Financial Guaranty Reserve for Premium Deficiency (PDR) In our financial guaranty segment, we recognize a net claim liability on our non-derivative transactions prior to an event  of default (insured event) when there is evidence that credit deterioration has occurred for a particular policy and that the  present value of the expected claim loss exceeds the unearned premium revenue.  The expected claim loss is based on the  probability-weighted present value of expected net cash outflows to be paid under , or in connection with, the policy. In  measuring the net claim liability, we develop the present value of expected net cash outflows by using our own assumptions  about the likelihood of various possible outcomes, including potential settlements or commutations, based on information  currently available. We determine the existence of credit deterioration on directly insured policies based on periodic reporting  from the insured party , indenture trustee or servicer and based on our surveillance ef forts. These expected cash outflows are  discounted using a risk-free rate. Our assumptions about the likelihood of outcomes, expected cash outflows and the appropriate  risk-free rate are updated each reporting period. For assumed policies, we use information provided by the ceding company , as  well as our specific knowledge of the credit for determining expected loss. There are both performing and under -performing credits in our financial guaranty portfolio.  Performing credits generally  have investment grade internal ratings, denoting nominal to moderate credit risk. However , net claim liabilities may be  established for performing credits if the expected losses on the credit exceed the unearned premium revenue for the contract  based on the present value of the expected net cash outflows. If our risk management department concludes that a directly  insured transaction should no longer be considered performing, it is placed in one of three designated watch list categories for  deteriorating credits: Special Mention, Intensified Surveillance or Case Reserve.  Assumed exposures in financial guaranty’ s  reinsurance portfolio are generally placed in one of these categories if the ceding company for such transaction downgrades it to  an equivalent watch list classification. However , should our financial guaranty risk management group disagree with the risk  rating assigned by the ceding company, we may assign our own risk rating rather than use the risk rating assigned by the ceding  company. The risk management function in our financial guaranty business is responsible for the identification, analysis,  measurement and surveillance of credit, market, legal and operational risk associated with our financial guaranty insurance  contracts. Risk management is also primarily responsible for claims prevention and loss mitigation strategies.  This discipline is  applied during the ongoing monitoring and surveillance of each exposure in the portfolio. Insurance enterprises are required to establish a PDR if the net present value of the expected future losses and expenses  for a particular product exceeds the net present value of expected future premiums and existing reserves for that product.  We  reassess our expectations for premiums, losses and expenses for our financial guaranty and mortgage insurance businesses at  least quarterly and update our premium deficiency analysis accordingly . Expected future expenses include consideration of  maintenance costs associated with maintaining records relating to insurance contracts and with the processing of premium  collections. We also consider investment income in the premium deficiency calculation through the use of our pre-tax  investment yield to discount certain cash flows for this analysis. For our mortgage insurance business, we group our mortgage insurance products into two products: first-lien and second- lien. To assess the need for a PDR on our first-lien insurance portfolio, we develop loss projections based on modeled loan  defaults related to our current RIF . This projection is based on recent trends in default experience, severity and rates of  defaulted loans moving to claim (such default to claim rates are net of our estimates of rescissions and denials), as well as  recent trends in the rate at which loans are prepaid. As of December 31, 2012, our modeled loan default projections for our  first-lien insured portfolio assume that the rate at which current loans will default will remain consistent for the next three  months with those rates observed during 2012, and then gradually return to normal historical levels over the subsequent three  years. For our first-lien insurance business, because the combination of the net present value of expected premiums and already  established reserves (net of reinsurance recoverables) exceeds the net present value of expected losses and expenses, a first-lien  PDR was not required as of December 31, 2012 or December 31, 2011. Our pre-tax investment yield used as the discount rate  in these present value calculations was 1.98% and 2.62% as of December 31, 2012 and 2011, respectively. Expected losses are  based on an assumed paid claim rate of approximately  11.7% on our total first-lien insurance portfolio ( 6.6% on performing  loans and 46.8% on defaulted loans). Assuming all other factors remained constant, if our assumed paid claim rate increased  from 11.7% to approximately 14.5%, we would be required to establish a PDR. New business originated since the beginning of  2009 is expected to be profitable, which has contributed to the overall expected net profitability of our first-lien portfolio. In  addition, estimated rescissions and denials on insured loans are expected to partially of fset the impact of expected defaults and  claims.  146