Contracts Accounted for as Credit Derivatives

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

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

Accounting Policy

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

Credit Derivative Net Par Outstanding by Sector

The components of the Company’s credit derivative net par outstanding are presented in the table below. The increase in credit derivative net par outstanding from year-end 2017 was a result of the June 1, 2018 SGI Transaction discussed in Note 2, Assumption of Insured Portfolio and Business Combinations. As part of that transaction, the Company reinsured SGI's insurance of credit derivatives within its portfolio, primarily infrastructure finance and regulated utility transactions, with a net par of $1.5 billion and a credit derivative liability of $68 million. The credit derivatives assumed from SGI have no expected losses. The estimated remaining weighted average life of credit derivatives was 11.6 years at December 31, 2018 and 11.7 years at December 31, 2017.

Credit Derivatives (1)



	As of December 31, 2018					As of December 31, 2017
Asset Type	Net Par Outstanding		Net Fair Value			Net Par Outstanding		Net Fair Value
	(in millions)
Pooled infrastructure	$	1,373	$	(34	)	$	1,561	$	(42	)
Infrastructure finance	1,300		(63		)	572		(36		)
Regulated utilities	1,096		(11		)	548		(10		)
Pooled corporate obligations (TruPS collateralized debt obligations (CDOs))	642		(28		)	878		(72		)
U.S. RMBS	641		(31		)	916		(53		)
Other (2)	1,130		(40		)	1,732		(56		)
Total	$	6,182	$	(207	)	$	6,207	$	(269	)

____________________

(1) Expected recoveries were $2 million as of December 31, 2018 and $14 million as of December 31, 2017.


(2)	This represents numerous transactions across various asset classes, such as health care revenue, municipal utilities and and consumer receivables.

Distribution of Credit Derivative Net Par Outstanding by Internal Rating



	As of December 31, 2018				As of December 31, 2017
Ratings	Net Par Outstanding		% of Total		Net Par Outstanding		% of Total
	(dollars in millions)
AAA	$	1,813	29.4	%	$	2,144	34.6	%
AA	1,690		27.3		1,170		18.8
A	1,171		18.9		1,517		24.5
BBB	1,351		21.9		1,038		16.7
BIG (1)	157		2.5		338		5.4
Credit derivative net par outstanding	$	6,182	100.0	%	$	6,207	100.0	%

____________________


(1)	BIG relates to U.S. RMBS exposures as of December 31, 2018 and both, U.S. RMBS and TruPS CDOs as of December 31, 2017.

Fair Value of Credit Derivatives

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



	Year Ended December 31,
	2018			2017			2016
	(in millions)
Realized gains on credit derivatives	$	9		$	17		$	56
Net credit derivative losses (paid and payable) recovered and recoverable and other settlements	(25		)	(27		)	(27		)
Realized gains (losses) and other settlements	(16		)	(10		)	29
Net unrealized gains (losses)	128			121			69
Net change in fair value of credit derivatives	$	112		$	111		$	98

During 2018, unrealized fair value gains were primarily generated by CDS terminations, run-off of CDS par and price improvements on the underlying collateral of the Company’s CDS. In addition, unrealized fair value gains were generated by the increase in credit given to the primary insurer on one of the Company's second-to-pay CDS policies during the period. The unrealized fair value gains were partially offset by unrealized fair value losses resulting from wider implied net spreads driven by the decreased cost to buy protection in AGC’s and AGM’s name, as the market cost of AGC’s and AGM’s credit protection decreased during the period. For those CDS transactions that were pricing at or above their floor levels, when the cost of purchasing CDS protection on AGC and AGM, which management refers to as the CDS spread on AGC and AGM, decreased the implied spreads that the Company would expect to receive on these transactions increased.

During 2017 and 2016, unrealized fair value gains were primarily generated by CDS terminations, run-off of net par outstanding, and price improvements on the underlying collateral of the Company’s CDS. The majority of the CDS transactions that were terminated were as a result of settlement agreements with several CDS counterparties. In 2016, the unrealized fair value gains were partially offset by unrealized losses resulting from wider implied net spreads. The wider implied net spreads were primarily a result of the decreased cost to buy protection in AGC’s and AGM’s name, as the market cost of AGC’s and AGM’s credit protection decreased significantly during the period. During 2017, the cost to buy protection in AGC’s and AGM’s name, specifically the five-year CDS spread, did not change materially during the period, and therefore did not have a material impact on the Company’s unrealized fair value gains and losses on CDS.

The following table summarizes the effects of terminations and settlements of credit derivative contracts.

Terminations and Settlements

of Direct Credit Derivative Contracts



	Year Ended December 31,
	2018		2017			2016
	(in millions)
Net par of terminated credit derivative contracts	$	601	$	331		$	3,811
Realized gains (losses) and other settlements	1		(15		)	20
Net unrealized gains (losses) on credit derivatives	5		26			103

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

CDS Spread on AGC and AGM

Quoted price of CDS contract (in bps)



	As of December 31, 2018	As of December 31, 2017	As of December 31, 2016
Five-year CDS spread:
AGC	110	163	158
AGM	116	145	158

One-year CDS spread
AGC	22	70	35
AGM	24	28	29

Fair Value of Credit Derivative Assets (Liabilities)

and Effect of AGC and AGM

Credit Spreads



	As of December 31, 2018			As of December 31, 2017
	(in millions)
Fair value of credit derivatives before effect of AGC and AGM credit spreads	$	(407	)	$	(555	)
Plus: Effect of AGC and AGM credit spreads	200			286
Net fair value of credit derivatives	$	(207	)	$	(269	)

The fair value of CDS contracts at December 31, 2018, before considering the implications of AGC’s and AGM’s credit spreads, is a direct result of continued wide credit spreads in the fixed income security markets and ratings downgrades. Offsetting the benefit attributable to AGC’s and AGM’s credit spread were higher credit spreads in the fixed income security markets. The higher credit spreads in the fixed income security market are due to the lack of liquidity in the TruPS CDO, pooled infrastructure, and infrastructure finance markets as well as continuing market concerns over the 2005-2007 vintages of RMBS.

Collateral Posting for Certain Credit Derivative Contracts

The transaction documentation with one counterparty for $250 million of CDS par insured by AGC requires AGC to post collateral, subject to a $250 million cap, to secure its obligation to make payments under such contracts. Eligible collateral is generally cash or U.S. government or agency securities; eligible collateral other than cash is valued at a discount to the face amount. The table below summarizes AGC’s CDS collateral posting requirements as of December 31, 2018 and December 31, 2017.

AGC Insured CDS Collateral Posting Requirements



	As of December 31, 2018		As of December 31, 2017
	(in millions)
Gross par of CDS with collateral posting requirement	$	250	$	497
Maximum posting requirement	250		464
Collateral posted	1		18

In the first quarter of 2018, the Company terminated all of the CDS contracts with a counterparty as to which it had collateral posting obligations, and the collateral that the Company had been posting to that counterparty was all returned to the Company. The Company still has collateral posting obligations with respect to one counterparty.