7. Covered Assets and Indemnification Asset

At the close of business on September 30, 2018, the loss-share agreement for commercial assets with the FDIC expired, except for certain obligations on the part of the Bank that survived. As discussed in Note 25 to the consolidated financial statements, on October 17, 2018, the Bank and the FDIC entered into a Termination Agreement pursuant to which each of the loss-share agreements for single family residential assets and commercial assets were terminated in exchange for the payment by the FDIC to the Bank of $6.26 million.

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. As of September 30, 2018, 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 were referred to as “covered assets”. Pursuant to the loss-share agreements, the FDIC had 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 were 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 through September 30, 2018, the amount of subsequent recoveries that were reimbursable to the FDIC for a particular asset was limited to book value losses and expenses actually billed plus any book value charge-offs incurred prior to the Bank Closing Date. There was 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 were originally in effect for approximately five years and ten years, respectively, from the Bank Closing Date, and the loss recovery provisions to the FDIC were 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 were not contractually embedded in the covered loans and were not transferable should the Bank had chosen to dispose of the covered loans.

In accordance with the loss-share agreements, the Bank may have been 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 were less than the FDIC’s initial estimate of losses on covered assets. The “true-up” payment was calculated using a defined formula set forth in the P&A Agreement. At September 30, 2018, the Bank had recorded a related “true-up” payment accrual of $16.6 million based on the then-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 were 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 6 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 similar 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,
	2018		2017
Commercial and industrial	$	890	$	1,055
Real estate		141,858		179,359
Construction and land development		1,280		1,715
		144,028		182,129
Allowance for covered loans		(1,291)		(2,729)
Total covered loans, net of allowance	$	142,737	$	179,400

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


	September 30,		December 31,
	2018		2017
Carrying amount	$	65,004	$	87,113
Outstanding balance		138,490		179,019

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


	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
Balance, beginning of period	$	81,393	$	128,307	$	91,833	$	143,731
Reclassifications from nonaccretable difference, net (1)		5,649		4,096		15,364		27,120
Transfer of loans to covered OREO (2)		(142)		(77)		(989)		(857)
Accretion		(6,987)		(10,040)		(26,295)		(47,708)
Balance, end of period	$	79,913	$	122,286	$	79,913	$	122,286

(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 $51.5 million and $72.7 million at September 30, 2018 and December 31, 2017, respectively. During the three and nine months ended September 30, 2018 and 2017, 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, 2018	Principal Balance		No Allowance		Allowance		Investment		Allowance
PCI
Commercial and industrial:
Secured	$	3,156	$	—	$	130	$	130	$	14
Unsecured		5,380		—		—		—		—
Real estate:
Secured by commercial properties		50,379		1,580		6,671		8,251		469
Secured by residential properties		112,174		186		56,437		56,623		785
Construction and land development:
Residential construction loans		643		—		—		—		—
Commercial construction loans and land development		9,790		—		—		—		—
		181,522		1,766		63,238		65,004		1,268
Non-PCI
Commercial and industrial:
Secured		44		—		—		—		—
Unsecured		—		—		—		—		—
Real estate:
Secured by commercial properties		—		—		—		—		—
Secured by residential properties		7,236		6,048		—		6,048		—
Construction and land development:
Residential construction loans		—		—		—		—		—
Commercial construction loans and land development		9		5		—		5		—
		7,289		6,053		—		6,053		—
	$	188,811	$	7,819	$	63,238	$	71,057	$	1,268


	Unpaid		Recorded		Recorded		Total
	Contractual		Investment with		Investment with		Recorded		Related
December 31, 2017	Principal Balance		No Allowance		Allowance		Investment		Allowance
PCI
Commercial and industrial:
Secured	$	3,783	$	—	$	194	$	194	$	19
Unsecured		5,732		—		—		—		—
Real estate:
Secured by commercial properties		80,223		2,388		21,171		23,559		1,817
Secured by residential properties		125,361		249		63,107		63,356		861
Construction and land development:
Residential construction loans		672		—		—		—		—
Commercial construction loans and land development		11,118		4		—		4		—
		226,889		2,641		84,472		87,113		2,697
Non-PCI
Commercial and industrial:
Secured		44		—		—		—		—
Unsecured		—		—		—		—		—
Real estate:
Secured by commercial properties		—		—		—		—		—
Secured by residential properties		6,279		5,370		—		5,370		—
Construction and land development:
Residential construction loans		—		—		—		—		—
Commercial construction loans and land development		18		12		—		12		—
		6,341		5,382		—		5,382		—
	$	233,230	$	8,023	$	84,472	$	92,495	$	2,697

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,
	2018		2017		2018		2017
Commercial and industrial:
Secured	$	139	$	396	$	162	$	775
Unsecured		—		105		—		170
Real estate:
Secured by commercial properties		12,817		28,110		15,905		39,323
Secured by residential properties		63,082		68,843		65,699		73,093
Construction and land development:
Residential construction loans		—		—		—		—
Commercial construction loans and land development		5		1,384		11		2,762
	$	76,043	$	98,838	$	81,777	$	116,123

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


	September 30,		December 31,
	2018		2017
Commercial and industrial:
Secured	$	—	$	—
Unsecured		—		—
Real estate:
Secured by commercial properties		—		—
Secured by residential properties		5,772		5,087
Construction and land development:
Residential construction loans		—		—
Commercial construction loans and land development		5		17
	$	5,777	$	5,104

At both September 30, 2018 and December 31, 2017, there were no covered non-accrual loans included in covered PCI loans 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 $0.3 million and $0.9 million during the three months ended September 30, 2018 and 2017, respectively, while interest income, including recoveries and cash payments, recorded on covered impaired loans during was $0.6 million and $1.2 million during the nine months ended September 30, 2018 and 2017, respectively. 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 6 to the consolidated financial statements. The Bank did not grant any TDRs during the three and nine months ended September 30, 2018 and 2017. Pooled Loans are not in the scope of the disclosure requirements for TDRs. At September 30, 2018 and December 31, 2017, the Bank had nominal unadvanced commitments to borrowers whose loans have been restructured in TDRs.

There were no TDRs granted during the twelve months preceding September 30, 2018 or 2017 for which payment was at least 30 days past due.

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, 2018	30‑59 Days		60‑89 Days		90 Days or More		Past Due Loans		Loans		Loans		Loans		90 Days or More
Commercial and industrial:
Secured	$	—	$	—	$	—	$	—	$	760	$	130	$	890	$	—
Unsecured		—		—		—		—		—		—		—		—
Real estate:
Secured by commercial properties		65		—		—		65		8,799		8,251		17,115		—
Secured by residential properties		2,342		555		2,293		5,190		62,930		56,623		124,743		—
Construction and land development:
Residential construction loans		—		—		—		—		—		—		—		—
Commercial construction loans and land development		—		—		—		—		1,280		—		1,280		—
	$	2,407	$	555	$	2,293	$	5,255	$	73,769	$	65,004	$	144,028	$	—


															Accruing Loans
	Loans Past Due		Loans Past Due		Loans Past Due		Total		Current		PCI		Total		(Non‑PCI) Past Due
December 31, 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	$	—	$	—	$	—	$	—	$	861	$	194	$	1,055	$	—
Unsecured		—		—		—		—		—		—		—		—
Real estate:
Secured by commercial properties		209		113		—		322		11,472		23,559		35,353		—
Secured by residential properties		5,624		1,211		3,226		10,061		70,589		63,356		144,006		283
Construction and land development:
Residential construction loans		—		—		—		—		—		—		—		—
Commercial construction loans and land development		38		—		—		38		1,673		4		1,715		—
	$	5,871	$	1,324	$	3,226	$	10,421	$	84,595	$	87,113	$	182,129	$	283

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 6 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, 2018	Pass		Special Mention		Substandard		PCI		Total
Commercial and industrial:
Secured	$	379	$	—	$	381	$	130	$	890
Unsecured		—		—		—		—		—
Real estate:
Secured by commercial properties		8,168		—		696		8,251		17,115
Secured by residential properties		64,100		395		3,625		56,623		124,743
Construction and land development:
Residential construction loans		—		—		—		—		—
Commercial construction loans and land development		1,264		—		16		—		1,280
	$	73,911	$	395	$	4,718	$	65,004	$	144,028


December 31, 2017	Pass		Special Mention		Substandard		PCI		Total
Commercial and industrial:
Secured	$	429	$	—	$	432	$	194	$	1,055
Unsecured		—		—		—		—		—
Real estate:
Secured by commercial properties		10,961		—		833		23,559		35,353
Secured by residential properties		68,544		356		11,750		63,356		144,006
Construction and land development:
Residential construction loans		—		—		—		—		—
Commercial construction loans and land development		1,649		—		62		4		1,715
	$	81,583	$	356	$	13,077	$	87,113	$	182,129

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 2017 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, 2018	Industrial		Real Estate		Land Development		Total
Balance, beginning of period	$	19	$	1,955	$	—	$	1,974
Recovery of loan losses		(1)		(677)		—		(678)
Loans charged off		—		(6)		—		(6)
Recoveries on charged off loans		—		1		—		1
Balance, end of period	$	18	$	1,273	$	—	$	1,291


	Commercial and				Construction and
Nine months ended September 30, 2018	Industrial		Real Estate		Land Development		Total
Balance, beginning of period	$	24	$	2,702	$	3	$	2,729
Recovery of loan losses		(6)		(1,367)		(9)		(1,382)
Loans charged off		—		(63)		—		(63)
Recoveries on charged off loans		—		1		6		7
Balance, end of period	$	18	$	1,273	$	—	$	1,291


	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 (recovery) for loan losses		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 for loan losses		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

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


	Commercial and				Construction and
September 30, 2018	Industrial		Real Estate		Land Development		Total
Loans individually evaluated for impairment	$	—	$	—	$	—	$	—
Loans collectively evaluated for impairment		760		76,984		1,280		79,024
PCI Loans		130		64,874		—		65,004
	$	890	$	141,858	$	1,280	$	144,028


	Commercial and				Construction and
December 31, 2017	Industrial		Real Estate		Land Development		Total
Loans individually evaluated for impairment	$	—	$	—	$	—	$	—
Loans collectively evaluated for impairment		861		92,444		1,711		95,016
PCI Loans		194		86,915		4		87,113
	$	1,055	$	179,359	$	1,715	$	182,129

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, 2018	Industrial		Real Estate		Land Development		Total
Loans individually evaluated for impairment	$	—	$	—	$	—	$	—
Loans collectively evaluated for impairment		4		19		—		23
PCI Loans		14		1,254		—		1,268
	$	18	$	1,273	$	—	$	1,291


	Commercial and				Construction and
December 31, 2017	Industrial		Real Estate		Land Development		Total
Loans individually evaluated for impairment	$	—	$	—	$	—	$	—
Loans collectively evaluated for impairment		5		24		3		32
PCI Loans		19		2,678		—		2,697
	$	24	$	2,702	$	3	$	2,729

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,
	2018		2017		2018		2017
Balance, beginning of period	$	34,895	$	42,304	$	36,744	$	51,642
Additions to covered OREO		438		1,039		5,284		6,166
Dispositions of covered OREO		(5,173)		(2,612)		(10,145)		(14,942)
Valuation adjustments in the period		(304)		(388)		(2,027)		(2,523)
Balance, end of period	$	29,856	$	40,343	$	29,856	$	40,343

During the three and nine months ended September 30, 2018 and 2017, 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 downward valuations recorded during the three and nine months ended September 30, 2018 and 2017 were related to covered assets subject to the loss-share agreements with the FDIC, which were terminated on October 17, 2018.

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,
	2018		2017		2018		2017
Balance, beginning of period	$	23,525	$	40,304	$	29,340	$	71,313
FDIC Indemnification Asset accretion (amortization)		(694)		(5,348)		(6,509)		(13,533)
Transfers to due from FDIC and other		—		(1,813)		—		(24,637)
Balance, end of period	$	22,831	$	33,143	$	22,831	$	33,143

As of September 30, 2018, the Bank had billed $147.8 million to and collected $145.8 million from the FDIC, which represented reimbursable covered losses and expenses through September 30, 2017. The previously discussed termination of the FDIC loss-share agreements includes settlement of all unbilled amounts since September 30, 2017.