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8-K - 8-K - ASSURED GUARANTY LTDa8-kagre3q2012cover.htm

Exhibit 99.1
Assured Guaranty Re Ltd.
(a wholly‑owned Subsidiary of Assured Guaranty Ltd.)
Consolidated Financial Statements
September 30, 2012



Assured Guaranty Re Ltd.
Index to Consolidated Financial Statements
September 30, 2012

 
Page(s)
Consolidated Balance Sheets (unaudited) as of September 30, 2012 and December 31, 2011
1
Consolidated Statements of Operations (unaudited) for the Three and Nine Months Ended September 30, 2012 and 2011
2
Consolidated Statements of Comprehensive Income (unaudited) for the Three and Nine Months Ended September 30, 2012 and 2011
3
Consolidated Statement of Shareholder’s Equity (unaudited) for the Nine Months Ended September 30, 2012
4
Consolidated Statements of Cash Flows (unaudited) for the Nine Months Ended September 30, 2012 and 2011
5
Notes to Consolidated Financial Statements (unaudited)
6





Assured Guaranty Re Ltd.
Consolidated Balance Sheets (unaudited)
(dollars in millions except per share and share amounts)
 
As of
September 30, 2012
 
As of
December 31, 2011
Assets
 
 
 
Investment portfolio:
 
 
 
Fixed maturity securities, available-for-sale, at fair value (amortized cost of $2,142 and $2,309)
$
2,323

 
$
2,443

Short-term investments, at fair value
70

 
76

Total investment portfolio
2,393

 
2,519

Loan receivable from affiliate
90

 

Cash
7

 
22

Premiums receivable, net of ceding commissions payable
237

 
273

Deferred acquisition costs
329

 
343

Salvage and subrogation recoverable
33

 
35

Credit derivative assets
66

 
77

Deferred tax asset, net
3

 
7

Current income tax receivable
2

 

Other assets
64

 
47

Total assets   
$
3,224

 
$
3,323

Liabilities and shareholder’s equity
 
 
 
Unearned premium reserve
$
1,181

 
$
1,244

Loss and loss adjustment expense reserve
238

 
242

Reinsurance balances payable, net
12

 
14

Credit derivative liabilities
423

 
337

Current income tax payable

 
1

Other liabilities
25

 
19

Total liabilities   
1,879

 
1,857

Commitments and contingencies (See Note 11)
 
 
 
Preferred stock ($0.01 par value, 2 shares authorized; none issued and outstanding in 2012 and 2011)

 

Common stock ($1.00 par value, 1,377,587 shares authorized, issued and outstanding in 2012 and 2011)
1

 
1

Additional paid-in capital
857

 
857

Retained earnings
314

 
481

Accumulated other comprehensive income, net of tax of $8 and $6
173

 
127

Total shareholder’s equity   
1,345

 
1,466

Total liabilities and shareholder’s equity   
$
3,224

 
$
3,323

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



1



Assured Guaranty Re Ltd.
Consolidated Statements of Operations (unaudited)
(in millions)
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
Revenues
 
 
 
 
 
 
 
Net earned premiums
$
40

 
$
33

 
$
110

 
$
108

Net investment income
22

 
24

 
66

 
72

Net realized investment gains (losses):
 
 
 
 
 
 
 
Other-than-temporary impairment losses

 
(1
)
 
(2
)
 
(2
)
Less: portion of other-than-temporary impairment loss recognized in other comprehensive income
0

 

 
(2
)
 

Other net realized investment gains (losses)
4

 
0

 
11

 
1

Net realized investment gains (losses)
4

 
(1
)
 
11

 
(1
)
Net change in fair value of credit derivatives:
 
 
 
 
 
 
 
Realized gains (losses) and other settlements
(4
)
 
(3
)
 
(13
)
 
(6
)
Net unrealized gains (losses)
0

 
215

 
(97
)
 
126

Net change in fair value of credit derivatives
(4
)
 
212

 
(110
)
 
120

Other income
(1
)
 
(2
)
 
(3
)
 
2

Total revenues   
61

 
266

 
74

 
301

Expenses
 
 
 
 
 
 
 
Loss and loss adjustment expenses
1

 
73

 
81

 
85

Amortization of deferred acquisition costs
11

 
9

 
28

 
32

Other operating expenses
5

 
4

 
15

 
16

Total expenses   
17

 
86

 
124

 
133

Income (loss) before income taxes   
44

 
180

 
(50
)
 
168

Provision (benefit) for income taxes   
2

 
2

 
7

 
4

Net income (loss)   
$
42

 
$
178

 
$
(57
)
 
$
164


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


2



Assured Guaranty Re Ltd.
Consolidated Statements of Comprehensive Income (unaudited)
(in millions)
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
Net income (loss)   
$
42

 
$
178

 
$
(57
)
 
$
164

Unrealized holding gains (losses) arising during the period on:
 
 
 
 
 
 
 
Investments with no other-than-temporary impairment, net of tax provision (benefit) of $2, $2, $3 and $3
35

 
37

 
61

 
42

Investments with other-than-temporary impairment, net of tax
(3
)
 
(1
)
 
(5
)
 
0

Unrealized holding gains (losses) arising during the period, net of tax
32

 
36

 
56

 
42

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

 
(1
)
 
10

 
(1
)
Other comprehensive income (loss)
28

 
37

 
46

 
43

Comprehensive income (loss)   
$
70

 
$
215

 
$
(11
)
 
$
207


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


3



Assured Guaranty Re Ltd.
Consolidated Statement of Shareholder’s Equity (unaudited)
For the Nine Months Ended September 30, 2012
(in millions)
 
Preferred
Stock
 
Common
Stock
 
Additional
Paid-in
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income
 
Total
Shareholder’s
Equity
Balance at December 31, 2011   
$

 
$
1

 
$
857

 
$
481

 
$
127

 
$
1,466

Net loss

 

 

 
(57
)
 

 
(57
)
Dividends

 

 

 
(110
)
 

 
(110
)
Other comprehensive income

 

 

 

 
46

 
46

Balance at September 30, 2012   
$

 
$
1

 
$
857

 
$
314

 
$
173

 
$
1,345


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


4



Assured Guaranty Re Ltd.
Consolidated Statements of Cash Flows (unaudited)
(in millions)
 
Nine Months Ended September 30,
 
2012
 
2011
Net cash flows provided by (used in) operating activities   
$
(6
)
 
$
207

Investing activities
 
 
 
Fixed maturity securities:
 
 
 
Purchases
(384
)
 
(488
)
Sales
341

 
195

Maturities
229

 
216

Net sales (purchases) of short-term investments
6

 
(71
)
Loan to affiliate
(90
)
 

Net cash flows provided by (used in) investing activities   
102

 
(148
)
Financing activities
 
 
 
Dividends paid
(111
)
 
(54
)
Net cash flows provided by (used in) financing activities   
(111
)
 
(54
)
Increase (decrease) in cash
(15
)
 
5

Cash at beginning of period
22

 
14

Cash at end of period   
$
7

 
$
19

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

 
$
0


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


5



Assured Guaranty Re Ltd.
Notes to Consolidated Financial Statements (unaudited)
September 30, 2012
1.
Business and Basis of Presentation
Business
Assured Guaranty Re Ltd. (“AG Re” or, together with its subsidiaries, the “Company”) is incorporated under the laws of Bermuda and is licensed as a Class 3B Insurer under the Insurance Act 1978 and related regulations of Bermuda. AG Re owns Assured Guaranty Overseas US Holdings Inc. (“AGOUS”), a Delaware corporation, which owns the entire share capital of a Bermuda reinsurer, Assured Guaranty Re Overseas Ltd. (“AGRO”). AG Re and AGRO primarily underwrite financial guaranty reinsurance. AG Re and AGRO have written business as reinsurers of third‑party primary insurers and as reinsurers/retrocessionaires of certain affiliated companies. Under a reinsurance agreement, the reinsurer, in consideration of a premium paid to it, agrees to indemnify another insurer, called the ceding company, for part or all of the liability of the ceding company under one or more insurance policies that the ceding company has issued. AGRO owns Assured Guaranty Mortgage Insurance Company (“AGMIC”), a New York corporation that is authorized to provide mortgage guaranty insurance and reinsurance.

AG Re is wholly owned by Assured Guaranty Ltd. (“AGL” and, together with its subsidiaries, “Assured Guaranty”), a Bermuda‑based holding company that provides, through its operating subsidiaries, credit protection products to the United States (“U.S.”) and international public finance (including infrastructure) and structured finance markets. The Company’s affiliates Assured Guaranty Corp. (“AGC”) and Assured Guaranty Municipal Corp. (“AGM” and, together with AGC, the “affiliated ceding companies”) account for the majority of all new business written by the Company in 2012 and 2011.

The Company reinsures financial guaranty insurance and credit derivative contracts under quota share and excess of loss reinsurance treaties. Financial guaranty insurance policies provide an unconditional and irrevocable guaranty that protects the holder of a financial obligation against non-payment of principal and interest ("Debt Service") when due. Upon an obligor’s default on scheduled principal or interest payments due on the obligation, the primary insurer is required under the financial guaranty policy to pay the principal or interest shortfall and the Company, as reinsurer, is required under the reinsurance agreement to pay its assumed share of such principal or interest shortfall. Public finance obligations assumed 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 its 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. Structured finance obligations assumed by the Company are generally issued by special purpose entities and backed by pools of assets such as residential or commercial mortgage loans, consumer or trade receivables, securities or other assets having an ascertainable cash flow or market value. The Company also includes within structured finance obligations other specialized financial obligations.

Financial guaranty contracts accounted for as credit derivatives are generally structured such that the circumstances giving rise to the guarantor’s obligation to make loss payments are similar to those for financial guaranty insurance contracts and only occurs upon one or more defined credit events such as failure to pay or bankruptcy, in each case, as defined within the transaction documents, with respect to one or more third party referenced securities or loans. Financial guaranty contracts accounted for as credit derivatives are primarily comprised of assumed credit default swaps (“CDS”). The Company’s affiliated ceding companies' credit derivative transactions are governed by International Swaps and Derivative Association, Inc. (“ISDA”) documentation.

When a rating agency assigns a public rating to a financial obligation guaranteed by one of AGL’s insurance company subsidiaries, it generally awards that obligation the same rating it has assigned to the financial strength of the AGL subsidiary that provides the guaranty. Investors in products insured by AGL’s insurance company subsidiaries frequently rely on ratings published by nationally recognized statistical rating organizations (“NRSROs”) because such ratings influence the trading value of securities and form the basis for many institutions’ investment guidelines as well as individuals’ bond purchase decisions. In addition, under the Company's reinsurance agreements, the primary insurer may have the right to recapture the ceded business or even terminate the agreement if the Company were unable to maintain financial strength ratings above specified levels. Therefore, the Company manages its business with the goal of achieving high financial strength ratings. However, the models used by NRSROs differ, presenting conflicting goals that may make it inefficient or impractical to reach the highest rating

6


level. The models are not fully transparent, contain subjective data (such as assumptions about future market demand for the Company’s products) and change frequently. Ratings reflect only the views of the respective NRSROs and are subject to continuous review and revision or withdrawal at any time.
Unless otherwise noted, ratings disclosed herein on the insured portfolio reflect Assured Guaranty’s internal ratings. Assured Guaranty’s ratings scale is similar to that used by the NRSROs; however, the ratings in these financial statements may not be the same as those assigned by any such rating agency. For example, the super senior category, which is not generally used by rating agencies, is used by Assured Guaranty in instances where Assured Guaranty’s AAA-rated exposure on its internal rating scale (which does not take into account Assured Guaranty’s financial guaranty) has additional credit enhancement due to either (1) the existence of another security rated AAA that is subordinated to Assured Guaranty’s exposure or (2) Assured Guaranty’s exposure benefiting from a different form of credit enhancement that would pay any claims first in the event that any of the exposures incurs a loss, and such credit enhancement, in management’s opinion, causes Assured Guaranty’s attachment point to be materially above the AAA attachment point.
Basis of Presentation
The unaudited interim consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and, in the opinion of management, reflect all adjustments that are of a normal recurring nature, necessary for a fair statement of the financial condition, results of operations and cash flows for the periods presented. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. These unaudited interim consolidated financial statements are as of September 30, 2012 and cover the three-month period ended September 30, 2012 (“Third Quarter 2012”), the three-month period ended September 30, 2011 (“Third Quarter 2011”), the nine-month period ended September 30, 2012 (“Nine Months 2012”) and the nine-month period ended September 30, 2011 (“Nine Months 2011”). The year-end balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP.
The unaudited interim consolidated financial statements include the accounts of AG Re and its subsidiaries. Intercompany accounts and transactions between and among AG Re and its subsidiaries have been eliminated. Certain prior year balances have been reclassified to conform to the current year’s presentation.
These unaudited interim consolidated financial statements should be read in conjunction with the consolidated financial statements included as Exhibit 99.2 in AGL’s Form 8-K dated May 17, 2012, furnished to the U.S. Securities and Exchange Commission (the “SEC”).


2.    Business Changes, Risks, Uncertainties and Accounting Developments
Summarized below are updates of the most significant recent events that have had, or may have in the future, a material effect on the financial position, results of operations or business prospects of the Company.
Rating Actions
In the last several years, Standard and Poor’s Ratings Services (“S&P”) and Moody’s Investors Service, Inc. (“Moody’s”) have downgraded the financial strength ratings of AG Re and its insurance subsidiaries. On March 20, 2012, Moody’s placed on review for possible downgrade the Insurance Financial Strength rating of the Company and the ratings of its affiliates that Moody's rates . Moody's is expected to finalize its review by the end of the year. There can be no assurance as to Moody's timeframe or the actions that Moody's may take on the Company's ratings or that S&P will not take further action on the Company’s ratings. For a discussion of the effect of rating actions by S&P or Moody's on the Company as of September 30, 2012, see the following:
Note 4, Financial Guaranty Insurance Contracts
Note 6, Financial Guaranty Contracts Accounted for as Credit Derivatives
Note 10, Reinsurance and Other Monoline Exposures

The Company's financial strength ratings are an important competitive factor in the financial guaranty insurance and reinsurance markets. If the financial strength or financial enhancement ratings of the Company were reduced below current levels, the Company expects it could have adverse effects on its future business opportunities as well as the premiums it could

7


charge for its insurance policies and reinsurance protection and consequently, a downgrade could harm the Company's new business production and results of operations in a material respect.
Accounting Changes
There has recently been significant GAAP rule making activity which has affected the accounting policies and presentation of the Company’s financial information beginning on January 1, 2012, particularly:

Adoption of new guidance that restricted the types and amounts of financial guaranty insurance acquisition costs that may be deferred. See Note 4, Financial Guaranty Insurance Contracts.

Adoption of guidance that changed the presentation of other comprehensive income (“OCI”). See “Consolidated Statements of Comprehensive Income.”

Adoption of guidance requiring additional fair value disclosures. See Note 5, Fair Value Measurement.

            
Deutsche Bank Agreement

On May 8, 2012, Assured Guaranty reached a settlement with Deutsche Bank AG and certain of its affiliates (collectively, “Deutsche Bank”), resolving claims related to certain residential mortgage-backed securities (“RMBS”) transactions issued, underwritten or sponsored by Deutsche Bank that were insured by AGM and AGC under financial guaranty insurance policies and to certain RMBS exposures in re-securitization transactions as to which AGC provides credit protection through CDS. As part of the settlement agreement (the “Deutsche Bank Agreement”), AGC and AGM settled their litigation against Deutsche Bank on three RMBS transactions. Assured Guaranty received a cash payment of $166 million from Deutsche Bank upon signing of the Deutsche Bank Agreement, a portion of which partially reimbursed Assured Guaranty for past losses on certain transactions.

Pursuant to the Deutsche Bank Agreement, Assured Guaranty and Deutsche Bank also entered into two loss sharing
arrangements, an "FG Reinsurance Agreement" and a "Re-REMIC Reinsurance Agreement", covering future RMBS related
losses, which are described below. Under the Deutsche Bank Agreement, Deutsche Bank AG placed eligible assets in trust in order to collateralize the obligations of a reinsurance affiliate under the loss-sharing arrangements. The Deutsche Bank reinsurance affiliate may be required to post additional collateral in the future to satisfy rating agency requirements. As of September 30, 2012, the balance of the assets held in trust of $282 million was sufficient to fully collateralize Deutsche Bank's obligations, based on Assured Guaranty's estimate of expected loss for the transactions covered under the agreement.

The settlement includes six AGM and two AGC-insured RMBS transactions (“Covered Transactions”), all of which the Company has reinsured. The Covered Transactions are backed by first lien and second lien mortgage loans. Under the FG Reinsurance Agreement, the Deutsche Bank reinsurance affiliate will reimburse 80% of Assured Guaranty’s future losses on the Covered Transactions until Assured Guaranty’s aggregate losses (including those to date that are partially reimbursed by the $166 million cash payment) reach $319 million. Assured Guaranty currently projects that in the base case the Covered Transactions will not generate aggregate losses in excess of $319 million. In the event aggregate losses exceed $389 million, the Deutsche Bank reinsurance affiliate is required to resume reimbursement at the rate of 85% of Assured Guaranty’s losses in excess of $389 million until such losses reach $600 million. AG Re's assumed portion of the par outstanding for the Covered Transactions as of September 30, 2012 is $57 million. AGM and AGC will be reimbursed under the FG Reinsurance Agreement for their respective future losses on the Covered Transactions as they pay claims on such Covered Transactions, and Assured Guaranty quarterly will allocate such reimbursements between the two insurers pro rata based on the cumulative amounts, net of recoveries, paid to date by each insurer with respect to the Covered Transactions.

Certain uninsured tranches (“Uninsured Tranches”) of three of the Covered Transactions are included as collateral in RMBS re-securitization transactions as to which AGC provides credit protection through CDS. Under the Re-REMIC Reinsurance Agreement, the Deutsche Bank reinsurance affiliate will reimburse losses on the CDS in an amount equal to 60% of losses in these Uninsured Tranches until the aggregate losses in the Uninsured Tranches reach $141 million. In the event aggregate losses exceed $161 million, reimbursement resumes at the rate of 60% until the aggregate losses reach $185 million. The Deutsche Bank reinsurance affiliate is required to reimburse any losses in excess of $185 million at the rate of 100% until the aggregate losses reach $248 million. As of September 30, 2012, lifetime losses in the Assured Guaranty base case are not expected to exceed $141 million (on an undiscounted basis). AG Re's assumed portion of the par outstanding for the Uninsured Tranches as of September 30, 2012 is $79 million.

8



Except for the Uninsured Tranches, the settlement does not include Assured Guaranty’s CDS with Deutsche Bank. The parties have agreed to continue efforts to resolve CDS-related claims.


3.
Outstanding Exposure
The Company’s financial guaranty contracts are written in different forms, but collectively are considered financial guaranty contracts. The Company seeks to limit its exposure to losses by underwriting obligations that are investment grade at inception, diversifying its insured portfolio and maintaining rigorous subordination or collateralization requirements on structured finance obligations.
Debt Service Outstanding
 
Gross Debt Service Outstanding
 
Net Debt Service Outstanding
 
September 30, 2012
 
December 31,
2011
 
September 30, 2012
 
December 31,
2011
 
(in millions)
Public finance
$
188,585

 
$
195,637

 
$
188,585

 
$
195,637

Structured finance
17,491

 
20,248

 
17,454

 
20,210

Total financial guaranty
$
206,076

 
$
215,885

 
$
206,039

 
$
215,847


In addition to the amounts shown in the table above, the Company’s net mortgage guaranty insurance in force was approximately $150 million as of September 30, 2012. The net mortgage guaranty insurance in force is assumed excess of loss business and comprises $135 million covering loans originated in Ireland and $15 million covering loans originated in the United Kingdom.
Financial Guaranty Portfolio by Internal Rating
 
As of September 30, 2012
 
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)
Super senior
$

 
%
 
$
388

 
3.4
%
 
$
1,010

 
9.0
%
 
$
426

 
10.9
%
 
1,824

 
1.4
%
AAA
867

 
0.8

 
71

 
0.6

 
3,169

 
28.2

 
1,219

 
31.1

 
5,326

 
4.1

AA
34,741

 
33.8

 
653

 
5.8

 
1,126

 
10.0

 
118

 
3.0

 
36,638

 
28.4

A
54,840

 
53.4

 
2,934

 
25.8

 
1,996

 
17.8

 
496

 
12.6

 
60,266

 
46.6

BBB
10,524

 
10.3

 
6,838

 
60.2

 
1,489

 
13.3

 
806

 
20.5

 
19,657

 
15.2

Below-investment grade (“BIG”)
1,773

 
1.7

 
472

 
4.2

 
2,431

 
21.7

 
857

 
21.9

 
5,533

 
4.3

Total net par outstanding
$
102,745

 
100.0
%
 
$
11,356

 
100.0
%
 
$
11,221

 
100.0
%
 
3,922

 
100.0
%
 
$
129,244

 
100.0
%
 

9


 
As of December 31, 2011
 
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)
Super senior
$—

 
%
 
$
391

 
3.4
%
 
$
1,576

 
12.0
%
 
$
417

 
9.4
%
 
$
2,384

 
1.8
%
AAA
1,043

 
1.0

 
69

 
0.6

 
3,569

 
27.2

 
1,361

 
30.8

 
6,042

 
4.5

AA
39,089

 
37.1

 
638

 
5.6

 
1,434

 
10.9

 
123

 
2.8

 
41,284

 
30.8

A
53,485

 
50.8

 
3,176

 
27.9

 
1,797

 
13.7

 
619

 
14.0

 
59,077

 
44.0

BBB
9,905

 
9.4

 
6,578

 
57.9

 
1,944

 
14.8

 
1,046

 
23.6

 
19,473

 
14.5

BIG
1,751

 
1.7

 
527

 
4.6

 
2,813

 
21.4

 
857

 
19.4

 
5,948

 
4.4

Total net par outstanding
$
105,273

 
100.0
%
 
$
11,379

 
100.0
%
 
$
13,133

 
100.0
%
 
$
4,423

 
100.0
%
 
$
134,208

 
100.0
%

Beginning in the first quarter 2012, the Company decided to classify 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. As of Third Quarter 2012, the Company applied this policy to the Bank of America Agreement and the Deutsche Bank Agreement (see Note 4, Financial Guaranty Insurance Contracts). The Bank of America Agreement was entered into in April 2011 and the reclassification in the first quarter 2012 resulted in a decrease in BIG net par outstanding as of December 31, 2011 of $96 million from that previously reported.
Economic Exposure to the Selected European Countries
Several European countries are experiencing significant economic, fiscal and/or political strains such that the likelihood of default on obligations with a nexus to those countries may be higher than the Company anticipated when such factors did not exist. The Company is closely monitoring its exposures in European countries where it believes heightened uncertainties exist, specifically, Greece, Hungary, Ireland, Italy, Portugal and Spain (the “Selected European Countries”). Published reports have identified countries that may be experiencing reduced demand for their sovereign debt in the current environment. The Company selected these European countries based on these reports and its view that their credit fundamentals are deteriorating. The Company’s economic exposure to the Selected European Countries (based on par for financial guaranty contracts and notional amount for financial guaranty contracts accounted for as derivatives) is shown in the following table net of ceded reinsurance.

10


Net Economic Exposure to Selected European Countries(1)
September 30, 2012
 
Greece
 
Hungary
 
Ireland
 
Italy
 
Portugal
 
Spain(2)
 
Total
 
(in millions)
Sub-sovereign exposure:
 
 
 
 
 
 
 
 
 
 
 
 
 
Public finance
$

 
$

 
$

 
$
177

 
$
14

 
$
46

 
$
237

Infrastructure finance

 
80

 
6

 
63

 
35

 
4

 
188

Sub-total

 
80

 
6

 
240

 
49

 
50

 
425

Non-sovereign exposure:
 
 
 
 
 
 
 
 
 
 
 
 
 
Regulated utilities

 

 

 
95

 

 
1

 
96

RMBS

 
6

 
135

 
18

 

 

 
159

Commercial receivables

 
0

 
4

 
5

 
2

 
4

 
15

Pooled corporate
8

 

 
28

 
38

 
1

 
107

 
182

Sub-total
8

 
6

 
167

 
156

 
3

 
112

 
452

Total
$
8

 
$
86

 
$
173

 
$
396

 
$
52

 
$
162

 
$
877

Total BIG
$

 
$
72

 
$
0

 
$
39

 
$
24

 
$
46

 
$
181

 ____________________
(1)
While the Company’s exposures are shown in U.S. dollars, the obligations the Company reinsures are in various currencies, including U.S. dollars, Euros and British pounds sterling. Included in the table above is $135 million of reinsurance assumed on a 2004 - 2006 pool of Irish residential mortgages that is part of the Company’s remaining legacy mortgage reinsurance business. One of the residential mortgage‑backed securities included in the table above includes residential mortgages in both Italy and Germany, and only the portion of the transaction equal to the portion of the original mortgage pool in Italian mortgages is shown in the table.

(2)
See Note 4, Financial Guaranty Insurance Contracts.
The Company no longer reinsures any sovereign bonds of the Selected European Countries. The exposure shown in the “Public Finance Category” is from transactions backed by receivable payments from sub-sovereigns in Italy, Spain and Portugal. Sub-sovereign debt is debt issued by a governmental entity or government backed entity, or supported by such an entity, that is other than direct sovereign debt of the ultimate governing body of the country. The Company understands that Moody's recently had undertaken a review of redenomination risk in selected countries in the Eurozone, including some of the Selected European Countries. No redenomination from the Euro to another currency has yet occurred and it may never occur. Therefore, it is not possible to be certain at this point how a redenomination of an issuer’s obligations might be implemented in the future and, in particular, whether any redenomination would extend to Assured Guaranty's obligations under a related financial guaranty. As of June 30, 2012, the Company had €72 million of net exposure to the sovereign debt of Greece. Assured Guaranty accelerated claims under its guaranties during the second quarter 2012, paying off in full its liabilities with respect to the Greek sovereign bonds it guaranteed. As of September 30, 2012, the Company no longer had any direct exposure to Greece. 

When a primary insurer affiliated with the Company directly insures an obligation, it assigns the obligation to a geographic location or locations based on its view of the geographic location of the risk. For direct exposure this can be a relatively straight-forward determination as, for example, a debt issue supported by availability payments for a toll road in a particular country. A primary insurer affiliated with the Company may also assign portions of a risk to more than one geographic location.  The Company may also have direct exposures to the Selected European Countries in business assumed from unaffiliated monoline insurance companies. The Company relies upon geographic information provided by the primary insurer, whether affiliated or not.
The Company has included in the exposure tables above its indirect economic exposure to the Selected European Countries through exposure it provides on (a) pooled corporate and (b) commercial receivables transactions. The Company considers economic exposure to a selected European Country to be indirect when the exposure relates to only a small portion of an insured transaction that otherwise is not related to a Selected European Country. In most instances, the trustees and/or servicers for such transactions provide reports that identify the domicile of the underlying obligors in the pool to the primary insurer (and such company relies on such reports). The primary insurers affiliated with the Company have reviewed transactions through which they believe they may have indirect exposure to the Selected European Countries that is material to the transaction and the Company has included in the tables above the proportion of the insured par equal to the proportion of

11


obligors so identified by its affiliated primary insurers as being domiciled in a Selected European Country. The Company may also have indirect exposures to Selected European Countries in business assumed from unaffiliated monoline insurance companies. However, unaffiliated primary insurers generally do not provide such information to the Company.

Surveillance Categories
The Company segregates its reinsurance 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.
The Company monitors its investment grade credits to determine whether any new credits need to be internally downgraded to BIG. The Company refreshes its internal credit ratings on individual credits in quarterly, semi-annual or annual cycles based on the Company’s view of the credit’s quality, loss potential, volatility and sector. Ratings on credits in sectors identified as under the most stress or with the most potential volatility are reviewed every quarter. The Company's insured credit ratings on assumed credits are based on the Company's reviews of low-rated credits or credits in volatile sectors, unless such information is not available, in which case, the ceding company's credit rating of the transactions are used. The Company models most assumed RMBS credits with par above $1 million, as well as certain RMBS credits below that amount.
Credits identified as BIG are subjected to further review to determine the probability of a loss (see Note 4, Financial Guaranty Insurance Contracts). Surveillance personnel then assign each BIG transaction to the appropriate BIG surveillance category based upon whether a lifetime loss is expected and whether a claim has been paid. The Company expects “lifetime 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 over the life of that transaction than it ultimately will have been reimbursed. For surveillance purposes, the Company calculates present value using a constant discount rate of 5%. (A risk-free rate is used for recording of reserves for financial statement purposes.)
Intense monitoring and intervention is employed for all BIG surveillance categories, with internal credit ratings reviewed quarterly. The three BIG categories are:
BIG Category 1: Below-investment-grade transactions showing sufficient deterioration to make lifetime losses possible, but for which none are currently expected. Transactions on which claims have been paid but are expected to be fully reimbursed (other than investment grade transactions on which only liquidity claims have been paid) are in this category.
BIG Category 2: Below-investment-grade transactions for which lifetime losses are expected but for which no claims (other than liquidity claims which is a claim that the Company expects to be reimbursed within one year) have yet been paid.
BIG Category 3: Below-investment-grade transactions for which lifetime losses are expected and on which claims (other than liquidity claims) have been paid. Transactions remain in this category when claims have been paid and only a recoverable remains.
 

12


Financial Guaranty Exposures
(Insurance and Credit Derivative Form)
 
As of September 30, 2012
 
BIG Net Par Outstanding
 
Net Par
 
BIG Net Par as a % of
Net Par
 
BIG 1
 
BIG 2
 
BIG 3
 
Total BIG
 
Outstanding
 
Outstanding
 
(in millions)
First lien U.S. RMBS:
 
 
 
 
 
 
 
 
 
 
 
Prime first lien
$
6

 
$
94

 
$
3

 
$
103

 
$
159

 
0.1
%
Alt-A first lien
25

 
403

 
276

 
704

 
872

 
0.5

Option ARM
12

 
71

 
30

 
113

 
165

 
0.1

Subprime
18

 
55

 
89

 
162

 
966

 
0.1

Second lien U.S. RMBS:
 
 
 
 
 
 


 
 
 


Closed end second lien

 
9

 
20

 
29

 
43

 
0.0

Home equity lines of credit (“HELOCs”)
17

 

 
348

 
365

 
409

 
0.3

Total U.S. RMBS
78

 
632

 
766

 
1,476

 
2,614

 
1.1

Trust preferred securities (“TruPS”)
392

 

 
236

 
628

 
1,419

 
0.5

Other structured finance
230

 
37

 
916

 
1,183

 
11,109

 
0.9

U.S. public finance
1,011

 
383

 
380

 
1,774

 
102,746

 
1.4

Non-U.S. public finance
472

 

 

 
472

 
11,356

 
0.4

Total
$
2,183

 
$
1,052

 
$
2,298

 
$
5,533

 
$
129,244

 
4.3
%

 
As of December 31, 2011
 
BIG Net Par Outstanding
 
Net Par
 
BIG Net Par as a % of
Net Par
 
BIG 1
 
BIG 2
 
BIG 3
 
Total BIG
 
Outstanding
 
Outstanding
 
(in millions)
First lien U.S. RMBS:
 
 
 
 
 
 
 
 
 
 
 
Prime first lien
$
25

 
$
88

 
$—

 
$
113

 
$
176

 
0.1
%
Alt-A first lien
391

 
108

 
305

 
804

 
988

 
0.6

Option ARM
5

 
100

 
17

 
122

 
193

 
0.1

Subprime
37

 
58

 
80

 
175

 
1,051

 
0.1

Second lien U.S. RMBS:
 
 
 
 
 
 
 
 
 
 


Closed end second lien

 
10

 
34

 
44

 
49

 
0.0

HELOCs
8

 

 
399

 
407

 
469

 
0.3

Total U.S. RMBS
466

 
364

 
835

 
1,665

 
2,926

 
1.2

TruPS
486

 

 
236

 
722

 
1,533

 
0.5

Other structured finance
256

 
251

 
774

 
1,281

 
13,097

 
1.0

U.S. public finance
1,046

 
240

 
467

 
1,753

 
105,273

 
1.3

Non-U.S. public finance(1)
434

 
93

 

 
527

 
11,379

 
0.4

Total
$
2,688

 
$
948

 
$
2,312

 
$
5,948

 
$
134,208

 
4.4
%
 ____________________
(1)
Includes $93 million in net par as of December 31, 2011 for bonds of the Hellenic Republic of Greece. See Note 4, Financial Guaranty Insurance Contracts.


13


Below Investment Grade Credits
By Category
 
As of September 30, 2012
 
Net Par Outstanding
 
Number of Risks(1)
Description
 
Financial
Guaranty
Insurance
 
Credit
Derivative
 
Total
 
Financial
Guaranty
Insurance
 
Credit
Derivative
 
Total
 
(dollars in millions)
BIG:
 
 
 
 
 
 
 
 
 
 
 
Category 1
$
1,735

 
$
448

 
$
2,183

 
84

 
28

 
112

Category 2
537

 
515

 
1,052

 
49

 
31

 
80

Category 3
1,765

 
533

 
2,298

 
103

 
24

 
127

Total BIG
$
4,037

 
$
1,496

 
$
5,533

 
236

 
83

 
319


 
As of December 31, 2011
 
 
Net Par Outstanding
 
Number of Risks(1)
Description
 
Financial
Guaranty
Insurance
 
Credit
Derivative
 
Total
 
Financial
Guaranty
Insurance
 
Credit
Derivative
 
Total
 
(dollars in millions)
BIG:
 
 
 
 
 
 
 
 
 
 
 
Category 1
$
1,832

 
$
856

 
$
2,688

 
96

 
35

 
131

Category 2
708

 
240

 
948

 
52

 
32

 
84

Category 3
1,744

 
568

 
2,312

 
90

 
20

 
110

Total BIG
$
4,284

 
$
1,664

 
$
5,948

 
238

 
87

 
325

____________________
(1)
A risk represents the aggregate of the financial guaranty policies that share the same revenue source for purposes of making Debt Service payments.

Hurricane Sandy

On October 29, 2012, Hurricane Sandy made landfall in New Jersey and caused significant loss of life and property damage in New Jersey, New York and Connecticut. While the Company is continuing to evaluate the effects of Hurricane Sandy on its insured portfolio, it does not expect any significant losses as a result of the hurricane at this time.


4.    Financial Guaranty Insurance Contracts

Change in accounting for deferred acquisition costs

In October 2010, the Financial Accounting Standards Board adopted Accounting Standards Update (“Update”) No. 2010-26. The Company adopted this guidance January 1, 2012, with retrospective application. The Update specifies that certain costs incurred in the successful acquisition of new and renewal insurance contracts should be capitalized. These costs include direct costs of contract acquisition that result directly from and are essential to the contract transaction such as ceding commissions and the cost of underwriting personnel. Management uses its judgment in determining the type and amount of cost to be deferred. The Company conducts an annual study to determine which operating costs qualify for deferral. Ceding commission income on business ceded to third party reinsurers reduces policy acquisition costs and is deferred. Costs incurred by the insurer for soliciting potential customers, market research, training, administration, unsuccessful acquisition efforts, and product development as well as all overhead type costs are charged to expense as incurred.

Expected losses, which include loss adjustment expenses (“LAE”), investment income, and the remaining costs of servicing the insured or reinsured business are considered in determining the recoverability of deferred acquisition costs. When an insured issue is retired early, the remaining related deferred acquisition cost is expensed at that time. Ceding commission expense and income associated with future installment premiums on assumed and ceded business, respectively, are calculated at their contractually defined rates and recorded in deferred acquisition costs on the consolidated balance sheets with a corresponding offset to net premium receivable or reinsurance balances payable.

14


As of January 1, 2011, the effect of retrospective application of the new guidance was a reduction to deferred acquisition costs of $8 million and a reduction to retained earnings of $8 million.
Effect of Retrospective Application of New Deferred Acquisition Cost Guidance
On Consolidated Statements of Operations

 
As Reported
Third Quarter 2011
 
Retroactive Application Adjustment
 
As Revised Third Quarter 2011
 
(in millions)
Amortization of deferred acquisition costs
$
9

 
$
0

 
$
9

Net income (loss)
178

 
0

 
178


 
As Reported
Nine Months 2011
 
Retroactive Application Adjustment
 
As Revised
Nine Months 2011
 
(in millions)
Amortization of deferred acquisition costs
$
33

 
$
(1
)
 
$
32

Net income (loss)
163

 
1

 
164


The portfolio of outstanding exposures discussed in Note 3, Outstanding Exposure, includes financial guaranty contracts that meet the definition of insurance contracts as well as those that meet the definition of derivative contracts. Amounts presented in this note relate only to financial guaranty insurance contracts. See Note 6, Financial Guaranty Contracts Accounted for as Credit Derivatives. Tables presented herein also include reconciliations to financial statement line items for other less significant types of insurance.

Net Earned Premiums
 
Third Quarter
 
Nine Months
 
2012
 
2011
 
2012
 
2011
 
(in millions)
Scheduled net earned premiums
$
27

 
$
24

 
$
76

 
$
80

Acceleration of premium earnings
11

 
7

 
27

 
20

Accretion of discount on net premiums receivable
2

 
2

 
6

 
7

Total financial guaranty
40

 
33

 
109

 
107

Other
0

 
0

 
1

 
1

Total net earned premiums
$
40

 
$
33

 
$
110

 
$
108



15


Gross Premium Receivable, Net of Ceding Commissions Roll Forward
 
Nine Months
 
2012
 
2011
 
(in millions)
Balance, beginning of period
$
273

 
$
348

Premium written, net
36

 
55

Premium payments received, net
(67
)
 
(95
)
Adjustments to the premium receivable:
 
 
 
Changes in the expected term of financial guaranty insurance contracts
(9
)
 
(64
)
Accretion of discount
5

 
5

Foreign exchange translation
1

 
(1
)
Other adjustments
(2
)
 

Balance, end of period
$
237

 
$
248


Gains or losses due to foreign exchange rate changes relate to installment premium receivables denominated in currencies other than the U.S. dollar. Approximately 24%, 18% and 20% of installment premiums at September 30, 2012, December 31, 2011 and September 30, 2011, respectively, are denominated in currencies other than the U.S. dollar, primarily in Euro and British Pound Sterling.
Actual collections may differ from expected collections in the tables below due to factors such as foreign exchange rate fluctuations, counterparty collectability issues, accelerations, commutations and changes in expected lives.
Expected Collections of Gross Premiums Receivable,
Net of Ceding Commissions (Undiscounted)
 
As of
September 30, 2012
 
(in millions)
2012 (October 1 – December 31)
$
22

2013
29

2014
26

2015
22

2016
18

2017-2021
72

2022-2026
47

2027-2031
36

After 2031
43

Total
$
315


The following table provides a schedule of the expected timing of the income statement recognition of pre-tax financial guaranty insurance net unearned premium reserve and the present value of net expected losses to be expensed. The amount and timing of actual premium earnings and loss and LAE may differ from the estimates shown below due to factors such as refundings, accelerations, commutations, changes in expected lives and updates to loss estimates. A loss and LAE reserve is only recorded for the amount by which net expected loss to be expensed exceeds unearned premium reserve determined on a contract-by-contract basis.

16


Expected Timing of
Premium and Loss Recognition
 
As of September 30, 2012
 
Scheduled Net
Earned Premium
 
Net Expected Loss
to be Expensed
 
Net
 
(in millions)
 
 
 
 
 
 
2012 (October 1 – December 31)
$
26

 
$
1

 
$
25

Subtotal 2012
26

 
1

 
25

2013
100

 
2

 
98

2014
93

 
2

 
91

2015
82

 
2

 
80

2016
77

 
2

 
75

2017-2021
311

 
8

 
303

2022-2026
210

 
6

 
204

2027-2031
139

 
4

 
135

After 2031
135

 
5

 
130

Total present value basis(1)
1,173

 
32

 
1,141

Discount
90

 
146

 
(56
)
Total future value
$
1,263

 
$
178

 
$
1,085

_____________________
(1)    Balances represent discounted amounts.
Selected Information for Policies Paid in Installments
 
As of
September 30, 2012
 
As of
December 31, 2011
 
(dollars in millions)
Premiums receivable, net of ceding commission payable
$
237

 
$
273

Gross unearned premium reserve
304

 
324

Weighted‑average risk-free rate used to discount premiums
3.6
%
 
3.2
%
Weighted‑average period of premiums receivable (in years)
9.5

 
9.8

Loss Estimation Process
The Company's loss reserve committee estimates expected loss to be paid (including any loss adjustment expenses). Surveillance personnel present analyses related to potential losses to the Company’s loss reserve committee for consideration in estimating the expected loss to be paid. Such analyses include the consideration of various scenarios with potential probabilities assigned to them. Depending upon the nature of the risk, the Company’s view of the potential size of any loss and the information available to the Company, that analysis may be based upon individually developed cash flow models, internal credit rating assessments and sector‑driven loss severity assumptions or judgmental assessments. In the case of its assumed business, the Company may conduct its own analysis as just described or, depending on the Company’s view of the potential size of any loss and the information available to the Company, the Company may use loss estimates provided by ceding insurers. The Company’s loss reserve committee reviews and refreshes the estimate of expected loss to be paid each quarter. The Company’s estimate of ultimate loss on a policy is subject to significant uncertainty over the life of the insured transaction due to the potential for significant variability in credit performance as a result of economic, fiscal and financial market variability over the long duration of most contracts. The determination of expected loss to be paid is an inherently subjective process involving numerous estimates, assumptions and judgments by management.

The following table presents a roll forward of the present value of net expected loss to be paid for financial guaranty insurance contracts by sector. Net expected loss to be paid is the estimate of the present value of future claim payments, net of

17


reinsurance and net of salvage and subrogation, which includes the present value benefit of estimated recoveries for breaches of representations and warranties (“R&W”). The Company used weighted average risk-free rates for U.S. dollar denominated obligations, which ranged from 0.0% to 3.19% as of September 30, 2012 and 0.0% to 3.27% as of December 31, 2011.

Present Value of Net Expected Loss to be Paid
Roll Forward by Sector

 
Net Expected
Loss to be
Paid as of
June 30, 2012
 
Economic
Loss
Development(1)
 
(Paid)
Recovered
Losses(2)
 
Net Expected
Loss to be
Paid as of
September 30, 2012(3)
 
(in millions)
U.S. RMBS:
 
 
 
 
 
 
 
First lien:
 
 
 
 
 
 
 
Prime first lien
$
1

 
$

 
$

 
$
1

Alt-A first lien
9

 

 

 
9

Option ARM
4

 
3

 
(2
)
 
5

Subprime
7

 
1

 
(1
)
 
7

Total first lien
21

 
4

 
(3
)
 
22

Second lien:
 
 
 
 
 
 
 
Closed end second lien
5

 

 
(1
)
 
4

HELOCs
19

 
4

 
(6
)
 
17

Total second lien
24

 
4

 
(7
)
 
21

Total U.S. RMBS
45

 
8

 
(10
)
 
43

TruPS
1

 
1

 

 
2

Other structured finance
162

 
(6
)
 
(1
)
 
155

U.S. public finance
45

 
(5
)
 
(7
)
 
33

Non-U.S. public finance
100

 
4

 
(96
)
 
8

Total financial guaranty
353

 
2

 
(114
)
 
241

Other
(4
)
 

 

 
(4
)
Total
$
349

 
$
2

 
$
(114
)
 
$
237



18


 
Net Expected
Loss to be
Paid as of
June 30, 2011
 
Economic
Loss
Development(1)
 
(Paid)
Recovered
Losses(2)
 
Net Expected
Loss to be
Paid as of
September 30, 2011
 
(in millions)
U.S. RMBS:
 
 
 
 
 
 
 
First lien:
 
 
 
 
 
 
 
Prime first lien
$
1

 
$

 
$

 
$
1

Alt-A first lien
9

 
2

 
(1
)
 
10

Option ARM
6

 
(3
)
 
1

 
4

Subprime
13

 
(1
)
 
1

 
13

Total first lien
29

 
(2
)
 
1

 
28

Second lien:
 
 
 
 
 
 
 
Closed end second lien
(7
)
 
4

 
(1
)
 
(4
)
HELOCs
22

 

 
(2
)
 
20

Total second lien
15

 
4

 
(3
)
 
16

Total U.S. RMBS
44

 
2

 
(2
)
 
44

TruPS
1

 
2

 

 
3

Other structured finance
115

 
51

 

 
166

U.S. public finance
18

 
17

 
(4
)
 
31

Non-U.S. public finance
3

 
2

 

 
5

Total financial guaranty
181

 
74

 
(6
)
 
249

Other
2

 

 

 
2

Total
$
183

 
$
74

 
$
(6
)
 
$
251




19


 
Net Expected
Loss to be
Paid as of
December 31, 2011(3)
 
Economic
Loss
Development(1)
 
(Paid)
Recovered
Losses(2)
 
Net Expected
Loss to be
Paid as of
September 30, 2012(3)
 
(in millions)
U.S. RMBS:
 
 
 
 
 
 
 
First lien:
 
 
 
 
 
 
 
Prime first lien
$
1

 
$

 
$

 
$
1

Alt-A first lien
10

 
(1
)
 

 
9

Option ARM
3

 
6

 
(4
)
 
5

Subprime
7

 
1

 
(1
)
 
7

Total first lien
21

 
6

 
(5
)
 
22

Second lien:
 
 
 
 
 
 
 
Closed end second lien
(6
)
 
1

 
9

 
4

HELOCs
24

 
9

 
(16
)
 
17

Total second lien
18

 
10

 
(7
)
 
21

Total U.S. RMBS
39

 
16

 
(12
)
 
43

TruPS
3

 
(1
)
 

 
2

Other structured finance
154

 
8

 
(7
)
 
155

U.S. public finance
30

 
19

 
(16
)
 
33

Non-U.S. public finance
8

 
37

 
(37
)
 
8

Total financial guaranty
234

 
79

 
(72
)
 
241

Other
2

 
(6
)
 

 
(4
)
Total
$
236

 
$
73

 
$
(72
)
 
$
237


 
Net Expected
Loss to be
Paid as of
December 31, 2010
 
Economic
Loss
Development(1)
 
(Paid)
Recovered
Losses(2)
 
Net Expected
Loss to be
Paid as of
September 30, 2011
 
(in millions)
U.S. RMBS:
 
 
 
 
 
 
 
First lien:
 
 
 
 
 
 
 
Prime first lien
$
1

 
$

 
$

 
$
1

Alt-A first lien
10

 
1

 
(1
)
 
10

Option ARM
14

 
(7
)
 
(3
)
 
4

Subprime
16

 
(3
)
 

 
13

Total first lien
41

 
(9
)
 
(4
)
 
28

Second lien:
 
 
 
 
 
 
 
Closed end second lien
1

 

 
(5
)
 
(4
)
HELOCs
(66
)
 
18

 
68

 
20

Total second lien
(65
)
 
18

 
63

 
16

Total U.S. RMBS
(24
)
 
9

 
59

 
44

TruPS
0

 
3

 

 
3

Other structured finance
107

 
61

 
(2
)
 
166

U.S. public finance
31

 
7

 
(7
)
 
31

Non-U.S. public finance
3

 
2

 

 
5

Total financial guaranty
117

 
82

 
50

 
249

Other
2

 

 

 
2

Total
$
119

 
$
82

 
$
50

 
$
251


20


_____________________
(1)
Economic loss development includes the effects of changes in assumptions based on observed market trends, changes in discount rates, accretion of discount and the economic effects of loss mitigation efforts.

(2)
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.

(3)
Includes expected LAE to be paid for mitigating claim liabilities of $6 million as of September 30, 2012 and $5 million as of December 31, 2011.

The table below provides a reconciliation of expected loss to be paid to expected loss to be expensed. Expected loss to be paid differs from expected loss to be expensed due to: (1) the addition of claim payments that have been made (and therefore are not included in expected loss to be paid) that are expected to be recovered in the future (and therefore have also reduced expected loss to be paid ), and (2) loss reserves that have already been established (and therefore expensed but not yet paid).
Reconciliation of Financial Guaranty Insurance Present Value of Net Expected Loss to be Paid
and Net Present Value of Net Expected Loss to be Expensed

 
As of
September 30, 2012
 
(in millions)
Net expected loss to be paid
$
241

Other recoveries (1)
1

Salvage and subrogation recoverable
27

Loss and LAE reserve
(236
)
Net expected loss to be expensed
$
33

____________________
(1)    R&W recoveries recorded in other assets on the consolidated balance sheet.

The Company’s Approach to Projecting Losses in U.S. RMBS
The Company projects losses on its assumed 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 to the projected performance of the collateral over time. The resulting projected claim payments or reimbursements are then discounted using risk-free rates. The majority of U.S. RMBS losses before R&W benefit are assumed from the affiliated ceding companies. For transactions where the affiliated ceding company projects it will receive recoveries from providers of R&W, it projects the amount of recoveries and either establishes a recovery for claims already paid or reduces its projected claim payments accordingly.
The further behind a mortgage borrower falls in making payments, the more likely it is that he or she will default. The rate at which borrowers from a particular delinquency category (number of monthly payments behind) eventually default is referred to as the “liquidation rate.” Liquidation rates may be derived from observed roll rates, which are the rates at which loans progress from one delinquency category to the next and eventually to default and liquidation. The Company applies liquidation rates to the mortgage loan collateral in each delinquency category and makes certain timing assumptions to project near-term mortgage collateral defaults from loans that are currently delinquent.
Mortgage borrowers that are not more than one payment behind (generally considered performing borrowers) have demonstrated an ability and willingness to pay throughout the recession and mortgage crisis, and as a result are viewed as less likely to default than delinquent borrowers. Performing borrowers that eventually default will also need to progress through delinquency categories before any defaults occur. The Company projects how many of the currently performing loans will default and when they will default, by first converting the projected near term defaults of delinquent borrowers derived from liquidation rates into a vector of conditional default rates ("CDR"), then projecting how the conditional default rates will develop over time. Loans that are defaulted pursuant to the conditional default rate after the liquidation of currently delinquent loans represent defaults of currently performing loans. A conditional default rate is the outstanding principal amount of

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defaulted loans liquidated in the current month divided by the remaining outstanding amount of the whole pool of loans (or “collateral pool balance”). The collateral pool balance decreases over time as a result of scheduled principal payments, partial and whole principal prepayments, and defaults.
In order to derive collateral pool losses from the collateral pool defaults it has projected, the Company applies a loss severity. The loss severity is the amount of loss the transaction experiences on a defaulted loan after the application of net proceeds from the disposal of the underlying property. The affiliated ceding companies project loss severities by sector based on the experience to date. Further detail regarding the assumptions and variables the Company used to project collateral losses in its U.S. RMBS portfolio may be found below in the sections “U.S. Second Lien RMBS Loss Projections: HELOCs and Closed-End Second Lien” and “U.S. First Lien RMBS Loss Projections: Alt-A First Lien, Option ARM, Subprime and Prime.”
The affiliated ceding companies are in the process of enforcing claims for breaches of R&W regarding the characteristics of the loans included in the collateral pools. The Company calculates a credit from the RMBS issuer for such recoveries where the R&W were provided by an entity the Company believes to be financially viable and where the affiliated ceding companies already have access or believe they will attain access to the underlying mortgage loan files. Where the affiliated ceding company has an agreement with an R&W provider (e.g., the Bank of America Agreement or the Deutsche Bank Agreement) or where the affiliated ceding company is in advanced discussions on a potential agreement, that credit is based on the agreement or potential agreement. In second lien RMBS transactions where there is no agreement or advanced discussions, this credit is based on a percentage of actual repurchase rates achieved across those transactions where material repurchases have been made. In first lien RMBS transactions where there is no agreement or advanced discussions, this credit is estimated by reducing collateral losses projected by the affiliated ceding companies to reflect a percentage of the recoveries the affiliated ceding companies believe they will achieve, based on a percentage of actual repurchase rates achieved or based on the amounts the affiliated ceding companies were able to negotiate under the Bank of America Agreement and Deutsche Bank Agreement. The first lien approach is different from the second lien approach because the Company’s first lien transactions have multiple tranches and a more complicated method is required to correctly allocate credit to each tranche. In each case, the credit is a function of the projected lifetime collateral losses in the collateral pool, so an increase in projected collateral losses generally increases the R&W credit calculated by the Company for the RMBS issuer. Further detail regarding how the Company calculates these credits may be found under “Breaches of Representations and Warranties” below. While the Company has sufficient information to project losses on most U.S. RMBS it has assumed from unaffiliated ceding companies, it does not establish a credit or reduce projected claim payments for R&W for these transactions. Also, it relies on unaffiliated ceding companies for rating estimates on a small number of U.S. RMBS and loss projections on a small number of U.S. RMBS, for which it has insufficient information to independently project performance. Expected loss on U.S. RMBS, before consideration of the R&W benefit, was $73 million and $96 million as of September 30, 2012 and December 31, 2011, respectively, of which $51 million and $76 million, respectively, was from affiliated ceding companies.
The Company projects the overall future cash flow from a collateral pool by adjusting the payment stream from the principal and interest contractually due on the underlying mortgages for (a) the collateral losses it projects as described above, (b) assumed voluntary prepayments and (c) recoveries for breaches of R&W as described above. The Company then applies an individual model of the structure of the transaction to the projected future cash flow from that transaction’s collateral pool to project the Company’s future claims and claim reimbursements for that individual transaction. Finally, the projected claims and reimbursements are discounted using risk free rates. As noted above, the Company runs several sets of assumptions regarding mortgage collateral performance, or scenarios, and probability weights them.
Third Quarter-End 2012 U.S. RMBS Loss Projections
The Company's RMBS loss projection methodology assumes that the housing and mortgage markets will eventually improve. Each quarter the Company makes a judgment as to whether to change its assumptions used to make RMBS loss projections based on its observation during the quarter of the performance of its insured transactions (including early stage delinquencies, late stage delinquencies and, for first liens, loss severity) as well as the residential property market and economy in general, and, to the extent it observes changes, it makes a judgment as whether those changes are normal fluctuations or part of a trend. Based on such observations, the Company chose to use essentially the same methodology and scenarios to project RMBS loss as of September 30, 2012 as it used as of June 30, 2012. The methodology and scenarios used as of September 30, 2012 were also essentially the same as those it used as of December 31, 2011, except that as compared to December 31, 2011 (i) in its most optimistic scenario, it reduced by three months the period it assumed it would take the mortgage market to recover and (ii) in its most pessimistic scenario, it increased by three months the period it assumed it would take the mortgage market to recover. The methodology the Company uses to project RMBS losses and the scenarios it employs are described in more detail below under "U.S. Second Lien RMBS Loss Projections: HELOCs and Closed-End Second Lien" and "U.S. First Lien RMBS Loss Projections: Alt A First Lien, Option ARM, Subprime and Prime."


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U.S. Second Lien RMBS Loss Projections: HELOCs and Closed End Second Lien
The Company reinsures two types of second lien RMBS: those secured by HELOCs and those secured by closed end second lien mortgages. HELOCs are revolving lines of credit generally secured by a second lien on a one to four family home. A mortgage for a fixed amount secured by a second lien on a one to four family home is generally referred to as a closed end second lien. Second lien RMBS sometimes include a portion of loan collateral with a different priority than the majority of the collateral. The Company has material exposure to second lien mortgage loans originated and serviced by a number of parties, but the Company’s most significant second lien exposure is to HELOCs originated and serviced by Countrywide, a subsidiary of Bank of America. See “Breaches of Representations and Warranties.”
The delinquency performance of HELOC and closed end second lien exposures included in transactions reinsured by the Company began to deteriorate in 2007, and such transactions continue to perform below the Company’s original underwriting expectations. While insured securities benefit from structural protections within the transactions designed to absorb collateral losses in excess of previous historically high levels, in many second lien RMBS projected losses now exceed those structural protections.
The Company believes the primary variables affecting its expected losses in second lien RMBS transactions are the amount and timing of future losses in the collateral pool supporting the transactions and the amount of loans repurchased for breaches of R&W (or agreements with R&W providers related to such obligations). Expected losses are also a function of the structure of the transaction; the voluntary prepayment rate (typically also referred to as conditional prepayment rate ("CPR") of the collateral); the interest rate environment; and assumptions about the draw rate and loss severity. These variables are interrelated, difficult to predict and subject to considerable volatility. If actual experience differs from the Company’s assumptions, the losses incurred could be materially different from the estimate. The Company continues to update its evaluation of these exposures as new information becomes available.
The following table shows the range of key assumptions for the calculation of expected loss to be paid for second lien U.S. RMBS.
Key Assumptions in Base Case Expected Loss Estimates
Second Lien RMBS(1)
HELOC key assumptions
 
As of
September 30, 2012
 
As of
June 30, 2012
 
As of
December 31, 2011
Plateau CDR
0.1%
-
20.5%
 
2.9%
-
20.9%
 
0.5%
-
27.9%
Final CDR trended down to
0.1%
-
3.2%
 
0.4%
-
3.2%
 
0.4%
-
3.2%
Expected period until final CDR
36 months
 
36 months
 
36 months
Initial CPR
0.9%
-
21.6%
 
2.7%
-
16.4%
 
0.0%
-
25.8%
Final CPR
10%
 
10%
 
10%
Loss severity
98%
 
98%
 
98%
Initial draw rate
0.0%
-
14.7%
 
0.0%
-
4.1%
 
0.0%
-
15.3%

Closed end second lien key assumptions
 
As of
September 30, 2012
 
As of
June 30, 2012
 
As of
December 31, 2011
Plateau CDR
6.2%
-
19.0%
 
4.3%
-
20.7%
 
6.9%
-
24.8%
Final CDR trended down to
3.3%
-
9.1%
 
3.3%
-
9.1%