6. Losses and Loss Expense Reserve

A loss reserve is recorded on the balance sheet on a policy-by-policy basis for the excess of: (a) the present value of expected net cash flows required to be paid under an insurance contract, over (b) the UPR for that contract. Below is the loss reserve roll-forward, net of subrogation recoverable and reinsurance for the nine months ended September 30, 2012 and the year ended December 31, 2011:


	Nine months Ended September 30, 2012			Year Ended December 31, 2011
Beginning balance of net loss reserves, net of subrogation recoverable and reinsurance	$	6,230,780		$	4,424,450
Changes in the loss reserves due to:
Current year:
Establishment of new loss reserves, gross of subrogation and net of reinsurance		239,294			503,697
Claim payments, net of subrogation and reinsurance		(11,508	)		(2,442	)
Establishment of subrogation recoveries, net of reinsurance		—			(9,761	)

Total current year		227,786			491,494
Prior year:
Change in previously established loss reserves, gross of subrogation and net of reinsurance		487,037			1,683,831
Claim payments, net of subrogation and reinsurance		(607,593	)		(179,440	)
Change in previously established subrogation recoveries, net of reinsurance		15,861			(324,151	)

Total prior year		(104,695	)		1,180,240
Changes in loss reserves		123,091			1,671,734
Net deconsolidation of certain VIEs		—			134,596

Ending loss reserves, net of subrogation recoverable and reinsurance	$	6,353,871		$	6,230,780

The adverse development in loss reserves established in prior years for the year ended December 31, 2011 was primarily due to the continued deterioration of collateral supporting structured finance policies, including RMBS and student loan exposures which resulted in greater expected ultimate losses, partially offset by higher expected subrogation recoveries related to representation and warranty breaches on insured RMBS securitizations.

The net change in loss and loss expense reserves, net of reinsurance, of $123,091 and $1,671,734 for the nine month period and year ended September 30, 2012 and December 31, 2011, respectively, are included in loss and loss expenses in the Consolidated Statements of Total Comprehensive Income.

Loss expense reserves, net of reinsurance, were $138,023 and $86,171 at September 30, 2012 and December 31, 2011. Such reserves are established for surveillance, legal and other mitigation expenses associated with adversely classified credits. Total loss and loss expenses of $(18,745) and $(60,238) for the three month periods ended September 30, 2012 and 2011, respectively, and $720,346 and $1,055,807 for the nine month periods ended September 30, 2012 and 2011, respectively, are included in the Consolidated Statements of Total Comprehensive Income. During the three and nine month periods ended September 30, 2012 and 2011, respectively, reinsurance recoveries of losses included in loss and loss expenses in the Consolidated Statements of Total Comprehensive Income were $5,502 and $1,892, respectively, and $27,354 and $26,634, respectively. The tables below summarize information related to policies currently included in Ambac’s loss reserves at September 30, 2012 and December 31, 2011:

Surveillance Categories (at September 30, 2012)


	I/SL			IA			II			III			IV			V			Total
Number of policies		26			9			26			99			151			1			312
Remaining weighted-average contract period (in years)		22			9			17			21			8			10			13
Gross insured contractual payments outstanding:
Principal		838,780			156,012			1,236,062			9,498,608			13,155,955			47			24,885,464
Interest		737,308			85,878			379,866			5,209,411			2,950,986			20			9,363,469

Total		1,576,088			241,890			1,615,928			14,708,019			16,106,941			67			34,248,933

Gross undiscounted claim liability		38,038			4,381			49,164			4,180,640			8,338,457			69			12,610,749
Discount, gross claim liability		(3,302	)		(189	)		(2,907	)		(1,351,849	)		(716,506	)		(17	)		(2,074,770	)

Gross claim liability before all subrogation and before reinsurance		34,736			4,192			46,257			2,828,791			7,621,951			52			10,535,979

Less:
Gross RMBS subrogation⁽¹⁾		—			—			—			(19,404	)		(2,698,190	)		—			(2,717,594	)
Discount, RMBS subrogation		—			—			—			356			28,371			—			28,727

Discounted RMBS subrogation, before reinsurance		—			—			—			(19,048	)		(2,669,819	)		—			(2,688,867	)

Less:
Gross other subrogation⁽²⁾		—			(19	)		—			(121,271	)		(723,612	)		—			(844,902	)
Discount, other subrogation		—			5			—			14,285			12,302			—			26,592

Discounted other subrogation, before reinsurance		—			(14	)		—			(106,986	)		(711,310	)		—			(818,310	)

Gross claim liability, net of all subrogation and discounts, before reinsurance		34,736			4,178			46,257			2,702,757			4,240,822			52			7,028,802

Less: Unearned premium reserves		(20,196	)		(1,801	)		(16,707	)		(473,814	)		(135,884	)		—			(648,402	)
Plus: Loss adjustment expenses reserves		—			—			—			—			139,740			—			139,740

Claim liability reported on Balance Sheet, before reinsurance⁽³⁾		14,540			2,377			29,550			2,228,943			4,244,678			52			6,520,140

Reinsurance recoverable reported on Balance Sheet		1,077			—			8,413			145,556			17,393			—			172,439

(1)	RMBS subrogation represents Ambac’s estimate of subrogation recoveries from RMBS transaction sponsors for representations and warranty breaches.

(2)	Other subrogation represents subrogation other than subrogation as defined in (1) above.

(3)	Claim liability reported is included in the Consolidated Balance Sheets as follows:


Loss and loss expense reserve (net of potential remediation subrogation of $1,903,348)	$	7,034,224
Subrogation recoverable (includes gross potential remediation of $785,519)		(514,084	)

	$	6,520,140

Loss reserves ceded to reinsurers at September 30, 2012 and December 31, 2011 were $166,269 and $153,480, respectively. Amounts were included in reinsurance recoverable on the Consolidated Balance Sheet.

Surveillance Categories (at December 31, 2011)


	I/SL			IA			II			III			IV			V			Total
Number of policies		27			10			38			125			129			1			330
Remaining weighted-average contract period (in years)		18			10			17			19			9			6			13
Gross insured contractual payments outstanding:
Principal	$	2,222,493		$	354,713		$	2,060,102		$	13,342,814		$	13,092,057		$	47		$	31,072,226
Interest		1,069,538			100,448			1,088,036			8,117,496			3,587,812			29			13,963,359

Total	$	3,292,031		$	455,161		$	3,148,138		$	21,460,310		$	16,679,869		$	76		$	45,035,585

Gross undiscounted claim liability	$	48,573		$	10,667		$	52,355		$	4,766,815		$	7,632,709		$	75		$	12,511,194
Discount, gross claim liability		(4,208	)		(2,316	)		(3,800	)		(1,440,704	)		(828,061	)		(20	)		(2,279,109	)

Gross claim liability before all subrogation and before reinsurance	$	44,365		$	8,351		$	48,555		$	3,326,111		$	6,804,648		$	55		$	10,232,085

Less:
Gross RMBS subrogation⁽¹⁾		—			—			—			(461,725	)		(2,316,920	)		—			(2,778,645	)
Discount, RMBS subrogation		—			—			—			12,278			46,101			—			58,379

Discounted RMBS subrogation, before reinsurance		—			—			—			(449,447	)		(2,270,819	)		—			(2,720,266	)

Less:
Gross other subrogation⁽²⁾		—			(256	)		—			(52,871	)		(667,744	)		—			(720,871	)
Discount, other subrogation		—			77			—			6,550			45,912			—			52,539

Discounted other subrogation, before reinsurance		—			(179	)		—			(46,321	)		(621,832	)		—			(668,332	)

Gross claim liability, net of all subrogation and discounts, before reinsurance		44,365			8,172			48,555			2,830,343			3,911,997			55			6,843,487

Less: Unearned premium reserves		(25,264	)		(5,126	)		(22,111	)		(335,332	)		(158,687	)		—			(546,520	)
Plus: Loss adjustment expenses reserves		—			—			—			—			87,294			—			87,294

Claim liability reported on Balance Sheet, before reinsurance⁽³⁾		19,101			3,046			26,444			2,495,011			3,840,603			55			6,384,260

Reinsurance recoverable reported on Balance Sheet		1,117			9			5,714			139,499			13,563			—			159,902

(1)	RMBS subrogation represents Ambac’s estimate of subrogation recoveries from RMBS transaction sponsors for representations and warranty breaches.

(2)	Other subrogation represents subrogation other than subrogation as defined in (1) above.

(3)	Claim liability reported is included in the Consolidated Balance Sheets as follows:


Loss and loss expense reserve (net of potential remediation subrogation of $1,890,797)	$	7,044,070
Subrogation recoverable (includes gross potential remediation of $829,469)		(659,810	)

	$	6,384,260

Ambac records estimated subrogation recoveries for breaches of representations and warranties by sponsors of certain RMBS transactions utilizing an Adverse and Random Sample approach. Ambac has updated its estimated subrogation recoveries to $2,688,867 ($2,660,930 net of reinsurance) at September 30, 2012 from $2,720,266 ($2,692,414 net of reinsurance) at December 31, 2011. The balance of subrogation recoveries and the related claim liabilities, by estimation approach, at September 30, 2012 and December 31, 2011, are as follows:


	September 30, 2012
Approach	Count⁽²⁾		Gross claim liability before subrogation recoveries		Subrogation recoveries⁽¹⁾			Gross claim liability after subrogation recoveries
Adverse samples		28	$	2,734,471	$	(1,508,150	)	$	1,226,321
Random samples		16		1,157,305		(1,180,717	)		(23,412	)

Totals		44	$	3,891,776	$	(2,688,867	)	$	1,202,909


	December 31, 2011
Approach	Count⁽²⁾		Gross claim liability before subrogation recoveries		Subrogation recoveries⁽¹⁾			Gross claim liability after subrogation recoveries
Adverse samples		30	$	2,637,479	$	(1,457,472	)	$	1,180,007
Random samples		16		1,140,102		(1,262,794	)		(122,692	)

Totals		46	$	3,777,581	$	(2,720,266	)	$	1,057,315

(1)

The amount of recorded subrogation recoveries related to each securitization is limited to ever-to-date paid losses plus the present value of projected future paid losses for each policy. To the extent significant losses have been paid but not yet recovered, the recorded amount of subrogation recoveries may exceed the expected future claims for a given policy. The net cash inflow for these policies is recorded as a “Subrogation recoverable” asset. For those transactions where the subrogation recovery is less than expected future claims, the net cash outflow for these policies is recorded as a “Loss and loss expense reserve” liability. Of the $2,688,867 of subrogation recoveries recorded at September 30, 2012, $785,519 was included in “Subrogation recoverable” and $1,903,348 was included in “Loss and loss expense reserves.” Of the $2,720,266 of subrogation recoveries recorded at December 31, 2011, $829,469 was included in “Subrogation recoverable” and $1,890,797 was included in “Loss and loss expense reserves.”

(2)

The sponsor’s repurchase obligation may differ depending on the terms of the particular transaction and the status of the specific loan, such as whether it is performing or has been liquidated or charged off. The estimated subrogation recovery for these transactions is based primarily on loan level data provided through trustee reports received in the normal course of our surveillance activities or provided by the sponsor. While this data may not include all the components of the sponsor’s contractual repurchase obligation we believe it is the best information available to estimate the subrogation recovery.

Below is the rollforward of RMBS subrogation, by estimation approach, for the period December 31, 2011 through September 30, 2012:


	Random sample			Number of transactions		Adverse sample		Number of transactions			Total
Rollforward:
Discounted RMBS subrogation (gross of reinsurance) at December 31, 2011	$	1,262,794			16	$	1,457,472		30		$	2,720,266

Additional transactions reviewed		—			n/a		—		n/a			—
Additional adverse sample loans reviewed		—			n/a		—		n/a			—
Adverse loans repurchased by the sponsor		—			n/a		35		n/a			35
All other changes⁽¹⁾		(82,077	)		n/a		50,643		(2	)		(31,434	)

Discounted RMBS subrogation (gross of reinsurance) at September 30, 2012	$	1,180,717			16	$	1,508,150		28		$	2,688,867

(1)

Other changes which may impact subrogation recoveries include changes in actual or projected collateral performance and/or the projected timing of recoveries. For the nine months ended September 30, 2012, two transactions were removed from the Adverse Sample subrogation population; however, the impacts on RMBS subrogation disclosed in the Adverse Sample column relate to multiple transactions.