NEW YORK (Reuters) - American International Group Inc disclosed potential losses in its derivatives portfolio, raising fears it would become the latest casualty of the credit crisis and pushing its shares down almost 12 percent to a five-year low.

AIG's disclosure, in a regulatory filing yesterday, is the latest sign that credit worries sparked by the sub-prime mortgage crisis are feeding through to insurers. Swiss Re, the world's largest reinsurer, last November stunned markets with a $1.1 billion write-down related to credit default swaps.

AIG's mark-to-market unrealised loss on its credit default swap (CDS) portfolio is expected to result in a charge of roughly $4.88 billion based on October and November pricing, according to Morgan Stanley analyst Nigel Dally in an investor note.

That is more than triple the decline in the value of the portfolio estimated by AIG in early December — a figure that benefited from a spread differential offset that the insurer said it will no longer factor into its calculations.

In December, AIG chief executive Martin Sullivan told investors it had "a high degree of certainty in what we have booked to date."

AIG has not yet disclosed if its analysis of December data will lead to further deterioration in the value of the CDS portfolio. The company is expected to report its fourth-quarter results later this month.

AIG employs around 200 people at its Bermuda office, which has been established on the Island for more than 40 years.

PricewaterhouseCoopers, AIG's outside auditors, concluded that AIG had a material weakness in its internal controls over financial reporting as a result of how it was valuing the credit default swap portfolio obligations held by AIG Financial Products Corp., according to the company's filing with the US Securities and Exchange Commission.

While Morgan Stanley's Dally wrote that AIG could reap back some, if not all, of the write-down over time, the development will likely rattle investors. "It will leave (them) worrying about other skeletons in the closet, and accordingly we expect the stock to be weak," Dally said in his note.

AIG shares closed down $5.94, or 11.7 percent, at $44.74 on the New York Stock Exchange. The stock was the top drag on bellwether indices such as the Dow Jones industrial average and the S&P 500.

AIG's new troubles seemed certain to remind investors of an accounting scandal that led to the ouster of former CEO Maurice (Hank) Greenberg in 2005. That accounting scandal was related to finite risk reinsurance contracts and led to a costly financial restatement.

"(We) believe AIG management will have an extremely difficult time regaining investor confidence," Standard & Poor's said in a note to investors yesterday.

S&P cut its price target on AIG shares by 38 percent to $43 and downgraded the shares to "sell" from "buy". It said the company's problems with valuing the derivatives portfolio were "very troubling" and that the lower price target — a discount to AIG's peers — was "warranted in light of these disclosures".

A credit default swap is a type of guarantee on the credit worthiness of the underlying investment such as collateralised debt obligations (CDOs).

CDOs are repackaged asset-backed securities that typically own pools of debt, including mortgage-backed securities. A rising number of CDOs have defaulted as credit deterioration in the market for sub-prime residential mortgage-backed securities has grown.

AIG, in a regulatory filing, said it has not yet determined how much the value of AIG Financial's super senior credit default swap portfolio had declined as of December 31.

Earlier valuation estimates had included a benefit from a spread differential. However, AIG said difficult market conditions mean it cannot reliably quantify the differential between spreads implied from CDO prices and credit spreads implied from the pricing of credit default swaps on the CDOs.

As a result, AIG said it will not include the spread differential adjustment in its valuation of AIG Financial's super senior credit default swap portfolio as of December 31.

Stripping out the benefit puts the cumulative unrealised valuation loss on the CDS portfolio at nearly $4.9 billion through the first two months of the fourth quarter, compared with $1.6 billion if the benefit was factored in.

¿ The news from AIG contributed to a bad day on the markets for the Bermuda insurance sector, especially for those companies with known exposures to sub-prime mortgage-related problems. XL Capital shares closed at $39.70 after losing $2.98, or seven percent, during the day's trading. And bond insurer Ram Holdings was even worse hit, as its shares plunged 11 percent to close on $1.42.

RenaissanceRe fell nearly three percent, as did Arch Capital and Castlepoint Holdings.