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Loss And Loss Adjustment Expense Reserves | 9 Months Ended
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Sep. 30, 2012
Loss And Loss Adjustment Expense Reserves | Note 5: Loss and Loss Adjustment Expense Reserves Loss and Loss Adjustment Expense Process As of September 30, 2012, the majority of the Company’s case basis reserves and insurance loss recoveries recorded in accordance with GAAP were related to insured second-lien and first-lien RMBS transactions. These reserves and recoveries do not include estimates for policies insuring credit derivatives. Policies insuring credit derivative contracts are accounted for as derivatives and carried at fair value under GAAP. The fair values of insured derivative contracts are influenced by a variety of market and transaction-specific factors that may be unrelated to potential future claim payments under the Company’s insurance policies. In the absence of credit impairments on insured derivative contracts or the early termination of such contracts at a loss, the cumulative unrealized losses recorded from fair valuing these contracts should reverse before or at the maturity of the contracts. Notwithstanding the difference in accounting under GAAP for financial guarantee policies and the Company’s insured derivatives, insured derivatives have similar terms, conditions, risks, and economic profiles to financial guarantee insurance policies, and, therefore, are evaluated by the Company for loss (referred to as credit impairment herein) and LAE periodically in a manner similar to the way that loss and LAE reserves are estimated for financial guarantee insurance policies. Credit impairments represent actual payments and collections plus the present value of estimated expected future claim payments, net of recoveries. MBIA Insurance Corporation’s expected future claim payments for insured derivatives were discounted using a rate of 5.59%, the same rate it used to calculate its statutory loss reserves as of September 30, 2012. These credit impairments, calculated in accordance with U.S. STAT, differ from the fair values recorded in the Company’s consolidated financial statements. The Company considers its credit impairment estimates as critical information for investors as it provides information about loss payments the Company expects to make on insured derivative contracts. As a result, the following loss and LAE process discussion includes information about loss and LAE activity recorded in accordance with GAAP for financial guarantee insurance policies and credit impairments estimated in accordance with U.S. STAT for insured derivative contracts. Refer to “Note 6: Loss and Loss Adjustment Expense Reserves” in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 for information about the Company’s monitoring of outstanding insured obligations and for additional information about its loss reserving process. Refer to “Note 6: Fair Value of Financial Instruments” included herein for additional information about the Company’s insured credit derivative contracts. RMBS Case Basis Reserves and Recoveries (Financial Guarantees) The Company’s RMBS reserves and recoveries relate to financial guarantee insurance policies. The Company calculated RMBS case basis reserves as of September 30, 2012 for both second-lien and first-lien RMBS transactions using a process called the “Roll Rate Methodology.” The Roll Rate Methodology is a multi-step process using a database of loan level information, a proprietary internal cash flow model, and a commercially available model to estimate expected ultimate cumulative losses on insured bonds. “Roll Rate” is defined as the probability that current loans become delinquent and that loans in the delinquent pipeline are charged-off or liquidated. Generally, Roll Rates are calculated for the previous three months and averaged. The loss reserve estimates are based on a probability-weighted average of three scenarios of loan losses (base case, stress case, and an additional stress case). In calculating ultimate cumulative losses for RMBS, the Company estimates the amount of loans that are expected to be charged-off (deemed uncollectible by servicers of the transactions) or liquidated in the future. The Company assumes that charged-off loans have zero recovery values. Second-lien RMBS Reserves The Company’s second-lien RMBS case basis reserves as of September 30, 2012 relate to RMBS backed by home equity lines of credit (“HELOC”) and closed-end second mortgages (“CES”). The Roll Rates for 30-59 day delinquent loans and 60-89 day delinquent loans are calculated on a transaction-specific basis. The Company assumes that the Roll Rate for 90+ day delinquent loans, excluding foreclosures, Real Estate Owned (“REO”) and bankruptcies, is 95%. The Roll Rates are applied to the amounts in the respective delinquency buckets based on delinquencies as of August 31, 2012 to estimate future losses from loans that are delinquent as of the current reporting period. Roll Rates for loans that are current as of August 31, 2012 (“Current Roll to Loss”) are calculated on a transaction-specific basis. A proportion of loans reported current as of August 31, 2012 is assumed to become delinquent every month, at a Current Roll to Loss rate that persists at a high level for a time and subsequently starts to decline. A key assumption in the model is the period of time in which the Company projects high levels of Current Roll to Loss to persist. In the Company’s base case, the Company assumes that the Current Roll to Loss begins to decline immediately and continues to decline over the next six months to 25% of their levels as of August 31, 2012. In the stress case, the period of elevated delinquency and loss is extended by six months. In the additional stress case, the Company assumes that the current trends in losses will remain through late 2013, after which time they will revert to the base case. For example, in the base case, as of August 31, 2012, if the amount of current loans which become 30-59 days delinquent is 10%, and recent performance suggests that 30% of those loans will be charged-off, the Current Roll to Loss for the transaction is 3%. In the base case, it is then assumed that the Current Roll to Loss will reduce linearly to 25% of its original value over the next six months (i.e., 3% will linearly reduce to 0.75% over the six months from September 2012 to February 2013). After that six-month period, the Company further reduces the Current Roll to Loss to 0% by early 2014 with the expectation that the performing seasoned loans will eventually result in loan performance reverting to historically low levels of default. In the model, the Company assumes that all current loans that are projected to become delinquent are charged-off. In addition, in the Company’s loss reserve models for transactions secured by HELOCs, the Company considers borrower draw and prepayment rates and factors that could affect the excess spread generated by current loans which offsets losses and reduces payments. For HELOCs, the current three-month average draw rate is generally used to project future draws on the line. For HELOCs and transactions secured by fixed-rate CES, the three-month average conditional prepayment rate is generally used to start the projection for trends in voluntary principal prepayments. Projected cash flows are also based on an assumed constant basis spread between floating rate assets and floating rate insured debt obligations (the difference between Prime and London Interbank Offered Rate (“LIBOR”) interest rates, minus any applicable fees). For all transactions, cash flow models consider allocations and other structural aspects of the transactions, including managed amortization periods, rapid amortization periods and claims against MBIA Corp.’s insurance policy consistent with such policy’s terms and conditions. In developing multiple loss scenarios, stress is applied by elongating the Current Roll to Loss rate for various periods, simulating a slower improvement in the transaction performance. The estimated net claims from the procedure above are then discounted using a risk-free rate to a net present value reflecting MBIA’s general obligation to pay claims over time and not on an accelerated basis. The above assumptions represent MBIA’s best estimates of how transactions will perform over time. The Company monitors portfolio performance on a monthly basis against projected performance, reviewing delinquencies, Roll Rates, and prepayment rates (including voluntary and involuntary). However, given the large percentage of mortgage loans that were not underwritten by the sellers/servicers in accordance with applicable underwriting guidelines, performance remains difficult to predict and losses may exceed expectations. In the event of a material deviation in actual performance from projected performance, the Company would increase or decrease the case basis reserves accordingly. If actual performance were to remain at the peak levels the Company is modeling for six months longer than in the probability-weighted outcome, the addition to the Company’s second-lien RMBS case basis reserves before considering potential recoveries would be approximately $125 million. Second-lien RMBS Recoveries As of September 30, 2012, the Company recorded estimated recoveries of $3.2 billion, gross of income taxes, related to second-lien RMBS put-back claims on ineligible mortgage loans, consisting of $2.1 billion included in “Insurance loss recoverable” and $1.1 billion included in “Loan repurchase commitments” presented under the heading “Assets of consolidated variable interest entities” on the Company’s consolidated balance sheets. As of September 30, 2012 and December 31, 2011, the Company’s estimated recoveries after income taxes calculated at the federal statutory rate of 35%, were $2.1 billion and $2.0 billion, respectively, which was 82% and 119% of the consolidated total shareholders’ equity of MBIA, excluding preferred stock of subsidiaries and noncontrolling interests. These estimated recoveries relate to the Company’s put-back claims of ineligible mortgage loans, which have been disputed by the loan sellers/servicers and are currently subject to litigation initiated by the Company to pursue recoveries. While the Company believes that it will prevail in enforcing its contractual rights, there is uncertainty with respect to the ultimate outcome. Furthermore, there is a risk that sellers/servicers or other responsible parties might not be able to satisfy their put-back obligations. Such risks are contemplated in the scenarios the Company utilizes to calculate recoveries. The Company assesses the financial abilities of the sellers/servicers using external credit ratings and other factors. The impact of such factors on cash flows related to expected recoveries is incorporated into the Company’s probability-weighted scenarios. Accordingly, the Company has not recognized any recoveries related to its IndyMac Bank, F.S.B. insured exposures and has subsequent to the ResCap bankruptcy filing reviewed the indicative scenarios and related probabilities assigned to each scenario to develop a distribution of possible outcomes. The Company’s expected recoveries may be discounted in the future based on additional reviews of the creditworthiness of other sellers/servicers. On May 14, 2012, ResCap, and its wholly-owned subsidiary companies, RFC and GMAC, each filed for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code. The Company believes that the claims against RFC and GMAC are stronger and better defined than most other unsecured creditor claims due to the following reasons:
| • |  | the direct contractual relationship between MBIA, GMAC and RFC related to the Company’s second-lien RMBS put-back claims on ineligible mortgage loans that were improperly included in the MBIA-insured transactions;
| • |  | MBIA’s legal claims against RFC and GMAC based on breach of contract and fraud have withstood motions to dismiss; and
| • |  | expert reports submitted in the RFC litigation which established a substantial breach rate in MBIA insured securitizations, and MBIA’s damages as a result thereof.
The Company has modeled scenario-based recoveries which are founded upon the strength of these claims as well as a range of estimated assets available to unsecured creditors of the ResCap companies. These outcomes are based upon information that was available to the Company as of the filing date. The Company continues to maintain the same probability-weighted scenarios for its non-GMAC and non-RFC exposures (non-ResCap exposures), which are primarily based on the percentage of incurred losses the Company would collect. The non-ResCap recovery estimates incorporate five scenarios that include full recovery of its incurred losses and limited/reduced recoveries due to litigation delays and risks and/or potential financial distress of the sellers/servicers. Probabilities were assigned across these scenarios, with most of the probability weight on partial recovery scenarios. The sum of the probabilities assigned to all scenarios is 100%. Expected cash inflows from recoveries are discounted using the current risk-free discount rates associated with the underlying transaction’s cash flows, which ranged from 0.7% to 1.6%, depending upon the transaction’s expected average life. However, based on the Company’s assessment of the strength of its contract claims, the Company believes it is entitled to collect and/or assert a claim for the full amount of its incurred losses on these transactions, which totaled $5.0 billion through September 30, 2012. The Company’s potential recoveries are typically based on either salvage rights, the rights conferred to MBIA through the transactional documents (inclusive of the insurance agreement), or subrogation rights embedded within financial guarantee insurance policies. The second-lien RMBS transactions with respect to which MBIA has estimated put-back recoveries provide the Company with such rights. Expected salvage and subrogation recoveries, as well as recoveries from other remediation efforts, reduce the Company’s claim liability. Once a claim payment has been made, the claim liability has been satisfied and MBIA’s right to recovery is no longer considered an offset to future expected claim payments, and is recorded as a salvage asset. The amount of recoveries recorded by the Company is limited to paid claims plus the present value of projected future claim payments. As claim payments are made, the recorded amount of potential recoveries may exceed the remaining amount of the claim liability for a given policy. To date, sellers/servicers have not substituted loans which MBIA has put-back, and the amount of loans repurchased has been insignificant. The unsatisfactory resolution of these put-backs led MBIA to initiate litigation against five of the sellers/servicers to enforce their obligations. The Company has alleged several causes of action in its complaints, including breach of contract, fraudulent inducement and indemnification. MBIA’s aggregate $3.2 billion of estimated potential recoveries do not include damages from causes of action other than breach of contract. Irrespective of amounts recorded in its financial statements, MBIA is seeking to recover and/or assert claims for the full amount of its incurred losses and other damages on these transactions. MBIA has not collected any material amounts of cash related to these recoveries. Additional information on the status of these litigations can be found in the “Recovery Litigation” discussion within “Note 13: Commitments and Contingencies.” MBIA has received five decisions with regard to the respective defendants’ motions to dismiss the Company’s claims. In each instance, the respective court denied the motion, allowing MBIA to proceed on, at minimum, its fraud and breach of contract claims. In December 2011, MBIA reached an agreement with one of the five sellers/servicers with whom it had initiated litigation and that litigation has been dismissed. The Company’s assessment of the recovery outlook for insured second-lien RMBS issues is principally based on the following factors:
| 1. | the strength of the Company’s existing contract claims related to ineligible mortgage loan substitution/repurchase obligations;
| 2. | the settlement of Assured Guaranty’s and Syncora’s put-back related claims with Bank of America;
| 3. | the improvement in the financial strength of certain sellers/servicers due to mergers and acquisitions and/or government assistance, which should facilitate the ability of these sellers/servicers and their successors to comply with required loan repurchase/substitution obligations. The Company is not aware of any provisions that explicitly preclude or limit successors’ obligations to honor the obligations of original sellers/servicers. The Company’s assessment of any credit risk associated with sellers/servicers (or their successors) is reflected in the Company’s probability-weighted potential recovery scenarios;
| 4. | evidence of ineligible mortgage loan repurchase/substitution by sellers/servicers for put-back requests made by other harmed parties; this factor is further enhanced by (i) Bank of America’s disclosure that it has resolved $8.0 billion of repurchase requests in the fourth quarter of 2010; (ii) the Fannie Mae settlements with Ally Bank announced on December 23, 2010 and with Bank of America (which also involved Freddie Mac) announced on December 31, 2010, and (iii) the Company’s settlement agreements entered into on July 16, 2010 and December 13, 2011 respectively, between MBIA Corp. and sponsors of certain MBIA Corp.-insured mortgage loan securitizations in which the Company received consideration in exchange for a release relating to its representation and warranty claims against the sponsors. These settlements resolved all of MBIA’s representation and warranty claims against the sponsors on mutually beneficial terms and in aggregate were slightly more than the recoveries previously recorded by the Company related to these exposures;
| 5. | the defendants’ failure to win dismissals of MBIA’s put-back litigations discussed above, allowing MBIA to continue to pursue its contract and fraud claims;
| 6. | Countrywide’s unsuccessful appeal of its failure to win dismissal of MBIA’s fraud claims in the Countrywide litigation, allowing MBIA to pursue its fraud claims;
| 7. | MBIA’s successful motion in the Countrywide litigation allowing MBIA to present evidence of liability and damages through the introduction of statistically valid random samples of loans rather than on a loan-by-loan basis and subsequent decisions consistent with that ruling;
| 8. | Bank of America’s failure to win dismissal of MBIA’s claims for successor liability in the Countrywide litigation, as well as the completion of discovery relating to MBIA’s successor liability claims against Bank of America;
| 9. | MBIA’s successful motion regarding causation and the right to rescissory damages in the Countrywide litigation, which provides that MBIA is not required to establish a direct causal link between Countrywide’s misrepresentations and MBIA’s claims payments made pursuant to the insurance policies at issue, and that MBIA may seek damages equal to the amount that it has been and will be required to pay under the relevant policies, less premiums received;
| 10. | Syncora’s and Assured Guaranty’s successful motions regarding causation in their Federal court put-back litigations with JP Morgan Chase and Flagstar Bank, respectively, which support the ruling on causation in MBIA’s litigation against Countrywide; and
| 11. | other loan repurchase reserves and/or settlements which have been publicly disclosed by certain sellers/servicers.
The Company continues to consider all relevant facts and circumstances, including the factors described above, in developing its assumptions on expected cash inflows, probability of potential recoveries (including the outcome of litigation) and recovery period. The estimated amount and likelihood of potential recoveries are expected to be revised and supplemented to the extent there are developments in the pending litigation, new litigation is initiated and/or changes to the financial condition of sellers/servicers occur. While the Company believes it will be successful in realizing recoveries from contractual and other claims, the ultimate amounts recovered may be materially different from those recorded by the Company given the inherent uncertainty of the manner of resolving the claims (e.g., litigation) and the assumptions used in the required estimation process for accounting purposes which are based, in part, on judgments and other information that are not easily corroborated by historical data or other relevant benchmarks. All of the Company’s policies insuring second-lien RMBS for which litigation has been initiated against sellers/servicers are in the form of financial guarantee insurance contracts. In accordance with U.S. GAAP, the Company has not recorded a gain contingency with respect to pending litigation. First-lien RMBS Reserves The Company’s first-lien RMBS case basis reserves as of September 30, 2012, which primarily relate to RMBS backed by alternative A-paper (“Alt-A”) and subprime mortgage loans were determined using the Roll Rate Methodology. The Company assumes that the Roll Rate for loans in foreclosure, REO and bankruptcy are 90%, 90% and 75%, respectively. Roll Rates for current, 30-59 day delinquent loans, 60-89 day delinquent loans and 90+ day delinquent loans are calculated on a transaction-specific basis. The Current Roll to Loss stay at the August 31, 2012 level for two months before declining to 25% of this level over a 24-month period. Additionally, the Company runs scenarios where the 90+ day roll rate to loss is set at 90%. The Roll Rates are applied to the amounts in the respective delinquency buckets based on delinquencies as of August 31, 2012 to estimate future losses from loans that are delinquent as of the current reporting period. In calculating ultimate cumulative losses for first-lien RMBS, the Company estimates the amount of loans that are expected to be liquidated through foreclosure or short sale. The time to liquidation for a defaulted loan is specific to the loan’s delinquency bucket with the latest three-month average loss severities generally used to calculate losses at loan liquidation. The loss severities are reduced over time to account for reduction in the amount of foreclosure inventory, anticipated future increases in home prices, principal amortization of the loan and government foreclosure moratoriums. ABS CDOs (Financial Guarantees and Insured Derivatives) MBIA’s insured ABS CDOs are transactions that include a variety of collateral ranging from corporate bonds to structured finance assets (which includes but are not limited to RMBS related collateral, ABS CDOs, corporate CDOs and collateralized loan obligations). These transactions were insured as either financial guarantee insurance policies or credit derivatives with the majority insured in the form of credit derivatives. Since the fourth quarter of 2007, MBIA’s insured par exposure within the ABS CDO portfolio has been substantially reduced through a combination of terminations and commutations. Accordingly, as of September 30, 2012, the insured par exposure of the ABS CDO financial guarantee insurance policies and credit derivatives portfolio has declined by approximately 88% of the insured amount as of December 31, 2007. The Company’s ABS CDOs originally benefited from two sources of credit enhancement. First, the subordination in the underlying securities collateralizing the transaction must be fully eroded and second, the subordination below the insured tranche in the CDO transaction must be fully eroded before the insured tranche is subject to a claim. The Company’s payment obligations after a default vary by transaction and by insurance type. The primary factor in estimating reserves on insured ABS CDO policies written as financial guarantee insurance policies and in estimating impairments on insured ABS CDO credit derivatives is the losses associated with the underlying collateral in the transactions. MBIA’s approach to establishing reserves or impairments in this portfolio employs a methodology which is similar to other structured finance asset classes insured by MBIA. The Company uses a total of four probability-weighted scenarios in order to estimate its reserves or impairments for ABS CDOs. As of September 30, 2012, the Company had loss and LAE reserves totaling $171 million related to ABS CDO financial guarantee insurance policies after the elimination of $242 million as a result of consolidating VIEs. For the nine months ended September 30, 2012, the Company incurred $6 million of losses and LAE recorded in earnings related to ABS CDO financial guarantee insurance policies after the elimination of an $18 million benefit as a result of consolidating VIEs. In the event of further deteriorating performance of the collateral referenced or held in ABS CDO transactions, the amount of losses estimated by the Company could increase materially. Credit Impairments Related to Structured CMBS Pools, CRE CDOs and CRE Loan Pools (Financial Guarantees and Insured Derivatives) Most of the structured CMBS pools, CRE CDOs and CRE loan pools insured by MBIA are accounted for as insured credit derivatives and are carried at fair value in the Company’s consolidated financial statements. Since the Company’s insured credit derivatives have similar terms, conditions, risks, and economic profiles to its financial guarantee insurance policies, the Company evaluates them for impairment in the same way that it estimates loss and LAE for its financial guarantee policies. The following discussion provides information about the Company’s process for estimating credit impairments on these contracts using its statutory loss reserve methodology, determined as the present value of the probability-weighted potential future losses, net of estimated recoveries, across multiple scenarios, plus actual payments and collections. The Company has developed multiple scenarios to consider the range of potential outcomes in the CRE market and their impact on MBIA. The approaches require substantial judgments about the future performance of the underlying loans, and include the following:
| • |  | The first approach considers the range of commutation agreements achieved and agreed to since 2010, which included 66 structured CMBS pools, CRE CDOs and CRE loan pool policies totaling $33.1 billion of gross insured exposure. The Company considers the range of commutations achieved over the past several years with multiple counterparties. This approach results in an estimated price to commute the remaining policies with price estimates, based on this experience. It is customized by counterparty and is dependent on the level of dialogue with the counterparty and the credit quality and payment profile of the underlying exposure.
| • |  | The second approach considers current delinquency rates and uses current and projected net operating income (“NOI”) and capitalization rates (“Cap Rates”) to project losses under two scenarios. Loans are stratified by size with larger loans being valued utilizing lower Cap Rates than for smaller loans. These scenarios also assume that Cap Rates and NOIs remain flat for the near term and then begin to improve gradually. Additionally, in these scenarios, any loan with a balance greater than $75 million with a debt service coverage ratio (“DSCR”) less than 1.0x or that was reported as being in any stage of delinquency, was reviewed individually so that performance and loss severity could be more accurately determined. Specific loan level assumptions for this large loan subset were then incorporated into these scenarios, as well as specific assumptions regarding certain smaller loans when there appeared to be a material change in the asset’s financial or delinquency performance over the preceding six months. As the Company continues to increase the level of granularity in its individual loan assessments, it analyzes and adjusts assumptions for loans with certain mitigating attributes, such as no lifetime delinquency, recent appraisals indicating sufficient value and large capital reserve levels. These scenarios project different levels of additional defaults with respect to loans that are current. This approach makes use of the most recent financial statements available at the property level.
| • |  | The third approach stratifies loans into buckets based on delinquency status (including a “current” bucket) and utilizes recent Roll Rates actually experienced within each of the commercial mortgage-backed index (“CMBX”) series in order to formulate an assumption to predict future delinquencies. Ultimately, this generates losses over a projected time horizon based on the assumption that loss severities will begin to decline from the high levels seen over the past two years. The Company further examines those loans referenced in the CMBX indices which were categorized as 90+ days delinquent or in the process of foreclosure and determined the average monthly balance of such loans which were cured. The Company then applies the most recent rolling six-month average balance of all such cured loans to all underperforming loans in the 90+ day delinquent bucket or in the foreclosure process (and those projected to roll into late stage delinquency from the current and lesser stage levels of delinquency) and assumes all other loans are liquidated. The Company assumes all loans in the REO category liquidate over the next twelve months.
| • |  | The fourth approach is based on a proprietary model developed by reviewing performance data on over 80,000 securitized CRE loans originated between 1992 and 2011. The time period covered during the performance review includes the years 2006 through 2011. The Company believes that these five years represent an appropriate time period in which to conduct a performance review because they encompass a period of extreme stress in the economy and the CRE market.
Based on a review of the data, the Company found property type and the DSCR to be the most significant determinants of a loan’s default probability, with other credit characteristics less influential. As a result, the Company developed a model in which the loans were divided into 168 representative cohorts based on their DSCR and property type. For each of these cohorts, the Company calculated the average annual probability of default, and then ran Monte Carlo simulations to estimate the timing of defaults. In addition, the model incorporated the following logic:
| • |  | NOI and Cap Rates were assumed to remain at current levels for loans in the Company’s classified portfolio, resulting in no modifications or extensions under the model, other than as described in the next bullet point, to reflect the possibility that the U.S. economy and CRE market could experience no growth for the foreseeable future.
| • |  | Any valuation estimates obtained by special servicers since a loan’s origination as well as the Company’s individual large loan level analysis for loans with balances greater than $75 million were incorporated as described in the second approach. However, in the fourth approach no adjustments were made for loans lower than $75 million regardless of any mitigating factors.
The loss severities projected by these scenarios vary widely, from moderate to substantial losses, with the majority of projected losses relating to a subset of transactions with a single counterparty. The Company previously incorporated an additional actuarial based approach, which has been eliminated as it did not reflect the best current market observations. Actual losses will be a function of the proportion of loans in the pools that are foreclosed and liquidated and the loss severities associated with those liquidations. If the deductibles in the Company’s insured transactions and underlying referenced CMBS transactions are fully eroded, additional property level losses upon foreclosures and liquidations could result in substantial losses for MBIA. Since foreclosures and liquidations have only begun to take place during this economic cycle, particularly for larger properties, ultimate loss rates remain uncertain. Whether CMBS collateral is included in a structured pool or in a CRE CDO, the Company believes the modeling related to the underlying bond should be the same. However, adjustments may be needed for structural or legal reasons. The Company assigns a wide range of probabilities to these scenarios, with lower severity scenarios being weighted more heavily than higher severity scenarios. This reflects the view that liquidations will continue to be mitigated by loan extensions and modifications, and that property values and NOIs have bottomed for many sectors and markets in the U.S. The weightings are customized to each counterparty. If macroeconomic stress were to increase or the U.S. goes into a recession, higher delinquencies, liquidations and/or higher severities of loss upon liquidation may result and the Company may incur substantial additional losses. The foreclosure and REO pipelines are still relatively robust, with several restructurings and liquidations yet to occur, so the range of possible outcomes is wider than those for the Company’s exposures to ABS CDOs and second-lien RMBS. In the CRE CDO portfolio, transaction-specific structures require managers to report reduced enhancement according to certain guidelines which often include downgrades even when the bond is still performing. As a result, as well as additional collateral defaults, reported enhancement has been reduced significantly in some CRE CDOs. Moreover, many of the CRE CDO positions are amortizing more quickly than originally expected as most or all interest proceeds that would have been allocated to more junior classes within the CDO have been diverted and redirected to pay down the senior most classes insured by MBIA. For the nine months ended September 30, 2012, the Company incurred $87 million of losses and LAE recorded in earnings related to CRE CDO financial guarantee insurance policies. For the nine months ended September 30, 2012, additional credit impairments and LAE on structured CMBS pools, CRE CDOs and CRE loan pools were estimated to be $502 million as a result of additional delinquencies and loan level liquidations, as well as continued refinements of MBIA’s assessment of various commutation possibilities. The majority of the increase relates to a subset of transactions with a single counterparty. The cumulative credit impairments and LAE on structured CMBS pools, CRE CDOs and CRE loan pools were estimated to be $3.3 billion through September 30, 2012. Although the pace of increases in the delinquency rate has slowed and many loans are being modified, liquidations have taken place. Some loans were liquidated with minimal losses of 1% to 2%, others experienced near complete losses, and in some cases severities exceeded 100%. These liquidations have led to losses in the CMBS market, and in many cases, have resulted in reductions of enhancement to the individual CMBS bonds referenced by the insured structured CMBS pools. In certain insured transactions, these losses have resulted in deductible erosion. Bond level enhancement and pool level deductibles are structural features intended to mitigate losses to the Company. However, some of the transactions reference similar rated subordinate tranches of CMBS bonds. When there are broad-based declines in property performance, this leverage can result in rapid deterioration in pool performance. Loss and LAE Activity Financial Guarantee Insurance Losses (Non-Derivative) The Company’s financial guarantee insurance losses and LAE for the nine months ended September 30, 2012 are presented in the following table:
Losses and LAE |
|  | Nine Months Ended September 30, 2012 |
In millions |  | Second-lien RMBS |  |  | Other(1) |  |  | Total |
Losses and LAE related to actual and expected payments |  | $ | 180 |  |  | $ | 273 |  |  | $ | 453 |
Recoveries of actual and expected payments |  |  | (74) |  |  |  | (49) |  |  |  | (123) |
Gross losses incurred |  |  | 106 |  |  |  | 224 |  |  |  | 330 |
Reinsurance |  |  | - |  |  |  | - |  |  |  | - |
Losses and LAE |  | $ | 106 |  |  | $ | 224 |  |  | $ | 330 |
(1) - Primarily first-lien RMBS and financial guarantee CMBS. The second-lien RMBS losses and LAE related to actual and expected payments included in the preceding table comprise net increases of previously established reserves. The second-lien RMBS recoveries of actual and expected payments comprise $154 million in recoveries resulting from ineligible mortgage loans included in insured exposures that are subject to contractual obligations by sellers/servicers to repurchase or replace such mortgages, offset by an $80 million reduction in excess spread. Other losses and LAE expense primarily resulted from credit deterioration within first-lien RMBS and CMBS transactions. The following table provides information about the financial guarantees and related claim liability included in each of MBIA’s surveillance categories as of September 30, 2012:
|  | Surveillance Categories |
$ in millions |  | Caution List Low |  |  | Caution List Medium |  |  | Caution List High |  |  | Classified List |  |  | Total |
Number of policies |  |  | 49 |  |  |  | 24 |  |  |  | 11 |  |  |  | 209 |  |  |  | 293 |
Number of issues(1) |  |  | 27 |  |  |  | 14 |  |  |  | 10 |  |  |  | 137 |  |  |  | 188 |
Remaining weighted average contract period (in years) |  |  | 8.7 |  |  |  | 4.6 |  |  |  | 7.8 |  |  |  | 9.4 |  |  |  | 8.7 |
Gross insured contractual payments outstanding(2): |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Principal |  | $ | 3,747 |  |  | $ | 1,409 |  |  | $ | 360 |  |  | $ | 9,671 |  |  | $ | 15,187 |
Interest |  |  | 2,690 |  |  |  | 334 |  |  |  | 115 |  |  |  | 5,387 |  |  |  | 8,526 |
Total |  | $ | 6,437 |  |  | $ | 1,743 |  |  | $ | 475 |  |  | $ | 15,058 |  |  | $ | 23,713 |
Gross claim liability |  | $ | - |  |  | $ | - |  |  | $ | - |  |  | $ | 1,670 |  |  | $ | 1,670 |
Less: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Gross potential recoveries |  |  | - |  |  |  | - |  |  |  | - |  |  |  | 3,844 |  |  |  | 3,844 |
Discount, net |  |  | - |  |  |  | - |  |  |  | - |  |  |  | 178 |  |  |  | 178 |
Net claim liability (recoverable) |  | $ | - |  |  | $ | - |  |  | $ | - |  |  | $ | (2,352) |  |  | $ | (2,352) |
Unearned premium revenue |  | $ | 130 |  |  | $ | 17 |  |  | $ | 3 |  |  | $ | 119 |  |  | $ | 269 |
(1) - An “issue” represents the aggregate of financial guarantee policies that share the same revenue source for purposes of making debt service payments. (2) - Represents contractual principal and interest payments due by the issuer of the obligations insured by MBIA. The following table provides information about the financial guarantees and related claim liability included in each of MBIA’s surveillance categories as of December 31, 2011:
|  | Surveillance Categories |
$ in millions |  | Caution List Low |  |  | Caution List Medium |  |  | Caution List High |  |  | Classified List |  |  | Total |
Number of policies |  |  | 54 |  |  |  | 28 |  |  |  | 14 |  |  |  | 200 |  |  |  | 296 |
Number of issues(1) |  |  | 32 |  |  |  | 18 |  |  |  | 11 |  |  |  | 130 |  |  |  | 191 |
Remaining weighted average contract period (in years) |  |  | 8.2 |  |  |  | 5.6 |  |  |  | 6.0 |  |  |  | 9.6 |  |  |  | 8.8 |
Gross insured contractual payments outstanding(2): |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Principal |  | $ | 4,310 |  |  | $ | 1,213 |  |  | $ | 561 |  |  | $ | 10,420 |  |  | $ | 16,504 |
Interest |  |  | 2,653 |  |  |  | 351 |  |  |  | 144 |  |  |  | 5,836 |  |  |  | 8,984 |
Total |  | $ | 6,963 |  |  | $ | 1,564 |  |  | $ | 705 |  |  | $ | 16,256 |  |  | $ | 25,488 |
Gross claim liability |  | $ | - |  |  | $ | - |  |  | $ | - |  |  | $ | 1,812 |  |  | $ | 1,812 |
Less: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Gross potential recoveries |  |  | - |  |  |  | - |  |  |  | - |  |  |  | 3,813 |  |  |  | 3,813 |
Discount, net |  |  | - |  |  |  | - |  |  |  | - |  |  |  | 177 |  |  |  | 177 |
Net claim liability (recoverable) |  | $ | - |  |  | $ | - |  |  | $ | - |  |  | $ | (2,178) |  |  | $ | (2,178) |
Unearned premium revenue |  | $ | 155 |  |  | $ | 16 |  |  | $ | 3 |  |  | $ | 134 |  |  | $ | 308 |
(1) - An “issue” represents the aggregate of financial guarantee policies that share the same revenue source for purposes of making debt service payments. (2) - Represents contractual principal and interest payments due by the issuer of the obligations insured by MBIA. The gross claim liability as of September 30, 2012 and December 31, 2011 in the preceding tables represents the Company’s estimate of undiscounted probability-weighted future claim payments, which principally relate to insured first-lien and second-lien RMBS transactions and U.S. public finance transactions. The gross potential recoveries represent the Company’s estimate of undiscounted probability-weighted recoveries of actual claim payments and recoveries of estimated future claim payments, and principally relate to insured second-lien RMBS transactions. Both amounts reflect the elimination of claim liabilities and potential recoveries related to VIEs consolidated by the Company. The following table presents the components of the Company’s loss and LAE reserves and insurance loss recoverable as reported on the Company’s consolidated balance sheets as of September 30, 2012 and December 31, 2011 for insured obligations within MBIA’s “Classified List.” The loss reserves (claim liability) and insurance claim loss recoverable included in the following table represent the present value of the probability-weighted future claim payments and recoveries reported in the preceding tables.
In millions |  | As of September 30, 2012 |  |  | As of December 31, 2011 |
Loss reserves (claim liability) |  | $ | 862 |  |  | $ | 781 |
LAE reserves |  |  | 83 |  |  |  | 55 |
Loss and LAE reserves |  | $ | 945 |  |  | $ | 836 |
Insurance claim loss recoverable |  | $ | (3,281) |  |  | $ | (3,032) |
LAE insurance loss recoverable |  |  | (35) |  |  |  | (14) |
Insurance loss recoverable |  | $ | (3,316) |  |  | $ | (3,046) |
Reinsurance recoverable on unpaid losses |  | $ | 13 |  |  | $ | 15 |
Reinsurance recoverable on paid losses |  |  | 2 |  |  |  | 1 |
Reinsurance recoverable on paid and unpaid losses |  | $ | 15 |  |  | $ | 16 |
As of September 30, 2012, loss and LAE reserves include $1.3 billion of reserves for expected future payments offset by expected recoveries of such future payments of $395 million. As of December 31, 2011, loss and LAE reserves included $1.4 billion of reserves for expected future payments offset by expected recoveries of such future payments of $562 million. As of September 30, 2012 and December 31, 2011, the insurance loss recoverable primarily related to estimated recoveries of payments made by the Company resulting from ineligible mortgage loans in certain insured second-lien residential mortgage loan securitizations that are subject to a contractual obligation by the sellers/servicers to repurchase or replace the ineligible mortgage loans and expected future recoveries on second-lien RMBS transactions resulting from expected excess spread generated by performing loans in such transactions. The Company expects to be reimbursed for the majority of its potential recoveries related to ineligible mortgage loans by the second quarter of 2013. Total paid losses and LAE, net of reinsurance and collections, for the nine months ended September 30, 2012 was $489 million, including $330 million related to insured second-lien RMBS transactions. For the nine months ended September 30, 2012, the increase in insurance loss recoverable related to paid losses totaled $270 million, and primarily related to insured second-lien RMBS transactions. The following table presents the Company’s second-lien RMBS exposure, gross undiscounted claim liability and potential recoveries for amounts excluding consolidated VIEs and amounts related to consolidated VIEs, as of September 30, 2012. All insured transactions with potential recoveries are included within the “Classified List.”
Second-lien RMBS Exposure |  |  |  |  | Outstanding |  |  | Gross Undiscounted |
$ in billions |  | Issues |  |  | Gross Principal |  |  | Gross Interest |  |  | Claim Liability |  |  | Potential Recoveries |
Excluding Consolidated VIEs: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Insured issues designated as “Classified List” |  |  | 22 |  |  | $ | 4.2 |  |  | $ | 1.7 |  |  | $ | 0.3 |  |  | $ | 3.2 |
Insured issues reviewed with potential recoveries |  |  | 15 |  |  | $ | 3.9 |  |  | $ | 1.6 |  |  | $ | 0.2 |  |  | $ | 3.1 |
Consolidated VIEs: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Insured issues designated as “Classified List” |  |  | 12 |  |  | $ | 2.3 |  |  | $ | 0.9 |  |  | $ | 0.1 |  |  | $ | 1.4 |
Insured issues reviewed with potential recoveries |  |  | 11 |  |  | $ | 2.2 |  |  | $ | 0.8 |  |  | $ | 0.1 |  |  | $ | 1.4 |
The Company has performed reviews on 29 of the 34 total insured issues designated as “Classified List” and recorded potential recoveries on 26 of those 29 issues, primarily related to four issuers (Countrywide, RFC, GMAC and Credit Suisse). In addition, the Company has received consideration on two transactions, including one Alt-A transaction, which have been excluded in the preceding table. The following table presents changes in the Company’s loss and LAE reserves for the nine months ended September 30, 2012. Changes in the loss and LAE reserves attributable to the accretion of the claim liability discount, changes in discount rates, changes in the timing and amounts of estimated payments and recoveries, changes in assumptions and changes in LAE reserves are recorded in “Losses and loss adjustment” expenses in the Company’s consolidated statements of operations. As of September 30, 2012, the weighted average risk-free rate used to discount the Company’s loss reserves (claim liability) was 1.26%. LAE reserves are expected to be settled within a one-year period and are not discounted.
In millions |  |  | Changes in Loss and LAE Reserves for the Nine Months Ended September 30, 2012 |  |  |  |
Gross Loss and LAE Reserves as of December 31, 2011 |  |  | Loss Payments for Cases with Reserves |  |  | Accretion of Claim Liability Discount |  |  | Changes in Discount Rates |  |  | Changes in Timing of Payments |  |  | Changes in Amount of Net Payments |  |  | Changes in Assumptions |  |  | Changes in Unearned Premium Revenue |  |  | Changes in LAE Reserves |  |  | Gross Loss and LAE Reserves as of September 30, 2012 |
$ | 836 |  |  | $ | (283) |  |  | $ | 9 |  |  | $ | 26 |  |  | $ | 52 |  |  | $ | 3 |  |  | $ | 267 |  |  | $ | 7 |  |  | $ | 28 |  |  | $ | 945 |
The increase in the Company’s gross loss and LAE reserves reflected in the preceding table was primarily due to changes in assumptions, timing of payments, and changes in LAE reserves, offset by decreases in reserves related to loss payments on insured first-lien and second-lien RMBS issues outstanding as of December 31, 2011. Current period changes in the Company’s estimate of potential recoveries may be recorded as an insurance loss recoverable asset, netted against the gross loss and LAE reserve liability, or both. The following table presents changes in the Company’s insurance loss recoverable and changes in recoveries on unpaid losses reported within the Company’s claim liability for the nine months ended September 30, 2012. Changes in insurance loss recoverable attributable to the accretion of the discount on the recoverable, changes in discount rates, changes in the timing and amounts of estimated collections, changes in assumptions and changes in LAE recoveries are recorded in “Losses and loss adjustment” expenses in the Company’s consolidated statements of operations.
|  |  |  |  | Changes in Insurance Loss Recoverable and Recoveries on Unpaid Losses for the Nine Months Ended September 30, 2012 |  |  |  |
In millions |  | Gross Reserve as of December 31, 2011 |  |  | Collections for Cases with Recoveries |  |  | Accretion of Recoveries |  |  | Changes in Discount Rates |  |  | Changes in Timing of Collections |  |  | Changes in Amount of Collections |  |  | Changes in Assumptions |  |  | Changes in LAE Recoveries |  |  | Gross Reserve as of September 30, 2012 |
Insurance loss recoverable |  | $ | 3,046 |  |  | $ | (6) |  |  | $ | 30 |  |  | $ | 8 |  |  | $ | - |  |  | $ | (149) |  |  | $ | 366 |  |  | $ | 21 |  |  | $ | 3,316 |
Recoveries on unpaid losses |  |  | 562 |  |  |  | - |  |  |  | 6 |  |  |  | 19 |  |  |  | - |  |  |  | - |  |  |  | (185) |  |  |  | (7) |  |  |  | 395 |
Total |  | $ | 3,608 |  |  | $ | (6) |  |  | $ | 36 |  |  | $ | 27 |  |  | $ | - |  |  | $ | (149) |  |  | $ | 181 |  |  | $ | 14 |  |  | $ | 3,711 |
The Company’s insurance loss recoverable increased during 2012 primarily due to changes in assumptions associated with issues outstanding as of December 31, 2011, which related to increases in excess spread and ineligible mortgage loans included in insured second-lien residential mortgage securitization exposures that are subject to contractual obligations by sellers/servicers to repurchase or replace such mortgages, partially offset by changes in the amount of collections. Recoveries on unpaid losses decreased primarily due to changes in assumptions as a result of a reduction of excess spread related to first-lien and second-lien RMBS transactions offset by changes in discount rates. The following table presents the Company’s total estimated recoveries from ineligible mortgage loans included in certain insured second-lien mortgage loan securitizations as of September 30, 2012. The total estimated recoveries from ineligible mortgage loans of $3.2 billion include $2.1 billion recorded as “Insurance loss recoverable” and $1.1 billion recorded as “Loan repurchase commitments” presented under the heading “Assets of consolidated variable interest entities” on the Company’s consolidated balance sheets.
In millions |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Total Estimated Recoveries from Ineligible Mortgage Loans as of December 31, 2011 |  |  | Accretion of Future Collections |  |  | Changes in Discount Rates |  |  | Recoveries (Collections) |  |  | Changes in Amount of Collections |  |  | Changes in Assumptions |  |  | Total Estimated Recoveries from Ineligible Mortgage Loans as of September 30, 2012 |
$ | 3,119 |  |  | $ | 34 |  |  | $ | 2 |  |  | $ | - |  |  | $ | - |  |  | $ | 92 |  |  | $ | 3,247 |
The Company’s total estimated recoveries from ineligible mortgage loans in the preceding table increased primarily as a result of the probability-weighted scenarios as described within the preceding “Second-lien RMBS Recoveries” section. Remediation actions may involve, among other things, waivers or renegotiations of financial covenants or triggers, waivers of contractual provisions, the granting of consents, transfer of servicing, consideration of restructuring plans, acceleration, security or collateral enforcement, actions in bankruptcy or receivership, litigation and similar actions. The types of remedial actions pursued are based on the insured obligation’s risk type and the nature and scope of the event giving rise to the remediation. As part of any such remedial actions, MBIA seeks to improve its security position and to obtain concessions from the issuer of the insured obligation. From time to time, the issuer of an MBIA-insured obligation may, with the consent of MBIA, restructure the insured obligation by extending the term, increasing or decreasing the par amount or decreasing the related interest rate, with MBIA insuring the restructured obligation. Costs associated with remediating insured obligations assigned to the Company’s “Caution List—Low,” “Caution List—Medium,” “Caution List—High” and “Classified List” are recorded as LAE. LAE is primarily recorded as part of the Company’s provision for its loss reserves and included in “Losses and loss adjustment” on the Company’s consolidated statements of operations. The following table presents the gross expenses related to remedial actions for insured obligations:
|  | Nine Months Ended September 30, |
In millions |  | 2012 |  |  | 2011 |
Loss adjustment expense incurred, gross |  | $ | 113 |  |  | $ | 76 |

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- Definition The entire disclosure for liabilities related to future policy benefits and unpaid claims and claim adjustments. + References Reference 1: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 944 -SubTopic 40 -Section 50 -Paragraph 6 -URI http://asc.fasb.org/extlink&oid=6482852&loc=d3e14931-158439 Reference 2: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 944 -SubTopic 40 -Section 50 -Paragraph 3 -URI http://asc.fasb.org/extlink&oid=6482485&loc=d3e14764-158437 Reference 3: http://www.xbrl.org/2003/role/presentationRef -Publisher AICPA -Name Statement of Position (SOP) -Number 94-5 -Paragraph 11 -LegacyDoc This reference is SUPERSEDED by the Accounting Standards Codification effective for interim and annual periods ending after September 15, 2009. This reference is included to help users transition from the previous accounting hierarchy and will be removed from future versions of this taxonomy. Reference 4: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 944 -SubTopic 40 -Section 50 -Paragraph 1 -URI http://asc.fasb.org/extlink&oid=6482485&loc=d3e14754-158437 Reference 5: http://www.xbrl.org/2003/role/presentationRef -Publisher SEC -Name Regulation S-X (SX) -Number 210 -Section 03 -Paragraph 13 -Article 7 Reference 6: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Statement of Financial Accounting Standard (FAS) -Number 60 -Paragraph 60 -LegacyDoc This reference is SUPERSEDED by the Accounting Standards Codification effective for interim and annual periods ending after September 15, 2009. This reference is included to help users transition from the previous accounting hierarchy and will be removed from future versions of this taxonomy. Reference 7: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 944 -SubTopic 210 -Section S99 -Paragraph 1 -Subparagraph (SX 210.7-03.13(a)(1),(b)) -URI http://asc.fasb.org/extlink&oid=6879938&loc=d3e572229-122910 + Details
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