National Public Finance Guarantee Corporation Statutory-Basis Financial Statements December 31, 2017 and 2016
Page(s) Independent Auditor s Report...1-2 Statutory-Basis Financial Statements Statements of Admitted Assets, Liabilities and Capital and Surplus... 3 Statements of Income... 4 Statements of Changes in Capital and Surplus... 5 Statements of Cash Flows... 6 Notes to Statutory-Basis Financial Statements... 7-43 Supplemental Schedules Summary Investment Schedule... 44 Supplemental Investment Risks Interrogatories... 45-50
STATUTORY-BASIS STATEMENTS OF ADMITTED ASSETS, LIABILITIES and CAPITAL and SURPLUS (Dollars in thousands except share and per share amounts) Admitted Assets December 31,2017 December 31, 2016 Investments: Fixed maturity securities, at amortized cost (fair value $3,253,867 and $3,946,254, respectively) $ 3,228,023 $ 3,920,790 Securities purchased under agreements to resell (parent) 124,000 128,500 Short-term investments, at amortized cost which approximates fair value 20,319 103,728 Investment in preferred stock, at fair value 663 406 Receivables for securities sold 562 161 Other invested assets 75,939 85,276 Total investments 3,449,506 4,238,861 Cash and cash equivalents 176,131 74,640 Total cash and investments 3,625,637 4,313,501 Accrued investment income 26,144 27,881 Current tax receivable 89,836 - Deferred tax asset 5,328 10,572 Other assets 6,995 3,249 Total admitted assets $ 3,753,940 $ 4,355,203 Liabilities, Capital and Surplus Liabilities: Deferred premium revenue $ 585,470 $ 786,074 Loss and loss adjustment expense reserves (net of subrogation recoverable) 227,334 (98,325) Contingency reserve 594,289 745,256 Securities sold under agreements to repurchase (parent) 124,000 128,500 Current income taxes - 5,813 Payable for investments purchased 33,720 31,868 Other liabilities 23,221 25,178 Total liabilities 1,588,034 1,624,364 Capital and Surplus: Common stock, par value $30 per share; authorized, issued and outstanding - 500,000 shares 15,000 15,000 Additional paid-in capital 574,441 574,441 Unassigned surplus 1,576,465 2,141,398 Total capital and surplus 2,165,906 2,730,839 Total liabilities, capital and surplus $ 3,753,940 $ 4,355,203 The accompanying notes are an integral part of the financial statements. 3
STATUTORY-BASIS STATEMENTS OF INCOME (Dollars in thousands) Revenues: Years ended December 31, 2017 2016 Gross premiums written $ 13,034 $ 19,039 Ceded premiums written - - Net premiums written 13,034 19,039 Decrease in unearned premiums 200,604 256,345 Premiums earned 213,638 275,384 Expenses: Losses incurred (benefit) 551,957 86,353 Loss adjustment expenses incurred 32,384 28,965 Other underwriting expenses incurred 66,746 61,441 Total underwriting expenses 651,087 176,759 Net underwriting gain (loss) (437,449) 98,625 Investment income: Net investment income (loss) 111,278 117,845 Net realized capital gains (losses), (less tax of $4,903 and $36,452) (85,014) 49,838 Net investment gain (loss) 26,264 167,683 Other income (expense), net (3,664) (14) Income (loss) before income taxes (after capital gains tax) (414,849) 266,294 Provision (benefit) for income taxes (93,463) 74,485 Net income (loss) $ (321,386) $ 191,809 The accompanying notes are an integral part of the financial statements. 4
STATUTORY-BASIS STATEMENTS OF CHANGES IN CAPITAL AND SURPLUS For the years ended December 31, 2017 and 2016 (Dollars in thousands except share amounts) Additional Total Common Stock Paid-in Unassigned Capital and Shares Amount Capital Surplus Surplus Balance, January 1, 2016 500,000 $ 15,000 $ 574,441 $ 1,888,102 $ 2,477,543 Net income (loss) - - - 191,809 191,809 Change in deferred income taxes - - - (52,268) (52,268) Change in non-admitted assets - - - 68,202 68,202 Change in contingency reserve - - - 164,786 164,786 Change in unrealized capital losses, net of tax - - - (931) (931) Dividends paid - - - (118,302) (118,302) Balance, December 31, 2016 500,000 $ 15,000 $ 574,441 $ 2,141,398 $ 2,730,839 Net income (loss) - - - (321,386) (321,386) Change in deferred income taxes - - - (132,656) (132,656) Change in non-admitted assets - - - (133,996) (133,996) Change in contingency reserve - - - 150,968 150,968 Change in unrealized capital losses, net of tax - - (10,037) (10,037) Dividends paid - - - (117,826) (117,826) Balance, December 31, 2017 500,000 $ 15,000 $ 574,441 $ 1,576,465 $ 2,165,906 The accompanying notes are an integral part of the financial statements. 5
STATUTORY-BASIS STATEMENTS OF CASH FLOWS (Dollars in thousands) Years Ended December 31, 2017 2016 Cash from operations Premiums collected, net of reinsurance $ 13,034 $ 19,037 Net investment income (loss) 114,380 125,820 Miscellaneous income (expense) (3,664) (15) Total 123,750 144,842 Loss payments (receipts) 238,322 174,754 Commissions, expenses paid and loss adjustment expenses paid 90,846 71,361 Federal and foreign income taxes paid (recovered) 28,066 78,754 Total 357,234 324,869 Net cash used by operating activities (233,484) (180,027) Cash from investments Proceeds from investments sold, matured or repaid: Fixed-maturity securities 2,609,475 2,723,073 Other invested assets 9,951 - Miscellaneous proceeds 1,324 897 Total investment proceeds 2,620,750 2,723,970 Cost of investments acquired: Fixed-maturity securities 1,987,486 2,376,389 Common stock 265,532 2,977 Other invested assets 197 75,000 Increase in payable for investments purchased, net 3 16 Total investments acquired 2,253,218 2,454,382 Net cash provided (used) by investment activities 367,532 269,588 Cash from financing and miscellaneous sources Securities under agreement to repurchase (4,500) (70,000) Dividends paid (117,826) (118,302) Other cash applied (used) 1,860 2,994 Net cash used for financing and miscellaneous sources (120,466) (185,308) Net change in cash, cash equivalents and short-term investments 13,582 (95,747) Cash, cash equivalents and short-term investments - beginning of year 306,868 402,615 Cash, cash equivalents and short-term investments - end of year $ 320,450 $ 306,868 Note: Supplemental disclosures of cash flow information for non-cash transactions: Receipt of underlying bonds in exchange for stocks $ - $ 131,673 Securities transfer to MBIA Inc. for partial payment of tax liabilities $ - $ 43,846 Securities transfer from MBIA Inc. for partial refund of tax payment $ 20,977 $ - The accompanying notes are an integral part of the financial statements. 6
1. Business Developments and Risks and Uncertainties National Public Finance Guarantee Corporation ( National or the Company ) is a wholly-owned subsidiary of MBIA Inc. ( the Parent or Parent Company ) through an intermediary holding company, National Public Finance Guarantee Holdings, Inc. ( National Holdings ). The financial guarantees issued by National provide unconditional and irrevocable guarantees of the payment of the principal of, and interest or other amounts owing on, insured obligations when due or, in the event National has exercised, at its discretion, the right to accelerate the payment under its policies upon the acceleration of the underlying insured obligations due to default or otherwise. Through its reinsurance of United States ( U.S. ) public finance financial guarantees from MBIA Insurance Corporation ( MBIA Corp. ) and transfers by novation of all policies under a reinsurance agreement with Financial Guaranty Insurance Company ( FGIC ), National s insurance portfolio consists of municipal bonds, including tax-exempt and taxable indebtedness of U.S. political subdivisions, as well as utility districts, airports, healthcare institutions, higher educational facilities, student loan issuers, housing authorities and other similar agencies and obligations issued by private entities that finance projects that serve a substantial public purpose. Municipal bonds and privately issued bonds used for the financing of public purpose projects generally are supported by taxes, assessments, user fees or tariffs related to the use of these projects, by lease payments or by other similar types of revenue streams. As of December 31, 2017, National had insured gross par outstanding of $71.9 billion. Business Developments Financial Strength Ratings On June 26, 2017, Standard & Poor s Financial Services LLC ( S&P ) downgraded the financial strength rating of National from AA- with a stable outlook to A with a stable outlook. National s ability to write new business and to compete with other financial guarantors is largely dependent on the financial strength ratings assigned to National by major rating agencies, and with the A rating assigned by S&P, it would be difficult for National to compete with higher-rated competitors. Therefore, at that time, National ceased its efforts to actively pursue writing new financial guarantee business. On November 28, 2017, the Company provided notice to S&P terminating the agreements by which S&P agreed to provide financial strength ratings to National. On December 1, 2017, S&P affirmed National s A with a stable outlook rating and subsequently withdrew all of its ratings. On September 28, 2017, National provided notice to Kroll Bond Rating Agency ( Kroll ) terminating the agreement by which Kroll agreed to provide a financial strength rating to National. On December 5, 2017, Kroll downgraded the financial strength rating of National from AA+ to AA with a negative outlook and subsequently withdrew its rating. On September 28, 2017, MBIA Inc., on behalf of its subsidiary, National, provided notice to Moody s Investors Services ( Moody s ) terminating the agreement by which Moody s agreed to provide financial strength ratings to National. On January 17, 2018, Moody s downgraded the financial strength rating of National to Baa2 from A3 with a stable outlook. Moody s, at its discretion and in the absence of any contract with the Company, continues to maintain ratings on MBIA Inc. and its subsidiaries. Key Lending Agreements Asset Swap National maintains a simultaneous and matched repurchase and reverse repurchase facility ( Asset Swap ) with MBIA Inc. which provides MBIA Inc. with eligible assets to pledge under investment agreements and derivative contracts. The Asset Swap facility resets on a quarterly basis. These agreements are accounted for as secured borrowings and are recorded at contract value plus accrued interest. The reverse repurchase agreement is included in securities purchased under agreements to resell (parent) and the repurchase agreement is included in securities sold under agreements to repurchase (parent) on the balance sheet, both of which are equal in amount. Refer to Note 3. Investments or further information. 7
Advances Agreement MBIA Inc., National, MBIA Corp. and certain other subsidiaries are party to an intercompany advances agreement (the MBIA Advances Agreement ). The MBIA Advances Agreement permits National to make advances to MBIA Inc. and other MBIA group companies that are party to the agreement at a rate per annum equal to London Inter-bank Offered Rate ( LIBOR ) plus 0.25%. The agreement also permits other affiliates to advance funds to National or MBIA Corp. at a rate per annum equal to LIBOR minus 0.10%. Advances by National cannot exceed 3% of its admitted assets as of the last quarter end. As of December 31, 2017 and 2016, there were no amounts drawn under the agreement. Dividend In both 2017 and 2016, National declared and paid dividends of $118 million, to its ultimate parent, MBIA Inc. Risks and Uncertainties National continues to surveil and remediate its existing insured portfolio and will seek opportunities to enhance shareholder value using its strong financial resources, while protecting the interests of all of its policyholders. Certain state and local governments and territory obligors that National insures remain under financial and budgetary stress. This could lead to an increase in defaults by such entities on the payment of their obligations and losses or impairments on a greater number of the Company s insured transactions. National monitors and analyzes these situations and other stressed credits closely, and the overall extent and duration of this stress is uncertain. In particular, the Commonwealth of Puerto Rico and certain of its instrumentalities ( Puerto Rico ) are experiencing significant fiscal stress and constrained liquidity due to, among other things, Puerto Rico s structural budget imbalance, the lack of access to the capital markets, a stagnating local economy, net migration of people out of Puerto Rico and a high debt burden. Although Puerto Rico has tried to address its challenges through various fiscal policies, it continues to experience significant fiscal stress. Puerto Rico defaulted on scheduled debt service for National insured bonds and National paid gross claims in the aggregate of $242 million during 2017. On January 1, 2018, Puerto Rico also defaulted on scheduled debt service for National insured bonds and National paid gross claims in the aggregate of $69 million. On September 20, 2017, Hurricane Maria made landfall in Puerto Rico as a Category 4 hurricane resulting in catastrophic damage to much of the island s basic infrastructure, including its electrical transmission and distribution grid, telecommunications network, housing, roads, bridges, water and sewer systems. On September 21, 2017, the President of the United States approved a Major Disaster Declaration for Puerto Rico and the Federal Emergency Management Agency ( FEMA ) made federal disaster assistance available to Puerto Rico to supplement its recovery efforts. Hurricane Maria s impact on Puerto Rico will likely also impact its ability to both repay its legacy indebtedness and participate in ongoing debt restructuring negotiations. The physical damage and resultant lost economic activity may exceed the collective aid Puerto Rico receives from private insurance, relief from FEMA and other federal agencies and programs. Economic activity in Puerto Rico may not return to pre-hurricane levels and Puerto Rico s recovery could be more shallow and protracted than that experienced by other similarly affected governments, given Puerto Rico s prior constrained liquidity and economic activity. While the federal government has made aid available to Puerto Rico, there can be no assurance that such aid will continue in the amounts necessary to offset the adverse impacts from Hurricane Maria in their entirety. In addition, the necessary and greater involvement of the federal government, through its actions to deliver disaster relief and other support services, in addition to the evolving role of the Financial Oversight and Management Board for Puerto Rico ( Oversight Board ) and the role of Puerto Rico in its own recovery, heightens political risk in connection with the restructuring of legacy debt. This risk could lead the Oversight Board, Puerto Rico or the federal government to seek to extract greater concessions from creditors based on the uncertainty of Puerto Rico s long-term recovery prospects. In this event, losses at National on select Puerto Rico exposures could increase materially. 2. Summary of Significant Accounting Policies Basis of Presentation The statutory financial statements of National are presented on the basis of accounting practices prescribed or permitted by the New York State Department of Financial Services ( NYSDFS ). The NYSDFS recognizes only statutory accounting practices prescribed or permitted by the State of New York for determining and reporting the financial condition and results of operations of an insurance company, and determining its solvency under the New York Insurance Law ( NYIL ). The National Association of 8
Insurance Commissioners ( NAIC ) Accounting Practices and Procedures Manual ( NAIC SAP ) has been adopted as a component of prescribed or permitted practices by the State of New York. The Superintendent of the NYSDFS has the right to permit other specific practices that deviate from prescribed practices. Effective January 1, 2010, National was granted a permitted practice by the NYSDFS to reset its unassigned funds (surplus) to zero by netting its negative unassigned surplus of $1.6 billion against $2.2 billion of gross paid-in and contributed surplus as summarized in the table below. Total policyholders surplus was not impacted by this permitted practice. In thousands 2017 2016 NET INCOME Net income (loss), state basis $ (321,386) $ 191,809 State prescribed practices that increase/decrease NAIC SAP: - - State prescribed practices that increase/decrease NAIC SAP: - - NAIC SAP basis $ (321,386) $ 191,809 SURPLUS Policyholders' surplus, state basis $ 2,165,906 $ 2,730,839 State prescribed practices that increase/decrease NAIC SAP: - - State prescribed practices that increase/decrease NAIC SAP: Gross paid-in and contributed surplus (1,623,146) (1,623,146) Unassigned surplus 1,623,146 1,623,146 NAIC SAP basis $ 2,165,906 $ 2,730,839 Use of Estimates in the Preparation of the Financial Statements The preparation of financial statements in conformity with Statutory Accounting Principles ( SAP ) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the period. As additional information becomes available or actual amounts become determinable, the recorded estimates are revised and reflected in operating results. Actual results could differ from those estimates. Cash, Cash Equivalents and Short-Term Investments Cash and cash equivalents include cash on hand and short-term, highly liquid investments with original maturities of three months or less at the date of purchase. Effective December 31, 2017, cash equivalents also includes money market funds. Short-term investments and cash equivalents are stated at amortized cost. 9
Investments Bonds with an NAIC designation of 1 or 2 that are not backed by other loans are reported at amortized cost. Amortized cost is calculated using the effective yield method. For bonds purchased at a price below par value, discounts are accreted over the remaining term of the bonds. For bonds purchased at a price above par value, which have call features, premiums are amortized to the call date that produces the lowest yield. For premium bonds that do not have call features, such premium is amortized over the remaining term of the bond. Investments in bonds, loan-backed bonds and structured securities with an NAIC designation of 3 through 6 that are not backed by other loans are reported at the lower of amortized cost (as described above) or fair value as determined by independent third-parties. In cases where specific market quotes are unavailable, interpreting market data and estimating market values require considerable judgment by management. Accordingly, the estimates presented are not necessarily indicative of the amount National could realize in the market. Statement of Accounting Principles ( SSAP ) No. 43R Loan-backed and Structured Securities Revised establishes principles for investments in loan-backed and structured securities and increased disclosures regarding other-than-temporarily impaired securities. Loan-backed bonds and structured securities with an NAIC designation of 1 or 2 are reported at amortized cost using the effective interest method, including anticipated prepayments at the date of purchase. Changes in the estimated cash flows from the original purchase assumptions are accounted for using the retrospective method. Prepayment assumptions for loan-backed and structured securities were obtained from an independent third-party data service or internal estimates. Investment income is recorded as earned. All investment income due and accrued with amounts that are over 90 days past due are recorded as non-admitted assets. Realized gains and losses on the sale of investments are determined using the first-in, first-out method and are included in the Statements of Income as a separate component of revenues. Unrealized gains and losses from the revaluation of bonds and common stocks not valued at amortized cost are credited or charged to unassigned surplus. Investments in shares of common stock of Parent Company are carried at fair value, which is based on quoted market prices, and reduced by elimination of the reciprocal ownership interest as required under SSAP No. 97 Investments in Subsidiary, Controlled and Affiliated Entities and NYIL. Preferred stock is stated at fair value based upon quoted market prices, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. During the fourth quarter of 2016, National acquired an ownership interest in a limited partnership. National recorded its ownership interest within Other invested assets on its Balance Sheets. National s ownership interest is reported using the equity method of accounting with the investment carried at fair value, as defined in SSAP No. 48 Joint Ventures, Partnerships and Limited Liability Companies. The remaining other invested assets pertain to investments in surplus debenture bonds carried at amortized cost. Refer to Note 5. Fair Value of Financial Instruments for further information regarding valuation methodologies and related disclosures. Other-Than-Temporary Impairments on Investment Securities National s securities, other than loan-backed and structured securities, for which fair value is less than amortized cost are reviewed no less than quarterly to assess whether such a decline in value is other-than-temporary. This evaluation includes both qualitative and quantitative considerations. In assessing whether a decline in value is other-than-temporary, National considers several factors, including but not limited to (a) the magnitude and duration of the decline, (b) credit indicators and the reasons for the decline, such as general interest rate or credit spread movements, credit rating downgrades, issuer-specific changes in credit spreads, and the financial condition of the issuer, (c) any guarantees associated with a security such as those provided by financial guarantee insurance companies, and (d) National s ability and intent to retain the investment for the period of time sufficient to allow for an anticipated recovery in value. Based on this assessment, if National determines that a decline in the value of an investment is otherthan-temporary, the investment is written down to its fair value and a realized loss is recorded in the Statements of Income. 10
For loan-backed and structured securities, National estimates cash flows expected to be collected over the life of the security. If National determines that based on current information and events, there is a decrease in cash flows expected to be collected (that is they will be unable to collect all cash flows expected at acquisition plus any additional cash flows expected to be collected arising from changes in estimates after acquisition) an other-than-temporary impairment ( OTTI ) shall be considered to have occurred. For loan-backed securities that management has no intent to sell and believes that it is more likely than not such securities will not be required to be sold prior to recovery, only the credit loss component of the OTTI is recognized as a realized loss representing the difference between the securities amortized cost basis and the present value of cash flows expected to be collected from these securities. If management intends to sell the security or if management believes that it is more likely than not such securities will be required to be sold prior to recovery, the entire amount of the unrealized loss is recognized as a realized loss. These assessments require management to exercise judgment as to whether an investment is impaired based on market conditions and trends and the availability of relevant data. See Note 5. Fair Value of Financial Instruments for further information regarding valuation methodologies and related disclosures. Premium Revenue Recognition National s premiums written consist of upfront premiums and installment premiums received and accrued for policies issued in current and prior years. Upfront premiums are earned proportionately to the ratio of scheduled periodic maturity of principal and payment of interest ( debt service ) to the original total principal and interest insured. Installment premiums are earned on a straight-line basis over each installment period, generally one year or less. Unearned premiums represent the portion of premiums written that is applicable to the unexpired risk of insured obligations. When an insured obligation is retired early, is called by the issuer, or is in substance paid in advance through a refunding accomplished by placing U.S. Government securities in escrow, the remaining unearned premium is earned at that time, since there is no longer risk to National. As the outstanding principal of an installment-based policy is paid down by the issuer of a National-insured obligation, less premium is collected and recognized by National. Additionally, National may receive premiums upon the early termination of installment-based policies, which are earned when received. Premiums ceded to reinsurers reduce the amount of earned premium National will recognize from its insurance policies. For both upfront and installment policies, ceded premium is recognized in earnings in proportion to and at the same time as the related gross premium revenue is recognized. Expenses incurred in connection with the acquisition of new insurance business, including ceding commissions expenses, are charged to operations as incurred. Expenses incurred are reduced for ceding commissions received or receivable, to the extent admissible. National does not utilize anticipated investment income as a factor in the premium deficiency calculation. National had no premium deficiency as of December 31, 2017 or 2016. Fees National collects insurance related fees for services performed in connection with certain transactions. Depending upon the type of fee received, the fee is either recognized when it is received or deferred and recognized as the related service has been completed. These fees are included as a reduction to Other underwriting expenses within the Statements of Income. Loss and Loss Adjustment Expense ( LAE ) Reserves National s financial guarantee insurance provides an unconditional and irrevocable guarantee of the payment of the principal of, and interest or other amounts owing on, insured obligations when due or, in the event that National has the right, at its discretion, to accelerate insured obligations upon default or otherwise, upon such acceleration by National. Loss and LAE reserves are established by National s Loss Reserve Committee, which consists of members of senior management, and require the use of judgment and estimates with respect to the occurrence, timing and amount of a loss on an insured obligation. 11
National recognizes loss reserves on a contract-by-contract basis where an insured event has occurred (i.e., a payment default on the insured obligation) or an insured event is expected in the future based upon credit deterioration which has already occurred and has been identified. Case reserves are measured based on the probability-weighted present value of expected net cash inflows and outflows to be paid under the contract, discounted using a rate equal to the yield-to-maturity of National s fixed-income investment portfolio, excluding cash and cash equivalents and other investments not intended to defease long-term liabilities. The loss reserve is subsequently remeasured each reporting period for expected increases or decreases due to changes in the likelihood of default and potential recoveries. Subsequent changes to the measurement of the loss reserves are recognized as losses incurred in the period of change. Measurement and recognition of loss reserves are reported net of any reinsurance. National estimates the likelihood of possible claims payments and possible recoveries using probability-weighted expected cash flows based on information available as of the measurement date, including market information. The methods for making such estimates are continually reviewed and any adjustments are reflected in the period determined. Once a case basis reserve is established for an insured obligation, National continues to record premium revenue to the extent premiums have been or are expected to be collected on that obligation. National does not establish loss reserves for all payments due under an insured obligation. Case basis reserves cover the estimated amount of principal and interest National expects to pay on its insured obligations and the costs of settlement and other loss mitigation expenses, net of expected recoveries. National recognizes potential salvage and subrogation recoveries on paid losses based on a similar probability-weighted net cash flow projection discounted using the same rate discussed above, as of the measurement date. When National becomes entitled to potential recoveries which are typically based on salvage rights, the rights conferred to National through the transactional documents (inclusive of the insurance agreement), subrogation rights embedded within insurance policies, or the underlying collateral of an insured obligation, it reports this type of salvage and subrogation as a contra-liability within Loss and LAE reserves on National s balance sheet. References in the aforementioned and following disclosures to these items should be considered to be salvage and subrogation for purposes of financial reporting on a statutory basis. A number of variables are taken into account in establishing specific case basis reserves for individual policies. These variables include creditworthiness of the underlying issuer of the insured obligation, whether the obligation is secured or unsecured and the expected recovery rates on the insured obligation, the projected cash flow or market value of any assets that support the insured obligation and the historical and projected loss rates on such assets. Factors that may affect the actual ultimate underwriting losses for any policy include the state of the economy, changes in interest rates, rates of inflation and the salvage values of specific collateral. Management believes that National s reserves are adequate to cover the net cost of claims. However, because the reserves are based on management s judgment and estimates, there can be no assurance that the ultimate liability will not exceed such estimates. Refer to Note 9. Loss and Loss Adjustment Expense Reserves for additional information regarding the Company s loss reserving methodology. Contingency Reserve A contingency reserve is established for the protection of all policyholders by direct charges to unassigned surplus and is established by National for past business and new business, as follows: 1. For policies in force prior to July 1, 1989, National establishes and maintains a contingency reserve equal to 50% of the cumulative earned premiums on such policies. 2. For policies written on or after July 1, 1989, a contingency reserve, which represents the greater of 50% of premiums written or a stated percentage of the principal guaranteed dependent on the category of obligation insured, is established over a 15 to 20 year period. The stated percentage ranges from 0.55% on municipal general obligation bonds to 2.5% on certain industrial development bonds and non-investment grade obligations. 12
Contingency reserves are established and maintained net of collateral and reinsurance. The reserves may be released in the same manner in which they were established and withdrawals, to the extent there may be excess, may be made with either the prior written approval of the Superintendent of the NYSDFS or upon thirty days prior written notice, depending upon the circumstances specified in Article 69, Section 6903 of the NYIL. Contingency reserves established for policies which are terminated, matured or net of refundings to the extent that the refunded issue is paid off or secured by obligations, which are directly payable or guaranteed by the U.S. Government, may be released without prior approval or notice. National continually assesses its contingency reserve to determine if amounts are excessive in relation to the outstanding insured obligations and could potentially release additional contingency reserves in the future upon demonstrating to the satisfaction of the NYSDFS that the amounts are excessive. Securities Purchased Under Agreements to Resell and Securities Sold Under Agreements to Repurchase National maintains an Asset Swap with MBIA Inc. Securities purchased under agreements to resell and securities sold under agreements to repurchase are accounted for as secured borrowings and are recorded at contract value plus accrued interest. The Asset Swap facility requires each of these agreements to be fully collateralized, with assets having an aggregate fair value in excess of the securities borrowed. The borrower of the securities is permitted to sell or repledge those securities. Under the facility, the fair value of the securities held as collateral by National is in excess of the fair value of the securities pledged as collateral to MBIA Inc. as National loans government and agency securities to MBIA Inc. in exchange for assets rated BBB or higher. Pledged collateral levels are monitored daily and are generally maintained at an agreed-upon percentage of the fair value of the amounts borrowed during the life of the transactions. In the event of decline in the fair value of the pledged collateral under these transactions, additional collateral is obtained or the contract value of the facility is adjusted. Refer to Note 1. Business Developments and Risks and Uncertainties and Note 11. Information Concerning Parent, Subsidiary and Affiliates for further information. Income Taxes National files its U.S. Corporation Income Tax Return as a member of MBIA Inc. consolidated group and participates in the MBIA Inc. tax sharing agreement under which National is allocated its share of the consolidated tax liability or tax benefit as determined under the tax sharing agreement. To the extent that the consolidated tax liability of the Parent Company and its subsidiaries is less than National s tax liability on a separate company basis, the difference would be held in escrow for two years in the event National were to incur a tax loss which could be carried back. Current tax losses not carried back on a separate return basis would be compensated for under the terms of the tax sharing agreement. Intercompany tax balances are settled annually following the Parent Company s filing of its federal income tax return. The provision for federal income taxes is based on income from operations. Deferred income taxes are provided based on temporary differences between the financial reporting and tax bases of recording assets and liabilities. Changes in net deferred income taxes are recognized as a separate component of unassigned surplus. Recently Adopted Accounting Pronouncements Effective January 1, 2017, SSAP No. 26 Bonds and SSAP No. 43R were amended to clarify what portion of investment proceeds reflects the prepayment penalty of a callable bond with make-whole provisions. Refer to Note 3. Investments, for required disclosures on the Company s prepayment penalties and acceleration fees. In December 2016, the NAIC adopted changes to SSAP No. 2 Cash, Cash Equivalents, Drafts and Short-term Investments to reflect that effective December 31, 2017, money market mutual funds should be classified as cash equivalents. This guidance superseded the guidance effective June 2016 that required these investments to be classified as short-term investments. The Company adopted this reclassification in its financial statements. Recent Accounting Pronouncements In December of 2016, the NAIC adopted changes to SSAP No. 103 Transfers and Servicing of Financial Assets and Extinguishment of Liabilities to create significant new disclosures for repurchase and reverse repurchase agreement transactions. These changes were effective as of December 31, 2017. Refer to Note 1: Business Developments and Risks and Uncertainties and Note 3. Investments, for the new disclosures relating to the Company s Asset Swap. 13
In April 2016, the NAIC adopted changes to SSAP No. 41, Surplus Notes, which change the measurement of surplus notes that are rated NAIC 2 through 6 or that do not have a rating. The new guidance permits NAIC designation of 1 rated surplus notes to continue to be measured at amortized cost and now permits NAIC designation of 2 rated surplus notes to also be measured at amortized cost. NAIC designation of 3 through 6 and non-rated surplus notes will now be rated at the lower of amortized cost or fair value. The changes were effective January 1, 2017 and the adoption of this guidance did not have a material impact to the Company s financial statements. 3. Investments The Company s investment objective is to optimize long-term returns while emphasizing the preservation of capital through maintenance of high-quality investments with adequate liquidity. The Company s investment policies limit the amount of credit exposure to any one issuer. The fixed-maturity portfolio comprises high quality taxable and tax-exempt investments of diversified maturities. The following tables set forth the book/adjusted carry value, gross unrealized gains and losses, and fair value of the fixed-maturity investments and equity investments included in the investment portfolio of National as of December 31, 2017 and 2016. As of December 31, 2017 Gross Gross Book/Adjusted Unrealized Unrealized Fair In thousands Carry Value Gains Losses Value U.S. governments $ 677,021 $ 1,736 $ (5,801) $ 672,956 All other governments 1,803 69 (21) 1,851 States, territories and possessions 162,571 1,042 (1,864) 161,749 Political subdivisions of states, territories and possessions 60,561 1,335 (190) 61,706 Special revenue and special assessment obligations 722,524 7,447 (5,652) 724,319 Industrial and miscellaneous 1,276,927 15,878 (6,817) 1,285,988 Hybrid securities 89,347 1,160 (149) 90,358 Parent, subsidiaries and affiliates 237,269 17,671-254,940 Total fixed-maturity investments 3,228,023 46,338 (20,494) 3,253,867 Investment in preferred stock 663 - - 663 Total investment in preferred stock 663 - - 663 Total fixed-maturity and equity investments $ 3,228,686 $ 46,338 $ (20,494) $ 3,254,530 14
As of December 31, 2016 Gross Gross Book/Adjusted Unrealized Unrealized Fair In thousands Carry Value Gains Losses Value U.S. governments $ 563,586 $ 1,300 $ (9,120) $ 555,766 All other governments 1,892 24 (161) 1,755 States, territories and possessions 217,849 1,779 (5,418) 214,210 Political subdivisions of states, territories and possessions 160,445 4,760 (274) 164,931 Special revenue and special assessment obligations 1,454,896 46,936 (17,665) 1,484,167 Industrial and miscellaneous 1,395,164 10,365 (28,338) 1,377,191 Hybrid securities 14,390 984 (60) 15,314 Parent, subsidiaries and affiliates 112,567 20,353-132,920 Total fixed-maturity investments 3,920,789 86,501 (61,036) 3,946,254 Investment in preferred stock 406 - - 406 Total investment in preferred stock 406 - - 406 Total fixed-maturity and equity investments $ 3,921,195 $ 86,501 $ (61,036) $ 3,946,660 Securities which are designated 5* are securities that are unrated but current on principal and interest. The Company did not have any 5* securities in its investment portfolio as of December 31, 2017 and 2016. The following table sets forth the distribution by contractual maturity of National s fixed-maturity and short-term investments at book/adjusted carry value and fair value as of December 31, 2017. Contractual maturities may differ from expected maturities because borrowers may have the right to call or prepay obligations. Book/Adjusted In thousands Carry Value Fair Value Due in one year or less $ 98,286 $ 98,300 Due after one year through five years 1,049,012 1,047,214 Due after five years through ten years 414,510 415,558 Due after ten years 977,974 1,007,291 Loan-backed and structured securities 708,561 705,783 Total fixed-maturity and short-term investments $ 3,248,343 $ 3,274,146 15
The following tables set forth the gross unrealized losses of National s fixed-maturity and equity investments as of December 31, 2017 and 2016. The tables have segregated investments that have been in a continuous unrealized loss position for less than twelve months from those that have been in a continuous unrealized loss position for twelve months or longer. The tables below exclude securities recorded at NAIC fair value where the fair value of these securities was lower than amortized cost. As of December 31, 2017 Less than 12 Months 12 Months or Longer Total Fair Unrealized Fair Unrealized Fair Unrealized In thousands Value Losses Value Losses Value Losses U.S. governments $ 471,503 $ (1,031) $ 136,227 $ (4,770) $ 607,730 $ (5,801) All other governments - - 310 (21) 310 (21) States, territories and possessions 71,358 (589) 59,687 (1,275) 131,045 (1,864) Political subdivisions of states, territories and possessions 14,603 (190) - - 14,603 (190) Special revenue and special assessment obligations 113,772 (639) 184,025 (5,013) 297,797 (5,652) Industrial and miscellaneous 309,360 (1,842) 148,302 (4,975) 457,662 (6,817) Hybrid securities 31,424 (149) - - 31,424 (149) Total fixed-maturity investments $ 1,012,020 $ (4,440) $ 528,551 $ (16,054) $ 1,540,571 $ (20,494) As of December 31, 2016 Less than 12 Months 12 Months or Longer Total Fair Unrealized Fair Unrealize Fair Unrealized d In thousands Value Losses Value Losses Value Losses U.S. governments $ 345,903 $ (7,304) $ 53,054 $ (1,816) $ 398,957 $ (9,120) All other governments 1,157 (161) - - 1,157 (161) States, territories and possessions 161,442 (5,418) - - 161,442 (5,418) Political subdivisions of states, territories and possessions 27,707 (264) 1,011 (10) 28,718 (274) Special revenue and special assessment obligations 518,161 (15,824) 64,810 (1,841) 582,971 (17,665) Industrial and miscellaneous 572,868 (27,768) 48,529 (570) 621,397 (28,338) Hybrid securities 2,151 (60) - - 2,151 (60) Total fixed-maturity investments $ 1,629,389 $ (56,799) $ 167,404 $ (4,237) $ 1,796,793 $ (61,036) The following tables set forth the unrealized losses of the Company s loan-backed and structured securities as of December 31, 2017 and 2016. The tables have segregated loan-backed and structured securities that have been in a continuous unrealized loss position for less than twelve months from those that have been in a continuous unrealized loss position for twelve months or longer. In thousands As of December 31, 2017 The aggregate amount of unrealized losses: Less than 12 Months $ (963) 12 Months or Longer $ (3,744) The aggregate related fair value of securities with unrealized losses: Less than 12 Months $ 197,230 12 Months or Longer $ 173,751 16
In thousands As of December 31, 2016 The aggregate amount of unrealized losses: Less than 12 Months $ (9,726) 12 Months or Longer $ (3,654) The aggregate related fair value of securities with unrealized losses: Less than 12 Months $ 513,487 12 Months or Longer $ 137,903 The Company concluded that it does not have the intent to sell securities in an unrealized loss position and it is more likely than not, that it would not have to sell these securities before recovery of their cost basis. In making this conclusion, the Company examined the cash flow projections for its investment portfolios, the potential sources and uses of cash in its businesses, and the cash resources available to its business other than sales of securities. It also considered the existence of any risk management or other plans as of December 31, 2017, that would require the sale of impaired securities. Impaired securities that the Company intends to sell before the expected recovery of such securities fair values have been written down to fair value. Prepayment Penalty and Acceleration Fees For securities sold, redeemed or otherwise disposed as a result of a callable feature (including make whole call provisions), the following table discloses the number of securities sold, disposed or otherwise redeemed and the aggregate amount of investment income generated as a result of a prepayment penalty and/or acceleration fees for the year ended December 31, 2017. For Year Ended In thousands December 31, 2017 Number of CUSIPs 15 Aggregate Amount of Investment Income $ 338 Restricted Assets The following tables summarize restricted assets, including pledged by restricted asset category as of December 31, 2017 and 2016. In thousands As of December 31, 2017 Gross (Admitted & Nonadmitted) Restricted Percentage Total Gross Admitted Total Protected Cell (Admitted & Restricted General Account Total Nonadmitted) to Total Restricted Asset Account Restricted Total From Increase/ Admitted Restricted to Admitted Category (G/A) Assets Total Prior Year (Decrease) Restricted Total Assets Assets Subject to repurchase agreements $ 129,221 $ - $ 129,221 $ 131,329 $ (2,108) $ 129,221 3.06 % 3.44 % Subject to reverse repurchase agreements 124,000-124,000 128,500 (4,500) 124,000 2.93 % 3.30 % On deposit with states 5,956-5,956 6,224 (268) 5,956 0.14 % 0.16 % Total Restricted Assets $ 259,177 $ - $ 259,177 $ 266,053 $ (6,876) $ 259,177 6.13 % 6.90 % 17
In thousands As of December 31, 2016 Gross (Admitted & Nonadmitted) Restricted Percentage Total Gross Admitted Total Protected Cell (Admitted & Restricted General Account Total Nonadmitted) to Total Restricted Asset Account Restricted Total From Increase/ Admitted Restricted to Admitted Category (G/A) Assets Total Prior Year (Decrease) Restricted Total Assets Assets Subject to repurchase agreements $ 131,329 $ - $ 131,329 $ 203,748 $ (72,419) $ 131,329 2.80 % 3.02 % Subject to reverse repurchase agreements 128,500-128,500 198,500 (70,000) 128,500 2.74 % 2.95 % On deposit with states 6,224-6,224 6,126 98 6,224 0.13 % 0.14 % Total Restricted Assets $ 266,053 $ - $ 266,053 $ 408,374 $ (142,321) $ 266,053 5.67 % 6.11 % Repurchase and Reverse Repurchase Agreements National maintains an Asset Swap with MBIA Inc. where National and MBIA Inc. are NY based entities. Cash collateral received under the repurchase agreement and cash collateral provided under the reverse repurchase agreement are equal in size and netted as permitted under these agreements. The following table discloses the carry value and fair value of securities sold under repurchase agreements as of December 31, 2017. As of December 31, 2017 NAIC Designation In thousands None NAIC 1 NAIC 2 NAIC 3 NAIC 4 NAIC 5 NAIC 6 Non-admitted Total Bonds - book/adjusted carry value $ - $ 129,221 $ - $ - $ - $ - $ - $ - $ 129,221 Bonds - fair value $ - $ 125,979 $ - $ - $ - $ - $ - $ - $ 125,979 The following table discloses the carry value and fair value of securities acquired under the repurchase agreements as of December 31, 2017. As of December 31, 2017 NAIC Designation In thousands None NAIC 1 NAIC 2 NAIC 3 NAIC 4 NAIC 5 NAIC 6 Non-admitted Total Bonds - book/adjusted carry value $ 10,423 $ 73,248 $ 33,624 $ 1,398 $ - $ - $ - $ - $ 118,693 Bonds - fair value $ 10,156 $ 84,296 $ 36,608 $ 1,418 $ - $ - $ - $ - $ 132,478 4. Investment Income and Gains and Losses As of December 31, 2017 and 2016, there were $1 thousand and $13 thousand, respectively, of non-admitted assets for investment income due and accrued past 90 days. The proceeds and the gross realized gains and losses from sales of fixed-maturity securities for the years ended December 31, 2017 and 2016 are as follows: Years Ended December 31, In thousands 2017 2016 Proceeds from sales $ 2,187,189 $ 2,229,273 Gross realized gains $ 28,251 $ 74,097 Gross realized losses $ (14,729) $ (6,597) 18
5. Fair Value of Financial Instruments The Company is required to measure and report certain financial instruments at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value measurement of financial instruments held or issued by the Company are determined through the use of observable market data when available. Market data is obtained from a variety of third-party sources, including dealer quotes. If dealer quotes are not available for an instrument that is infrequently traded, the Company uses alternate valuation methods, including either dealer quotes for similar instruments or pricing models that use market data inputs. The use of alternate valuation methods generally requires considerable judgment in the application of estimates and assumptions and changes to such estimates and assumptions may produce materially different fair values. SSAP No. 100 Fair Value establishes a fair value hierarchy that categorizes into three levels the inputs used to measure fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available and reliable. Observable inputs are those the Company believes that market participants would use in pricing an asset or liability based on available market data. Unobservable inputs are those that reflect the Company s beliefs about the assumptions market participants would use in pricing an asset or liability based on available information. The three levels of the fair value hierarchy are defined as follows: Level 1 Valuations based on quoted prices in active markets for identical assets or liabilities that the Company can access. Valuations are based on quoted prices that are readily and regularly available in an active market, with significant trading volumes. Level 2 Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly. Level 2 assets include debt securities with quoted prices that are traded less frequently than exchange-traded instruments, securities which are priced using observable inputs. Level 3 Valuations based on inputs that are unobservable or supported by little or no market activity and that are significant to the overall fair value measurement. The availability of observable inputs can vary from financial instrument to financial instrument and period to period depending on the type of instrument, market activity, the approach used to measure fair value, and other factors. The Company categorizes a financial instrument within the fair value hierarchy based on the least observable input that is significant to the fair value measurement. When the inputs used to measure fair value of an asset or a liability are categorized within different levels based on the definition of the fair value hierarchy, the fair value measurement is categorized in its entirety in the same level of the fair value hierarchy as the lowest level input that is significant to the entire measurement. Valuation Techniques Valuation techniques for financial instruments measured at fair value are described below. These determinations were based on available market information and valuation methodologies. Considerable judgment is required to interpret market data to develop estimates and therefore, estimates may not necessarily be indicative of the amount the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. Fixed-maturity securities and Short-term investments - Fixed-maturity securities and short-term investments with an NAIC designation of 1 and 2 are carried at amortized cost while fixed-maturity securities and short-term investments with an NAIC designation of 3 through 6 are carried at the lower of amortized cost or fair value. Fair value of fixed-maturity securities and short-term investments are valued based on recently executed transaction prices or quoted market prices that are generally provided by independent third-party pricing vendors. When quoted market prices are not available, fair value is generally determined using quoted prices of similar securities or a valuation model based on observable and unobservable inputs. Inputs vary depending on the type of security. Observable inputs include contractual cash flows, interest rate yield curves, credit default swap spreads, prepayment and volatility scores, diversity scores, cross-currency basis index spreads, and credit spreads for structures similar to the financial instrument in terms of issuer, maturity and seniority. Unobservable inputs 19