Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended March 31, 2013

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 1-10777

 

 

Ambac Financial Group, Inc.

(Exact name of Registrant as specified in its charter)

 

 

 

Delaware   13-3621676
(State of incorporation)   (I.R.S. employer
identification no.)

One State Street Plaza

New York, New York

  10004
(Address of principal executive offices)   (Zip code)

(212) 668-0340

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act): (Check one):

 

Large accelerated filer   ¨    Accelerated filer   ¨
Non-accelerated filer   ¨    Smaller reporting company   x

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of May 9, 2013, 45,000,000 shares of common stock, par value $0.01 per share, of the Registrant were outstanding.

 

 

 


Table of Contents

Ambac Financial Group, Inc. and Subsidiaries

TABLE OF CONTENTS

 

         PAGE  

PART I FINANCIAL INFORMATION

  

Item 1.

  Financial Statements of Ambac Financial Group, Inc. and Subsidiaries   
  Consolidated Balance Sheets – March 31, 2013 (unaudited) and December 31, 2012      3   
 

Consolidated Statements of Total Comprehensive Income (unaudited) – three months ended March 31, 2013 and 2012

     4   
 

Consolidated Statements of Stockholders’ Equity (unaudited) – three months ended March 31, 2013 and 2012

     5   
 

Consolidated Statements of Cash Flows (unaudited) – three months ended March 31, 2013 and 2012

     6   
  Notes to Unaudited Consolidated Financial Statements      7   

Item 2.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations      59   

Item 3.

  Quantitative and Qualitative Disclosures About Market Risk      88   

Item 4.

  Controls and Procedures      88   

PART II OTHER INFORMATION

  

Item 1.

  Legal Proceedings      89   

Item 1A.

  Risk Factors      89   

Item 6.

  Exhibits      91   

SIGNATURES

     92   

INDEX TO EXHIBITS

     93   

 

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Table of Contents

Part I Financial Information

 

Item 1. Financial Statements of Ambac Financial Group, Inc. and Subsidiaries

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

(DEBTOR-IN-POSSESSION)

Consolidated Balance Sheets

 

(Dollars in Thousands)    March 31,
2013
    December 31,
2012
 
     (Unaudited)        

Assets:

    

Investments:

    

Fixed income securities, at fair value (amortized cost of $4,657,096 in 2013 and $4,751,824 in 2012)

   $ 5,402,290      $ 5,402,395   

Fixed income securities pledged as collateral, at fair value (amortized cost of $228,066 in 2013 and $265,517 in 2012)

     228,228        265,779   

Short-term investments, at fair value (amortized cost of $767,919 in 2013 and $661,219 in 2012)

     767,932        661,658   

Other investments, at fair value

     113,812        100   
  

 

 

   

 

 

 

Total investments

     6,512,262        6,329,932   

Cash

     53,135        43,837   

Receivable for securities

     40,822        761   

Investment income due and accrued

     33,944        39,742   

Premium receivables

     1,543,098        1,620,621   

Reinsurance recoverable on paid and unpaid losses

     160,682        159,086   

Deferred ceded premium

     170,032        177,893   

Subrogation recoverable

     545,007        497,346   

Deferred acquisition costs

     192,306        199,160   

Loans

     8,691        9,203   

Derivative assets

     112,811        126,106   

Other assets

     40,365        39,715   

Variable interest entity assets:

    

Fixed income securities, at fair value

     2,414,607        2,261,294   

Restricted cash

     2,258        2,290   

Investment income due and accrued

     1,338        4,101   

Loans (includes $14,116,811 and $15,359,073 at fair value)

     14,327,840        15,568,711   

Other assets

     5,462        5,467   
  

 

 

   

 

 

 

Total assets

   $ 26,164,660      $ 27,085,265   
  

 

 

   

 

 

 

Liabilities and Stockholders’ Equity:

    

Liabilities:

    

Liabilities subject to compromise

   $ 1,704,641      $ 1,704,904   

Unearned premiums

     2,623,445        2,778,401   

Losses and loss expense reserve

     6,590,216        6,619,486   

Ceded premiums payable

     92,085        94,527   

Obligations under investment agreements

     357,371        356,091   

Obligations under investment repurchase agreements

     5,926        5,926   

Deferred taxes

     1,540        1,586   

Current taxes

     97,274        96,778   

Long-term debt

     153,873        150,170   

Accrued interest payable

     246,378        228,835   

Derivative liabilities

     505,746        531,315   

Other liabilities

     91,057        102,488   

Payable for securities purchased

     17,051        25   

Variable interest entity liabilities:

    

Accrued interest payable

     828        3,618   

Long-term debt (includes $13,996,531 and $15,200,538 at fair value)

     14,229,373        15,436,008   

Derivative liabilities

     2,317,625        2,221,781   

Other liabilities

     301        293   
  

 

 

   

 

 

 

Total liabilities

     29,034,730        30,332,232   
  

 

 

   

 

 

 

Stockholders’ deficit:

    

Preferred stock

     —         —    

Common stock

     3,080        3,080   

Additional paid-in capital

     2,172,027        2,172,027   

Accumulated other comprehensive income

     720,071        625,385   

Accumulated deficit

     (6,015,025     (6,297,264

Common stock held in treasury at cost

     (410,695     (410,755
  

 

 

   

 

 

 

Total Ambac Financial Group, Inc. stockholders’ deficit

     (3,530,542     (3,907,527

Noncontrolling interest

     660,472        660,560   
  

 

 

   

 

 

 

Total stockholders’ deficit

     (2,870,070     (3,246,967
  

 

 

   

 

 

 

Total liabilities and stockholders’ deficit

   $ 26,164,660      $ 27,085,265   
  

 

 

   

 

 

 

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

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Table of Contents

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

(DEBTOR-IN-POSSESSION)

Consolidated Statements of Total Comprehensive Income (Unaudited)

 

(Dollars in Thousands, Except Share Data)    Three Months March 31,  
     2013     2012  

Revenues:

    

Net premiums earned

   $ 100,256      $ 94,950   

Net investment income:

    

Securities available-for-sale and short-term

     85,612        112,117  

Other investments

     (543     —     
  

 

 

   

 

 

 

Total net investment income

     85,069        112,117   

Other-than-temporary impairments:

    

Total other-than-temporary impairment losses

     —          (4,604

Portion of loss recognized in other comprehensive income

     —          1,533   
  

 

 

   

 

 

 

Net other-than-temporary impairment losses recognized in earnings

     —          (3,071

Net realized investment gains

     46,060        392   

Change in fair value of credit derivatives:

    

Realized gains and other settlements

     2,509        3,254   

Unrealized gains (losses)

     10,278        (10,476
  

 

 

   

 

 

 

Net change in fair value of credit derivatives

     12,787        (7,222

Derivative products

     (569     46,957   

Other income

     9,498        64,793   

Income on variable interest entities

     38,326        15,220   
  

 

 

   

 

 

 

Total revenues before expenses and reorganization items

     291,427        324,136   
  

 

 

   

 

 

 

Expenses:

    

Losses and loss expenses

     (51,135     (2,320

Underwriting and operating expenses

     34,429        36,534   

Interest expense

     23,165        33,839   
  

 

 

   

 

 

 

Total expenses before reorganization items

     6,459        68,053   
  

 

 

   

 

 

 

Pre-tax income from continuing operations before reorganization items

     284,968        256,083   

Reorganization items

     2,059        2,461   
  

 

 

   

 

 

 

Pre-tax income from continuing operations

     282,909        253,622   

Provision for income taxes

     657        300   
  

 

 

   

 

 

 

Net income

   $ 282,252      $ 253,322   

Less: net (loss) income attributable to the noncontrolling interest

     (47     2   
  

 

 

   

 

 

 

Net income attributable to common shareholders

   $ 282,299      $ 253,320   
  

 

 

   

 

 

 

Other comprehensive income, after tax:

    

Net income

   $ 282,252      $ 253,322   
  

 

 

   

 

 

 

Unrealized gain (loss) on securities, net of deferred income taxes of $0

     94,098        (16,852

(Loss) gain on foreign currency translation, net of deferred income taxes of $0

     (261     3,213   

Amortization of postretirement benefit, net of tax of $0

     808        (3,792
  

 

 

   

 

 

 

Total other comprehensive income (loss), net of tax

     94,645        (17,431
  

 

 

   

 

 

 

Total comprehensive income

     376,897        235,891   

Less: comprehensive (loss) income attributable to the noncontrolling interest:

    

Net (loss) income

     (47     2   

Currency translation adjustments

     (41     31   
  

 

 

   

 

 

 

Total comprehensive income attributable to Ambac Financial Group, Inc.

     376,985        235,858   
  

 

 

   

 

 

 

Net income per share attributable to Ambac Financial Group, Inc. common shareholders

   $ 0.93      $ 0.84   
  

 

 

   

 

 

 

Net income per diluted share attributable to Ambac Financial Group, Inc. common shareholders

   $ 0.93      $ 0.84   
  

 

 

   

 

 

 

Weighted-average number of common shares outstanding:

    

Basic

     302,469,516        302,466,328   

Diluted

     302,579,254        302,580,597   

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

(DEBTOR-IN-POSSESSION)

Consolidated Statements of Stockholders’ Equity (Unaudited)

 

           Ambac Financial Group, Inc.        
(Dollars in Thousands)    Total     Accumulated
Deficit
    Accumulated
Other
Comprehensive
Income
    Preferred
Stock
     Common
Stock
     Paid-in
Capital
     Common
Stock Held
in Treasury,
at Cost
    Noncontrolling
Interest
 

Balance at January 1, 2012

   ($ 3,149,533   ($ 6,039,922   $ 463,259      $ —         $ 3,080       $ 2,172,027       ($ 411,419   $ 663,442   

Total comprehensive income

     235,891        253,320        (17,462                33   

Stock-based compensation

     (338     (338               

Shares issued under equity plans

     338                     338     
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Balance at March 31, 2012

   ($ 2,913,642   ($ 5,786,940   $ 445,797      $ —         $ 3,080       $ 2,172,027       ($ 411,081   $ 663,475   
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

 

           Ambac Financial Group, Inc.        
(Dollars in Thousands)    Total     Accumulated
Deficit
    Accumulated
Other
Comprehensive
Income
     Preferred
Stock
     Common
Stock
     Paid-in
Capital
     Common
Stock Held
in Treasury,
at Cost
    Noncontrolling
Interest
 

Balance at January 1, 2013

   ($ 3,246,967   ($ 6,297,264   $ 625,385       $ —         $ 3,080       $ 2,172,027       ($ 410,755   $ 660,560   

Total comprehensive income

     376,897        282,299        94,686                    (88

Stock-based compensation

     (60     (60                

Shares issued under equity plans

     60                      60     
  

 

 

   

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Balance at March 31, 2013

   ($ 2,870,070   ($ 6,015,025   $ 720,071       $ —         $ 3,080       $ 2,172,027       ($ 410,695   $ 660,472   
  

 

 

   

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

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Table of Contents

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

(DEBTOR-IN-POSSESSION)

Consolidated Statements of Cash Flows (Unaudited)

 

     Three Months Ended March 31,  
     2013     2012  
(Dollars in Thousands)             

Cash flows from operating activities:

    

Net income attributable to common shareholders

   $ 282,299      $ 253,320   

Noncontrolling interest in subsidiaries’ earnings

     (47     2   
  

 

 

   

 

 

 

Net income

   $ 282,252      $ 253,322   

Adjustments to reconcile net income to net cash used in operating activities:

    

Depreciation and amortization

     727        820   

Amortization of bond premium and discount

     (42,421     (64,542

Reorganization items

     2,059        2,461   

Deferred income taxes

     (46     —     

Current income taxes

     496        300   

Deferred acquisition costs

     6,854        4,509   

Unearned premiums, net

     (147,095     (146,928

Losses and loss expenses, net

     (78,527     9,785   

Ceded premiums payable

     (2,442     (15,912

Investment income due and accrued

     5,798        5,497   

Premium receivables

     77,523        110,943   

Accrued interest payable

     17,543        26,684   

Net mark-to-market (gains) losses

     (10,278     10,476   

Net realized investment gains

     (46,060     (392

Other-than-temporary impairment charges

     —          3,071   

Variable interest entity activities

     (38,326     (15,220

Other, net

     49,273        (144,524
  

 

 

   

 

 

 

Net cash provided by operating activities

     77,330        40,350   
  

 

 

   

 

 

 

Cash flows from investing activities:

    

Proceeds from sales of bonds

     120,603        35,024   

Proceeds from matured bonds

     255,664        208,133   

Purchases of bonds

     (243,006     (182,008

Other investments, net

     (113,712     —     

Change in short-term investments

     (106,274     (110,751

Loans, net

     512        (247

Change in swap collateral receivable

     1,740        41,046   

Other, net

     20,508        85   
  

 

 

   

 

 

 

Net cash used in investing activities

     (63,965     (8,718
  

 

 

   

 

 

 

Cash flows from financing activities:

    

Paydowns of variable interest entity secured borrowing

     (4,067     (7,280

Payments for investment and repurchase agreement draws

     —          (420
  

 

 

   

 

 

 

Net cash used in financing activities

     (4,067     (7,700
  

 

 

   

 

 

 

Net cash flow

     9,298        23,932   

Cash at January 1

     43,837        15,999   
  

 

 

   

 

 

 

Cash at March 31

   $ 53,135      $ 39,931   
  

 

 

   

 

 

 

Supplemental disclosure of cash flow information:

    

Cash paid during the year for:

    

Income taxes

   $ 229      $ —    

Interest on variable interest entity secured borrowing

   $ 218      $ 429   

Interest on investment agreements

   $ 1,724      $ 3,072   

Cash receipts and payments related to reorganization items:

    

Professional fees paid for services rendered in connection with the Chapter 11 proceeding

   $ 3,246      $ 1,641   

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

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Table of Contents

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

DEBTOR-IN-POSSESSION

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

1. BACKGROUND AND BUSINESS DESCRIPTION

These unaudited consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes thereto included in Ambac’s 2012 Annual Report on Form 10-K. Certain reclassifications may have been made to prior periods’ amounts to conform to the current period’s presentation.

Ambac Financial Group, Inc.

Ambac Financial Group, Inc. (“Ambac” or the “Company”), headquartered in New York City, is a financial services holding company incorporated in the state of Delaware. On November 8, 2010, Ambac filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code (“Bankruptcy Code”) in the United States Bankruptcy Court for the Southern District of New York (“Bankruptcy Court”). The Company, as debtor and debtor-in-possession, filed a Fifth Amended Plan of Reorganization on March 12, 2012, which was confirmed by order of the Bankruptcy Court on March 14, 2012 and modified in accordance with orders entered by the Bankruptcy Court on April 29, 2013 (such Fifth Amended Plan of Reorganization, as so modified, the “Reorganization Plan”). On April 30, 2013, Ambac executed a closing agreement with the United States Internal Revenue Service (the “IRS”) to conclude the settlement of a dispute with the IRS (the “IRS Settlement”), and concurrently paid $1,900, while the Segregated Account (as defined below) paid $100,000, to the United States in connection with such settlement. This closing agreement represented the final material contingency under the Reorganization Plan required for the adoption of fresh start reporting. On May 1, 2013 (the “Effective Date”), the Reorganization Plan became effective and Ambac emerged from bankruptcy.

Pursuant to the Reorganization Plan, Ambac distributed 45,000,000 shares of new common stock on May 1, 2013, consisting of (1) 43,946,750 shares to holders of senior debt securities outstanding prior to the Effective Date with claims against the Company of approximately $1,246,129 that were discharged in the bankruptcy case; (2) 378,250 shares to holders of allowed general unsecured claims against the Company in the aggregate amount of approximately $14,328 that were discharged in the bankruptcy case; and (3) 675,000 shares to holders of subordinate debt securities outstanding prior to the Effective Date with claims against the Company of approximately $444,183 that were discharged in the bankruptcy case. We have reserved approximately 10,000 shares for possible future distributions to holders of disputed general unsecured claims when such claims are resolved. Under the Reorganization Plan Ambac also distributed warrants to (1) the aforementioned holders of allowed general unsecured claims, which entitle such holders to acquire an additional 42,424 shares of new common stock of the Company at an exercise price of $16.67 per share at any time on or prior to April 30, 2023 and (2) the aforementioned holders of subordinate debt securities, which entitle such holders to acquire an additional 5,004,714 shares of new common stock of the Company at an exercise price of $16.67 per share at any time on or prior to April 30, 2023. The new common stock and warrants were listed on NASDAQ and began trading under the symbols “AMBC” and “AMBCW,” respectively, on May 1, 2013. All such common stock and warrants were issued without registration under the Securities Act of 1933, as amended, or state securities laws, in reliance on Section 1145 of the Bankruptcy Code. The common stock of the Company in existence prior to the Effective Date was cancelled on the Effective Date and the holders of such stock did not receive, and will not receive, any distributions under the Reorganization Plan.

In addition to the distributions described above, the Company may be required to distribute additional new common stock and warrants to claimholders in its Chapter 11 case and will need to make cash payments in respect of allowed administrative claims and professional fees relating to its bankruptcy. On or before the date that is thirty (30) days after the Effective Date, all entities holding claims arising from the rejection of executory contracts or unexpired leases must file such claims in accordance with the procedures prescribed by the Bankruptcy Court. Any allowed claims arising from the rejection of the Company’s executory contracts or unexpired leases would be classified as general unsecured claims, entitling the holders thereof to receive new common stock as warrants in accordance with the Reorganization Plan. On or before the date that is forty-five (45) days after the Effective Date, requests for the payment of certain administrative claims must be filed and served on the Company pursuant to the procedures prescribed by the Bankruptcy Court. The Company will pay any such allowed claims in cash. On or before the date that is sixty (60) days after the Effective Date, all entities holding claims for accrued professional compensation, must file and serve on the Company and certain other parties a final application for the allowance of such claims. The Company will pay any such allowed claims in cash.

 

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Table of Contents

Pursuant to the Mediation Agreement, dated September 21, 2011 (the “Mediation Agreement”) among the Company, the statutory committee of creditors appointed by the United States Trustee on November 17, 2010 (the “Creditors’ Committee”), Ambac Assurance Corporation (“Ambac Assurance”), the Segregated Account of Ambac Assurance Corporation (the “Segregated Account”), the Commissioner of Insurance of the State of Wisconsin, as the court-appointed rehabilitator of the Segregated Account (the “Rehabilitator”), and the Wisconsin Office of the Commissioner of Insurance (“OCI”), the terms of which formed an integral part of the Reorganization Plan, Ambac Assurance transferred $30,000 from an escrow account to Ambac on the Effective Date. Additionally, the Segregated Account issued a Junior Surplus Note in the amount of $350,000 to Ambac on the Effective Date in accordance with the Mediation Agreement. No payment of interest on or principal of Segregated Account Junior Surplus Notes may be made until all existing and future indebtedness of the Segregated Account, including Segregated Account Surplus Notes, policy claims and claims having statutory priority have been paid in full. All payments of principal and interest on Segregated Account Junior Surplus Notes are subject to the prior approval of the OCI. If the OCI does not approve the payment of interest on the Segregated Account Junior Surplus Notes, such interest will accrue and compound annually until paid.

As of the Effective Date, the Company was generally discharged and released from all pre-Effective Date debts, liabilities, claims, causes of action and interests in accordance with the provisions of the Reorganization Plan. Holders of claims and equity interests are also generally barred from commencing or continuing any action or proceeding relating to such claims, causes of action or interests. The Reorganization Plan also provides for broad exculpation and releases of the Company, Ambac Assurance, the Segregated Account, OCI, the Rehabilitator, the board of directors and board committees of the Company and Ambac Assurance, all individual directors, officers and employees of the Company and Ambac Assurance, the Creditors’ Committee and the individual members thereof, and each of the respective representatives of such parties, for actions or omissions that occurred on or prior to the Effective Date.

As provided for in the Reorganization Plan, Ambac’s Amended and Restated Certificate of Incorporation and revised Bylaws became effective on the Effective Date. Pursuant to the Amended and Restated Certificate of Incorporation of Ambac, Ambac is authorized to issue 150,000,000 shares of capital stock, consisting of 130,000,000 shares of common stock, par value $0.01 per share and 20,000,000 shares of preferred stock, par value $0.01 per share. In accordance with the Reorganization Plan and the bylaws of the reorganized Company, the Board of Directors of Ambac now consists of Ambac’s Chief Executive Officer and three other Directors selected by the pre-Effective Date creditors of the Company. The Reorganization Plan provides for a fifth Director to be selected by the Creditors’ Committee within 60 days of the Effective Date.

Ambac’s Amended and Restated Certificate of Incorporation limits voting and transfer rights of shareholders in significant ways. Article IV contains voting restrictions applicable to any person owning at least 10% of Ambac’s common stock so that such person shall not be entitled to cast votes in excess of one vote less than 10% of the votes entitled to be cast by all common stock holders, except as otherwise approved by OCI. Article XII generally prohibits transfers of common stock to the extent that, as a result of such transfer, either (i) the transferee would become the beneficial owner of 5% or more of the Company’s outstanding stock or (ii) the percentage stock ownership interest in the Company of any existing beneficial owner of 5% or more of the Company’s outstanding stock would be increased. A purported transferee of such a prohibited transfer shall not be recognized as a shareholder of Ambac for any purpose whatsoever in respect of the shares of common stock which comprise the prohibited transfer. The Board of Directors of Ambac may grant exceptions to the restrictions of Article XII. Furthermore, on September 27, 2012, the Bankruptcy Court entered an order (the “Trading Order”), amending and restating an order entered on November 30, 2010, establishing procedures for certain pre-Effective Date transfers or acquisitions of equity interests in and claims (including debt securities) against the Company. The Bankruptcy Court retains jurisdiction after the Effective Date to enforce the Trading Order with respect to pre-Effective Date violations of the Trading Order.

Upon emergence from bankruptcy the Company will adopt fresh start reporting, as described more fully in Note 14. The adoption of fresh start accounting principles reflects the Company’s becoming a new entity for financial reporting purposes. Accordingly, the financial statements as of the Fresh Start Reporting Date (as defined in Note 14) and for subsequent periods will report the results of the new entity with no beginning retained earnings. Such financial statements will not be comparable to the financial statements prior to emergence.

 

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Segregated Account of Ambac Assurance Corporation

Ambac Assurance is Ambac’s principal operating subsidiary. In March 2010, Ambac Assurance established the Segregated Account pursuant to Wisc. Stat. §611.24(2) to segregate certain segments of Ambac Assurance’s liabilities, and OCI commenced rehabilitation proceedings in the Dane County, Wisconsin Circuit Court (the “Rehabilitation Court”) with respect to the Segregated Account (the “Segregated Account Rehabilitation Proceedings”) in order to permit OCI to facilitate an orderly run-off and/or settlement of the liabilities allocated to the Segregated Account pursuant to the provisions of the Wisconsin Insurers Rehabilitation and Liquidation Act. Net par exposure as of March 31, 2013 for policies allocated to the Segregated Account is $26,122,693.

In 2010, Ambac Assurance issued a $2,000,000 secured note due in 2050 (the “Secured Note”) to the Segregated Account. Interest on the Secured Note accrues at the rate of 4.5% per annum, and accrued interest will be added to principal quarterly. The Segregated Account has the ability to demand payment from time to time to pay claims and other liabilities. The balance of the Secured Note is $358,568 at March 31, 2013, including capitalized interest since the date of issuance. In addition, once the Secured Note has been exhausted, the Segregated Account has the ability to demand payment from time to time under an aggregate excess of loss reinsurance agreement provided by Ambac Assurance (the “Reinsurance Agreement”) to pay claims and other liabilities.

Ambac Assurance is not obligated to make payments on the Secured Note or under the Reinsurance Agreement if its surplus as regards to policyholders is less than $100,000 (the “Minimum Surplus Amount”). As long as the surplus as regards to policyholders is not less than the Minimum Surplus Amount, payments by Ambac Assurance to the Segregated Account under the Reinsurance Agreement are not capped. At March 31, 2013, insurance liabilities for policies allocated to the Segregated Account were $6,211,471. At March 31, 2013, Ambac Assurance’s surplus as regards to policyholders of $159,451 exceeds the Minimum Surplus Amount.

On October 8, 2010, the Rehabilitator filed a plan of rehabilitation for the Segregated Account (the “Segregated Account Rehabilitation Plan”) in the Circuit Court of Dane County, Wisconsin in which the Segregated Account Rehabilitation Proceedings are pending (the “Rehabilitation Court”). The Rehabilitation Court confirmed the Segregated Account Rehabilitation Plan on January 24, 2011. The confirmed Segregated Account Rehabilitation Plan also makes permanent the injunctions issued by the Rehabilitation Court on March 24, 2010.

The Segregated Account Rehabilitation Plan has not been made effective and is subject to modification. On June 4, 2012, the Rehabilitation Court approved a motion made by the Rehabilitator to make partial interim policy claim payments to Segregated Account policyholders. In accordance with such approval, on August 1, 2012, the Rehabilitator promulgated Rules Governing the Submission, Processing and Partial Payment of Policy Claims in accordance with the June 4, 2012 Interim Cash Payment Order (the “Policy Claim Rules”). Pursuant to the Policy Claim Rules, with effect from August 1, 2012, holders of policies allocated to the Segregated Account were, and continue to be, allowed to submit policy claims for review and partial payment equating to 25% of the permitted policy claim amount. The Rehabilitator is considering seeking approval from the Rehabilitation Court for the Segregated Account to make cash payments in excess of 25% of the permitted policy claim amount (“Supplemental Payments”) with respect to certain insured securities so that cash flow in the related securitization trusts that would have been available to reimburse Ambac Assurance had it paid claims in full is not diverted to uninsured holders who would not have received such cash flow if claims had been paid in full. Without making such Supplemental Payments, Ambac Assurance would likely realize lower levels of reimbursements than currently contemplated by our reserves in the relevant transactions as cash flow that would have been available for the benefit of Ambac Assurance would be lost to such uninsured holders. It is presently anticipated that the Rehabilitator will initially identify approximately 14 transactions on which the Segregated Account would make Supplemental Payments.

The Rehabilitator has informed the Company that it intends to seek rulings from the IRS as to certain tax issues associated with potential amendments to the Segregated Account Rehabilitation Plan. Pursuant to such amendments, surplus notes would not be issued with respect to the unpaid balance of permitted policy claims, but such balance would be recorded by the Segregated Account as outstanding policy obligations which would accrue interest at a rate of 5.1%, compounded annually until paid (any such outstanding policy obligation, including accrued interest thereon, being a “Deferred Amount”). If favorable rulings are received by the Rehabilitator from the IRS as to such tax issues, then the Rehabilitator would likely file amendments to the Segregated Account Rehabilitation Plan to provide for Deferred Amounts to be established, rather than for surplus notes to be issued, with respect to the unpaid portion of permitted policy claims. The timing and likelihood of such amendments to the Segregated Account Rehabilitation Plan are presently unclear, but such amendments would result in a material change to our financial results.

2. DEBTOR IN POSSESSION FINANCIAL INFORMATION

Entities operating in bankruptcy and expecting to reorganize under Chapter 11 of the Bankruptcy Code are subject to the additional accounting and financial reporting guidance in ASC Topic 852 “Reorganizations”. In accordance with ASC Topic 852, following the date Ambac filed its Chapter 11 petition, we discontinued recording interest expense on debt classified as Liabilities subject to compromise, which amounted to $232,556 as of March 31, 2013. The stated contractual interest on debt classified as Liabilities subject to compromise amounted to $20,660 and $24,162 for the three months ended as of March 31, 2013 and March 31, 2012, respectively. As required by ASC Topic 852, the amount of the Liabilities subject to compromise represents our estimate of known or potential pre-petition claims to be addressed in connection with the bankruptcy. The Liabilities subject to compromise in the Consolidated Balance Sheets consists of the following:

 

     March 31,
2013
     December 31,
2012
 

Debt obligations and accrued interest payable

   $ 1,690,312       $ 1,690,312   

Accounts payable

     14,329         14,592   
  

 

 

    

 

 

 

Consolidated liabilities subject to compromise

     1,704,641         1,704,904   

Payable to non-debtor subsidiaries

     —           35   
  

 

 

    

 

 

 

Debtor’s Liabilities subject to compromise

   $ 1,704,641       $ 1,704,939   
  

 

 

    

 

 

 

 

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Professional advisory fees and other costs directly associated with our reorganization are reported separately as reorganization items pursuant to ASC Topic 852. Reorganization items also include adjustments to reflect the carrying value of certain pre-petition liabilities at their allowable claim amounts. The reorganization items in the Consolidated Statements of Total Comprehensive Income for the three months ended March 31, 2013 and 2012 consisted of the following items:

 

     Three months ended
March 31, 2013
     Three months ended
March 31, 2012
 

U.S. Trustee fees

   $ 10       $ 20   

Professional fees

     2,049         2,441   
  

 

 

    

 

 

 

Total reorganization items

   $ 2,059       $ 2,461   
  

 

 

    

 

 

 

3. SPECIAL PURPOSE ENTITIES, INCLUDING VARIABLE INTEREST ENTITIES

Ambac, through its subsidiaries, has engaged in transactions with special purpose entities, including variable interest entities (“VIEs”), in various capacities. Ambac most commonly has provided financial guarantees, including credit derivative contracts, for various debt obligations issued by special purpose entities, including VIEs. Ambac has also sponsored two special purpose entities that issued medium-term notes to fund the purchase of certain financial assets. Ambac is also an investor in collateralized debt obligations, mortgage-backed and other asset-backed securities issued by VIEs and its ownership interest is generally insignificant to the VIE and/or Ambac does not have rights that direct the activities that are most significant to such VIE. In 2011, Ambac Assurance entered into a secured borrowing transaction under which two VIEs were created for the purpose of resecuritizing certain invested assets and collateralizing the borrowing. These VIEs are consolidated because Ambac Assurance was involved in their design and holds a significant amount of the beneficial interests issued by the VIEs or guarantees the assets held by the VIEs. VIE debt outstanding to third parties under this secured borrowing transaction was $10,521 and $14,588 as of March 31, 2013 and December 31, 2012, respectively. The debt represents the senior-most tranche of the securitization structure and is to be repaid from the non-insurance proceeds of certain RMBS securities which are guaranteed by Ambac Assurance. Such securities had a fair value of $218,735 and $201,329 as of March 31, 2013 and December 31, 2012, respectively. Refer to Note 8, Investments for further discussion of the restrictions on these securities.

Financial Guarantees:

Ambac’s subsidiaries provided financial guarantees in respect of assets held or debt obligations of special purpose entities, including VIEs. Ambac’s primary variable interest exists through this financial guarantee insurance or credit derivative contract. The transaction structure provides certain financial protection to Ambac. This financial protection can take several forms; however, the most common are over-collateralization, first loss and excess spread. In the case of over-collateralization (i.e., the principal amount of the securitized assets exceeds the principal amount of the debt obligations guaranteed), the structure allows the transaction to experience defaults among the securitized assets before a default is experienced on the debt obligations that have been guaranteed by Ambac’s subsidiaries. In the case of first loss, the financial guarantee insurance policy or credit derivative contract only covers a senior layer of losses on assets held or debt issued by special purpose entities, including VIEs. The first loss with respect to the assets is either retained by the asset seller or sold off in the form of equity or mezzanine debt to other investors. In the case of excess spread, the securitized assets contributed to special purpose entities, including VIEs, generate interest cash flows that are in excess of the interest payments on the related debt; such excess cash flow is applied to redeem debt, thus creating over-collateralization. Generally, upon deterioration in the performance of a transaction or upon an event of default as specified in the transaction legal documents, Ambac will obtain certain loss remediation rights. These rights may enable Ambac to direct the activities of the entity that most significantly impact the entity’s economic performance.

We determined that Ambac’s subsidiaries generally have the obligation to absorb the VIE’s expected losses given that they have issued financial guarantees supporting the liabilities (and in certain cases assets) of a VIE. As further described below, we consolidated certain VIEs because: a) we determined for certain transactions that experienced the aforementioned performance deterioration, that Ambac’s subsidiaries had the power, through voting rights or similar rights, to direct the activities of certain VIEs that most significantly impact the VIE’s economic performance because certain triggers had been breached in these transactions resulting in their ability to exercise certain loss remediation activities, or b) due to the passive nature of the VIEs’ activities, Ambac’s subsidiaries’ contingent loss remediation rights upon a breach of certain triggers in the future is considered to be the power to direct the activities that most significantly impact the VIEs’ economic performance. With respect to existing VIEs involving Ambac financial guarantees, Ambac is generally required to

 

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consolidate a VIE in the period that applicable triggers result in Ambac having control over the VIE’s most significant economic activities. A VIE is deconsolidated in the period that Ambac no longer has such control, which occurred in connection with insurance policies that were allocated to the Segregated Account, execution of remediation activities on the transaction or amortization of insured exposure, any of which may reduce the degree of Ambac’s control over a VIE.

Ambac Sponsored VIEs:

A subsidiary of Ambac has transferred financial assets to two special purpose entities. The business purpose of these entities is to provide certain financial guarantee clients with funding for their debt obligations. These special purpose entities are legal entities that are demonstrably distinct from Ambac. Ambac, its affiliates or its agents cannot unilaterally dissolve these entities. The permitted activities of these entities are limited to those outlined below. Ambac does not consolidate these entities because Ambac Assurance’s policies issued to these entities have been allocated to the Segregated Account, thereby limiting Ambac’s control over the entities’ most significant economic activities. Ambac has elected to account for its equity interest in these entities at fair value under the fair value option in accordance with ASC Topic 825, Financial Instruments. We believe that the fair value of the investments in these entities provides for greater transparency for recording profit or loss as compared to the equity method under ASC Topic 323, Investments—Equity Method in Joint Ventures. Refer to Note 7 for further information on the valuation technique and inputs used to measure the fair value of Ambac’s equity interest in these entities. At March 31, 2013 and December 31, 2012 the fair value of these entities is $14,230 and $14,557, respectively, and is reported within Other assets on the Consolidated Balance Sheets. The change in fair value of these entities is ($327) and ($756) for the three months ended March 31, 2013 and 2012, respectively.

Since their inception, there have been 15 individual transactions with these entities, of which 3 transactions were outstanding as of March 31, 2013. Total principal amount of debt outstanding was $464,495 and $466,938 at March 31, 2013 and December 31, 2012, respectively. In each case, Ambac sold assets to these entities. The assets are composed of utility obligations with a weighted average rating of BBB+ at March 31, 2013 and weighted average life of 8.7 years. The purchase by these entities was financed through the issuance of medium-term notes (“MTNs”), which are cross-collateralized by the purchased assets. The MTNs have the same expected weighted average life as the purchased assets. Derivative contracts (interest rate swaps) are used within the entities for economic hedging purposes only. Derivative positions were established at the time MTNs were issued to purchase financial assets. The activities of these entities are contractually limited to purchasing assets from Ambac, issuing MTNs to fund such purchase, executing derivative hedges and obtaining financial guarantee policies with respect to indebtedness incurred. As of March 31, 2013 Ambac Assurance had financial guarantee insurance policies issued for all assets, MTNs and derivative contracts owned and outstanding by the entities.

Insurance premiums paid to Ambac Assurance by these entities are earned in a manner consistent with other insurance policies, over the risk period. Additionally, any losses incurred on such insurance policies are included in Ambac’s Consolidated Statements of Total Comprehensive Income. Under the terms of an Administrative Agency Agreement, Ambac provides certain administrative duties, primarily collecting amounts due on the obligations and making interest payments on the MTNs.

There were no assets sold to these entities during the three months ended March 31, 2013 and 2012. Ambac Assurance earned premiums for issuing the financial guarantee policies on the assets, MTNs and derivative contracts of $30 and $145 for the three months ended March 31, 2013 and 2012, respectively. Ambac was not presented with claims on insurance policies issued to these entities during the three months ended March 31, 2013 and 2012, but did receive recoveries of $1,455 and $134 in respect of previously paid claims for the three months ended March 31, 2013 and 2012, respectively. Ambac also earned fees for providing other services amounting to $2 and $11 for the three months ended March 31, 2013 and 2012, respectively.

Derivative contracts are provided by Ambac Financial Services (“AFS”), Ambac’s derivative products subsidiary, to these entities. Ambac accounts for these contracts on a trade date basis at fair value. AFS paid $93 and $138 for the three months ended March 31, 2013 and 2012, respectively, under these derivative contracts.

Consolidation of VIEs:

Upon initial consolidation of a VIE, we recognize a gain or loss in earnings for the difference between: (i) the fair value of the consideration paid, the fair value of any non-controlling interests and the reported amount of any previously held interests and (ii) the net amount, as measured on a fair value basis, of the assets and liabilities consolidated. Upon deconsolidation of a VIE, we recognize a gain or loss for the difference between: (i) the fair value of any consideration received, the fair value of any retained non-controlling investment in the VIE and the carrying amount of any non-controlling interest in the VIE and (ii) the carrying amount of the VIE’s assets and liabilities. Gains or losses from consolidation and deconsolidation that are reported in earnings are reported within Income on variable interest entities.

 

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The variable interest in a VIE generally involves one or more of the following: a financial guarantee policy issued to the VIE, a written credit derivative contract that references liabilities of the VIE or an investment in securities issued by the VIE. The impact of consolidating such VIEs on Ambac’s balance sheet is the elimination of transactions between the consolidated VIEs and Ambac’s operating subsidiaries and the inclusion of the VIE’s third party assets and liabilities. For a financial guarantee policy issued to a consolidated VIE, Ambac does not reflect the financial guarantee insurance policy in accordance with the related insurance accounting rules under ASC Topic 944, Financial Services—Insurance. Consequently, Ambac eliminates insurance assets (premium receivables, reinsurance recoverable, deferred ceded premium, subrogation recoverable and deferred acquisition costs) and insurance liabilities (unearned premiums, loss and loss expense reserves and ceded premiums payable) from the Consolidated Balance Sheets. For investment securities owned by Ambac that are debt instruments issued by the VIE, the investment securities balance is eliminated upon consolidation. Ambac did not consolidate any VIEs solely as a result of purchases of the VIE’s debt instruments.

As of March 31, 2013 consolidated VIE assets and liabilities relating to 18 consolidated entities were $16,751,505 and $16,548,127, respectively. As of December 31, 2012, consolidated VIE assets and liabilities relating to 18 consolidated entities were $17,841,863 and $17,661,700, respectively. Ambac is not primarily liable for, and does not guarantee all of the debt obligations issued by the VIEs. Ambac would only be required to make payments on the guaranteed debt obligations in the event that the issuer of such debt obligations defaults on any principal or interest due. Additionally, Ambac’s creditors do not have rights with regard to the assets of the VIEs. Ambac evaluates the net income statement effects and earnings per share effects to determine attributions between Ambac and non-controlling interests as a result of consolidating a VIE. Ambac has determined that the net changes in fair value of most consolidated VIE assets and liabilities are attributable to Ambac due to Ambac’s interest through financial guarantee premium and loss payments with the VIE.

The financial reports of certain VIEs are prepared by outside trustees and are not available within the time constraints Ambac requires to ensure the financial accuracy of the operating results. As such, the financial results of certain VIEs are consolidated on a time lag that is no longer than 90 days.

The table below provides the fair value of fixed income securities, by asset-type, held by consolidated VIEs as of March 31, 2013 and December 31, 2012:

 

     March 31, 2013      December 31, 2012  

Investments:

     

Corporate obligations

   $ 2,414,607       $ 2,261,294   
  

 

 

    

 

 

 

Total variable interest entity assets: Fixed income securities

   $ 2,414,607       $ 2,261,294   
  

 

 

    

 

 

 

The following table provides supplemental information about the loans held as assets and long-term debt associated with the VIEs for which the fair value option has been elected as of March 31, 2013 and December 31, 2012:

 

     Estimated fair value      Unpaid principal balance  

March 31, 2013:

     

Loans

   $ 14,116,811       $ 12,522,933   

Long-term debt

   $ 13,996,531       $ 13,893,522   

December 31, 2012:

     

Loans

   $ 15,359,073       $ 13,995,141   

Long-term debt

   $ 15,200,538       $ 15,460,530   

 

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Variable Interests in Non-Consolidated VIEs

The following table displays the carrying amount of the assets, liabilities and maximum exposure to loss of Ambac’s variable interests in non-consolidated VIEs resulting from financial guarantee and credit derivative contracts by major underlying asset classes, as of March 31, 2013 and December 31, 2012:

 

     Carrying Value of Assets and Liabilities  
     Maximum
Exposure To
Loss(1)
     Insurance
Assets(2)
     Insurance
Liabilities(3)
     Derivative
Liabilities(4)
 

March 31, 2013:

           

Global Structured Finance:

           

Collateralized debt obligations

   $ 8,880,445       $ 7,656       $ 10,922       $ 104,544   

Mortgage-backed—residential

     21,936,226         645,742         3,875,478         —    

Mortgage-backed—commercial

     610,872         —          —          2,788   

Other consumer asset-backed

     5,755,161         98,185         1,120,657         38,018   

Other commercial asset-backed

     9,611,024         420,513         1,196,286         9,427   

Other

     5,257,351         129,485         607,600         5,475   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Global Structured Finance

     52,051,079         1,301,581         6,810,943         160,252   

Global Public Finance

     35,730,898         524,309         606,981         29,470   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 87,781,977       $ 1,825,890       $ 7,417,924       $ 189,722   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

     Carrying Value of Assets and Liabilities  
     Maximum
Exposure To
Loss(1)
     Insurance
Assets(2)
     Insurance
Liabilities(3)
     Derivative
Liabilities(4)
 

December 31, 2012:

           

Global Structured Finance:

           

Collateralized debt obligations

   $ 10,176,522       $ 9,673       $ 13,328       $ 113,057   

Mortgage-backed—residential

     24,008,616         603,867         3,969,336         —    

Mortgage-backed—commercial

     643,387         —          —          2,418   

Other consumer asset-backed

     5,895,377         101,494         1,042,522         45,610   

Other commercial asset-backed

     10,192,858         451,048         1,215,074         7,293   

Other

     5,505,007         132,004         590,017         4,393   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Global Structured Finance

     56,421,767         1,298,086         6,830,277         172,771   

Global Public Finance

     37,096,228         542,179         633,358         28,663   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 93,517,995       $ 1,840,265       $ 7,463,635       $ 201,434   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Maximum exposure to loss represents the gross maximum future payments of principal and interest on insured obligations and credit derivative contracts. Ambac’s maximum exposure to loss does not include the benefit of any financial instruments (such as reinsurance or hedge contracts) that Ambac may utilize to mitigate the risks associated with these variable interests.
(2) Insurance assets represent the amount recorded in “Premium receivables” and “Subrogation recoverable” for financial guarantee contracts on Ambac’s Consolidated Balance Sheets.
(3) Insurance liabilities represent the amount recorded in “Losses and loss expense reserve” and “Unearned premiums” for financial guarantee contracts on Ambac’s Consolidated Balance Sheets.
(4) Derivative liabilities represent the fair value recognized on credit derivative contracts on Ambac’s Consolidated Balance Sheets.

 

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4. COMPREHENSIVE INCOME

The following table displays the changes in the balances of each component of accumulated other comprehensive income for the three months ended March 31, 2013:

 

     Unrealized
Gains (Losses)
on Available-
for-Sale
Securities (1)
    Loss on
Foreign
Currency
Translation (1)
    Amortization of
Postretirement
Benefit (1)
    Total  

Balance at December 31, 2012

   $ 651,272      $ (20,027   $ (5,860   $ 625,385   
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income before reclassifications

     100,180        (220     —          99,960   

Amounts reclassified from accumulated other comprehensive income

     (6,082     —          808        (5,274
  

 

 

   

 

 

   

 

 

   

 

 

 

Net current period other comprehensive income

     94,098        (220     808        94,686   
  

 

 

   

 

 

   

 

 

   

 

 

 

Balance at March 31, 2013

   $ 745,370      $ (20,247   $ (5,052   $ 720,071   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) All amounts are net of tax and noncontrolling interest. Amounts in parentheses indicate debits.

 

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The following table displays the significant amounts reclassed out of each component of accumulated other comprehensive income for the three months ended March 31, 2013:

 

Details about Accumulated Other

Comprehensive Income Components

   Amount
Reclassified
from
Accumulated
Other
Comprehensive
Income (1)
   

Affected Line Item in the Consolidated
Statement of Total Comprehensive  Income

Unrealized Gains (Losses) on Available-for-Sale Securities

    
   $ 6,082      Net realized investment gains
     —        Tax (expense) benefit
  

 

 

   
   $ 6,082      Net of tax and noncontrolling interest (3)
  

 

 

   

Amortization of Postretirement Benefit

    

Prior service cost

   $ (1,707   Underwriting and operating expenses (2)

Actuarial gains (losses)

     899      Underwriting and operating expenses (2)
  

 

 

   
     (808   Total before tax
     —        Tax (expense) benefit
  

 

 

   
   $ (808   Net of tax and noncontrolling interest (3)
  

 

 

   

Total reclassifications for the period

   $ 5,274      Net of tax and noncontrolling interest (3)
  

 

 

   

 

(1) Amounts in parentheses indicate debits to profit/loss.
(2) These accumulated other comprehensive income components are included in the computation of net periodic benefit cost.
(3) Amount agrees with amount reported as reclassifications from AOCI in the disclosure about changes in AOCI balances.

5. NET INCOME PER SHARE

Basic net income per share is computed by dividing net income available to common stockholders by the weighted-average number of common shares outstanding. Common shares outstanding includes common stock issued plus restricted stock units for which no future service is required as a condition to the delivery of the underlying common stock less treasury shares. Diluted net income per share is computed by dividing net income attributable to common stockholders by the weighted-average number of common shares outstanding plus all dilutive potential common shares outstanding during the period. All dilutive potential common shares outstanding consider common stock deliverable pursuant to nonvested restricted stock units. These dilutive shares totaled 109,738 and 114,269 from the assumed settlement of diluted nonvested restricted stock units at March 31, 2013 and 2012, respectively. The following table presents securities outstanding that could potentially dilute basic EPS in the future that were not included in the computation of diluted EPS because they were antidilutive for years ended March 31, 2013 and 2012:

 

     Three Months Ended
March  31, 2013
     Three Months Ended
March  31, 2012
 

Stock options

     480,350         887,672   

 

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In connection with Ambac’s emergence from bankruptcy in the second quarter of 2013, Ambac’s pre-Effective Date common stock and equity interests, including stock options, warrants and other rights to acquire shares, have been cancelled. Accordingly, the stock options and restricted stock units referenced in the table above will not be antidilutive to the new common stock that was issued in May 2013.

6. FINANCIAL GUARANTEE INSURANCE CONTRACTS

Net Premiums Earned:

Amounts presented in this Note relates only to Ambac’s non-derivative insurance business for insurance policies issued to beneficiaries, including VIEs, for which we do not consolidate the VIE.

Gross premiums are received either upfront (typical of public finance obligations) or in installments (typical of structured finance obligations). For premiums received upfront, an unearned premium revenue (“UPR”) liability is established, which is initially recorded as the cash amount received. For installment premium transactions, a premium receivable asset and offsetting UPR liability is initially established in an amount equal to: (i) the present value of future contractual premiums due (the “contractual” method) or, (ii) if the underlying insured obligation is a homogenous pool of assets which are contractually prepayable, the present value of premiums to be collected over the expected life of the transaction (the “expected” method). An appropriate risk-free rate corresponding to the weighted average life of each policy and currency is used to discount the future premiums contractually due or expected to be collected. For example, U.S. dollar exposures are discounted using U.S. Treasury rates while exposures denominated in a foreign currency are discounted using the appropriate risk-free rate for the respective currency. The weighted average risk-free rate at March 31, 2013 and December 31, 2012, were 2.7% and 2.6%, respectively, and the weighted average period of future premiums used to estimate the premium receivable at March 31, 2013 and December 31, 2012, were 9.8 years and 9.6 years, respectively.

Insured obligations consisting of homogeneous pools for which Ambac uses expected future premiums to estimate the premium receivable and UPR include residential mortgage-backed securities. As prepayment assumptions change for homogenous pool transactions, or if there is an actual prepayment for a “contractual” method installment transaction, the related premium receivable and UPR are adjusted in equal and offsetting amounts with no immediate effect on earnings using new premium cash flows and the then current risk-free rate.

Generally, the priority for the payment of financial guarantee premiums to Ambac, as required by the bond indentures of the insured obligations, is very senior in the waterfall. Additionally, in connection with the allocation of certain liabilities to the Segregated Account, trustees are required under the Segregated Account Rehabilitation Plan and related court orders to continue to pay installment premiums, notwithstanding the Segregated Account Rehabilitation Proceedings. In evaluating the credit quality of the premiums receivable, management evaluates the internal ratings of the transactions underlying the premiums receivable. As of March 31, 2013 and December 31, 2012, approximately 40% of the premiums receivable related to transactions with non-investment grade internal ratings, comprised mainly of non-investment grade MBS, student loan transactions and a certain asset-backed transaction, which comprised 7%, 9%, and 15% of the total premiums receivable at March 31, 2013 and December 31, 2012, respectively. As of March 31, 2013 and December 31, 2012, $119,162 and $118,961, respectively, of premium receivables relating to a non-investment obligation were deemed uncollectable. Past due premiums on policies insuring non-investment grade obligations amounted to less than $500 at March 31, 2013.

 

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Below is the gross premium receivable roll-forward (direct and assumed contracts) for the periods ended March 31, 2013 and December 31, 2012:

 

     March 31,
2013
    December 31,
2012
 

Beginning premium receivable

   $ 1,620,621      $ 2,028,479   

Premium payments received

     (35,115     (155,626

Adjustments for changes in expected life of homogeneous pools and actual changes to contractual cash flows

     (14,524     (299,906

Accretion of premium receivable discount

     11,190        50,407   

Uncollectible premiums

     (201     (28,031

Other adjustments (including foreign exchange)

     (38,873     25,298   
  

 

 

   

 

 

 

Ending premium receivable

   $ 1,543,098      $ 1,620,621   
  

 

 

   

 

 

 

 

Similar to gross premiums, premiums ceded to reinsurers are paid either upfront or in installments. Premiums ceded to reinsurers reduce the amount of premiums earned by Ambac from its financial guarantee insurance policies.

When a bond issue insured by Ambac Assurance has been retired, including those retirements due to refundings or calls, any remaining UPR is recognized at that time to the extent the financial guarantee contract is legally extinguished, causing accelerated premium revenue. For installment premium paying transactions, we offset the recognition of any remaining UPR by the reduction of the related premium receivable to zero (as it will not be collected as a result of the retirement), which may cause negative accelerated premium revenue. Accelerated premium revenue for retired obligations for the three months ended March 31, 2013 and 2012 were $29,360 and $15,790, respectively. Certain obligations insured by Ambac have been legally defeased whereby government securities are purchased by the issuer with the proceeds of a new bond issuance, or less frequently with other funds of the issuer, and held in escrow (a pre-refunding). The principal and interest received from the escrowed securities are then used to retire the Ambac-insured obligations at a future date either to their maturity date or a specified call date. Ambac has evaluated the provisions in certain financial guarantee insurance policies issued on legally defeased obligations and determined those insurance policies have not been legally extinguished and, therefore, premium revenue recognition has not been accelerated. The effect of reinsurance on premiums written and earned was as follows:

 

     Three Months Ended March 31,  
     2013     2012  
     Written     Earned     Written     Earned  

Direct

   ($ 3,530   $ 107,079      ($ 92,594   $ 97,148   

Assumed

     —          24        —          25   

Ceded

     1,014        (6,847     16,854        (2,223
  

 

 

   

 

 

   

 

 

   

 

 

 

Net premiums

   ($ 2,516   $ 100,256      ($ 75,740   $ 94,950   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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Table of Contents

The table below summarizes the future gross undiscounted premiums expected to be collected, and future expected premiums earned, net of reinsurance at March 31, 2013:

 

     Future
premiums
expected
to be
collected (1)
     Future
expected
premiums to
be earned,
net of
reinsurance (1)
 

Three months ended:

     

June 30, 2013

   $ 34,028       $ 58,929   

September 30, 2013

     32,009         55,616   

December 31, 2013

     30,709         52,685   

Twelve months ended:

     

December 31, 2014

     132,258         194,154   

December 31, 2015

     126,751         177,515   

December 31, 2016

     120,311         165,528   

December 31, 2017

     114,183         154,685   

Five years ended:

     

December 31, 2022

     502,819         639,948   

December 31, 2027

     396,110         452,156   

December 31, 2032

     283,899         290,129   

December 31, 2037

     149,835         149,612   

December 31, 2042

     51,437         42,639   

December 31, 2047

     15,846         14,828   

December 31, 2052

     3,639         4,692   

December 31, 2057

     92         297   
  

 

 

    

 

 

 

Total

   $ 1,993,926       $ 2,453,413   
  

 

 

    

 

 

 

 

(1) The future premiums expected to be collected and future premiums expected to be earned, net of reinsurance disclosed in the above table relate to the discounted premium receivable asset and unearned premium liability recorded on Ambac’s balance sheet. The use of contractual lives for many bond types which do not have homogeneous pools of underlying collateral is required in the calculation of the premium receivable as described above, which results in a higher premium receivable balance than if expected lives were considered. If installment paying policies are retired early premiums reflected in the premium receivable asset and amounts reported in the above table for such policies may not be collected in the future.

 

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Table of Contents

Loss and Loss Expense Reserves:

A loss reserve is recorded on the balance sheet on a policy-by-policy basis for the excess of: (a) the present value of expected net cash flows required to be paid under an insurance contract, over (b) the UPR for that contract. Below is the loss reserve roll-forward, net of subrogation recoverable and reinsurance for the three months ended March 31, 2013 and the year ended December 31, 2012:

 

     Three Months Ended
March  31,
2013
    Year Ended
December 31,
2012
 

Beginning balance of loss and loss expense reserves, net of subrogation recoverable and reinsurance

   $ 5,974,731      $ 6,230,780   
  

 

 

   

 

 

 

Changes in the loss and loss expense reserves due to:

    

Current year:

    

Establishment of new loss and loss expense reserves, gross of RMBS subrogation and net of reinsurance

     4,083        464,058   

Paid claims and loss expenses, net of subrogation and reinsurance

     (58     (20,765

Establishment of RMBS subrogation recoveries, net of reinsurance

     (188 )     —    
  

 

 

   

 

 

 

Total current year

     3,837        443,293   
  

 

 

   

 

 

 

Prior years:

    

Change in previously established loss and loss expense reserves, gross of RMBS subrogation and net of reinsurance

     (129,090     72,700   

Paid claims and loss expenses, net of subrogation and reinsurance

     12,365        (944,860

Change in previously established RMBS subrogation recoveries, net of reinsurance

     34,617        172,818   
  

 

 

   

 

 

 

Total prior years

     (82,108     (699,342
  

 

 

   

 

 

 

Net change in loss and loss expense reserves

     (78,271     (256,049
  

 

 

   

 

 

 

Ending loss and loss expense reserves, net of subrogation recoverable and reinsurance

   $ 5,896,460      $ 5,974,731   
  

 

 

   

 

 

 

The positive development in loss reserves established in prior years for the three months ended March 31, 2013 was primarily due to the strengthening of collateral supporting sub-prime RMBS exposures which resulted in lower expected ultimate losses and lower expected subrogation recoveries related to representation and warranty breaches (“RMBS subrogation recoveries”) on insured RMBS securitizations.

The change in net loss and loss expense reserves of ($78,271) and ($256,049) for the three months ended March 31, 2013 and year ended December 31, 2012, respectively, are included in loss and loss expenses in the Consolidated Statement of Total Comprehensive Income. Loss expense reserves are established for surveillance, legal and other mitigation expenses associated with adversely classified credits. Total net loss expense reserves, included in the above table, were $134,477 and $136,790 at March 31, 2013 and December 31, 2012, respectively. Total loss and loss expense of ($51,135) and ($2,320) for the three month periods ended March 31, 2013 and 2012, respectively, are included in loss and loss expenses in the Consolidated Statement of Total Comprehensive Income. During the three month periods ended March 31, 2013 and 2012, respectively, reinsurance recoveries of losses included in loss and loss expenses in the Consolidated Statements of Total Comprehensive Income were $3,881 and $12,518, respectively.

 

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The tables below summarize information related to policies currently included in Ambac’s loss reserves or subrogation recoverable at at March 31, 2013 and December 31, 2012. The weighted average risk-free rate used to discount loss reserves at March 31, 2013 and December 31, 2012 was 2.2% and 1.6%, respectively.

Surveillance Categories (at March 31, 2013)

 

     I/SL     IA     II     III     IV     V     Total  

Number of policies

     13        19        23        100        149        1        305   

Remaining weighted-average contract period (in years)

     13        19        20        19        7        6        12   

Gross insured contractual payments outstanding:

              

Principal

   $ 375,901      $ 1,720,891      $ 1,204,275      $ 7,567,920      $ 12,001,394      $ 47      $ 22,870,428   

Interest

     217,054        1,286,857        535,433        3,574,483        2,421,012        18        8,034,857   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ 592,955      $ 3,007,748      $ 1,739,708      $ 11,142,403      $ 14,422,406      $ 65      $ 30,905,285   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross undiscounted claim liability

   $ 6,442      $ 56,453      $ 42,156      $ 4,036,278      $ 7,973,957      $ 65      $ 12,115,351   

Discount, gross claim liability

     (525     (4,740     (8,465     (1,367,508     (900,496     (2     (2,281,736
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross claim liability before all subrogation and before reinsurance

   $ 5,917      $ 51,713      $ 33,691      $ 2,668,770      $ 7,073,461      $ 63      $ 9,833,615   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less:

              

Gross RMBS subrogation(1)

     —         (93     —          (6,417     (2,490,885     —          (2,497,395

Discount, RMBS subrogation

     —          1       —          18        10,007        —          10,026   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted RMBS subrogation, before reinsurance

     —          (92 )     —          (6,399     (2,480,878     —          (2,487,369
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less:

              

Gross other subrogation(2)

     —          —          (20,043 )     (139,834     (779,446     —          (939,323

Discount, other subrogation

     —          —          7,644       22,212        36,059        —          65,915   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted other subrogation, before reinsurance

     —          —          (12,399 )     (117,622     (743,387     —          (873,408
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross claim liability, net of all subrogation and discounts, before reinsurance

   $ 5,917      $ 51,621      $ 21,292      $ 2,544,749      $ 3,849,196      $ 63      $ 6,472,838   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less: Unearned premium reserves

     (3,931     (30,958     (10,341     (413,644     (104,597     —          (563,471

Plus: Loss adjustment expenses reserves

     —          32       3,300       5,593       126,917        —          135,842   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Claim liability reported on Balance Sheet, before reinsurance(3)

   $ 1,986      $ 20,695      $ 14,251      $ 2,136,698      $ 3,871,516      $ 63      $ 6,045,209   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Reinsurance recoverable reported on Balance Sheet

   $ —        $ 2,781      $ 2,465      $ 137,915      $ 17,521      $ —        $ 160,682   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) RMBS subrogation represents Ambac’s estimate of subrogation recoveries from RMBS transaction sponsors for representation and warranty breaches.
(2) Other subrogation represents subrogation, including subrogation from RMBS transactions, other than subrogation as defined in (1) above.

 

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Table of Contents
(3) Claim liability reported on the Balance Sheet, before reinsurance is included in the Consolidated Balance Sheets as follows:

 

Loss and loss expense reserve (net of potential subrogation recoveries of $2,482,302)

   $ 6,590,216   

Subrogation recoverable (includes gross potential recovery of $878,475)

     (545,007
  

 

 

 
   $ 6,045,209   
  

 

 

 

Surveillance Categories (at December 31, 2012)

 

     I/SL     IA     II     III     IV     V     Total  

Number of policies

     14        12        28        114        147        1        316   

Remaining weighted-average contract period (in years)

     15        21        18        20        8        6        13   

Gross insured contractual payments outstanding:

              

Principal

   $ 311,157      $ 786,998      $ 1,245,793      $ 9,161,747      $ 12,554,628      $ 47      $ 24,060,370   

Interest

     166,276        715,129        379,237        4,905,775        3,076,746        20        9,243,183   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ 477,433      $ 1,502,127      $ 1,625,030      $ 14,067,522      $ 15,631,374      $ 67      $ 33,303,553   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross undiscounted claim liability

   $ 2,135      $ 40,898      $ 49,521      $ 4,051,076      $ 7,976,765      $ 67      $ 12,120,462   

Discount, gross claim liability

     (219     (3,532     (3,247     (1,342,910     (788,720     (3     (2,138,631
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross claim liability before all subrogation and before reinsurance

   $ 1,916      $ 37,366      $ 46,274      $ 2,708,166      $ 7,188,045      $ 64      $ 9,981,831   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less:

              

Gross RMBS subrogation(1)

     —          —          —          (16,170     (2,544,993     —          (2,561,163

Discount, RMBS subrogation

     —          —          —          312        37,626        —          37,938   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted RMBS subrogation, before reinsurance

     —          —          —          (15,858     (2,507,367     —          (2,523,225
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less:

              

Gross other subrogation(2)

     —          —          —          (141,012     (766,717     —          (907,729

Discount, other subrogation

     —          —          —          21,238        15,711        —          36,949   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted other subrogation, before reinsurance

     —          —          —          (119,774     (751,006     —          (870,780
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross claim liability, net of all subrogation and discounts, before reinsurance

   $ 1,916      $ 37,366      $ 46,274      $ 2,572,534      $ 3,929,672      $ 64      $ 6,587,826   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less: Unearned premium reserves

     (1,179     (21,626     (17,120     (450,247     (113,622     —          (603,794

Plus: Loss adjustment expenses reserves

   $ —        $ —        $ —        $ —        $ 138,108      $ —        $ 138,108   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Claim liability reported on Balance Sheet, before reinsurance(3)

   $ 737      $ 15,740      $ 29,154      $ 2,122,287      $ 3,954,158      $ 64      $ 6,122,140   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Reinsurance recoverable reported on Balance Sheet

   $ —        $ 1,078      $ 7,085      $ 128,333      $ 22,590      $ —        $ 159,086   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) RMBS subrogation represents Ambac’s estimate of subrogation recoveries from RMBS transaction sponsors for representation and warranty breaches.
(2) Other subrogation represents subrogation, including subrogation from RMBS transactions, other than subrogation as defined in (1) above.

 

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(3) Claim liability reported on the Balance Sheet, before reinsurance is included in the Consolidated Balance Sheets as follows:

 

Loss and loss expense reserve (net of potential subrogation recoveries of $2,611,430)

   $ 6,619,486   

Subrogation recoverable (includes gross potential recovery of $782,575)

     (497,346
  

 

 

 
   $ 6,122,140   
  

 

 

 

Loss and loss expense reserves ceded to reinsurers at March 31, 2013 and December 31, 2012 were $148,749 and $147,409, respectively. Amounts were included in reinsurance recoverable on the Consolidated Balance Sheets.

Ambac records estimated subrogation recoveries for breaches of representations and warranties by sponsors of certain RMBS transactions utilizing an Adverse and Random Sample approach. Ambac has recorded RMBS subrogation recoveries of $2,487,369 ($2,460,389 net of reinsurance) and $2,523,225 ($2,497,233 net of reinsurance) at March 31, 2013 and December 31, 2012, respectively. The balance of RMBS subrogation recoveries and the related claim liabilities, by estimation approach, at March 31, 2013 and December 31, 2012, are as follows:

 

     March 31, 2013  

Approach

   Count      Gross loss reserve
before subrogation
recoveries
     Subrogation
recoveries(1) (2)
    Gross loss reserve
after subrogation
recoveries
 

Adverse samples

     29       $ 2,424,630       $ (1,483,726   $ 940,904   

Random samples

     20         1,015,011         (1,003,643     11,368   
  

 

 

    

 

 

    

 

 

   

 

 

 

Totals

     49       $ 3,439,641       $ (2,487,369   $ 952,272   
  

 

 

    

 

 

    

 

 

   

 

 

 
     December 31, 2012  

Approach

   Count      Gross loss reserve
before subrogation
recoveries
     Subrogation
recoveries  (1) (2)
    Gross loss reserve
after subrogation
recoveries
 

Adverse samples

     27       $ 2,331,878       $ (1,442,817   $ 889,061   

Random samples

     22         1,231,466         (1,080,408     151,058   
  

 

 

    

 

 

    

 

 

   

 

 

 

Totals

     49       $ 3,563,344       $ (2,523,225   $ 1,040,119   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

(1) The amount of recorded subrogation recoveries related to each securitization is limited to ever-to-date paid losses plus projected future paid losses for each policy. To the extent significant losses have been paid but not yet recovered, the recorded amount of RMBS subrogation recoveries may exceed the expected future claims for a given policy. The net cash inflow for these policies is recorded as a “Subrogation recoverable” asset. For those transactions where the subrogation recovery is less than expected future claims, the net cash outflow for these policies is recorded as a “Loss and loss expense reserve” liability.
(2) The sponsor’s repurchase obligation may differ depending on the terms of the particular transaction and the status of the specific loan, such as whether it is performing or has been liquidated or charged off. The estimated subrogation recovery for these transactions is based primarily on loan level data provided through trustee reports received in the normal course of our surveillance activities or provided by the sponsor. While this data may not include all the components of the sponsor’s contractual repurchase obligation we believe it is the best information available to estimate the subrogation recovery.

 

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Below is the rollforward of RMBS subrogation, by estimation approach, for the period December 31, 2012 through March 31, 2013:

 

     Random
sample
    Number of
transactions
    Adverse
sample
     Number of
transactions
     Total  

Rollforward:

            

Discounted RMBS subrogation (gross of reinsurance) at December 31, 2012

   $ 1,080,408        22      $ 1,442,817         27       $ 2,523,225   
  

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 

Changes recognized in 2013:

            

Additional transactions reviewed

     —          n/a        —           n/a         —     

Additional adverse sample loans reviewed

     —          n/a        —           n/a         —     

Impact of sponsor actions (1)

     (54,195     (2     —           n/a         (54,195

All other changes (2)

     (22,570 )     n/a        40,909         2         18,339   
  

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 

Discounted RMBS subrogation (gross of reinsurance) at March 31, 2013

   $ 1,003,643        20      $ 1,483,726         29       $ 2,487,369   
  

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 

 

(1) Sponsor actions include loan repurchases, direct payments to Ambac, and other contributions from sponsors.
(2) Other changes which may impact RMBS subrogation recoveries include changes in actual or projected collateral performance, changes in the creditworthiness of a sponsor, and/or the projected timing of recoveries. For the three months ended March 31, 2013, an additional two transactions were added to the Adverse Sample subrogation population; however, the impacts on RMBS subrogation disclosed in the Adverse Sample column relate to those, as well as other, transactions.

 

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7. FAIR VALUE MEASUREMENTS

ASC Topic 820, Fair Value Measurements and Disclosures, establishes a framework for measuring fair value and disclosures about fair value measurements.

Fair value Hierarchy:

ASC Topic 820 specifies a fair value hierarchy based on whether the inputs to valuation techniques used to measure fair value are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect Company-based assumptions. In accordance with ASC Topic 820, the fair value hierarchy prioritizes model inputs into three broad levels as follows:

 

•   Level 1

      Quoted prices for identical instruments in active markets. Assets and liabilities classified as Level 1 include US Treasury securities, exchange traded futures contracts, variable rate demand obligations, money market funds and mutual funds.

•   Level 2

      Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets. Assets and liabilities classified as Level 2 generally include direct investments in fixed income securities representing municipal, asset-backed and corporate obligations, financial services derivatives (including certain interest rate derivatives), and most long-term debt of variable interest entities consolidated under ASC Topic 810. Also included are equity interests in pooled investment funds measured at fair value where the investment can be redeemed in the near term at a value based on the net asset value.

•   Level 3

      Model derived valuations in which one or more significant inputs or significant value drivers are unobservable. This hierarchy requires the use of observable market data when available. Assets and liabilities classified as Level 3 include credit derivative contracts written as part of the financial guarantee business, certain financial services interest rate swap contracts, call options on long-term debt, equity interests in Ambac sponsored special purpose entities and certain investments in fixed income securities. Additionally, Level 3 assets and liabilities generally include fixed income securities, loan receivables, and certain long-term debt of variable interest entities consolidated under ASC Topic 810.

 

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The following table sets forth the carrying amount and fair value of Ambac’s financial assets and liabilities as of March 31, 2013 and December 31, 2012, including the level within the fair value hierarchy at which fair value measurements are categorized. As required by ASC Topic 820, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

 

     Carrying
Amount
    Total Fair
Value
    Fair Value Measurements Categorized as:  
       Level 1      Level 2     Level 3  

March 31, 2013

           

Financial assets:

           

Fixed income securities:

           

Municipal obligations

   $ 1,794,355      $ 1,794,355      $ —        $ 1,794,355      $ —    

Corporate obligations

     1,069,073        1,069,073        —          1,065,421        3,652   

Foreign obligations

     11,878        11,878        —          11,878        —    

U.S. government obligations

     98,312        98,312        98,312         —         —    

U.S. agency obligations

     53,975        53,975        —          53,975        —    

Residential mortgage-backed securities

     1,536,889        1,536,889        —          1,536,889        —    

Collateralized debt obligations

     27,357        27,357        —          23,452        3,905   

Other asset-backed securities

     810,451        810,451        —          760,217        50,234   

Fixed income securities, pledged as collateral:

           

U.S. government obligations

     228,228        228,228        228,228         —         —    

Short term investments

     767,932        767,932        765,379         2,553        —    

Other investments

     113,812        113,812        —          113,712       100   

Cash

     53,135        53,135        53,135         —         —    

Loans

     8,691        7,119        —          —         7,119   

Derivative assets:

           

Interest rate swaps—asset position

     112,811        112,811        —          112,811        —     

Interest rate swaps—liability position

     —         —         —          —         —    

Futures contracts

     —         —         —          —         —    

Other assets

     14,230        14,230        —          —         14,230   

Variable interest entity assets:

           

Fixed income securities:

           

Corporate obligations

     2,414,607        2,414,607        —          —         2,414,607   

Restricted cash

     2,258        2,258        2,258         —         —    

Loans

     14,327,840        14,318,834        —          202,023        14,116,811   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Total financial assets

   $ 23,445,834      $ 23,435,256      $ 1,147,312       $ 5,677,286      $ 16,610,658   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Financial liabilities:

           

Obligations under investment and repurchase agreements

   $ 363,297      $ 362,208      $ —        $ —       $ 362,208   

Liabilities subject to compromise

     1,690,312        909,138        —          909,138        —    

Long term debt, including accrued interest

     399,505        1,110,259        —          —         1,110,259   

Derivative liabilities:

           

Credit derivatives

     203,307        203,307        —          —         203,307   

Interest rate swaps—asset position

     (65,636     (65,636     —          (65,636     —    

Interest rate swaps—liability position

     366,949        366,949        —          241,567        125,382   

Futures contracts

     911       911       911        —         —    

Other contracts

     215        215        —          215        —    

Liabilities for net financial guarantees written

     6,921,299        4,576,031        —          —         4,576,031   

Variable interest entity liabilities:

           

Long-term debt

     14,229,373        14,207,206        —          12,296,617        1,910,589   

Derivative liabilities:

           

Interest rate swaps—liability position

     2,231,863        2,231,863        —          2,231,863        —    

Currency swaps—liability position

     85,762        85,762        —          85,762        —    
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Total financial liabilities

   $ 26,427,157      $ 23,988,213      $ 911       $ 15,699,526      $ 8,287,776   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

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     Carrying
Amount
    Total Fair
Value
    Fair Value Measurements Categorized as:  
       Level 1      Level 2     Level 3  

December 31, 2012

           

Financial assets:

           

Fixed income securities:

           

Municipal obligations

   $ 1,848,932      $ 1,848,932      $ —        $ 1,848,932      $ —    

Corporate obligations

     1,077,972        1,077,972        —          1,074,316        3,656   

Foreign obligations

     70,112        70,112        —          70,112        —    

U.S. government obligations

     127,283        127,283        127,283         —         —    

U.S. agency obligations

     82,535        82,535        —          82,535        —    

Residential mortgage-backed securities

     1,455,582        1,455,582        —          1,455,582        —    

Collateralized debt obligations

     33,342        33,342        —          26,860        6,482   

Other asset-backed securities

     706,637        706,637        —          656,373        50,264   

Fixed income securities, pledged as collateral:

           

U.S. government obligations

     265,779        265,779        265,779         —         —    

Short term investments

     661,658        661,658        657,886         3,772        —    

Other investments

     100        100        —          —         100   

Cash

     43,837        43,837        43,837         —         —    

Loans

     9,203        7,387        —          —         7,387   

Derivative assets:

           

Interest rate swaps—asset position

     124,853        124,853        —          124,853        —    

Interest rate swaps—liability position

     —         —         —          —         —    

Futures contracts

     1,253        1,253        1,253        —         —    

Other assets

     14,557        14,557        —          —         14,557   

Variable interest entity assets:

           

Fixed income securities:

           

Corporate obligations

     2,261,294        2,261,294        —          —         2,261,294   

Restricted cash

     2,290        2,290        2,290         —         —    

Loans

     15,568,711        15,560,051        —          200,978        15,359,073   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Total financial assets

   $ 24,355,930      $ 24,345,454      $ 1,098,328       $ 5,544,313      $ 17,702,813   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Financial liabilities:

           

Obligations under investment and repurchase agreements

   $ 362,017      $ 361,905      $ —        $ —       $ 361,905   

Liabilities subject to compromise

     1,690,312        434,823        —          434,823        —    

Long term debt, including accrued interest

     377,524        801,277        —          —         801,277   

Derivative liabilities:

           

Credit derivatives

     213,585        213,585        —          —         213,585   

Interest rate swaps—asset position

     (73,264     (73,264     —          (73,264     —    

Interest rate swaps—liability position

     390,774        390,774        —          282,022        108,752   

Futures contracts

     —         —         —                —    

Other contracts

     220        220        —          220        —    

Liabilities for net financial guarantees written

     7,074,808        3,091,257        —          —         3,091,257   

Variable interest entity liabilities:

           

Long-term debt

     15,436,008        15,414,233        —          12,457,732        2,956,501   

Derivative liabilities:

           

Interest rate swaps—liability position

     2,131,315        2,131,315        —          2,131,315        —    

Currency swaps—liability position

     90,466        90,466        —          90,466        —    
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Total financial liabilities

   $ 27,693,765      $ 22,856,591      $ —        $ 15,323,314      $ 7,533,277   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

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Determination of Fair Value:

When available, the Company generally uses quoted active market prices specific to the financial instrument to determine fair value, and classifies such items within Level 1. Because many fixed income securities do not trade on a daily basis, pricing sources apply available information through processes such as matrix pricing to calculate fair value. In those cases the items are classified within Level 2. If quoted market prices are not available, fair value is based upon models that use, where possible, current market-based or independently-sourced market parameters. Items valued using valuation models are classified according to the lowest level input or value driver that is significant to the valuation. Thus, an item may be classified in Level 3 even though there may be significant inputs that are readily observable.

The determination of fair value for financial instruments categorized in Level 2 or 3 involves significant judgment due to the complexity of factors contributing to the valuation. Third-party sources from which we obtain independent market quotes also use assumptions, judgments and estimates in determining financial instrument values and different third parties may use different methodologies or provide different prices for securities. We believe the potential for differences in third-party pricing levels is particularly significant with respect to residential mortgage-backed and certain other asset-backed securities held in our investment portfolio and referenced in our credit derivative portfolio, due to the low levels of trading activity for such securities. In addition, the use of internal valuation models may require assumptions about hypothetical or inactive markets. As a result of these factors, the actual trade value of a financial instrument in the market, or exit value of a financial instrument position by Ambac, may be significantly different from its recorded fair value.

Ambac’s financial instruments carried at fair value are mainly comprised of investments in fixed income securities, equity interests in pooled investment funds, derivative instruments, most variable interest entity assets and liabilities and equity interests in Ambac sponsored special purpose entities. Valuation of financial instruments is performed by Ambac’s Finance group using methods approved by senior financial management with consultation from risk management and portfolio managers as appropriate. Preliminary valuation results are discussed with portfolio managers quarterly to assess consistency with market transactions and trends as applicable. Market transactions such as trades or negotiated settlements of similar positions, if any, are reviewed quarterly to validate fair value model results. However many of the financial instruments valued using significant unobservable inputs have very little or no observable market activity. Methods and significant inputs and assumptions used to determine fair values across portfolios are reviewed quarterly by senior financial management. Additionally, changes to fair value methods and assumptions are reviewed with the CEO and the Audit and Risk Management Committee when such changes may be material to the company’s financial position or results. Other valuation control procedures specific to particular portfolios are described further below.

We reflect Ambac’s own creditworthiness in the fair value of financial liabilities by including a credit valuation adjustment (“CVA”) in the determination of fair value. A decline (increase) in Ambac’s creditworthiness as perceived by market participants will generally result in a higher (lower) CVA, thereby lowering (increasing) the fair value of Ambac’s financial liabilities as reported.

Fixed Income Securities:

The fair values of fixed income investment securities held by Ambac and its operating subsidiaries are based primarily on market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. Such quotes generally consider a variety of factors, including recent trades of the same and similar securities. For those fixed income investments where quotes were not available, fair values are based on internal valuation models. Key inputs to the internal valuation models include maturity date, coupon and yield curves for asset-type and credit rating characteristics that closely match those characteristics of the specific investment securities being valued. Longer (shorter) expected maturities or higher (lower) yields used in the valuation model will, in isolation, result in decreases (increases) in fair value. Generally, lower credit ratings or longer expected maturities will be accompanied by higher yields used to value a security. At March 31, 2013, approximately 9%, 90%, and 1% of the investment portfolio (excluding variable interest entity investments) was valued using dealer quotes, alternative pricing sources with reasonable levels of price transparency and internal valuation models, respectively. At December 31, 2012, approximately 10%, 89%, and 1% of the investment portfolio (excluding variable interest entity investments) was valued using dealer quotes, alternative pricing sources with reasonable levels of price transparency and internal valuation models, respectively.

 

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Ambac performs various review and validation procedures to quoted and modeled prices for fixed income securities, including price variance analyses, missing and static price reviews, overall valuation analyses by senior traders and finance managers and reviews associated with our ongoing impairment analysis. Unusual prices identified through these procedures will be evaluated further against separate broker quotes (if available) or internally modeled prices, and the pricing source values will be challenged as necessary. Price challenges generally result in the use of the pricing source’s quote as originally provided or as revised by the source following their internal diligence process. A price challenge may result in a determination that the pricing source cannot provide a reasonable value for a security or cannot adequately support a quote, in which case Ambac would resort to using either other quotes or internal models. Results of price challenges are reviewed and approved by senior traders and finance managers.

Third party quotes represent the only input to the reported fair value of Level 2 fixed income securities. Information about the valuation inputs for fixed income securities classified as Level 3 is included below:

Corporate obligations: These securities represent interest only strips of investment grade corporate obligations. The fair value of such securities classified as Level 3 was $3,652 and $3,656 at March 31, 2013 and December 31, 2012, respectively. Fair value was calculated using a discounted cash flow approach with the discount rate determined from the yields of corporate bonds from the same issuers. Significant inputs for the interest only strips valuation at March 31, 2013 and December 31, 2012 include the following weighted averages:

March 31, 2013

 

  a. Coupon rate: 0.345%

 

  b. Maturity: 20.89 years

 

  c. Yield: 6.03%

December 31, 2012

 

  a. Coupon rate: 0.345%

 

  b. Maturity: 21.14 years

 

  c. Yield: 6.08%

Collateralized debt obligations (“CDO”): Securities are floating rate senior notes where the underlying securities of the CDO consist of subordinated bank perpetual preferred securities. The fair value of such securities classified as Level 3 was $3,905 and $6,482 at March 31, 2013 and December 31, 2012, respectively. Fair value was calculated using a discounted cash flow approach with expected future cash flows discounted using a yield curve consistent with the security type and rating. Significant inputs for the valuation at March 31, 2013 and December 31, 2012 include the following weighted averages:

March 31, 2013

 

  a. Coupon rate: 0.85%

 

  b. Maturity: 1.24 years

 

  c. Yield: 3.85%

December 31, 2012

 

  a. Coupon rate: 1.05%

 

  b. Maturity: 1.51 years

 

  c. Yield: 5.92%

Other asset-backed securities: These securities are floating rate investment grade notes collateralized by various asset types. The fair value of such securities classified as Level 3 was $50,234 and $50,264 at March 31, 2013 and December 31, 2012, respectively. Fair value was calculated using a discounted cash flow approach with expected future cash flows discounted using a yield curve consistent with the security type and rating. Significant inputs for the valuation at March 31, 2013 and December 31, 2012 include the following weighted averages:

 

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March 31, 2013

 

  a. Coupon rate: 0.69%

 

  b. Maturity: 7.62 years

 

  c. Yield: 7.50%

December 31, 2012

 

  a. Coupon rate: 0.71%

 

  b. Maturity: 7.86 years

 

  c. Yield: 7.50%

Equity Interests in Pooled Investment Funds:

Investments in pooled investment funds are valued using the NAV per share, calculated on at least a monthly basis where NAV is the basis for determining the redemption value of the investment. These investments are classified as Level 2 as redemptions may be made in the near term (within 90 days) without significant impediments or restrictions. Ambac assesses impediments to redemption and other factors that may restrict the ability to redeem investments in the near term or at values approximating the NAV and may classify the investments as Level 3 if such factors exist.

Derivative Instruments:

Ambac’s derivative instruments primarily comprise interest rate and credit default swaps, and exchange traded futures contracts. All call options to repurchase surplus notes were exercised or expired in June 2012. Fair value is determined based upon market quotes from independent sources, when available. When independent quotes are not available, fair value is determined using valuation models. These valuation models require market-driven inputs, including contractual terms, credit spreads and ratings on underlying referenced obligations, yield curves and tax-exempt interest ratios. The valuation of certain interest rate as well as all credit derivative contracts also require the use of data inputs and assumptions that are determined by management and are not readily observable in the market. Under ASC Topic 820, Ambac is required to consider its own credit risk when measuring the fair value of derivative and other liabilities. The fair value of credit derivative liabilities was reduced by $191,683 and $261,203 at March 31, 2013 and December 31, 2012, as a result of incorporating a CVA into the valuation model for these transactions. Interest rate swaps and other derivative liabilities may also require an adjustment to fair value to reflect Ambac’s credit risk. Factors considered in estimating the amount of any Ambac CVA on such contracts include collateral posting provisions, right of set-off with the counterparty, the period of time remaining on the derivatives and the pricing of recent terminations and amendments. Derivative liabilities were reduced by $91,781 and $121,928 at March 31, 2013 and December 31, 2012, as a result of Ambac CVA adjustments to derivative contracts other than credit derivatives.

As described further below, certain valuation models require other inputs that are not readily observable in the market. The selection of a model to value a derivative depends on the contractual terms of, and specific risks inherent in the instrument as well as the availability of pricing information in the market.

For derivatives that are less complex and trade in liquid markets or may be valued primarily by reference to interest rates and yield curves that are observable and regularly quoted, such as interest rate swaps, we utilize vendor-developed models. These models provide the net present value of the derivatives based on contractual terms and observable market data. Downgrades of Ambac Assurance, as guarantor of the financial services derivatives, have increased collateral requirements and triggered termination provisions in certain interest rate swaps. Increased termination activity since the initial rating downgrades of Ambac Assurance provided additional information about the replacement and/or exit value of certain financial services derivatives, which has been incorporated into the fair value of these derivatives as appropriate. Generally, the need for counterparty (or Ambac) CVAs is mitigated by the existence of collateral posting agreements under which adequate collateral has been posted. Derivative contracts entered into with financial guarantee customers are not typically subject to collateral posting agreements. Counterparty credit risk related to such customer derivative assets is included in our fair value adjustments.

For derivatives that do not trade, or trade in less liquid markets such as credit derivatives, a proprietary model is used because such instruments tend to be unique, contain complex or heavily modified and negotiated terms, and pricing information is not readily available in the market. Derivative fair value models and the related assumptions are continuously re-evaluated by management and enhanced, as appropriate, based on improvements in modeling techniques. Ambac has not made any significant changes to its modeling techniques or related model inputs for the periods presented.

 

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Credit Derivatives (“CDS”):

Fair value of Ambac’s CDS is determined using internal valuation models and represents the net present value of the difference between the fees Ambac originally charged for the credit protection and our estimate of what a financial guarantor of comparable credit worthiness would hypothetically charge to provide the same protection at the balance sheet date. Ambac competed in the financial guarantee market, which differs from the credit markets where Ambac-insured obligations may trade. As a financial guarantor, Ambac assumes only credit risk; we do not assume other risks and costs inherent in direct ownership of the underlying reference securities. Additionally, as a result of having the ability to influence our CDS counterparty in certain investor decisions, financial guarantors generally have the ability to actively remediate the credit, potentially reducing the loss given a default. Financial guarantee contracts, including CDS, issued by Ambac and its competitors are typically priced to capture some portion of the spread that would be observed in the capital markets for the underlying (insured) obligation, with minimum pricing constrained by objective estimates of expected loss and financial guarantor required rates of return. Such pricing was well established by historical financial guarantee fees relative to capital market spreads as observed and executed in competitive markets, including in financial guarantee reinsurance and secondary market transactions. Because of this relationship and in the absence of severe credit deterioration, changes in the fair value of our credit default swaps will generally be less than changes in the fair value of the underlying reference obligations.

Key variables used in our valuation of substantially all of our credit derivatives include the balance of unpaid notional, expected term, fair values of the underlying reference obligations, reference obligation credit ratings, assumptions about current financial guarantee CDS fee levels relative to reference obligation spreads and the CVA applied against Ambac Assurance liabilities by market participants. Notional balances, expected remaining term and reference obligation credit ratings are monitored and determined by Ambac’s Risk Group. Fair values of the underlying reference obligations are obtained from broker quotes when available, or are derived from other market indications such as new issuance spreads and quoted values for similar transactions. Implicit in the fair values we obtain on the underlying reference obligations are the market’s assumptions about default probabilities, default timing, correlation, recovery rates and collateral values.

Broker quotes on the reference obligations named in our CDS contracts represent an input to determine the estimated fair value of the CDS contract. Broker quotes are indicative values for the reference obligation and generally do not represent a bid or doing-business quote for the reference instrument. Such quotes follow methodologies that are generally consistent with those used to value similar assets on the quote providers’ own books. Methodologies may differ among brokers but are understood to reflect observable trading activity (when available) and modeling that relies on empirical data and reasonable assumptions. For certain CDS contracts referencing unsecuritized pools of assets, we will obtain counterparty quotes on the credit derivative itself. Such quotes are adjusted to reflect Ambac’s own credit risk when determining the fair value of credit derivative liabilities. Third party reference obligation values or specific credit derivative quotes were used in the determination of CDS fair values related to transactions representing 80% of CDS gross par outstanding and 76% of the CDS derivative liability as of March 31, 2013.

When broker quotes for reference obligations are not available, reference obligation prices used in the valuation model are estimated internally based on averages of the quoted prices for other transactions of the same bond type and Ambac rating as well as changes in published credit spreads for securities with similar collateral and ratings characteristics. When price quotes of a similar bond type vary significantly or the number of similar transactions is small, management will consider additional factors, such as specific collateral composition and performance and contractual subordination, to identify similar transactions. Reference obligation prices derived internally as described above were used in the determination of CDS fair values related to transactions representing 20% of CDS gross par outstanding and 24% of the CDS derivative liability as of March 31, 2013.

Ambac’s CDS fair value calculations are adjusted for changes in our estimates of expected loss on the reference obligations and observable changes in financial guarantee market pricing. If no adjustment is considered necessary, Ambac maintains the same percentage of the credit spread (over LIBOR) demanded in the market for the reference obligation as existed at the inception of the CDS. Therefore, absent changes in expected loss on the reference obligations or financial guarantee CDS market pricing, the financial guarantee CDS fee used for a particular contract in Ambac’s fair value calculations represent a consistent percentage, period to period, of the credit spread determinable from the reference obligation value at the balance sheet date. This results in a CDS fair value balance that fluctuates in proportion with the reference obligation value.

The amount of expected loss on a reference obligation is a function of the probability that the obligation will default and severity of loss in the event of default. Ambac’s CDS transactions were all originally underwritten with extremely low expected losses. Both the reference obligation spreads and Ambac’s CDS fees at the inception of these transactions reflect these low expected losses. When reference obligations experience credit deterioration, there is an increase in the probability of default on the obligation and, therefore, an increase in expected loss. Ambac reflects the effects of changes in expected loss on the fair value of its CDS contracts by increasing the percentage of the reference obligation spread (over LIBOR) which would be captured as a CDS fee (“relative change ratio”) at the valuation date, resulting in a higher mark-to-market

 

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loss on our CDS relative to any price decline on the reference obligation. The fundamental assumption is that financial guarantee CDS fees will increase relative to reference obligation spreads as the underlying credit quality of the reference obligation deteriorates and approaches payment default. For example, if the credit spread of an underlying reference obligation was 80 basis points at the inception of a transaction and Ambac received a 20 basis point fee for issuing a CDS on that obligation, the relative change ratio, which represents the CDS fee to cash market spread Ambac would utilize in its valuation calculation, would be 25%. If the reference obligation spread increased to 100 basis points in the current reporting period, absent any observable changes in financial guarantee CDS market pricing or credit deterioration, Ambac’s current period CDS fee would be computed by multiplying the current reference obligation spread of 100 basis points by the relative change ratio of 25%, resulting in a 25 basis point fee. Thus, the model indicates we would need to receive an additional 5 basis points (25 basis points currently less the 20 basis points contractually received) for issuing a CDS in the current reporting period for this reference obligation. We would then discount the product of the notional amount of the CDS and the 5 basis point hypothetical CDS fee increase, over the weighted average life of the reference obligation to compute the current period mark-to-market loss. Using the same example, if the reference obligation spread increased to 100 basis points and there was credit deterioration as evidenced by an internal rating downgrade which increased the relative change ratio from 25% to 35%, we would estimate a 15 basis point CDS fee increase in our model (35% of 100 basis points reference obligation spread, or 35 basis points currently, less the 20 basis points contractually received). Therefore, we would record a higher mark-to-market loss based on the computations described above absent any observable changes in financial guarantee CDS market pricing.

We do not adjust the relative change ratio until an actual internal rating downgrade has occurred unless we observe new pricing on financial guarantee CDS contracts. However, because we have active surveillance procedures in place for our entire CDS portfolio, particularly for transactions at or near a below investment grade threshold, we believe it is unlikely that an internal downgrade would lag the actual credit deterioration of a transaction for any meaningful time period. The factors used to increase the relative change ratio are based on rating agency probability of default percentages determined by management to be appropriate for the relevant bond type. That is, the probability of default associated with the respective tenor and internal rating of each CDS transaction is utilized in the computation of the relative change ratio in our CDS valuation model. The new relative change ratio in the event of an internal downgrade of the reference obligation is calculated as the weighted average of: (i) a given transaction’s inception relative change ratio and (ii) a ratio of 100%. The weight given to the inception relative change ratio is 100% minus the current probability of default (the probability of non-default) and the weight given to using a 100% relative change ratio is the probability of default. For example, assume a transaction having an inception relative change ratio of 33% is downgraded to B-during the period, at which time it has an estimated remaining life of 8 years. If the estimated probability of default for an 8 year, B-rated credit of this type is 60% then the revised relative change ratio will be 73.2%. The revised relative change ratio can be calculated as 33% x (100%-60%) + 100% x 60% = 73.2%.

As noted above, reference obligation spreads incorporate market perceptions of default probability and loss severity, as well as liquidity risk and other factors. Loss severities are generally correlated to default probabilities during periods of economic stress. By increasing the relative change ratio in our calculations proportionally to default probabilities, Ambac incorporates into its CDS fair value the higher expected loss on the reference obligation (probability of default x loss severity), by increasing the portion of reference obligation spread that should be paid to the CDS provider.

Ambac incorporates its own credit risk into the valuation of its CDS liabilities by applying a CVA to the calculations described above. Under our methodology, determination of the CDS fair value requires estimating hypothetical financial guarantee CDS fees for a given credit at the valuation date and estimating the present value of those fees. Our approach begins with pricing in the risk of default of the reference obligation using that obligation’s credit spread. The widening of the reference obligation spread results in a mark-to-market loss to Ambac, as the credit protection seller, and a gain to the credit protection buyer because the cost of credit protection on the reference obligation (ignoring CDS counterparty credit risk) will be greater than the amount of the actual contractual CDS fees. The Ambac CVA represents the difference between the present value of the hypothetical fees discounted at Libor compared to rates that incorporate Ambac credit risk. The discount rates used to determine the Ambac CVA are estimated using relevant data points, including quoted prices of securities guaranteed by Ambac Assurance which indicate the value placed by market participants on Ambac Assurance’s insurance obligations and the fair value of Ambac Assurance surplus notes. The resulting Ambac CVA, as a percentage of the CDS mark-to-market liability determined by discounting at Libor, was 48.5% and 55.0% as of March 31, 2013 and December 31, 2012, respectively. In instances where narrower reference obligation spreads result in a CDS asset to Ambac, those hypothetical future CDS fees are discounted at a rate which incorporates our counterparty’s credit spread (i.e. the discount rate used is LIBOR plus the current credit spread of the counterparty).

In addition, when there are sufficient numbers of new observable transactions, negotiated settlements or other market indications of a general change in market pricing trends for CDS on a given bond type, management will adjust its assumptions about the percentage of reference obligation spreads captured as CDS fees to match the current market. No such adjustments were made during the periods presented. Ambac is not transacting CDS business currently and other guarantors have stated they have exited this product. Additionally, there have been no negotiated settlements of CDS contracts during the periods presented.

 

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Key variables which impact the “Realized gains and losses and other settlements” component of “Net change in fair value of credit derivatives” in the Consolidated Statements of Total Comprehensive Income are the most readily observable variables since they are based solely on the CDS contractual terms and cash settlements. Those variables include premiums received and accrued and losses paid and payable on written credit derivative contracts for the appropriate accounting period. Losses paid and payable reported in “Realized gains and losses and other settlements” include those arising after a credit event that requires a payment under the contract terms has occurred or in connection with a negotiated termination of a contract. The remaining key variables described above impact the “Unrealized gains (losses)” component of “Net change in fair value of credit derivatives.”

The net notional outstanding of Ambac’s CDS contracts were $10,204,738 and $11,281,777 at March 31, 2013 and December 31, 2012, respectively. Credit derivative liabilities at March 31, 2013 and December 31, 2012 had a combined fair value of $203,307 and $213,585, respectively, and related to underlying reference obligations that are classified as either collateralized loan obligations (“CLOs”) or Other. Information about the above described model inputs used to determine the fair value of each class of credit derivatives, including the CVA as a percentage of the gross mark-to-market liability before considering Ambac credit risk (“CVA percentage”), as of March 31, 2013 and December 31, 2012 is summarized below:

As of March 31, 2013

 

     CLOs     Other(1)  

Notional outstanding

   $ 5,702,366      $ 3,238,742   

Weighted average reference obligation price

     97.4        86.9   

Weighted average life (WAL) in years

     2.1        4.5   

Weighted average credit rating

     AA-        A   

Weighted average relative change ratio

     34.5     37.8

CVA percentage

     41.4     49.4

Fair value of derivative liabilities

   $ (30,736   $ (115,014

As of December 31, 2012

 

     CLOs     Other(1)  

Notional outstanding

   $ 6,155,767      $ 3,701,387   

Weighted average reference obligation price

     96.5        86.9   

Weighted average life (WAL) in years

     2.2        4.2   

Weighted average credit rating

     AA-        A   

Weighted average relative change ratio

     34.4     38.2

CVA percentage

     55.0     55.0

Fair value of derivative liabilities

   $ (34,645   $ (116,086

 

(1) Excludes contracts for which fair values are based on credit derivative quotes rather than reference obligation quotes. Such contracts have a combined notional outstanding of $1,263,630, WAL of 7.5 years and liability fair value of ($57,557) as of March 31, 2013. Other inputs to the valuation of these transactions at March 31, 2013 include weighted average quotes of 9% of notional, weighted average rating of A and Ambac CVA percentage of 50.0%. As of December 31, 2012, these contracts had a combined notional outstanding of $1,424,623, WAL of 7.9 years and liability fair value of ($62,854). Other inputs to the valuation of these transactions at December 31, 2012 include weighted average quotes of 10% of notional, weighted average rating of A and Ambac CVA percentage of 55.0%.

Significant unobservable inputs for credit derivatives include WAL, internal credit rating, relative change ratio and CVA percentage. A longer (shorter) WAL, lower (higher) reference obligation credit rating, higher (lower) relative change ratio or lower (higher) CVA, in isolation, would result in an increase (decrease) in the fair value liability measurement. A change in an internal credit rating of a reference obligation in our model will generally result in a directionally opposite change in the relative change ratio. Also, a shorter (longer) WAL will generally correspond with a lower (higher) CVA percentage.

 

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Call options on long-term debt:

The fair value of Ambac Assurance’s options to repurchase Ambac Assurance surplus notes at a discount to par was estimated based on a combination of internal discounted cash flow analysis and market observations. The discounted cash flow analysis used multiple discount rate scenarios to determine the present value of the surplus notes assuming exercise and non-exercise of the options, with the difference representing the option value under that scenario. The results were probability weighted to determine the recorded option value. All options to repurchase Ambac Assurance surplus notes that were stand-alone derivatives and reported at fair value on the Consolidated Balance Sheets were exercised in June 2012.

Financial Guarantees:

Fair value of net financial guarantees written represents our estimate of the cost to Ambac to completely transfer its insurance obligation to another market participant of comparable credit worthiness. In theory, this amount should be the same amount that another market participant of comparable credit worthiness would hypothetically charge in the market place, on a present value basis, to provide the same protection as of the balance sheet date. This fair value estimate of financial guarantees is presented on a net basis and includes direct and assumed contracts written, net of ceded reinsurance contracts.

U.S. GAAP requires that the nonperformance risk of a financial liability be included in the estimation of fair value, which includes considering Ambac Assurance’s own credit risk. As a result, because the aggregate balances related to direct contracts written and assumed were in a net liability (cash outflow) position, we included an Ambac CVA in the fair value estimate to reflect Ambac’s credit risk, consistent with that used for credit derivative contracts guaranteed by Ambac Assurance. Refer to “Credit Derivatives” above for additional information on the determination of the CVA. The aggregate balances related to ceded reinsurance contracts were in a net asset (cash inflow) position and therefore we included adjustments in the discount rate to reflect reinsurer counterparty credit risk.

The fair value estimate of financial guarantees is computed by utilizing cash flows calculated at the policy level. For direct and assumed contracts, projected net cash flows for each policy included: (i) installment premium receipts, (ii) estimated gross claim payments, and (iii) subrogation receipts. For ceded reinsurance contracts, projected net cash flows for each policy included: (i) installment ceded premium payments, (ii) ceding commission receipts, (iii) ceded claim receipts, and iv) ceded subrogation payments. For each individual direct, assumed, and ceded reinsurance contract, the respective undiscounted cash flow components are aggregated to determine if we are in a net asset or net liability position. For each contract in a net liability position, we estimate the fair value using internally developed discount rates that incorporate Ambac’s own credit risk and subsequently apply a profit margin. This profit margin represents what another market participant would require to assume the financial guarantee contracts. Given the unique nature of financial guarantees and current inactive state of the industry there is a lack of observable market information to make this estimate. A profit margin of 20% was developed based on discussions with the third-party institutions with valuation expertise, discussions with industry participants and yields on Ambac Assurance surplus notes. The discount rates used for contracts in a net liability position are derived from the rates implicit in the fair value of surplus notes and guaranteed securities with future cash flows that are highly dependent upon Ambac financial guarantee payments. For each contract in a net asset position, we estimate the fair value using a discount rate that is commensurate with a market participant’s cost of capital.

There are a number of factors that limit our ability to accurately estimate the fair value of our financial guarantees. The first limitation is the lack of observable pricing data points as a result of Ambac no longer writing new financial guarantee business. Additionally, although the fair value accounting guidance for liabilities requires a company to consider the cost to completely transfer its obligation to another party of comparable credit worthiness, our primary insurance obligation is irrevocable and thus there is no established active market for transferring such obligations.

The fair value of liabilities for net financial guarantees written presented above is as of March 31, 2013, which differs from our Fresh Start Reporting Date (as defined in Note 14). Further revisions and adjustments, based on any updated valuations, actual amounts, applicable economic conditions as of the Fresh Start Reporting Date and results of operations through the Fresh Start Reporting Date could result in a significant difference between the financial guarantee fair value estimate disclosed in this Note at March 31, 2013 and the aggregate fair value of the insurance assets and liabilities to be reported on our balance sheet at Ambac’s bankruptcy emergence date.

Liabilities Subject to Compromise:

The fair value of Ambac’s debt included in Liabilities Subject to Compromise is based on quoted market prices.

 

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Long-term Debt:

The fair value of surplus notes issued by Ambac Assurance and classified as long-term debt is internally estimated considering market transactions when available and internally developed discounted cash flow models. Surplus notes were initially recorded at fair value at the date of issuance. In subsequent periods, surplus notes are carried at their face value less unamortized discount.

Other Financial Assets and Liabilities:

The fair values of Ambac’s equity interest in Ambac sponsored special purpose entities (included in Other assets), Loans, and Obligations under investment and repurchase agreements are estimated based upon internal valuation models that discount expected cash flows using discount rates consistent with the credit quality of the obligor after considering collateralization.

Variable Interest Entity Assets and Liabilities:

The financial assets and liabilities of VIEs consolidated under ASC Topic 810 consist primarily of fixed income securities, loans, and derivative and debt instruments and are generally carried at fair value. These consolidated VIEs are securitization entities which have liabilities and/or assets guaranteed by Ambac Assurance. The fair values of VIE debt instruments are determined using the same methodologies used to value Ambac’s fixed income securities in its investment portfolio as described above. VIE debt fair value is based on market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. Such quotes are considered Level 2 and generally consider a variety of factors, including recent trades of the same and similar securities. For those VIE debt instruments where quotes were not available, the debt instrument fair values are considered Level 3 and are based on internal discounted cash flow models. Comparable to the sensitivities of investments in fixed income securities described above, longer (shorter) expected maturities or higher (lower) yields used in the valuation model will, in isolation, result in decreases (increases) in fair value liability measurement for VIE debt. VIE debt instruments considered Level 3 include fixed rate, floating rate and zero coupon notes secured by various asset types, primarily European ABS. Information about the valuation inputs for the various VIE debt categories classified as Level 3 is as follows:

European ABS transactions: The fair value of such obligations classified as Level 3 was $1,910,589 and $2,956,501 at March 31, 2013 and December 31, 2012, respectively. Fair values were calculated by using a discounted cash flow approach. The discount rates used were based on the rates implied from the third party quoted values (Level 2) for comparable notes from the same securitization. Significant inputs for the valuation at March 31, 2013 and December 31, 2012 include the following weighted averages:

March 31, 2013

 

  a. Coupon rate: 1.59%

 

  b. Maturity: 18.26 years

 

  c. Yield: 3.98%

December 31, 2012

 

  a. Coupon rate: 1.64%

 

  b. Maturity: 12.34 years

 

  c. Yield: 4.02%

VIE derivative asset and liability fair values are determined using valuation models. When specific derivative contractual terms are available and may be valued primarily by reference to interest rates, foreign exchange rates and yield curves that are observable and regularly quoted, the derivatives are valued using vendor-developed models. Other derivatives within the VIEs that include significant unobservable valuation inputs are valued using internally developed models. VIE derivative fair value balances at March 31, 2013 and December 31, 2012 were developed using vendor-developed models and do not use significant unobservable inputs.

The fair value of VIE assets are obtained from market quotes when available. Typically the asset fair values are not readily available from market quotes and are estimated internally. The consolidated VIEs are securitization entities in which net cash flows from assets and derivatives (after adjusting for financial guarantor cash flows and other expenses) will be paid out to note holders or equity interests. Our valuation of VIE assets (fixed income securities or loans), therefore, are derived from the fair value of notes and derivatives, as described above, adjusted for the fair value of cash flows from Ambac’s financial guarantee. The fair value of financial guarantee cash flows include: (i) estimated future premiums discounted at a rate consistent with that implicit in the fair value of the VIE’s liabilities and (ii) internal estimates of future

 

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loss payments by Ambac discounted at a rate that includes Ambac’s own credit risk. Estimated future premium payments to be paid by the VIEs were discounted at a weighted average rate of 4.8% and 7.6% at March 31, 2013 and December 31, 2012, respectively. The value of future loss payments to be paid by Ambac to the VIEs was adjusted to include an Ambac CVA appropriate for the term of expected Ambac claim payments.

Additional Fair Value Information:

The following tables present the changes in the Level 3 fair value category for the three months ended March 31, 2013 and 2012. Ambac classifies financial instruments in Level 3 of the fair value hierarchy when there is reliance on at least one significant unobservable input to the valuation model. In addition to these unobservable inputs, the valuation models for Level 3 financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly. Thus, the gains and losses presented below include changes in the fair value related to both observable and unobservable inputs.

Level-3 financial assets and liabilities accounted for at fair value

 

                       VIE Assets and Liabilities        

Three months ended

March 31, 2013

   Investments     Other
assets
    Derivatives     Investments     Loans     Long-term
debt
    Total  

Balance, beginning of period

   $ 60,402      $ 14,557      $ (322,337   $ 2,261,294      $ 15,359,073      $ (2,956,501   $ 14,416,488   

Additions of VIEs consolidated

     —          —          —          —          —          —          —     

Total gains/(losses) realized and unrealized:

              

Included in earnings

     (23     (327     (3,162     297,294        400,456        (127,393     566,845   

Included in other comprehensive income

     698        —          —          (143,981     (955,455     193,905        (904,833

Purchases

     —          —          —          —          —          —          —     

Issuances

     —          —          —          —          —          —          —     

Sales

     —          —          —          —          —          —          —     

Settlements

     (3,286     —          (3,190     —          (687,263     4,864        (688,875

Transfers in Level 3

     —          —          —          —          —          —          —     

Transfers out of Level 3

     —          —          —          —          —          974,536        974,536   

Deconsolidation of VIEs

     —          —          —          —          —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, end of period

   $ 57,791      $ 14,230      $ (328,689   $ 2,414,607      $ 14,116,811      $ (1,910,589   $ 14,364,161   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date

   $ —        $ (327   $ (5,684   $ 297,294      $ 400,456      $ (127,393   $ 564,346   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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                       VIE Assets and Liabilities        

Three months ended

March 31, 2012

   Investments     Other
assets
    Derivatives     Investments     Loans     Long-term
debt
    Total  

Balance, beginning of period

   $ 97,522      $ 16,779      $ (486,775   $ 2,199,338      $ 14,126,994      $ (1,934,642   $ 14,019,216   

Additions of VIEs consolidated

     —          —          —          —          —          —          —     

Total gains/(losses) realized and unrealized:

              

Included in earnings

     (49     (756     122,327        (82,816     166,665        (136,563     68,808   

Included in other comprehensive income

     7,814        —          —          68,143        415,857        (63,205     428,609   

Purchases

     —          —          —          —          —          —          —     

Issuances

     —          —          —          —          —          —          —     

Sales

     —          —          —          —          —          —          —     

Settlements

     (2,742     —          8,832        —          (249,439     13,030        (230,319

Transfers in Level 3

     58,905        —          —          —          —          (665,264     (606,359

Transfers out of Level 3

     —          —          —          —          —          —          —     

Deconsolidation of VIEs

     —          —          —          —          —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, end of period

   $ 161,450      $ 16,023      $ (355,616   $ 2,184,665      $ 14,460,077      $ (2,786,644   $ 13,679,955   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date

   $ —        $ (756   $ 107,245      $ (82,816   $ 167,146      $ (136,563   $ 54,256   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The tables below provide roll-forward information by class of investments and derivatives measured using significant unobservable inputs.

Level-3 Investments by class

 

Three months ended March 31, 2013

   Collateralized
Debt
Obligations
    Other Asset
Backed
Securities
    Corporate
Obligations
    U.S. Agency
Obligations
     Total
Investments
 

Balance, beginning of period

   $ 6,482      $ 50,264      $ 3,656      $  —         $ 60,402   

Total gains/(losses) realized and unrealized:

           

Included in earnings

     (3     —          (20     —           (23

Included in other comprehensive income

     113        569        16        —           698   

Purchases

     —          —          —          —           —     

Issuances

     —          —          —          —           —     

Sales

     —          —          —          —        

Settlements

     (2,687     (599     —          —           (3,286

Transfers in Level 3

     —          —          —          —           —     

Transfers out of Level 3

     —          —          —          —           —     
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Balance, end of period

   $ 3,905      $ 50,234      $ 3,652      $ —         $ 57,791   
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date

   $ —        $ —        $ —        $ —         $ —     
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

 

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Level-3 Investments by class

 

Three months ended March 31, 2012

   Collateralized
Debt
Obligations
    Other Asset
Backed
Securities
     Corporate
Obligations
    U.S. Agency
Obligations
    Total
Investments
 

Balance, beginning of period

   $ 12,482      $ 75,886       $ 7,930      $ 1,224      $ 97,522   

Total gains/(losses) realized and unrealized:

           

Included in earnings

     (2     —           (46     (1     (49

Included in other comprehensive income

     101        8,072         (354     (5     7,814   

Purchases

     —          —           —          —          —     

Issuances

     —          —           —          —          —     

Sales

     —          —           —          —          —     

Settlements

     (2,742     —           —          —          (2,742

Transfers in Level 3

     —          53,068         5,837        —          58,905   

Transfers out of Level 3

     —          —           —          —          —     
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Balance, end of period

   $ 9,839      $ 137,026       $ 13,367      $ 1,218      $ 161,450   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date

   $ —        $ —         $ —        $ —        $ —     
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Level-3 Derivatives by class

 

Three months ended March 31, 2013

   Interest Rate
Swaps
    Credit
Derivatives
    Call Options
on Long-term
debt
     Total
Derivatives
 

Balance, beginning of period

   $ (108,752   $ (213,585   $  —         $ (322,337 )

Additions of VIEs consolidated

         

Total gains/(losses) realized and unrealized:

         

Included in earnings

     (15,949     12,787        —           (3,162 )

Included in other comprehensive income

     —          —          —           —     

Purchases

     —          —