SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended September 30, 2001 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number: 1-10777 Ambac Financial Group, Inc. (Exact name of Registrant as specified in its charter) Delaware 13-3621676 (State of incorporation) (I.R.S. employer identification no.) One State Street Plaza New York, New York 10004 (Address of principal executive offices) (Zip code) (212) 668-0340 (Registrant's telephone number, including area code) Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No As of October 31 2001, 105,533,118 shares of Common Stock, par value $0.01 per share, (net of 487,419 treasury shares) of the Registrant were outstanding.
Ambac Financial Group, Inc. and Subsidiaries INDEX ----- <TABLE> <CAPTION> PAGE ---- <S> <C> PART I FINANCIAL INFORMATION Item 1. Financial Statements of Ambac Financial Group, Inc. and Subsidiaries Consolidated Balance Sheets - September 30, 2001 And December 31, 2000 ..................................................................... 3 Consolidated Statements of Operations - three months and nine months Ended September 30, 2001 and 2000 ......................................................... 4 Consolidated Statements of Stockholders' Equity - nine months ended September 30, 2001 and 2000 ...................................................................................... 5 Consolidated Statements of Cash Flows - nine months ended September 30, 2001 and 2000 ............................................................... 6 Notes to Consolidated Unaudited Financial Statements ...................................... 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ....................................................... 11 Item 3. Quantitative and Qualitative Disclosures About Market Risk ............................................................................... 22 PART II OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K .......................................................... 24 SIGNATURES ........................................................................................ 25 INDEX TO EXHIBITS.................................................................................. 26 </TABLE>
PART I - FINANCIAL INFORMATION Item 1 - Financial Statements of Ambac Financial Group, Inc. and Subsidiaries Ambac Financial Group, Inc. and Subsidiaries Consolidated Balance Sheets September 30, 2001 and December 31, 2000 (Dollars in Thousands) <TABLE> <CAPTION> September 30, 2001 December 31, 2000 ------------------ ----------------- (unaudited) Assets - ------ <S> <C> <C> Investments: Fixed income securities, at fair value (amortized cost of $7,643,798 in 2001 and $6,743,450 in 2000) $7,866,192 $6,825,152 Fixed income securities pledged as collateral, at fair value (amortized cost of $1,067,256 in 2001 and $1,238,401 in 2000) 1,083,593 1,239,349 Short-term investments, at cost (approximates fair value) 184,809 253,519 Other 1,933 5,852 ---------------------- ---------------------- Total investments 9,136,527 8,323,872 Cash 99,585 20,493 Cash pledged as collateral 11,842 24,935 Securities purchased under agreements to resell 361,100 255,786 Receivable for investment agreements 67,518 6,663 Receivable for securities sold 5,381 1,926 Investment income due and accrued 119,456 130,692 Reinsurance recoverable 1,919 1,091 Prepaid reinsurance 265,811 242,604 Deferred acquisition costs 160,765 153,424 Loans 720,327 695,251 Other assets 460,272 263,563 ---------------------- ---------------------- Total assets $11,410,503 $10,120,300 ====================== ====================== Liabilities and Stockholders' Equity Liabilities: Unearned premiums $1,719,890 $1,546,290 Losses and loss adjustment expense reserve 146,613 132,445 Ceded reinsurance balances payable 20,159 10,892 Obligations under investment and payment agreements 3,653,081 3,509,049 Obligations under investment repurchase agreements 1,527,055 1,383,882 Deferred income taxes 167,183 106,035 Current income taxes 60,206 25,628 Debentures 416,633 424,061 Accrued interest payable 75,280 90,575 Other liabilities 500,138 291,394 Payable for securities purchased 160,323 3,935 ---------------------- ---------------------- Total liabilities 8,446,561 7,524,186 ---------------------- ---------------------- Stockholders' equity: Preferred stock - - Common stock 1,060 1,060 Additional paid-in capital 544,519 533,558 Accumulated other comprehensive income 136,651 45,154 Retained earnings 2,303,313 2,035,209 Common stock held in treasury at cost (21,601) (18,867) ---------------------- ---------------------- Total stockholders' equity 2,963,942 2,596,114 ---------------------- ---------------------- Total liabilities and stockholders' equity $11,410,503 $10,120,300 ====================== ====================== </TABLE> See accompanying Notes to Consolidated Unaudited Financial Statements 3
Ambac Financial Group, Inc. and Subsidiaries Consolidated Statements of Operations (Unaudited) For the Periods Ended September 30, 2001 and 2000 (Dollars in Thousands Except Share Data) <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ------------------------------------- -------------------------------------- 2001 2000 2001 2000 ------------------------------------- -------------------------------------- Revenues: Financial Guarantee: <S> <C> <C> <C> <C> Gross premiums written $152,918 $147,949 $499,253 $338,956 Ceded premiums written (35,874) (20,077) (72,342) (62,451) ----------------- ----------------- ------------------ ----------------- Net premiums written $117,044 $127,872 $426,911 $276,505 ================= ================= ================== ================= Net premiums earned $98,019 $78,695 $276,547 $230,774 Net fees and other premiums earned 3,323 5,645 16,423 10,693 Net investment income 67,318 61,090 196,852 177,623 Net realized gains (losses) 6,633 (2,535) 3,009 (2,103) Financial Services: Revenue 10,231 10,856 36,457 46,425 Net realized losses (3,589) (600) (2,524) (7,871) Other: Revenue 786 517 3,093 1,522 Net realized losses (1,383) - (1,383) - ----------------- ----------------- ------------------ ----------------- Total revenues 181,338 153,668 528,474 457,063 ----------------- ----------------- ------------------ ----------------- Expenses: Financial Guarantee: Losses and loss adjustment expenses 5,100 3,908 14,500 10,757 Underwriting and operating expenses 16,602 13,208 50,671 40,562 Financial Services 5,023 5,808 16,627 18,563 Interest 9,370 9,394 28,338 28,153 Other 921 2,010 4,372 5,424 ----------------- ----------------- ------------------ ----------------- Total expenses 37,016 34,328 114,508 103,459 ----------------- ----------------- ------------------ ----------------- Income before income taxes 144,322 119,340 413,966 353,604 Provision for income taxes 33,314 28,432 97,398 84,418 ----------------- ----------------- ------------------ ----------------- Income before accounting change 111,008 90,908 316,568 269,186 Cumulative effect of accounting change (net of income taxes of $219) - - (408) - ----------------- ----------------- ------------------ ----------------- Net income $111,008 $90,908 $316,160 $269,186 ================= ================= ================== ================= Net income per share: Basic $1.05 $0.86 $2.99 $2.57 ================= ================= ================== ================= Diluted $1.02 $0.84 $2.90 $2.51 ================= ================= ================== ================= Weighted average number of common shares outstanding: Basic 105,781,745 105,111,708 105,753,654 104,882,927 ================= ================= ================== ================= Diluted 109,077,058 107,732,178 108,980,936 107,051,811 ================= ================= ================== ================= </TABLE> See accompanying Notes to Consolidated Unaudited Financial Statements 4
Ambac Financial Group, Inc. and Subsidiaries Consolidated Statements of Stockholders' Equity (Unaudited) For The Periods Ended September 30, 2001 and 2000 (Dollars in Thousands) <TABLE> <CAPTION> 2001 2000 ------------------------------- -------------------------------- Retained Earnings: <S> <C> <C> <C> <C> Balance at January 1 $2,035,209 $1,713,446 Net income 316,160 $316,160 269,186 $269,186 ---------------- ---------------- Dividends declared - common stock (26,439) (23,775) Exercise of stock options (21,617) (10,035) --------------- ---------------- Balance at September 30 $2,303,313 $1,948,822 --------------- ---------------- Accumulated Other Comprehensive Income (Loss): Balance at January 1 $45,154 ($187,540) Unrealized gains on securities, $148,148 and $168,221, pre-tax in 2001 and 2000, respectively(1) 93,021 103,552 Cumulative effect of accounting change (880) - Loss on derivative transactions (377) - Foreign currency translation loss (267) (1,881) ---------------- ---------------- Other comprehensive income 91,497 91,497 101,671 101,671 ------------------------------- -------------------------------- Comprehensive income $407,657 $370,857 ================ ================ Balance at September 30 $136,651 ($85,869) --------------- ---------------- Preferred Stock: Balance at January 1 and September 30 $- $- --------------- ---------------- Common Stock: Balance at January 1 and September 30 $1,060 $707 --------------- ---------------- Additional Paid-in Capital: Balance at January 1 $533,558 $525,012 Exercise of stock options tax benefit 10,961 7,741 --------------- ---------------- Balance at September 30 $544,519 $532,753 --------------- ---------------- Common Stock Held in Treasury at Cost: Balance at January 1 ($18,867) ($33,175) Cost of shares acquired (35,855) (15,037) Shares issued under equity plans 33,121 24,343 --------------- ---------------- Balance at September 30 ($21,601) ($23,869) --------------- ---------------- Total Stockholders' Equity at September 30 $2,963,942 $2,372,544 =============== ================ (1) Disclosure of reclassification amount: Unrealized holding gains arising during period $94,505 $97,069 Less: reclassification adjustment for net gains (losses) included in net income 1,484 (6,483) --------------- ---------------- Net unrealized gains on securities $93,021 $103,552 =============== ================ </TABLE> See accompanying Notes to Consolidated Unaudited Financial Statements. 5
Ambac Financial Group, Inc. and Subsidiaries Consolidated Statements of Cash Flows (Unaudited) For The Periods Ended September 30, 2001 and 2000 (Dollars in Thousands) <TABLE> <CAPTION> Nine Months Ended September 30, ------------------------------------- 2001 2000 ---------------- --------------- Cash flows from operating activities: <S> <C> <C> Net income $316,160 $269,186 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 2,630 2,708 Amortization of bond premium and discount (14,065) (8,812) Current income taxes 34,578 (3,955) Deferred income taxes 6,859 15,255 Deferred acquisition costs (7,341) (12,089) Unearned premiums, net 150,393 45,161 Losses and loss adjustment expenses 13,340 6,716 Ceded reinsurance balances payable 9,267 (1,421) Investment income due and accrued 11,236 10,620 Accrued interest payable (15,295) (5,714) Net realized losses 898 9,974 Other, net (1,168) (1,499) ---------------- --------------- Net cash provided by operating activities 507,492 326,130 ---------------- --------------- Cash flows from investing activities: Proceeds from sales of bonds 985,901 899,561 Proceeds from matured bonds 1,874,727 1,340,538 Purchases of bonds (3,418,853) (1,643,518) Change in short-term investments 68,710 70,682 Securities purchased under agreements to resell (105,314) (83,009) Loans (25,076) (11,302) Other, net (11,264) (4,441) ---------------- --------------- Net cash (used in) provided by investing activities (631,169) 568,511 ---------------- --------------- Cash flows from financing activities: Dividends paid (26,439) (23,775) Proceeds from issuance of investment agreements 2,045,119 1,314,928 Payments for investment agreement draws (1,820,596) (2,205,135) Payment agreements 1,826 11,302 Payment for buyback of debentures (7,500) - Proceeds from sale of treasury stock 33,121 24,343 Purchases of treasury stock (35,855) (15,037) ---------------- --------------- Net cash provided by (used in) financing activities 189,676 (893,374) ---------------- --------------- Net cash flow 65,999 1,267 Cash and cash pledged as collateral at January 1 45,428 13,588 ---------------- --------------- Cash and cash pledged as collateral at September 30 $111,427 $14,855 ================ =============== Supplemental disclosures of cash flow information: Cash paid during the period for: Income taxes $45,000 $65,400 ================ =============== Interest expense on debt $30,575 $30,481 ================ =============== Interest expense on investment agreements $170,601 $217,823 ================ =============== </TABLE> See accompanying Notes to Consolidated Unaudited Financial Statements 6
Ambac Financial Group, Inc. and Subsidiaries Notes to Consolidated Unaudited Financial Statements (Dollars in thousands) (1) Basis of Presentation Ambac Financial Group, Inc., headquartered in New York City, is a holding company whose affiliates provide 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 provider of financial guarantees for municipal 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, interest rate swaps, funding conduits, investment advisory and cash management services, principally to its financial guarantee clients which include municipalities and their authorities, school districts, healthcare organizations and asset-backed issuers. Ambac's consolidated unaudited interim financial statements have been prepared on the basis of accounting principles generally accepted in the United States of America ("GAAP") and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of Ambac's financial condition, results of operations and cash flows for the periods presented. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported revenues and expenses during the reporting period. Actual results could differ from those estimates. The results of operations for the three and nine months ended September 30, 2001 may not be indicative of the results that may be expected for the full year ending December 31, 2001. These consolidated financial statements and notes should be read in conjunction with the financial statements and notes included in the audited consolidated financial statements of Ambac Financial Group, Inc. and its subsidiaries contained in (i) Ambac's Annual Report on Form 10-K for the year ended December 31, 2000, which was filed with the Securities and Exchange Commission on March 28, 2001, (ii) Ambac's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2001, which was filed with the SEC on May 15, 2001, and (iii) Ambac's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2001, which was filed with the SEC on August 10, 2001. The consolidated financial statements include the accounts of Ambac and each of its subsidiaries. All significant intercompany balances have been eliminated. Certain reclassifications have been made to prior period's amounts to conform to the current period's presentation. (2) Segment Information Ambac has two reportable segments, as follows: (1) financial guarantee, which provides financial guarantees (including structured credit derivatives) for municipal and structured finance obligations; and (2) financial services, which provides investment agreements, interest rate swaps, funding conduits, and investment advisory and cash management services. 7
Notes to Consolidated Unaudited Financial Statements (Continued) (Dollars in thousands) Ambac's reportable segments are strategic business units that offer different products and services. They are managed separately because each business requires different marketing strategies, personnel skill sets and technology. 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, but which are eliminated in the consolidated financial statements. Such premiums are accounted for as if they were premiums to third parties, that is, at current market prices. Information provided below for "Corporate and Other" relates to Ambac Financial Group, Inc. corporate activities. Corporate and other revenue from unaffiliated customers consists primarily of interest income and realized gains or losses from investment securities. Intersegment revenues consist of dividends received. The following tables summarize the financial information by reportable segment as of and for the three and nine-month periods ended September 30, 2001 and 2000: <TABLE> <CAPTION> Financial Financial Corporate Intersegment Three months ended September 30, Guarantee Services And Other Eliminations Consolidated -------------- --------------- ------------- ---------------- ---------------- 2001: Revenues: <S> <C> <C> <C> <C> <C> Unaffiliated customers ....... $175,293 $6,642 ($597) $- $181,338 Intersegment ................. 1,031 (972) 17,000 (17,059) - -------------- --------------- ------------- ---------------- ---------------- Total revenues.................... $176,324 $5,670 $16,403 ($17,059) $181,338 -------------- --------------- ------------- ---------------- ---------------- Income before income taxes: Unaffiliated customers ....... $153,591 $1,619 ($10,888) $- $144,322 Intersegment ................. 1,087 (958) 16,653 (16,782) - -------------- --------------- ------------- ---------------- ---------------- Total income before income taxes.. $154,678 $661 $5,765 ($16,782) $144,322 -------------- --------------- ------------- ---------------- ---------------- Identifiable assets............... $5,581,637 $5,775,782 $53,084 $- $11,410,503 -------------- --------------- ------------- ---------------- ---------------- 2000: Revenues: Unaffiliated customers ....... $142,895 $10,256 $517 $- $153,668 Intersegment ................. 909 (815) 15,958 (16,052) - -------------- --------------- ------------- ---------------- ---------------- Total revenues.................... $143,804 $9,441 $16,475 ($16,052) $153,668 -------------- --------------- ------------- ---------------- ---------------- Income before income taxes: Unaffiliated customers ....... $125,779 $4,448 ($10,887) $- $119,340 Intersegment ................. 909 (809) 15,957 (16,057) - -------------- --------------- ------------- ---------------- ---------------- Total income before income taxes.. $126,688 $3,639 $5,070 ($16,057) $119,340 -------------- --------------- ------------- ---------------- ---------------- Identifiable assets............... $4,591,374 $5,474,619 $48,731 $- $10,114,724 -------------- --------------- ------------- ---------------- ---------------- </TABLE> 8
Notes to Consolidated Unaudited Financial Statements (Continued) (Dollars in thousands) <TABLE> <CAPTION> Financial Financial Corporate Intersegment Nine months ended September 30, Guarantee Services And Other Eliminations Consolidated -------------- --------------- ------------- ---------------- ---------------- 2001: Revenues: <S> <C> <C> <C> <C> <C> Unaffiliated customers ....... $492,831 $33,933 $1,710 $- $528,474 Intersegment ................. 3,422 (2,916) 52,000 (52,506) - -------------- --------------- ------------- ---------------- ---------------- Total revenues.................... $496,253 $31,017 $53,710 ($52,506) $528,474 -------------- --------------- ------------- ---------------- ---------------- Income before income taxes: Unaffiliated customers ....... $427,660 $17,306 ($31,000) $- $413,966 Intersegment ................. 3,742 (2,775) 50,959 (51,926) - -------------- --------------- ------------- ---------------- ---------------- Total income before income taxes.. $431,402 $14,531 $19,959 ($51,926) $413,966 -------------- --------------- ------------- ---------------- ---------------- Identifiable assets............... $5,581,637 $5,775,782 $53,084 $- $11,410,503 -------------- --------------- ------------- ---------------- ---------------- 2000: Revenues: Unaffiliated customers ....... $416,987 $38,554 $1,522 $- $457,063 Intersegment ................. 2,679 (2,463) 47,886 (48,102) - -------------- --------------- ------------- ---------------- ---------------- Total revenues.................... $419,666 $36,091 $49,408 ($48,102) $457,063 -------------- --------------- ------------- ---------------- ---------------- Income before income taxes: Unaffiliated customers ....... $365,668 $19,991 ($32,055) $- $353,604 Intersegment ................. 2,679 (2,412) 47,885 (48,152) - -------------- --------------- ------------- ---------------- ---------------- Total income before income taxes.. $368,347 $17,579 $15,830 ($48,152) $353,604 -------------- --------------- ------------- ---------------- ---------------- Identifiable assets............... $4,591,374 $5,474,619 $48,731 $- $10,114,724 -------------- --------------- ------------- ---------------- ---------------- </TABLE> The following table summarizes unaffiliated gross premiums written and net premiums earned included in the financial guarantee segment by location of risk for the three and nine-month periods ended September 30, 2001 and 2000. <TABLE> <CAPTION> Three Months Nine Months ---------------------------------- ---------------------------------- Gross Premiums Net Premiums Gross Premiums Net Premiums 2001: Written Earned Written Earned ----------------- --------------- ------------------ --------------- <S> <C> <C> <C> <C> United States ...................... $128,544 $81,340 $382,997 $232,002 United Kingdom ..................... 7,307 2,922 34,732 6,958 Japan............................... 3,298 2,332 8,808 6,486 Mexico.............................. 4,061 1,885 12,087 5,568 Australia........................... 2,107 994 7,158 2,787 France.............................. 95 274 531 822 Internationally diversified (1)..... 4,247 4,481 24,993 11,801 Other international................. 3,259 3,791 27,947 10,123 ----------------- --------------- ------------------ --------------- Total........................... $152,918 $98,019 $499,253 $276,547 ----------------- --------------- ------------------ --------------- 2000: United States ...................... $124,160 $65,262 $256,963 $196,399 United Kingdom ..................... 1,930 2,130 15,429 4,554 Japan............................... 1,903 1,737 5,374 4,943 Mexico.............................. 3,960 1,942 12,106 5,555 Australia........................... 9,163 942 26,589 2,386 France ............................. 129 268 650 861 Internationally diversified (1)..... 3,709 4,299 9,656 9,727 Other international................. 2,995 2,115 12,189 6,349 ----------------- --------------- ------------------ --------------- Total........................... $147,949 $78,695 $338,956 $230,774 ----------------- --------------- ------------------ --------------- </TABLE> 1) Internationally diversified includes guarantees with multiple locations of risk and includes components of domestic exposure. 9
Notes to Consolidated Unaudited Financial Statements (Continued) (Dollars in thousands) (3) Cumulative Effect of Accounting Change In June 1998, the Financial Accounting Standards Board issued FAS Statement 133, "Accounting for Derivative Instruments and Hedging Activities". FAS 133, as amended by FAS 138 and related guidance, established accounting and reporting standards for derivative instruments and hedging activities. Ambac adopted FAS 133 and its related guidance on January 1, 2001, that resulted in transition adjustment losses of $0.9 million (net of related income tax) in Accumulated Other Comprehensive Income and $0.4 million (net of related income tax) in net income. (4) Goodwill and Other Intangible Assets In July 2001, the FASB issued FAS Statement 142, "Goodwill and Other Intangible Assets". FAS 142 addresses the initial recognition and measurement of intangible assets either singly or within a group of assets, as well as the measurement of goodwill and other intangible assets subsequent to their initial acquisition. FAS 142 changes the accounting for goodwill and intangible assets that have indefinite useful lives from an amortization approach to an impairment-only approach that requires that those assets be tested at least annually for impairment. Intangible assets that have finite useful lives will continue to be amortized over their useful lives, but without an arbitrary ceiling on their useful lives. FAS 142 is required to be applied starting with fiscal years beginning after December 15, 2001 and is required to be applied at the beginning of an entity's fiscal year. The statement is to be applied to all goodwill and other intangible assets recognized in an entity's financial statements at that date. Impairment losses for goodwill and indefinite lived intangible assets that arise due to the initial application of FAS 142 (resulting from an impairment test) are to be reported as a change in accounting principle. Retroactive application is not permitted. Ambac has not yet determined the impact that FAS 142 will have on its consolidated financial statements. 10
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following paragraphs describe the consolidated results of operations of Ambac and its subsidiaries for the three and nine-month periods ended September 30, 2001 and 2000, and its financial condition as of September 30, 2001 and December 31, 2000. These results are presented for Ambac's two reportable segments: Financial Guarantee and Financial Services. Materials in this Form 10-Q may contain information that includes or is based upon forward-looking statements within the meaning of the Securities Litigation Reform Act of 1995. Forward-looking statements give Ambac's expectations or forecasts of future events. You can identify these statements by the fact that they do not relate strictly to historical or current facts and relate to future operating or financial performance. Any or all of Ambac's forward-looking statements here or in other publications may turn out to be wrong and are based on current expectations and the current economic environment. Ambac's actual results may vary materially, and there are no guarantees about the performance of our securities. Among factors that could cause actual results to differ materially are: (1) changes in the economic, credit or interest rate environment in the United States and abroad; (2) the level of activity within the national and worldwide debt markets; (3) competitive conditions and pricing levels; (4) legislative and regulatory developments; (5) changes in tax laws, (6) the policies and actions of the United States and other governments and (7) other risks and uncertainties that have not been identified at this time. Ambac is not obligated to publicly correct or update any forward-looking statement if we later become aware that it is not likely to be achieved, except as required by law. You are advised, however, to consult any further disclosures we make on related subjects in Ambac's reports to the SEC. Results of Operations Consolidated Net Income Ambac's net income for the three months ended September 30, 2001 was $111.0 million or $1.02 per diluted share. This represents a 22% increase from the three months ended September 30, 2000 in net income of $90.9 million and a 21% increase in net income per diluted share from $0.84 in the three months ended September 30, 2000. The increase in net income was primarily attributable to higher Financial Guarantee operating earnings driven by a $32.4 million, or 23%, increase in revenues, partially offset by lower financial services revenues. Ambac's net income for the nine months ended September 30, 2001 was $316.2 million, or $2.90 per diluted share. This represents an increase of 17% from the comparable prior period net income of $269.2 million, and a 16% increase in net income per diluted share from $2.51 per diluted share for the nine months ended September 30, 2000. Financial Guarantee Ambac provides financial guarantees for municipal and structured finance obligations through its principal operating subsidiary, Ambac Assurance. Ambac Assurance serves clients in international markets through its wholly owned subsidiary, Ambac Assurance UK Limited. Ambac Credit Products, L.L.C., a wholly owned subsidiary of Ambac Assurance, also provides credit protection in the global markets in the form of structured credit derivatives. 11
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Gross Par Written. Ambac Assurance guaranteed $15.9 billion in par value ----------------- bonds during the three months ended September 30, 2001, a 4% decrease from $16.5 billion in par during the comparable prior year period. Par value written for the third quarter of 2001 was comprised of $8.8 billion from municipal bond obligations, $3.9 billion from structured finance obligations and $3.2 billion from international obligations, compared to $7.7 billion, $5.5 billion and $3.3 billion, respectively, in the third quarter of 2000. During the nine months ended September 30, 2001, Ambac Assurance guaranteed $60.5 billion in par value bonds, a 14% increase from $53.1 billion in par during the first nine months of 2000. Par value written for the nine months ended September 30, 2001 was comprised of $26.2 billion from municipal bond obligations, $19.7 billion from structured finance obligations and $14.6 billion from international obligations, compared to $14.2 billion, $22.0 billion, and $16.9 billion, respectively, for the nine months ended September 30, 2000. Municipal obligations issued for the three and nine-month periods ended September 30, 2001 saw increases of 18% and 39% respectively, versus comparable prior year periods. The increase in total issuance was largely the result of the lower interest rate environment. Although Ambac's new issue market share dropped from 29% in the third quarter of 2000 to 24% during the third quarter of 2001, there were increases in insured market penetration during the periods, contributing to the increase in Ambac's insured municipal obligations. Despite the decline in the third quarter of 2001, Ambac's new issue municipal market share increased from 21% for the first nine months of 2000 to 25% for the first nine months of 2001. Declines in structured finance guarantees resulted from lower mortgage-backed guarantees offset by greater penetration into other consumer asset-backed types (auto rental, credit card and lease securitizations). Changes to international guarantees primarily relate to guarantees of structured credit derivatives. Structured credit derivative par guarantees were $1.3 billion and $8.8 billion for the three and nine months ended September 30, 2001, an increase of 117% from $0.6 billion in par in the three months ended September 30, 2000 and a decrease of 12% from $10.0 billion in par during the nine months ended September 30, 2000. Gross Premiums Written. Gross premiums written for the three and nine-month ---------------------- periods ended September 30, 2001 were $152.9 million and $499.3 million, respectively, an increase of 3% over $147.9 million in the three-month period ended September 30, 2000 and an increase of 47% from $339.0 million in the nine months ended September 30, 2000. Installment premiums written for the three and nine months ended September 30, 2001 were $62.3 million and $176.4 million, respectively, an increase of 29% from $48.3 million in the three months ended September 30, 2000 and an increase of 33% over $132.7 million in the nine months ended September 30, 2000. The growth in installment premiums is due to the growing book of business in all segments. Structured finance premiums collected up-front decreased from $6.9 million to $0.5 million as a result of a decline in leveraged lease utility transactions. On the municipal side, Ambac saw an increase in writings for the three and nine months ended September 30, 2001. As mentioned above under "Gross Par Written", this was a result of increases in municipal market volume partially offset by a decline in market share for the third quarter of 2001. The following tables set forth the amounts of gross premiums written and the related gross par written by type: 12
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) <TABLE> <CAPTION> Three Months Ended September 30, ---------------------------------------------------- (Dollars in Millions) 2001 2000 ------------------------- ------------------------- Gross Gross Gross Gross Premiums Par Premiums Par Written Written Written Written ------------ ----------- ------------ ----------- Municipal finance: Up-front: <S> <C> <C> <C> <C> New issue......................................... $81.1 $7,811 $80.9 $6,720 Secondary market.................................. 2.2 192 2.2 246 ------------ ----------- ------------ ----------- Sub-total up-front ............................. 83.3 8,003 83.1 6,966 Installment......................................... 9.5 771 4.2 685 ------------ ----------- ------------ ----------- Total municipal finance...................... 92.8 8,774 87.3 7,651 ------------ ----------- ------------ ----------- Structured finance: Up-front.......................................... 0.5 206 6.9 316 Installment....................................... 35.2 3,702 29.9 5,187 ------------ ----------- ------------ ----------- Total structured finance.................... 35.7 3,908 36.8 5,503 ------------ ----------- ------------ ----------- International(1): Up-front....................................... 6.8 898 9.6 696 Installment.................................... 17.6 2,304 14.2 2,614 ------------ ----------- ------------ ----------- Total international...................... 24.4 3,202 23.8 3,310 ------------ ----------- ------------ ----------- Total..................................... $152.9 $15,884 $147.9 $16,464 ============ =========== ============ =========== Total up-front.......................................... $90.6 $9,107 $99.6 $7,978 Total installment....................................... 62.3 6,777 48.3 8,486 ------------ ----------- ------------ ----------- Total..................................... $152.9 $15,884 $147.9 $16,464 ============ =========== ============ =========== Nine Months Ended September 30, ---------------------------------------------------- (Dollars in Millions) 2001 2000 ------------------------- ------------------------- Gross Gross Gross Gross Premiums Par Premiums Par Written Written Written Written ------------ ----------- ------------ ----------- Municipal finance: Up-front: New issue......................................... $233.3 $22,177 $129.9 $11,898 Secondary market.................................. 17.7 1,416 8.6 842 ------------ ----------- ------------ ----------- Sub-total up-front ............................. 251.0 23,593 138.5 12,740 Installment......................................... 23.4 2,642 14.5 1,500 ------------ ----------- ------------ ----------- Total municipal finance...................... 274.4 26,235 153.0 14,240 ------------ ----------- ------------ ----------- Structured finance: Up-front.......................................... 7.4 940 25.5 2,176 Installment....................................... 101.2 18,699 78.5 19,776 ------------ ----------- ------------ ----------- Total structured finance.................... 108.6 19,639 104.0 21,952 ------------ ----------- ------------ ----------- International(1): Up-front....................................... 64.5 2,690 42.2 2,435 Installment.................................... 51.8 11,944 39.8 14,469 ------------ ----------- ------------ ----------- Total international...................... 116.3 14,634 82.0 16,904 ------------ ----------- ------------ ----------- Total..................................... $499.3 $60,508 $339.0 $53,096 ============ =========== ============ =========== Total up-front.......................................... $322.9 $27,223 $206.3 $17,351 Total installment....................................... 176.4 33,285 132.7 35,745 ------------ ----------- ------------ ----------- Total..................................... $499.3 $60,508 $339.0 $53,096 ============ =========== ============ =========== </TABLE> (1) International par written includes structured credit derivatives of $1,337 million and $646 million for the three months ended September 30, 2001 and 2000, respectively, and $8,848 million and $9,975 million for the nine months ended September 30, 2001 and 2000, respectively. Previously, gross par written was net of par related to international deals that were ceded to MBIA Insurance Corporation pursuant to a joint venture agreement that ceased during 2000. Prior period amounts have been restated. 13
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Ceded Premiums Written. Ceded premiums written for the three and nine ---------------------- months ended September 30, 2001 were $35.9 million and $72.3 million, respectively, an increase of 79% from $20.1 million in the three months ended September 30, 2000 and an increase of 16% from $62.5 million in the nine months ended September 30, 2000. Ceded premiums written were 23.5% and 14.5% of gross premiums written for the three and nine months ended September 30, 2001, respectively, compared with 13.6% and 18.4% for the three and nine months ended September 30, 2000, respectively. The increase in ceded premiums written for the third quarter of 2001 was largely due to higher cessions of municipal premiums pursuant to a reinsurance treaty that Ambac Assurance put into place earlier this year. This treaty is designed to limit single risk exposure. The increase in ceded premiums written for the nine months ended September 30, 2001 was primarily from higher cessions of municipal premiums, partly offset by lower cessions on international policies. Net Premiums Written. Net premiums written for the three and nine months -------------------- ended September 30, 2001 were $117.0 million and $426.9 million, respectively. The 9% decrease from $127.9 million in the three months ended September 30, 2000 reflects the higher level of municipal cessions during the third quarter of 2001, partially offset by slightly higher gross premiums written. The increase of 54% from $276.5 million in the nine months ended September 30, 2000 reflects the higher level of gross premiums written, partially offset by higher premiums ceded to reinsurers in the nine months ended September 30, 2001. Net Premiums Earned. Net premiums earned during the three and nine months ------------------- ended September 30, 2001 were $98.0 million and $276.5 million, respectively, an increase of 25% from $78.7 million in the three months ended September 30, 2000, and an increase of 20% from $230.8 million in the nine months ended September 30, 2000. These increases were primarily the result of the larger financial guarantee book of business during the periods. Normal net premiums earned (defined as net premiums earned excluding the effects of refundings, calls and other accelerations of previously insured obligations, collectively referred to as "refundings") increased 16% from $75.4 million in the third quarter of 2000 to $87.5 million in the third quarter of 2001. Normal net premiums earned for the nine months ended September 30, 2001 were $249.3 million, an increase of 17% from $212.6 million in the nine months ended September 30, 2000. The increases in normal net premiums earned resulted primarily from strong business written from prior periods in all areas. Net premiums earned include accelerated premiums that result from refundings. When a guaranteed issue is called by the issuer or is in substance paid in advance through a refunding, the remaining unearned premium is recognized at that time. Refunding levels vary depending upon a number of conditions, primarily the relationship between current interest rates and interest rates on outstanding debt. Net premiums earned for the three and nine months ended September 30, 2001 included $10.5 million (which had a net income per diluted share effect of $0.05) and $27.2 million (which had a net income per diluted share effect of $0.14) from refundings. Net premiums earned for the three and nine months ended September 30, 2000 included $3.3 million (which had a net income per diluted share effect of $0.02) and $18.2 million (which had a net income per diluted share effect of $0.10) from refundings. Net Investment Income. Net investment income for the three and nine months --------------------- ended September 30, 2001 was $67.3 million and $196.9 million, respectively, an increase of 10% from $61.1 million in the three months ended September 30, 2000 and an increase of 11% from $177.6 million in the nine months ended September 30, 2000. The increases were 14
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) primarily attributable to the growth of the investment portfolio from ongoing operations, partially offset by a lower reinvestment rate due to the current interest rate environment. The average pre-tax yield-to-maturity on the investment portfolio was 5.82% and 6.15% as of September 30, 2001 and 2000, respectively. Ambac Assurance's investments in tax-exempt securities amounted to 68% of the total fair value of its portfolio as of September 30, 2001, versus 75% at September 30, 2000. Net Realized Gains (Losses). Net realized gains for the three and nine --------------------------- months ended September 30, 2001 were $6.6 million and $3.0 million, respectively. This compares to net realized losses of $2.5 million and $2.1 million for the three and nine months ended September 30, 2000. Included in net realized gains for the three and nine months ended September 30, 2001 are foreign exchange gains of $2.6 million and losses of $1.5 million, respectively, related to Ambac Assurance's foreign denominated short-term investments. Foreign exchange losses related to Ambac Assurance's foreign denominated short-term investments for the three and nine months ended September 30, 2000 were $2.3 million and $5.0 million, respectively. Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses ----------------------------------- for the three and nine months ended September 30, 2001 were $5.1 million and $14.5 million, respectively, compared to $3.9 million and $10.8 million for the three and nine months ended September 30, 2000, respectively. Losses and loss adjustment expenses are based upon estimates of the ultimate aggregate losses inherent in the financial guarantee portfolio. The liability for losses and loss adjustment expenses consists of the active credit reserve, which represents an estimate of the expected annual levels of debt service defaults resulting from credit failures on currently guaranteed issues that are not presently or imminently in default, and case basis loss reserves for obligations in monetary default, or, in the judgement of management, for which default is imminent. The following table summarizes Ambac's loss reserves split between case basis loss reserves and active credit reserves at September 30, 2001 and December 31, 2000. <TABLE> <CAPTION> (Dollars in millions) September 30, December 31, 2001 2000 ------------------------------------------------------ ------------------ ------------------ Net loss and loss adjustment expense reserves: <S> <C> <C> Case basis reserves * $31.9 $31.0 Active credit reserves 112.8 100.3 ------------------ ------------------ Total $144.7 $131.3 ------------------ ------------------ </TABLE> (*) After netting reinsurance recoverable amounting to $1.9 million and $1.1 million at September 30, 2001 and December 31, 2000, respectively. Management continually reviews and monitors the guaranteed book of business for potential problem credits. Net additions were made to the case reserves of $5.9 million and $5.1 million for the nine months ended September 30, 2001 and 2000, respectively. Losses paid and recoveries of previously paid losses were $2.2 million and $1.1 million for the nine months ended September 30, 2001, respectively, and $4.0 million and zero for the nine months ended September 30, 2000, respectively. The entire case reserves, losses paid and recoveries relate to the municipal finance book of business for all periods presented. Underwriting and Operating Expenses. Underwriting and operating expenses ----------------------------------- for the three and nine months ended September 30, 2001 were $16.6 million and $50.7 million, respectively, an increase of 26% from $13.2 million in the three months ended September 30, 2000 and an increase of 25% from $40.6 million in the nine months ended September 30, 2000. Underwriting and operating expenses consist of gross underwriting and operating 15
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) expenses, less the deferral to future periods of expenses and reinsurance commissions related to the acquisition of new insurance contracts, plus the amortization of previously deferred expenses and reinsurance commissions. During the three and nine month periods ended September 30, 2001, gross underwriting and operating expenses were $21.5 million and $72.8 million, respectively, a decrease of 4% from $22.5 million in the three months ended September 30, 2000 and an increase of 15% from $63.5 million in the nine months ended September 30, 2000. The decrease in the three months ended September 30, 2001 is a result of lower premium taxes as a result of a refund, partially offset by increased compensation related to new hires. The increase in expenses for the nine months ended September 20, 2001 reflects the overall increased business activity during the period due to increased compensation costs related to new hires. Underwriting and operating expenses deferred for the three and nine months ended September 30, 2001 were $12.2 million and $43.5 million, respectively, and $14.7 million and $39.7 million for the three and nine months ended September 30, 2000, respectively. The amortization of previously deferred expenses and reinsurance commissions for the three and nine months ended September 30, 2001 were $7.3 million and $21.4 million, respectively, and $5.6 million and $16.9 million for the three and nine months ended September 30, 2000, respectively. Financial Services Through its financial services subsidiaries, Ambac provides financial and investment products including investment agreements, interest rate swaps, funding conduits, investment advisory and cash management services, principally to its financial guarantee clients which include municipalities and their authorities, school districts, health care organizations and asset-backed issuers. Revenues. Revenues, excluding realized gains and losses, for the three and -------- nine months ended September 30, 2001 were $10.2 million and $36.5 million, respectively, a decrease of 6% from $10.9 million in revenues for the third quarter of 2000 and a decrease of 21% from $46.4 million for the nine months ended September 30, 2000. Investment agreements declined 24%, from $4.6 million in revenues in the third quarter of 2000 to $3.5 million in the third quarter of 2001, due to lower interest rate spreads. An increase in municipal swap revenues of 27%, to $3.3 million in the third quarter of 2001 from $2.6 million in the third quarter of 2000, was due to higher post inception revenue during the third quarter of 2001. Investment advisory and cash management revenues decreased 6% to $3.5 million in the third quarter of 2001 compared to $3.7 million in the third quarter of 2000. Investment agreement revenues for the nine months ended September 30, 2001 were $9.8 million, down 36% from $15.4 million in the nine months ended September 30, 2000. Interest rate swap revenues for the nine months ended September 30, 2001 were $16.4 million, down 23% from $21.4 million in the nine months ended September 30, 2000. Investment advisory and cash management revenues for the nine months ended September 30, 2001 were $10.1 million, up 5% from $9.6 million in the nine months ended September 30, 2000. Expenses. Expenses for the three and nine months ended September 30, 2001 -------- were $5.0 million and $16.6 million, respectively, down 14% from $5.8 million in the three months ended September 30, 2000 and down 11% from $18.6 million in the nine months ended September 30, 2000. 16
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Corporate Items Income Taxes. Income taxes for the three and nine months ended September ------------ 30, 2001 were at an effective rate of 23.1% and 23.5%, respectively, versus 23.8% and 23.9% for the three and nine months ended September 30, 2000. Supplemental Analytical Financial Data Management, equity analysts and investors consider the following three measures important in analyzing the financial results of Ambac: core earnings; operating earnings; and adjusted gross premiums written. However, none of these measures are promulgated in accordance with GAAP and should not be considered as substitutes for net income and gross premiums written. The definitions of core earnings, operating earnings, and adjusted gross premiums written described below may differ from the definitions used by other public holding companies of financial guarantee insurers. Core Earnings. Ambac defines core earnings as consolidated net income, less ------------- the effect of net realized gains and losses, unrealized mark-to-market gains and losses in the Company's structured credit derivatives business, net insurance premiums earned from refundings and calls and certain non-recurring items. Core earnings for the three and nine months ended September 30, 2001 were $105.9 million and $303.6 million, respectively, an increase of 16% from $91.5 million for the three months ended September 30, 2000 and an increase of 14% from $266.5 million for the nine months ended September 30, 2000. These increases were primarily the result of higher normal net premiums earned from the growth in the financial guarantee book of business, higher net investment income and higher structured credit derivative revenue (excluding unrealized mark-to-market losses), all from financial guarantee operations. These increases were partially offset by higher expenses in the financial guarantee segment and lower revenues from the investment agreement business in the financial services segment. Operating Earnings. Ambac defines operating earnings as consolidated net ------------------ income, less the effect of net realized gains and losses, unrealized mark-to-market gains and losses in the Company's structured credit derivatives business and certain non-recurring items. Operating earnings for the three and nine months ended September 30, 2001 were $111.9 million and $319.1 million, respectively, an increase of 20% from $93.4 million in the three months ended September 30, 2000 and an increase of 15% from $276.9 million for the nine months ended September 30, 2000. 17
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) The following table reconciles net income computed in accordance with GAAP to operating earnings and core earnings for the three and nine months ended September 30, 2001 and 2000: <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ------------------------------- -- ----------------------------- (Dollars in Millions) 2001 2000 2001 2000 -------------- ------------- ------------- ------------ <S> <C> <C> <C> <C> Net Income............................................ $111.0 $90.9 $316.2 $269.2 Net realized (gains) losses, after tax................ (1.1) 2.0 0.6 6.5 Unrealized mark-to-market losses, after tax........... 2.0 0.5 1.9 1.2 Non-recurring item, after tax......................... - - 0.4 - -------------- ------------- ------------- ------------ Operating earnings........................... 111.9 93.4 319.1 276.9 Premiums earned from refundings, calls and other accelerations, after tax.............................. (6.0) (1.9) (15.5) (10.4) -------------- ------------- ------------- ------------ Core earnings................................ $105.9 $91.5 $303.6 $266.5 ============== ============= ============= ============ </TABLE> Adjusted Gross Premiums Written. Ambac defines adjusted gross premiums written - ------------------------------- as gross (direct and assumed) up-front premiums written plus the present value of estimated installment premiums written on insurance policies and structured credit derivatives issued in the period. Previously, adjusted gross premiums was net of premiums related to international deals that were ceded to MBIA Insurance Corporation pursuant to a joint venture that ceased during 2000. Prior period amounts have been restated. Adjusted gross premiums for the three and nine months ended September 30, 2001 were $180.6 million and $646.1 million, respectively, up 1% from $179.3 million in the three months ended September 30, 2000 and up 26% from $514.0 million in the nine months ended September 30, 2000. The increases in 2001 were primarily due to increased activity in municipal finance and international, partially offset by a decline in structured finance. On the municipal side, Ambac benefited from increased municipal volume resulting from the lower interest rate environment and insured penetration, partially offset by lower market share in the third quarter of 2001. The structured business was negatively impacted by the tragic events of September 11, with several large transactions postponed. Adjusted gross premiums for the five largest structured transactions decreased from $28.9 million (three transactions greater than $6 million) in the third quarter of 2000 to $14.9 million (no transactions greater than $6 million) in the third quarter of 2001. International premiums written in the third quarter of 2001 was dominated by a large health care securitization in the United Kingdom. 18
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) The following table sets forth the amounts of adjusted gross premiums by type and percent of total for the three and nine months ended September 30, 2001 and 2000: <TABLE> <CAPTION> Three Months Ended September 30, Nine Months Ended September 30, -------------------------------------- --------------------------------------- (Dollars in Millions) 2001 % 2000 % 2001 % 2000 % ---------- -------- --------- -------- --------- ------- --------- -------- Municipal Finance: Up-front: <S> <C> <C> <C> <C> <C> <C> <C> <C> New issue........................... $81.1 45% $80.9 45% $233.3 36% $130.0 25% Secondary market.................... 2.2 1 2.2 1 17.7 3 8.6 2 ---------- -------- --------- -------- --------- ------- --------- -------- Sub-total up-front ............... 83.3 46 83.1 46 251.0 39 138.6 27 Installment........................... 15.5 9 6.5 4 41.2 6 20.4 4 ---------- -------- --------- -------- --------- ------- --------- -------- Total Municipal Finance........ 98.8 55 89.6 50 292.2 45 159.0 31 ---------- -------- --------- -------- --------- ------- --------- -------- Structured Finance: Up-front............................ 0.5 - 7.0 4 7.4 1 25.5 5 Installment......................... 27.1 15 46.6 26 153.5 24 150.8 29 ---------- -------- --------- -------- --------- ------- --------- -------- Total Structured Finance......... 27.6 15 53.6 30 160.9 25 176.3 34 ---------- -------- --------- -------- --------- ------- --------- -------- International (1): Up-front......................... 6.8 4 9.6 5 64.5 10 42.2 8 Installment...................... 47.4 26 26.5 15 128.5 20 136.5 27 ---------- -------- --------- -------- --------- ------- --------- -------- Total International............. 54.2 30 36.1 20 193.0 30 178.7 35 ---------- -------- --------- -------- --------- ------- --------- -------- Total adjusted gross premiums............. $180.6 100% $179.3 100% $646.1 100% $514.0 100% ========== ======== ========= ======== ========= ======= ========= ======== Total up-front............................ $90.6 50% $99.7 56% $322.9 50% $206.3 40% Total installment......................... 90.0 50 79.6 44 323.2 50 307.7 60 ---------- -------- --------- -------- --------- ------- --------- -------- Total adjusted gross premiums............ $180.6 100% $179.38 100% $646.1 100% $514.0 100% ========== ======== ========= ======== ========= ======= ========= ======== </TABLE> (1) Adjusted gross premiums written include reinsurance assumed of $7.0 million and $48.6 million in the third quarter and nine months of 2001. Adjusted gross premiums written also include structured credit derivatives of $7.4 million and $22.1 million for the three and nine months ended September 30,2001, respectively, and $2.0 million and $29.4 million for the three and nine months ended September 30, 2000, respectively. Liquidity and Capital Resources 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 and other subsidiaries' ability to pay dividends or make payments to Ambac; and (ii) external financings. Pursuant to Wisconsin insurance laws, Ambac Assurance may declare dividends, provided that, after giving effect to the distribution, it would not violate certain statutory equity, solvency and asset tests. During the nine months ended September 30, 2001, Ambac Assurance paid dividends of $51.0 million on its common stock to Ambac. Also during the nine months ended September 30, 2001, Ambac Capital Corporation, a financial services wholly-owned subsidiary paid dividends of $1.0 million on its common stock to Ambac. Ambac's principal uses of liquidity are for the payment of its operating expenses, interest on its debt, dividends on its shares of common stock, purchases of its common stock in the open market and capital investments in its subsidiaries. Based on the amount of dividends that it expects to receive from Ambac Assurance and other subsidiaries during the next twelve months and the income it expects to receive from its investment portfolio, management believes that Ambac will have sufficient liquidity to satisfy its liquidity 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 19
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) sufficient liquidity to meet its debt service and other obligations over the long term, no guarantee can be given that Ambac Assurance will be permitted to dividend amounts sufficient to pay all of Ambac's operating expenses, debt service obligations and dividends on its common stock. On October 17, 2001, Ambac issued $200.0 million in principal amount of 7.0% debentures due on October 17, 2051. Ambac may not redeem the debentures prior to October 17, 2006. On or after October 17, 2006, Ambac may redeem the debentures at 100% of their principal amount, plus accrued interest to the date of redemption. Use of the net proceeds received from the sale of the debentures will be for general corporate purposes, which include additions to working capital of subsidiaries, acquisitions and repurchases of common stock. These debentures will be listed on the New York Stock Exchange. Ambac Assurance Liquidity. The principal uses of Ambac Assurance's ------------------------- liquidity are the payment of operating expenses, reinsurance premiums, income taxes, dividends to Ambac and capital investments in its subsidiaries. Management believes that Ambac Assurance's operating liquidity needs can be funded exclusively from its operating cash flow. The principal sources of Ambac Assurance's liquidity are gross premiums written, scheduled investment maturities, net investment income and receipts from structured credit derivatives. Financial Services Liquidity. The principal uses of liquidity by financial ---------------------------- services subsidiaries are payment of investment agreement obligations pursuant to defined terms, net obligations under interest rate swaps and related hedges, operating expenses, income taxes and dividends to Ambac. Management believes that its financial services liquidity needs can be funded primarily from its operating cash flow and the maturity of its invested assets. 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 matching the maturity schedule of its obligations under the investment agreements), net receipts from interest rate swaps and related hedges, and fees for investment management services. Additionally, from time to time, liquidity needs of the financial services subsidiaries are satisfied by short-term inter-company loans from Ambac. 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. Financial services maintain a portion of their assets in short-term investments and repurchase agreements in order to meet unexpected liquidity needs. Credit Facilities. Ambac and Ambac Assurance have a revolving credit ----------------- facility with four major international banks for $200 million, which expires in August 2002 and provides a two-year term loan provision. The facility is available for general corporate purposes, including the payment of claims. As of September 30, 2001 and December 31, 2000, no amounts were outstanding under this credit facility. Ambac Assurance maintains third party capital support in the form of seven-year irrevocable limited recourse credit facilities from a group of highly rated banks for $800 million. These credit facilities provide liquidity to Ambac Assurance in the event claims from municipal or certain structured obligations in its covered portfolios exceed specified levels. Repayments of amounts drawn under the credit facilities are limited primarily to the amount of any recoveries of losses related to policy obligations in the covered portfolios. The line expires in 20
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) June 2008. As of September 30, 2001 and December 31, 2000, no amounts were outstanding under these facilities. Ambac Credit Products, L.L.C. has a revolving credit facility with one major international bank for $50 million that expires in June 2002 and provides a three-year term loan provision. The facility is available to Ambac Credit Products for general corporate purposes, including payments in regard to its structured credit derivative activities. As of September 30, 2001 and December 31, 2000, no amounts were outstanding under this facility. Stock Repurchase Program. The Board of Directors of Ambac has authorized ------------------------ the establishment of a stock repurchase program that permits the repurchase of up to 12,000,000 shares of Ambac's Common Stock. During the nine months ended September 30, 2001, Ambac acquired approximately 680,000 shares for an aggregate amount of $35.9 million. Since inception of the Stock Repurchase Program, Ambac has acquired approximately 8,170,000 shares for an aggregate amount of $219.8 million. Balance Sheet. Total assets as of September 30, 2001 were $11.41 billion, ------------- an increase of 13% from $10.12 billion at December 31, 2000. This increase was primarily due to an increase in the fair value of Ambac's investment portfolio. As of September 30, 2001, stockholders' equity was $2.96 billion, a 14% increase from year-end 2000 stockholders' equity of $2.60 billion. The increase stemmed primarily from net income during the period and an increase in the value of the investment portfolio due to a decline in interest rates. Cash Flows. Net cash provided by operating activities was $507.5 million ---------- and $326.1 million during the nine months ended September 30, 2001 and 2000, respectively. These cash flows were primarily provided by financial guarantee operations. Net cash provided by financing activities was $189.7 million during the nine months ended September 30, 2001, of which $224.5 million was provided by investment agreements issued (net of draws paid). For the nine months ended September 30, 2000, $893.4 million was used in financing activities, of which $890.2 million was used by investment agreements draws paid (net of investment agreements issued). Net cash used in investing activities was $631.2 million during the nine months ended September 30, 2001, of which $3,418.9 million was used to purchase bonds, partially offset by the proceeds from sales and maturities of bonds of $2,860.6 million. For the nine months ended September 30, 2000, $568.5 million was provided by investing activities, of which $2,240.1 million was provided by sales and maturities of bonds, partially offset by purchases of bonds totaling $1,643.5 million. Material Commitments. Ambac has made no commitments for material capital -------------------- expenditures within the next twelve months. 21
Item 3. Quantitative and Qualitative Disclosures About Market Risk In the ordinary course of business, Ambac, through its affiliates, manages a variety of risks, principally market, credit, liquidity, operational, and legal. These risks are identified, measured and monitored through a variety of control mechanisms that are in place at different levels throughout the organization. Market risk represents the potential for losses that may result from changes in the value of a financial instrument as a result of changes in market conditions. The primary market risks that would impact the value of Ambac's financial instruments are interest rate risk, basis risk (taxable interest rates relative to tax-exempt interest rates, discussed below) and credit spread risk. Senior managers in Ambac's Risk Management Group are responsible for monitoring risk limits and applying risk measurement methodologies. The estimation of potential losses arising from adverse changes in market conditions is a key element in managing market risk. Ambac utilizes various systems, models and stress test scenarios to monitor and manage market risk. This process includes frequent analyses of parallel and non-parallel shifts in the yield curve, "Value-at-Risk" and changes in credit spreads. These models include estimates, made by management, which utilize current and historical market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Financial instruments that may be adversely affected by changes in interest rates consist primarily of investment securities, investment agreement liabilities, debentures, certain derivative contracts (primarily interest rate swaps) used for hedging purposes. Financial instruments that may be adversely affected by changes in basis include Ambac's municipal interest rate swap portfolio. Ambac, through its affiliate Ambac Financial Services, L.P., is a provider of interest rate swaps to states, municipalities and their authorities and other entities in connection with their financings. Ambac Financial Services manages its business with the goal of being market neutral to changes in overall interest rates, while seeking to profit from retaining some basis risk. If actual or projected tax-exempt interest rates change in relation to taxable interest rates, Ambac will experience a mark-to-market gain or loss. Since late 1995, most municipal interest rate swaps transacted by Ambac Financial Services contain provisions that are designed to protect Ambac against certain forms of tax reform, thus mitigating its basis risk. The estimation of potential losses arising from adverse changes in market relationships, known as VaR, is a key element in management's monitoring of basis risk for the municipal interest rate swap portfolio. Ambac has developed a VaR methodology to estimate potential losses over a specified holding period and based on certain probabilistic assessments. Ambac's methodology estimates VaR using a 300-day historical "look back" period. This means that changes in market values are simulated using market inputs from the past 300 days. Since no single measure can capture all dimensions of market risk, Ambac supplements its VaR methodology by performing analyses of parallel and non-parallel shifts in yield curves and stress test scenarios which measure the potential impact of normal market conditions, which might cause abnormal volatility swings or disruptions of market relationships. 22
Item 3. Quantitative and Qualitative Disclosures About Market Risk (Continued) Financial instruments that may be adversely affected by changes in credit spreads include Ambac's outstanding structured credit derivative contracts. Ambac, through its affiliate, Ambac Credit Products, enters into structured credit derivative contracts. These contracts require Ambac Credit Products to make payments upon the occurrence of certain defined credit events relating to underlying obligations (generally fixed income obligations). If credit spreads of the underlying obligations change, the market value of the related structured credit derivative changes. As such, Ambac Credit Products could experience mark-to-market gains or losses. Market liquidity could also impact valuations. Changes in credit spreads are generally caused by changes in the market's perception of the credit quality of the underlying obligations. The majority of Ambac Credit Product's contracts are partially hedged with various financial institutions or structured with first loss protection. Such structuring mitigates Ambac Credit Product's risk of loss and reduces the price volatility of these financial instruments. Personnel in Ambac's credit surveillance group monitor credit spread risk. Additionally, management models the potential impact of credit spread changes on the value of its contracts. 23
PART II - OTHER INFORMATION Items 1, 2, 3, 4 and 5 are omitted either because they are inapplicable or because the answer to such question is negative. Item 6 - Exhibits and Reports on Form 8-K (a) The following are annexed as exhibits: <TABLE> <CAPTION> Exhibit Number Description - --------- ---------------------------------------------------------------- <S> <C> 4.08 Form of 7.00% Debenture due October 17,2051. (Filed as Exhibit 1 to the company's Registration Statement on Form 8-A dated October 26, 2001 and incorporated herein by reference.) 4.09 Indenture dated as of August 24, 2001 between the Company and The Chase Manhattan Bank as trustee. (Filed as Exhibit 4.1 to the Company's Registration Statement on Form S-3 (Reg. No. 333-57206) and incorporated herein by reference.) 99.07 Ambac Assurance Corporation and Subsidiaries Consolidated Unaudited Financial Statements as of September 30, 2001 and December 31, 2000 and for the periods ended September 30, 2001 and 2000. </TABLE> (b) Reports on Form 8-K: On September 17, 2001, Ambac filed a Current Report on Form 8-K with its September 13, 2001 press release announcing that Ambac does not expect any material claims as a result of the World Trade Center tragedy. On September 19, 2001, Ambac filed a Current Report on Form 8-K with its September 18, 2001 press release providing additional information related to the World Trade Center tragedy. On October 22, 2001, Ambac filed a Current Report on Form 8-K with its October 17, 2001 press release containing unaudited interim financial information and accompanying discussion for the three and nine months ended September 30, 2001. 24
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized. Ambac Financial Group, Inc. (Registrant) Dated: November 14, 2001 By: /s/ Frank J. Bivona ---------------------------- Frank J. Bivona Vice Chairman and Chief Financial Officer (Principal Financial and Accounting Officer and Duly Authorized Officer) 25
INDEX TO EXHIBITS Exhibit Number Description - --------- ---------------------------------------------------------------- 99.07 Ambac Assurance Corporation and Subsidiaries Consolidated Unaudited Financial Statements as of September 30, 2001 and December 31, 2000 and for the periods ended September 30, 2001 and 2000. 26