Fair Value Measurement

The Company carries a significant portion of its assets and liabilities at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e., exit price). The price represents the price available in the principal market for the asset or liability. If there is no principal market, then the price is based on a hypothetical market that maximizes the value received for an asset or minimizes the amount paid for a liability (i.e., the most advantageous market).

Fair value is based on quoted market prices, where available. If listed prices or quotes are not available, fair value is based on either internally developed models that primarily use, as inputs, market-based or independently sourced market parameters, including but not limited to yield curves, interest rates and debt prices or with the assistance of an independent third-party using a discounted cash flow approach and the third party’s proprietary pricing models. In addition to market information, models also incorporate transaction details, such as maturity of the instrument and contractual features designed to reduce the Company’s credit exposure, such as collateral rights as applicable.

Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments include amounts to reflect counterparty credit quality, the Company’s creditworthiness and constraints on liquidity. As markets and products develop and the pricing for certain products becomes more or less transparent, the Company may refine its methodologies and assumptions. During First Quarter 2013, no changes were made to the Company’s valuation models that had or are expected to have, a material impact on the Company’s consolidated balance sheets or statements of operations and comprehensive income.

The Company’s methods for calculating fair value produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. The use of different methodologies or assumptions to determine fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

The fair value hierarchy is determined based on whether the inputs to valuation techniques used to measure fair value are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect Company estimates of market assumptions. The fair value hierarchy prioritizes model inputs into three broad levels as follows, with Level 1 being the highest and Level 3 the lowest. An asset or liability’s categorization within the fair value hierarchy is based on the lowest level of significant input to its valuation.

Level 1—Quoted prices for identical instruments in active markets. The Company generally defines an active market as a market in which trading occurs at significant volumes. Active markets generally are more liquid and have a lower bid-ask spread than an inactive market.

Level 2—Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and observable inputs other than quoted prices, such as interest rates or yield curves and other inputs derived from or corroborated by observable market inputs.

Level 3—Model derived valuations in which one or more significant inputs or significant value drivers are unobservable. Financial instruments are considered Level 3 when their values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable. Level 3 financial instruments also include those for which the determination of fair value requires significant management judgment or estimation.

Transfers between Levels 1, 2 and 3 are recognized at the end of the period when the transfer occurs. The Company reviews the classification between Levels 1, 2 and 3 quarterly to determine whether a transfer is necessary. During the periods presented, there were no transfers between Level 1, 2 and 3.

Measured and Carried at Fair Value

Fixed Maturity Securities and Short-term Investments

The fair value of bonds in the investment portfolio is generally based on prices received from third party pricing services or alternative pricing sources with reasonable levels of price transparency. The pricing services prepare estimates of fair value measurements using their pricing applications, which include available relevant market information, benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing. Additional valuation factors that can be taken into account are nominal spreads and liquidity adjustments. The pricing services evaluate each asset class based on relevant market and credit information, perceived market movements, and sector news. The market inputs used in the pricing evaluation, listed in the approximate order of priority include: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, reference data and industry and economic events. Benchmark yields have in many cases taken priority over reported trades for securities that trade less frequently. The extent of the use of each input is dependent on the asset class and the market conditions. Given the asset class, the priority of the use of inputs may change or some market inputs may not be relevant. Additionally, the valuation of fixed maturity investments is more subjective when markets are less liquid due to the lack of market based inputs, which may increase the potential that the estimated fair value of an investment is not reflective of the price at which an actual transaction would occur. The vast majority of fixed maturities are classified as Level 2.

Short-term investments, that are traded in active markets, are classified within Level 1 in the fair value hierarchy and are based on quoted market prices. Securities such as discount notes are classified within Level 2 because these securities are typically not actively traded due to their approaching maturity and, as such, their cost approximates fair value.

Prices determined based upon model processes where at least one significant model assumption or input is unobservable, are considered to be Level 3 in the fair value hierarchy. At March 31, 2013, the Company used model processes to price 35 fixed maturity securities, which was 5.1% or $542 million of the Company’s fixed maturity securities and short-term investments at fair value. Level 3 securities were priced with the assistance of an independent third-party. The pricing is based on a discounted cash flow approach using the third-party’s proprietary pricing models. The models use inputs such as projected prepayment speeds; severity assumptions; recovery lag assumptions; estimated default rates (determined on the basis of an analysis of collateral attributes, historical collateral performance, borrower profiles and other features relevant to the evaluation of collateral credit quality); house price depreciation/appreciation rates based on macroeconomic forecasts and recent trading activity. The yield used to discount the projected cash flows is determined by reviewing various attributes of the bond including collateral type, weighted average life, sensitivity to losses, vintage, and convexity, in conjunction with market data on comparable securities. Significant changes to any of these inputs could materially change the expected timing of cash flows within these securities which is a significant factor in determining the fair value of the securities.

Other Invested Assets

Other invested assets includes certain investments that are carried and measured at fair value on a recurring basis and non-recurring basis, as well as assets not carried at fair value. Within other invested assets, $73 million are carried at fair value on a recurring basis as of March 31, 2013. These assets primarily comprise certain short-term investments and fixed maturity securities classified as trading and are Level 2 in the fair value hierarchy. Also carried at fair value on a recurring basis are $1 million in notes classified as Level 3 in the fair value hierarchy. The fair value of these notes is determined by calculating the present value of the expected cash flows. The unobservable inputs used in the fair value measurement of the notes are discount rate, prepayment speed and default rate.

Within other invested assets, $6 million are carried at fair value on a non-recurring basis as of March 31, 2013. These assets are comprised of mortgage loans which are classified as Level 3 in the fair value hierarchy as there are significant unobservable inputs used in the valuation of such loans. The non-performing portion of these mortgage loans is valued using an average recovery rate. The performing loans are valued using management’s determination of future cash flows arising from these loans, discounted at the rate of return that would be required by a market participant. The unobservable inputs used in the fair value measurement of the mortgage loans are discount rate, recovery on delinquent loans, loss severity, prepayment speed and default rate.

Other Assets

Committed Capital Securities

The fair value of committed capital securities ("CCS"), which is recorded in “other assets” on the consolidated balance sheets, represents the difference between the present value of remaining expected put option premium payments under AGC’s CCS (the “AGC CCS Securities”) and AGM’s Committed Preferred Trust Securities (the “AGM CPS Securities”) agreements, and the estimated present value that the Company would hypothetically have to pay currently for a comparable security (see Note 15, Long Term Debt and Credit Facilities). The estimated current cost of the Company’s CCS depends on several factors, including broker-dealer quotes for the outstanding securities, the U.S. dollar forward swap curve, London Interbank Offered Rate ("LIBOR") curve projections and the term the securities are estimated to remain outstanding.

Supplemental Executive Retirement Plans

The Company classifies the fair value measurement of the assets of the Company's various supplemental executive retirement plans as either Level 1 or Level 2. The fair value of these assets is valued based on the observable published daily values of the underlying mutual fund included in the aforementioned plans (Level 1) or based upon the net asset value of the funds if a published daily value is not available (Level 2).

Financial Guaranty Contracts Accounted for as Credit Derivatives

The Company’s credit derivatives consist primarily of insured CDS contracts, and also include interest rate swaps that fall under derivative accounting standards requiring fair value accounting through the statement of operations. The Company does not enter into CDS with the intent to trade these contracts and the Company may not unilaterally terminate a CDS contract absent an event of default or termination event that entitles the Company to terminate; however, the Company has mutually agreed with various counterparties to terminate certain CDS transactions. Such terminations generally are completed for an amount that approximates the present value of future premiums, not at fair value.

The terms of the Company’s CDS contracts differ from more standardized credit derivative contracts sold by companies outside the financial guaranty industry. Management considers the non-standard terms of its credit derivative contracts in determining the fair value of these contracts. The non-standard terms include the absence of collateral support agreements or immediate settlement provisions. In addition, the Company employs relatively high attachment points and does not exit derivatives it sells or purchases for credit protection purposes, except under specific circumstances such as mutual agreements with counterparties to terminate certain CDS contracts.

Due to the lack of quoted prices for its instruments or for similar instruments, the Company determines the fair value of its credit derivative contracts primarily through modeling that uses various inputs to derive an estimate of the fair value of the Company’s contracts in principal markets. Observable inputs other than quoted market prices exist; however, these inputs reflect contracts that do not contain terms and conditions similar to the credit derivative contracts issued by the Company. Management does not believe there is an established market where financial guaranty insured credit derivatives are actively traded. The terms of the protection under an insured financial guaranty credit derivative do not, except for certain rare circumstances, allow the Company to exit its contracts. Management has determined that the exit market for the Company’s credit derivatives is a hypothetical one based on its entry market. Management has tracked the historical pricing of the Company’s deals to establish historical price points in the hypothetical market that are used in the fair value calculation. These contracts are classified as Level 3 in the fair value hierarchy since there is reliance on at least one unobservable input deemed significant to the valuation model, most importantly the Company’s estimate of the value of the non-standard terms and conditions of its credit derivative contracts and of the Company’s current credit standing.

The Company’s models and the related assumptions are continuously reevaluated by management and enhanced, as appropriate, based upon improvements in modeling techniques and availability of more timely and relevant market information.

The fair value of the Company’s credit derivative contracts represents the difference between the present value of remaining premiums the Company expects to receive or pay for the credit protection under the contract and the estimated present value of premiums that a financial guarantor of comparable credit-worthiness would hypothetically charge or pay the Company for the same protection. The fair value of the Company’s credit derivatives depends on a number of factors, including notional amount of the contract, expected term, credit spreads, changes in interest rates, the credit ratings of referenced entities, the Company’s own credit risk and remaining contractual cash flows. The expected remaining contractual cash flows are the most readily observable inputs since they are based on the CDS contractual terms. These cash flows include premiums to be received or paid under the terms of the contract. Credit spreads capture the effect of recovery rates and performance of underlying assets of these contracts, among other factors. If credit spreads of the underlying obligations change, the fair value of the related credit derivative changes. Market liquidity also affects valuations of the underlying obligations. Consistent with the previous several quarters, market conditions at March 31, 2013 were such that market prices of the Company’s CDS contracts were not available. Since market prices were not available, the Company used proprietary valuation models that used both unobservable and observable market data inputs as described under “Assumptions and Inputs” below. These models are primarily developed internally based on market conventions for similar transactions.

Valuation models include management estimates and current market information. Management is also required to make assumptions of how the fair value of credit derivative instruments is affected by current market conditions. Management considers factors such as current prices charged for similar agreements, when available, performance of underlying assets, life of the instrument, and the nature and extent of activity in the financial guaranty credit derivative marketplace. The assumptions that management uses to determine the fair value may change in the future due to market conditions. Due to the inherent uncertainties of the assumptions used in the valuation models to determine the fair value of these credit derivative products, actual experience may differ from the estimates reflected in the Company’s consolidated financial statements and the differences may be material.

Assumptions and Inputs

Listed below are various inputs and assumptions that are key to the establishment of the Company’s fair value for CDS contracts.


•	How gross spread is calculated.


•	The allocation of gross spread among:


◦	the profit the originator, usually an investment bank, realizes for putting the deal together and funding the transaction (“bank profit”);


◦	premiums paid to the Company for the Company’s credit protection provided (“net spread”); and


◦	the cost of CDS protection purchased by the originator to hedge their counterparty credit risk exposure to the Company (“hedge cost”).


•	The weighted average life which is based on expected remaining contractual cash flows and Debt Service schedules. .


•	The rates used to discount future expected premium cash flows.

The expected future premium cash flows for the Company’s credit derivatives were discounted at rates ranging from 0.24% to 3.00% at March 31, 2013 and 0.21% to 2.81% at December 31, 2012.

Gross spread is used to ultimately determine the net spread a comparable financial guarantor would charge the Company to transfer its risk at the reporting date. The Company obtains gross spreads on risks assumed from market data sources published by third parties (e.g. dealer spread tables for the collateral similar to assets within the Company’s transactions) as well as collateral-specific spreads provided by trustees or obtained from market sources. If observable market credit spreads are not available or reliable for the underlying reference obligations, then market indices are used that most closely resemble the underlying reference obligations, considering asset class, credit quality rating and maturity of the underlying reference obligations. These indices are adjusted to reflect the non-standard terms of the Company’s CDS contracts. Market sources determine credit spreads by reviewing new issuance pricing for specific asset classes and receiving price quotes from their trading desks for the specific asset in question. Management validates these quotes by cross-referencing quotes received from one market source against quotes received from another market source to ensure reasonableness. In addition, the Company compares the relative change in price quotes received from one quarter to another, with the relative change experienced by published market indices for a specific asset class. Collateral specific spreads obtained from third-party, independent market sources are un-published spread quotes from market participants or market traders who are not trustees. Management obtains this information as the result of direct communication with these sources as part of the valuation process.

With respect to CDS transactions for which there is an expected claim payment within the next twelve months, the allocation of gross spread reflects a higher allocation to the cost of credit rather than the bank profit component. In the current market, it is assumed that a bank would be willing to accept a lower profit on distressed transactions in order to remove these transactions from its financial statements.

The following spread hierarchy is utilized in determining which source of gross spread to use, with the rule being to use CDS spreads where available. If not available, CDS spreads are either interpolated or extrapolated based on similar transactions or market indices.


•	Actual collateral specific credit spreads (if up-to-date and reliable market-based spreads are available).


•	Deals priced or closed during a specific quarter within a specific asset class and specific rating.


•	Credit spreads interpolated based upon market indices.


•	Credit spreads provided by the counterparty of the CDS.


•	Credit spreads extrapolated based upon transactions of similar asset classes, similar ratings, and similar time to maturity.

Information by Credit Spread Type



	As of March 31, 2013		As of December 31, 2012
Based on actual collateral specific spreads	6	%	6	%
Based on market indices	88	%	88	%
Provided by the CDS counterparty	6	%	6	%
Total	100	%	100	%

Over time the data inputs can change as new sources become available or existing sources are discontinued or are no longer considered to be the most appropriate. It is the Company’s objective to move to higher levels on the hierarchy whenever possible, but it is sometimes necessary to move to lower priority inputs because of discontinued data sources or management’s assessment that the higher priority inputs are no longer considered to be representative of market spreads for a given type of collateral. This can happen, for example, if transaction volume changes such that a previously used spread index is no longer viewed as being reflective of current market levels.

The Company interpolates a curve based on the historical relationship between the premium the Company receives when a credit derivative is closed to the daily closing price of the market index related to the specific asset class and rating of the deal. This curve indicates expected credit spreads at each indicative level on the related market index. For transactions with unique terms or characteristics where no price quotes are available, management extrapolates credit spreads based on an alternative transaction for which the Company has received a spread quote from one of the first three sources within the Company’s spread hierarchy. This alternative transaction will be within the same asset class, have similar underlying assets, similar credit ratings, and similar time to maturity. The Company then calculates the percentage of relative spread change quarter over quarter for the alternative transaction. This percentage change is then applied to the historical credit spread of the transaction for which no price quote was received in order to calculate the transactions’ current spread. Counterparties determine credit spreads by reviewing new issuance pricing for specific asset classes and receiving price quotes from their trading desks for the specific asset in question. These quotes are validated by cross-referencing quotes received from one market source with those quotes received from another market source to ensure reasonableness.

The premium the Company receives is referred to as the “net spread.” The Company’s pricing model takes into account not only how credit spreads on risks that it assumes affect pricing, but also how the Company’s own credit spread affects the pricing of its deals. The Company’s own credit risk is factored into the determination of net spread based on the impact of changes in the quoted market price for credit protection bought on the Company, as reflected by quoted market prices on CDS referencing AGC or AGM. For credit spreads on the Company’s name the Company obtains the quoted price of CDS contracts traded on AGC and AGM from market data sources published by third parties. The cost to acquire CDS protection referencing AGC or AGM affects the amount of spread on CDS deals that the Company retains and, hence, their fair value. As the cost to acquire CDS protection referencing AGC or AGM increases, the amount of premium the Company retains on a deal generally decreases. As the cost to acquire CDS protection referencing AGC or AGM decreases, the amount of premium the Company retains on a deal generally increases. In the Company’s valuation model, the premium the Company captures is not permitted to go below the minimum rate that the Company would currently charge to assume similar risks. This assumption can have the effect of mitigating the amount of unrealized gains that are recognized on certain CDS contracts. Given the current market conditions and the Company’s own credit spreads, approximately 32%, as of March 31, 2013 and approximately 71% as of December 31, 2012 of our CDS contracts are fair valued using this minimum premium. The change period over period is driven by AGM's and AGC's credit spreads narrowing to levels not seen since 2008. As a result of this, the cost to hedge AGC's and AGM's names has declined significantly causing more transactions to price above previously established floor levels. The Company corroborates the assumptions in its fair value model, including the portion of exposure to AGC and AGM hedged by its counterparties, with independent third parties each reporting period. The current level of AGC’s and AGM’s own credit spread has resulted in the bank or deal originator hedging a significant portion of its exposure to AGC and AGM. This reduces the amount of contractual cash flows AGC and AGM can capture as premium for selling its protection.

The amount of premium a financial guaranty insurance market participant can demand is inversely related to the cost of credit protection on the insurance company as measured by market credit spreads assuming all other assumptions remain constant. This is because the buyers of credit protection typically hedge a portion of their risk to the financial guarantor, due to the fact that the Company’s contracts’ contractual terms typically do not require the posting of collateral by the guarantor. The widening of a financial guarantor’s own credit spread increases the cost to buy credit protection on the guarantor, thereby reducing the amount of premium the guarantor can capture out of the gross spread on the deal. The extent of the hedge depends on the types of instruments insured and the current market conditions.

A fair value resulting in a credit derivative asset on protection sold is the result of contractual cash inflows on in-force deals in excess of what a hypothetical financial guarantor could receive if it sold protection on the same risk as of the reporting date. If the Company were able to freely exchange these contracts (i.e., assuming its contracts did not contain proscriptions on transfer and there was a viable exchange market), it would be able to realize a gain representing the difference between the higher contractual premiums to which it is entitled and the current market premiums for a similar contract. The Company determines the fair value of its CDS contracts by applying the difference between the current net spread and the contractual net spread for the remaining duration of each contract to the notional value of its CDS contracts.

Example

Following is an example of how changes in gross spreads, the Company’s own credit spread and the cost to buy protection on the Company affect the amount of premium the Company can demand for its credit protection. The assumptions used in these examples are hypothetical amounts. Scenario 1 represents the market conditions in effect on the transaction date and Scenario 2 represents market conditions at a subsequent reporting date.



	Scenario 1			Scenario 2
	bps	% of Total		bps	% of Total
Original gross spread/cash bond price (in bps)	185			500
Bank profit (in bps)	115	62	%	50	10	%
Hedge cost (in bps)	30	16	%	440	88	%
The Company premium received per annum (in bps)	40	22	%	10	2	%

In Scenario 1, the gross spread is 185 basis points. The bank or deal originator captures 115 basis points of the original gross spread and hedges 10% of its exposure to AGC, when the CDS spread on AGC was 300 basis points (300 basis points × 10% = 30 basis points). Under this scenario the Company received premium of 40 basis points, or 22% of the gross spread.

In Scenario 2, the gross spread is 500 basis points. The bank or deal originator captures 50 basis points of the original gross spread and hedges 25% of its exposure to AGC, when the CDS spread on AGC was 1,760 basis points (1,760 basis points × 25% = 440 basis points). Under this scenario the Company would receive premium of 10 basis points, or 2% of the gross spread. Due to the increased cost to hedge AGC’s name, the amount of profit the bank would expect to receive, and the premium the Company would expect to receive decline significantly.

In this example, the contractual cash flows (the Company premium received per annum above) exceed the amount a market participant would require the Company to pay in today’s market to accept its obligations under the CDS contract, thus resulting in an asset. This credit derivative asset is equal to the difference in premium rates discounted at the corresponding LIBOR over the weighted average remaining life of the contract.

Strengths and Weaknesses of Model

The Company’s credit derivative valuation model, like any financial model, has certain strengths and weaknesses.

The primary strengths of the Company’s CDS modeling techniques are:


•	The model takes into account the transaction structure and the key drivers of market value. The transaction structure includes par insured, weighted average life, level of subordination and composition of collateral.


•	The model maximizes the use of market-driven inputs whenever they are available. The key inputs to the model are market-based spreads for the collateral, and the credit rating of referenced entities. These are viewed by the Company to be the key parameters that affect fair value of the transaction.


•	The model is a consistent approach to valuing positions. The Company has developed a hierarchy for market-based spread inputs that helps mitigate the degree of subjectivity during periods of high illiquidity.

The primary weaknesses of the Company’s CDS modeling techniques are:


•	There is no exit market or actual exit transactions. Therefore the Company’s exit market is a hypothetical one based on the Company’s entry market.


•	There is a very limited market in which to validate the reasonableness of the fair values developed by the Company’s model.


•	At March 31, 2013 and December 31, 2012, the markets for the inputs to the model were highly illiquid, which impacts their reliability.


•	Due to the non-standard terms under which the Company enters into derivative contracts, the fair value of its credit derivatives may not reflect the same prices observed in an actively traded market of credit derivatives that do not contain terms and conditions similar to those observed in the financial guaranty market.

As of March 31, 2013 these contracts were classified as Level 3 in the fair value hierarchy because there is a reliance on at least one unobservable input deemed significant to the valuation model, most significantly the Company's estimate of the value of non-standard terms and conditions of its credit derivative contracts and of amount of protection purchased on AGC or AGM's name.

Fair Value Option on FG VIEs’ Assets and Liabilities

The Company elected the fair value option for all the FG VIEs’ assets and liabilities. See Note 9, Consolidation of Variable Interest Entities.

The FG VIEs that are consolidated by the Company issued securities collateralized by HELOCs, first lien and second lien RMBS, subprime automobile loans, and other loans and receivables. The lowest level input that is significant to the fair value measurement of these assets and liabilities in its entirety was a Level 3 input (i.e. unobservable), therefore management classified them as Level 3 in the fair value hierarchy. Prices were generally determined with the assistance of an independent third-party. The pricing is based on a discounted cash flow approach and the third-party’s proprietary pricing models. The models to price the FG VIEs’ liabilities used, where appropriate, inputs such as estimated prepayment speeds; market values of the assets that collateralize the securities; estimated default rates (determined on the basis of an analysis of collateral attributes, historical collateral performance, borrower profiles and other features relevant to the evaluation of collateral credit quality); discount rates implied by market prices for similar securities; house price depreciation/appreciation rates based on macroeconomic forecasts and, for those liabilities insured by the Company, the benefit from the Company’s insurance policy guaranteeing the timely payment of principal and interest for the FG VIE tranches insured by the Company, taking into account the timing of the potential default and the Company’s own credit rating. These inputs are utilized to project the future cash flows of the security and to evaluate the overall bond profile. The third-party also utilizes an internal model to determine an appropriate yield at which to discount the cash flows of the security, by factoring in collateral types, weighted-average lives, and other structural attributes specific to the security being priced. The expected yield is further calibrated by utilizing algorithm’s designed to aggregate market color, received by the third-party, on comparable bonds.

Changes in fair value of the FG VIEs’ assets and liabilities are included in fair value gains (losses) on FG VIEs within the consolidated statement of operations. Except for net credit impairment that triggers a claim on the financial guaranty contract (i.e. net expected loss to be paid as described in Note 5), the unrealized fair value gains (losses) related to the consolidated FG VIEs will reverse to zero over the terms of these financial instruments.

The fair value of the Company’s FG VIE assets is sensitive to changes related to estimated prepayment speeds; estimated default rates (determined on the basis of an analysis of collateral attributes such as: historical collateral performance, borrower profiles and other features relevant to the evaluation of collateral credit quality); discount rates implied by market prices for similar securities; and house price depreciation/appreciation rates based on macroeconomic forecasts. Significant changes to some of these inputs could materially change the market value of the FG VIE’s assets and the implied collateral losses within the transaction. In general, the fair value of the FG VIE asset is most sensitive to changes in the projected collateral losses, where an increase in collateral losses typically leads to a decrease in the fair value of FG VIE assets, while a decrease in collateral losses typically leads to an increase in the fair value of FG VIE assets. These factors also directly impact the fair value of the Company’s FG VIE liabilities.

The fair value of the Company’s FG VIE liabilities is also sensitive to changes relating to estimated prepayment speeds; market values of the assets that collateralize the securities; estimated default rates (determined on the basis of an analysis of collateral attributes such as: historical collateral performance, borrower profiles and other features relevant to the evaluation of collateral credit quality); discount rates implied by market prices for similar securities; and house price depreciation/appreciation rates based on macroeconomic forecasts. In addition, the Company’s FG VIE liabilities with recourse are also sensitive to changes in the Company’s implied credit worthiness. Significant changes to any of these inputs could materially change the timing of expected losses within the insured transaction which is a significant factor in determining the implied benefit from the Company’s insurance policy guaranteeing the timely payment of principal and interest for the tranches of debt issued by the FG VIE that is insured by the Company. In general, extending the timing of expected loss payments by the Company into the future typically leads to a decrease in the value of the Company’s insurance and a decrease in the fair value of the Company’s FG VIE liabilities with recourse, while a shortening of the timing of expected loss payments by the Company typically leads to an increase in the value of the Company’s insurance and an increase in the fair value of the Company’s FG VIE liabilities with recourse.

Not Carried at Fair Value

Financial Guaranty Insurance Contracts

The fair value of the Company’s financial guaranty contracts accounted for as insurance was based on management’s estimate of what a similarly rated financial guaranty insurance company would demand to acquire the Company’s in-force book of financial guaranty insurance business. This amount was based on the pricing assumptions management has observed for portfolio transfers that have occurred in the financial guaranty market and included adjustments to the carrying value of unearned premium reserve for stressed losses, ceding commissions and return on capital. The significant inputs were not readily observable. The Company accordingly classified this fair value measurement as Level 3.

Long-Term Debt

The Company’s long-term debt, excluding notes payable, is valued by broker-dealers using third party independent pricing sources and standard market conventions. The market conventions utilize market quotations, market transactions for the Company’s comparable instruments, and to a lesser extent, similar instruments in the broader insurance industry. The fair value measurement was classified as Level 2 in the fair value hierarchy.

The fair value of the notes payable that are recorded within long-term debt was determined by calculating the present value of the expected cash flows. The Company determines discounted future cash flows using market driven discount rates and a variety of assumptions, including LIBOR curve projections, prepayment and default assumptions, and AGM CDS spreads. The fair value measurement was classified as Level 3 in the fair value hierarchy because there is a reliance on significant unobservable inputs to the valuation model, including the discount rates, prepayment and default assumptions, loss severity and recovery on delinquent loans.

Other Invested Assets

The fair value of the other invested assets, which primarily consist of assets acquired in refinancing transactions, was determined by calculating the present value of the expected cash flows. The Company uses a market approach to determine discounted future cash flows using market driven discount rates and a variety of assumptions, including prepayment and default assumptions. The fair value measurement was classified as Level 3 in the fair value hierarchy because there is a reliance on significant unobservable inputs to the valuation model, including the discount rates, prepayment and default assumptions, loss severity and recovery on delinquent loans.

Other Assets and Other Liabilities

The Company’s other assets and other liabilities consist predominantly of accrued interest, receivables for securities sold and payables for securities purchased, the carrying values of which approximate fair value.

Financial Instruments Carried at Fair Value

Amounts recorded at fair value in the Company’s financial statements are included in the tables below.

Fair Value Hierarchy of Financial Instruments Carried at Fair Value

As of March 31, 2013



			Fair Value Hierarchy
	Fair Value		Level 1		Level 2		Level 3
	(in millions)
Assets:
Investment portfolio, available-for-sale:
Fixed maturity securities
U.S. government and agencies	$	877	$	—	$	877	$	—
Obligations of state and political subdivisions	5,602		—		5,567		35
Corporate securities	1,040		—		1,040		—
Mortgage-backed securities:
RMBS	1,196		—		975		221
Commercial mortgage-backed securities ("CMBS")	505		—		505		—
Asset-backed securities	495		—		209		286
Foreign government securities	270		—		270		—
Total fixed maturity securities	9,985		—		9,443		542
Short-term investments	729		562		167		—
Other invested assets(1)	80		—		73		7
Credit derivative assets	125		—		—		125
FG VIEs’ assets, at fair value	2,813		—		—		2,813
Other assets(2)	58		27		5		26
Total assets carried at fair value	$	13,790	$	589	$	9,688	$	3,513
Liabilities:
Credit derivative liabilities	$	2,518	$	—	$	—	$	2,518
FG VIEs’ liabilities with recourse, at fair value	2,071		—		—		2,071
FG VIEs’ liabilities without recourse, at fair value	1,107		—		—		1,107
Total liabilities carried at fair value	$	5,696	$	—	$	—	$	5,696

Fair Value Hierarchy of Financial Instruments Carried at Fair Value

As of December 31, 2012



			Fair Value Hierarchy
	Fair Value		Level 1		Level 2		Level 3
	(in millions)
Assets:
Investment portfolio, available-for-sale:
Fixed maturity securities
U.S. government and agencies	$	794	$	—	$	794	$	—
Obligations of state and political subdivisions	5,631		—		5,596		35
Corporate securities	1,010		—		1,010		—
Mortgage-backed securities:
RMBS	1,266		—		1,047		219
CMBS	520		—		520		—
Asset-backed securities	531		—		225		306
Foreign government securities	304		—		304		—
Total fixed maturity securities (3)	10,056		—		9,496		560
Short-term investments	817		446		371		—
Other invested assets(1)	120		—		112		8
Credit derivative assets	141		—		—		141
FG VIEs’ assets, at fair value	2,688		—		—		2,688
Other assets(2)	65		24		5		36
Total assets carried at fair value	$	13,887	$	470	$	9,984	$	3,433
Liabilities:
Credit derivative liabilities	$	1,934	$	—	$	—	$	1,934
FG VIEs’ liabilities with recourse, at fair value	2,090		—		—		2,090
FG VIEs’ liabilities without recourse, at fair value	1,051		—		—		1,051
Total liabilities carried at fair value	$	5,075	$	—	$	—	$	5,075

____________________


(1)	Includes mortgage loans that are recorded at fair value on a non-recurring basis. At March 31, 2013 and December 31, 2012, such investments were carried at their market value of $6 million and $7 million, respectively.

(2) Includes fair value of CCS and supplemental executive retirement plan assets.

(3) See Note 10, Investments and Cash.

Changes in Level 3 Fair Value Measurements

The table below presents a roll forward of the Company’s Level 3 financial instruments carried at fair value on a recurring basis during First Quarter 2013 and 2012.

Fair Value Level 3 Rollforward

Recurring Basis

First Quarter 2013



	Fixed Maturity Securities
	Obligations of State and Political Subdivisions					RMBS					Asset- Backed Securities					Other Invested Assets		FG VIEs’ Assets at Fair Value					Other Assets					Credit Derivative Asset (Liability), net(5)					FG VIEs' Liabilities with Recourse, at Fair Value					FG VIEs’ Liabilities without Recourse, at Fair Value
	(in millions)
Fair value as of December 31, 2012	$	35				$	219				$	306				$	1	$	2,688				$	36				$	(1,793	)			$	(2,090	)			$	(1,051	)
Total pretax realized and unrealized gains/(losses) recorded in:(1)
Net income (loss)	1			(2	)	5			(2	)	4			(2	)	0		215			(3	)	(10		)	(4	)	(592		)	(6	)	(81		)	(3	)	(74		)	(3	)
Other comprehensive income (loss)	0					7					(22		)			0		—					—					—					—					—
Purchases	—					3					—					—		—					—					—					—					—
Settlements	(1		)			(11		)			(2		)			—		(138		)			—					(8		)			112					55
FG VIE consolidations	—					(2		)			—					—		48					—					—					(12		)			(37		)
Fair value as of March 31, 2013	$	35				$	221				$	286				$	1	$	2,813				$	26				$	(2,393	)			$	(2,071	)			$	(1,107	)
Change in unrealized gains/(losses) related to financial instruments held as of March 31, 2013	$	0				$	9				$	(22	)			$	0	$	199				$	(10	)			$	(611	)			$	(83	)			$	(94	)

Fair Value Level 3 Rollforward

Recurring Basis

First Quarter 2012



	Fixed Maturity Securities
	Obligations of state and political subdivisions			RMBS					Asset Backed Securities					Other Invested Assets		FG VIEs’ Assets at Fair Value					Other Assets					Credit Derivative Asset (Liability), net(5)					FG VIEs’ Liabilities with Recourse, at Fair Value					FG VIEs’ Liabilities without Recourse, at Fair Value
	(in millions)
Fair value as of December 31, 2011	$	10		$	134				$	235				$	2	$	2,819				$	54				$	(1,304	)			$	(2,397	)			(1,061	)
Total pretax realized and unrealized gains/(losses) recorded in:(1)
Net income (loss)	0			1			(2	)	6			(2	)	—		132			(3	)	(14		)	(4	)	(691		)	(6	)	(86		)	(3	)	(80	)	(3	)
Other comprehensive income (loss)	0			10					0					0		—					—					—					—					—
Purchases	—			—					18					—		—					—					—					—					—
Settlements	(1		)	(9		)			(1		)			—		(138		)			—					42					138					55
FG VIE consolidations	—			—					—					—		15					—					—					(20		)
Fair value as of March 31, 2012	$	9		$	136				$	258				$	2	$	2,828				$	40				$	(1,953	)			$	(2,365	)			(1,086	)
Change in unrealized gains/(losses) related to financial instruments held as of March 31, 2012	$	0		$	10				$	0				$	0	$	231				$	(14	)			$	(635	)			$	(107	)			(118	)

___________________


(1)	Realized and unrealized gains (losses) from changes in values of Level 3 financial instruments represent gains (losses) from changes in values of those financial instruments only for the periods in which the instruments were classified as Level 3.


(2)	Included in net realized investment gains (losses) and net investment income.


(3)	Included in fair value gains (losses) on FG VIEs.


(4)	Recorded in fair value gains (losses) on committed capital securities.


(5)	Represents net position of credit derivatives. The consolidated balance sheet presents gross assets and liabilities based on net counterparty exposure.


(6)	Reported in net change in fair value of credit derivatives.

Level 3 Fair Value Disclosures

Quantitative Information About Level 3 Fair Value Inputs

At March 31, 2013



Financial Instrument Description	Fair Value at March 31, 2013 (in millions)		Valuation Technique	Significant Unobservable Inputs	Range
Assets:
Fixed maturity securities:
Obligations of state and political subdivisions	$	35	Discounted	Rate of inflation	1.0		%	-	3.0%
			cash flow	Cash flow receipts	4.9		%	-	85.8%
				Yield	4.3		%		9.0%
				Collateral recovery period	1 month			-	43 years

RMBS	221		Discounted	CPR	0.8		%	-	7.5%
			cash flow	CDR	4.4		%	-	25.8%
				Severity	47.9		%	-	102.8%
				Yield	3.0		%	-	9.6%
Asset-backed securities:
Whole business securitization	63		Discounted cash flow	Annual gross revenue projections (in millions)		$54		-	$96
				Value of primary financial guaranty policy	43.8%
				Liquidity discount	5.0		%	-	20.0%

Investor owned utility	162		Discounted cash flow	Liquidation value (in millions)		$217		-	$242
				Years to liquidation	0 years			-	3 years
				Collateral recovery period	9 months			-	6 years
				Discount factor	15.3%

XXX life insurance transactions	61		Discounted	Yield	12.0%
XXX life insurance transactions	61		cash flow

Other invested assets	7		Discounted cash flow	Discount for lack of liquidity	10.0		%	-	20.0%
				Recovery on delinquent loans	20.0		%	-	60.0%
				Default rates	1.0		%	-	12.0%
				Loss severity	40.0		%	-	90.0%
				Prepayment speeds	6.0		%	-	15.0%

FG VIEs’ assets, at fair value	2,813		Discounted	CPR	0.4		%	-	11.0%
			cash flow	CDR	1.8		%	-	28.6%
				Loss severity	37.5		%	-	106.4%
				Yield	3.0		%	-	20.0%



Financial Instrument Description	Fair Value at March 31, 2013 (in millions)		Valuation Technique	Significant Unobservable Inputs	Range
Other assets	26		Discounted cash flow	Quotes from third party pricing	$51		-	$55
Other assets			Discounted cash flow	Term (years)	3 years

Liabilities:
Credit derivative liabilities, net	(2,393	)	Discounted	Year 1 loss estimates	0.0	%	-	68.0%
			cash flow	Hedge cost (in bps)	14.8		-	397.5
				Bank profit (in bps)	1.0		-	1,336.5
				Internal floor (in bps)	7.0		-	100.0
				Internal credit rating	AAA		-	BIG

FG VIEs’ liabilities, at fair value	(3,178	)	Discounted	CPR	0.4	%	-	11.0%
			cash flow	CDR	1.8	%	-	28.6%
				Loss severity	37.5	%	-	106.4%
				Yield	3.0	%	-	20.0%

Quantitative Information About Level 3 Fair Value Inputs

At December 31, 2012



Financial Instrument Description	Fair Value at December 31, 2012 (in millions)		Valuation Technique	Significant Unobservable Inputs	Range
Assets:
Fixed maturity securities:
Obligations of state and political subdivisions	$	35	Discounted	Rate of inflation	1.0		%	-	3.0%
			cash flow	Cash flow receipts	4.9		%	-	85.8%
				Discount rates	4.3		%		9.0%
				Collateral recovery period	1 month			-	43 years

RMBS	219		Discounted	CPR	0.8		%	-	7.5%
			cash flow	CDR	4.4		%	-	28.6%
				Severity	48.1		%	-	102.8%
				Yield	3.5		%	-	12.8%
Asset-backed securities:
Whole business securitization	63		Discounted cash flow	Annual gross revenue projections (in millions)		$54		-	$96
				Value of primary financial guaranty policy	43.8%
				Liquidity discount	5.0		%	-	20.0%

Investor owned utility	186		Discounted cash flow	Liquidation value (in millions)		$212		-	$242
				Years to liquidation	0 years			-	3 years
				Discount factor	15.3%

XXX life insurance transactions	57		Discounted	Yield	12.5%
XXX life insurance transactions	57		cash flow

Other invested assets	8		Discounted cash flow	Discount for lack of liquidity	10.0		%	-	20.0%
				Recovery on delinquent loans	20.0		%	-	60.0%
				Default rates	1.0		%	-	12.0%
				Loss severity	40.0		%	-	90.0%
				Prepayment speeds	6.0		%	-	15.0%

FG VIEs’ assets, at fair value	2,688		Discounted	CPR	0.5		%	-	10.9%
			cash flow	CDR	3.0		%	-	28.6%
				Loss severity	37.5		%	-	103.8%
				Yield	4.5		%	-	20.0%



Financial Instrument Description	Fair Value at December 31, 2012 (in millions)		Valuation Technique	Significant Unobservable Inputs	Range
Other assets	36		Discounted cash flow	Quotes from third party pricing	$38		-	$51
Other assets			Discounted cash flow	Term (years)	3 years

Liabilities:
Credit derivative liabilities, net	(1,793	)	Discounted	Year 1 loss estimates	0.0	%	-	58.7%
			cash flow	Hedge cost (in bps)	64.2		-	678.4
				Bank profit (in bps)	1.0		-	1,312.9
				Internal floor (in bps)	7.0		-	60.0
				Internal credit rating	AAA		-	BIG

FG VIEs’ liabilities, at fair value	(3,141	)	Discounted	CPR	0.5	%	-	10.9%
			cash flow	CDR	3.0	%	-	28.6%
				Loss severity	37.5	%	-	103.8%
				Yield	4.5	%	-	20.0%

The carrying amount and estimated fair value of the Company’s financial instruments are presented in the following table.

Fair Value of Financial Instruments



	As of March 31, 2013				As of December 31, 2012
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
	(in millions)
Assets:
Fixed maturity securities	$	9,985	$	9,985	$	10,056	$	10,056
Short-term investments	729		729		817		817
Other invested assets	119		122		177		182
Credit derivative assets	125		125		141		141
FG VIEs’ assets, at fair value	2,813		2,813		2,688		2,688
Other assets	210		210		166		166
Liabilities:
Financial guaranty insurance contracts(1)	3,591		5,955		3,918		6,537
Long-term debt	832		1,131		836		1,091
Credit derivative liabilities	2,518		2,518		1,934		1,934
FG VIEs’ liabilities with recourse, at fair value	2,071		2,071		2,090		2,090
FG VIEs’ liabilities without recourse, at fair value	1,107		1,107		1,051		1,051
Other liabilities	88		88		47		47

____________________


(1)	Carrying amount includes the assets and liabilities related to financial guaranty insurance contract premiums, losses, and salvage and subrogation and other recoverables net of reinsurance.