The executive office of Ambac Financial Group is located at One State Street Plaza, New York, New York 10004, which consists of approximately 145,000 square feet of office space, under an agreement that expires in September 2019. This office houses operations for all reportable business segments.
Ambac’s financial guarantee business segment also maintains offices internationally, with the principal office located at 6 Broadgate, London EC2, which consists of approximately 12,600 square feet of office space under an agreement that expires in September 2013. International operations are also conducted in three offices located in Australia (Sydney), Italy (Milan) and Japan (Tokyo).
Ambac Financial Group owns an office building in Ronkonkoma, New York, which consists of approximately 15,000 square feet of office space and storage and was leased to PFM Asset Management, LLC under an agreement that expired in January 2006. We are evaluating various options for future use of the property.
Ambac recorded record revenues of $1.7 billion, an 18% increase as compared to 2004. Return on average shareholders’ equity was 14.4%.
Ambac reports its financial guarantee segment broken out into three principal markets: Public Finance, Structured Finance and International Finance. Public Finance includes all U.S. municipal issuance including general obligations, lease and tax-backed obligations, health care, public utilities, transportation and higher education, as well as certain infrastructure privatization transactions, such as stadium financings, military housing and student housing. Structured Finance covers U.S. structured finance transactions, including mortgage-backed securities and other consumer asset-backed securities, commercial asset-backed securities, collateralized debt obligations, investor-owned utilities and asset-backed commercial paper conduits. International Finance covers both infrastructure privatization transactions and the structured finance markets outside of the U.S. Pre-tax income growth in the Financial Guarantee segment was the result of increased net premiums earned and other credit enhancement fee revenues, partially offset by increased losses and loss expenses due to Hurricane Katrina.
accepted accounting principles (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets and liabilities, revenues and expenses and related disclosure of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions.
Financial Guarantee Insurance Losses and Loss Expenses. The loss reserve for financial guarantee insurance discussed in this critical accounting estimates disclosure relates only to Ambac’s non-derivative insurance business. 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. The evaluation process for determining the level of reserves is subject to certain estimates and judgments.
The table below outlines the estimated impact on the December 31, 2005 consolidated loss reserve estimate (both active credit and case basis reserve) of reasonably possible changes in the loss severity assumptions. These changes in the loss severity assumptions, while maintaining the current probability of default and adversely classified credit rating constant, represent management’s estimate of reasonably possible changes in severity and are based upon our historical experience.
Ambac’s management believes that the reserves for losses and loss expenses are adequate to cover the ultimate net cost of claims, but the reserves, including the probability of default and loss severity assumptions are based on estimates and there can be no assurance that the ultimate liability for losses will not exceed such estimates.
securities being valued. The valuation results from these models could differ materially from amounts that would actually be realized in the market. The percentage of the investment portfolio that is based upon internal valuation models was 1% and 2% at December 31, 2005 and 2004, respectively.
Income From Continuing Operations. Ambac’s income from continuing operations in 2005 was $751.0 million or $6.87 per diluted share, an increase of $25.2 million, compared to $725.8 million or $6.54 per diluted share in 2004. Ambac’s income before income taxes was $1,022.8 million in 2005, an increase of 5% from income before income taxes of $976.8 million in 2004. Of the $1,022.8 million of income (loss) before income taxes in 2005, $1,009.3 million was from Financial Guarantee, $81.0 million from Financial Services and $(67.5) million from Corporate. Corporate consists primarily of Ambac’s interest expense on debentures outstanding. That compares to income (loss) before income
Ambac’s income from continuing operations in 2004 increased $97.7 million compared to $628.1 million or $5.74 per diluted share, in 2003. Ambac’s income before income taxes in 2004 was up 15% from income before income taxes of $849.6 million in 2003. This increase was attributable to growth in both the Financial Guarantee and Financial Services segments. Income (loss) before income taxes in 2003 consisted of $888.1 million from Financial Guarantee, $23.0 million from Financial Services and $(61.5) million from Corporate.
(1) The decline in International net par outstanding resulted primarily from calls, terminations and paydowns of pooled debt and mortgage-backed transactions.
(2) $7.5 billion of the net par outstanding increase in 2005 was a result of the Radian reinsurance cancellation noted above.
The following tables provide a rating distribution of guaranteed net par outstanding based upon internal Ambac Assurance credit ratings at December 31, 2005 and 2004 and a distribution by bond type of Ambac Assurance’s below investment grade exposures at December 31, 2005 and 2004. Below investment grade are defined as those exposures with a credit rating below BBB-:
require more structuring skills. Certain projects, which had been financed by the local or U.S. government alone, are now being financed through public-private partnerships. In these transactions, debt service on the bonds, rather than being paid solely by tax revenues or other governmental funds, is being paid from a variety of revenue sources, including revenues derived from the project itself. Examples of such transactions include stadium financings, student housing and military housing. Included in transportation obligations is exposure to U.S. airports of $8.8 billion at December 31, 2005. Airport obligations are generally supported by (i) terminal lease revenues, parking and other concession revenues; (ii) passenger facility charges; or (iii) payments in respect of specific airport facilities.
The table below shows the percentage, by bond type, of new Public Finance business gross par guaranteed by Ambac Assurance during each of the last three years.
Structured finance obligations include securitizations of a variety of asset types such as mortgages, home equity loans, student loans and credit card receivables; commercial asset-backed securities; leases; pooled debt obligations; investor-owned utilities and asset-backed commercial paper conduits originated in the United States (“Structured Finance”). Included within the commercial asset-backed sector are securitizations of operating assets, including aircraft, rental car fleets, and rail cars, as well as film and publishing royalties. Exposures to Enhanced Equipment Trust Certificates were $1.6 billion at December 31, 2005. Enhanced Equipment Trust Certificates are secured financings used by the airline industry to finance aircraft. The financings are tranched to create a priority of interests in the aircraft collateral. Pooled debt obligations, including structured credit derivative transactions, involve the securitization of a diverse portfolio of corporate bonds and loan obligations and asset-backed securities (the “Securitized Assets”). Ambac Assurance’s exposure to these Securitized Assets is mitigated through first loss protection. Typically, first loss protection is in the form of over-collateralization (i.e., the principal amount of the Securitized Assets exceeds the principal amount of the structured finance obligations guaranteed by Ambac Assurance) or excess spread (i.e., interest cash flows on the
Structured Finance obligations par value written was $58.8 billion, $53.4 billion and $50.2 billion in 2005, 2004 and 2003, respectively. The increase in Structured Finance obligations guaranteed for 2005 as compared to 2004 resulted primarily from higher par written in pooled debt obligations, partially offset by a decline in the consumer asset-backed sector of the market (including mortgage-backed securities). The increase in Structured Finance obligations guaranteed in 2004 compared to 2003 resulted from higher par written in the consumer asset-backed sector of the market (including mortgage-backed securities), partially offset by a decline in pooled debt obligations and commercial asset-backed transactions.
The table below shows the percentage, by bond type, of new Structured Finance business gross par guaranteed by Ambac Assurance during each of the last three years.
Reinsurance. Ambac Assurance’s reinsurance program is principally comprised of a surplus share treaty and facultative reinsurance. The surplus share treaty requires Ambac Assurance to cede covered transactions while retaining flexibility to cede those transactions within a predefined range. Certain types of transactions are excluded from the surplus share treaty and management may use facultative reinsurance to cede such risks. Ceded premiums written in 2005 were $99.7 million, up 41% from $70.9 million in 2004. During 2005, Ambac completed a cancellation of a reinsurance contract with Radian. Included in ceded premiums written in 2005 is $55.8 million in return premiums from the cancellation. In 2004, Ambac completed the cancellation of certain reinsurance contracts with two reinsurers, AXA Re Finance S.A. and American Re-Insurance Company. Included in ceded premiums written in 2004 is $64.8 million in return premiums from the cancellations. Excluding the return premiums from both 2005 and 2004, ceded premiums were $155.5 million for 2005 compared to $135.7 million in 2004, an increase of 15%. Ceded premiums (exclusive of the return premiums) as a percentage of gross premiums written were 14.2% and 13.0% for 2005 and 2004, respectively. The mix of business underwritten and greater treaty participation drove the increase. Ceded premiums written in 2004 were down 49% from $138.1 million in 2003, which represented ceded premiums as a percentage of gross premiums written of 12.1%. This decrease is due to the return premiums from the cancellation of reinsurance contracts in 2004 mentioned above.
Net Premiums Earned and Other Credit Enhancement Fees. Net premiums earned and other credit enhancement fees during 2005 were $866.1 million, an increase of 13% from $764.0 million in 2004. This increase was primarily the result of the higher refundings or calls of previously insured obligations
and other accelerations, such as reinsurance cancellations, (collectively referred to as “accelerated earnings”) and the larger Financial Guarantee book of business.
Overall, the business environment has become more competitive. Increased competition from the uninsured market in the form of senior/subordinated securitizations and other triple-A-rated financial guarantors has increased. This increased competition has had an adverse impact on pricing. The growth in normal earned premiums in Structured Finance and International Finance that has been exhibited over the past several years has moderated as those lines of business have grown significantly, resulting in more difficult comparisons. The mortgage-backed securities and pooled debt obligation exposures have relatively short average lives. As a result, the earnings from those types of exposures are recognized quickly. A significant portion of the recent premium writings in Public Finance and for certain bond types within Structured Finance and International are for longer-term transactions. While the earned premium impact from such writings is not as immediate as the mortgage-backed or pooled debt obligations, they increase the stability of earned premiums over time. Similarly, due to a tight credit spread environment in International Finance, our exposures relating to pooled debt obligations have decreased significantly, adversely impacting earned premiums and other credit enhancement fees. This, combined with the continued high level of run-off in the mortgage-backed securities book, adversely impacted overall earned premium growth.
Other credit enhancement fees in 2005, which is primarily comprised of fees received from the structured credit derivatives product, were $50.1 million, an increase of 6% from $47.3 million in 2004. Credit spreads in the current environment have narrowed and this has had an adverse impact on new credit derivative business in 2005 (when credit spreads are narrow, the pricing for guaranteed products is reduced).
The following table provides a breakdown of net premiums earned by market sector and other credit enhancement fees:
Net Realized Investment Gains. Net realized investment gains in 2005 were $6.3 million, compared to net realized gains of $30.0 million and $40.2 million in 2004 and 2003, respectively. The following table details amounts included in net realized gains:
Net Mark-to-Market Gains on Credit Derivative Contracts. Net mark-to-market gains on credit derivative contracts in 2005 were $13.6 million, compared to net mark-to-market gains of $17.7 million and $0.0 million in 2004 and 2003, respectively. The change in estimated fair value of structured credit derivative contracts reflects net mark-to-market gains due to improvements in credit spreads on the underlying obligations. There were no realized net losses paid on structured credit derivatives for the years ended December 31, 2005 and 2004, and $1.2 million for the year ended December 31, 2003.
Other Income (Loss). Other income (loss) in 2005 was $12.3 million, as compared to ($4.1) million in 2004. Included in other income are deal structuring fees, commitment fees and income from Ambac’s Qualifying Special Purpose Entities (“QSPEs”). Included in 2004 is a $13.6 million mark-to-market loss on interest rate derivative contracts relating to Ambac’s medium-term funding conduit. Also included within other income (loss) are structuring fees of $0.5 million and $1.9 million for 2005 and 2004, respectively. Structuring fees are negotiated for certain domestic and international structured finance transactions, typically are collected at close of the transactions, and are earned ratably over the life of the transactions. Ambac has approximately $16.4 million and $9.8 million of deferred structuring and commitment fees included in “Other liabilities” on the Consolidated Balance Sheets as of December 31, 2005 and 2004, respectively. Other income decreased $9.1 million in 2004 from $5.0 million in 2003, primarily due to the mark-to-market loss on interest rate derivative contracts mentioned above.
The 2005 loss and loss expenses were primarily driven by a provision for losses of $91.5 million for municipal exposures impacted by Hurricane Katrina and losses of $70.1 million from three credits that experienced credit deterioration, partially offset by favorable development in other aspects of our adversely classified credit listing.
Ambac’s exposure to losses as a result of the hurricane is derived primarily from its guarantees of municipal bonds in the greater New Orleans area and the Gulf-front regions that were most severely impacted by the storm. Ambac has added 33 individual obligations to the adversely classified credit list with total net par outstanding of approximately $1.1 billion. To date, Ambac has paid three claims on
obligations in the region, totaling approximately $2.0 million and has subsequently recovered the full amounts. In determining our loss estimate, our analysis has considered the unprecedented nature of the disaster, including the displacement of the communities’ residents, and the unique aspects of each insured bond, such as the nature of the revenue source, the level of debt service reserves, if any, and other transaction protections. Ambac’s estimate of losses related to the hurricane was made without regard to any potential federal, state or local government assistance to individual municipalities or institutions. The credit loss estimation process involves the exercise of considerable judgment. Due to the nature of the loss reserve estimate, Ambac’s ultimate loss associated with the hurricane may be materially different than the current estimate and thereby may affect future operating results. Ambac will continue to assess the impact of Hurricane Katrina on subsequent periods as more information becomes available.
Case basis credit reserves at December 31, 2005 and 2004 were comprised of 10 and 11 credits, respectively, with net par outstanding of $839.0 million and $661.4 million, respectively. Decrease to the case basis credit reserves is primarily due to (i) the settlement of a claim relating to one EETC, and (ii) a decrease in case reserves for three mortgage-backed securities transactions as a result of loss payments during 2005 and prepayments of the underlying insured par. Offsetting the decrease in case reserves were additions for healthcare and the public finance transportation issues noted and one general obligation bond impacted by Hurricane Katrina.
(1) The 2005 and 2004 cancellations of reinsurance contracts disclosed above impacted net reinsurance commissions received by ($17.4) million and ($19.8) million, respectively and the amortization of previously deferred expenses by $15.9 million and $16.3 million, respectively.
Through its Financial Services subsidiaries, Ambac provides financial and investment products including investment agreements, funding conduits, interest rate swaps, currency swaps and total return swaps, principally to clients of the financial guarantee business, which includes municipalities and other public entities, health care organizations, and asset-backed and structured finance issuers. The investment agreement business is managed with the goal of approximately matching the cash flows of the investment agreement liabilities with the cash flows of the related investment portfolio. To achieve this goal in the investment agreement business, derivative contracts are used for hedging purposes. The primary activities in the derivative products business are intermediation of interest rate and currency swap transactions and taking total return swap positions on certain fixed income obligations. Most of the swap intermediation is done on a fully hedged basis with the exception of certain municipal interest
rate swaps that are not hedged for the basis difference between taxable and tax-exempt interest rates. As such, changes in the relationship between taxable and tax-exempt interest rates will result in mark-to-market gains or losses.
During 2003 realized losses included an impairment write-down of $10.5 million related to asset-backed notes issued by National Century Financial Enterprises, Inc (“NCFE”). This loss was in addition to the loss reported in 2002 which amounted to $139.7 million. These notes, which were backed by health care receivables and rated triple-A until October 25, 2002, have defaulted and NCFE filed for protection under Chapter 11 of the U.S. Bankruptcy Code in November 2002. The loss was specific to the NCFE notes and had no impact on other investments held. In 2005 and 2004, Ambac has received cash recoveries of $10.8 million and $17.9 million, respectively, resulting from distributions under the NCFE Bankruptcy Plan, payments made by a Trust created under the Plan and litigation settlements. Ambac received additional NCFE related cash recoveries of approximately $6 million during February 2006. Also in February 2006, Ambac, and a group of certain other note holders, entered into a litigation settlement agreement. During the same month, a Trust of which Ambac is a beneficiary also entered into a litigation settlement agreement. Recoveries resulting from these separate settlement agreements have been placed into escrow accounts and Ambac’s shares aggregate to approximately $36 million.
Expenses. Financial Services expenses were $252.9 million, $183.6 million and $208.4 million for 2005, 2004 and 2003, respectively. Included in the above are expenses related to investment and payment agreements of $239.2 million, $168.9 million and $196.3 million for 2005, 2004 and 2003, respectively. The increase in 2005 compared to 2004 is primarily related to higher rates in floating rate investment agreements. The decrease in 2004 compared to 2003 is primarily related to decreases in the
average volume of investment agreements outstanding and were impacted by lower rates on floating rate investment agreements.
Ambac Financial Group, Inc. Liquidity. Ambac’s liquidity, both on a short-term basis (for the next twelve months) and a long-term basis (beyond the next twelve months), is largely dependent upon: (i) Ambac Assurance’s ability to pay dividends or make other payments to Ambac; (ii) external financings and (iii) investment income from its investment portfolio. Pursuant to Wisconsin insurance laws, Ambac Assurance may pay dividends, provided that, after giving effect to the distribution, it would not violate certain statutory surplus, solvency and asset tests. Additionally, no quarterly dividend may exceed the dividend paid in the corresponding quarter of the preceding year by more than 15% without regulatory approval. Based upon these tests, without regulatory approval, the maximum amount that will be available during 2006 for payment of dividends by Ambac Assurance is $332.7 million. Ambac Assurance paid dividends of $353.4 million in 2005. Ambac received regulatory approval for these amounts since it exceeded the statutorily prescribed thresholds.
The following table includes aggregated information about contractual obligations for Ambac, excluding those of entities consolidated under the provisions of the Financial Accounting Standards Board (“FASB”) Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). For a further discussion of FIN 46, see Note 2, “Significant Accounting Policies” and Note 10 “Special Purpose Entities and Variable Interest Entities” of the Consolidated Financial Statements, located in Part II, Item 8. These contractual obligations impact Ambac’s and its subsidiaries short-and long-term liquidity and capital resource needs. The table includes information about payments due under specified contractual obligations, aggregated by type of contractual obligation, including claim payments, principal payments of Ambac’s consolidated long-term debt obligations, investment agreement obligations, payment agreement obligations and payments due under operating leases.
(1) For additional information about long-term debt, see Note 7 to the Consolidated Financial Statements, located in Part II, Item 8 .
Based on the amount of dividends that it expects to receive from Ambac Assurance and other subsidiaries during 2006, and the income it expects to receive from its investment portfolio, management believes that Ambac will have sufficient liquidity to satisfy its needs over the next twelve months, including the ability to pay dividends on its common stock in accordance with its dividend policy. Beyond the next twelve months, Ambac Assurance’s ability to declare and pay dividends to Ambac may be influenced by a variety of factors including adverse market changes, insurance regulatory changes and changes in general economic conditions. Consequently, although management believes that Ambac will continue to have sufficient liquidity to meet its debt service and other obligations over the long term, no guarantee can be given that Ambac Assurance will be able to
dividend amounts sufficient to pay all of Ambac’s operating expenses, debt service obligations and dividends on its common stock.
A subsidiary of Ambac Financial Group provides a $360 million liquidity facility to a reinsurance company which acts as reinsurer with respect to a portfolio of life insurance policies. The liquidity facility, which is guaranteed by Ambac Assurance, provides temporary funding in the event that the reinsurance company’s capital is insufficient to make payments under the reinsurance agreement. The reinsurance company is required to repay all amounts drawn under the liquidity facility. No amounts have been drawn under this facility at December 31, 2005.
Financial Services Liquidity. The principal uses of liquidity by Financial Services subsidiaries are payment of investment and payment agreement obligations pursuant to defined terms, net obligations under interest rate, total return and currency swaps, operating expenses and income taxes. Management believes that its Financial Services liquidity needs can be funded from its operating cash flow, the maturity of its invested assets and from time to time, by short-term inter-company loans from Ambac Assurance. The principal sources of this segment’s liquidity are proceeds from issuance of investment agreements, net investment income, maturities of securities from its investment portfolio (which are invested with the objective of closely matching the cash flows of its obligations under the investment agreements) and net receipts from interest rate, currency and total return swaps. The investment objectives with respect to investment agreements are to achieve the highest after-tax total return, subject to a minimum average quality rating of AA on invested assets, and to maintain cash flow matching of invested assets to funded liabilities to minimize interest rate and liquidity risk. Financial Services subsidiaries maintain a portion of their assets in short-term investments in order to meet unexpected liquidity needs.
Investment agreements subject Ambac to liquidity risk associated with unscheduled withdrawals of principal allowed by the terms of the investment agreements. As of December 31, 2005, approximately $4.9 billion, or 77%, of the outstanding investment agreements (at amortized cost) relate to either fixed or contingent draw, floating rate investment agreements, which expose Ambac to minimal liquidity risk. Contingent draw floating rate investment agreements are sourced in the structured finance markets and will only permit a draw in the event that well-defined, observable events have occurred. Ambac considers these contingent draw events to be remote. The remaining portfolio of investment agreements, approximating $1.5 billion at December 31, 2005, consists of fixed rate investment agreements, primarily relating to debt service reserve and construction funds in support of municipal bond transactions. Debt service reserve fund investment agreements may be drawn unexpectedly upon a payment default by the municipal issuer. Ambac also considers these draw events to be remote. Construction fund investment agreements may be drawn faster or slower than anticipated when construction of the underlying municipal project does not proceed as expected.
Credit Ratings and Collateral. Downgrades in Ambac Assurance’s triple-A financial strength rating would adversely affect Ambac’s ability to compete for business. Credit ratings are very important to the
Ambac manages this liquidity risk through the maintenance of liquid collateral and bank liquidity facilities. Additionally, Ambac generally has the right to re-hypothecate collateral that it receives under derivative contracts to counterparties.
of Ambac and/or Ambac Assurance. Ambac and/or Ambac Assurance has the option of selecting either (i) a Base Rate, a fluctuating rate equal to the higher of Citibank’s Base Rate and the Federal Funds Rate plus 0.5%, plus the Applicable Margin (as defined in the Credit Facility) or (ii) a Eurocurrency Rate, a periodic fixed rate equal to LIBOR plus the Applicable Margin. There are no outstanding loans under the Credit Facility. Neither Ambac nor Ambac Assurance have previously incurred any borrowing under this or prior similar facilities.
The Credit Facility contains customary representations, warranties and covenants for this type of financing, including two financial covenants requiring Ambac to: (i) maintain as of the end of each fiscal quarter a debt-to-capital ratio, excluding debt consolidated under FIN 46, of not more than 30%, and (ii) maintain at all times total stockholder’s equity equal to or greater than $2.87 billion. The stockholders’ equity financial covenant will increase annually, in an amount equal to 15% of the prior fiscal year’s net income and 15% of the net proceeds of any future equity issuances. The Credit Facility also provides for certain events of default with corresponding grace periods, including failure to pay any principal or interest when due, failure to comply with covenants, any material representation or warranty made by Ambac or Ambac Assurance proving to be false in any material respect, certain bankruptcy, insolvency or receivership events affecting Ambac or Ambac Assurance, defaults relating to other indebtedness, imposition of certain judgments and a change in ownership of Ambac and/or Ambac Assurance.
Balance Sheet. Total assets as of December 31, 2005 were $19.73 billion, an increase of 5% from total assets of $18.75 billion at December 31, 2004. This increase was due primarily to cash generated from operations during 2005 and from the proceeds of a $400 million debt issuance in December 2005, offset by stock repurchases during the year amounting to $309.7 million and the decrease in the unrealized gains in the investment portfolio driven by higher long-term interest rates. Stockholders’
The Financial Services investment portfolio consists primarily of assets funded with proceeds from the issuance of investment agreement liabilities. The investment objectives with respect to investment agreements are to achieve the highest after-tax total return, subject to a minimum average credit quality rating of Aa/AA on invested assets, and to maintain cash flow matching of invested assets to funded liabilities to minimize interest rate and liquidity exposure. The investment portfolio is subject to internal investment guidelines. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits.
The following table summarizes the composition of the fair value of Ambac’s investment portfolio by segment at December 31, 2005 and 2004:
The following table represents mortgage-backed securities guaranteed by either a U.S. government agency or U.S. government sponsored enterprise at December 31, 2005 and 2004 by segment:
The following table summarizes, for all securities sold at a loss during 2005 and 2004, the aggregate fair value and realized loss by length of time those securities were continuously in an unrealized loss position prior to the sale date:
Short-term investments in the Financial Guarantee portfolio consisted primarily of domestic and foreign currency denominated money market funds. Short-term investments in the Financial Services portfolio consisted of money market funds.
Cash Flows. Net cash provided by operating activities was $1,007.5 million, $949.7 million and $1,005.7 million during 2005, 2004 and 2003, respectively. These cash flows were primarily provided by net insurance premium receipts of $996.0 million, $976.9 million, and $1,005.6 million in 2005, 2004 and 2003, respectively, partially offset by net claim payments of $86.7 million, $18.9 million and $34.1 million in 2005, 2004 and 2003, respectively. Future net cash provided by operating activities will be impacted by the level of claim payments. 2006 claim payments are estimated to be approximately $73.6 million for credits that are in default at December 31, 2005. Net cash provided by financing activities was $465.0 million, $655.3 million and $69.1 million during 2005, 2004 and 2003,
respectively. Financing activities for the years ended 2005 and 2004 included $347.6 million and $12.8 million, respectively, in net investment and payment agreements issued (net of investment and payment agreement draws), which were provided primarily by the investment agreement business. Financing activities for the years ended 2005 and 2004 included $100.0 million and $885.2 million, respectively, in long-term debt issued by variable interest entities consolidated under the provisions of FIN46, and the net proceeds from the issuance of long-term debt by Ambac Financial Group, Inc. of $396.3 million in 2005. 2005 financing activities also included net purchases of common stock held in treasury of $279.1 million compared to $21.7 million in 2004. Financing activities for the year ended 2003 included $223.1 million used primarily by the investment agreement business for net investment and payment agreement draws paid (net of investment and payment agreements issued). Financing activities for the year 2003 also included the proceeds from the issuance of long-term debt of $363.2 million and the payment for the repurchase of Ambac’s long-term debt of $200.0 million. Net cash used in investing activities in 2005, 2004 and 2003 were $1,464.2 million, $1,609.6 million and $1,076.1 million, respectively. These investing activities were primarily net purchases of fixed income investment securities. Total cash provided by (used in) operating, investing and financing activities was $8.3 million, ($4.6) million and ($1.3) million during 2005, 2004 and 2003, respectively.
Please refer to Note 2, “Significant Accounting Policies” of the Consolidated Financial Statements, located in Part II, Item 8, for a discussion of the impact of recent accounting pronouncements on Ambac’s financial condition and results of operations.
The management of Ambac Financial Group, Inc. is responsible for the integrity and objectivity of the Consolidated Financial Statements and all other financial information presented in this Form 10-K and for assuring that such information fairly presents the consolidated financial position and operating results of Ambac Financial Group, Inc. The accompanying Consolidated Financial Statements have been prepared in conformity with U.S. generally accepted accounting principles using management’s best estimates and judgment. The financial information presented elsewhere in this Form 10-K is consistent with that in the Consolidated Financial Statements.
The management of Ambac Financial Group, Inc. (“Ambac”) is responsible for establishing and maintaining adequate internal control over financial reporting. Ambac’s internal control over financial reporting is a process designed under the supervision of the chief executive officer and chief financial officer and effected by Ambac’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of Ambac’s financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles. Ambac’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets of Ambac; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of Ambac; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of Ambac’s assets that could have a material effect on the financial statements.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Ambac Financial Group, Inc. and subsidiaries (the “Company” or “Ambac”) maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
In our opinion, management’s assessment that Ambac maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Ambac maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
and 2004, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2005, and our report dated March 10, 2006, expressed an unqualified opinion on those consolidated financial statements.
Ambac Financial Group, Inc. is a holding company incorporated in the state of Delaware. Ambac through its subsidiaries provides financial guarantees and financial services to clients in both the public and private sectors around the world. Ambac’s principal operating subsidiary, Ambac Assurance Corporation, a leading guarantor of public finance and structured finance obligations, has earned triple-A ratings, the highest ratings available from Moody’s Investors Service, Inc., Standard & Poor’s Ratings Services, Fitch Inc. and Rating and Investment Information, Inc. Ambac’s Financial Services segment provides financial and investment products including investment agreements, funding conduits, interest rate, currency and total return swaps, principally to its insurance clients which include municipalities and other public entities, health care organizations and asset-backed issuers.
The accompanying consolidated financial statements of Ambac and subsidiaries have been prepared on the basis of U.S. generally accepted accounting principles (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and disclosures of contingent assets and liabilities. Actual results could differ from those estimates. The significant accounting policies of Ambac are described below:
There are two different accounting frameworks applicable to SPEs; the qualifying SPE (“QSPE”) framework under Statement of Financial Accounting Standards (“SFAS”) No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (a replacement of FASB Statement No. 125); and the variable interest entity (“VIE”) framework under Financial Interpretation Number (“FIN”) 46R “Consolidation of Variable Interest Entities”. The applicable framework depends on the nature of the entity and Ambac’s relation to that entity.
The QSPE framework is applicable when an entity transfers (sells) financial assets to a SPE meeting certain criteria as defined in SFAS 140. These criteria are designed to ensure that the activities of the entity are essentially predetermined in their entirety at the inception of the vehicle; decision making is limited and restricted to certain events, and that the transferor of the financial assets cannot exercise control over the entity and the assets therein. Entities meeting these criteria are not
consolidated by the transferor or other counterparty, as long as the entity does not have the unilateral ability to liquidate or to cause it to no longer meet the QSPE criteria. Ambac follows the QSPE model for its medium-term note issuance program and does not consolidate those SPEs.
When the SPE does not meet the QSPE criteria, consolidation is assessed pursuant to FIN 46R. Under FIN 46R, a VIE is defined as an entity that is not assessed for consolidation by determining which party maintains a controlling financial interest. As such, a VIE (i) lacks enough equity investment at risk to permit the entity to finance it’s activities without additional subordinated financial support from other parties, (ii) its equity owners lack the right to make significant decisions affecting the entity’s operations, and (iii) its equity owners do not have an obligation to absorb or the right to receive the entity’s losses or returns.
Prior to Ambac’s adoption of FIN 46 on December 31, 2003, the decision of whether or not to consolidate depended on the applicable accounting principles for non QSPEs, including a determination regarding the nature and amount of investment made by third parties in the SPE. Consideration was given to, among other factors, whether a third party had made a substantive equity investment in the SPE; which party had voting rights, if any; who made decisions about the assets in the SPE; and who was at risk of loss.
Securities purchased under agreements to resell and securities sold under agreements to repurchase, represent short-term collateralized financing transactions and are recorded at their contracted amounts, plus accrued interest. Ambac nets securities purchased under agreements to resell and securities sold under agreements to repurchase that are executed with the same counterparty under legally enforceable netting agreements that meet the applicable netting criteria. Ambac takes possession of securities purchased under agreements to resell, makes delivery of securities sold under agreements to repurchase, monitors the market value of these securities on a daily basis and delivers or obtains additional collateral as appropriate. At December 31, 2005 and 2004, collateral underlying securities purchased under agreements to resell had an average credit rating of triple-A and a weighted average maturity of 93 days and 27 days, respectively.
Loans are reported at their outstanding unpaid principal balances, net of fair value hedge adjustments. These fair value hedge adjustments are discussed further in “Derivative Contracts used for Hedging Purposes” below. Interest income is accrued on the unpaid principal balance. A loan is considered impaired when, based on current events and the financial condition of the issuer, it is probable that Ambac will be unable to collect all principal and interest due according to the contractual terms of the loan agreement.
Case basis credit reserves are for losses on insured obligations that have defaulted. We believe our definition of case basis credit reserves differs from other financial guarantee industry participants. Upon the occurrence of a payment default, the related active credit reserve is transferred to case basis credit reserve. Additional provision for losses upon further credit deterioration of a case basis exposure are initially recorded through the active credit reserve and subsequently transferred to case basis credit reserves. Our case reserves represent the present value of anticipated loss and loss expense payments expected over the estimated period of default. Loss and loss expenses consider anticipated defaulted debt service payments, estimated expenses associated with settling the claims and estimated recoveries under collateral and subrogation rights. The estimate does not consider future installment premium receipts, as the likelihood of such receipts is remote. Ambac discounts these estimated net payments using discount rates that approximate the average taxable equivalent yield on our investment portfolio.
Ambac provides information on the classification of its loss reserve between active credit reserve and case basis credit reserve for the purpose of disclosing the components of the total reserve that relate to exposures that have not yet defaulted and those that have defaulted. The total reserve (active credit and case basis) was $304,139 and $254,055 at December 31, 2005 and 2004, respectively. Due to the relatively small number and large size of certain insured obligations comprising the active and case basis credit reserves, improvements or further deterioration in any one credit may significantly impact our loss provision in a given period. The provision for losses and loss expenses in the accompanying Consolidated Statements of Operations represents the expense recorded to bring the total reserve to a level determined by management to be adequate for losses inherent in the non-derivative financial guarantee insurance portfolio.
Our liabilities for credit losses are based in part on the short-duration accounting guidance in SFAS No. 60, “Accounting and Reporting by Insurance Enterprises.” The trustee (on behalf of the insured party), named beneficiary or custodian has a right to a claim payment under the financial guarantee insurance policy at the date of the first scheduled debt service payment of a defaulted security in the amount equal to the payment shortfall. We believe a loss event occurs for financial guarantee insurance products at the time the issuers’ financial condition deteriorates to an impaired credit status rather than at the time the insured party has a right to a claim payment. Because of this belief and the ambiguities discussed below in the application of SFAS No. 60 to the financial guarantee industry, Ambac does not believe that SFAS No. 60 alone provides sufficient guidance. As a result, Ambac supplements the guidance in SFAS No. 60 with the guidance in SFAS No. 5, “Accounting for Contingencies,” which calls for a loss to be accrued if it is probable that a liability has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated. Ambac also relies by analogy on EITF Issue No. 85-20, “Recognition of Fees for Guaranteeing a Loan,” which states that a guarantor should perform an ongoing assessment of the probability of loss to determine if a liability (and a loss) should be recognized under SFAS No. 5.
Investment agreements - Ambac provides investment agreements and investment repurchase agreements principally to asset-backed and structured finance issuers, states, municipalities and municipal authorities, whereby Ambac agrees to pay an agreed-upon return based on funds deposited. Proceeds from these investment agreement and investment repurchase agreement obligations are used to invest in high credit quality fixed income investments. Interest income from these investments is included in Financial Services revenues.
SFAS 133 “Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS 138 and SFAS 149, establishes accounting and reporting standards for derivative instruments. All derivatives, whether designed for hedging relationships or not, are required to be recorded on the Consolidated Balance Sheets at fair value. When available, quotes are obtained from independent market sources. However, when quotes are not available, Ambac uses internally developed valuation models. These valuation models require market-driven inputs, including contractual terms, credit spreads on underlying referenced obligations, yield curves and tax-exempt interest ratios. The valuation results from these models could differ materially from amounts that would actually be realized in the market. In accordance with the Emerging Issues Task Force (EITF) Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities” (EITF 02-3), recognition of a trading profit at inception of a derivative transaction is prohibited unless fair value of that derivative is obtained from a quoted market price, supported by comparison to other observable market transactions, or based upon a valuation technique incorporating observable market data. Ambac defers trade date gains or losses on derivative transactions where the fair value is not determined based upon observable market transactions and market data. The deferral is recognized in income when the market data becomes observable or over
Interest rate and currency swaps are utilized to hedge exposure to changes in fair value of assets or liabilities resulting from changes in interest rates and foreign exchange rates, respectively. These
interest rate and currency swap hedges are referred to as “fair value” hedges. Gains and losses on derivative hedges are recognized currently in net income. If the provisions of the derivative contract meet the technical requirements for hedge accounting under SFAS 133, the gain or loss on the hedged asset or liability attributable to the hedged risk (interest rate or foreign exchange risk) adjusts the carrying amount of the hedged item and is recognized currently in net income. The net amount representing hedge ineffectiveness, recorded as a component of “Net mark-to-market gains on non-trading derivative contracts” in the accompanying Consolidated Statements of Operations, was $327, $132 and $792 for 2005, 2004 and 2003, respectively.
Depreciation of furniture and fixtures and electronic data processing equipment is charged over the estimated useful lives of the respective assets, ranging from three to five years, using the straight-line method. Amortization of leasehold improvements is charged over the lesser of ten years or the remaining term of the operating leases, ranging from one to ten years, using the straight-line method.
Effective January 1, 2003, Ambac began to account for stock-based employee compensation in accordance with the fair-value method prescribed by SFAS Statement 123, “Accounting for Stock-Based Compensation,” (“SFAS 123”) as amended by SFAS Statement 148, “Accounting for Stock-Based Compensation - Transition and Disclosure,” (“SFAS 148”), prospectively to all employee awards granted after January 1, 2003. Under this method of adoption, compensation expense is recognized over the relevant service period based on the fair value of stock options and restricted stock units granted for 2003 and future years. No unearned compensation is included in “Stockholders’ Equity” for such stock options and restricted stock units granted. Rather, such stock options and restricted stock units are included in “Stockholders’ Equity” under SFAS 123 when services required from employees in exchange for the awards are rendered and expensed. Compensation expense for restricted stock units is recognized over the relevant service periods based on the applicable vesting provisions.
Foreign currency transaction gains and losses of Ambac’s U.S. dollar functional currency subsidiaries’, arising primarily from sales of long-term foreign denominated investment securities, short-term investment securities and cash denominated in foreign currencies, are reflected in net income.
The Consolidated Statements of Operations include pre-tax gains from such foreign exchange items of $6,270, $6,600 and $10,027 for 2005, 2004 and 2003, respectively.
On November 3, 2005, the FASB issued FASB Staff Position (FSP) FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”.
On February 16, 2006, the FASB issued SFAS 155, “Accounting for Certain Hybrid Financial Instruments”. SFAS 155 amends SFAS 133 and SFAS 140, and addresses issues raised in SFAS 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” The primary objectives of SFAS 155 are: (i) with respect to SFAS 133, to address the accounting for beneficial interests in securitized financial assets and (ii) with respect to SFAS 140, eliminate a restriction on the passive derivative instruments that a QSPE may hold. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Earlier adoption is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements, including financial statements for any interim period for that fiscal year. Ambac is currently evaluating the implications of SFAS 155 on its financial statements.
The amortized cost and estimated fair value of investments at December 31, 2005 and 2004 were as follows:
Included in gross realized losses were impairment write-downs of $340, $0, and $0 in 2005, 2004 and 2003, respectively.
(3) Cash and Securities pledged to Ambac under derivative agreements -Ambac may repledge securities it holds from certain derivative counterparties as described in (1) above, to other derivative counterparties in accordance with its rights and obligations under those agreements.
loans ranged from 6.25% to 8.06%. The range of expected final maturity dates of these loans is January 2013 to January 2027 as of December 31, 2005.
Investment Partnerships: Ambac has senior secured short-term loans outstanding to certain investment partnerships which invest in diversified portfolios of assets, primarily high-yield debt obligations and bank loans. The loans are collateralized with a first priority lien and security interest in the invested assets. As of December 31, 2005, Ambac had outstanding loan balances of $26,773 with interest rates ranging from 4.98% to 5.75%. The range of maturity dates for these loans was January 2006 to June 2006. As of December 31, 2004, Ambac had outstanding loan balances of $21,478 with interest rates ranging from 3.07% to 3.34%. The range of maturity dates for these loans was February 2005 to April 2005.
To minimize exposure to significant losses from reinsurers, Ambac Assurance (i) monitors the financial condition of its reinsurers; (ii) is entitled to receive collateral from its reinsurance counterparty in certain reinsurance contracts; and (iii) has certain termination triggers that can be exercised by Ambac Assurance in the event of a rating downgrade of a reinsurer. For the years ended December 31, 2005, 2004 and 2003, reinsurance recoveries, which reduced loss and loss expenses incurred, amounted to $22,936, $2,581 and $4,041, respectively. Reinsurance recoverables on paid losses and loss expenses as of December 31, 2005, 2004 and 2003 were $263, $266 and $495, respectively.
In January 2006, Ambac exercised its termination rights and cancelled the remaining reinsurance contracts with AXA Re Finance S.A. and American Reinsurance Company. This cancellation will result in approximately $37,000 in return premiums to Ambac Assurance, of which approximately $29,300 will be deferred. The difference of $7,700 results from the difference between the negotiated amount of return premiums and the associated unearned premiums remaining on the underlying guarantees, and will be earned in 2006.
default of the underlying credit, the reserve is transferred from active credit reserves to case basis credit reserves. Additional provisions for losses upon further credit deterioration of a defaulted exposure are initially recorded in active credit reserve and subsequently transferred to case basis credit reserve.
A domestic health care institution, which defaulted in a prior year, continued to experience significant financial stress in 2005. Ambac believes the primary factor causing the loss on this exposure is the competitive local environment for health care delivery and the resulting impact on revenue generation. Ambac is closely surveilling this credit and is in frequent communication with the issuer’s management. An enhanced equipment trust that was impacted by a bankruptcy of a commercial airline in 2004, experienced additional losses in 2005 upon the settlement of the trust. In connection with the settlement of the trust, Ambac purchased three airplanes. In February 2006, Ambac sold these airplanes and recognized a realized gain of approximately $25,000. Transfers to case reserves for these two credits amounted to $46,399 and $42,315 in 2005 and 2004, respectively.
December 31 of each year. The debentures may not be redeemed prior to October 17, 2006 and were sold at 100% of their principal amount. On or after October 17, 2006, Ambac may redeem the debentures, in whole at any time or in part from time to time, at 100% of their principal amount, plus accrued interest to the date of redemption.
The variable interest entity notes were issued by consolidated VIEs. Ambac is the primary beneficiary of these VIEs as a result of providing financial guarantees on the variable interest notes. Consequently, Ambac has consolidated these variable interest entity notes, and all other assets and liabilities of these VIEs. Ambac is not primarily liable for the debt obligations of these entities. Ambac would only be required to make these payments on these debt obligations in the event that the issuer defaults on any principal or interest due. Ambac’s creditors do not have rights with regard to the assets of these VIEs. Please refer to Note 10 for a detailed description of the variable interest entity notes.
On July 28, 2005, Ambac and its wholly-owned subsidiary, Ambac Assurance, as borrowers, entered into a $400,000 five year unsecured, committed revolving credit facility (the “Credit Facility”) with a group of highly rated banks. The Credit Facility expires on July 28, 2010. The Credit Facility provides for borrowings by Ambac and Ambac Assurance on a revolving basis up to an aggregate of
Ambac Assurance has a series of perpetual put options on its own preferred stock. The counterparty to these put options are trusts established by a major investment bank. The trusts were created as a vehicle for providing capital support to Ambac Assurance by allowing it to obtain immediate access to new capital at its sole discretion at any time through the exercise of the put option. If the put option were exercised, Ambac Assurance would receive up to $800 million in return for the issuance of its own perpetual preferred stock, the proceeds of which may be used for any purpose, including the payment of claims. The preferred stock would give investors the rights of an equity investor in Ambac Assurance. Such rights are subordinate to insurance claims, as well as to the general unsecured creditors of Ambac Assurance. Dividend payments on the preferred stock are cumulative only if Ambac Assurance pays dividends on its common stock. Each trust is restricted to holding high-quality short-term commercial paper investments to ensure that it can meet its obligations under the put option. To fund these investments, each trust has issued its own auction market perpetual securities. Each trust is rated AA/Aa2 by Standard & Poor’s and Moody’s, respectively. During 2005 and 2004, Ambac Assurance paid put option fees of $5,035 and $4,698, respectively. Put option fees are included as Corporate expenses in the Consolidated Statement of Operations for 2005 and recorded in adjusted paid-in capital in the Consolidated Balance Sheets for 2004 and prior.
Obligations under investment agreements, including those structured in the form of repurchase agreements, are recorded on a trade-date basis. Certain obligations may be called at various times prior to maturity at the option of the counterparty. As of December 31, 2005 and 2004, the contractual interest rates for these agreements, which include both fixed and variable, ranged from 1.57% to 8.08% and from 1.10% to 8.08% respectively. As of December 31, 2005 and 2004, obligations under investment agreements and investment repurchase agreements, excluding fair value hedge adjustments, were $6,424,159 and $6,058,282 respectively. There were no unsettled obligations as of December 31, 2005 and 2004.
Net payments due under settled investment agreements in each of the next five years ending December 31, and the periods thereafter, based on expected draw dates, are as follows:
The total effect of income taxes on income and stockholders’ equity for the years ended December 31, 2005 and 2004 was as follows:
The release of tax reserves relates to the expiration of the statute of limitations of earlier tax years.
As of December 31, 2005, Ambac is the primary beneficiary, and therefore consolidated VIEs under three transactions, as a result of providing financial guarantees to these entities. Ambac consolidated these entities since the structural financial protections are outside the VIEs. These structural protections, had they existed inside the VIEs, would have absorbed a majority of the VIEs’ expected losses and consequently Ambac would not have consolidated these entities. All consolidated VIEs are bankruptcy remote special purpose financing entities created by the issuer of debt securities to facilitate the sale of notes guaranteed by Ambac Assurance. Ambac is not primarily liable for the debt obligations of these entities. Ambac would only be required to make payments on these debt obligations in the event that the issuer defaults on any principal or interest due. Additionally, Ambac’s creditors do not have rights with regard to the assets of these VIEs.
Proceeds from the note issuance of the first VIE transaction, which closed in 2002, were used to purchase senior mortgage-backed floating rate notes of a South Korean mortgage-backed securities issuer. Protections afforded Ambac Assurance in this transaction were in the form of a reserve fund and the issuance of subordinated debt. Ambac Assurance will pay claims under its financial guarantee only in the event that losses on the mortgage assets of the South Korean issuer reduce the reserve fund to zero and exceed the principal amount of the subordinated notes. Total long-term debt outstanding under this note issuance was $64,522 with a maturity date of December 3, 2022 and a variable rate of interest which was 4.26% and 2.30% at December 31, 2005 and 2004, respectively.
Proceeds from the note issuances of the other transactions, both of which closed in 2004, were used to purchase notes issued by special purpose reinsurance companies in connection with their reinsurance of defined blocks of life insurance contracts. Protections afforded Ambac Assurance were in the form of capital contributed to the reinsurance companies and the issuance of subordinated debt by the VIEs. Ambac Assurance will pay claims under its financial guarantees in these transactions if cash flows generated under the reinsurance agreements and the proceeds from the contributed capital and subordinated debt are insufficient to repay the noteholders. Total debt outstanding under these note issuances were $977,325 at December 31, 2005, with maturity dates ranging from April 15, 2016 to February 6, 2025. At December 31, 2005 the interest rate on these notes ranged from 4.30% to 4.91%. Under one of these transactions, Ambac is subject to potential consolidation of an additional $300,000 of assets and liabilities in connection with future utilization of the VIE by the reinsurer.
Ambac’s exposures under these financial guarantee insurance policies as of December 31, 2005 and December 31, 2004 are included in the disclosure in Note 15 “Guarantees in Force”. Pursuant to the terms of Ambac Assurance’s insurance policy, insurance premiums are paid to Ambac Assurance by the QSPEs and are earned in a manner consistent with other insurance policies, over the risk period. Any losses incurred would be included in Ambac’s Consolidated Statements of Operations. 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.
Assets sold to the QSPEs during 2005, 2004 and 2003 were $0, $195,000 and $250,000, respectively. No gains or losses were recognized on these sales. As of December 31, 2005, the estimated fair value of financial assets, MTN liabilities and derivative hedge liabilities were $1,622,242, $1,647,829 and $14,101, respectively. When market quotes are not available, estimated fair value is determined utilizing valuation models. These models include estimates, made by Ambac management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Ambac Assurance received gross premiums for issuing financial guarantee policies on the assets, MTNs and derivative contracts of $5,713, $6,042 and $5,278 for the years ended December 31, 2005, 2004 and 2003, respectively. Ambac also received fees for providing other services amounting to $321, $393, and $461 for 2005, 2004 and 2003, respectively.
Ambac owns a beneficial interest in a special purpose entity that meets the definition of a VIE. This entity has issued floating rate beneficial interests to investors and invested the proceeds in fixed income municipal investment securities. These beneficial interests are directly secured by the related municipal investment securities. Ambac is the primary beneficiary of this entity as a result of its beneficial interest. The fixed income municipal investment securities, which are reported as Investments in fixed income securities, at fair value on the Consolidated Balance Sheets, were $258,806 and $257,300 as of December 31, 2005 and 2004. The beneficial interests issued to third parties, are reported as Obligations under investment and payment agreements on the Consolidated Balance Sheets, were $248,760 and $249,140 as of December 31, 2005 and 2004. As of December 31, 2005 and 2004, the interest rates on these beneficial interests ranged from 1.49% to 3.55% and from 0.87% to 2.03%, respectively.
are estimated to be approximately $2,000. Contributions are intended to provide not only for benefits attributed to service-to-date, but also for those expected to be earned in the future.
The table below sets forth a reconciliation of the beginning and ending projected benefit obligation, beginning and ending balances of the fair value of pension plan assets, and the funded status of the pension plan as of December 31, 2005 and 2004.
The following table sets forth projected benefit payments from Ambac’s defined benefit pension and postretirement plans and reflects expected future service where appropriate:
The following assumptions were used to determine the projected benefit obligations for the pension and postretirement plans at the measurement date (December 31) and the net periodic cost for the year:
The discount rate used in determining the projected benefit obligations for the pension and postretirement plans is selected by reference to the year-end Moody’s corporate AA rate, as well as other high-quality indices with similar duration to that of the benefit plans. The return on plan assets reflects the weighted-average of the expected long-term rates of return for the security classes of investments. Consideration is given for historical returns and current economic conditions.
policy establishes a target allocation for each class which is rebalanced as deemed necessary. Target asset allocations are 40% large capitalization U.S. equity index mutual funds, 30% U.S. bond index mutual funds, 20% international equity mutual funds and 10% small capitalization U.S. equity mutual funds.
Substantially all employees of Ambac are covered by a defined contribution plan (the “Savings Incentive Plan”). Ambac makes an employer matching contribution of 50% of the employee’s contributions up to 6% of such participants’ base compensation, subject to limits set by the Internal Revenue Code. Ambac may also make a Basic Profit Sharing contribution of 3% of base compensation and a Supplemental Profit Sharing contribution of an additional 3% of base compensation to eligible employees. The total cost of the Savings Incentive Plan was $3,521, $3,256 and $3,508 in 2005, 2004 and 2003, respectively.
The Ambac 1997 Equity Plan (the “Equity Plan”) provides for the granting of stock options, stock appreciation rights, restricted stock units (“RSUs”), performance units and other awards that are valued or determined by reference to the Common Stock. Ambac also maintains the Ambac 1997 Non-Employee Directors Equity Plan, which provides awards of stock options and restricted stock units to non-employee members of the Ambac’s Board of Directors. As of December 31, 2005, approximately 8,151,078 shares were available for future grant under the Equity Plan and the Directors Equity Plan. The number of options and their exercise price, and the number of restricted stock units awarded to each non-employee director under the Directors Equity Plan are determined by formula.
Stock option expense was $10,169, $11,945 and $10,169 in 2005, 2004 and 2003, respectively.
Ambac has an annual incentive program (the “Program”) that makes available to all eligible employees awards that are based upon the performance of Ambac, the performance of the employee’s department and the performance of the employee. The Program awards consist of cash and RSUs for all employees and, in lieu of a predetermined percentage of cash, RSUs that may be granted to officers at the level of Managing Director and above. RSUs granted in lieu of the first twenty-five percent of the
cash award are granted at a twenty-five percent discount to the average of the high and low of Ambac common stock on the date of grant. An eligible employee can elect to defer more than twenty-five percent of their cash award in the form of RSUs, however, the aforementioned discount does not apply. RSUs granted in lieu of the cash award vest equally over three years. The RSUs representing the twenty-five percent discount vest on the fourth anniversary of the date of grant. Prior to vesting, the RSUs cannot be sold or transferred by the participant and are subject to cancellation if the participant’s employment is terminated. All RSU agreements provide that vesting is accelerated in certain circumstances, such as retirement or death. Of the total RSUs outstanding at December 31, 2005 (i) 471,652 units require future service as a condition to the delivery of the underlying shares of common stock and (ii) 1,020,128 units did not require future service. The expense of the cash component of the program for the years ended December 31, 2005, 2004 and 2003 amounted to $35,280, $37,447 and $33,346, respectively.
Rent expense for the aforementioned leases amounted to $10,018, $8,507 and $7,434 for the years ended December 31, 2005, 2004 and 2003, respectively. Total future rental receipts under lease and sublease agreements are estimated at $16.
reinsurance company is required to repay all amounts drawn under the liquidity facility. No amounts have been drawn under this facility at December 31, 2005.
As of December 31, 2005 and 2004, the International Finance guaranteed portfolio is shown in the following table by location of risk:
Gross financial guarantees in force (principal and interest) was $801,085,000 and $757,037,000 at December 31, 2005 and 2004, respectively. Net financial guarantees in force (after giving effect to reinsurance) was $726,612,000 and $685,234,000 as of December 31, 2005 and 2004, respectively.
In the United States, California and New York were the states with the highest aggregate net par amounts in force, accounting for 10.5% and 6.9% of the total at December 31, 2005. No other state accounted for more than five percent. The highest single insured risk represented less than 1% of aggregate net par amount insured.
The following fair value amounts were determined by using independent market information when available, and valuation models when market quotes were not available. In cases where specific market quotes are unavailable, interpreting market data and estimating fair values require considerable judgment by management. Accordingly, the estimates presented are not necessarily indicative of the amount Ambac could realize in a current market exchange. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
Investment income due and accrued: The fair value of investment income due and accrued approximates carrying value.
Derivative contracts: The fair values of interest rate swaps, currency swaps, total return swaps and structured credit derivative transactions are determined by market quotes or valuation models when market quotes are not available.
The carrying amount and estimated fair value of financial instruments are presented below:
The New York Financial Guarantee Insurance Law establishes single risk limits applicable to obligations insured by Ambac Assurance. Such limits are specific to the type of insured obligation (for example, municipal or asset-backed). The limits compare the insured net par outstanding and average annual debt service, net of reinsurance and collateral, for a single risk to the insurer’s qualified statutory capital, which is defined as the sum of the insurer’s policyholders’ surplus and contingency reserves. As of December 31, 2005 and 2004, Ambac Assurance and its subsidiaries were in compliance with these regulatory requirements.
services. They are managed separately because each business requires different marketing strategies, personnel skill sets and technology.
The accounting policies of the segments are described in Note 2, “Significant Accounting Policies.” Pursuant to insurance and indemnity agreements, Ambac Assurance guarantees the swap and investment agreement obligations of those Financial Services subsidiaries. Intersegment revenues include the premiums earned under those agreements and dividends received. Such premiums are determined as if they were premiums to third parties, that is, at current market prices.
The following tables summarize gross premiums written and net premiums earned included in the Financial Guarantee segment, by location of risk for the years ended December 31, 2005, 2004 and 2003:
In November 2003, Ambac announced that it had entered into an agreement to sell the operations of Cadre Financial Services, Inc. (“Cadre”) and Ambac Securities, Inc., (“Ambac Securities”) its investment advisory and cash management business. As a registered adviser with the SEC, Cadre was subject to regulation in certain aspects of its business, particularly with respect to investment advisory services provided to investment companies and clients. Cadre provided investment advisory and administrative services to money market funds that are primarily offered to qualified participants, including school districts, health care service providers and municipalities. Ambac Securities’ principal business was the distribution of money market funds to the education, health care and municipal sectors, as well as the brokering of short-term fixed income securities trades on behalf of its clients. This business had been part of Ambac’s Financial Services segment. The decision to sell its investment advisory and cash management business has enabled Ambac to focus on its core financial guarantee business. The sale closed during the first quarter of 2004.