Income Taxes

The components of our consolidated income tax provision (benefit) are as follows:



	Year Ended December 31
(In thousands)	2011		2010			2009
Current	$	59,604	$	(155,219	)	$	(39,057	)
Deferred	6,758		381,408			(55,344		)
Total income tax provision (benefit)	$	66,362	$	226,189		$	(94,401	)

The reconciliation of taxes computed at the statutory tax rate of 35% for 2011, 2010 and 2009 to the provision (benefit) for income taxes is as follows:



	Year Ended December 31
(In thousands)	2011			2010			2009
Provision (benefit) for income taxes computed at the statutory tax rate	$	128,979		$	(552,887	)	$	(84,798	)
Change in tax resulting from:
Tax-exempt municipal bond interest and dividends received deduction (net of proration)	(5,237		)	(15,592		)	(31,539		)
Foreign tax benefit	(13,496		)	(10,397		)	(4,766		)
State tax benefit	(6,224		)	(15,692		)	(7,353		)
Unrecognized tax benefits	17,860			(25,915		)	28,192
Valuation allowance	(50,582		)	844,975			6,882
Other, net	(4,938		)	1,697			(1,019		)
Provision (benefit) for income taxes	$	66,362		$	226,189		$	(94,401	)

The significant components of our net deferred tax assets and liabilities are summarized as follows:



	December 31
(In thousands)	2011		2010
Deferred tax assets:
Accrued expenses	$	41,011	$	39,295
Unearned premiums	14,327		21,926
Premium deficiency reserves	1,275		3,758
Net operating loss	666,407		738,032
Differences in fair value of derivative and other financial instruments	—		347,772
Net unrealized loss on investments	—		15,016
Rescission premium	20,015		15,227
State net operating loss carryforward	31,825		24,499
Foreign tax credit carryforward	26,884		26,661
Depreciation	5,037		2,227
Partnership investments	64,544		—
Other	57,127		53,811
Total deferred tax assets	928,452		1,288,224
Deferred tax liabilities:
Deferred policy acquisition costs	48,969		51,916
Partnership investments	—		277,422
Convertible debt	32,091		35,164
Differences in fair value of derivative and other financial instruments	3,591		—
Net unrealized gain on investments	4,191		—
Loss reserves	9,744		9,592
Foreign currency	22		11,375
Other	16,169		23,367
Total deferred tax liabilities	114,777		408,836
Valuation allowance	797,700		851,857
Net deferred tax asset	$	15,975	$	27,531

As of December 31, 2011, we recorded a net current income tax payable of approximately $137.8 million, which primarily consists of liabilities related to applying the standards of accounting for uncertainty in income taxes and a current federal income tax recoverable of approximately $5.8 million. For federal income tax purposes, we have approximately $1.9 billion of NOL carryforwards and $26.9 million of foreign tax credit carryforwards as of December 31, 2011. To the extent not utilized, the NOL carryforwards will expire during tax years 2028 through 2030 and the foreign tax credit carryforwards will expire during tax years 2018 through 2021. Certain entities within our consolidated group have also generated approximately $31.8 million of state and local NOL carryforwards, which if unutilized, will expire during various future tax periods. During 2011, we recognized approximately $728.0 million of estimated cancellation of indebtedness taxable income resulting from our partnership interest in C-BASS, which filed for Subchapter 11 bankruptcy protection on November 12, 2010, and was formerly liquidated pursuant to the Plan of Liquidation that was confirmed on April 25, 2011. Such cancellation of indebtedness income was fully offset by our current inventory of NOLs.

For the quarter ended September 30, 2010, we determined that it was more likely than not that all of our DTA, except for approximately $10.4 million, would be realized. This determination was made after weighing both negative and positive evidence including the pre-tax profit realized for the quarter ended September 30, 2010. For the quarter ended December 31, 2010, we incurred a pre-tax loss, which was significantly higher than our projected loss. As a result of this loss, which solidified our cumulative position, coupled with expectations of an operating loss in 2011 and ongoing economic uncertainty, we concluded that our ability to rely on our projections for future taxable income, and the positive weight afforded those projections, had been severely diminished. In light of these factors, we concluded that as of December 31, 2010, an additional valuation allowance of $841.5 million was required, for a total valuation allowance of approximately $851.9 million against our total net DTA of $879.4 million. At December 31, 2011, a valuation allowance of approximately $797.7 million was recorded against our net DTA of approximately $813.7 million. The remaining DTA of approximately $16.0 million, against which we have not recorded a valuation allowance, represents our NOL carryback, which we believe may be utilized against the proposed adjustments to our taxable income by the IRS for taxable years 2000 through 2007, as described in more detail below. For the year ended December 31, 2011, our valuation allowance decreased by approximately $54.2 million, of which approximately $3.6 million of the decrease was included in other comprehensive income.

Our ability to fully use our tax assets such as NOLs and tax credit carryforwards would be substantially limited if we experience an “ownership change” within the meaning of Section 382 of the Internal Revenue Code of 1986, as amended(“IRC”). Section 382 rules governing when a change in ownership occurs are complex and subject to interpretation; however, in general, an ownership change would occur if our five percent shareholders, as defined under Section 382, collectively increase their ownership by more than 50 percentage points over a rolling three-year period. As of December 31, 2011, we have not experienced an ownership change under Section 382. However, if we were to experience a change in ownership under Section 382 in a future period, then we may be limited in our ability to fully utilize our NOL and tax credit carryforwards in future periods.

On October 8, 2009, our board of directors adopted a Tax Benefit Preservation Plan, which, as amended, was approved by our stockholders at the 2010 annual meeting. We also adopted certain amendments to our amended and restated bylaws and our stockholders approved at the 2010 annual meeting certain amendments to our amended and restated certificate of incorporation. The plan, the bylaw amendment and the charter amendment were implemented in order to protect our ability to utilize our NOLs and other tax assets and prevent an “ownership change” under U.S. federal income tax rules. These provisions restrict or discourage certain transfers of our common stock that would (i) create or result in a person becoming a five-percent shareholder under Section 382 of the IRC or (ii) increase the stock ownership of any existing five-percent shareholder under Section 382 of the IRC.

We are currently contesting proposed adjustments resulting from the examination by the IRS for the 2000 through 2007 tax years. The IRS opposes the recognition of certain tax losses and deductions that were generated through our investment in a portfolio of residual interests in REMICs and has proposed adjustments denying the associated tax benefits of these items. The proposed adjustments relating to the 2000 through 2007 tax years, if sustained, will increase our tax liability for those years by approximately $128 million, in addition to any associated penalties and interest. We appealed these proposed adjustments to the IRS Office of Appeals (“Appeals”) and made “qualified deposits” with the U.S. Department of the Treasury to avoid the accrual of above-market-rate interest with respect to the proposed adjustments in the amount of approximately $85 million relating to the 2000 through 2004 tax years, and approximately $4 million relating to the 2005 through 2007 tax years. In late December 2010, we reached a tentative settlement agreement with Appeals. However, because we had claimed a refund of approximately $105 million with respect to our 2006 and 2007 taxable years based on a carryback of a net operating loss generated from our 2008 taxable year, review of the tentative settlement agreement by the Joint Committee on Taxation ("JCT") was required. Based on its review, the JCT has indicated that it is opposed to the currently structured settlement agreement and has recommended that Appeals reconsider the settlement agreement. Following the JCT review, Appeals has now indicated that it is reconsidering the terms of our settlement.

We are currently attempting to address the concerns regarding the proposed settlement that have been raised by Appeals and the JCT, but there is a substantial risk that we may not be able to settle the proposed adjustments with the IRS or, alternatively, that the terms of any final settlement will be significantly less favorable to us than the currently proposed settlement. Additionally, we would be required to litigate the proposed adjustments to our taxable income, if we are unable to reach any settlement, in order to avoid a full concession of the proposed tax liabilities, penalties, and interest to the IRS. If we determine that we cannot reach a settlement with the IRS and determine that our interests may be better served through litigation of the proposed adjustments, then we may incur substantial legal expenses and the litigation process may be lengthy. Based on the indication that Appeals will reconsider the proposed settlement agreement, we remeasured our tax provision and liabilities associated with these proposed IRS adjustments during the fourth quarter of 2011. After discussions with outside counsel about the issues raised in the examination and the issues surrounding the reconsideration of our settlement agreement, we believe that an adequate provision for income taxes has been made for potential liabilities that may result. However, if the final settlement agreement differs materially from our current expectations or we are unable to enter into a final settlement agreement and decide to pursue litigation of the proposed adjustments, there could be a material impact on our effective tax rate, results of operations and cash flows.

As of December 31, 2011, we have approximately $61.9 million of unrecognized tax benefits that, if recognized, would affect the effective tax rate. Our policy for the recognition of interest and penalties associated with uncertain tax positions is to record such items as a component of our income tax provision. The table below details the cumulative effect of applying the provisions of the standard relating to accounting for uncertainty of income taxes as of December 31, 2011.

The effect of unrecognized tax benefits on our consolidated balance sheets and results of operations is as follows:



(In thousands)	December 31, 2010		Increase		December 31, 2011
Unrecognized tax benefits	$	92,845	$	32,912	$	125,757
Unrecognized tax benefits that, if recognized, would affect the effective tax rate	$	44,040	$	17,861	$	61,901
Interest and penalties accrued	$	31,169	$	22,673	$	53,842
Interest and penalties charged to income tax expense					$	22,673

A reconciliation of the beginning and ending unrecognized tax benefits is as follows:



	Year Ended December 31
(In thousands)	2011			2010
Balance at beginning of period	$	92,845		$	143,391
Tax positions related to the current year:
Increases	1,268			2,313
Decreases	(2,005		)	—
Tax positions related to prior years:
Increases	51,480			47,020
Decreases	(17,831		)	(54,874		)
Changes in judgment	—			(5,331		)
Lapses of applicable statute of limitation	—			(39,674		)
Balance at end of period	$	125,757		$	92,845

We have taken a position in various jurisdictions that we are not required to remit taxes with regard to the income generated from our investment in certain partnership interests. Although we believe that these tax positions are more likely than not to succeed if adjudicated in a court of last resort, measurement under this standard of the potential amount of liability for state and local taxes and the potential for penalty and interest thereon is performed on a quarterly basis. Our net unrecognized tax benefits related to prior years increased approximately $33.6 million. This net increase primarily reflects the remeasurement of the tentative settlement agreement that we reached with Appeals in December 2010, and which we recently received notification that Appeals is currently reconsidering at the recommendation of the JCT. Over the next 12 months, if we are able to reach a settlement agreement with the IRS on the proposed adjustments relating to our 2000 through 2007 taxable years, then we estimate a reduction in our unrecognized tax benefits of approximately $62.4 million. In the event we are not successful in our defense of the tax positions taken for U.S. Federal income tax purposes, and for which we have recorded unrecognized tax benefits, then such adjustments originating in NOL or NOL carryback years may serve as a reduction to our existing NOL.

The following calendar tax years, listed by major jurisdiction, remain subject to examination:



U.S. Federal Corporation Income Tax	2000 - 2010(1)
Significant State and Local Jurisdictions (2)	1999 - 2010

_________________________

(1)

We are currently contesting proposed adjustments resulting from the examination by the IRS for the 2000 through 2007 tax years. As part of this process, we have agreed to extend all relevant statute of limitations for the assessment of tax to December 31, 2012. All such statute of limitation extensions have limited the scope of the examinations to the recognition of certain tax benefits that were generated through our investment in a portfolio of residual interests in REMICs.


(2)	Arizona, California, Florida, Georgia, New York, Ohio, Pennsylvania, Texas and New York City.