XML 134 R15.htm IDEA: XBRL DOCUMENT v2.4.1.9
Expected Loss to be Paid
 12 Months Ended
Dec. 31, 2014
Expected Losses [Abstract]  
Expected Loss to be Paid
Expected Loss to be Paid
 
The insured portfolio includes policies accounted for under three separate accounting models depending on the characteristics of the contract and the Company's control rights. The Company has paid and expects to pay future losses on policies which fall under each of the three accounting models. The following provides a summarized description of the three accounting models prescribed by GAAP with a reference to the notes that describe the accounting policies and required disclosures throughout this report. The three models are: (1) insurance, (2) derivative and (3) VIE consolidation.

In order to effectively evaluate and manage the economics and liquidity of the entire insured portfolio, management compiles and analyzes loss information for all policies on a consistent basis. The Company monitors and assigns ratings and calculates expected losses in the same manner for all its exposures regardless of form or differing accounting models.

This note provides information regarding expected claim payments to be made under all contracts in the insured portfolio. Net expected loss to be paid in the tables below consists of the present value of future: expected claim and LAE payments, expected recoveries of excess spread in the transaction structures, cessions to reinsurers, and expected recoveries for breaches of representations and warranties ("R&W") and other loss mitigation strategies.

Accounting Policy

Insurance Accounting

For contracts accounted for as financial guaranty insurance, loss and LAE reserve is recorded only to the extent and for the amount that expected losses to be paid exceed unearned premium reserve. As a result, the Company has expected loss to be paid that have not yet been expensed. Such amounts will be recognized in future periods as deferred premium revenue amortizes into income. Expected loss to be paid is important from a liquidity perspective in that it represents the present value of amounts that the Company expects to pay or recover in future periods, regardless of the accounting model. Expected loss to be paid is an important measure used by management to analyze the net economic loss on all contacts. Expected loss to be expensed is important because it presents the Company's projection of incurred losses that will be recognized in future periods (excluding accretion of discount). See Note 7, Financial Guaranty Insurance Losses.

Derivative Accounting, at Fair Value

For contracts that do not meet the financial guaranty scope exception in the derivative accounting guidance (primarily due to the fact that the insured is not required to be exposed to the insured risk throughout the life of the contract), the Company records such credit derivative contracts at fair value on the consolidated balance sheet with changes in fair value recorded in the consolidated statement of operations. The fair value recorded on the balance sheet represents an exit price in a hypothetical market because the Company does not trade its credit derivative contracts. The fair value is determined using significant Level 3 inputs in an internally developed model while the expected loss to be paid (which represents the net present value of expected cash outflows) uses methodologies and assumptions consistent with financial guaranty insurance expected losses to be paid. See Note 8, Fair Value Measurement and Note 9, Financial Guaranty Contracts Accounted for as Credit Derivatives.

VIE Consolidation, at Fair Value

For financial guaranty insurance contracts issued on the debt of variable interest entities over which the Company is deemed to be the primary beneficiary due to its control rights, as defined in GAAP, the Company consolidates the FG VIE. The Company carries the assets and liabilities of the FG VIEs at fair value under the fair value option election. Management assesses the losses on the insured debt of the consolidated FG VIEs in the same manner as other financial guaranty insurance and credit derivative contracts. See Note 10, Consolidated Variable Interest Entities.
     
Expected Loss to be Paid

The expected loss to be paid is equal to the present value of expected future cash outflows for claim and LAE payments, net of inflows for expected salvage and subrogation (e.g. excess spread on the underlying collateral, and estimated and contractual recoveries for breaches of representations and warranties), using current risk-free rates. When the Company becomes entitled to the cash flow from the underlying collateral of an insured credit under salvage and subrogation rights as a result of a claim payment or estimated future claim payment, it reduces the expected loss to be paid on the contract. Net expected loss to be paid is defined as expected loss to be paid, net of amounts ceded to reinsurers.

The current risk-free rate is based on the remaining period of the contract used in the premium revenue recognition calculation (i.e., the contractual or expected period, as applicable). The Company updates the discount rate each quarter and records the effect of such changes in economic loss development. Expected cash outflows and inflows are probability weighted cash flows that reflect the likelihood of all possible outcomes. The Company estimates the expected cash outflows and inflows using management's assumptions about the likelihood of all possible outcomes based on all information available to it. Those assumptions consider the relevant facts and circumstances and are consistent with the information tracked and monitored through the Company's risk-management activities.

Economic Loss Development

Economic loss development represents the change in net expected loss to be paid attributable to 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.

Expected loss to be paid and economic loss development include the effects of loss mitigation strategies such as negotiated and estimated recoveries for breaches of representations and warranties, and purchases of insured debt obligations. Additionally, in certain cases, issuers of insured obligations elected, or the Company and an issuer mutually agreed as part of a negotiation, to deliver the underlying collateral or insured obligation to the Company.

In circumstances where the Company has purchased its own insured obligations that have expected losses, expected loss to be paid is reduced by the proportionate share of the insured obligation that is held in the investment portfolio. The difference between the purchase price of the obligation and the fair value excluding the value of the Company's insurance, is treated as a paid loss. Assets that are purchased by the Company are recorded in the investment portfolio, at fair value, excluding the value of the Company's insurance. See Note 11, Investments and Cash and Note 8, Fair Value Measurement.

Loss Estimation Process
 
The Company’s loss reserve committees estimate expected loss to be paid for all contracts. Surveillance personnel present analyses related to potential losses to the Company’s loss reserve committees for consideration in estimating the expected loss to be paid. Such analyses include the consideration of various scenarios with corresponding probabilities assigned to them. Depending upon the nature of the risk, the Company’s view of the potential size of any loss and the information available to the Company, that analysis may be based upon individually developed cash flow models, internal credit rating assessments and sector-driven loss severity assumptions or judgmental assessments. 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 committees review and refresh 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.
 
The following tables present a roll forward of the present value of net expected loss to be paid for all contracts, whether accounted for as insurance, credit derivatives or FG VIEs, by sector, before and after the benefit for net expected recoveries for contractual breaches of R&W. The Company used weighted average risk-free rates for U.S. dollar denominated obligations, that ranged from 0.0% to 2.95% as of December 31, 2014 and 0.0% to 4.44% as of December 31, 2013.

Net Expected Loss to be Paid
Before Net Expected Recoveries for Breaches of R&W
Roll Forward by Sector
Year Ended December 31, 2014

 
Net Expected
Loss to be
Paid (Recovered) as of
December 31, 2013(2)
 
Economic Loss
Development
 
(Paid)
Recovered
Losses(1)
 
Net Expected
Loss to be
Paid (Recovered) as of
December 31, 2014(2)
 
(in millions)
U.S. RMBS:
 

 
 

 
 

 
 

First lien:
 

 
 

 
 

 
 

Prime first lien
$
25

 
$
(17
)
 
$
(2
)
 
$
6

Alt-A first lien
578

 
(13
)
 
(155
)
 
410

Option ARM
164

 
(45
)
 
(120
)
 
(1
)
Subprime
422

 
43

 
(53
)
 
412

Total first lien
1,189

 
(32
)
 
(330
)
 
827

Second lien:
 

 
 

 
 

 
 

Closed-end second lien
87

 
(3
)
 
9

 
93

HELOCs
(71
)
 
35

 
17

 
(19
)
Total second lien
16

 
32

 
26

 
74

Total U.S. RMBS
1,205

 
0

 
(304
)
 
901

TruPS
51

 
(28
)
 
—

 
23

Other structured finance
120

 
96

 
2

 
218

U.S. public finance
264

 
183

 
(144
)
 
303

Non-U.S. public finance
57

 
(12
)
 
—

 
45

Other insurance
(3
)
 
(1
)
 
—

 
(4
)
Total
$
1,694

 
$
238

 
$
(446
)
 
$
1,486


Net Expected Loss to be Paid
Before Net Expected Recoveries for Breaches of R&W
Roll Forward by Sector
Year Ended December 31, 2013

 
Net Expected
Loss to be
Paid (Recovered) as of
December 31, 2012
 
Economic Loss
Development
 
(Paid)
Recovered
Losses(1)
 
Net Expected
Loss to be
Paid (Recovered) as of
December 31, 2013(2)
 
(in millions)
U.S. RMBS:
 

 
 

 
 

 
 

First lien:
 

 
 

 
 

 
 

Prime first lien
$
10

 
$
16

 
$
(1
)
 
$
25

Alt-A first lien
693

 
(40
)
 
(75
)
 
578

Option ARM
460

 
63

 
(359
)
 
164

Subprime
351

 
101

 
(30
)
 
422

Total first lien
1,514

 
140

 
(465
)
 
1,189

Second lien:
 

 
 

 
 

 
 

Closed-end second lien
99

 
(3
)
 
(9
)
 
87

HELOCs
39

 
3

 
(113
)
 
(71
)
Total second lien
138

 
0

 
(122
)
 
16

Total U.S. RMBS
1,652

 
140

 
(587
)
 
1,205

TruPS
27

 
7

 
17

 
51

Other structured finance
312

 
(41
)
 
(151
)
 
120

U.S. public finance
7

 
239

 
18

 
264

Non-U.S. public finance
52

 
17

 
(12
)
 
57

Other insurance
(3
)
 
(10
)
 
10

 
(3
)
Total
$
2,047

 
$
352

 
$
(705
)
 
$
1,694

____________________
(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 $37 million and $54 million in LAE for the years ended December 31, 2014 and 2013, respectively.

(2)
Includes expected LAE to be paid of $16 million as of December 31, 2014 and $34 million as of December 31, 2013.


Net Expected Recoveries from
Breaches of R&W Rollforward
Year Ended December 31, 2014
 
 
Future Net
R&W Benefit as of
December 31, 2013
 
R&W Development
and Accretion of
Discount
During 2014
 
R&W (Recovered)
During 2014
 
Future Net
R&W Benefit as of
December 31, 2014 (1)
 
(in millions)
U.S. RMBS:
 
 
 
 
 
 
 
First lien:
 
 
 
 
 
 
 
Prime first lien
$
4

 
$
(1
)
 
$
(1
)
 
$
2

Alt-A first lien
274

 
131

 
(299
)
 
106

Option ARM
173

 
14

 
(172
)
 
15

Subprime
118

 
50

 
(59
)
 
109

Total first lien
569

 
194

 
(531
)
 
232

Second lien:
 
 
 
 
 
 
 
Closed-end second lien
98

 
(6
)
 
(7
)
 
85

HELOC
45

 
80

 
(125
)
 
—

Total second lien
143

 
74

 
(132
)
 
85

Total
$
712

 
$
268

 
$
(663
)
 
$
317

 
Net Expected Recoveries from
Breaches of R&W Rollforward
Year Ended December 31, 2013

 
Future Net
R&W Benefit as of
December 31, 2012
 
R&W Development
and Accretion of
Discount
During 2013
 
R&W (Recovered) During 2013
 
Future Net
R&W Benefit as of
December 31, 2013
 
(in millions)
U.S. RMBS:
 
 
 
 
 
 
 
First lien:
 
 
 
 
 
 
 
Prime first lien
$
4

 
$
—

 
$
—

 
$
4

Alt-A first lien
378

 
41

 
(145
)
 
274

Option ARM
591

 
161

 
(579
)
 
173

Subprime
109

 
9

 
—

 
118

Total first lien
1,082

 
211

 
(724
)
 
569

Second lien:
 
 
 
 
 
 
 
Closed-end second lien
138

 
(9
)
 
(31
)
 
98

HELOC
150

 
94

 
(199
)
 
45

Total second lien
288

 
85

 
(230
)
 
143

Total
$
1,370

 
$
296

 
$
(954
)
 
$
712

____________________
(1)
See the section "Breaches of Representations and Warranties" below for eligible assets held in trust.

Net Expected Loss to be Paid
After Net Expected Recoveries for Breaches of R&W
Roll Forward by Sector
Year Ended December 31, 2014

 
Net Expected
Loss to be
Paid (Recovered) as of
December 31, 2013
 
Economic Loss
Development
 
(Paid)
Recovered
Losses(1)
 
Net Expected
Loss to be
Paid (Recovered) as of
December 31, 2014
 
(in millions)
U.S. RMBS:
 

 
 

 
 

 
 

First lien:
 

 
 

 
 

 
 

Prime first lien
$
21

 
$
(16
)
 
$
(1
)
 
$
4

Alt-A first lien
304

 
(144
)
 
144

 
304

Option ARM
(9
)
 
(59
)
 
52

 
(16
)
Subprime
304

 
(7
)
 
6

 
303

Total first lien
620

 
(226
)
 
201

 
595

Second lien:
 

 
 

 
 

 
 

Closed-end second lien
(11
)
 
3

 
16

 
8

HELOCs
(116
)
 
(45
)
 
142

 
(19
)
Total second lien
(127
)
 
(42
)
 
158

 
(11
)
Total U.S. RMBS
493

 
(268
)
 
359

 
584

TruPS
51

 
(28
)
 
—

 
23

Other structured finance
120

 
96

 
2

 
218

U.S. public finance
264

 
183

 
(144
)
 
303

Non-U.S. public finance
57

 
(12
)
 
—

 
45

Other insurance
(3
)
 
(1
)
 
—

 
(4
)
Total
$
982

 
$
(30
)
 
$
217

 
$
1,169


Net Expected Loss to be Paid
After Net Expected Recoveries for Breaches of R&W
Roll Forward by Sector
Year Ended December 31, 2013

 
Net Expected
Loss to be
Paid (Recovered) as of
December 31, 2012
 
Economic Loss
Development
 
(Paid)
Recovered
Losses(1)
 
Net Expected
Loss to be
Paid (Recovered) as of
December 31, 2013
 
(in millions)
U.S. RMBS:
 

 
 

 
 

 
 

First lien:
 

 
 

 
 

 
 

Prime first lien
$
6

 
$
16

 
$
(1
)
 
$
21

Alt-A first lien
315

 
(81
)
 
70

 
304

Option ARM
(131
)
 
(98
)
 
220

 
(9
)
Subprime
242

 
92

 
(30
)
 
304

Total first lien
432

 
(71
)
 
259

 
620

Second lien:
 

 
 

 
 

 
 

Closed-end second lien
(39
)
 
6

 
22

 
(11
)
HELOCs
(111
)
 
(91
)
 
86

 
(116
)
Total second lien
(150
)
 
(85
)
 
108

 
(127
)
Total U.S. RMBS
282

 
(156
)
 
367

 
493

TruPS
27

 
7

 
17

 
51

Other structured finance
312

 
(41
)
 
(151
)
 
120

U.S. public finance
7

 
239

 
18

 
264

Non-U.S. public finance
52

 
17

 
(12
)
 
57

Other insurance
(3
)
 
(10
)
 
10

 
(3
)
Total
$
677

 
$
56

 
$
249

 
$
982

 ____________________
(1)
Net of ceded paid losses, whether or not such amounts have been settled with reinsurers. Ceded paid losses and recoveries 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 following tables present the present value of net expected loss to be paid for all contracts by accounting model, by sector and after the benefit for estimated and contractual recoveries for breaches of R&W.  

Net Expected Loss to be Paid (Recovered)
By Accounting Model
As of December 31, 2014

 
 
Financial
Guaranty
Insurance
 
FG VIEs(1)
 
Credit
Derivatives(2)
 
Total
 
(in millions)
U.S. RMBS:
 

 
 

 
 

 
 

First lien:
 

 
 

 
 

 
 

Prime first lien
$
2

 
$
—

 
$
2

 
$
4

Alt-A first lien
288

 
17

 
(1
)
 
304

Option ARM
(15
)
 
—

 
(1
)
 
(16
)
Subprime
163

 
71

 
69

 
303

Total first lien
438

 
88

 
69

 
595

Second lien:
 

 
 

 
 

 
 

Closed-end second lien
(27
)
 
31

 
4

 
8

HELOCs
(26
)
 
7

 
—

 
(19
)
Total second lien
(53
)
 
38

 
4

 
(11
)
Total U.S. RMBS
385

 
126

 
73

 
584

TruPS
1

 
—

 
22

 
23

Other structured finance
255

 
—

 
(37
)
 
218

U.S. public finance
303

 
—

 
—

 
303

Non-U.S. public finance
45

 
—

 
—

 
45

Subtotal
$
989

 
$
126

 
$
58

 
1,173

Other
 
 
 
 
 
 
(4
)
Total
 
 
 
 
 
 
$
1,169


Net Expected Loss to be Paid (Recovered)
By Accounting Model
As of December 31, 2013

 
Financial
Guaranty
Insurance
 
FG VIEs(1)
 
Credit
Derivatives(2)
 
Total
 
(in millions)
U.S. RMBS:
 

 
 
 
 

 
 

First lien:
 

 
 
 
 

 
 

Prime first lien
$
3

 
$
—

 
$
18

 
$
21

Alt-A first lien
199

 
31

 
74

 
304

Option ARM
(18
)
 
(2
)
 
11

 
(9
)
Subprime
149

 
81

 
74

 
304

Total first lien
333

 
110

 
177

 
620

Second lien:
 

 
 

 
 

 
 

Closed-end second lien
(34
)
 
25

 
(2
)
 
(11
)
HELOCs
(41
)
 
(75
)
 
—

 
(116
)
Total second lien
(75
)
 
(50
)
 
(2
)
 
(127
)
Total U.S. RMBS
258

 
60

 
175

 
493

TruPS
3

 
—

 
48

 
51

Other structured finance
161

 
—

 
(41
)
 
120

U.S. public finance
264

 
—

 
—

 
264

Non-U.S. public finance
55

 
—

 
2

 
57

Subtotal
$
741

 
$
60

 
$
184

 
985

Other
 
 
 
 
 
 
(3
)
Total
 
 
 
 
 
 
$
982

___________________
(1)    Refer to Note 10, Consolidated Variable Interest Entities.

(2)    Refer to Note 9, Financial Guaranty Contracts Accounted for as Credit Derivatives.


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

Net Economic Loss Development (Benefit)
By Accounting Model
Year Ended December 31, 2014

 
 
Financial
Guaranty
Insurance
 
FG VIEs(1)
 
Credit
Derivatives(2)
 
Total
 
(in millions)
U.S. RMBS:
 

 
 

 
 

 
 

First lien:
 

 
 

 
 

 
 

Prime first lien
$
—

 
$
—

 
$
(16
)
 
$
(16
)
Alt-A first lien
(87
)
 
(13
)
 
(44
)
 
(144
)
Option ARM
(48
)
 
1

 
(12
)
 
(59
)
Subprime
(15
)
 
6

 
2

 
(7
)
Total first lien
(150
)
 
(6
)
 
(70
)
 
(226
)
Second lien:
 

 
 

 
 

 
 

Closed-end second lien
(2
)
 
8

 
(3
)
 
3

HELOCs
(128
)
 
83

 
—

 
(45
)
Total second lien
(130
)
 
91

 
(3
)
 
(42
)
Total U.S. RMBS
(280
)
 
85

 
(73
)
 
(268
)
TruPS
(2
)
 
—

 
(26
)
 
(28
)
Other structured finance
97

 
—

 
(1
)
 
96

U.S. public finance
183

 
—

 
—

 
183

Non-U.S. public finance
(10
)
 
—

 
(2
)
 
(12
)
Subtotal
$
(12
)
 
$
85

 
$
(102
)
 
(29
)
Other
 
 
 
 
 
 
(1
)
Total
 
 
 
 
 
 
$
(30
)

Net Economic Loss Development (Benefit)
By Accounting Model
Year Ended December 31, 2013

 
Financial
Guaranty
Insurance
 
FG VIEs(1)
 
Credit
Derivatives(2)
 
Total
 
(in millions)
U.S. RMBS:
 

 
 
 
 

 
 

First lien:
 

 
 
 
 

 
 

Prime first lien
$
(1
)
 
$
—

 
$
17

 
$
16

Alt-A first lien
(54
)
 
5

 
(32
)
 
(81
)
Option ARM
(62
)
 
(36
)
 
—

 
(98
)
Subprime
48

 
32

 
12

 
92

Total first lien
(69
)
 
1

 
(3
)
 
(71
)
Second lien:
 

 
 

 
 

 
 

Closed-end second lien
30

 
(34
)
 
10

 
6

HELOCs
(91
)
 
(1
)
 
1

 
(91
)
Total second lien
(61
)
 
(35
)
 
11

 
(85
)
Total U.S. RMBS
(130
)
 
(34
)
 
8

 
(156
)
TruPS
—

 
—

 
7

 
7

Other structured finance
(36
)
 
—

 
(5
)
 
(41
)
U.S. public finance
239

 
—

 
—

 
239

Non-U.S. public finance
16

 
—

 
1

 
17

Subtotal
$
89

 
$
(34
)
 
$
11

 
66

Other
 
 
 
 
 
 
(10
)
Total
 
 
 
 
 
 
$
56

___________________
(1)    Refer to Note 10, Consolidated Variable Interest Entities.

(2)    Refer to Note 9, Financial Guaranty Contracts Accounted for as Credit Derivatives.

Approach to Projecting Losses in U.S. RMBS
 
The Company projects losses on its insured U.S. RMBS on a transaction-by-transaction basis by projecting the performance of the underlying pool of mortgages over time and then applying the structural features (i.e., payment priorities and tranching) of the RMBS to the projected performance of the collateral over time. The resulting projected claim payments or reimbursements are then discounted using risk-free rates. For transactions where the 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.” The Company derives its liquidation rate assumptions 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 near-term liquidation of currently delinquent loans represent defaults of currently performing loans and projected re-performing loans. A conditional default rate is the outstanding principal amount of 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 Company projects loss severities by sector based on its experience to date. The Company continues to update its evaluation of these exposures as new information becomes available.
 
The Company has been enforcing claims for breaches of R&W regarding the characteristics of the loans included in the collateral pools. The Company calculates a credit for R&W recoveries to include in its cash flow projections. Where the Company has an agreement with an R&W provider (such as its agreements with Bank of America, Deutsche Bank and UBS, which are described in more detail under "Breaches of Representations and Warranties" below), that credit is based on the agreement or potential agreement. Where the Company does not have an agreement with the R&W provider but the Company believes the R&W provider to be economically viable, the Company estimates what portion of its past and projected future claims it believes will be reimbursed by that provider.
 
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 the collateral losses it projects as described above; assumed voluntary prepayments; and servicer advances. 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. The Company runs several sets of assumptions regarding mortgage collateral performance, or scenarios, and probability weights them.

The ultimate performance of the Company’s RMBS transactions remains highly uncertain, may differ from the Company's projections and may be subject to considerable volatility due to the influence of many interrelated factors that are difficult to predict, including the level and timing of loan defaults, changes in housing prices, results from the Company’s loss mitigation activities and other variables. The Company will continue to monitor the performance of its RMBS exposures and will adjust its RMBS loss projection assumptions and scenarios based on actual performance and management’s view of future performance. If actual experience differs from the Company’s assumptions, the losses incurred could be materially different from the estimate.

The Company's RMBS loss projection methodology assumes that the housing and mortgage markets will continue improving. Each period the Company makes a judgment as to whether to change the assumptions it uses to make RMBS loss projections based on its observation during the period of the performance of its insured transactions (including early stage delinquencies, late stage delinquencies and loss severity) as well as the residential property market and economy in general, and, to the extent it observes changes, it makes a judgment as whether those changes are normal fluctuations or part of a trend.
 
Year-End 2014 Compared to Year-End 2013 U.S. RMBS Loss Projections

Based on its observations of the performance of its insured transactions (including early stage delinquencies, late stage delinquencies and loss severity) as well as the residential property market and economy in general, the Company chose to use the same general methodology to project first lien RMBS losses as of December 31, 2014 as it used as of December 31, 2013, but it made a number of refinements to reflect its observations, notably:
•
updated the liquidation rates it uses on delinquent loans based on observations and on an assumption that loan modifications (which improve liquidation rates) would over the next year be less frequent than they were over the most recent year

•
updated the liquidation rate it uses for loans reported as current but that had been reported as modified over the previous twelve months, based on observed data

•
established a liquidation rate assumption for loans reported as current and not modified in the past twelve months but that had been reported as delinquent in the previous twelve months

•
established loss severity assumptions by vintage category as well as product type, rather than just product type as done previously

•
beginning with the third quarter 2014, each quarter shortened by three months the period it is projecting it will take in the base case to reach the final CDR

The methodology and revised assumptions the Company uses to project first lien RMBS losses and the scenarios it employs are described in more detail below under " - U.S. First Lien RMBS Loss Projections: Alt A First Lien, Option ARM, Subprime and Prime". The Company estimated the impact of all of the refinements to its first lien RMBS assumptions described above to be a decrease of expected losses of approximately $42 million (before adjustments for settlements or loss mitigation purchases).
Based on its observations of the performance of its insured transactions (including early stage delinquencies, late stage delinquencies and loss severity) as well as the residential property market and economy in general, the Company chose to use the same general methodology to project second lien RMBS losses as of December 31, 2014 as it used as of December 31, 2013, but it made a number of refinements to reflect its observations, notably with respect to most HELOC projections to:
•
reflect increased recoveries on newly defaulted loans as well as previously defaulted loans

•
project incremental defaults associated with increased monthly payments that occur when interest-only periods end

•
increase the assumed final conditional prepayment rate ("CPR") from 10% to 15%

The net impact of the refinements in the first two bullet points, which were implemented in the third quarter 2014, was an increase of $36 million in expected losses in the Company's base case as of September 30, 2014. The net impact of the refinements in the third bullet point was an increase in $13 million in expected losses in the Company's base case as of December 31, 2014.
The methodology and assumptions the Company uses to project second lien 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".
Year-End 2013 Compared to Year-End 2012 U.S. RMBS Loss Projections
 
Based on the Company's observation during the year of the performance of its insured RMBS transactions (including early stage delinquencies, late stage delinquencies and loss severity) as well as the residential property market and economy in general, the Company chose to use the same general methodology (with the refinements described below) to project RMBS losses as of December 31, 2013 as it used as of December 31, 2012. The Company's use of the same general approach to project RMBS losses as of December 31, 2013 as it used as of December 31, 2012 was consistent with its view at December 31, 2013 that the housing and mortgage market recovery was occurring at a slower pace than it anticipated at December 31, 2012.

The Company refined its first lien RMBS loss projection methodology as of December 31, 2013 to model explicitly the behavior of borrowers with loans that had been modified. The Company has observed that mortgage loan servicers were modifying more mortgage loans (reducing or forbearing from collecting interest or principal or both due on mortgage loans) to reduce the borrowers’ monthly payments and so improve their payment performance than was the case before the mortgage crisis. Borrowers who are current based on their new, reduced monthly payments are generally reported as current, but are more likely to default than borrowers who are current and whose loans have not been modified. The Company believes modified loans are most likely to default again during the first year after modification. The Company set its liquidation rate assumptions as of December 31, 2012 based on observed roll rates and with modification activity in mind. As of December 31, 2013 the Company made a number of refinements to its first lien RMBS loss projection assumptions to treat loan modifications explicitly. Specifically, in the base case approach, it:

•
established a liquidation rate assumption for loans reported as current but that had been reported as modified in the previous 12 months,

•
assumed that currently delinquent loans that did not roll to liquidation would behave like modified loans, and so applied the modified loan liquidation rate to them,
•
increased from two to three years the period over which it calculates the initial CDR based on assumed liquidations of non-performing loans and modified loans, to account for the longer period modified loans will take to default,

•
increased the period it assumes the transactions will experience the initial loss severity assumption before it improves and the period during which the transaction will experience low voluntary prepayment rates,

•
established an assumption for servicers not to advance loan payments on all delinquent loans

The methodology and revised assumptions the Company uses to project first lien RMBS losses and the scenarios it employs are described in more detail below under " - U.S. First Lien RMBS Loss Projections: Alt A First Lien, Option ARM, Subprime and Prime". The refinement in assumptions described above resulted in a reduction of the initial CDRs but the application of the initial CDRs for a longer period, which generally resulted in a higher amount of loans being liquidated at the initial CDR under the refined assumptions than under the initial CDR under the previous assumptions. The Company estimated the impact of all of the refinements to its assumptions described above to be an increase of expected losses of approximately $8 million (before adjustments for settlements or loss mitigation purchases) by running on the first lien RMBS portfolio as of December 31, 2013 base case assumptions similar to what it used as of December 31, 2012 and comparing those results to those results from the refined assumptions.

During 2013 the Company observed improvements in the performance of its second lien RMBS transactions that, when viewed in the context of their performance prior to 2013, suggested those transactions were beginning to respond to the improvements in the residential property market and economy being widely reported by market observers. Based on such observations, in projecting losses for second lien RMBS the Company chose to decrease by two months in its base scenario and by three months in its optimistic scenario the period it assumed it would take the mortgage market to recover as compared to December 31, 2012. Also during 2013 the Company observed material improvements in the delinquency measures of certain second lien RMBS for which the servicing had been transferred, and made certain adjustments on just those transactions to reflect its view that much of this improvement was due to loan modifications and reinstatements made by the new servicer and that such recently modified and reinstated loans may have a higher likelihood of defaulting again. The methodology and assumptions the Company used to project second lien RMBS losses and the scenarios it employed are described in more detail below under " - U.S. Second Lien RMBS Loss Projections: HELOCs and Closed-End Second Lien".

The Company observed some improvement in delinquency trends in most of its RMBS transactions during 2013, with some of that improvement in second liens driven by servicing transfers it effectuated. Such improvement is naturally transmitted to its projections for each individual RMBS transaction, since the projections are based on the delinquency performance of the loans in that individual transaction.

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

     The majority of projected losses in first lien RMBS transactions are expected to come from non-performing mortgage loans (those that have been modified or have been delinquent in the previous 12 months, are two or more payments behind, are in foreclosure or that have been foreclosed and so the RMBS issuer owns the underlying real estate). 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 year the Company reviews the most recent twenty-four months of this data and adjusts its liquidation rates based on its observations. The following table shows liquidation assumptions for various non-performing categories.
 
First Lien Liquidation Rates

 
December 31, 2014
 
December 31, 2013
 
December 31, 2012
Current Loans Modified in Previous 12 Months
 
 
 
 
 
Alt A and Prime
25%
 
35%
 
N/A
Option ARM
25
 
35
 
N/A
Subprime
25
 
35
 
N/A
Current Loans Delinquent in the Previous 12 Months
 
 
 
 
 
Alt A and Prime
25
 
N/A
 
N/A
Option ARM
25
 
N/A
 
N/A
Subprime
25
 
N/A
 
N/A
30 – 59 Days Delinquent
 
 
 
 
 
Alt A and Prime
35
 
50
 
35%
Option ARM
40
 
50
 
50
Subprime
35
 
45
 
30
60 – 89 Days Delinquent
 
 
 
 
 
Alt A and Prime
50
 
60
 
55
Option ARM
55
 
65
 
65
Subprime
40
 
50
 
45
90+ Days Delinquent
 
 
 
 
 
Alt A and Prime
60
 
75
 
65
Option ARM
65
 
70
 
75
Subprime
55
 
60
 
60
Bankruptcy
 
 
 
 
 
Alt A and Prime
45
 
60
 
55
Option ARM
50
 
60
 
70
Subprime
40
 
55
 
50
Foreclosure
 
 
 
 
 
Alt A and Prime
75
 
85
 
85
Option ARM
80
 
80
 
85
Subprime
70
 
70
 
80
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 CDR trend. The start of that CDR trend is based on the defaults the Company projects will emerge from currently nonperforming, recently nonperforming and modified loans. The total amount of expected defaults from the non-performing loans is translated into a constant CDR (i.e., the CDR plateau), which, if applied for each of the next 36 months, would be sufficient to produce approximately the amount of defaults that were calculated to emerge from the various delinquency categories. The CDR thus calculated individually on the delinquent collateral pool for each RMBS is then used as the starting point for the CDR curve used to project defaults of the presently performing loans.
 
In the base case, after the initial 36-month CDR plateau period, each transaction’s CDR is projected to improve over 12 months to an intermediate CDR (calculated as 20% of its CDR plateau); that intermediate CDR is held constant for 36 months and then trails off in steps to a final CDR of 5% of the CDR plateau. In the base case, the Company assumes the final CDR will be reached eight years and six months after the initial 36-month CDR plateau period, which is six months shorter than assumed as of December 31, 2013 but the same calendar date as it assumed as of June 30, 2014. Under the Company’s methodology, defaults projected to occur in the first 36 months represent defaults that can be attributed to loans that were modified or delinquent in the last 12 months or that are currently delinquent or in foreclosure, while the defaults projected to occur using the projected CDR trend after the first 36 month period represent defaults attributable to borrowers that are currently performing or are projected to reperform.
     Another important driver of loss projections is loss severity, which is the amount of loss the transaction incurs on a loan after the application of net proceeds from the disposal of the underlying property. Loss severities experienced in first lien transactions have reached historic high levels, and the Company is assuming in the base case that these high levels generally will continue for another 18 months. The Company determines its initial loss severity based on actual recent experience. The Company then assumes that loss severities begin returning to levels consistent with underwriting assumptions beginning after the initial 18 month period, declining to 40% in the base case over 2.5 years. Beginning for December 31, 2014, the Company differentiated the loss severity assumptions depending on the vintage of the transaction, as shown in the table below.
 
The following table shows the range as well as the average, weighted by outstanding net insured par, for key assumptions used in the calculation of expected loss to be paid for individual transactions for direct vintage 2004 - 2008 first lien U.S. RMBS.
Key Assumptions in Base Case Expected Loss Estimates
First Lien RMBS(1)

 
As of
December 31, 2014
 
As of
December 31, 2013
 
As of
December 31, 2012
 
Range
 
Weighted Average
 
Range
 
Weighted Average
 
Range
 
Weighted Average
Alt-A First Lien
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Plateau CDR
2.0
%
–
13.4%
 
7.3%
 
2.8
%
–
18.4%
 
9.7%
 
3.8
%
–
23.2%
 
13.3%
Intermediate CDR
0.4
%
–
2.7%
 
1.5%
 
0.6
%
–
3.7%
 
1.9%
 
0.8
%
–
4.6%
 
2.7%
Period until intermediate CDR
48 months
 
 
 
48 months
 
 
 
36 months
 
 
Final CDR
0.1
%
–
0.7%
 
0.3%
 
0.1
%
–
0.9%
 
0.5%
 
0.2
%
–
1.2%
 
0.6%
Initial loss severity:
 
 
 
 
 
 
 
 
 
 
 
2005 and prior
60%
 
 
 
65%
 
 
 
65%
 
 
2006
70%
 
 
 
65%
 
 
 
65%
 
 
2007
65%
 
 
 
65%
 
 
 
65%
 
 
Initial CPR
1.7
%
–
21.0%
 
7.7%
 
0.0
%
–
34.2%
 
9.7%
 
0.0
%
–
39.4%
 
7.4%
Final CPR(2)
15%
 
 
 
15%
 
 
 
15%
 
 
Option ARM
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Plateau CDR
4.3
%
–
14.2%
 
10.6%
 
4.9
%
–
16.8%
 
11.9%
 
7.0
%
–
26.1%
 
18.4%
Intermediate CDR
0.9
%
–
2.8%
 
2.1%
 
1.0
%
–
3.4%
 
2.4%
 
1.4
%
–
5.2%
 
3.7%
Period until intermediate CDR
48 months
 
 
 
48 months
 
 
 
36 months
 
 
Final CDR
0.2
%
–
0.7%
 
0.5%
 
0.2
%
–
0.8%
 
0.5%
 
0.4
%
–
1.3%
 
0.8%
Initial loss severity:
 
 
 
 
 
 
 
 
 
 
 
2005 and prior
60%
 
 
 
65%
 
 
 
65%
 
 
2006
70%
 
 
 
65%
 
 
 
65%
 
 
2007
65%
 
 
 
65%
 
 
 
65%
 
 
Initial CPR
1.1
%
–
11.8%
 
4.9%
 
0.4
%
–
13.1%
 
4.7%
 
0.0
%
–
10.7%
 
4.0%
Final CPR(2)
15%
 
 
 
15%
 
 
 
15%
 
 
Subprime
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Plateau CDR
4.9
%
–
15.0%
 
10.6%
 
5.6
%
–
16.2%
 
11.8%
 
7.3
%
–
26.2%
 
17.3%
Intermediate CDR
1.0
%
–
3.0%
 
2.1%
 
1.1
%
–
3.2%
 
2.4%
 
1.5
%
–
5.2%
 
3.5%
Period until intermediate CDR
48 months
 
 
 
48 months
 
 
 
36 months
 
 
Final CDR
0.2
%
–
0.7%
 
0.4%
 
0.3
%
–
0.8%
 
0.4%
 
0.4
%
–
1.3%
 
0.6%
Initial loss severity:
 
 
 
 
 
 
 
 
 
 
 
2005 and prior
75%
 
 
 
90%
 
 
 
90%
 
 
2006
90%
 
 
 
90%
 
 
 
90%
 
 
2007
90%
 
 
 
90%
 
 
 
90%
 
 
Initial CPR
0.0
%
–
10.5%
 
6.1%
 
0.0
%
–
15.7%
 
4.1%
 
0.0
%
–
17.6%
 
3.6%
Final CPR(2)
15%
 
 
 
15%
 
 
 
15%
 
 
____________________
(1)                                Represents variables for most heavily weighted scenario (the “base case”).

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

 The rate at which the principal amount of loans is voluntarily prepaid may impact both the amount of losses projected (since that amount is a function of the conditional default rate, the loss severity and the loan balance over time) as well as the amount of excess spread (the amount by which the interest paid by the borrowers on the underlying loan exceeds the amount of interest owed on the insured obligations). The assumption for the voluntary CPR follows a similar pattern to that of the conditional default rate. The current level of voluntary prepayments is assumed to continue for the plateau period before gradually increasing over 12 months to the final CPR, which is assumed to be 15% in the base case. For transactions where the initial CPR is higher than the final CPR, the initial CPR is held constant and the final CPR is not used. These assumptions are the same as those the Company used for December 31, 2013 and December 31, 2012 except that, as of December 31, 2014 and December 31, 2013 the period of initial CDRs were assumed to last 12 months longer than they were assumed to last as of December 31, 2012, so the initial CPR is also held constant 12 months longer as of December 31, 2014 and December 31, 2013 than it was as of December 31, 2012.
 
 In estimating expected losses, the Company modeled and probability weighted sensitivities for first lien transactions by varying its assumptions of how fast a recovery is expected to occur. One of the variables used to model sensitivities was how quickly the conditional default rate returned to its modeled equilibrium, which was defined as 5% of the initial conditional default rate. The Company also stressed CPR and the speed of recovery of loss severity rates. The Company probability weighted a total of five scenarios (including its base case) as of December 31, 2014. The Company used a similar approach to establish its pessimistic and optimistic scenarios as of December 31, 2014 as it used as of December 31, 2013 and December 31, 2012, increasing and decreasing the periods of stress from those used in the base case, except that all of the stress periods were longer as of December 31, 2014 and December 31, 2013 than they were as of December 31, 2012.

In a somewhat more stressful environment than that of the base case, where the conditional default rate plateau was extended six months (to be 42 months long) before the same more gradual conditional default rate recovery and loss severities were assumed to recover over 4.5 rather than 2.5 years (and subprime loss severities were assumed to recover only to 60% and Option ARM and Alt A loss severities to only 45%), expected loss to be paid would increase from current projections by approximately $29 million for Alt-A first liens, $9 million for Option ARM, $73 million for subprime and $2 million for prime transactions.

In an even more stressful scenario where loss severities were assumed to rise and then recover over nine years and the initial ramp-down of the conditional default rate was assumed to occur over 15 months and other assumptions were the same as the other stress scenario, expected loss to be paid would increase from current projections by approximately $79 million for Alt-A first liens, $21 million for Option ARM, $102 million for subprime and $7 million for prime transactions.

In a scenario with a somewhat less stressful environment than the base case, where conditional default rate recovery was somewhat less gradual, expected loss to be paid would increase from current projections by approximately $0.3 million for Alt-A first lien and would decrease by $12 million for Option ARM, $10 million for subprime and $0.1 million for prime transactions.

In an even less stressful scenario where the conditional default rate plateau was six months shorter (30 months, effectively assuming that liquidation rates would improve) and the conditional default rate recovery was more pronounced, (including an initial ramp-down of the conditional default rate over nine months), expected loss to be paid would decrease from current projections by approximately $28 million for Alt-A first lien, $26 million for Option ARM, $52 million for subprime and $1 million for prime transactions.
 
 U.S. Second Lien RMBS Loss Projections: HELOCs and Closed-End Second Lien
 
The Company believes the primary variable affecting its expected losses in second lien RMBS transactions is the amount and timing of future losses in the collateral pool supporting the transactions. Expected losses are also a function of the structure of the transaction; the voluntary prepayment rate (typically also referred to as CPR of the collateral); the interest rate environment; and assumptions about the draw rate and loss severity.
 
The following table shows the range as well as the average, weighted by outstanding net insured par, for key assumptions for the calculation of expected loss to be paid for individual transactions for direct vintage 2004 - 2008 second lien U.S. RMBS.
 
Key Assumptions in Base Case Expected Loss Estimates
Second Lien RMBS(1)
 
HELOC key assumptions
As of
December 31, 2014
 
As of
December 31, 2013
 
As of
December 31, 2012
 
Range
 
Weighted Average
 
Range
 
Weighted Average
 
Range
 
Weighted Average
Plateau CDR
2.8
%
–
6.8%
 
4.1%
 
2.3
%
–
7.7%
 
4.9%
 
3.8
%
–
15.9%
 
8.8%
Final CDR trended down to
0.5
%
–
3.2%
 
1.2%
 
0.4
%
–
3.2%
 
1.1%
 
0.4
%
–
3.2%
 
1.2%
Period until final CDR
34 months
 
 
 
34 months
 
 
 
36 months
 
 
Initial CPR
6.9
%
–
21.8%
 
11.0%
 
2.7
%
–
21.5%
 
9.9%
 
2.9
%
–
15.4%
 
6.6%
Final CPR(2)
15.0
%
–
21.8%
 
15.5%
 
10%
 
 
 
10%
 
 
Loss severity
90
%
–
98%
 
90.4%
 
98%
 
 
 
98%
 
 
 
Closed-end second lien key assumptions
As of
December 31, 2014
 
 
 
As of
December 31, 2013
 
 
 
As of
December 31, 2012
 
Range
 
Weighted Average
 
Range
 
Weighted Average
 
Range
 
Weighted Average
Plateau CDR
5.5
%
–
12.5%
 
7.2%
 
7.3
%
–
15.1%
 
8.5%
 
7.3
%
–
20.7%
 
12.7%
Final CDR trended down to
3.5
%
–
9.1%
 
4.9%
 
3.5
%
–
9.1%
 
5.0%
 
3.5
%
–
9.1%
 
4.9%
Period until final CDR
34 months
 
 
 
34 months
 
 
 
36 months
 
 
Initial CPR
2.8
%
–
13.9%
 
9.9%
 
3.1
%
–
12.0%
 
7.1%
 
1.9
%
–
12.5%
 
4.0%
Final CPR(2)
15%
 
 
 
10%
 
 
 
10%
 
 
Loss severity
98%
 
 
 
98%
 
 
 
98%
 
 
 ____________________
(1)
Represents variables for most heavily weighted scenario (the “base case”).

(2) 
For transactions where the initial CPR is higher than the final CPR, the initial CPR is held constant and the final CPR is not used.
 
In second lien transactions the projection of near-term defaults from currently delinquent loans is relatively straightforward because loans in second lien transactions are generally “charged off” (treated as defaulted) by the securitization’s servicer once the loan is 180 days past due. Most second lien transactions report the amount of loans in five monthly delinquency categories (i.e., 30-59 days past due, 60-89 days past due, 90-119 days past due, 120-149 days past due and 150-179 days past due). The Company estimates the amount of loans that will default over the next five months by calculating current representative liquidation rates (the percent of loans in a given delinquency status that are assumed to ultimately default) from selected representative transactions and then applying an average of the preceding twelve months’ liquidation rates to the amount of loans in the delinquency categories. The amount of loans projected to default in the first through fifth months is expressed as a CDR. The first four months’ CDR is calculated by applying the liquidation rates to the current period past due balances (i.e., the 150-179 day balance is liquidated in the first projected month, the 120-149 day balance is liquidated in the second projected month, the 90-119 day balance is liquidated in the third projected month and the 60-89 day balance is liquidated in the fourth projected month). For the fifth month the CDR is calculated using the average 30-59 day past due balances for the prior three months, adjusted as necessary to reflect one-time service events. The fifth month CDR is then used as the basis for the plateau period that follows the embedded five months of losses.

For the base case scenario, the CDR (the “plateau CDR”) was held constant for one month. Once the plateau period has ended, the CDR is assumed to gradually trend down in uniform increments to its final long-term steady state CDR. (The long-term steady state CDR is calculated as the constant CDR that would have yielded the amount of losses originally expected at underwriting.) In the base case scenario, the time over which the CDR trends down to its final CDR is 28 months. Therefore, the total stress period for second lien transactions is 34 months, comprising five months of delinquent data, a one month plateau period and 28 months of decrease to the steady state CDR, the same as of December 31, 2013. This is two months shorter than used for December 31, 2012.

HELOC loans generally permit the borrower to pay only interest for an initial period (often ten years) and, after that period, require the borrower to make both the monthly interest payment and a monthly principal payment, and so increase the borrower's aggregate monthly payment. Some of the HELOC loans underlying the Company's insured HELOC transactions have reached their principal amortization period. Based on the Company’s observation, including information obtained over the last year on the performance of certain loans reaching their principal amortization period and its views of the efficacy of planned servicer intervention, it introduced this year an assumption in the projections for most of its HELOC transactions that 7.5% of loans reaching their amortization periods will default around the time of the payment increase. These projected defaults are in addition to those generated using the CDR curve as described above.

When a second lien loan defaults, there is generally a very low recovery. The Company had assumed as of December 31, 2013 that it will recover only 2% of the collateral defaulting. However, based on additional information the Company obtained over the last year, it increased this recovery assumption in the projections for most of its HELOC transactions as of December 31, 2014 to 10% of collateral defaulting in the future, and also assumed declining additional post-default receipts on previously defaulted collateral.

The rate at which the principal amount of loans is prepaid may impact both the amount of losses projected as well as the amount of excess spread. In the base case, the current CPR (based on experience of the most recent three quarters) is assumed to continue until the end of the plateau before gradually increasing to the final CPR over the same period the CDR decreases. For transactions where the initial CPR is higher than the final CPR, the initial CPR is held constant and the final CPR is not used. The final CPR is assumed to be 15% for both HELOC and closed-end second lien transactions, which is lower than the historical average but reflects the Company’s continued uncertainty about the projected performance of the borrowers in these transactions. This pattern is consistent with how the Company modeled the CPR at December 31, 2013. To the extent that prepayments differ from projected levels it could materially change the Company’s projected excess spread and losses.
 
The net impact of the three refinements the Company made to projecting expected losses in certain HELOC transactions described above (increased defaults of loans reaching their amortization period, increased recoveries, decreased the redefault rate on modified loans and the increase in the final CPR to 15%) was an increase of approximately $53 million in expected losses in the Company's base case as of December 31, 2014 compared to what it would have been without the refinements. The Company uses a number of other variables in its second lien loss projections, including the spread between relevant interest rate indices and HELOC draw rates (the amount of new advances provided on existing HELOCs expressed as a percentage of the current pool balance). These variables have been relatively stable over the past several quarters and in the relevant ranges have less impact on the projection results than the variables discussed above. However, in a number of HELOC transactions the servicers have been modifying poorly performing loans from floating to fixed rates, and, as a result, rising interest rates would negatively impact the excess spread available from these modified loans to support the transactions.  The Company incorporated these modifications in its assumptions.
 
In estimating expected losses, the Company modeled and probability weighted three possible CDR curves applicable to the period preceding the return to the long-term steady state CDR using the same approaches and weightings as it did as of December 31, 2013. The Company believes that the level of the elevated CDR and the length of time it will persist is the primary driver behind the likely amount of losses the collateral will suffer. The Company continues to evaluate the assumptions affecting its modeling results.
 
The Company’s base case assumed a one month CDR plateau and a 28 month ramp-down (for a total stress period of 34 months). The Company also modeled a scenario with a longer period of elevated defaults and another with a shorter period of elevated defaults. Increasing the CDR plateau to four months and increasing the ramp-down by five months to 33-months (for a total stress period of 42 months) would increase the expected loss by approximately $14 million for HELOC transactions and $1 million for closed-end second lien transactions. On the other hand, keeping the CDR plateau at one month but decreasing the length of the CDR ramp-down to 18 months (for a total stress period of 24 months) would decrease the expected loss by approximately $15 million for HELOC transactions and $1 million for closed-end second lien transactions.

Breaches of Representations and Warranties
 
Generally, when mortgage loans are transferred into a securitization, the loan originator(s) and/or sponsor(s) provide R&W that the loans meet certain characteristics, and a breach of such R&W often requires that the loan be repurchased from the securitization. In many of the transactions the Company insures, it is in a position to enforce these R&W provisions. The Company has pursued breaches of R&W on a loan-by-loan basis or in cases where a provider of R&W refused to honor its repurchase obligations, the Company sometimes chose to initiate litigation. See “Recovery Litigation” below. The Company's success in pursuing these strategies permitted the Company to enter into agreements with R&W providers under which those providers made payments to the Company, agreed to make payments to the Company in the future, and / or repurchased loans from the transactions, all in return for releases of related liability by the Company. In some instances, the entity providing the R&W (or an affiliate of that entity) also benefited from credit protection sold by the Company through a CDS, and the Company entered into an agreement terminating the CDS protection it provided (and so avoiding future losses on that transaction), again in return for releases of related liability by the Company and in certain instances other consideration. Such agreements with R&W providers provide the Company with many of the benefits of pursuing the R&W claims on a loan by loan basis or through litigation, but without the related expense and uncertainty. The Company continues to pursue these strategies against R&W providers with which it does not yet have agreements.

Through December 31, 2014 the Company has caused entities providing R&Ws to pay, or agree to pay, or to terminate insurance protection on future projected losses of, approximately $4.2 billion (gross of reinsurance) in respect of their R&W liabilities for transactions in which the Company has provided insurance.

Based on this success, the Company has included in its net expected loss estimates as of December 31, 2014 an estimated net benefit of $317 million (net of reinsurance). Most of this net benefit is projected to be received pursuant to existing agreements with R&W providers, although some is projected to be received in connection with transactions where the company does not yet have such an agreement. Most of the amount projected to be received pursuant to existing agreements with R&W providers benefits from eligible assets placed in trusts to collateralize the R&W provider’s future reimbursement obligation, with the amount of such collateral subject to increase or decrease from time to time as determined by rating agency requirements. Currently the Company has agreements with three counterparties where a future reimbursement obligation is collateralized by eligible assets held in trust:

•
Bank of America. Under the Company's agreement with Bank of America Corporation and certain of its subsidiaries (“Bank of America”), Bank of America agreed to reimburse the Company for 80% of claims on the first lien transactions covered by the agreement that the Company pays in the future, until the aggregate lifetime collateral losses (not insurance losses or claims) on those transactions reach $6.6 billion. As of December 31, 2014 aggregate lifetime collateral losses on those transactions was $4.1 billion, and the Company was projecting in its base case that such collateral losses would eventually reach $5.1 billion. Bank of America's reimbursement obligation is secured by $574 million of collateral held in trust for the Company's benefit.

•
Deutsche Bank. Under the Company's May 2012 agreement with Deutsche Bank AG and certain of its affiliates (collectively, “Deutsche Bank”), Deutsche Bank agreed to reimburse the Company for certain claims it pays in the future on eight first and second lien transactions, including 80% of claims it pays on those transactions until the aggregate lifetime claims (before reimbursement) reach $319 million. As of December 31, 2014, the Company was projecting in its base case that such aggregate lifetime claims would remain below $319 million. In the event aggregate lifetime claims paid exceed $389 million, Deutsche Bank must reimburse the Company for 85% of such claims paid (in excess of $389 million) until such claims paid reach $600 million.

When the agreement was first signed, Deutsche Bank was also required to reimburse AGC for future claims it pays on certain RMBS resecuritizations. AGC and Deutsche Bank terminated one of the resecuritization transactions on October 10, 2013, another on September 12, 2014 and two more in the fourth quarter of 2014. In the fourth quarter of 2014, AGC and Deutsche Bank also terminated one other BIG transaction under which AGC had provided credit protection to Deutsche Bank through a CDS. In connection with the 2014 terminations, AGC and Deutsche Bank agreed to terminate Deutsche Bank’s reimbursement obligation on all of the RMBS resecuritizations, and AGC made a termination payment to Deutsche Bank and released some of the collateral that had been held in trust. Deutsche Bank remains liable to reimburse the Company for certain claims it pays on eight first and second lien transactions, as described above, and such reimbursement obligation remains secured by $77 million of collateral held in trust for the Company’s benefit.

•
UBS. On May 6, 2013, the Company entered into an agreement with UBS Real Estate Securities Inc. and affiliates ("UBS") and a third party resolving the Company’s claims and liabilities related to specified RMBS transactions that were issued, underwritten or sponsored by UBS and insured by AGM or AGC under financial guaranty insurance policies. Under the agreement, UBS agreed to reimburse the Company for 85% of future losses on three first lien RMBS transactions, and such reimbursement obligation is secured by $109 million of collateral held in trust for the Company's benefit.

For the expected recovery from breaches of R&W in transactions not covered by agreements as of December 31, 2014, the Company did not incorporate any gain contingencies from potential litigation in its estimated repurchases. The amount the Company will ultimately recover related to such contractual R&W is uncertain and subject to a number of factors including the counterparty's ability to pay, the number and loss amount of loans determined to have breached R&W and, potentially, negotiated settlements or litigation recoveries. As such, the Company's estimate of recoveries is uncertain and actual amounts realized may differ significantly from these estimates. In arriving at the expected recovery from breaches of R&W not already covered by agreements, the Company considered the creditworthiness of the provider of the R&W, the number of breaches found on defaulted loans, the success rate in resolving these breaches across those transactions where material repurchases have been made and the potential amount of time until the recovery is realized. The calculation of expected recovery from breaches of such contractual R&W involved a variety of scenarios which ranged from the Company recovering substantially all of the losses it incurred due to violations of R&W to the Company realizing limited recoveries. These scenarios were probability weighted in order to determine the recovery incorporated into the Company's estimate of expected losses. This approach was used for both loans that had already defaulted and those assumed to default in the future. The Company adjusts the calculation of its expected recovery from breaches of R&W based on changing facts and circumstances with respect to each counterparty and transaction.

The Company uses the same RMBS projection scenarios and weightings to project its future R&W benefit as it uses to project RMBS losses on its portfolio. To the extent the Company increases its loss projections, the R&W benefit (whether pursuant to an R&W agreement or not) generally will also increase, subject to the agreement limits and thresholds described above. Similarly, to the extent the Company decreases its loss projections, the R&W benefit (whether pursuant to an R&W agreement or not) generally will also decrease, subject to the agreement limits and thresholds described above.

The number of risks subject to R&W recovery is 29, with related net debt service of $2.1 billion as of December 31, 2014 compared to 42 with net debt service of $5.0 billion as of December 31, 2013. Included in these amounts is net debt service related to transactions not yet subject to an agreement. A risk represents the aggregate of the financial guaranty policies that share the same revenue source for purposes of making Debt Service payments.
 
The following table provides a breakdown of the development and accretion amount in the roll forward of estimated recoveries associated with claims for breaches of R&W.

Components of R&W Development

 
Year Ended December 31,
 
2014
 
2013
 
(in millions)
Inclusion or removal of deals with breaches of R&W during period
$
—

 
$
6

Change in recovery assumptions as the result of recovery success
31

 
(6
)
Estimated increase (decrease) in defaults that will result in additional (lower) breaches
(37
)
 
(8
)
Settlements and anticipated settlements
263

 
289

Accretion of discount on balance
11

 
15

Total
$
268

 
$
296


  
Trust Preferred Securities Collateralized Debt Obligations
 
The Company has insured or reinsured $4.3 billion of net par (72% of which is in CDS form) of collateralized debt obligations (“CDOs”) backed by TruPS and similar debt instruments, or “TruPS CDOs.” Of the $4.3 billion, $1.3 billion is rated BIG. The underlying collateral in the TruPS CDOs consists of subordinated debt instruments such as TruPS issued by bank holding companies and similar instruments issued by insurance companies, real estate investment trusts (“REITs”) and other real estate related issuers.
 
The Company projects losses for TruPS CDOs by projecting the performance of the asset pools across several scenarios (which it weights) and applying the CDO structures to the resulting cash flows. At December 31, 2014, the Company has projected expected losses to be paid for TruPS CDOs of $23 million. During 2014 there was positive economic development of approximately $28 million, which was due primarily to improving collateral performance throughout 2014.

“XXX” Life Insurance Transactions
 
The Company’s $3.1 billion net par of XXX life insurance transactions as of December 31, 2014 include $598 million rated BIG. The BIG “XXX” life insurance reserve securitizations are based on discrete blocks of individual life insurance business. In each such transaction the monies raised by the sale of the bonds insured by the Company were used to capitalize a special purpose vehicle that provides reinsurance to a life insurer or reinsurer. The monies are invested at inception in accounts managed by third-party investment managers.
 
The BIG “XXX” life insurance transactions consist of two transactions, notes issued by each of Ballantyne Re p.l.c and Orkney Re II p.l.c. These transactions had material amounts of their assets invested in U.S. RMBS. Based on its analysis of the information currently available, including estimates of future investment performance, and projected credit impairments on the invested assets and performance of the blocks of life insurance business at December 31, 2014, the Company’s projected net expected loss to be paid is $161 million. The economic loss development during 2014 was approximately $93 million, which was due primarily to changes in lapse assumptions on the underlying life insurance policies, modest deterioration in life insurance cash flow projections, and a decrease in the risk free rates used to discount the losses.
 
Manufactured Housing

The Company insures or reinsures a total of $223 million net par of securities backed by manufactured housing loans, of which $160 million is rated BIG. The Company has expected loss to be paid of $25 million as of December 31, 2014. The economic loss development during 2014 was relatively flat.

Student Loan Transactions
 
The Company has insured or reinsured $2.5 billion net par of student loan securitizations, of which $1.8 billion was issued by private issuers and classified as asset-backed and $0.7 billion was issued by public authorities and classified as public finance. Of these amounts, $196 million and $101 million, respectively, are rated BIG. The Company is projecting approximately $83 million of net expected loss to be paid in these portfolios. In general, the losses are due to: (i) the poor credit performance of private student loan collateral and high loss severities, or (ii) high interest rates on auction rate securities with respect to which the auctions have failed. The economic loss development during 2014 was approximately $18 million, which was due to a decrease during 2014 in the risk free rates used to discount the losses, and some deterioration in collateral performance during the first six months of 2014.

Selected U.S. Public Finance Transactions
    
The Company insures general obligation bonds of the Commonwealth of Puerto Rico and various obligations of its related authorities and public corporations aggregating $4.9 billion net par. The Company rates $4.7 billion net par of that amount BIG. For additional information regarding the Company's exposure to general obligations of Commonwealth of Puerto Rico and various obligations of its related authorities and public corporations, please refer to "Exposure to Puerto Rico" in Note 3, Outstanding Exposure.

The Company has net par exposure to the City of Detroit, Michigan of $2.0 billion as of December 31, 2014 to the general obligation and water and sewer utility sectors, as described below (which exposures are now investment grade by virtue of improvements and agreements reached through the bankruptcy process and settlement). In December 2014, the City of Detroit emerged from bankruptcy under Chapter 9 of the U.S. Bankruptcy Code. The City’s proposed plan of adjustment and disclosure statement with the Bankruptcy Court was approved in November 2014.

•
The Company has net par exposure to $1.0 billion of sewer revenue bonds and $878 million of water revenue bonds. The sewer and water systems provide services to areas that extend beyond the city limits, and the bonds are secured by a lien on "special revenues." The Company rates the bonds, which are secured by a lien on "special revenues," BBB. The exposure reflects the City's issuance in September 2014 of new series of sewer and water revenue bonds to finance (i) the purchase of outstanding sewer and water revenue bonds offered and accepted under a tender offer commenced by the City and (ii) the refunding of certain other sewer revenue and revenue refunding bonds, and the Company's insurance of a portion of such issuance. In connection with these transactions, approximately $677 million of the Company's then combined $1.8 billion net par exposure to the sewer and water revenue bonds was purchased in the tender offer or refunded, and the Company insured approximately $841 million gross par of the new sewer and water revenue bonds. Under the City's amended plan of adjustment, the impairment of all outstanding sewer and water revenue bonds (even those not purchased pursuant to the tender offer or refunded) that had been proposed was removed, including those provisions which provided for the impairment of interest rates and call protection on such bonds.

•
The Company has net par exposure of $107 million to Michigan Finance Authority by virtue of a court ordered exchange with all holders of the City’s general obligation bonds which occurred upon emergence from bankruptcy in December 2014.  The Michigan Finance Authority bonds are secured by a pledge of the unlimited tax, full faith, credit and resources of the City and the specific ad valorem taxes approved by the voters solely to pay debt service on the general obligation bonds and additional security in the form of a subordinate statutory lien on, and intercept of, the City’s distributable state aid.

•
The Company no longer has  exposure to the City's Pension Obligation Certificates.   Upon the effective date of the City’s plan of adjustment, a commutation agreement between AG Re and Financial Guaranty Insurance Co. ("FGIC") pursuant to which FGIC commuted all the reinsurance AG Re provided to FGIC with respect to the Pension Obligation Certificates became effective.

On June 28, 2012, the City of Stockton, California filed for bankruptcy protection under Chapter 9 of the U.S. Bankruptcy Code. The Company's net exposure to the City's general fund is $117 million, consisting of pension obligation bonds. The Company also had exposure to lease revenue bonds; as of December 31, 2014, the Company owned all of such bonds and held them in its investment portfolio. On October 3, 2013, the Company reached a settlement with the City regarding the treatment of the bonds insured by the Company in the City's plan of adjustment. Under the terms of the settlement, the Company will continue to receive net revenues from an office building and an option to take title to that building, and will be entitled to certain fixed payments and certain variable payments contingent on the City's revenue growth. On October 30, 2014, the bankruptcy court confirmed the City's plan of adjustment, which includes the terms of such settlement, and the plan became effective on February 25, 2015.
The Company has $336 million of net par exposure to the Louisville Arena Authority. The bond proceeds were used to construct the KFC Yum Center, home to the University of Louisville men's and women's basketball teams. Actual revenues available for Debt Service are well below original projections, and under the Company's internal rating scale, the transaction is BIG.

The Company projects that its total net expected loss across its troubled U.S. public finance credits as of December 31, 2014, which incorporated the likelihood of the outcomes mentioned above, will be $303 million, compared with a net expected loss of $264 million as of December 31, 2013. Economic loss development in 2014 was approximately $183 million, which was primarily attributable to Puerto Rico and Detroit exposures.

Certain Selected European Country Transactions

The Company insures and reinsures credits with sub-sovereign exposure to various Spanish and Portuguese issuers where a Spanish and Portuguese sovereign default may cause the regions also to default. The Company's gross exposure to these Spanish and Portuguese credits is $521 million and $114 million, respectively and exposure net of reinsurance for Spanish and Portuguese credits is $374 million and $102 million, respectively. The Company rates most of these issuers in the BB category due to the financial condition of Spain and Portugal and their dependence on the sovereign. The Company's Hungary exposure is to infrastructure bonds dependent on payments from Hungarian governmental entities and covered mortgage bonds issued by Hungarian banks. The Company's gross exposure to these Hungarian credits is $529 million and its exposure net of reinsurance is $499 million, most of which is rated BIG. The Company estimated net expected losses of $45 million related to these Spanish, Portuguese and Hungarian credits. The positive economic loss development during 2014 was approximately $5 million, which was primarily attributable to the favorable movement in the exchange rates between the US Dollar and both the Euro and Hungarian Forint during the year.
 
 Infrastructure Finance

The Company has insured exposure of approximately $3.0 billion to infrastructure transactions with refinancing risk as to which the Company may need to make claim payments that it did not anticipate paying when the policies were issued. Although the Company may not experience ultimate loss on a particular transaction, the aggregate amount of the claim payments may be substantial and reimbursement may not occur for an extended time, if at all. These transactions generally involve long-term infrastructure projects that were financed by bonds that mature prior to the expiration of the project concession. The Company expected the cash flows from these projects to be sufficient to repay all of the debt over the life of the project concession, but also expected the debt to be refinanced in the market at or prior to its maturity. If the issuer is unable to refinance the debt due to market conditions, the Company may have to pay a claim when the debt matures, and then recover its payment from cash flows produced by the project in the future. The Company generally projects that in most scenarios it will be fully reimbursed for such payments. However, the recovery of the payments is uncertain and may take from 10 to 35 years, depending on the transaction and the performance of the underlying collateral. The Company estimates total claims for the two largest transactions with significant refinancing risk, assuming no refinancing, and based on certain performance assumptions could be $1.8 billion on a gross basis; such claims would be payable from 2017 through 2022.
    
Recovery Litigation
 
“XXX” Life Insurance Transactions
 
In December 2008, AGUK filed an action against J.P. Morgan Investment Management Inc. (“JPMIM”), the investment manager in the Orkney Re II transaction, in the Supreme Court of the State of New York alleging that JPMIM engaged in breaches of fiduciary duty, gross negligence and breaches of contract based upon its handling of the investments of Orkney Re II. After AGUK’s claims were dismissed with prejudice in January 2010, AGUK was successful in its subsequent motions and appeals and, as of December 2011, all of AGUK’s claims for breaches of fiduciary duty, gross negligence and contract were reinstated in full. Separately, at the trial court level, discovery is ongoing.

RMBS Transactions
 
In November 2014, AGM and its affiliate AGC reached a confidential settlement with DLJ Mortgage Capital, Inc., Credit Suisse First Boston Mortgage Securities Corp. and Credit Suisse Securities (USA) LLC to resolve a lawsuit relating to six first lien U.S. RMBS transactions.  AGM and AGC sought damages for alleged breaches of representations and warranties in respect of the underlying loans in these transactions, and failure to cure or repurchase defective loans identified by AGM and AGC.  On November 25, 2014, the parties filed a joint stipulation discontinuing the lawsuit with prejudice.  However, on November 20, 2014, U.S. Bank National Association, as trustee for the transactions, had filed a motion to intervene as a plaintiff in the lawsuit.  On November 26, 2014, the trustee submitted a letter stating that the joint stipulation is ineffective and that the lawsuit may be discontinued only by court order, and requesting an opportunity to review and potentially oppose the settlement.  The court has yet to rule on the trustee’s motion or the trustee’s letter. AGM believes the trustee’s motion and letter are without merit. In the fourth quarter of 2014, AGM recorded a benefit in connection with the settlement.

Previously, AGM also had sued Deutsche Bank AG affiliates DB Structured Products, Inc. and ACE Securities Corp. on a second lien U.S. RMBS transaction that it had insured. In November 2014, AGM resolved those claims against Deutsche Bank and filed a stipulation with the Supreme Court of the State of New York to dismiss the lawsuit; the court ordered the dismissal of the matter on November 17, 2014.