American Express 2002 Annual Report Download - page 50

of the CDO and SLT investments and AEFA’s projected return are based on discounted cash flow projections that require a sig-
nificant degree of management judgment as to assumptions primarily related to default and recovery rates of the high-yield
bonds and/or bank loans either held directly by the CDO or in the reference portfolio of the SLT and, as such, are subject to
change. Generally, the SLTs are structured such that the principal amount of the loans in the reference portfolio may be up to
five times that of the par amount of the notes held by AEFA. Although the exposure associated with AEFA’s investment in
CDOs and SLTs is limited to the carrying value of such investments, they are volatile investments and have a substantial degree
of risk associated with them because the amount of the initial value of the loans and/or other debt obligations in the related
portfolios is significantly greater than AEFA’s exposure. Deterioration in the value of the high-yield bonds or bank loans would
likely result in deterioration of AEFA’s investment return with respect to the relevant CDO or SLT, as the case may be. In the
event of significant deterioration of a portfolio, the relevant CDO or SLT may be subject to early liquidation, which could result
in further deterioration of the investment return or, in severe cases, loss of the carrying amount. See Note 1 to the Consolidated
Financial Statements.
During 2001 the company placed a majority of its rated CDO securities and related accrued interest, as well as a relatively minor
amount of other liquid securities (collectively referred to as transferred assets), having an aggregate book value of $905 million,
into a securitization trust. In return, the company received $120 million in cash (excluding transaction expenses) relating to sales
to unaffiliated investors and retained interests in the trust with allocated book amounts aggregating $785 million. As of Decem-
ber 31, 2002, the retained interests had a carrying value of $754 million, of which $520 million is considered investment grade.
The company has no obligations, contingent or otherwise, to such unaffiliated investors. One of the results of this transaction is
that increases and decreases in future cash flows of the individual CDOs are combined into one overall cash flow for purposes of
determining the carrying value of the retained interests and related impact on results of operations.
AEFA’s client contract reserves are for current and future obligations related to fixed annuities, investment certificates, and life and
disability insurance. The obligations for fixed annuities, universal life contracts and investment certificates are based on the under-
lying contract accumulation values. The obligations for other traditional life insurance products are based on various assump-
tions, including mortality rates, morbidity rates and policy persistency. To the extent that actual future experience differs with
respect to other traditional life insurance products, these reserves would be adjusted through the provision for losses and benefits.
Separate account assets, primarily investments carried at market value, and liabilities represent funds held for the exclusive
benefit of variable annuity and variable life insurance contract holders. AEFA earns investment management, administration
and other fees from the related accounts.
The National Association of Insurance Commissioners (NAIC) adopted Risk Based Capital (RBC) requirements for life
insurance companies. The RBC requirements are to be used as minimum capital requirements by the NAIC and states to
identify companies that merit further regulatory action. At December 31, 2002, AEFA’s life insurance businesses had adjusted
capital in excess of amounts requiring regulatory action. Any dividend distributions in 2003 in excess of 10% of statutory
capital and surplus would require approval of the Department of Commerce of the State of Minnesota.
In light of the investment losses recorded during the first half of 2001, AEFA received a capital contribution of $490 million
from the Parent Company during 2001.
Risk Management
At AEFA, interest rate exposures arise primarily within its insurance and investment certificate subsidiaries. Rates credited to
customers’ accounts generally reset at shorter intervals than the yield on underlying investments. Therefore, AEFA’s interest
spread margins are affected by changes in the general level of interest rates. The extent to which the level of rates affects spread
margins is managed primarily by a combination of modifying the maturity structure of the investment portfolio and entering
into swaps or other derivative instruments that effectively lengthen the rate reset interval on customer liabilities. Interest rate
derivatives with notional amounts totaling approximately $4.8 billion were outstanding at December 31, 2002 to hedge inter-
est rate exposures.
The negative effect on AEFA’s pretax earnings of a 100 basis point increase in interest rates, which assumes repricings and
customer behavior based on the application of proprietary models, to the book of business at December 31, 2002 and 2001,
would be approximately $21 million and $35 million for 2002 and 2001, respectively.
I48 AXP IFINANCIAL REVIEW