Contracts Accounted for as Credit Derivatives

The Company has a portfolio of financial guaranty contracts that meet the definition of a derivative in accordance with GAAP (primarily CDS). The credit derivative portfolio also includes interest rate swaps.

Credit derivative transactions are governed by ISDA documentation and have different characteristics from financial guaranty insurance contracts. For example, the Company’s control rights with respect to a reference obligation under a credit derivative may be more limited than when the Company issues a financial guaranty insurance contract. In addition, there are more circumstances under which the Company may be obligated to make payments. Similar to a financial guaranty insurance contract, the Company would be obligated to pay if the obligor failed to make a scheduled payment of principal or interest in full. However, the Company may also be required to pay if the obligor becomes bankrupt or if the reference obligation were restructured if, after negotiation, those credit events are specified in the documentation for the credit derivative transactions. Furthermore, the Company may be required to make a payment due to an event that is unrelated to the performance of the obligation referenced in the credit derivative. If events of default or termination events specified in the credit derivative documentation were to occur, the non-defaulting or the non-affected party, which may be either the Company or the counterparty, depending upon the circumstances, may decide to terminate a credit derivative prior to maturity. In that case, the Company may be required to make a termination payment to its swap counterparty upon such termination. Absent such an event of default or termination event, the Company may not unilaterally terminate a CDS contract; however, the Company on occasion has mutually agreed with various counterparties to terminate certain CDS transactions.

Accounting Policy

Credit derivatives are recorded at fair value. Changes in fair value are recorded in “net change in fair value of credit derivatives” on the consolidated statement of operations. Realized gains (losses) and other settlements on credit derivatives include credit derivative premiums received and receivable for credit protection the Company has sold under its insured CDS contracts, premiums paid and payable for credit protection the Company has purchased, claims paid and payable and received and receivable related to insured credit events under these contracts, ceding commission expense or income and realized gains or losses related to their early termination. Fair value of credit derivatives is reflected as either net assets or net liabilities determined on a contract by contract basis in the Company's consolidated balance sheets. See Note 7, Fair Value Measurement, for a discussion on the fair value methodology for credit derivatives.

Credit Derivative Net Par Outstanding by Sector

The estimated remaining weighted average life of credit derivatives was 11.7 years at December 31, 2017 and 5.3 years at December 31, 2016. The increase in the weighted average life of the credit derivative portfolio was primarily attributable to the run-off of short-dated pooled corporate obligations. The components of the Company’s credit derivative net par outstanding are presented below.

Credit Derivatives



	As of December 31, 2017			As of December 31, 2016
Asset Type	Net Par Outstanding		Weighted Average Credit Rating	Net Par Outstanding		Weighted Average Credit Rating
	(dollars in millions)
Pooled corporate obligations:
CLO /collateralized bond obligations	$	—	--	$	2,022	AAA
Synthetic investment grade pooled corporate	—		--	7,224		AAA
TruPS CDOs	878		A	1,179		BBB+
Total pooled corporate obligations	878		A	10,425		AAA
U.S. RMBS	916		AA	1,142		AA-
Pooled infrastructure	1,561		AAA	1,513		AAA
Infrastructure finance	572		A	1,021		BBB+
Other(1)	2,280		A-	2,896		A
Total	$	6,207	AA-	$	16,997	AA+

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(1)	This comprises numerous transactions across various asset classes, such as commercial receivables, international RMBS, regulated utilities and consumer receivables.

The underlying collateral in TruPS CDOs consists primarily of subordinated debt instruments such as TruPS issued by bank holding companies and similar instruments issued by insurance companies, real estate investment trusts and other real estate related issuers. Due to the fact that the debt is subordinated, TruPS CDOs were typically structured with higher levels of embedded credit enhancement, which allowed the Company to mitigate the risks associated with TruPS CDOs.

Distribution of Credit Derivative Net Par Outstanding by Internal Rating



	As of December 31, 2017				As of December 31, 2016
Ratings	Net Par Outstanding		% of Total		Net Par Outstanding		% of Total
	(dollars in millions)
AAA	$	2,144	34.6	%	$	10,967	64.6	%
AA	1,170		18.8		2,167		12.7
A	1,517		24.5		1,499		8.8
BBB	1,038		16.7		1,391		8.2
BIG	338		5.4		973		5.7
Credit derivative net par outstanding	$	6,207	100.0	%	$	16,997	100.0	%

Fair Value of Credit Derivatives

Net Change in Fair Value of Credit Derivative Gain (Loss)



	Year Ended December 31,
	2017			2016			2015
	(in millions)
Realized gains on credit derivatives	$	17		$	56		$	63
Net credit derivative losses (paid and payable) recovered and recoverable and other settlements	(27		)	(27		)	(81		)
Realized gains (losses) and other settlements	(10		)	29			(18		)
Net unrealized gains (losses):
Pooled corporate obligations	35			(16		)	147
U.S. RMBS	23			22			396
Pooled infrastructure	5			17			17
Infrastructure finance	4			4			0
Other	54			42			186
Net unrealized gains (losses)	121			69			746
Net change in fair value of credit derivatives	$	111		$	98		$	728

Terminations and Settlements

of Direct Credit Derivative Contracts



	Year Ended December 31,
	2017			2016		2015
	(in millions)
Net par of terminated credit derivative contracts	$	331		$	3,811	$	2,777
Realized gains on credit derivatives	0			20		13
Net credit derivative losses (paid and payable) recovered and recoverable and other settlements	(15		)	—		(116		)
Net unrealized gains (losses) on credit derivatives	26			103		465

During 2017, unrealized fair value gains were generated primarily as a result of CDS terminations, run-off of net par outstanding, and price improvements on the underlying collateral of the Company’s CDS. The termination of several CDS transactions in the pooled corporate CLO, U.S. RMBS and Other sectors was the primary driver of the unrealized fair value gains. The cost to buy protection in AGC’s and AGM’s name, specifically the five-year CDS spread, did not change materially during the period, and therefore did not have a material impact on the Company’s unrealized fair value gains and losses on CDS.

During 2016, unrealized fair value gains were generated primarily as a result of CDS terminations in the U.S. RMBS and other sectors, run-off of CDS par and price improvements on the underlying collateral of the Company’s CDS. The majority of the CDS transactions that were terminated were as a result of settlement agreements with several CDS counterparties. The unrealized fair value gains were partially offset by unrealized losses resulting from wider implied net spreads across all sectors. The wider implied net spreads were primarily a result of the decreased cost to buy protection in AGC’s and AGM’s name, as the market cost of AGC’s and AGM’s credit protection decreased significantly during the period. For those CDS transactions that were pricing at or above their floor levels, when the cost of purchasing CDS protection on AGC and AGM, which management refers to as the CDS spread on AGC and AGM, decreased the implied spreads that the Company would expect to receive on these transactions increased.

During 2015, unrealized fair value gains were generated primarily as a result of CDS terminations. The Company reached a settlement agreement with one CDS counterparty to terminate five Alt-A first lien CDS transactions resulting in unrealized fair value gains of $213 million and was the primary driver of the unrealized fair value gains in the U.S. RMBS sector. The Company also terminated a CMBS transaction, a Triple-X life insurance securitization transaction, and a distressed middle market CLO securitization during the period and recognized unrealized fair value gains of $41 million, $99 million and $99 million, respectively. These were the primary drivers of the unrealized fair value gains in the CMBS, Other, and pooled corporate CLO sectors, respectively, during the period. The remainder of the fair value gains for the period were a result of tighter implied net spreads across all sectors. The tighter implied net spreads were primarily a result of the increased cost to buy protection in AGC’s and AGM’s name, particularly for the one year CDS spread. For those CDS transactions that were pricing at or above their floor levels, when the cost of purchasing CDS protection on AGC and AGM increased, the implied spreads that the Company would expect to receive on these transactions decreased. Finally, during 2015, there was a refinement in methodology to address an instance in a U.S. RMBS transaction where the Company now expects recoveries. This refinement resulted in approximately $49 million in fair value gains in 2015.

The impact of changes in credit spreads will vary based upon the volume, tenor, interest rates, and other market conditions at the time these fair values are determined. In addition, since each transaction has unique collateral and structural terms, the underlying change in fair value of each transaction may vary considerably. The fair value of credit derivative contracts also reflects the change in the Company’s own credit cost based on the price to purchase credit protection on AGC and AGM. The Company determines its own credit risk based on quoted CDS prices traded on the Company at each balance sheet date.

CDS Spread on AGC and AGM

Quoted price of CDS contract (in basis points)



	As of December 31, 2017	As of December 31, 2016	As of December 31, 2015
Five-year CDS spread:
AGC	163	158	376
AGM	145	158	366

One-year CDS spread
AGC	70	35	139
AGM	28	29	131

Fair Value of Credit Derivatives Assets (Liabilities)

and Effect of AGC and AGM

Credit Spreads



	As of December 31, 2017			As of December 31, 2016
	(in millions)
Fair value of credit derivatives before effect of AGC and AGM credit spreads	$	(555	)	$	(811	)
Plus: Effect of AGC and AGM credit spreads	286			422
Net fair value of credit derivatives	$	(269	)	$	(389	)

The fair value of CDS contracts at December 31, 2017, before considering the implications of AGC’s and AGM’s credit spreads, is a direct result of continued wide credit spreads in the fixed income security markets and ratings downgrades. The asset classes that remain most affected are TruPS, pooled infrastructure and infrastructure finance securities, as well as 2005-2007 vintages of Alt-A, Option ARM and subprime RMBS transactions. The mark to market benefit between December 31, 2017 and December 31, 2016, resulted primarily from several CDS terminations, run-off of net par outstanding, and a narrowing of credit spreads related to the Company's TruPS and U.S. RMBS obligations.

Management believes that the trading level of AGC’s and AGM’s credit spreads over the past several years has been due to the correlation between AGC’s and AGM’s risk profile and the current risk profile of the broader financial markets. Offsetting the benefit attributable to AGC’s and AGM’s credit spread were higher credit spreads in the fixed income security markets. The higher credit spreads in the fixed income security market are due to the lack of liquidity in the TruPS CDO, and pooled infrastructure markets as well as continuing market concerns over the 2005-2007 vintages of RMBS.

The following table presents the fair value and the present value of expected claim payments or recoveries (i.e., net expected loss to be paid as described in Note 5) for contracts accounted for as derivatives.

Net Fair Value and Expected Losses

of Credit Derivatives



	As of December 31, 2017			As of December 31, 2016
	(in millions)
Fair value of credit derivative asset (liability), net	$	(269	)	$	(389	)
Expected loss to be (paid) recovered	14			(10		)

Collateral Posting for Certain Credit Derivative Contracts

The transaction documentation for $497 million of the CDS insured by AGC requires AGC to post collateral, in some cases subject to a cap, to secure its obligation to make payments under such contracts. Eligible collateral is generally cash or U.S. government or agency securities; eligible collateral other than cash is valued at a discount to the face amount. The table below summarizes AGC’s CDS collateral posting requirements as of December 31, 2017 and December 31, 2016.

AGC Insured CDS Collateral Posting Requirements



	As of December 31, 2017		As of December 31, 2016
	(in millions)
Gross par of CDS with collateral posting requirement	$	497	$	690
Maximum posting requirement	464		674
Collateral posted	18		116

The reduction in the collateral posting requirement is primarily attributable to the termination in February 2017 by the Company of its remaining CDS contracts with one of its counterparties as to which it had a posting requirement; the CDS contracts related to approximately $183 million in gross par and $73 million of collateral posted as of December 31, 2016.

Sensitivity to Changes in Credit Spread

The following table summarizes the estimated change in fair values on the net balance of the Company’s credit derivative positions assuming immediate parallel shifts in credit spreads on AGC and AGM and on the risks that they both assume.

Effect of Changes in Credit Spread

As of December 31, 2017



Credit Spreads(1)	Estimated Net Fair Value (Pre-Tax)			Estimated Change in Gain/(Loss) (Pre-Tax)
	(in millions)
100% widening in spreads	$	(501	)	$	(232	)
50% widening in spreads	(385		)	(116		)
25% widening in spreads	(327		)	(58		)
10% widening in spreads	(292		)	(23		)
Base Scenario	(269		)	—
10% narrowing in spreads	(250		)	19
25% narrowing in spreads	(222		)	47
50% narrowing in spreads	(174		)	95

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(1)	Includes the effects of spreads on both the underlying asset classes and the Company’s own credit spread.