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 JUNE 30, 1998
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER: 1-10777
AMBAC FINANCIAL GROUP, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 13-3621676
(STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.)
ONE STATE STREET PLAZA
NEW YORK, NEW YORK 10004
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(212) 668-0340
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No__
-
As of June 30, 1998, 69,989,047 shares of Common Stock, par value $0.01
per share, (net of 691,337 treasury shares) of the Registrant were outstanding.
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
INDEX
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PAGE
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PART I FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets - June 30, 1998
and December 31, 1997................................................................. 3
Consolidated Statements of Operations - three months and six months
ended June 30, 1998 and June 30, 1997 June 30, 1998 and June 30, 1997.............. 4
Consolidated Statements of Stockholders' Equity - six months ended
June 30, 1998 and June 30, 1997....................................................... 5
Consolidated Statements of Cash Flows -six months ended
June 30, 1998 and June 30, 1997....................................................... 6
Notes to Consolidated Financial Statements............................................ 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations................................................. 8
Item 3. Quantitative and Qualitative Disclosures About
Market Risk......................................................................... 22
PART II OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders................................. 24
Item 6. Exhibits and Reports on Form 8-K.................................................... 25
SIGNATURES..................................................................................... 26
INDEX TO EXHIBITS.............................................................................. 27
Ambac Financial Group, Inc. and Subsidiaries
Consolidated Balance Sheets
June 30, 1998 and December 31, 1997
(Dollars in Thousands)
June 30, 1998 December 31, 1997
(unaudited)
Assets
Investments:
Fixed income securities, at fair value
(amortized cost of $7,506,272 in 1998 and $6,525,650 in 1997) $7,791,952 $6,773,844
Short-term investments, at cost (approximates fair value) 177,427 136,278
Preferred stock, at cost 5,000 5,000
---------------- --------------------
Total investments 7,974,379 6,915,122
Cash 28,490 9,256
Securities purchased under agreements to resell 214,318 85,466
Receivable for investment agreements 50,163 -
Receivable for securities sold 14,725 106,246
Investment income due and accrued 87,157 78,690
Reinsurance recoverable 4,119 4,219
Prepaid reinsurance 202,265 183,492
Deferred acquisition costs 110,973 105,996
Loans 676,912 503,192
Receivable from brokers and dealers 683,192 183,041
Other assets 188,447 116,985
---------------- --------------------
Total assets $10,235,140 $8,291,705
================ ====================
Liabilities and Stockholders' Equity
Liabilities:
Unearned premiums $1,220,701 $1,178,990
Losses and loss adjustment expenses 112,651 103,345
Ceded reinsurance balances payable 7,878 9,258
Obligations under investment and payment agreements 3,731,550 3,230,052
Obligations under investment repurchase agreements 1,557,845 1,090,912
Deferred income taxes 140,478 135,228
Current income taxes 2,263 9,016
Debentures 423,897 223,864
Accrued interest payable 54,914 46,017
Accounts payable and other liabilities 181,789 117,153
Payable to brokers and dealers 500,000 -
Payable for securities purchased 311,240 275,388
---------------- --------------------
Total liabilities 8,245,206 6,419,223
---------------- --------------------
Stockholders' equity:
Preferred stock - -
Common stock 707 707
Additional paid-in capital 512,039 500,107
Accumulated other comprehensive income 153,516 135,223
Retained earnings 1,355,957 1,262,740
Common stock held in treasury at cost (32,285) (26,295)
---------------- --------------------
Total stockholders' equity 1,989,934 1,872,482
---------------- --------------------
Total liabilities and stockholders' equity $10,235,140 $8,291,705
================ ====================
See accompanying Notes to Consolidated Financial Statements
3
Ambac Financial Group, Inc. and Subsidiaries
Consolidated Statements of Operations
(Unaudited)
For the Periods Ended June 30, 1998 and 1997
(Dollars in Thousands Except Share Data)
Three Months Ended Six Months Ended
June 30, June 30,
----------------------------- ------------------------------
1998 1997 1998 1997
----------------------------- ------------------------------
Revenues:
Financial Guarantee Insurance:
Gross premiums written $88,042 $73,740 $165,529 $125,532
Ceded premiums written (10,048) (7,195) (36,135) (12,627)
------------- -------------- -------------- --------------
Net premiums written 77,994 66,545 129,394 112,905
Increase in unearned premiums (24,676) (30,159) (22,892) (39,486)
------------- -------------- -------------- --------------
Net premiums earned 53,318 36,386 106,502 73,419
Net investment income 45,872 39,258 90,912 77,705
Net realized (losses) gains (509) 3,479 666 4,291
Other income 235 2,285 2,200 3,388
Financial Management Services:
Income 12,732 6,150 25,486 13,372
Net realized (losses) gains (6,350) 79 (7,248) 79
Other:
Income 4,047 1,828 5,403 3,689
Net realized gains 910 - 1,517 788
------------- -------------- -------------- --------------
Total revenues 110,255 89,465 225,438 176,731
------------- -------------- -------------- --------------
Expenses:
Financial Guarantee Insurance:
Losses and loss adjustment expenses 1,423 664 3,000 1,392
Underwriting and operating expenses 11,190 9,732 23,208 18,824
Financial Management Services 8,603 5,474 16,046 14,454
Interest 8,782 5,303 14,394 10,544
Other 1,744 456 4,080 1,285
------------- -------------- -------------- --------------
Total expenses 31,742 21,629 60,728 46,499
------------- -------------- -------------- --------------
Income before income taxes 78,513 67,836 164,710 130,232
Provision for income taxes 17,717 14,223 38,256 26,881
------------- -------------- -------------- --------------
Net income $60,796 $53,613 $126,454 $103,351
============= ============== ============== ==============
Net income per share $0.87 $0.77 $1.81 $1.48
============= ============== ============== ==============
Net income per diluted share $0.85 $0.75 $1.77 $1.46
============= ============== ============== ==============
Weighted average number of
shares outstanding 70,015,177 69,957,352 70,027,486 69,922,344
============= ============== ============== ==============
Weighted average number of diluted
shares outstanding 71,665,662 71,093,321 71,619,424 71,008,013
============= ============== ============== ==============
See accompanying Notes to Consolidated Financial Statements
4
Ambac Financial Group, Inc. and Subsidiaries
Consolidated Statements of Stockholders' Equity
(Unaudited)
For the Periods Ended June 30, 1998 and 1997
(Dollars in Thousands)
1998 1997
-------------------------- --------------------------
Retained Earnings:
Balance at January 1 $1,262,740 $1,072,418
Net income 126,454 $126,454 103,351 $103,351
------------- -------------
Dividends declared - common stock (12,593) (11,562)
Exercise of stock options (20,644) (7,109)
------------- -------------
Balance at June 30 $1,355,957 $1,157,098
------------- -------------
Accumulated Other Comprehensive Income:
Balance at January 1 $135,223 $58,911
Unrealized gains (losses)on securities,
($28,464 pre-tax and ($7,783) pre-tax in
1998 and 1997, respectively)(1) 18,120 (4,794)
Foreign currency 173 397
------------- -------------
Other comprehensive income (loss) 18,293 18,293 (4,397) (4,397)
-------------------------- --------------------------
Comprehensive income $144,747 $98,954
============= =============
Balance at June 30 $153,516 $54,514
------------- -------------
Preferred Stock:
Balance at January 1 and June 30 $- $-
------------- -------------
Common Stock:
Balance at January 1 and June 30 $707 $353
------------- -------------
Additional Paid-in Capital:
Balance at January 1 $500,107 $498,401
Issuance of stock - (3,560)
Exercise of stock options 11,905 4,377
Other 27 26
------------- -------------
Balance at June 30 $512,039 $499,244
------------- -------------
Common Stock Held in Treasury at Cost:
Balance at January 1 ($26,295) ($15,067)
Cost of shares acquired (20,856) (32,203)
Shares issued under equity plans 14,866 27,227
------------- -------------
Balance at June 30 ($32,285) ($20,043)
------------- -------------
Total Stockholders' Equity at June 30 $1,989,934 $1,691,166
============= =============
(1) Disclosure of reclassification amount:
Unrealized holding gains (losses) arising during period $19,580 ($1,441)
Less: reclassification adjustment for gains
included in net income 1,460 3,353
------------- -------------
Net unrealized gains (losses) on securities $18,120 ($4,794)
============= =============
See accompanying Notes to Consolidated Financial Statements.
5
Ambac Financial Group, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(Unaudited)
For The Periods Ended June 30, 1998 and 1997
(Dollars in Thousands)
Six Months Ended
June 30,
-------------------------------
1998 1997
------------- -------------
Cash flows from operating activities:
Net income $126,454 $103,351
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 792 872
Amortization of bond premium and discount (2,416) (723)
Current income taxes (6,753) 2,254
Deferred income taxes (5,094) 5,299
Deferred acquisition costs (4,977) (7,179)
Unearned premiums, net 22,938 39,499
Losses and loss adjustment expenses 9,306 821
Ceded reinsurance balances payable (1,380) 4,285
Investment income due and accrued (8,467) (3,977)
Accrued interest payable 8,897 7,751
Loss (gain) on sales of investments 5,065 (5,158)
Accounts payable and other liabilities 64,636 (11,916)
Other, net (75,256) (12,389)
------------- -------------
Net cash provided by operating activities 133,745 122,790
------------- -------------
Cash flows from investing activities:
Proceeds from sales of bonds 265,478 859,455
Proceeds from matured bonds 1,157,445 582,984
Purchases of bonds (2,268,960) (2,091,575)
Change in short-term investments (41,149) (29,826)
Securities purchased under agreements to resell (128,852) 19,087
Loans (173,720) -
Other, net (18,138) 4,638
------------- -------------
Net cash used in investing activities (1,207,896) (655,237)
------------- -------------
Cash flows from financing activities:
Dividends paid (12,593) (11,562)
Proceeds from issuance of investment agreements 1,705,983 1,158,705
Payments for investment agreement draws (961,435) (610,702)
Proceeds from issuance of debentures 193,700 -
Payment agreements 173,720 -
Proceeds from sale of treasury stock 14,866 27,227
Purchases of treasury stock (20,856) (32,203)
------------- -------------
Net cash provided by financing activities 1,093,385 531,465
------------- -------------
Net cash flow 19,234 (982)
Cash at January 1 9,256 7,734
------------- -------------
Cash at June 30 $28,490 $6,752
============= =============
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Income taxes $41,250 $14,110
============= =============
Interest expense on debt $14,515 $10,896
============= =============
Interest expense on investment agreements $115,551 $76,099
============= =============
See accompanying Notes to Consolidated Financial Statements
6
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS
(1) Basis of Presentation
Ambac Financial Group, Inc., (the "Company") headquartered in New York
City, is a holding company whose affiliates provide financial guarantee
insurance and financial management services to clients in both the public and
private sectors in the U.S. and abroad. The Company's principal operating
subsidiary, Ambac Assurance Corporation ("Ambac Assurance"), a leading insurer
of municipal and structured finance obligations, has earned triple-A claims-
paying ability ratings, the highest ratings available from Moody's Investors
Service, Inc., Fitch IBCA, Inc., and Japan Rating and Investment Information,
Inc., and a financial strength rating of triple-A from Standard & Poor's Ratings
Group. Ambac Financial Group, Inc.'s Financial Management Services segment
provides investment agreements, interest rate swaps, investment advisory and
cash management services, and electronic commerce solutions, principally to
states, municipalities and their authorities, school districts, and hospitals
and health organizations.
The Company's consolidated unaudited interim financial statements have
been prepared on the basis of generally accepted accounting principles ("GAAP")
and, in the opinion of management, reflect all adjustments, consisting only of
normal recurring adjustments, necessary for a fair presentation of the Company'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 months and six months ended
June 30, 1998 may not be indicative of the results that may be expected for the
full year ending December 31, 1998. These consolidated financial statements and
notes should be read in conjunction with the financial statements and notes
included in the audited consolidated financial statements of Ambac Financial
Group, Inc. and its subsidiaries contained in (i) the Company's Annual Report on
Form 10-K for the year ended December 31, 1997, which was filed with the
Securities and Exchange Commission (the "Commission") on March 31, 1998, and
(ii) the Company's Quarterly Report on Form 10-Q for the quarterly period ended
March 31, 1998, which was filed with the Commission on May 15, 1998.
The consolidated financial statements include the accounts of the
Company and each of its subsidiaries. All significant intercompany balances have
been eliminated.
Certain reclassifications have been made to prior periods' amounts to
conform to the current period's presentation. In December 1997, the Company
implemented Financial Accounting Standard ("FAS") No. 128, Earnings per Share.
All prior periods presented have been restated to reflect this requirement.
All common stock data has been retroactively adjusted to reflect the
two-for-one stock split effective September 10, 1997.
(2) NEW ACCOUNTING STANDARDS
As of January 1, 1998, the Company adopted FAS No. 130, Reporting
Comprehensive Income. This statement establishes standards for the reporting and
presentation of comprehensive income and its components in a full set of
financial statements. Comprehensive income
7
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (CONTINUED)
encompasses all changes in stockholders' equity (except those arising from
transactions with stockholders) and includes net income, net unrealized capital
gains or losses on available-for-sale securities and foreign currency
translation adjustments. As this new standard only requires additional
information in the financial statements, it does not affect the Company's
financial position or results of operations.
In June 1998, the Financial Accounting Standards Board issued Statement No. 133,
Accounting for Derivative Instruments and Hedging Activities, which is required
to be adopted in years beginning after June 15, 1999. The Company expects to
adopt the new Statement effective January 1, 2000. The Statement will require
the Company to recognize all derivatives on the balance sheet at fair value.
Derivatives that are not hedges must be adjusted to fair value through income.
If the derivative qualifies as a hedge, depending on the nature of the hedge,
changes in the fair value of the derivative will either be offset against the
change in fair value of the hedged assets or liabilities through earnings or
recognized in other comprehensive income until the hedged item is recognized in
earnings. The ineffective portion of a derivative's change in fair value will
be immediately recognized in earnings.
The Company uses derivatives (primarily interest rate swaps and exchange traded
futures contracts) for hedging purposes as part of its overall interest rate
risk management. The provisions of Statement 133 are applicable to all of the
Company's derivative hedge positions. The Company has not yet determined what
the effect of Statement 133 will be on the earnings and financial position of
the Company. In addition to hedging, the Company, through its affiliate, Ambac
Financial Services, L.P., uses derivatives which are classified as held for
trading purposes. All derivatives held for trading purposes are recorded at fair
value, with changes in fair value immediately recognized in earnings. As such,
Statement 133 will have no effect on derivatives held for trading purposes.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following paragraphs describe the consolidated results of operations of
Ambac Financial Group, Inc. and its subsidiaries (sometimes collectively
referred to as the "Company") for the three and six month periods ended June
30, 1998 and 1997, and its financial condition as of June 30, 1998 and December
31, 1997. These results include the Company's two business segments: Financial
Guarantee Insurance and Financial Management Services.
In this Form 10-Q, we make statements about our future results that are
considered "forward-looking statements" under the Private Securities Litigation
Reform Act of 1995. These statements are based on our current expectations and
the current economic environment. We caution you that these statements are not
guarantees of future performance. They involve a number of risks and
uncertainties that are difficult to predict. Our actual results could differ
materially from those expressed or implied in the forward-looking statements.
Among the factors that could cause actual results to differ materially are (1)
changes in the economic or interest rate environment in the U.S. and abroad, (2)
the level of national and worldwide fixed income markets, (3) competitive
conditions and pricing levels, (4) legislative and regulatory developments, (5)
changes in tax laws and (6) other risks and uncertainties that we identify from
time to time in our public filings with the Securities and Exchange Commission.
We undertake
8
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
no obligation to publicly correct or update any forward-looking statement if we
later become aware that it is not likely to be achieved.
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 1998 VERSUS
THREE MONTHS ENDED JUNE 30, 1997
CONSOLIDATED NET INCOME
The Company's net income for the three months ended June 30, 1998 was $60.8
million or $0.85 per diluted share. This represents a 13% increase from the
three months ended June 30, 1997 net income of $53.6 million, and a 13% increase
in net income per diluted share from $0.75 for the prior period. This increase
in net income was primarily attributable to the growth in net premiums earned
and increased investment income from the Financial Guarantee Insurance segment.
FINANCIAL GUARANTEE INSURANCE
Gross Par Written. Ambac Assurance insured $16.3 billion in par value
-----------------
bonds during the three months ended June 30, 1998, an increase of 58% from $10.3
billion in the three months ended June 30, 1997. Par value written for the
second quarter of 1998 was comprised of $8.6 billion from domestic municipal
bond obligations, $6.5 billion from domestic structured finance obligations and
$1.2 billion from international obligations, compared to $7.3 billion, $2.4
billion and $0.6 billion, respectively, in the second quarter of 1997. The
increase in insured domestic municipal bond obligations resulted primarily from
increased market issuance, partially offset by Ambac Assurance's lower market
share for the quarter. The increase in insured domestic structured finance
obligations was principally in the mortgage-backed/home equity loan and asset-
backed sectors. The increase in insured international obligations resulted from
greater acceptance of financial guarantee insurance, primarily in Europe and
Japan.
Management believes that in the foreseeable future, domestic structured
finance and international markets will grow more rapidly than the domestic
municipal market. Domestic structured finance and international insured par may
see large quarterly variances, primarily due to the developmental nature of
these markets.
Ambac serves clients in international markets through its wholly-owned
subsidiary Ambac Insurance UK Limited and through its participation in MBIA-
AMBAC International, a joint venture with MBIA Insurance Corporation.
Gross Premiums Written. Gross premiums written for the three months ended
----------------------
June 30, 1998 were $88.0 million, an increase of 19% from $73.7 million in the
three months ended June 30, 1997. The following table sets forth the amounts of
gross premiums written by type and percent of total:
9
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
Three Months Ended June 30,
-------------------------------------------------------------
(Dollars in Millions) 1998 % 1997 %
------------ ---------- ------------- -----------
Domestic:
Municipal finance policies:
Up-front policies:
New issue...................................................... $49.8 56% $47.7 65%
Secondary market............................................... 7.8 9 7.3 10
------------ ---------- ------------- -----------
Sub-total up-front............................................ 57.6 65 55.0 75
------------ ---------- ------------- -----------
Installment policies:
Annual policies................................................ 3.5 4 3.0 4
Portfolio products............................................. 0.6 1 0.8 1
------------ ---------- ------------- -----------
Sub-total installment...................................... 4.1 5 3.8 5
------------ ---------- ------------- -----------
Total municipal finance policies............................ 61.7 70 58.8 80
------------ ---------- ------------- -----------
Structured finance policies:
Up-front....................................................... 0.7 1 0.6 1
Installment.................................................... 8.1 9 4.5 6
------------ ---------- ------------- -----------
Total structured finance policies......................... 8.8 10 5.1 7
------------ ---------- ------------- -----------
Total domestic written................................. 70.5 80 63.9 87
------------ ---------- ------------- -----------
International:
Up-front................................................. 14.9 17 8.3 11
Installment.............................................. 2.6 3 1.5 2
------------ ---------- ------------- -----------
Total international written............................ 17.5 20 9.8 13
------------ ---------- ------------- -----------
Total gross premiums written........................... $88.0 100% $73.7 100%
============ ========== ============= ===========
Total up-front written............................................ $73.2 83% $63.9 87%
Total installment written......................................... 14.8 17 9.8 13
------------ ---------- ------------- -----------
Total gross premiums written..................................... $88.0 100% $73.7 100%
============ ========== ============= ===========
Ceded Premiums Written. Ceded premiums written for the second quarter of
----------------------
1998 were $10.0 million, compared to $7.2 million in the second quarter of 1997.
The 39% increase in ceded premiums written is broken out as follows: (i) an
increase of $1.5 million ceded on international policies; and (ii) an increase
of $1.4 million ceded on municipal finance policies. Ceded premiums written were
11.4% and 9.8% of gross premiums written for the three months ended June 30,
1998 and 1997, respectively.
Net Premiums Written. Net premiums written for the three months ended June
--------------------
30, 1998 were $78.0 million, an increase of 17% from $66.5 million in the three
months ended June 30, 1997. This increase reflects higher gross premiums
written, partially offset by higher premiums ceded to reinsurers in the three
months ended June 30, 1998 compared with the corresponding prior period.
Net Premiums Earned. Net premiums earned during the three months ended June
-------------------
30, 1998 were $53.3 million, an increase of 46% from $36.4 million in the three
months ended June 30, 1997. The increase was primarily the result of increased
premiums earned from refundings, calls, and other accelerations and an increase
in premiums earned from the underlying book of business. Net premiums earned for
the three months ended June 30, 1998 included $13.9 million (which had a net
income per diluted share effect of $0.11) from refundings, calls and other
accelerations of previously insured issues. Net premiums earned in the three
months ended June 30, 1997 included $5.8 million (which had a net income per
diluted share effect of $0.05) from refundings, calls and other accelerations.
Refunding levels vary depending upon a
10
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
number of conditions, primarily the relationship between current interest rates
and interest rates on outstanding debt. Excluding the effect of accelerated
earnings from refundings, calls and other accelerations, net premiums earned for
the three months ended June 30, 1998 were $39.5 million, an increase of 29% from
$30.6 million in the three months ended June 30, 1997.
Net Investment Income. Net investment income for the three months ended
---------------------
June 30, 1998 was $45.9 million, an increase of 17% from $39.3 million in the
three months ended June 30, 1997. The increase was primarily attributable to the
growth of the investment portfolio from ongoing operations and the net increase
in the investment portfolio from the acquisition of Connie Lee Insurance Company
("Connie Lee") in December, 1997. Ambac Assurance's investments in tax-exempt
securities amounted to 71% of the total market value of its portfolio as of June
30, 1998, versus 80% at June 30, 1997. The average pre-tax yield-to-maturity on
the investment portfolio was 6.39% and 6.40% as of June 30, 1998 and 1997,
respectively.
Net Realized (Losses) Gains. Net realized losses were $0.5 million for the
---------------------------
three months ended June 30, 1998, compared to $3.5 million in net realized gains
for the comparative prior period in 1997.
Other Income. Other income was $0.2 million for the three months ended
-------------
June 30, 1998, compared to $2.3 million for the three months ended June 30,
1997. This decrease was primarily due to lower income from certain real estate
interests.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses
-----------------------------------
for the three months ended June 30, 1998 were $1.4 million, versus $0.7 million
for the three months ended June 30, 1997. Salvage received was $5.5 million and
$0 for the three months ended June 30, 1998 and 1997, respectively. The Company
increased the contribution to the loss reserve for the entire amount of salvage
received. The increase was a result of the growth in the insured book of
business, as loss expenses and related reserves are based upon estimates of the
ultimate aggregate losses inherent in the obligations insured.
Underwriting and Operating Expenses. Underwriting and operating expenses
-----------------------------------
for the second quarter of 1998 were $11.2 million, an increase of 15% from $9.7
million in the second quarter of 1997, primarily as a result of higher
compensation costs. Underwriting and operating expenses consist of gross
underwriting and operating expenses, less the deferral to future periods of
expenses and reinsurance commissions related to the acquisition of new insurance
contracts, plus the amortization of previously deferred expenses and reinsurance
commissions. During the three months ended June 30, 1998, gross underwriting and
operating expenses were $16.4 million, an increase of 14% from $14.4 million in
the three months ended June 30, 1997. This increase reflects the overall
increased business activity during the period. Underwriting and operating
expenses deferred were $9.5 million and $8.0 million for the three months ended
June 30, 1998 and 1997, respectively. Reinsurance commissions which related to
the current period (net of deferred) were $0.3 million and $0 for the three
months ended June 30, 1998 and 1997, respectively. The amortization of
previously deferred expenses and reinsurance commissions was $4.6 million and
$3.3 million for the three months ended June 30, 1998 and 1997, respectively.
11
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
FINANCIAL MANAGEMENT SERVICES
Through its financial management services subsidiaries, the Company
provides investment agreements, interest rate swaps, investment advisory and
cash management services, and electronic commerce solutions, principally to
states, municipalities and their authorities, school districts, and hospitals
and health organizations. Revenues for the three months ended June 30, 1998 were
$12.7 million (excludes $6.4 million in net realized losses), up 105% from $6.2
million (excludes $0.1 million in net realized gains) for the three months ended
June 30, 1997. This increase is primarily due to (i) higher revenues on interest
rate swaps which totaled $5.1 million in the period, up 410% from $1.0 million
in the comparable prior period, and (ii) higher investment agreement revenue
which totaled $5.0 million in the period, up 79% on increased volume, from $2.8
million in the comparable prior period. A small percentage of the Company's
investment portfolio is maintained as a trading position. This position contains
high quality municipal bonds hedged with treasury futures. A change in the
relationship between municipal bonds and treasury bonds has created a mark-to-
market loss in the second quarter of 1998 equal to $6.4 million. Expenses for
the second quarter of 1998 were $8.6 million, up 56% from $5.5 million in the
second quarter of 1997. This increase results from higher compensation expenses
in the investment agreement and swap businesses, as well as increased
expenditures to develop the money management and electronic commerce businesses.
CORPORATE ITEMS
Other Revenue. Other revenue includes investment income of the holding
-------------
company, Ambac Financial Group, Inc. Other revenue for the three months ended
June 30, 1998 was $4.0 million, up 122% from $1.8 million for the comparable
prior period. The increase is attributable to higher investment income generated
from investing the proceeds of the Company's issuance of $200 million in
debentures on April 1, 1998.
Interest Expense. Interest expense for the three months ended June 30, 1998
----------------
was $8.8 million, up 66% from $5.3 million for the three months ended June 30,
1997. The increase is attributable to the Company's issuance of $200 million in
debentures (see Liquidity and Capital Resources section) on April 1, 1998.
Income Taxes. Income taxes for the three months ended June 30, 1998 were at
------------
an effective rate of 22.6%, versus 20.9% in the three months ended June 30,
1997. This increase was primarily due to the higher level of pre-tax income and
a lower percentage of tax-exempt investment income.
SUPPLEMENTAL ANALYTICAL FINANCIAL DATA
Management, equity analysts and investors consider the following four
measures important in analyzing the financial results, and measuring the
intrinsic value of the Company: core earnings; operating earnings; adjusted
gross premiums written; and adjusted book value. However, none of these measures
are promulgated in accordance with GAAP and should not be considered as
substitutes for net income, gross premiums written and book value. The
definitions of core earnings, operating earnings, adjusted gross premiums
written and adjusted
12
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
book value described below may differ from the definitions used by other public
holding companies of financial guarantee insurers.
Core Earnings. Core earnings for the three months ended June 30, 1998 were
-------------
$56.8 million, an increase of 18% from $48.0 million for the three months ended
June 30, 1997. The increase in core earnings was primarily the result of
continued higher premiums earned from the growth in the insurance book of
business and higher net investment income from insurance operations, as well as
higher revenues from the investment agreement and swap businesses in the
financial management services segment. The Company defines core earnings as
consolidated net income, less the effect of net realized gains and losses, net
insurance premiums earned from refundings and calls and certain non-recurring
items.
Operating Earnings. Operating earnings for the second quarter of 1998 were
------------------
$64.7 million, an increase of 26% from $51.3 million in the second quarter of
1997. The Company defines operating earnings as consolidated net income, less
the effect of net realized gains and losses and certain non-recurring items.
The following table reconciles net income computed in accordance with
GAAP to operating earnings and core earnings for the three months ended June 30,
1998 and 1997:
(Dollars in Millions) 1998 1997
---------------- ----------------
Net Income................................................................................... $60.8 $53.6
Net realized losses (gains), after tax....................................................... 3.9 (2.3)
---------------- ----------------
Operating earnings........................................................................ 64.7 51.3
Premiums earned from refundings, calls and other accelerations, after tax.................... (7.9) (3.3)
---------------- ----------------
Core earnings............................................................................. $56.8 $48.0
================ ================
The weighted average number of diluted shares outstanding during the second
quarter of 1998 and 1997 was 71.7 million and 71.1 million, respectively.
Adjusted Gross Premiums Written. Adjusted gross premiums written were
-------------------------------
$114.4 million in the second quarter of 1998, up 43% from $79.8 million in the
second quarter of 1997. The Company defines adjusted gross premiums written as
up-front premiums written (less amounts ceded to MBIA Insurance Corporation
under our international joint venture) plus the present value of estimated
future installment premiums written in the period. While most premiums are
collected up-front at policy issuance, a growing portion of premiums are
collected on an installment basis. The net present value of estimated future
installment premiums written in the second quarter of 1998 was $46.5 million, an
increase of 138% from $19.5 million written in the second quarter of 1997. The
aggregate net present value of estimated future installment premiums was $249.8
million and $210.8 million as of June 30, 1998 and December 31, 1997,
respectively.
The following table reconciles total up-front premiums written to adjusted
gross premiums written for the three months ended June 30, 1998 and 1997:
13
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
(Dollars in Millions) 1998 1997
---------------- ----------------
Adjusted Gross Premium Analysis (1):
Total Up-front premiums written.............................................................. $ 67.9 $60.3
PV of estimated future installment premiums.................................................. 46.5 19.5
---------------- ----------------
Adjusted gross premiums written.......................................................... $114.4 $79.8
================ ================
(1) Excludes amounts ceded to MBIA Insurance Corporation under our international
joint venture of $8.2 million and $4.7 million for the three months ended June
30, 1998 and 1997, respectively.
Adjusted Book Value. Adjusted book value ("ABV") per common share increased
-------------------
5% to $38.57 at June 30, 1998 compared to $36.59 at December 31, 1997. The
Company derives ABV by beginning with stockholders' equity (book value) and
adding or subtracting the after-tax value of: the net unearned premium reserve;
deferred acquisition costs; the present value of estimated net future
installment premiums; and the unrealized gain or loss on investment agreement
liabilities. These adjustments will not be realized until future periods and may
differ materially from the amounts used in determining ABV.
The following table reconciles book value per share to ABV per share as of
June 30, 1998 and December 31, 1997:
June 30, December 31,
1998 1997
--------------------------- ---------------------------
Book value per share.................................................. $28.43 $26.77
After-tax value of:
Net unearned premium reserve........................................ 9.46 9.25
Deferred acquisition costs.......................................... (1.03) (0.99)
Present value of installment premiums............................... 2.32 1.96
Unrealized gain on investment agreement liabilities................. (0.61) (0.40)
--------------------------- ---------------------------
Adjusted book value per share......................................... $38.57 $36.59
=========================== ===========================
RESULTS OF OPERATIONS
SIX MONTHS ENDED JUNE 30, 1998 VERSUS
SIX MONTHS ENDED JUNE 30, 1997
CONSOLIDATED NET INCOME
The Company's net income for the six months ended June 30, 1998 was $126.5
million or $1.77 per diluted share. This represents a 22% increase from the
comparable prior period net income of $103.4 million, and a 21% increase in net
income per diluted share from $1.46. This increase in net income was primarily
attributable to the growth in net premiums earned and increased investment
income from the Financial Guarantee Insurance segment as well as higher
operating income in the Financial Management Services segment.
FINANCIAL GUARANTEE INSURANCE
Gross Par Written. Ambac Assurance insured $30.9 billion in par value
-----------------
bonds during the six months ended
14
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
June 30, 1998, an increase of 70% from $18.2 billion in the six months ended
June 30, 1997. Par value written for the six months ended June 30, 1998 was
comprised of $17.7 billion from domestic municipal bond obligations, $11.0
billion from domestic structured finance obligations and $2.2 billion from
international obligations, compared to $12.6 billion, $4.8 billion and $0.8
billion, respectively, in the six months ended June 30, 1997. The increase in
insured domestic municipal bond obligations resulted primarily from increased
market issuance. The increase in insured domestic structured finance obligations
was principally in the mortgage-backed/home equity loan and asset-backed
sectors. The increase in insured international obligations resulted from greater
acceptance of financial guarantee insurance, primarily in Europe and Japan.
Management believes that in the foreseeable future, domestic structured
finance and international markets will grow more rapidly than the domestic
municipal market. Domestic structured finance and international insured par may
see large quarterly variances, primarily due to the developmental nature of
these markets.
Ambac serves clients in international markets through its wholly-owned
subsidiary Ambac Insurance UK Limited and through its participation in MBIA-
AMBAC International, a joint venture with MBIA Insurance Corporation.
Gross Premiums Written. Gross premiums written for the six months ended
----------------------
June 30, 1998 were $165.5 million, an increase of 32% from $125.5 million in the
six months ended June 30, 1997. The following table sets forth the amounts of
gross premiums written by type and percent of total:
Six Months Ended June 30
---------------------------------------------------------------------
(Dollars in Millions) 1998 % 1997 %
-------------- -------------- -------------- --------------
Domestic:
Municipal finance policies:
Up-front policies:
New issue............................................. $ 99.3 60% $ 79.6 63%
Secondary market...................................... 10.7 7 11.9 10
-------------- -------------- -------------- --------------
Sub-total up-front................................... 110.0 67 91.5 73
-------------- -------------- -------------- --------------
Installment policies:
Annual policies....................................... 5.6 3 4.8 4
Portfolio products.................................... 1.2 1 1.6 1
-------------- -------------- -------------- --------------
Sub-total installment............................. 6.8 4 6.4 5
-------------- -------------- -------------- --------------
Total municipal finance policies................... 116.8 71 97.9 78
-------------- -------------- -------------- --------------
Structured finance policies:
Up-front.............................................. 0.7 - 7.8 6
Installment........................................... 14.8 9 8.2 7
-------------- -------------- -------------- --------------
Total structured finance policies................ 15.5 9 16.1 13
-------------- -------------- -------------- --------------
Total domestic written........................ 132.3 80 114.0 91
-------------- -------------- -------------- --------------
International:
Up-front........................................ 28.5 17 9.1 7
Installment..................................... 4.7 3 2.5 2
-------------- -------------- -------------- --------------
Total international written................... 33.2 20 11.6 9
-------------- -------------- -------------- --------------
Total gross premiums written.................. $165.5 100% $125.5 100%
============== ============== ============== ==============
Total up-front written................................... $139.2 84% $108.4 86%
Total installment written................................ 26.3 16 17.1 14
-------------- -------------- -------------- --------------
Total gross premiums written............................ $165.5 100% $125.5 100%
============== ============== ============== ==============
15
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
Ceded Premiums Written. Ceded premiums written for the first six months of
----------------------
1998 were $36.1 million, compared to $12.6 million in the first six months of
1997. The 187% increase in ceded premiums written is broken down as follows: (i)
the reinsurance of $11.8 million of the portfolio purchased through the
acquisition of Connie Lee; (ii) an increase of $7.7 million ceded on
international policies; and (iii) an increase of $4.1 million ceded on municipal
finance policies. Ceded premiums written were 21.8% (14.7% excluding the Connie
Lee reinsurance transaction) and 10.0% of gross premiums written for the six
months ended June 30, 1998 and 1997, respectively.
Net Premiums Written. Net premiums written for the six months ended June
--------------------
30, 1998 were $129.4 million, an increase of 15% from $112.9 million in the six
months ended June 30, 1997. This increase reflects higher gross premiums
written, partially offset by higher premiums ceded to reinsurers in the six
months ended June 30, 1998 compared with the corresponding prior period.
Net Premiums Earned. Net premiums earned during the six months ended June
-------------------
30, 1998 were $106.5 million, an increase of 45% from $73.4 million in the six
months ended June 30, 1997. The increase was primarily the result of increased
premiums earned from refundings, calls, and other accelerations and an increase
in premiums earned from the underlying book of business. Net premiums earned for
the six months ended June 30, 1998 included $30.2 million (which had a net
income per diluted share effect of $0.24) from refundings, calls and other
accelerations of previously insured issues. Net premiums earned in the six
months ended June 30, 1997 included $13.4 million (which had a net income per
diluted share effect of $0.11) from refundings, calls and other accelerations.
Refunding levels vary depending upon a number of conditions, primarily the
relationship between current interest rates and interest rates on outstanding
debt. Excluding the effect of accelerated earnings from refundings, calls and
other accelerations, net premiums earned for the six months ended June 30, 1998
were $76.3 million, an increase of 27% from $60.0 million in the six months
ended June 30, 1997.
Net Investment Income. Net investment income for the six months ended June
---------------------
30, 1998 was $90.9 million, an increase of 17% from $77.7 million in the six
months ended June 30, 1997. The increase was primarily attributable to the
growth of the investment portfolio from ongoing operations and the net increase
in the investment portfolio from the acquisition of Connie Lee.
Net Realized Gains. Net realized gains were $0.7 million for the six months
------------------
ended June 30, 1998, compared to $4.3 million in net realized gains for the
comparative prior period in 1997.
Other Income. Other income was $2.2 million for the six months ended June
-------------
30, 1998, compared to $3.4 million for the six months ended June 30, 1997. This
decrease was primarily due to lower income from certain real estate interests.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses
-----------------------------------
for the six months ended June 30, 1998 were $3.0 million, versus $1.4 million
for the six months ended June 30, 1997. Salvage received was $7.2 million and $0
for the six months ended June 30, 1998 and 1997, respectively. The Company
increased the contribution to the loss reserve for the entire amount of salvage
received. The increase was a result of the growth in the insured book
16
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
of business, as loss expenses and related reserves are based upon estimates of
the ultimate aggregate losses inherent in the obligations insured.
Underwriting and Operating Expenses. Underwriting and operating expenses
-----------------------------------
for the six months ended June 30, 1998 were $23.2 million, an increase of 23%
from $18.8 million in the six months ended June 30, 1997, primarily as a result
of higher compensation expenses and higher amortization of previously deferred
acquisition costs during the period. Underwriting and operating expenses consist
of gross underwriting and operating expenses, less the deferral to future
periods of expenses and reinsurance commissions related to the acquisition of
new insurance contracts, plus the amortization of previously deferred expenses
and reinsurance commissions. During the six month period ended June 30, 1998,
gross underwriting and operating expenses were $31.9 million, an increase of 14%
from $28.0 million in the six months ended June 30, 1997. This increase reflects
the overall increased business activity during the period. Underwriting and
operating expenses deferred were $17.7 million and $15.9 million for the six
months ended June 30, 1998 and 1997, respectively. Reinsurance commissions which
related to the current period (net of deferred) were $0.4 million and $0 for the
six months ended June 30, 1998 and 1997, respectively. The amortization of
previously deferred expenses and reinsurance commissions was $9.4 million and
$6.7 million for the six months ended June 30, 1998 and 1997, respectively.
FINANCIAL MANAGEMENT SERVICES
Revenues for the six months ended June 30, 1998 were $25.5 million
(excludes $7.2 million in net realized losses), up 90% from $13.4 million
(excludes $0.1 million in net realized gains) for the six months ended June 30,
1997. This increase is primarily due to (i) higher revenues on interest rate
swaps which totaled $10.5 million in the period, up 250% from $3.0 million in
the comparable prior period, and (ii) higher investment agreement revenue which
totaled $9.7 million in the period, up 67% on increased volume, from $5.8
million in the comparable prior period. A small percentage of the Company's
investment portfolio is maintained as a trading position. This position contains
high quality municipal bonds hedged with treasury futures. A change in the
relationship between municipal bonds and treasury bonds has created a mark-to-
market loss in the first six months of 1998 equal to $7.3 million. Expenses for
the six months ended June 30,1998 were $16.0 million, up 10% from $14.5 million
in the six months ended June 30, 1997. This increase results from higher
compensation expenses in the investment agreement and swap businesses, as well
as increased expenditures to develop the money management and electronic
commerce businesses, partially offset by a one-time $3.5 million restructuring
charge in 1997.
CORPORATE ITEMS
Other Revenue. Other revenue includes investment income of the holding
-------------
company, Ambac Financial Group, Inc. Other revenue for the six months ended June
30, 1998 was $5.4 million, up 46% from $3.7 million for the comparable prior
period. The increase is attributable to higher investment income generated from
investing the proceeds of the Company's issuance of $200 million in debentures
on April 1, 1998.
17
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
Interest Expense. Interest expense for the six months ended June 30, 1998
----------------
was $14.4 million, up 37% from $10.5 million for the six months ended June 30,
1997, primarily due to the Company's issuance of $200 million in debentures (see
Liquidity and Capital Resources section) on April 1, 1998.
Income Taxes. Income taxes for the six months ended June 30, 1998 were at
------------
an effective rate of 23.2%, versus 20.6% in the six months ended June 30, 1997.
This increase was primarily due to the higher level of pre-tax income and a
lower percentage of tax-exempt investment income.
SUPPLEMENTAL ANALYTICAL FINANCIAL DATA
Core Earnings. Core earnings for the six months ended June 30, 1998 were
-------------
$112.5 million, an increase of 19% from $94.5 million for the six months ended
June 30, 1997. The increase in core earnings was primarily the result of
continued higher premiums earned from the growth in the insurance book of
business and higher net investment income from insurance operations, as well as
higher revenues from the investment agreement and swap businesses in the
financial management services segment. The Company defines core earnings as
consolidated net income, less the effect of net realized gains and losses, net
insurance premiums earned from refundings and calls and certain non-recurring
items.
Operating Earnings. Operating earnings for the six months ended June 30,
------------------
1998 were $129.7 million, an increase of 27% from $102.1 million in the six
months ended June 30, 1997. The Company defines operating earnings as
consolidated net income, less the effect of net realized gains and losses and
certain non-recurring items.
The following table reconciles net income computed in accordance with
GAAP to operating earnings and core earnings for the six months ended June 30,
1998 and 1997:
(Dollars in Millions) 1998 1997
---------------- ----------------
Net Income................................................................................... $126.5 $103.4
Net realized losses (gains), after tax....................................................... 3.2 (3.4)
Non-recurring item, after tax................................................................ - 2.1
---------------- ----------------
Operating earnings........................................................................ 129.7 102.1
Premiums earned from refundings, calls and other accelerations, after tax.................... (17.2) (7.6)
---------------- ----------------
Core earnings............................................................................. $112.5 $ 94.5
================ ================
The weighted average number of diluted shares outstanding during the six
months ended June 30, 1998 and 1997 was 71.6 million and 71.0 million,
respectively.
Adjusted Gross Premiums Written. Adjusted gross premiums written were
-------------------------------
$199.6 million in the six months ended June 30, 1998, up 34% from $148.7 million
in the six months ended June 30, 1997. The Company defines adjusted gross
premiums written as up-front premiums written (less amounts ceded to MBIA
Insurance Corporation under our international joint venture) plus the present
value of estimated future installment premiums written in the period. While most
premiums are collected up-front at policy issuance, a growing portion of
premiums
18
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
are collected on an installment basis. The net present value of estimated future
installment premiums written in the six months ended June 30, 1998 was $71.6
million, an increase of 61% from $44.4 million written in the six months ended
June 30, 1997. The aggregate net present value of estimated future installment
premiums was $249.8 million and $210.8 million as of June 30, 1998 and December
31, 1997, respectively.
The following table reconciles total up-front premiums written to adjusted
gross premiums written for the six months ended June 30, 1998 and 1997:
(Dollars in Millions) 1998 1997
---------------- ----------------
Adjusted Gross Premium Analysis (1):
Total Up-front premiums written.............................................................. $128.0 $104.3
PV of estimated future installment premiums.................................................. 71.6 44.4
---------------- ----------------
Adjusted gross premiums written.......................................................... $199.6 $148.7
================ ================
(1) Excludes amounts ceded to MBIA Insurance Corporation under our
international joint venture of $15.5 million and $5.1 million for the six
months ended June 30, 1998 and 1997, respectively.
LIQUIDITY AND CAPITAL RESOURCES
Ambac Financial Group, Inc. Liquidity. The Company'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 Ambac Assurance's ability to pay
dividends or make payments to the Company and external financings.
Pursuant to Wisconsin insurance laws, Ambac Assurance may declare
dividends, provided that, after giving effect to the distribution, it would not
violate certain statutory equity, solvency and asset tests. During the six
months ended June 30, 1998, Ambac Assurance paid dividends of $24.0 million on
its common stock to the Company.
The Company's principal uses of liquidity are for the payment of its
operating expenses, interest on its debt, dividends on its shares of common
stock and capital investments in its subsidiaries. Based on the amount of
dividends that Ambac Assurance expects to pay during 1998 and the income it
expects to receive from its investment portfolio, the Company believes it will
have sufficient liquidity to satisfy its liquidity needs over the next twelve
months, including the payment of dividends on the Common Stock in accordance
with its dividend policy. Beyond the next twelve months, Ambac Assurance's
ability to declare and pay dividends to the Company may be influenced by a
variety of factors, including adverse market changes, insurance regulatory
changes and changes in general economic conditions. Consequently, although the
Company believes that it 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 the Company's operating expenses, debt service obligations and cash dividends
on its Common Stock.
On April 1, 1998, the Company issued $200.0 million in principal amount of
its 7.08% debentures due on March 31, 2098. The Company may not redeem the
debentures prior to March 31, 2003. On or after March 31, 2003, the Company may
redeem the debentures, in whole at any time or in part from time to time, at
100% of their principal amount, plus accrued
19
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
interest to the date of redemption. Use of the net proceeds received from the
sale of the debentures will be for general corporate purposes, which include
additions to working capital of subsidiaries, acquisitions, and repurchases of
common stock. These debentures are listed on the New York Stock Exchange.
Ambac Assurance Liquidity. The principal uses of Ambac Assurance's
--------------------------
liquidity are the payment of operating expenses, reinsurance premiums, income
taxes and dividends to the Company. The Company 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 and net investment income. The majority
of premiums for Ambac Assurance's financial guarantee insurance policies are
payable in full at the outset of the term of the policy, even though premiums
are earned over the life of such policies for financial accounting purposes.
Financial Management Services Liquidity. The principal uses of liquidity by
----------------------------------------
the Company's financial management services subsidiaries are the payment of
investment agreement obligations pursuant to defined terms, net obligations
under interest rate swaps and related hedges, operating expenses and income
taxes. The Company believes that its financial management services liquidity
needs can be funded primarily from its operating cash flow and the maturity of
its invested assets. The principal sources of this segments 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 duration of its obligations under the investment
agreements, net receipts from interest rate swaps and related hedges and fees
for investment management services. The Company's investment objectives with
respect to investment agreements are to achieve the highest after-tax total
return, subject to a minimum average 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. The Company maintains a portion
of its financial management services assets in short-term investments and
repurchase agreements in order to meet unexpected liquidity needs.
Credit Facilities. The Company and Ambac Assurance have a $150.0 million
------------------
revolving credit facility with three major international banks. The facility
expires August, 1999 and provides a two-year term loan provision. The facility
is available for general corporate purposes, including the payment of claims and
has replaced a $100.0 million credit facility which expired August, 1998. As of
June 30, 1998 and 1997, no amounts were outstanding under this credit facility.
Ambac Assurance has an agreement with a group of AAA/Aaa-rated
international banks for a $450.0 million credit facility, expiring December 2,
2004. This facility is a seven-year stand-by irrevocable limited recourse line-
of-credit, which will provide liquidity to Ambac Assurance in the event that
claims from municipal obligations exceed specified levels. Repayment of any
amounts drawn under the line will be limited primarily to the amount of any
recoveries of losses related to policy obligations. As of June 30, 1998 and
1997, no amounts were outstanding under this line.
Connie Lee has an agreement with commercial banks for a $50.0 million
standby credit facility, expiring in 2003. The line will provide a source of
additional claims-paying resources for insured transactions. The obligation to
repay is a limited recourse obligation payable solely from,
20
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
and collateralized by, a pledge of recoveries realized on defaulted insured
obligations including installment premiums and other collateral. As of June 30,
1998, no amounts were outstanding under this line.
Stock Repurchase Program. The Board of Directors of the Company has
-------------------------
authorized the establishment of a stock repurchase program which permits the
repurchase of up to 6,000,000 shares of the Company's Common Stock. During the
six months ended June 30, 1998, the Company acquired approximately 458,000
shares for an aggregate amount of $25.7 million. Since inception of the Stock
Repurchase Program, the Company has acquired approximately 3,730,000 shares for
an aggregate amount of $115.6 million.
Balance Sheet. As of June 30, 1998, the fair value of the Company's
--------------
consolidated investment portfolio was $7.97 billion, an increase of 15% from
$6.92 billion at December 31, 1997. This increase was primarily due to the
increased volume in investment and payment agreements and cash flow from
operations.
Cash Flows. Net cash provided by operating activities was $133.7 million
-----------
and $122.8 million during the six months ended June 30, 1998 and 1997,
respectively. These cash flows were primarily provided from insurance
operations. Net cash provided by financing activities was $1,093.4 and $531.5
million during the six months ended June 30, 1998 and 1997, respectively. This
activity included $744.5 million and $548.0 million in investment agreements
issued (net of draws paid) in the six months ended June 30, 1998 and 1997,
respectively. The total cash provided by operating and financing activities was
$1,227.1 million and $654.3 million for the six months ended June 30, 1998. From
these totals, $1,207.9 million and $655.2 million was used in investing
activities, principally purchases of investment securities, during the six
months ended June 30, 1998 and 1997, respectively.
Material Commitments. The Company has made no commitments for material
---------------------
capital expenditures within the next twelve months. However, management
continually evaluates opportunities to expand the Company's businesses through
internal development of new products as well as acquisitions.
Year 2000. The Company recognizes the worldwide challenge for all computer
----------
systems to recognize the date change for the year 2000 and is assessing its own
computer systems to provide for their continued functionality. This is a high
priority undertaking and crucial to the operation of the Company's business.
The Company does not, however, expect the costs to be material. The Company has
established a budget of approximately $1.0 million to address this issue. It is
anticipated that all costs will be funded with operating income.
The Company has established a Year 2000 Steering Committee comprised of
members of senior management. The committee has full responsibility and
authority to establish methodologies and budgets and to allocate necessary
resources. Under this committee, there is a Year 2000 Project Office that
manages all internal business and staff units, as well as the efforts of outside
consultants. The office is charged with the responsibility of evaluating (and
remediating, if necessary) critical internal technology systems, whether
internally-developed systems or purchased from vendors.
21
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
The Company's year 2000 testing plan incorporates a three phase process
encompassing critical business systems, both internally developed and externally
provided. The plan is targeted for completion by December 31, 1998. Phase one,
the Assessment and Impact Analysis phase, which included inventory and code
scanning, is complete. Phase two, the Testing and Review phase, is currently in
process. This critical phase involves test case development, year 2000
simulation, transaction testing, business unit validation, and vendor
management. Phase three is the remediation phase. Remediation of the Company's
internal systems is not expected to be significant based upon the status of work
performed to date. Remediation to vendor-provided systems is not expected to be
significant, based upon representations received from such vendors.
A potential exposure to the Company is the failure by any insured issuer,
municipal or non-municipal, to make debt service payments due to an issuer's
systems failure. An issuer's failure to make debt service payments due to year
2000-related systems failures may result in a claim under an Ambac Assurance
insurance policy. In such event, the Company would utilize its sources of
liquidity to pay claims. The Company would expect full recovery of such claims
when year 2000 problems are resolved.
Many of the findings discussed above are preliminary. The Company can make
no assurances at this time regarding the ultimate outcome of the efforts
described herein. Furthermore, the Company cannot guarantee that the systems of
external entities (such as securities exchanges or funds and securities clearing
organizations) which may impact the Company will be year 2000 compliant. A
failure to comply by such external entities, could have a material impact on the
operations of the Company.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
In the ordinary course of business, the Company, through its affiliates,
manages a variety of risks, principally market, credit, liquidity, operational
and legal. These risks are identified, measured and monitored through a variety
of control mechanisms, which are in place at different levels throughout the
organization.
Market risk generally represents the risk of loss that may result from the
potential change in the fair value of a financial instrument as a result of
changes in prices and interest rates. The Company has financial instruments
held for purposes other than trading and for trading purposes. The principal
market risk for the Company's financial instruments held for purposes other than
trading is interest rate risk. An independent risk management group is involved
in setting and monitoring risk limits and the application of risk measurement
methodologies. The estimation of potential losses arising from adverse changes
in market conditions is a key element in managing market risk. The Company
utilizes various models and stress test scenarios to monitor and manage
interest rate risk. This process includes frequent analyses of both parallel
and non-parallel shifts in the yield curve. These models include estimates made
by management and the valuation results could differ materially from amounts
that would actually be realized in the market. Financial instruments held for
purposes other than trading which may be adversely affected by changes in
interest rates, consist primarily of investment securities,
22
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK (CONTINUED)
investment agreement liabilities, debentures, and related derivative contracts
(primarily interest rate swaps and futures) used for hedging purposes.
The Company, through its affiliate Ambac Financial Services, L.P.
("AFSLP"), is a provider of interest rate swaps to states, municipalities and
their authorities and other entities in connection with their financings. AFSLP
manages its business with the goal of being market neutral to changes in overall
interest rates, while retaining basis risk, the relationship between floating
tax-exempt and floating taxable interest rates. If actual or projected floating
tax-exempt interest rates change in relation to floating taxable interest rates,
AFSLP will experience an unrealized mark-to-market gain or loss. The AFSLP swap
portfolio is considered held for trading purposes. Market risk for financial
instruments held for trading purposes relates to the impact of pricing changes
on future earnings. The principal market risk is basis risk. Since late 1995,
most municipal interest rate swaps transacted contain provisions which are
designed to protect the Company against certain forms of tax reform, thus
mitigating its basis risk. An independent risk management group monitors
trading risk limits and, together with senior management, is involved in the
application of risk measurement methodologies.
23
PART II - OTHER INFORMATION
Items 1, 2, 3, and 5 are omitted either because they are inapplicable or
because the answer to such question is negative.
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The following matters were voted upon at the Annual Meeting of Stockholders
of the Company held on May 13, 1998, and received the votes set forth below:
Proposal 1. The following directors were elected to serve on the Company's
----------
Board of Directors:
Number of Votes Cast
-------------------------------------------------
For Withheld
-------------------------------------------------
Phillip B. Lassiter 59,622,611 389,010
Michael A. Callen 59,629,006 382,615
Renso L. Caporali 57,258,546 2,753,075
Richard Dulude 59,626,811 384,810
W. Grant Gregory 59,630,481 381,140
C. Roderick O'Neil 59,627,076 384,545
There were no broker non-votes for this proposal.
Proposal 2. The proposal to approve the amendment to the Charter to
----------
increase the number of authorized shares of Common Stock to 200 million was
adopted, with 57,721,540 votes in favor, 2,248,883 votes against and 41,198
votes abstaining. There were no broker non-votes for this proposal.
PROPOSAL 3. The proposal to ratify the selection of KPMG Peat Marwick LLP
----------
as independent auditors of the Company and its subsidiaries for 1998 was
adopted, with 59,960,426 votes in favor, 18,903 votes against and 32,291 votes
abstaining. There were no broker non-votes for this proposal.
24
PART II - OTHER INFORMATION (CONTINUED)
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
(A) THE FOLLOWING ARE ANNEXED AS EXHIBITS:
EXHIBIT
NUMBER Description
- ---------- -----------------------------------------------------------------------
4.04 Conformed Copy of the Certificate of Amendment to the Amended and
Restated Certificate of Incorporation of the Company with the
Secretary of State of the State of Delaware on May 13, 1998.
10.22 Conformed Copy of U.S. $150,000,000 Credit Agreement, dated as of
August 3, 1998 (the "BNS Credit Agreement") among the Company and
Ambac Assurance Corporation as the Borrowers, Certain Commercial
Lending Institutions as the Lenders, Citibank, N.A. , as the
Documentation Agent, First National Bank of Chicago, as the
Co-Agent, and The Bank of Nova Scotia, acting through its New York
Agency, as the Arranger and the Administrative Agent.
27.00 Financial Data Schedule.
99.03 Ambac Assurance Corporation and Subsidiaries Consolidated Unaudited
Financial Statements as of June 30, 1998 and December 31, 1997 and
for the periods ended June 30, 1998 and 1997.
(B) REPORTS ON FORM 8-K:
There were no reports on Form 8-K filed during the second quarter of 1998.
____________________________________--
* Management contract or compensatory plan, contract or arrangement required to
be filed as an exhibit pursuant to Item 6(a) of Form 10-Q.
----------
25
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: AUGUST 14, 1998 BY: /S/ FRANK J. BIVONA
-------------------
FRANK J. BIVONA
EXECUTIVE VICE PRESIDENT, CHIEF
FINANCIAL OFFICER AND TREASURER
(PRINCIPAL FINANCIAL AND ACCOUNTING
OFFICER AND DULY AUTHORIZED OFFICER)
26
INDEX TO EXHIBITS
EXHIBIT
NUMBER Description
- ---------- ----------------------------------------------------------------------
4.04 Conformed Copy of the Certificate of Amendment to the Amended and
Restated Certificate of Incorporation of the Company with the
Secretary of State of the State of Delaware on May 13, 1998.
10.22 Conformed Copy of U.S. $150,000,000 Credit Agreement, dated as of
August 3, 1998 (the "BNS Credit Agreement") among the Company and
Ambac Assurance Corporation as the Borrowers, Certain Commercial
Lending Institutions as the Lenders, Citibank, N.A. , as the
Documentation Agent, First National Bank of Chicago, as the
Co-Agent, and The Bank of Nova Scotia, acting through its New York
Agency, as the Arranger and the Administrative Agent.
27.00 Financial Data Schedule.
99.03 Ambac Assurance Corporation and Subsidiaries Consolidated Unaudited
Financial Statements as of June 30, 1998 and December 31, 1997 and
for the periods ended June 30, 1998 and 1997.
27