This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) contains certain financial measures, in particular the presentation of Operating Earnings (Losses) and Adjusted Book Value, which are not presented in accordance with accounting principles generally accepted in the United States (“GAAP”). We are presenting these non-GAAP financial measures because they provide greater transparency and enhanced visibility into the underlying drivers of our business. We do not intend for these non-GAAP financial measures to be a substitute for any GAAP financial measures and they may differ from similar reporting provided by other companies. Readers of this Form 10-K should use these non-GAAP financial measures only in conjunction with the comparable GAAP financial measures. Operating Earnings (Losses) and Adjusted Book Value are non-GAAP financial measures that adjust for the impact of certain non-recurring or non-economic GAAP accounting requirements and include the addition of certain items that the Company has or expects to realize in the future, but that are not reported under GAAP. We also provide reconciliations to the most directly comparable GAAP measures; Operating Earnings (Losses) to Net income (loss) attributable to common stockholders and Adjusted Book Value to Total Ambac Financial Group, Inc. stockholders’ equity.
Third party settlements: To the extent that we are aware of settlements between issuers and investors or trustees which may provide for recoveries within certain insured RMBS trusts, we have incorporated in our modeling of collateral losses in such trusts scenarios reflecting our estimate of the probable amount and timing of these settlements.
We develop and assign probabilities to multiple cash flow scenarios based on each transaction’s unique characteristics. Probabilities assigned are based on available data related to the credit, information from contact with the issuer (if applicable), and any economic or market information that may impact the outcomes of the various scenarios being evaluated. Our base case usually projects deal performance out to maturity using expected loss assumptions and interest rates utilizing the projected forward interest rate curve at the reporting date. As appropriate, we also develop other cases that incorporate various upside and downside scenarios that may include changes to defaults, recoveries and interest rates.
The fair market values of financial instruments held are determined by using independent market sources when available and valuation models when market quotes are not available or cannot be reasonably corroborated. The Fair Value Measurement Topic of the ASC requires the categorization of these assets and liabilities according to a fair value valuation hierarchy. Approximately 81% of our assets and approximately 66% of our liabilities are carried at fair value and categorized in either Level 2 of the valuation hierarchy (meaning that their fair value was determined by reference to quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in inactive markets and other observable inputs) or Level 3 (meaning that their fair value was determined by reference to significant inputs that are unobservable in the market and therefore require a greater degree of management judgment). The determination of fair value for financial instruments categorized in Level 2 or 3 involves significant judgment due to the complexity of factors contributing to the valuation. Third-party sources from which we obtain independent market quotes also use assumptions, judgments and estimates in determining financial instrument values and different third parties may use different methodologies or provide different prices for securities. In addition, the use of internal valuation models for certain highly structured instruments, such as credit default swaps, require assumptions about markets in which there has been a negligible amount of trading activity for several years. As a result of these factors, the actual trade value of a financial instrument in the market, or exit value of a financial instrument owned by Ambac, may be significantly different from its recorded fair value. Refer to Note 10. Fair Value Measurements to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for discussion related to the transfers in and/or out of Level 1, 2 and 3 fair value categories.
For the 2014 annual assessment, we performed step one of the goodwill impairment test for the Financial Guarantee reporting unit. We estimated the fair value of the Financial Guarantee reporting unit using a market approach, which incorporated Ambac’s market capitalization, fair value estimates of noncontrolling interests and an estimated control premium. After completing our annual impairment review for 2014, we concluded that goodwill is not impaired.
As noted above, as a result of Fresh Start, insurance and reinsurance assets and liabilities are measured using the same accounting policies for both Successor and Predecessor periods. Net premiums earned for the year ended December 31, 2014 decreased by $97.1 million or 28.3% as compared to net premiums earned for the year ended December 31, 2013. Net premiums earned for the year ended December 31, 2013 decreased by $71.1 million or 17.1% as compared to net premiums earned for the year ended December 31, 2012. Net premiums earned were affected by changes in the collectability of certain premium receivables, primarily within Structured Finance. These changes resulted in a decrease in net premiums earned of $2.2 million, $13.9 million, $0.6 million, and $25.9 million for the year ended December 31, 2014, the eight months ended December 31, 2013, the four months ended April 30, 2013 and the year ended December 31, 2012.
Realized gains and other settlements on credit derivative contracts represent premiums received and accrued on such contracts. Realized gains and other settlements were $3.0 million for the year ended December 31, 2014, a decrease of $10.2 million from the year ended December 31, 2013. Realized gains and other settlements for the year ended December 31, 2013 declined by $0.5 million compared to gains of $13.7 million for the year ended December 31, 2012. The declines over time are due to reduced premium receipts resulting from continued runoff of the credit derivative portfolio. Included in realized gains and other settlements on credit derivatives were fees received in connection with transaction terminations of $0.5 million, $5.6 million, $0.0 million and $1.2 million for the years ended December 31, 2014, eight months ended December 31, 2013, four months ended April 30, 2013 and the year ended December 31, 2012 respectively. There were no loss or settlement payments in the periods presented.
Derivative Product Revenues. The derivative products portfolio is positioned to benefit from rising rates as an economic hedge against interest rate exposure in the financial guarantee portfolio. Net losses reported in derivative product revenues for the year ended December 31, 2014 were $(181.1) million, reflecting a decline of $262.2 million as compared to the net gains for the year ended December 31, 2013. Derivative product revenues for the year ended December 31, 2013 increased by $206.0 million compared to net losses reported for the year ended December 31, 2012 of $125.0 million. Results in derivative product revenues were primarily driven by mark-to-market (losses) gains in the portfolio caused by (falling) rising interest rates during the periods, net of the impact of the Ambac CVA as discussed below. Additionally, 2012 included a realized loss related to the negotiated termination of a derivative asset.
The decrease in total investments since December 31, 2013 is primarily due to the partial redemptions of Ambac Assurance and Segregated Account surplus notes and the equalizing payments on Deferred Amounts.
The deficit in Ambac UK’s shareholder funds under UK GAAP was £103.2 million at December 31, 2014 as compared to a deficit of £165.4 million at December 31, 2013. Ambac UK’s improvement in shareholders’ funds was primarily due to net income. Notwithstanding the deficit in shareholders’ funds, the directors remain satisfied that Ambac UK has adequate resources to meet its obligations as they fall due and that Ambac UK remains a going concern. At December 31, 2014, the carrying value of cash and investments was £337.6 million, an increase from £297.2 million at December 31, 2013. The increase in cash and investments is due to the continued receipt of premium income and investment coupons from Ambac UK's investment portfolio.
Elimination of the gains (losses) on call options on certain surplus notes of Ambac Assurance. Under GAAP accounting, Ambac recorded only a portion of its call options as derivatives. This adjustment allows for all such call options to be accounted for consistently. All call options were either exercised or expired in June 2012. Gains (losses) on call option exercises are not being adjusted for within Operating Earnings (Losses), consistent with other gains and losses.
Pursuant to the Amended Plan Settlement, (i) the Company, Ambac Assurance and certain affiliates entered into an amended and restated tax sharing agreement (the “Amended TSA”), (ii) the Company, Ambac Assurance and certain affiliates entered into an expense sharing and cost allocation agreement (the “Cost Allocation Agreement”) and (iii) the Company, Ambac Assurance, the Segregated Account and OCI entered into an amendment of the Cooperation Agreement (as defined below) (the “Cooperation Agreement Amendment”).
Pursuant to the Mediation Agreement, Ambac Assurance transferred $30,000 (plus accrued interest) from an escrow account to Ambac on the Effective Date. Additionally, the Segregated Account issued a junior surplus note in the amount of $350,000 to Ambac on the Effective Date in accordance with the Mediation Agreement. On August 28, 2014, Ambac deposited this junior surplus note plus accrued but unpaid interest thereon, into a newly formed Trust in exchange for cash of $224,262 and a subordinated owner trust certificate (the "Owner Trust Certificate") issued by the Trust in the face amount of $74,794. The Trust funded the cash portion of its purchase of the junior surplus note with proceeds of the private placement of $299,175 face amount of notes to third party investors ("Notes"), which amount equates to approximately 80% of par plus accrued and unpaid interest on the junior surplus note. The Notes have a final maturity of August 28, 2039. Interest on the Notes will accrue at 5.1% per annum and compound annually on June 7th of each year up to and including the maturity date. Payments on the Notes will be made when and to the extent that the Segregated Account makes payments on the junior surplus note. The Notes must be paid in full before any payments will be made on the Owner Trust Certificate. The Notes and Owner Trust Certificate are non-recourse to Ambac, Ambac Assurance and the Segregated Account, but are collateralized by the junior surplus note. Ambac records the Owner Trust Certificate as an equity investment and will reflect the activities of the non-consolidated Trust within Net investment income on the Consolidated Statements of Total Comprehensive Income (Loss). Refer to Note 14. Long-term Debt for the key terms of the junior surplus note.
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, although it did not become effective at such time. The confirmed Segregated Account Rehabilitation Plan also made permanent the injunctions issued by the Rehabilitation Court on March 24, 2010. On June 4, 2012, the Rehabilitation Court approved a motion made by the Rehabilitator to make partial interim policy claim payments to Segregated Account policyholders. In accordance with such approval, on August 1, 2012, the Rehabilitator promulgated Rules Governing the Submission, Processing and Partial Payment of Policy Claims in accordance with the June 4, 2012 Interim
The Company has entered into derivative contracts both for trading purposes and to hedge certain economic risks inherent in its financial asset and liability portfolios. Derivatives for trading include credit derivatives, interest rate and currency swaps, and futures contracts. None of Ambac’s derivative contracts were designated as hedges under the Derivatives and Hedging Topic of the ASC. Ambac’s credit derivative contracts are accounted for at fair value since they do not qualify for the financial guarantee scope exception under the Derivatives and Hedging Topic of the ASC. Changes in fair value of credit derivatives are recorded in Net change in fair value of credit derivatives on the Consolidated Statements of Total Comprehensive Income (Loss). Ambac provides interest rate and currency swaps principally to states, municipalities and their authorities and asset-backed issuers in connection with their financings. In 2012, Ambac terminated its remaining currency swap transactions. Changes in fair value of interest rate and currency swaps are recorded in Derivative product revenue on the Consolidated Statements of Total Comprehensive Income (Loss). VIEs consolidated under the Consolidation Topic of the ASC entered into derivative contracts to meet specified purposes within their securitization structure. Changes in fair value of consolidated VIE derivatives are included within Income (loss) on variable interest entities on the Consolidated Statements of Total Comprehensive Income (Loss). The Company had certain options to repurchase Ambac Assurance’s surplus notes at a discount to par value which were required to be accounted for as stand-alone derivatives. Changes in fair value of these options, which were exercised in June 2012, were recorded in Other income on the Consolidated Statements of Total Comprehensive Income (Loss).
Ambac provides postretirement and postemployment benefits, including health and life benefits covering employees who meet certain age and service requirements. Ambac accounts for these benefits under the accrual method of accounting. Amounts related to the postretirement health benefits liability are established and charged to expense based on actuarial determinations.
Effective January 1, 2014, Ambac adopted ASU No. 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The ASU requires an entity to present an unrecognized tax benefit in the financial statements as a reduction to a deferred tax asset for an NOL carryforward, a similar tax loss, or a tax credit carryforward except when: i) an NOL carryforward, a similar tax loss, or a tax credit carryforward is not available as of the reporting date under the governing tax law to settle taxes that would result from the disallowance of the tax position and ii) the entity does not intend to use the deferred tax asset for this purpose. If either of these conditions exists, an entity should present an unrecognized tax benefit in the financial statements as a liability and should not net the unrecognized tax benefit with a deferred tax asset. The adoption of this ASU did not have a material effect on Ambac’s financial statements.
In August 2014, the FASB issued ASU 2014-15, Presentation of Financial Statements - Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. Currently, there is no guidance in U.S. GAAP about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern or to provide related footnote disclosures. The ASU requires management to assess, at each interim and annual reporting period, whether substantial doubt exists about the company’s ability to continue as a going concern within one year after the date that the financial statements are issued or available to be issued. If management determines there is substantial doubt, it should also consider whether the substantial doubt is overcome by management’s plans, and provide certain disclosures based on facts and circumstances. The ASU is effective for annual periods and interim periods within those annual periods beginning after December 15, 2016, with early adoption permitted. Ambac will adopt ASU 2014-14 on January 1, 2017. As this is a disclosure requirement, adoption of this ASU will not have a material effect on Ambac’s financial statements.
The net cash flows used in the valuation analysis include income relating to, but not limited to, interest and principal on notes receivable; interest receipts on invested assets; reimbursement from Ambac Assurance for operating expenses; tolling payments and the upfront cash payment from Ambac Assurance, which are outlined in the Mediation Agreement and further described below. Expenses include operating expenses; intercompany settlements and tax payments. In addition, the long-term financial projections include value from the junior surplus note issued to Ambac by the Segregated Account, excess net operating tax losses (the “NOL Valuation”) and a residual equity dividend from Ambac Assurance.
from March 2017, an additional $4,000 per annum reimbursement for operating expenses (the “Additional Opex Subsidy”). There is uncertainty as to whether or not the Additional Opex Subsidy will be approved by the Rehabilitator and, if approved, for what period of time it would be in effect.
Insurance intangible asset-Pursuant to the business combinations guidance for insurance entities in the Financial Services-Insurance Topic of the ASC, Successor Ambac accounted for the insurance and reinsurance assets and liabilities acquired as new contracts, and measured them at fair value in two components as follows:
Due to losses experienced by Ambac Assurance, Ambac Assurance has been unable to pay common dividends to Ambac since 2008 and will be unable to pay common dividends in 2015 without the prior consent of the OCI, which is unlikely. Ambac Assurance’s ability to pay dividends is further restricted by the Settlement Agreement (as described below) and by certain covenants made for the benefit of the Segregated Account. See Note 1. Background and Business Description for further information.
Other asset-backed securities: These securities are floating rate investment grade notes collateralized by various asset types. The fair value of such securities classified as Level 3 was $0 and $64,073 at December 31, 2014 and 2013, respectively. Fair value was calculated using a discounted cash flow approach with expected future cash flows discounted using a yield curve consistent with the security type and rating. Significant inputs for the valuation at December 31, 2013 include the following weighted averages:
Non-Agency RMBS securities: These securities are guaranteed under policies that are subject to the Segregated Account Rehabilitation Plan and have projected future cash flows consisting solely of Deferred Amounts under such policies including interest thereon. The fair value of such securities classified as Level 3 was $194,393 at December 31, 2014. Fair value was calculated based on the valuation of Ambac Assurance surplus notes which, under the terms of the Segregated Account Rehabilitation Plan, are to be redeemed in proportion with the payment of Deferred Amounts on or about the dates when such payments are made. Refer to Note 1. Background and Business Description for further description of the Segregated Account Rehabilitation Plan and its impact on the payment of Segregated Account policy claims and surplus note redemptions.
The following table presents a roll-forward of Ambac’s cumulative credit losses on debt securities held as of December 31, 2014 and 2013 for which a portion of an other-than-temporary impairment was recognized in other comprehensive income:
The following table presents (i) the sources of collateral either received from various counterparties where Ambac is permitted to sell or re-pledge the collateral or collateral held directly in the investment portfolio and (ii) how that collateral was pledged to various investment agreement, derivative and repurchase agreement counterparties at December 31, 2014 and 2013:
Credit derivatives, which are privately negotiated contracts, provide the counterparty with credit protection against the occurrence of a specific event such as a payment default or bankruptcy relating to an underlying obligation. Upon a credit event, Ambac is generally required to make payments equal to the difference between the scheduled debt service payment and the actual payment made by the issuer. Substantially all of Ambac’s credit derivative contracts relate to structured finance transactions. Credit derivatives issued are insured by Ambac Assurance. None of the outstanding credit derivative transactions at December 31, 2014 include ratings based collateral-posting triggers or otherwise require Ambac to post collateral regardless of Ambac’s ratings or the size of the mark to market exposure to Ambac.
Certain VIEs consolidated under the Consolidation Topic of the ASC entered into derivative contracts to meet specified purposes within the securitization structure. The notional for VIE derivatives outstanding as of December 31, 2014 and 2013 are as follows:
Included in these balances at December 31, 2014, December 31, 2013, April 30, 2013 and December 31, 2012 are $0, $0, $0 and $96,900, respectively, of unrecognized tax benefits that, if recognized, would affect the effective tax rate. During the Successor period for the year ended December 31, 2014 and from May 1 to December 31, 2013, the Predecessor period January 1 to April 30, 2013 and the year ended December 31, 2012, Ambac recognized interest of approximately $0, $0, $0 and $0, respectively. Ambac had approximately $0, $0, $0 and $0 for the payment of interest accrued at December 31, 2014, December 31, 2013, April 30, 2013 and December 31, 2012, respectively.
Stock options were awarded to directors in 2013 that vested on April 30, 2014 with a term of seven years from the grant date. The Company intends to use Treasury shares first and then, if necessary, issue new shares to satisfy stock option exercises. No stock options were awarded to directors in 2014. Additionally, no stock options have been awarded to employees or consultants under the 2013 Plan.
When restricted stock unit awards issued by Ambac become taxable compensation to employees, shares may be withheld to cover the employee’s withholding taxes. In December 2014 and 2013, Ambac purchased shares from employees that settled restricted stock units to meet the required tax withholdings.
parties filed a stipulation withdrawing defendants’ appeal and Ambac Assurance’s cross-appeal of the court’s July 18, 2013 decision. Discovery is ongoing. No trial date has been set.
Information provided below for unaffiliated “Corporate and Other” primarily relates to investment income on Ambac's investment portfolio. Equity in net income of investees accounted for by the equity method relates to the Owner Trust Certificate received when Ambac deposited its Segregated Account junior surplus note into a Trust (see Note 1. Background and Business Description for further information relating to the sale by Ambac of a junior surplus note issued to it by the Segregated Account). Inter-segment for "Corporate and Other" relates to amounts received by Ambac under the Mediation Agreement dated September 21, 2011 (as more fully described in Note 1. Background and Business Description), including accrual of interest on the junior surplus notes issued by the Segregated Account prior to Ambac's deposit into a Trust.