Item 7A. Quantitative and Qualitative Disclosures About Market Risk
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss due to factors that affect the overall performance of the financial markets or movements in market prices. The Company’s primary market risk exposures include interest rate risk, foreign currency exchange rate risk and credit spread risk. Interest rate risk is the risk that financial instruments’ values will change due to changes in the level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. The Company is primarily affected by market risk in the following areas.
• The fair value of credit derivatives within the financial guaranty portfolio of insured obligations is sensitive to changes in credit spreads of the underlying obligations and the Company’s own credit spreads.
• The fair value of the investment portfolio is primarily driven by changes in interest rates and also affected by changes in credit spreads.
• New business production is sensitive to changes in interest rates.
• Expected loss to be paid (recovered) is sensitive to changes in interest rates.
• The fair value of the investment portfolio contains non-U.S. dollar denominated securities whose value also fluctuates based on changes in foreign exchange rates. The carrying value of premiums receivable includes foreign denominated receivables whose values fluctuate based on changes in foreign exchange rates.
• The fair value of CIVs are sensitive to changes in market risk.
• The fair value of the assets and liabilities of consolidated FG VIEs may fluctuate based on changes in prepayments, spreads, default rates, interest rates and house prices. The fair value of the FG VIEs’ liabilities also fluctuates based on changes in the Company’s credit spread.
Sensitivity of Credit Derivatives to Changes in Credit Spreads
Fair value gains and losses on credit derivatives are sensitive to changes in credit spreads of the underlying obligations and the Company’s own credit spread. Market liquidity could also impact valuations of the underlying obligations. The Company considers the impact of its own credit risk, together with credit spreads on the exposures that it insured through CDS contracts, in determining their fair value.
The Company determines its own credit risk based on quoted CDS prices traded on AGC at each balance sheet date. The quoted price of five-year CDS contracts traded on AGC at December 31, 2023 and December 31, 2022 was 66 bps and 63 bps, respectively. Movements in AGM’s CDS prices do not have a significant impact on the estimated fair value of the
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Company’s credit derivative contracts due to the relatively low volume and characteristics of CDS contracts in AGM’s portfolio.
The impact of changes in credit spreads will vary based upon the volume, tenor, interest rates and other market conditions at the time these fair values are determined. In addition, since each transaction has unique collateral and structural terms, the underlying change in fair value of each transaction may vary considerably. An overall narrowing of spreads generally results in a fair value gain on credit derivatives for the Company, and an overall widening of spreads generally results in a fair value loss for the Company.
The fair value of credit derivative contracts also reflects the change in the Company’s own credit cost, based on the price to purchase credit protection on AGC. Historically, the price of CDS traded on AGC typically moved directionally the same as general market spreads, although this may not always be the case. In certain circumstances, due to the fact that spread movements are not perfectly correlated, the narrowing or widening of the price of CDS traded on AGC can have a more significant financial statement impact than the changes in credit spread of risks it insures.
In the Company’s valuation model, the premium the Company captures is not permitted to go below the minimum rate that the Company would currently charge to assume similar risks. This assumption can have the effect of mitigating the amount of fair value gains that are recognized on certain CDS contracts. Based on fair value, approximately 11.5% of the Company’s CDS contracts used this minimum premium in determining fair value as of December 31, 2023. As of December 31, 2022, the use of the minimum premium did not have an effect on fair value. The percentage of transactions that price using the minimum premium fluctuates due to changes in AGC’s credit spreads. In general, when AGC’s credit spreads narrow, the cost to hedge AGC’s name declines and more transactions price above previously established floor levels. Meanwhile, when AGC’s credit spreads widen, the cost to hedge AGC’s name increases causing more transactions to price at established floor levels.
The following table summarizes the estimated change in fair values on the net balance of the Company’s credit derivative positions assuming an immediate shift in the net spreads assumed by the Company. The net spread includes the spread of the underlying collateral and the credit spreads on AGC.
Effect of Changes in Credit Spread on Credit Derivatives
As of December 31, 2023 As of December 31, 2022
Credit Spreads Estimated Net
Fair Value
(Pre-Tax) Estimated Change
in Gain/(Loss)
(Pre-Tax) Estimated Net
Fair Value
(Pre-Tax) Estimated Change
in Gain/(Loss)
(Pre-Tax)
(in millions)
Increase of 25 bps $ (115) $ (65) $ (233) $ (71)
Base Scenario (50) — (162) —
Decrease of 25 bps (29) 21 (99) 63
All transactions priced at floor (12) 38 (27) 135
See Part II, Item 8, Financial Statements and Supplementary Data, Note 6, Contracts Accounted for as Credit Derivatives, for additional information.
Sensitivity of Investment Portfolio to Interest Rate Risk
The Company is exposed to interest rate risk in its investment portfolio. As interest rates rise for an available-for-sale investment portfolio, the fair value of fixed-maturity securities generally decreases; as interest rates fall for an available-for-sale portfolio, the fair value of fixed-maturity securities generally increases. The Company’s policy is generally to hold assets in the investment portfolio to maturity. Therefore, barring a default, interest rate movements do not result in realized gains or losses unless securities are sold prior to maturity. The Company does not hedge interest rate risk; instead, interest rate fluctuation risk is managed through the investment guidelines which limit duration and prohibit investment in historically high volatility sectors.
Interest rate sensitivity in the investment portfolio can be estimated by projecting a hypothetical instantaneous increase or decrease in interest rates. The following table presents the estimated pre-tax change in fair value of the Company’s fixed-maturity securities and short-term investments from instantaneous parallel shifts in interest rates.
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Increase (Decrease) in Fair Value (Pre-Tax)
of Fixed-Maturity Securities and Short-Term Investments
from Changes in Interest Rates (1)
As of December 31,
2023 2022
(in millions)
Decrease of 300 bps $ 804 $ 1,315
Decrease of 200 bps 547 854
Decrease of 100 bps 267 404
Increase of 100 bps (261) (378)
Increase of 200 bps (520) (734)
Increase of 300 bps (774) (1,069)
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(1) Sensitivity analysis assumes a floor of zero for interest rates.
See Part II, Item 8, Financial Statements and Supplementary Data, Note 7, Investments and Cash, for additional information.
Sensitivity of New Business Production to Interest Rate Risk
Fluctuations in interest rates also affect the demand for the Company’s product. When interest rates are lower or when the market is otherwise relatively less risk averse, the spread between insured and uninsured obligations typically narrows and, as a result, financial guaranty insurance typically provides lower cost savings to issuers than it would during periods of relatively wider spreads. These lower cost savings generally lead to a corresponding decrease in demand and premiums obtainable for financial guaranty insurance. In addition, increases in prevailing interest rate levels can lead to a decreased volume of capital markets activity and, correspondingly, a decreased volume of insured transactions. See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, Results of Operations — Insurance Segment — New Business Production, for additional information.
Sensitivity of Expected Loss to be Paid (Recovered) to Interest Rates
Expected losses to be paid (recovered), and therefore loss reserves and loss and LAE, are sensitive to changes in interest rates in several ways. First, expected losses to be paid are discounted at the end of each reporting period at the risk-free rate, such that an increase in discount rates has the effect of reducing net expected loss to be paid or reducing net expected recoverables. The effect of changes in discount rates on expected losses to be paid was a loss of $3 million in 2023, a gain of $115 million in 2022, and a gain of $33 million in 2021. The gain related to changes in discount rates was highest in 2022 as interest rates rose from historically low levels during 2022.
Some of the Company’s expected losses to be paid (recovered) relate to insured obligations with variable interest rates.
Fluctuations in interest rates impact the performance of insured transactions where there are differences between the interest rates on the underlying collateral and the interest rates on the insured securities. For example, a rise in interest rates could increase the amount of losses the Company projects for certain RMBS and student loan transactions. The impact of fluctuations in interest rates on such transactions varies, depending on, among other things, the interest rates on the underlying collateral and insured securities, the relative amounts of underlying collateral and liabilities, the structure of the transaction and the sensitivity to interest rates of the behavior of the underlying borrowers and the value of the underlying assets.
In the case of RMBS, fluctuations in interest rates impact the amount of periodic excess spread, which is created when a trust’s underlying collateral produce interest that exceeds the amount required to pay interest on the insured notes. There are several RMBS transactions in the Company’s insured portfolio which benefit from excess spread either by using it to cover losses in a particular period or to reimburse past claims under the Company’s policies. As of December 31, 2023, the Company projects that the maximum potential excess spread at risk in the U.S. RMBS transactions is approximately $20 million.
Since RMBS excess spread is determined by the relationship between interest rates on the underlying collateral and of the trust’s certificates, it can be affected by unmatched moves in either of these interest rates. For example, modifications to underlying mortgage rates (e.g., rate reductions for troubled borrowers) can reduce excess spread when an upswing in short-term rates that increases the trust’s certificate interest rate is not met with equal increases to the interest rates on the underlying mortgages. These potential reductions in excess spread are often mitigated by an interest rate cap, which goes into effect once
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the collateral rate falls below the stated certificate rate. Interest due on most of the RMBS transactions the Company insures is capped at the collateral rate. The Company is not obligated to pay additional claims when the collateral interest rate drops below the trust's certificate stated interest rate, rather this just causes the Company to lose the benefit of potential positive excess spread. Additionally, faster than expected prepayments can decrease the dollar amount of excess spread and therefore reduce the cash flow available to cover losses or reimburse past claims. Interest rates can also have indirect effects on the underlying performance or value of collateral backing an obligation. Higher interest rates can lead to slower prepayments of debt, and can cause market prices of financed assets to decline. Conversely, lower interest rates can lead to faster prepayment and higher potential recovery values.
In addition, the value of expected recoveries that are in the form of bonds or other securities (which are sensitive to changes in interest rates) also affects the net expected loss to be paid (recovered). See Item 8, Financial Statements and Supplementary Data, Note 3, Outstanding Exposure and Note 4, Expected Loss to be Paid (Recovered).
Sensitivity to Foreign Exchange Rate Risk
Foreign exchange risk is the risk that a financial instrument’s value will change due to a change in the foreign currency exchange rates. The Company has foreign denominated securities in its investment portfolio as well as foreign denominated premium receivables. The Company’s material exposure is to changes in U.S. dollar/pound sterling and U.S. dollar/euro exchange rates. Securities denominated in currencies other than U.S. dollar were 9.1% and 9.2% of the fixed-maturity securities and short-term investments as of December 31, 2023 and 2022, respectively. Changes in fair value of available-for-sale investments attributable to changes in foreign exchange rates are recorded in other comprehensive income. Approximately 70% and 74% of installment premiums at December 31, 2023 and December 31, 2022, respectively, are denominated in currencies other than the U.S. dollar, primarily the pound sterling and euro. Changes in premiums receivable attributable to changes in foreign exchange rates are reported in the consolidated statement of operations.
Increase (Decrease) in Carrying Value
of Fixed-Maturity Securities and Short-Term Investments and Premiums Receivable
from Changes in Foreign Exchange Rates
Fixed-Maturity Securities and Short-Term Investments Premium Receivable, net of Reinsurance and Commissions Payable
As of December 31, As of December 31,
2023 2022 2023 2022
(in millions)
Decrease of 30% $ (227) $ (226) $ (305) $ (288)
Decrease of 20% (151) (151) (204) (192)
Decrease of 10% (76) (75) (102) (96)
Increase of 10% 76 75 102 96
Increase of 20% 151 151 204 192
Increase of 30% 227 226 305 288
See Part II, Item 8, Financial Statements and Supplementary Data, Note 7, Investments and Cash and Note 5, Contracts Accounted for as Insurance, for additional information.
Sensitivity of CIVs to Market Risk
The fair value of the consolidated CLO fund, which is the largest CIV, is generally sensitive to changes related to: estimated prepayment speeds; estimated default rates (determined on the basis of an analysis of collateral attributes such as historical collateral performance, borrower profiles and other features relevant to the evaluation of collateral credit quality); reinvestment assumptions; yields implied by market prices for similar securities; and changes to the market prices of loans similar to those held by the CLO fund. Significant changes to some of these inputs could materially change the NAV of the consolidated CLO fund, as these are all inputs used to project and discount future cash flows.
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The Company’s sensitivity to changes in fair value of the CIVs is summarized below.
Sensitivity of CIVs
to Changes in Fair Value (Pre-Tax)
As of December 31,
2023 2022
(in millions)
Decrease of 10% $ (28) $ (19)
Increase of 10% 28 19
See Part II, Item 8, Financial Statements and Supplementary Data, Note 7, Investments and Cash, for additional information.
Sensitivity of FG VIEs’ Assets and Liabilities to Market Risk
The fair value of the Company’s FG VIEs’ assets is generally sensitive to changes related to estimated prepayment speeds; estimated default rates (determined on the basis of an analysis of collateral attributes such as: historical collateral performance, borrower profiles and other features relevant to the evaluation of collateral credit quality); yields implied by market prices for similar securities; and house price depreciation/appreciation rates based on macroeconomic forecasts. Significant changes to some of these inputs could materially change the fair value of the FG VIEs’ assets and the implied collateral losses within the transaction. In general, the fair value of the FG VIEs’ assets is most sensitive to changes in the projected collateral losses, where an increase in collateral losses typically leads to a decrease in the fair value of FG VIEs’ assets, while a decrease in collateral losses typically leads to an increase in the fair value of FG VIEs’ assets. The third-party pricing provider utilizes an internal model to determine an appropriate yield at which to discount the cash flows of the security, by factoring in collateral types, weighted average lives and other structural attributes specific to the security being priced. The expected yield is further calibrated by utilizing algorithms designed to aggregate market color, received by the independent third party, on comparable bonds.
The models to price the FG VIEs’ liabilities used, where appropriate, the same inputs used in determining fair value of FG VIEs’ assets and, for those liabilities insured by the Company, the benefit from the Company's insurance policy guaranteeing the timely payment of principal and interest, taking into account the Company’s own credit risk.
Significant changes to certain of the inputs described above could materially change the timing of expected losses within the insured transaction which is a significant factor in determining the implied benefit from the Company’s insurance policy guaranteeing the timely payment of principal and interest for the tranches of debt issued by the FG VIEs that is insured by the Company. In general, extending the timing of expected loss payments by the Company into the future typically leads to a decrease in the value of the Company’s insurance and a decrease in the fair value of the Company’s FG VIEs’ liabilities with recourse, while a shortening of the timing of expected loss payments by the Company typically leads to an increase in the value of the Company’s insurance and an increase in the fair value of the Company’s FG VIEs’ liabilities with recourse.
See Part II, Item 8, Financial Statements and Supplementary Data, Note 8, Financial Guaranty Variable Interest Entities and Consolidated Investment Vehicles, for additional information.
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