Guaranty

Assured Guaranty Municipal Corp.




Exhibit 99.1






Assured Guaranty Municipal Corp.

Condensed Combined Financial Statements

(Unaudited)

September 30, 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
September 30, 2018
 
As of
December 31, 2017
Assets
 
 
 
Investment portfolio:
 
 
 
Fixed-maturity securities, available-for-sale, at fair value (amortized cost of $5,415 and $5,479)
$
5,434

 
$
5,659

Short-term investments, at fair value
319

 
364

Other invested assets (includes Surplus Note from affiliate of $300 and $300)
371

 
378

Total investment portfolio
6,124

 
6,401

Cash
56

 
36

Premiums receivable
701

 
730

Ceded unearned premium reserve
694

 
757

Reinsurance recoverable on unpaid losses
157

 
227

Salvage and subrogation recoverable
298

 
297

Financial guaranty variable interest entities’ assets, at fair value
490

 
577

Other assets
187

 
159

Total assets   
$
8,707

 
$
9,184

Liabilities and shareholder's equity
 
 
 
Unearned premium reserve
$
2,610

 
$
2,746

Loss and loss adjustment expense reserve
756

 
931

Reinsurance balances payable, net
187

 
197

Financial guaranty variable interest entities’ liabilities with recourse, at fair value
432

 
495

Financial guaranty variable interest entities’ liabilities without recourse, at fair value
103

 
128

Other liabilities
436

 
437

Total liabilities   
4,524

 
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
3,290

 
3,199

Accumulated other comprehensive income (loss), net of tax provision (benefit) of $(4) and $32
(43
)
 
118

Total shareholder's equity attributable to Assured Guaranty Municipal Corp.
3,964

 
4,034

Noncontrolling interest
219

 
216

Total shareholder's equity
4,183

 
4,250

Total liabilities and shareholder's equity   
$
8,707

 
$
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 September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Revenues
 
 
 
 
 
 
 
Net earned premiums
$
77

 
$
96

 
$
234

 
$
261

Net investment income
51

 
53

 
155

 
171

Net realized investment gains (losses):
 
 
 
 
 
 
 
Other-than-temporary impairment losses
(7
)
 
(18
)
 
(19
)
 
(20
)
Less: portion of other-than-temporary impairment loss recognized in other comprehensive income
1

 
(7
)
 
(2
)
 
4

Net impairment loss
(8
)
 
(11
)
 
(17
)
 
(24
)
Other net realized investment gains (losses)
2

 
18

 
10

 
42

Net realized investment gains (losses)
(6
)
 
7

 
(7
)
 
18

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

 
0

 
0

 
16

Net unrealized gains (losses)
0

 
(1
)
 
1

 
5

Net change in fair value of credit derivatives
0

 
(1
)
 
1

 
21

Fair value gains (losses) on financial guaranty variable interest entities
3

 
3

 
7

 
21

Commutation gains (losses)
2

 
251

 
(15
)
 
324

Foreign exchange gain (loss) on remeasurement
(7
)
 
16

 
(19
)
 
47

Other income (loss)
2

 
3

 
1

 
8

Total revenues   
122

 
428

 
357

 
871

Expenses
 
 
 
 
 
 
 
Loss and loss adjustment expenses
0
 
129

 
36

 
185

Other operating expenses
28

 
27

 
90

 
88

Total expenses   
28

 
156

 
126

 
273

Income (loss) before income taxes   
94

 
272

 
231

 
598

Provision (benefit) for income taxes
 
 
 
 
 
 
 
Current
1

 
(56
)
 
0
 
21

Deferred
3

 
142

 
17

 
147

Total provision (benefit) for income taxes   
4

 
86

 
17

 
168

Net income (loss)
90


186


214


430

Less: Noncontrolling interest
6

 
8

 
19

 
22

Net income (loss) attributable to Assured Guaranty Municipal Corp.
$
84

 
$
178

 
$
195

 
$
408


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 September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Net income (loss)   
$
90

 
$
186

 
$
214

 
$
430

Unrealized holding gains (losses) arising during the period on:
 
 
 
 
 
 
 
Investments with no other-than-temporary impairment, net of tax provision (benefit) of $(7), $6, $(28) and $40
(36
)
 
22

 
(126
)
 
90

Investments with other-than-temporary impairment, net of tax provision (benefit) of $0, $(7), $(1) and $0
(6
)
 
(14
)
 
(11
)
 
(1
)
Unrealized holding gains (losses) arising during the period, net of tax
(42
)
 
8

 
(137
)
 
89

Less: reclassification adjustment for gains (losses) included in net income (loss), net of tax provision (benefit) of $0, $2, $(1) and $6
(6
)
 
5

 
(5
)
 
13

Change in net unrealized gains (losses) on investments
(36
)
 
3

 
(132
)
 
76

 
 
 
 
 
 
 
 
Net unrealized gains (losses) arising during the period on financial guaranty variable interest entities' liabilities with recourse attributable to changes in instrument-specific credit risk, net of tax provision (benefit) of $(1), $-, $(1) and $- (see Note 1)
(3
)
 

 
(5
)
 

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

 
(4
)
 

Change in net unrealized gains (losses) on financial guaranty variable interest entities' liabilities with recourse
(2
)
 

 
(1
)
 

 
 
 
 
 
 
 
 
Change in cumulative translation adjustment, net of tax provision (benefit) of $(1), $3, $(1) and $2
(2
)
 
2

 
(6
)
 
14

Other comprehensive income (loss)
(40
)
 
5

 
(139
)
 
90

Comprehensive income (loss)
50

 
191

 
75

 
520

Less: Comprehensive income (loss) attributable to noncontrolling interest
5

 
8

 
14

 
24

Comprehensive income (loss) attributable to Assured Guaranty Municipal Corp.
$
45

 
$
183

 
$
61

 
$
496


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 Nine Months Ended September 30, 2018 and 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 (Loss)
 
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

 

 

 
195

 

 
195

 
19

 
214

Dividends

 

 

 
(131
)
 

 
(131
)
 
(11
)
 
(142
)
Other comprehensive loss

 

 

 

 
(134
)
 
(134
)
 
(5
)
 
(139
)
Effect of adoption of ASU 2016-01 (see Note 1)

 

 

 
27

 
(27
)
 

 

 

Balance at September 30, 2018
163

 
$
15

 
$
702

 
$
3,290

 
$
(43
)
 
$
3,964

 
$
219

 
$
4,183



 
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

 

 

 
408

 

 
408

 
22

 
430

Dividends

 

 

 
(143
)
 

 
(143
)
 
(42
)
 
(185
)
Other comprehensive income

 

 

 

 
88

 
88

 
2

 
90

Return of capital

 

 

 

 

 

 
(68
)
 
(68
)
Effect of common control acquisitions (see Note 2)

 
(62
)
 
24

 

 

 
(38
)
 

 
(38
)
Balance at September 30, 2017
205

 
$
15

 
$
802

 
$
3,284

 
$
100

 
$
4,201

 
$
209

 
$
4,410



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)

 
Nine Months Ended September 30,
 
2018
 
2017
Net cash flows provided by (used in) operating activities
$
52

 
$
472

Investing activities
 
 
 
Fixed-maturity securities:
 
 
 
Purchases
(863
)
 
(847
)
Sales
396

 
671

Maturities
518

 
424

Net sales (purchases) of short-term investments
61

 
(381
)
Net proceeds from paydowns on financial guaranty variable interest entities’ assets
71

 
93

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

 
72

Cash paid to acquire European Subsidiaries from affiliate

 
(139
)
Purchases of other invested assets

 
(23
)
Other
1

 
(5
)
Net cash flows provided by (used in) investing activities   
184

 
(135
)
Financing activities
 
 
 
Dividends paid to Assured Guaranty Municipal Holdings Inc.
(131
)
 
(142
)
Dividends paid to Assured Guaranty Corp. (see Note 11)
(11
)
 
(42
)
Return of capital to Assured Guaranty Corp. (see Note 11)

 
(70
)
Repayment of notes payable
(1
)
 
(2
)
Net paydowns of financial guaranty variable interest entities' liabilities
(71
)
 
(100
)
Net cash flows provided by (used in) financing activities   
(214
)
 
(356
)
Effect of foreign exchange rate changes
(2
)
 
4

Increase (decrease) in cash and restricted cash
20

 
(15
)
Cash and restricted cash at beginning of period (see Note 10)
36

 
40

Cash and restricted cash at end of period (see Note 10)
$
56

 
$
25

Supplemental cash flow information
 
 
 
Cash paid (received) during the period for:
 
 
 
Income taxes
$
(7
)
 
$
6

Interest on notes payable
$
0

 
$
0


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

5



Assured Guaranty Municipal Corp.
Notes to Condensed Combined Financial Statements (unaudited)
September 30, 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 United Kingdom (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 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. The Company combined the operations of its European subsidiaries and AGE in a transaction that was completed on November 7, 2018. In the combination, the European Subsidiaries transferred their insurance portfolios to and merged with and into AGE (the Combination).

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). In management's opinion, all material adjustments 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), are reflected in the periods presented and are of a normal recurring nature. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that

6



affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. These unaudited interim condensed combined financial statements are as of September 30, 2018 and cover the three-month period ended September 30, 2018 (Third Quarter 2018), the three-month period ended September 30, 2017 (Third Quarter 2017), the nine-month period ended September 30, 2018 (Nine Months 2018) and the nine-month period ended September 30, 2017 (Nine Months 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 condensed combined balance sheet data was derived from audited financial statements but does not include all disclosures required by GAAP.

The unaudited interim condensed combined financial statements include the accounts of AGM, its direct and indirect subsidiaries, and its consolidated financial guaranty variable interest entities (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 and Combination 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 (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 VIEs’ 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 VIEs’ liabilities with recourse, the portion of the change in fair value caused by changes in instrument specific credit risk (ISCR) (i.e., in the case of FG VIEs’ liabilities, the Company's own credit risk) must now be separately presented in other comprehensive income (OCI) as opposed to the statement of operations. See Note 9, 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 now recorded in other income in the condensed combined statements of operations effective January 1, 2018. Equity securities carried at cost as of December 31, 2017, are now 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 $27 million loss, net of tax, from retained earnings to accumulated OCI (AOCI).

Income Taxes

In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740) - Intra-Entity Transfers of Assets Other Than Inventory, which removed the 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

7



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 was applied using a modified retrospective approach (i.e., by recording a cumulative effect adjustment to retained earnings 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.

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). Subsequent to the issuance of this ASU, Topic 842 was amended by various updates that clarified the impact and implementation of ASU 2016-02. Collectively, these updates will require lessees to present right-of-use assets and lease liabilities on the balance sheet.  The Company currently accounts for its lease agreements, where the Company is the lessee, as operating leases and, therefore, does not record these leases on its condensed combined balance sheet.  Upon adoption, the Company will report an increase in both assets and liabilities as a result of including right-of-use assets and lease liabilities, primarily related to the Company’s office space leases. The amended guidance will allow entities to recognize and measure leases at the adoption date prospectively. These updates are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company plans to adopt these updates on January 1, 2019.

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 ASU provides a new current expected credit loss model to account for credit losses on certain financial assets and off-balance sheet exposures (e.g., reinsurance recoverables, premium receivables, held-to- maturity debt securities, and loan commitments). That model requires an entity to estimate lifetime credit losses related to those financial assets recorded at amortized cost, based on relevant historical information, adjusted for current conditions and reasonable and supportable forecasts that could affect the collectability of the reported amount. The ASU also makes targeted amendments to the current impairment model for available-for-sale debt securities, which includes requiring the recognition of an allowance rather than a direct write-down of the investment. The allowance may be reversed in the event that the credit of an issuer improves. In addition, the ASU eliminates the existing guidance for purchased credit impaired assets and introduces a new model for purchased financial assets with credit deterioration, such as the Company's loss mitigation securities. That new model would require the recognition of an initial allowance for credit losses, which is added to the purchase price rather than being reported as a credit loss expense.

The ASU is effective for fiscal years, and interim period within those fiscal years, beginning after December 15, 2019. For reinsurance recoverables, premiums receivable and debt instruments such as 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. Early adoption of the amendments is permitted. The Company does not plan to early adopt this ASU.  The Company is evaluating the effect that this ASU will have on its financial statements.

Targeted Improvements to the Accounting for Long-Duration Contracts

In August 2018, the FASB issued ASU 2018-12, Financial Services - Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts.  The amendments in this ASU:

improve the timeliness of recognizing changes in the liability for future policy benefits and modify the rate used to discount future cash flows,

8



simplify and improve the accounting for certain market-based options or guarantees associated with deposit (or account balance) contracts,
simplify the amortization of deferred acquisition costs, and
improve the effectiveness of the required disclosures.

This ASU does not impact the Company’s financial guaranty insurance contracts. This ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early adoption of the amendments is permitted. The Company does not expect this ASU to have an impact on its condensed combined financial statements.

Changes to the Disclosure Requirements for Fair Value Measurement

            In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement.  This ASU removed, modified and added additional disclosure requirements on fair value measurements in Topic 820.  This ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Certain amendments will be applied prospectively for only the most recent interim or annual period presented in the initial fiscal year of adoption. All other amendments will be applied retrospectively to all periods presented upon their effective date.  Early adoption is permitted.  An entity is permitted to early adopt any removed or modified disclosures upon issuance of this ASU and delay adoption of the additional disclosures until their effective date.  The Company is in the process of determining what impact this ASU will have on its condensed combined financial statements.

2.
    Common Control Acquisition and Combination

The Company's purchase of the European Subsidiaries from AGC on June 26, 2017 was an initial step in Assured Guaranty's efforts to combine the operations of its four affiliated European insurance companies (the European Subsidiaries and AGE). That Combination was completed on November 7, 2018. In the Combination, the European subsidiaries transferred their insurance portfolios to and merged with and into AGE. See Note 1, Business and Basis of Presentation.

As the Company and the European Subsidiaries were under common control at the time of the Company's acquisition of the European Subsidiaries, U.S. GAAP requires that the acquisition be accounted for 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.
    
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.

Reinsurance and Support Agreements

AGM provides support to AGE through a quota share and excess of loss reinsurance agreement (the AGM Reinsurance Agreement) and a net worth maintenance agreement (the AGE Net Worth Agreement).

The versions of such agreements currently in force became effective on November 7, 2018 upon completion of the Combination. These new agreements clarified the application of the prior agreements to AGE upon the Combination. They also incorporated changes to certain terms of the prior agreements requested by the PRA during its review of the Combination, including a change to the amount of collateral that AGM is obligated to post to secure its reinsurance of AGE. Except for such changes, the new agreements do not materially alter the terms or coverage of the prior agreements.
    
The AGM Reinsurance Agreement: Quota Share Reinsurance

Under the quota share cover of the prior AGM Reinsurance Agreement AGM reinsured between approximately 95% - 99% of AGE's retention of each AGE financial guaranty insurance policy after cessions to other reinsurers. Such range of proportionate reinsurance by AGM was the result of a formula in the prior AGM Reinsurance Agreement that fixed AGM’s

9



reinsurance of AGE policies issued during a particular calendar year based upon the respective prior year-end capitalization of AGE and AGM.

The AGE policies reinsured pursuant to the prior AGM Reinsurance Agreement were limited to ones issued in 2011 and prior years because:

(a) AGE and AGM in 2011 implemented a co-guarantee structure pursuant to which (i) AGE, rather than guaranteeing directly all of the obligations issued in a particular transaction, directly guarantees, instead, only the portion of the guaranteed obligations in an amount equal to what would have been AGE's pro rata retention percentage under the quota share cover of the prior AGM Reinsurance Agreement, (ii) AGM directly guarantees the balance of the guaranteed obligations, and (iii) AGM also provides a second-to-pay guarantee for AGE's portion of the guaranteed obligations; and

(b) the prior AGM Reinsurance Agreement excluded AGE’s insured portion of the co-guaranteed obligations from reinsurance by AGM, and all AGE business since 2011 has consisted of transactions insured pursuant to such co-guarantee structure.

The new AGM Reinsurance Agreement maintains in place AGM’s proportionate reinsurance of all AGE policies covered under the prior AGM Reinsurance Agreement. The new agreement provides, however, that to the extent AGE issues a future qualifying policy without utilizing the co-guarantee structure described above, AGM will reinsure a fixed 85% share of AGE’s gross liabilities under such policy, rather than a percentage share based on AGE’s and AGM’s respective prior year-end capitalization. Similarly, the percentages of a future transaction’s obligations that AGE and AGM co-guarantee will be split 15% by AGE and 85% by AGM, so that AGM”s co-guaranteed portion continues to mirror the percentage of quota share reinsurance AGM otherwise would provide for the transaction under the new AGM Reinsurance Agreement.

The AGM Reinsurance Agreement: Excess of Loss Reinsurance    

Under the excess of loss cover of the prior AGM Reinsurance Agreement, AGM was obligated to pay AGE quarterly the amount, if any, by which (i) the sum of (a) AGE’s incurred losses calculated in accordance with U.K. GAAP as reported by AGE in its financial returns filed with the PRA and (b) AGE’s paid losses and LAE, in both cases net of all other performing reinsurance, including the reinsurance provided by the Company under the quota share cover of the AGM Reinsurance Agreement, exceeded (ii) an amount equal to (a) AGE’s capital resources under U.K. law minus (b) 110% of the greatest of the amounts as might be required by the PRA as a condition for AGE to maintain its authorization to carry on a financial guarantee business in the U.K. The new AGM Reinsurance Agreement provides this same form of excess of loss reinsurance; it simply clarifies that such reinsurance covers the legacy portfolios transferred to AGE by its European Subsidiaries in addition to the legacy AGE policies reinsured under the prior AGM Reinsurance Agreement.

Other Provisions of the AGM Reinsurance Agreement

Under the new AGM Reinsurance Agreement, AGM’s required collateral is 102% of the sum of AGM’s assumed share of the following for all AGE policies for which AGM provides proportionate reinsurance: (a) AGE’s unearned premium reserve (net of AGE’s reinsurance premium payable to AGM); (b) AGE’s provisions for unpaid losses and allocated loss adjustment expenses (net of any salvage recoverable), and (c) any unexpired risk provisions of AGE, in each case (a) - (c) as calculated by AGE in accordance with U.K. GAAP. This new, post-Combination collateral measure is in contrast to (i) AGM’s collateral measure prevailing from December 2014 through 2015, which was based, in part, upon the losses expected to be borne by AGM (and two other affiliated reinsurers of AGE, Assured Guaranty Re Ltd. (AG Re) and Assured Guaranty Re Overseas Ltd. (AGRO)) at the 99.5% confidence interval under the PRA’s FG Benchmark Model; and (ii) AGM’s collateral measure prevailing from 2016 up to the time of the Combination, which was based on the same losses calculated under AGE’s internal capital requirement model instead of the FG Benchmark Model. As a result of this new collateral measure, AGM’s total collateral required for AGE increased by approximately $52 million upon the Combination. AGM funded such increase promptly following the Combination.

The quota share and excess loss covers under the prior AGM Reinsurance Agreement excluded transactions guaranteed by AGE on or after July 1, 2009 that were not municipal, utility, project finance or infrastructure risks or similar types of risks. The new AGM Reinsurance Agreement retains the same exclusion. The old AGM Reinsurance Agreement also permitted AGE to terminate the agreement upon the following events: a downgrade of AGM’s ratings by Moody’s below Aa3 or by S&P below AA- if AGM fails to restore its rating(s) to the required level within a prescribed period of time; AGM's insolvency; failure by AGM to maintain the minimum capital required by its domiciliary jurisdiction; or AGM filing a petition in bankruptcy, going into liquidation or rehabilitation or having a receiver appointed. The new AGM Reinsurance Agreement

10



preserves these same termination rights by AGE, and also adds an additional termination right enabling AGE to terminate the agreement should AGM fail to maintain its required collateral.

The AGE Net Worth Agreement

Pursuant to the prior AGE Net Worth Agreement, AGM was obligated to cause AGE to maintain capital resources equal to 110% of the greatest of the amounts as may be required by the PRA as a condition for AGE to maintain its authorization to carry on a financial guarantee business in the U.K., provided that AGM's contributions (a) did not exceed 35% of AGM's policyholders' surplus on an accumulated basis as determined by the laws of the State of New York, and (b) were in compliance with Section 1505 of the New York Insurance Law. AGM’s obligation remains the same under the new AGE Net Worth Agreement, which simply clarifies that it applies to AGE’s expanded insurance and investment portfolios resulting from the Combination. AGM has never been required to make a contribution to AGE's capital under any version of the AGE Net Worth Agreement - either the current agreement or any prior net worth maintenance agreements. The new AGE Net Worth Agreement also permits AGE to terminate such agreement without also triggering an automatic termination of the AGM Reinsurance Agreement (as would have occurred under the prior AGE Net Worth Agreement).

The NYDFS approved each of the changes described above to the AGM Reinsurance Agreement and AGE Net Worth Maintenance Agreement.

AGC’s Support Agreements in Respect of AGUK

Prior to the Combination, the Company's affiliate, AGC, provided support to AGUK through a Further Amended and Restated quota share reinsurance agreement (the AGC Quota Share Agreement), a Further Amended and Restated excess of loss reinsurance agreement (the AGC XOL Agreement), and a Further Amended and Restated net worth maintenance agreement (the AGUK Net Worth Agreement). The latter two agreements were terminated effective upon the Combination because AGUK’s legacy policies became part of AGE’s portfolio upon the Combination and, therefore, are now covered by the excess of loss portion of the new AGM Reinsurance Agreement and the new AGE Net Worth Maintenance Agreement, as described above. The AGC Quota Share Agreement, pursuant to which AGC provided 90% quota share reinsurance of AGUK’s legacy policies, was also terminated upon the Combination, but it was replaced with a new quota share reinsurance agreement between AGE and AGC (the New AGC Reinsurance Agreement). This new agreement preserves AGC’s 90% quota share reinsurance of the legacy AGUK policies that are now part of AGE’s portfolio, but it has no application to new business written by AGE following the Combination. The new AGC Reinsurance Agreement also imposes a new collateral requirement on AGC that is the same as AGM’s collateral requirement under the new AGM Reinsurance Agreement, as described above, except that AGC continues also to post as collateral its share of two AGE-guaranteed (formerly, pre-Combination, AGUK-guaranteed) triple-X insurance bonds that have been purchased by AGC for loss mitigation (as AGC had similarly done under the prior AGC Quota Share Agreement).

The Maryland Insurance Administration (the Administration) approved the termination of the prior AGC XOL Agreement, AGUK Net Worth Agreement and the AGC Quota Share Agreement and the replacement of the latter with the new AGC Reinsurance Agreement.

AGC’s Letter of Support in Respect of CIFGE

AGC was a party to a letter of support dated December 6, 2001 issued to CIFGE.  Pursuant to such letter of support, AGC agreed to maintain CIFGE’s statutory capital and surplus to policyholders under French law and regulation in an amount not less than €20 million for so long as CIFGE carried on business. No capital contributions were made to CIFGE by AGC pursuant to this letter of support from the time AGC succeeded CIFG Assurance North America, Inc. as the parent of CIFGE in July 2016 up to the Combination on November 7, 2018. The letter of support was terminated, with the Administration’s approval, effective upon the Combination since the legacy CIFGE policies are now part of AGE and, therefore, are covered by the excess of loss portion of the new AGM Reinsurance Agreement and the new AGE Net Worth Agreement.


11



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 from certain of its companies.

 
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) (6/26/18)
 
AA+ (stable) (1/23/18)
 
A2 (stable) (5/7/18)
MAC
AA (stable) (6/26/18)
 
AA+ (stable) (7/12/18)
 
AGE (1)
AA (stable) (6/26/18)
 
 
A2 (stable) (5/7/18)
____________________
(1)
As a result of the Combination, each of S&P Global Ratings, a division of Standard & Poor’s Financial Services LLC (S&P), and Moody’s Investors Service Inc. (Moody’s) withdrew their ratings on AGLN and AGUK.
    
There can be no assurance that any of the rating agencies will not take negative action on the financial strength ratings (or similar ratings) of AGM or its insurance subsidiaries in the future or cease to rate one or more of AGM's insurance subsidiaries, either voluntarily or at the request of AGM or that subsidiary.    

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.
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 on occasion it may underwrite new issuances that it views as below-investment-grade (BIG), typically as part of its loss mitigation strategy for existing troubled exposures. The Company also may seek to acquire portfolios of insurance from financial guarantors that are no longer writing new business by acquiring such companies, providing reinsurance on a portfolio of insurance or reassuming a portfolio of reinsurance it had previously ceded; in such instances, it evaluates the risk characteristics of the target portfolio, which may include some BIG exposures, as a whole in the context of the proposed transaction. The Company diversifies its insured portfolio across asset classes and, in the structured finance portfolio, typically 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, 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 include 100% of the exposures of AGM and its consolidated subsidiaries 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. For financial statement measurement purposes, the Company uses risk-free rates, which are determined each quarter, to calculate the expected loss.
 

12



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:
 
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 September 30, 2018 and December 31, 2017, the Company excluded $640 million and $678 million, respectively, of net par attributable to loss mitigation securities and other loss mitigation strategies (which are mostly BIG). The following table presents the gross and net debt service for financial guaranty contracts.

Financial Guaranty
Debt Service Outstanding

 
Gross Debt Service Outstanding(1)
 
Net Debt Service Outstanding(1)
 
September 30, 2018
 
December 31, 2017
 
September 30, 2018
 
December 31, 2017
 
(in millions)
Public finance
$
310,544

 
$
341,451

 
$
223,407

 
$
247,424

Structured finance
6,491

 
7,386

 
6,050

 
6,828

Total financial guaranty
$
317,035

 
$
348,837

 
$
229,457

 
$
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 $42.6 billion and $56.3 billion as of both September 30, 2018 and December 31, 2017, respectively, from MAC.


In addition to amounts shown in the tables above, the Company had outstanding commitments to provide guaranties of approximately $1.0 billion of gross par as of the date of this filing. The commitments are contingent on the satisfaction of all conditions set forth in them and may expire unused or be canceled at the counterparty’s request. Therefore, the total commitment amount does not necessarily reflect actual future guaranteed amounts.


13



Financial Guaranty Portfolio by Internal Rating
As of September 30, 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
$
342

 
0.3
%
 
$
836

 
2.7
%
 
$
663

 
16.4
%
 
$
123

 
23.7
%
 
$
1,964

 
1.3
%
AA
13,965

 
12.3

 
195

 
0.6

 
1,503

 
37.2

 
25

 
4.8

 
15,688

 
10.5

A
66,409

 
58.6

 
11,596

 
37.1

 
85

 
2.1

 
62

 
11.9

 
78,152

 
52.4

BBB
29,761

 
26.2

 
17,798

 
57.0

 
177

 
4.4

 
223

 
43.0

 
47,959

 
32.2

BIG
2,917

 
2.6

 
808

 
2.6

 
1,615

 
39.9

 
86

 
16.6

 
5,426

 
3.6

Total net par outstanding (1)
$
113,394

 
100.0
%
 
$
31,233

 
100.0
%
 
$
4,043

 
100.0
%
 
$
519

 
100.0
%
 
$
149,189

 
100.0
%
_____________________
(1)
Includes $30.5 billion of net par outstanding as of September 30, 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%.



14



Components of BIG Portfolio

Components of BIG Net Par Outstanding
As of September 30, 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
$
898

 
$

 
$
2,019

 
$
2,917

 
$
113,394

Non-U.S. public finance
609

 
199

 

 
808

 
31,233

Public finance
1,507

 
199

 
2,019

 
3,725

 
144,627

Structured finance:
 
 
 
 
 
 
 
 
 
U.S. Residential mortgage-backed securities (RMBS)
93

 
59

 
1,395

 
1,547

 
2,612

Other structured finance
119

 

 
35

 
154

 
1,950

Structured finance
212

 
59

 
1,430

 
1,701

 
4,562

Total
$
1,719

 
$
258

 
$
3,449

 
$
5,426

 
$
149,189

____________________
(1)
There is no BIG net par outstanding for credit derivatives as of September 30, 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.



15



Exposure to Puerto Rico

The Company had 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 $2.2 billion net par as of September 30, 2018. Of that amount, $2.1 billion was rated BIG, while the remainder was rated AA because it relates to second-to-pay policies on obligations insured by an affiliate of the Company. Puerto Rico has 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 the 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), Puerto Rico Infrastructure Financing Authority (PRIFA), and Puerto Rico Convention Center District Authority (PRCCDA). 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 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 United States District Court for the District of Puerto Rico (Federal District Court for 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.

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, the Tax Act may have adverse consequences to Puerto Rico’s economy. However, the Company is unable to predict the impact of the Tax Act on Puerto Rico.

The Oversight Board has certified a number of fiscal plans (in some instances certifying revisions of previously certified plans) for the Commonwealth, PRHTA and PREPA. The Company does not believe the certified fiscal plans for the Commonwealth, PRHTA or PREPA comply with certain mandatory requirements of PROMESA.

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.

The Company participates in mediation and negotiations relating to its Puerto Rico exposure. The Company is a party to a consensual resolution for COFINA debt memorialized in an agreement dated September 20, 2018. The Company has not agreed to the potential resolution of the PREPA debt announced in July 2018. See discussions below.

16




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 Federal District Court for 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 September 30, 2018, the Company had $647 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.

On October 23, 2018, the Oversight Board certified a revised fiscal plan for the Commonwealth. The revised certified Commonwealth fiscal plan indicates an expected primary budget surplus, if fiscal plan reforms are enacted, of $17.0 billion that would be available for debt service over the six-year forecast period ending 2023. The Company believes the available surplus set forth in the Oversight Board's revised certified fiscal plan (which assumes certain fiscal reforms are implemented by the Commonwealth) should be sufficient to cover contractual debt service of Commonwealth general obligation issuance and of authorities and public corporations directly implicated by the Commonwealth’s general fund during the forecast period. However, the revised certified Commonwealth fiscal plan indicates a net primary budget deficit for the period from 2023 through 2058, and there can be no assurance that the fiscal reforms will be enacted or, if they are, that the forecasted primary budget surplus will occur or, if it does, that such funds will be used to cover contractual debt service.

Puerto Rico Public Buildings Authority (PBA). As of September 30, 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.


17



Public Corporations - Certain Revenues Potentially Subject to Clawback

PRHTA. As of September 30, 2018, the Company had $233 million insured net par outstanding of PRHTA (transportation revenue) bonds and $351 million insured net par outstanding 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.

On June 28, 2018, the Oversight Board certified a revised fiscal plan for PRHTA. The revised certified PRHTA fiscal plan projects very limited capacity to pay debt service over the six-year forecast period.

Other Public Corporations

PREPA. As of September 30, 2018, the Company had $544 million insured net par outstanding of PREPA obligations, which are secured by a lien on the revenues of the electric system. The Company has been making claim payments on these bonds since July 1, 2017.

On December 24, 2015, AGM and AGC entered into a Restructuring Support Agreement (PREPA 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 PREPA 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.

On July 30, 2018, the Oversight Board and the Governor of Puerto Rico announced that they had reached a tentative agreement with a certain group of PREPA bondholders regarding approximately $3 billion, or approximately one-third, of PREPA’s outstanding debt. Bondholders would be able to exchange their debt for new securitization debt maturing in 40 years at 67% of par, plus growth bonds tied to the recovery of Puerto Rico at 10% of par. The Company and certain other creditors of PREPA have not agreed to the terms of that tentative agreement.

On August 1, 2018, the Oversight Board certified a revised fiscal plan for PREPA.

MFA. As of September 30, 2018, the Company had $189 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 September 30, 2018, the Company had $264 million insured net par outstanding of subordinate 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.


18



On September 20, 2018, the Commonwealth, the Oversight Board, and senior and subordinate COFINA creditors, including the Company, representing a total of approximately $10 billion of COFINA debt, executed an amended and restated Plan Support Agreement (COFINA PSA) allocating between the senior and subordinate COFINA bondholders the portion to be received by COFINA of the pledged sales tax base amount (PSTBA) of the 5.5% Sales and Use Taxes (SUT). Under the COFINA PSA, the Company expects implied recoveries, including fees for parties to the COFINA PSA, will total in the mid-90% range for the senior bonds and approach 60% for the subordinate bonds, and both senior and subordinate COFINA creditors will exchange their positions for new senior closed lien COFINA bonds. The COFINA PSA includes a term sheet that details the terms and conditions of the settlement reached on June 7, 2018 among the court-appointed agents for COFINA and the Commonwealth to resolve a dispute between the Commonwealth and COFINA regarding ownership of the PSTBA. The June 7, 2018 agreement in principle, which was filed with the Federal District Court for Puerto Rico, requires, among other things, that future challenges to it be barred by the court or made illegal, and provides that, beginning July 1, 2018, the SUT would be paid first to COFINA until it has received 53.65% of the PSTBA and that the remaining 46.35% of the PSTBA would be paid to the Commonwealth thereafter. The June 7, 2018 agreement in principle does not impact SUT in excess of the PSTBA, which is paid to the Commonwealth. The Company is reserving its contractual voting rights as sole bondholder of certain Commonwealth general obligation bonds and its related subrogee rights with respect to both the SUT revenues allocated to the Commonwealth and other available resources of the Commonwealth. Under the Constitution of the Commonwealth, such revenues and resources must be used to pay general obligation debt before any other claim, debt or expense, including government expenses.

In November 2018 the Oversight Board filed with the PROMESA Title III court a COFINA plan of adjustment and disclosure statement, and the disclosure statement was approved by that court.  The solicitation process for the approval of the COFINA plan of adjustment will be conducted in December 2018 and January 2019.  The Company currently expects the COFINA plan of adjustment confirmation hearing to be held in late January 2019.

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 (Ambac) commenced an action for declaratory judgment and injunctive relief in the Federal District Court for 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, the PRCCDA and the PRIFA. The Commonwealth defendants filed a motion to dismiss the action for lack of subject matter jurisdiction, which the court denied on October 4, 2016. On October 14, 2016, the Commonwealth defendants filed a notice of PROMESA automatic stay. 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 for 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 September 20, 2018, the Oversight Board, the Commonwealth, and senior and subordinate COFINA bondholders, including AGM, entered into the COFINA PSA described above. The Company believes that the dispute would be resolved if the court approved the COFINA PSA.

On June 3, 2017, AGM and AGC filed an adversary complaint in the Federal District Court for 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 court rendered an opinion dismissing the complaint and holding, among other things, that (x) 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 (y) actions to enforce liens on pledged special revenues remain stayed.

19



AGC and AGM are appealing the district court's decision to the United States Court of Appeals for the First Circuit (First Circuit).

On June 26, 2017, AGM and AGC filed a complaint in the Federal District Court for 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 in the Federal District Court for Puerto Rico 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. The court denied the motion on September 14, 2017, but on August 8, 2018, the First Circuit vacated and remanded the court's decision. On October 3, 2018, AGM and AGC, together with other bond insurers, filed a motion with the court to lift the automatic stay to commence an action against PREPA for the appointment of a receiver.

On May 23, 2018, AGM and AGC filed an adversary complaint in the Federal District Court for 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. On August 13, 2018, the court-appointed magistrate judge granted the Commonwealth's and the Oversight Board's motion to stay this adversary proceeding pending a decision by the First Circuit in an appeal of an unrelated adversary proceeding decision by Ambac, which may resolve certain similar issues.

On July 23, 2018, AGC and AGM filed an adversary complaint in the Federal District Court for Puerto Rico seeking a judgment (i) declaring the members of the Oversight Board are officers of the U.S. whose appointments were unlawful under the Appointments Clause of the U.S. Constitution; (ii) declaring void ab initio the unlawful actions taken by the Oversight Board to date, including (x) development of the Commonwealth's Fiscal Plan, (y) development of PRHTA's Fiscal Plan, and (z) filing of the Title III cases on behalf of the Commonwealth and PRHTA; and (iii) enjoining the Oversight Board from taking any further action until the Oversight Board members have been lawfully appointed in conformity with the Appointments Clause of the U.S. Constitution. The Title III court dismissed a similar lawsuit filed by another party in the Commonwealth’s Title III case in July 2018. On August 3, 2018, a stipulated judgment was entered against AGM and AGC at their request based upon the court's July decision in the other Appointments Clause lawsuit and, on the same date, AGM and AGC appealed the stipulated judgment to the First Circuit. On August 15, 2018, the court consolidated, for purposes of briefing and oral argument, AGM and AGC's appeal with the other Appointments Clause lawsuit. The United States Court of Appeals for the First Circuit consolidated AGM's and AGC's appeal with a third Appointments Clause lawsuit on September 7, 2018 and held a hearing on December 3, 2018.

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
 
September 30, 2018
 
December 31, 2017
 
September 30, 2018
 
December 31, 2017
 
(in millions)
Exposure to Puerto Rico
$
3,233

 
$
3,368

 
$
5,014

 
$
5,318


20




Puerto Rico
Net Par Outstanding
 
As of
September 30, 2018
 
As of
December 31, 2017
 
(in millions)
Commonwealth Constitutionally Guaranteed
 
 
 
Commonwealth of Puerto Rico - General Obligation Bonds (1)
$
646

 
$
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
647

 
670

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

 
9

Public Corporations - Certain Revenues Potentially Subject to Clawback
 
 
 
PRHTA (Transportation revenue) (1)
154

 
167

PRHTA (Transportation revenue) (Second-to-pay policies on affiliate exposure)
79

 
85

PRHTA (Transportation revenue) total
233

 
252

PRHTA (Highways revenue) (1)
351

 
358

Other Public Corporations
 
 
 
PREPA (1)
544

 
547

COFINA (1)
264

 
263

MFA
189

 
221

Total net exposure to Puerto Rico
$
2,237

 
$
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.


21



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 September 30, 2018

 
Scheduled BIG Net Par Amortization
 
Scheduled BIG Net Debt Service Amortization
 
(in millions)
2018 (October 1 - December 31)
$
0

 
$
2

2019 (January 1 - March 31)
0

 
52

2019 (April 1 - June 30)
0

 
2

2019 (July 1 - September 30)
107

 
160

2019 (October 1 - December 31)
0

 
2

Subtotal 2019
107

 
216

2020
111

 
214

2021
69

 
167

2022
70

 
163

2023-2027
633

 
1,017

2028-2032
424

 
682

2033-2037
481

 
612

2038-2043
253

 
307

Total
$
2,148

 
$
3,380


Exposure to the U.S. Virgin Islands

As of September 30, 2018, the Company had $329 million insured net par outstanding to the U.S. Virgin Islands and its related authorities (USVI), of which it rated $146 million BIG. The $183 million USVI net par the Company rated investment grade was composed 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 $146 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

22



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 3.20% with a weighted average of 3.03% as of September 30, 2018 and from 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 5.0% and 5.5% of the total as of September 30, 2018 and December 31, 2017, respectively.

Net Expected Loss to be Paid
Roll Forward

 
Third Quarter
 
Nine Months
 
2018
 
2017
 
2018
 
2017
 
(in millions)
Net expected loss to be paid, beginning of period
$
667

 
$
587

 
$
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

 
13

 
10

Changes in discount rates
(3
)
 
(3
)
 
(8
)
 
12

Changes in timing and assumptions
(15
)
 
107

 
(2
)
 
110

Total economic loss development (benefit)
(14
)
 
107

 
3

 
132

Net (paid) recovered losses
(86
)
 
(63
)
 
(132
)
 
(43
)
Net expected loss to be paid, end of period
$
567

 
$
631

 
$
567

 
$
631




23



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

 
Net Expected
Loss to be Paid (Recovered) as of
June 30, 2018
 
Economic Loss
Development / (Benefit)
 
(Paid)
Recovered
Losses (1)
 
Net Expected
Loss to be Paid (Recovered) as of
September 30, 2018 (2)
 
(in millions)
Public finance:
 
 
 
 
 
 
 
U.S. public finance
$
449

 
$
15

 
$
(96
)
 
$
368

Non-U.S. public finance
32

 
(3
)
 

 
29

Public finance
481

 
12

 
(96
)
 
397

Structured finance:
 
 
 
 
 
 
 
U.S. RMBS
175

 
(26
)
 
11

 
160

Other structured finance
11

 
0

 
(1
)
 
10

Structured finance
186

 
(26
)
 
10

 
170

Total
$
667

 
$
(14
)
 
$
(86
)
 
$
567



Net Expected Loss to be Paid
Roll Forward by Sector
Third Quarter 2017
 
Net Expected
Loss to be Paid (Recovered) as of
June 30, 2017
 
Economic Loss
Development / (Benefit)
 
(Paid)
Recovered
Losses (1)
 
Net Expected
Loss to be Paid (Recovered) as of
September 30, 2017
 
(in millions)
Public finance:
 
 
 
 
 
 
 
U.S. public finance
$
389

 
$
121

 
$
(79
)
 
$
431

Non-U.S. public finance
32

 
0

 
5

 
37

Public finance
421

 
121

 
(74
)
 
468

Structured finance:
 
 
 
 
 
 
 
U.S. RMBS
149

 
(13
)
 
11

 
147

Other structured finance
17

 
(1
)
 
0

 
16

Structured finance
166

 
(14
)
 
11

 
163

Total
$
587

 
$
107

 
$
(63
)
 
$
631




24



Net Expected Loss to be Paid
Roll Forward by Sector
Nine Months 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
September 30, 2018 (2)
 
(in millions)
Public finance:
 
 
 
 
 
 
 
U.S. public finance
$
482

 
$
42

 
$
(156
)
 
$
368

Non-U.S. public finance
36

 
(7
)
 
0

 
29

Public finance
518

 
35

 
(156
)
 
397

Structured finance:
 
 
 
 
 
 
 
U.S. RMBS
163

 
(28
)
 
25

 
160

Other structured finance
15

 
(4
)
 
(1
)
 
10

Structured finance
178

 
(32
)
 
24

 
170

Total
$
696

 
$
3

 
$
(132
)
 
$
567



Net Expected Loss to be Paid
Roll Forward by Sector
Nine Months 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
September 30, 2017
 
(in millions)
Public finance:
 
 
 
 
 
 
 
 
 
U.S. public finance
$
323

 
$

 
$
188

 
$
(80
)
 
$
431

Non-U.S. public finance
22

 
13

 
(3
)
 
5

 
37

Public finance
345

 
13

 
185

 
(75
)
 
468

Structured finance:
 
 
 
 
 
 
 
 
 
U.S. RMBS
147

 

 
(35
)
 
35

 
147

Other structured finance
29

 
8

 
(18
)
 
(3
)
 
16

Structured finance
176

 
8

 
(53
)
 
32

 
163

Total
$
521

 
$
21

 
$
132

 
$
(43
)
 
$
631

___________________
(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 $3 million in loss adjustment expenses (LAE) for Third Quarter 2018 and 2017, respectively, and $7 million and $6 million in LAE for Nine Months 2018 and 2017, respectively.

(2)    Includes expected LAE to be paid of $4 million as of September 30, 2018 and $9 million as of December 31, 2017.


25



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
September 30, 2018
 
As of
December 31, 2017
 
Third Quarter 2018
 
Third Quarter 2017
 
Nine Months 2018
 
Nine Months 2017
 
(in millions)
Financial guaranty insurance
$
497

 
$
618

 
$
(10
)
 
$
108

 
$
9

 
$
143

FG VIEs (1)
70

 
78

 
(4
)
 
(1
)
 
(6
)
 
(3
)
Credit derivatives (2)

 

 

 

 

 
(8
)
Total
$
567

 
$
696

 
$
(14
)
 
$
107

 
$
3

 
$
132

___________________
(1)    See Note 9, 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 $2.2 billion net par as of September 30, 2018, $2.1 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 September 30, 2018, the Company had insured $203 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 the first quarter of 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 September 30, 2018, the Company’s net par subject to the plan consisted of $60 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 September 30, 2018, including those mentioned above, would be $368 million, compared with a net expected loss of $482 million as of December 31, 2017. The economic loss development in Third Quarter 2018 was $15 million, which was primarily attributable to Puerto Rico exposures. The economic loss development for Nine Months 2018 was $42 million, which was primarily attributable to Puerto Rico exposures, partially offset by a benefit related 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 $356 million and $68 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.


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The Company also has exposure to infrastructure bonds dependent on payments from Hungarian governmental entities. The Company's exposure net of reinsurance to these Hungarian transactions is $139 million, all of which was rated BIG.

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 $199 million of net par outstanding as of September 30, 2018. This transaction has been underperforming due to higher costs compared with expectations at underwriting. In the first quarter of 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 $29 million as of September 30, 2018, compared with $36 million as of December 31, 2017. The economic benefit of approximately $3 million for Third Quarter 2018 was attributable mainly to changes in certain probability of default assumptions. The economic benefit of approximately $7 million during Nine Months 2018 was attributable mainly to the U.K. arterial road and changes in probability of default assumptions mentioned above.
 
U.S. RMBS Loss Projections

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.
 
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.

The following table presents the U.S. RMBS net economic loss development (benefit).

Net Economic Loss Development (Benefit)
U.S. RMBS

 
Third Quarter
 
Nine Months
 
2018
 
2017
 
2018
 
2017
 
(in millions)
First lien U.S. RMBS
$
(5
)
 
$
1

 
$
11

 
$
(4
)
Second lien U.S. RMBS.
(21
)
 
(14
)
 
(39
)
 
(31
)


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.


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First Lien Liquidation Rates

 
September 30, 2018
 
June 30, 2018
 
December 31, 2017
Delinquent/Modified in the Previous 12 Months
 
 
 
 
 
Alt-A
20%
 
20%
 
20%
Option ARM
20
 
20
 
20
Subprime
20
 
20
 
20
30 - 59 Days Delinquent
 
 
 
 
 
Alt-A and Prime
30
 
30
 
30
Option ARM
35
 
35
 
35
Subprime
40
 
40
 
40
60 - 89 Days Delinquent
 
 
 
 
 
Alt-A
35
 
35
 
40
Option ARM
45
 
45
 
50
Subprime
50
 
50
 
50
90 + Days Delinquent
 
 
 
 
 
Alt-A
40
 
40
 
55
Option ARM
55
 
55
 
60
Subprime
55
 
55
 
55
Bankruptcy
 
 
 
 
 
Alt-A
45
 
45
 
45
Option ARM
50
 
50
 
50
Subprime
40
 
40
 
40
Foreclosure
 
 
 
 
 
Alt-A
55
 
55
 
65
Option ARM
65
 
65
 
70
Subprime
65
 
65
 
65
Real Estate Owned
 
 
 
 
 
All
100
 
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 4.75 years after the initial 36-month CDR plateau period. Under the Company’s methodology, defaults projected to occur in the first 36 months represent defaults that can be attributed to loans that were modified or delinquent in the last 12 months or that are currently delinquent or in foreclosure, while the defaults projected to occur using the projected CDR trend after the first 36 month period represent defaults attributable to borrowers that are currently performing or are projected to reperform.

Another important driver of loss projections is loss severity, which is the amount of loss the transaction incurs on a loan after the application of net proceeds from the disposal of the underlying property. Loss severities experienced in first lien transactions reached historically high levels, and the Company is assuming in the base case that elevated 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. The Company

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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 vintage 2004 - 2008 first lien U.S. RMBS.

Key Assumptions in Base Case Expected Loss Estimates
First Lien RMBS

 
As of
September 30, 2018
 
As of
June 30, 2018
As of
December 31, 2017
 
Range
 
Weighted Average
 
Range

Weighted Average

Range
 
Weighted Average
Alt-A First Lien
 
 
 
 
 
 
 
 
 
 
 
Plateau CDR
2.9% - 11.2%
 
5.2%
 
2.5% - 12.2%
 
5.4%
 
3.1% - 9.8%
 
5.5%
Final CDR
0.1% - 0.6%
 
0.3%
 
0.1% - 0.6%
 
0.3%
 
0.2% - 0.5%
 
0.3%
Initial loss severity:
 
 
 
 
 
 
 
 
 
 
 
2005 and prior
60%
 
 
 
60%
 
 
 
60%
 
 
2006
70%
 
 
 
80%
 
 
 
80%
 
 
2007+
70%
 
 
 
70%
 
 
 
70%
 
 
Option ARM
 
 
 
 
 
 
 
 
 
 
 
Plateau CDR
2.5% - 8.7%
 
6.0%
 
2.6% - 8.5%
 
6.1%
 
3.4% - 7.0%
 
6.0%
Final CDR
0.1% - 0.4%
 
0.3%
 
0.1% - 0.4%
 
0.3%
 
0.2% - 0.3%
 
0.3%
Initial loss severity:
 
 
 
 
 
 
 
 
 
 
 
2005 and prior
60%
 
 
 
60%
 
 
 
60%
 
 
2006
60%
 
 
 
70%
 
 
 
70%
 
 
2007+
70%
 
 
 
75%
 
 
 
75%
 
 
Subprime
 
 
 
 
 
 
 
 
 
 
 
Plateau CDR
3.8% - 9.6%
 
6.7%
 
3.8% - 10.4%
 
7.0%
 
4.3% - 11.5%
 
7.8%
Final CDR
0.2% - 0.5%
 
0.3%
 
0.2% - 0.5%
 
0.3%
 
0.2% - 0.6%
 
0.4%
Initial loss severity:
 
 
 
 
 
 
 
 
 
 
 
2005 and prior
80%
 
 
 
80%
 
 
 
80%
 
 
2006
75%
 
 
 
85%
 
 
 
90%