Ambac Financial (AMBC) 10-Q 2004 Q3 Quarterly report

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, 2004

¨ 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  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

As of October 29, 2004, 108,667,550 shares of Common Stock, par value $0.01 per share, (net of 121,323 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, 2004 (unaudited) and December 31, 2003	3
	Consolidated Statements of Operations (unaudited) – three and nine months ended September 30, 2004 and 2003	4
	Consolidated Statements of Stockholders’ Equity (unaudited) – nine months ended September 30, 2004 and 2003	5
	Consolidated Statements of Cash Flows (unaudited) – nine months ended September 30, 2004 and 2003	6
	Notes to Unaudited Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	40
Item 4.	Controls and Procedures	41
PART II  OTHER INFORMATION
Item 6.	Exhibits and Reports on Form 8-K	42
SIGNATURES		43
INDEX TO EXHIBITS		44

PART 1 - FINANCIAL INFORMATION

Item 1 - Financial Statements of Ambac Financial Group, Inc. and Subsidiaries

Ambac Financial Group, Inc. and Subsidiaries

Consolidated Balance Sheets

September 30, 2004 and December 31, 2003

(Dollars in Thousands)

	September 30, 2004			December 31, 2003
	(unaudited)
Assets
Investments:
Fixed income securities, at fair value (amortized cost of $13,063,997 in 2004 and $12,592,398 in 2003)	$	13,530,312		$	13,049,219
Fixed income securities pledged as collateral, at fair value (amortized cost of $519,902 in 2004 and $662,046 in 2003)		518,053			661,422
Short-term investments, at cost (approximates fair value)		176,705			250,382
Other (cost of $4,233 in 2004 and $4,528 in 2003)		4,453			4,417
Total investments		14,229,523			13,965,440
Cash		25,838			24,539
Securities purchased under agreements to resell		62,000			54,015
Receivable for securities and loans sold		173,973			4,425
Investment income due and accrued		143,930			159,680
Reinsurance recoverable on paid and unpaid losses		1,773			3,030
Prepaid reinsurance		286,201			325,461
Deferred acquisition costs		194,186			175,296
Loans		676,690			837,981
Derivative product assets		1,128,726			1,146,408
Other assets		69,577			51,039
Total assets	$	16,992,417		$	16,747,314
Liabilities and Stockholders' Equity
Liabilities:
Unearned premiums	$	2,731,657		$	2,545,490
Loss and loss expense reserves		229,586			189,414
Ceded reinsurance balances payable		4,325			15,383
Obligations under investment and payment agreements		6,313,378			6,545,759
Obligations under investment repurchase agreements		295,816			530,644
Variable interest entity floating rate notes		134,098			189,151
Securities sold under agreement to repurchase		159,200			225,500
Deferred income taxes		192,482			171,058
Current income taxes		33,917			43,176
Debentures		791,823			791,775
Accrued interest payable		59,932			74,235
Derivative product liabilities		932,317			946,178
Other liabilities		225,158			222,163
Payable for securities purchased		79,890			2,830
Total liabilities		12,183,579			12,492,756
Stockholders' equity:
Preferred stock		—			—
Common stock		1,088			1,073
Additional paid-in capital		672,411			606,468
Accumulated other comprehensive income		285,192			266,919
Retained earnings		3,860,248			3,380,098
Common stock held in treasury at cost		(10,101	)		—
Total stockholders’ equity		4,808,838			4,254,558
Total liabilities and stockholders’ equity	$	16,992,417		$	16,747,314

See accompanying Notes to Unaudited Consolidated Financial Statements

3

Ambac Financial Group, Inc. and Subsidiaries

Consolidated Statements of Operations

(Unaudited)

For the Three and Nine Months Ended September 30, 2004 and 2003

(Dollars in Thousands Except Share Data)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
Revenues:
Financial Guarantee:
Gross premiums written	$	210,587		$	280,330		$	800,217		$	863,554
Ceded premiums written		(18,649	)		(17,451	)		(36,586	)		(90,932	)
Net premiums written	$	191,938		$	262,879		$	763,631		$	772,622
Net premiums earned	$	183,499		$	159,626		$	538,527		$	446,370
Other credit enhancement fees		11,839			11,936			35,084			34,594
Net premiums earned and other credit enhancement fees		195,338			171,562			573,611			480,964
Net investment income		89,593			80,890			264,378			237,377
Net realized investment gains		7,358			7,037			22,523			33,757
Net mark-to-market (losses) gains on credit derivative contracts		(330	)		(4,053	)		9,888			(6,227	)
Variable interest entity		861			—			2,761			—
Other income (loss)		799			949			(10,065	)		3,705
Financial Services:
Interest from investment and payment agreements		48,452			47,227			146,542			161,699
Derivative products		10,452			17,251			25,570			13,254
Net realized investment (losses) gains		(830	)		(1,161	)		5,013			3,788
Net mark-to-market gains on derivative hedge contracts		22			11			126			739
Corporate:
Net investment income		416			1,977			1,172			5,016
Net realized investment gains		—			—			18			—
Total revenues		352,131			321,690			1,041,537			934,072
Expenses:
Financial Guarantee:
Loss and loss expenses		17,700			15,900			52,700			36,600
Underwriting and operating expenses		26,157			23,795			81,057			66,974
Variable interest entity		739			—			2,344			—
Financial Services:
Interest from investment and payment agreements		41,736			45,890			125,106			149,482
Other expenses		3,349			3,350			10,425			8,864
Interest		13,722			13,750			40,808			40,741
Corporate		2,678			1,938			7,468			12,438
Total expenses		106,081			104,623			319,908			315,099
Income before income taxes		246,050			217,067			721,629			618,973
Provision for income taxes		61,632			56,986			184,560			158,073
Income from continuing operations		184,418			160,081			537,069			460,900
Discontinued operations:
Loss from discontinued operations		(799	)		(686	)		(1,349	)		(1,229	)
Income tax expense (benefit)		160			(274	)		(60	)		(492	)
Net loss from discontinued operations		(959	)		(412	)		(1,289	)		(737	)
Net income	$	183,459		$	159,669		$	535,780		$	460,163
Earnings per share:
Income from continuing operations	$	1.68		$	1.50		$	4.90		$	4.33
Discontinued operations	$	(0.01	)	$	0.00		$	(0.01	)	$	(0.01	)
Net income	$	1.67		$	1.50		$	4.89		$	4.32
Earnings per diluted share:
Income from continuing operations	$	1.66		$	1.45		$	4.85		$	4.22
Discontinued operations	$	(0.01	)	$	0.00		$	(0.01	)	$	(0.01	)
Net income	$	1.65		$	1.45		$	4.84		$	4.21
Weighted average number of common shares outstanding:
Basic		109,771,249			106,779,009			109,468,844			106,418,669
Diluted		111,107,367			109,944,141			110,777,264			109,280,533

See accompanying Notes to Unaudited Consolidated Financial Statements

4

Ambac Financial Group, Inc. and Subsidiaries

Consolidated Statements of Stockholders’ Equity

(Unaudited)

For The Nine Months Ended September 30, 2004 and 2003

(Dollars in Thousands)

	2004					2003
Retained Earnings:
Balance at January 1	$	3,380,098				$	2,820,281
Net income		535,780		$	535,780		460,163			460,163
Dividends declared - common stock		(37,315	)				(32,979	)
Exercise of stock options		(18,315	)				(11,823	)
Balance at September 30	$	3,860,248				$	3,235,642
Accumulated Other Comprehensive Income:
Balance at January 1	$	266,919				$	265,427
Unrealized gains on securities, $6,730 and $9,093, pre-tax in 2004 and 2003, respectively(1)					3,315					5,863
Gain on derivative hedges					14,439					(515	)
Foreign currency translation gain					519					718
Other comprehensive income		18,273			18,273		6,066			6,066
Comprehensive income				$	554,053				$	466,229
Balance at September 30	$	285,192				$	271,493
Preferred Stock:
Balance at January 1 and September 30	$	—				$	—
Common Stock:
Balance at January 1	$	1,073				$	1,062
Issuance of stock		15					7
Balance at September 30	$	1,088				$	1,069
Additional Paid-in Capital:
Balance at January 1	$	606,468				$	550,289
Employee benefit plans		30,696					18,168
Issuance of stock		38,735					16,161
Capital issuance costs		(3,488	)				(3,535	)
Balance at September 30	$	672,411				$	581,083
Common Stock Held in Treasury at Cost:
Balance at January 1	$	0				$	(11,880	)
Cost of shares acquired		(51,573	)				(25,183	)
Shares issued under equity plans		41,472					37,063
Balance at September 30	$	(10,101	)			$	0
Total Stockholders’ Equity at September 30	$	4,808,838				$	4,089,287
(1) Disclosure of reclassification amount:
Unrealized holding gains arising during period	$	22,283				$	34,024
Less: reclassification adjustment for net gains included in net income		18,968					28,161
Net unrealized gains on securities	$	3,315				$	5,863

See accompanying Notes to Unaudited Consolidated Financial Statements

5

Ambac Financial Group, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

For The Nine Months Ended September 30, 2004 and 2003

(Dollars in Thousands)

	Nine Months Ended September 30,
	2004			2003
Cash flows from operating activities:
Net income	$	535,780		$	460,163
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		2,230			2,366
Amortization of bond premium and discount		(3,199	)		15,013
Current income taxes		(9,259	)		(4,144	)
Deferred income taxes		8,404			547
Deferred acquisition costs		(18,890	)		(5,786	)
Unearned premiums, net		225,427			326,983
Loss and loss expenses		41,429			16,582
Ceded reinsurance balances payable		(11,058	)		(7,941	)
Investment income due and accrued		15,750			1,950
Accrued interest payable		(14,303	)		(16,705	)
Net realized investment gains		(27,554	)		(37,545	)
Net mark-to-market (gains) losses on credit derivative contracts and derivative hedge contracts		(10,014	)		4,266
Other, net		(32,374	)		39,907
Net cash provided by operating activities		702,369			795,656
Cash flows from investing activities:
Proceeds from sales of bonds		2,357,912			2,638,940
Proceeds from matured bonds		1,131,446			2,191,984
Proceeds from the sale of Cadre Financial Services, Inc.		3,676			—
Purchases of bonds		(3,775,037	)		(5,862,012	)
Change in short-term investments		73,677			230,909
Securities purchased under agreements to resell		(7,985	)		155,113
Loans		3,170			6,583
Other, net		4,822			(6,708	)
Net cash used in investing activities		(208,319	)		(645,191	)
Cash flows from financing activities:
Dividends paid		(37,315	)		(32,979	)
Securities sold under agreements to repurchase		(66,300	)		12,380
Proceeds from issuance of investment and payment agreements		1,182,043			1,369,298
Payments for investment and payment agreement draws		(1,615,492	)		(1,675,679	)
Proceeds from issuance of debentures		—			363,188
Payment for buyback of debentures		—			(200,000	)
Capital issuance costs		(3,488	)		(3,535	)
Issuance of common stock		38,751			16,167
Proceeds from sale of treasury stock		41,472			37,063
Purchases of treasury stock		(51,573	)		(25,183	)
Net cash collateral received		19,151			—
Net cash used in financing activities		(492,751	)		(139,280	)
Net cash flow		1,299			11,185
Cash at January 1		24,539			25,816
Cash at September 30	$	25,838		$	37,001
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Income taxes	$	126,170		$	127,756
Interest expense on debt	$	43,308		$	42,565
Interest expense on investment agreements	$	116,949		$	138,561

See accompanying Notes to Unaudited Consolidated Financial Statements

6

Ambac Financial Group, Inc. and Subsidiaries

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands)

(1) Background and 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’s principal operating subsidiary, Ambac Assurance Corporation, a leading provider of financial guarantees for public finance and structured finance obligations, has earned triple-A ratings, the highest ratings available from Moody’s Investors Service, Inc., Standard & Poor’s Ratings Services, Fitch Inc., and Ratings and Investment Information, Inc. These triple-A ratings are an essential part of Ambac Assurance’s ability to provide financial guarantees and compete in the marketplace. Ambac Assurance provides financial guarantees for bond issues and other forms of debt financing. Financial guarantee insurance is a promise to pay scheduled interest and principal if the issuer fails to meet its obligations. A bond guaranteed by Ambac receives triple-A ratings, typically resulting in lower financing costs for the issuer and generally makes the issue more marketable, both in the primary and secondary markets.

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 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, 2004 may not be indicative of the results that may be expected for the full year ending December 31, 2004. 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, 2003, which was filed with the Securities and Exchange Commission on March 15, 2004, (ii) Ambac’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2004, which was filed with the SEC on May 10, 2004, and (iii) Ambac’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2004, which was filed with the SEC on August 9, 2004.

The consolidated financial statements include the accounts of Ambac, its subsidiaries and a variable interest entity for which Ambac is the primary beneficiary. 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 guarantee products (including structured credit derivatives) for public finance, structured finance and other obligations; and (2) Financial Services, which provides investment agreements, interest rate swaps, total return and currency swaps and funding conduits, principally to clients of the financial guarantee business, which includes municipalities and other public entities, health care organizations and asset-backed issuers. 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.

7

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

Pursuant to insurance and indemnity agreements, Ambac Assurance guarantees the swap and investment agreement obligations of Ambac’s Financial Services subsidiaries. Intersegment revenues include the premiums earned under those agreements and dividends received. Such premiums are determined as if they were premiums to third parties, that is, at current market prices.

Information provided below for “Corporate and Other” relates to Ambac Financial Group, Inc. corporate activities, including interest expense on debentures. Corporate and other revenue from unaffiliated customers consists primarily of interest income. Intersegment revenues consist of dividends received.

The following table summarizes the financial information from continuing operations by reportable segment as of and for the three and nine month periods ended September 30, 2004 and 2003:

(Dollars in thousands) Three months ended September 30,	Financial Guarantee		Financial Services			Corporate And Other			Intersegment Eliminations			Consolidated
2004:
Revenues:
Unaffiliated customers	$	293,619	$	58,096		$	416		$	—		$	352,131
Intersegment		5,239		(1,557	)		25,891			(29,573	)		—
Total revenues	$	298,858	$	56,539		$	26,307		$	(29,573	)	$	352,131
Income before income taxes:
Unaffiliated customers	$	249,023	$	13,011		$	(15,984	)	$	—		$	246,050
Intersegment		6,631		(1,609	)		25,164			(30,186	)		—
Total income before income taxes	$	255,654	$	11,402		$	9,180		$	(30,186	)	$	246,050
Identifiable assets	$	8,877,144	$	8,024,950		$	90,323		$	—		$	16,992,417
2003:
Revenues:
Unaffiliated customers	$	256,385	$	63,328		$	1,977		$	—		$	321,690
Intersegment		8,411		(1,588	)		22,400			(29,223	)		—
Total revenues	$	264,796	$	61,740		$	24,377		$	(29,223	)	$	321,690
Income before income taxes:
Unaffiliated customers	$	216,690	$	14,088		$	(13,711	)	$	—		$	217,067
Intersegment		9,023		(1,144	)		21,974			(29,853	)		—
Total income before income taxes	$	225,713	$	12,944		$	8,263		$	(29,853	)	$	217,067
Identifiable assets	$	7,829,038	$	8,315,561		$	199,836		$	—		$	16,344,435

8

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

(Dollars in thousands) Nine months ended September 30,	Financial Guarantee		Financial Services			Corporate And Other			Intersegment Eliminations			Consolidated
2004:
Revenues:
Unaffiliated customers	$	863,096	$	177,251		$	1,190		$	—		$	1,041,537
Intersegment		16,555		(4,272	)		81,067			(93,350	)		—
Total revenues	$	879,651	$	172,979		$	82,257		$	(93,350	)	$	1,041,537
Income before income taxes:
Unaffiliated customers	$	726,995	$	41,720		$	(47,086	)	$	—		$	721,629
Intersegment		20,731		(4,428	)		79,168			(95,471	)		—
Total income before income taxes	$	747,726	$	37,292		$	32,082		$	(95,471	)	$	721,629
Identifiable assets	$	8,877,144	$	8,024,950		$	90,323		$	—		$	16,992,417
2003:
Revenues:
Unaffiliated customers	$	749,576	$	179,480		$	5,016		$	—		$	934,072
Intersegment		11,399		(4,241	)		67,200			(74,358	)		—
Total revenues	$	760,975	$	175,239		$	72,216		$	(74,358	)	$	934,072
Income before income taxes:
Unaffiliated customers	$	646,002	$	21,134		$	(48,163	)	$	—		$	618,973
Intersegment		13,032		(2,891	)		65,922			(76,063	)		—
Total income before income taxes	$	659,034	$	18,243		$	17,759		$	(76,063	)	$	618,973
Identifiable assets	$	7,829,038	$	8,315,561		$	199,836		$	—		$	16,344,435

The following table summarizes unaffiliated gross premiums written and net premiums earned and other credit enhancement fees included in the financial guarantee segment by location of risk for the three and nine months ended September 30, 2004 and 2003:

	Three Months				Nine Months
(Dollars in thousands)	Gross Premiums Written		Net Premiums Earned and Other Credit Enhancement Fees		Gross Premiums Written		Net Premiums Earned and Other Credit Enhancement Fees
2004:
United States	$	162,718	$	144,694	$	643,015	$	416,973
United Kingdom		17,338		15,141		70,713		45,493
Japan		8,077		8,179		21,592		23,389
Italy		1,371		1,968		8,991		5,844
Mexico		3,695		1,697		11,427		5,245
Australia		2,927		1,665		3,850		5,199
Germany		500		1,453		1,600		4,635
Internationally diversified(1)		6,801		13,189		20,636		41,723
Other international		7,160		7,352		18,393		25,110
Total	$	210,587	$	195,338	$	800,217	$	573,611
2003:
United States	$	244,069	$	129,372	$	684,426	$	358,694
United Kingdom		13,637		9,548		92,281		23,825
Japan		6,112		6,817		19,280		19,118
Italy		1,281		1,847		10,316		4,650
Mexico		4,361		1,997		12,330		5,758
Australia		196		1,377		4,543		4,089
Germany		432		1,527		1,254		4,406
Internationally diversified(1)		5,884		13,679		21,896		42,954
Other international		4,358		5,398		17,228		17,470
Total	$	280,330	$	171,562	$	863,554	$	480,964

1) Internationally diversified includes guarantees with multiple locations of risk and includes components of United States exposure.

9

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

(3) Stock Options

Ambac sponsors the “1997 Equity Plan”, where awards are granted to eligible employees of Ambac in the form of non-qualified stock options and other stock-based awards. Prior to 2003, Ambac accounted for such awards under the recognition and measurement provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees”. Effective January 1, 2003, Ambac adopted the fair value recognition provisions of SFAS Statement No. 123, “Accounting for Stock-Based Compensation”, prospectively to all employee awards granted after January 1, 2003. The following table illustrates the effect on net income and earnings per share if the fair value based method had been applied to all outstanding and unvested awards in each period:

	Three Months Ended September 30,						Nine Months Ended September 30,
(Dollars in thousands, except per share information)	2004			2003			2004			2003
Net income, as reported	$	183,459		$	159,669		$	535,780		$	460,163
Add: Stock-based employee compensation included in reported net income, net of tax		1,076			1,280			3,320			2,902
Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards, net of tax		(2,941	)		(4,031	)		(8,916	)		(11,156	)
Pro-forma net income	$	181,594		$	156,918		$	530,184		$	451,909
Earnings per share:
As reported	$	1.69		$	1.50		$	4.95		$	4.32
Pro-forma	$	1.67		$	1.47		$	4.90		$	4.25
Earnings per diluted share:
As reported	$	1.65		$	1.45		$	4.84		$	4.21
Pro-forma	$	1.63		$	1.43		$	4.79		$	4.14

10

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

(4) Special Purpose and Variable Interest Entities

In January 2003, the Financial Accounting Standards Board (“FASB”) released FASB Interpretation No. 46 “Consolidation of Variable Interest Entities” (“FIN 46”). In December 2003, the FASB released a revision of FIN 46 (“FIN 46-R”), which includes substantial changes from the original FIN 46. Ambac adopted FIN 46-R as of December 31, 2003. FIN 46 and FIN 46-R provides accounting and disclosure rules for determining whether certain entities should be consolidated in Ambac’s consolidated financial statements. An entity is subject to FIN 46 and FIN 46-R, and is called a Variable Interest Entity (“VIE”), if it has (i) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support or (ii) equity investors that cannot make significant decisions about the entity’s operations or that do not absorb the majority of expected losses or receive the majority of expected residual returns of the entity. A VIE is consolidated by its primary beneficiary, which is the party that has a majority of the expected losses or a majority of the expected residual returns of the VIE or both. FIN 46 requires disclosures for companies that have either a primary or significant variable interest in a VIE. All other entities not considered VIEs are evaluated for consolidation under SFAS No. 94, “Consolidation of all Majority-Owned Subsidiaries”.

Ambac has involvement with special purpose entities, including VIEs in two ways. First, Ambac is a provider of financial guarantee insurance for various securitized asset-backed debt obligations, including mortgage-backed security obligations, collateralized debt obligations (“CDO”) and other asset-backed securitization obligations. Second, Ambac has sponsored two special purpose entities that issue medium-term notes (“MTNs”) to fund the purchase of certain financial assets. As discussed in detail below, these Ambac sponsored special purpose entities are considered Qualifying Special Purpose Entities (“QSPEs”).

Financial Guarantees:

Ambac provides financial guarantee insurance to securitized asset-backed debt obligations of special purpose entities, including VIEs. Ambac’s primary variable interest exists through this financial guarantee insurance contract. The transaction structure provides certain financial protection to Ambac. This financial protection can take several forms, however, the most common are over-collateralization, first loss retention and excess spread. In the case of over-collateralization (i.e., the principal amount of the securitized assets exceeds the principal amount of the structured finance obligations guaranteed by Ambac Assurance), the structure allows the transaction to experience defaults among the securitized assets before a default is experienced on the structured finance obligations that have been guaranteed by Ambac. In the case of first loss retention, the financial guarantee insurance policy only covers a senior layer of losses on debt issued by special purpose entities, including VIEs. The first loss with respect to the assets is either retained by the seller or sold off in the form of equity or mezzanine debt to other investors. In the case of excess spread, the financial assets contributed to special purpose entities, including VIEs, generate interest cash flows that are in excess of the interest payments on the related debt. All or a portion of this excess spread accumulates and is available to absorb losses in the transaction or is applied to create over-collateralization.

Ambac is the primary beneficiary of one VIE with assets and liabilities of $134,546 at September 30, 2004 and $189,482 at December 31, 2003. Ambac consolidated this entity since the structural financial protections are outside the VIE. This VIE is a bankruptcy remote special purpose financing entity created to facilitate the sale of floating rate notes. This VIE was capitalized in 2002 through the issuance of $299,600 of floating rate notes, guaranteed by Ambac Assurance. The proceeds of the VIE note issuance were used to purchase senior mortgage-

11

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

backed floating rate notes of a Korean mortgage-backed securities issuer. Ambac’s creditors do not have rights with regard to the assets of the VIE. Protections afforded Ambac Assurance in this transaction were in the form of a reserve fund and first loss protection through subordinated debt issued of approximately $40,000. Ambac Assurance will pay claims under its financial guarantee only in the event that losses on the mortgage assets of the Korean issuer reduce the reserve fund to zero and exceed the principal amount of the subordinated notes.

The following table provides supplemental information about assets and liabilities associated with this entity. The assets and liabilities of the VIE are consolidated into the respective Balance Sheet caption.

	At September 30, 2004		At December 31, 2003
Assets:
Cash	$	220	$	90
Investment in fixed income securities		134,098		189,151
Investment income due and accrued		228		241
Total	$	134,546	$	189,482
Liabilities:
Variable interest entity floating rate notes	$	134,098	$	189,151
Accrued interest payable		191		294
Other liabilities		257		37
Total	$	134,546	$	189,482

Qualified Special Purpose Entities:

Ambac has transferred financial assets to two special purpose entities. The business purpose of these entities is to provide certain financial guarantee clients with funding for their debt obligations. These entities meet the characteristics of QSPEs in accordance with Statement of Financial Accounting Standards 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”). QSPEs are not subject to the requirements of FIN 46-R and accordingly are not consolidated in Ambac’s financial statements. However, see the discussion below on the Exposure Draft issued by the FASB that could change the accounting rules for QSPEs in the future. The QSPEs are legal entities that are demonstrably distinct from Ambac. Ambac, its affiliates or its agents cannot unilaterally dissolve the QSPEs. The QSPEs permitted activities are limited to those outlined below.

As of September 30, 2004, there have been 14 individual transactions (1 in 2004) processed through the QSPEs of which 10 are outstanding. In each case, Ambac sells fixed income debt obligations to the QSPEs. These transactions are true sales based upon the bankruptcy remote nature of the QSPE and the absence of any agreement or obligation for Ambac to repurchase or redeem assets of the QSPE. The purchase by the QSPE is financed through the issuance of MTNs, which are collateralized by the purchased assets. The cash flows of the MTNs approximately match the cash flows of the assets purchased. Derivative contracts (interest rate and currency swaps) may be used for hedging purposes only. Derivative hedges are established at the time MTNs are issued to purchase financial assets. The activities of the QSPEs are contractually limited to purchasing assets from Ambac, issuing MTNs to fund such purchase, executing derivative hedges and related administrative services. Ambac Assurance may issue a financial guarantee insurance policy on the assets sold, the MTNs issued or both. As of September 30, 2004, Ambac Assurance had financial guarantee insurance policies issued for all assets and MTNs owned and outstanding by the QSPEs.

Ambac’s exposures under these financial guarantee insurance policies as of December 31, 2003 is included in the disclosure in Note 12 “Guarantees in Force” of Ambac’s 2003 Annual Report. Pursuant to the terms of Ambac Assurance’s insurance policy, insurance

12

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

premiums are paid to Ambac Assurance by the QSPEs and are earned in a manner consistent with other insurance policies, over the risk period. Any losses incurred would be included in Ambac’s Consolidated Statements of Operations. Under the terms of an Administrative Agency Agreement, Ambac provides certain administrative duties, primarily collecting amounts due on the obligations and making interest payments on the MTNs.

Assets sold to the QSPEs during the nine months ended September 30, 2004 and the year ended December 31, 2003 were $195,000 and $250,000, respectively. No gains or losses were recognized on these sales. As of September 30, 2004, the estimated fair value of financial assets, MTN liabilities and derivative hedge liabilities were $1,882,938, $1,773,175 and $97,618, respectively. When market quotes are not available, estimated fair value is determined utilizing valuation models. These models include estimates, made by Ambac management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Ambac Assurance received gross premiums for issuing financial guarantee policies on the assets, MTNs and derivative contracts of $4,480 and $5,278 for the nine months ended September 30, 2004 and the year ended December 31, 2003, respectively. Ambac also received fees for providing other services amounting to $288 and $461 for the nine months ended September 30, 2004 and the year ended December 31, 2003, respectively.

In June 2003, the FASB issued an Exposure Draft for proposed Statement of Financial Accounting Standards entitled “Qualifying Special-Purposes Entities and Isolation of Transferred Assets”, an amendment of FASB Statement No. 140 (“The Exposure Draft”). The Exposure Draft is a proposal that is subject to change and as such, is not yet authoritative. If the proposal is enacted in its current form, it will amend and clarify SFAS 140. The Exposure Draft would prohibit an entity from being a QSPE if it enters into an agreement that obligates a transferor of financial assets, its affiliates, or its agents to deliver additional cash or other assets to fulfill the SPE’s obligations to beneficial interest holders. If this Exposure Draft becomes enacted as currently proposed and if the QSPEs issue new beneficial interests after the effective date and receive assets other than those they are committed to receive under commitments to beneficial interest holders made before the effective date of the final statement, management believes Ambac would be required to consolidate. This conclusion is based upon the fact that Ambac provides financial support to these entities such as financial guarantees and liquidity commitments. Should Ambac be required to consolidate under this Exposure Draft if enacted as proposed, the financial statement impact would be to gross up Ambac’s consolidated balance sheet for the assets and liabilities held by the QSPEs that approximate $1,800,000 at September 30, 2004. Additionally, fees received by Ambac from the QSPEs (primarily insurance premiums) would be eliminated in consolidation and essentially reclassified to net interest income. The risk characteristics of these transactions are not impacted by consolidation.

(5) Pension and Postretirement Benefits

Pensions:

Ambac has a defined benefit pension plan covering substantially all employees of Ambac. The benefits are based on years of service and the employee’s highest salary during five consecutive years of employment within the last ten years of employment. Ambac’s funding policy is to contribute annually the maximum amount that can be deducted for Federal income tax purposes. A contribution in the third quarter of 2004 was made in the amount of $2,300. Contributions are intended to provide not only for benefits attributed to service-to-date, but also for those expected to be earned in the future.

13

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

Net periodic pension costs for the three and nine months ended September 30 include the following components:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
Service cost	$	408		$	413		$	1,225		$	1,240
Interest cost		331			288			994			863
Expected return on plan assets		(487	)		(416	)		(1,462	)		(1,248	)
Amortization of prior service cost		(36	)		(32	)		(108	)		(98	)
Recognized net loss		51			9			153			28
Net periodic pension cost		267			262			802			785
Other		—			—			136			—
Total pension expense	$	267		$	262		$	938		$	785

Postretirement and Other Benefits:

Ambac provides certain medical and life insurance benefits for retired employees and eligible dependents. All plans are contributory. None of the plans are currently funded. Post retirement benefit expense was $25 and $155 for the three and nine months ended September 30, 2004, respectively, compared to $33 and $112 for the three and nine months ended September 30, 2003, respectively.

(6) Stockholders’ Equity

Ambac is authorized to issue 350,000,000 shares of Common Stock, par value $0.01 per share, of which 108,788,873 were issued as of September 30, 2004. Ambac is also authorized to issue 4,000,000 shares of Preferred Stock, $0.01 par value per share, none of which was issued and outstanding as of September 30, 2004.

(7) Accounting Standards

Postretirement Benefits

In May 2004, the FASB issued FASB Staff Position FAS 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (“FSP FAS 106-2”), which superceded FSP FAS 106-1, in response to the December 2003 enactment of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“the Act”). The Act introduces a prescription drug benefit for individuals under Medicare (Medicare Part D) as well as a federal subsidy equal to 28% of prescription drug claims for sponsors of retiree health care plans with drug benefits that are at least actuarially equivalent to those to be offered under Medicare Part D. If a plan is determined to be actuarially equivalent to Medicare Part D, FSP FAS 106-2 requires plan sponsors to disclose the effect of the subsidy on the net periodic expense and the accumulated postretirement benefit obligation in their interim and annual financial statements for periods beginning after June 15, 2004. Plan sponsors who initially elected to defer accounting for the effects of the subsidy are allowed the option of retroactive application to the date of enactment or prospective application from the date of adoption. Under FSP FAS 106-1, Ambac elected to defer the accounting for the effects of the Act. However, Ambac believes that our plans are eligible for the subsidy and decided to adopt FSP FAS 106-2 in the third quarter of 2004 retroactive to January 1, 2004. The adoption of FSP FAS 106-2 did not have a material effect on Ambac’s operating results.

14

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

Other-Than-Temporary Impairments of Certain Investments

On March 31, 2004, the FASB ratified EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” (EITF 03-1) which provides guidance on recognizing other-than-temporary impairments on certain investments. The Issue is effective for other-than-temporary impairment evaluations for investments accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” On September 30, 2004, the FASB voted unanimously to delay the effective date of certain provisions in EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments”. The delay applies to both debt and equity securities and specifically applies to impairments caused by changes in interest rate and credit spreads. In addition, the provisions of EITF 03-1 that have been delayed relate to the requirements that a company declare its intent to hold the security to recovery and designate a recovery period in order to avoid recognizing an other-than-temporary impairment charge through earnings. The FASB will be issuing implementation guidance related to this topic. Once issued, Ambac will evaluate the impact of adopting EITF 03-1.

15

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

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 Financial Group provides financial guarantees for public finance and structured finance obligations through its principal operating subsidiary, Ambac Assurance Corporation. Through its financial services subsidiaries, Ambac Financial Group provides financial and investment products including investment agreements, interest rate, currency and total return swaps and funding conduits, principally to its clients which include municipalities and other public entities, health care organizations and asset-backed issuers. Additional information about Ambac Financial Group is available through our website athttp://www.ambac.com. In addition, our press releases and filings with the Securities and Exchange Commission (“SEC”) are available free of charge on the investor relations portion of our website.

Ambac Assurance, which serves the global capital markets, is primarily engaged in guaranteeing public finance and structured finance debt obligations and is the successor to the founding financial guarantee insurance company, which wrote the first bond insurance policy in 1971. Financial guarantee insurance policies written by Ambac Assurance generally guarantee payment when due of the principal of and interest on the guaranteed obligation. Ambac Assurance seeks to minimize the risk inherent in its financial guarantee portfolio by maintaining a diverse portfolio which spreads its risk across a number of criteria, including issue size, type of obligation, geographic area and obligor.

Ambac Assurance has earned triple-A ratings, the highest ratings available from Moody’s Investors Service, Inc. (“Moody’s”), Standard & Poor’s Ratings Services (“S&P”), Fitch, Inc. (“Fitch”) and Rating and Investment Information, Inc. (“R&I”). These ratings are an essential part of Ambac Assurance’s ability to provide credit enhancement and compete effectively in the marketplace.

Ambac Credit Products LLC, a wholly owned subsidiary of Ambac Assurance, provides credit protection in the global markets in the form of structured credit derivatives. These structured credit derivatives, which are privately negotiated contracts, provide the counterparty with credit protection against the occurrence of a specific event such as a payment default or bankruptcy relating to an underlying obligation (generally a fixed income obligation). Upon a credit event, Ambac Credit Products is required to either (i) purchase the underlying obligation at its par value and a realize a loss for the difference between the par and market value of the underlying obligation or (ii), make a payment equivalent to the difference between the par value and market value of the underlying obligation. Substantially all of Ambac’s structured credit derivative contracts are structured with first loss protection. Structured credit derivatives issued by Ambac Credit Products are guaranteed by Ambac Assurance.

In addition to the guarantees on fixed income obligations described above, Ambac, from time to time, enters into transactions that expose the company to risks which may not be correlated to credit risk, for example weather-related or other disasters, mortality or other property and casualty type risk characteristics. Ambac underwrites such risks so that first loss must occur before Ambac would become liable in respect of such risks. Additionally, Ambac underwrites such business primarily in relation to broad indices and reference pools which embody diverse risk characteristics.

16

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Ambac Financial Group’s investment agreement business, conducted through its subsidiary, Ambac Capital Funding, Inc., provides investment agreements primarily to municipalities and their authorities, issuers of structured finance obligations and international issuers. Investment agreements are primarily used by issuers to invest bond proceeds until the proceeds can be used for their intended purpose. The investment agreement provides for the guaranteed return of principal invested, and for the payment of interest thereon at a guaranteed rate.

Ambac Financial Group provides interest rate and currency swaps through its subsidiary Ambac Financial Services, LLC, primarily to states, municipalities and their authorities, issuers of asset-backed securities and other entities in connection with their financings. Ambac Financial Group also enters into total return swaps with professional counterparties through its subsidiary Ambac Capital Services LLC. Total return swaps are only used for fixed income obligations which meet Ambac Assurance’s credit underwriting criteria.

Critical Accounting Policies

Management has identified the accounting for loss and loss expenses and the valuation of financial instruments as critical accounting policies.

The liability for loss and loss expenses consists of active credit reserves and case basis credit reserves. Active credit reserves are established based upon estimated probable debt service defaults resulting from losses, as a result of credit deterioration. Reserve amounts are reasonably estimated based on management’s review of the financial guarantee portfolio. When defaults occur, case basis credit 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. These reserves are discounted in accordance with discount rates prescribed or permitted by state regulatory authorities. All or parts of case basis credit loss reserves are allocated from any active credit reserves available. Management believes that the reserves for loss and loss 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 sheets at fair value: fixed income investment securities, derivatives used for hedging purposes, derivatives held for trading purposes and certain hedged investment agreements. 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 or internal 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.

17

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Forward-Looking Statements

Materials in this Form 10-Q may contain information that includes or is based upon forward-looking statements within the meaning of the Private 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.

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, 2004 and 2003, and its financial condition as of September 30, 2004 and December 31, 2003. These results are presented for Ambac’s two reportable segments: Financial Guarantee and Financial Services.

Income From Continuing Operations

Ambac’s income from continuing operations for the three months ended September 30, 2004 was $184.4 million or $1.66 per diluted share, an increase of $24.3 million, compared to $160.1 million or $1.45 per diluted share in the three months ended September 30, 2003. Ambac’s income before income taxes was $246.0 million for the three months ended September 30, 2004, an increase of 13% from income before income taxes of $217.1 million in the three months ended September 30, 2003. Of the $246.0 million of income before income taxes in the third quarter of 2004, $249.0 million was from Financial Guarantee, $13.0 million from Financial Services and $(16.0) million from Corporate, compared to $216.7 million, $14.1 million and $(13.7) million for Financial Guarantee, Financial Services and Corporate, respectively in the third quarter of 2003.

Ambac’s income from continuing operations for the nine months ended September 30, 2004 was $537.1 million or $4.85 per diluted share, an increase of $76.2 million, compared to $460.9 million or $4.22 per diluted share in the nine months ended September 30, 2003. Ambac’s income before income taxes was $721.6 million for the nine months ended September 30, 2004, an increase of 17% from income before income taxes of $619.0 million in the nine months ended September 30, 2003. Of the $721.6 million of income before income taxes in the first nine months of 2004, $727.0 million was from Financial Guarantee, $41.7 million from Financial Services and $(47.1) million from Corporate, compared to $646.0 million, $21.2 million and $(48.2) million for Financial Guarantee, Financial Services and Corporate, respectively in the first nine months of 2003.

18

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Corporate consists primarily of Ambac’s interest expense and other expenses, partially offset by investment income. Financial Guarantee income before income taxes for the three months ended September 30, 2004 increased primarily as a result of (i) higher net premiums earned, (ii) higher net investment income, and (iii) lower net mark-to-market losses on credit derivative contracts, partially offset by (i) a higher provision for loss and loss expenses, and (ii) higher underwriting and operating expenses. The Financial Services decrease in the third quarter of 2004 is primarily attributable to lower derivative product revenues, partially offset by higher investment agreement business revenues. Financial Guarantee income before income taxes for the first nine months of 2004 increased primarily as a result of (i) higher net premiums earned, (ii) higher net investment income, and (iii) higher net mark-to-market gains on credit derivative contracts, partially offset by (i) lower net realized investment gains, (ii) increased other loss, (iii) a higher provision for loss and loss expenses, and (iv) higher underwriting and operating expenses. The Financial Services increase in the first nine months of 2004 is primarily attributable to significantly higher derivative product and investment agreement business revenues.

Included in the nine months income from continuing operations in the Financial Guarantee segment, is the impact of cancellations of certain reinsurance contracts with two reinsurers that had been downgraded by the rating agencies in 2003. Included in the nine months ended September 30, 2004 ceded premiums written in the Consolidated Statement of Operations is $64.8 million in returned premiums from the cancellation, of which approximately $54.4 million was deferred. The difference, $10.4 million included in net earned premiums, results from the difference between the negotiated amount of returned premiums and the associated unearned premium remaining on the underlying guarantees. In addition to the $10.4 million in earned premiums, expenses were increased by approximately $3.5 million of reinsurance commissions. The net impact of this cancellation to the Consolidated Statements of Operations in 2004 amounted to approximately $7.0 million, $4.5 million after-tax, or $0.04 per diluted share.

Net Loss From Discontinued Operations

As previously disclosed, Ambac had entered into an agreement during the fourth quarter of 2003 to sell the operations of Cadre Financial Services, Inc. and Ambac Securities, Inc., its former investment advisory and cash management business. The transaction closed during the first quarter of 2004, with proceeds of $3.7 million in cash and $4.7 million in a note. This business had been part of the Financial Services segment. The net loss from discontinued operations for the three and nine months ended September 30, 2004 were $1.0 million and $1.3 million, respectively, compared to $0.4 million and $0.7 million for the three and nine months ended September 30, 2003. The primary reason for this loss was a purchase price adjustment due to lower than anticipated revenues.

Financial Guarantee

Ambac provides financial guarantees for 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.

19

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Ambac Assurance guaranteed $29.3 billion in par value bonds during the three months ended September 30, 2004, an increase of 31% from $22.4 billion in par value bonds guaranteed during the comparable prior year period. During the nine months ended September 30, 2004, Ambac Assurance guaranteed $82.9 billion in par value bonds, a 3% decrease from $85.8 billion in par during the first nine months of 2003.

The following table provides a breakdown of guaranteed net par outstanding by market sector at September 30, 2004 and December 31, 2003:

(Dollars in billions)	September 30, 2004		December 31, 2003
Public Finance	$	232.0	$	215.3
Structured Finance		130.4		124.1
International Finance		80.4		86.4
Total net par outstanding(1)	$	442.8	$	425.8

(1) $8.5 billion of the net par outstanding increase in 2004 was a result of the reinsurance cancellation noted above.

The following table provides a rating distribution of financial guarantee net par based upon internal Ambac Assurance credit ratings at September 30, 2004 and December 31, 2003:

	Percentage of Guaranteed Portfolio(1)
	September 30, 2004	December 31, 2003
AAA	8	10
AA	22	22
A	47	47
BBB	22	20
Below investment grade	1	1
Total	100	100

(1) Internal Ambac Assurance credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac and may differ from ratings determined by the ratings agencies. They are subject to revision at any time and do not constitute investment advice. Ambac Assurance, or one of its affiliates, has insured the obligations listed and may also provide other products or services to the issuers of these obligations for which Ambac may have received premiums or fees.

Public 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, health care and other general purpose projects. Included in transportation obligations is exposure to U.S. airports. Airport obligations are generally supported by (i) terminal lease revenues, parking and other concession revenues; (ii) passenger facility charges; or (iii) payments in respect of specific airport facilities. Although Ambac guarantees the full range of Public Finance obligations, Ambac concentrates on those projects that require more structuring skills. Certain projects, which had been financed by the local or U.S. government alone, are now being financed through public-private partnerships. In these transactions, debt service on the bonds, rather than being paid solely by tax revenues or other governmental funds, is being paid from a variety of revenue sources, including revenues derived from the project itself. Examples of these transactions include stadium financings, student housing and military housing.

20

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Public Finance bond obligations par value written for the third quarter of 2004 was $9.0 billion, compared to $11.3 billion of par value written for the third quarter of 2003. During the nine months ended September 30, 2004, par value written was $31.0 billion, compared to $31.8 billion in the nine months ended September 30, 2003. Although Ambac’s market share based upon par insured for the three and nine months ended September 30, 2004 is up approximately 2% and 3%, respectively, from the three and nine months ended September 30, 2003 and insured market penetration was up (58% and 55% for the three and nine months ended September 30, 2004 compared to 54% and 53% for the three and nine months ended September 30, 2003), fewer of the large, structured municipal transactions came to market during the third quarter of 2004, resulting in a decrease in guaranteed Public Finance obligations during these time periods.

Structured Finance:

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”). Included within Structured Finance are exposures to Enhanced Equipment Trust Certificates which are secured financings used by the airline industry to finance aircraft. The financings are tranched to create a priority of interests in the aircraft collateral. Ambac issues a financial guarantee on the most senior tranche of the structures. Currently, the largest component of Ambac’s Structured Finance business relates to the securitization of mortgages and home equity loans. Another component in Structured Finance is the credit enhancement of pooled debt obligations including structured credit derivatives. These transactions involve the securitization of a diverse portfolio of corporate bonds and loan obligations and asset-backed securities (the “Securitized Assets”). Ambac’s exposure to these Securitized Assets is mitigated through first loss protection. Typically, first loss protection is in the form of over-collateralization (i.e., the principal amount of the Securitized Assets exceeds the principal amount of the structured finance obligations guaranteed by Ambac Assurance), or excess spread (i.e., interest cash flows on the Securitized Assets is in excess of the interest on the debt obligations guaranteed by Ambac Assurance), which allows the transaction to experience defaults among the Securitized Assets before a default is experienced on the structured finance obligations.

Structured Finance bond obligations par value written for the third quarter of 2004 was $18.4 billion, compared to $9.4 billion of par value written for the third quarter of 2003. During the nine months ended September 30, 2004, par value written was $38.0 billion, compared to $40.1 billion in the nine months ended September 30, 2003. The increase in Structured Finance obligations guaranteed for the three months ended September 30, 2004 as compared to the three months ended September 30, 2003 resulted primarily from higher par written in the consumer asset-backed sector of the market. This helped to offset the significantly lower par written in the mortgage-backed sector during the first half of 2004.

International Finance:

International finance obligations include public purpose infrastructure projects and asset-backed securities originated outside 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

21

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

government has been privatizing certain infrastructure finance activities. Ambac also participates in less developed 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.

International Finance bond obligations par value written for the third quarter of 2004 was $1.9 billion, compared to $1.7 billion of par value written for the third quarter of 2003. During the nine months ended September 30, 2004, par value written was $13.9 billion, flat compared to the nine months ended September 30, 2003. International Finance obligations guaranteed during the three months ended September 30, 2004 increased from its comparable 2003 period primarily due to strong writings in the utilities sector. International Finance obligations guaranteed during the nine months ended September 30, 2004 is relatively flat as compared with the nine months ended September 30, 2003 where decreases in pooled debt obligations and transportation revenue obligations were partially offset by higher asset-backed, mortgage-backed and utility obligations guaranteed.

Gross Premiums Written. Ambac receives insurance premiums either upfront at policy issuance or on an installment basis over the life of the transaction. The collection method is determined at the time of policy issuance. Gross premiums written for the three and nine months ended September 30, 2004 were $210.6 million and $800.2 million, respectively, a decrease of $69.7 million or 25% from 280.3 million in the three months ended September 30, 2003 and a decrease of $63.4 million or 7% from $863.6 million in the nine months ended September 30, 2003. Up-front premiums written during the three and nine months ended September 30, 2004 were $93.7 million and $449.2 million, respectively, a decrease of 49% from $183.4 million in the three months ended September 30, 2003 and a decrease of 21% from $568.5 million in the nine months ended September 30, 2003. The decreases in up-front gross premiums written in the third quarter of 2004 compared to the third quarter of 2003 was primarily a result of decreased up-front premiums written in both the Public and Structured Finance sectors, partially offset by slightly higher up-front gross premiums written in the International Finance sector. Up-front gross premiums written for the nine months ended September 30, 2004 decreased in all market sectors for the nine months ended September 30, 2004 compared to the prior year period.

Installment premiums written for the three and nine months ended September 30, 2004 were $116.9 million and $351.0 million, respectively, an increase of 21% from $96.9 million in the three months ended September 30, 2003, and an increase of 19% from $295.1 million in the nine months ended September 30, 2003.

22

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

The following tables set forth the amounts of gross premiums written and the related gross par written by type:

	Three Months Ended September 30,
	2004				2003
(Dollars in Millions)	Gross Premiums Written		Gross Par Written		Gross Premiums Written		Gross Par Written
Public Finance:
Up-front	$	87.8		8,578	$	146.0	$	10,956
Installment		5.3		414		2.6		314
Total Public Finance		93.1		8,992		148.6		11,270
Structured Finance:
Up-front		2.1		153		34.4		3,280
Installment		67.5		18,249		61.0		6,098
Total Structured Finance		69.6		18,402		95.4		9,378
International Finance:
Up-front		3.8		266		3.0		478
Installment		44.1		1,634		33.3		1,247
Total International Finance		47.9		1,900		36.3		1,725
Total	$	210.6	$	29,294	$	280.3	$	22,373
Total up-front	$	93.7	$	8,997	$	183.4	$	14,714
Total installment		116.9		20,297		96.9		7,659
Total	$	210.6	$	29,294	$	280.3	$	22,373

	Nine Months Ended September 30,
	2004				2003
(Dollars in Millions)	Gross Premiums Written		Gross Par Written		Gross Premiums Written		Gross Par Written
Public Finance:
Up-front	$	414.1	$	30,397	$	428.4	$	31,266
Installment		17.7		603		10.6		525
Total Public Finance		431.8		31,000		439.0		31,791
Structured Finance:
Up-front		17.1		1,257		67.6		5,172
Installment		194.1		36,734		177.9		34,953
Total Structured Finance		211.2		37,991		245.5		40,125
International Finance:
Up-front		18.0		2,338		72.5		2,305
Installment		139.2		11,537		106.6		11,576
Total International Finance		157.2		13,875		179.1		13,881
Total	$	800.2	$	82,866	$	863.6	$	85,797
Total up-front	$	449.2	$	33,992	$	568.5	$	38,743
Total installment		351.0		48,874		295.1		47,054
Total	$	800.2	$	82,866	$	863.6	$	85,797

Reinsurance. Ambac’s reinsurance program is principally comprised of a surplus share treaty and facultative reinsurance. The surplus share treaty requires Ambac to cede covered transactions while retaining flexibility to cede those transactions within a predefined range. Certain types of transactions are excluded from the surplus share treaty and management may use facultative reinsurance to cede such risks. Ceded premiums written for the three and nine months ended September 30, 2004 were $18.6 million and $36.6 million, respectively, an increase of 6.3% from $17.5 million in the three months ended September 30, 2003 and a decrease of 59.7% from $90.9 million in the nine months ended September 30, 2003.

23

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

In the second quarter of 2004, Ambac completed the cancellation of certain reinsurance contracts with two reinsurers, AXA Re Finance S.A. and American Re-Insurance Company, both of which had been downgraded by the rating agencies in 2003. The net par that was recaptured totaled approximately $8.5 billion. Included in ceded premiums written for the nine months ended September 30, 2004 is $64.8 million in return premiums from the cancellations. Ceded premiums as a percentage of gross premiums written (excluding the return premiums mentioned) were 9% and 13% for the three and nine months ended September 30, 2004, respectively, compared with 6% and 11% for the three and nine months ended September 30, 2003, respectively. The increase in ceded premiums as a percentage of gross premiums resulted from higher cessions of Public Finance transactions in 2004.

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 nonetheless, be liable to its policyholders in the full amount of its policy. To minimize exposure to significant losses from reinsurers, Ambac (i) monitors the financial condition of its reinsurers; (ii) has collateral provisions in certain reinsurance contracts; and (iii) has certain termination triggers that can be exercised by Ambac in the event of a rating downgrade of a reinsurer. Ambac held letters of credit and collateral at September 30, 2004 amounting to approximately $150.4 million from its reinsurers. The following table provides ceded par outstanding by financial strength rating of Ambac’s reinsurers, on a Standard and Poor’s (“S&P) basis:

(Dollars in billions)	September 30, 2004		December 31, 2003
AAA	$	19.4	$	19.3
AA		17.8		15.9
A		2.7		7.7
Not rated		2.2		6.7
Total	$	42.1	$	49.6

Net Premiums Earned and Other Credit Enhancement Fees. Net premiums earned and other credit enhancement fees for the three and nine months ended September 30, 2004 were $195.3 million and $573.6 million, an increase of 14% from $171.6 million for the three months ended September 30, 2003 and an increase of 19% from $481.0 million for the nine months ended September 30, 2003. These increases were primarily the result of the larger Financial Guarantee book of business for the three and nine months ended September 30, 2004, as well as higher refundings, calls and other accelerations of previously insured obligations (collectively referred to as “accelerated earnings”) for the nine months ended September 30, 2004.

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. The level of refundings or calls vary depending upon a number of conditions, primarily the relationship between current interest rates and interest rates on outstanding debt. The current relatively low interest rate environment continues to prompt the high levels of refundings. When interest rates further rise in the future, refundings should decline. Net premiums earned during the three and nine months ended September 30, 2004 included $21.0 million and $69.2 million, respectively, from accelerated earnings as compared to $20.8 million and $54.0 million for the three and nine months ended September 30, 2003, respectively. Included in the nine months ended September 30, 2004 accelerated earnings amount was approximately $10.4 million from the cancellation of certain reinsurance contracts as previously mentioned. This is a result of the difference between the negotiated amount of returned premiums ($64.8 million) and the associated unearned premium remaining on the underlying guarantees ($54.4 million).

24

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Excluding the effect of accelerated earnings, normal net premiums earned (which is defined as net premiums earned less accelerated earnings and reconciled to total net premiums earned in the table below) increased 17% from $138.9 million in the third quarter of 2003 to $162.5 million in the third quarter of 2004. Normal net premiums earned for the nine months ended September 30, 2004 were $469.3 million, an increase of 20% from $392.4 million in the nine months ended September 30, 2003. 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, 2004 increased 18%, 9% and 32% for Public, Structured and International Finance, respectively, from the three months ended September 30, 2003. Normal net premiums earned during the nine months ended September 30, 2004 increased 19%, 15% and 30% for Public, Structured and International Finance, respectively, from the nine months ended September 30, 2003.

Overall, the business environment has become more competitive. Increased competition from senior/subordinated structures and other triple-A rated financial guarantors has increased. This increased competition has had a moderately adverse impact on pricing. Credit spreads and pricing continue to provide adequate returns in most markets. The growth in normal earned premiums in Structured Finance and International Finance that has been exhibited over the past several years has moderated as those lines of business have grown significantly, resulting in more difficult comparisons quarter on quarter. Additionally, in the mortgage-backed sector, financial guarantors have faced increased competition from senior/subordinated debt structures and other triple-A rated financial guarantors over the past few quarters resulting in lower premiums written. This combined with the continued high level of run-off in the mortgage-backed securities book adversely impacted earned premiums.

The mortgage-backed securities and pooled debt obligation exposures have relatively short average lives. As a result, the earnings from those types of exposures are recognized quickly and can bring some volatility to the earned premium line. A significant portion of the recent premium writings in public finance and for certain bond types within structured finance and international are for longer-term transactions. While the earned premium impact from such writings is not as immediate as the mortgage-backed or pooled debt obligations, they do contribute stability to the earned premiums over time. Similarly, due to a tight credit spread environment in International Finance, the pooled debt obligation market has decreased significantly, adversely impacting earned premium growth and other credit enhancement fee growth. Competitive and credit trends such as the ones we are currently experiencing in domestic mortgage-backed securities and international pooled debt obligations are a normal part of Ambac’s business.

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, 2004 were $11.8 million and $35.1 million, respectively, a decrease of 1% from $11.9 million in the three months ended September 30, 2003 and an increase of 1% from $34.6 million in the nine months ended September 30, 2003. Credit spreads on corporate credits in the current environment have narrowed and this has had a significant adverse impact on new credit derivative business in the last few quarters (when credit spreads are narrow, the demand for guaranteed products is reduced).

25

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

The following table provides a breakdown of net premiums earned by market sector and other credit enhancement fees:

	Three Months Ended September 30,				Nine Months Ended September 30,
(Dollars in Millions)	2004		2003		2004		2003
Public Finance	$	53.5	$	45.3	$	153.3	$	128.9
Structured Finance		66.9		61.7		196.7		171.4
International Finance		42.1		31.9		119.3		92.1
Total normal premiums earned		162.5		138.9		469.3		392.4
Accelerated earnings		21.0		20.8		69.2		54.0
Total net premiums earned		183.5		159.7		538.5		446.4
Other credit enhancement fees		11.8		11.9		35.1		34.6
Total net premiums earned and other credit enhancement fees	$	195.3	$	171.6	$	573.6	$	481.0

Net Investment Income. Net investment income for the three and nine months ended September 30, 2004 was $89.6 million and $264.4 million, increases of 11% from $80.9 million and $237.4 million in the three and nine months ended September 30, 2003. These increases were primarily attributable to (i) the growth of the investment portfolio resulting from the growth in the Financial Guarantee book of business and (ii) a capital contribution from Ambac Financial Group, Inc. of $125 million in the fourth quarter of 2003. The growth in investment income was partially offset by lower reinvestment rates. Investments in tax-exempt securities amounted to 73% of the total fair value of the portfolio as of September 30, 2004, versus 75% at September 30, 2003. The average pre-tax yield-to-maturity on the investment portfolio was 4.76% as of September 30, 2004 compared with 5.01% at September 30, 2003.

26

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Net Realized Investment Gains. Net realized investment gains in the three and nine months ended September 30, 2004 were $7.4 million and $22.5 million, respectively, compared to net realized gains of $7.0 million and $33.8 million for the three and nine months ended September 30, 2003, respectively. The following table details amounts included in net realized investment gains:

	Three Months Ended September 30,				Nine Months Ended September 30,
(Dollars in Millions)	2004		2003		2004		2003
Net gains on securities sold	$	6.8	$	6.5	$	19.5	$	26.4
Foreign exchange gains on investments		0.6		0.5		3.0		7.4
Net securities gains	$	7.4	$	7.0	$	22.5	$	33.8

Net Mark-to-Market (Losses) Gains on Credit Derivative Contracts.Net mark-to-market (losses) gains on credit derivative contracts for the three and nine months ended September 30, 2004 were ($0.3) million and $9.9 million, respectively, compared to net mark-to-market (losses) of ($4.1) million and ($6.2) million in the three and nine months ended September 30, 2003, respectively. The changes in estimated fair value of structured credit derivative contracts reflects net mark-to-market gains and losses due to changes in credit spreads on the underlying obligations. Net losses paid on structured credit derivatives in the three and nine months ended September 30, 2004 were $0 as compared to $0 and $1.2 million for the three and nine months ended September 30, 2003.

Other Income (Loss). Other income (loss) for the three and nine months ended September 30, 2004 was $0.8 million and ($10.1) million, respectively, compared to other income of $0.9 million and $3.7 million for the three and nine months ended September 30, 2003, respectively. Included in other income are deal structuring fees, commitment fees and income from Ambac’s QSPEs. Ambac provides clients, on a limited basis the ability to fund through a medium-term note (“MTN”) conduit vehicle. This conduit issues MTNs and purchases client issued fixed income securities with the proceeds. An equity loss of approximately $15 million was recorded during the first quarter from this funding conduit. The loss relates to a mark-to-market on certain derivative contracts used to hedge interest rate risk associated with underlying investments and MTN liabilities. The derivatives serve as effective economic hedges; however, they did not meet the requirements of effective accounting hedges as defined in FASB No. 133, as amended (“FAS 133”). Therefore, the change in the market value of the derivatives was recorded through the income statement without taking the offsetting gain from the hedged instruments.

Loss and Loss Expenses. Loss and loss expenses for the three and nine months ended September 30, 2004 were $17.7 million and $52.7 million, respectively, compared to $15.9 million and $36.6 million for the three and nine months ended September 30, 2003. This increase reflects downward credit migration on certain exposures in the financial guarantee portfolio. Losses and loss expenses are based upon estimates of the ultimate aggregate losses inherent in the Financial Guarantee portfolio. In most instances, claim payments are forecasted in advance as a result of Ambac’s active surveillance of the insured book of business. Based upon company and industry experience, claim payments become probable and estimable once the issuer’s credit profile has migrated to certain impaired credit levels. The insured party has the right to a claim under Ambac’s financial insurance policy at the first scheduled debt service date of the defaulted obligation. The trustee for the insured obligation notifies Ambac of the payment default so that a claim payment can be made. The trustee reports payment defaults at or prior to the scheduled payment date. Subsequent claims would be paid if payment defaults continue and would be based on the interest and principal payment schedule.

27

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

The liability for loss and loss expenses consists of case basis credit and active credit reserves. Case basis credit reserves are established for losses on guaranteed obligations that have already defaulted. These 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 collateral and subrogation rights. As noted above, the payment pattern and ultimate costs are fixed and determinable on an individual claim basis (i.e., the scheduled debt service of the insured obligation). Ambac discounts these reserves in accordance with discount rates prescribed or permitted by state regulatory authorities. Consistent with industry practice, Ambac establishes and accrues an active credit reserve, which is separate from the case basis credit reserves noted above. Ambac believes, based on our active surveillance of the insured portfolio, along with historical defaults and related loss data and current economic factors, that additional losses are probable and estimable in our portfolio. Current economic factors considered include estimates of current defaults and recovery values from collateral or subrogation rights. The active credit reserves are established based upon probable debt service defaults from losses, as a result of credit deterioration. Reserve amounts are reasonably estimated based on management’s review of the financial guarantee portfolio. Active surveillance of the insured portfolio enables Ambac to track credit migration of insured obligations from period to period. Our Surveillance group, which is comprised of senior credit professionals, all of whom are independent from transaction execution, is responsible for ongoing monitoring of the insured portfolio on a regular basis to identify deteriorating credits. Senior Management meets with Surveillance to review the status of their work to determine the adequacy of Ambac’s loss reserves and makes any necessary adjustments. The following table summarizes Ambac’s loss reserves split between case basis credit loss reserves and active credit reserves at September 30, 2004 and December 31, 2003.

(Dollars in millions)	September 30, 2004		December 31, 2003
Net loss and loss expense reserves:
Case basis reserves(*)	$	65.2	$	54.7
Active credit reserves		162.8		132.2
Total	$	228.0	$	186.9

(*) After netting reinsurance recoverable amounting to $1.6 million and $2.5 million at September 30, 2004 and December 31, 2003, respectively.

The following table summarizes the changes in the total net loss reserves for the nine months ended September 30, 2004 and the year-ended December 31, 2003:

(Dollars in millions)	September 30, 2004			December 31, 2003
Beginning balance of net loss reserves	$	186.9		$	167.6
Additions to loss reserves		52.7			53.4
Losses paid		(47.2	)		(45.6	)
Recoveries of losses paid from reinsurers		2.3			4.0
Other recoveries, net of reinsurance		33.3			7.5
Ending balance of net loss reserves	$	228.0		$	186.9

Additions made to the case basis credit reserve totaled $10.5 million and $5.7 million for the nine months ended September 30, 2004 and the year ended December 31, 2003, respectively. The increase during the nine months was primarily due to $33.0 million of recoveries (net of reinsurance) received and an increase of $21.5 million in reserves for a healthcare credit, offset by $44.9 million in net claim payments.

28

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

The following tables provide details of losses paid, net of recoveries received for the nine months ended September 30, 2004 and 2003 and net case basis credit reserves at September 30, 2004 and December 31, 2003 by market sector:

(Dollars in millions)	September 30, 2004			September 30, 2003
Net losses paid:
Public Finance	$	19.7		$	1.9
Structured Finance		(10.1	)		17.5
International Finance		2.0			0.3
Total	$	11.6		$	19.7

(Dollars in millions)	September 30, 2004		December 31, 2003
Net case basis credit reserves(*):
Public Finance	$	28.3	$	22.6
Structured Finance		30.3		26.7
International Finance		6.6		5.4
Total	$	65.2	$	54.7

(*) After netting reinsurance recoverable amounting to $1.6 million and $2.5 million at September 30, 2004 and December 31, 2003, respectively.

At September 30, 2004 future estimated claim payments, net of estimated recoveries, through 2018 for exposures with case basis credit reserves totaled $70.7 million. Related future payments are $3.8 million, $34.2 million, $15.4 million, $8.9 million and $8.5 million for the remainder of 2004, 2005, 2006, 2007 and 2008, respectively.

Underwriting and Operating Expenses. Underwriting and operating expenses for the three and nine months ended September 30, 2004 were $26.2 million and $81.1 million, respectively, an increase of 10% from $23.8 million in the three months ended September 30, 2003 and an increase of 21% from $67.0 million in the nine months ended September 30, 2003. Underwriting and operating expenses consist of gross underwriting and operating expenses, less the deferral to future periods of expenses related to the acquisition of new insurance contracts and reinsurance commissions, plus the amortization of previously deferred expenses and reinsurance commissions. The increases in gross underwriting and operating expenses reflects the overall increased business activity and is primarily attributable to higher compensation costs related to the addition of staff. Included in the nine months ended September 30, 2004 numbers above are approximately $3.5 million of reinsurance commissions returned in excess of the unamortized reinsurance commissions previously deferred as a result of the cancellation of certain reinsurance contracts, previously mentioned under the heading “Income From Continuing Operations”. For the three and nine months ended September 30, 2004, gross underwriting and operating expenses were $34.7 million and $108.1 million, respectively, an increase of 2% from $34.1 million for the three months ended September 30, 2003 and an increase of 7% from $101.4 million for the nine months ended September 30, 2003. Underwriting and operating expenses deferred for the three and nine months ended September 30, 2004 were $19.1 million and $61.7 million, respectively, compared to $20.3 million and $60.9 million for the three and nine months ended September 30, 2003. The amortization of previously deferred expenses and reinsurance commissions for the three and nine months ended September 30, 2004 were $10.8 million and $16.3 million, respectively, compared to $10.0 million and $29.0 million for the three and nine months ended September 30, 2003, respectively.

29

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Financial Services

Through its Financial Services subsidiaries, Ambac provides financial and investment products including investment agreements, interest rate swaps, currency swaps, total return swaps and funding conduits, which includes municipalities and their authorities, health care organizations and asset-backed issuers.

Net Revenues. Financial Services net revenue is defined and analyzed by management as gross interest income less gross interest expense from investment and payment agreements plus revenue from derivative products, and excludes net realized and net mark-to-market gains and losses. Net revenues for the three and nine months ended September 30, 2004 was $17.2 million and $47.0 million, respectively, a decrease from $18.6 million in the three months ended September 30, 2003 and an increase from $25.5 million in the nine months ended September 30, 2003. The decrease of $1.4 million comparing the third quarter of 2004 was primarily due to: (i) lower derivative product revenue of $6.8 million as a result of a large swap transacted in the third quarter of 2003 and a positive $4.8 million mark-to-market adjustment in the third quarter of 2003 and (ii) partially offset by higher investment and payment agreement revenue of $5.4 million on improved interest spreads. The increase in net revenues for the nine months ended September 30, 2004 compared to the nine months ended September 30, 2003 was primarily due to: (i) higher derivative product revenue of $12.3 million on increased swap activity in the current year and net negative mark-to-market adjustments of approximately $7.2 million recorded in the comparable prior period related to the ratio of tax-exempt interest rates to taxable interest rates. The ratio has largely come back down to historical levels since that time and the mark-to-market was largely reversed in later periods.

Net realized investment (losses) gains were ($0.8) million and $5.0 million for the three and nine months ended September 30, 2004, respectively, compared to ($1.2) million and $3.8 million for the three and nine months ended September 30, 2003, respectively. Gains and losses from investment securities are due to the normal operations of the investment agreement business, and shaping of the investment portfolio to maximize yield within our defined risk guidelines. Ambac does not maintain a trading portfolio.

Other Expenses. Other expenses for the three and nine months ended September 30, 2004 were $3.3 million and $10.4 million, respectively, relatively flat from $3.4 million in the three months ended September 30, 2003 and up 17% from $8.9 million in the nine months ended September 30, 2003. The increases are primarily attributable to increased business activity in the derivative products business.

Corporate Items

Interest Expense. Interest expense for the three and nine months ended September 30, 2004 was $13.7 million and $40.8 million, respectively, relatively flat compared to $13.8 million and $40.7 million in the three and nine months ended September 30, 2003.

Corporate Expense. Corporate expenses include the operating expenses of Ambac Financial Group. Corporate expenses for the three and nine months ended September 30, 2004

30

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

were $2.7 million and $7.5 million, respectively, compared to $1.9 million and $12.4 million for the three and nine months ended September 30, 2003, respectively. The decrease in expenses during the first nine months of 2004 is primarily attributable to a $6.5 million write-off of previously deferred debt issuance expenses in the first quarter of 2003, related to the 1998 issuance of $200 million, 7.08% Debentures, that was redeemed at par at the end of April 2003.

Income Taxes. Income taxes for the three and nine months ended September 30, 2004 were at an effective rate of 25.0% and 25.6%, respectively, compared to 26.2% and 25.5% for the three and nine months ended September 30, 2003, respectively. The decrease in the three- month effective rate is caused predominantly from an increase in the ratio of tax-exempt investment income to taxable underwriting profits.

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, 2004, Ambac Assurance paid dividends of $77.3 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 and the income it expects to receive from its investment portfolio, management believes that Ambac will have sufficient liquidity to satisfy its needs over the next twelve months, including the ability to pay dividends on its common stock in accordance with its dividend policy. Beyond the next twelve months, Ambac Assurance’s ability to declare and pay dividends to Ambac may be influenced by a variety of factors, including adverse market changes, insurance regulatory changes and changes in general economic conditions. Consequently, although management believes that Ambac will continue to have sufficient liquidity to meet its debt service and other obligations over the long term, no guarantee can be given that Ambac Assurance will be 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, claim payments, 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 and payment agreement obligations pursuant to defined terms, net obligations under interest rate and total return swaps, operating expenses, and income taxes. 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

31

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

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) and net receipts from interest rate and total return swaps. 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. Beginning in July 2004, Ambac and Ambac Assurance have a new revolving credit facility with six major international banks for $300 million, which expires in July 2005 and provides a two-year term loan provision. The facility is available for general corporate purposes, including the payment of claims. This new 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 $2.0 billion. At September 30, 2004, Ambac met all of these requirements.

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 provide capital support to Ambac Assurance by allowing it to obtain immediate access to new capital at its sole discretion at any time through the exercise of the put option. If the put option were exercised, 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. Ambac Assurance pays a put option fee. Each trust is rated AA/Aa2 by Standard & Poor’s and Moody’s, respectively.

From time to time Ambac accesses the capital markets to support the growth of its businesses. In April 2003, Ambac filed Form S-3 with the SEC utilizing a “shelf” registration process. Under this process, Ambac may issue up to $500 million of the securities described in the prospectus filed as part of the registration, namely, common stock, preferred stock and debt securities of Ambac.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Shares Repurchased. 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. The following table summarizes Ambac’s repurchase program during the first nine months of 2004:

(In thousands, except per share amounts)	Total Shares Repurchased	Average Price Per Share		Shares Remaining for Repurchase
January 2004	—	$	—	3,150
February 2004	20	$	74.09	3,130
March 2004	298	$	78.90	2,832
First quarter 2004	318	$	78.60	2,832
April 2004	339	$	73.19	2,493
May 2004	27	$	64.61	2,466
June 2004	—	$	—	2,466
Second quarter 2004	366	$	72.55	2,466
July 2004	—	$	—	2,466
August 2004	84	$	73.02	2,382
September 2004	—	$	—	2,382
Third quarter 2004	84	$	73.02	2,382

Balance Sheet. Total assets as of September 30, 2004 were $16.99 billion, an increase of 1% from total assets of $16.75 billion at December 31, 2003. This increase was due primarily to cash generated from business written during the period. As of September 30, 2004, stockholders’ equity was $4.81 billion, a 13% increase from year-end 2003 stockholders’ equity of $4.25 billion. The increase stemmed primarily from net income during the period.

Investments. The Financial Guarantee and the Financial Services investment portfolios are subject to internal investment guidelines. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits. Ambac has a review process for all securities in its investment portfolio, including a review for impairment losses. Factors considered when assessing impairment include: (i) securities whose fair values have declined by 20% or more below amortized cost; (ii) securities whose fair values have declined below amortized cost for a continuous period of at least six months; (iii) recent credit downgrades by rating agencies; (iv) the financial condition of the issuer; (v) whether scheduled interest payments are past due; and (vi) whether Ambac has the ability and intent to hold the security for a sufficient period of time to allow for anticipated recoveries in fair value. If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss, net of tax, in Accumulated Other Comprehensive Income in stockholders’ equity on our Consolidated Balance Sheets. If we believe the decline is “other than temporary”, we write-down the carrying value of the investment and record a loss on our Consolidated Statements of Operations. Ambac’s assessment of a decline in value includes management’s current judgment of the factors noted above. If that judgment changes in the future, Ambac may ultimately record a loss after having originally concluded that the decline in value was temporary. The following table summarizes, for all securities in an unrealized loss position as of September 30, 2004 and December 31, 2003, the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position:

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

	September 30, 2004				December 31, 2003
(Dollars in millions)	Estimated Fair Value		Gross Unrealized Losses		Estimated Fair Value		Gross Unrealized Losses
Municipal obligations in continuous unrealized loss for:
0 – 6 months	$	197.3	$	1.6	$	208.8	$	1.2
7 - 12 months		309.4		4.8		225.1		4.8
Greater than 12 months		110.4		1.9		6.5		0.4
		617.1		8.3		440.4		6.4
Corporate obligations in continuous unrealized loss for:
0 – 6 months		4.0		0.1		100.6		1.8
7 - 12 months		—		—		—		—
Greater than 12 months		42.5		3.7		100.8		4.6
		46.5		3.8		201.4		6.4
Foreign government obligations in continuous unrealized loss for:
0 – 6 months		14.7		—		36.6		0.7
7 - 12 months		8.1		—		—		—
Greater than 12 months		36.7		0.8		—		—
		59.5		0.8		36.6		0.7
U.S. government obligations in continuous unrealized loss for:
0 – 6 months		10.6		0.1		50.2		0.4
7 – 12 months		—		—		—		—
Greater than 12 months		—		—		—		—
		10.6		0.1		50.2		0.4
Mortgage and asset-backed securities in continuous unrealized loss for:
0 – 6 months		1,027.0		6.1		969.6		10.7
7 - 12 months		142.7		1.4		616.2		9.6
Greater than 12 months		698.8		10.8		166.0		1.7
		1,868.5		18.3		1,751.8		22.0
Other in continuous unrealized loss for:
0 – 6 months		—		—		—		—
7 - 12 months		0.2		—		0.2		—
Greater than 12 months		1.3		0.4		1.5		0.4
		1.5		0.4		1.7		0.4
Total	$	2,603.7	$	31.7	$	2,482.1	$	36.3

There were no impairment write-downs during the nine months ended September 30, 2004 and 2003. The net realized investment gains in the three and nine months ended September 30, 2004 and 2003 were the result of security sales made in the usual course of business in order to achieve Ambac’s investment objectives for the Financial Guarantee and Financial Services investment portfolios.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

The amortized cost and estimated fair value of investments in fixed income securities and short-term investments at September 30, 2004 were as follows:

	September 30, 2004				December 31, 2003
(Dollars in thousands)	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
Fixed income securities:
Municipal obligations	$	6,099,483	$	6,435,124	$	5,404,013	$	5,734,046
Corporate obligations		759,059		803,763		1,029,950		1,086,231
Foreign government obligations		175,008		191,393		156,901		177,179
U.S. government obligations		123,498		125,728		88,894		89,950
Mortgage and asset-backed securities		5,906,949		5,974,304		5,723,489		5,961,813
Short-term		176,705		176,705		250,382		250,382
		13,240,702		13,707,017		12,653,629		13,299,601
Fixed income securities pledged as collateral:
U.S. government obligations		—		—		12,209		12,262
Mortgage and asset-backed securities (includes U.S. government agency obligations)		519,902		518,053		649,837		649,160
		519,902		518,053		662,046		661,422
Total	$	13,760,604	$	14,225,070	$	13,315,675	$	13,961,023

Approximately 46% and 47% of the mortgage and asset-backed securities in the investment portfolio is composed of securities issued by the Government National Mortgage Association (“GNMA”), the Federal National Mortgage Association (“FNMA”), and the Federal Home Loan Mortgage Corporation (“FHLMC”), as of September 30, 2004 and December 31, 2003, respectively.

The following table provides the ratings distribution of the Financial Guarantee investment portfolio, at fair values of $8.21 billion and $7.33 billion at September 30, 2004 and December 31, 2003, respectively:

Rating(1)	September 30, 2004		December 31, 2003
AAA(2)	80	%	75	%
AA	16		16
A	3		6
BBB	<1		1
Below investment grade	<1		<1
Not Rated	<1		1
	100	%	100	%

(1) Ratings represent Standard & Poor’s classifications. If unavailable, Moody’s rating is used.

(2) Includes U.S. Treasury and agency obligations (including GNMA’s, FNMA’s and FHLMC’s), which comprised approximately 19% and 15% of the Financial Guarantee investment portfolio as of September 30, 2004 and December 31, 2003, respectively.

Short-term investments in the Financial Guarantee portfolio consisted primarily of money market funds, and foreign and domestic time deposits.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

The Financial Services investment portfolio consists primarily of assets funded with the proceeds from the issuance of investment agreement liabilities. The investment objectives of the portfolio are to match the investment security maturity schedule to the maturity schedule of related liabilities under the investment agreements and achieve the highest after-tax net investment income.

The following table provides the ratings distribution of the Financial Services investment portfolio, at fair values of $5.96 billion and $6.39 billion at September 30, 2004 and December 31, 2003, respectively:

Rating(1)	September 30, 2004		December 31, 2003
AAA(2)	89	%	92	%
AA	3		2
A	5		3
BBB	3		2
Below investment grade	<1		<1
	100	%	100	%

(1) Ratings represent Standard & Poor’s classifications. If unavailable, Moody’s rating is used.

(2) Includes U.S. Treasury and agency obligations (including GNMA’s, FNMA’s and FHLMC’s), which comprised approximately 26% and 31% of the Financial Services investment portfolio as of September 30, 2004 and December 31, 2003, respectively.

Special Purpose and Variable Interest Entities. In January 2003, the Financial Accounting Standards Board (“FASB”) released FASB Interpretation No. 46 “Consolidation of Variable Interest Entities” (“FIN 46”). In December 2003, the FASB released a revision of FIN 46 (“FIN 46-R”), which includes substantial changes from the original FIN 46. Ambac adopted FIN 46-R as of December 31, 2003. FIN 46 and FIN 46-R provides accounting and disclosure rules for determining whether certain entities should be consolidated in Ambac’s consolidated financial statements. An entity is subject to FIN 46 and FIN 46-R, and is called a Variable Interest Entity (VIE), if it has (i) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support or (ii) equity investors that cannot make significant decisions about the entity’s operations or that do not absorb the majority of expected losses or receive the majority of expected residual returns of the entity. A VIE is consolidated by its primary beneficiary, which is the party that has a majority of the expected losses or a majority of the expected residual returns of the VIE or both. FIN 46 requires disclosures for companies that have either a primary or significant variable interest in a VIE. All other entities not considered VIEs are evaluated for consolidation under SFAS No. 94, “Consolidation of all Majority-Owned Subsidiaries”.

Ambac has involvement with special purpose entities, including VIEs in two ways. First, Ambac is a provider of financial guarantee insurance for various securitized asset-backed debt obligations, including mortgage-backed security obligations, collateralized debt obligations (“CDO”) and other asset-backed securitization obligations. Second, Ambac has sponsored two special purpose entities that issue medium-term notes (“MTNs”) to fund the purchase of certain financial assets. As discussed in detail below, these Ambac sponsored special purpose entities are considered Qualifying Special Purpose Entities (“QSPEs”).

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Financial Guarantees:

Ambac provides financial guarantee insurance to securitized asset-backed debt obligations of special purpose entities, including VIEs. Ambac’s primary variable interest exists through this financial guarantee insurance contract. The transaction structure provides certain financial protection to Ambac. This financial protection can take several forms, however, the most common are over-collateralization, first loss retention and excess spread. In the case of over-collateralization (i.e., the principal amount of the securitized assets exceeds the principal amount of the structured finance obligations guaranteed by Ambac Assurance), the structure allows the transaction to experience defaults among the securitized assets before a default is experienced on the structured finance obligations that have been guaranteed by Ambac. In the case of first loss retention, the financial guarantee insurance policy only covers a senior layer of losses on debt issued by special purpose entities, including VIEs. The first loss with regards to the assets is either retained by the seller or sold off in the form of equity or mezzanine debt to other investors. In the case of excess spread, the financial assets contributed to special purpose entities, including VIEs, generate interest cash flows that are in excess of the interest payments on the related debt. All or a portion of this excess spread accumulates and is available to absorb losses in the transaction or is applied to create over-collateralization.

Ambac is the primary beneficiary of one VIE with assets and liabilities of $134.5 million at September 30, 2004 and $189.5 million at December 31, 2003. Ambac consolidated this entity since the structural financial protections are outside the VIE. This VIE is a bankruptcy remote special purpose financing entity created to facilitate the sale of floating rate notes. This VIE was capitalized in 2002 through the issuance of $299.6 million of floating rate notes, guaranteed by Ambac Assurance. The proceeds of the VIE note issuance were used to purchase senior mortgage-backed floating rate notes of a Korean mortgage-backed securities issuer. Ambac’s creditors do not have rights with regard to the assets of the VIE. Protections afforded Ambac Assurance in this transaction were in the form of a reserve fund and first loss protection through subordinated debt issued of approximately $40 million. Ambac Assurance will pay claims under its financial guarantee only in the event that losses on the mortgage assets of the Korean issuer reduce the reserve fund to zero and exceed the principal amount of the subordinated notes.

Ambac does not consolidate other VIEs since we are not the primary beneficiary. It is possible in the future that Ambac will consolidate other entities for which it will issue a financial guarantee insurance policy. If Ambac issues a financial guarantee insurance policy for the obligations of a VIE and does not receive structural financial protection adequate to absorb the majority of expected loss, Ambac may be required to consolidate the related VIE in accordance with FIN 46-R. Ambac underwrites its insurance to a remote loss standard and normally demands structural financial protection that absorbs the majority of expected loss in a transaction. However, management is committed to take actions to reduce economic loss regardless of any requirement to consolidate. Consolidation is an important accounting concept, however, it does not change the economic risk profile of the insurance exposure.

Qualified Special Purpose Entities. Ambac has transferred financial assets to two special purpose entities. The business purpose of these entities is to provide certain financial guarantee clients with funding for their debt obligations. These entities meet the characteristics of QSPEs in accordance with Statement of Financial Accounting Standards 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”). QSPEs are not subject to the requirements of FIN 46-R and accordingly are not consolidated in Ambac’s financial statements. However, see the discussion below on the Exposure Draft issued by the FASB that could change the accounting rules for QSPEs in the

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

future. The QSPEs are legal entities that are demonstrably distinct from Ambac. Ambac, its affiliates or its agents cannot unilaterally dissolve the QSPEs. The QSPEs permitted activities are limited to those outlined below.

As of September 30, 2004, there have been 14 individual transactions processed through the QSPEs of which 10 remain. In each case, Ambac sells fixed income debt obligations to the QSPEs. These transactions are true sales based upon the bankruptcy remote nature of the QSPE and the absence of any agreement or obligation for Ambac to repurchase or redeem assets of the QSPE. The purchase by the QSPE is financed through the issuance of MTNs, which are collateralized by the purchased assets. The cash flows of the MTNs approximately match the cash flows of the assets purchased. Derivative contracts (interest rate and currency swaps) may be used for hedging purposes only. Derivative hedges are established at the time MTNs are issued to purchase financial assets. The activities of the QSPEs are contractually limited to purchasing assets from Ambac, issuing MTNs to fund such purchase, executing derivative hedges and related administrative services. Ambac Assurance may issue a financial guarantee insurance policy on the assets sold, the MTNs issued or both. As of September 30, 2004, Ambac Assurance had financial guarantee insurance policies issued for all assets and MTNs owned and outstanding by the QSPEs.

Ambac’s exposures under these financial guarantee insurance policies as of December 31, 2003 is included in the disclosure in Note 12 “Guarantees in Force” of Ambac’s 2003 Annual Report. Pursuant to the terms of Ambac Assurance’s insurance policy, insurance premiums are paid to Ambac Assurance by the QSPEs and are earned in a manner consistent with other insurance policies, over the risk period. Any losses incurred would be included in Ambac’s Consolidated Statements of Operations. Under the terms of an Administrative Agency Agreement, Ambac provides certain administrative duties, primarily collecting amounts due on the obligations and making interest payments on the MTNs.

Assets sold to the QSPEs during the nine months ended September 30, 2004 and the year ended December 31, 2003 were $195.0 million and $250.0 million, respectively. No gains or losses were recognized on these sales. As of September 30, 2004, the estimated fair value of financial assets, MTN liabilities and derivative hedge liabilities were $1,882.9 million, $1,773.2 million and $97.6 million, respectively. When market quotes are not available, estimated fair value is determined utilizing valuation models. These models include estimates, made by Ambac management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Ambac Assurance received gross premiums for issuing financial guarantee policies on the assets, MTNs and derivative contracts of $4.5 million and $5.3 million for the nine months ended September 30, 2004 and the year ended December 31, 2003, respectively. Ambac also received fees for providing other services amounting to $0.3 million and $0.5 million for the nine months ended September 30, 2004 and the year ended December 31, 2003, respectively.

In June 2003, the FASB issued an Exposure Draft for proposed Statement of Financial Accounting Standards entitled “Qualifying Special-Purposes Entities and Isolation of Transferred Assets”, an amendment of FASB Statement No. 140 (“The Exposure Draft”). The Exposure Draft is a proposal that is subject to change and as such, is not yet authoritative. If the proposal is enacted in its current form, it will amend and clarify SFAS 140. The Exposure Draft would prohibit an entity from being a QSPE if it enters into an agreement that obligates a transferor of financial assets, its affiliates, or its agents to deliver additional cash or other assets to fulfill the SPE’s obligations to beneficial interest holders. If this Exposure Draft becomes enacted as currently proposed and if the QSPEs issue new beneficial interests after the

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

effective date and receive assets other than those they are committed to receive under commitments to beneficial interest holders made before the effective date of the final Statement, management believes Ambac would be required to consolidate. This conclusion is based upon the fact that Ambac provides financial support to these entities such as financial guarantees and liquidity commitments. Should Ambac be required to consolidate under this Exposure Draft, if enacted as proposed, the financial statement impact would be to gross up Ambac’s consolidated balance sheet for the assets and liabilities held by the QSPEs that approximate $1.8 billion at September 30, 2004. Additionally, fees received by Ambac from the QSPEs (primarily insurance premiums) would be eliminated in consolidation and essentially reclassified to net interest income. The risk characteristics of these transactions are not impacted by consolidation.

Cash Flows. Net cash provided by operating activities was $702.4 million and $795.7 million during the nine months ended September 30, 2004 and 2003, respectively. These cash flows were primarily provided by Financial Guarantee operations.

Net cash used in financing activities was $492.8 million and $139.3 million during the nine months ended September 30, 2004 and 2003, respectively. Financing activities for the nine months ended September 30, 2004 included $433.4 million in net investment and payment agreement draws paid (net of investment and payment agreement issued). Financing activities for the nine months ended September 30, 2003 included $306.4 million in net investment and payments agreements draws paid (net of investment and payment agreement issued). Financing activities for the nine months ended September 30, 2003 also included proceeds from the issuance of debentures of $363.2 million, partially offset by $200 from the redemption of debentures.

Net cash used in investing activities was $208.3 million during the nine months ended September 30, 2004, of which $3,775.0 million was used to purchase bonds, partially offset by the proceeds from sales and maturities of bonds of $3,489.4 million. For the nine months ended September 30, 2003, $645.2 million was used in investing activities, of which $5,862.0 million was used to purchase bonds, partially offset by the proceeds and maturities of bonds of $4,830.9 million.

Net cash provided by operating, investing and financing activities was $1.3 million and $11.2 million during the nine months ended September 30, 2004 and 2003, respectively.

Material Commitments. In the third quarter of 2004, a subsidiary of Ambac Financial Group provided a $360 million liquidity facility to a reinsurance company which acts as reinsurer with respect to a portfolio of life insurance policies. The liquidity facility provides temporary funding in the event that the reinsurance company’s capital is insufficient to make payments under the reinsurance agreement. The reinsurance company is required to repay all amounts drawn under the liquidity facility. No amounts have been drawn under this facility at September 30, 2004. Ambac has no other material changes in the contractual obligations table as presented in Ambac’s 2003 Annual Report.

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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 Risk Analysis and Reporting 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 analyses of both 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, obligations under certain payment agreements, debentures, and certain derivative contracts (primarily interest rate swaps and futures) used for hedging purposes.

Ambac, through its affiliate Ambac Financial Services, 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 municipal interest rate swap business with the goal of being market neutral to changes in overall interest rates, while seeking to profit from retaining some basis risk. Ambac’s municipal interest rate swap portfolio may be adversely affected by changes in basis. 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. Ambac supplements its VaR methodology, which is a good risk management tool in normal markets, by performing rigorous stress testing to measure the potential for losses in abnormally volatile markets. These stress tests include (i) parallel and non-parallel shifts in the yield curve and (ii) immediate changes in normal basis relationships, such as those between taxable and tax-exempt markets.

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 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.

40

Item 3. Quantitative and Qualitative Disclosures About Market Risk (Continued)

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. Ambac Credit Products structures its contracts with partial hedges from various financial institutions or with first loss protection. Such structuring mitigates Ambac Credit Products’ risk of loss and reduces the price volatility of these financial instruments. Management models the potential impact of credit spread changes on the value of its contracts.

Other financial instruments that may be adversely affected by changes in credit spreads include total return swap contracts, which are entered into by Ambac through its affiliate, Ambac Capital Services. These contracts require Ambac Capital Services to pay a specified spread in excess of LIBOR in exchange for receiving the total return of an underlying fixed income obligation over a specified period of time. If credit spreads of the underlying obligations change, the market value of the related total return swaps changes and Ambac Capital Services could experience mark-to-market gains or losses.

Item 4. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures. Ambac Financial Group’s management, with the participation of Ambac Financial Group’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of Ambac Financial Group’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on this evaluation, Ambac Financial Group’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, Ambac Financial Group’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by Ambac Financial Group (including its consolidated subsidiaries) in the reports that it files or submits under the Exchange Act.

(b) Changes in Internal Control Over Financial Reporting. There have not been any changes in Ambac Financial Group’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during Ambac Financial Group’s fiscal quarter ended September 30, 2004 that have materially affected, or are reasonably likely to materially affect, Ambac Financial Group’s internal control over financial reporting.

41

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:

Exhibit Number	Description
31.1	Certification of CEO Pursuant to Exchange Act Rules 13a-14 and 15d-14.
31.2	Certification of CFO Pursuant to Exchange Act Rules 13a-14 and 15d-14.
32.1	Certification of CEO Pursuant to 18 U.S.C. Section 1350.
32.2	Certification of CFO Pursuant to 18 U.S.C. Section 1350.
99.08	Ambac Assurance Corporation and Subsidiaries Consolidated Unaudited Financial Statements as of September 30, 2004 and December 31, 2003 and for the periods ended September 30, 2004 and 2003.

(b) Reports on Form 8-K:

On August 20, 2004, Ambac Financial Group, Inc. filed a Current Report onForm 8-K with its August 19, 2004 press release announcing the appointment of Thomas C. Theobald to its Board of Directors.

On October 20, 2004, Ambac Financial Group, Inc. filed a Current Report onForm 8-K with its October 20, 2004 press release containing unaudited financial information and accompanying discussion for the three and nine months ended September 30, 2004.

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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 9, 2004	By:	/s/ Thomas J. Gandolfo
		Thomas J. Gandolfo
		Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer and Duly Authorized Officer)

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INDEX TO EXHIBITS

Exhibit Number	Description
31.1	Certification of CEO Pursuant to Exchange Act Rules 13A-14 and 15D-14, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of CFO Pursuant to Exchange Act Rules 13A-14 and 15D-14, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of CEO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of CFO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.08	Ambac Assurance Corporation and Subsidiaries Consolidated Unaudited Financial Statements as of September 30, 2004 and December 31, 2003 and for the periods ended September 30, 2004 and 2003.

44