Document


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 June 30, 2016
¨
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)
212-658-7470
(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
x
Accelerated filer
¨
Non-accelerated filer
¨
Smaller reporting company
¨
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  ¨    No  x
Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.    Yes  x    No  ¨
As of August 5, 2016, 45,121,788 shares of common stock, par value $0.01 per share, of the Registrant were outstanding.



AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
TABLE OF CONTENTS
 
 
PAGE
 
 
 
 
PART I.
FINANCIAL INFORMATION
 
 
Item 1.
Unaudited Consolidated Financial Statements of Ambac Financial Group, Inc. and Subsidiaries
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 3.
 
Item 4.
 
 
 
 
 
PART II.
OTHER INFORMATION
 
 
Item 1.
 
Item 1A.
 
Item 2.
 
Item 3.
 
 
Item 4.
 
Item 5.
 
Item 6.
 
 
 
 
 
 




PART I.    FINANCIAL INFORMATION
Item 1.     Financial Statements of Ambac Financial Group, Inc. and Subsidiaries
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
 
June 30,
 
December 31,
(Dollars in thousands, except share data) (June 30, 2016 (Unaudited))
2016
 
2015
Assets:
 
 
 
Investments:
 
 
 
Fixed income securities, available for sale, at fair value (amortized cost: $5,550,887 and $4,992,756)
$
5,709,464

 
$
5,043,776

Fixed income securities pledged as collateral, available for sale, at fair value (amortized cost: $64,721 and $64,612)
65,068

 
64,555

Short-term investments, available for sale, at fair value (amortized cost: $336,222 and $225,789)
336,222

 
225,789

Other investments (includes $383,107 and $285,261 at fair value)
410,727

 
310,600

Total investments
6,521,481

 
5,644,720

Cash and cash equivalents
23,044

 
35,744

Receivable for securities
2,400

 
44,030

Investment income due and accrued
25,082

 
25,264

Premium receivables
741,414

 
831,575

Reinsurance recoverable on paid and unpaid losses
28,704

 
43,999

Deferred ceded premium
82,055

 
96,758

Subrogation recoverable
677,157

 
1,229,293

Loans
4,615

 
5,206

Derivative assets
104,353

 
84,995

Insurance intangible asset
1,075,605

 
1,212,112

Other assets
252,163

 
185,877

Variable interest entity assets:
 
 
 
Fixed income securities, at fair value
2,577,293

 
2,588,556

Restricted cash
5,461

 
5,822

Investment income due and accrued
1,167

 
1,213

Loans, at fair value
11,074,772

 
11,690,324

Other assets
2,345

 
2,582

Total assets
$
23,199,111

 
$
23,728,070

Liabilities and Stockholders’ Equity:
 
 
 
Liabilities:
 
 
 
Unearned premiums
$
1,122,946

 
$
1,280,282

Loss and loss expense reserves
4,327,938

 
4,088,106

Ceded premiums payable
45,727

 
53,494

Obligations under investment agreements
82,358

 
100,358

Deferred taxes
1,712

 
2,205

Current taxes
4,858

 
5,835

Long-term debt
1,112,920

 
1,124,950

Accrued interest payable
380,117

 
355,536

Derivative liabilities
437,163

 
353,358

Other liabilities
59,040

 
61,134

Payable for securities purchased
54,696

 
84,690

Variable interest entity liabilities:
 
 
 
Accrued interest payable
870

 
3,230

Long-term debt, at fair value
11,444,892

 
12,327,960

Derivative liabilities
2,060,878

 
1,928,403

Other liabilities
159

 
183

Total liabilities
21,136,274

 
21,769,724

Commitments and contingencies (see Note 11)
 
 
 
Stockholders’ equity:

 

Preferred stock, par value $0.01 per share; 20,000,000 shares authorized; issued and outstanding shares—none

 

Common stock, par value $0.01 per share; 130,000,000 shares authorized; issued and outstanding shares: 45,121,788 and 45,044,222
451

 
450

Additional paid-in capital
193,074

 
190,813

Accumulated other comprehensive income
50,775

 
15,215

Retained earnings
1,551,724

 
1,478,439

Treasury stock, shares at cost: 0 and 8,202

 
(118
)
Total Ambac Financial Group, Inc. stockholders’ equity
1,796,024

 
1,684,799

Noncontrolling interest
266,813

 
273,547

Total stockholders’ equity
2,062,837

 
1,958,346

Total liabilities and stockholders’ equity
$
23,199,111

 
$
23,728,070

See accompanying Notes to Unaudited Consolidated Financial Statements


| Ambac Financial Group, Inc. 1 2016 Second Quarter FORM 10-Q |



AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Total Comprehensive Income (Unaudited)
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(Dollars in thousands, except share data)
2016
 
2015
 
2016
 
2015
Revenues:
 
 
 
 
 
 
 
Net premiums earned
$
41,402

 
$
60,879

 
$
94,202

 
126,597

Net investment income:
 
 
 
 
 
 
 
Securities available-for-sale and short-term
64,368

 
62,278

 
122,350

 
125,610

Other investments
6,390

 
2,475

 
9,229

 
12,126

Total net investment income
70,758

 
64,753

 
131,579

 
137,736

Other-than-temporary impairment losses:
 
 
 
 
 
 
 
Total other-than-temporary impairment losses
(18,880
)
 
(1,391
)
 
(66,950
)
 
(11,752
)
Portion of other-than-temporary impairment recognized in other comprehensive income
11,439

 
371

 
50,175

 
7,613

Net other-than-temporary impairment losses recognized in earnings
(7,441
)
 
(1,020
)
 
(16,775
)
 
(4,139
)
Net realized investment gains (losses)
14,897

 
(5,353
)
 
15,999

 
48,748

Change in fair value of credit derivatives:
 
 
 
 
 
 
 
Realized gains and other settlements
233

 
407

 
485

 
826

Unrealized gains (losses)
3,722

 
9,886

 
16,336

 
6,968

Net change in fair value of credit derivatives
3,955

 
10,293

 
16,821

 
7,794

Derivative products
(36,331
)
 
50,999

 
(119,755
)
 
13,225

Net realized gains (losses) on extinguishment of debt
3,586

 
(1,246
)
 
4,821

 
(1,339
)
Other income (expense)
6,919

 
(1,156
)
 
14,918

 
(1,944
)
Income (loss) on variable interest entities
8,987

 
52,603

 
(18,176
)
 
59,565

Total revenues
106,732

 
230,752

 
123,634

 
386,243

Expenses:
 
 
 
 
 
 
 
Losses and loss expense (benefit)
(52,496
)
 
(147,477
)
 
(157,777
)
 
(298,429
)
Insurance intangible amortization
39,013

 
38,088

 
89,903

 
75,520

Operating expenses
27,995

 
25,873

 
56,004

 
50,396

Interest expense
30,709

 
28,173

 
61,139

 
56,081

Total expenses (benefit)
45,221

 
(55,343
)
 
49,269

 
(116,432
)
Pre-tax income
61,511

 
286,095

 
74,365

 
502,675

Provision for income taxes
3,156

 
3,917

 
6,595

 
5,626

Net income
58,355

 
282,178

 
67,770

 
497,049

Less: net (gain) loss attributable to noncontrolling interest
(292
)
 
(517
)
 
(292
)
 
(357
)
Net income attributable to common stockholders
$
58,647

 
$
282,695

 
$
68,062

 
$
497,406

Other comprehensive income, after tax:
 
 
 
 
 
 
 
Net income
$
58,355

 
$
282,178

 
$
67,770

 
$
497,049

Unrealized gains (losses) on securities, net of deferred income taxes of $0
48,170

 
(113,839
)
 
107,961

 
(131,287
)
Gains (losses) on foreign currency translation, net of deferred income taxes of $0
(55,152
)
 
40,490

 
(72,933
)
 
6,685

Changes to postretirement benefit, net of tax of $0
(255
)
 
(220
)
 
532

 
(247
)
Total other comprehensive income (loss), net of tax
(7,237
)
 
(73,569
)
 
35,560

 
(124,849
)
Total comprehensive income
51,118

 
208,609

 
103,330

 
372,200

Less: comprehensive (loss) gain attributable to the noncontrolling interest:
 
 
 
 
 
 
 
Net (gain) loss
(292
)
 
(517
)
 
(292
)
 
(357
)
Currency translation adjustments

 
398

 

 
72

Total comprehensive income attributable to Ambac Financial Group, Inc.
$
51,410

 
$
208,728

 
$
103,622

 
$
372,485

Net income per share attributable to Ambac Financial Group, Inc. common stockholders
 
 
 
 
 
 
 
Basic
$
1.30

 
$
6.26

 
$
1.51

 
$
11.01

Diluted
$
1.29

 
$
6.05

 
$
1.50

 
$
10.62

See accompanying Notes to Unaudited Consolidated Financial Statements


| Ambac Financial Group, Inc. 2 2016 Second Quarter FORM 10-Q |



AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Stockholders’ Equity (Unaudited)
 
 
 
Ambac Financial Group, Inc.
 
 
(Dollars in thousands)
Total
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income
 
Preferred
Stock
 
Common
Stock
 
Additional Paid-in
Capital
 
Common
Stock Held
in Treasury,
at Cost
 
Noncontrolling
Interest
Balance at January 1, 2016
$
1,958,346

 
$
1,478,439

 
$
15,215

 
$

 
$
450

 
$
190,813

 
$
(118
)
 
$
273,547

Total comprehensive income
103,330

 
68,062

 
35,560

 

 

 

 

 
(292
)
Adjustment to initially apply ASU 2014-13

 
6,442

 

 

 

 

 

 
(6,442
)
Stock-based compensation
2,777

 

 

 

 

 
2,777

 

 

Cost of shares (acquired) issued under equity plan
(9
)
 
(127
)
 

 

 

 

 
118

 

Cost of warrants acquired
(1,610
)
 
(1,092
)
 

 

 

 
(518
)
 

 

Issuance of common stock
1

 

 

 

 
1

 
 
 

 

Warrants exercised
2

 

 

 

 

 
2

 

 

Balance at June 30, 2016
$
2,062,837

 
$
1,551,724

 
$
50,775

 
$

 
$
451

 
$
193,074

 
$

 
$
266,813

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at January 1, 2015
1,673,735

 
989,290

 
220,283

 

 
450

 
189,138

 
(56
)
 
274,630

Total comprehensive income (loss)
372,200

 
497,406

 
(124,921
)
 

 

 

 

 
(285
)
Stock-based compensation
1,274

 

 

 

 

 
1,274

 

 

Warrants exercised
2

 

 

 

 

 
2

 

 

Balance at June 30, 2015
$
2,047,211

 
$
1,486,696

 
$
95,362

 
$

 
$
450

 
$
190,414

 
$
(56
)
 
$
274,345

See accompanying Notes to Unaudited Consolidated Financial Statements


| Ambac Financial Group, Inc. 3 2016 Second Quarter FORM 10-Q |



AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows (Unaudited)
 
 
Six Months Ended June 30,
(Dollars in thousands)
 
2016
 
2015
Cash flows from operating activities:
 
 
 
 
Net income attributable to common stockholders
 
$
68,062

 
$
497,406

Noncontrolling interest in subsidiaries’ earnings
 
(292
)
 
(357
)
Net income
 
67,770

 
497,049

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation and amortization
 
635

 
1,489

Amortization of bond premium and discount
 
(56,353
)
 
(64,478
)
Share-based compensation
 
2,777

 
1,274

Deferred income taxes
 
(493
)
 
(124
)
Current income taxes
 
(977
)
 
(4,031
)
Unearned premiums, net
 
(115,760
)
 
(134,487
)
Losses and loss expenses, net
 
857,605

 
(299,879
)
Ceded premiums payable
 
(7,767
)
 
(2,434
)
Investment income due and accrued
 
182

 
(264
)
Premium receivables
 
62,761

 
63,683

Accrued interest payable
 
24,581

 
34,867

Amortization of insurance intangible assets
 
89,903

 
75,520

Net mark-to-market (gains) losses
 
(16,336
)
 
(6,968
)
Net realized investment gains
 
(15,999
)
 
(48,748
)
Other-than-temporary impairment charges
 
16,775

 
4,139

Net realized (gains) losses on extinguishment of debt
 
(4,821
)
 
1,339

Variable interest entity activities
 
18,176

 
(59,565
)
Other, net
 
(52,350
)
 
(20,043
)
Net cash provided by operating activities
 
870,309

 
38,339

Cash flows from investing activities:
 
 
 
 
Proceeds from sales of bonds
 
305,100

 
705,104

Proceeds from matured bonds
 
585,274

 
469,630

Purchases of bonds
 
(1,415,796
)
 
(1,385,652
)
Proceeds from sales of other invested assets
 
35,433

 
96,691

Purchases of other invested assets
 
(145,788
)
 
(81,696
)
Change in short-term investments
 
(110,433
)
 
162,995

Loans, net
 
591

 
40

Change in swap collateral receivable
 
(90,966
)
 
19,710

Other, net
 
6,353

 
(1,477
)
Net cash (used in) investing activities
 
(830,232
)
 
(14,655
)
Cash flows from financing activities:
 
 
 
 
Paydowns of a secured borrowing
 
(13,630
)
 

Payments for investment agreement draws
 
(17,989
)
 
(49,872
)
Payments for extinguishment of long-term debt
 
(19,550
)
 
(13,752
)
Proceeds from warrant exercises
 
2

 
2

Cost of warrants acquired
 
(1,610
)
 

Net cash (used in) financing activities
 
(52,777
)
 
(63,622
)
Net cash flow
 
(12,700
)
 
(39,938
)
Cash and cash equivalents at beginning of period
 
35,744

 
73,903

Cash and cash equivalents end of period
 
$
23,044

 
$
33,965

 
 
 
 
 
Supplemental disclosure of cash flow information:
 
 
 
 
Cash paid during the period for:
 
 
 
 
Income taxes
 
$
7,662

 
$
9,685

Interest on secured borrowing
 
2,053

 

Interest on investment agreements
 
299

 
159

See accompanying Notes to Unaudited Consolidated Financial Statements


| Ambac Financial Group, Inc. 4 2016 Second Quarter FORM 10-Q |



AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
1. BACKGROUND AND BUSINESS DESCRIPTION
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 April 29, 1991.
Ambac has two reportable business segments: Financial Guarantee and Financial Services.
Ambac’s financial guarantee business segment is conducted through its primary operating subsidiary, Ambac Assurance Corporation (“Ambac Assurance”), and its wholly owned subsidiary, Ambac Assurance UK Limited (“Ambac UK”). Insurance policies issued by Ambac Assurance and Ambac UK generally guarantee payment when due of the principal and interest on the obligations guaranteed. Ambac Assurance also has another wholly-owned financial guarantee subsidiary, Everspan Financial Guarantee Corp. (“Everspan”), which has been in runoff since its acquisition in 1997. The deterioration of Ambac Assurance’s financial condition resulting from losses in its insured portfolio since 2007 has prevented Ambac Assurance from being able to write new business. An inability to write new business has and will continue to negatively impact Ambac’s future operations and financial results. Ambac Assurance’s ability to pay dividends and, as a result, Ambac’s liquidity, have been significantly restricted by the deterioration of Ambac Assurance’s financial condition, by the rehabilitation of the Segregated Account (as defined below) and by the terms of the Settlement Agreement, dated as of June 7, 2010 (the "Settlement Agreement"), by and among Ambac Assurance, Ambac Credit Products LLC (“ACP”), Ambac and certain counterparties to credit default swaps with ACP that were guaranteed by Ambac Assurance. Ambac Assurance is also restricted in its ability to pay dividends pursuant to regulatory restrictions, the terms of its Auction Market Preferred Shares and the terms of agreements entered into with the Segregated Account. It is highly unlikely that Ambac Assurance will be able to make dividend payments to Ambac for the foreseeable future.
Ambac’s financial services business segment is conducted through subsidiaries of Ambac Assurance, which provide financial products, including investment agreements, funding conduits and interest rate swaps, principally to the clients of its financial guarantee business. Ambac Assurance insured all of the obligations of its financial services subsidiaries. These businesses are in active runoff, which is being effectuated by transaction terminations, settlements and scheduled amortization of contracts. The Financial Services business also maintains interest rate derivatives to mitigate exposure to floating rate insured obligations in the Financial Guarantee segment.
Ambac’s primary goal is to maximize stockholder value by executing the following key strategies:
Active runoff of Ambac Assurance and its subsidiaries through accretive transaction terminations, policy commutations, settlements and restructurings, and maximizing the risk-adjusted return on invested assets;
Loss recovery through litigation and exercise of contractual and legal rights;
Improved cost effectiveness and efficiency of the operating platform;
Rationalization of Ambac Assurance's capital and liability structures, enabling simplification of corporate governance and facilitating the successful rehabilitation of the Segregated Account; and
Selective business transactions offering attractive risk-adjusted returns that, among other things, may permit utilization of Ambac’s tax net operating loss carry-forwards.
In March 2010, Ambac Assurance established a Segregated Account pursuant to Wisc. Stat. §611.24 (2) (the “Segregated Account”) to segregate certain segments of Ambac Assurance’s liabilities, and the Office of the Commissioner of Insurance for the State of Wisconsin (“OCI” (which term shall be understood to refer to such office as regulator of Ambac Assurance and to refer to the Commissioner of Insurance for the State of Wisconsin as rehabilitator of the Segregated Account (the “Rehabilitator”), as the context requires)) 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. On October 8, 2010, OCI filed a plan of rehabilitation for the Segregated Account (the “Segregated Account Rehabilitation Plan”) in the Rehabilitation Court. The Rehabilitation Court confirmed the Segregated Account Rehabilitation Plan on January 24, 2011. On June 11, 2014, the Rehabilitation Court approved amendments to the Segregated Account Rehabilitation Plan and the Segregated Account Rehabilitation Plan, as amended, became effective on June 12, 2014. Net par exposure as of June 30, 2016 for policies allocated to the Segregated Account was $13,260,537. Policy obligations not allocated to the Segregated Account remain in the General Account of Ambac Assurance, and such policies in the General Account are not subject to and, therefore, are not directly impacted by the Segregated Account Rehabilitation Plan.
To pay claims and other liabilities, 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”). In addition, certain operating and administrative costs and expenses of the Segregated Account are reimbursable by Ambac Assurance pursuant to the Cooperation Agreement, dated as of March 24,


| Ambac Financial Group, Inc. 5 2016 Second Quarter FORM 10-Q |


2010, by and between the Segregated Account and Ambac Assurance, as amended (the “Cooperation Agreement”). Ambac Assurance is not obligated to make payments under the Reinsurance Agreement or Cooperation 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 and Cooperation Agreement are not capped. At June 30, 2016, Ambac Assurance’s surplus as regards to policyholders of $754,609 exceeded the Minimum Surplus Amount. In the event that Ambac Assurance does not maintain surplus in excess of the Minimum Surplus Amount, the Segregated Account would experience a shortfall in funds available to pay its liabilities. Any such shortfall would be a consideration for the Rehabilitator in the determination of whether any changes to the Segregated Account Rehabilitation Plan and/or the amount of partial policy claim payments are necessary or appropriate or whether to institute general rehabilitation proceedings against Ambac Assurance.
Ambac Assurance is evaluating possibilities for concluding the Segregated Account Rehabilitation Proceedings. In pursuing this objective, Ambac Assurance is considering the possibility of entering into transactions whereby it would monetize certain assets and/or restructure or exchange certain outstanding debt and insurance obligations. Towards this objective, Ambac Assurance is also discussing with OCI potential options for addressing outstanding Deferred Amounts, including accrued interest thereon, and surplus notes (other than junior surplus notes). While the terms, conditions, and timing of a potential conclusion of the Segregated Account Rehabilitation Proceedings are in the sole discretion of the OCI, and ultimately the Rehabilitation Court, from time to time Ambac Assurance has discussed with several counterparty creditors a potential exchange pursuant to which outstanding Deferred Amounts, including accrued interest, and surplus notes (other than junior surplus notes) would be exchanged for new securities and cash. In addition, on July 12, 2016, the Special Deputy Commissioner ("SDC") for the Segregated Account met with policy beneficiaries and holders of surplus notes of Ambac Assurance and the Segregated Account during which the SDC stated his objective of seeking an exit of the Segregated Account from rehabilitation. The SDC also stated that his preference is to achieve an exit through a plan that is consensual among Ambac Assurance, the Segregated Account, policy beneficiaries and other stakeholders. However, the SDC also stated that he is advising OCI on all available means of accomplishing an exit from rehabilitation that is successful, durable and enhances Ambac Assurance's long-term claims-paying ability. As of the date of this filing, Ambac Assurance has not reached any agreement on the terms of a potential transaction, and we cannot provide assurance that any such transaction will be entered into by Ambac Assurance in the future, or if it is, as to the timing, terms or conditions of any such transaction. Any such transaction would remain subject to the prior approval of the board of Ambac Assurance, OCI and the Rehabilitation Court.
The execution of Ambac’s strategy to increase the value of its investment in Ambac Assurance is subject to the authority of the Rehabilitator to control the management of the Segregated Account. In exercising such authority, the Rehabilitator will act for the benefit of policyholders, and will not take into account the interests of Ambac. The Rehabilitator's authority includes, but is not limited to, sole discretion over the rate at which the Segregated Account pays claims (the "Interim Payment Percentage" or "IPP") and the accretion rate on Deferred Amounts. Similarly, by operation of the contracts executed in connection with the establishment, and subsequent rehabilitation, of the Segregated Account, the Rehabilitator retains rights to oversee and approve certain actions taken by or in respect of Ambac Assurance. Opportunities for remediating losses on poorly performing insured transactions also depend on market conditions, including the perception of Ambac Assurance’s creditworthiness, the structure of the underlying risk and associated policy as well as other counterparty specific factors. Oversight by the Rehabilitator could impair Ambac’s ability to execute certain of its strategies. Ambac Assurance's ability to commute policies or purchase certain investments may also be limited by available liquidity.
Although we are exploring new business opportunities for Ambac, no assurance can be given that we will be able to execute the acquisition or development of any new business. In addition, there can be no assurance that we will be able to obtain the financial and other resources that may be required to finance the acquisition or development of new businesses. Due to these factors, as well as uncertainties relating to the ability of Ambac Assurance to deliver value to Ambac, the value of our securities is speculative.
As a result of uncertainties associated with the aforementioned oversight by the Rehabilitator of the Segregated Account, management has concluded that there is substantial doubt about Ambac's ability to continue as a going concern. Ambac’s financial statements as of and for the three and six months ended June 30, 2016 and the year ended December 31, 2015, are prepared assuming Ambac continues as a going concern and do not include any adjustment that might result from its inability to continue as a going concern.
United Kingdom Referendum
In a non-binding referendum on the United Kingdom’s (“UK”) membership in the European Union in June 2016, a majority of those who voted approved the UK’s withdrawal from the European Union (“EU”). Any withdrawal by the UK from the European Union (“Brexit”) would occur after, or possibly concurrently with, a process of negotiation regarding the future terms of the UK’s relationship with the EU, which could result in the UK losing access to certain aspects of the single EU market and the global trade deals negotiated by the EU on behalf of its members. The Brexit vote and the perceptions as to the impact of the withdrawal of the UK may adversely affect business activity, political stability and economic conditions in the UK, the Eurozone, the EU and elsewhere. The economic outlook could be further adversely affected by (i) the risk that one or more other EU countries could come under increasing pressure to leave the EU, (ii) the risk of a greater demand for independence by Scottish nationalists or for unification in Ireland, or (iii) the risk that the Euro as the single currency of the Eurozone could cease to exist. Any of these developments, or the perception that any of these developments are likely to occur, could have a material adverse effect on economic growth or business activity in the UK, the Eurozone, or the EU, and could result in the relocation of businesses, cause business interruptions, lead to economic recession or depression, and impact the stability of the financial markets, the availability of credit, political systems or financial institutions and the financial and monetary system. Consequently the medium and longer term impact on the UK generally, and Ambac Assurance


| Ambac Financial Group, Inc. 6 2016 Second Quarter FORM 10-Q |


UK Limited ("Ambac UK") specifically, is uncertain.  The immediate impact on the UK included a decline in the value of the British Pound against major currencies and asset volatility.
2. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES
The Company has disclosed its significant accounting policies in Note 2. Significant Accounting Policies in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2015. The following significant accounting policies provide an update to those included in the Company’s Annual Report on Form 10-K/A.
Basis of Presentation
The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP") for interim financial reporting and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and disclosures required by GAAP for annual periods. These financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Annual Report on Form 10-K/A for the year ended December 31, 2015. The accompanying consolidated financial statements have not been audited by an independent registered public accounting firm in accordance with the standards of the Public Company Accounting Oversight Board (U.S.), but in the opinion of management such financial statements include all adjustments necessary for the fair presentation of the Company’s consolidated financial position and results of operations. All intercompany balances and transactions have been eliminated. The results of operations for the three and six months ended June 30, 2016 may not be indicative of the results that may be expected for the year ending December 31, 2016. The December 31, 2015 consolidated balance sheet was derived from audited financial statements.
The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. As additional information becomes available or actual amounts become determinable, the recorded estimates are revised and reflected in operating results.
Reclassifications
Certain reclassifications have been made to prior years' amounts to conform to the current year's presentation.
Recently Adopted and Recently Issued Accounting Standards
Adopted:
Effective January 1, 2016, Ambac adopted the following accounting standards:
ASU 2014-12, Compensation - Stock Compensation (Topics 718) - Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period. Generally, share-based payment awards that require a specific performance target to be met also require an employee to render service until the performance target is achieved. However, in some cases, the terms of an award may provide that the performance target could be achieved after the employee completes the requisite service period. Under previous U.S. GAAP, there was no explicit guidance on how to account for share-based payment awards with performance targets that could be achieved after the requisite service period. This ASU is intended to resolve diversity in practice with respect to how the performance target is considered in the grant-date fair value of the award, which impacts the amount of compensation cost recognized over time. The ASU requires that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. As a result, the performance target would not be reflected in estimating the fair value of the award at the grant date. As Ambac previously followed the guidance in ASU 2014-12 for its share-based awards which have performance targets, the adoption of this ASU had no impact on Ambac's financial statements.
ASU 2014-13, Consolidation (Topic 810): Measuring the Financial Assets and the Financial Liabilities of a Consolidated Collateralized Financing Entity. A collateralized financing entity ("CFE") is a variable interest entity with nominal or no equity that holds financial assets and issues beneficial interests in those financial assets. The beneficial interests, which are financial liabilities of the CFE, have contractual recourse only to the related assets of the CFE. Currently, a reporting entity that is required to consolidate a CFE may elect to measure the financial assets and financial liabilities of the CFE at fair value. Under the ASU, a reporting entity may elect to measure such assets and liabilities using either: i) the measurement principles in the Fair Value Measurement Topic of the ASC or ii) an alternative measurement approach specified in the ASU. The alternative measurement approach uses the more observable of either the fair value of the financial assets or financial liabilities to measure both. However, a reporting entity may not use the alternative measurement approach if it guarantees all or a portion of the CFE's beneficial interests. Furthermore, entities that do not (or may not) use the alternative measurement approach may not attribute any of the CFE's earnings to noncontrolling interests. The ASU is intended to address diversity in practice in accounting for the measurement difference between financial assets and financial liabilities of CFEs. Most of the CFEs consolidated by Ambac are the result of Ambac’s guarantee of the CFEs' respective beneficial interests. As a result, we may not apply the measurement alternative in this ASU to those CFEs.  Previously, Ambac had one consolidated CFE where we elected to measure the financial assets and financial liabilities at fair value and where a portion of the CFEs earnings were attributed to noncontrolling interests. As a result, we have elected to use a modified retrospective approach in adopting this ASU and have reclassified $6,442 related to this CFE from noncontrolling interest to retained earnings on the balance sheet effective January 1, 2016. There was no impact on the Statement of Comprehensive Income.


| Ambac Financial Group, Inc. 7 2016 Second Quarter FORM 10-Q |



ASU 2014-16, Derivatives and Hedging (Topic 815): Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share Is More Akin to Debt or to Equity. The objective of this ASU is to eliminate the existing diversity in practice in accounting for hybrid financial instruments issued in the form of a share. A hybrid financial instrument consists of a “host contract” into which one or more derivative terms have been embedded. The ASU requires an entity to consider the terms and features of the entire financial instrument, including the embedded derivative features, in order to determine whether the nature of the host contract is more akin to debt or to equity. Adoption of this ASU did not affect Ambac’s financial statements.
ASU 2015-01, Income Statement - Extraordinary and Unusual Items (Subtopic 225-20): Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items. Extraordinary items are defined as both unusual in nature and infrequent in occurrence. Under previous guidance, a reporting entity was required to separately present and disclose extraordinary items. This ASU eliminates from current U.S. GAAP the concept of extraordinary items. However, the ASU retains the presentation and disclosure guidance for items that are unusual in nature or occur infrequently. Items that meet either or both of these criteria must be presented as a separate component on the face of the income statement or, alternatively, disclosed in the notes to the financial statements. Adoption of this ASU did not affect Ambac’s financial statements.
ASU 2015-02, Consolidation (Topic 810): Amendments to the Consolidation Analysis. This ASU makes changes to the variable interest ("VIE") model and voting interest ("VOE") model consolidation guidance. The main provisions of the ASU include the following: i) adding a requirement that limited partnerships and similar legal entities must provide partners with either substantive kick-out rights or substantive participating rights over the general partner to qualify as a VOE rather than a VIE; ii) eliminating the presumption that the general partner should consolidate a limited partnership; iii) eliminating certain conditions that need to be met when evaluating whether fees paid to a decision maker or service provider are considered a variable interest; iv) excluding certain fees paid to decision makers or service providers when evaluating which party is the primary beneficiary of a VIE; and v) revising how related parties are evaluated under the VIE guidance. Lastly, the ASU eliminates the indefinite deferral of FAS 167, which allowed reporting entities with interests in certain investment funds to follow previous guidance in FIN 46 (R). However, the ASU permanently exempts reporting entities from consolidating registered money market funds that operate in accordance with Rule 2a-7 of the Investment Company Act of 1940. Adoption of this ASU did not affect Ambac’s financial statements.
ASU 2015-03, Interest - Imputation of Interest (Subtopic 835-30). This ASU simplifies the presentation of debt issuance costs by requiring that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts, rather than as a deferred asset. The recognition and measurement guidance for debt issuance costs are not affected by the amendments in this ASU. The ASU requires retrospective application to all prior periods presented. Adoption of this ASU did not have a material effect on Ambac’s financial statements.
ASU 2015-07, Fair Value Measurement (Topic 820) - Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent). Reporting entities are permitted to use net asset value ("NAV") as a practical expedient to measure the fair value of certain investments. Under previous GAAP, investments that use the NAV practical expedient to measure fair value were categorized within the fair value hierarchy as level 2 or level 3 investments depending on their redemption attributes, which has led to diversity in practice. This ASU will remove the requirement to categorize within the fair value hierarchy all investments that use the NAV practical expedient for fair value measurement purposes. Furthermore, the ASU will remove the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the NAV practical expedient. Upon adoption Ambac applied this ASU retrospectively to all prior periods presented, which was not material to Ambac's financial statements. Disclosures that were impacted by adoption of this ASU are shown in Note 7 - Fair Value Measurements.
Issued:
In March 2016, the FASB issued ASU 2016-06, Derivatives and Hedging (Topic 815) - Contingent Put and Call Options in Debt Instruments. Current accounting rules require that embedded derivatives be separated from the host contract in a financial instrument and accounted for separately as derivatives if certain criteria are met. One of these criteria is that the economic characteristics and risks of the embedded derivatives are not "clearly and closely related" to the host contract. The objective of the ASU is to resolve diversity in practice in assessing embedded contingent put and call options. The ASU clarifies what steps are required when assessing whether the economic characteristics and risk of put and call options are clearly and closely related to their debt host contracts. The ASU is effective for fiscal years beginning after December 15, 2016 and interim periods within those fiscal years, with early adoption permitted. The ASU must be applied on a modified retrospective basis to existing debt instruments as of the beginning of the fiscal year for which the amendments are effective. Ambac will adopt this ASU on January 1, 2017. Adoption of this ASU is not expected to have a material impact on Ambac's financial statements.
In March 2016, the FASB issued ASU 2016-07, Investments-Equity Method and Joint Ventures (Topic 323) - Simplifying the Transition to the Equity Method of Accounting. This ASU eliminates the requirement that when an investment qualifies for use of the equity method as a result of an increase in the level of ownership interest or degree of influence, an investor must adjust the investment, results of operations, and retained earnings retroactively as if the equity method had been in effect during all previous periods that the investment had been owned. The ASU will now require that at the date an available-for-sale equity security becomes qualified for the equity method of accounting, the reporting entity will recognize through earnings the unrealized holding gain or loss in accumulated other comprehensive income. The ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 31, 2016, with early adoption permitted. The amendments should be applied prospectively upon adoption. Ambac may choose to early adopt this ASU to the extent we hold an available-for-sale equity security that becomes qualified for the equity method of accounting. Adoption of this ASU is not expected to have a material effect on Ambac's financial statements.


| Ambac Financial Group, Inc. 8 2016 Second Quarter FORM 10-Q |



In March 2016, the FASB issued ASU 2016-09, Compensation-Stock Compensation (Topic 718) - Improvements to Employee Share-Based Payment Accounting. The objective of this ASU is to improve and simplify the accounting for employee share-based payment accounting. The amendments are as follows: (i) recognizing excess tax benefits and tax deficiencies as income tax expense, (ii) recognizing excess tax benefits regardless of whether it reduces taxes payable in the current period, (iii) classifying excess tax benefits related to share-based payments along with other income tax cash flows as an operating activity on the statement of cash flows, (iv) allowing companies to make an accounting policy election to either estimate forfeitures or account for forfeitures as they occur, for purposes of accruing compensation cost, (v) to qualify for equity classification treatment, permitting tax withholding by employees up to the maximum statutory tax rate and (vi) classifying cash paid by an employer to a taxing authority when directly withholding shares as a financing activity on the statement of cash flows. The ASU is effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods, with early adoption permitted. Depending on the amendment, application will be prospective, retrospective or using a modified retrospective approach. Ambac will adopt this ASU on January 1, 2017. We are evaluating the impact of this ASU on Ambac's financial statements.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326) - Measurement of Credit Losses on Financial Instruments. This ASU significantly affects how reporting entities will measure credit losses for financial assets that are not accounted for at fair value through net income, which include loans, debt securities, trade receivables, net investments in leases, and certain off-balance sheet credit exposures. For financial assets measured at amortized cost, the ASU replaces the "incurred loss" model, which generally delayed recognition of the full amount of credit losses until the loss was probable of occurring, with an "expected loss" model, which reflects an entity's current estimate of all expected credit losses. Expected credit losses for amortized cost assets will be recorded as a valuation allowance, with subsequent increases or decreases in the allowance reflected in the income statement each period. For available-for-sale debt securities, credit losses under the ASU will be measured similarly to current GAAP. However, under the ASU, credit losses for available-for-sale securities will be recorded as a valuation allowance (similar to the amortized cost assets approach described above), rather than as a direct write-down of the security as is required under current GAAP. As a result, improvements to estimated credit losses for available-for-sale debt securities will be recognized immediately in the income statement rather than as interest income over time. The ASU is effective for annual periods beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted as of the fiscal year beginning after December 15, 2018. Ambac has not determined whether it will early adopt this ASU and we are currently evaluating its impact on Ambac's financial statements.
3. SPECIAL PURPOSE ENTITIES, INCLUDING VARIABLE INTEREST ENTITIES ("VIEs")
Ambac, with its subsidiaries, has engaged in transactions with special purpose entities, including VIEs, in various capacities. Ambac most commonly provides financial guarantees, including credit derivative contracts, for various debt obligations issued by special purpose entities, including VIEs. Ambac has also sponsored certain special purpose entities 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.
Financial Guarantees
Ambac’s subsidiaries provide 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 structures provide 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 a VIE's expected losses given that they have issued financial guarantees supporting the liabilities (and in certain cases assets). As further described below, we consolidated certain VIEs because: (i) 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 (ii) 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 VIEs involving Ambac financial guarantees, Ambac is required to 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 could occur in connection with insurance policies that are 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. Assets and liabilities of VIEs that are consolidated as a result of Ambac's variable interest arising from financial guarantees written by Ambac's subsidiaries are reported within Variable interest entity assets or Variable interest entity liabilities on the Consolidated Balance Sheets. Results from such VIEs are reported within Income (loss) on variable interest entities in the Consolidated Statements of Total Comprehensive Income.


| Ambac Financial Group, Inc. 9 2016 Second Quarter FORM 10-Q |



Ambac Sponsored VIEs
A subsidiary of Ambac transferred financial assets to two special purpose entities. The business purpose of these entities was to provide certain financial guarantee clients with funding for their debt obligations. These special purpose entities were established as separate legal entities, demonstrably distinct from Ambac and that Ambac, its affiliates or its agents could not unilaterally dissolve. The permitted activities of these entities were 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. Effective February 17, 2015, one of the special purpose entities was liquidated as it no longer had any outstanding liabilities. Ambac has not consolidated these entities because Ambac Assurance’s policies issued to these entities were allocated to the Segregated Account, thereby limiting Ambac’s control over the entities’ most significant economic activities. Ambac elected to account for its equity interest in these entities at fair value under the fair value option in accordance with the Financial Instruments Topic of the ASC. 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 the Investments – Equity Method and Joint Ventures Topic of the ASC. Refer to Note 7. Fair Value Measurements for further information on the valuation technique and inputs used to measure the fair value of Ambac’s equity interest in these entities. At June 30, 2016 and December 31, 2015 the fair value of the remaining entity was $8,687 and $8,696, respectively, and is reported within Other assets on the Consolidated Balance Sheets.
Since their inception, there have been 15 individual transactions with these entities, of which three transactions remain outstanding as of June 30, 2016. In each case, Ambac sold assets to these entities. The purchase by these entities of financial assets 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. Total principal amount of MTN debt outstanding was $420,760 and $465,160 at June 30, 2016 and December 31, 2015, respectively. The assets are composed of utility obligations with a weighted average rating of BBB+ at June 30, 2016 and weighted average life of 5.9 years. As of June 30, 2016 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.
In July 2015, Ambac Assurance entered into a secured borrowing transaction whereby it sold 17 Ambac insured residential mortgage-backed securities (the "Securities") and all rights associated therewith as of May 31, 2015, to a Delaware statutory trust (the "Trust") in exchange for an equity certificate in the Trust, all financial guarantee claim payments associated with the Securities and cash of $146,000 (prior to expenses associated with the transaction). The Securities had par and fair value of $355,049 and $376,266 as of June 30, 2016, respectively. Although the Securities were legally sold to the Trust, the Securities will remain in Invested assets on the Consolidated Balance Sheets. Refer to Note 8. Investments for further discussion of the restrictions on the invested assets. At the same time, a second Delaware statutory trust (the "Issuer"), issued $146,000 of debt securities and used the proceeds, together with an equity certificate of the Issuer, to purchase from the Trust a certificate entitling the Issuer to, and secured by, all principal and interest payments (other than financial guarantee claim payments) on the Securities. Interest on the debt securities is payable monthly at an annual rate of one month LIBOR + 2.8%. Both the Trust and the Issuer are consolidated VIEs because Ambac Assurance was involved in their design and holds a significant amount of the beneficial interests issued by the VIEs or guaranteed the assets held by the VIEs. VIE debt outstanding to third parties under this secured borrowing transaction had a carrying value of $117,641 as of June 30, 2016 and is reported in Long-Term Debt on the Consolidated Balance Sheets.
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 (when applicable), 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 (when applicable), 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 (loss) on variable interest entities on the Consolidated Statements of Total Comprehensive Income.
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 insurance policy issued to a consolidated VIE, Ambac does not reflect the financial guarantee insurance policy in accordance with the related insurance accounting rules under the Financial Services – Insurance Topic of the ASC. Consequently, upon consolidation, Ambac eliminates the insurance assets and liabilities associated with the policy from the Consolidated Balance Sheets. Such insurance assets and liabilities may include premium receivables, reinsurance recoverable, deferred ceded premium, subrogation recoverable, unearned premiums, loss and loss expense reserves, ceded premiums payable and insurance intangible assets. Furthermore, with respect to the consolidation or deconsolidation of VIEs related to financial guarantee insurance policies, there typically is no consideration paid or received by Ambac, and consequently has no impact on the above described gain or loss calculation. For investment


| Ambac Financial Group, Inc. 10 2016 Second Quarter FORM 10-Q |



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 for any of the periods presented.
As of June 30, 2016, consolidated VIE assets and liabilities relating to 15 consolidated entities were $13,661,038 and $13,506,799, respectively. As of December 31, 2015, consolidated VIE assets and liabilities relating to 15 consolidated entities were $14,288,497 and $14,259,776, respectively. As of June 30, 2016 and December 31, 2015, eight and seven consolidated VIEs related to transaction insured by Ambac UK and Ambac Assurance, respectively. As of June 30, 2016 VIE assets and liabilities of $13,194,359 and $13,067,541 and as of December 31, 2015, VIE assets and liabilities of $13,769,985 and $13,636,628 related to transactions guaranteed by Ambac UK. The remaining balance of consolidated VIE assets and liabilities are related to transactions guaranteed by Ambac Assurance. Ambac is not primarily liable for, and generally does not guarantee all of the debt obligations issued by the VIEs. Ambac would only be required to make payments on the VIE debt obligations in the event that the issuer of such debt obligations defaults on any principal or interest due and such obligation is guaranteed by Ambac. Additionally, Ambac’s general creditors, other than those specific policy holders which own the VIE debt obligations, do not have rights with regard to the assets of the VIEs. Ambac evaluates the net income 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 income and earnings per share effect of most consolidated VIEs are attributable to Ambac’s interests 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 June 30, 2016 and December 31, 2015
 
June 30,
2016
 
December 31,
2015
Investments:
 
 
 
Corporate obligations
$
2,577,293

 
$
2,588,556

Total variable interest entity assets: fixed income securities
$
2,577,293

 
$
2,588,556

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 June 30, 2016 and December 31, 2015:
 
Estimated fair value
 
Unpaid principal balance
June 30, 2016:
 
 
 
Loans
$
11,074,772

 
$
8,252,444

Long-term debt
11,444,892

 
9,543,681

December 31, 2015:
 
 
 
Loans
$
11,690,324

 
$
9,182,284

Long-term debt
12,327,960

 
10,803,729

For the six months ended June 30, 2016, Ambac did not consolidate or deconsolidated any VIEs. For the six months ended June 30, 2015, Ambac deconsolidated one VIE when the associated financial guarantee exposure matured. There was no gain or loss resulting from this deconsolidation.
Variable Interests in Non-Consolidated VIEs
On August 28, 2014, Ambac monetized its ownership of the junior surplus note issued to it by the Segregated Account by depositing the junior surplus note into a newly formed VIE trust in exchange for cash and an owner trust certificate, which represents Ambac's right to residual cash flows from the junior surplus note. Ambac does not consolidate the VIE. Ambac reports its interest in the VIE as an equity investment within Other investments on the Consolidated Balance Sheets with associated results from operations included within Net investment income: Other investments on the Consolidated Statements of Total Comprehensive Income. The equity investment had a carrying value of $27,620 and $25,339 as of June 30, 2016 and December 31, 2015.


| Ambac Financial Group, Inc. 11 2016 Second Quarter FORM 10-Q |



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 derivative contracts by major underlying asset classes, as of June 30, 2016 and December 31, 2015:
 
Carrying Value of Assets and Liabilities
 
Maximum
Exposure
To Loss
(1)
 
Insurance
Assets
(2)
 
Insurance
Liabilities
(3)
 
Net Derivative
Assets (Liabilities) 
(4)
June 30, 2016:
 
 
 
 
 
 
 
Global structured finance:
 
 
 
 
 
 
 
Collateralized debt obligations
$
903,540

 
$
232

 
$
3,469

 
$
(167,626
)
Mortgage-backed—residential
15,988,051

 
723,524

 
3,022,345

 

Other consumer asset-backed
2,454,061

 
28,599

 
329,172

 

Other commercial asset-backed
1,885,561

 
76,941

 
72,606

 

Other
3,084,963

 
72,584

 
486,598

 
17,235

Total global structured finance
24,316,176

 
901,880

 
3,914,190

 
(150,391
)
Global public finance
26,867,551

 
365,981

 
398,267

 
(9,607
)
Total
$
51,183,727

 
$
1,267,861

 
$
4,312,457

 
$
(159,998
)
 
 
 
 
 
 
 
 
December 31, 2015:
 
 
 
 
 
 
 
Global structured finance:
 
 
 
 
 
 
 
Collateralized debt obligations
$
980,935

 
$
264

 
$
3,639

 
$
(129,525
)
Mortgage-backed—residential
17,081,002

 
1,279,650

 
2,680,739

 

Other consumer asset-backed
3,853,443

 
47,346

 
535,090

 

Other commercial asset-backed
2,393,805

 
104,033

 
94,191

 

Other
3,286,568

 
81,017

 
461,364

 
15,410

Total global structured finance
27,595,753

 
1,512,310

 
3,775,023

 
(114,115
)
Global public finance
28,586,582

 
377,412

 
427,299

 
(24,860
)
Total
$
56,182,335

 
$
1,889,722

 
$
4,202,322

 
$
(138,975
)
(1)
Maximum exposure to loss represents the maximum future payments of principal and interest on insured obligations and derivative contracts plus Deferred Amounts and accrued and unpaid interest thereon. 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 “Loss and loss expense reserves” and “Unearned premiums” for financial guarantee contracts on Ambac’s Consolidated Balance Sheets.
(4)
Net derivative assets (liabilities) represent the fair value recognized on credit derivative contracts and interest rate swaps on Ambac’s Consolidated Balance Sheets.


| Ambac Financial Group, Inc. 12 2016 Second Quarter FORM 10-Q |



4. COMPREHENSIVE INCOME
The following tables detail the changes in the balances of each component of accumulated other comprehensive income for the affected periods:
 
Unrealized Gains
(Losses) on
Available- for
Sale Securities
(1)
 
Amortization of
Postretirement
Benefit
(1)
 
Gain (Loss) on
Foreign Currency
Translation
(1)
 
Total
Three Months Ended June 30, 2016:
 
 
 
 
 
 
 
Beginning Balance
$
110,754

 
$
10,131

 
$
(62,873
)
 
$
58,012

Other comprehensive income before reclassifications
55,623

 

 
(55,152
)
 
471

Amounts reclassified from accumulated other comprehensive income
(7,453
)
 
(255
)
 

 
(7,708
)
Net current period other comprehensive income (loss)
48,170

 
(255
)
 
(55,152
)
 
(7,237
)
Balance at June 30, 2016
$
158,924

 
$
9,876

 
$
(118,025
)
 
$
50,775

 
 
 
 
 
 
 
 
Three Months Ended June 30, 2015:
 
 
 
 
 
 
 
Beginning Balance
$
193,245

 
$
10,004

 
$
(33,920
)
 
$
169,329

Other comprehensive income before reclassifications
(120,209
)
 

 
40,092

 
(80,117
)
Amounts reclassified from accumulated other comprehensive income
6,370

 
(220
)
 

 
6,150

Net current period other comprehensive income (loss)
(113,839
)
 
(220
)
 
40,092

 
(73,967
)
Balance at June 30, 2015
$
79,406

 
$
9,784

 
$
6,172

 
$
95,362

 
Unrealized Gains
(Losses) on
Available- for
Sale Securities
(1)
 
Amortization of
Postretirement
Benefit
(1)
 
Gain (Loss) on
Foreign Currency
Translation
(1)
 
Total
Six Months Ended June 30, 2016:
 
 
 
 
 
 
 
Beginning Balance
$
50,963

 
$
9,344

 
$
(45,092
)
 
$
15,215

Other comprehensive income before reclassifications
107,185

 

 
(72,933
)
 
34,252

Amounts reclassified from accumulated other comprehensive income
776

 
532

 

 
1,308

Net current period other comprehensive income (loss)
107,961

 
532

 
(72,933
)
 
35,560

Balance at June 30, 2016
$
158,924

 
$
9,876

 
$
(118,025
)
 
$
50,775

 
 
 
 
 
 
 
 
Six Months Ended June 30, 2015:
 
 
 
 
 
 
 
Beginning Balance
$
210,693

 
$
10,031

 
$
(441
)
 
$
220,283

Other comprehensive income before reclassifications
(86,655
)
 

 
6,613

 
(80,042
)
Amounts reclassified from accumulated other comprehensive income
(44,632
)
 
(247
)
 

 
(44,879
)
Net current period other comprehensive income (loss)
(131,287
)
 
(247
)
 
6,613

 
(124,921
)
Balance at June 30, 2015
$
79,406

 
$
9,784

 
$
6,172

 
$
95,362

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


| Ambac Financial Group, Inc. 13 2016 Second Quarter FORM 10-Q |



The following table details the significant amounts reclassified from each component of accumulated other comprehensive income, shown in the above rollforward tables, for the affected periods:
 
 
Amount Reclassified from Accumulated
Other Comprehensive Income
(1)
 
Affected Line Item in the
Details about Accumulated Other
 
Three Months Ended June 30,
 
Consolidated Statement of
Comprehensive Income Components
 
2016
 
2015
 
Total Comprehensive Income
Unrealized Gains (Losses) on Available-for-Sale Securities
 
 
 
 
 
 
 
 
$
(7,453
)
 
$
6,370

 
Net realized investment (losses) gains and other-than-temporary impairment losses
 
 

 

 
Tax (expense) benefit
 
 
$
(7,453
)
 
$
6,370

 
Net of tax and noncontrolling interest 
Amortization of Postretirement Benefit
 
 
 
 
 
 
Prior service cost
 
$
(167
)
 
$
(167
)
 
Operating expenses (2)
Actuarial (losses)
 
(88
)
 
(53
)
 
Operating expenses (2)
 
 
(255
)
 
(220
)
 
Total before tax
 
 

 

 
Tax (expense) benefit
 
 
$
(255
)
 
$
(220
)
 
Net of tax and noncontrolling interest 
Total reclassifications for the period
 
$
(7,708
)
 
$
6,150

 
Net of tax and noncontrolling interest 
 
 
Amount Reclassified from Accumulated
Other Comprehensive Income
(1)
 
Affected Line Item in the
Details about Accumulated Other
 
Six Months Ended June 30,
 
Consolidated Statement of
Comprehensive Income Components
 
2016
 
2015
 
Total Comprehensive Income
Unrealized Gains (Losses) on Available-for-Sale Securities
 
 
 
 
 
 
 
 
$
776

 
$
(44,632
)
 
Net realized investment (losses) gains and other-than-temporary impairment losses
 
 

 

 
Tax (expense) benefit
 
 
$
776

 
$
(44,632
)
 
Net of tax and noncontrolling interest 
Amortization of Postretirement Benefit
 
 
 
 
 
 
Prior service cost
 
$
(333
)
 
$
(333
)
 
Operating expenses (2)
Actuarial gains
 
865

 
86

 
Operating expenses (2)
 
 
532

 
(247
)
 
Total before tax
 
 

 

 
Tax (expense) benefit
 
 
$
532

 
$
(247
)
 
Net of tax and noncontrolling interest 
Total reclassifications for the period
 
$
1,308

 
$
(44,879
)
 
Net of tax and noncontrolling interest 
(1)
Amounts in parentheses indicate debits to the Consolidated Statement of Total Comprehensive Income.
(2)
These accumulated other comprehensive income components are included in the computation of net periodic benefit cost.
5. NET INCOME PER SHARE
On May 1, 2013, pursuant to the Second Modified Fifth Amended Plan of Reorganization of Ambac (the "Reorganization Plan"), 45,000,000 shares of new common stock at par value of $0.01 per share and 5,047,138 of warrants were issued. Warrants entitled such holders to acquire up to 5,047,138 shares of new common stock at an exercise price of $16.67 per share at any time on or prior to April 30, 2023. For the six months ended June 30, 2016 and 2015, 136 and 398 warrants were exercised, respectively, resulting in an issuance of 136 and 207 shares of common stock, respectively.
On June 30, 2015, the Board of Directors of Ambac authorized the establishment of a warrant repurchase program that permits the repurchase of up to $10,000 of warrants. For the six months ended June 30, 2016, Ambac repurchased 228,500 warrants at a cost of $1,610. As of June 30, 2016, Ambac has repurchased 860,100 warrants totaling $6,983, (average cost of $8.12 per warrant) leaving 4,178,901 warrants outstanding.
Basic net income per share is computed by dividing net income attributable to common stockholders by the weighted-average number of common shares outstanding and vested restricted stock units. Diluted net income per share is computed by dividing net income attributable to common stockholders by the weighted-average number of common shares used for basic earnings per share plus all potential dilutive common shares outstanding during the period. All potential dilutive common shares outstanding consider common stock deliverable pursuant to warrants issued


| Ambac Financial Group, Inc. 14 2016 Second Quarter FORM 10-Q |



under the Reorganization Plan and vested and unvested options, unvested restricted stock and performance stock units granted under employee and director compensation plans.
The following table provides a reconciliation of the common shares used for basic net income per share to the diluted shares used for diluted net income per share:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2016
 
2015
 
2016
 
2015
Basic weighted average shares outstanding
45,212,484

 
45,190,089

 
45,194,731

 
45,173,239

Effect of potential dilutive shares:
 
 
 
 
 
 
 
Warrants

 
1,480,990

 

 
1,625,901

Stock options

 
8,409

 

 
10,625

Restricted stock units
104,457

 
18,242

 
80,680

 
21,628

Performance stock units
58,147

 
5,042

 
34,132

 
4,094

Diluted weighted average shares outstanding
45,375,088

 
46,702,772

 
45,309,543

 
46,835,487

Antidilutive securities for the three and six months ended June 30, 2016 included stock options and warrants to purchase 176,668 and 4,178,901 shares of common stock, respectively, where the exercise price was greater than the average market price and 23,334 restricted stock units. Antidilutive securities for the three and six months ended June 30, 2015 included stock options to purchase 110,000 shares of common stock where the exercise price was greater than the average market price.
6. FINANCIAL GUARANTEE INSURANCE CONTRACTS
Amounts presented in this Note relate only to Ambac’s non-derivative insurance business for insurance policies issued to beneficiaries, including VIEs, for which we do not consolidate the VIE.
Net Premiums Earned:
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 assets underlying the insured obligation are homogenous pools 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 June 30, 2016 and December 31, 2015, was 2.5% and 2.7%, respectively, and the weighted average period of future premiums used to estimate the premium receivable at June 30, 2016 and December 31, 2015, was 9.1 years and 9.2 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 senior in the waterfall. Additionally, in connection with the allocation of certain liabilities to the Segregated Account, trustees and other parties 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 premium receivables, management evaluates the transaction waterfall structures and the internal ratings of the transactions underlying the premium receivables. Uncollectable premiums are determined on a policy basis and utilize a combination of historical premium collection data in addition to cash flow analysis to determine if an impairment in the related policy's premium receivables exist. As of June 30, 2016 and December 31, 2015, approximately 26% and 27% of the premium receivables related to transactions with non-investment grade internal ratings, comprised mainly of non-investment grade RMBS, structured insurance, lease securitizations and student loan transactions, which comprised 8%, 6%, 4%, and 3%, of the total premium receivables at June 30, 2016 and 8%, 5%, 5%, and 5% of the total premium receivables at December 31, 2015, respectively. At June 30, 2016 and December 31, 2015, $10,903 and $15,240 respectively, of premium receivables were deemed uncollectable. Past due premiums on policies insuring non-investment grade obligations amounted to less than $500 at June 30, 2016.


| Ambac Financial Group, Inc. 15 2016 Second Quarter FORM 10-Q |



Below is the gross premium receivable roll-forward for the affected periods:
 
 
Six Months Ended June 30,
 
 
2016
 
2015
Beginning premium receivable
 
$
831,575

 
$
1,000,607

Premium receipts
 
(39,569
)
 
(49,040
)
Adjustments for changes in expected and contractual cash flows
 
(43,125
)
 
(25,513
)
Accretion of premium receivable discount
 
9,967

 
12,576

Changes to uncollectable premiums
 
4,337

 
2,807

Other adjustments (including foreign exchange)
 
(21,771
)
 
(4,513
)
Ending premium receivable
 
$
741,414

 
$
936,924

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 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, the recognition of any remaining UPR is offset 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. Ambac’s accelerated premium revenue for retired obligations for the three and six months ended June 30, 2016 was $5,081 and $20,057, and the three and six months ended June 30, 2015 was $13,641 and $36,493, 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. 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 (a refunding) or a specified call date (a pre-refunding). Ambac has evaluated the provisions in policies issued on legally defeased obligations and determined those insurance policies have not been legally extinguished. For policies with refunding securities, premium revenue recognition is not impacted as the escrowed maturity date is the same as the previous legal maturity date. For policies with pre-refunding securities, the maturity date of the pre-refunded security has been shortened from its previous legal maturity. Although premium revenue recognition has not been accelerated in the period of the pre-refunding, it results in an increase in the rate at which the policy's remaining UPR is to be recognized.
The effect of reinsurance on premiums written and earned for the respective periods was as follows:
 
Three Months Ended June 30, 2016
 
Three Months Ended June 30, 2015
 
Written
 
Earned
 
Written
 
Earned
Direct
$
(4,041
)
 
$
44,974

 
$
(11,192
)
 
$
65,156

Assumed

 
21

 

 
22

Ceded
(854
)
 
3,593

 
(1,142
)
 
4,299

Net premiums
$
(3,187
)
 
$
41,402

 
$
(10,050
)
 
$
60,879

 
Six Months Ended June 30, 2016
 
Six Months Ended June 30, 2015
 
Written
 
Earned
 
Written
 
Earned
Direct
$
(28,821
)
 
$
101,963

 
$
(10,130
)
 
$
136,806

Assumed

 
43

 

 
43

Ceded
(6,899
)
 
7,804

 
(777
)
 
10,252

Net premiums
$
(21,922
)
 
$
94,202

 
$
(9,353
)
 
$
126,597



| Ambac Financial Group, Inc. 16 2016 Second Quarter FORM 10-Q |



The table below summarizes the future gross undiscounted premiums to be collected and future premiums earned, net of reinsurance at June 30, 2016:
 
Future premiums
to be collected
(1)
 
Future
premiums to
be earned net of
reinsurance
(1)
Three months ended:
 
 
 
September 30, 2016
$
21,184

 
$
30,477

December 31, 2016
17,936

 
28,639

Twelve months ended:
 
 
 
December 31, 2017
69,067

 
94,811

December 31, 2018
64,564

 
80,752

December 31, 2019
60,977

 
74,629

December 31, 2020
57,954

 
70,147

Five years ended:
 
 
 
December 31, 2025
237,920

 
282,657

December 31, 2030
193,274

 
195,912

December 31, 2035
126,150

 
114,686

December 31, 2040
43,602

 
41,486

December 31, 2045
20,112

 
17,600

December 31, 2050
7,238

 
7,796

December 31, 2055
601

 
1,299

Total
$
920,579

 
$
1,040,891

(1)
Future premiums to be collected are undiscounted and are used to derive the discounted premium receivable asset recorded on Ambac's balance sheet. Future premiums to be earned, net of reinsurance relate to the unearned premium liability and deferred ceded premium asset 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 further described in Note 2. Basis of Presentation and Significant Accounting Principles in the Notes to Consolidated Financial Statements included in Ambac's Annual Report on Form 10-K/A for the year ended December 31, 2015. This results in a different premium receivable balance than if expected lives were considered. If installment paying policies are retired or prepay early, premiums reflected in the premium receivable asset and amounts reported in the above table for such policies may not be collected. Future premiums to be earned also considers the use of contractual lives for many bond types which do not have homogeneous pools of underlying collateral, which may result in different unearned premium than if expected lives were considered. If those bonds types are retired early, premium earnings may be negative in the period of call or refinancing.
Loss and Loss Expense Reserves:
The loss and loss expense reserve (“loss reserve”) policy for financial guarantee insurance 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. Losses and loss expenses are based upon estimates of the ultimate aggregate losses inherent in the non-derivative financial guarantee portfolio as of the reporting date. A loss reserve is recorded on the balance sheet on a policy-by-policy basis. Loss reserve components of an insurance policy include unpaid claims and the present value ("PV") of expected net cash flows required to be paid under an insurance contract, further described below:
Unpaid claims represent the sum of (i) claims presented and not yet paid for policies allocated to the Segregated Account, including Deferred Amounts and (ii) accrued interest on Deferred Amounts as required by the amended Segregated Account Rehabilitation Plan that became effective on June 12, 2014. Refer to Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in Ambac's Annual Report on Form 10-K/A for further discussion of the amended Segregated Account Rehabilitation Plan. Unpaid claims are measured based on the cost of settling the claims, which is principal plus accrued interest.
The PV of expected net cash flows represents the PV of expected cash outflows less the PV of expected cash inflows. The PV of expected net cash flows are impacted by: (i) expected future claims to be paid under an insurance contract, including the impact of potential settlement outcomes upon future installment premiums, (ii) expected recoveries from contractual breaches of RMBS representations and warranties by transaction sponsors, (iii) excess spread within the underlying transaction's cash flow structure, and (iv) other subrogation recoveries. Expected receipts from third parties within the underlying transaction's cash flow structure relating to contractual breaches in non-RMBS securitizations may also reduce expected future claims. Ambac’s approach to resolving disputes involving contractual breaches by transaction sponsors or other third parties has included negotiations and/or pursuing litigation. Ambac does not include potential recoveries attributed solely to fraudulent inducement claims in our estimate of subrogation recoveries, since any remedies under such claims would be non-contractual.
Net cash outflow policies represent contracts where the sum of unpaid claims plus the PV of expected cash outflows are greater than the PV of expected cash inflows. For such policies, a “Loss and loss expense reserves” liability is recorded for the sum of: (i) unpaid claims plus (ii) the excess of the PV of expected net cash outflows over the unearned premium reserve. Net cash inflow policies represent contracts where losses


| Ambac Financial Group, Inc. 17 2016 Second Quarter FORM 10-Q |



have been paid, but not yet recovered, such that the PV of expected cash inflows are greater than the sum of unpaid claims plus the PV of expected cash outflows. For such policies, a “Subrogation recoverable” asset is recorded for the difference between (i) the PV of expected net cash inflows and (ii) unpaid claims.
The approaches used to estimate expected future claims and expected future recoveries considers the likelihood of all possible outcomes. The evaluation process for determining expected losses is subject to certain estimates and judgments based on our assumptions regarding the probability of default by the issuer of the insured security, probability of settlement outcomes (which may include commutation settlements, refinancing and/or other settlement outcomes) and expected severity of credits for each insurance contract. Ambac’s loss reserves are based on management’s on-going review of the financial guarantee credit portfolio. Below are the components of the Loss and loss expense reserves liability and the Subrogation recoverable asset at June 30, 2016 and December 31, 2015:
 
Unpaid Claims
 
Present Value of Expected
Net Cash Flows
 
 
 
 
Balance Sheet Line Item
Claims
 
Accrued
Interest
 
Claims and
Loss Expenses
 
Recoveries
 
Unearned
Premium
Revenue
 
Gross Loss and
Loss Expense
Reserves
June 30, 2016:
 
 
 
 
 
 
 
 
 
 
 
Loss and loss expense reserves
$
2,353,165

 
$
449,012

 
$
2,996,249

 
$
(1,309,352
)
 
$
(161,136
)
 
$
4,327,938

Subrogation recoverable
649,661

 
125,894

 
110,428

 
(1,563,140
)
 

 
(677,157
)
Totals
$
3,002,826

 
$
574,906

 
$
3,106,677

 
$
(2,872,492
)
 
$
(161,136
)
 
$
3,650,781

 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2015:
 
 
 
 
 
 
 
 
 
 
 
Loss and loss expense reserves
$
2,138,952

 
$
349,668

 
$
3,265,349

 
$
(1,476,276
)
 
$
(189,587
)
 
$
4,088,106

Subrogation recoverable
828,802

 
141,349

 
207,674

 
(2,407,118
)
 

 
(1,229,293
)
Totals
$
2,967,754

 
$
491,017

 
$
3,473,023

 
$
(3,883,394
)
 
$
(189,587
)
 
$
2,858,813

Below is the loss and loss expense reserve roll-forward, net of subrogation recoverable and reinsurance, for the affected periods:
 
Six Months Ended June 30,
 
2016
 
2015
Beginning gross loss and loss expense reserves
$
2,858,813

 
$
3,798,733

Less reinsurance on loss and loss expense reserves
44,059

 
100,355

Beginning balance of net loss and loss expense reserves
$
2,814,754

 
$
3,698,378

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
12

 
737

Total current year
12

 
737

Prior years:
 
 
 
Change in previously established loss and loss expense reserves, gross of RMBS subrogation and net of reinsurance
(157,403
)
 
(262,962
)
Claim and loss expense (payments) recoveries, net of subrogation and reinsurance
1,011,957

 
(88,387
)
(Increase) decrease in previously established RMBS subrogation recoveries, net of reinsurance
(48,647
)
 
(32,785
)
Total prior years
805,907

 
(384,134
)
Net change in net loss and loss expense reserves
805,919

 
(383,397
)
Ending net loss and loss expense reserves
3,620,673

 
3,314,981

Add reinsurance on loss and loss expense reserves (1)
30,108

 
71,031

Ending gross loss and loss expense reserves
$
3,650,781

 
$
3,386,012

(1)
Reinsurance recoverable reported on the Balance Sheet also includes reinsurance recoverables (payables) of previously presented loss and loss expenses of $(1,404) and $4,974 as of June 30, 2016 and 2015, respectively.
The increase in loss and loss expense reserves established in prior years for the six months ended June 30, 2016 was primarily due to the receipt of RMBS subrogation recoverables, the receipt of recoveries related to an omnibus settlement with investors in Countrywide securitizations, higher loss expenses and UPR amortization. Offsetting this increase in loss and loss expense reserves was positive loss development primarily due to the impact of lower interest rates, executed commutations in the student loan insured portfolio, claim payments and interest on Deferred Amounts. The increase in loss and loss expense reserves established in prior years for the six months ended June 30, 2015 was primarily due to the impact of executed commutations in the student loan insured portfolio and reduced future claims for both the Ambac UK and RMBS portfolios partially offset by negative development in certain public finance transactions and interest accrued on Deferred Amounts.


| Ambac Financial Group, Inc. 18 2016 Second Quarter FORM 10-Q |



The net change in net loss and loss expense reserves are included in losses and loss expenses in the Consolidated Statements of Total Comprehensive Income. Reinsurance recoveries of losses included in losses and loss expenses in the Consolidated Statements of Total Comprehensive Income were a benefit of $1,847 and an expense of $7,607 for the three and six months ended June 30, 2016 and an expense of $3,219 and $23,821 for the three and six months ended June 30, 2015, respectively.
The tables below summarize information related to policies currently included in Ambac’s loss and loss expense reserves or subrogation recoverable at June 30, 2016 and December 31, 2015. Gross par exposures include capital appreciation bonds which are reported at the par amount at the time of issuance of the insurance policy. The weighted average risk-free rate used to discount loss reserves at June 30, 2016 and December 31, 2015 was 1.8% and 2.4%, respectively.
Surveillance Categories as of June 30, 2016
 
I/SL
 
IA
 
II
 
III
 
IV
 
V
 
Total
Number of policies
41

 
14

 
26

 
48

 
167

 
3

 
299

Remaining weighted-average contract period (in years)
9

 
16

 
28

 
18

 
15

 
6

 
16

Gross insured contractual payments outstanding:
 
 
 
 
 
 
 
 
 
 
 
 
 
Principal
$
1,902,757

 
$
259,528

 
$
1,910,439

 
$
2,107,764

 
$
8,595,851

 
$
49,248

 
$
14,825,587

Interest
760,420

 
111,177

 
6,820,692

 
1,469,457

 
2,401,664

 
15,424

 
11,578,834

Total
$
2,663,177

 
$
370,705

 
$
8,731,131

 
$
3,577,221

 
$
10,997,515

 
$
64,672

 
$
26,404,421

Gross undiscounted claim liability (1)
$
7,163

 
$
5,486

 
$
187,914

 
$
980,082

 
$
6,246,780

 
$
64,671

 
$
7,492,096

Discount, gross claim liability
(394
)
 
(434
)
 
(88,856
)
 
(225,668
)
 
(561,883
)
 
(3,854
)
 
(881,089
)
Gross claim liability before all subrogation and before reinsurance
$
6,769

 
$
5,052

 
$
99,058

 
$
754,414

 
$
5,684,897

 
$
60,817

 
$
6,611,007

Less:
 
 
 
 
 
 
 
 
 
 
 
 
 
Gross RMBS subrogation (2)

 

 
(1,666
)
 

 
(1,891,061
)
 

 
(1,892,727
)
Discount, RMBS subrogation

 

 
7

 

 
8,894

 

 
8,901

Discounted RMBS subrogation, before reinsurance

 

 
(1,659
)
 

 
(1,882,167
)