Ambac Financial (AMBC) 10-Q 2006 Q1 Quarterly report

EXHIBIT 99.03

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

(a wholly owned subsidiary of Ambac Financial Group, Inc.)

Consolidated Unaudited Financial Statements

As of March 31, 2006 and December 31, 2005

and for the Three Months Ended March 31, 2006 and 2005

Ambac Assurance Corporation and Subsidiaries

Consolidated Balance Sheets

March 31, 2006 and December 31, 2005

(Dollars in Thousands Except Share Data)

	March 31, 2006		December 31, 2005
	(unaudited)
ASSETS
Investments:
Fixed income securities, at fair value (amortized cost of $9,500,624 in 2006 and $8,940,769 in 2005)	$	9,610,146	$	9,153,354
Short-term investments, at cost (approximates fair value)		193,702		406,530
Other (cost of $13,043 in 2006 and $13,025 in 2005)		13,551		13,308
Total investments		9,817,399		9,573,192
Cash		21,988		21,145
Securities purchased under agreements to resell		192,000		97,000
Receivable for securities sold		22,871		1,269
Investment income due and accrued		110,854		120,771
Reinsurance recoverable on paid and unpaid losses		5,327		3,730
Prepaid reinsurance		281,835		303,383
Deferred acquisition costs		215,436		202,195
Derivative assets		798,168		1,029,657
Loans		683,193		681,625
Other assets		79,900		140,751
Total assets	$	12,228,971	$	12,174,718
LIABILITIES AND STOCKHOLDER’S EQUITY
Liabilities:
Unearned premiums	$	2,977,667	$	2,966,426
Loss and loss expense reserves		298,160		304,139
Ceded reinsurance balances payable		15,737		23,746
Obligations under payment agreements		248,750		248,760
Long-term debt		1,090,435		1,041,848
Deferred income taxes		173,711		201,043
Current income taxes		99,790		31,468
Payable for securities purchased		119,996		11,641
Derivative liabilities		699,975		935,440
Other liabilities		198,426		239,152
Total liabilities		5,922,647		6,003,663
Stockholder’s equity:
Preferred stock, par value $1,000 per share; authorized shares - 285,000; issued and outstanding shares - none		—		—
Common stock, par value $2.50 per share; authorized shares - 40,000,000; issued and outstanding shares - 32,800,000 at March 31, 2006 and December 31, 2005		82,000		82,000
Additional paid-in capital		1,463,035		1,453,060
Accumulated other comprehensive income		71,025		136,897
Retained earnings		4,690,264		4,499,098
Total stockholder’s equity		6,306,324		6,171,055
Total liabilities and stockholder’s equity	$	12,228,971	$	12,174,718

See accompanying Notes to Consolidated Unaudited Financial Statements.

2

Ambac Assurance Corporation and Subsidiaries

Consolidated Statements of Operations

(Unaudited)

For The Three Months Ended March 31, 2006 and 2005

(Dollars in Thousands)

	Three Months Ended March 31,
	2006			2005
Revenues:
Financial Guarantee:
Gross premiums written	$	219,722		$	230,575
Ceded premiums written		8,757			26,627
Net premiums written	$	228,479		$	257,202
Net premiums earned	$	195,896		$	200,237
Other credit enhancement fees		13,530			12,067
Net premiums earned and other credit enhancement fees		209,426			212,304
Net investment income		113,940			102,008
Net realized investment (losses) gains		(379	)		2,021
Net mark-to-market gains on credit derivative contracts		1,953			5,266
Other income		28,507			1,405
Financial Services:
Interest from payment agreements		3,009			3,011
Other revenue		10,019			8,844
Total revenues		366,475			334,859
Expenses:
Financial Guarantee:
Loss and loss expenses		127			23,472
Underwriting and operating expenses		37,896			33,403
Interest expense on variable interest entity notes		12,623			11,579
Financial Services:
Interest from payment agreements		2,067			1,313
Other expenses		1,646			1,878
Total expenses		54,359			71,645
Income before income taxes		312,116			263,214
Provision for income taxes		86,950			70,079
Net income	$	225,166		$	193,135

See accompanying Notes to Consolidated Unaudited Financial Statements

3

Ambac Assurance Corporation and Subsidiaries

Consolidated Statements of Stockholder’s Equity

(Unaudited)

For The Three Months Ended March 31, 2006 and 2005

(Dollars in Thousands)

	2006						2005
Retained Earnings:
Balance at January 1	$	4,499,098					$	4,094,381
Net income		225,166		$	225,166			193,135		$	193,135
Dividends declared - common stock		(34,000	)					(29,600	)
Balance at March 31	$	4,690,264					$	4,257,916
Accumulated Other Comprehensive (Loss) Income:
Balance at January 1	$	136,897					$	237,632
Unrealized losses on securities, ($102,799) and ($119,159), pre-tax, in 2006 and 2005, respectively(1)					(66,820	)					(77,453	)
Foreign currency translation gain (loss)					948						(1,145	)
Other comprehensive (loss) income		(65,872	)		(65,872	)		(78,598	)		(78,598	)
Comprehensive income				$	159,294					$	114,537
Balance at March 31	$	71,025					$	159,034
Preferred Stock:
Balance at January 1 and March 31	$	—					$	—
Common Stock:
Balance at January 1 and March 31	$	82,000					$	82,000
Additional Paid-in Capital:
Balance at January 1	$	1,453,060					$	1,232,701
Capital issuance costs		(894	)					(1,177	)
Employee benefit plans		7,109						7,061
Excess tax benefit related to share-based compensation		3,760						600
Balance at March 31	$	1,463,035					$	1,239,185
Total Stockholder’s Equity at March 31	$	6,306,324					$	5,738,135
(1)      Disclosure of reclassification amount:
Unrealized holding losses arising during period		($67,156	)					($75,992	)
Less: reclassification adjustment for net securities (losses) gains included in net income		(336	)					1,461
Net unrealized losses on securities		($66,820	)					($77,453	)

See accompanying Notes to Consolidated Unaudited Financial Statements.

4

Ambac Assurance Corporation and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

For The Three Months Ended March 31, 2006 and 2005

(Dollars in Thousands)

	Three Months Ended March 31,
	2006			2005
Cash flows from operating activities:
Net income	$	225,165		$	193,135
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		643			618
Amortization of bond premium and discount		5,181			4,183
Share based compensation		7,926			7,061
Current income taxes		68,322			59,497
Deferred income taxes		8,922			9,260
Deferred acquisition costs		(12,292	)		(16,877	)
Unearned premiums, net		32,789			56,654
Loss and loss expenses		(7,576	)		(812	)
Ceded reinsurance balances payable		(8,009	)		(4,555	)
Net realized investment gains		379			(2,021	)
Other, net		23,532			7,268
Net cash provided by operating activities		344,982			313,411
Cash flows from investing activities:
Proceeds from sales of bonds		104,257			133,601
Proceeds from maturities of bonds		100,741			91,598
Purchases of bonds		(682,516	)		(485,300	)
Change in short-term investments		212,828			92,695
Loans		5,341			12,976
Securities purchased under agreements to resell		(95,000	)		(40,000	)
Purchases of securitization collateral		—			(101,600	)
Other, net		(766	)		1,673
Net cash used in investing activities		(355,115	)		(294,357	)
Cash flows from financing activities:
Dividends paid		(34,000	)		(29,600	)
Capital issuance costs		(894	)		(1,177	)
Proceeds from issuance of long-term debt		50,000			50,000
Payment for redemption of long-term debt		(8,583	)		(27,337	)
Payment agreements		(10	)		(40	)
Net cash collateral received		703			5,810
Excess tax benefit related to share-based compensation		3,760			—
Net cash provided by (used in) financing activities		10,976			(2,344	)
Net cash flow		843			16,710
Cash at January 1		21,145			17,360
Cash at March 31	$	21,988		$	34,070
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Income taxes	$	5,885		$	1,235
Interest on payment agreements	$	1,651		$	1,274
Interest on long-term debt	$	12,197			2,421

See accompanying Notes to Consolidated Unaudited Financial Statements.

5

Ambac Assurance Corporation and Subsidiaries

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands)

(1) Background and Basis of Presentation

Ambac Assurance Corporation is a leading provider of financial guarantees to clients in both the public and private sectors around the world. Ambac Assurance provides financial guarantees on public finance and structured finance obligations. Ambac Assurance has earned triple-A ratings, the highest ratings available from Moody’s Investors Service, Inc., Standard & Poor’s Ratings Services, Fitch, Inc., and Rating and Investment Information, Inc. These ratings are an essential part of Ambac Assurance’s ability to provide credit enhancement and any reduction in these ratings could have a material adverse affect on Ambac Assurance’s ability to compete in the financial guarantee business. 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 is a wholly owned subsidiary of Ambac Financial Group, Inc, 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. As of March 31, 2006, Ambac Assurance’s net guarantees in force (principal and interest) were $753,747,658.

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. Upon a credit event, Ambac Credit Products is required to either (i) purchase the underlying obligation at its par value and a loss is realized for the difference between the par and market value of the underlying obligation, (ii) make a payment equivalent to the difference between the par value and market value of the underlying obligation or (iii) make payments for the difference between the scheduled debt service payment due and the actual payment made by the issuer. Substantially all of Ambac Assurance’s structured credit derivative contracts relate to senior tranches of structured finance transactions and are partially hedged with various financial institutions or structured with first loss protection. Structured credit derivatives issued by Ambac Credit Products are insured by Ambac Assurance.

Ambac UK, an Ambac Assurance wholly owned subsidiary, is licensed to transact credit, suretyship and financial guarantee insurance in the United Kingdom and to offer insurance services in thirteen other European Union (“EU”) countries. EU directives allow Ambac UK to conduct business in EU states other than the United Kingdom in compliance with the scope of permission granted these companies by the Financial Services Authority (“FSA”) without the necessity of additional licensing or authorization in other EU jurisdictions. In February 2005, Ambac UK established a branch office in Milan, Italy. Ambac UK has entered into net worth maintenance and reinsurance agreements with Ambac Assurance, which support its triple-A ratings. Ambac Credit Products Limited, also an Ambac Assurance wholly-owned subsidiary, is licensed in the United Kingdom to transact credit default derivatives, as well as act as agent for Ambac Credit Products LLP. Ambac Credit Products Limited is currently able to offer services in two other European Union countries.

6

Ambac Assurance Corporation and Subsidiaries

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

Ambac Assurance, through its affiliate Ambac Financial Services, is a provider of interest rate and currency swaps to states, municipalities and their authorities, issuers of asset-backed securities and other entities in connection with their financings. The interest rate and currency swaps provided by Ambac Financial Services are guaranteed by Ambac Assurance through policies that guarantee the obligations of Ambac Financial Services and its counterparties. Ambac Assurance, through its subsidiary Ambac Capital Services, enters into total return swaps with professional counterparties. Total return swaps are generally used for fixed income obligations, which meet Ambac Assurance’s credit underwriting criteria.

The accompanying consolidated unaudited interim financial statements have been prepared on the basis of U.S. generally accepted accounting principles (“GAAP”). 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. Actual results could differ from those estimates. The results of operations for the three months ended March 31, 2006 may not be indicative of the results that may be expected for the full year ending December 31, 2006. These consolidated financial statements and notes should be read in conjunction with the financial statements and notes included in the audited consolidated financial statements of Ambac Assurance and subsidiaries as of December 31, 2005 and 2004, and for each of the years in the three-year period ended December 31, 2005 which was filed with the Securities and Exchange Commission on March 13, 2006 as Exhibit 99.01 to Ambac Financial Group Inc.’s Form 10-K.

The consolidated financial statements include the accounts of Ambac Assurance and all other entities in which Ambac Assurance has a controlling financial interest. The usual condition for a controlling financial interest is ownership of a majority of the voting interests of an entity. However, a controlling financial interest may also exist in entities, such as special purpose entities (“SPEs”), through arrangements that do not involve controlling voting interests. 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) Loss and Loss Expenses

Ambac Assurance’s financial guarantee insurance is a promise to pay scheduled interest and principal if the issuer of the insured obligation fails to meet its obligation. The loss reserve policy for financial guarantee insurance discussed in this footnote relates only to Ambac’s non-derivative insurance business. Losses and loss expenses are based upon estimates of the ultimate aggregate losses inherent in the non-derivative financial guarantee portfolio as of the reporting date. The evaluation process for determining the level of reserves is subject to certain estimates and judgments. In most instances, claim payments are forecasted in advance of issuer default as a result of active surveillance of the insured book of business and observance of

7

Ambac Assurance Corporation and Subsidiaries

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

deterioration in the obligor’s credit standing. Based upon Ambac Assurance’s experience, claim payments become probable and estimable once the issuer’s credit profile has migrated to certain impaired credit levels. The trustee, on behalf of the insured party, named beneficiary, or custodian has the right to make a claim under Ambac Assurance’s financial guarantee insurance policy at the first scheduled debt service date of the defaulted obligation. As discussed in the last paragraph of this note, the accounting for credit loss reserves is subject to change.

The liability for losses and loss expenses consists of active credit and case basis credit reserves. Active credit reserves are for probable and estimable losses due to credit deterioration on insured credits that have not yet defaulted or been reported and are reflected on an undiscounted basis as of the reporting date. The establishment of reserves for exposures that have not yet defaulted is a common practice in the financial guarantee industry. However, Ambac Assurance is aware that there are differences in the specific methodologies applied by other financial guarantors in establishing such reserves. Ambac Assurance’s active credit reserve is based on management’s on-going review of the non-derivative financial guarantee credit portfolio. Active surveillance of the insured portfolio enables Ambac’s Surveillance Group to track credit migration of insured obligations from period to period and prepare an adversely classified credit listing. The active credit reserve is established only for adversely classified credits. The criteria for an exposure to be included on the adversely classified credit listing includes the deterioration in an issuer’s financial condition, underperformance of the underlying collateral (for collateral dependent transactions such as mortgage-backed securitizations), problems with the servicer of the underlying collateral and other adverse economic events or trends. The servicer of the underlying collateral of an insured securitization transaction is a consideration in assessing credit quality because the servicer’s performance can directly impact the performance of the related issuer. For example, a servicer of a mortgage-backed securitization that does not remain current in their collection efforts could cause an increase in the delinquency and potential default of the underlying obligation.

The active credit reserve is established through a process that begins with estimates of probable losses inherent in the adversely classified credit portfolio. Estimates are computed for each adversely classified credit. These estimates are based upon: (i) Ambac Assurance’s internal system of credit ratings, which are analogous to the risk ratings of the major rating agencies; (ii) internally developed historical default information (taking into consideration ratings and average life of an obligation); (iii) internally developed loss severities; and (iv) the net par outstanding on the adversely classified credit. The loss severities and default information are based on rating agency information and are specific to each bond type and are established and approved by Ambac Assurance’s Portfolio Risk Management Committee. The Portfolio Risk Management Committee is comprised of senior risk management professionals and other senior management of Ambac Assurance. For certain credit exposures that have deteriorated significantly, Ambac Assurance will undertake additional monitoring and loss remediation efforts. Additional remediation can include various actions by Ambac Assurance. The most common actions include obtaining detailed appraisal information on collateral, more frequent meetings with the issuer’s or servicer’s management to review operations, financial condition and financial forecasts and more frequent analysis of the issuer’s financial statements. For these credits Ambac would use relevant information obtained from its remediation efforts to adjust the estimate discussed above. Senior

8

Ambac Assurance Corporation and Subsidiaries

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

management meets at least quarterly with the Surveillance Group to review the status of their work to determine the adequacy of Ambac’s loss reserves and make any necessary adjustments. Active credit reserves were $171,697 and $197,607 at March 31, 2006 and December 31, 2005, respectively. The active credit reserves at March 31, 2006 and December 31, 2005 was comprised of 78 and 90 credits with net par outstanding of $5,755,585 and $6,319,724, respectively. Included in the calculation of active credit reserves at March 31, 2006 and December 31, 2005 was the consideration of $19,460 and $17,479, respectively, of reinsurance which would be due to Ambac Assurance from the reinsurers, upon default of the insured obligation.

Case basis credit reserves are for losses on insured obligations that have defaulted. We believe our definition of case basis credit reserves differs from other financial guarantee industry participants. Upon the occurrence of a payment default, the related active credit reserve is transferred to case basis credit reserve. Additional provision for losses upon further credit deterioration of a case basis exposure are initially recorded through the active credit reserve and subsequently transferred to case basis credit reserves. Our case reserves represent the present value of anticipated loss and loss expense payments expected over the estimated period of default. Loss and loss expenses consider anticipated defaulted debt service payments, estimated expenses associated with settling the claims and estimated recoveries under collateral and subrogation rights. The estimate does not consider future installment premium receipts, as the likelihood of such receipts is remote. Ambac assurance discounts these estimated net payments using discount rates that approximate the average taxable equivalent yield on our investment portfolio.

Discount rates applied to case basis credit reserves were 4.75% at March 31, 2006 and December 31, 2005, respectively. Case basis credit reserves were $121,310 and $106,532 at March 31, 2006 and December 31, 2005, respectively. The case basis credit reserves at March 31, 2006 and December 31, 2005 were comprised of 10 credits, with net par outstanding of $740,551 and $838,975, respectively. Additionally, we have reinsurance recoverables on case basis credit reserves of $5,153 and $3,468 at March 31, 2006 and December 31, 2005, respectively.

Ambac Assurance provides information on the classification of its loss reserve between active credit reserve and case basis credit reserve for the purpose of disclosing the components of the total reserve that relate to exposures that have not yet defaulted and those that have defaulted. The total reserve (active credit and case basis) was $298,160 and $304,139 at March 31, 2006 and December 31, 2005, respectively. Due to the relatively small number and large size of certain insured obligations comprising the active and case basis credit reserves, improvements or further deterioration in any one credit may significantly impact our loss provision in a given period. The provision for losses and loss expenses in the accompanying Consolidated Statements of Operations represents the expense recorded to bring the total reserve to a level determined by management to be adequate for losses inherent in the non-derivative financial guarantee insurance portfolio.

Our liabilities for credit losses are based in part on the short-duration accounting guidance in SFAS No. 60, “Accounting and Reporting by Insurance Enterprises.” The trustee (on behalf of

9

Ambac Assurance Corporation and Subsidiaries

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

the insured party), named beneficiary or custodian has a right to a claim payment under the financial guarantee insurance policy at the date of the first scheduled debt service payment of a defaulted security in the amount equal to the payment shortfall. We believe a loss event occurs for financial guarantee insurance products at the time the issuers’ financial condition deteriorates to an impaired credit status rather than at the time the insured party has a right to a claim payment. Because of this belief and the ambiguities discussed below in the application of SFAS No. 60 to the financial guarantee industry, Ambac Assurance does not believe that SFAS No. 60 alone provides sufficient guidance. As a result, Ambac Assurance supplements the guidance in SFAS No. 60 with the guidance in SFAS No. 5, “Accounting for Contingencies,” which calls for a loss to be accrued if it is probable that a liability has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated. Ambac Assurance also relies by analogy on EITF Issue No. 85-20, “Recognition of Fees for Guaranteeing a Loan,” which states that a guarantor should perform an ongoing assessment of the probability of loss to determine if a liability (and a loss) should be recognized under SFAS No. 5.

In management’s view, the accounting guidance noted above does not comprehensively address the attributes of financial guarantee insurance contracts, primarily due to the fact that SFAS No. 60 was developed prior to the maturity of the financial guarantee industry. Financial guarantee contracts have elements of long-duration insurance contracts in that they are generally irrevocable and extend over a period of time that may be 30 years or more but are considered and reported for regulatory purposes as property and casualty insurance, normally considered short-duration contracts. The short-duration and long-duration classifications have different methods of accounting for premium revenue, deferred acquisition costs and contract liability recognition.

Ambac Assurance is aware that there are certain differences regarding the measurement of liabilities for credit losses among participants in the financial guarantee industry. Difficulties applying the existing insurance accounting literature such as the classification of the insurance contracts as either short-duration or long-duration to the attributes of financial guarantee insurance, different measurement models and assumptions utilized, regulatory guidance provided to certain entities, and the existence of accounting literature providing guidance with respect to liability recognition for loan guarantees are the reasons for differences among the industry participants.

In January and February of 2005, the Securities and Exchange Commission (“SEC”) staff discussed with the financial guarantee industry participants differences in loss reserve recognition practices among those participants. In June 2005, the Financial Accounting Standards Board (“FASB”) added a project to its agenda to consider the accounting by financial guarantee insurers for claims liability recognition, premium recognition and deferred acquisition costs. The proposed and final documents are expected to be issued in 2006. When the FASB or SEC reach a conclusion on this issue, Ambac Assurance and the rest of the financial guarantee industry may be required to change some aspects of their loss reserving policies and the potential changes could extend to premium and expense recognition. Ambac cannot predict how the FASB or SEC will resolve this issue and the resulting impact on our financial statements. Until the issue is resolved, Ambac Assurance intends to continue to apply its existing policy with respect to the establishment of both case and active credit reserves.

10

Ambac Assurance Corporation and Subsidiaries

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

(3) Segment Information

Ambac Assurance has two reportable segments, as follows: (1) financial guarantee, which provides financial guarantees (including structured credit derivatives) for public finance and structured finance obligations; and (2) financial services, which provides payment agreements, interest rate, currency and total return swaps.

Ambac Assurance’s reportable segments are strategic business units that offer different products and services. They are managed separately because each business requires different marketing strategies, personnel skill sets and technology.

Pursuant to insurance and indemnity agreements between Ambac Financial Services and Ambac Assurance, Ambac Financial Services’ payment obligations under its swap agreements are guaranteed by Ambac Assurance. Additionally, the payment obligations of Ambac Financial Services’ counterparties, under their swap agreements with Ambac Financial Services, are guaranteed by Ambac Assurance pursuant to insurance and indemnity agreements. Intersegment revenues include the premiums earned under those agreements. Such premiums are determined as if they were premiums to third parties, that is, at current market prices. In the three months ended March 31, 2006 and 2005, Financial Guarantee intersegment revenues include dividends of $11,000 and $0, respectively, from the Financial Services segment.

The following tables summarize the financial information by reportable segment as of and for the three months ended March 31, 2006 and 2005:

(Dollars in thousands) Three months ended March 31,	Financial Guarantee		Financial Services			Intersegment Eliminations			Consolidated
2006:
Revenues:
External customers	$	353,447	$	13,028		$	—		$	366,475
Intersegment		11,700		—			(11,700	)		—
Total revenues	$	365,147	$	13,028			($11,700)		$	366,475
Income before income taxes:
External customers	$	302,801	$	9,315		$	—		$	312,116
Intersegment		12,374		(1,374	)		(11,000	)		—
Total income before income taxes	$	315,175	$	7,941			($11,000)		$	312,116
Total assets	$	11,081,256	$	1,147,715		$	—		$	12,228,971
2005:
Revenues:
External customers	$	323,004	$	11,855		$	—		$	334,859
Intersegment		648		—			(648	)		—
Total revenues	$	323,652	$	11,855			($648)		$	334,859
Income before income taxes:
External customers	$	254,550	$	8,664		$	—		$	263,214
Intersegment		1,227		(1,227	)		—			—
Total income before income taxes	$	255,777	$	7,437		$	—		$	263,214
Total assets	$	10,332,074	$	1,474,593		$	—		$	11,806,667

11

Ambac Assurance Corporation and Subsidiaries

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

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 months ended March 31, 2006 and 2005:

	Three Months 2006				Three Months 2005
(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
United States	$	171,805	$	157,750	$	182,763	$	158,387
United Kingdom		16,146		15,204		18,184		15,941
Japan		6,660		6,115		7,072		7,209
Australia		682		3,034		691		2,180
Brazil		2,553		2,237		2,964		2,404
Italy		1,476		2,066		1,503		2,081
Mexico		1,210		1,095		3,497		1,611
Internationally diversified(1)		9,396		12,855		8,466		14,622
Other international		9,794		9,070		5,435		7,869
Total	$	219,722	$	209,426	$	230,575	$	212,304

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

(4) Employee Benefit Plans

Stock-based Compensation:

The Ambac Financial Group 1997 Equity Plan (the “Equity Plan”) provides for the granting of stock options, stock appreciation rights, restricted stock units (“RSUs”), performance units and other awards that are valued or determined by reference to Ambac Financial Group’s Common Stock. Ambac Financial Group also maintains the Ambac 1997 Non-Employee Directors Equity Plan, which provides awards of stock options and restricted stock units to non-employee members of the Ambac’s Board of Directors. Stock options and RSUs granted under these plans provide that vesting is accelerated in certain circumstances such as upon retirement or death. The number of options and their exercise price, and the number of restricted stock units awarded to each non-employee director under the Directors Equity Plan are determined by formula. As of March 31, 2006, approximately 7,442,943 shares were available for future grant under the Equity Plan and the Directors Equity Plan.

Since January 1, 2003, Ambac Assurance accounted for stock-based employee compensation in accordance with the fair-value method prescribed by SFAS No. 123 as amended by SFAS Statement 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” (“SFAS 148”), prospectively to all employee awards granted after January 1, 2003.

12

Ambac Assurance Corporation and Subsidiaries

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

Effective January 1, 2006, Ambac Assurance adopted SFAS No. 123-R, “Share-Based Payment”, (“SFAS No. 123-R”) by using the modified prospective approach to all employee awards granted after the effective date. Beginning with the effective date, SFAS 123-R requires entities to recognize compensation cost for all equity-classified awards after the effective date and for all awards granted to employees prior to the effective date of SFAS No. 123-R that remain unvested on the effective date using the fair-value measurement method and estimating forfeitures for all unvested awards. Key differences between SFAS No. 123-R and SFAS No. 123 are:

SFAS No. 123-R provides further clarification that the Black-Scholes-Merton model is not appropriate for stock options containing a market condition that affects vesting and the ability to exercise. Stock options granted in 2006 will vest on the earlier of Ambac’s common stock achieving certain price targets (market conditions) or meeting the requisite service requirement. The fair value of each market condition award was estimated on the date of grant using a Monte Carlo simulation model. Stock options granted prior to the adoption of SFAS 123-R were valued using the Black-Scholes-Merton model.

SFAS 123-R requires compensation expense be recognized for partially vested awards outstanding at its effective date. Expense will be recognized for the remainder of the requisite service period. Certain market condition stock option grants previously accounted for under APB No. 25 were partially vested as of January 1, 2006. For the quarter ended March 31, 2006 approximately $205 of compensation expense is recorded for these partially vested awards.

SFAS No.123-R requires the grant date expensing of share-based awards granted to retirement-eligible employees. This is consistent with how Ambac Assurance recognized such awards under SFAS 123. Under SFAS No. 123-R Ambac Assurance must elect to continue to expense awards to retirement eligible employees on the grant date or accrue in the year prior to the grant date. Ambac Assurance elected to accrue the estimated cost of the 2007 stock-compensation grants to retirement-eligible employees over the service period. Therefore, Ambac Assurance will accrue the estimated cost of such awards over the course of the fiscal year preceding the grant date ($1,766 recognized in the first quarter of 2006). Stock options and restricted stock unit expenses are allocated to each of Ambac Financial Group’s subsidiaries based on the actual number of stock options and restricted stock units granted to each subsidiary’s employees.

Pensions:

Ambac Financial Group 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 of $2,000 is estimated to be made in 2006. 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.

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Ambac Assurance Corporation and Subsidiaries

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

Net periodic pension costs for the three months ended March 31, 2006 and 2005 include the following components:

	March 31, 2006			March 31, 2005
Service cost	$	543		$	471
Interest cost		425			363
Expected return on plan assets		(651	)		(599	)
Amortization of prior service cost		(26	)		(36	)
Recognized net loss		66			36
Total pension expense	$	357		$	235

Pension expense is allocated to each of Ambac Financial Group’s subsidiaries based on percentage of payroll. Pension expense recorded by Ambac Assurance amounted to $364 and $213 for the three months ended March 31, 2006 and 2005, respectively.

Postretirement and Other Benefits:

Ambac Financial Group provides postretirement and postemployment benefits, including health and life benefits that cover substantially all employees who meet certain age and service requirements. Amounts related to postretirement health benefits are charged based on actuarial determinations. These expenses are allocated for each of Ambac Financial Group’s subsidiaries based on a percentage of payroll. All plans are contributory. None of the plans are currently funded. Ambac Assurance’s postretirement benefit expense was $164 and $110 for the three months ended March 31, 2006 and 2005, respectively. Ambac Assurance’s post employment benefit expense was $67 and $72 for the three months ended March 31, 2006 and 2005, respectively.

(5) Special Purpose and Variable Interest Entities

Ambac Financial Group has involvement with special purpose entities, including variable interest entities (“VIEs”) in the following ways. First, Ambac Assurance is a provider of financial guarantee insurance for various debt obligations. Second, Ambac Financial Group 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 Financial Group sponsored special purpose entities are considered QSPEs. Lastly, Ambac Assurance is an investor in asset-backed securities issued by VIEs, and, in one transaction, has a beneficial interest in a VIE that purchases fixed rate municipal bonds with proceeds from the issuance of floating rate short term beneficial interests as discussed in detail below.

Financial Guarantees:

Ambac Assurance provides financial guarantees to debt obligations of special purpose entities, including VIEs. Ambac Assurance’s primary variable interest exists through this financial guarantee insurance or credit derivative contract. The transaction structure provides certain financial protection to Ambac Assurance. This financial protection can take several forms; however, the most common are over-collateralization, first loss and excess spread. In the case of over-collateralization, (i.e., the principal amount of the securitized assets exceeds

14

Ambac Assurance Corporation and Subsidiaries

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

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 Assurance. In the case of first loss, 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.

As of March 31, 2006, Ambac Assurance is the primary beneficiary under three transactions as a result of providing financial guarantees to these entities. Ambac Assurance consolidated these entities since the structural financial protections are outside the VIEs. These structural protections, had they existed inside the VIEs, would have absorbed a majority of the VIEs’ expected losses and consequently Ambac Assurance would not have consolidated these entities. All consolidated VIEs are bankruptcy remote special purpose financing entities created by the issuer of debt securities to facilitate the sale of notes guaranteed by Ambac Assurance. Ambac Assurance is not primarily liable for the debt obligations of these entities. Ambac Assurance would only be required to make payments on these debt obligations in the event that the issuer defaults on any principal or interest due. Additionally, Ambac Assurance’s creditors do not have rights with regard to the assets of these VIEs.

Proceeds from the note issuance of the first VIE transaction, which closed in 2002, were used to purchase senior mortgage-backed floating rate notes of a South Korean mortgage-backed securities issuer. Protections afforded Ambac Assurance in this transaction were in the form of a reserve fund and the issuance of subordinated debt. Ambac Assurance will pay claims under its financial guarantee only in the event that losses on the mortgage assets of the South Korean issuer reduce the reserve fund to zero and exceed the principal amount of the subordinated notes. Total long-term debt outstanding under this note issuance was $55,939 and $64,522 with a maturity date of December 3, 2022 and a variable rate of interest which was 4.94% and 4.26% at March 31, 2006 and December 31, 2005, respectively.

Proceeds from the note issuances of the other transactions, both of which closed in 2004, were used to purchase notes issued by special purpose reinsurance companies in connection with their reinsurance of defined blocks of life insurance contracts. Protections afforded Ambac Assurance were in the form of capital contributed to the reinsurance companies and the issuance of subordinated debt by the VIEs. Ambac Assurance will pay claims under its financial guarantees in these transactions if cash flows generated under the reinsurance agreements and the proceeds from the contributed capital and subordinated debt are insufficient to repay the noteholders. Total debt outstanding under these note issuances was $1,034,496 at March 31, 2006, with maturity dates ranging from April 15, 2016 to February 6, 2025. At March 31, 2006 the interest rate on these notes ranged from 4.65% to 4.91%. Under one of these transactions, Ambac Assurance is subject to potential consolidation of an additional $250,000 of assets and liabilities in connection with future utilization of the VIE by the reinsurer.

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Ambac Assurance Corporation and Subsidiaries

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

The following table provides supplemental information about the combined assets and liabilities associated with the VIEs discussed above. The assets and liabilities of these VIEs are consolidated into the respective Balance Sheet captions.

	At March 31, 2006		At December 31, 2005
Assets:
Cash	$	666	$	676
Loans Investment in fixed income securities		660,840 431,335		659,379 390,423
Investment income due and accrued		7,474		7,448
Total assets	$	1,100,315	$	1,057,926
Liabilities:
Long-term debt	$	1,090,435	$	1,041,848
Other Liabilities		9,790		15,493
Total liabilities		1,100,225		1,057,341
Stockholders’ equity:
Accumulated other comprehensive income		90		585
Total liabilities and stockholders’ equity	$	1,100,315	$	1,057,926

Qualified Special Purpose Entities:

Ambac Financial Group 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 SFAS 140. QSPEs are not subject to the requirements of FIN 46-R and accordingly are not consolidated in Ambac Financial Group’s or Ambac Assurance’s financial statements. The QSPEs are legal entities that are demonstrably distinct from Ambac Financial Group, and Ambac Financial Group, its affiliates or its agents cannot unilaterally dissolve the QSPEs. The QSPEs permitted activities are limited to those outlined below.

As of March 31, 2006, there have been 14 individual transactions processed through the QSPEs of which 9 are outstanding. In each case, Ambac Financial Group sold 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 Financial Group to repurchase or redeem assets of the QSPE. Additionally, Ambac Financial Group’s creditors do not have any rights with regards to the assets of the QSPEs. The purchase by the QSPE is financed through the issuance of MTNs, which are collateralized by the purchased assets. 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 Financial Group, 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 March 31, 2006, Ambac

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Ambac Assurance Corporation and Subsidiaries

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

Assurance had financial guarantee insurance policies issued for all assets and MTNs owned and outstanding by the QSPEs.

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 Assurance’s Consolidated Statements of Operations. Under the terms of an Administrative Agency Agreement, Ambac Financial Group provides certain administrative duties, primarily collecting amounts due on the obligations and making interest payments on the MTNs.

There were no assets sold to the QSPEs during the three months ended March 31, 2006 and the year ended December 31, 2005, respectively. As of March 31, 2006, the estimated fair value of financial assets, MTN liabilities and derivative hedge assets was $1,571,256, $1,610,929 and $4,094, respectively. When market quotes are not available, estimated fair value is determined utilizing valuation models. These models include estimates, made by Ambac Financial Group 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 $1,737 and $1,462 for the three months ended March 31, 2006 and 2005, respectively. Ambac Financial Group also received fees for providing other services amounting to $63 and $90 for the three months ended March 31, 2006 and 2005, respectively.

VIE Beneficial Interest:

Ambac Assurance owns a beneficial interest in a special purpose entity that meets the definition of a VIE. This entity has issued floating rate beneficial interests to investors and invested the proceeds in fixed income municipal investment securities. These beneficial interests are directly secured by the related municipal investment securities. Ambac Assurance is the primary beneficiary of this entity as a result of its beneficial interest. The fixed income municipal investment securities, which are reported as Investments in fixed income securities, at fair value on the Consolidated Balance Sheets, were $256,719 and $258,806 as of March 31, 2006 and December 31, 2005. The beneficial interests issued to third parties, are reported as Obligations payment agreements on the Consolidated Balance Sheets, were $248,750 and $248,760 as of March 31, 2006 and December 31, 2005. As of March 31, 2006 and December 31, 2005, the interest rates on these beneficial interests ranged from 2.95% to 3.26% and from 1.49% to 3.55%, respectively.

(6) Accounting Standards

On February 16, 2006, the FASB issued SFAS 155, “Accounting for Certain Hybrid Financial Instruments”. SFAS 155 amends SFAS 133 and SFAS 140, and addresses issues raised in SFAS 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” The primary objectives of SFAS 155 are: (i) with respect to SFAS 133, to address the accounting for beneficial interests in securitized financial assets and (ii) with respect to SFAS 140, eliminate a restriction on the passive derivative

17

Ambac Assurance Corporation and Subsidiaries

Notes to Unaudited Consolidated Financial Statements (Continued)

(Dollars in thousands)

instruments that a QSPE may hold. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Earlier adoption is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements, including financial statements for any interim period for that fiscal year. Ambac Assurance will adopt SFAS 155 on January 1, 2007 and is currently evaluating the implications of SFAS 155 on its financial statements.

On April 13, 2006, the FASB issued Staff Position (“FSP”) No. FIN 46(R)-6 “Determining the Variability to be Considered in Applying FASB Interpretation No. 46(R)”. This FSP addresses the approach to determine the variability to consider when applying FIN 46 (R) and includes illustrative examples of how the variability should be considered. The variability that is considered may affect the determination as to whether the entity is a VIE, the determination of which interest are variable interests in the entity, if necessary, the calculation of expected losses and residual returns of the entity, and the determination of which party is the primary beneficiary of the VIE. The effective date for prospective application is the first day of the first reporting period beginning after June 15, 2006. Retrospective application, if elected, should be completed no later than the end of the annual reporting period after July 15, 2006, effectively December 31, 2006 for Ambac. Ambac Assurance is currently evaluating the implications of this FSP on its financial statements.

The FASB is currently working on a number of amendments to the existing accounting standards governing financial guarantees, asset transfers, securitization, consolidation, and fair value of financial instruments. Upon completion of these standards, Ambac Assurance will need to reevaluate its accounting and disclosures. In addition, the FASB is currently working on a project that will change the accounting and reporting for pension and postretirement plans. Management expects the new standard to require companies to record an asset or liability on the Consolidated Balance Sheet equal to the funded status of the plans. Any other plan assets or liabilities would be reflected net as an adjustment to stockholders’ equity.

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