ASSURED GUARANTY LTD - FORM 8-K - EX-99.1 - AGC FINANCIAL STATEMENTS - December 21, 2016

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Exhibit 99.1
















Assured Guaranty Corp.

Consolidated Financial Statements

(Unaudited)

September 30, 2016






























Assured Guaranty Corp.

Index to Consolidated Financial Statements

September 30, 2016




Assured Guaranty Corp.

Consolidated Balance Sheets (unaudited)

(dollars in millions except per share and share amounts)

 
As of
September 30, 2016
 
As of
December 31, 2015
Assets
 
 
 
Investment portfolio:
 
 
 
Fixed-maturity securities, available-for-sale, at fair value (amortized cost of $2,631 and $2,473)
2,791

 
$
2,547

Short-term investments, at fair value
149

 
72

Other invested assets
90

 
88

Equity method investments in affiliates
303

 
390

Total investment portfolio
3,333

 
3,097

Cash
33

 
22

Premiums receivable, net of commissions payable
218

 
222

Ceded unearned premium reserve
334

 
420

Reinsurance recoverable on unpaid losses
295

 
313

Salvage and subrogation recoverable
147

 
18

Credit derivative assets
83

 
106

Deferred tax asset, net
475

 
255

Current income tax receivable
—

 
5

Financial guaranty variable interest entities’ assets, at fair value
236

 
526

Other assets
255

 
227

Total assets   
$
5,409

 
$
5,211

Liabilities and shareholder’s equity
 
 
 
Unearned premium reserve
$
1,320

 
$
1,301

Loss and loss adjustment expense reserve
500

 
589

Reinsurance balances payable, net
82

 
78

Note payable to affiliate
300

 
300

Credit derivative liabilities
378

 
332

Current income tax payable
33

 
—

Financial guaranty variable interest entities’ liabilities with recourse, at fair value
208

 
512

Financial guaranty variable interest entities’ liabilities without recourse, at fair value
46

 
3

Other liabilities
226

 
198

Total liabilities   
3,093

 
3,313

Commitments and contingencies (See Note 15)
 
 
 
Preferred stock ($1,000 liquidation preference, 200,004 shares authorized; none issued and outstanding)
—

 
—

Common stock ($720 par value, 500,000 shares authorized; 20,834 shares issued and outstanding)
15

 
15

Additional paid-in capital
1,041

 
1,042

Retained earnings
1,171

 
793

Accumulated other comprehensive income, net of tax of $44 and $18
89

 
48

Total shareholder’s equity   
2,316

 
1,898

Total liabilities and shareholder’s equity   
$
5,409

 
$
5,211


The accompanying notes are an integral part of these consolidated financial statements.

1

Assured Guaranty Corp.

Consolidated Statements of Operations (unaudited)

(in millions)

 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2016
 
2015
 
2016
 
2015
Revenues
 
 
 
 
 
 
 
Net earned premiums
$
90

 
$
61

 
$
192

 
$
153

Net investment income
22

 
20

 
60

 
59

Net realized investment gains (losses):
 
 
 
 
 
 
 
Other-than-temporary impairment losses
(1
)
 
(2
)
 
(9
)
 
(6
)
Less: portion of other-than-temporary impairment loss recognized in other comprehensive income
0

 
—

 
(4
)
 
0

Net impairment loss
(1
)
 
(2
)
 
(5
)
 
(6
)
Other net realized investment gains (losses)
1

 
(1
)
 
12

 
16

Net realized investment gains (losses)
0

 
(3
)
 
7

 
10

Net change in fair value of credit derivatives:
 
 
 
 
 
 
 
Realized gains (losses) and other settlements
11

 
0

 
25

 
6

Net unrealized gains (losses)
(7
)
 
(4
)
 
(40
)
 
156

Net change in fair value of credit derivatives
4

 
(4
)
 
(15
)
 
162

Fair value gains (losses) on committed capital securities
(12
)
 
(7
)
 
(27
)
 
5

Fair value gains (losses) on financial guaranty variable interest entities
1

 
(1
)
 
9

 
1

Bargain purchase gain and settlement of pre-existing relationships
257

 
—

 
257

 
54

Other income (loss)
(16
)
 
3

 
5

 
7

Total revenues   
346

 
69

 
488

 
451

Expenses   
 
 
 
 
 
 


Loss and loss adjustment expenses
(20
)
 
48

 
48

 
120

Amortization of deferred ceding commissions
(1
)
 
0

 
(2
)
 
0

Interest expense
3

 
3

 
8

 
11

Other operating expenses
24

 
15

 
63

 
59

Total expenses   
6

 
66

 
117

 
190

Income (loss) before income taxes and equity in net earnings of investee
340

 
3

 
371

 
261

Provision (benefit) for income taxes
 
 
 
 
 
 

Current
19

 
23

 
41

 
38

Deferred
(35
)
 
(25
)
 
(52
)
 
27

Total provision (benefit) for income taxes
(16
)
 
(2
)
 
(11
)
 
65

Equity in net earnings of investee
11

 
10

 
34

 
30

Net income (loss)
$
367

 
$
15

 
$
416

 
$
226


The accompanying notes are an integral part of these consolidated financial statements.


2

Assured Guaranty Corp.

Consolidated Statements of Comprehensive Income (unaudited)

(in millions)

 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2016
 
2015
 
2016
 
2015
Net income (loss)    
$
367

 
$
15

 
$
416

 
$
226

Unrealized holding gains (losses) arising during the period on:
 
 
 
 
 
 
 
Investments with no other-than-temporary impairment, net of tax provision (benefit) of $4, $6, $25 and $(7)
3

 
13

 
46

 
(17
)
Investments with other-than-temporary impairment, net of tax provision (benefit) of $6, $(3), $7 and $(3)
14

 
(5
)
 
15

 
(5
)
Unrealized holding gains (losses) arising during the period, net of tax
17

 
8

 
61

 
(22
)
Less: reclassification adjustment for gains (losses) included in net income (loss), net of tax provision (benefit) of $0, $(1), $2 and $4
0

 
(2
)
 
5

 
6

Change in net unrealized gains on investments
17

 
10

 
56

 
(28
)
Change in cumulative translation adjustment, net of tax provision (benefit) of $1, $(2), $(4) and $(3)
(5
)
 
(4
)
 
(15
)
 
(3
)
Other comprehensive income (loss)
$
12

 
$
6

 
$
41

 
$
(31
)
Comprehensive income (loss)
$
379

 
$
21

 
$
457

 
$
195


The accompanying notes are an integral part of these consolidated financial statements.


3

Assured Guaranty Corp.

Consolidated Statement of Shareholder’s Equity (unaudited)

For the Nine Months Ended September 30, 2016

(in millions)

 
Common
Stock
 
Additional
Paid-in
Capital
 
Retained
Earnings
 
Accumulated Other Comprehensive Income
 
Total
Shareholder’s
Equity
Balance at December 31, 2015
$
15

 
$
1,042

 
$
793

 
$
48

 
$
1,898

Net income
—

 
—

 
416

 
—

 
416

Dividends
—

 
—

 
(38
)
 
—

 
(38
)
Other comprehensive income
—

 
—

 
—

 
41

 
41

Other
—

 
(1
)
 
—

 
—

 
(1
)
Balance at September 30, 2016
$
15

 
$
1,041

 
$
1,171

 
$
89

 
$
2,316




The accompanying notes are an integral part of these consolidated financial statements.


4

Assured Guaranty Corp.

Consolidated Statements of Cash Flows (unaudited)

(in millions)

 
Nine Months Ended September 30,
 
2016
 
2015
Net cash flows provided by (used in) operating activities    
$
(58
)
 
$
18

Investing activities
 
 
 
Fixed-maturity securities:
 
 
 
Purchases
(312
)
 
(678
)
Sales
546

 
929

Maturities
142

 
132

Net sales (purchases) of short-term investments
135

 
400

Net proceeds from paydowns on financial guaranty variable interest entities’ assets
501

 
29

Acquisition of Radian Asset, net of cash acquired
—

 
(800
)
Acquisition of CIFG, net of cash acquired (see Note 2)
(442
)
 
—

Proceeds from return of capital (see Note 11)
4

 
—

Repayment of notes receivable from affiliate
3

 
4

Other
(3
)
 
29

Net cash flows provided by (used in) investing activities    
574

 
45

Financing activities
 
 
 
Dividends paid
(38
)
 
(50
)
Net paydowns of financial guaranty variable interest entities’ liabilities
(466
)
 
(20
)
Net cash flows provided by (used in) financing activities    
(504
)
 
(70
)
Effect of foreign exchange rate changes
(1
)
 
0

Increase (decrease) in cash
11

 
(7
)
Cash at beginning of period
22

 
26

Cash at end of period    
$
33

 
$
19

Supplemental cash flow information
 
 
 
Cash paid (received) during the period for:
 
 
 
Income taxes
$
—

 
$
—

Interest
$
—

 
$
0


The accompanying notes are an integral part of these consolidated financial statements.

5

Assured Guaranty Corp.

Notes to Consolidated Financial Statements (unaudited)

September 30, 2016

1.
Business and Basis of Presentation

Business

Assured Guaranty Corp. (“AGC” and, together with its subsidiaries, the “Company”), a Maryland domiciled insurance company, is an indirect and wholly-owned operating subsidiary of Assured Guaranty Ltd. (“AGL” and, together with its subsidiaries, “Assured Guaranty”). AGL is a Bermuda-based holding company that provides, through its operating subsidiaries, credit protection products to the United States (“U.S.”) and international public finance (including infrastructure) and structured finance markets.     

The Company applies its credit underwriting judgment, risk management skills and capital markets experience to offer financial guaranty insurance that protects holders of debt instruments and other monetary obligations from defaults in scheduled payments. If an obligor defaults on a scheduled payment due on an obligation, including a scheduled principal or interest payment (“debt service”), the Company is required under its unconditional and irrevocable financial guaranty to pay the amount of the shortfall to the holder of the obligation. The Company markets its financial guaranty insurance directly to issuers and underwriters of public finance and structured finance securities as well as to investors in such obligations. The Company guarantees obligations issued principally in the U.S. and the United Kingdom ("U.K."), and also guarantees obligations issued in other countries and regions, including Australia and Western Europe.

In the past, the Company sold credit protection by issuing policies that guaranteed payment obligations under credit derivatives, primarily credit default swaps ("CDS"). Financial guaranty contracts accounted for as credit derivatives are generally structured such that the circumstances giving rise to the Company’s obligation to make loss payments are similar to those for financial guaranty insurance contracts. The Company’s credit derivative transactions are governed by International Swaps and Derivative Association, Inc. (“ISDA”) documentation.

The Company has not entered into any new CDS in order to sell credit protection since the beginning of 2009, when regulatory guidelines were issued that limited the terms under which such protection could be sold. The capital and margin requirements applicable under the Dodd-Frank Wall Street Reform and Consumer Protection Act also contributed to the Company not entering into such new CDS since 2009. The Company actively pursues opportunities to terminate existing CDS, which have the effect of reducing future fair value volatility in income and/or reducing rating agency capital charges.

Basis of Presentation

The unaudited interim consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and, in the opinion of management, reflect all adjustments that are of a normal recurring nature, necessary for a fair statement of the financial condition, results of operations and cash flows of the Company and its consolidated variable interest entities (“VIEs”) for the periods presented. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. These unaudited interim consolidated financial statements are as of September 30, 2016 and cover the three-month period ended September 30, 2016 ("Third Quarter 2016"), the three-month period ended September 30, 2015 ("Third Quarter 2015"), the nine-month period ended September 30, 2016 ("Nine Months 2016") and the nine-month period ended September 30, 2015 ("Nine Months 2015"). Certain financial information that is normally included in annual financial statements prepared in accordance with GAAP, but is not required for interim reporting purposes, has been condensed or omitted. The year-end balance sheet data was derived from audited financial statements.

The unaudited interim consolidated financial statements include the accounts of AGC and its subsidiaries and its consolidated VIEs. Intercompany accounts and transactions between and among all consolidated entities have been eliminated. Certain prior year balances have been reclassified to conform to the current year's presentation.

These unaudited interim consolidated financial statements should be read in conjunction with the annual consolidated financial statements of AGC included in Exhibit 99.1 in AGL's Form 8-K dated April 8, 2016, filed with the U.S. Securities and

6

Exchange Commission (the “SEC”).

AGC's principal subsidiary is Assured Guaranty (UK) Ltd. (“AGUK”), a company incorporated in the U.K. as a U.K. insurance company. AGC owns 100% of AGUK's outstanding shares and elected to place AGUK into runoff in 2010. AGC owns 39.3% of the outstanding shares of Municipal Assurance Holdings Inc. ("MAC Holdings"), a Delaware company formed to hold all of the outstanding shares of Municipal Assurance Corp. ("MAC"), a New York domiciled insurance company.

Future Application of Accounting Standards

Income Taxes

In October 2016, the FASB issued Accounting Standards Update ("ASU") 2016-16, Income Taxes (Topic 740) - Intra-Entity Transfers of Assets Other Than Inventory, which removes the current prohibition against immediate recognition of the current and deferred income tax effects of intra-entity transfers of assets other than inventory.  Under the ASU, the selling (transferring) entity is required to recognize a current income tax expense or benefit upon transfer of the asset.  Similarly, the purchasing (receiving) entity is required to recognize a deferred tax asset or deferred tax liability, as well as the related deferred tax benefit or expense, upon receipt of the asset.  The ASU is effective for annual periods beginning after December 15, 2017, including interim periods within those annual periods, and early adoption is permitted.  The ASU’s amendments are to be applied on a modified retrospective basis recognizing the effects in retained earnings as of the beginning of the year of adoption.  The Company is currently evaluating the effect on its Consolidated Financial Statements of adopting this ASU.

Statement of Cash Flows

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force), which addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The issues addressed in the new guidance include debt prepayment or debt extinguishment costs, settlement of zero-coupon debt instruments, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, proceeds from the settlement of corporate-owned life insurance policies, including bank-owned life insurance policies, distributions received from equity method investments, beneficial interests in securitization transactions and separately identifiable cash flows and application of the predominance principle. The amendments in this ASU are effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. An entity that elects early adoption must adopt all of the amendments in the same period. The Company is currently evaluating the effect on its Consolidated Financial Statements of adopting this ASU.

Credit Losses on Financial Instruments

In June 2016, the Financial Accounting Standards Board ("FASB") issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.  The amendments in this ASU are intended to improve financial reporting by requiring timelier recording of credit losses on loans and other financial instruments held by financial institutions and other organizations. The ASU requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts.  Financial institutions will use forward-looking information to better inform their credit loss estimates as a result of the ASU. While many of the loss estimation techniques applied today will still be permitted, the inputs to those techniques will change to reflect the full amount of expected credit losses. The ASU requires enhanced disclosures to help investors and other financial statement users to better understand significant estimates and judgments used in estimating credit losses, as well as credit quality and underwriting standards of an organization’s portfolio. 

In addition, the ASU amends the accounting for credit losses on available-for-sale securities and purchased financial assets with credit deterioration. The ASU makes targeted improvements to the existing “other than temporary” impairment model for certain available-for-sale debt securities to eliminate the concept of “other than temporary” from that model. Accordingly, the ASU states that an entity must use an allowance approach, must limit the allowance to an amount at which the security’s fair value is less than its amortized cost basis, may not consider the length of time fair value has been less than amortized cost, and may not consider recoveries in fair value after the balance sheet date when assessing whether a credit loss exists. For purchased financial assets with credit deterioration, the ASU requires an entity’s method for measuring credit losses to be consistent with its method for measuring expected losses for originated and purchased non-credit-deteriorated assets.


7

The ASU is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. For most debt instruments, entities will be required to record a cumulative-effect adjustment to the statement of financial position as of the beginning of the first reporting period in which the guidance is adopted.  The changes to the impairment model for available-for-sale securities and changes to purchased financial assets with credit deterioration are to be applied prospectively.  For the Company, this would be as of January 1, 2020.  Early adoption is permitted for fiscal years, and interim periods with those fiscal years, beginning after December 15, 2018.  The Company is currently evaluating the effect on its Consolidated Financial Statements of adopting this ASU.

Share-Based Payments

In March 2016, the FASB issued ASU 2016-09, Compensation - Stock Compensation (Topic 718) - Improvements to Employee Share-Based Payment, which simplifies several aspects of the accounting for employee share-based payment transactions, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows.  The new guidance will require all income tax effects of awards to be recognized in the income statement when the awards vest or are settled. It also will allow an employer to repurchase more of an employee’s shares than it can today for tax withholding purposes without triggering liability accounting and to make a policy election to account for forfeitures as they occur.  The ASU is effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years, and early adoption is permitted.  The Company does not expect that the ASU will have a material effect on its Consolidated Financial Statements.

2.
    Acquisitions

Consistent with one of its key business strategies of supplementing its book of business through acquisitions, the Company has acquired two financial guaranty companies since January 1, 2015, and has entered into an agreement to acquire another financial guaranty company, as described below.

CIFG Holding Inc.
    
On July 1, 2016, AGC acquired all of the issued and outstanding capital stock of CIFG Holding Inc. (together with its subsidiaries “CIFGH"), the parent of financial guaranty insurer CIFG Assurance North America, Inc. ("CIFG"), (the "CIFG Acquisition"), for $450.6 million in cash. AGC merged CIFG with and into AGC, with AGC as the surviving company, on July 5, 2016. The CIFG Acquisition added $4.4 billion of net par insured to the Company on July 1, 2016. The CIFG Acquisition also caused the cancellation of a retrocession from AGC to Assured Guaranty Re Ltd. ("AG Re") of $1.2 billion of insured par that had been reinsured by AGC from CIFG, so the CIFG Acquisition added $5.6 billion of net par insured to AGC on July 1, 2016.

At the time of the CIFG Acquisition, CIFG had a subsidiary financial guaranty company domiciled and licensed in France, CIFG Europe S.A. (“CIFGE”). CIFG had reinsured all of CIFGE’s outstanding financial guaranty business and also had issued a “second-to-pay policy” pursuant to which CIFG guaranteed the full and complete payment of any shortfall in amounts due from CIFGE on its insured portfolio; AGC assumed these obligations as part of the CIFG merger with and into AGC. CIFGE is in run-off, and remains a separate subsidiary, now owned by AGC. At September 30, 2016, CIFGE had investment assets of $43 million and gross par exposure of $828 million, and is not currently expected to pay dividends.
    
The CIFG Acquisition was accounted for under the acquisition method of accounting which requires that the assets and liabilities acquired be recorded at fair value. The Company exercised significant judgment to determine the fair value of the assets it acquired and liabilities it assumed in the CIFG Acquisition. The most significant of these determinations related to the valuation of CIFGH's financial guaranty insurance and credit derivative contracts. On an aggregate basis, CIFGH's contractual premiums for financial guaranty contracts were less than the premiums a market participant of similar credit quality would demand to acquire those contracts at the date of the CIFG Acquisition (the "CIFG Acquisition Date"), particularly for below-investment-grade transactions, resulting in a significant amount of the purchase price being allocated to these contracts. For information on the methodology the Company used to measure the fair value of assets it acquired and liabilities it assumed in the CIFG Acquisition, including financial guaranty insurance and credit derivative contracts, please refer to Note 7, Fair Value Measurement.

The fair value of the Company's stand-ready obligation on the CIFG Acquisition Date is recorded in unearned premium reserve. After the CIFG Acquisition Date, loss reserves and loss and loss adjustment expenses ("LAE") will be recorded when the expected losses for each contract exceeds the remaining unearned premium reserve, in accordance with the Company's accounting policy described in the annual consolidated financial statements of the Company. The expected losses

8

acquired by the Company as part of the CIFG Acquisition are included in the description of expected losses to be paid under Note 5, Expected Losses to be Paid.

The excess of the fair value of net assets acquired over the consideration transferred was recorded as a bargain purchase gain in "bargain purchase gain and settlement of pre-existing relationships" in net income. In addition, the Company and CIFG had pre-existing reinsurance relationships, which were also effectively settled at fair value on the CIFG Acquisition Date. The loss on settlement of these pre-existing reinsurance relationships represents the net difference between the historical assumed balances that were recorded by AGC and the fair value of ceded balances acquired from CIFG. The Company believes the bargain purchase gain resulted from the nature of the financial guaranty business and the desire of investors in CIFGH to monetize their investments in CIFGH. The bargain purchase gain reflects the fair value of CIFGH’s assets and liabilities, as well as tax attributes that were recorded in deferred taxes comprising net operating losses (after Internal Revenue Code change in control provisions) and other temporary book-to-tax differences for which CIFGH had recorded a full valuation allowance.

The following table shows the net effect of the CIFG Acquisition, including the effects of the settlement of pre-existing relationships.
 
Fair Value of Net Assets Acquired, before Settlement of Pre-existing Relationships
 
Net effect of Settlement of Pre-existing Relationships
 
Net Effect of CIFG Acquisition
 
(in millions)
Cash Purchase Price (1)
$
450

 
$
—

 
$
450

Identifiable assets acquired:
 
 
 
 
 
Investments
775

 
—

 
775

Cash
8

 
—

 
8

Premiums receivable, net of commissions payable
18

 
—

 
18

Ceded unearned premium reserve
173

 
(173
)
 
—

Deferred acquisition costs
1

 
(1
)
 
0

Salvage and subrogation recoverable
23

 
—

 
23

Credit derivative assets
1

 
—

 
1

Deferred tax asset, net
194

 
34

 
228

Other assets
4

 
—

 
4

Total assets
1,197

 
(140
)
 
1,057

 
 

 
 
 
 
Liabilities assumed:
 
 
 
 
 
Unearned premium reserves
306

 
(10
)
 
296

Loss and loss adjustment expense reserve
1

 
(66
)
 
(65
)
Credit derivative liabilities
68

 
0

 
68

Other liabilities
17

 
—

 
17

Total liabilities
392

 
(76
)
 
316

Net asset effect of CIFG Acquisition
805

 
(64
)
 
741

Bargain purchase gain and settlement of pre-existing relationships resulting from CIFG Acquisition, after-tax
355

 
(64
)
 
291

Deferred tax
—

 
(34
)
 
(34
)
Bargain purchase gain and settlement of pre-existing relationships resulting from CIFG Acquisition, pre-tax
$
355

 
$
(98
)
 
$
257

_____________________
(1)
The cash purchase price of $450 million was the cash transferred for the acquisition which was allocated as follows: (1) $277 million for the purchase of net assets of $632 million and (2) the settlement of pre-existing relationships between CIFG and AGC at a fair value of $173 million.


9

           Revenue and net income related to CIFGH from the CIFG Acquisition Date through September 30, 2016 included in the consolidated statement of operations were approximately $270 million and $297 million, respectively. For Third Quarter 2016 and Nine Months 2016, the Company recognized transaction expenses related to the CIFG Acquisition. These expenses were primarily driven by the fees paid to the Company's legal and financial advisors and to the Company's independent auditor.

CIFG Acquisition-Related Expenses

 
Third Quarter 2016
 
Nine Months
2016
 
(in millions)
Professional services
$
1

 
$
2

Financial advisory fees
3

 
4

Total
$
4

 
$
6


The Company has determined that the presentation of pro-forma information is impractical for the CIFG Acquisition as historical financial records are not available on a U.S. GAAP basis.

Radian Asset Assurance Inc.

On April 1, 2015, AGC completed the acquisition (“Radian Asset Acquisition”) of all of the issued and outstanding capital stock of financial guaranty insurer Radian Asset Assurance Inc. (“Radian Asset”) for $804.5 million. Radian Asset was merged with and into AGC, with AGC as the surviving company of the merger. The Radian Asset Acquisition added $13.6 billion to the Company's net par outstanding on April 1, 2015.

Please refer to Note 2, Acquisition of Radian Asset Assurance Inc., in the annual consolidated financial statements of AGC included in Exhibit 99.1 in AGL's Form 8-K dated April 8, 2016, filed with SEC for additional information on the acquisition of Radian Asset including the purchase price and the allocation of the purchase price to net assets acquired and the resulting bargain purchase gain.

MBIA UK Insurance Limited

On September 29, 2016, Assured Guaranty Ltd. announced that its subsidiary AGC entered into an agreement to acquire MBIA UK Insurance Limited ("MBIA UK"), the European operating subsidiary of MBIA Insurance Corporation. The parties expect the transaction to close in early January 2017, subject to receipt of regulatory approvals and the satisfaction of other customary closing conditions. There can be no assurance that all regulatory approvals will be obtained.
    
Under the agreement, AGC will deliver all of the notes issued in the Zohar II 2005-1 transaction that AGC holds, and the seller, MBIA UK (Holdings) Limited, will transfer to AGC all of the outstanding shares of MBIA UK plus $23 million in cash. The Zohar notes to be transferred had, as of September 30, 2016, a total outstanding principal of approximately $347 million. MBIA Insurance Corporation insures all of the notes issued in the Zohar II 2005-1 transaction.

    As of June 30, 2016, MBIA UK had an insured portfolio of approximately $13 billion of net par. Assured Guaranty currently plans to maintain MBIA UK as a stand-alone entity but could combine it with other European affiliates in the future.

3.
Rating Actions

     When a rating agency assigns a public rating to a financial obligation guaranteed by AGC or its subsidiary AGUK, it generally awards that obligation the same rating it has assigned to the financial strength of AGC or AGUK. Investors in products insured by AGC or AGUK frequently rely on ratings published by the rating agencies because such ratings influence the trading value of securities and form the basis for many institutions' investment guidelines as well as individuals' bond purchase decisions. Therefore, AGC and AGUK manage their business with the goal of achieving strong financial strength ratings. However, the methodologies and models used by rating agencies differ, presenting conflicting goals that may make it inefficient or impractical to reach the highest rating level. The methodologies and models are not fully transparent, contain subjective elements and data (such as assumptions about future market demand for the Company's products) and change frequently. Ratings are subject to continuous review and revision or withdrawal at any time. If the financial strength ratings of AGC were reduced below current levels, the Company expects it could have adverse effects on AGC's future business opportunities as well as the premiums AGC could charge for its insurance policies.


10

The Company periodically assesses the value of each rating assigned to it, and as a result of such assessment may request that a rating agency add or drop a rating on AGC or AGUK. The Company's rated affiliates make similar periodic assessments and have made such requests. For example, the Kroll Bond Rating Agency ("KBRA") ratings were first assigned to MAC in 2013, to Assured Guaranty Municipal Corp. ("AGM") in 2014, and to AGC in 2016, while the A.M. Best Company, Inc. ("Best") rating was first assigned to Assured Guaranty Re Overseas Ltd. ("AGRO") in 2015, and a Moody's Investors Service, Inc. ("Moody's") rating was never requested for MAC and was dropped from AG Re and AGRO in 2015.

In the last several years, S&P Global Ratings, a division of Standard & Poor's Financial Services LLC ("S&P") and Moody's have changed, multiple times, their financial strength ratings of AGC and AGUK, or changed the outlook on such ratings. More recently, KBRA have assigned a financial strength rating to AGC. The rating agencies' most recent actions related to AGC and AGUK are:

•
On September 20, 2016, KBRA assigned an insurance financial strength rating of AA (stable outlook) to AGC.

•
On August 8, 2016, Moody's affirmed the A3 insurance financial strength rating on AGC and AGUK, and raised the outlook to stable from negative.

•
On July 27, 2016, S&P affirmed the AA (stable) financial strength ratings of AGC and AGUK.

There can be no assurance that any of the rating agencies will not take negative action on the financial strength ratings of AGC or AGUK in the future.

For a discussion of the effects of rating actions on the Company, see the following:

•
Note 6, Financial Guaranty Insurance
•
Note 8, Financial Guaranty Contracts Accounted for as Credit Derivatives
•
Note 14, Reinsurance and Other Monoline Exposures

4.
Outstanding Exposure

The Company’s financial guaranty contracts are written in either insurance or credit derivative form, but collectively are considered financial guaranty contracts. The Company seeks to limit its exposure to losses by underwriting obligations that it views as investment grade at inception, although, as part of its loss mitigation strategy for existing troubled credits, it may underwrite new issuances that it views as below-investment-grade ("BIG"). The Company diversifies its insured portfolio across asset classes and, in the structured finance portfolio, requires rigorous subordination or collateralization requirements. Reinsurance may be used in order to reduce net exposure to certain insured transactions.

     Public finance obligations insured by the Company consist primarily of general obligation bonds supported by the taxing powers of U.S. state or municipal governmental authorities, as well as tax-supported bonds, revenue bonds and other obligations supported by covenants from state or municipal governmental authorities or other municipal obligors to impose and collect fees and charges for public services or specific infrastructure projects. The Company also includes within public finance obligations those obligations backed by the cash flow from leases or other revenues from projects serving substantial public purposes, including utilities, toll roads, health care facilities and government office buildings. The Company also includes within public finance similar obligations issued by territorial and non-U.S. sovereign and sub-sovereign issuers and governmental authorities.

Structured finance obligations insured by the Company are generally issued by special purpose entities, including VIEs, and backed by pools of assets having an ascertainable cash flow or market value or other specialized financial obligations. Some of these VIEs are consolidated as described in Note 9, Consolidated Variable Interest Entities. Unless otherwise specified, the outstanding par and debt service amounts presented in this note include outstanding exposures on VIEs whether or not they are consolidated.

Surveillance Categories

The Company segregates its insured portfolio into investment grade and BIG surveillance categories to facilitate the appropriate allocation of resources to monitoring and loss mitigation efforts and to aid in establishing the appropriate cycle for periodic review for each exposure. BIG exposures include all exposures with internal credit ratings below BBB-. The Company’s internal credit ratings are based on internal assessments of the likelihood of default and loss severity in the event of default. Internal credit ratings are expressed on a ratings scale similar to that used by the rating agencies and are generally

11

reflective of an approach similar to that employed by the rating agencies, except that the Company's internal credit ratings focus on future performance rather than lifetime performance.

The Company monitors its investment grade credits to determine whether any need to be internally downgraded to BIG and refreshes its internal credit ratings on individual credits in quarterly, semi-annual or annual cycles based on the Company’s view of the credit’s quality, loss potential, volatility and sector. Ratings on credits in sectors identified as under the most stress or with the most potential volatility are reviewed every quarter. The Company’s credit ratings on assumed credits are based on the Company’s reviews of low-rated credits or credits in volatile sectors, unless such information is not available, in which case, the ceding company’s credit rating of the transactions are used.

Credits identified as BIG are subjected to further review to determine the probability of a loss. See Note 5, Expected Loss to be Paid, for additional information. Surveillance personnel then assign each BIG transaction to the appropriate BIG surveillance category based upon whether a future loss is expected and whether a claim has been paid. For surveillance purposes, the Company calculates present value using a discount rate of 4%. (A risk-free rate is used for calculating the expected loss for financial statement measurement purposes.)

More extensive monitoring and intervention is employed for all BIG surveillance categories, with internal credit ratings reviewed quarterly. The Company expects “future losses” on a transaction when the Company believes there is at least a 50% chance that, on a present value basis, it will pay more claims in the future of that transaction than it will have reimbursed. The three BIG categories are:
 
•
BIG Category 1: Below-investment-grade transactions showing sufficient deterioration to make future losses possible, but for which none are currently expected.
 
•
BIG Category 2: Below-investment-grade transactions for which future losses are expected but for which no claims (other than liquidity claims, which are claims that the Company expects to be reimbursed within one year) have yet been paid.
 
•
BIG Category 3: Below-investment-grade transactions for which future losses are expected and on which claims (other than liquidity claims) have been paid.

Components of Outstanding Exposure

Unless otherwise noted, ratings disclosed herein on the Company's insured portfolio reflect its internal ratings. The Company classifies those portions of risks benefiting from reimbursement obligations collateralized by eligible assets held in trust in acceptable reimbursement structures as the higher of 'AA' or their current internal rating.

The Company purchases securities that it has insured, and for which it has expected losses to be paid, in order to
mitigate the economic effect of insured losses ("loss mitigation securities"). The Company excludes amounts attributable to loss mitigation securities (unless otherwise indicated) from par and debt service outstanding, because it manages such securities as investments and not insurance exposure. The following table presents the gross and net debt service for all financial guaranty contracts.

Financial Guaranty
Debt Service Outstanding

 
Gross Debt Service
Outstanding
 
Net Debt Service
Outstanding
 
September 30,
2016
 
December 31,
2015
 
September 30,
2016
 
December 31,
2015
 
(in millions)
Public finance
$
97,288

 
$
115,200

 
$
49,131

 
$
55,466

Structured finance
15,338

 
20,024

 
11,500

 
14,532

Total financial guaranty
$
112,626

 
$
135,224

 
$
60,631

 
$
69,998


    

12

Financial Guaranty Portfolio by Internal Rating
As of September 30, 2016 (1)

 
 
Public Finance
U.S.
 
Public Finance
Non-U.S.
 
Structured Finance
U.S.
 
Structured Finance
Non-U.S.
 

Total
Rating
Category
 
Net Par
Outstanding
 
%
 
Net Par
Outstanding
 
%
 
Net Par
Outstanding
 
%
 
Net Par
Outstanding
 
%
 

Net Par
Outstanding
 


%
 
 
(dollars in millions)
AAA
 
$
71

 
0.3
%
 
$
81

 
1.9
%
 
$
4,566

 
47.9
%
 
$
239

 
17.2
%
 
$
4,957

 
11.8
%
AA
 
3,520

 
13.2

 
1,065

 
24.5

 
1,947

 
20.4

 
80

 
5.7

 
6,612

 
15.8
A
 
12,700

 
47.7

 
590

 
13.6

 
1,263

 
13.3

 
391

 
28.1

 
14,944

 
35.7
BBB
 
7,241

 
27.3

 
2,244

 
51.4

 
321

 
3.4

 
592

 
42.5

 
10,398

 
24.9
BIG
 
3,068

 
11.5

 
374

 
8.6

 
1,427

 
15.0

 
91

 
6.5

 
4,960

 
11.8
Total net par outstanding(2)
 
$
26,600

 
100.0
%
 
$
4,354

 
100.0
%
 
$
9,524

 
100.0
%
 
$
1,393

 
100.0
%
 
$
41,871

 
100.0
%
_____________________
(1)
The September 30, 2016 amounts include $4.8 billion of net par related to CIFG Acquisition and the related retrocession cancellation.

(2)
As of September 30, 2016, excludes $706 million of net par as a result of loss mitigation strategies, including loss mitigation securities held in the investment portfolio, which are primarily BIG.


Financial Guaranty Portfolio by Internal Rating
As of December 31, 2015

 
 
Public Finance
U.S.
 
Public Finance
Non-U.S.
 
Structured Finance
U.S.
 
Structured Finance
Non-U.S.
 

Total
Rating Category
 
Net Par
Outstanding
 
%
 
Net Par
Outstanding
 
%
 
Net Par
Outstanding
 
%
 
Net Par
Outstanding
 
%
 

Net Par
Outstanding
 


%
 
 
(dollars in millions)
AAA
 
$
75

 
0.2
%
 
$
78

 
2.1
%
 
$
4,776

 
40.9
%
 
$
685

 
38.5
%
 
$
5,614

 
11.7
%
AA
 
3,769

 
12.4

 
1,469

 
40.0

 
2,666

 
22.8

 
97

 
5.4

 
8,001

 
16.8
A
 
14,895

 
48.8

 
476

 
13.0

 
1,645

 
14.1

 
180

 
10.1

 
17,196

 
36.1
BBB
 
8,486

 
27.8

 
1,348

 
36.7

 
703

 
6.0

 
737

 
41.4

 
11,274

 
23.7
BIG
 
3,281

 
10.8

 
303

 
8.2

 
1,897

 
16.2

 
81

 
4.6

 
5,562

 
11.7
Total net par outstanding(1)
 
$
30,506

 
100.0
%
 
$
3,674

 
100.0
%
 
$
11,687

 
100.0
%
 
$
1,780

 
100.0
%
 
$
47,647

 
100.0
%
_____________________
(1)
As of December 31, 2015, excludes $230 million of net par as a result of loss mitigation strategies, including loss mitigation securities held in the investment portfolio, which are primarily BIG.

In addition to amounts shown in the tables above, AGC had outstanding commitments to provide guaranties of $15.2 million for public finance obligations as of September 30, 2016, all of which expired prior to the date of this filing. As of September 30, 2016, AGC also had outstanding commitments to insure $64 million of obligations; the beneficiary had the right to choose insurance from either AGC or AGC's affiliate AGM. The expiration dates for the public finance commitments range between October 1, 2016 and February 25, 2017. The commitments are contingent on the satisfaction of all conditions set forth in them and may expire unused or be canceled at the counterparty’s request. Therefore, the total commitment amount does not necessarily reflect actual future guaranteed amounts.

13

Components of BIG Portfolio

Components of BIG Net Par Outstanding
(Insurance and Credit Derivative Form)
As of September 30, 2016

 
BIG Net Par Outstanding
 
Net Par
 
BIG 1
 
BIG 2
 
BIG 3
 
Total BIG
 
Outstanding
 
 
 
 
 
(in millions)
 
 
 
 
U.S. public finance
$
1,077

 
$
1,354

 
637

 
$
3,068

 
26,600

Non-U.S. public finance
314

 
60

 
—

 
374

 
4,354

Structured finance:
 
 
 
 
 
 
 
 
 
First lien U.S. residential mortgage-backed securities ("RMBS"):
 
 
 
 
 
 
 

 
 
Prime first lien
12

 
35

 
14

 
61

 
117

Alt-A first lien
49

 
33

 
104

 
186

 
473

Option ARM
12

 
5

 
18

 
35

 
69

Subprime
65

 
88

 
72

 
225

 
945

Second lien U.S. RMBS
10

 
2

 
233

 
245

 
245

Total U.S. RMBS
148

 
163

 
441

 
752

 
1,849

Triple-X life insurance transactions
—

 
—

 
149

 
149

 
556

Trust preferred securities (“TruPS”)
340

 
95

 
—

 
435

 
2,059

Other structured finance
44

 
135

 
3

 
182

 
6,453

Total
$
1,923

 
$
1,807

 
$
1,230

 
$
4,960

 
$
41,871



Components of BIG Net Par Outstanding
(Insurance and Credit Derivative Form)
As of December 31, 2015

 
BIG Net Par Outstanding
 
Net Par
 
BIG 1
 
BIG 2
 
BIG 3
 
Total BIG
 
Outstanding
 
 
 
 
 
(in millions)
 
 
 
 
U.S. public finance
$
2,064

 
$
1,196

 
$
21

 
$
3,281

 
$
30,506

Non-U.S. public finance
92

 
211

 
—

 
303

 
3,674

Structured finance:
 
 
 
 
 
 
 
 
 
First lien U.S. RMBS:
 
 
 
 
 
 
 

 
 
Prime first lien
184

 
10

 
16

 
210

 
300

Alt-A first lien
76

 
35

 
131

 
242

 
568

Option ARM
31

 
10

 
33

 
74

 
116

Subprime
98

 
70

 
78

 
246

 
972

Second lien U.S. RMBS
65

 
1

 
173

 
239

 
271

Total U.S. RMBS
454

 
126

 
431

 
1,011

 
2,227

Triple-X life insurance transactions
—

 
—

 
149

 
149

 
721

TruPS
528

 
96

 
—

 
624

 
3,496

Other structured finance
102

 
91

 
1

 
194

 
7,023

Total
$
3,240

 
$
1,720

 
$
602

 
$
5,562

 
$
47,647



14

BIG Net Par Outstanding
and Number of Risks
As of September 30, 2016

 
 
Net Par Outstanding
 
Number of Risks(2)
Description
 
Financial
Guaranty
Insurance(1)
 
Credit
Derivative
 
Total
 
Financial
Guaranty
Insurance(1)
 
Credit
Derivative
 
Total
 
 
(dollars in millions)
BIG:
 
 

 
 

 
 

 
 

 
 

 
 

Category 1
 
1,386

 
$
537

 
$
1,923

 
151

 
11

 
162

Category 2
 
1,651

 
156

 
1,807

 
62

 
5

 
67

Category 3
 
1,114

 
116

 
1,230

 
103

 
11

 
114

Total BIG
 
$
4,151

 
$
809

 
$
4,960

 
316

 
27

 
343



BIG Net Par Outstanding
and Number of Risks
As of December 31, 2015

 
 
Net Par Outstanding
 
Number of Risks(2)
Description
 
Financial
Guaranty
Insurance(1)
 
Credit
Derivative
 
Total
 
Financial
Guaranty
Insurance(1)
 
Credit
Derivative
 
Total
 
 
(dollars in millions)
BIG:
 
 

 
 

 
 

 
 

 
 

 
 

Category 1
 
$
2,519

 
$
721

 
$
3,240

 
170

 
12

 
182

Category 2
 
1,354

 
366

 
1,720

 
63

 
8

 
71

Category 3
 
508

 
94

 
602

 
99

 
12

 
111

Total BIG
 
$
4,381

 
$
1,181

 
$
5,562

 
332

 
32

 
364

 ____________________
(1)
Includes net par outstanding for VIEs.

(2)
A risk represents the aggregate of the financial guaranty policies that share the same revenue source for purposes of making debt service payments.

Exposure to Puerto Rico
         
The Company has insured exposure to general obligation bonds of the Commonwealth of Puerto Rico (“Puerto Rico” or the “Commonwealth”) and various obligations of its related authorities and public corporations aggregating $1.7 billion net par as of September 30, 2016, all of which are rated BIG.

Puerto Rico has experienced significant general fund budget deficits in recent years. In addition to high debt levels, Puerto Rico faces a challenging economic environment; the economy has declined nearly every year since 2007, while the population has shrunk every year since 2006 as residents have emigrated.

On June 28, 2015, Governor García Padilla of Puerto Rico (the "Governor") publicly stated that the Commonwealth’s public debt, considering the current level of economic activity, was unpayable and that a comprehensive debt restructuring might be necessary.

On November 30, 2015 and December 8, 2015, the Governor issued executive orders (“Clawback Orders”) directing the Puerto Rico Department of Treasury and the Puerto Rico Tourism Company to retain or transfer certain taxes pledged to secure the payment of bonds issued by the Puerto Rico Highways and Transportation Authority ("PRHTA"), Puerto Rico Infrastructure Financing Authority ("PRIFA"), and Puerto Rico Convention Center District Authority ("PRCCDA"). On January 7, 2016, the Company sued various Puerto Rico governmental officials in the United States District Court, District of Puerto

15

Rico, asserting that this attempt to “claw back” pledged taxes is unconstitutional, and demanding declaratory and injunctive relief. The Puerto Rico credits insured by the Company subject to the Clawback Orders are shown in the table “Puerto Rico Net Par Outstanding” below.

On January 1, 2016, PRIFA defaulted on payment of a portion of the interest due on its bonds on that date, resulting in a claim on the Company for those PRIFA bonds the Company insures. There have been additional payment defaults on this and other Puerto Rico credits since then, including, on July 1, 2016, a default on the payment of the Commonwealth’s general obligation bonds. The Company has now paid claims on several Puerto Rico credits as shown in the table “Puerto Rico Net Par Outstanding” below.

On April 6, 2016, the Governor signed into law the Puerto Rico Emergency Moratorium & Financial Rehabilitation Act (the “Moratorium Act”). The Moratorium Act purportedly empowers the Governor to declare, entity by entity, states of emergencies and moratoriums on debt service payments on obligations of the Commonwealth and its related authorities and public corporations, as well as instituting a stay against related litigation, among other things. The Governor has used the authority of the Moratorium Act to take a number of actions related to issuers of obligations the Company insures. National Public Finance Guarantee Corporation ("National") (another financial guarantor), holders of the Commonwealth general obligation bonds and certain Puerto Rico residents (the "National Plaintiffs") have filed suits to invalidate the Moratorium Act, and after the passage of the Puerto Rico Oversight, Management, and Economic Stability Act (“PROMESA”), the National Plaintiffs sought a relief from the stay of litigation imposed by PROMESA to pursue the action. On July 21, 2016, the Company filed a motion and form of complaint in the U.S. District Court for the District of Puerto Rico seeking relief from the stay of litigation imposed by PROMESA to seek a declaration that the Moratorium Act is preempted by Federal bankruptcy law. In November 2016 the Court denied both the Company's and the National Plaintiffs' motions for relief from stay in the respective actions. The PROMESA stay expires on February 15, 2017, although it may be extended.
  
On June 13, 2016, the Supreme Court of the United States affirmed rulings of lower courts finding that the Puerto Rico Public Corporation Debt Enforcement and Recovery Act, which was enacted by Puerto Rico in June 2014 in order to provide a legislative framework for certain public corporations experiencing severe financial stress to restructure their debt, was preempted by the U.S. Bankruptcy Code and therefore void.

On June 30, 2016, PROMESA was signed into law by the President of the United States. PROMESA establishes a seven-member federal financial oversight board (“Oversight Board”) with authority to require that balanced budgets and fiscal plans be adopted and implemented by Puerto Rico. PROMESA provides a legal framework under which the debt of the Commonwealth and its related authorities and public corporations may be voluntarily restructured, and grants the Oversight Board the sole authority to file restructuring petitions in a federal court to restructure the debt of the Commonwealth and its related authorities and public corporations if voluntary negotiations fail, provided that any such restructuring must be in accordance with an Oversight Board approved fiscal plan that respects the liens and priorities provided under Puerto Rico law. PROMESA also appears to preempt at least portions of the Moratorium Act and appears to stay debt-related litigation, possibly including the Company’s litigation regarding the Clawback Orders. On August 31, 2016, the President of the United States appointed the seven members of the Oversight Board.

The Oversight Board has begun meeting. Press reports indicate that the Oversight Board has set a target of mid-January 2017 for hiring an executive director and is considering intervening in certain litigation relating to the Moratorium Act or otherwise related to Puerto Rico’s debt problems. On October 28, 2016, the Oversight Board filed a motion to intervene in the litigation noted above initiated by the Company on July 21, 2016, and seeking relief from the PROMESA stay. That motion was denied on November 1, 2016, without prejudice, on procedural grounds. The Oversight Board also may seek in the future to intervene in litigation initiated by the Company. The Oversight Board has announced its intention to certify a fiscal plan for the Commonwealth and its tax-supported authorities and public corporations under PROMESA by no later than January 31, 2017.

The final shape, timing and validity of responses to Puerto Rico’s distress eventually enacted or implemented under the auspices of PROMESA and the Oversight Board or otherwise, and the impact of any such responses on obligations insured by the Company, is uncertain.

The Company groups its Puerto Rico exposure into three categories:

•
Constitutionally Guaranteed. The Company includes in this category public debt benefiting from Article VI of the Constitution of the Commonwealth, which expressly provides that interest and principal payments on the public debt are to be paid before other disbursements are made.


16

•
Public Corporations – Certain Revenues Potentially Subject to Clawback. The Company includes in this category the debt of public corporations for which applicable law permits the Commonwealth to claw back, subject to certain conditions and for the payment of public debt, at least a portion of the revenues supporting the bonds the Company insures. As a Constitutional condition to clawback, available Commonwealth revenues for any fiscal year must be insufficient to pay Commonwealth debt service before the payment of any appropriations for that year.  The Company believes that this condition has not been satisfied to date, and accordingly that the Commonwealth has not to date been entitled to clawback revenues supporting debt insured by the Company. As noted above, the Company sued various Puerto Rico governmental officials in the United States District Court, District of Puerto Rico asserting that Puerto Rico's recent attempt to “claw back” pledged taxes is unconstitutional, and demanding declaratory and injunctive relief.

•
Other Public Corporations. The Company includes in this category the debt of public corporations that are supported by revenues it does not believe are subject to clawback.

Constitutionally Guaranteed

General Obligation. As of September 30, 2016, the Company had $378 million insured net par outstanding of the general obligations of Puerto Rico, which are supported by the good faith, credit and taxing power of the Commonwealth. On July 1, 2016, despite the requirements of Article VI of its Constitution but pursuant to an executive order issued by the Governor under the Moratorium Act, the Commonwealth defaulted on most of the debt service payment due that day, and the Company made its first claim payments on these bonds.

Puerto Rico Public Buildings Authority (“PBA”). As of September 30, 2016, the Company had $169 million insured net par outstanding of PBA bonds, which are supported by a pledge of the rents due under leases of government facilities to departments, agencies, instrumentalities and municipalities of the Commonwealth, and that benefit from a Commonwealth guaranty supported by a pledge of the Commonwealth’s good faith, credit and taxing power. On July 1, 2016, despite the requirements of Article VI of its Constitution but pursuant to an executive order issued by the Governor under the Moratorium Act, the PBA defaulted on most of the debt service payment due that day, and the Company made its first claim payments on these bonds.

Public Corporations - Certain Revenues Potentially Subject to Clawback

PRHTA. As of September 30, 2016, the Company had $519 million insured net par outstanding of PRHTA (Transportation revenue) bonds and $93 million insured net par of PRHTA (Highways revenue) bonds. The transportation revenue bonds are secured by a subordinate gross pledge of gasoline and gas oil and diesel oil taxes, motor vehicle license fees and certain tolls, plus a first lien on up to $120 million annually of taxes on crude oil, unfinished oil and derivative products. The highways revenue bonds are secured by a gross pledge of gasoline and gas oil and diesel oil taxes, motor vehicle license fees and certain tolls. The Clawback Orders cover Commonwealth-derived taxes that are allocated to PRHTA. The Company believes that such sources represented a substantial majority of PRHTA’s revenues in 2015. The PRHTA bonds are subject to executive orders issued pursuant to the Moratorium Act. As noted above, the Company filed a motion and form of complaint in the U.S. District Court for the District of Puerto Rico seeking relief from the PROMESA stay to seek a declaration that the Moratorium Act is preempted by Federal bankruptcy law and that certain gubernatorial executive orders diverting PRHTA pledged toll revenues (which are not subject to the Clawback Orders) are preempted by PROMESA and violate the U.S. Constitution, and also seeking damages and injunctive relief. That motion was denied on November 2, 2016, on procedural grounds. The PROMESA stay expires on February 15, 2017. There were sufficient funds in the PRHTA bond accounts to make the July 1, 2016, PRHTA debt service payments guaranteed by the Company, and those payments were made in full.

PRCCDA. As of September 30, 2016, the Company had $152 million insured net par outstanding of PRCCDA bonds, which are secured by certain hotel tax revenues. These revenues are sensitive to the level of economic activity in the area and are subject to the Clawback Orders, and the bonds are subject to an executive order issued pursuant to the Moratorium Act. There were sufficient funds in the PRCCDA bond accounts to make the July 1, 2016 PRCCDA bond payments guaranteed by the Company, and those payments were made in full.

PRIFA. As of September 30, 2016, the Company had $17 million insured net par outstanding of PRIFA bonds, which are secured primarily by the return to Puerto Rico of federal excise taxes paid on rum. These revenues are subject to the Clawback Orders and the bonds are subject to an executive order issued pursuant to the Moratorium Act. The Company made its first claim payment on PRIFA bonds in January 2016, and has continued to make claim payments on PRIFA bonds.


17

Other Public Corporations

Puerto Rico Electric Power Authority ("PREPA"). As of September 30, 2016, the Company had $73 million insured net par outstanding of PREPA obligations, which are payable from a pledge of net revenues of the electric system.

On December 24, 2015, AGM and AGC entered into a Restructuring Support Agreement (“RSA”) with PREPA, an ad hoc group of uninsured bondholders and a group of fuel-line lenders that would, subject to certain conditions, result in, among other things, modernization of the utility and a restructuring of current debt. Upon finalization of the contemplated restructuring transaction, insured PREPA revenue bonds (with no reduction to par or stated interest rate or extension of maturity) will be supported by securitization bonds issued by a special purpose corporation and secured by a transition charge assessed on ratepayers. To facilitate the securitization transaction and in exchange for a market premium, Assured Guaranty will issue surety insurance policies in an aggregate amount not expected to exceed $113 million ($14 million for AGC and $99 million for AGM) to support a portion of the reserve fund for the securitization bonds. Certain of the creditors also agreed, subject to certain conditions, to participate in a bridge financing, which was closed in two tranches on May 19, 2016 and June 22, 2016. AGM's and AGC's share of the bridge financing was approximately $15 million ($2 million for AGC and $13 million for AGM). Legislation meeting the requirements of the RSA was enacted on February 16, 2016, and a transition charge to be paid by PREPA rate payers for debt service on the securitization bonds as contemplated by the RSA was approved by the Puerto Rico Energy Commission on June 20, 2016. The closing of the restructuring transaction and the issuance of the surety bonds are subject to certain conditions, including execution of acceptable documentation and legal opinions. The RSA has been extended to March 31, 2017 with a new milestone date of January 31, 2017, for PREPA and the RSA creditors to reach agreement on revisions to allow for implementation under PROMESA or another mechanism.

On July 1, 2016, PREPA made full payment of the $41 million of principal and interest due on PREPA revenue bonds insured by AGM and AGC. That payment was funded in part by AGM’s purchase of $26 million of PREPA bonds maturing in 2020. Upon finalization of the transactions contemplated by the RSA, these new PREPA revenue bonds will be supported by securitization bonds contemplated by the RSA. In early 2016, PREPA repaid in full the $74 million in aggregate principal amount of PREPA revenue bonds purchased by AGM and AGC in July 2015 to replenish some of the operating funds PREPA used to make the July 2015 payments on the PREPA revenue bonds insured by AGM and AGC.

There can be no assurance that the conditions in the RSA will be met or that, if the conditions are met, the RSA's other provisions, including those related to the insured PREPA revenue bonds, will be implemented. In addition, the impact of PROMESA and the Moratorium Act or any attempt to exercise the power purportedly granted by the Moratorium Act on the implementation of the RSA is uncertain. PREPA, during the pendency of the agreements, has suspended deposits into its debt service fund.

Puerto Rico Aqueduct and Sewer Authority (“PRASA”). As of September 30, 2016, the Company had $285 million of insured net par outstanding to PRASA bonds, which are secured by the gross revenues of the water and sewer system. On September 15, 2015, PRASA entered into a settlement with the U.S. Department of Justice and the U.S. Environmental Protection Agency that requires it to spend $1.6 billion to upgrade and improve its sewer system island-wide. According to a material event notice PRASA filed on March 4, 2016, PRASA owed its contractors $140 million. The PRASA Revitalization Act, which establishes a securitization mechanism that could facilitate debt issuance, was signed into law on July 13, 2016. While certain bonds benefiting from a guarantee by the Commonwealth are subject to an executive order issued under the Moratorium Act, bonds insured by the Company are not subject to that order. There were sufficient funds in the PRASA bond accounts to make the July 1, 2016, PRASA bond payments guaranteed by the Company, and those payments were made in full.
    
Municipal Finance Agency ("MFA"). As of September 30, 2016, the Company had $61 million net par outstanding of bonds issued by MFA secured by a pledge of local property tax revenues. There were sufficient funds in the MFA bond accounts to make the July 1, 2016 MFA bond payments guaranteed by the Company, and those payments were made in full.

University of Puerto Rico (“U of PR”). As of September 30, 2016, the Company had $1 million insured net par outstanding of U of PR bonds, which are general obligations of the university and are secured by a subordinate lien on the proceeds, profits and other income of the University, subject to a senior pledge and lien for the benefit of outstanding university system revenue bonds. The U of PR bonds are subject to an executive order issued under the Moratorium Act. There were no debt service payments due on July 1, 2016 on Company-insured U of PR bonds, and, as of the date of this filing, all payments on Company-insured U of PR bonds had been made.

All Puerto Rico exposures are internally rated triple-C or below. The following tables show the Company’s insured exposure to general obligation bonds of Puerto Rico and various obligations of its related authorities and public corporations.


18

Puerto Rico
Gross Par and Gross Debt Service Outstanding

 
Gross Par Outstanding
 
Gross Debt Service Outstanding
 
September 30,
2016
 
December 31,
2015
 
September 30,
2016
 
December 31,
2015
 
(in millions)
Exposure to Puerto Rico
$
2,128

 
$
2,238

 
$
3,697

 
$
3,900



Puerto Rico
Net Par Outstanding

 
As of
September 30, 2016 (2)
 
As of
December 31, 2015
 
(in millions)
Commonwealth Constitutionally Guaranteed
 
 
 
Commonwealth of Puerto Rico - General Obligation Bonds (1)
$
378

 
$
415

Puerto Rico Public Buildings Authority (1)
169

 
137

Public Corporations - Certain Revenues Potentially Subject to Clawback
 
 
 
PRHTA (Transportation revenue)
519

 
475

PRHTA (Highways revenue)
93

 
101

PRCCDA
152

 
82

PRIFA (1)
17

 
10

Other Public Corporations
 
 
 
PREPA
73

 
74

PRASA
285

 
296

MFA
61

 
65

U of PR
1

 
1

Total net exposure to Puerto Rico
$
1,748

 
$
1,656

____________________
(1)
As of the date of this filing, the Company has paid claims on these credits.  

(2)
In Third Quarter 2016, the Company's Puerto Rico exposures increased due to the CIFG Acquisition, which increased net par outstanding by $213 million.


    

19

The following table shows the scheduled amortization of the insured general obligation bonds of Puerto Rico and various obligations of its related authorities and public corporations. The Company guarantees payments of interest and principal when those amounts are scheduled to be paid and cannot be required to pay on an accelerated basis. In the event that obligors default on their obligations, the Company would only be required to pay the shortfall between the principal and interest due in any given period and the amount paid by the obligors.

Amortization Schedule of Puerto Rico Net Par Outstanding
and Net Debt Service Outstanding
As of September 30, 2016
 
 
Scheduled Net Par Amortization
 
Scheduled Net Debt Service Amortization
 
(in millions)
2016 (October 1 – December 31)
$
0

 
$
0

2017 (January 1 - March 31)
0

 
44

2017 (April 1 - June 30)
0

 
0

2017 (July 1 - September 30)
85

 
125

2017 (October 1 - December 31)
0

 
0

Subtotal 2017
85

 
169

2018
79

 
165

2019
67

 
149

2020
118

 
195

2021-2025
202

 
544

2026-2030
351

 
607

2031-2035
413

 
598

2036-2040
206

 
288

2041-2045
101

 
154

2046-2047
126

 
136

Total
$
1,748

 
$
3,005




20

Exposure to Selected European Countries

The European countries where the Company has exposure and believes heightened uncertainties exist are: Hungary, Italy, Portugal, Spain and Turkey (collectively, the “Selected European Countries”). The Company added Turkey to its list of Selected European Countries as of June 30, 2016, as a result of the recent political turmoil in the country. The Company’s direct economic exposure to the Selected European Countries (based on par for financial guaranty contracts and notional amount for financial guaranty contracts accounted for as derivatives) is shown in the following table, net of ceded reinsurance.

Net Direct Economic Exposure to Selected European Countries(1)
As of September 30, 2016

 
 
Hungary
 
Italy
 
Portugal
 
Spain
 
Turkey
 
Total
 
 
(in millions)
Sub-sovereign exposure(2)
 
$
14

 
$
165

 
$
2

 
$
45

 
$
—

 
$
226

Non-sovereign exposure(3)
 
5

 
19

 
—

 
—

 
180

 
$
204

Total
 
$
19

 
$
184

 
$
2

 
$
45

 
$
180

 
$
430

Total BIG (See Note 5)
 
$
18

 
$
—

 
$
2

 
$
45

 
$
—

 
$
65

____________________
(1)
While the Company’s exposures are shown in U.S. dollars, the obligations the Company insures are in various currencies, primarily Euros.
 
(2)
Sub-sovereign exposure in Selected European Countries includes transactions backed by receivables from or supported by sub-sovereigns, which are governmental or government-backed entities other than the ultimate governing body of the country.

(3)
Non-sovereign exposure in Selected European Countries includes debt of regulated utilities, RMBS and diversified payment rights ("DPR") securitizations.

The Company has excluded from the exposure tables above its indirect economic exposure to the Selected European Countries through policies it provides on pooled corporate and commercial receivables transactions. The Company calculates indirect exposure to a country by multiplying the par amount of a transaction insured by the Company times the percent of the relevant collateral pool reported as having a nexus to the country. On that basis, the Company has calculated exposure of $103 million to Selected European Countries (plus Greece) in transactions with $0.9 billion of net par outstanding. The indirect exposure to credits with a nexus to Greece is $3 million across several highly rated pooled corporate obligations with net par outstanding of $91 million.

The $180 million net insured par exposure in Turkey is to DPR securitizations sponsored by a major Turkish bank. These DPR securitizations were established outside of Turkey and involve payment orders in U.S. dollars, pounds sterling and Euros from persons outside of Turkey to beneficiaries in Turkey who are customers of the sponsoring bank. The sponsoring bank's correspondent banks have agreed to remit all such payments to a trustee-controlled account outside Turkey, where debt service payments for the DPR securitization are given priority over payments to the sponsoring bank.

5.
Expected Loss to be Paid

Loss Estimation Process

This note provides information regarding expected claim payments to be made under all contracts in the insured portfolio, regardless of the accounting model. The Company’s loss reserve committees estimate expected loss to be paid for all contracts by reviewing analyses that consider various scenarios with corresponding probabilities assigned to them. Depending upon the nature of the risk, the Company’s view of the potential size of any loss and the information available to the Company, that analysis may be based upon individually developed cash flow models, internal credit rating assessments and sector-driven loss severity assumptions or judgmental assessments.

The financial guaranties issued by the Company insure the credit performance of the guaranteed obligations over an extended period of time, in some cases over 30 years, and in most circumstances, the Company has no right to cancel such financial guaranties. The determination of expected loss to be paid is an inherently subjective process involving numerous estimates, assumptions and judgments by management, using both internal and external data sources with regard to frequency,

21

severity of loss, economic projections, governmental actions, negotiations and other factors that affect credit performance. These estimates, assumptions and judgments, and the factors on which they are based, may change materially over a quarter, and as a result the Company’s loss estimates may change materially over that same period.

The Company does not use traditional actuarial approaches to determine its estimates of financial guaranty expected losses. Actual losses will ultimately depend on future events or transaction performance and may be influenced by many interrelated factors that are difficult to predict. As a result, the Company's current projections of probable and estimable losses may be subject to considerable volatility and may not reflect the Company's ultimate claims paid. For information on the Company's loss estimation process, please refer to Note 5, Expected Losses to be Paid, of the annual consolidated financial statements of AGC for the year ended December 31, 2015 included in Exhibit 99.1 in AGL's Form 8-K dated April 8, 2016, filed with the SEC.

The following tables present a roll forward of the present value of net expected loss to be paid for all contracts, whether accounted for as insurance, credit derivatives or financial guaranty ("FG") VIEs, by sector, after the benefit for expected recoveries for breaches of representations and warranties ("R&W") and other expected recoveries. The Company used weighted average risk-free rates for U.S. dollar denominated obligations that ranged from 0.0% to 2.42% as of September 30, 2016 and 0.0% to 3.25% as of December 31, 2015.    

Net Expected Loss to be Paid
After Net Expected Recoveries for Breaches of R&W
Roll Forward

 
Third Quarter
 
Nine Months
 
2016
 
2015
 
2016
 
2015
 
(in millions)
Net expected loss to be paid, beginning of period
$
413

 
$
402

 
$
419

 
$
146

Net expected loss to be paid on CIFG portfolio as of July 1, 2016
22

 
—

 
22

 
—

Net expected loss to be paid on Radian Asset portfolio as of April 1, 2015
—

 
—

 
—

 
190

Economic loss development due to:
 
 
 
 
 
 
 
Accretion of discount
1

 
2

 
6

 
5

Changes in discount rates
(8
)
 
2

 
28

 
12

Changes in timing and assumptions
14

 
(7
)
 
11

 
51

Total economic loss development
7

 
(3
)
 
45

 
68

Paid losses
(101
)
 
(26
)
 
(145
)
 
(31
)
Net expected loss to be paid, end of period
$
341

 
$
373

 
$
341

 
$
373




22

Net Expected Loss to be Paid
After Net Expected Recoveries for Breaches of R&W
Roll Forward by Sector
Third Quarter 2016

 
Net Expected
Loss to be
Paid (Recovered) as of
June 30, 2016
 
Net Expected
Loss to be
Paid 
(Recovered)
on CIFG as of
July 1, 2016
 
Economic Loss
Development
 
(Paid)
Recovered
Losses (1)
 
Net Expected
Loss to be
Paid (Recovered) as of
September 30,
 2016 (2)
 
(in millions)
Public Finance:
 
 
 
 
 
 
 
 
 
U.S. public finance
$
408

 
$
40

 
$
29

 
$
(88
)
 
$
389

Non-U.S. public finance
5

 
2

 
0

 
—

 
7

Public Finance
413

 
42

 
29

 
(88
)
 
396

Structured Finance:
 
 
 
 
 
 
 
 
 
U.S. RMBS:
 

 
 
 
 
 
 
 
 
First lien:
 

 
 
 
 
 
 
 
 
Prime first lien
2

 
—

 
0

 
0

 
2

Alt-A first lien
(16
)
 
0

 
1

 
3

 
(12
)
Option ARM
(8
)
 
—

 
(3
)
 
1

 
(10
)
Subprime
26

 
—

 
0

 
2

 
28

Total first lien
4

 
0

 
(2
)
 
6

 
8

Second lien
25

 
(22
)
 
1

 
1

 
5

Total U.S. RMBS
29

 
(22
)
 
(1
)
 
7

 
13

Triple-X life insurance transactions
(14
)
 
—

 
(22
)
 
(20
)
 
(56
)
Other structured finance
(15
)
 
2

 
1

 
0

 
(12
)
Structured Finance
0

 
(20
)
 
(22
)
 
(13
)
 
(55
)
Total
$
413

 
$
22

 
$
7

 
$
(101
)
 
$
341





23

Net Expected Loss to be Paid
After Net Expected Recoveries for Breaches of R&W
Roll Forward by Sector
Third Quarter 2015

 
Net Expected
Loss to be
Paid (Recovered) as of June 30, 2015
 
Economic Loss
Development
 
(Paid)
Recovered
Losses (1)
 
Net Expected
Loss to be
Paid (Recovered) as of
September 30, 2015
 
(in millions)
Public Finance:
 
 
 
 
 
 
 
U.S. public finance
$
218

 
$
57

 
$
0

 
$
275

Non-U.S public finance
6

 
0

 
—

 
6

Public Finance
224

 
57

 
0

 
281

Structured Finance:
 
 
 
 
 
 
 
U.S. RMBS:
 

 
 

 
 

 
 

First lien:
 

 
 

 
 

 
 

Prime first lien
0

 
0

 
0

 
0

Alt-A first lien
53

 
(54
)
 
(22
)
 
(23
)
Option ARM
4

 
0

 
0

 
4

Subprime
51

 
2

 
(5
)
 
48

Total first lien
108

 
(52
)
 
(27
)
 
29

Second lien
8

 
2

 
1

 
11

Total U.S. RMBS
116

 
(50
)
 
(26
)
 
40

Triple-X life insurance transactions
(20
)
 
4

 
0

 
(16
)
Other structured finance
82

 
(14
)
 
0

 
68

Structured Finance
178

 
(60
)
 
(26
)
 
92

Total
$
402

 
$
(3
)
 
$
(26
)
 
$
373





















24

Net Expected Loss to be Paid
After Net Expected Recoveries for Breaches of R&W
Roll Forward by Sector
Nine Months 2016

 
Net Expected
Loss to be
Paid (Recovered)
as of
December 31, 2015 (2)
 
Net Expected
Loss to be
Paid 
(Recovered)
on CIFG as of
July 1, 2016
 
Economic Loss
Development
 
(Paid)
Recovered
Losses (1)
 
Net Expected
Loss to be
Paid (Recovered)
as of
September 30,
2016 (2)
 
(in millions)
Public Finance:
 
 
 
 
 
 
 
 
 
U.S. public finance
$
353

 
$
40

 
$
87

 
$
(91
)
 
$
389

Non-U.S. public finance
6

 
2

 
(1
)
 
—

 
7

Public Finance
359

 
42

 
86

 
(91
)
 
396

Structured Finance:
 
 
 
 
 
 
 
 
 
U.S. RMBS:
 
 
 
 
 
 
 
 
 
First lien:
 
 
 
 
 
 
 
 
 
Prime first lien
(2
)
 
—

 
0

 
4

 
2

Alt-A first lien
31

 
0

 
(9
)
 
(34
)
 
(12
)
Option ARM
2

 
—

 
(14
)
 
2

 
(10
)
Subprime
32

 
—

 
(3
)
 
(1
)
 
28

Total first lien
63

 
0

 
(26
)
 
(29
)
 
8

Second lien
13

 
(22
)
 
3

 
11

 
5

Total U.S. RMBS
76

 
(22
)
 
(23
)
 
(18
)
 
13

Triple-X life insurance transactions
(14
)
 
—

 
(21
)
 
(21
)
 
(56
)
Other structured finance
(2
)
 
2

 
3

 
(15
)
 
(12
)
Structured Finance
60

 
(20
)
 
(41
)
 
(54
)
 
(55
)
Total
$
419

 
$
22

 
$
45

 
$
(145
)
 
$
341
























25

Net Expected Loss to be Paid
After Net Expected Recoveries for Breaches of R&W
Roll Forward by Sector
Nine Months 2015

 
Net Expected
Loss to be
Paid (Recovered)
as of
December 31, 2014 (2)
 
Net Expected
Loss to be
Paid 
(Recovered)
on Radian Asset portfolio as of
April 1, 2015
 
Economic Loss
Development
 
(Paid)
Recovered
Losses (1)
 
Net Expected
Loss to be
Paid (Recovered)
as of
September 30, 2015
 
(in millions)
Public Finance:
 
 
 
 
 
 
 
 
 
U.S. public finance
$
49

 
$
81

 
$
148

 
$
(3
)
 
$
275

Non-U.S. public finance
2

 
4

 
0

 
—

 
6

Public Finance
51

 
85

 
148

 
(3
)
 
281

Structured Finance:
 

 
 
 
 

 
 

 
 

U.S. RMBS:
 

 
 
 
 

 
 

 
 

First lien:
 
 
 
 
 
 
 
 
 
Prime first lien
3

 
—

 
(1
)
 
(2
)
 
0

Alt-A first lien
58

 
7

 
(64
)
 
(24
)
 
(23
)
Option ARM
1

 
0

 
4

 
(1
)
 
4

Subprime
61

 
(4
)
 
(1
)
 
(8
)
 
48

Total first lien
123

 
3

 
(62
)
 
(35
)
 
29

Second lien
4

 
1

 
3

 
3

 
11

Total U.S. RMBS
127

 
4

 
(59
)
 
(32
)
 
40

Triple-X life insurance transactions
(19
)
 
—

 
4

 
(1
)
 
(16
)
Other structured finance
(13
)
 
101

 
(25
)
 
5

 
68

Structured Finance
95

 
105

 
(80
)
 
(28
)
 
92

Total
$
146

 
$
190

 
$
68

 
$
(31
)
 
$
373

_________________
(1)
Net of ceded paid losses, whether or not such amounts have been settled with reinsurers. Ceded paid losses are typically settled 45 days after the end of the reporting period. Such amounts are recorded in reinsurance recoverable on paid losses included in other assets. The Company paid $1 million and $2 million in LAE for Third Quarter 2016 and 2015, respectively, and $3 million and $5 million in LAE for Nine Months 2016 and 2015, respectively.

(2)
Includes expected LAE to be paid of $6 million as of September 30, 2016 and $5 million as of December 31, 2015.
















26

Future Net R&W Recoverable (Payable)(1)

 
As of
September 30, 2016
 
As of
December 31, 2015
 
(in millions)
U.S. RMBS:
 
 
 
First lien
$
11

 
$
6

Second lien
21

 
7

Total
$
32

 
$
13

____________________
(1)
The Company’s agreements with R&W providers generally provide that, as the Company makes claim payments, the R&W providers reimburse it for those claims; if the Company later receives reimbursement through the transaction (for example, from excess spread), the Company repays the R&W providers. See the section “Breaches of Representations and Warranties” for information about the R&W agreements and eligible assets held in trust with respect to such agreements. When the Company projects receiving more reimbursements in the future than it projects paying in claims on transactions covered by R&W settlement agreements, the Company will have a net R&W payable.


The following tables present the present value of net expected loss to be paid for all contracts by accounting model, by sector and after the benefit for expected recoveries for breaches of R&W.

Net Expected Loss to be Paid (Recovered)
By Accounting Model
As of September 30, 2016
 
 
Financial
Guaranty
Insurance
 
FG VIEs(1) and Other
 
Credit
Derivatives(2)
 
Total
 
(in millions)
Public Finance:
 
 
 
 
 
 
 
U.S. public finance
$
389

 
$
—

 
$
0

 
$
389

Non-U.S. public finance
7

 
—

 
—

 
7

Public Finance
396

 
—

 
0

 
396

Structured Finance:
 
 
 
 
 
 
 
U.S. RMBS:
 
 
 
 
 
 
 

First lien:
 
 
 
 
 
 
 

Prime first lien
2

 
—

 
—

 
2

Alt-A first lien
(14
)
 
—

 
2

 
(12
)
Option ARM
(7
)
 
—

 
(3
)
 
(10
)
Subprime
(1
)
 
1

 
28

 
28

Total first lien
(20
)
 
1

 
27

 
8

Second lien
(8
)
 
13

 
0

 
5

Total U.S. RMBS
(28
)
 
14

 
27

 
13

Triple-X life insurance transactions
(64
)
 
—

 
8

 
(56
)
Other structured finance
17

 
1

 
(30
)
 
(12
)
Structured Finance
(75
)
 
15

 
5

 
(55
)
Total
$
321

 
$
15

 
$
5

 
$
341



27

Net Expected Loss to be Paid (Recovered)
By Accounting Model
As of December 31, 2015
 
 
Financial
Guaranty
Insurance
 
FG VIEs(1) and Other
 
Credit
Derivatives(2)
 
Total
 
(in millions)
Public Finance:
 
 
 
 
 
 
 
U.S. public finance
$
353

 
$
—

 
$
0

 
$
353

Non-U.S. public finance
6

 
—

 
—

 
6

Public Finance
359

 
—

 
0

 
359

Structured Finance:
 
 
 
 
 
 
 
U.S. RMBS:
 

 
 

 
 

 
 

First lien:
 

 
 

 
 

 
 

Prime first lien
1

 
—

 
(3
)
 
(2
)
Alt-A first lien
31

 
—

 
0

 
31

Option ARM
3

 
—

 
(1
)
 
2

Subprime
(1
)
 
0

 
33

 
32

Total first lien
34

 
0

 
29

 
63

Second lien
6

 
7

 
0

 
13

Total U.S. RMBS
40

 
7

 
29

 
76

Triple-X life insurance transactions
(22
)
 
—

 
8

 
(14
)
Other structured finance
14

 
16

 
(32
)
 
(2
)
Structured Finance
32

 
23

 
5

 
60

Total
$
391

 
$
23

 
$
5

 
$
419

___________________
(1)
Refer to Note 9, Consolidated Variable Interest Entities.

(2)    Refer to Note 8, Financial Guaranty Contracts Accounted for as Credit Derivatives.

    

28

The following tables present the net economic loss development for all contracts by accounting model, by sector and after the benefit for expected recoveries for breaches of R&W.

Net Economic Loss Development (Benefit)
By Accounting Model
Third Quarter 2016

 
Financial
Guaranty
Insurance
 
FG VIEs(1) and Other
 
Credit
Derivatives(2)
 
Total
 
(in millions)
Public Finance:
 
 
 
 
 
 
 
U.S. public finance
$
29

 
$
—

 
$
—

 
$
29

Non-U.S. public finance
0

 
—

 
—

 
0

Public Finance
29

 
—

 
—

 
29

Structured Finance:
 
 
 
 
 
 
 
U.S. RMBS:
 

 
 

 
 

 
 

First lien:
 

 
 

 
 

 
 

Prime first lien
0

 
—

 
—

 
0

Alt-A first lien
1

 
—

 
0

 
1

Option ARM
(3
)
 
—

 
0

 
(3
)
Subprime
0

 
1

 
(1
)
 
0

Total first lien
(2
)
 
1

 
(1
)
 
(2
)
Second lien
2

 
(1
)
 
0

 
1

Total U.S. RMBS
0

 
0

 
(1
)
 
(1
)
Triple-X life insurance transactions
(22
)
 
—

 
0

 
(22
)
Other structured finance
(1
)
 
0

 
2

 
1

Structured Finance
(23
)
 
0

 
1

 
(22
)
Total
$
6

 
$
0

 
$
1

 
$
7



29

Net Economic Loss Development (Benefit)
By Accounting Model
Third Quarter 2015

 
Financial
Guaranty
Insurance
 
FG VIEs(1) and Other
 
Credit
Derivatives(2)
 
Total
 
(in millions)
Public Finance:
 
 
 
 
 
 
 
U.S. public finance
$
57

 
$
—

 
$
—

 
$
57

Non-U.S. public finance
0

 
—

 
0

 
0

Public Finance
57

 
—

 
0

 
57

Structured Finance:
 
 
 
 
 
 
 
U.S. RMBS:
 
 
 
 
 
 
 
First lien:
 
 
 
 
 
 
 
Prime first lien
—

 
—

 
0

 
0

Alt-A first lien
(7
)
 
—

 
(47
)
 
(54
)
Option ARM
0

 
—

 
0

 
0

Subprime
—

 
—

 
2

 
2

Total first lien
(7
)
 
—

 
(45
)
 
(52
)
Second lien
3

 
(1
)
 
0

 
2

Total U.S. RMBS
(4
)
 
(1
)
 
(45
)
 
(50
)
Triple-X life insurance transactions
3

 
—

 
1

 
4

Other structured finance
0

 
0

 
(14
)
 
(14
)
Structured Finance
(1
)
 
(1
)
 
(58
)
 
(60
)
Total
$
56

 
$
(1
)
 
$
(58
)
 
$
(3
)






















30

Net Economic Loss Development (Benefit)
By Accounting Model
Nine Months 2016

 
Financial
Guaranty
Insurance
 
FG VIEs(1) and Other
 
Credit
Derivatives(2)
 
Total
 
(in millions)
Public Finance:
 
 
 
 
 
 
 
U.S. public finance
$
87

 
$
—

 
$
—

 
$
87

Non-U.S. public finance
(1
)
 
—

 
—

 
(1
)
Public Finance
86

 
—

 
—

 
86

Structured Finance:
 
 
 
 
 
 
 
U.S. RMBS:
 
 
 
 
 
 
 
First lien:
 
 
 
 
 
 
 
Prime first lien
0

 
—

 
—

 
0

Alt-A first lien
(8
)
 
—

 
(1
)
 
(9
)
Option ARM
(12
)
 
—

 
(2
)
 
(14
)
Subprime
0

 
1

 
(4
)
 
(3
)
Total first lien
(20
)
 
1

 
(7
)
 
(26
)
Second lien
4

 
(1
)
 
0

 
3

Total U.S. RMBS
(16
)
 
0

 
(7
)
 
(23
)
Triple-X life insurance transactions
(21
)
 
—

 
0

 
(21
)
Other structured finance
3

 
1

 
(1
)
 
3

Structured Finance
(34
)
 
1

 
(8
)
 
(41
)
Total
$
52

 
$
1

 
$
(8
)
 
$
45









31

Net Economic Loss Development (Benefit)
By Accounting Model
Nine Months 2015

 
Financial
Guaranty
Insurance
 
FG VIEs(1) and Other
 
Credit
Derivatives(2)
 
Total
 
(in millions)
Public Finance:
 
 
 
 
 
 
 
U.S. public finance
$
155

 
$
—

 
$
(7
)
 
$
148

Non-U.S. public finance
0

 
—

 
0

 
0

Public Finance
155

 
—

 
(7
)
 
148

Structured Finance:
 
 
 
 
 
 
 
U.S. RMBS:
 
 
 
 
 
 
 
First lien:
 
 
 
 
 
 
 
Prime first lien
(1
)
 
—

 
—

 
(1
)
Alt-A first lien
(9
)
 
—

 
(55
)
 
(64
)
Option ARM
1

 
—

 
3

 
4

Subprime
1

 
—

 
(2
)
 
(1
)
Total first lien
(8
)
 
—

 
(54
)
 
(62
)
Second lien
5

 
(2
)
 
—

 
3

Total U.S. RMBS
(3
)
 
(2
)
 
(54
)
 
(59
)
Triple-X life insurance transactions
2

 
—

 
2

 
4

Other structured finance
(1
)
 
0

 
(24
)
 
(25
)
Structured Finance
(2
)
 
(2
)
 
(76
)
 
(80
)
Total
$
153

 
$
(2
)
 
$
(83
)
 
$
68

____________________
(1)    Refer to Note 9, Consolidated Variable Interest Entities.

(2)    Refer to Note 8, Financial Guaranty Contracts Accounted for as Credit Derivatives.


32

Selected U.S. Public Finance Transactions

The Company insures general obligation bonds of the Commonwealth of Puerto Rico and various obligations of its related authorities and public corporations aggregating $1.7 billion net par as of September 30, 2016, all of which are BIG. For additional information regarding the Company's exposure to general obligations of Commonwealth of Puerto Rico and various obligations of its related authorities and public corporations, please refer to "Exposure to Puerto Rico" in Note 4, Outstanding Exposure.

The Company also has $3.7 billion of net par exposure to healthcare transactions. The BIG net par outstanding in this sector is $225 million.

The Company projects that its total net expected loss across its troubled U.S. public finance credits as of September 30, 2016 including those mentioned above, which incorporated the likelihood of the various outcomes, will be $389 million, compared with a net expected loss of $353 million as of December 31, 2015. On July 1, 2016, the CIFG Acquisition added $40 million in net economic losses to be paid for U.S. public finance credits. Economic loss development in Third Quarter 2016 and Nine Months 2016 was $29 million and $87 million, respectively, which was primarily attributable to Puerto Rico exposures.

Approach to Projecting Losses in U.S. RMBS

The Company projects losses on its insured U.S. RMBS on a transaction-by-transaction basis by projecting the performance of the underlying pool of mortgages over time and then applying the structural features (i.e., payment priorities and tranching) of the RMBS and any R&W agreements to the projected performance of the collateral over time. The resulting projected claim payments or reimbursements are then discounted using risk-free rates.

Third Quarter and Nine Months 2016 U.S. RMBS Loss Projections

Based on its observation during the period of the performance of its insured transactions (including early stage delinquencies, late stage delinquencies and loss severity) as well as the residential property market and economy in general, the Company chose to use the same general assumptions to project RMBS losses as of September 30, 2016 as it used as of June 30, 2016. For Nine Months 2016, the Company chose to use the same general assumptions to project RMBS losses as of September 30, 2016 as it used as of December 31, 2015, except it (1) increased severities for specific vintages of Alt-A first lien, Option ARM and subprime transactions, (2) decreased liquidation rates for certain vintages of subprime and (3) increased liquidation rates for second lien transactions based on observed data.

33

U.S. First Lien RMBS Loss Projections: Alt-A First Lien, Option ARM, Subprime and Prime

The majority of projected losses in first lien RMBS transactions are expected to come from non-performing mortgage loans (those that are or in the past twelve months have been two or more payments behind, have been modified, are in foreclosure, or have been foreclosed upon). Changes in the amount of non-performing loans from the amount projected in the previous period are one of the primary drivers of loss development in this portfolio. In order to determine the number of defaults resulting from these delinquent and foreclosed loans, the Company applies a liquidation rate assumption to loans in each of various non-performing categories. The Company arrived at its liquidation rates based on data purchased from a third party provider and assumptions about how delays in the foreclosure process and loan modifications may ultimately affect the rate at which loans are liquidated. Each quarter the Company reviews the most recent twelve months of this data and (if necessary) adjusts its liquidation rates based on its observations. The following table shows liquidation assumptions for various non-performing categories.

First Lien Liquidation Rates

 
September 30, 2016
 
June 30, 2016
 
December 31, 2015
Current Loans Modified in the Previous 12 Months
 
 
 
 
 
Alt-A and Prime
25%
 
25%
 
25%
Option ARM
25
 
25
 
25
Subprime
25
 
25
 
25
Current Loans Delinquent in the Previous 12 Months
 
 
 
 
 
Alt-A and Prime
25
 
25
 
25
Option ARM
25
 
25
 
25
Subprime
25
 
25
 
25
30 – 59 Days Delinquent
 
 
 
 
 
Alt-A and Prime
35
 
35
 
35
Option ARM
40
 
40
 
40
Subprime
45
 
45
 
45
60 – 89 Days Delinquent
 
 
 
 
 
Alt-A and Prime
45
 
45
 
45
Option ARM
50
 
50
 
50
Subprime
50
 
50
 
55
90+ Days Delinquent
 
 
 
 
 
Alt-A and Prime
55
 
55
 
55
Option ARM
60
 
60
 
60
Subprime
55
 
55
 
60
Bankruptcy
 
 
 
 
 
Alt-A and Prime
45
 
45
 
45
Option ARM
50
 
50
 
50
Subprime
40
 
40
 
40
Foreclosure
 
 
 
 
 
Alt-A and Prime
65
 
65
 
65
Option ARM
70
 
70
 
70
Subprime
65
 
65
 
70
Real Estate Owned
 
 
 
 
 
All
100
 
100
 
100



34

While the Company uses liquidation rates as described above to project defaults of non-performing loans (including current loans modified or delinquent within the last 12 months), it projects defaults on presently current loans by applying a conditional default rate ("CDR") trend. The start of that CDR trend is based on the defaults the Company projects will emerge from currently nonperforming, recently nonperforming and modified loans. The total amount of expected defaults from the non-performing loans is translated into a constant CDR (i.e., the CDR plateau), which, if applied for each of the next 36 months, would be sufficient to produce approximately the amount of defaults that were calculated to emerge from the various delinquency categories. The CDR thus calculated individually on the delinquent collateral pool for each RMBS is then used as the starting point for the CDR curve used to project defaults of the presently performing loans.

In the base case, after the initial 36-month CDR plateau period, each transaction’s CDR is projected to improve over 12 months to an intermediate CDR (calculated as 20% of its CDR plateau); that intermediate CDR is held constant for 36 months and then trails off in steps to a final CDR of 5% of the CDR plateau. In the base case, the Company assumes the final CDR will be reached 6.75 years after the initial 36-month CDR plateau period. Under the Company’s methodology, defaults projected to occur in the first 36 months represent defaults that can be attributed to loans that were modified or delinquent in the last 12 months or that are currently delinquent or in foreclosure, while the defaults projected to occur using the projected CDR trend after the first 36 month period represent defaults attributable to borrowers that are currently performing or are projected to reperform.

Another important driver of loss projections is loss severity, which is the amount of loss the transaction incurs on a loan after the application of net proceeds from the disposal of the underlying property. Loss severities experienced in first lien transactions have reached historically high levels, and the Company is assuming in the base case that these high levels generally will continue for another 18 months. The Company determines its initial loss severity based on actual recent experience. As a result, as of March 31, 2016, the Company updated severities for specific vintages of Alt-A first lien and subprime transactions based on observed data and as of June 30, 2016 the Company updated severities again for certain vintages of Alt-A, as well as Option ARM. The Company then assumes that loss severities begin returning to levels consistent with underwriting assumptions beginning after the initial 18 month period, declining to 40% in the base case over 2.5 years.

The following table shows the range as well as the average, weighted by outstanding net insured par, for key assumptions used in the calculation of expected loss to be paid for individual transactions for direct vintage 2004 - 2008 first lien U.S. RMBS.

35

Key Assumptions in Base Case Expected Loss Estimates
First Lien RMBS (1)

 
As of
September 30, 2016
 
As of
June 30, 2016
 
As of
December 31, 2015
 
Range
 
Weighted Average
 
Range
 
Weighted Average
 
Range
 
Weighted Average
Alt-A First Lien
 
 
 
 
 
 
 
 
 
 
 
Plateau CDR
0.1% - 20.8%
 
5.9%
 
0.9% - 27.0%
 
5.9%
 
1.7% - 26.4%
 
5.8%
Intermediate CDR
0.0% - 4.2%
 
1.2%
 
0.2% - 5.4%
 
1.2%
 
0.3% - 5.3%
 
1.2%
Period until intermediate CDR
48 months
 
 
 
48 months
 
 
 
48 months
 
 
Final CDR
0.0% - 1.0%
 
0.3%
 
0.0% - 1.3%
 
0.3%
 
0.1% - 1.3%
 
0.3%
Initial loss severity:
 
 
 
 
 
 
 
 
 
 
 
2005 and prior
60.0%
 
 
 
60.0%
 
 
 
60.0%
 
 
2006
80.0%
 
 
 
80.0%
 
 
 
70.0%
 
 
2007
70.0%
 
 
 
70.0%
 
 
 
65.0%
 
 
Initial conditional prepayment rate ("CPR")
6.1% - 26.6%
 
10.7%
 
5.2% - 29.3%
 
11.0%
 
4.6% - 32.5%
 
11.5%
Final CPR (2)
15.0%
 
 
 
15%
 
 
 
15%
 
 
Option ARM
 
 
 
 
 
 
 
 
 
 
 
Plateau CDR
3.7% - 8.0%
 
6.8%
 
4.1% - 7.9%
 
6.8%
 
4.8% - 9.3%
 
7.5%
Intermediate CDR
0.7% - 1.6%
 
1.4%
 
0.8% - 1.6%
 
1.4%
 
1.0% - 1.9%
 
1.5%
Period until intermediate CDR
48 months
 
 
 
48 months
 
 
 
48 months
 
 
Final CDR
0.2% - 0.4%
 
0.3%
 
0.2% - 0.4%
 
0.3%
 
0.2% - 0.5%
 
0.4%
Initial loss severity:
 
 
 
 
 
 
 
 
 
 
 
2005 and prior
60.0%
 
 
 
60.0%
 
 
 
60.0%
 
 
2006
70.0%
 
 
 
70.0%
 
 
 
70.0%
 
 
2007
75.0%
 
 
 
75.0%
 
 
 
65.0%
 
 
Initial CPR
4.2% - 14.4%
 
6.8%
 
3.5% - 13.2%
 
5.7%
 
3.0% - 10.9%
 
5.1%
Final CPR (2)
15.0%
 
 
 
15%
 
 
 
15%
 
 
Subprime
 
 
 
 
 
 
 
 
 
 
 
Plateau CDR
4.5% - 12.8%
 
7.7%
 
4.4% - 12.7%
 
7.9%
 
4.7% - 12.7%
 
8.2%
Intermediate CDR
0.9% - 2.6%
 
1.5%
 
0.9% - 2.5%
 
1.6%
 
0.9% - 2.5%
 
1.6%
Period until intermediate CDR
48 months
 
 
 
48 months
 
 
 
48 months
 
 
Final CDR
0.2% - 0.6%
 
0.4%
 
0.2% - 0.6%
 
0.4%
 
0.2% - 0.6%
 
0.4%
Initial loss severity:
 
 
 
 
 
 
 
 
 
 
 
2005 and prior
80.0%
 
 
 
80.0%
 
 
 
75.0%
 
 
2006
90.0%
 
 
 
90.0%
 
 
 
90.0%
 
 
2007
90.0%
 
 
 
90.0%
 
 
 
90.0%
 
 
Initial CPR
1.8% - 12.1%
 
5.2%
 
2.3% - 11.3%
 
4.9%
 
0.0% - 10.1%
 
3.6%
Final CPR (2)
15%
 
 
 
15%
 
 
 
15%
 
 
____________________
(1)
Represents variables for most heavily weighted scenario (the “base case”).

(2)
For transactions where the initial CPR is higher than the final CPR, the initial CPR is held constant and the final CPR is not used.


36

 The rate at which the principal amount of loans is voluntarily prepaid may impact both the amount of losses projected (since that amount is a function of the CDR, the loss severity and the loan balance over time) as well as the amount of excess spread (the amount by which the interest paid by the borrowers on the underlying loan exceeds the amount of interest owed on the insured obligations). The assumption for the voluntary CPR follows a similar pattern to that of the CDR. The current level of voluntary prepayments is assumed to continue for the plateau period before gradually increasing over 12 months to the final CPR, which is assumed to be 15% in the base case. For transactions where the initial CPR is higher than the final CPR, the initial CPR is held constant and the final CPR is not used. These CPR assumptions are the same as those the Company used for June 30, 2016 and December 31, 2015.

In estimating expected losses, the Company modeled and probability weighted sensitivities for first lien transactions by varying its assumptions of how fast a recovery is expected to occur. One of the variables used to model sensitivities was how quickly the CDR returned to its modeled equilibrium, which was defined as 5% of the initial CDR. The Company also stressed CPR and the speed of recovery of loss severity rates. The Company probability weighted a total of five scenarios as of September 30, 2016. The Company used a similar approach to establish its pessimistic and optimistic scenarios as of September 30, 2016 as it used as of June 30, 2016 and December 31, 2015, increasing and decreasing the periods of stress from those used in the base case.

In a somewhat more stressful environment than that of the base case, where the CDR plateau was extended six months (to be 42 months long) before the same more gradual CDR recovery and loss severities were assumed to recover over 4.5 rather than 2.5 years (and subprime loss severities were assumed to recover only to 60% and Option ARM and Alt A loss severities to only 45%), expected loss to be paid would increase from current projections by approximately $2 million for Alt-A first liens, $0.1 million for Option ARM, $5 million for subprime and $0.1 million for prime transactions.

In an even more stressful scenario where loss severities were assumed to rise and then recover over nine years and the initial ramp-down of the CDR was assumed to occur over 15 months and other assumptions were the same as the other stress scenario, expected loss to be paid would increase from current projections by approximately $5 million for Alt-A first liens, $8 thousand for Option ARM, $7 million for subprime and $0.3 million for prime transactions.

In a scenario with a somewhat less stressful environment than the base case, where CDR recovery was somewhat less gradual, expected loss to be paid would increase from current projections by approximately $0.2 million for subprime and would decrease from current projections by approximately $1 million for Alt-A first liens, $3 million for Option ARM and $10 thousand for prime transactions.

In an even less stressful scenario where the CDR plateau was six months shorter (30 months, effectively assuming that liquidation rates would improve) and the CDR recovery was more pronounced, (including an initial ramp-down of the CDR over nine months), expected loss to be paid would decrease from current projections by approximately $3 million for Alt-A first liens, $4 million for Option ARM, $2 million for subprime and $0.1 million for prime transactions.

U.S. Second Lien RMBS Loss Projections

Second lien RMBS transactions include both home equity lines of credit ("HELOC") and closed end second lien. The Company believes the primary variable affecting its expected losses in second lien RMBS transactions is the amount and timing of future losses in the collateral pool supporting the transactions. Expected losses are also a function of the structure of the transaction; the voluntary prepayment rate (typically also referred to as CPR of the collateral); the interest rate environment; and assumptions about the draw rate and loss severity.
    
In second lien transactions the projection of near-term defaults from currently delinquent loans is relatively straightforward because loans in second lien transactions are generally “charged off” (treated as defaulted) by the securitization’s servicer once the loan is 180 days past due. The Company estimates the amount of loans that will default over the next six months by calculating current representative liquidation rates. A liquidation rate is the percent of loans in a given cohort (in this instance, delinquency category) that ultimately default. Similar to first liens, the Company then calculates a CDR for six months, which is the period over which the currently delinquent collateral is expected to be liquidated. That CDR is then used as the basis for the plateau CDR period that follows the embedded five months of losses. Liquidation rates assumed as of September 30, 2016 were from 25% to 100%, which were the same as of June 30, 2016 and December 31, 2015.

37

For the base case scenario, the CDR (the “plateau CDR”) was held constant for six months. Once the plateau period has ended, the CDR is assumed to gradually trend down in uniform increments to its final long-term steady state CDR. (The long-term steady state CDR is calculated as the constant CDR that would have yielded the amount of losses originally expected at underwriting.) In the base case scenario, the time over which the CDR trends down to its final CDR is 28 months. Therefore, the total stress period for second lien transactions is 34 months, comprising five months of delinquent data, a one month plateau period and 28 months of decrease to the steady state CDR, the same as of June 30, 2016 and December 31, 2015.

HELOC loans generally permit the borrower to pay only interest for an initial period (often ten years) and, after that period, require the borrower to make both the monthly interest payment and a monthly principal payment, and so increase the borrower's aggregate monthly payment. Some of the HELOC loans underlying the Company's insured HELOC transactions have reached their principal amortization period. The Company has observed that the increase in monthly payments occurring when a loan reaches its principal amortization period, even if mitigated by borrower relief offered by the servicer, is associated with increased borrower defaults. Thus, most of the Company's HELOC projections incorporate an assumption that a percentage of loans reaching their amortization periods will default around the time of the payment increase. These projected defaults are in addition to those generated using the CDR curve as described above. This assumption is similar to the one used as of June 30, 2016 and December 31, 2015. For September 30, 2016 the Company used the same general approach as of June 30, 2016 and December 31, 2015.

When a second lien loan defaults, there is generally a very low recovery. The Company had assumed as of September 30, 2016 that it will generally recover only 2% of the collateral defaulting in the future and declining additional amounts of post-default receipts on previously defaulted collateral. This is the same assumption used as of June 30, 2016 and December 31, 2015.

The rate at which the principal amount of loans is prepaid may impact both the amount of losses projected as well as the amount of excess spread. In the base case, an average CPR (based on experience of the past year) is assumed to continue until the end of the plateau before gradually increasing to the final CPR over the same period the CDR decreases. The final CPR is assumed to be 15% for second lien transactions, which is lower than the historical average but reflects the Company’s continued uncertainty about the projected performance of the borrowers in these transactions. For transactions where the initial CPR is higher than the final CPR, the initial CPR is held constant and the final CPR is not used. This pattern is generally consistent with how the Company modeled the CPR as of June 30, 2016 and December 31, 2015. To the extent that prepayments differ from projected levels it could materially change the Company’s projected excess spread and losses.

The Company uses a number of other variables in its second lien loss projections, including the spread between relevant interest rate indices. These variables have been relatively stable and in the relevant ranges have less impact on the projection results than the variables discussed above. However, in a number of HELOC transactions the servicers have been modifying poorly performing loans from floating to fixed rates, and, as a result, rising interest rates would negatively impact the excess spread available from these modified loans to support the transactions.  The Company incorporated these modifications in its assumptions.

In estimating expected losses, the Company modeled and probability weighted five possible CDR curves applicable to the period preceding the return to the long-term steady state CDR. The Company used five scenarios at September 30, 2016 and December 31, 2015. The Company believes that the level of the elevated CDR and the length of time it will persist, the ultimate prepayment rate, and the amount of additional defaults because of the expiry of the interest only period, are the primary drivers behind the likely amount of losses the collateral will suffer. The Company continues to evaluate the assumptions affecting its modeling results.


38

Most of the Company's projected second lien RMBS losses are from HELOC transactions. The following table shows the range as well as the average, weighted by outstanding net insured par, for key assumptions for the calculation of expected loss to be paid for individual transactions for direct vintage 2004-2008 HELOCs.

Key Assumptions in Base Case Expected Loss Estimates
HELOCs (1)

 
As of
September 30, 2016
 
As of
June 30, 2016
 
As of
December 31, 2015
 
Range
 
Weighted Average
 
Range
 
Weighted Average
 
Range
 
Weighted Average
Plateau CDR
7.1% - 17.5%
 
13.5%
 
8.1% - 17.0%
 
12.6%
 
7.0% - 13.0%
 
7.6%
Final CDR trended down to
0.5% - 2.5%
 
1.4%
 
0.5% - 2.2%
 
1.4%
 
0.5% - 2.2%
 
1.3%
Period until final CDR
34 months
 
 
 
34 months
 
 
 
34 months
 
 
Initial CPR
11.6% - 15.1%
 
13.6%
 
11.0%
 
 
 
10.9%
 
 
Final CPR(2)
15.0% - 15.1%
 
15.0%
 
10.0% - 15.0%
 
13.3%
 
10.0% - 15.0%
 
13.3%
Loss severity
98.0%
 
 
 
98.0%
 
 
 
98.0%
 
 
___________________
(1)
Represents variables for most heavily weighted scenario (the “base case”).

(2)
For transactions where the initial CPR is higher than the final CPR, the initial CPR is held constant and the final CPR is not used.

The Company’s base case assumed a six month CDR plateau and a 28 month ramp-down (for a total stress period of 34 months). The Company also modeled a scenario with a longer period of elevated defaults and another with a shorter period of elevated defaults. Increasing the CDR plateau to eight months and increasing the ramp-down by three months to 31 months (for a total stress period of 39 months), and doubling the defaults relating to the end of the interest only period would increase the expected loss by approximately $9 million for HELOC transactions. On the other hand, reducing the CDR plateau to four months and decreasing the length of the CDR ramp-down to 25 months (for a total stress period of 29 months), and lowering the ultimate prepayment rate to 10% would decrease the expected loss by approximately $3 million for HELOC transactions.

Breaches of Representations and Warranties

The Company entered into agreements with R&W providers under which those providers made payments to the Company, agreed to make payments to the Company in the future, and / or repurchased loans from the transactions, all in return for releases of related liability by the Company.

As of September 30, 2016, the Company had a net R&W recoverable of $32 million to R&W counterparties, compared to an R&W recoverable of $13 million as of December 31, 2015. The increase was primarily due to the addition of R&W recoverable related to RMBS insured by CIFG and still being pursued by the Company, partially offset by the improvements in underlying collateral performance. The Company’s agreements with providers of R&W generally provide for reimbursement to the Company as claim payments are made and, to the extent the Company later receives reimbursements of such claims from excess spread or other sources, for the Company to provide reimbursement to the R&W providers. When the Company projects receiving more reimbursements in the future than it projects to pay in claims on transactions covered by R&W settlement agreements, the Company will have a net R&W payable. Most of the amount projected to be received pursuant to agreements with R&W providers benefits from eligible assets placed in trusts to collateralize the R&W provider’s future reimbursement obligation, with the amount of such collateral subject to increase or decrease from time to time as determined by rating agency requirements. Currently the Company has agreements with one counterparty where a future reimbursement obligation is collateralized by eligible assets held in trust:

•
Bank of America. Under Assured Guaranty's agreement with Bank of America Corporation and certain of its subsidiaries (“Bank of America”), Bank of America agreed to reimburse Assured Guaranty for 80% of claims on the first lien transactions covered by the agreement that Assured Guaranty pays in the future, until the aggregate lifetime collateral losses (not insurance losses or claims) on those transactions reach $6.6 billion. As of September 30, 2016 aggregate lifetime collateral losses on those transactions was $4.5 billion ($4.17 billion for AGM and $0.36 billion for AGC), and Assured Guaranty was projecting in its base case that such collateral losses would eventually reach $5.2 billion ($4.72 billion for AGM and $0.43 billion for AGC). Bank of America's reimbursement obligation is secured by

39

$80 million of collateral held in trust for the Company's benefit and $370 million of collateral held in trust that is available for either AGC or AGM.

Under Assured Guaranty's previous agreement with Deutsche Bank AG and certain of its affiliates (collectively, “Deutsche Bank”), Deutsche Bank agreed to reimburse Assured Guaranty for certain claims it pays in the future on eight first and second lien transactions, including 80% of claims it pays on those transactions until the aggregate lifetime claims (before reimbursement) reach $319 million. In May 2016, Deutsche Bank's reimbursement obligations under the May 2012 agreement were terminated in return for a cash payment to Assured Guaranty.

The Company uses the same RMBS projection scenarios and weightings to project its future R&W benefit as it uses to project RMBS losses on its portfolio. To the extent the Company increases its loss projections, the R&W benefit generally will also increase, subject to the agreement limits and thresholds described above. Similarly, to the extent the Company decreases its loss projections, the R&W benefit generally will also decrease, subject to the agreement limits and thresholds described above.

Triple-X Life Insurance Transactions
 
The Company had $556 million of net par exposure to financial guaranty Triple-X life insurance transactions as of September 30, 2016. Two of these transactions, with $149 million of net par outstanding, are rated BIG. The Triple-X life insurance transactions are based on discrete blocks of individual life insurance business. In older vintage Triple-X life insurance transactions, which include the two BIG-rated transactions, the amounts raised by the sale of the notes insured by the Company were used to capitalize a special purpose vehicle that provides reinsurance to a life insurer or reinsurer. The amounts are invested at inception in accounts managed by third-party investment managers. In the case of the two BIG-rated transactions, material amounts of their assets were invested in U.S. RMBS. Based on its analysis of the information currently available, including estimates of future investment performance, and projected credit impairments on the invested assets and performance of the blocks of life insurance business at September 30, 2016, the Company’s projected net expected loss to be recovered is $56 million. The economic benefit during Third Quarter 2016 was approximately $22 million, which was due primarily to a benefit resulting from the purchase of a portion of an insured obligation to mitigate loss, changes in interest rates and updates to the projected asset cash flows. The economic benefit during Nine Months 2016 was approximately $21 million, which was due primarily to benefit resulting from a purchase of a portion of an insured obligation to mitigate loss, changes in discount rates and updates to the projected life insurance cash flows.

TruPS and other structured finance

The Company's TruPS sector has BIG par of $435 million and all other structured finance BIG par totaled $182 million, comprising primarily transactions backed by perpetual preferred securities, commercial receivables and manufactured housing loans. The Company has expected loss to be recovered of $12 million for TruPS and other structured finance transactions as of September 30, 2016. The economic loss development during Third Quarter 2016 was $1 million, which was attributable primarily to reduction in expected salvage value for a CDS transaction. The economic loss development during Nine Months 2016 was $3 million, which was attributable primarily to a new BIG transaction in the first quarter.

Recovery Litigation
 
Public Finance Transactions

On January 7, 2016, AGC, AGM and Ambac Assurance Corporation (“Ambac”) commenced an action for declaratory judgment and injunctive relief in the U.S. District Court for the District of Puerto Rico to invalidate the executive orders issued by the Governor on November 30, 2015 and December 8, 2015 directing that the Secretary of the Treasury of the Commonwealth of Puerto Rico and the Puerto Rico Tourism Company retain or transfer (in other words, "claw back") certain taxes and revenues pledged to secure the payment of bonds issued by the PRHTA, the PRCCDA and the PRIFA. The Commonwealth defendants filed a motion to dismiss the action for lack of subject matter jurisdiction, which the Court denied on October 4, 2016. On October 14, 2016, the Commonwealth defendants filed a notice of PROMESA automatic stay.

On July 21, 2016, AGC and AGM filed a motion and form of complaint in the U.S. District Court for the District of Puerto Rico seeking relief from the stay provided by PROMESA. Upon a grant of relief from the PROMESA stay, the lawsuit further seeks a declaration that the Moratorium Act is preempted by Federal bankruptcy law and that certain gubernatorial executive orders diverting PRHTA pledged toll revenues (which are not subject to the Clawback) are preempted by PROMESA and violate the U.S. Constitution. Additionally, it seeks damages for the value of the PRHTA toll revenues diverted and injunctive relief prohibiting the defendants from taking any further action under these executive orders. On October 28, 2016, the Oversight Board filed a motion seeking leave to intervene in the action, which motion was denied on November 1, 2016,

40

without prejudice, on procedural grounds. On November 2, 2016, the Court denied AGC’s and AGM’s motion for relief from the PROMESA stay on procedural grounds. The PROMESA stay expires on February 15, 2017.

On November 1, 2013, Radian Asset commenced a declaratory judgment action in the U.S. District Court for the Southern District of Mississippi against Madison County, Mississippi and the Parkway East Public Improvement District to establish its rights under a contribution agreement from the County supporting certain special assessment bonds issued by the District and insured by Radian Asset (now AGC). As of September 30, 2016, $20 million of such bonds were outstanding. The County maintained that its payment obligation is limited to two years of annual debt service, while AGC contended the County’s obligations under the contribution agreement continue so long as the bonds remain outstanding. On April 27, 2016, the Court granted AGC's motion for summary judgment, agreeing with AGC's interpretation of the County's obligations. On May 11, 2016, the County filed a notice of appeal of that ruling to the United States Court of Appeals for the Fifth Circuit.

Triple-X Life Insurance Transactions
 
In December 2008 AGUK filed an action in the Supreme Court of the State of New York against J.P. Morgan Investment Management Inc. (“JPMIM”), the investment manager for a triple-X life insurance transaction, Orkney Re II plc ("Orkney"), involving securities guaranteed by AGUK. The action alleges that JPMIM engaged in breaches of fiduciary duty, gross negligence and breaches of contract based upon its handling of the Orkney investments. After AGUK’s claims were dismissed with prejudice in January 2010, AGUK was successful in its subsequent motions and appeals and, as of December 2011, all of AGUK’s claims for breaches of fiduciary duty, gross negligence and contract were reinstated in full. On January 22, 2016, AGUK filed a motion for partial summary judgment with respect to one of its claims for breach of contract relating to a failure to invest in compliance with the Delaware insurance code. Discovery was completed on February 22, 2016, and oral argument on the motion for partial summary judgment took place on August 16, 2016. A trial date has been tentatively set for mid-March 2017.

RMBS Transactions

On February 5, 2009, U.S. Bank National Association, as indenture trustee ("U.S. Bank”), CIFG, as insurer of the Class Ac Notes, and Syncora Guarantee Inc. ("Syncora"), as insurer of the Class Ax Notes, filed a complaint in the Supreme Court of the State of New York against GreenPoint Mortgage Funding, Inc. ("GreenPoint") alleging GreenPoint breached its representations and warranties with respect to the underlying mortgage loans in the GreenPoint Mortgage Funding Trust 2006-HE1 transaction.  On March 3, 2010, the court dismissed CIFG's and Syncora’s causes of action on standing grounds. On December 16, 2013, GreenPoint moved to dismiss the remaining claims of U.S. Bank on the grounds that it too lacked standing. U.S. Bank cross-moved for partial summary judgment striking GreenPoint’s defense that U.S. Bank lacked standing to directly pursue claims against GreenPoint. On January 28, 2016, the court denied GreenPoint’s motion for summary judgment and granted U.S. Bank’s cross-motion for partial summary judgment, finding that as a matter of law U.S. Bank has standing to directly assert claims against GreenPoint.  On November 28, 2016, Greenpoint filed an appeal.

On November 26, 2012, CIFG filed a complaint in the Supreme Court of the State of New York against JP Morgan Securities LLC ("JP Morgan") for material misrepresentation in the inducement of insurance and common law fraud, alleging that JP Morgan fraudulently induced CIFG to insure $400 million of securities issued by ACA ABS CDO 2006-2 Ltd. and $325 million of securities issued by Libertas Preferred Funding II, Ltd. On June 26, 2015, the Court dismissed with prejudice CIFG’s material misrepresentation in the inducement of insurance claim and dismissed without prejudice CIFG’s common law fraud claim. On September 24, 2015, the Court denied CIFG’s motion to amend but allowed CIFG to re-plead a cause of action for common law fraud. On November 20, 2015, CIFG filed a motion for leave to amend its complaint to re-plead common law fraud. On April 29, 2016, CIFG filed an appeal to reverse the Court’s decision dismissing CIFG’s material misrepresentation in the inducement of insurance claim. On November 29, 2016, the Appellate Division of the Supreme Court of the State of New York ruled that the Court’s decision dismissing with prejudice CIFG’s material misrepresentation in the inducement of insurance claim should be modified to grant CIFG leave to replead such claim.

On January 15, 2013, CIFG filed a complaint in the Supreme Court of the State of New York against Goldman, Sachs & Co. ("Goldman") for material misrepresentation in the inducement of insurance and common law fraud, alleging that Goldman fraudulently induced CIFG to insure $325 million of Class A-1 Notes (the “Class A-1 Notes”) and to purchase $10 million of Class A-2 Notes (the “Class A-2 Notes”) issued by Fortius II Funding, Ltd. CDO. CIFG and Goldman agreed to separately arbitrate the issue of liability with respect to CIFG’s purchase of the Class A-2 Notes, and on February 4, 2015, an arbitration panel awarded CIFG $2.5 million in damages. On September 11, 2015, CIFG filed an amended complaint to allege that the arbitration award collaterally estopped Goldman from disputing its liability for fraudulent inducement in respect of the Class A-1 Notes. On October 20, 2016, AGC (as successor to CIFG) and Goldman reached a settlement of the action.


41

6.
Financial Guaranty Insurance

Financial Guaranty Insurance Premiums

The portfolio of outstanding exposures discussed in Note 4, Outstanding Exposure, includes financial guaranty contracts that meet the definition of insurance contracts as well as those that meet the definition of a derivative under GAAP. Amounts presented in this note relate to financial guaranty insurance contracts, unless otherwise noted. See Note 8, Financial Guaranty Contracts Accounted for as Credit Derivatives for amounts that relate to CDS and Note 9, Consolidated Variable Interest Entities for amounts that relate to FG VIEs.

Net Earned Premiums

 
Third Quarter
 
Nine Months
 
2016
 
2015
 
2016
 
2015
 
(in millions)
Scheduled net earned premiums
$
34

 
$
30

 
$
86

 
$
79

Accelerations
 
 
 
 
 
 
 
Refundings
52

 
27

 
96

 
68

Terminations
3

 
4

 
7

 
4

Total Accelerations
55

 
31

 
103

 
72

Accretion of discount on net premiums receivable
1

 
0

 
3

 
2

Net earned premiums(1)
$
90

 
$
61

 
$
192

 
$
153

___________________
(1)
Excludes $0.4 million and $0.6 million for Third Quarter 2016 and 2015, respectively, and $0.4 million and $1.5 million for Nine Months 2016 and 2015, respectively, related to consolidated FG VIEs.


Components of
Unearned Premium Reserve
 
 
As of September 30, 2016
 
As of December 31, 2015
 
Gross
 
Ceded
 
Net(1)
 
Gross
 
Ceded
 
Net(1)
 
(in millions)
Deferred premium revenue
$
1,329

 
$
334

 
$
995

 
$
1,305

 
$
420

 
$
885

Contra-paid (2)
(9
)
 
0

 
(9
)
 
(4
)
 
—

 
(4
)
Unearned premium reserve
$
1,320

 
$
334

 
$
986

 
$
1,301

 
$
420

 
$
881

 ____________________
(1)
Excludes $8 million and $13 million of deferred premium revenue related to FG VIEs as of September 30, 2016 and December 31, 2015, respectively.

(2)
See "Financial Guaranty Insurance Losses – Insurance Contracts' Loss Information" below for an explanation of "contra-paid".



42

Gross Premium Receivable,
Net of Commissions on Assumed Business
Roll Forward
 
Nine Months
 
2016
 
2015
 
(in millions)
Beginning of period, December 31
$
222

 
$
214

Premiums receivable from acquisitions (see Note 2)
18

 
15

Gross written premiums on new business, net of commissions on assumed business
1

 
24

Gross premiums received, net of commissions on assumed business
(24
)
 
(22
)
Adjustments:
 
 
 
Changes in the expected term
(2
)
 
(4
)
Accretion of discount, net of commissions on assumed business
4

 
4

Foreign exchange translation
(1
)
 
(1
)
End of period, September 30 (1)
$
218

 
$
230

___________________
(1)
Excludes $6 million and $14 million as of September 30, 2016 and September 30, 2015, respectively, related to consolidated FG VIEs.

Foreign exchange translation relates to installment premium receivables denominated in currencies other than the U.S. dollar. Approximately 10%, 11% and 13% of installment premiums at September 30, 2016, December 31, 2015 and September 30, 2015, respectively, are denominated in currencies other than the U.S. dollar, primarily the Euro and British Pound Sterling.

The timing and cumulative amount of actual collections may differ from expected collections in the tables below due to factors such as foreign exchange rate fluctuations, counterparty collectability issues, accelerations, commutations and changes in expected lives.

Expected Collections of
Financial Guaranty Insurance Gross Premiums Receivable,
Net of Commissions on Assumed Business
(Undiscounted)

 
As of
September 30, 2016
 
(in millions)
2016 (October 1 – December 31)
$
7

2017
27

2018
23

2019
21

2020
21

2021-2025
82

2026-2030
40

2031-2035
27

After 2035
15

Total(1)
$
263

___________________
(1)
Excludes expected cash collections on FG VIEs of $8 million.



43

Scheduled Financial Guaranty Insurance Net Earned Premiums
 
 
As of
September 30, 2016
 
(in millions)
2016 (October 1 – December 31)
$
31

2017
110

2018
95

2019
85

2020
76

2021-2025
283

2026-2030
171

2031-2035
95

After 2035
49

Net deferred premium revenue(1)
995

Future accretion
31

Total future net earned premiums
$
1,026

____________________
(1)
Excludes scheduled net earned premiums on consolidated FG VIEs of $8 million.


Selected Information for Financial Guaranty Insurance
Policies Paid in Installments

 
As of
September 30, 2016
 
As of
December 31, 2015
 
(dollars in millions)
Premiums receivable, net of commission payable
$
218

 
$
222

Gross deferred premium revenue
277

 
249

Weighted-average risk-free rate used to discount premiums
2.8
%
 
3.0
%
Weighted-average period of premiums receivable (in years)
7.7

 
7.6



44

Financial Guaranty Insurance Losses

Insurance Contracts' Loss Information

The following table provides information on loss and LAE reserves and salvage and subrogation recoverable, net of reinsurance. The Company used weighted average risk-free rates for U.S. dollar denominated financial guaranty insurance obligations that ranged from 0.0% to 2.42% as of September 30, 2016 and 0.0% to 3.25% as of December 31, 2015.

Loss and LAE Reserve
and Salvage and Subrogation Recoverable
Net of Reinsurance
Insurance Contracts

 
As of September 30, 2016
 
As of December 31, 2015
 
Loss and
LAE
Reserve, net
 
Salvage and
Subrogation
Recoverable, net 
 
Net Reserve (Recoverable)
 
Loss and
LAE
Reserve, net
 
Salvage and
Subrogation
Recoverable, net 
 
Net Reserve (Recoverable)
 
(in millions)
Public Finance:
 
 
 
 
 
 
 
 
 
 
 
U.S. public finance
$
222

 
$
61

 
$
161

 
$
231

 
$
7

 
$
224

Non-U.S. public finance
2

 
—

 
2

 
2

 
—

 
2

Public Finance
224

 
61

 
163

 
233

 
7

 
226

Structured Finance:
 
 
 
 
 
 
 
 
 
 
 
U.S. RMBS:
 
 
 
 
 
 
 
 
 
 
 
First lien:
 
 
 
 
 
 
 
 
 
 
 
Prime first lien
2

 
—

 
2

 
1

 
—

 
1

Alt-A first lien
15

 
33

 
(18
)
 
26

 
—

 
26

Option ARM
2

 
5

 
(3
)
 
5

 
1

 
4

Subprime
3

 
6

 
(3
)
 
2

 
6

 
(4
)
First lien
22

 
44

 
(22
)
 
34

 
7

 
27

Second lien
23

 
23

 
0

 
9

 
2

 
7

Total U.S. RMBS
45

 
67

 
(22
)
 
43

 
9

 
34

Triple-X life insurance transactions
(66
)
 
—

 
(66
)
 
(25
)
 
—

 
(25
)
Other structured finance
11

 
—

 
11

 
27

 
1

 
26

Structured Finance
(10
)
 
67

 
(77
)
 
45

 
10

 
35

Subtotal
214

 
128

 
86

 
278

 
17

 
261

Other recoverables
—

 
5

 
(5
)
 
—

 
3

 
(3
)
Subtotal
214

 
133

 
81

 
278

 
20

 
258

Effect of consolidating
FG VIEs
(9
)
 
—

 
(9
)
 
(2
)
 
0

 
(2
)
Total(1)
$
205

 
$
133

 
$
72

 
$
276

 
$
20

 
$
256

 ___________________
(1)
See “Components of Net Reserves (Salvage)” table for loss and LAE reserve and salvage and subrogation recoverable components.



45

Components of Net Reserves (Salvage)

 
As of
September 30, 2016
 
As of
December 31, 2015
 
(in millions)
Loss and LAE reserve
$
500

 
$
589

Reinsurance recoverable on unpaid losses
(295
)
 
(313
)
Loss and LAE reserve, net
205

 
276

Salvage and subrogation recoverable
(147
)
 
(18
)
Salvage and subrogation payable(1)
19

 
1

Other recoverables
(5
)
 
(3
)
Salvage and subrogation recoverable, net and other recoverable
(133
)
 
(20
)
Net reserves (salvage)
$
72

 
$
256

___________________
(1)
Recorded as a component of reinsurance balances payable.

The table below provides a reconciliation of net expected loss to be paid to net expected loss to be expensed. Expected loss to be paid differs from expected loss to be expensed due to: (i) the contra-paid which represent the claim payments made and recoveries received that have not yet been recognized in the statement of operations, (ii) salvage and subrogation recoverable for transactions that are in a net recovery position where the Company has not yet received recoveries on claims previously paid (having the effect of reducing net expected loss to be paid by the amount of the previously paid claim and the expected recovery), but will have no future income effect (because the previously paid claims and the corresponding recovery of those claims will offset in income in future periods), and (iii) loss reserves that have already been established (and therefore expensed but not yet paid).

Reconciliation of Net Expected Loss to be Paid and
Net Expected Loss to be Expensed
Financial Guaranty Insurance Contracts

 
As of September 30, 2016
 
(in millions)
Net expected loss to be paid - financial guaranty insurance (1)
$
321

Contra-paid, net
9

Salvage and subrogation recoverable, net of reinsurance
128

Loss and LAE reserve - financial guaranty insurance contracts, net of reinsurance
(204
)
Other recoveries
5

Net expected loss to be expensed (present value) (2)
$
259

___________________
(1)
See "Net Expected Loss to be Paid (Recovered) by Accounting Model" table in Note 5, Expected Loss to be Paid.

(2)
Excludes $5 million as of September 30, 2016, related to consolidated FG VIEs.


46

The following table provides a schedule of the expected timing of net expected losses to be expensed. The amount and timing of actual loss and LAE may differ from the estimates shown below due to factors such as accelerations, commutations, changes in expected lives and updates to loss estimates. This table excludes amounts related to FG VIEs, which are eliminated in consolidation.

Net Expected Loss to be Expensed
Financial Guaranty Insurance Contracts

 
 
As of September 30, 2016
 
(in millions)
2016 (October 1 – December 31)
$
2

Subtotal 2016
2

2017
12

2018
13

2019
16

2020
16

2021-2025
76

2026-2030
71

2031-2035
39

After 2035
14

Net expected loss to be expensed
259

Future accretion
56

Total expected future loss and LAE
$
315

 



47

The following table presents the loss and LAE recorded in the consolidated statements of operations by sector for insurance contracts. Amounts presented are net of reinsurance.

Loss and LAE
Reported on the
Consolidated Statements of Operations

 
Third Quarter
 
Nine Months
 
2016
 
2015
 
2016
 
2015
 
(in millions)
Public Finance:
 
 
 
 
 
 
 
U.S. public finance
$
(1
)
 
$
47

 
$
56

 
$
122

Non-U.S. public finance
—

 
0

 
0

 
0

Public finance
(1
)
 
47

 
56

 
122

Structured Finance:
 
 
 
 
 
 
 
U.S. RMBS:
 
 
 
 
 
 
 
First lien:
 
 
 
 
 
 
 
Prime first lien
0

 
0

 
0

 
0

Alt-A first lien
0

 
(4
)
 
10

 
(6
)
Option ARM
0

 
(1
)
 
(3
)
 
(2
)
Subprime
0

 
0

 
1

 
1

First lien
0

 
(5
)
 
8

 
(7
)
Second lien
1

 
3

 
4

 
4

Total U.S. RMBS
1

 
(2
)
 
12

 
(3
)
Triple-X life insurance transactions
(20
)
 
3

 
(19
)
 
2

Other structured finance
(1
)
 
0

 
(1
)
 
(1
)
Structured finance
(20
)
 
1

 
(8
)
 
(2
)
Loss and LAE on insurance contracts before FG VIE consolidation
(21
)
 
48

 
48

 
120

Effect of consolidating FG VIEs
1

 
0

 
0

 
0

Loss and LAE
$
(20
)
 
$
48

 
$
48

 
$
120








48

The following table provides information on financial guaranty insurance contracts categorized as BIG.

Financial Guaranty Insurance BIG Transaction Loss Summary
As of September 30, 2016

 
 
BIG Categories
 
 
BIG 1
 
BIG 2
 
BIG 3
 
Total BIG, Net
 
Effect of
Consolidating FG VIEs
 
Total
 
 
Gross
 
Ceded
 
Gross
 
Ceded
 
Gross
 
Ceded
 
 
 
 
 
(dollars in millions)
Number of risks(1)
 
151

 
(31
)
 
62

 
(13
)
 
103

 
(26
)
 
316

 
—

 
316

Remaining weighted-average contract period (in years)
 
9.3

 
9.6

 
15.6

 
17.1

 
8.7

 
11.0

 
11.2

 
—

 
11.2

Outstanding exposure:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

Principal
 
$
1,629

 
$
(243
)
 
$
2,072

 
$
(421
)
 
$
1,653

 
$
(539
)
 
$
4,151

 
—

 
$
4,151

Interest
 
748

 
(115
)
 
1,674

 
(369
)
 
405

 
(59
)
 
2,284

 
—

 
2,284

Total(2)
 
$
2,377

 
$
(358
)
 
$
3,746

 
$
(790
)
 
$
2,058

 
$
(598
)
 
$
6,435

 
$
—

 
$
6,435

Expected cash outflows (inflows)
 
$
89

 
$
(8
)
 
$
615

 
$
(122
)
 
$
449

 
$
(343
)
 
$
680

 
$
(55
)
 
$
625

Potential recoveries
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Undiscounted R&W
 
—

 
—

 
(2
)
 
1

 
(24
)
 
1

 
(24
)
 
—

 
(24
)
Other (3)
 
(193
)
 
28

 
(31
)
 
1

 
(76
)
 
10

 
(261
)
 
37

 
(224
)
Total potential recoveries
 
(193
)
 
28

 
(33
)
 
2

 
(100
)
 
11

 
(285
)
 
37

 
(248
)
Subtotal
 
(104
)
 
20

 
582

 
(120
)
 
349

 
(332
)
 
395

 
(18
)
 
377

Discount
 
23

 
(5
)
 
(127
)
 
29

 
(92
)
 
112

 
(60
)
 
4

 
(56
)
Present value of
expected cash flows
 
$
(81
)
 
$
15

 
$
455

 
$
(91
)
 
$
257

 
$
(220
)
 
$
335

 
$
(14
)
 
$
321

Deferred premium revenue
 
$
142

 
$
(1
)
 
$
241

 
$
(10
)
 
$
209

 
$
(10
)
 
$
571

 
$
(5
)
 
$
566

Reserves (salvage)
 
$
(118
)
 
$
17

 
$
303

 
$
(82
)
 
$
171

 
$
(211
)
 
$
80

 
$
(9
)
 
$
71



49

Financial Guaranty Insurance BIG Transaction Loss Summary
As of December 31, 2015

 
 
BIG Categories
 
 
BIG 1
 
BIG 2
 
BIG 3
 
Total BIG, Net
 
Effect of
Consolidating FG VIEs
 
Total
 
 
Gross
 
Ceded
 
Gross
 
Ceded
 
Gross
 
Ceded
 
 
 
 
 
(dollars in millions)
Number of risks(1)
 
170

 
(33
)
 
63

 
(13
)
 
99

 
(24
)
 
332

 
—

 
332

Remaining weighted-average contract period (in years)
 
9.1

 
8.2

 
17.0

 
17.7

 
10.6

 
13.7

 
11.4

 
—

 
11.4

Outstanding exposure:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Principal
 
$
3,052

 
$
(533
)
 
$
1,845

 
$
(491
)
 
$
1,034

 
$
(526
)
 
$
4,381

 
$
—

 
$
4,381

Interest
 
1,393

 
(215
)
 
1,666

 
(451
)
 
155

 
(42
)
 
2,506

 
—

 
2,506

Total(2)
 
$
4,445

 
$
(748
)
 
$
3,511

 
$
(942
)
 
$
1,189

 
$
(568
)
 
$
6,887

 
$
—

 
$
6,887

Expected cash outflows (inflows)
 
$
113

 
$
(14
)
 
$
601

 
$
(163
)
 
$
494

 
$
(380
)
 
$
651

 
$
(56
)
 
$
595

Potential recoveries
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Undiscounted R&W
 
0

 
—

 
(2
)
 
0

 
(10
)
 
2

 
(10
)
 
7

 
(3
)
Other (3)
 
(34
)
 
4

 
(36
)
 
7

 
(70
)
 
10

 
(119
)
 
37

 
(82
)
Total potential recoveries
 
(34
)
 
4

 
(38
)
 
7

 
(80
)
 
12

 
(129
)
 
44

 
(85
)
Subtotal
 
79

 
(10
)
 
563

 
(156
)
 
414

 
(368
)
 
522

 
(12
)
 
510

Discount
 
(10
)
 
1

 
(160
)
 
47

 
(155
)
 
153

 
(124
)
 
5

 
(119
)
Present value of
expected cash flows
 
$
69

 
$
(9
)
 
$
403

 
$
(109
)
 
$
259

 
$
(215
)
 
$
398

 
$
(7
)
 
$
391

Deferred premium revenue
 
$
280

 
$
(2
)
 
$
105

 
$
(10
)
 
$
49

 
$
(10
)
 
$
412

 
$
(8
)
 
$
404

Reserves (salvage)
 
$
9

 
$
(7
)
 
$
328

 
$
(100
)
 
$
219

 
$
(205
)
 
$
244

 
$
(2
)
 
$
242

___________________
(1)
A risk represents the aggregate of the financial guaranty policies that share the same revenue source for purposes of making debt service payments. The ceded number of risks represents the number of risks for which the Company ceded a portion of its exposure.

(2)
Includes BIG amounts related to FG VIEs.

(3)
Includes excess spread.

Ratings Impact on Financial Guaranty Business

A downgrade of AGC or AGUK may result in increased claims under financial guaranties issued by the Company if the insured obligors were unable to pay.

For example, with respect to variable rate demand obligations (“VRDOs”) for which a bank has agreed to provide a liquidity facility, a downgrade of AGC may provide the bank with the right to give notice to bondholders that the bank will terminate the liquidity facility, causing the bondholders to tender their bonds to the bank. Bonds held by the bank accrue interest at a “bank bond rate” that is higher than the rate otherwise borne by the bond (typically the prime rate plus 2.00% - 3.00%, and capped at the lesser of 25% and the maximum legal limit). In the event the bank holds such bonds for longer than a specified period of time, usually 90-180 days, the bank has the right to demand accelerated repayment of bond principal, usually through payment of equal installments over a period of not less than five years. In the event that a municipal obligor is unable to pay interest accruing at the bank bond rate or to pay principal during the shortened amortization period, a claim could be submitted to AGC under its financial guaranty policy. As of September 30, 2016, AGC had insured approximately $0.8 billion net par of VRDOs, of which approximately $0.1 billion of net par constituted VRDOs issued by municipal obligors rated BBB– or lower pursuant to the Company’s internal rating. The specific terms relating to the rating levels that trigger the bank’s

50

termination right, and whether it is triggered by a downgrade by one rating agency or a downgrade by all rating agencies then rating the insurer, vary depending on the transaction.

7.    Fair Value Measurement

The Company carries a significant portion of its assets and liabilities at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e., exit price). The price represents the price available in the principal market for the asset or liability. If there is no principal market, then the price is based on a hypothetical market that maximizes the value received for an asset or minimizes the amount paid for a liability (i.e., the most advantageous market).

Fair value is based on quoted market prices, where available. If listed prices or quotes are not available, fair value is based on either internally developed models that primarily use, as inputs, market-based or independently sourced market parameters, including but not limited to yield curves, interest rates and debt prices or with the assistance of an independent third-party using a discounted cash flow approach and the third party’s proprietary pricing models. In addition to market information, models also incorporate transaction details, such as maturity of the instrument and contractual features designed to reduce the Company’s credit exposure, such as collateral rights as applicable.

Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments include amounts to reflect counterparty credit quality, the Company’s creditworthiness and constraints on liquidity. As markets and products develop and the pricing for certain products becomes more or less transparent, the Company may refine its methodologies and assumptions. During Nine Months 2016, no changes were made to the Company’s valuation models that had or are expected to have, a material impact on the Company’s consolidated balance sheets or statements of operations and comprehensive income.

The Company’s methods for calculating fair value produce a fair value that may not be indicative of net realizable value or reflective of future fair values. The use of different methodologies or assumptions to determine fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

The categorization within the fair value hierarchy is determined based on whether the inputs to valuation techniques used to measure fair value are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect Company estimates of market assumptions. The fair value hierarchy prioritizes model inputs into three broad levels as follows, with Level 1 being the highest and Level 3 the lowest. An asset or liability’s categorization is based on the lowest level of significant input to its valuation.

Level 1—Quoted prices for identical instruments in active markets. The Company generally defines an active market as a market in which trading occurs at significant volumes. Active markets generally are more liquid and have a lower bid-ask spread than an inactive market.

Level 2—Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and observable inputs other than quoted prices, such as interest rates or yield curves and other inputs derived from or corroborated by observable market inputs.

Level 3—Model derived valuations in which one or more significant inputs or significant value drivers are unobservable. Financial instruments are considered Level 3 when their values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable. Level 3 financial instruments also include those for which the determination of fair value requires significant management judgment or estimation.

Transfers between Levels 1, 2 and 3 are recognized at the end of the period when the transfer occurs. The Company reviews the classification between Levels 1, 2 and 3 quarterly to determine whether a transfer is necessary. During the periods
presented, there were no transfers between Level 1 and Level 2. There were transfers of fixed-maturity securities from Level 2 into Level 3 during Third Quarter 2016 and Nine Months 2016 because of a lack of observability relating to the valuation inputs and collateral pricing. There were no transfers into or out Level 3 during Nine Months 2015.



51

Measured and Carried at Fair Value

Fixed-Maturity Securities and Short-Term Investments

The fair value of bonds in the investment portfolio is generally based on prices received from third party pricing services or alternative pricing sources with reasonable levels of price transparency. The pricing services prepare estimates of fair value measurements using their pricing models, which include available relevant market information, benchmark curves, benchmarking of like securities, and sector groupings. Additional valuation factors that can be taken into account are nominal spreads and liquidity adjustments. The pricing services evaluate each asset class based on relevant market and credit information, perceived market movements, and sector news. The market inputs used in the pricing evaluation include: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, reference data and industry and economic events. Benchmark yields have in many cases taken priority over reported trades for securities that trade less frequently or those that are distressed trades, and therefore may not be indicative of the market. The extent of the use of each input is dependent on the asset class and the market conditions. Given the asset class, the priority of the use of inputs may change or some market inputs may not be relevant. Additionally, the valuation of fixed-maturity investments is more subjective when markets are less liquid due to the lack of market based inputs, which may increase the potential that the estimated fair value of an investment is not reflective of the price at which an actual transaction would occur.

Short-term investments, that are traded in active markets, are classified within Level 1 in the fair value hierarchy and their value is based on quoted market prices. Securities such as discount notes are classified within Level 2 because these securities are typically not actively traded due to their approaching maturity and, as such, their cost approximates fair value. Short term securities that were obtained as part of loss mitigation efforts and whose prices were determined based on models, where at least one significant model assumption or input is unobservable, are considered to be Level 3 in the fair value hierarchy.

Annually, the Company reviews each pricing service’s procedures, controls and models used in the valuations of the Company’s investment portfolio, as well as the competency of the pricing service’s key personnel. In addition, on a quarterly basis, the Company holds a meeting of the internal valuation committee (comprised of individuals within the Company with market, valuation, accounting, and/or finance experience) that reviews and approves prices and assumptions used by the pricing services.

For Level 1 and 2 securities, the Company, on a quarterly basis, reviews internally developed analytic packages that highlight, at a CUSIP level, price changes from the previous quarter to the current quarter. Where unexpected price movements are noted for a specific CUSIP, the Company formally challenges the price provided, and reviews all key inputs utilized in the third party’s pricing model, and compares such information to management’s own market information.

For Level 3 securities, the Company, on a quarterly basis:

•
reviews methodologies, any model updates and inputs and compares such information to management’s own market information and, where applicable, the internal models,

•
reviews internally developed analytic packages that highlight, at a CUSIP level, price changes from the previous quarter to the current quarter, and evaluates, documents, and resolves any significant pricing differences with the assistance of the third party pricing source, and

•
compares prices received from different third party pricing sources, and evaluates, documents the rationale for, and resolves any significant pricing differences.

As of September 30, 2016, the Company used models to price 34 fixed-maturity securities (primarily securities that were purchased or obtained for loss mitigation or other risk management purposes), which were 17% or $497 million of the Company’s fixed-maturity securities and short-term investments at fair value. Most Level 3 securities were priced with the assistance of an independent third-party. The pricing is based on a discounted cash flow approach using the third-party’s proprietary pricing models. The models use inputs such as projected prepayment speeds;  severity assumptions; recovery lag assumptions; estimated default rates (determined on the basis of an analysis of collateral attributes, historical collateral performance, borrower profiles and other features relevant to the evaluation of collateral credit quality); home price appreciation/depreciation rates based on macroeconomic forecasts and recent trading activity. The yield used to discount the projected cash flows is determined by reviewing various attributes of the bond including collateral type, weighted average life, sensitivity to losses, vintage, and convexity, in conjunction with market data on comparable securities. Significant changes to

52

any of these inputs could materially change the expected timing of cash flows within these securities which is a significant factor in determining the fair value of the securities.

Other Invested Assets

Other invested assets include equity securities carried as Level 3.

Other Assets

Committed Capital Securities

The fair value of committed capital securities ("CCS"), which is recorded in “other assets” on the consolidated balance sheets, represents the difference between the present value of remaining expected put option premium payments under AGC’s CCS (the “AGC CCS”) agreement, and the estimated present value that the Company would hypothetically have to pay currently for a comparable security (see Note 16, Note Payable to Affiliate and Credit Facilities). The AGC CCS are carried at fair value with changes in fair value recorded in the consolidated statement of operations. The estimated current cost of the Company’s CCS is based on several factors, including AGC CDS spreads, the U.S. dollar forward swap curve, London Interbank Offered Rate ("LIBOR") curve projections and the term the securities are estimated to remain outstanding.

Supplemental Executive Retirement Plans

The Company classifies the fair value measurement of the assets of AGC’s various supplemental executive retirement plans as either Level 1 or Level 2. The fair value of these assets is valued based on the observable published daily values of the underlying mutual fund included in the aforementioned plans (Level 1) or based upon the net asset value ("NAV") of the funds if a published daily value is not available (Level 2). The NAV are based on observable information.

Financial Guaranty Contracts Accounted for as Credit Derivatives

The Company’s credit derivatives consist primarily of insured CDS contracts, and also include interest rate swaps and hedges on other financial guarantors that fall under derivative accounting standards requiring fair value accounting through the statement of operations. The following is a description of the fair value methodology applied to the Company's insured credit default swaps that are accounted for as credit derivatives, which constitute the vast majority of the net credit derivative liability in the consolidated balance sheets. The Company did not enter into CDS with the intent to trade these contracts and the Company may not unilaterally terminate a CDS contract absent an event of default or termination event that entitles the Company to terminate such contracts; however, the Company has mutually agreed with various counterparties to terminate certain CDS transactions. Such terminations generally are not completed at fair value but instead for an amount that approximates the present value of future premiums or for a negotiated amount.

The terms of the Company’s CDS contracts differ from more standardized credit derivative contracts sold by companies outside the financial guaranty industry. The non-standard terms include the absence of collateral support agreements or immediate settlement provisions. In addition, the Company employs relatively high attachment points and does not exit derivatives it sells or purchases for credit protection purposes, except under specific circumstances such as mutual agreements with counterparties. Management considers the non-standard terms of its credit derivative contracts in determining the fair value of these contracts.

Due to the lack of quoted prices and other observable inputs for its instruments or for similar instruments, the Company determines the fair value of its credit derivative contracts primarily through internally developed, proprietary models that use both observable and unobservable market data inputs to derive an estimate of the fair value of the Company's contracts in its principal markets (see "Assumptions and Inputs"). There is no established market where financial guaranty insured credit derivatives are actively traded, therefore, management has determined that the exit market for the Company’s credit derivatives is a hypothetical one based on its entry market. Management has tracked the historical pricing of the Company’s deals to establish historical price points in the hypothetical market that are used in the fair value calculation. These contracts are classified as Level 3 in the fair value hierarchy since there is reliance on at least one unobservable input deemed significant to the valuation model, most importantly the Company’s estimate of the value of the non-standard terms and conditions of its credit derivative contracts and of the Company’s current credit standing.

The Company’s models and the related assumptions are continuously reevaluated by management and enhanced, as appropriate, based upon improvements in modeling techniques and availability of more timely and relevant market information.


53

The fair value of the Company’s credit derivative contracts represents the difference between the present value of remaining premiums the Company expects to receive or pay and the estimated present value of premiums that a financial guarantor of comparable credit-worthiness would hypothetically charge or pay at the reporting date for the same protection. The fair value of the Company’s credit derivatives depends on a number of factors, including notional amount of the contract, expected term, credit spreads, changes in interest rates, the credit ratings of referenced entities, the Company’s own credit risk and remaining contractual cash flows. The expected remaining contractual premium cash flows are the most readily observable inputs since they are based on the CDS contractual terms. Credit spreads capture the effect of recovery rates and performance of underlying assets of these contracts, among other factors. Consistent with previous years, market conditions at September 30, 2016 were such that market prices of the Company’s CDS contracts were not available.

Management considers factors such as current prices charged for similar agreements, when available, performance of underlying assets, life of the instrument, and the nature and extent of activity in the financial guaranty credit derivative marketplace. The assumptions that management uses to determine the fair value may change in the future due to market conditions. Due to the inherent uncertainties of the assumptions used in the valuation models, actual experience may differ from the estimates reflected in the Company’s consolidated financial statements and the differences may be material.

Assumptions and Inputs

The various inputs and assumptions that are key to the establishment of the Company’s fair value for CDS contracts are as follows:

•Gross spread.

•The allocation of gross spread among: 
◦
the profit the originator, usually an investment bank, realizes for putting the deal together and funding the transaction (“bank profit”); 
◦
 premiums paid to the Company for the Company’s credit protection provided (“net spread”); and 
◦
the cost of CDS protection purchased by the originator to hedge their counterparty credit risk exposure to the Company (“hedge cost”).
 
•The weighted average life which is based on debt service schedules.

The rates used to discount future expected premium cash flows ranged from 0.87% to 1.85% at September 30, 2016 and 0.44% to 2.51% at December 31, 2015.

The Company obtains gross spreads on its outstanding contracts from market data sources published by third parties (e.g., dealer spread tables for the collateral similar to assets within the Company’s transactions), as well as collateral- specific spreads provided by trustees or obtained from market sources. If observable market credit spreads are not available or reliable for the underlying reference obligations, then market indices are used that most closely resemble the underlying reference obligations, considering asset class, credit quality rating and maturity of the underlying reference obligations. These indices are adjusted to reflect the non-standard terms of the Company’s CDS contracts. Market sources determine credit spreads by reviewing new issuance pricing for specific asset classes and receiving price quotes from their trading desks for the specific asset in question. Management validates these quotes by cross-referencing quotes received from one market source against quotes received from another market source to ensure reasonableness. In addition, the Company compares the relative change in price quotes received from one quarter to another, with the relative change experienced by published market indices for a specific asset class. Collateral specific spreads obtained from third-party, independent market sources are un-published spread quotes from market participants or market traders who are not trustees. Management obtains this information as the result of direct communication with these sources as part of the valuation process.

With respect to CDS transactions for which there is an expected claim payment within the next twelve months, the allocation of gross spread reflects a higher allocation to the cost of credit rather than the bank profit component. In the current market, it is assumed that a bank would be willing to accept a lower profit on distressed transactions in order to remove these transactions from its financial statements.

The following spread hierarchy is utilized in determining which source of gross spread to use, with the rule being to use CDS spreads where available. If not available, CDS spreads are either interpolated or extrapolated based on similar transactions or market indices.

•
Actual collateral specific credit spreads (if up-to-date and reliable market-based spreads are available).


54

•
Deals priced or closed during a specific quarter within a specific asset class and specific rating. No transactions closed during the periods presented.

•
Credit spreads interpolated based upon market indices.

•
Credit spreads provided by the counterparty of the CDS.

•
Credit spreads extrapolated based upon transactions of similar asset classes, similar ratings, and similar time to maturity.

Information by Credit Spread Type (1)

 
As of
September 30, 2016
 
As of
December 31, 2015
Based on actual collateral specific spreads
13
%
 
23
%
Based on market indices
72
%
 
60
%
Provided by the CDS counterparty
15
%
 
17
%
Total
100
%
 
100
%
 ____________________
(1)    Based on par.

Over time the data inputs can change as new sources become available or existing sources are discontinued or are no longer considered to be the most appropriate. It is the Company’s objective to move to higher levels on the hierarchy whenever possible, but it is sometimes necessary to move to lower priority inputs because of discontinued data sources or management’s assessment that the higher priority inputs are no longer considered to be representative of market spreads for a given type of collateral. This can happen, for example, if transaction volume changes such that a previously used spread index is no longer viewed as being reflective of current market levels.

The Company interpolates a curve based on the historical relationship between the premium the Company receives when a credit derivative is closed to the daily closing price of the market index related to the specific asset class and rating of the deal. This curve indicates expected credit spreads at each indicative level on the related market index. For transactions with unique terms or characteristics where no price quotes are available, management extrapolates credit spreads based on a similar transaction for which the Company has received a spread quote from one of the first three sources within the Company’s spread hierarchy. This alternative transaction will be within the same asset class, have similar underlying assets, similar credit ratings, and similar time to maturity. The Company then calculates the percentage of relative spread change quarter over quarter for the alternative transaction. This percentage change is then applied to the historical credit spread of the transaction for which no price quote was received in order to calculate the transactions’ current spread. Counterparties determine credit spreads by reviewing new issuance pricing for specific asset classes and receiving price quotes from their trading desks for the specific asset in question. These quotes are validated by cross- referencing quotes received from one market source with those quotes received from another market source to ensure reasonableness.

The premium the Company receives is referred to as the “net spread.” The Company’s pricing model takes into account not only how credit spreads on risks that it assumes affect pricing, but also how the Company’s own credit spread affects the pricing of its deals. The Company’s own credit risk is factored into the determination of net spread based on the impact of changes in the quoted market price for credit protection bought on the Company, as reflected by quoted market prices on CDS referencing AGC. For credit spreads on the Company’s name the Company obtains the quoted price of CDS contracts traded on AGC from market data sources published by third parties. The cost to acquire CDS protection referencing AGC affects the amount of spread on CDS deals that the Company retains and, hence, their fair value. As the cost to acquire CDS protection referencing AGC increases, the amount of premium the Company retains on a deal generally decreases. As the cost to acquire CDS protection referencing AGC decreases, the amount of premium the Company retains on a deal generally increases. In the Company’s valuation model, the premium the Company captures is not permitted to go below the minimum rate that the Company would currently charge to assume similar risks. This assumption can have the effect of mitigating the amount of unrealized gains that are recognized on certain CDS contracts. Given the current market conditions and the Company’s own credit spreads, approximately 23%, 14%, and 22%, based on number of deals, of the Company's CDS contracts are fair valued using this minimum premium as of September 30, 2016, June 30, 2016 and December 31, 2015, respectively. The percentage of deals that price using the minimum premiums fluctuates due to changes in AGC's credit spreads. In general when AGC's credit spreads narrow, the cost to hedge AGC's name declines and more transactions price

55

above previously established floor levels. Meanwhile, when AGC's credit spreads widen, the cost to hedge AGC's name increases causing more transactions to price at previously established floor levels. The Company corroborates the assumptions in its fair value model, including the portion of exposure to AGC hedged by its counterparties, with independent third parties each reporting period. The current level of AGC’s own credit spread has resulted in the bank or deal originator hedging a significant portion of its exposure to AGC. This reduces the amount of contractual cash flows AGC can capture as premium for selling its protection.

The amount of premium a financial guaranty insurance market participant can demand is inversely related to the cost of credit protection on the insurance company as measured by market credit spreads assuming all other assumptions remain constant. This is because the buyers of credit protection typically hedge a portion of their risk to the financial guarantor, due to the fact that the contractual terms of the Company's contracts typically do not require the posting of collateral by the guarantor. The extent of the hedge depends on the types of instruments insured and the current market conditions.

A fair value resulting in a credit derivative asset on protection sold is the result of contractual cash inflows on in-force deals in excess of what a hypothetical financial guarantor could receive if it sold protection on the same risk as of the reporting date. If the Company were able to freely exchange these contracts (i.e., assuming its contracts did not contain proscriptions on transfer and there was a viable exchange market), it would be able to realize a gain representing the difference between the higher contractual premiums to which it is entitled and the current market premiums for a similar contract. The Company determines the fair value of its CDS contracts by applying the difference between the current net spread and the contractual net spread for the remaining duration of each contract to the notional value of its CDS contracts and taking the present value of such amounts discounted at the corresponding LIBOR over the weighted average remaining life of the contract.

Example

The following is an example of how changes in gross spreads, the Company’s own credit spread and the cost to buy protection on the Company affect the amount of premium the Company can demand for its credit protection. The assumptions used in these examples are hypothetical amounts. Scenario 1 represents the market conditions in effect on the transaction date and Scenario 2 represents market conditions at a subsequent reporting date.

 
Scenario 1
 
Scenario 2
 
bps
 
% of Total
 
bps
 
% of Total
Original gross spread/cash bond price (in bps)
185

 
 
 
500

 
 
Bank profit (in bps)
115

 
62
%
 
50

 
10
%
Hedge cost (in bps)
30

 
16
%
 
440

 
88
%
The premium the Company receives per annum (in bps)
40

 
22
%
 
10

 
2
%

In Scenario 1, the gross spread is 185 basis points. The bank or deal originator captures 115 basis points of the original gross spread and hedges 10% of its exposure to AGC, when the CDS spread on AGC was 300 basis points (300 basis points × 10% = 30 basis points). Under this scenario the Company receives premium of 40 basis points, or 22% of the gross spread.

In Scenario 2, the gross spread is 500 basis points. The bank or deal originator captures 50 basis points of the original gross spread and hedges 25% of its exposure to AGC, when the CDS spread on AGC was 1,760 basis points (1,760 basis points × 25% = 440 basis points). Under this scenario the Company would receive premium of 10 basis points, or 2% of the gross spread. Due to the increased cost to hedge AGC’s name, the amount of profit the bank would expect to receive, and the premium the Company would expect to receive decline significantly.

In this example, the contractual cash flows (the Company premium received per annum above) exceed the amount a market participant would require the Company to pay in today’s market to accept its obligations under the CDS contract, thus resulting in an asset.

Strengths and Weaknesses of Model

The Company’s credit derivative valuation model, like any financial model, has certain strengths and weaknesses.

The primary strengths of the Company’s CDS modeling techniques are:

•
The model takes into account the transaction structure and the key drivers of market value. The transaction

56

structure includes par insured, weighted average life, level of subordination and composition of collateral.

•
The model maximizes the use of market-driven inputs whenever they are available. The key inputs to the model are market-based spreads for the collateral, and the credit rating of referenced entities. These are viewed by the Company to be the key parameters that affect fair value of the transaction.

•
The model is a consistent approach to valuing positions. The Company has developed a hierarchy for market-based spread inputs that helps mitigate the degree of subjectivity during periods of high illiquidity.

The primary weaknesses of the Company’s CDS modeling techniques are:

•
There is no exit market or actual exit transactions. Therefore the Company’s exit market is a hypothetical one based on the Company’s entry market.

•
There is a very limited market in which to validate the reasonableness of the fair values developed by the Company’s model.

•
The markets for the inputs to the model were highly illiquid, which impacts their reliability.

•
Due to the non-standard terms under which the Company enters into derivative contracts, the fair value of its credit derivatives may not reflect the same prices observed in an actively traded market of credit derivatives that do not contain terms and conditions similar to those observed in the financial guaranty market.

These contracts were classified as Level 3 in the fair value hierarchy because there is a reliance on at least one unobservable input deemed significant to the valuation model, most significantly the Company's estimate of the value of non-standard terms and conditions of its credit derivative contracts and amount of protection purchased on AGC's name.

Fair Value Option on FG VIEs’ Assets and Liabilities

The Company elected the fair value option for all the FG VIEs’ assets and liabilities. See Note 9, Consolidated Variable Interest Entities.

The FG VIEs issued securities collateralized by first lien and second lien RMBS as well as loans and receivables. The lowest level input that is significant to the fair value measurement of these assets and liabilities was a Level 3 input (i.e., unobservable), therefore management classified them as Level 3 in the fair value hierarchy. Prices are generally determined with the assistance of an independent third-party, based on a discounted cash flow approach. The models to price the FG VIEs’ liabilities used, where appropriate, inputs such as estimated prepayment speeds; market values of the assets that collateralize the securities; estimated default rates (determined on the basis of an analysis of collateral attributes, historical collateral performance, borrower profiles and other features relevant to the evaluation of collateral credit quality); yields implied by market prices for similar securities; house price depreciation/appreciation rates based on macroeconomic forecasts and, for those liabilities insured by the Company, the benefit from the Company’s insurance policy guaranteeing the timely payment of principal and interest, taking into account the timing of the potential default and the Company’s own credit rating. The third-party also utilizes an internal model to determine an appropriate yield at which to discount the cash flows of the security, by factoring in collateral types, weighted-average lives, and other structural attributes specific to the security being priced. The expected yield is further calibrated by utilizing algorithms designed to aggregate market color, received by the third-party, on comparable bonds.

The fair value of the Company’s FG VIE assets is generally sensitive to changes related to estimated prepayment speeds; estimated default rates (determined on the basis of an analysis of collateral attributes such as: historical collateral performance, borrower profiles and other features relevant to the evaluation of collateral credit quality); discount rates implied by market prices for similar securities; and house price depreciation/appreciation rates based on macroeconomic forecasts. Significant changes to some of these inputs could materially change the market value of the FG VIE’s assets and the implied collateral losses within the transaction. In general, the fair value of the FG VIE asset is most sensitive to changes in the projected collateral losses, where an increase in collateral losses typically leads to a decrease in the fair value of FG VIE assets, while a decrease in collateral losses typically leads to an increase in the fair value of FG VIE assets. These factors also directly impact the fair value of the Company’s FG VIE liabilities.


57

The fair value of the Company’s FG VIE liabilities is generally sensitive to the various model inputs described above. In addition, the Company’s FG VIE liabilities with recourse are also sensitive to changes in the Company’s implied credit worthiness. Significant changes to any of these inputs could materially change the timing of expected losses within the insured transaction which is a significant factor in determining the implied benefit from the Company’s insurance policy guaranteeing the timely payment of principal and interest for the tranches of debt issued by the FG VIE that is insured by the Company. In general, extending the timing of expected loss payments by the Company into the future typically leads to a decrease in the value of the Company’s insurance and a decrease in the fair value of the Company’s FG VIE liabilities with recourse, while a shortening of the timing of expected loss payments by the Company typically leads to an increase in the value of the Company’s insurance and an increase in the fair value of the Company’s FG VIE liabilities with recourse.

Not Carried at Fair Value

Financial Guaranty Insurance Contracts

For financial guaranty insurance contracts that are acquired in a business combination, the Company measures each contract at fair value on the date of acquisition, and then follows insurance accounting guidance on a recurring basis thereafter.  On a quarterly basis, the Company also discloses the fair value of its outstanding financial guaranty insurance contracts.  In both cases, fair value is  based on management’s estimate of what a similarly rated financial guaranty insurance company would demand to acquire the Company’s in-force book of financial guaranty insurance business. It is based on a variety of factors that may include pricing assumptions management has observed for portfolio transfers, commutations, and acquisitions that have occurred in the financial guaranty market, as well as prices observed in the credit derivative market with an adjustment for illiquidity so that the terms would be similar to a financial guaranty insurance contract, and includes adjustments to the carrying value of unearned premium reserve for stressed losses, ceding commissions and return on capital. The significant inputs were not readily observable. The Company accordingly classified this fair value measurement as Level 3.

Note Payable to Affiliate

The fair value of the Company’s note payable to AGM is determined by calculating the present value of the expected cash flows. The Company determines discounted future cash flows using the effect of changes in U.S. Treasury yield at the end of each reporting period as well as the change in its own credit spread. The significant inputs were not readily observable. The Company accordingly classified this fair value measurement as Level 3.

Other Invested Assets

The other invested assets not carried at fair value consist primarily of investments in a guaranteed investment contract for future claims payments. The fair value of the investments in the guaranteed investment contract approximated their carrying value due to their short term nature. The fair value measurement of the investments in the guaranteed investment contract was classified as Level 2 in the fair value hierarchy.

Other Assets and Other Liabilities
 
The Company’s other assets and other liabilities consist predominantly of accrued interest, receivables for securities sold and payables for securities purchased, the carrying values of which approximate fair value.


58

Financial Instruments Carried at Fair Value

Amounts recorded at fair value in the Company’s financial statements are presented in the tables below.

Fair Value Hierarchy of Financial Instruments Carried at Fair Value
As of September 30, 2016

 
 
 
Fair Value Hierarchy
 
Fair Value
 
Level 1
 
Level 2
 
Level 3
 
(in millions)
Assets:
 
 
 
 
 
 
 
Investment portfolio, available-for-sale:
 
 
 
 
 
 
 
Fixed-maturity securities
 
 
 
 
 
 
 
Obligations of state and political subdivisions
$
1,467

 
$
—

 
$
1,464

 
$
3

U.S. government and agencies
154

 
—

 
154

 
—

Corporate securities
369

 
—

 
369

 
—

Mortgage-backed securities:
 
 
 
 
 
 
 
RMBS
98

 
—

 
63

 
35

Commercial mortgage-backed securities ("CMBS")
115

 
—

 
115

 
—

Asset-backed securities
498

 
—

 
39

 
459

Foreign government securities
90

 
—

 
90

 
—

Total fixed-maturity securities
2,791

 
—

 
2,294

 
497

Short-term investments
149

 
54

 
95

 
0

Other invested assets
2

 
—

 
0

 
2

Credit derivative assets
83

 
—

 
—

 
83

FG VIEs’ assets, at fair value
236

 
—

 
—

 
236

Other assets
45

 
12

 
27

 
6

Total assets carried at fair value    
$
3,306

 
$
66

 
$
2,416

 
$
824

Liabilities:
 
 
 
 
 
 
 
Credit derivative liabilities
$
378

 
$
—

 
$
—

 
$
378

FG VIEs’ liabilities with recourse, at fair value
208

 
—

 
—

 
208

FG VIEs’ liabilities without recourse, at fair value
46

 
—

 
—

 
46

Total liabilities carried at fair value    
$
632

 
$
—

 
$
—

 
$
632


59

Fair Value Hierarchy of Financial Instruments Carried at Fair Value
As of December 31, 2015

 
 
 
Fair Value Hierarchy
 
Fair Value
 
Level 1
 
Level 2
 
Level 3
 
(in millions)
Assets:
 
 
 
 
 
 
 
Investment portfolio, available-for-sale:
 
 
 
 
 
 
 
Fixed-maturity securities
 
 
 
 
 
 
 
Obligations of state and political subdivisions
$
1,526

 
$
—

 
$
1,526

 
$
—

U.S. government and agencies
179

 
—

 
179

 
—

Corporate securities
129

 
—

 
129

 
—

Mortgage-backed securities:
 
 
 
 
 
 
 
RMBS
187

 
—

 
164

 
23

CMBS
34

 
—

 
34

 
—

Asset-backed securities
391

 
—

 
3

 
388

Foreign government securities
101

 
—

 
101

 
—

Total fixed-maturity securities
2,547

 
—

 
2,136

 
411

Short-term investments
72

 
72

 
0

 
0

Other invested assets
2

 
—

 
0

 
2

Credit derivative assets
106

 
—

 
—

 
106

FG VIEs’ assets, at fair value
526

 
—

 
—

 
526

Other assets
67

 
13

 
21

 
33

Total assets carried at fair value    
$
3,320

 
$
85

 
$
2,157

 
$
1,078

Liabilities:
 
 
 
 
 
 
 
Credit derivative liabilities
$
332

 
$
—

 
$
—

 
$
332

FG VIEs’ liabilities with recourse, at fair value
512

 
—

 
—

 
512

FG VIEs’ liabilities without recourse, at fair value
3

 
—

 
—

 
3

Total liabilities carried at fair value    
$
847

 
$
—

 
$
—

 
$
847




60

Changes in Level 3 Fair Value Measurements

The table below presents a roll forward of the Company’s Level 3 financial instruments carried at fair value on a recurring basis during Third Quarter 2016 and 2015, and Nine Months 2016 and 2015.

Fair Value Level 3 Rollforward
Recurring Basis
Third Quarter 2016

 
Fixed-Maturity Securities
 
 
 
 
 
 
 
 
 
 
 
 
Obligations
of State and
Political
Subdivisions
 
RMBS
 
Asset-
Backed
Securities
 
FG VIEs’ Assets at 
Fair Value
 
Other
Assets(8)
 
Credit
Derivative Asset
(Liability),
net(5)
 
FG VIEs’
Liabilities with
Recourse,
at Fair Value
 
FG VIEs’
Liabilities without
Recourse,
at Fair Value
 
 
(in millions)
Fair value as of June 30, 2016
$
2

 
$
18

 
$
360

 
$
140

 
$
20

 
$
(232
)
 
$
(155
)
 
$
(3
)
 
CIFG Acquisition
1

 
20

 
36

 
—

 
—

 
(67
)
 
—

 
—

 
Total pretax realized and unrealized gains/(losses) recorded in:(1)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income (loss)
0

(2)
1

(2)
4

(2)
5

(3)
(12
)
(4)
16

(6)
(4
)
(3)
—

(3)
Other comprehensive income (loss)
0

 
(1
)
 
45

 
—

 
0

 
—

 
—

 
—

 
Purchases
—

 
—

 
53

 
—

 
—

 
—

 
—

 
—

 
Settlements
—

 
(3
)
 
(40
)
 
(6
)
 
—

 
(12
)
 
5

 
0

 
FG VIE consolidations
—

 
—

 
—

 
97

 
—

 
—

 
(54
)
 
(43
)
 
FG VIE deconsolidations
—

 
—

 
—

 
—

 
—

 
—

 
—

 
—

 
Transfers into Level 3
—

 
—

 
1

 
—

 
—

 
—

 
—

 
—

 
Fair value as of September 30, 2016
$
3

 
$
35

 
$
459

 
$
236

 
$
8

 
$
(295
)
 
$
(208
)
 
$
(46
)
 
Change in unrealized gains/(losses) related to financial instruments held as of September 30, 2016
$
0

 
$
(1
)
 
$
45

 
$
5

 
$
(12
)
 
$
(16
)
 
$
(4
)
 
$
0

 
























61

Fair Value Level 3 Rollforward
Recurring Basis
Third Quarter 2015

 
Fixed-Maturity Securities
 
 
 
 
 
 
 
 
 
 
 
 
Obligations
of State and
Political
Subdivisions
 
RMBS
 
Asset-
Backed
Securities
 
FG VIEs’
Assets at Fair
Value
 
Other
Assets(8)
 
Credit
Derivative Asset
(Liability),
net(5)
 
FG VIEs’
Liabilities with
Recourse,
at Fair Value
 
FG VIEs’
Liabilities without
Recourse,
at Fair Value
 
 
(in millions)
 
Fair value as of June 30, 2015
$
—

 
$
28

 
$
138

 
$
686

 
$
32

 
$
(571
)
 
$
(550
)
 
$
(42
)
 
Radian Asset Acquisition
—

 
—

 
—

 
—

 
—

 
—

 
—

 
—

 
Total pretax realized and unrealized gains/(losses) recorded in:(1)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income (loss)
—

 
0

(2)
1

(2)
(7
)
(3)
(7
)
(4)
(4
)
(6)
4

(3)
(1
)
(3)
Other comprehensive income (loss)
—

 
(1
)
 
(8
)
 
—

 
0

 
—

 
—

 
—

 
Purchases
—

 
—

 
—

 
—

 
—

 
—

 
—

 
—

 
Settlements
—

 
(2
)
 
(1
)
 
(13
)
 
—

 
(1
)
 
8

 
1

 
FG VIE consolidations
—

 
—

 
—

 
—

 
—

 
—

 
—

 
—

 
Fair value as of September 30, 2015
$
—

 
$
25

 
$
130

 
$
666

 
$
25

 
$
(576
)
 
$
(538
)
 
$
(42
)
 
Change in unrealized gains/(losses) related to financial instruments held as of September 30, 2015
$
—

 
$
(2
)
 
$
(7
)
 
$
(4
)
 
$
(7
)
 
$
(4
)
 
$
4

 
$
(1
)
 



62

Fair Value Level 3 Rollforward
Recurring Basis
Nine Months 2016

 
Fixed-Maturity Securities
 
 
 
 
 
 
 
 
 
 
 
 
Obligations
of State and
Political
Subdivisions
 
RMBS
 
Asset-
Backed
Securities
 
FG VIEs’ Assets at 
Fair Value
 
Other
Assets(8)
 
Credit
Derivative Asset
(Liability),
net(5)
 
FG VIEs’
Liabilities with
Recourse,
at Fair Value
 
FG VIEs’
Liabilities without
Recourse,
at Fair Value
 
 
(in millions)
 
Fair value as of
  December 31, 2015
$
—

 
$
23

 
$
388

 
$
526

 
$
35

 
$
(226
)
 
$
(512
)
 
$
(3
)
 
CIFG Acquisition
1

 
20

 
36

 
—

 
—

 
(67
)
 
—

 
—

 
Total pretax realized and unrealized gains/(losses) recorded in:(1)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income (loss)
0

(2)
2

(2)
2

(2)
114

(3)
(27
)
(4)
(3
)
(6)
(108
)
(3)
0

(3)
Other comprehensive income(loss)
0

 
(3
)
 
37

 
—

 
0

 
—

 
—

 
—

 
Purchases
2

 
—

 
53

 
—

 
—

 
—

 
—

 
—

 
Settlements
0

 
(7
)
 
(58
)
 
(501
)
 
—

 
1

 
466

 
0

 
FG VIE consolidations
—

 
—

 
—

 
97

 
—

 
—

 
(54
)
 
(43
)
 
FG VIE deconsolidations
—

 
0

 
—

 
0

 
—

 
—

 
0

 
—

 
Transfers into Level 3
—

 
—

 
1

 
—

 
—

 
—

 
—

 
—

 
Fair value as of September 30, 2016
$
3

 
$
35

 
$
459

 
$
236

 
$
8

 
$
(295
)
 
$
(208
)
 
$
(46
)
 
Change in unrealized gains/(losses) related to financial instruments held as of September 30, 2016
$
0

 
$
(3
)
 
$
37

 
$
3

 
$
(27
)
 
$
(105
)
 
$
5

 
$
0

 



63

Fair Value Level 3 Rollforward
Recurring Basis
Nine Months 2015

 
Fixed-Maturity Securities
 
 
 
 
 
 
 
 
 
 
 
 
Obligations
of State and
Political
Subdivisions
 
RMBS
 
Asset-
Backed
Securities
 
FG VIEs’
Assets at Fair
Value
 
Other
Assets(8)
 
Credit
Derivative Asset
(Liability),
net(5)
 
FG VIEs’
Liabilities with
Recourse,
at Fair Value
 
FG VIEs’
Liabilities without
Recourse,
at Fair Value
 
 
(in millions)
 
Fair value as of
  December 31, 2014
$
30

 
$
26

 
$
133

 
$
575

 
$
18

 
$
(493
)
 
$
(448
)
 
$
(28
)
 
Radian Asset Acquisition
—

 
4

 
—

 
122

 
2

 
(241
)
 
(114
)
 
(4
)
 
Total pretax realized and unrealized gains/(losses) recorded in:(1)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income (loss)
3

(2)
1

(2)
1

(2)
(2
)
(3)
5

(4)
162

(6)
5

(3)
(11
)
(3)
Other comprehensive income (loss)
(3
)
 
(2
)
 
(2
)
 
—

 
0

 
—

 
—

 
—

 
Purchases
—

 
1

 
—

 
—

 
—

 
—

 
—

 
—

 
Settlements
(30
)
(7)
(4
)
 
(2
)
 
(29
)
 
—

 
(4
)
 
19

 
1

 
FG VIE consolidations
—

 
(1
)
 
—

 
—

 
—

 
—

 
—

 
—

 
Fair value as of September 30, 2015
$
—

 
$
25

 
$
130

 
$
666

 
$
25

 
$
(576
)
 
$
(538
)
 
$
(42
)
 
Change in unrealized gains/(losses) related to financial instruments held as of September 30, 2015
$
—

 
$
(2
)
 
$
(2
)
 
$
2

 
$
5

 
$
156

 
$
9

 
$
(11
)
 
____________________
(1)
Realized and unrealized gains (losses) from changes in values of Level 3 financial instruments represent gains (losses) from changes in values of those financial instruments only for the periods in which the instruments were classified as Level 3.

(2)
Included in net realized investment gains (losses) and net investment income.

(3)
Included in fair value gains (losses) on FG VIEs.

(4)
Recorded in fair value gains (losses) on CCS.

(5)
Represents net position of credit derivatives. The consolidated balance sheet presents gross assets and liabilities based on net counterparty exposure.

(6)
Reported in net change in fair value of credit derivatives and other income.

(7)
Primarily non-cash transaction.

(8)
Includes CCS and other invested assets.



64

Level 3 Fair Value Disclosures

Quantitative Information About Level 3 Fair Value Inputs
At September 30, 2016

Financial Instrument Description (1)
 
Fair Value at
September 30, 2016
(in millions)
 
Significant Unobservable Inputs
 
Range
 
Weighted Average as a Percentage of Current Par Outstanding
Assets (2):
 
 
 
 
 
 
 
 
 
 
Fixed-maturity securities:
 
 
 
 
 
 
 
 
 
 
Obligations of state and political subdivisions
 
$
3

 
Yield
 
9.4
%
-
24.6%
 
16.7%
 
 
 
 
 
 
 
 
 
 
 
RMBS
 
35

 
CPR
 
2.3
%
-
20.0%
 
9.2%
 
 
CDR
 
1.5
%
-
6.2%
 
4.6%
 
 
Loss severity
 
30.0
%
-
100.0%
 
78.2%
 
 
Yield
 
3.3
%
-
6.2%
 
5.5%
Asset-backed securities:
 
 
 
 
 
 
 
 
 
 
Triple-X life insurance transactions
 
181

 
Yield
 
5.3%
 
 
 
 
 
 
 
 
 
 
 
 
 
Collateralized debt obligations ("CDO")
 
260

 
Yield
 
15.0%
 
 
 
 
 
 
 
 
 
 
 
 
 
CLO/TruPS
 
1

 
Yield
 
3.6
%
-
3.8%
 
3.8%
 
 
 
 
 
 
 
 
 
 
 
Others
 
17

 
Yield
 
5.8%
 
 
 
 
 
 
 
 
 
 
 
 
 
FG VIEs’ assets, at fair value
 
236

 
CPR
 
4.2
%
-
8.0%
 
5.7%
 
 
CDR
 
1.2
%
-
8.3%
 
4.9%
 
 
Loss severity
 
60.0
%
-
100.0%
 
84.4%
 
 
Yield
 
3.4
%
-
9.6%
 
5.4%
 
 
 
 
 
 
 

 
 
 
Other assets
 
6

 
Quotes from third party pricing
 
$83
 
 
 
 
Term (years)
 
5 years
 
 
Liabilities:
 
 
 
 
 
 
 
 
 
 
Credit derivative liabilities, net
 
(295
)
 
Year 1 loss estimates
 
0.0
%
-
55.0%
 
2.5%
 
 
Hedge cost (in bps)
 
7.6

-
127.5
 
31.6
 
 
Bank profit (in bps)
 
3.9

-
1,575.7
 
96.6
 
 
Internal floor (in bps)
 
7.0

-
65.0
 
13.0
 
 
Internal credit rating
 
AAA

-
CCC
 
AA
 
 
 
 
 
 
 
 
 
 
 
FG VIEs’ liabilities, at fair value
 
(254
)
 
CPR
 
4.2
%
-
8.0%
 
5.7%
 
 
CDR
 
1.2
%
-
8.3%
 
4.9%
 
 
Loss severity
 
60.0
%
-
100.0%
 
84.4%
 
 
Yield
 
3.4
%
-
9.5%
 
4.7%
___________________
(1)
Discounted cash flow is used as valuation technique for all financial instruments.

(2)
Excludes an investment recorded in other invested assets with fair value of $2 million.

65

Quantitative Information About Level 3 Fair Value Inputs
At December 31, 2015

Financial Instrument Description (1)
 
Fair Value at
December 31, 2015
(in millions)
 
Significant Unobservable Inputs
 
Range
 
Weighted Average as a Percentage of Current Par Outstanding
Assets (2):
 
 
 
 
 
 
 
 
 
 
Fixed-maturity securities:
 
 
 
 
 
 
 
 
 
 
RMBS
 
$
23

 
CPR
 
3.5
%
-
8.9%
 
6.4%
 
 
CDR
 
2.7
%
-
6.7%
 
5.2%
 
 
Loss severity
 
65.0
%
-
72.5%
 
68.9%
 
 
Yield
 
5.5
%
-
6.6%
 
6.4%
Asset-backed securities:
 
 
 
 
 
 
 
 
 
 
Triple-X life insurance transactions
 
129

 
Yield
 
7.5%
 
 
 
 
 
 
 
 
 
 
 
 
 
Collateralized debt obligations
 
259

 
Yield
 
20.0%
 
 
 
 
 
 
 
 
 
 
 
 
 
FG VIEs’ assets, at fair value
 
526

 
CPR
 
0.3
%
-
9.2%
 
4.0%
 
 
CDR
 
1.2
%
-
10.0%
 
3.9%
 
 
Loss severity
 
50.0
%
-
100.0%
 
93.6%
 
 
Yield
 
1.9
%
-
9.7%
 
5.9%
 
 
 
 
 
 
 
 
 
 
 
Other assets
 
33

 
Quotes from third party pricing
 
$46
 
 
 
 
 
 
Term (years)
 
5 years
 
 
Liabilities:
 
 
 
 
 
 
 
 
 
 
Credit derivative liabilities, net
 
(226
)
 
Year 1 loss estimates
 
0.0
%
-
29.0%
 
1.1%
 
 
 
Hedge cost (in bps)
 
34.8

-
282.0
 
87.3
 
 
 
Bank profit (in bps)
 
3.9

-
674.9
 
138.7
 
 
 
Internal floor (in bps)
 
7.0

-
70.0
 
12.3
 
 
 
Internal credit rating
 
AAA

-
CCC
 
AA
 
 
 
 
 
 
 
 
 
 
 
FG VIEs’ liabilities, at fair value
 
(515
)
 
CPR
 
0.3
%
-
9.2%
 
4.0%
 
 
CDR
 
1.2
%
-
10.0%
 
3.9%
 
 
Loss severity
 
50.0
%
-
100.0%
 
93.6%
 
 
Yield
 
1.9
%
-
9.7%
 
5.5%
___________________
(1)
Discounted cash flow is used as valuation technique for all financial instruments.

(2)
Excludes an investment recorded in other invested assets with fair value of $2 million.



66

The carrying amount and estimated fair value of the Company’s financial instruments are presented in the following table.
Fair Value of Financial Instruments

 
As of
September 30, 2016
 
As of
December 31, 2015
 
Carrying
Amount
 
Estimated
Fair Value
 
Carrying
Amount
 
Estimated
Fair Value
 
(in millions)
Assets:
 
 
 
 
 
 
 
Fixed-maturity securities
$
2,791

 
$
2,791

 
$
2,547

 
$
2,547

Short-term investments 
149

 
149

 
72

 
72

Other invested assets (1)
88

 
88

 
85

 
85

Credit derivative assets
83

 
83

 
106

 
106

FG VIEs’ assets, at fair value
236

 
236

 
526

 
526

Other assets
96

 
96

 
92

 
92

Liabilities:
 
 
 
 
 
 
 
Financial guaranty insurance contracts (2)
863

 
2,238

 
1,001

 
2,355

Note payable to affiliate
300

 
327

 
300

 
234

Credit derivative liabilities
378

 
378

 
332

 
332

FG VIEs’ liabilities with recourse, at fair value
208

 
208

 
512

 
512

FG VIEs’ liabilities without recourse, at fair value
46

 
46

 
3

 
3

Other liabilities
22

 
22

 
—

 
—

____________________
(1)
Includes investments not carried at fair value with a carrying value of $86 million and $83 million as of September 30, 2016 and December 31, 2015, respectively. Excludes investments carried under the equity method.

(2)
Carrying amount includes the assets and liabilities related to financial guaranty insurance contract premiums, losses and salvage and subrogation and other recoverables net of reinsurance.

8.
Financial Guaranty Contracts Accounted for as Credit Derivatives

The Company has a portfolio of financial guaranty contracts that meet the definition of a derivative in accordance with GAAP (primarily CDS).

Credit derivative transactions are governed by ISDA documentation and have different characteristics from financial guaranty insurance contracts. For example, the Company’s control rights with respect to a reference obligation under a credit derivative may be more limited than when the Company issues a financial guaranty insurance contract. In addition, there are more circumstances under which the Company may be obligated to make payments. Similar to a financial guaranty insurance contract, the Company would be obligated to pay if the obligor failed to make a scheduled payment of principal or interest in full. However, the Company may also be required to pay if the obligor becomes bankrupt or if the reference obligation were restructured if, after negotiation, those credit events are specified in the documentation for the credit derivative transactions. Furthermore, the Company may be required to make a payment due to an event that is unrelated to the performance of the obligation referenced in the credit derivative. If events of default or termination events specified in the credit derivative documentation were to occur, the non-defaulting or the non-affected party, which may be either the Company or the counterparty, depending upon the circumstances, may decide to terminate a credit derivative prior to maturity. In that case, the Company may be required to make a termination payment to its swap counterparty upon such termination. Absent such an event of default or termination event, the Company may not unilaterally terminate a CDS contract; however, the Company on occasion has mutually agreed with various counterparties to terminate certain CDS transactions.


67

Credit Derivative Net Par Outstanding by Sector

The estimated remaining weighted average life of credit derivatives was 6.4 years at September 30, 2016 and 7.3 years at December 31, 2015. The components of the Company’s credit derivative net par outstanding are presented below.

Credit Derivatives
Subordination and Ratings

 
 
As of September 30, 2016
 
As of December 31, 2015
Asset Type
 
Net Par
Outstanding
 
Original
Subordination 
(1)
 
Current
Subordination
(1)
 
Weighted
Average
Credit
Rating
 
Net Par
Outstanding
 
Original
Subordination
(1)
 
Current
Subordination
(1)
 
Weighted
Average
Credit
Rating
 
 
(dollars in millions)
Pooled corporate obligations:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Collateralized loan obligation ("CLO")/collateralized bond obligations
 
$
739

 
30.3
%
 
53.3
%
 
AAA
 
$
1,551

 
34.1
%
 
45.3
%
 
AAA
Synthetic investment grade pooled
corporate
 
2,988

 
22.8

 
20.6

 
AAA
 
2,189

 
21.5

 
19.1

 
AAA
TruPS CDOs
 
1,435

 
42.8

 
42.7

 
BBB+
 
2,815

 
46.1

 
43.4

 
A-
Total pooled corporate
obligations
 
5,162

 
29.4

 
31.5

 
AA+
 
6,555

 
35.0

 
35.7

 
AA
U.S. RMBS:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Option ARM and Alt-A first lien
 
226

 
9.4

 
12.7

 
 A+
 
287

 
10.5

 
12.7

 
A+
Subprime first lien
 
691

 
27.8

 
45.0

 
 AA
 
761

 
27.7

 
45.2

 
AA-
Prime first lien
 
—

 
—

 
—

 
—
 
148

 
10.9

 
0.0

 
BB
Total U.S. RMBS
 
917

 
25.1

 
40.3

 
AA-
 
1,196

 
24.1

 
37.4

 
A+
CMBS
 
134

 
56.9

 
78.9

 
AAA
 
449

 
44.7

 
52.5

 
AAA
Other
 
3,279

 
—

 
—

 
A
 
3,080

 
—

 
—

 
A+
Total (2)
 
$
9,492

 
 
 
 
 
AA
 
$
11,280

 
 
 
 
 
AA
________________
(1)
Represents the sum of subordinate tranches and over-collateralization and does not include any benefit from excess interest collections that may be used to absorb losses.

(2)
The September 30, 2016 total amount includes $2.5 billion net par outstanding of credit derivatives acquired from CIFG.
    
Except for TruPS CDOs, the Company’s exposure to pooled corporate obligations is highly diversified in terms of obligors and industries. Most pooled corporate transactions are structured to limit exposure to any given obligor and industry. The majority of the Company’s pooled corporate exposure consists of CLO or synthetic pooled corporate obligations. Most of these CLOs have an average obligor size of less than 1% of the total transaction and typically restrict the maximum exposure to any one industry to approximately 10%. The Company’s exposure also benefits from embedded credit enhancement in the transactions which allows a transaction to sustain a certain level of losses in the underlying collateral, further insulating the Company from industry specific concentrations of credit risk on these deals.

The Company’s TruPS CDO asset pools are generally less diversified by obligors and industries than the typical CLO asset pool. Also, the underlying collateral in TruPS CDOs consists primarily of subordinated debt instruments such as TruPS issued by bank holding companies and similar instruments issued by insurance companies, real estate investment trusts and other real estate related issuers while CLOs typically contain primarily senior secured obligations. However, to mitigate these risks, TruPS CDOs were typically structured with higher levels of embedded credit enhancement than typical CLOs.


68

The Company’s exposure to “Other” CDS contracts is also highly diversified. It includes $0.7 billion of exposure to one pooled infrastructure transaction comprising diversified pools of international infrastructure project transactions and loans to regulated utilities. These pools were all structured with underlying credit enhancement sufficient for the Company to attach at AAA levels at origination. The remaining $2.6 billion of exposure in “Other” CDS contracts comprises numerous deals across various asset classes, such as commercial receivables, international RMBS, infrastructure, regulated utilities and consumer receivables.

Distribution of Credit Derivative Net Par Outstanding by Internal Rating

 
 
As of September 30, 2016
 
As of December 31, 2015
Ratings
 
Net Par
Outstanding
 
% of Total
 
Net Par
Outstanding
 
% of Total
 
 
(dollars in millions)
AAA
 
$
4,322

 
45.5
%
 
$
4,924

 
43.6
%
AA
 
2,395

 
25.2

 
3,253

 
28.8

A
 
896

 
9.5

 
909

 
8.1

BBB
 
1,070

 
11.3

 
1,013

 
9.0

BIG
 
809

 
8.5

 
1,181

 
10.5

Credit derivative net par outstanding
 
$
9,492

 
100.0
%
 
$
11,280

 
100.0
%


Fair Value of Credit Derivatives

Net Change in Fair Value of Credit Derivatives Gain (Loss)

 
Third Quarter
 
Nine Months
 
2016
 
2015
 
2016
 
2015
 
(in millions)
Realized gains on credit derivatives
$
7

 
$
6

 
$
21

 
$
20

Net credit derivative losses (paid and payable) recovered and recoverable and other settlements
4

 
(6
)
 
4

 
(14
)
Realized gains (losses) and other settlements
11

 
0

 
25

 
6

Net unrealized gains (losses):
 
 
 
 
 
 
 
Pooled corporate obligations
(8
)
 
(19
)
 
(44
)
 
19

U.S. RMBS
(9
)
 
10

 
2

 
118

CMBS
0

 
(2
)
 
0

 
1

Other
10

 
7

 
2

 
18

Net unrealized gains (losses)
(7
)
 
(4
)
 
(40
)
 
156

Net change in fair value of credit derivatives
$
4

 
$
(4
)
 
$
(15
)
 
$
162



Net Par and Realized Gains
from Terminations and Settlements of Credit Derivative Contracts

 
Third Quarter
 
Nine Months
 
2016
 
2015
 
2016
 
2015
 
(in millions)
Net par of terminated credit derivative contracts
$
906

 
$
35

 
$
2,539

 
$
482

Realized gains on credit derivatives
2

 
0

 
7

 
1

Net unrealized gains (losses) on credit derivatives
9

 
0

 
65

 
0



69

During Third Quarter 2016, unrealized fair value losses were generated primarily as a result of wider implied net spreads across all sectors. The wider implied net spreads were primarily a result of the decreased cost to buy protection in AGC’s name, particularly for the one year CDS spread, as the market cost of AGC’s credit protection decreased during the period. For those CDS transactions that were pricing at or above their floor levels, when the cost of purchasing CDS protection on AGC, which management refers to as the CDS spread on AGC decreased, the implied spreads that the Company would expect to receive on these transactions increased. This was the primary driver of the unrealized fair value losses in the pooled corporate CLO, and U.S. RMBS sectors. The unrealized fair value losses were partially offset by unrealized gains generated primarily as a result of CDS terminations in the pooled corporate and other sectors and price improvements on the underlying collateral of the Company’s CDS.

During Nine Months 2016, unrealized fair value losses were generated primarily in the trust preferred sector, due to wider implied net spreads. The wider implied net spreads were primarily a result of the decreased cost to buy protection in AGC’s name, particularly for the one year and five year CDS spread, as the market cost of AGC’s credit protection decreased during the period. For those CDS transactions that were pricing at or above their floor levels, when the cost of purchasing CDS protection on AGC decreased, the implied spreads that the Company would expect to receive on these transactions increased. The unrealized fair value losses were partially offset by unrealized fair value gains which resulted from the terminations of several CDS transactions during the period. The majority of the CDS transactions were terminated as a result of settlement agreements with several CDS counterparties.

During Third Quarter 2015, unrealized fair value losses were generated primarily in the pooled corporate sector, due to wider implied net spreads. The wider implied net spreads were primarily a result of the decreased cost to buy protection in AGC’s name, particularly for the one year and five year CDS spread, as the market cost of AGC’s credit protection decreased during the period. For those CDS transactions that were pricing at or above their floor levels, when the cost of purchasing CDS protection on AGC decreased the implied spreads that the Company would expect to receive on these transactions increased.

During Nine Months 2015, unrealized fair value gains were generated primarily in the U.S. RMBS Alt-A and prime first lien and Option ARM and subprime sectors, and the trust preferred sector, due to tighter implied net spreads. The tighter implied net spreads were primarily a result of the increased cost to buy protection in AGC's name, particularly for the one year and five year CDS spread, as the market cost of AGC's credit protection increased during the period. For those CDS transactions that were pricing at or above their floor levels, when the cost of purchasing CDS protection on AGC increased, the implied spreads that the Company would expect to receive on these transactions decreased. In addition, during Nine Months 2015 there was a refinement in methodology to address an instance in a U.S. RMBS transaction that changed from an expected loss to an expected recovery position. This refinement resulted in approximately $41 million in fair value gains in Nine Months 2015.
    
The impact of changes in credit spreads will vary based upon the volume, tenor, interest rates, and other market conditions at the time these fair values are determined. In addition, since each transaction has unique collateral and structural terms, the underlying change in fair value of each transaction may vary considerably. The fair value of credit derivative contracts also reflects the change in the Company’s own credit cost based on the price to purchase credit protection on AGC. The Company determines its own credit risk based on quoted CDS prices traded on the Company at each balance sheet date.

CDS Spread on AGC
Quoted price of CDS contract (in basis points)

 
As of
September 30, 2016
 
As of
June 30, 2016
 
As of
December 31, 2015
 
As of
September 30, 2015
 
As of
June 30, 2015
 
As of
December 31, 2014
Five-year CDS spread
170

 
265

 
376

 
331

 
390

 
323

One-year CDS spread
31

 
45

 
139

 
112

 
120

 
80




70

Fair Value of Credit Derivatives Assets (Liabilities)
and Effect of AGC
Credit Spreads

 
As of
September 30, 2016
 
As of
December 31, 2015
 
(in millions)
Fair value of credit derivatives before effect of AGC credit spread
$
(727
)
 
$
(1,065
)
Plus: Effect of AGC credit spread
432

 
839

Net fair value of credit derivatives
$
(295
)
 
$
(226
)

The fair value of CDS contracts at September 30, 2016, before considering the implications of AGC’s credit spreads, is a direct result of continued wide credit spreads in the fixed income security markets and ratings downgrades. The asset classes that remain most affected are 2005-2007 vintages of prime first lien, Alt-A, Option ARM, subprime RMBS deals as well as TruPS and pooled corporate securities. Comparing September 30, 2016 with December 31, 2015, there were several CDS terminations as well as a narrowing of spreads primarily related to the Company's TruPS obligations which resulted in mark-to-market benefit.

Management believes that the trading level of AGC’s credit spreads over the past several years has been due to the correlation between AGC’s risk profile and the current risk profile of the broader financial markets, as well as the overall lack of liquidity in the CDS market. Offsetting the benefit attributable to AGC’s credit spread were higher credit spreads in the fixed income security markets. The higher credit spreads in the fixed income security market are due to the lack of liquidity in the high yield CDO, TruPS CDO, and CLO markets as well as continuing market concerns over the 2005-2007 vintages of RMBS.

The following table presents the fair value and the present value of expected claim payments or recoveries (i.e. net expected loss to be paid as described in Note 5) for contracts accounted for as derivatives.

Net Fair Value and Expected Losses
of Credit Derivatives by Sector

 
 
Fair Value of Credit Derivative
Asset (Liability), net
 
Expected Loss to be (Paid) Recovered
Asset Type
 
As of
September 30, 2016
 
As of
December 31, 2015
 
As of
September 30, 2016
 
As of
December 31, 2015
 
 
(in millions)
Pooled corporate obligations
 
$
(120
)
 
$
(72
)
 
$
(3
)
 
$
(3
)
U.S. RMBS
 
(78
)
 
(104
)
 
(27
)
 
(29
)
Other
 
(97
)
 
(50
)
 
25

 
27

Total
 
$
(295
)
 
$
(226
)
 
$
(5
)
 
$
(5
)


Ratings Sensitivities of Credit Derivative Contracts

Within the Company's insured CDS portfolio, the transaction documentation for approximately $0.7 billion in CDS gross par insured as of September 30, 2016 requires AGC to post eligible collateral to secure its obligations to make payments under such contracts. This constitutes a reduction of approximately $3.1 billion from the $3.8 billion subject to such a requirement as of December 31, 2015, primarily due to an agreement reached in May 2016 with a CDS counterparty reducing the collateral posting requirement with respect to that counterparty to zero. Eligible collateral is generally cash or U.S. government or agency securities; eligible collateral other than cash is valued at a discount to the face amount.

•
For approximately $0.6 billion gross par of such contracts, AGC has negotiated caps such that the posting requirement cannot exceed a certain fixed amount, regardless of the mark-to-market valuation of the exposure or the financial strength ratings of AGC. For such contracts, AGC need not post on a cash basis an aggregate of more than $500 million, although the value of the collateral posted may exceed such fixed amount depending on the advance rate agreed with the counterparty for the particular type of collateral posted.


71

•
For the remaining approximately $178 million gross par of such contracts, AGC could be required from time to time to post additional collateral without such cap based on movements in the mark-to-market valuation of the underlying exposure. 

As of September 30, 2016, AGC was posting approximately $130 million to secure its obligations under CDS, of which approximately $17 million related to the $178 million of gross par described above, as to which the obligation to collateralize is not capped. As of December 31, 2015, AGC was posting approximately $305 million to secure its obligations under CDS, of which approximately $23 million related to $221 million of gross par as to which the obligation to collateralize was not capped. The obligation to post collateral could impair the Company's liquidity and results of operations.
    
Sensitivity to Changes in Credit Spread

The following table summarizes the estimated change in fair values on the net balance of the Company’s credit derivative positions assuming immediate parallel shifts in credit spreads on AGC and on the risks that it assumes.

Effect of Changes in Credit Spread
As of September 30, 2016

Credit Spreads(1)
 
Estimated Net
Fair Value (Pre-Tax)
 
Estimated Change in
Gain/(Loss) (Pre-Tax)
 
 
(in millions)
100% widening in spreads
 
$
(600
)
 
$
(305
)
50% widening in spreads
 
(448
)
 
(153
)
25% widening in spreads
 
(372
)
 
(77
)
10% widening in spreads
 
(326
)
 
(31
)
Base Scenario
 
(295
)
 
—

10% narrowing in spreads
 
(266
)
 
29

25% narrowing in spreads
 
(224
)
 
71

50% narrowing in spreads
 
(154
)
 
141

____________________
(1)
Includes the effects of spreads on both the underlying asset classes and the Company’s own credit spread.

9.
Consolidated Variable Interest Entities

Consolidated FG VIEs

The Company provides financial guaranties with respect to debt obligations of special purpose entities, including VIEs. AGC does not act as the servicer or collateral manager for any VIE obligations that it insures. The transaction structure generally provides certain financial protections to the Company. This financial protection can take several forms, the most common of which are overcollateralization, first loss protection (or subordination) and excess spread. In the case of overcollateralization (i.e., the principal amount of the securitized assets exceeds the principal amount of the structured finance obligations guaranteed by the Company), the structure allows defaults of the securitized assets before a default is experienced on the structured finance obligation guaranteed by the Company. In the case of first loss, the financial guaranty insurance policy only covers a senior layer of losses experienced by multiple obligations issued by special purpose entities, including VIEs. The first loss exposure with respect to the assets is either retained by the seller or sold off in the form of equity or mezzanine debt to other investors. In the case of excess spread, the financial assets contributed to special purpose entities, including VIEs, generate interest income that are in excess of the interest payments on the debt issued by the special purpose entity. Such excess spread is typically distributed through the transaction’s cash flow waterfall and may be used to create additional credit enhancement, applied to redeem debt issued by the special purpose entities, including VIEs (thereby, creating additional overcollateralization), or distributed to equity or other investors in the transaction.

AGC is not primarily liable for the debt obligations issued by the VIEs it insures and would only be required to make payments on those insured debt obligations in the event that the issuer of such debt obligations defaults on any principal or interest due and only for the amount of the shortfall. AGC’s creditors do not have any rights with regard to the collateral supporting the debt issued by the FG VIEs. Proceeds from sales, maturities, prepayments and interest from such underlying collateral may only be used to pay debt service on VIE liabilities. Net fair value gains and losses on FG VIEs are expected to

72

reverse to zero at maturity of the VIE debt, except for net premiums received and net claims paid by AGC under the financial guaranty insurance contract. The Company’s estimate of expected loss to be paid for FG VIEs is included in Note 5, Expected Loss to be Paid.

As part of the terms of its financial guaranty contracts, the Company obtains certain protective rights with respect to the VIE that are triggered by the occurrence of certain events, such as failure to be in compliance with a covenant due to poor deal performance or a deterioration in a servicer or collateral manager's financial condition. At deal inception, the Company typically is not deemed to control a VIE; however, once a trigger event occurs, the Company's control of the VIE typically increases. The Company continuously evaluates its power to direct the activities that most significantly impact the economic performance of VIEs that have debt obligations insured by the Company and, accordingly, where the Company is obligated to absorb VIE losses or receive benefits that could potentially be significant to the VIE. The Company obtains protective rights under its insurance contracts that give the Company additional controls over a VIE if there is either deterioration of deal performance or in the financial health of the deal servicer. The Company is deemed to be the control party for certain VIEs under GAAP, typically when its protective rights give it the power to both terminate and replace the deal servicer, which are characteristics specific to the Company's financial guaranty contracts. If the protective rights that could make the Company the control party have not been triggered, then the VIE is not consolidated. If the Company is deemed no longer to have those protective rights, the transaction is deconsolidated.

Number of FG VIEs Consolidated

 
Nine Months
 
2016
 
2015
 
 
Beginning of the period, December 31
10

 
7

Radian Asset Acquisition
—

 
4

Consolidated (1)
1

 
—

Deconsolidated (1)
(1
)
 
—

Matured
(1
)
 
—

End of the period, September 30
9

 
11

____________________
(1)
Net loss on consolidation and deconsolidation was de minimis in Nine Months 2016. Net loss on consolidation was less than $1 million in 2015 and related to the Radian Asset Acquisition, and was recorded in “fair value gains (losses) on FG VIEs" in the consolidated statement of operations.

The total unpaid principal balance for the FG VIEs’ assets that were over 90 days or more past due was approximately $38 million at September 30, 2016 and $18 million at December 31, 2015. The aggregate unpaid principal of the FG VIEs’ assets was approximately $78 million greater than the aggregate fair value at September 30, 2016. The aggregate unpaid principal of the FG VIEs’ assets was approximately $194 million greater than the aggregate fair value at December 31, 2015, excluding the effect of R&W settlements.

The change in the instrument-specific credit risk of the FG VIEs’ assets held as of September 30, 2016 that was recorded in the consolidated statements of operations for Third Quarter 2016 and Nine Months 2016 were losses of $1 million and gains of $8 million, respectively. The change in the instrument-specific credit risk of the FG VIEs’ assets held as of September 30, 2015, that was recorded in the consolidated statements of operations for Third Quarter 2015 and Nine Months 2015 were losses of $49 million and $21 million, respectively. To calculate the instrument specific credit risk, the changes in the fair value of the FG VIE assets are allocated between changes that are due to the instrument specific credit risk and changes due to other factors, including interest rates. The instrument specific credit risk amount is determined by using expected contractual cash flows versus current expected cash flows discounted at original contractual rate. The net present value is calculated by discounting the expected cash flows of the underlying security, excluding the Company’s financial guaranty insurance, at the relevant effective interest rate.

The unpaid principal for FG VIE liabilities with recourse, which represent obligations insured by AGC, was $225 million and $634 million as of September 30, 2016 and December 31, 2015, respectively. FG VIE liabilities with recourse will mature at various dates ranging from 2031 to 2038. The aggregate unpaid principal balance of the FG VIE liabilities with and without recourse was approximately $31 million greater than the aggregate fair value of the FG VIEs’ liabilities as of September 30, 2016. The aggregate unpaid principal balance was approximately $138 million greater than the aggregate fair value of the FG VIEs’ liabilities as of December 31, 2015.


73

The table below shows the carrying value of the consolidated FG VIEs’ assets and liabilities in the consolidated financial statements, segregated by the types of assets that collateralize their respective debt obligations for FG VIE liabilities with recourse.

Consolidated FG VIEs
By Type of Collateral

 
As of September 30, 2016
 
As of December 31, 2015
 
Assets
 
Liabilities
 
Assets
 
Liabilities
 
(in millions)
With recourse:
 
 
 
 
 
 
 
U.S. RMBS first lien
$
83

 
$
80

 
$
57

 
$
26

U.S. RMBS second lien
30

 
51

 
35

 
55

Life insurance
—

 
—

 
347

 
347

Manufactured housing
77

 
77

 
84

 
84

Total with recourse
190

 
208

 
523

 
512

Without recourse
46

 
46

 
3

 
3

Total
$
236

 
$
254

 
$
526

 
$
515



The consolidation of FG VIEs affects net income and shareholder’s equity due to (i) changes in fair value gains (losses) on FG VIE assets and liabilities, (ii) the elimination of premiums and losses related to the AGC FG VIE liabilities with recourse and (iii) the elimination of investment balances related to the Company’s purchase of AGC insured FG VIE debt. Upon consolidation of a FG VIE, the related insurance and, if applicable, the related investment balances, are considered intercompany transactions and therefore eliminated. Such eliminations are included in the table below to present the full effect of consolidating FG VIEs.

Effect of Consolidating FG VIEs on Net Income,
Cash Flows From Operating Activities and Shareholder’s Equity

 
Third Quarter
 
Nine Months
 
2016
 
2015
 
2016
 
2015
 
(in millions)
Net earned premiums
$
0

 
$
0

 
$
0

 
$
(1
)
Net investment income
0

 
(1
)
 
(4
)
 
(3
)
Net realized investment gains (losses)
0

 
3

 
0

 
7

Fair value gains (losses) on FG VIEs
1

 
(1
)
 
9

 
1

Bargain purchase gain
—

 
—

 
—

 
2

Loss and LAE
(1
)
 
0

 
0

 
0

Effect on income before tax
0

 
1

 
5

 
6

Less: tax provision (benefit)
0

 
0

 
2

 
1

Effect on net income (loss)
$
0

 
$
1

 
$
3

 
$
5

 
 
 
 
 
 
 
 
Effect on cash flows from operating activities
$
0

 
$
2

 
$
(5
)
 
$
3


 
As of
September 30, 2016
 
As of
December 31, 2015
 
(in millions)
Effect on shareholder’s equity (decrease) increase
$
(10
)
 
$
(14
)


74

Fair value gains (losses) on FG VIEs represent the net change in fair value on the consolidated FG VIEs’ assets and liabilities. During Third Quarter 2016 and Nine Months 2016, the Company recorded a pre-tax net fair value gain on consolidated FG VIEs of $1 million and $9 million, respectively. The primary driver of the gains was market-to-market gains due to price appreciation on the FG VIE assets during the quarter and nine months.

During Third Quarter 2015, the Company recorded a pre-tax net fair value loss on consolidated FG VIEs of $1 million. The fair values of the consolidated FG VIEs assets and liabilities remained consistent with the prior quarter. During Nine Months 2015, the Company recorded a pre-tax net fair value gain on consolidated FG VIEs of $1 million. The primary driver of this gain was price appreciation on the Company's FG VIE assets resulting from improvements in the underlying collateral.

Other Consolidated VIEs

In certain instances where the Company consolidates a VIE that was established as part of a loss mitigation negotiation settlement agreement that results in the termination of the original insured financial guaranty insurance or credit derivative contract the Company classifies the assets and liabilities of those VIEs in the line items that most accurately reflect the nature of the items, as opposed to within the FG VIE assets and FG VIE liabilities.

Non-Consolidated VIEs

As of September 30, 2016 and December 31, 2015 the Company had financial guaranty contracts outstanding for approximately 340 and 390 VIEs, respectively, that it did not consolidate. To date, the Company’s analyses have indicated that it does not have a controlling financial interest in any other VIEs and, as a result, they are not consolidated. The Company’s exposure provided through its financial guaranties with respect to debt obligations of special purpose entities is included within net par outstanding in Note 4, Outstanding Exposure.

10.
Investments and Cash

Net Investment Income and Realized Gains (Losses)
 
Net investment income is a function of the yield that the Company earns on invested assets and the size of the portfolio. The investment yield is a function of market interest rates at the time of investment as well as the type, credit quality and maturity of the invested assets. Accrued investment income, which is recorded in Other Assets, was $25 million and $24 million as of September 30, 2016 and December 31, 2015, respectively.

Net Investment Income

 
Third Quarter
 
Nine Months
 
2016
 
2015
 
2016
 
2015
 
(in millions)
Income from fixed-maturity securities managed by third parties
$
16

 
$
18

 
$
49

 
$
50

Income from internally managed securities
7

 
2

 
13

 
10

Gross investment income
23

 
20

 
62

 
60

Investment expenses
(1
)
 
0

 
(2
)
 
(1
)
Net investment income
$
22

 
$
20

 
$
60

 
$
59




75

Net Realized Investment Gains (Losses)

 
Third Quarter
 
Nine Months
 
2016
 
2015
 
2016
 
2015
 
(in millions)
Gross realized gains on available-for-sale securities
$
1

 
$
1

 
$
13

 
$
22

Gross realized losses on available-for-sale securities
0

 
(2
)
 
(1
)
 
(7
)
Net realized gains (losses) on other invested assets
—

 
0

 
—

 
1

Other-than-temporary impairment
(1
)
 
(2
)
 
(5
)
 
(6
)
Net realized investment gains (losses)
$
0

 
$
(3
)
 
$
7

 
$
10



The following table presents the roll-forward of the credit losses of fixed-maturity securities for which the Company has recognized an other-than-temporary-impairment and where the portion of the fair value adjustment related to other factors was recognized in other comprehensive income ("OCI").

Roll Forward of Credit Losses in the Investment Portfolio

 
Third Quarter
 
Nine Months
 
2016
 
2015
 
2016
 
2015
 
(in millions)
Balance, beginning of period
$
8

 
$
8

 
$
8

 
$
19

Additions for credit losses on securities for which an other-than-temporary-impairment was not previously recognized
—

 
—

 
0

 
—

Reductions for securities sold and other settlement during the period
—

 
—

 
—

 
(12
)
Additions for credit losses on securities for which an other-than-temporary-impairment was previously recognized
0

 
—

 
0

 
1

Balance, end of period
$
8

 
$
8

 
$
8

 
$
8



76

Investment Portfolio

Fixed-Maturity Securities and Short-Term Investments
by Security Type
As of September 30, 2016

Investment Category
 
Percent
of
Total(1)
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
AOCI(2)
Gain
(Loss) on
Securities
with
Other-Than-Temporary Impairment
 
Weighted
Average
Credit
Rating(3)
 
 
(dollars in millions)
Fixed-maturity securities:
 
 
Obligations of state and political subdivisions
 
49
%
 
$
1,364

 
$
104

 
$
(1
)
 
$
1,467

 
$
14

 
AA-
U.S. government and
agencies
 
5

 
147

 
7

 
0

 
154

 
—

 
AA+
Corporate securities
 
13

 
363

 
6

 
0

 
369

 
1

 
A
Mortgage-backed securities (4):
 
 
 
 
 
 
 
 
 
 
 
 
 
 
RMBS
 
4

 
101

 
1

 
(4
)
 
98

 
(3
)
 
A
CMBS
 
4

 
113

 
2

 
0

 
115

 
—

 
AAA
Asset-backed securities
 
17

 
458

 
40

 
0

 
498

 
18

 
B-
Foreign government
securities
 
3

 
85

 
5

 
0

 
90

 
—

 
AA
Total fixed-maturity securities
 
95

 
2,631

 
165

 
(5
)
 
2,791

 
30

 
A
Short-term investments
 
5

 
149

 
0

 
0

 
149

 
—

 
AA-
Total investment portfolio
 
100
%
 
$
2,780

 
$
165

 
$
(5
)
 
$
2,940

 
$
30

 
A



77

Fixed-Maturity Securities and Short-Term Investments
by Security Type
As of December 31, 2015

Investment Category
 
Percent
of
Total(1)
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
AOCI Gain
(Loss) on
Securities
with
Other-Than-Temporary Impairment
 
Weighted
Average
Credit
Rating(3)
 
 
(dollars in millions)
Fixed-maturity securities:
 
 
Obligations of state and political subdivisions
 
58
%
 
$
1,465

 
$
69

 
$
(8
)
 
$
1,526

 
$
3

 
AA-
U.S. government and
agencies
 
7

 
173

 
7

 
(1
)
 
179

 
—

 
AA+
Corporate securities
 
5

 
127

 
3

 
(1
)
 
129

 
0

 
A+
Mortgage-backed securities (4):
 
 
 
 
 
 
 
 
 
 
 
 
 
 
RMBS
 
7

 
188

 
1

 
(2
)
 
187

 
(1
)
 
AA-
CMBS
 
1

 
34

 
0

 
0

 
34

 
—

 
AAA
Asset-backed securities
 
15

 
389

 
3

 
(1
)
 
391

 
2

 
CCC+
Foreign government
securities
 
4

 
97

 
4

 
0

 
101

 
—

 
AA+
Total fixed-maturity securities
 
97

 
2,473

 
87

 
(13
)
 
2,547

 
4

 
A
Short-term investments
 
3

 
72

 
—

 
0

 
72

 
—

 
AAA
Total investment portfolio
 
100
%
 
$
2,545

 
$
87

 
$
(13
)
 
$
2,619

 
$
4

 
A+
___________________
(1)
Based on amortized cost.

(2)
Accumulated OCI ("AOCI"). See also Note 17, Other Comprehensive Income.

(3)
Ratings in the tables above represent the lower of the Moody’s and S&P classifications except for bonds purchased for loss mitigation or risk management strategies, which use internal ratings classifications. The Company’s portfolio consists primarily of high-quality, liquid instruments.

(4)
Government-agency obligations were approximately 31% of mortgage backed securities as of September 30, 2016 and 78% as of December 31, 2015 based on fair value.

The Company’s investment portfolio in tax-exempt and taxable municipal securities includes issuances by a wide number of municipal authorities across the U.S. and its territories. Under the Company's investment guidelines, securities rated lower than A-/A3 by S&P or Moody’s are typically not purchased for the Company’s portfolio unless acquired for loss mitigation or risk management strategies.

The majority of the investment portfolio is managed by four outside managers. The Company has established detailed guidelines regarding credit quality, exposure to a particular sector and exposure to a particular obligor within a sector.


78

The following tables summarize, for all fixed-maturity securities in an unrealized loss position, the aggregate fair value and gross unrealized loss by length of time the amounts have continuously been in an unrealized loss position.

Fixed-Maturity Securities
Gross Unrealized Loss by Length of Time
As of September 30, 2016

 
Less than 12 months
 
12 months or more
 
Total
 
Fair
Value
 
Unrealized
Loss
 
Fair
Value
 
Unrealized
Loss
 
Fair
Value
 
Unrealized
Loss
 
(dollars in millions)
Obligations of state and political subdivisions
$
65

 
$
(1
)
 
$
7

 
$
0

 
$
72

 
$
(1
)
U.S. government and agencies
30

 
0

 
—

 
—

 
30

 
0

Corporate securities
140

 
0

 
—

 
—

 
140

 
0

Mortgage-backed securities:
 
 
 
 
 
 
 
 
 
 
 
RMBS
23

 
(1
)
 
7

 
(3
)
 
30

 
(4
)
CMBS
54

 
0

 
—

 
—

 
54

 
0

Asset-backed securities
18

 
0

 
0

 
0

 
18

 
0

Foreign government securities
5

 
0

 
—

 
—

 
5

 
0

Total
$
335

 
$
(2
)
 
$
14

 
$
(3
)
 
$
349

 
$
(5
)
Number of securities (1)
 
 
127

 
 
 
10

 
 
 
136

Number of securities with other-than-temporary impairment
 
 
2

 
 
 
2

 
 
 
4



Fixed-Maturity Securities
Gross Unrealized Loss by Length of Time
As of December 31, 2015

 
Less than 12 months
 
12 months or more
 
Total
 
Fair
Value
 
Unrealized
Loss
 
Fair
Value
 
Unrealized
Loss
 
Fair
Value
 
Unrealized
Loss
 
(dollars in millions)
Obligations of state and political subdivisions
$
175

 
$
(8
)
 
$
3

 
$
0

 
$
178

 
$
(8
)
U.S. government and agencies
55

 
(1
)
 
—

 
—

 
55

 
(1
)
Corporate securities
38

 
(1
)
 
—

 
—

 
38

 
(1
)
Mortgage-backed securities:
 
 
 
 
 
 
 
 
 
 
 
RMBS
153

 
(2
)
 
—

 
—

 
153

 
(2
)
CMBS
30

 
0

 
—

 
—

 
30

 
0

Asset-backed securities
262

 
(1
)
 
—

 
—

 
262

 
(1
)
Foreign government securities
5

 
0

 
—

 
—

 
5

 
0

Total
$
718

 
$
(13
)
 
$
3

 
$
0

 
$
721

 
$
(13
)
Number of securities
 
 
116

 
 
 
29

 
 
 
145

Number of securities with other-than-temporary impairment
 
 
3

 
 
 
—

 
 
 
3

___________________
(1)
The number of securities does not add across because lots consisting of the same securities have been purchased at different times and appear in both categories above (i.e., less than 12 months and 12 months or more). If a security appears in both categories, it is counted only once in the total column.


79

Of the securities in an unrealized loss position for 12 months or more as of September 30, 2016, two securities had unrealized losses greater than 10% of book value. The total unrealized loss for these securities as of September 30, 2016 was $2.7 million. As of December 31, 2015, no securities had unrealized losses greater than 10% of book value. The Company has determined that the unrealized losses recorded as of September 30, 2016 and December 31, 2015 were yield related and not the result of other-than-temporary-impairment.

The amortized cost and estimated fair value of available-for-sale fixed-maturity securities by contractual maturity as of September 30, 2016 are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

Distribution of Fixed-Maturity Securities
by Contractual Maturity
As of September 30, 2016

 
Amortized
Cost
 
Estimated
Fair Value
 
(in millions)
Due within one year
$
283

 
$
301

Due after one year through five years
519

 
532

Due after five years through 10 years
393

 
418

Due after 10 years
1,222

 
1,327

Mortgage-backed securities:
 
 
 
RMBS
101

 
98

CMBS
113

 
115

Total
$
2,631

 
$
2,791


The investment portfolio contains securities and cash that are either held in trust for the benefit of third party reinsurers in accordance with statutory requirements, invested in a guaranteed investment contract for future claims payments, placed on deposit to fulfill state licensing requirements, or otherwise restricted in the amount of $109 million and $93 million, based on fair value, as of September 30, 2016 and December 31, 2015, respectively. The investment portfolio also contains securities that are held in trust for the benefit of Assured Guaranty (Europe) Ltd., a subsidiary of AGM, in accordance with statutory and regulatory requirements in the amount of $11 million as of September 30, 2016, based on fair value. On July 13, 2016, in order to comply with a requirement of the Prudential Regulation Authority of the Bank of England, AGC secured its reinsurance obligations to its wholly owned subsidiary, AGUK, by depositing in trust assets with a carrying value of approximately $149 million as of September 30, 2016.

The fair value of the Company’s pledged securities to secure its obligations under its CDS exposure totaled $130 million and $305 million as of September 30, 2016 and December 31, 2015, respectively.

No material investments of the Company were non-income producing for Nine Months 2016 and Nine Months 2015, respectively.

Internally Managed Portfolio

The investment portfolio tables shown above include both assets managed externally and internally. In the table below, more detailed information is provided for the component of the total investment portfolio that is internally managed (excluding short-term investments). The internally managed portfolio, excluding equity method investments in affiliates, as defined below, represents approximately 21% and 18% of the investment portfolio, on a fair value basis as of September 30, 2016 and December 31, 2015, respectively. The internally managed portfolio consists primarily of the Company's investments in securities for (i) loss mitigation purposes, (ii) other risk management purposes and (iii) where the Company believes a particular security presents an attractive investment opportunity.

One of the Company's strategies for mitigating losses has been to purchase securities it has insured that have expected losses, at discounted prices (loss mitigation securities). In addition, the Company holds other invested assets that were obtained or purchased as part of negotiated settlements with insured counterparties or under the terms of our financial guaranties (other risk management assets).


80

Internally Managed Portfolio
Carrying Value

 
As of September 30, 2016
 
As of December 31, 2015
 
(in millions)
Assets purchased for loss mitigation and other risk management purposes:
 
 
 
Fixed-maturity securities, at fair value
$
611

 
$
455

Other invested assets
84

 
83

Other
6

 
5

Total
$
701

 
$
543


The internally managed portfolio also includes primarily equity method investments in affiliates which consist of investment in MAC Holdings of $293 million as of September 30, 2016 and $377 million as of December 31, 2015 and investment in AG PFC Holding LLC ("AGPFC") of $10 million as of September 30, 2016 and $13 million as of December 31, 2015.

11.     Investment in MAC Holdings

Summarized Financial Information of MAC Holdings

The table below presents summarized financial information for MAC Holdings as of and for the periods ended September 30, 2016 and December 31, 2015. AGC owns approximately 39% of the outstanding MAC Holdings common stock.

Summarized Financial Information of MAC Holdings

 
As of and for the Nine Months Ended September 30, 2016
 
As of and for the Year Ended December 31, 2015
 
(in millions)
Total assets
$
1,178

 
$
1,561

Total liabilities
432

 
601

Total revenues
136

 
156

Net income
87

 
100


On June 30, 2016, MAC obtained approval from the New York State Department of Financial Services to repay its $300 million surplus note to MAC Holdings and its $100 million surplus note (plus accrued interest) to AGM. Accordingly, on June 30, 2016, MAC transferred cash and/or marketable securities to (i) MAC Holdings in an aggregate amount equal to $300 million, and (ii)  AGM in an aggregate amount of $102.5 million. MAC Holdings, upon receipt of such $300 million from MAC, distributed cash and/or marketable securities in an aggregate amount of $300 million to its shareholders, AGM and AGC, in proportion to their respective 60.7% and 39.3% ownership interests such that AGM received $182 million and AGC received $118 million.

12.
Insurance Company Regulatory Requirements

Dividend Restrictions and Capital Requirements

AGC is a Maryland domiciled insurance company. Under Maryland's insurance law, AGC may, with prior notice to the Maryland Insurance Administration ("MIA"), pay an ordinary dividend that, together with all dividends paid in the prior 12 months, does not exceed the lesser of 10% of its policyholders' surplus (as of the prior December 31) or 100% of its adjusted net investment income during that period. The maximum amount available during 2016 for AGC to distribute as ordinary dividends is approximately $79 million, of which approximately $41 million is available for distribution in the fourth quarter of 2016.


81

U.K. company law prohibits AGUK from declaring a dividend to its shareholder unless it has “profits available for distribution.” The determination of whether a company has profits available for distribution is based on its accumulated realized profits less its accumulated realized losses. While the U.K. insurance regulatory laws impose no statutory restrictions on a general insurer's ability to declare a dividend, the Prudential Regulation Authority's capital requirements may in practice act as a restriction on dividends. The Company does not expect AGUK to distribute any dividends at this time.

Dividends
 
Third Quarter
 
Nine Months
 
2016
 
2015
 
2016
 
2015
 
(in millions)
Dividends paid by AGC to Assured Guaranty US Holdings Inc.
$
15

 
$
15

 
$
38

 
$
50


13.
Income Taxes

Overview

The Company files its U.S. federal tax return as a part of the consolidated group for Assured Guaranty US Holdings Inc. ("AGUS"), its direct parent holding company. Each member of the AGUS consolidated tax group is part of a tax sharing agreement and pays or receives its proportionate share of the consolidated regular federal tax liability for the group as if each company filed on a separate return basis.

AGC and AGUK are subject to U.S. and U.K. income tax, respectively. AGC and AGUK are subject to income taxes imposed by U.S. and U.K. authorities at marginal corporate income tax rate of 35% and 20%, respectively, and file applicable tax returns. For periods subsequent to April 1, 2015, the U.K. corporation tax rate has been reduced to 20% and will remain unchanged until April 1, 2017. For the period April 1, 2014 to April 1, 2015 the U.K. corporation tax rate was 21% resulting in a blended tax rate of 20.25% in 2015.

Provision for Income Taxes

The Company's provision for income taxes for interim financial periods is not based on an estimated annual effective
rate due, for example, to the variability in fair value of its credit derivatives, which prevents the Company from projecting a reliable estimated annual effective tax rate and pretax income for the full year 2016. A discrete calculation of the provision is calculated for each interim period.

A reconciliation of the difference between the provision for income taxes and the expected tax provision at statutory rates in taxable jurisdictions is presented below.

Effective Tax Rate Reconciliation

 
Third Quarter
 
Nine Months
 
2016
 
2015
 
2016
 
2015
 
(in millions)
Expected tax provision (benefit) at statutory rates
$
119

 
$
1

 
$
130

 
$
91

Tax-exempt interest
(3
)
 
(4
)
 
(10
)
 
(10
)
Gain on bargain purchase
(124
)
 
—

 
(124
)
 
(19
)
Change in liability for uncertain tax positions
3

 
3

 
4

 
4

True-up from tax return filing
(9
)
 
(3
)
 
(9
)
 
(3
)
Other
(2
)
 
1

 
(2
)
 
2

Total provision (benefit) for income taxes
$
(16
)
 
$
(2
)
 
$
(11
)
 
$
65

Effective tax rate
(4.8
)%
 
(53.0
)%
 
(3.1
)%
 
25.1
%


82

The expected tax provision at statutory rates in taxable jurisdictions is calculated as the sum of pretax income in each jurisdiction multiplied by the statutory tax rate of the jurisdiction by which it will be taxed. Pretax income of the Company’s subsidiaries which are not U.S. or U.K. domiciled but are subject to U.S. tax as controlled foreign corporations, are included at the U.S. statutory tax rate.

Valuation Allowance

As part of the Radian Asset Acquisition, the Company acquired $19 million of foreign tax credits (“FTC”) which will expire between 2018 and 2020. After reviewing positive and negative evidence, the Company came to the conclusion that it is more likely than not that the FTC will not be utilized, and therefore recorded a valuation allowance with respect to this tax attribute.

The Company came to the conclusion that it is more likely than not that the remaining net deferred tax asset will be fully realized after weighing all positive and negative evidence available as required under GAAP. The positive evidence that was considered included the cumulative income the Company has earned over the last three years, and the significant unearned premium income to be included in taxable income. The positive evidence outweighs any negative evidence that exists. As such, the Company believes that no valuation allowance is necessary in connection with this deferred tax asset. The Company will continue to analyze the need for a valuation allowance on a quarterly basis.

Audits

AGUS has open tax years with the U.S. Internal Revenue Service for 2009 forward and is currently under audit for the 2009 - 2012 tax years. CIFG, which was acquired by AGC during 2016, is not currently under examination and has open tax years of 2013 forward.
 
Uncertain Tax Positions

The Company's policy is to recognize interest and penalties related to uncertain tax positions in income tax expense and has accrued $0.7 million for Nine Months 2016 and $0.5 million for 2015. As of September 30, 2016 and December 31, 2015, the Company has accrued $3.0 million and $2.3 million of interest, respectively.

The total amount of unrecognized tax benefits as of September 30, 2016 and December 31, 2015, that would affect the effective tax rate, if recognized, was $28.0 million and $23.6 million, respectively.

14.
Reinsurance and Other Monoline Exposures

AGC assumes exposure on insured obligations (“Assumed Business”) and may cede portions of its exposure on obligations it has insured (“Ceded Business”) in exchange for premiums, net of ceding commissions. AGC has historically entered into ceded reinsurance contracts in order to obtain greater business diversification and reduce the net potential loss from large risks.

Assumed and Ceded Business

The Company assumes business from other monoline financial guaranty companies. Under these relationships, the Company assumes a portion of the ceding company’s insured risk in exchange for a premium. The Company may be exposed to risk in this portfolio in that the Company may be required to pay losses without a corresponding premium in circumstances where the ceding company is experiencing financial distress and is unable to pay premiums. The Company’s facultative and treaty agreements are generally subject to termination at the option of the ceding company:

•
if the Company fails to meet certain financial and regulatory criteria and to maintain a specified minimum financial strength rating, or

•
upon certain changes of control of the Company.

Upon termination under these conditions, the Company may be required (under some of its reinsurance agreements) to return to the ceding company unearned premiums (net of ceding commissions) and loss reserves, calculated on a statutory basis of accounting, attributable to reinsurance assumed pursuant to such agreements after which the Company would be released from liability with respect to the Assumed Business.


83

Upon the occurrence of the conditions set forth in the first bullet above, whether or not an agreement is terminated, the Company may be required to obtain a letter of credit or alternative form of security to collateralize its obligation to perform under such agreement or it may be obligated to increase the level of ceding commission paid.

The downgrade of the financial strength ratings of AGC gives certain ceding companies the right to recapture business they had ceded to AGC, which would lead to a reduction in the Company's unearned premium reserve and related earnings on such reserve. With respect to a significant portion of the Company’s in-force financial guaranty assumed business, based on AGC's current ratings and subject to the terms of each reinsurance agreement, the third party ceding company may have the right to recapture business it had ceded to AGC, and in connection therewith, to receive payment from AGC of an amount equal to the statutory unearned premium (net of ceding commissions) and statutory loss reserves (if any) associated with that business, plus, in certain cases, an additional ceding commission. As of September 30, 2016, if each third party insurer ceding business to AGC had a right to recapture such business, and chose to exercise such right, the aggregate amounts that AGC could be required to pay to all such companies would be approximately $21 million.

The Company has Ceded Business to affiliated and non-affiliated companies to limit its exposure to risk. Under these relationships, the Company ceded a portion of its insured risk in exchange for a premium paid to the reinsurer. The Company remains primarily liable for all risks it directly underwrites and is required to pay all gross claims. It then seeks reimbursement from the reinsurer for its proportionate share of claims. The Company may be exposed to risk for this exposure if it were required to pay the gross claims and not be able to collect ceded claims from an assuming company experiencing financial distress. A number of the financial guaranty insurers to which the Company has ceded par have experienced financial distress and been downgraded by the rating agencies as a result. In addition, state insurance regulators have intervened with respect to some of these insurers. The Company’s ceded contracts generally allow the Company to recapture Ceded Business after certain triggering events, such as reinsurer downgrades.

The following table presents the components of premiums and losses reported in the consolidated statement of operations and the contribution of the Company's Assumed and Ceded Businesses.

Effect of Reinsurance on Statement of Operations

 
Third Quarter
 
Nine Months
 
2016
 
2015
 
2016
 
2015
 
(in millions)
Premiums Written:
 
 
 
 
 
 
 
Direct
$
2

 
$
0

 
$
0

 
$
20

Assumed
0

 
0

 
(1
)
 
0

Ceded (1)
6

 
0

 
8

 
(2
)
Net
$
8

 
$
0

 
$
7

 
$
18

Premiums Earned:
 
 
 
 
 
 
 
Direct
$
110

 
$
72

 
$
233

 
$
185

Assumed
10

 
15

 
39

 
33

Ceded
(30
)
 
(26
)
 
(80
)
 
(65
)
Net
$
90

 
$
61

 
$
192

 
$
153

Loss and LAE:
 
 
 
 
 
 
 
Direct
$
(31
)
 
$
57

 
$
56

 
$
159

Assumed
6

 
30

 
21

 
44

Ceded
5

 
(39
)
 
(29
)
 
(83
)
Net
$
(20
)
 
$
48

 
$
48

 
$
120

____________________
(1)
Positive ceded premiums written were due to commutations and changes in expected debt service schedules.



84

Other Monoline Exposures

In addition to assumed and ceded reinsurance arrangements, the Company may also have exposure to some financial guaranty reinsurers (i.e., monolines) in other areas. Second-to-pay insured par outstanding represents transactions the Company has insured that were previously insured by other monolines. The Company underwrites such transactions based on the underlying insured obligation without regard to the primary insurer. Another area of exposure is in the investment portfolio where the Company holds fixed-maturity securities that are wrapped by monolines and whose value may change based on the rating of the monoline. As of September 30, 2016, based on fair value, the Company had fixed-maturity securities in its investment portfolio consisting of $8 million insured by Ambac, $25 million insured by National, and $13 million insured by AGM.

In addition, the Company acquired bonds for loss mitigation or other risk management purposes. As of September 30, 2016 these bonds had a fair value of $260 million insured by MBIA Insurance Corporation.

Exposure by Reinsurer
 
 
Ratings at
 
Par Outstanding (1)
 
 
December 15, 2016
 
As of September 30, 2016
Reinsurer
 
Moody’s
Reinsurer
Rating
 
S&P
Reinsurer
Rating
 
Ceded Par
Outstanding
 
Second-to-Pay
Insured
Par
Outstanding
 
Assumed
Par
Outstanding
 
 
(dollars in millions)
Affiliated Companies:
 
 
 
 
 
 
 
 
 
 
AG Re (2)
 
WR(4)
 
AA
 
$
18,103

 
$
—

 
$
—

AGM (3) and Assured Guaranty (Europe) Ltd.
 
A2
 
AA
 
21

 
426

 
2,840

MAC (3)
 
NR(5)
 
AA
 
17,688

 
—

 
—

Affiliated Companies
 
 
 
 
 
35,812

 
426

 
2,840

Non-Affiliated Companies:
 
 
 
 
 
 
 
 
 
 
American Overseas Reinsurance Company Limited (2)
 
WR
 
WR
 
637

 
—

 
—

Ambac
 
WR
 
WR
 
115

 
557

 
465

National (6)
 
A3
 
AA-
 
—

 
831

 
1,629

Syncora Guarantee Inc.
 
WR
 
WR
 
—

 
570

 
52

FGIC
 
(7)
 
(7)
 
—

 
271

 
10

MBIA
 
(8)
 
(8)
 
—

 
461

 
337

Ambac Assurance Corp. Segregated Account
 
NR
 
NR
 
—

 
1

 
72

Other
 
Various
 
Various
 
41

 
292

 
78

Non-Affiliated Companies
 
 
 
 
 
793

 
2,983

 
2,643

Total
 
 
 
 
 
$
36,605

 
$
3,409

 
$
5,483

____________________
(1)    Includes par related to insured credit derivatives.
(2)
The total collateral posted by all affiliated and non-affiliated reinsurers required or agreeing to post collateral as of September 30, 2016, was approximately $480 million.
(3)     AGM and MAC are rated AA+ (stable outlook) by KBRA.
(4)    Represents “Withdrawn Rating.”
(5)    Represents “Not Rated.”
(6)    Rated AA+ by KBRA.
(7)
FGIC includes subsidiaries Financial Guaranty Insurance Company and FGIC UK Limited, both of which had their ratings withdrawn by rating agencies.
(8)
MBIA includes subsidiaries MBIA Insurance Corp. rated CCC by S&P and Caa1 by Moody's and MBIA UK Insurance Ltd. rated BB by S&P and Ba2 by Moody’s.

85

Amounts Due (To) From Reinsurers
As of September 30, 2016

 
Assumed
Premium, net
of Commissions
 
Ceded
Premium, net
of Commissions
 
Assumed
Expected
Loss and LAE
 
Ceded
Expected
Loss and LAE
 
(in millions)
AGM and Assured Guaranty (Europe) Ltd.
$
10

 
$
—

 
$
(29
)
 
$
—

AG Re
—

 
(58
)
 
—

 
298

MAC
—

 
(1
)
 
—

 
0

American Overseas Reinsurance Company Limited
—

 
(1
)
 
—

 
1

Ambac
2

 
—

 
(1
)
 
—

National
1

 
—

 
8

 
—

MBIA
4

 
—

 
(8
)
 
—

Ambac Assurance Corp. Segregated Account
0

 
—

 
(6
)
 
—

Other
0

 
(2
)
 
0

 
—

Total
$
17

 
$
(62
)
 
$
(36
)
 
$
299


Excess of Loss Reinsurance Facility

AGC, AGM and MAC entered into a $360 million aggregate excess of loss reinsurance facility with a number of reinsurers, effective as of January 1, 2016. This facility replaces a similar $450 million aggregate excess of loss reinsurance facility that AGC, AGM and MAC had entered into effective January 1, 2014 and which terminated on December 31, 2015. The new facility covers losses occurring either from January 1, 2016 through December 31, 2023, or January 1, 2017 through December 31, 2024, at the option of AGC, AGM and MAC. It terminates on January 1, 2018, unless AGC, AGM and MAC choose to extend it. The new facility covers certain U.S. public finance credits insured or reinsured by AGC, AGM and MAC as of September 30, 2015, excluding credits that were rated non-investment grade as of December 31, 2015 by Moody’s or S&P or internally by AGC, AGM or MAC and is subject to certain per credit limits. Among the credits excluded are those associated with the Commonwealth of Puerto Rico and its related authorities and public corporations. The new facility attaches when AGC’s, AGM’s and MAC’s net losses (net of AGC’s and AGM's reinsurance (including from affiliates) and net of recoveries) exceed $1.25 billion in the aggregate. The new facility covers a portion of the next $400 million of losses, with the reinsurers assuming pro rata in the aggregate $360 million of the $400 million of losses and AGC, AGM and MAC jointly retaining the remaining $40 million. The reinsurers are required to be rated at least AA- or to post collateral sufficient to provide AGM, AGC and MAC with the same reinsurance credit as reinsurers rated AA-. AGM, AGC and MAC are obligated to pay the reinsurers their share of recoveries relating to losses during the coverage period in the covered portfolio. AGC, AGM and MAC paid approximately $9 million of premiums in 2016 (of which AGC paid approximately $1 million) for the term January 1, 2016 through December 31, 2016 and deposited approximately $9 million of securities into trust accounts for the benefit of the reinsurers to be used to pay the premium for January 1, 2017 through December 31, 2017. The main differences between the new facility and the prior facility that terminated on December 31, 2015 are the reinsurance attachment point ($1.25 billion versus $1.5 billion), the total reinsurance coverage ($360 million part of $400 million versus $450 million part of $500 million) and the annual premium ($9 million versus $19 million).
15.
Commitments and Contingencies

Legal Proceedings

Lawsuits arise in the ordinary course of the Company’s business. It is the opinion of the Company’s management, based upon the information available, that the expected outcome of litigation against the Company, individually or in the aggregate, will not have a material adverse effect on the Company’s financial position or liquidity, although an adverse resolution of litigation against the Company in a fiscal quarter or year could have a material adverse effect on the Company’s results of operations in a particular quarter or year.

In addition, in the ordinary course of their respective businesses, the Company and its affiliates assert claims in legal proceedings against third parties to recover losses paid in prior periods or prevent losses in the future, as described in the "Recovery Litigation" section of Note 5, Expected Loss to be Paid. For example, in January 2016, the Company commenced an

86

action for declaratory judgment and injunctive relief in the U.S. District Court for the District of Puerto Rico to invalidate executive orders issued by the Governor of Puerto Rico directing the retention or transfer of certain taxes and revenues pledged to secure the payment of certain bonds insured by the Company, and in July 2016, the Company filed a motion and form of complaint in the U.S. District Court for the District of Puerto Rico seeking relief from the PROMESA stay in order to file a complaint to protect its interest in certain pledged PRHTA toll revenues. The amounts, if any, the Company will recover in these and other proceedings to recover losses are uncertain, and recoveries, or failure to obtain recoveries, in any one or more of these proceedings during any quarter or year could be material to the Company’s results of operations in that particular quarter or year.

The Company establishes accruals for litigation and regulatory matters to the extent it is probable that a loss has been incurred and the amount of that loss can be reasonably estimated. For litigation and regulatory matters where a loss may be reasonably possible, but not probable, or is probable but not reasonably estimable, no accrual is established, but if the matter is material, it is disclosed, including matters discussed below. The Company reviews relevant information with respect to its litigation and regulatory matters on a quarterly and annual basis and updates its accruals, disclosures and estimates of reasonably possible loss based on such reviews.

Litigation
 
The Company receives subpoenas duces tecum and interrogatories from regulators from time to time.
 
On November 28, 2011, Lehman Brothers International (Europe) (in administration) (“LBIE”) sued AG Financial Products Inc. ("AGFP"), an affiliate of AGC which in the past had provided credit protection to counterparties under credit default swaps. AGC acts as the credit support provider of AGFP under these credit default swaps. LBIE’s complaint, which was filed in the Supreme Court of the State of New York, alleged that AGFP improperly terminated nine credit derivative transactions between LBIE and AGFP and improperly calculated the termination payment in connection with the termination of 28 other credit derivative transactions between LBIE and AGFP. Following defaults by LBIE, AGFP properly terminated the transactions in question in compliance with the agreement between AGFP and LBIE, and calculated the termination payment properly. AGFP calculated that LBIE owes AGFP approximately $29 million in connection with the termination of the credit derivative transactions, whereas LBIE asserted in the complaint that AGFP owes LBIE a termination payment of approximately $1.4 billion. On February 3, 2012, AGFP filed a motion to dismiss certain of the counts in the complaint, and on March 15, 2013, the court granted AGFP's motion to dismiss the count relating to improper termination of the nine credit derivative transactions and denied AGFP's motion to dismiss the counts relating to the remaining transactions. On February 22, 2016, AGFP filed a motion for summary judgment on the remaining causes of action asserted by LBIE and on AGFP's counterclaims. Oral argument on AGFP's motion took place on July 21, 2016. LBIE's administrators disclosed in an April 10, 2015 report to LBIE’s unsecured creditors that LBIE’s valuation expert has calculated LBIE's claim for damages in aggregate for the 28 transactions to range between a minimum of approximately $200 million and a maximum of approximately $500 million, depending on what adjustment, if any, is made for AGFP's credit risk and excluding any applicable interest.

On December 22, 2014, Deutsche Bank National Trust Company, as indenture trustee for the AAA Trust 2007-2 Re-REMIC (the Trustee), filed a “trust instructional proceeding” petition in the State of California Superior Court (Probate Division, Orange County), seeking the court’s instruction as to how it should allocate the losses resulting from its December 2014 sale of four RMBS owned by the AAA Trust 2007-2 Re-REMIC. This sale of approximately $70 million principal balance of RMBS was made pursuant to AGC’s liquidation direction in November 2014, and resulted in approximately $27 million of gross proceeds to the Re-REMIC. On December 22, 2014, AGC directed the indenture trustee to allocate to the uninsured Class A-3 Notes the losses realized from the sale. On May 4, 2015, the Superior Court rejected AGC’s allocation direction, and ordered the Trustee to allocate to the Class A-3 noteholders a pro rata share of the $27 million of gross proceeds. AGC is appealing the Superior Court’s decision to the California Court of Appeal.

Proceedings Resolved Since December 31, 2015

On May 28, 2014, Houston Casualty Company Europe, Seguros y Reseguros, S.A. (“HCCE”) notified Radian Asset that it was demanding arbitration against Radian Asset in connection with housing cooperative losses presented to Radian Asset by HCCE under several years of quota-share surety reinsurance contracts. Through November 30, 2015, HCCE had presented AGC, as successor to Radian Asset, with approximately €15 million in claims. In January 2016, Assured Guaranty and HCCE settled all the claims related to the Spanish housing cooperative losses.


87

16.
Note Payable to Affiliates and Credit Facilities

Note Payable to Affiliates

On December 18, 2009, AGC issued a surplus note with a principal amount of $300 million to AGM. This Note Payable to Affiliate carries a simple interest rate of 5.0% per annum and matures on December 31, 2029. On April 11, 2016, the surplus note agreement was amended to reduce the simple interest rate to 3.5% per annum effective January 1, 2016. Principal is payable at the option of AGC prior to the final maturity of the note in 2029 and interest is payable on the note annually in arrears as of December 31st of each year, commencing December 31, 2010. Payments of principal and interest are subject to AGC having policyholders’ surplus in excess of statutory minimum requirements after such payment and to prior written approval by the MIA.

Committed Capital Securities

On April 8, 2005, AGC entered into separate agreements (the “Put Agreements”) with four custodial trusts (each, a “Custodial Trust”) pursuant to which AGC may, at its option, cause each of the Custodial Trusts to purchase up to $50 million of perpetual preferred stock of AGC (the “AGC Preferred Stock”). The custodial trusts were created as a vehicle for providing capital support to AGC by allowing AGC to obtain immediate access to new capital at its sole discretion at any time through the exercise of the put option. If the put options were exercised, AGC would receive $200 million in return for the issuance of its own perpetual preferred stock, the proceeds of which may be used for any purpose, including the payment of claims. The put options have not been exercised through the date of this filing.

Distributions on the AGC CCS are determined pursuant to an auction process. Beginning on April 7, 2008 this auction process failed, thereby increasing the annualized rate on the AGC CCS to one-month LIBOR plus 250 basis points.

See Note 7, Fair Value Measurement, –Other Assets–Committed Capital Securities, for a fair value measurement discussion.

17.    Other Comprehensive Income

The following tables present the changes in each component of AOCI and the effect of reclassifications out of AOCI on the respective line items in net income.

Changes in Accumulated Other Comprehensive Income by Component
Third Quarter 2016

 
Net Unrealized
Gains (Losses) on
Investments with no Other-Than-Temporary Impairment
 
Net Unrealized
Gains (Losses) on
Investments with Other-Than-Temporary Impairment
 
Cumulative
Translation
Adjustment
 
Total Accumulated
Other
Comprehensive
Income
 
(in millions)
Balance, June 30, 2016
$
96

 
$
6

 
$
(25
)
 
$
77

Other comprehensive income (loss) before reclassifications
3

 
14

 
(5
)
 
12

Amounts reclassified from AOCI to:
 
 
 
 
 
 
 
Net realized investment gains (losses)
0

 
0

 
—

 
0

Tax (provision) benefit
0

 
0

 
—

 
0

Total amount reclassified from AOCI, net of tax
0

 
0

 
—

 
0

Net current period other comprehensive income (loss)
3

 
14

 
(5
)
 
12

Balance, September 30, 2016
$
99

 
$
20

 
$
(30
)
 
$
89




88

Changes in Accumulated Other Comprehensive Income by Component
Third Quarter 2015

 
Net Unrealized
Gains (Losses) on
Investments with no Other-Than-Temporary Impairment
 
Net Unrealized
Gains (Losses) on
Investments with Other-Than-Temporary Impairment
 
Cumulative
Translation
Adjustment
 
Total Accumulated
Other
Comprehensive
Income
 
(in millions)
Balance, June 30, 2015
$
40

 
$
8

 
$
(8
)
 
$
40

Other comprehensive income (loss) before reclassifications
13

 
(5
)
 
(4
)
 
4

Amounts reclassified from AOCI to:
 
 
 
 
 
 
 
Net realized investment gains (losses)
2

 
1

 
—

 
3

Tax (provision) benefit
(1
)
 
0

 
—

 
(1
)
Total amount reclassified from AOCI, net of tax
1

 
1

 
—

 
2

Net current period other comprehensive income (loss)
14

 
(4
)
 
(4
)
 
6

Balance, September 30, 2015
$
54

 
$
4

 
$
(12
)
 
$
46



Changes in Accumulated Other Comprehensive Income by Component
Nine Months 2016

 
Net Unrealized
Gains (Losses) on
Investments with no Other-Than-Temporary Impairment
 
Net Unrealized
Gains (Losses) on
Investments with Other-Than-Temporary Impairment
 
Cumulative
Translation
Adjustment
 
Total Accumulated
Other
Comprehensive
Income
 
(in millions)
Balance, December 31, 2015
$
60

 
$
3

 
$
(15
)
 
$
48

Other comprehensive income (loss) before reclassifications
46

 
15

 
(15
)
 
46

Amounts reclassified from AOCI to:
 
 
 
 
 
 
 
Net realized investment gains (losses)
(10
)
 
3

 
—

 
(7
)
Tax (provision) benefit
3

 
(1
)
 
—

 
2

Total amount reclassified from AOCI, net of tax
(7
)
 
2

 
—

 
(5
)
Net current period other comprehensive income (loss)
39

 
17

 
(15
)
 
41

Balance, September 30, 2016
$
99

 
$
20

 
$
(30
)
 
$
89




89

Changes in Accumulated Other Comprehensive Income by Component
Nine Months 2015

 
Net Unrealized
Gains (Losses) on
Investments with no Other-Than-Temporary Impairment
 
Net Unrealized
Gains (Losses) on
Investments with Other-Than-Temporary Impairment
 
Cumulative
Translation
Adjustment
 
Total Accumulated
Other
Comprehensive
Income
 
(in millions)
Balance, December 31, 2014
$
80

 
$
6

 
$
(9
)
 
$
77

Other comprehensive income (loss) before reclassifications
(17
)
 
(5
)
 
(3
)
 
(25
)
Amounts reclassified from AOCI to:
 
 
 
 
 
 
 
Net realized investment gains (losses)
(14
)
 
4

 
—

 
(10
)
Tax (provision) benefit
5

 
(1
)
 
—

 
4

Total amount reclassified from AOCI, net of tax
(9
)
 
3

 
—

 
(6
)
Net current period other comprehensive income (loss)
(26
)
 
(2
)
 
(3
)
 
(31
)
Balance, September 30, 2015
$
54

 
$
4

 
$
(12
)
 
$
46



18.
Subsequent Events

Subsequent events have been considered through December 21, 2016, the date on which these financial statements were issued.

90