Guaranty

Assured Guaranty Municipal Corp.




Exhibit 99.1






Assured Guaranty Municipal Corp.

Condensed Combined Financial Statements

(Unaudited)

March 31, 2018








ASSURED GUARANTY MUNICIPAL CORP.
INDEX TO CONDENSED COMBINED FINANCIAL STATEMENTS






Assured Guaranty Municipal Corp.
Condensed Combined Balance Sheets (unaudited)
(dollars in millions except per share and share amounts)
 
As of
March 31, 2018
 
As of
December 31, 2017
Assets
 
 
 
Investment portfolio:
 
 
 
Fixed-maturity securities, available-for-sale, at fair value (amortized cost of $5,450 and $5,479)
$
5,559

 
$
5,659

Short-term investments, at fair value
274

 
364

Other invested assets (includes Surplus Note from affiliate of $300 and $300)
373

 
378

Total investment portfolio
6,206

 
6,401

Cash
66

 
36

Premiums receivable
765

 
730

Ceded unearned premium reserve
766

 
757

Reinsurance recoverable on unpaid losses
191

 
227

Salvage and subrogation recoverable
275

 
297

Financial guaranty variable interest entities’ assets, at fair value
534

 
577

Other assets
166

 
159

Total assets   
$
8,969

 
$
9,184

Liabilities and shareholder's equity
 
 
 
Unearned premium reserve
$
2,723

 
$
2,746

Loss and loss adjustment expense reserve
822

 
931

Reinsurance balances payable, net
202

 
197

Current income tax payable
110

 
121

Financial guaranty variable interest entities’ liabilities with recourse, at fair value
473

 
495

Financial guaranty variable interest entities’ liabilities without recourse, at fair value
108

 
128

Other liabilities
293

 
316

Total liabilities   
4,731

 
4,934

Commitments and contingencies (See Note 14)
 
 
 
Preferred stock ($1,000 par value, 5,000.1 shares authorized; 0 shares issued and outstanding)

 

Common stock ($92,025 par value, 163 shares authorized, issued and outstanding)
15

 
15

Additional paid-in capital
702

 
702

Retained earnings
3,256

 
3,199

Accumulated other comprehensive income, net of tax of $7 and $32
45

 
118

Total shareholder's equity attributable to Assured Guaranty Municipal Corp.
4,018

 
4,034

Noncontrolling interest
220

 
216

Total shareholder's equity
4,238

 
4,250

Total liabilities and shareholder's equity   
$
8,969

 
$
9,184


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

1



Assured Guaranty Municipal Corp.
Condensed Combined Statements of Operations (unaudited)
(in millions)

 
Three Months Ended March 31,
 
2018
 
2017
Revenues
 
 
 
Net earned premiums
$
76

 
$
78

Net investment income
51

 
58

Net realized investment gains (losses):
 
 
 
Other-than-temporary impairment losses
(10
)
 
(1
)
Less: portion of other-than-temporary impairment loss recognized in other comprehensive income
(2
)
 
7

Net impairment loss
(8
)
 
(8
)
Other net realized investment gains (losses)
5

 
1

Net realized investment gains (losses)
(3
)
 
(7
)
Net change in fair value of credit derivatives:
 
 
 
Realized gains (losses) and other settlements
0

 
14

Net unrealized gains (losses)
(1
)
 
7

Net change in fair value of credit derivatives
(1
)
 
21

Fair value gains (losses) on financial guaranty variable interest entities
2

 
8

Commutation gains (see Note 13)
1

 
73

Other income (loss)
20

 
11

Total revenues   
146

 
242

Expenses
 
 
 
Loss and loss adjustment expenses
(8
)
 
16

Amortization of deferred ceding commissions
(2
)
 
(4
)
Other operating expenses
37

 
36

Total expenses   
27

 
48

Income (loss) before income taxes   
119

 
194

Provision (benefit) for income taxes
 
 
 
Current
(8
)
 
67

Deferred
17

 
(11
)
Total provision (benefit) for income taxes   
9

 
56

Net income (loss)
110

 
138

Less: Noncontrolling interest
7

 
8

Net income (loss) attributable to Assured Guaranty Municipal Corp.
$
103

 
$
130


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


2



Assured Guaranty Municipal Corp.
Condensed Combined Statements of Comprehensive Income (unaudited)
(in millions)

 
Three Months Ended March 31,
 
2018
 
2017
Net income (loss)   
$
110

 
$
138

Unrealized holding gains (losses) arising during the period on:
 
 
 
Investments with no other-than-temporary impairment, net of tax provision (benefit) of $(19) and $16
(43
)
 
32

Investments with other-than-temporary impairment, net of tax provision (benefit) of $(2) and $8
(9
)
 
15

Unrealized holding gains (losses) arising during the period, net of tax
(52
)
 
47

Less: reclassification adjustment for gains (losses) included in net income (loss), net of tax provision (benefit) of $(1) and $(3)
(1
)
 
(3
)
Change in net unrealized gains (losses) on investments
(51
)
 
50

 
 
 
 
Net unrealized gains (losses) arising during the period on FG VIE liabilities with recourse attributable to changes in instrument-specific credit risk, net of tax provision (benefit) of $(1) (see Note 1)
(3
)
 

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

Change in net unrealized gains (losses) on FG VIE liabilities with recourse
(2
)
 

 
 
 
 
Other, net of tax provision
4

 
1

Comprehensive income (loss)
61

 
189

Less: Comprehensive income (loss) attributable to noncontrolling interest
4

 
10

Comprehensive income (loss) attributable to Assured Guaranty Municipal Corp.
$
57

 
$
179


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


3



Assured Guaranty Municipal Corp.
Condensed Combined Statements of Shareholder’s Equity (unaudited)

For the Three Months Ended March 31, 2018
(dollars in millions, except share data)

 
Assured Guaranty Municipal Corp. Common Shares Outstanding
 
Common Stock Par Value
 
Additional
Paid-in
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive Income
 
Total
Shareholder's
Equity
Attributable to Assured Guaranty Municipal Corp.
 
Noncontrolling
Interest
 
Total
Shareholder's
Equity
Balance at December 31, 2017
163

 
$
15

 
$
702

 
$
3,199

 
$
118

 
$
4,034

 
$
216

 
$
4,250

Net income

 

 

 
103

 

 
103

 
7

 
110

Dividends

 

 

 
(73
)
 

 
(73
)
 

 
(73
)
Other comprehensive loss

 

 

 

 
(46
)
 
(46
)
 
(3
)
 
(49
)
Effect of adoption of ASU 2016-01 (see Note 1)

 

 

 
27

 
(27
)
 

 

 

Balance at March 31, 2018
163

 
$
15

 
$
702

 
$
3,256

 
$
45

 
$
4,018

 
$
220

 
$
4,238




For the Three Months Ended March 31, 2017
(dollars in millions, except share data)

 
Assured Guaranty Municipal Corp. Common Shares Outstanding
 
Common Stock Par Value
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive Income
 
Total
Shareholder's
Equity
Attributable to Assured Guaranty Municipal Corp.
 
Noncontrolling
Interest
 
Total
Shareholder's
Equity
Balance at December 31, 2016
205

 
$
77

 
$
778

 
$
3,019

 
$
12

 
$
3,886

 
$
295

 
$
4,181

Net income

 

 

 
130

 

 
130

 
8

 
138

Dividends

 

 

 
(79
)
 

 
(79
)
 
(5
)
 
(84
)
Other comprehensive income

 

 

 

 
49

 
49

 
2

 
51

Effect of common control acquisitions (see Note 2)

 
84

 
282

 

 

 
366

 

 
366

Balance at March 31, 2017
205

 
$
161

 
$
1,060

 
$
3,070

 
$
61

 
$
4,352

 
$
300

 
$
4,652



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


4



Assured Guaranty Municipal Corp.
Condensed Combined Statements of Cash Flows (unaudited)
(in millions)

 
Three Months Ended March 31,
 
2018
 
2017
Net cash flows provided by (used in) operating activities
$
(49
)
 
$
134

Investing activities
 
 
 
Fixed-maturity securities:
 
 
 
Purchases
(219
)
 
(251
)
Sales
108

 
120

Maturities
169

 
168

Net sales (purchases) of short-term investments
97

 
(103
)
Net proceeds from paydowns on financial guaranty variable interest entities’ assets
26

 
33

Effect of common control combination for acquisitions (see Note 2)

 
72

Other
(1
)
 
(14
)
Net cash flows provided by (used in) investing activities   
180

 
25

Financing activities
 
 
 
Dividends paid to Assured Guaranty Municipal Holdings Inc.
(73
)
 
(79
)
Dividends paid to AGC (see Note 11)

 
(5
)
Repayment of notes payable
0

 
(1
)
Net paydowns of financial guaranty variable interest entities' liabilities
(26
)
 
(35
)
Net cash flows provided by (used in) financing activities   
(99
)
 
(120
)
Effect of foreign exchange rate changes
1

 
0

Increase (decrease) in cash and restricted cash
33

 
39

Cash and restricted cash at beginning of period (see Note 10)
36

 
40

Cash and restricted cash at end of period (see Note 10)
$
69

 
$
79

Supplemental cash flow information
 
 
 
Cash paid (received) during the period for:
 
 
 
Income taxes
$
10

 
$

Interest
$
0

 
$
0


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

5



Assured Guaranty Municipal Corp.
Notes to the Condensed Combined Financial Statements (unaudited)
March 31, 2018

1.    Business and Basis of Presentation

Business

Assured Guaranty Municipal Corp. (AGM, or together with its subsidiaries, the Company), a New York domiciled insurance company, is a wholly owned subsidiary of Assured Guaranty Municipal Holdings Inc. (AGMH). AGMH is an indirect, wholly owned 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. AGM was formerly known as Financial Security Assurance Inc.

The Company applies its credit underwriting judgment, risk management skills and capital markets experience primarily 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. Obligations insured by the Company include bonds issued by U.S. state or municipal governmental authorities and notes issued to finance international infrastructure projects. AGM had previously offered insurance and reinsurance in the global structured finance market, but has not done so since mid-2008. AGM and its indirect subsidiary Municipal Assurance Corp. (MAC) each markets its financial guaranty insurance directly to issuers and underwriters of, and investors in, public finance securities. In addition, AGM's direct subsidiary, Assured Guaranty (Europe) plc (AGE, formerly Assured Guaranty (Europe) Ltd.), provides financial guaranties for the international public finance (including infrastructure) market and, with the approval of the U.K. Prudential Regulation Authority (PRA), the asset-backed and other structured finance market. AGM provides reinsurance and second-to-pay financial guaranties on financial guaranties provided by AGE for the international public finance (including infrastructure) market. 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). 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 in the U.S. since 2008. Regulatory guidelines were issued in 2009 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 in the U.S. since 2009. The Company actively pursues opportunities to terminate existing CDS, which terminations have the effect of reducing future fair value volatility in income and/or reducing rating agency capital charges.

On June 26, 2017, AGM purchased from its affiliate, Assured Guaranty Corp. (AGC), all of the shares of AGC’s direct, wholly owned subsidiaries, Assured Guaranty (UK) plc (AGUK, formerly Assured Guaranty (UK) Ltd.), CIFG Europe S.A. (CIFGE) and Assured Guaranty (London) plc (AGLN, formerly MBIA UK Insurance Ltd.) (collectively, the European Subsidiaries), and then immediately contributed the European Subsidiaries to AGM’s wholly owned subsidiary, AGE. See Note 2, Common Control Acquisition.

Basis of Presentation

The unaudited interim condensed combined 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 material 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

6



those estimates. These unaudited interim condensed combined financial statements are as of March 31, 2018 and cover the three-month period ended March 31, 2018 (First Quarter 2018) and the three-month period ended March 31, 2017 (First Quarter 2017). 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 the AGM combined audited financial statements.

The unaudited interim condensed combined financial statements include the accounts of AGM, its direct and indirect subsidiaries, and its consolidated FG VIEs. In addition, amounts for all periods prior to June 26, 2017 have been retrospectively adjusted to include the European Subsidiaries from the date the common control began for each subsidiary (combined basis). See Note 2, Common Control Acquisition for additional information.

Intercompany accounts and transactions between and among all consolidated and combined entities have been eliminated. Certain prior year balances have been reclassified to conform to the current year's presentation.

These unaudited interim condensed combined financial statements should be read in conjunction with the annual combined financial statements of AGM included in Exhibit 99.1 in AGL's Form 8-K dated March 20, 2018, filed with the U.S. Securities and Exchange Commission (the SEC).

AGM owns 100% of AGE, organized in the U.K., and 60.7% of Municipal Assurance Holdings Inc. (MAC Holdings), incorporated in Delaware. AGM's affiliate, AGC owns the remaining 39.3% of MAC Holdings. MAC Holdings owns 100% of MAC, domiciled in New York.

Adopted Accounting Standards

Financial Instruments
    
In January 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-01, Financial Instruments - Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities.  The amendments in this ASU are intended to make targeted improvements to GAAP by addressing certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. Amendments under this ASU apply to the Company's FG VIE liabilities, which the Company has historically elected to measure through the statement of operations under the fair value option, and to certain equity securities in the Company’s investment portfolio.

For FG VIE liabilities with recourse, the portion of the change in fair value caused by changes in instrument specific credit risk (ISCR) must now be separately presented in other comprehensive income (OCI) as opposed to the statement of operations. See Note 9, Consolidated Variable Interest Entities for additional information.

Amendments under this ASU also apply to equity securities, except those that are accounted for under the equity method of accounting or that resulted in consolidation of the investee by the Company. For equity securities accounted for at fair value, changes in fair value that previously were recorded in OCI, are recorded in other income in the condensed consolidated statements of operations effective January 1, 2018. Equity securities carried at cost as of December 31, 2017, are recorded at cost less impairment plus or minus the change resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. See Note 10, Investments and Cash for additional information.

Effective January 1, 2018, the Company adopted this ASU with a cumulative-effect adjustment to the statement of financial position as of January 1, 2018. This resulted in a reclassification of a net $27 million loss, net of tax, from retained earnings to accumulated OCI (AOCI). See Note 16, Other Comprehensive Income, for additional information.

Income Taxes

In October 2016, the FASB issued 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 to be applied on a modified retrospective basis (i.e. by recording 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 ASU was adopted on January 1, 2018 with no material effect on the condensed combined financial statements.


7



Future Application of Accounting Standards

Premium Amortization on Purchased Callable Debt Securities

In March 2017, the FASB issued ASU 2017-08, Receivables-Nonrefundable Fees and Other Costs (Topic 310-20) - Premium Amortization on Purchased Callable Debt Securities.  This ASU shortens the amortization period for the premium on certain purchased callable debt securities to the earliest call date.  This ASU has no effect on the accounting for purchased callable debt securities held at a discount.  It is to be applied using a modified retrospective approach and the ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company does not expect this ASU to have a material effect on its condensed combined financial statements.

Leases
    
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). This ASU requires lessees to present right-of-use assets and lease liabilities on the balance sheet. ASU 2016-02 is to be applied using a modified retrospective approach and is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company intends to adopt this ASU on January 1, 2019. The Company is evaluating the effect that this ASU will have on its condensed combined financial statements. The Company currently accounts for its lease agreements where the Company is the lessee as operating leases and, therefore, recognizes its lease expense on a straight-line basis.

Credit Losses on Financial Instruments

In June 2016, the 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 be required to 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 also eliminates the concept of “other than temporary” from the impairment model for certain available-for-sale securities. Accordingly, the ASU states that an entity must use an allowance approach, must limit the allowance to an amount by 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.

The ASU is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. For debt instruments such as reinsurance recoverables, loans and held to maturity securities, 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. The Company is evaluating the effect that this ASU will have on its condensed combined financial statements.


8



2.
    Common Control Acquisitions

The purchase of the European Subsidiaries on June 26, 2017 was an initial step in Assured Guaranty's efforts to merge the operations of its four affiliated European insurance companies (the European Subsidiaries and AGE). The acquisition from AGC of the European Subsidiaries was approved by the New York State Department of Financial Services, the Maryland Insurance Administration (MIA) and the PRA. While Assured Guaranty, the European Subsidiaries and AGE received regulatory approvals for this initial step of the proposed combination of the European Subsidiaries and AGE, that combination is subject to further regulatory approvals and to certain court approvals. As a result, the Company cannot predict whether, or when, such combination will be completed.

As the Company and the European Subsidiaries were under common control at the time of the acquisition, it is required under U.S. GAAP to account for this acquisition in a method that is similar to the pooling-of-interests method. Under this method of accounting, AGM's combined financial statements and disclosures reflect the European Subsidiaries' historical carryover basis in the assets and liabilities instead of reflecting the fair value of the assets and liabilities.

The financial statements and disclosures for all periods presented in this report prior to June 26, 2017 have been retrospectively adjusted, as applicable, to reflect the combination of AGM and the European Subsidiaries as if the combinations had been in effect from the date common control began for each of the subsidiaries. As such, AGUK and CIFGE are reflected within these financial statements for all periods presented, while AGLN is reflected for the periods subsequent to its purchase by Assured Guaranty on January 10, 2017. The consideration paid, which occurred on June 26, 2017, the date of transfer, is not reflected in First Quarter 2017 financial results.
    
See Note 2, Common Control Acquisitions, in the annual combined financial statements of AGM included in Exhibit 99.1 in AGL's Form 8-K dated March 20, 2018, filed with the SEC, for additional information.

3.    Ratings

The financial strength ratings (or similar ratings) for AGM and its insurance company subsidiaries, along with the date of the most recent rating action (or confirmation) by the rating agency, are shown in the table below. Ratings are subject to continuous rating agency review and revision or withdrawal at any time.  In addition, AGM periodically assesses the value of each rating assigned to it and its insurance company subsidiaries, and as a result of such assessment may request that a rating agency add or drop a rating.

 
S&P Global Ratings, a division of Standard & Poor’s Financial Services LLC
 
Kroll Bond Rating Agency
 
Moody’s Investors Service Inc.
AGM
AA (stable) (6/26/17)
 
AA+ (stable) (1/23/18)
 
A2 (stable) (5/7/18)
MAC
AA (stable) (6/26/17)
 
AA+ (stable) (7/14/17)
 
AGE
AA (stable) (6/26/17)
 
 
A2 (stable) (5/7/18)
AGUK
AA (stable) (6/26/17)
 
 
(1)
AGLN
BB (positive) (1/12/17)
 
 
(2)
CIFGE
 
 
____________________
(1)
AGC requested that Moody’s Investors Service, Inc. (Moody's) withdraw its financial strength ratings of AGC and AGUK in January 2017, but Moody's denied that request. Moody’s continues to rate AGC A3 (stable) and AGUK A3. Moody's put AGUK on review for upgrade on June 27, 2017, following its transfer to AGM. On May 7, 2018, Moody's continued its review of AGUK for upgrade.

(2)
Assured Guaranty did not request that Moody's rate AGLN. Moody's continues to rate AGLN, and upgraded its rating to Baa2 (stable) on January 13, 2017, following its acquisition by AGC, and then to Baa1 on review for further upgrade on June 27, 2017, following its transfer to AGM. On May 7, 2018, Moody's continued its review of AGLN for further upgrade.

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

For a discussion of the effects of rating actions on the Company, see Note 6, Contracts Accounted for as Insurance, and Note 13, Reinsurance and Other Monoline Exposures.

9



4.    Outstanding Exposure

The Company primarily writes financial guaranty contracts in insurance form. Until 2008, the Company also wrote some of its financial guaranty contracts in credit derivative form. Whether written as an insurance contract or as a credit derivative, the Company considers these 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 exposures, 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.

The Company has issued financial guaranty insurance policies on public finance obligations and, prior to mid-2008, structured finance obligations. 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. While AGM has ceased insuring new originations of asset-backed securities, a significant portfolio of such obligations remains outstanding. AGM's wholly owned subsidiary, AGE, provides financial guarantees in the international public finance market and intends to provide such guarantees in the international structured finance market.

Debt service and par outstanding exposures presented in these financial statements are presented on a consolidated and combined basis. That is, amounts presented include 100% of the exposures of AGM, AGE, the European Subsidiaries and MAC, despite the fact that AGM indirectly owns only 60.7% of MAC.

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 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 insured portfolio and refreshes its internal credit ratings on individual exposures in quarterly, semi-annual or annual cycles based on the Company’s view of the exposure’s quality, loss potential, volatility and sector. Ratings on exposures in sectors identified as under the most stress or with the most potential volatility are reviewed every quarter.
 
Exposures 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. The Company uses a tax-equivalent yield, which reflects long-term trends in interest rates, to calculate the present value of projected payments and recoveries and determine whether a future loss is expected in order to assign the appropriate BIG surveillance category to a transaction. On the other hand, the Company uses risk-free rates, which are determined each quarter, to calculate 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 on that transaction in the future than it will have reimbursed. The three BIG categories are:

10



 
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.

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.

Components of Outstanding Exposure

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 from par and debt service outstanding, which amounts are included in the investment portfolio, because it manages such securities as investments and not insurance exposure. As of March 31, 2018 and December 31, 2017, the Company excluded $663 million and $678 million, respectively, of net par attributable to loss mitigation securities (which are mostly BIG) and other loss mitigation strategies. The following table presents the gross and net debt service for financial guaranty contracts.

Financial Guaranty
Debt Service Outstanding

 
Gross Debt Service Outstanding
 
Net Debt Service Outstanding(1)
 
March 31, 2018
 
December 31, 2017
 
March 31, 2018
 
December 31, 2017
 
(in millions)
Public finance
$
334,813

 
$
341,451

 
$
241,386

 
$
247,424

Structured finance
7,114

 
7,386

 
6,643

 
6,828

Total financial guaranty
$
341,927

 
$
348,837

 
$
248,029

 
$
254,252

_____________________
(1)
Includes 100% of MAC's gross and net debt service outstanding. However, AGM's indirect ownership of MAC is only 60.7%. The net debt service outstanding amount includes $52.3 billion and $56.3 billion as of both March 31, 2018 and December 31, 2017, respectively, from MAC.


Outstanding 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, any total commitment amount would not necessarily reflect actual future guaranteed amounts. All of the outstanding commitments AGM had as of March 31, 2018 have expired as of the date of this filing.

11



Financial Guaranty Portfolio by Internal Rating
As of March 31, 2018

 
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
$
728

 
0.6
%
 
$
818

 
2.5
%
 
$
701

 
15.7
%
 
$
124

 
22.1
%
 
$
2,371

 
1.5
%
AA
17,977

 
14.3

 
201

 
0.6

 
1,728

 
38.7

 
28

 
5.0

 
19,934

 
12.2

A
73,000

 
58.2

 
12,263

 
37.6

 
54

 
1.2

 
70

 
12.5

 
85,387

 
52.3

BBB
30,601

 
24.4

 
17,896

 
54.8

 
59

 
1.3

 
248

 
44.3

 
48,804

 
29.9

BIG
3,154

 
2.5

 
1,478

 
4.5

 
1,924

 
43.1

 
90

 
16.1

 
6,646

 
4.1

Total net par outstanding (1)
$
125,460

 
100.0
%
 
$
32,656

 
100.0
%
 
$
4,466

 
100.0
%
 
$
560

 
100.0
%
 
$
163,142

 
100.0
%
_____________________
(1)
Includes $38.4 billion of net par outstanding as of March 31, 2018, from MAC, which represents 100% of MAC's net par outstanding. However, AGM's indirect ownership of MAC is only 60.7%.


Financial Guaranty Portfolio by Internal Rating
As of December 31, 2017

 
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
$
736

 
0.6
%
 
$
809

 
2.5
%
 
$
666

 
14.6
%
 
$
124

 
22.3
%
 
$
2,335

 
1.5
%
AA
19,797

 
15.2

 
200

 
0.6

 
1,822

 
39.7

 
27

 
4.8

 
21,846

 
13.0

A
74,860

 
57.5

 
12,011

 
37.4

 
74

 
1.6

 
71

 
12.7

 
87,016

 
51.9

BBB
31,453

 
24.1

 
17,680

 
55.0

 
60

 
1.3

 
246

 
44.2

 
49,439

 
29.5

BIG
3,403

 
2.6

 
1,452

 
4.5

 
1,965

 
42.8

 
89

 
16.0

 
6,909

 
4.1

Total net par outstanding (1)
$
130,249

 
100.0
%
 
$
32,152

 
100.0
%
 
$
4,587

 
100.0
%
 
$
557

 
100.0
%
 
$
167,545

 
100.0
%
_____________________
(1)
Includes $41.5 billion of net par outstanding as of December 31, 2017, from MAC, which represents 100% of MAC's net par outstanding. However, AGM's indirect ownership of MAC is only 60.7%.



12



Components of BIG Portfolio

Components of BIG Net Par Outstanding
As of March 31, 2018

 
BIG Net Par Outstanding
 
Net Par
 
BIG 1
 
BIG 2
 
BIG 3
 
Total BIG (1)
 
Outstanding
 
(in millions)
Public finance:
 
 
 
 
 
 
 
 
 
U.S. public finance
$
1,086

 
$

 
$
2,068

 
$
3,154

 
$
32,656

Non-U.S. public finance
1,256

 
222

 

 
1,478

 
125,460

Public finance
2,342

 
222

 
2,068

 
4,632

 
158,116

Structured finance:
 
 
 
 
 
 
 
 
 
U.S. Residential mortgage-backed securities (RMBS)
173

 
160

 
1,517

 
1,850

 
2,851

Other structured finance
127

 

 
37

 
164

 
2,175

Structured finance
300

 
160

 
1,554

 
2,014

 
5,026

Total
$
2,642

 
$
382

 
$
3,622

 
$
6,646

 
$
163,142

____________________
(1)
There is no BIG net par outstanding for credit derivatives as of March 31, 2018.


Components of BIG Net Par Outstanding
As of December 31, 2017

 
BIG Net Par Outstanding
 
Net Par
 
BIG 1
 
BIG 2
 
BIG 3
 
Total BIG (1)
 
Outstanding
 
(in millions)
Public finance:
 
 
 
 
 
 
 
 
 
U.S. public finance
$
1,334

 
$
264

 
$
1,805

 
$
3,403

 
$
130,249

Non-U.S. public finance
1,231

 
221

 

 
1,452

 
32,152

Public finance
2,565

 
485

 
1,805

 
4,855

 
162,401

Structured finance:
 
 
 
 
 
 
 
 
 
U.S. RMBS
190

 
163

 
1,535

 
1,888

 
2,908

Other structured finance
90

 
38

 
38

 
166

 
2,236

Structured finance
280

 
201

 
1,573

 
2,054

 
5,144

Total
$
2,845

 
$
686

 
$
3,378

 
$
6,909

 
$
167,545

____________________
(1)
There is no BIG net par outstanding for credit derivatives as of December 31, 2017.



13



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 $2.3 billion net par as of March 31, 2018. Of that amount, $2.2 billion was rated BIG, while the remainder was rated AA since it relates to second-to-pay policies on obligations insured by an affiliate of the Company. Puerto Rico experienced significant general fund budget deficits and a challenging economic environment since at least the financial crisis. Beginning on January 1, 2016, a number of Puerto Rico exposures have defaulted on bond payments, and the Company has now paid claims on all of its BIG Puerto Rico exposures except for Municipal Finance Agency (MFA).

On November 30, 2015 and December 8, 2015, the former governor of Puerto Rico (Former Governor) issued executive orders (Clawback Orders) directing the Puerto Rico Department of Treasury and the Puerto Rico Tourism Company to "claw back" certain taxes pledged to secure the payment of bonds issued by the Puerto Rico Highways and Transportation Authority (PRHTA), the Puerto Rico Infrastructure Financing Authority and the Puerto Rico Convention Center District Authority. The Puerto Rico exposures insured by the Company subject to clawback are shown in the table “Puerto Rico Net Par Outstanding”.

On June 30, 2016, the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) was signed into law by the President of the United States. PROMESA established 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.
    
In May and July 2017 the Oversight Board filed petitions under Title III of PROMESA with the Federal District Court of Puerto Rico for the Commonwealth, the Puerto Rico Sales Tax Financing Corporation (COFINA), PRHTA, and Puerto Rico Electric Power Authority (PREPA). Title III of PROMESA provides for a process analogous to a voluntary bankruptcy process under chapter 9 of the United States Bankruptcy Code (Bankruptcy Code).

Judge Laura Taylor Swain of the Southern District of New York was selected by Chief Justice John Roberts of the United States Supreme Court to preside over any legal proceedings under PROMESA. Judge Swain has selected a team of five federal judges to act as mediators for certain issues and disputes.
    
On September 20, 2017, Hurricane Maria made landfall in Puerto Rico as a Category 4 hurricane on the Saffir-Simpson scale, causing loss of life and widespread devastation in the Commonwealth. Damage to the Commonwealth’s infrastructure, including the power grid, water system and transportation system, was extensive, and rebuilding and economic recovery are expected to take years. While the federal government is expected to provide substantial resources for relief and rebuilding -- which is expected to help economic activity and address the Commonwealth’s infrastructure needs in the intermediate and longer term -- economic activity in general and tourism in particular, as well as tax collections, have declined in the aftermath of the storm, and out migration to the mainland also has increased.

In December 2017, legislation known as the 2017 Tax Cuts and Jobs Act (Tax Act) was enacted. Many of the provisions under the Tax Act are geared toward increasing production in the U.S. and discouraging companies from having operations or intangibles off-shore.  Since Puerto Rico is considered a foreign territory under the U.S. tax system, it is possible the Tax Act may have adverse consequences to Puerto Rico’s economy.  However, the Company is unable to predict the full impact of the Tax Act on Puerto Rico.

The Commonwealth released fiscal plans for itself and for a number of its authorities and public corporations, and in response to notices of violation from the Oversight Board and the enactment of a significant federal disaster relief package by the U.S. Congress, Puerto Rico released one or more revised fiscal plans for the Commonwealth and a number of its authorities and public corporations. The most recent fiscal plans submitted by the Commonwealth for the Commonwealth, PRHTA, PREPA and Puerto Rico Aqueduct and Sewer Authority (PRASA) were released on April 5, 2018. The Commonwealth and the Oversight Board did not agree on final fiscal plans, and on April 18 and April 19, 2018, the Oversight Board released its own versions of fiscal plans for the Commonwealth, PRHTA, PREPA and PRASA, which it certified on April 19 or 20, 2018.

On May 30, 2018, the Oversight Board certified a revised version of the fiscal plan for the Commonwealth as developed by the Oversight Board. The revised certified Commonwealth fiscal plan (which the Company believes covers its

14



general obligations as well as obligations of certain of its other authorities and public corporations) indicates a primary budget surplus of $6.1 billion that would be available for debt service over the six-year forecast period (as compared to contractual debt service of approximately $15.5 billion over the same period). The certified PRHTA fiscal plan projects very limited capacity to pay debt service over the six-year forecast period, as the Commonwealth anticipates continuing to retain approximately three-fourths of PRHTA's total revenues. The certified PREPA fiscal plan indicates that no funds will be available for legacy debt service payments over the six-year forecast period unless rates are adjusted. Additionally, the current governor of Puerto Rico (Governor) has announced an intention to privatize PREPA. The certified PRASA fiscal plan projects cash flows available for debt service to equal approximately 56% of aggregate debt service during the six-year projection period, based on projection assumptions (including receipt of certain federal funding). The Company does not believe the certified fiscal plans for the Commonwealth, PRHTA, PREPA or PRASA comply with certain mandatory requirements of PROMESA.

On June 7, 2018, the court-appointed agents for COFINA and the Commonwealth filed with the U.S. District Court for Puerto Rico an agreement in principle to resolve a dispute between the Commonwealth and COFINA regarding ownership of the 5.5% Sales and Use Taxes (SUT). The agreement in principle, which requires, among other things, that future challenges to it be barred by the court or made illegal, provides that, beginning July 1, SUT would be paid first to COFINA until it has received 53.65% of the pledged sales tax base amount (PTSBA) and that the remaining 46.35% of the PTSBA would be paid to the Commonwealth thereafter. The agreement in principle does not address the proportion of the amount to be paid to COFINA that would be paid to the senior versus the junior creditors, nor does it address the restructuring of COFINA. Additionally, it does not address whether the Commonwealth’s portion of the proceeds will be used for debt service payments on the Commonwealth's General Obligation and Puerto Rico Public Buildings Authority bonds.
    
The Company believes that a number of the actions taken by the Commonwealth, the Oversight Board and others with respect to obligations the Company insures are illegal or unconstitutional or both, and has taken legal action, and may take additional legal action in the future, to enforce its rights with respect to these matters. See “Puerto Rico Recovery Litigation” below.

Litigation and mediation related to the Commonwealth’s debt have been delayed by Hurricane Maria. The final form and timing of responses to Puerto Rico’s financial distress and the devastation of Hurricane Maria eventually taken by the federal government or implemented under the auspices of PROMESA and the Oversight Board or otherwise, and the final impact, after resolution of legal challenges, of any such responses on obligations insured by the Company, are 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.

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 claw back revenues supporting debt insured by the Company. Prior to the enactment of PROMESA, the Company sued various Puerto Rico governmental officials in the United States District Court, District of Puerto Rico asserting that Puerto Rico's attempt to “claw back” pledged taxes is unconstitutional, and demanding declaratory and injunctive relief. See "Puerto Rico Recovery Litigation" below.

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 March 31, 2018, the Company had $670 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. Despite the requirements of Article VI of its Constitution, the Commonwealth defaulted on the debt service payment due on July 1, 2016, and the Company has been making claim payments on these bonds since that date. As noted above, the Oversight Board filed a petition under Title III of PROMESA with respect to the Commonwealth.

15



Puerto Rico Public Buildings Authority (PBA). As of March 31, 2018, the Company had $9 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. Despite the requirements of Article VI of its Constitution, the PBA defaulted on most of the debt service payment due on July 1, 2016, and the Company has been making claim payments on these bonds since then.

Public Corporations - Certain Revenues Potentially Subject to Clawback

PRHTA. As of March 31, 2018, the Company had $252 million insured net par outstanding of PRHTA (transportation revenue) bonds and $358 million insured net par of PRHTA (highways revenue) bonds. The transportation revenue bonds are secured by a subordinate gross lien on 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 lien on gasoline and gas oil and diesel oil taxes, motor vehicle license fees and certain tolls. The non-toll revenues consisting of excise taxes and fees collected by the Commonwealth on behalf of PRHTA and its bondholders that are statutorily allocated to PRHTA and its bondholders are potentially subject to clawback. Despite the presence of funds in relevant debt service reserve accounts that the Company believes should have been employed to fund debt service, PRHTA defaulted on the full July 1, 2017 insured debt service payment, and the Company has been making claim payments on these bonds since that date. As noted above, the Oversight Board filed a petition under Title III of PROMESA with respect to PRHTA.

Other Public Corporations

PREPA. As of March 31, 2018, the Company had $547 million insured net par outstanding of PREPA obligations, which are secured by a lien on the 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, subject to certain conditions, would have resulted in, among other things, modernization of the utility and a restructuring of current debt.

The Oversight Board did not certify the RSA under Title VI of PROMESA as the Company believes was required by PROMESA, but rather, on July 2, 2017, commenced proceedings for PREPA under Title III of PROMESA. The Company has been making claim payments on these bonds since July 1, 2017.

MFA. As of March 31, 2018, the Company had $221 million net par outstanding of bonds issued by MFA secured by a lien on local property tax revenues. The MFA bond accounts contained sufficient funds to make the MFA bond payments due through the date of this filing that were guaranteed by the Company, and those payments were made in full.

COFINA. As of March 31, 2018, the Company had $264 million insured net par outstanding of junior COFINA bonds, which are secured primarily by a second lien on certain sales and use taxes. As noted above, the Oversight Board filed a petition on behalf of COFINA under Title III of PROMESA. COFINA bond debt service payments were not made on August 1, 2017, and the Company made its first claim payments on these bonds. The Company has continued to make claim payments on these bonds. Also as noted above, court-appointed agents have come to an agreement in principle regarding ownership of the sales and use taxes securing COFINA bonds.
  
Puerto Rico Recovery Litigation

The Company believes that a number of the actions taken by the Commonwealth, the Oversight Board and others with respect to obligations it insures are illegal or unconstitutional or both, and has taken legal action, and may take additional legal action in the future, to enforce its rights with respect to these matters.

On January 7, 2016, AGM, AGC and Ambac Assurance Corporation commenced an action for declaratory judgment and injunctive relief in the U.S. District Court for the District of Puerto Rico (Federal District Court in Puerto Rico) to invalidate the executive orders issued by the Former 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 claw back certain taxes and revenues pledged to secure the payment of bonds issued by the PRHTA, Puerto Rico Convention Center District Authority and Puerto Rico Infrastructure Financing Authority. 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

16



defendants filed a notice of PROMESA automatic stay. While the PROMESA automatic stay expired on May 1, 2017, on May 17, 2017, the Court stayed the action under Title III of PROMESA.

On May 16, 2017, The Bank of New York Mellon, as trustee for the bonds issued by COFINA, filed an adversary complaint for interpleader and declaratory relief with the Federal District Court in Puerto Rico to resolve competing and conflicting demands made by various groups of COFINA bondholders, insurers of certain COFINA Bonds and COFINA, regarding funds held by the trustee for certain COFINA bond debt service payments scheduled to occur on and after June 1, 2017. On May 19, 2017, an order to show cause was entered permitting AGM to intervene in this matter.

On June 3, 2017, AGM and AGC filed an adversary complaint in Federal District Court in Puerto Rico seeking (i) a judgment declaring that the application of pledged special revenues to the payment of the PRHTA Bonds is not subject to the PROMESA Title III automatic stay and that the Commonwealth has violated the special revenue protections provided to the PRHTA Bonds under the Bankruptcy Code; (ii) an injunction enjoining the Commonwealth from taking or causing to be taken any action that would further violate the special revenue protections provided to the PRHTA Bonds under the Bankruptcy Code; and (iii) an injunction ordering the Commonwealth to remit the pledged special revenues securing the PRHTA Bonds in accordance with the terms of the special revenue provisions set forth in the Bankruptcy Code. On January 30, 2018, the district court rendered an opinion dismissing the complaint and holding, among other things, that (i) even though the special revenue provisions of the Bankruptcy Code protect a lien on pledged special revenues, those provisions do not mandate the turnover of pledged special revenues to the payment of bonds and (ii) actions to enforce liens on pledged special revenues remain stayed. On February 9, 2018, AGC and AGM filed a notice of appeal of the district court's decision to the United States Court of Appeals for the First Circuit.

On June 26, 2017, AGM and AGC filed a complaint in Federal District Court in Puerto Rico seeking (i) a declaratory judgment that the PREPA RSA is a “Preexisting Voluntary Agreement” under Section 104 of PROMESA and the Oversight Board’s failure to certify the PREPA RSA is an unlawful application of Section 601 of PROMESA; (ii) an injunction enjoining the Oversight Board from unlawfully applying Section 601 of PROMESA and ordering it to certify the PREPA RSA; and (iii) a writ of mandamus requiring the Oversight Board to comply with its duties under PROMESA and certify the PREPA RSA. On July 21, 2017, in light of its PREPA Title III petition on July 2, 2017, the Oversight Board filed a notice of stay under PROMESA.

On July 18, 2017, AGM and AGC filed a motion for relief from the automatic stay in the PREPA Title III bankruptcy proceeding and a form of complaint seeking the appointment of a receiver for PREPA. That motion was denied on September 14, 2017. AGM and AGC are appealing the trial court's decision with the United States Court of Appeals for the First Circuit.

On May 23, 2018, AGM and AGC filed an adversary complaint in Federal District Court in Puerto Rico seeking a judgment declaring that (i) the Oversight Board lacked authority to develop or approve the new fiscal plan for Puerto Rico which it certified on April 19, 2018 (Revised Fiscal Plan); (ii) the Revised Fiscal Plan and the Fiscal Plan Compliance Law (Compliance Law) enacted by the Commonwealth to implement the original Commonwealth fiscal plan violate various sections of PROMESA; (iii) the Revised Fiscal Plan, the Compliance Law and various moratorium laws and executive orders enacted by the Commonwealth to prevent the payment of debt service (a) are unconstitutional and void because they violate the Contracts, Takings and Due Process Clauses of the U.S. Constitution and (b) are preempted by various sections of PROMESA; and (iv) no Title III plan of adjustment based on the Revised Fiscal Plan can be confirmed under PROMESA.

Puerto Rico Par and Debt Service Schedules

All Puerto Rico exposures are internally rated BIG, except the General Obligation, PBA and PRHTA (Transportation revenue) second-to-pay policies on an affiliate exposure which are rated AA based on the obligation of the Company's affiliate to pay under its insurance policy if the obligor fails to pay. 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.

Puerto Rico
Gross Par and Gross Debt Service Outstanding

 
Gross Par Outstanding
 
Gross Debt Service Outstanding
 
March 31, 2018
 
December 31, 2017
 
March 31, 2018
 
December 31, 2017
 
(in millions)
Exposure to Puerto Rico
$
3,369

 
$
3,368

 
$
5,236

 
$
5,318


17



Puerto Rico
Net Par Outstanding
 
As of
March 31, 2018
 
As of
December 31, 2017
 
(in millions)
Commonwealth Constitutionally Guaranteed
 
 
 
Commonwealth of Puerto Rico - General Obligation Bonds (1)
$
669

 
$
669

Commonwealth of Puerto Rico - General Obligation Bonds (Second-to-pay policy on affiliate exposure)
1

 
1

Commonwealth of Puerto Rico - General Obligation Bonds total
670

 
670

PBA (Second-to-pay policies on affiliate exposure)
9

 
9

Public Corporations - Certain Revenues Potentially Subject to Clawback
 
 
 
PRHTA (Transportation revenue) (1)
167

 
167

PRHTA (Transportation revenue) (Second-to-pay policies on affiliate exposure)
85

 
85

PRHTA (Transportation revenue) total
252

 
252

PRHTA (Highways revenue) (1)
358

 
358

Other Public Corporations
 
 
 
PREPA (1)
547

 
547

COFINA (1)
264

 
263

MFA
221

 
221

Total net exposure to Puerto Rico
$
2,321

 
$
2,320

__________________
(1)
As of the date of this filing, the Oversight Board has certified a filing under Title III of PROMESA for these exposures.


18



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 rated BIG by the Company. 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 BIG Net Par Outstanding
and Net Debt Service Outstanding
As of March 31, 2018

 
Scheduled BIG Net Par Amortization
 
Scheduled BIG Net Debt Service Amortization
 
(in millions)
2018 (April 1 - June 30)
$
0

 
$
2

2018 (July 1 - September 30)
77

 
131

2018 (October 1 - December 31)
0

 
2

Subtotal 2018
77

 
135

2019
107

 
215

2020
111

 
214

2021
69

 
167

2022
69

 
164

2023-2027
634

 
1,017

2028-2032
426

 
682

2033-2037
481

 
612

2038-2043
252

 
307

Total
$
2,226

 
$
3,513



Exposure to the U.S. Virgin Islands

As of March 31, 2018, the Company had $331 million insured net par outstanding to the U.S. Virgin Islands and its related authorities (USVI), of which it rated $148 million BIG. The $183 million USVI net par the Company rated investment grade was comprised primarily of bonds secured by a lien on matching fund revenues related to excise taxes on products produced in the USVI and exported to the U.S., primarily rum. The $148 million BIG USVI net par comprised (a) Public Finance Authority bonds secured by a gross receipts tax and the general obligation, full faith and credit pledge of the USVI and (b) bonds of the Virgin Islands Water and Power Authority secured by a net revenue pledge of the electric system.

Hurricane Irma caused significant damage in St. John and St. Thomas, while Hurricane Maria made landfall on St. Croix as a Category 4 hurricane on the Saffir-Simpson scale, causing loss of life and substantial damage to St. Croix’s businesses and infrastructure, including the power grid. The USVI is benefiting from the federal response to the 2017 hurricanes and has made its debt service payments to date.

5.    Expected Loss to be Paid

This note provides information regarding expected claim payments to be made under all contracts in the insured portfolio.

Loss Estimation Process

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, sector-driven loss severity assumptions and/or judgmental assessments. The Company monitors the performance of its transactions with expected losses and each quarter

19



the Company’s loss reserve committees review and refresh their loss projection assumptions, scenarios and the probabilities they assign to those scenarios based on actual developments during the quarter and their view of future performance.

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. As a result, the Company's estimate of ultimate losses on a policy is subject to significant uncertainty over the life of the insured transaction. Credit performance can be adversely affected by economic, fiscal and financial market variability over the life of most contracts.

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, 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 reporting period, 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 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 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, see Note 5, Expected Loss to be Paid, of the annual combined financial statements of AGM for the year ended December 31, 2017 included in Exhibit 99.1 in AGL's Form 8-K dated March 20, 2018, filed with the SEC.

In some instances, the terms of the Company's policy gives it the option to pay principal losses that have been recognized in the transaction but which it is not yet required to pay, thereby reducing the amount of guaranteed interest due in the future. The Company has sometimes exercised this option, which uses cash but reduces projected future losses.

The following tables present a roll forward of net expected loss to be paid for all contracts. The Company used risk-free rates for U.S. dollar denominated obligations that ranged from 0.0% to 3.11% with a weighted average of 2.82% as of March 31, 2018 and 0.0% to 2.78% with a weighted average of 2.40% as of December 31, 2017. Expected losses to be paid for transactions denominated in currencies other than the U.S. dollar represented approximately 5.5% and 5.5% of the total as of March 31, 2018 and December 31, 2017, respectively.

Net Expected Loss to be Paid
Roll Forward

 
First Quarter
 
2018
 
2017
 
(in millions)
Net expected loss to be paid, beginning of period
$
696

 
$
521

Net expected loss to be paid on the AGLN portfolio as of January 10, 2017

 
21

Economic loss development (benefit) due to:
 
 
 
Accretion of discount
4

 
3

Changes in discount rates
(4
)
 
4

Changes in timing and assumptions
(9
)
 
(6
)
Total economic loss development (benefit)
(9
)
 
1

Net (paid) recovered losses
(40
)
 
12

Net expected loss to be paid, end of period
$
647

 
$
555



20



Net Expected Loss to be Paid
Roll Forward by Sector
First Quarter 2018

 
Net Expected
Loss to be Paid (Recovered) as of
December 31, 2017 (2)
 
Economic Loss
Development / (Benefit)
 
(Paid)
Recovered
Losses (1)
 
Net Expected
Loss to be Paid (Recovered) as of
March 31, 2018 (2)
 
(in millions)
Public finance:
 
 
 
 
 
 
 
U.S. public finance
$
482

 
$
(22
)
 
$
(52
)
 
$
408

Non-U.S. public finance
36

 
(2
)
 
0

 
34

Public finance
518

 
(24
)
 
(52
)
 
442

Structured finance:
 
 
 
 
 
 
 
U.S. RMBS
163

 
17

 
12

 
192

Other structured finance
15

 
(2
)
 
0

 
13

Structured finance
178

 
15

 
12

 
205

Total
$
696

 
$
(9
)
 
$
(40
)
 
$
647



Net Expected Loss to be Paid
Roll Forward by Sector
First Quarter 2017
 
Net Expected
Loss to be Paid (Recovered) as of
December 31, 2016
 
Net Expected
Loss to be Paid
on AGLN as of
January 10, 2017
 
Economic Loss
Development / (Benefit)
 
(Paid)
Recovered
Losses (1)
 
Net Expected
Loss to be Paid (Recovered) as of
March 31, 2017
 
(in millions)
Public finance:
 
 
 
 
 
 
 
 
 
U.S. public finance
$
323

 
$

 
$
30

 
$
0

 
$
353

Non-U.S. public finance
22

 
13

 
(3
)
 

 
32

Public finance
345

 
13

 
27

 
0

 
385

Structured finance:
 
 
 
 
 
 
 
 
 
U.S. RMBS
147

 

 
(12
)
 
12

 
147

Other structured finance
29

 
8

 
(14
)
 
0

 
23

Structured finance
176

 
8

 
(26
)
 
12

 
170

Total
$
521

 
$
21

 
$
1

 
$
12

 
$
555

____________________
(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 $2 million and $1 million in loss adjustment expenses (LAE) for First Quarter 2018 and 2017, respectively.

(2)    Includes expected LAE to be paid of $7 million as of March 31, 2018 and $9 million as of December 31, 2017.


21



The following table presents the present value of net expected loss to be paid and the net economic loss development for all contracts by accounting model.

Net Expected Loss to be Paid (Recovered) and
Net Economic Loss Development (Benefit)
By Accounting Model

 
Net Expected Loss to be Paid (Recovered)
 
Net Economic Loss Development (Benefit)
 
As of
March 31, 2018
 
As of
December 31, 2017
 
First Quarter 2018
 
First Quarter 2017
 
(in millions)
Financial guaranty insurance
$
567

 
$
618

 
$
(12
)
 
$
12

FG VIEs (1)
80

 
78

 
3

 
(3
)
Credit derivatives (2)

 

 

 
(8
)
Total
$
647

 
$
696

 
$
(9
)
 
$
1

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

(2)    See Note 8, Contracts Accounted for as Credit Derivatives.


Selected U.S. Public Finance Transactions
    
The Company insured general obligation bonds of the Commonwealth of Puerto Rico and various obligations of its related authorities and public corporations aggregating $2.3 billion net par as of March 31, 2018, $2.2 billion of which was BIG. For additional information regarding the Company's exposure to general obligations of the Commonwealth of Puerto Rico and various obligations of its related authorities and public corporations, see "Exposure to Puerto Rico" in Note 4, Outstanding Exposure.

As of March 31, 2018, the Company had insured $209 million net par outstanding of general obligation bonds issued by the City of Hartford, Connecticut, most of which was rated BIG at December 31, 2017. In First Quarter 2018, the State of Connecticut entered into a contract assistance agreement with the City of Hartford under which the state will pay the debt service costs of the City’s general obligation bonds, including those insured by the Company. As a result, the Company reduced the corresponding expected losses as of March 31, 2018 and upgraded this exposure to investment grade.

On February 25, 2015, a plan of adjustment resolving the bankruptcy filing of the City of Stockton, California under chapter 9 of the U.S. Bankruptcy Code became effective. As of March 31, 2018, the Company’s net par subject to the plan consisted of $61 million of pension obligation bonds. As part of the plan of adjustment, the City will repay any claims paid on the pension obligation bonds from certain fixed payments and certain variable payments contingent on the City’s revenue growth. 
    
The Company projected that its total net expected loss across its troubled U.S. public finance exposures as of March 31, 2018, including those mentioned above, would be $408 million, compared with a net expected loss of $482 million as of December 31, 2017. The economic benefit in First Quarter 2018 was $22 million, which was primarily attributable to the State of Connecticut's agreement to pay the debt service costs of certain bonds of the City of Hartford, including the bonds insured by the Company.

Selected Non - U.S. Public Finance Transactions

The Company insures and reinsures transactions with sub-sovereign exposure to various Spanish and Portuguese issuers where a Spanish and Portuguese sovereign default may cause the sub-sovereigns also to default. The Company's exposure net of reinsurance to these Spanish and Portuguese exposures is $384 million and $71 million, respectively. The Company rates all of these exposures BIG due to the financial condition of Spain and Portugal and their dependence on the sovereign. The Company's Hungary exposure is to infrastructure bonds dependent on payments from Hungarian governmental entities. The Company's exposure net of reinsurance to these Hungarian exposures is $161 million, all of which is rated BIG.


22



The Company also insures an obligation backed by the availability and toll revenues of a major arterial road into a city in the U.K. with $222 million of net par outstanding as of March 31, 2018. This transaction has been underperforming due to higher costs compared with expectations at underwriting. In First Quarter 2018, the Company changed its traffic assumptions for this road, resulting in a benefit.

These transactions, together with other non-U.S. public finance insured obligations, had expected loss to be paid of $34 million as of March 31, 2018, compared with $36 million as of December 31, 2017. The economic benefit of approximately $2 million during First Quarter 2018 was attributable mainly to the U.K. arterial road mentioned above.
 
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 expected representation and warranty (R&W) recoveries/payables to the projected performance of the collateral over time. The resulting projected claim payments or reimbursements are then discounted using risk-free rates.
 
U.S. RMBS Loss Projections
 
Based on its observation during the period of the performance of its insured transactions (including delinquencies, liquidation rates and loss severities) as well as the residential property market and economy in general, the Company chose to make the changes to the assumptions it uses to project RMBS losses shown in the tables of assumptions in the sections below. In First Quarter 2018, the economic loss development was $22 million for first lien U.S. RMBS and the economic benefit was $5 million for second lien U.S. RMBS. In First Quarter 2017 the economic benefit was $4 million for first lien U.S. RMBS and the economic benefit was $8 million for second lien U.S. RMBS.

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

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.


23



First Lien Liquidation Rates

 
March 31, 2018
 
December 31, 2017
Delinquent/Modified in the Previous 12 Months
 
 
 
Alt-A
20%
 
20%
Option ARM
20
 
20
Subprime
20
 
20
30 - 59 Days Delinquent
 
 
 
Alt-A
30
 
30
Option ARM
35
 
35
Subprime
45
 
40
60 - 89 Days Delinquent
 
 
 
Alt-A
40
 
40
Option ARM
45
 
50
Subprime
50
 
50
90 + Days Delinquent
 
 
 
Alt-A
45
 
55
Option ARM
55
 
60
Subprime
55
 
55
Bankruptcy
 
 
 
Alt-A
45
 
45
Option ARM
50
 
50
Subprime
40
 
40
Foreclosure
 
 
 
Alt-A
55
 
65
Option ARM
65
 
70
Subprime
65
 
65
Real Estate Owned
 
 
 
All
100
 
100

    
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 most heavily weighted scenario (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 5.25 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. Each quarter the Company reviews available data and (if necessary) adjusts its severities based on its observations.

24



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.

Key Assumptions in Base Case Expected Loss Estimates
First Lien RMBS

 
As of
March 31, 2018
 
As of
December 31, 2017
 
Range
 
Weighted Average
 
Range
 
Weighted Average
Alt-A First Lien
 
 
 
 
 
 
 
Plateau CDR
3.0% - 9.0%
 
5.0%
 
3.1% - 9.8%
 
5.5%
Final CDR
0.2% - 0.5%
 
0.2%
 
0.2% - 0.5%
 
0.3%
Initial loss severity:
 
 
 
 
 
 
 
2005 and prior
60%
 
 
 
60%
 
 
2006
80%
 
 
 
80%
 
 
2007+
70%
 
 
 
70%
 
 
Option ARM
 
 
 
 
 
 
 
Plateau CDR
3.1% - 7.8%
 
6.1%
 
3.4% - 7.0%
 
6.0%
Final CDR
0.2% - 0.4%
 
0.3%
 
0.2% - 0.3%
 
0.3%
Initial loss severity:
 
 
 
 
 
 
 
2005 and prior
60%
 
 
 
60%
 
 
2006
70%
 
 
 
70%
 
 
2007+
75%
 
 
 
75%
 
 
Subprime
 
 
 
 
 
 
 
Plateau CDR
4.3% - 11.2%
 
7.7%
 
4.3% - 11.5%
 
7.8%
Final CDR
0.2% - 0.6%
 
0.4%
 
0.2% - 0.6%
 
0.4%
Initial loss severity:
 
 
 
 
 
 
 
2005 and prior
80%
 
 
 
80%
 
 
2006
85%
 
 
 
90%
 
 
2007+
95%
 
 
 
95%
 
 


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 conditional prepayment rate (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 December 31, 2017.
 
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 March 31, 2018.


25



Total expected loss to be paid on all first lien U.S. RMBS was $133 million and $109 million as of March 31, 2018 and December 31, 2017, respectively. The Company used a similar approach to establish its pessimistic and optimistic scenarios as of March 31, 2018 as it used as of December 31, 2017, increasing and decreasing the periods of stress from those used in the base case.

In the Company's most 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, expected loss to be paid would increase from current projections by approximately $51 million for all first lien U.S. RMBS transactions.

In the Company's least 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 $35 million for all first lien U.S. RMBS 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 mortgages. 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 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. 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 plateau losses.

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 six months of delinquent loan liquidations, followed by 28 months of decrease to the steady state CDR, the same as of December 31, 2017.

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. This causes the borrower's total monthly payment to increase, sometimes substantially, at the end of the initial interest-only period. In the prior periods, as the HELOC loans underlying the Company's insured HELOC transactions reached their principal amortization period, the Company incorporated an assumption that a percentage of loans reaching their principal amortization periods would default around the time of the payment increase.

Most of the HELOC loans underlying the Company's insured HELOC transactions are now past their interest-only reset date, although a significant number of HELOC loans were modified to extend the interest-only period for another five years. As a result, in 2017, the Company eliminated the CDR increase that was applied when such loans reached their principal amortization period. In addition, based on the average performance history, starting in third quarter 2017, the Company applied a CDR floor of 2.5% for the future steady state CDR on all its HELOC transactions.

When a second lien loan defaults, there is generally a very low recovery. The Company assumed as of March 31, 2018 that it will generally recover only 2% of future defaulting collateral at the time of charge-off, with additional amounts of post charge-off recoveries assumed to come in over time. This is the same assumption used as of December 31, 2017.

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 (in the base case), 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

26



generally consistent with how the Company modeled the CPR as of December 31, 2017. To the extent that prepayments differ from projected levels it could materially change the Company’s projected excess spread and losses.
 
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 March 31, 2018 and December 31, 2017. The Company believes that the level of the elevated CDR and the length of time it will persist and the ultimate prepayment rate 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. The Company believes the most important driver of its projected second lien RMBS losses is the performance of its HELOC transactions. Total expected loss to be paid on all second lien U.S. RMBS was $59 million and $54 million as of March 31, 2018 and December 31, 2017, respectively.

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

 
As of
March 31, 2018
 
As of
December 31, 2017
 
Range
 
Weighted Average
 
Range
 
Weighted Average
Plateau CDR
2.5% - 18.4%
 
10.6%
 
2.7% - 19.9%
 
11.4%
Final CDR trended down to
2.5% - 3.2%
 
2.5%
 
2.5% - 3.2%
 
2.5%
Liquidation rates:
 
 
 
 
 
 
 
Delinquent/Modified in the Previous 12 Months
20%
 
 
 
20%
 
 
30 - 59 Days Delinquent
40
 
 
 
45
 
 
60 - 89 Days Delinquent
60
 
 
 
60
 
 
90+ Days Delinquent
75
 
 
 
75
 
 
Bankruptcy
55
 
 
 
55
 
 
Foreclosure
65
 
 
 
70
 
 
Real Estate Owned
100
 
 
 
100
 
 
Loss severity
98%
 
 
 
98%
 
 


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) would increase the expected loss by approximately $8 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 $8 million for HELOC transactions.

Breaches of Representations and Warranties

As of March 31, 2018, the Company had a net R&W payable of $13 million to R&W counterparties, compared to an R&W payable of $25 million as of December 31, 2017.

Other Structured Finance

The Company's other structured finance sector has BIG net par of $164 million, comprising transactions backed by manufactured housing loans, international RMBS and perpetual repackagings and triple-X life insurance transactions. The amounts initially raised by the sale of the notes insured by the Company in triple-X life insurance transactions were used to capitalize special purpose vehicles that provide life reinsurance; the special purpose vehicles’ funds were invested in accounts

27



managed by third-party investment managers. The economic benefit during First Quarter 2018 was $2 million, which was attributable primarily to increased expected payouts from the primary insurer of a second-to-pay policy.

Recovery Litigation

In the ordinary course of their respective businesses, the Company asserts claims in legal proceedings against third parties to recover losses paid in prior periods or prevent losses in the future.

Public Finance Transactions

The Company has asserted claims in a number of legal proceedings in connection with its exposure to Puerto Rico. See Note 4, Outstanding Exposure, for a discussion of the Company's exposure to Puerto Rico and related recovery litigation being pursued by the Company.

6.    Contracts Accounted for as Insurance

Premiums
    
The portfolio of outstanding exposures discussed in Note 4, Outstanding Exposure, includes contracts that meet the definition of insurance contracts, contracts that meet the definition of a derivative, and contracts that are accounted for as consolidated FG VIEs. Amounts presented in this note relate to insurance contracts. See Note 8, 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

 
First Quarter
 
2018
 
2017
 
(in millions)
Scheduled net earned premiums
$
54

 
$
57

Accelerations:
 
 
 
Refundings
14

 
18

Terminations
6

 
1

Total Accelerations
20

 
19

Accretion of discount on net premiums receivable
2

 
2

Net earned premiums (1)
$
76

 
$
78

____________________
(1)
Excluded $3 million and $4 million for First Quarter 2018 and 2017, respectively, related to consolidated FG VIEs.



28



Gross Premium Receivable
Roll Forward

 
First Quarter
 
2018
 
2017
 
(in millions)
December 31,
$
730

 
$
358

Premiums receivable from acquisitions

 
274

Gross written premiums (2)
74

 
110

Gross premiums received
(57
)
 
(86
)
Adjustments:
 
 
 
Changes in the expected term
(1
)
 
0

Accretion of discount
(5
)
 
3

Foreign exchange translation
24

 
9

March 31, (1)
$
765

 
$
668

____________________
(1)
Excluded $4 million and $4 million as of March 31, 2018 and March 31, 2017, respectively, related to consolidated FG VIEs.

(2)
For transactions where the Company replaces a previous financial guaranty contract of the Company, gross premiums written represents only the incremental gross premium written in excess of the original gross premiums written.


Foreign exchange translation relates to installment premiums receivable denominated in currencies other than the U.S. dollar. Approximately 90%, 89% and 88% of installment premiums at March 31, 2018, December 31, 2017 and March 31, 2017, respectively, are denominated in currencies other than the U.S. dollar, primarily the euro and 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
(Undiscounted)

 
As of
March 31, 2018
 
(in millions)
2018 (April 1 - June 30)
$
30

2018 (July 1 - September 30)
23

2018 (October 1 - December 31)
13

2019
66

2020
79

2021
62

2022
56

2023-2027
240

2028-2032
165

2033-2037
87

After 2037
95

Total (1)
$
916

____________________
(1)
Excluded expected cash collections on consolidated FG VIEs of $5 million.

29



Scheduled Financial Guaranty Insurance Net Earned Premiums

 
As of
March 31, 2018
 
(in millions)
2018 (April 1 - June 30)
$
53

2018 (July 1 - September 30)
51

2018 (October 1 - December 31)
49

Subtotal 2018
153

2019
176

2020
161

2021
145

2022
133

2023-2027
516

2028-2032
333

2033-2037
199

After 2037
175

Net deferred premium revenue(1)
1,991

Future accretion
106

Total future net earned premiums
$
2,097

____________________
(1)
Excluded scheduled net earned premiums on consolidated FG VIEs of $66 million.

Selected Information for Financial Guaranty Insurance
Policies Paid in Installments

 
As of
March 31, 2018
 
As of
December 31, 2017
 
(dollars in millions)
Premiums receivable
$
765

 
$
730

Gross deferred premium revenue
983

 
994

Weighted-average risk-free rate used to discount premiums
2.2
%
 
2.3
%
Weighted-average period of premiums receivable (in years)
9.5

 
9.6




30



Financial Guaranty Insurance Losses

Insurance Contracts' Loss Information

The following table provides information on net reserve (salvage), comprised of loss and LAE reserves and salvage and subrogation recoverable, both net of reinsurance. The Company used risk-free rates for U.S. dollar denominated financial guaranty insurance obligations that ranged from 0.0% to 3.11% with a weighted average of 2.82% as of March 31, 2018 and 0.0% to 2.78% with a weighted average of 2.40% as of December 31, 2017.

Net Reserve (Salvage)

 
As of
March 31, 2018
 
As of
December 31, 2017
 
(in millions)
Public finance:
 
 
 
U.S. public finance
$
373

 
$
447

Non-U.S. public finance
15

 
15

Public finance
388

 
462

Structured finance:
 
 
 
U.S. RMBS
79

 
53

Other structured finance
9

 
10

Structured finance
88

 
63

Subtotal
476

 
525

Elimination of losses attributable to FG VIEs
(53
)
 
(47
)
Total
$
423

 
$
478



Components of Net Reserves (Salvage)

 
As of
March 31, 2018
 
As of
December 31, 2017
 
(in millions)
Loss and LAE reserve
$
822

 
$
931

Reinsurance recoverable on unpaid losses
(191
)
 
(227
)
Loss and LAE reserve, net
631

 
704

Salvage and subrogation recoverable
(275
)
 
(297
)
Salvage and subrogation payable(1)
67

 
71

Salvage and subrogation recoverable, net
(208
)
 
(226
)
Net reserves (salvage)
$
423

 
$
478

____________________
(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 (and therefore recognized in income but not yet received), and (iii) loss reserves that have already been established (and therefore expensed but not yet paid).


31



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

 
As of
March 31, 2018
 
(in millions)
Net expected loss to be paid - financial guaranty insurance (1)
$
567

Contra-paid, net
33

Salvage and subrogation recoverable, net of reinsurance
208

Loss and LAE reserve, net of reinsurance
(631
)
Net expected loss to be expensed (present value) (2)
$
177

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

(2)    Excluded $44 million as of March 31, 2018, related to consolidated FG VIEs.


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
March 31, 2018
 
(in millions)
2018 (April 1 - June 30)
$
4

2018 (July 1 - September 30)
5

2018 (October 1 - December 31)
5

Subtotal 2018
14

2019
23

2020
19

2021
16

2022
13

2023-2027
52

2028-2032
24

2033-2037
13

After 2037
3

Net expected loss to be expensed
177

Future accretion
38

Total expected future loss and LAE
$
215




32



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

Loss and LAE
Reported on the
Condensed Combined Statements of Operations

 
Loss (Benefit)
 
First Quarter
 
2018
 
2017
 
(in millions)
Public finance:
 
 
 
U.S. public finance
$
(22
)
 
$
40

Non-U.S. public finance
(1
)
 
0

Public finance
(23
)
 
40

Structured finance:
 
 
 
U.S. RMBS
23

 
(13
)
Other structured finance
(1
)
 
(9
)
Structured finance
22

 
(22
)
Loss and LAE on insurance contracts before FG VIE consolidation
(1
)
 
18

Gain (loss) related to FG VIE consolidation
(7
)
 
(2
)
Loss and LAE
$
(8
)
 
$
16


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

Financial Guaranty Insurance
BIG Transaction Loss Summary
As of March 31, 2018

 
 
BIG Categories
 
 
BIG 1
 
BIG 2
 
BIG 3
 
Total BIG, Net
 
Effect of
Consolidating VIEs
 
Total
 
 
Gross
 
Ceded
 
Gross
 
Ceded
 
Gross
 
Ceded
 
 
 
 
 
(dollars in millions)
Number of risks(1)
 
65

 
(53
)
 
5

 
(4
)
 
53

 
(51
)
 
123

 

 
123

Remaining weighted-average contract period (in years)
 
8.9

 
7.4

 
4.9

 
3.2

 
9.6

 
10.1

 
9.1

 

 
9.1

Outstanding exposure:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Principal
 
$
3,356

 
$
(714
)
 
$
436

 
$
(54
)
 
$
4,742

 
$
(1,120
)
 
$
6