposure of its various trading positions and transactions from adverse movements of interest rates, exchange rates and commodity prices. AIGTG supports its trading activities largely through trading 20
22 liabilities, unrealized losses on swaps, short-term borrowings and spot commodities sold but not yet purchased. (See also the discussions under "Capital Resources" and "Derivatives" herein.) DERIVATIVES Derivatives are financial arrangements among two or more parties whose returns are linked to or "derived" from some underlying equity, debt, commodity or other asset, liability, or index. Derivatives payments may be based on interest rates and exchange rates and/or prices of certain securities, certain commodities, or financial or commodity indices. The more significant types of derivative arrangements in which AIG transacts are swaps, forwards, futures, options and related instruments. The most commonly used swaps are interest rate and currency swaps. An interest rate swap is a contract between two parties to exchange interest rate payments (typically a fixed interest rate versus a variable interest rate) calculated on a notional principal amount for a specified period of time. The notional amount is not exchanged. A currency swap is similar but the notional amounts are different currencies which are typically exchanged at the commencement and termination of the swap based upon negotiated exchange rates. A futures or forward contract is a legal contract between two parties to purchase or sell at a specified future date a specified quantity of a commodity, security, currency, financial index or other instrument, at a specified price. A futures contract is traded on an exchange, while a forward contract is executed over the counter. An option contract generally provides the option purchaser with the right but not the obligation to buy or sell during a period of time or at a specified date the underlying instrument at a set price. The option writer is obligated to sell or buy the underlying item if the option purchaser chooses to exercise his right. The option writer receives a nonrefundable fee or premium paid by the option purchaser. Derivatives are generally either negotiated over the counter contracts or standardized contracts executed on an exchange. Standardized exchange traded derivatives include futures and options which can be readily bought or sold over recognized security or commodity exchanges and settled daily through such clearing houses. Negotiated over the counter derivatives include forwards, swaps and options. Over the counter derivatives are generally not traded like exchange traded securities. However, in the normal course of business, with the agreement of the original counterparty, these contracts may be terminated early or assigned to another counterparty. All significant derivatives activities are conducted through AIGFP and AIGTG permitting AIG to participate in the derivatives dealer market acting primarily as principal. In these derivative operations, AIG structures agreements which generally allow its counterparties to enter into transactions with respect to changes in interest and exchange rates, securities' prices and certain commodities and financial or commodity indices. Generally, derivatives are used by AIG's customers, such as corporations, financial institutions, multinational organizations, sovereign entities, government agencies and municipalities. For example, a futures, forward or option contract can be used to protect the customers' assets or liabilities against price fluctuations. The senior management of AIG defines the policies and establishes general operating parameters for AIGFP and AIGTG. AIG's senior management has established various oversight committees to review the various financial market, operational and credit issues of AIGFP and AIGTG. The senior managements of AIGFP and AIGTG report the results of their respective operations and review future strategies with AIG's senior management. AIG actively manages the exposures to limit potential losses, while maximizing the rewards afforded by these business opportunities. In doing so, AIG must manage a variety of exposures including credit, market, liquidity, operational and legal risks. Market risk principally arises from the uncertainty that future earnings are exposed to potential changes in volatility, interest rates, foreign exchange rates, and equity and commodity prices. AIG generally controls its exposure to market risk by taking offsetting positions. AIG's philosophy with respect to its financial services operations is to minimize or set limits for open or uncovered positions that are to be carried. Credit risk exposure is separately managed. (See the discussion on the management of credit risk below.) AIG's Market Risk Management Department provides detailed independent review of AIG's mar- 21
23 ket exposures, particularly those market exposures of AIGFP and AIGTG. This department determines whether AIG's market risks, as well as those market risks of individual subsidiaries, are within the parameters established by AIG's senior management. Well established market risk management techniques such as value at risk and scenario analysis are used. Additionally, this department verifies that specific market risks of each of certain subsidiaries are managed and hedged by that subsidiary. AIGFP does not seek to manage the market risk of each of its transactions through an individual offsetting transaction. Rather, AIGFP takes a portfolio approach to the management of its market risk exposure. AIGFP values its portfolio at market value or estimated fair value when market values are not readily available. These valuations represent an assessment of the present values of expected future cash flows of AIGFP's transactions and may include reserves for such risks as are deemed appropriate by AIGFP's and AIG's management. AIGFP evaluates the portfolio's discounted cash flows with reference to current market conditions, maturities within the portfolio and other relevant factors. Based upon this evaluation, AIGFP determines what, if any, offsetting transactions are necessary to reduce the market risk exposure of the portfolio. The aforementioned estimated fair values are based upon the use of valuation models. These models utilize, among other things, current interest, foreign exchange and volatility rates. These valuation models are integrated into the evaluation of the portfolio, as described above, in order to provide timely information for the market risk management of the portfolio. Additionally, depending upon the nature of interest rates and market movements during the day, the system will produce reports for management's consideration for intra-day offsetting positions. Overnight, the system generates reports which recommend the types of offsets management should consider for the following day. Additionally, AIGFP operates in major business centers overseas and is essentially open for business 24 hours a day. Thus, the market exposure and offset strategies are monitored, reviewed and coordinated around the clock. Therefore, offsetting adjustments can be made as and when necessary from any AIGFP office in the world. As part of its monitoring and controlling of its exposure to market risk, AIGFP applies various testing techniques which reflect potential market movements. These techniques vary by currency and are regularly changed to reflect factors affecting the derivatives portfolio. In addition to the daily monitoring, AIGFP's senior management and local risk managers conduct a weekly review of the derivatives portfolio and existing hedges. This review includes an examination of the portfolio's risk measures, such as aggregate option sensitivity to movements in market variables. AIGFP's management may change these measures to reflect their judgment and evaluation of the dynamics of the markets. This management group will also determine whether additional or alternative action is required in order to manage the portfolio. AIG utilizes an outside consultant to provide the managements of AIG and AIGFP with comfort that the system produces representative values. AIGTG's approach to managing market risk is to establish an appropriate offsetting position to a particular transaction or group of transactions depending upon the extent of market risk AIGTG wishes to reduce. AIGTG's senior management has established positions and stop-loss limits for each line of business. AIGTG's traders are required to maintain positions within these limits. These positions are monitored during the day either manually and/or through on-line computer systems. In addition, these positions are reviewed by AIGTG's management. Reports which present each trading book's position and the prior day's profit and loss are reviewed by traders, head traders and AIGTG's senior management. Based upon these and other reports, AIGTG's senior management determines whether to adjust AIGTG's risk profile. AIGTG attempts to secure reliable current market prices, such as published prices or third party quotes, to value its derivatives. Where such prices are not available, AIGTG uses an internal methodology which includes interpolation or extrapolation from verifiable prices nearest to the dates of the transactions. The methodology may reflect interest and exchange rates, commodity prices, volatility rates and other relevant factors. A significant portion of AIGTG's business is transacted in liquid markets. Certain of AIGTG's derivative product exposures are evaluated using simulation techniques which consider such factors as changes in currency and commodity prices, interest rates, volatility levels and the effect of time. 22
24 Though not indicative of the future, past volatile market scenarios have represented profit opportunities for AIGTG. The gross unrealized gains and gross unrealized losses of AIGFP and AIGTG included in the financial services assets and liabilities at September 30, 1997 were as follows: (in thousands) - ------------------------------------------------------ <TABLE> <CAPTION> GROSS GROSS BALANCE UNREALIZED UNREALIZED SHEET GAINS LOSSES AMOUNT - ------------------------------------------------------ <S> <C> <C> <C> Securities available for sale, at market value $ 225,070 $ 216,384 $7,742,935 Unrealized gain/loss on interest rate and currency swaps, options and forward transactions(a)(b) 7,853,575 5,146,522 -- Trading securities, at market value -- -- 2,339,416 Trading assets 7,714,982 5,293,914 6,044,710 Spot commodities, at market value -- 48,492 471,153 Trading liabilities -- 3,107,014 4,887,581 Securities and spot commodities sold but not yet purchased, at market value 186,771 -- 4,001,156 - ------------------------------------------------------ </TABLE> (a)These amounts are also presented as the respective balance sheet amounts. (b)At September 30, 1997, AIGTG's net replacement values with respect to interest rate and currency swaps were $412.9 million. The interest rate risk on securities available for sale, at market, is managed by taking offsetting positions on a security by security basis, thereby offsetting a significant portion of the unrealized appreciation or depreciation. At September 30, 1997, the unrealized gains and losses remaining after benefit of the offsets were $12.7 million and $4.0 million, respectively. AIGFP carries its derivatives at market or estimated fair value, whichever is appropriate. Because of limited liquidity of certain of these instruments, the recorded estimated fair values of these derivatives may be different than the values that might be realized if AIGFP were to sell or close out the transactions prior to maturity. (See also the discussions under "Operational Review: Financial Services" and "Liquidity" herein.) Trading securities, at market value, and securities and spot commodities sold but not yet purchased, at market value are marked to market daily with the unrealized gain or loss being recognized in income at that time. These securities are held to meet the short-term risk management objectives of AIGFP and AIGTG. AIGTG conducts, as principal, market making and trading activities in foreign exchange, interest rates, precious and base metals and natural gas and other energy products. AIGTG owns inventories in the commodities in which it trades. These inventories are carried at market and may be substantially hedged. AIGTG uses derivatives to manage the economic exposure of its various trading positions and transactions from adverse movements in interest rates, exchange rates and commodity prices. (See also the discussions under "Operational Review: Financial Services" and "Liquidity" herein.) A counterparty may default on any obligation to AIG, including a derivative contract. Credit risk is a consequence of extending credit and/or carrying trading and investment positions. Credit risk exists for a derivative contract when that contract has an estimated positive fair value. To help manage this risk, the credit departments of AIGFP and AIGTG operate within the guidelines of the AIG Credit Risk Committee, which sets credit policy and limits for counterparties and provides limits for derivative transactions with counterparties having different credit ratings. In addition to credit ratings, this committee takes into account other factors, including the industry and country of the counterparty. Transactions which fall outside these pre-established guidelines require the approval of the AIG Credit Risk Committee. It is also AIG's policy to establish reserves for potential credit impairment when necessary. AIGFP and AIGTG determine the credit quality of each of their counterparties taking into account credit ratings assigned by recognized statistical rating organizations. If it is determined that a counterparty requires credit enhancement, then one or more enhancement techniques will be used. Examples of such enhancement techniques include letters of credit, guarantees, collateral credit triggers and credit derivatives and margin agreements. A significant majority of AIGFP's transactions are contracted and documented under ISDA Master Agreements that provide for legally enforceable set-off and close out netting of exposures in the 23
25 event of default. Under such agreements, in connection with the early termination of a transaction, AIGFP is permitted to set-off its receivables from a counterparty against AIGFP's payables to that same counterparty arising out of all included transactions. Excluding regulated exchange transactions, AIGTG, whenever possible, enters into netting agreements with its counterparties which are similar in effect to those discussed above. The following tables provide the notional and contractual amounts of AIGFP's and AIGTG's derivatives portfolio at September 30, 1997 and December 31, 1996. The notional amounts used to express the extent of AIGFP's and AIGTG's involvement in swap transactions represent a standard of measurement of the volume of AIGFP's and AIGTG's swaps business. Notional amount is not a quantification of market risk or credit risk and it may not necessarily be recorded on the balance sheet. Notional amounts represent those amounts used to calculate contractual cash flows to be exchanged and are not paid or received, except for certain contracts such as currency swaps. The timing and the amount of cash flows relating to AIGFP's and AIGTG's foreign exchange forwards and exchange traded futures and options contracts are determined by each of the respective contractual agreements. The net replacement value most closely represents the net credit risk to AIGFP or the maximum amount exposed to potential loss after the application of the aforementioned strategies, ISDA Master Agreements and collateral held. The following table presents AIGFP's derivatives portfolio by maturity and type of derivative at September 30, 1997 and December 31, 1996: (in thousands) - -------------------------------------------------------------------------------- <TABLE> <CAPTION> REMAINING LIFE --------------------------------------------------- ONE TWO THROUGH SIX THROUGH AFTER TEN TOTAL TOTAL YEAR FIVE YEARS TEN YEARS YEARS 1997 1996 - ------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> Interest rate, currency and equity/commodity swaps and swaptions: Notional amount: Interest rate swaps $58,300,600 $79,481,400 $45,723,800 $10,364,400 $193,870,200 $165,771,800 Currency swaps 12,581,400 18,735,800 11,149,500 4,222,600 46,689,300 39,182,900 Equity/commodity swaps 20,900 16,600 29,200 50,000 116,700 103,600 Swaptions 630,200 1,444,500 1,556,000 630,900 4,261,600 5,617,700 - ------------------------------------------------------------------------------------------------------------------ Total $71,533,100 $99,678,300 $58,458,500 $15,267,900 $244,937,800 $210,676,000 - ------------------------------------------------------------------------------------------------------------------ Futures and forward contracts: Exchange traded futures contracts contractual amount $ 3,498,200 -- -- -- $ 3,498,200 $ 6,867,300 - ------------------------------------------------------------------------------------------------------------------ Over the counter forward contracts contractual amount $ 6,830,800 -- -- -- $ 6,830,800 $ 5,952,200 - ------------------------------------------------------------------------------------------------------------------ </TABLE> 24
26 AIGFP determines counterparty credit quality by reference to ratings from independent rating agencies or internal analysis. At September 30, 1997 and December 31, 1996, the counterparty credit quality by derivative product with respect to the net replacement value of AIGFP's derivatives portfolio was as follows: (in thousands) - -------------------------------------------------------------------------------- <TABLE> <CAPTION> NET REPLACEMENT VALUE ----------------------------- SWAPS AND FUTURES AND TOTAL Total SWAPTIONS FORWARD CONTRACTS 1997 1996 - ------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> Counterparty credit quality: AAA $1,677,247 $ -- $1,677,247 $1,732,315 AA 1,995,479 16,442 2,011,921 2,021,878 A 2,800,589 415 2,801,004 1,461,063 BBB 891,167 456 891,623 1,150,420 Below investment grade 38,308 -- 38,308 26,293 - ------------------------------------------------------------------------------------------------------------------ Total $7,402,790 $17,313 $7,420,103 $6,391,969 - ------------------------------------------------------------------------------------------------------------------ </TABLE> At September 30, 1997 and December 31, 1996, the counterparty breakdown by industry with respect to the net replacement value of AIGFP's derivatives portfolio was as follows: (in thousands) - -------------------------------------------------------------------------------- <TABLE> <CAPTION> NET REPLACEMENT VALUE ----------------------------- SWAPS AND FUTURES AND TOTAL Total SWAPTIONS FORWARD CONTRACTS 1997 1996 - ------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> Non-U.S. banks $2,364,426 $12,806 $2,377,232 $2,330,481 Insured municipalities 665,002 -- 665,002 656,373 U.S. industrials 984,972 -- 984,972 894,942 Governmental 464,882 4,073 468,955 894,284 Non-U.S. financial service companies 51,472 -- 51,472 34,383 Non-U.S. industrials 934,356 -- 934,356 497,839 Special purpose 770,577 -- 770,577 121,137 U.S. banks 416,235 -- 416,235 251,641 U.S. financial service companies 594,471 434 594,905 534,965 Supranationals 156,397 -- 156,397 175,924 - ------------------------------------------------------------------------------------------------------------------ Total $7,402,790 $17,313 $7,420,103 $6,391,969 - ------------------------------------------------------------------------------------------------------------------ </TABLE> The following tables provide the contractual and notional amounts of AIGTG's derivatives portfolio at September 30, 1997 and December 31, 1996. In addition, the estimated positive fair values associated with the derivatives portfolio are also provided and include a maturity profile for the September 30, 1997 balances based upon the expected timing of the future cash flows. The gross replacement values presented represent the sum of the estimated positive fair values of all of AIGTG's derivatives contracts at September 30, 1997 and December 31, 1996. These values do not represent the credit risk to AIGTG. Net replacement values presented represent the net sum of estimated positive fair values after the application of legally enforceable master closeout netting agreements and collateral held. The net replacement values most closely represent the net credit risk to AIGTG or the maximum amount exposed to potential loss. 25
27 The following tables present AIGTG's derivatives portfolio and the associated credit exposure, if applicable, by maturity and type of derivative at September 30, 1997 and December 31, 1996: (in thousands) - -------------------------------------------------------------------------------- <TABLE> <CAPTION> REMAINING LIFE -------------------------------------------------- ONE TWO THROUGH SIX THROUGH AFTER TEN TOTAL TOTAL YEAR FIVE YEARS TEN YEARS YEARS 1997 1996 - ------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> Contractual amount of futures, forwards and options: Exchange traded futures and options $ 17,595,453 $3,038,726 $ 58,135 $ -- $ 20,692,314 $ 17,004,692 - ------------------------------------------------------------------------------------------------------------------ Forwards $253,535,640 $12,550,473 $1,819,409 $ 28,507 $267,934,029 $216,775,766 - ------------------------------------------------------------------------------------------------------------------ Over the counter purchased options $ 42,957,810 $9,242,723 $1,127,956 $ -- $ 53,328,489 $ 27,377,217 - ------------------------------------------------------------------------------------------------------------------ Over the counter sold options(a) $ 45,552,100 $7,923,228 $ 806,072 $ -- $ 54,281,400 $ 31,049,529 - ------------------------------------------------------------------------------------------------------------------ Notional amount: Interest rate swaps and forward rate agreements $ 59,130,282 $16,327,763 $1,557,731 $ -- $ 77,015,776 $ 66,306,480 Currency swaps 1,205,250 4,582,257 924,383 300,661 7,012,551 5,853,194 - ------------------------------------------------------------------------------------------------------------------ Total $ 60,335,532 $20,910,020 $2,482,114 $300,661 $ 84,028,327 $ 72,159,674 - ------------------------------------------------------------------------------------------------------------------ Credit Exposure: Futures, forwards and purchased options contracts and interest rate and currency swaps: Gross replacement value $ 8,213,460 $1,339,342 $ 285,857 $ 15,453 $ 9,854,112 $ 7,489,766 Master netting arrangements (4,995,209) (501,405) (112,853) (12,819) (5,622,286) (3,872,291) Collateral (67,721) (48,619) (12,696) -- (129,036) (149,347) - ------------------------------------------------------------------------------------------------------------------ Net replacement value (b) $ 3,150,530 $ 789,318 $ 160,308 $ 2,634 $ 4,102,790 $ 3,468,128 - ------------------------------------------------------------------------------------------------------------------ </TABLE> (a) Sold options obligate AIGTG to buy or sell the underlying item if the option purchaser chooses to exercise. The amounts do not represent credit exposures. (b) The net replacement values with respect to exchange traded futures and options, forward contracts and purchased over the counter options are presented as a component of trading assets in the accompanying balance sheet. The net replacement values with respect to interest rate and currency swaps are presented as a component of unrealized gain on interest rate and currency swaps, options and forward transactions in the accompanying balance sheet. 26
28 AIGTG determines counterparty credit quality by reference to ratings from independent rating agencies or internal analysis. At September 30, 1997 and December 31, 1996, the counterparty credit quality and counterparty breakdown by industry with respect to the net replacement value of AIGTG's derivatives portfolio was as follows: (in thousands) - -------------------------------------------------------------------------------- <TABLE> <CAPTION> NET REPLACEMENT VALUE ----------------------------- 1997 1996 - --------------------------------------------------------------------------------------------------------------------- <S> <C> <C> Counterparty credit quality: AAA $ 441,517 $ 447,236 AA 1,317,752 1,075,713 A 1,408,542 1,133,332 BBB 457,897 518,485 Below investment grade 141,152 115,810 Not externally rated, including exchange traded futures and options* 335,930 177,552 - --------------------------------------------------------------------------------------------------------------------- Total $4,102,790 $3,468,128 - --------------------------------------------------------------------------------------------------------------------- Counterparty breakdown by industry: Non-U.S. banks $1,425,199 $1,269,399 U.S. industrials 644,135 761,634 Governmental 105,174 121,278 Non-U.S. financial service companies 373,897 186,476 Non-U.S. industrials 198,896 192,669 U.S. banks 502,566 309,154 U.S. financial service companies 516,993 449,966 Exchanges* 335,930 177,552 - --------------------------------------------------------------------------------------------------------------------- Total $4,102,790 $3,468,128 - --------------------------------------------------------------------------------------------------------------------- </TABLE> * Exchange traded futures and options are not deemed to have significant credit exposure as the exchanges guarantee that every contract will be properly settled on a daily basis. Generally, AIG manages and operates its businesses in the currencies of the local operating environment. Thus, exchange gains or losses occur when AIG's foreign currency net investment is affected by changes in the foreign exchange rates relative to the U.S. dollar from one reporting period to the next. As an end user, AIG and its subsidiaries, including its insurance subsidiaries, use derivatives to aid in managing AIG's foreign exchange translation exposure. Derivatives may also be used to minimize certain exposures with respect to AIG's debt financing and insurance investment operations; to date, such activities have been minor. AIG, through its Foreign Exchange Operating Committee, evaluates its worldwide consolidated net asset or liability positions and manages AIG's translation exposure to adverse movement in currency exchange rates. AIG may use forward exchange contracts and purchase options where the cost of such is reasonable and markets are liquid to reduce these exchange translation exposures. The exchange gain or loss with respect to these hedging instruments is recorded on an accrual basis as a component of the cumulative translation adjustment account in capital funds. AIG's largest currency net investments have had historically stable exchange rates with respect to the U.S. dollar. Management of AIG's liquidity profile is designed to ensure that even under adverse conditions AIG is able to raise funds at the most economical cost to fund maturing liabilities and capital and liquidity requirements of its subsidiaries. Sources of funds considered in meeting these objectives include guaranteed investment agreements, issuance of long and short-term debt, maturities and sales of securities available for sale, securities sold under repurchase agreements, trading liabilities, securities and spot commodities sold, not yet purchased, issuance of equity, and cash provided from operations. AIG's strong capital position is integral to managing liquidity, as it enables AIG to raise funds in diverse markets worldwide. (See also the discussions under "Capital Resources" and "Liquidity" herein.) Legal risk arises from the uncertainty of the enforceability, through legal or judicial processes, of the obligations of AIG's clients and counterparties, including contractual provisions intended to reduce credit exposure by providing for the netting of mutual obligations. (See also the discussion on master netting agreements above.) AIG seeks to eliminate or minimize such uncertainty through continuous consultation with internal and external 27
29 legal advisors, both domestically and abroad, in order to understand the nature of legal risk, to improve documentation and to strengthen transaction structure. Over the counter derivatives are not transacted in an exchange traded environment. The futures exchanges maintain considerable financial requirements and surveillance to ensure the integrity of exchange traded futures and options. ACCOUNTING STANDARDS In June 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 130 "Reporting Comprehensive Income" (FASB 130) and Statement of Financial Accounting Standards No. 131 "Disclosure about Segments of an Enterprise and Related Information" (FASB 131). FASB 130 establishes standards for reporting comprehensive income and its components in a full set of general purpose financial statements. FASB 130 is effective for AIG as of January 1, 1998. FASB 131 establishes standards for the way AIG reports information about its operating segments in its annual financial statements and selected information in its interim financial statements. FASB 131 establishes, where practicable, standards with respect to geographic areas, among other things. Certain descriptive information is also required. FASB 131 is effective for AIG December 31, 1998, and earlier application is encouraged. AIG is reviewing both FASB 130 and FASB 131. AIG has not determined if it will adopt either or both prior to the aforementioned effective dates. RECENT DEVELOPMENTS In August 1997, AIG entered into an agreement to sell the capital stock of AIG Trading Corporation, which constitutes the energy operations of AIGTG. It is not anticipated that the sale of these operations will have any significant impact on AIG. The transaction is subject to regulatory review and approval. 28
30 PART II -- OTHER INFORMATION ITEM 6 -- EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits See accompanying Exhibit Index. (b) There have been no reports on Form 8-K filed during the quarter ended September 30, 1997. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. AMERICAN INTERNATIONAL GROUP, INC. -------------------------------------- (Registrant) s/s HOWARD I. SMITH -------------------------------------- Howard I. Smith Executive Vice President, Chief Financial Officer and Comptroller Dated: November 13, 1997 29
31 EXHIBIT INDEX <TABLE> <CAPTION> EXHIBIT NUMBER DESCRIPTION LOCATION - ------ ---------------------------------------------------------------- ------------------ <S> <C> <C> 2 Plan of acquisition, reorganization, arrangement, liquidation or succession...................................................... None 3(ii) By-laws of AIG.................................................. Filed herewith. 4 Instruments defining the rights of security holders, including indentures...................................................... Not required to be filed. 10 Material contracts.............................................. None 11 Statement re computation of per share earnings.................. Filed herewith. 12 Statement re computation of ratios.............................. Filed herewith. 15 Letter re unaudited interim financial information............... None 18 Letter re change in accounting principles....................... None 19 Report furnished to security holders............................ None 22 Published report regarding matters submitted to vote of security holders......................................................... None 23 Consents of experts and counsel................................. None 24 Power of attorney............................................... None 27 Financial Data Schedule......................................... Provided herewith. 99 Additional exhibits............................................. None </TABLE> 30