SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 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 September 30, 1998, 69,702,482 shares of Common Stock, par value
$0.01 per share, (net of 977,902 treasury shares) of the Registrant were
outstanding.
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
INDEX
-----
PART I FINANCIAL INFORMATION PAGE
----
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets - September 30, 1998
and December 31, 1997................................................................... 3
Consolidated Statements of Operations - three months and nine months
ended September 30, 1998 and September 30, 1997......................................... 4
Consolidated Statements of Stockholders' Equity - nine months ended
September 30, 1998 and September 30, 1997............................................... 5
Consolidated Statements of Cash Flows - nine months ended
September 30, 1998 and September 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............................................................................ 20
PART II OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K....................................................... 21
SIGNATURES........................................................................................ 22
INDEX TO EXHIBITS................................................................................. 23
PART 1 - FINANCIAL INFORMATION
Item 1 - Financial Statements of Ambac Financial Group, Inc. and Subsidiaries
Ambac Financial Group, Inc. and Subsidiaries
Consolidated Balance Sheets
September 30, 1998 and December 31, 1997
(Dollars in Thousands)
September 30, 1998 December 31, 1997
------------------ -----------------
(unaudited)
Assets
- ------
Investments:
Fixed income securities, at fair value
(amortized cost of $7,690,339 in 1998 and $6,525,650 in 1997) $8,089,199 $6,773,844
Short-term investments, at cost (approximates fair value) 169,986 136,278
Other 5,456 5,000
----------------- ------------------
Total investments 8,264,641 6,915,122
Cash 9,622 9,256
Securities purchased under agreements to resell 336,801 85,466
Receivable for investment agreements 351,563 -
Receivable for securities sold 137,820 106,246
Investment income due and accrued 100,142 78,690
Reinsurance recoverable 3,777 4,219
Prepaid reinsurance 199,264 183,492
Deferred acquisition costs 116,630 105,996
Loans 679,140 503,192
Receivable from brokers and dealers 663,326 183,041
Other assets 228,980 116,985
----------------- ------------------
Total assets $11,091,706 $8,291,705
================= ==================
Liabilities and Stockholders' Equity
- ------------------------------------
Liabilities:
Unearned premiums $1,251,619 $1,178,990
Losses and loss adjustment expenses 117,053 103,345
Ceded reinsurance balances payable 3,776 9,258
Obligations under investment and payment agreements 4,597,186 3,230,052
Obligations under investment repurchase agreements 1,353,639 1,090,912
Deferred income taxes 168,544 135,228
Current income taxes 9,955 9,016
Debentures 423,913 223,864
Accrued interest payable 64,562 46,017
Accounts payable and other liabilities 257,648 117,153
Payable to brokers and dealers 475,000 -
Payable for securities purchased 284,428 275,388
----------------- ------------------
Total liabilities 9,007,323 6,419,223
----------------- ------------------
Stockholders' equity:
Preferred stock - -
Common stock 707 707
Additional paid-in capital 513,222 500,107
Accumulated other comprehensive income 205,963 135,223
Retained earnings 1,410,184 1,262,740
Common stock held in treasury at cost (45,693) (26,295)
----------------- ------------------
Total stockholders' equity 2,084,383 1,872,482
----------------- ------------------
Total liabilities and stockholders' equity $11,091,706 $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 September 30, 1998 and 1997
(Dollars in Thousands Except Share Data)
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------------- ------------------------------
1998 1997 1998 1997
--------------------------------- ------------------------------
Revenues:
Financial Guarantee Insurance:
Gross premiums written $88,731 $52,371 $254,260 $177,903
Ceded premiums written (4,764) (6,495) (40,899) (19,122)
--------------- -------------- -------------- -------------
Net premiums written 83,967 45,876 213,361 158,781
Increase in unearned premiums (33,824) (10,204) (56,716) (49,690)
--------------- -------------- -------------- -------------
Net premiums earned 50,143 35,672 156,645 109,091
Net investment income 47,436 40,109 138,348 117,814
Net realized gains 537 13,931 1,203 18,222
Other income 385 881 2,585 4,269
Financial Management Services:
Income 13,541 9,062 39,027 22,434
Net realized gains (losses) 156 1,069 (7,092) 1,148
Other:
Income 4,450 1,901 9,853 5,590
Net realized gains (losses) 709 (40) 2,226 748
--------------- -------------- -------------- -------------
Total revenues 117,357 102,585 342,795 279,316
--------------- -------------- -------------- -------------
Expenses:
Financial Guarantee Insurance:
Losses and loss adjustment expenses 1,500 730 4,500 2,122
Underwriting and operating expenses 11,844 10,173 35,052 28,997
Financial Management Services 8,237 5,751 24,283 20,205
Interest 9,254 5,391 23,648 15,935
Other 1,323 903 5,403 2,188
--------------- -------------- -------------- -------------
Total expenses 32,158 22,948 92,886 69,447
--------------- -------------- -------------- -------------
Income before income taxes 85,199 79,637 249,909 209,869
Provision for income taxes 19,817 18,842 58,073 45,723
--------------- -------------- -------------- -------------
Net income $65,382 $60,795 $191,836 $164,146
=============== ============== ============== =============
Net income per share $0.94 $0.87 $2.74 $2.35
=============== ============== ============== =============
Net income per diluted share $0.92 $0.85 2.68 2.31
=============== ============== ============== =============
Weighted average number of
shares outstanding 69,823,032 70,108,341 69,959,334 69,984,344
=============== ============== ============== =============
Weighted average number of diluted
shares outstanding 71,389,724 71,453,062 71,509,315 71,166,837
=============== ============== ============== =============
See accompanying Notes to Consolidated Financial Statements.
4
Ambac Financial Group, Inc. and Subsidiaries
Consolidated Statements of Stockholders' Equity
(Unaudited)
For The Nine Months Ended September 30, 1998 and 1997
(Dollars in Thousands)
1998 1997
--------------------------- -------------------------
Retained Earnings:
Balance at January 1 $1,262,740 $1,072,418
Net income 191,836 $191,836 164,146 $164,146
-------------- -------------
Dividends declared - common stock (19,594) (17,871)
Exercise of stock options (24,798) (7,808)
------------- ------------
Balance at September 30 $1,410,184 $1,210,885
------------- ------------
Accumulated Other Comprehensive Income:
Balance at January 1 $135,223 $58,911
Unrealized gains on securities, ($109,563, pre-tax,
and $59,187, pre-tax, in 1998 and 1997, respectively)(1) 70,067 36,917
Foreign currency gain (loss) 673 (154)
-------------- -------------
Other comprehensive income 70,740 70,740 36,763 36,763
--------------------------- -------------------------
Comprehensive income $262,576 $200,909
============== =============
Balance at September 30 $205,963 $95,674
------------- ------------
Preferred Stock:
Balance at January 1 and September 30 $- $-
------------- ------------
Common Stock:
Balance at January 1 $707 $353
Stock split effected as dividend - 354
------------- ------------
Balance at September 30 $707 $707
------------- ------------
Additional Paid-in Capital:
Balance at January 1 $500,107 $498,401
Issuance of stock - (3,560)
Exercise of stock options 13,075 5,298
Stock split effected as dividend - (354)
Other 40 40
------------- ------------
Balance at September 30 $513,222 $499,825
------------- ------------
Common Stock Held in Treasury at Cost:
Balance at January 1 ($26,295) ($15,067)
Cost of shares acquired (45,649) (32,203)
Shares issued under equity plans 26,251 28,131
------------- ------------
Balance at September 30 ($45,693) ($19,139)
------------- ------------
Total Stockholders' Equity at September 30 $2,084,383 $1,787,952
============= ============
(1) Disclosure of reclassification amount:
Unrealized holding gains arising during period $78,711 $47,331
Less: reclassification adjustment for net gains
included in net income 8,644 10,414
------------- ------------
Net unrealized gains on securities $70,067 $36,917
============= ============
See accompanying Notes to Consolidated Financial Statements.
5
Ambac Financial Group, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(Unaudited)
For The Nine Months Ended September 30, 1998 and 1997
(Dollars in Thousands)
Nine Months Ended
September 30,
----------------------------------------------------
1998 1997
---------------------- ---------------------
Cash flows from operating activities:
Net income $191,836 $164,146
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 1,785 1,292
Amortization of bond premium and discount (3,948) (1,881)
Current income taxes 939 5,205
Deferred income taxes (6,181) 13,364
Deferred acquisition costs (10,634) (9,710)
Unearned premiums, net 56,857 49,681
Losses and loss adjustment expenses 14,150 867
Ceded reinsurance balances payable (5,482) (2,894)
Investment income due and accrued (21,452) (3,195)
Accrued interest payable 18,545 16,863
Loss (gain) on sales of investments 3,663 (20,118)
Other, net 15,748 45,238
---------------------- ---------------------
Net cash provided by operating activities 255,826 258,858
---------------------- ---------------------
Cash flows from investing activities:
Proceeds from sales of bonds 1,347,504 1,413,892
Proceeds from matured bonds 887,467 838,475
Purchases of bonds (3,423,562) (3,035,714)
Change in short-term investments (33,708) (36,515)
Securities purchased under agreements to resell (251,335) 21,574
Loans (175,948) -
Other, net (38,884) (1,258)
---------------------- ---------------------
Net cash used in investing activities (1,688,466) (799,546)
---------------------- ---------------------
Cash flows from financing activities:
Dividends paid (19,594) (17,871)
Proceeds from issuance of investment agreements 2,670,496 1,716,586
Payments for investment agreement draws (1,568,146) (1,161,644)
Proceeds from issuance of debentures 193,700 -
Payment agreements 175,948 -
Proceeds from sale of treasury stock 26,251 28,131
Purchases of treasury stock (45,649) (32,203)
---------------------- ---------------------
Net cash provided by financing activities 1,433,006 532,999
---------------------- ---------------------
Net cash flow 366 (7,689)
Cash at January 1 9,256 7,734
---------------------- ---------------------
Cash at September 30 $9,622 $45
====================== =====================
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Income taxes $53,338 $20,663
====================== =====================
Interest expense on debt $25,934 $18,460
====================== =====================
Interest expense on investment agreements $179,610 $113,695
====================== =====================
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., 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. Ambac Financial Group, Inc.'s principal operating subsidiary,
Ambac Assurance Corporation ("Ambac Assurance"), a leading insurer of municipal
and structured finance obligations, has earned triple-A ratings, the highest
ratings available from Moody's Investors Service, Inc., Standard & Poor's
Ratings Group, Fitch IBCA, Inc., and Japan Rating and Investment Information,
Inc. 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.
Ambac Financial Group, Inc. and Subsidiaries, (the "Company")
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 nine months ended September 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 and (iii) the Company's
Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1998,
which was filed with the Commission on August 14, 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.
(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 encompasses all changes in
stockholders' equity (except those arising
7
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (CONTINUED)
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 hedge 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 nine month periods ended
September 30, 1998 and 1997, and its financial condition as of September 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
8
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
Exchange Commission. We undertake 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
CONSOLIDATED NET INCOME
The Company's net income for the three months ended September 30, 1998 was
$65.4 million or $0.92 per diluted share. This represents an 8% increase from
the three months ended September 30, 1997 net income of $60.8 million or $0.85
per diluted share. This increase in net income was primarily attributable to the
growth in net premiums earned and increased investment income, partially offset
by lower net realized gains from the Financial Guarantee Insurance segment as
well as increased revenues on interest rate swaps from the Company's Financial
Management Services segment. The Company's net income for the nine months ended
September 30, 1998 was $191.8 million or $2.68 per diluted share. This
represents a 17% increase from the comparable prior period net income of $164.1
million, and a 16% increase in net income per diluted share from $2.31. This
increase in net income was primarily attributable to the growth in net premiums
earned and increased investment income, partially offset by lower net realized
gains 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 $14.4 billion in par value
-----------------
bonds during the three months ended September 30, 1998 and $45.3 billion in par
value bonds during the nine months ended September 30, 1998, an increase of 64%
from $8.8 billion in the three months ended September 30, 1997 and an increase
of 68% from $27.0 billion in par value bonds during the nine months ended
September 30, 1997. Par value written for the third quarter of 1998 was
comprised of $8.5 billion from domestic municipal bond obligations, $5.1
billion from domestic structured finance obligations and $0.8 billion from
international obligations, compared to $5.9 billion, $1.7 billion and $1.2
billion, respectively, in the third quarter of 1997. Par value written for the
nine months ended September 30, 1998 was comprised of $26.2 billion from
domestic municipal bond obligations, $16.1 billion from domestic structured
finance obligations and $3.0 billion from international obligations, compared to
$18.4 billion, $6.6 billion and $2.0 billion, respectively, in the nine months
ended September 30, 1997. The increases in insured domestic municipal bond
obligations resulted primarily from increased market issuance. The increases in
insured domestic structured finance obligations was principally in the mortgage-
backed/home equity loan and asset-backed sectors. The increases 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.
9
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
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 and nine
----------------------
months ended September 30, 1998 were $88.7 million and $254.3 million,
respectively, an increase of 69% from $52.4 million and an increase of 43% from
$177.9 million, in the three and nine months ended September 30, 1997,
respectively. The following table sets forth the amounts of gross premiums
written by type and percent of total:
Three Months Ended September 30, Nine Months Ended September 30,
----------------------------------- ---------------------------------
(Dollars in Millions) 1998 % 1997 % 1998 % 1997 %
------ ------ ------- ------- ------- ------- ------- -----
Domestic:
Municipal finance policies:
Up-front policies:
New issue................. $66.4 75% $33.3 63% $165.7 65% $112.9 63%
Secondary market.......... 1.6 2 2.0 4 12.3 5 13.9 8
------ ------ ------- ------- ------- ------- ------- -----
Sub-total up-front....... 68.0 77 35.3 67 178.0 70 126.8 71
------ ------ ------- ------- ------- ------- ------- -----
Installment policies:
Annual policies........... 3.4 4 2.4 5 9.0 3 7.2 4
Portfolio products........ 0.6 - 0.7 1 1.8 1 2.3 1
------ ------ ------- ------- ------- ------- ------- -----
Sub-total installment... 4.0 4 3.1 6 10.8 4 9.5 5
------ ------ ------- ------- ------- ------- ------- -----
Total municipal finance 72.0 81 38.4 73 188.8 74 136.3 77
------ ------ ------- ------- ------- ------- ------- -----
Structured finance policies:
Up-front.................. 0.2 - 0.9 2 1.0 - 8.7 5
Installment............... 9.5 11 5.2 10 24.3 10 13.5 8
------ ------ ------- ------- ------- ------- ------- -----
Total structured
finance................ 9.7 11 6.1 12 25.3 10 22.2 12
------ ------ ------- ------- ------- ------- ------- -----
Total domestic written. 81.7 92 44.5 85 214.1 84 158.5 89
------ ------ ------- ------- ------- ------- ------- -----
International:
Up-front.................. 4.3 5 6.5 12 32.7 13 15.6 9
Installment............... 2.7 3 1.4 3 7.5 3 3.8 2
------ ------ ------- ------- ------- ------- ------- -----
Total international
written................ 7.0 8 7.9 15 40.2 16 19.4 11
------ ------ ------- ------- ------- ------- ------- -----
Total gross premiums
written................ $88.7 100% $52.4 100% $254.3 100% $177.9 100%
====== ====== ======= ======= ======= ======= ======= =====
Total up-front written....... $72.5 82% $42.7 81% $211.7 83% $151.1 85%
Total installment written.... 16.2 18 9.7 19 42.6 17 26.8 15
------ ------ ------- ------- ------- ------- ------- -----
Total gross premiums written $88.7 100% $52.4 100% $254.3 100% $177.9 100%
====== ====== ======= ======= ======= ======= ======= =====
Ceded Premiums Written. Ceded premiums written for the three and nine
----------------------
months ended September 30, 1998 were $4.8 million and $40.9 million,
respectively, a decrease of 26% from $6.5 million in the three months ended
September 30, 1997 and an increase of 114% from $19.1 million in the nine months
ended September 30,1997. The decrease in ceded premiums written for the third
quarter of 1998 is broken out as follows: (i) a decrease of $1.1 million ceded
on international policies; and (ii) a decrease of $0.6 million ceded on
municipal finance policies. The increase in ceded premiums for the nine months
ended September 30, 1998 is broken out as follows: (i) $11.8 million of the
portfolio purchased through the acquisition of Connie Lee Insurance Company
("Connie Lee") ceded during the first quarter of 1998; (ii) an increase of $6.5
million ceded on international policies; and (iii) an increase of $3.4 million
ceded on municipal finance policies. Ceded premiums written were 5.4% and 16.1%
(11.4% excluding the Connie Lee reinsurance transaction) of gross premiums
written for the three and nine months ended
10
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
September 30, 1998, respectively, compared with 12.4% and 10.7% for the three
and nine months ended September 30, 1997, respectively.
Net Premiums Written. Net premiums written for the three and nine months
--------------------
ended September 30, 1998 were $84.0 million and $213.4 million, respectively, an
increase of 83% from $45.9 million in the three months ended September 30, 1997
and an increase of 34% from $158.8 million in the nine months ended September
30, 1997. These increases are primarily from higher gross premiums written in
the three and nine months ended September 30, 1998.
Net Premiums Earned. Net premiums earned during the three and nine months
-------------------
ended September 30, 1998 were $50.1 million and $156.6 million, respectively, an
increase of 40% from $35.7 million in the three months ended September 30, 1997
and an increase of 44% from $109.1 million in the nine months ended September
30, 1997. These increases were primarily the result of higher premiums earned
from the underlying book of business and increased premiums earned from
refundings, calls, and other accelerations during the period. Net premiums
earned for the three and nine months ended September 30, 1998 included $6.9
million and $37.1 million, respectively, (which had a net income per diluted
share effect of $0.06 and $0.30, respectively) from refundings, calls and other
accelerations of previously insured issues. Net premiums earned in the three and
nine months ended September 30, 1997 included $3.5 million and $16.9 million,
respectively, (which had a net income per diluted share effect of $0.03 and
$0.14, respectively) from refundings, calls and other accelerations of
previously insured issues. 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
three and nine months ended September 30, 1998 were $43.2 million and $119.5
million, respectively, an increase of 34% from $32.2 million in the three months
ended September 30, 1997 and an increase of 30% from $92.2 million in the nine
months ended September 30, 1997.
Net Investment Income. Net investment income for the three and nine months
---------------------
ended September 30, 1998 were $47.4 million and $138.3 million, respectively, an
increase of 18% from $40.1 million in the three months ended September 30, 1997
and an increase of 17% from $117.8 million in the nine months ended September
30, 1997. The increases were primarily attributable to the growth of the
investment portfolio from ongoing operations and the net increase in the
investment portfolio from the December 1997 acquisition of Connie Lee. Ambac
Assurance's investments in tax-exempt securities amounted to 72% of the total
market value of its portfolio as of September 30, 1998, versus 79% at September
30, 1997. The average pre-tax yield-to-maturity on the investment portfolio was
6.33% and 6.35% as of September 30, 1998 and 1997, respectively.
Net Realized Gains. Net realized gains for the three and nine months ended
------------------
September 30, 1998 were $0.5 million and $1.2 million , respectively, compared
to $13.9 million and $18.2 million in the three and nine months ended September
30, 1997, respectively.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses
-----------------------------------
for the three and nine months ended September 30, 1998 were $1.5 million and
$4.5 million, respectively, compared to $0.7 million and $2.1 million for the
three and nine months ended September 30, 1997. In 1998, the Company increased
its active credit reserve by $5.2 million and $15.4 million for the three and
nine month periods ended September 30, 1998. These amounts compare to $0.8
million and $2.3 million for the three and nine months ended September 30,
11
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
1997. Increased insurance written in the domestic structured finance and
international markets has increased the need for active credit reserves. It is
not expected that this level of increased contributions will continue to be
necessary in future periods. Salvage received was $3.7 million and $10.9 million
for the three and nine months ended September 30, 1998, compared to $0.1 million
for both the three and nine months ended September 30, 1997.
Underwriting and Operating Expenses. Underwriting and operating expenses
-----------------------------------
for the three and nine months ended September 30, 1998 were $11.8 million and
$35.1 million, respectively, an increase of 16% from $10.2 million in the three
months ended September 30, 1997 and an increase of 21% from $29.0 million in the
nine months ended September 30, 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 and nine months ended September 30, 1998, gross
underwriting and operating expenses were $18.2 million and $50.1 million,
respectively, an increase of 27% from $14.3 million in the three months ended
September 30, 1997 and an increase of 18% from $42.3 million in the nine months
ended September 30, 1997. The increases reflect the overall increased business
activity during the respective periods. Underwriting and operating expenses
deferred were $10.4 million and $28.1 million for the three and nine months
ended September 30, 1998, respectively, compared to $7.5 million and $23.4
million for the three and nine months ended September 30, 1997, respectively.
Reinsurance commissions which related to the current period (net of deferred)
were $0.2 million and $0.5 million for the three and nine months ended September
30, 1998, respectively, compared to $0 for the three and nine months ended
September 30, 1997, respectively. The amortization of previously deferred
expenses and reinsurance commissions were $4.2 million and $13.6 million for the
three and nine months ended September 30, 1998, respectively, compared to $3.4
million and $10.1 million for the three and nine months ended September 30,
1997, respectively.
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 and nine months ended September
30, 1998 were $13.5 million (excludes $0.2 million in net realized gains) and
$39.0 million (excludes $7.1 million in net realized losses), respectively, up
48% from $9.1 million (excludes $1.1 million in net realized gains) for the
three months ended September 30, 1997 and an increase of 74% from $22.4 million
(excludes $1.1 million in net realized gains) for the nine months ended
September 30, 1997. These increases are primarily due to (i) higher revenues on
interest rate swaps which totaled $5.8 million and $16.3 million, in the three
and nine months ended September 30, 1998, respectively, up 142% from $2.4
million in the three months ended September 30, 1997 and an increase of 208%
from $5.3 million in the nine months ended September 30, 1997; and (ii) higher
investment agreement revenue which totaled $4.6 million and $14.2 million in the
three and nine months ended September 30, 1998, respectively, up 24% on
increased volume, from $3.7 million in the three months ended September 30, 1997
and an increase of 49% on increased volume, from $9.5 million in the nine months
ended September 30, 1997. Realized gains on fixed income securities in the three
and nine months ended September 30, 1998 of $9.8 million and $9.9 million,
respectively, were partially offset by a mark-to-market
12
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
loss in a trading position of $9.7 million and $17.0 million in the three and
nine months ended September 30, 1998, respectively. This trading position, which
represented a small portion of the Company's assets, contained high quality
municipal bonds hedged with treasury futures. The loss was due to a change in
the relationship between municipal and treasury interest rates. This trading
position was closed in October 1998. Expenses for the three and nine months
ended September 30, 1998 were $8.2 million and $24.3 million, respectively, up
41% from $5.8 million in the three months ended September 30, 1997 and an
increase of 20% from $20.2 million in the nine months ended September 30, 1997.
These increases result 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 and nine months
ended September 30, 1998 was $4.5 million and $9.9 million, respectively, up
137% from $1.9 million for the three months ended September 30, 1997 and an
increase of 77% from $5.6 million for the nine months ended September 30, 1997.
The increases are 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 and nine months ended
----------------
September 30, 1998 was $9.3 million and $23.6 million, respectively, up 72% from
$5.4 million for the three months ended September 30, 1997 and an increase of
48% from $15.9 million for the nine months ended September 30, 1997. The
increase is attributable to the Company's issuance of $200 million in debentures
on April 1, 1998.
Income Taxes. Income taxes for the three and nine months ended September
------------
30, 1998 were at an effective rate of 23.3% and 23.2%, respectively, compared to
23.7% and 21.8% in the three and nine months ended September 30, 1997,
respectively.
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 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 and nine months ended September
-------------
30, 1998 were $60.5 million and $173.1 million, respectively, an increase of 22%
from $49.5 million for the three months ended September 30, 1997 and an increase
of 20% from $144.0 million for the nine months ended September 30, 1997. The
increases in core earnings were 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
13
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
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 three and nine months ended
------------------
September 30, 1998 were $64.5 million and $194.2 million, respectively, an
increase of 25% from $51.5 million in the three months ended September 30, 1997
and an increase of 26% from $153.6 million for the nine months ended September
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 three and nine months ended
September 30, 1998 and 1997:
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------------------------
(Dollars in Millions) 1998 1997 1998 1997
----------- ---------- ---------- ---------
Net Income................................................ $65.4 $60.8 $191.8 $164.1
Net realized losses (gains), after tax.................... (0.9) (9.3) 2.4 (12.6)
Non-recurring item, after tax............................. - - - 2.1
----------- ---------- ---------- ---------
Operating earnings..................................... 64.5 51.5 194.2 153.6
Premiums earned from refundings, calls and other
accelerations, after tax................................. (4.0) (2.0) (21.1) (9.6)
----------- ---------- ---------- ---------
Core earnings.......................................... $60.5 $49.5 $173.1 $144.0
=========== ========== ========== =========
The weighted average number of diluted shares outstanding during the three
and nine months ended September 30, 1998 were 71.4 million shares and 71.5
million shares, respectively. The weighted average number of diluted shares
outstanding during the three and nine months ended September 30, 1997 were 71.5
million shares and 71.2 million shares, respectively.
Adjusted Gross Premiums Written. Adjusted gross premiums written for the
-------------------------------
three and nine months ended September 30, 1998 were $113.0 million and $312.7
million, respectively, up 90% from $59.6 million in the three months ended
September 30, 1997 and up 50% from $208.4 million in the nine months ended
September 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 are collected on an
installment basis. The net present value of estimated future installment
premiums written in the three and nine months ended September 30, 1998 were
$40.8 million and $112.4 million, respectively, an increase of 127% from $18.0
million written in the three months ended September 30, 1997 and an increase of
80% from $62.4 million in the nine months ended September 30, 1997. The
increases are primarily a result of increased premium writings of structured and
international policies, the majority of which are written on an installment
basis. The aggregate net present value of estimated future installment premiums
was $265.7 million and $210.8 million as of September 30, 1998 and December 31,
1997, respectively.
14
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
The following table sets forth the amounts of adjusted gross premiums
written by type and percent of total for the three and nine months ended
September 30, 1998 and 1997:
Three Months Ended September 30, Nine Months Ended September 30,
---------------------------------- ---------------------------------
(Dollars in Millions) 1998 % 1997 % 1998 % 1997 %
------- ------ ------ ----- ------ ----- ------ ----
Domestic:
Municipal finance policies:
Up-front policies:
New issue................. $ 66.4 59% $33.3 56% $165.7 53% $112.9 54%
Secondary market.......... 1.6 1 2.0 3 12.3 4 14.0 7
------ ------ ------ ----- ------ ----- ------ ----
Sub-total up-front....... 68.0 60 35.3 59 178.0 57 126.9 61
------- ------ ------ ----- ------ ----- ------ ----
Installment policies:
Annual policies........... 4.0 4 3.4 6 15.8 5 11.5 5
Portfolio products........ - - - - - - - -
------ ------ ------ ----- ------ ----- ------ ----
Sub-total installment... 4.0 4 3.4 6 15.8 5 11.5 5
------- ------ ------ ----- ------ ----- ------ ----
Total municipal finance 72.0 64 38.7 65 193.8 62 138.4 66
------- ------ ------ ----- ------ ----- ------ ----
Structured finance policies:
Up-front.................. 0.2 - 0.9 2 1.0 - 8.7 4
Installment............... 17.8 16 6.8 11 48.2 16 36.9 18
------- ------ ------ ----- ------ ----- ------ ----
Total structured
finance................ 18.0 16 7.7 13 49.2 16 45.6 22
------- ------ ------ ----- ------ ----- ------ ----
Total domestic written. 90.0 80 46.4 78 243.0 78 184.0 88
------- ------ ------ ----- ------ ----- ------ ----
International (1):
Up-front................. 4.0 3 5.4 9 21.3 7 10.4 5
Installment.............. 19.0 17 7.8 13 48.4 15 14.0 7
------- ------ ------ ----- ------ ----- ------ ----
Total international
written................ 23.0 20 13.2 22 69.7 22 24.4 12
------- ------ ------ ----- ------ ----- ------ ----
Total adjusted gross
premiums written............ $113.0 100% $59.6 100% $312.7 100% $208.4 100%
======= ====== ====== ===== ====== ===== ====== ====
Total up-front written....... $ 72.2 64% $41.6 70% $200.3 64% $146.0 70%
Total installment written.... 40.8 36 18.0 30 112.4 36 62.4 30
------- ------ ------ ----- ------ ----- ------ ----
Total adjusted gross
premiums written............ $113.0 100% $59.6 100% $312.7 100% $208.4 100%
======= ====== ====== ===== ====== ===== ====== ====
(1) Excludes amounts ceded to MBIA Insurance Corporation under our international
joint venture of $1.9 million and $3.2 million for the three months ended
September 30, 1998 and 1997, respectively, and $17.4 million and $8.3 million
for the nine months ended September 30, 1998 and 1997, respectively.
Adjusted Book Value. Adjusted book value ("ABV") per common share increased
-------------------
9% to $39.99 at September 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.
15
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
The following table reconciles book value per share to ABV per share as of
September 30, 1998 and December 31, 1997:
September 30, December 31,
1998 1997
Book value per share.................................................. $29.90 $26.77
After-tax value of:
Net unearned premium reserve........................................ 9.81 9.25
Deferred acquisition costs.......................................... (1.09) (0.99)
Present value of installment premiums............................... 2.48 1.96
Unrealized loss on investment agreement liabilities................. (1.11) (0.40)
--------------------------- -------------------------
Adjusted book value per share......................................... $39.99 $36.59
=========================== =========================
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 (i) Ambac Assurance's ability to
pay dividends or make payments to the Company, and (ii) external financings.
Pursuant to Wisconsin insurance laws, Ambac Assurance may declare
dividends, provided that, after giving effect to the distribution, it would not
violate certain statutory equity, solvency and asset tests. During the nine
months ended September 30, 1998, Ambac Assurance paid dividends of $36.0 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 its 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.
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
16
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
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 segment's liquidity are proceeds from issuance of investment
agreements, net investment income, maturities of securities from its investment
portfolio which are invested with the objective of matching the 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
September 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 September 30, 1998 and
1997, no amounts were outstanding under this line.
Connie Lee has an agreement with commercial banks for a $50.0 million
stand-by 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, and collateralized
by, a pledge of recoveries realized on defaulted insured obligations including
installment premiums and other collateral. As of September 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
nine months ended September 30, 1998, the Company acquired approximately 858,000
shares for an aggregate amount of $45.7 million. Since inception of the Stock
Repurchase Program, the Company has acquired approximately 4,130,000 shares for
an aggregate amount of $135.6 million.
Balance Sheet. As of September 30, 1998, the fair value of the Company's
-------------
consolidated investment portfolio was $8.26 billion, an increase of 19% from
$6.92 billion at December 31, 1997. This increase was primarily due to the
increased volume in investment agreements and cash flow from operations.
17
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
Cash Flows. Net cash provided by operating activities was $255.8 million
----------
and $258.9 million during the nine months ended September 30, 1998 and 1997,
respectively. These cash flows were primarily provided from insurance
operations. Net cash provided by financing activities was $1,433.0 million and
$533.0 million during the nine months ended September 30, 1998 and 1997,
respectively. This activity included $1,102.4 million and $554.9 million in
investment agreements issued (net of draws paid) in the nine months ended
September 30, 1998 and 1997, respectively. The total cash provided by operating
and financing activities was $1,688.8 million and $791.9 million for the nine
months ended September 30, 1998 and 1997, respectively. From these totals,
$1,688.5 million and $799.5 million was used in investing activities,
principally purchases of investment securities, during the nine months ended
September 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 is addressing the issue of computer programs' and
---------
embedded computer chips' ability to distinguish between the year 1900 and the
year 2000, commonly known as the Y2K problem ("Y2K"). The Company is assessing
the risks to its businesses related to the functionality of its own computer
systems and those of third parties. This is a high priority undertaking and
crucial to the operation of the Company's businesses.
The Company has established a Y2K 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. The
committee is responsible for the coordination of internal and external resources
with the goal of evaluating and remediating, if necessary, critical internal and
external technology systems. The Company has also contracted with an outside
consultant to support its Y2K initiative.
In connection with this initiative, the Company has embarked on a three
phase process. Phase I is an inventory analysis and impact assessment.
Inventory includes: (a) those information technology systems which are deemed
critical to running the businesses, (b) non-information technology systems such
as fire systems, elevators and the like, (c) material third parties such as
electronic data interchange ("EDI") partners, (d) hardware and software vendors,
and (e) business user spreadsheets. Phase II is the testing phase during which:
(a) all critical systems will be tested, (b) transactions will be run through
critical systems by applying various permutations and combinations of Y2K
sensitive dates, and (c) results will be reviewed independently by each business
unit. In Phase III, the extent of code repair will be determined and, if
necessary, remediated.
The status of the Company's project is as follows:
Phase I - Inventory Analysis and Impact Assessment - 100% complete.
Phase II - Testing - approximately 30% complete; target completion March 31,
1999.
Phase III - Code Repair - if necessary, target completion June 30, 1999.
The Company also has potential Y2K risk from certain third parties,
including software vendors and EDI Partners. In conjunction with Phase I of the
Y2K plan, the Company identified
18
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
certain vendors and EDI partners who are critical to the business. Each was
contacted regarding Y2K compliance. All declare that they are either currently
compliant or are expected to be in compliance, insofar as their applications
could or do affect the Company, by December 1998. Testing to be done as part of
Phase II of the Company's Y2K plan will verify compliance. Contingency plans
will be developed for critical applications.
The Company anticipates that the cost of identifying, testing and
remediating its critical systems will not be material. Total costs are
estimated to be approximately $1.0 million, $0.6 million of which will be
incurred in 1998.
The Company's principal Y2K risks can be grouped into four categories. The
first is the risk that the Company does not successfully ready its operations
for the next century. The second is the risk of disruption of Company
operations due to operational failures of third parties. The third is the risk
of business interruption among obligors of Ambac-insured obligations such that
the scheduled payment of debt service does not occur, thus triggering a claim
under its insurance policy. The fourth is financial institution risk. These
risks are further described below.
Company's Internal Systems Risk. The Company, like other financial
institutions, is heavily dependent upon its computer systems. Y2K problems in
the Company's internal systems could result in an interruption in, or failure
of, certain normal business activities or operations. Such failures could
adversely affect the Company's operations.
Third Party Risk. Computer failure of third parties may also jeopardize
Company operations, but how seriously depends on the nature and duration of such
failures. Such third parties could include suppliers of telecommunications,
electric power suppliers, and services provided by governmental agencies.
Although the Company's inquiries are underway, the Company does not yet have the
information to estimate the likelihood of significant disruptions among its
suppliers. Y2K problems in third party systems could have an adverse impact on
Company operations.
Issuer Risk. A potential exposure to the Company is the failure by any
insured issuer to make debt service payments due to an issuer's systems failure.
An issuer's failure to make debt service payments due to Y2K 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 Y2K problems are
resolved. The Company is assessing the Y2K status of its insured issuers during
its underwriting and surveillance processes and expects to have meaningful
information available by the first quarter of 1999 to assess possible Y2K
liquidity requirements, if any.
Financial Institution Risk. Financial institution risk includes trustees
or paying agents on transactions insured by the Company. The Company relies on
the operating systems of such trustees to identify the correct interest payment
dates, calculate the correct payments and, through various payment systems, to
move the funds to the bondholders. This risk is mitigated by the fact that Ambac
Assurance's obligation to pay claims is related to the creditworthiness of the
issuer and not the trustee. However, to minimize payment disruption and
identify potential future problems, the Company will request compliance
statements from certain trustees or paying agents of its insured transactions,
review the appropriate publicly available disclosures and monitor the activities
of the banking regulatory agencies for Y2K developments. Additionally,
19
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
financial institution risk relates to custodians of securities held for its own
account and the accounts of others. The procedures outlined above will be
applied to such custodians as well.
With respect to the Company's internal operations, management is in the
process of developing alternative procedures in the event its critical systems
should fail. However, preliminary findings do not give any indications that
these systems will be non-compliant.
With respect to third parties, although the Company's inquiries are
underway, the Company does not yet have the information to estimate the
likelihood of significant disruptions among vendors, EDI partners, issuers and
financial institutions. The Company will develop appropriate contingency plans
when its inquiries are complete.
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, 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.
20
PART II - OTHER INFORMATION
Items 1, 2, 3, 4 and 5 are omitted either because they are inapplicable or
because the answer to such question is negative.
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
(A) THE FOLLOWING ARE ANNEXED AS EXHIBITS:
EXHIBIT
NUMBER Description
- ---------- -----------------------------------------------------------------------
27.00 Financial Data Schedule.
99.04 Ambac Assurance Corporation and Subsidiaries Consolidated Unaudited
Financial Statements as of September 30, 1998 and December 31, 1997
and for the periods ended September 30, 1998 and 1997.
(B) REPORTS ON FORM 8-K:
There were no reports on Form 8-K filed during the three months ended
September 30, 1998.
21
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THE
REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE
UNDERSIGNED THEREUNTO DULY AUTHORIZED.
AMBAC FINANCIAL GROUP, INC.
(REGISTRANT)
DATED: NOVEMBER 13, 1998 BY: /S/ FRANK J. BIVONA
-------------------
Frank J. Bivona
Executive Vice President and Chief
Financial Officer (Principal Financial
and Accounting Officer and Duly
Authorized Officer)
22
INDEX TO EXHIBITS
EXHIBIT
NUMBER Description
- ---------- ----------------------------------------------------------------------
27.00 Financial Data Schedule.
99.04 Ambac Assurance Corporation and Subsidiaries Consolidated Unaudited
Financial Statements as of September 30, 1998 and December 31, 1997
and for the periods ended September 30, 1998 and 1997.
23