We have audited Ambac Financial Group, Inc. and subsidiaries’ (the “Company” or “Ambac”) internal control over financial reporting as of December 31, 2007, 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, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
Gross premiums are received either upfront (typical of public finance obligations), or in installments (typical of structured finance obligations). Up-front insurance premiums written are received for an entire bond issue, which may contain several maturities; and are recorded as unearned premiums. The premium is allocated to each bond maturity proportionately based on total principal amount guaranteed and is recognized as premiums on a straight-line basis over the term of each maturity. Installment insurance premiums written are recognized as premiums earned over each installment period, typically one year or less, on a straight-line basis. Premium earnings under both the upfront and installment revenue recognition methods are in proportion to the principal amount guaranteed and result in higher premium earnings during periods where guaranteed principal is higher. When an issue insured by Ambac Assurance has been refunded or called, the remaining unrecognized premium (net of refunding credits, if any) is recognized at that time.
The amortized cost and estimated fair value of investments at December 31, 2007, by contractual maturity, were as follows:
predominately rated AAA. Ambac has concluded that these unrealized losses are temporary in nature based upon (a) no principal and interest payment defaults on these securities; (b) analysis of the creditworthiness of the issuer and analysis of projected defaults on the underlying collateral; and (c) Ambac’s ability and current intent to hold these securities until a recovery in fair value or maturity. There were no individual securities with material unrealized losses as of December 31, 2007 and 2006. Of the $397,631 and $12,962 that have been in a gross unrealized loss position for less than a year, 100% are rated investment grade. Of the $27,512 and $52,523 that have been in a gross unrealized loss position for a year or more, 100% are rated investment grade.
Based on rating agency actions as described in footnote 1, management subsequently identified certain investment securities in the Financial Services investment portfolio to potentially sell in order to satisfy additional collateral posting requirements upon a further ratings downgrade. A portion of the securities identified are in an unrealized loss position at December 31, 2007. Ambac does not believe the securities in an unrealized loss position are credit impaired. However, management has recorded an impairment write-down of $40,080 for the securities identified which are in an unrealized loss position because management does not have the intent and ability to hold the securities for a period of time sufficient to allow for any anticipated recovery in market value. This impairment write-down was recorded in Net realized investment (losses)/gains at December 31, 2007.
Loans have been extended to customers participating in certain structured municipal transactions. The loans are collateralized with cash in amounts adequate to repay the loan balance. Equipment and other assets underlying the transactions serve as additional collateral for the loans. Ambac acts as the payment custodian and holds the funds posted as collateral. At December 31, 2007 and 2006, both the loan balances outstanding and collateral held were $586,395 and $609,821, respectively. As of December 31, 2007 and 2006, the interest rates on these 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, 2007.
An international public finance transportation credit was favorably settled in 2007, including recoveries received from claims paid during 2006. Continued deterioration in a previously impaired public finance infrastructure issue was experienced in 2006, offset by favorable development resulting from the final settlement of several credits (including the health care institution discussed below). A domestic health care institution, which defaulted in a year prior to 2005, continued to experience significant financial stress in 2005.
The variable interest entity notes were issued by a consolidated VIE. Ambac is the primary beneficiary of the VIE as a result of providing financial guarantees on the variable interest notes. Consequently, Ambac has consolidated this variable interest entity note and all other assets and liabilities of the VIE. Ambac is not primarily liable for the debt obligations of this entity. 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 this VIE. Please refer to Note 11 for a detailed description of the variable interest entity note.
The total effect of income taxes on income and stockholders’ equity for the years ended December 31, 2007 and 2006 was as follows:
$1,968,714 and $53,449, respectively. When market quotes are not available, fair values are based on internal valuation models, 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 $6,213, $5,022 and $5,713 for the years ended December 31, 2007, 2006 and 2005, respectively. Ambac also received fees for providing other services amounting to $245, $328 and $321 for 2007, 2006 and 2005, respectively.
Structured Finance includes exposure to sub-prime mortgage-backed securities. Ambac Assurance has exposure to the U.S. subprime mortgage market through direct guarantees, CDOs and, to a lesser extent, guarantees of bank sponsored multi seller conduits that contain residential mortgage-backed securities in their collateral pool. Sub-prime loans involve elevated credit risk and uncertainty.