6. Covered Assets and Indemnification Asset

The Bank acquired certain assets and assumed certain liabilities of FNB in connection with an FDIC-assisted transaction on September 13, 2013 (the “Bank Closing Date”). As part of the Purchase and Assumption Agreement by and among the FDIC (as receiver of FNB), the Bank and the FDIC (the “P&A Agreement”), the Bank and the FDIC entered into loss-share agreements covering future losses incurred on certain acquired loans and OREO. The Company refers to acquired commercial and single family residential loan portfolios and OREO that are subject to the loss-share agreements as “covered loans” and “covered OREO”, respectively, and these assets are presented as separate line items in the Company’s consolidated balance sheets. Collectively, covered loans and covered OREO are referred to as “covered assets”. Pursuant to the loss-share agreements, the FDIC has agreed to reimburse the Bank the following amounts with respect to the covered assets: (i) 80% of net losses on the first $240.4 million of net losses incurred; (ii) 0% of net losses in excess of $240.4 million up to and including $365.7 million of net losses incurred; and (iii) 80% of net losses in excess of $365.7 million of net losses incurred. Net losses are defined as book value losses plus certain defined expenses incurred in the resolution of assets, less subsequent recoveries. Under the loss-share agreement for commercial assets, the amount of subsequent recoveries that are reimbursable to the FDIC for a particular asset is limited to book value losses and expenses actually billed plus any book value charge-offs incurred prior to the Bank Closing Date. There is no limit on the amount of subsequent recoveries reimbursable to the FDIC under the loss-share agreement for single family residential assets. The loss-share agreements for commercial and single family residential assets are in effect for five years and ten years, respectively, from the Bank Closing Date, and the loss recovery provisions to the FDIC are in effect for eight years and ten years, respectively, from the Bank Closing Date. The asset arising from the loss-share agreements, referred to as the “FDIC Indemnification Asset,” is measured separately from the covered loan portfolio because the agreements are not contractually embedded in the covered loans and are not transferable should the Bank choose to dispose of the covered loans.

In accordance with the loss-share agreements, the Bank may be required to make a “true-up” payment to the FDIC approximately ten years following the Bank Closing Date if its actual net realized losses over the life of the loss-share agreements are less than the FDIC’s initial estimate of losses on covered assets. The “true-up” payment is calculated using a defined formula set forth in the P&A Agreement. At September 30, 2017, the Bank has recorded a related “true-up” payment accrual of $16.1 million based on the current estimate of aggregate realized losses on covered assets over the life of the loss-share agreements.

Covered Loans and Allowance for Covered Loan Losses

Loans acquired in the FNB Transaction that are subject to a loss-share agreement are referred to as “covered loans” and reported separately in the consolidated balance sheets. Covered loans are reported exclusive of the cash flow reimbursements that may be received from the FDIC.

The Bank’s portfolio of acquired covered loans had a fair value of $1.1 billion as of the Bank Closing Date, with no carryover of any allowance for loan losses. Acquired covered loans were preliminarily segregated between those considered to be PCI loans and those without credit impairment at acquisition.

In connection with the FNB Transaction, the Bank acquired loans both with and without evidence of credit quality deterioration since origination. The Company’s accounting policies for acquired covered loans, including covered PCI loans, are consistent with the accounting policies for acquired non-covered loans, as described in Note 5 to the consolidated financial statements. The Company has established under its PCI accounting policy a framework to aggregate certain acquired covered loans into various loan pools based on a minimum of two layers of common risk characteristics for the purpose of determining their respective fair values as of their acquisition dates, and for applying the subsequent recognition and measurement provisions for income accretion and impairment testing.

The following table presents the carrying value of the covered loans summarized by portfolio segment (in thousands).


	September 30,		December 31,
	2017		2016
Commercial and industrial	$	1,242	$	2,697
Real estate		186,777		244,469
Construction and land development		2,391		8,961
		190,410		256,127
Allowance for covered loans		(2,141)		(413)
Total covered loans, net of allowance	$	188,269	$	255,714

The following table presents the carrying value and the outstanding contractual balance of covered PCI loans (in thousands).


	September 30,		December 31,
	2017		2016
Carrying amount	$	90,583	$	133,754
Outstanding balance		190,352		266,098

Changes in the accretable yield for covered PCI loans were as follows (in thousands).


	Three Months Ended September 30,				Nine Months Ended September 30,
	2017		2016		2017		2016
Balance, beginning of period	$	128,307	$	157,604	$	143,731	$	176,719
Reclassifications from nonaccretable difference, net(1)		4,096		6,954		27,120		25,397
Transfer of loans to covered OREO(2)		(77)		(250)		(857)		(421)
Accretion		(10,040)		(17,460)		(47,708)		(54,847)
Balance, end of period	$	122,286	$	146,848	$	122,286	$	146,848

(1)

Reclassifications from nonaccretable difference are primarily due to net increases in expected cash flows in the quarterly recasts, but may also include the reclassification and immediate income recognition of nonaccretable difference due to the favorable resolution of loans accounted for individually. Reclassifications to nonaccretable difference occur when accruing loans are moved to non-accrual and expected cash flows are no longer predictable and the accretable yield is eliminated.

(2)

Transfer of loans to covered OREO is the difference between the value removed from the pool and the expected cash flows for the loan.

The remaining nonaccretable difference for covered PCI loans was $53.1 million and $94.5 million at September 30, 2017 and December 31, 2016, respectively. During the three and nine months ended September 30, 2017 and 2016, a combination of factors affecting the inputs to the Bank’s quarterly recast process led to the reclassifications from nonaccretable difference to accretable yield. These transfers resulted from revised cash flows that reflect better-than-expected performance of the covered PCI loan portfolio as a result of the Bank’s strategic decision to dedicate resources to the liquidation of covered loans during the noted periods.

Covered impaired loans include non-accrual loans, TDRs, PCI loans and partially charged-off loans. The amounts shown in the following tables include Pooled Loans, as well as loans accounted for on an individual basis. For Pooled Loans, the recorded investment with allowance and the related allowance consider impairment measured at the pool level.

Covered impaired loans, segregated between those considered to be PCI loans and those without credit impairment at acquisition, are summarized by class in the following tables (in thousands).


	Unpaid		Recorded		Recorded		Total
	Contractual		Investment with		Investment with		Recorded		Related
September 30, 2017	Principal Balance		No Allowance		Allowance		Investment		Allowance
PCI
Commercial and industrial:
Secured	$	4,010	$	—	$	240	$	240	$	46
Unsecured		6,324		—		41		41		29
Real estate:
Secured by commercial properties		90,640		1,484		24,214		25,698		1,368
Secured by residential properties		129,275		47,295		17,023		64,318		384
Construction and land development:
Residential construction loans		694		—		—		—		—
Commercial construction loans and land development		11,940		—		286		286		281
		242,883		48,779		41,804		90,583		2,108
Non-PCI
Commercial and industrial:
Secured		43		44		—		44		—
Unsecured		—		—		—		—		—
Real estate:
Secured by commercial properties		—		—		—		—		—
Secured by residential properties		4,695		3,929		—		3,929		—
Construction and land development:
Residential construction loans		—		—		—		—		—
Commercial construction loans and land development		19		13		—		13		—
		4,757		3,986		—		3,986		—
	$	247,640	$	52,765	$	41,804	$	94,569	$	2,108


	Unpaid		Recorded		Recorded		Total
	Contractual		Investment with		Investment with		Recorded		Related
December 31, 2016	Principal Balance		No Allowance		Allowance		Investment		Allowance
PCI
Commercial and industrial:
Secured	$	10,579	$	1,024	$	189	$	1,213	$	13
Unsecured		3,259		299		—		299		—
Real estate:
Secured by commercial properties		143,934		26,415		26,222		52,637		271
Secured by residential properties		148,384		73,240		1,161		74,401		60
Construction and land development:
Residential construction loans		766		—		—		—		—
Commercial construction loans and land development		23,522		5,204		—		5,204		—
		330,444		106,182		27,572		133,754		344
Non-PCI
Commercial and industrial:
Secured		52		52		—		52		—
Unsecured		—		—		—		—		—
Real estate:
Secured by commercial properties		396		310		—		310		—
Secured by residential properties		4,175		3,537		—		3,537		—
Construction and land development:
Residential construction loans		—		—		—		—		—
Commercial construction loans and land development		24		20		—		20		—
		4,647		3,919		—		3,919		—
	$	335,091	$	110,101	$	27,572	$	137,673	$	344

Average investment in covered impaired loans is summarized by class in the following table (in thousands).


	Three Months Ended September 30,				Nine Months Ended September 30,
	2017		2016		2017		2016
Commercial and industrial:
Secured	$	396	$	3,286	$	775	$	4,299
Unsecured		105		1,331		170		1,511
Real estate:
Secured by commercial properties		28,110		76,693		39,323		82,477
Secured by residential properties		68,843		84,129		73,093		91,424
Construction and land development:
Residential construction loans		—		—		—		331
Commercial construction loans and land development		1,384		10,568		2,762		15,269
	$	98,838	$	176,007	$	116,123	$	195,311

Covered non-accrual loans are summarized by class in the following table (in thousands).


	September 30,		December 31,
	2017		2016
Commercial and industrial:
Secured	$	44	$	52
Unsecured		—		—
Real estate:
Secured by commercial properties		—		730
Secured by residential properties		3,438		3,035
Construction and land development:
Residential construction loans		—		—
Commercial construction loans and land development		299		19
	$	3,781	$	3,836

At September 30, 2017 and December 31, 2016, covered non-accrual loans included covered PCI loans of $0.3 million and $0.4 million, respectively, for which discount accretion had been suspended because the extent and timing of cash flows from these covered PCI loans could no longer be reasonably estimated.

Interest income, including recoveries and cash payments, recorded on covered impaired loans was $0.9 million and $1.2 million during the three and nine months ended September 30, 2017, respectively, while interest income recorded on covered impaired loans during the three and nine months ended September 30, 2016 was nominal. Except as noted above, covered PCI loans are considered to be performing due to the application of the accretion method.

The Bank classifies loan modifications of covered loans as TDRs in a manner consistent with that of non-covered loans as discussed in Note 5 to the consolidated financial statements. The Bank did not grant any TDRs during the three and nine months ended September 30, 2017 and 2016. Pooled Loans are not in the scope of the disclosure requirements for TDRs. At September 30, 2017 and December 31, 2016, the Bank had nominal unadvanced commitments to borrowers whose loans have been restructured in TDRs.

The following table presents information regarding TDRs granted during the twelve months preceding September 30, 2017 and 2016, respectively, for which a payment was at least 30 days past due (dollars in thousands).


	Twelve Months Preceding September 30, 2017					Twelve Months Preceding September 30, 2016
	Number of	Balance at		Balance at		Number of	Balance at		Balance at
	Loans	Extension		End of Period		Loans	Extension		End of Period
Commercial and industrial:
Secured	—	$	—	$	—	—	$	—	$	—
Unsecured	—		—		—	—		—		—
Real estate:
Secured by commercial properties	—		—		—	—		—		—
Secured by residential properties	—		—		—	2		204		197
Construction and land development:
Residential construction loans	—		—		—	—		—		—
Commercial construction loans and land development	—		—		—	—		—		—
	—	$	—	$	—	2	$	204	$	197

An analysis of the aging of the Bank’s covered loan portfolio is shown in the following tables (in thousands).


															Accruing Loans
	Loans Past Due		Loans Past Due		Loans Past Due		Total		Current		PCI		Total		(Non‑PCI) Past Due
September 30, 2017	30‑59 Days		60‑89 Days		90 Days or More		Past Due Loans		Loans		Loans		Loans		90 Days or More
Commercial and industrial:
Secured	$	—	$	—	$	43	$	43	$	918	$	240	$	1,201	$	—
Unsecured		—		—		—		—		—		41		41		—
Real estate:
Secured by commercial properties		71		—		—		71		12,724		25,698		38,493		—
Secured by residential properties		3,945		2,296		1,440		7,681		76,285		64,318		148,284		—
Construction and land development:
Residential construction loans		—		—		—		—		—		—		—		—
Commercial construction loans and land development		8		—		—		8		2,097		286		2,391		—
	$	4,024	$	2,296	$	1,483	$	7,803	$	92,024	$	90,583	$	190,410	$	—


															Accruing Loans
	Loans Past Due		Loans Past Due		Loans Past Due		Total		Current		PCI		Total		(Non‑PCI) Past Due
December 31, 2016	30‑59 Days		60‑89 Days		90 Days or More		Past Due Loans		Loans		Loans		Loans		90 Days or More
Commercial and industrial:
Secured	$	—	$	6	$	96	$	102	$	1,083	$	1,213	$	2,398	$	44
Unsecured		—		—		—		—		—		299		299		—
Real estate:
Secured by commercial properties		96		229		—		325		19,132		52,637		72,094		—
Secured by residential properties		3,511		1,345		1,479		6,335		91,639		74,401		172,375		129
Construction and land development:
Residential construction loans		—		—		—		—		—		—		—		—
Commercial construction loans and land development		15		—		—		15		3,742		5,204		8,961		—
	$	3,622	$	1,580	$	1,575	$	6,777	$	115,596	$	133,754	$	256,127	$	173

The Bank assigns a risk grade to each of its covered loans in a manner consistent with the existing loan review program and risk grading matrix used for non-covered loans, as described in Note 5 to the consolidated financial statements. The following tables present the internal risk grades of covered loans in the portfolio by class (in thousands).


September 30, 2017	Pass		Special Mention		Substandard		PCI		Total
Commercial and industrial:
Secured	$	464	$	—	$	497	$	240	$	1,201
Unsecured		—		—		—		41		41
Real estate:
Secured by commercial properties		11,832		—		963		25,698		38,493
Secured by residential properties		75,322		438		8,206		64,318		148,284
Construction and land development:
Residential construction loans		—		—		—		—		—
Commercial construction loans and land development		1,863		—		242		286		2,391
	$	89,481	$	438	$	9,908	$	90,583	$	190,410


December 31, 2016	Pass		Special Mention		Substandard		PCI		Total
Commercial and industrial:
Secured	$	592	$	—	$	593	$	1,213	$	2,398
Unsecured		—		—		—		299		299
Real estate:
Secured by commercial properties		17,996		—		1,461		52,637		72,094
Secured by residential properties		90,563		461		6,950		74,401		172,375
Construction and land development:
Residential construction loans		—		—		—		—		—
Commercial construction loans and land development		2,281		—		1,476		5,204		8,961
	$	111,432	$	461	$	10,480	$	133,754	$	256,127

The Bank’s impairment methodology for covered loans is consistent with the methodology for non-covered loans, and is discussed in detail in Notes 5 and 6 to the consolidated financial statements included in the Company’s 2016 Form 10-K.

Changes in the allowance for covered loan losses, distributed by portfolio segment, are shown below (in thousands).


	Commercial and				Construction and
Three months ended September 30, 2017	Industrial		Real Estate		Land Development		Total
Balance, beginning of period	$	47	$	684	$	628	$	1,359
Provision charged to (recapture from) operations		34		1,093		(346)		781
Loans charged off		—		—		—		—
Recoveries on charged off loans		—		—		1		1
Balance, end of period	$	81	$	1,777	$	283	$	2,141


	Commercial and				Construction and
Nine months ended September 30, 2017	Industrial		Real Estate		Land Development		Total
Balance, beginning of period	$	35	$	378	$	—	$	413
Provision charged to operations		46		1,915		276		2,237
Loans charged off		(6)		(521)		—		(527)
Recoveries on charged off loans		6		5		7		18
Balance, end of period	$	81	$	1,777	$	283	$	2,141


	Commercial and				Construction and
Three months ended September 30, 2016	Industrial		Real Estate		Land Development		Total
Balance, beginning of period	$	55	$	1,400	$	—	$	1,455
Provision charged to (recapture from) operations		162		(888)		(3)		(729)
Loans charged off		—		—		—		—
Recoveries on charged off loans		—		—		3		3
Balance, end of period	$	217	$	512	$	—	$	729


	Commercial and				Construction and
Nine months ended September 30, 2016	Industrial		Real Estate		Land Development		Total
Balance, beginning of period	$	758	$	774	$	—	$	1,532
Provision charged to (recapture from) operations		(535)		(237)		(53)		(825)
Loans charged off		(6)		(42)		(51)		(99)
Recoveries on charged off loans		—		17		104		121
Balance, end of period	$	217	$	512	$	—	$	729

The covered loan portfolio was distributed by portfolio segment and impairment methodology as shown below (in thousands).


	Commercial and				Construction and
September 30, 2017	Industrial		Real Estate		Land Development		Total
Loans individually evaluated for impairment	$	—	$	—	$	—	$	—
Loans collectively evaluated for impairment		961		96,761		2,105		99,827
PCI Loans		281		90,016		286		90,583
	$	1,242	$	186,777	$	2,391	$	190,410


	Commercial and				Construction and
December 31, 2016	Industrial		Real Estate		Land Development		Total
Loans individually evaluated for impairment	$	—	$	—	$	—	$	—
Loans collectively evaluated for impairment		1,185		117,431		3,757		122,373
PCI Loans		1,512		127,038		5,204		133,754
	$	2,697	$	244,469	$	8,961	$	256,127

The allowance for covered loan losses was distributed by portfolio segment and impairment methodology as shown below (in thousands).


	Commercial and				Construction and
September 30, 2017	Industrial		Real Estate		Land Development		Total
Loans individually evaluated for impairment	$	—	$	—	$	—	$	—
Loans collectively evaluated for impairment		6		25		2		33
PCI Loans		75		1,752		281		2,108
	$	81	$	1,777	$	283	$	2,141


	Commercial and				Construction and
December 31, 2016	Industrial		Real Estate		Land Development		Total
Loans individually evaluated for impairment	$	—	$	—	$	—	$	—
Loans collectively evaluated for impairment		22		47		—		69
PCI Loans		13		331		—		344
	$	35	$	378	$	—	$	413

Covered Other Real Estate Owned

A summary of the activity in covered OREO is as follows (in thousands).


	Three Months Ended September 30,				Nine Months Ended September 30,
	2017		2016		2017		2016
Balance, beginning of period	$	42,304	$	67,634	$	51,642	$	99,090
Additions to covered OREO		1,039		2,422		6,166		11,703
Dispositions of covered OREO		(2,612)		(5,516)		(14,942)		(34,521)
Valuation adjustments in the period		(388)		(2,552)		(2,523)		(14,284)
Balance, end of period	$	40,343	$	61,988	$	40,343	$	61,988

During the three and nine months ended September 30, 2017 and 2016, the Bank wrote down certain covered OREO assets to fair value to reflect new appraisals on certain OREO acquired in the FNB Transaction and OREO acquired from the foreclosure on certain FNB loans acquired in the FNB Transaction. Although the Bank recorded a fair value discount on the acquired assets upon acquisition, in some cases additional downward valuations were required. The majority of the downward valuations recorded during the three and nine months ended September 30, 2017 and 2016 were related to covered assets subject to the loss-share agreements with the FDIC.

These additional downward valuation adjustments reflect changes to the assumptions regarding the fair value of the OREO, including in some cases the intended use of the OREO due to the availability of more information, as well as the passage of time. The process of determining fair value is subjective in nature and requires the use of significant estimates and assumptions. Although the Bank makes market-based assumptions when valuing acquired assets, new information may come to light that causes estimates to increase or decrease. When the Bank determines, based on subsequent information, that its estimates require adjustment, the Bank records the adjustment. The accounting for such adjustments requires that the decreases to the initially recorded fair value be recorded at the time such new information is received, while increases to fair value are recorded when the asset is subsequently sold.

FDIC Indemnification Asset

A summary of the activity in the FDIC Indemnification Asset is as follows (in thousands).


	Three Months Ended September 30,				Nine Months Ended September 30,
	2017		2016		2017		2016
Balance, beginning of period	$	40,304	$	74,460	$	71,313	$	91,648
FDIC Indemnification Asset accretion (amortization)		(5,348)		33		(13,533)		189
Transfers to due from FDIC and other		(1,813)		(1,142)		(24,637)		(18,486)
Balance, end of period	$	33,143	$	73,351	$	33,143	$	73,351

As of September 30, 2017, the Bank had billed and collected $145.5 million from the FDIC, which represented reimbursable covered losses and expenses through June 30, 2017.