As described in Note 2 – Natural Disasters Affecting First BanCorp. in 2017, hurricanes Irma and Maria hit the Eastern Caribbean region and Puerto Rico in September 2017, affecting the Corporation’s service areas during 2017. These hurricanes caused widespread property damage, flooding, power outages, and water and communication services interruptions, and have severely disrupted normal economic activity in the affected areas.

Damages associated with the storm-related events will have significant short-term economic repercussions, both positive and negative, for the Corporation’ s commercial and individual loan customers in the most severely affected parts of Puerto Rico and the Virgin Islands. While these events have affected certain asset quality metrics, including higher delinquencies and non-performing loans, the storms’ ultimate effect on loan collections is uncertain.

The Corporation’s loan portfolio in Puerto Rico and the Virgin Islands totaled $7.2 billion as of December 31, 2017, or 81% of the entire portfolio. The composition of these loans generally reflects the composition of the entire portfolio, which is close to 60% of residential and consumer loans to individual customers and 40% of commercial and construction loans.

During 2017, management determined a separate qualitative element of the allowance to capture the estimate of inherent losses associated with the effect of Hurricanes Maria and Irma on the Corporation’s loan portfolio in Puerto Rico and Virgin Islands. This estimate is judgmental and subject to changes as conditions evolve. This qualitative element of the allowance was determined based on the estimated effect that the storms could have on current employment levels (e.g., an unemployment rate that significantly increases from current levels in Puerto based on statistics observed in the aftermath of similar natural disasters in the U.S. mainland like Hurricane Katrina), economic activity in the Corporation’s geographic regions, and the time it could take for the affected regions to return to a more normalized operating environment. Refer to Note 2 – Natural Disasters Affecting first BanCorp in 2017, for additional information about the impact of Hurricanes Maria and Irma in the Corporation’s financial results.

The Corporation’s credit risk modeling framework used to determine the storm-related qualitative estimate is similar to the one used for benchmarking purposes as part of the annual Dodd-Frank Act Stress Testing (“DFAST”) regulatory exercise. Models were developed following a regression modeling approach in which relationships between portfolio-level loss rates and key economic indicators were derived based on historical behavior. These models went through an extensive model specification and selection process that resulted in the use of certain variables, such as the unemployment rate and the Puerto Rico Economic Activity Index, which showed the highest predictive power of potential losses in the Corporation’s outstanding loan portfolio.

For large commercial and construction loan relationships, loan officers performed individual reviews of the storms’ effect on these borrowers sources of repayment. These large relationships, that represent 80% of the outstanding balance of the Corporation’s commercial and construction loan portfolio, were analyzed and divided into three storm-affected categories (i.e. Low, Medium, and High). Clients categorized as Low had no effect, or relatively insignificant effect, as a result of the storms. Clients in the Medium category had demonstrated that they have sufficient liquidity to satisfy their obligations, but the complexity of the insurance claim process may affect their primary or secondary source of repayment. Finally, clients categorized as High could potentially have problems with their primary or secondary sources of repayment as they have a higher degree of uncertainty with respect to the timing of the insurance claim resolution, and the full reestablishment of their businesses is highly dependent on the timely receipt of insurance proceeds. Reserve levels were then recognized for these loans based on this stratification. For loans in the Low category, no additional qualitative storm-related reserve was calculated. For loans in the Medium and High risk categories, the Corporation stressed the general reserve loss factors applicable to these loans to reflect higher default probabilities not reflected in the historical data.

This review also resulted in downgrades in the credit risk classification of certain loans and their reserves were determined following the methodology applicable to criticized and adversely classified loans, as appropriate.

For commercial and construction loans not individually reviewed, as well as residential and consumer loans, the estimated losses associated with the storms was determined following the above-described qualitative storm-related model with resulting loss factors applied to the overall performing balance of each portfolio.

The detailed review process applied to commercial and constructions loans was not logistically feasible for the residential mortgage and consumer loans. Residential and consumer loans are underwritten principally on income streams, with collateral viewed as a second source of repayment. The storms’ impact varies widely within the residential and consumer portfolio, with some individual borrowers experiencing the devastation of loss of both home and employment and others with both homes and jobs intact. Properties used as collateral generally require insurance minimizing the potential loss from property damages. In general, management followed the aforementioned described model for the determination of the qualitative storm- related allowance for these portfolios.

As a result of the aforementioned analyses, the Corporation recorded a provision of $71.3 million in 2017 associated with the storms. As of December 31, 2017, the storm-related allowance was $68.5 million (net of a $2.8 million charge-off taken in the fourth quarter of 2017), composed of $62.9 million for Puerto Rico and $5.6 million for the Virgin Islands. On a portfolio basis, the storm-related allowance as of December 31, 2017 was composed of: (i) $14.6 million for residential mortgage loans; (ii) $15.9 million for commercial and industrial loans; (iii) $12.1 million for commercial mortgage loans; (iv) $0.9 million for construction loans; and (v) a $25.0 million for consumer loans. As the Corporation acquires additional information on overall economic prospects in the storm-affected areas and the performance of consumer credits that had been under payment deferral programs and obtains further assessments of individual borrowers, the loss estimate will be revised as needed.

As of December 31, 2017, the Corporation maintained a $0.7 million reserve for unfunded loan commitments (2016 - $1.6 million), mainly related to outstanding commitments on floor plan revolving lines of credit. The reserve for unfunded loan commitments is an estimate of the losses inherent in off-balance sheet loan commitments to borrowers that are experiencing financial difficulties at the balance sheet date. It is calculated by multiplying an estimated loss factor by an estimated probability of funding, and then by the period-end amounts for unfunded commitments. The reserve for unfunded loan commitments is included as part of accounts payable and other liabilities in the consolidated statements of financial condition and any changes to the reserve is included as part of non-interest expenses in the consolidated statements of income.