UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2002
o
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
No
As of October 31, 2002, 105,977,949 shares of Common Stock, par value $0.01 per share, (net of 233,518 treasury shares) of the Registrant were outstanding.
Ambac Financial Group, Inc. and Subsidiaries
INDEX
PAGE
PART I
FINANCIAL INFORMATION
Item 1.
Financial Statements of Ambac Financial Group, Inc. and Subsidiaries
Consolidated Balance Sheets – September 30, 2002 and December 31, 2001
3
Consolidated Statements of Operations – three and nine months ended September 30, 2002 and 2001
4
Consolidated Statements of Stockholders’ Equity – nine months ended September 30, 2002 and 2001
5
Consolidated Statements of Cash Flows – nine months ended September 30, 2002 and 2001
6
Notes to Consolidated 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
26
Item 4.
Controls and Procedures
27
PART II
OTHER INFORMATION
Item 6.
Exhibits and Reports on Form 8-K
28
SIGNATURES
29
CERTIFICATIONS
30
INDEX TO EXHIBITS
32
2
PART I -FINANCIAL INFORMATION Item 1 -Financial Statements of Ambac Financial Group, Inc. and Subsidiaries
Ambac Financial Group, Inc. and SubsidiariesConsolidated Balance Sheets September 30, 2002 and December 31, 2001 (Dollars in Thousands)
September 30, 2002
December 31, 2001
(unaudited)
Assets
Investments:
Fixed income securities, at fair value (amortized cost of $10,163,780 in 2002 and $8,355,596 in 2001)
$
10,710,694
8,469,157
Fixed income securities pledged as collateral, at fair value (amortized cost of $809,274 in 2002 and $1,393,193 in 2001)
815,742
1,401,528
Short-term investments, at cost (approximates fair value)
137,369
415,002
Other
2,159
2,163
Total investments
11,665,964
10,287,850
Cash
32,342
76,580
Securities purchased under agreements to resell
24,504
11,200
Receivable for investment agreements
21,369
4,101
Receivable for securities sold
508,156
8,922
Investment income due and accrued
127,961
144,463
Reinsurance recoverable
2,195
2,259
Prepaid reinsurance
273,931
267,655
Deferred acquisition costs
172,718
163,477
Loans
848,399
901,194
Derivative product assets
961,250
383,959
Other assets
49,290
100,460
Total assets
14,688,079
12,352,120
Liabilities and Stockholders’ Equity
Liabilities:
Unearned premiums
1,926,789
1,780,272
Losses and loss adjustment expense reserve
167,045
152,352
Ceded reinsurance balances payable
11,248
10,146
Obligations under investment and payment agreements
5,246,902
4,089,777
Obligations under investment repurchase agreements
1,085,946
1,422,151
Securities sold under agreement to repurchase
460,495
425,000
Deferred income taxes
270,930
123,077
Current income taxes
36,675
98,145
Debentures
612,717
619,315
Accrued interest payable
70,278
84,225
799,719
325,922
Other liabilities
138,175
175,135
Payable for securities purchased
241,036
62,915
Total liabilities
11,067,955
9,368,432
Stockholders’ equity:
Preferred stock
—
Common stock
1,062
1,060
Additional paid-in capital
548,823
538,135
Accumulated other comprehensive income
319,793
62,476
Retained earnings
2,772,509
2,403,473
Common stock held in treasury at cost
(22,063
)
(21,456
Total stockholders’ equity
3,620,124
2,983,688
Total liabilities and stockholders’ equity
See accompanying Notes to Consolidated Financial Statements
Ambac Financial Group, Inc. and SubsidiariesConsolidated Statements of Operations (Unaudited) For the Periods Ended September 30, 2002 and 2001 (Dollars in Thousands Except Share Data)
Three Months Ended September 30,
Nine Months Ended September 30,
2002
2001
Revenues:
Financial Guarantee:
Gross premiums written
205,110
152,918
550,154
499,253
Ceded premiums written
(26,854
(35,874
(71,108
(72,342
Net premiums written
178,256
117,044
479,046
426,911
Net premiums earned
122,396
98,019
339,680
276,547
Other credit enhancement fees
7,307
5,876
20,171
15,524
Net premiums earned and other credit enhancement fees
129,703
103,895
359,851
292,071
Net investment income
75,895
67,318
222,035
196,852
Net securities (losses) gains
(1,500
3,578
(10,581
(10
Other income
472
502
2,586
3,918
Financial Services:
Revenue
13,582
10,231
41,139
36,457
Net securities gains (losses)
1,402
(3,589
2,168
(3,151
Other:
974
786
2,659
3,093
Net securities losses
(127
(1,383
(571
Total revenues
220,401
181,338
619,286
527,847
Expenses:
Losses and loss adjustment expenses
6,100
5,100
17,700
14,500
Underwriting and operating expenses
18,467
16,602
55,631
50,671
Financial Services
5,380
5,023
16,215
16,627
Interest
10,774
9,370
32,256
28,338
1,884
921
5,365
4,372
Total expenses
42,605
37,016
127,167
114,508
Income before income taxes
177,796
144,322
492,119
413,339
Provision for income taxes
46,105
33,314
123,715
97,179
Net income
131,691
111,008
368,404
316,160
Net income per share:
Basic
1.24
1.05
3.48
2.99
Diluted
1.21
1.02
3.38
2.90
Weighted average number of common shares outstanding:
105,865,884
105,781,745
105,940,661
105,753,654
108,959,876
109,077,058
109,148,469
108,980,936
Ambac Financial Group, Inc. and SubsidiariesConsolidated Statements of Stockholders’ Equity (Unaudited) For The Nine Months Ended September 30, 2002 and 2001 (Dollars in Thousands)
Retained Earnings:
Balance at January 1
2,035,209
Dividends declared - common stock
(29,654
(26,439
Exercise of stock options
30,286
(21,617
Balance at September 30
2,303,313
Accumulated Other Comprehensive Income:
45,154
Unrealized gains on securities, $421,900 and $148,148, pre-tax in 2002 and 2001, respectively(1)
268,014
93,021
Cumulative effect of accounting change
(880
Loss on derivative hedges
(12,330
(377
Foreign currency translation gain (loss)
1,633
(267
Other comprehensive income
257,317
91,497
Comprehensive income
625,721
407,657
136,651
Preferred Stock:
Balance at January 1 and September 30
Common Stock:
Issuance of stock
Additional Paid-in Capital:
533,558
13,371
10,961
4,286
Capital issuance costs
(6,969
544,519
Common Stock Held in Treasury at Cost:
(18,867
Cost of shares acquired
(38,654
(35,855
Shares issued under equity plans
38,047
33,121
(21,601
Total Stockholders’ Equity at September 30
2,963,942
(1) Disclosure of reclassification amount:
Unrealized holding gains arising during period
273,288
94,505
Less: reclassification adjustment for net gains included in net income
5,274
1,484
Net unrealized gains on securities
See accompanying Notes to Consolidated Financial Statements.
Ambac Financial Group, Inc. and SubsidiariesConsolidated Statements of Cash Flows (Unaudited) For The Nine Months Ended September 30, 2002 and 2001 (Dollars in Thousands)
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
2,608
2,630
Amortization of bond premium and discount
3,891
(14,065
(61,470
34,578
2,186
6,859
(9,241
(7,341
Unearned premiums, net
140,241
150,393
14,757
13,340
1,102
9,267
16,502
11,236
(13,947
(15,295
8,984
4,544
Other, net
7,979
(4,814
Net cash provided by operating activities
481,996
507,492
Cash flows from investing activities:
Proceeds from sales of bonds
1,525,160
985,901
Proceeds from matured bonds
1,586,991
1,874,727
Purchases of bonds
(4,599,837
(3,418,853
Change in short-term investments
277,633
68,710
(13,304
(105,314
Securities sold under agreements to repurchase
(14,366
52,795
(25,076
(29,110
(11,264
Net cash used in investing activities
(1,214,038
(631,169
Cash flows from financing activities:
Dividends paid
Proceeds from issuance of investment agreements
2,105,362
2,045,119
Payments for investment agreement draws
(1,378,861
(1,820,596
Payment agreements
(5,755
1,826
Payment for buyback of debentures
(7,500
Issuance of common stock
4,288
Proceeds from sale of treasury stock
Purchases of treasury stock
Net cash provided by financing activities
687,804
189,676
Net cash flow
(44,238
65,999
Cash and cash pledged as collateral at January 1
45,428
Cash and cash pledged as collateral at September 30
111,427
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Income taxes
122,500
45,000
Interest expense on debt
38,407
30,575
Interest expense on investment agreements
164,261
170,601
Ambac Financial Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands)
(1) Basis of Presentation
Ambac Financial Group, Inc., headquartered in New York City, is a holding company whose subsidiaries provide financial guarantee products and other financial services to clients in both the public and private sectors around the world. Ambac provides financial guarantees for public finance and structured finance obligations through its principal operating subsidiary, Ambac Assurance Corporation. Through its financial services subsidiaries, Ambac provides financial and investment products including investment agreements, interest rate, currency and total return swaps, funding conduits, investment advisory and cash management services, principally to its clients which include municipalities and other public entities, school districts, healthcare organizations and asset-backed issuers.
Ambac Assurance 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. These ratings are an essential part of Ambac Assurance’s ability to provide financial guarantees.
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, 2002 may not be indicative of the results that may be expected for the full year ending December 31, 2002. These consolidated financial statements and notes should be read in conjunction with the financial statements and notes included in the 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, 2001, which was filed with the Securities and Exchange Commission on March 26, 2002, (ii) Ambac’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2002, which was filed with the SEC on May 13, 2002, and (iii) Ambac’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2002, which was filed with the SEC on August 14, 2002.
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.
Notes to Consolidated Financial Statements (Continued)(Dollars in thousands)
(2) Segment Information
Ambac has two reportable segments, as follows: (1) financial guarantee, which provides financial guarantee products (including structured credit derivatives) for public finance and structured finance obligations; and (2) financial services, which provides investment agreements, interest rate swaps, total return swaps, funding conduits, and investment advisory and cash management services. 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. 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, 2002 and 2001:
Three months ended September 30,
Financial Guarantee
Corporate And Other
Intersegment Eliminations
Consolidated
2002:
Unaffiliated customers
204,570
14,984
847
Intersegment
1,795
(1,438
19,500
(19,857
206,365
13,546
20,347
Income before income taxes:
180,003
9,604
(11,811
2,029
(155
19,173
(21,047
Total income before income taxes
182,032
9,449
7,362
Identifiable assets
6,788,160
7,793,700
106,219
2001:
175,293
6,642
(597
1,031
(972
17,000
(17,059
176,324
5,670
16,403
153,591
1,619
(10,888
1,087
(958
16,653
(16,782
154,678
661
5,765
5,581,637
5,775,782
53,084
11,410,503
8
Nine months ended September 30,
573,891
43,307
2,088
7,055
(3,499
62,000
(65,556
580,946
39,808
64,088
500,560
27,092
(35,533
7,733
(2,005
61,019
(66,747
508,293
25,087
25,486
492,831
33,306
1,710
3,422
(2,916
52,000
(52,506
496,253
30,390
53,710
427,660
16,679
(31,000
3,742
(2,775
50,959
(51,926
431,402
13,904
19,959
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, 2002 and 2001:
Three Months
Nine Months
Gross Premiums Written
Net Premiums Earned
United States
168,479
94,956
452,140
271,851
United Kingdom
7,605
5,597
30,825
13,812
Japan
6,042
4,950
15,985
12,602
Mexico
4,083
1,912
12,268
5,764
Australia
8,942
1,713
9,208
3,627
France
142
286
557
829
Internationally diversified (1)
4,562
7,443
11,466
15,120
Other international
5,255
5,539
17,705
16,075
Total
128,544
82,882
382,997
236,436
2,922
34,732
6,958
3,298
2,332
8,808
6,486
4,061
1,885
12,087
5,568
2,107
994
7,158
2,787
95
274
531
822
4,247
2,939
24,993
7,367
3,259
3,791
27,947
10,123
1) Internationally diversified includes guarantees with multiple locations of risk and includes components of United States exposure.
9
Other credit enhancement fees for the three and nine months ended September 30, 2002 were $7.3 million and $20.2 million, respectively. Of the $7.3 million, 14% were domestic and 86% were internationally diversified. Of the $20.2 million, 13% were domestic and 87% were internationally diversified. Other credit enhancement fees for the three and nine months ended September 30, 2001 were $5.9 million and $15.5 million, respectively. Of the $5.9 million and $15.5 million, 8% were domestic and 92% were internationally diversified.
(3) Accounting Standards
In July 2001, the FASB issued SFAS Statement 142, “Goodwill and Other Intangible Assets”. SFAS 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. SFAS 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. At September 30, 2002, Ambac had goodwill of $12.5 million. Ambac adopted SFAS 142 effective January 1, 2002. Implementation of SFAS 142 did not have a material impact on the consolidated financial statements.
In August 2001, the FASB issued SFAS Statement 143, “Accounting for Asset Retirement Obligations”(“SFAS 143”.) SFAS 143 requires companies to record the fair value of an asset retirement obligation as a liability in the period in which it incurs a legal obligation associated with the retirement of tangible long-lived assets that result from the acquisition, construction, development and/or normal use of the assets. Companies also record a corresponding asset which is depreciated over the life of the asset. Subsequent to the initial measurement of the asset retirement obligation, the obligation is adjusted at the end of each period to reflect the passage of time and changes in the estimated future cash flows underlying the obligation. Ambac is required to adopt SFAS 143 on January 1, 2003. Ambac does not anticipate that SFAS 143 will have a material impact on the consolidated financial statements.
In October 2001, the FASB issued SFAS Statement 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”(“SFAS 144”.) SFAS 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This Statement requires that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. SFAS Statement 144 requires companies to separately report discontinued operations and extends that reporting to a component of an entity that either has been disposed of (by sale, abandonment, or in a distribution to owners) or is classified as held for sale. Assets to be disposed of are reported at the lower of the carrying amount or fair value less cost to sell. Ambac adopted SFAS 144 effective January 1, 2002. This statement did not have an effect on Ambac’s consolidated financial statements.
Ambac has decided to voluntarily adopt the fair value based method of accounting for stock-based compensation plans as prescribed in Statement of Financial Accounting Standards number 123 “Accounting for Stock-Based Compensation” (“SFAS 123”) beginning in the first quarter of 2003. The fair value based method requires expensing the estimated cost of employee stock options. Currently, Ambac estimates the net income effect of prospectively adopting FAS 123 will be approximately $0.01 per diluted share on a quarterly basis, for options granted in 2003.
10
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Ambac Financial Group, Inc., headquartered in New York City, is a holding company whose subsidiaries provide financial guarantee products and financial services to clients in both the public and private sectors around the world. Management has identified the accounting for loss and loss adjustment expenses and the valuation of financial instruments as critical accounting policies.
The reserve for losses and loss adjustment expenses consists of the active credit reserve and case basis loss and loss adjustment expense reserves. The development of the active credit reserve is based upon estimates of the expected levels of debt service defaults resulting from credit failures on currently guaranteed issues that are not presently or imminently in default. When losses occur (actual monetary defaults or defaults, in the opinion of management, which are imminent on guaranteed obligations), case basis loss reserves are established in an amount that is sufficient to cover the present value of the anticipated defaulted debt service payments over the expected period of default and estimated expenses associated with settling the claims, less estimated recoveries under salvage or subrogation rights. All or parts of case basis loss reserves are allocated from any active credit reserves available. Management believes that the reserves for losses and loss adjustment expenses are adequate to cover the ultimate net cost of claims, but the reserves are necessarily based on estimates and there can be no assurance that the ultimate liability will not exceed such estimates.
The following financial instruments are carried in the accompanying balance sheet at fair value: fixed income investment securities and derivatives used for hedging purposes and derivatives held for trading purposes. The fair values of fixed income investment securities are based primarily on quoted market prices received from a nationally recognized pricing service or dealer quotes. When quotes are not available, fair values are estimated based upon internal valuation models. The fair values of all derivatives are based on quoted dealer prices, current settlement values, or pricing valuation models. All valuation 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.
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 Securities and Exchange Commission.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)
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, 2002 and 2001, and its financial condition as of September 30, 2002 and December 31, 2001. These results are presented for Ambac’s two reportable segments: Financial Guarantee and Financial Services.
Consolidated Net Income
Ambac’s net income for the three months ended September 30, 2002 was $131.7 million or $1.21 per diluted share. This represents a 19% increase from the three months ended September 30, 2001 net income of $111.0 million, or $1.02 per diluted share for the three months ended September 30, 2001. The increase in net income was primarily attributable to growth in Financial Guarantee operating income. Financial Guarantee revenues increased $29.3 million, or 17%. Excluding realized and unrealized gains and losses from investment securities and structured credit derivatives, Financial Guarantee revenues increased by 20%. Financial Guarantee total expenses increased $2.9 million, or 13% from the three months ended September 30, 2001. Ambac’s net income for the nine months ended September 30, 2002 was $368.4 million or $3.38 per diluted share. This represents an increase of 17% from the comparable prior period net income of $316.2 million or $2.90 per diluted share in the nine months ended September 30, 2001.
Ambac provides financial guarantees for debt obligations through its principal operating subsidiary, Ambac Assurance, as well as credit protection in the form of structured credit derivatives through Ambac Credit Products LLC, a wholly owned subsidiary of Ambac Assurance. Ambac provides these services in three principal markets: public finance, structured finance and international finance.
Public finance obligations are bonds issued by states, municipalities and other governmental or not-for-profit entities located in the United States (“Public Finance”). Bond proceeds are used to finance or refinance a broad spectrum of public purpose initiatives, including education, utility, transportation, healthcare and other general purpose projects. Although Ambac generally guarantees the full range of Public Finance obligations, more recently Ambac has been concentrating on those deals in the Public Finance area which require more structuring skills. Certain projects which had been financed by the local or U.S. government alone are now being financed through public-private partnerships. In these transactions, debt service on the bonds, rather than being paid solely by tax revenues or other governmental funds, are being paid from a variety of revenue sources, including revenues derived from the project itself. Examples of these deals include stadium financings, student housing and military housing.
Structured finance obligations include the securitization of a variety of asset types such as mortgages, home equity loans, leases and pooled debt obligations originated in the United States (“Structured Finance”). Currently, the largest component of Ambac’s structured business stems from the securitization of mortgages and home equity loans. Another target area in Structured Finance is the credit enhancement of pooled debt obligations and structured credit derivatives. These transactions involve the securitization of a portfolio of corporate or asset-
12
backed obligations and, as with all securitizations, Ambac’s participation is generally structured with first loss protection.
International finance obligations include public purpose infrastructure projects and asset-backed securities originated outside of the United States (“International Finance”). Ambac’s emphasis internationally has been on Western Europe, Japan and Australia. In the United Kingdom, Ambac has participated extensively in the Private Finance Initiative whereby the government has been privatizing certain activities. In Japan, Ambac has an alliance with Sampo Japan Financial Guarantee Co. Ltd. (formerly known as Yasuda Kasai Financial Guarantee Insurance Co. Ltd.). Ambac also participates in developing markets through certain structures such as pooled debt obligations or future flow transactions. Future flow transactions essentially securitize future revenue streams derived from operating receivables or the sale of commodities.
Gross Par Written. Ambac Assurance guaranteed $33.7 billion in par value bonds during the three months ended September 30, 2002, more than double the $15.9 billion in par value bonds guaranteed during the comparable prior year period. Par value written for the third quarter of 2002 was comprised of $10.1 billion from Public Finance bond obligations, $14.5 billion from Structured Finance obligations and $9.1 billion from international obligations, compared to $7.7 billion, $5.4 billion and $2.8 billion, respectively, in the third quarter of 2001.
During the nine months ended September 30, 2002, Ambac Assurance guaranteed $73.2 billion in par value bonds, a 21% increase from $60.5 billion in par during the first nine months of 2001. Par value written for the nine months ended September 30, 2002 was comprised of $28.9 billion from Public Finance bond obligations, $30.2 billion from Structured Finance obligations and $14.1 billion from International Finance obligations, compared to $24.1 billion, $23.3 billion and $13.1 billion, respectively, in the nine months ended September 30, 2001.
The volume of new issue Public Finance bonds for the three and nine months ended September 30, 2002 increased by 55% and 30%, respectively. The increase in total issuance was largely the result of the lower interest rate environment, causing an increase in both the refinancing and new money components of the market. Additionally, insured penetration increased to 51% in the nine months ended September 30, 2002, as compared to 48% for the comparable period in the prior year.
Structured Finance obligations guaranteed during the three and nine months ended September 30, 2002 increased by 171% and 29% compared to their respective periods in 2001. This was largely the result of brisk activity in the consumer asset-backed market (mortgage, auto and credit card). Additionally, the events of September 2001 delayed the issuance of some transactions until the fourth quarter of 2001.
International Finance obligations guaranteed during the three and nine months ended September 30, 2002 increased by 225% and 8% compared to their respective periods in 2001. This was a result of higher writings of structured credit derivatives during the third quarter of 2002. Structured credit derivatives written for the three and nine months ended September 30, 2002 were $6.0 billion and $7.2 billion, respectively, compared to $0.9 billion and $7.3 billion in the three and nine months ended September 30, 2001, respectively.
Gross Premiums Written. Gross premiums written for the three and nine-month periods ended September 30, 2002 were $205.1 million and $550.2 million, an increase of $52.2 million
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or 34% from $152.9 million in the three months ended September 30, 2001 and an increase of $50.9 million or 10% from $499.3 million in the nine months ended September 30, 2001. The increase for the three months ended September 30, 2002 is a result of higher premiums written in all three markets – Public Finance, Structured Finance, and International Finance. The increase for the nine months ended September 30, 2002 is due to higher Public and Structured Finance gross premiums written, partially offset by lower International Finance gross premiums written.
Installment premiums written for the three and nine months ended September 30, 2002 were $82.4 million and $242.7 million, respectively, an increase of 32% from $62.3 million in the three months ended September 30, 2001 and an increase of 38% from $176.4 in the nine months ended September 30, 2001.The growth in installment premiums is due to the growing book of business from all markets. Guaranteed par that collects premiums on an installment basis has grown to approximately $126 billion at September 30, 2002, a 25% increase from September 30, 2001. Up-front premiums written for the three and nine months ended September 30, 2002 were $122.7 million and $307.5 million, an increase of 35% from $90.6 million in the three months ended September 30, 2001 and a decrease of 5% from $322.9 million in the nine months ended September 30, 2001.
The following tables set forth the amounts of gross premiums written and the related gross par written by type:
(Dollars in Millions)
Gross Par Written
Public Finance:
Up-front:
New issue
106.5
8,863
73.3
7,316
Secondary market
1.3
105
0.7
112
Sub-total up-front
107.8
8,968
74.0
7,428
Installment
7.3
1,141
5.5
310
Total Public Finance
115.1
10,109
79.5
7,738
Structured Finance:
Up-front
6.3
305
9.8
781
47.1
14,189
40.5
4,567
Total Structured Finance
53.4
14,494
50.3
5,348
International Finance:
8.6
386
6.8
898
28.0
8,682
16.3
1,900
Total International Finance
36.6
9,068
23.1
2,798
205.1
33,671
152.9
15,884
Total up-front
122.7
9,659
90.6
9,107
Total installment
82.4
24,012
62.3
6,777
14
254.1
24,575
217.5
21,218
4.0
438
7.2
936
258.1
25,013
224.7
22,154
27.9
3,866
16.7
1,909
286.0
28,879
241.4
24,063
26.7
2,243
33.7
2,379
139.5
27,985
112.5
20,976
166.2
30,228
146.2
23,355
22.7
1,008
64.5
2,690
75.3
13,092
47.2
10,400
98.0
14,100
111.7
13,090
550.2
73,207
499.3
60,508
307.5
28,264
322.9
27,223
242.7
44,943
176.4
33,285
Ceded Premiums Written. Ceded premiums written for the three and nine months ended September 30, 2002 were $26.9 million and $71.1 million, respectively, a decrease of 25% from $35.9 million in the three months ended September 30, 2001 and a decrease of 2% from $72.3 million in the nine months ended September 30, 2001. Ceded premiums written were 13.1% and 12.9% of gross premiums written for the three and nine months ended September 30, 2002, respectively, compared with 23.5% and 14.5% for the three and nine months ended September 30, 2001, respectively. The decrease in ceded premiums written for the three and nine months ended September 30, 2002 as compared to the three and nine months ended September 30, 2001 stems primarily from lower utilization of the reinsurance program for Public Finance transactions. Public Finance ceded premiums written were 11.2% and 13.2% of Public Finance gross premiums written for the nine months ended September 30, 2002 and 2001, respectively.
The reinsurance of risk does not relieve Ambac of its original liability to its policyholders. In the event that any of Ambac’s reinsurers are unable to meet their obligations under reinsurance contracts, Ambac would be liable for such defaulted amounts. To minimize exposure to significant losses to reinsurers, Ambac (1) evaluates the financial condition of its reinsurers; (2) has collateral provisions in certain reinsurance contracts; and (3) has certain termination triggers that can be exercised by Ambac in the event of a rating downgrade of a reinsurer. During 2002, both S&P and Moody’s have lowered the financial strength ratings on certain reinsurers. Subsequent to these reinsurer downgrades, both on an S&P and Moody’s ratings basis, approximately 99% of Ambac’s reinsurers are rated at least AA- and Aa3, respectively. Additionally, Ambac held letters of credit and collateral amounting to approximately $130.0 million from its reinsurers.
Net Premiums Written. Net premiums written for the three and nine months ended September 30, 2002 were $178.3 million and $479.0 million, respectively, an increase of 52% from $117.0 million in the three months ended September 30, 2001 and an increase of 12% from $426.9 million for the nine months ended September 30, 2001, respectively. The increases
15
reflect both the higher amounts of gross premiums written and the lower amounts of cessions to reinsurers in 2002.
Net Premiums Earned and Other Credit Enhancement Fees. Net premiums earned and other credit enhancement fees during the three and nine months ended September 30, 2002 were $129.7 million and $359.9 million, respectively, an increase of 25% from $103.9 million for the three months ended September 30, 2001 and an increase of 23% from $292.1 million for the nine months ended September 30, 2001. These increases were primarily the result of the larger Financial Guarantee book of business, higher other credit enhancement fees earned from the structured credit derivatives business and higher refundings, calls and other accelerations of previously insured obligations (collectively referred to as “refundings”).
When an issue insured by Ambac Assurance has been refunded or called, any remaining unearned premium (net of refunding credits, if any) is earned at that time. Earnings on refundings typically relate to insured Public Finance obligations, where the premium is usually paid up front for the life of the policy. 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 during the three and nine months ended September 30, 2002 included $15.7 million (which had a net income per diluted share effect of $0.08) and $34.2 million (which had a net income per diluted share effect of $0.18) from refundings of previously insured issues. Included in the three and nine months ended September 30, 2002 refunding amounts is $4.3 million from International Finance transactions. Net premiums earned during 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 of previously insured issues. There were no International Finance refundings in the three and nine months ended September 30, 2001.
Excluding the effect of accelerated earnings related to refundings, normal net premiums earned (which is defined as net premiums earned less refundings) increased 22% from $87.5 million in the third quarter of 2001 to $106.7 million in the third quarter of 2002. Normal net premiums earned for the nine months ended September 30, 2002 were $305.5 million, an increase of 23% from $249.4 million in the nine months ended September 30, 2001. The increases in normal net premiums earned resulted primarily from the continued growth in the insured book of business in all markets. Normal net premiums earned during the three months ended September 30, 2002 increased 11%, 20% and 53% for Public, Structured and International Finance, respectively, from the three months ended September 30, 2001. Normal net premiums earned during the nine months ended September 30, 2002 increased 13%, 18% and 58% for Public, Structured and International Finance, respectively, from the nine months ended September 30, 2001.
Other credit enhancement fees, which is primarily comprised of fees received from the structured credit derivatives product, during the three and nine months ended September 30, 2002 were $7.3 million and $20.2 million, respectively, an increase of 24% from $5.9 million in the three months ended September 30, 2001 and an increase of 30% from $15.5 million in the nine months ended September 30, 2001. The increases are due to the continued growth in the structured credit derivatives business.
The following table provides a breakdown of net premiums earned by market sector and other credit enhancement fees:
16
Public Finance
39.0
35.1
114.3
101.5
Structured Finance
44.6
37.3
127.7
International Finance
15.1
63.5
40.1
Total normal premiums earned
106.7
87.5
305.5
249.4
Refundings
15.7
10.5
34.2
27.2
Total net premiums earned
122.4
339.7
276.6
5.9
20.2
15.5
Total net premiums earned and other credit enhancement fees
129.7
103.9
359.9
292.1
Net Investment Income. Net investment income for the three and nine months ended September 30, 2002 were $75.9 million and $222.0 million, increases of 13% from $67.3 million and $196.9 million in the three and nine months ended September 30, 2001, respectively. These increases were primarily attributable to (i) the growth of the investment portfolio resulting from the growth in the Financial Guarantee book of business, partially offset by a lower reinvestment rate due to the current interest rate environment; and (ii) a capital contribution from Ambac Financial Group, Inc. totaling approximately $176 million during the fourth quarter of 2001. The capital contribution is a result of Ambac Financial Group’s issuance of $200.0 million of debentures in October 2001. Ambac Assurance’s investments in tax-exempt securities amounted to 69% of the total fair value of its portfolio as of September 30, 2002, versus 68% at September 30, 2001.
The average pre-tax yield-to-maturity on the investment portfolio was 5.62% and 5.82% as of September 30, 2002 and 2001, respectively.
Net Securities (Losses) Gains. Net securities losses for the three and nine months ended September 30, 2002 were $1.5 million and $10.6 million, respectively. This compares to net securities gains of $3.6 million for the three months ended September 30, 2001 and net securities losses of $0.0 million for the nine months ended September 30, 2001. The following table details amounts included in net securities (losses) gains:
Net gains on securities sold
5.8
6.6
4.5
Foreign exchange gains (losses) on investments
(0.4
2.6
1.8
(1.5
Change in fair value of structured credit derivatives
(6.9
(3.0
(19.0
3.6
(10.6
(0.0
The change in fair value of structured credit derivatives relates to unrealized mark-to-market gains and losses. Additionally, realized losses paid on structured credit derivatives totaled $2.5 million and $4.0 million in the three and nine months ended September 30, 2002.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses for the three and nine months ended September 30, 2002 were $6.1 million and $17.7 million, respectively, compared to $5.1 million and $14.5 million for the three and nine months ended September 30, 2001, respectively. The following table summarizes Ambac’s loss reserves split between case basis loss reserves and active credit reserves at September 30, 2002 and December 31, 2001.
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(Dollars in millions)
Net loss and loss adjustment expense reserves:
Case basis reserves *
45.0
27.8
Active credit reserves
119.8
122.3
164.8
150.1
(*)
After netting reinsurance recoverable amounting to $2.2 million and $2.3 million at September 30, 2002 and December 31, 2001, respectively.
The following table summarizes the changes in the total net loss reserves for the nine months ended September 30, 2002 and the year-ended December 31, 2001:
Beginning balance of net loss reserves
131.3
Additions to loss reserves
17.7
20.0
Losses paid
(3.3
(2.6
Recoveries of previously paid losses
0.3
1.4
Ending balance of net loss reserves
Management continually reviews and monitors the guaranteed book of business for potential problem credits. Case reserves on guaranteed issues presently in monetary default were $10.8 million at September 30, 2002. These obligations in monetary default require debt service through 2026 totaling $16.6 million. Debt service payments are $0.0 million, $0.9 million, $0.8 million, $3.1 million and $0.6 million for the remainder of 2002, 2003, 2004, 2005 and 2006, respectively. Case reserves on guaranteed issues not presently in monetary default were $34.2 million at September 30, 2002. Net par related to the $34.2 million in case reserves amounted to $512.0 million at September 30, 2002. Additions made to the case reserve totaled $17.2 million and $5.8 million for the nine months ended September 30, 2002 and 2001, respectively. The following tables provide details of losses paid for the nine months ended September 30, 2002 and 2001 and case reserves at September 30, 2002 and December 31, 2001 by market sector:
September 30, 2001
Losses paid:
3.2
2.2
0.1
3.3
Case reserves:
39.2
2.0
3.8
Underwriting and Operating Expenses. Underwriting and operating expenses for the three and nine months ended September 30, 2002 were $18.5 million and $55.6 million, respectively, an increase of 11% from $16.6 million in the three months ended September 30, 2001 and an increase of 10% from $50.7 million in the nine months ended September 30, 2001.
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Underwriting and operating expenses consist of gross underwriting and operating 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 months ended September 30, 2002, gross underwriting and operating expenses were $27.8 million and $83.0 million, respectively, an increase of 29% from $21.5 million in the three months ended September 30, 2001 and an increase of 14% from $72.8 million in the nine months ended September 30, 2001. These increases in the three and nine months ended September 30, 2002 reflects the overall increased business activity and is primarily attributable to higher compensation costs related to the addition of staff and higher premium taxes as a result of higher direct premiums written. Underwriting and operating expenses deferred for the three and nine months ended September 30, 2002 were $17.4 million and $51.3 million, respectively, and $12.2 million and $43.5 million for the three and nine months ended September 30, 2001, respectively. The amortization of previously deferred expenses and reinsurance commissions for the three and nine months ended September 30, 2002 were $8.2 million and $24.0 million, respectively, and $7.3 million and $21.4 million for the three and nine months ended September 30, 2001, respectively.
Through its financial services subsidiaries, Ambac provides financial and investment products including investment agreements, interest rate swaps, total return 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 securities gains and losses, for the three and nine months ended September 30, 2002 were $13.6 million and $41.1 million, respectively, an increase of 33% from $10.2 million in the three months ended September 30, 2001 and an increase of 13% from $36.5 million for the nine months ended September 30, 2001. The increase in third quarter 2002 amounts is primarily due to higher investment agreement revenues of $7.2 million in the third quarter of 2002, better than double the third quarter 2001 revenues of $3.5 million, stemming from improved net interest spreads and higher volume. Swap revenues and the investment advisory and cash management business revenues were relatively flat, at $3.2 million and $3.1 million, respectively, in the third quarter of 2002 compared to 2001. The increase in revenues in the nine months ended September 30, 2002 is a result of higher investment agreement revenues of $19.3 million, compared to $9.8 million in the nine months ended September 30, 2001. Partially offsetting this increase were swap revenues of $11.5 million in the nine months ended September 30, 2002, which were $4.9 million lower than the nine months ended September 30, 2001 swap revenues of $16.4 million. This decrease was mainly due to an adjustment of $3.8 million on a transaction executed in early 2000 and terminated in the second quarter of 2002.
Expenses. Expenses for the three and nine months ended September 30, 2002 were $5.4 million and $16.2 million, respectively, up 8% from $5.0 million in the three months ended September 30, 2001 and a decrease of 2% from $16.6 million in the nine months ended September 30, 2001.
Corporate Items
Interest Expense.Interest expense for the three and nine months ended September 30, 2002 was $10.8 million and $32.3 million, respectively, an increase of 15% from $9.4 million in
19
the three months ended September 30, 2001 and an increase of 14% from $28.3 million in the nine months ended September 30, 2001. The increase is attributable to Ambac’s issuance of $200 million in 50-year debentures in October 2001.
Income Taxes. Income taxes for the three and nine months ended September 30, 2002 were at an effective rate of 25.9% and 25.1%, respectively, versus 23.1% and 23.5% for the three and nine months ended September 30, 2001. The increase in the effective rate is primarily the result of the growth in underwriting profits and a favorable settlement of certain tax audits during the third quarter of 2001.
Supplemental Analytical Financial Data
Management, equity analysts and investors consider adjusted gross premiums written important in analyzing the financial results of Ambac. However, adjusted gross premiums written is not promulgated in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and should not be considered a substitute for gross premiums written. The definition of adjusted gross premiums written described below may differ from the definition used by other public holding companies of financial guarantee insurers.
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. Adjusted gross premiums for the three and nine months ended September 30, 2002 were $305.6 million and $794.2 million, respectively, an increase of 69% from $180.6 million in the three months ended September 30, 2001 and an increase of 23% from $646.1 million in the nine months ended September 30, 2001. During 2002, adjusted gross premium growth was achieved in all markets.
Public Finance adjusted gross premiums for the three and nine months ended September 30, 2002 were $126.8 million and $335.7 million, respectively, an increase of 59% from $79.5 million in the three months ended September 30, 2001 and an increase of 35% from $249.5 million in the nine months ended September 30, 2001. These increases resulted from higher issuance and higher insured penetration, partially offset by Ambac’s lower par market share. Ambac continues to focus on the more highly structured part of this market that carries higher premiums and risk weighted returns. This is accomplished without compromising Ambac’s historical underwriting standards.
Structured Finance adjusted gross premiums for the three and nine months ended September 30, 2002 were $85.6 million and $266.5 million, respectively, an increase of 67% from $51.4 million in the three months ended September 30, 2001 and an increase of 25% from $212.6 million in the nine months ended September 30, 2001. Increases in this market were driven by strong demand in many areas of the consumer asset-backed market, primarily mortgage-backed, auto and credit card transactions.
International Finance adjusted gross premiums for the three and nine months ended September 30, 2002 were $93.2 million and $192.0 million, respectively, an increase of 88% from $49.7 million in the three months ended September 30, 2001 and an increase of 4% from $184.0 million in the nine months ended September 30, 2001. International Finance continues to be dominated by large deals, thus creating some variability in premiums writings. Deal flow was especially strong in the transportation, utilities, mortgage-backed and collateralized debt obligations.
20
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, 2002 and 2001:
%
35
41
34
3.9
1
258.0
19.0
77.7
24.8
126.8
44
335.7
42
249.5
39
6.2
79.4
41.6
23
239.8
178.9
85.6
51.4
266.5
212.6
33
International Finance (1):
8.7
22.8
84.5
42.9
24
169.2
21
119.5
93.2
31
49.7
192.0
184.0
Total adjusted gross premiums
305.6
100
180.6
794.2
646.1
40
50
182.9
60
90.0
486.7
61
323.2
(1) Adjusted gross premiums written include reinsurance assumed of $17.6 million and $18.5 million in the third quarter and nine months ended September 2002, respectively, and $7.0 million and $48.6 million in the third quarter and nine months ended September 2001, 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 ability to pay dividends or make other payments to Ambac; (ii) external financings; and (iii) investment income from its investment portfolio. Pursuant to Wisconsin insurance laws, Ambac Assurance may 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, 2002, Ambac Assurance paid dividends of $58.5 million on its common stock to Ambac.
Ambac’s principal uses of liquidity are for the payment of its operating expenses, income taxes, 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 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.
Ambac Assurance Liquidity. The principal uses of Ambac Assurance’s liquidity are the payment of operating expenses, claims paid, reinsurance premiums, 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 Assurance. 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 subsidiaries 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 six major international banks for $300 million, which expires in July 2003 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, 2002 and December 31, 2001, no amounts were outstanding under this credit facility. This facility’s financial covenants require that Ambac: (i) maintain as of the end of each fiscal quarter a debt to capital ratio of not more than 30% and (ii) maintain at all times total stockholders’ equity equal to or greater than $1.75 billion.
Capital Support.
Ambac Assurance has a series of perpetual put options on its own preferred stock. The counterparty to these put options are trusts established by a major investment bank. The trusts were created as a vehicle for providing capital support to Ambac Assurance by allowing Ambac Assurance to obtain immediate access to new capital at its sole discretion at any time through the exercise of the put option. If the put option were exercised, the preferred stock holdings of Ambac Assurance would give investors the rights of an equity investor in Ambac Assurance. Such rights are subordinate to insurance claims, as well as to the general unsecured creditors of Ambac Assurance. If exercised, Ambac Assurance would receive up to $800 million in return for the issuance of its own perpetual preferred stock, the proceeds of which may be used for any purpose including the payment of claims. Dividend payments on the preferred stock are cumulative only if Ambac Assurance pays dividends on its common stock. Each trust is restricted to holding high quality short-term commercial paper investments to ensure that it can meet its obligations under the put option. To fund these investments, each trust has issued its
22
own auction market perpetual preferred stock. Ambac Assurance pays a floating put option fee. Each trust is rated AA/Aa2 by Standard & Poor’s and Moody’s respectively.
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, 2002, Ambac acquired approximately 657,000 shares for an aggregate amount of $38.7million. Since inception of the Stock Repurchase Program, Ambac has acquired approximately 8,929,000 shares for an aggregate amount of $263.5 million.
Balance Sheet. Total assets as of September 30, 2002 were $14.69 billion, an increase of 19% from $12.35 billion at December 31, 2001. This increase was due primarily to cash generated from business written during the period and higher volume in the guaranteed investment agreement business. As of September 30, 2002, stockholders’ equity was $3.62 billion, a 21% increase from year-end 2001 stockholders’ equity of $2.98 billion. The increase stemmed primarily from net income during the period and an increase in the market value of fixed income investment securities. The increased market value was primarily due to a decrease in interest rates during the nine months ended September 30, 2002.
Ambac’s investment portfolio consists primarily of investments in fixed income securities that are considered available-for-sale and are carried at fair value. Fair value is based primarily on quotes obtained from independent market sources. When quotes are not available, valuation models are used to estimate fair value. These models include estimates, made by management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Short-term investments are carried at cost, which approximates fair value. Unrealized gains and losses, net of deferred income taxes, are included as a component of “Accumulated Other Comprehensive Income” in stockholders’ equity.
The amortized cost and estimated fair value of investments in fixed income securities and short-term investments at September 30, 2002 were as follows:
(Dollars in thousands)
Amortized Cost
Estimated Fair Value
Fixed income securities:
Municipal obligations
4,120,273
4,479,997
Corporate obligations
1,658,041
1,702,150
Foreign government obligations
105,925
115,170
U.S. government obligations
98,501
108,245
Mortgage and asset-backed securities (includes U.S. government agency obligations)
4,181,040
4,305,132
Short-term
10,301,149
10,848,063
Fixed income securities pledged as collateral:
809,274
11,110,423
11,663,805
The credit rating composition of Ambac’s investment portfolio at September 30, 2002 was as follows: (1)
Rating
% of Investment Portfolio
AAA (2)
77
AA
A
BBB
BIG (3)
<1
Not Rated
(1)
Ratings are based on Standard & Poor’s ratings. If unavailable, Moody’s rating are used.
(2)
Includes U.S. Treasury and Agency obligations, which comprised approximately 30% of the total investment portfolio.
(3)
Below investment grade
Investment securities are regularly reviewed for impairment based on criteria that include the extent to which cost exceeds market value and a financial assessment of the security. Of those securities whose amortized cost exceeded fair value at September 30, 2002, approximately $11.9 million ($7.7 million after tax) is at risk of being charged to earnings in the next 12 months. No impairment losses were recognized during the 9 months ended September 30, 2002 or 2001. Ambac owns investments in National Century Financial Enterprises, Inc. Sponsored Programs note NPF XII ($54.0 million), and note NPF VI ($120.5 million) in its financial services investment portfolio. The notes were downgraded by Moody’s Investors Service from Aaa to below investment grade on November 6, 2002. The downgrades resulted from a technical default in the NPF XII note related to a deficit in the reserve accounts. Ambac, as part of a group of investors, is in the process of investigating the concerns at the issuer. Ambac has no financial guarantee exposure to National Century Financial Enterprises, Inc. Sponsored Programs.
Special Purpose Entities. Ambac has sponsored two special purpose entities. The business purpose of these entities is to provide certain financial guarantee clients with funding for their debt obligations. Ambac receives financial guarantee premiums and may receive other fees for this service. Ambac accounts for these entities as Qualified Special Purpose Entities (“QSPEs”) in accordance with Statement of Financial Accounting Standards 140. The QSPEs are non-consolidated. Ambac purchases debt obligations from certain financial guarantee clients and sells these obligations to the QSPEs. The purchase by the QSPE is financed through the issuance of medium-term notes (“MTNs”), which are collateralized by the purchased assets. These MTNs are generally structured to match the cash flow of the assets purchased. Derivative contracts may be used (interest rate and currency swaps) for hedging purposes only. Derivative hedges are established at the time MTNs are issued to purchase financial assets. Ambac Assurance may issue a financial guarantee insurance policy on the assets sold, the MTNs issued or both. As of September 30, 2002, Ambac Assurance had insurance policies issued for all assets owned by and all MTNs outstanding of the QSPEs. Since these exposures are insured, any losses incurred would be included in Ambac’s Consolidated Statements of Operations. As of September 30, 2002, the outstanding MTN liabilities were $1.2 billion. Under the terms of an Administrative Agency Agreement, Ambac provides certain administrative duties, including asset and liability servicing responsibilities.
Cash Flows. Net cash provided by operating activities was $482.0 million and $507.5 million during the nine months ended September 30, 2002 and 2001, respectively. These cash flows were primarily provided by financial guarantee operations.
Net cash provided by financing activities was $687.8 million and $189.7 million during the nine months ended September 30, 2002 and 2001, respectively, of which $726.5 million and $224.5 million was provided by investment agreements issued (net of draws paid) for the nine months ended September 30, 2002 and 2001, respectively.
Net cash used in investing activities was $1,214.0 million during the nine months ended September 30, 2002, of which $4,599.8 million was used to purchase bonds, partially offset by the proceeds from sales and maturities of bonds of $3,112.2 million. For the nine months ended September 30, 2001, $631.2 million was used in investing activities, of which $3,418.9 million was used to purchase bonds, partially offset by the proceeds and maturities of bonds of $2,860.6 million.
Material Commitments. Ambac has made no commitments for material capital expenditures within the next twelve months.
25
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 credit, market, 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 (e.g. taxable interest rates relative to tax-exempt interest rates, discussed below) and credit spread risk. Senior managers in Ambac’s Portfolio 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, where applicable, frequent analyses of parallel and non-parallel shifts in the yield curve, “Value-at-Risk” (“VaR”) 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, and certain derivative contracts (primarily interest rate swaps and futures) 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. 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.
Financial instruments that may be adversely affected by changes in credit spreads include Ambac’s outstanding structured credit derivative contracts and fixed income investment securities. 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 a fixed income obligation). 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.
Item 3. Quantitative and Qualitative Disclosures About Market Risk (Continued)
Changes in credit spreads are generally caused by changes in the market’s perception of the credit quality of the underlying obligations. Substantially all 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 Financial Control group monitor credit spread risk. Additionally, management models the potential impact of credit spread changes on the value of its credit derivative contracts.
Item 4. Controls and Procedures
(a)
Evaluation of Disclosure Controls and Procedures. Ambac’s Chief Executive Officer and Chief Financial Officer completed an evaluation of the effectiveness of Ambac’s disclosure controls and procedures (as such term is defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”). Based on this evaluation, Ambac’s Chief Executive Officer and Ambac’s Chief Financial Officer have concluded that, as of the Evaluation Date, Ambac’s disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to Ambac (including its consolidated subsidiaries) required to be included in Ambac’s reports filed or submitted under the Exchange Act.
(b)
Changes in Internal Controls. Since the Evaluation Date, there have not been any significant changes in Ambac’s internal controls or in other factors that could significantly affect such controls. There were no significant deficiencies or material weaknesses identified in the evaluation and therefore, no corrective actions were taken.
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
The following are annexed as exhibits:
Exhibit Number
Description
99.11
Ambac Assurance Corporation and Subsidiaries Consolidated Unaudited Financial Statements as of September 30, 2002 and December 31, 2001 and for the periods ended September 30, 2002 and 2001.
99.12
Certification of CFO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.13
Certification of CEO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Reports on Form 8-K:
On August 14, 2002, Ambac filed a Current Report on Form 8-K with statements under oath of the principal executive officer and the principal financial officer regarding facts and circumstances relating to Exchange Act filings.
On October 17, 2002, Ambac filed a Current Report on Form 8-K with its October 16, 2002 press release containing unaudited financial information and accompanying discussion for the three and nine months ended September 30, 2002.
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, 2002
By:
/s/ FRANK J. BIVONA
Frank J. Bivona Vice Chairman and Chief Financial Officer (Principal Financial and Accounting Officer and Duly Authorized Officer)
Ambac Financial Group, Inc.Certifications
I, Phillip B. Lassiter, certify that:
1.
I have reviewed this quarterly report on Form 10-Q of Ambac Financial Group, Inc;
2.
Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
3.
Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
4.
The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a.
designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
b.
evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
c.
presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5.
The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weakness in internal controls; and
any fraud, whether or not material, that involves management or other employees who have significant role in the registrant’s internal controls; and
6.
The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
/s/ PHILLIP B. LASSITER
Phillip B. Lassiter Chairman and Chief Executive Officer
Date: November 14, 2002
Ambac Financial Group, Inc. Certifications
I, Frank J. Bivona, certify that
Frank J. Bivona Vice Chairman and Chief Financial Officer