EXHIBIT 13
FINANCIAL
HIGHLIGHTS
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Ambac Financial Group, Inc. and Subsidiaries Years Ended December 31,
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(Dollars in millions, except per share amounts) 1998 1997 1996* 1995 1994
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STATEMENT OF OPERATIONS HIGHLIGHTS
Gross premiums written $ 361.0 $ 286.2 $ 247.2 $ 193.3 $ 189.9
Net premiums earned 212.7 154.0 136.6 111.8 117.5
Net investment income 186.2 159.7 144.9 131.0 117.1
Financial management services revenue 49.5 35.2 22.0 13.1 15.9
Total revenues 457.0 381.8 452.9 282.3 242.3
Losses and loss adjustment expenses 6.0 2.9 3.8 3.4 2.6
Financial guarantee insurance underwriting and
operating expenses 46.7 40.7 37.2 34.5 32.8
Financial management services expenses 35.5 28.0 12.0 7.8 6.1
Interest expense 32.8 21.3 20.9 20.9 18.8
Net income 254.0 223.0 276.3 167.6 141.1
Net income per share 3.63 3.19 3.95 2.39 2.00
Net income per diluted share 3.56 3.13 3.91 2.37 1.99
Return on equity 12.8% 12.8% 18.3% 13.8% 13.2%
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Ambac Financial Group, Inc. and Subsidiaries As of December 31,
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(Dollars in millions) 1998 1997 1996 1995 1994
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BALANCE SHEET HIGHLIGHTS
Total investments, at fair value $ 8,748.4 $ 6,915.1 $ 5,200.5 $ 4,441.6 $ 3,764.2
Prepaid reinsurance 199.9 183.5 168.8 153.4 139.9
Total assets 11,212.3 8,291.7 5,876.4 5,309.3 4,287.0
Unearned premiums 1,294.2 1,179.0 991.2 903.0 836.6
Losses and loss adjustment expenses 115.8 103.3 60.6 66.0 65.7
Obligations under investment agreements, investment
repurchase agreements and payment agreements 5,956.8 4,321.0 2,754.6 2,426.9 2,025.3
Debentures 423.9 223.9 223.8 223.7 223.7
Total stockholders' equity 2,096.1 1,872.5 1,615.0 1,404.0 1,033.5
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* 1996 includes a one-time gain from the sale of a subsidiary equal to $155.6
million pre-tax and $100.6 million after-tax.
4
FIVE YEAR
HIGHLIGHTS
[THE FOLLOWING DATA WAS REPRESENTED BY A BAR GRAPH]
ADJUSTED GROSS
TOTAL REVENUES NET INCOME CORE EARNINGS PREMIUMS WRITTEN/2/
($ MILLIONS) PER DILUTED SHARE PER DILUTED SHARE/1/ ($ MILLIONS)
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94 $242.3 $1.99 $1.85 $197.1
95 $282.3 $2.37 $2.05 $216.6
96 $452.9* $3.91* $2.41 $286.8
97 $381.8 $3.13 $2.75 $329.3
98 $457.0 $3.56 $3.32 $458.0
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1 Core earnings is not a substitute for net income computed in accordance with
Generally Accepted Accounting Principles (GAAP). It excludes the effect on
net income from net realized gains and losses, net insurance premiums earned
from refundings and calls and certain non-recurring items. The definition of
core earnings used by Ambac Financial Group, Inc. may differ from definitions
of core earnings used by other public holding companies of financial
guarantee insurers.
2 Adjusted gross premiums written is not promulgated under GAAP. It includes
gross up-front premiums written plus the present value of estimated future
installment premiums written in the period. The definition of adjusted gross
premiums written used by Ambac Financial Group, Inc. may differ from
definitions of adjusted gross premiums written used by other public holding
companies of financial guarantee insurers.
* 1996 includes a one-time gain from the sale of a subsidiary equal to $155.6
million pre-tax and $100.6 million after-tax.
5
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
GENERAL
Ambac Financial Group, Inc. ("AFGI"), headquartered in New York City, is a
holding company whose subsidiaries provide financial guarantee insurance and
financial management services to clients in both the public and private sectors
in the United States and abroad.
The following paragraphs describe the consolidated results of operations of AFGI
and its subsidiaries (collectively referred to as the "Company") for 1998, 1997
and 1996, and its financial condition as of December 31, 1998 and 1997. These
results are presented for the Company's two reportable segments: Financial
Guarantee Insurance and Financial Management Services. This discussion should be
read in conjunction with the consolidated financial statements included
elsewhere in this report.
In this Annual Report, we may 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, credit, or interest rate environment in the United
States and abroad; (2) the level of activity within the national and worldwide
debt markets; (3) competitive conditions and pricing levels; (4) legislative and
regulatory developments; (5) changes in tax laws; and (6) other risks and
uncertainties that have not been identified at this time. 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 in 1998 was $254.0 million or
$3.56 per diluted share, an increase of 14% from $223.0 million or $3.13 per
diluted share in 1997. This increase was primarily attributable to the growth in
both Financial Guarantee Insurance and Financial Management Services revenues,
partially offset by lower net realized gains and higher net realized losses in
the Financial Guarantee Insurance segment and the Financial Management Services
segment, respectively, in 1998. The Company's net income in 1997 decreased 19%
from $276.3 million or $3.91 per diluted share in 1996. This decrease was
primarily the result of a net realized gain in 1996 of $155.6 million (which had
a net income per diluted share effect of $1.42) from the Company's sale of its
former subsidiary, HCIA Inc. ("HCIA"). Excluding the effect of this one-time
gain, 1997 net income increased 27% over 1996 primarily due to higher net income
in the Financial Guarantee Insurance segment, partially offset by lower net
income in the Financial Management Services segment.
FINANCIAL GUARANTEE INSURANCE
The Company provides financial guarantee insurance through its principal
operating subsidiary, Ambac Assurance Corporation ("Ambac Assurance"), which is
a leading insurer of municipal and structured finance obligations both in the
United States and abroad.
In December 1997, Ambac Assurance acquired Connie Lee Holdings, Inc. and its
triple-A rated financial guarantee insurance subsidiary, Connie Lee Insurance
Company ("Connie Lee"). No new business was written by Connie Lee in 1998.
GROSS PAR VALUE WRITTEN. Ambac Assurance insured $61.5 billion of par value
bonds during 1998, an increase of 35% from $45.5 billion in 1997. Par value
[PHOTO]
23
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
written in 1997 represented an increase of 27% from $35.7 billion in 1996. Par
value written in 1998 comprised $33.9 billion from the insurance of domestic
municipal bond obligations, $22.6 billion from domestic structured finance
obligations and $5.0 billion from international obligations, versus $29.4
billion, $12.9 billion and $3.2 billion, respectively, in 1997 and $26.8
billion, $6.4 billion and $2.5 billion, respectively, in 1996. The 1998 increase
in insured domestic municipal bond obligations resulted primarily from a 30%
increase in market issuance and an increase in insured penetration, partially
offset by lower market share. The 1998 increase in insured domestic structured
finance obligations was attributable to increased market issuance, higher market
penetration and a higher market share in the home equity loan and mortgage-
backed sectors, as well as increased market presence in the commercial asset-
backed sector. The 1998 increase in insured international obligations resulted
from greater acceptance of financial guarantee insurance, primarily in Europe,
Japan and Latin America.
Management believes, based on growth experienced in the last few years, 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 Assurance serves clients in international markets through its wholly-owned
subsidiary Ambac Insurance UK Limited and through an arrangement with MBIA
Insurance Company ("MBIA") to participate in MBIA.AMBAC International, an
unincorporated joint venture with MBIA (the "JV Arrangement"). See Note 5 of
Notes to Consolidated Financial Statements for further discussion about the JV
Arrangement.
GROSS PREMIUMS WRITTEN. Gross premiums written in 1998 were $361.0 million, an
increase of 26% from $286.2 million in 1997. This increase was primarily driven
by a 28% increase in new issue municipal finance premiums and a 46% increase in
international premiums. Gross premiums written in 1997 increased 16% from
$247.2 million in 1996. This increase was primarily due to higher new issue
municipal finance premiums written. The following table sets forth the amounts
of gross premiums written and related gross par written by type:
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(Dollars in millions) 1998 1997 1996
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Gross Gross Gross Gross Gross Gross
Premiums Par Premiums Par Premiums Par
Written Written Written Written Written Written
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Domestic:
Municipal finance:
Up-front:
New issue $228.2 $29,616 $178.9 $25,889 $182.9 $23,735
Secondary market 14.6 1,400 19.6 1,530 20.4 1,362
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Sub-total up-front 242.8 31,016 198.5 27,419 203.3 25,097
Installment 17.7 2,899 13.5 2,024 13.0 1,641
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Total municipal finance 260.5 33,915 212.0 29,443 216.3 26,738
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Structured finance:
Up-front 1.4 1,985 11.1 922 1.2 156
Installment 35.7 20,581 19.6 11,952 8.8 6,255
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Total structured finance 37.1 22,566 30.7 12,874 10.0 6,411
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Total domestic 297.6 56,481 242.7 42,317 226.3 33,149
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International:
Up-front 52.8 2,463 37.6 1,566 18.0 690
Installment 10.6 2,553 5.9 1,575 2.9 1,839
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Total international 63.4 5,016 43.5 3,141 20.9 2,529
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Total $361.0 $61,497 $286.2 $45,458 $247.2 $35,678
===========================================================================================================================
Total up-front $297.0 $35,464 $247.2 $29,907 $222.5 $25,943
Total installment 64.0 26,033 39.0 15,551 24.7 9,735
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Total $361.0 $61,497 $286.2 $45,458 $247.2 $35,678
===========================================================================================================================
ADJUSTED GROSS PREMIUMS. (1) While the majority of Ambac Assurance's premiums
written are collected up front at policy issuance, a growing portion of premiums
are collected on an installment basis. Adjusted gross premiums written, which
are defined as up-front premiums written plus the present value of estimated
future installment premiums written in the period, were $458.0 million in 1998,
up 39% from $329.3 million in 1997. The increase in 1998 was primarily due to
increased up-front premiums written in all markets, combined with the increase
in the present value of international installment policies. Adjusted gross
premiums written in 1997 increased 15% from $286.8 million in 1996. The present
value of estimated future installment premiums written in 1998 was $173.4
million, an increase of 94% from $89.3 million in 1997. The present value of
estimated future installment premiums written in 1997 increased 27% from $70.3
million in 1996. The aggregate net present value of estimated future installment
premiums was $308.4 million, $210.8 million, and $157.7 million as of December
31, 1998, 1997 and 1996, respectively.
24
CEDED PREMIUMS WRITTEN. Ceded premiums written in 1998 were $49.6 million, up
53% from $32.5 million in 1997. The increase in ceded premiums written is
primarily due to the cession of $11.6 million of premiums related to Connie
Lee's insured portfolio. In 1997, Ambac Assurance began using only facultative
reinsurance to reduce its risk and manage its insurance portfolio. Ceded
premiums written in 1996 were $37.8 million. The 14% decrease from 1996 to 1997
is primarily due to the non-renewal of automatic treaty reinsurance, partially
offset by higher ceded premiums for international business pursuant to the JV
Arrangement. Ceded premiums written were 14%, 11%, and 15% of gross premiums
written in 1998, 1997 and 1996, respectively.
NET PREMIUMS EARNED. Net premiums earned during 1998 were $212.7 million, an
increase of 38% from $154.0 million in 1997. This increase was primarily the
result of higher premiums earned from the growth of the book of business and
increased premiums earned from refundings, calls and other accelerations
(collectively referred to as "refundings") during the year.
When an issue insured by Ambac Assurance has been refunded or called,
the remaining unearned premium (net of refunding credits, if any) is generally
earned at that time. Refunding levels vary depending upon a number of
conditions, primarily the relationship between current interest rates and
interest rates on outstanding debt. Net premiums earned in 1998 included $46.9
million (net income per diluted share effect of $0.37) from refundings. Net
premiums earned in 1997 included $28.0 million (net income per diluted share
effect of $0.22) from refundings. Excluding the effect of accelerated earnings
related to refundings, net premiums earned in 1998 were $165.8 million, an
increase of 32% from $126.0 million in 1997.
Net premiums earned during 1997 increased 13% from $136.6 million in
1996. This increase was primarily the result of higher premiums earned from the
growth of the book of business during the year, partially offset by a decline in
premiums earned from refundings in 1997. Net premiums earned in 1996 included
$31.3 million (net income per diluted share effect of $0.25) from refundings.
Excluding the effect of accelerated earnings related to refundings, net premiums
earned in 1997 increased 20% from $105.3 million in 1996.
NET INVESTMENT INCOME. Net investment income in 1998 was $186.2 million, an
increase of 17% from $159.7 million in 1997. This 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, partially offset by lower yields. Investments in tax-exempt securities
amounted to 74% of the total market value of the portfolio as of December 31,
1998, versus 75% and 79% as of December 31, 1997 and 1996, respectively. The
average pre-tax yield-to-maturity on the investment portfolio was 6.17% as of
December 31, 1998 compared with 6.40% and 6.47% for December 31, 1997 and 1996,
respectively. Net investment income in 1997 increased 10% from $144.9 million in
1996. This increase was primarily attributable to the growth of the investment
portfolio, partially offset by lower yields.
NET REALIZED GAINS (LOSSES). Net realized gains in 1998 were $3.7 million,
compared to $21.1 million in net realized gains in 1997. The 1998 and 1997 net
realized gains were generated as a result of the ongoing management of the
investment portfolio. Net realized losses of $20.5 million in 1996 were realized
for tax planning purposes to partially offset the realized gain from the sale of
HCIA.
LOSSES AND LOSS ADJUSTMENT EXPENSES. Losses and loss adjustment expenses in 1998
were $6.0 million, versus $2.9 million in 1997 and $3.8 million in 1996. Losses
and loss adjustment expenses are based upon estimates of the ultimate aggregate
losses inherent in the insured portfolio. The liability for losses and loss
adjustment expenses consists of the active credit reserve ("ACR"), which
represents an estimate of unidentified losses, and case basis loss reserves for
obligations in monetary default, or, in the judgement of management, for which
default is imminent. The Company regularly reviews its outstanding obligations
to determine an appropriate reserve for losses and loss adjustment expenses. The
following table summarizes the Company's loss reserves split between case basis
loss reserves and ACR at December 31, 1998 and 1997:
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(Dollars in millions) 1998 1997
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Net loss and loss adjustment expense reserves:
Case basis* $ 33.9 $50.9
ACR 78.2 48.2
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Total $112.1 $99.1
===========================================================================
* After netting reinsurance recoverable amounting to $3.6 million and $4.2
million in 1998 and 1997, respectively.
Paid losses, net of salvage received, were ($7.0) million, $2.5 million
and $9.6 million in 1998, 1997 and 1996, respectively.
UNDERWRITING AND OPERATING EXPENSES. Underwriting and operating expenses were
$46.7 million in 1998, an increase of 15% from $40.7 million in 1997.
Underwriting and operating expenses in 1997 increased 9% from $37.2 million in
1996. 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 1998, gross underwriting and operating expenses were $67.8
million, an increase of 15% from $59.2 million in 1997. During 1997, gross
underwriting and operating expenses increased 5% from $56.4 million in 1996. The
increase in gross underwriting and operating expenses in both 1998 and 1997
reflects the overall increased business activity in those years. Underwriting
and operating expenses deferred were $38.2 million,
25
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
$32.8 million, and $32.3 million in 1998, 1997 and 1996, respectively. The
amortization of previously deferred expenses and reinsurance commissions was
$18.2 million, $14.2 million, and $12.5 million in 1998, 1997 and 1996,
respectively.
FINANCIAL MANAGEMENT SERVICES
Through its financial management services subsidiaries, the Company provides
investment agreements, interest rate swaps, investment advisory and cash
management services, principally to states, municipalities and their
authorities, school districts, and hospitals and health organizations. In the
fourth quarter of 1998, the Company discontinued development of electronic
commerce applications for the municipal marketplace. This effort had been
underway as a pilot operation through a subsidiary, Ambac Connect, Inc. ("Ambac
Connect"). The decision resulted in an after-tax charge of $9.5 million, or
$0.13 in net income per diluted share. This charge did not affect operating or
core earnings.(2)
Revenues in 1998 were $49.5 million (excludes $17.1 million in net
realized losses), versus $35.2 million (excludes $0.6 million in net realized
losses) in 1997. This increase is primarily due to higher revenues on interest
rate swaps and investment agreements primarily due to increased volume. In 1998,
realized gains on fixed-income securities in the investment agreement business
of $10.1 million were offset by a realized loss of $11.5 million, representing
the write-off of the Company's entire investment in Ambac Connect (this
write-off is included in the $9.5 million after-tax charge discussed above), and
a $15.7 million loss in a trading position. 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 during the fourth quarter of 1998. Revenues in 1997
reflected a 60% increase from $22.0 million (excludes $0.4 million in net
realized gains) in 1996. The increase was primarily due to revenues of Cadre
Financial Services, Inc. ("Cadre"), acquired at the end of 1996, which provides
investment advisory and cash management services primarily to school districts,
and higher revenues from investment agreements, due to higher volume.
Expenses in 1998 were $32.5 million (excluding a $3.0 million
restructuring charge for Ambac Connect), versus $24.5 million (excluding a $3.5
million restructuring charge for consolidating certain operations in New York)
in 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. Expenses in
1997 increased 104% (excluding the $3.5 million 1997 restructuring charge for
consolidating certain operations in New York) from $12.0 million in 1996. This
increase reflects expenses for Cadre and start-up expenses for Ambac Connect.
CORPORATE ITEMS
INTEREST EXPENSE. Interest expense in 1998 was $32.8 million, an increase of 54%
from $21.3 million in 1997. The increase is attributable to AFGI's issuance of
$200 million in debentures in April 1998. Interest expense in 1996 was $20.9
million.
OTHER INCOME. Other income includes investment income of AFGI. Other income
increased to $13.7 million in 1998 from $7.2 million in 1997, primarily due to
higher investment income generated from investing the proceeds of AFGI's $200
million in debentures. Other income decreased in 1997 from $7.9 million in 1996.
OTHER NET REALIZED GAINS. The other net realized gain in 1996 resulted primarily
from the sale of the Company's remaining holdings in HCIA in a secondary public
offering yielding net proceeds of $202.6 million. The sale resulted in a net
realized gain of $155.6 million pre-tax, $100.6 million after-tax (net income
per diluted share effect of $1.42).
OTHER EXPENSES. Other expenses include the operating expenses of AFGI. Other
expenses were $7.1 million in 1998, $2.9 million in 1997, and $3.5 million in
1996. Other expenses were higher in 1998 compared to 1997 primarily due to
increased compensation costs.
INCOME TAXES. Income taxes for 1998 were at an effective rate of 22.8%, compared
to 22.0% and 26.4% for 1997 and 1996, respectively. The 1996 effective tax rate
was higher compared to 1998 and 1997 due to the realized gain of the sale of
HCIA as discussed above.
SUPPLEMENTAL ANALYTICAL FINANCIAL DATA
CORE EARNINGS. (2) In 1998 core earnings were $236.5 million, an increase of 21%
from $195.8 million in 1997. This increase 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. In 1997 core earnings increased 15% from $170.5
million in 1996. The increase 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. Core earnings, which the Company
reports as analytical data, exclude the effect on consolidated net income from
net realized gains and losses, net insurance premiums earned from refundings and
certain non-recurring items.
OPERATING EARNINGS. (2) Operating earnings in 1998 were $263.3 million, an
increase of 24% from $211.8 million in 1997. Operating earnings in 1997
increased 12% from $188.3 million in 1996. The Company defines operating
earnings as net income, less the effect of net realized gains and losses and
certain non-recurring items.
Following is a table reconciling net income computed in accordance with
U.S. Generally Accepted Accounting
26
Principles ("GAAP") to operating earnings and core earnings for the years ended
December 31, 1998, 1997 and 1996:
===========================================================================
(Dollars in Millions) 1998 1997 1996
- ---------------------------------------------------------------------------
Net income $254.0 $223.0 $276.3
Net realized losses (gains), after tax 7.1 (13.3) (88.0)
Non-recurring item, after tax 2.2 2.1 -
- ---------------------------------------------------------------------------
Operating earnings 263.3 211.8 188.3
Premiums earned from refundings,
after tax (26.8) (16.0) (17.8)
- ---------------------------------------------------------------------------
Core earnings $236.5 $195.8 $170.5
===========================================================================
LIQUIDITY AND CAPITAL RESOURCES
AFGI LIQUIDITY. AFGI'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 AFGI; 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 1998, Ambac Assurance paid dividends of $48.0 million on its
common stock to AFGI. For further discussion, see Note 8 of Notes to
Consolidated Financial Statements.
AFGI'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 1999 and the income it expects to receive
from its investment portfolio, management believes AFGI 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 AFGI may be influenced by a variety of factors, including
adverse market changes, insurance regulatory changes and changes in general
economic conditions. Consequently, although management believes that AFGI 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 AFGI's operating
expenses, debt service obligations and dividends on its common stock.
On April 1, 1998, AFGI issued $200.0 million in principal amount of its
7.08% debentures due on March 31, 2098. AFGI may not redeem the debentures prior
to March 31, 2003. On or after March 31, 2003, AFGI may redeem the debentures,
in whole at any time or in part from time to time, at 100% of their principal
amount, plus accrued 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.
AMBAC ASSURANCE LIQUIDITY. The principal uses of Ambac Assurance's liquidity are
the payment of operating expenses, reinsurance premiums, income taxes, and
dividends to AFGI. Management believes that Ambac Assurance's operating
liquidity needs can be funded exclusively from its operating cash flow. The
principal sources of Ambac Assurance's liquidity are gross premiums written,
scheduled investment maturities 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
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. Management
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. Additionally, from time to time, liquidity needs are satisfied by
short-term inter-company loans from AFGI. The 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. A portion of Financial Management Services
assets are maintained in short-term investments and repurchase agreements in
order to meet unexpected liquidity needs.
CREDIT FACILITIES. AFGI and Ambac Assurance have a revolving credit facility
with three major international banks for $150 million, which expires in August
1999 and provides a two-year term loan provision. The facility is available for
general corporate purposes, including the payment of claims. As of December 31,
1998 and 1997, no amounts were outstanding under this credit facility.
Ambac Assurance maintains third party capital support in the form of a
seven-year irrevocable limited recourse credit facility from a group of
highly-rated international banks. This credit facility provides liquidity to
Ambac Assurance in the event claims from municipal obligations in its covered
portfolio exceed specified levels. Repayment of amounts drawn under the credit
facility are limited primarily to the amount of any recoveries of losses related
to policy obligations. During 1998, total third party capital support was
increased from $500 million to $555 million and its expiration reset to
27
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
December 2, 2005. As of December 31, 1998 and 1997, no amounts were outstanding
under this facility.
STOCK REPURCHASE PROGRAM. The Board of Directors of AFGI has authorized the
establishment of a stock repurchase program that permits the purchase of up to
6,000,000 shares of AFGI's common stock. During 1998, AFGI acquired
approximately 976,000 treasury shares for an aggregate amount of $52.7 million.
Since inception of the Stock Repurchase Program, AFGI has acquired approximately
4,248,000 shares for an aggregate amount of $142.7 million.
ADJUSTED BOOK VALUE.(3) Adjusted Book Value ("ABV") per share increased 15% to
$41.98 at December 31, 1998 from $36.59 at December 31, 1997.
The following table reconciles book value per share to ABV per share as
of December 31, 1998 and 1997:
=============================================================================
1998 1997
- -----------------------------------------------------------------------------
Book value per share $29.97 $26.77
After-tax value of:
Net unearned premium reserve 10.17 9.25
Deferred acquisition costs (1.12) (0.99)
Present value of installment premiums 2.86 1.96
Unrealized gain (loss) on investment agreements 0.10 (0.40)
- -----------------------------------------------------------------------------
Adjusted book value per share $41.98 $36.59
=============================================================================
BALANCE SHEET. Total assets as of December 31, 1998 were $11.21 billion, an
increase of 35% over $8.29 billion at December 31, 1997. The increase was
primarily due to the increased volume in investment agreements and positive net
cash flow from the Financial Guarantee Insurance segment. Stockholders' equity
as of December 31, 1998 was $2.10 billion, an increase of 12% from $1.87 billion
at year-end 1997. This increase was primarily due to net income for the year and
higher net unrealized gains in the investment portfolio, partially offset by
dividends to shareholders and stock option exercises.
CASH FLOWS. Net cash provided by operating activities was $337.7 million, $324.5
million and $190.6 million during 1998, 1997 and 1996, respectively. These cash
flows were primarily provided by the Financial Guarantee Insurance operations.
Net cash provided by financing activities was $1,723.0 million, $1,564.3 million
and $463.2 million during 1998, 1997 and 1996, respectively. This activity
included $1,391.9 million, $1,096.5 million and $499.2 million in investment
agreements issued (net of draws paid) in 1998, 1997 and 1996, respectively. The
total cash provided by operating and financing activities was $2,060.7 million,
$1,888.8 million and $653.8 million during 1998, 1997 and 1996, respectively.
From these totals, $2,061.7 million, $1,887.3 million and $658.2 million was
used in investing activities, principally net purchases of investment
securities, during 1998, 1997 and 1996, respectively.
MATERIAL COMMITMENTS. The Company has made no commitments for material capital
expenditures within the next twelve months.
RISK MANAGEMENT
In the ordinary course of business, the Company, through its subsidiaries,
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 represents the potential for losses that may result from
changes in the market value of a financial instrument as a result of changes in
market conditions. 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 market 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, which utilize current and historical market information. The
valuation results from these models could differ materially from amounts that
would actually be realized in the market. Financial instruments 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 financial futures) used for hedging purposes.
The following table summarizes the estimated change in fair value (based
primarily on the valuation models discussed above) on the net balance of
financial instruments held for purposes other than trading assuming immediate
changes in interest rates at specified levels at December 31, 1998 and 1997:
(Dollars in Millions)
===============================================================================
Estimated fair value of net
Change in financial instruments held Estimated change
interest rates for purposes other than trading in fair value
- -------------------------------------------------------------------------------
1998:
300 basis point rise $2,172 $(757)
200 basis point rise 2,401 (529)
100 basis point rise 2,655 (275)
Base Scenario 2,930 -
100 basis point decline 3,215 285
200 basis point decline 3,500 570
300 basis point decline 3,802 872
1997:
300 basis point rise $2,071 $(560)
200 basis point rise 2,264 (367)
100 basis point rise 2,489 (142)
Base Scenario 2,631 -
100 basis point decline 2,801 170
200 basis point decline 2,965 334
300 basis point decline 3,136 505
===============================================================================
28
The Company, through its subsidiary 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 seeking to profit from retaining some basis risk. If
actual or projected floating tax-exempt interest rates change in relation to
floating taxable interest rates, the Company will experience an unrealized mark-
to-market gain or loss. The AFSLP swap portfolio is considered held for trading
purposes. Since late 1995, most municipal interest rate swaps transacted by
AFSLP contain provisions which are designed to protect the Company against
certain forms of tax reform, thus mitigating its basis risk. An independent
market risk management group monitors trading risk limits and, together with
senior management, is involved in the application of risk measurement
methodologies.
The estimation of potential losses arising from adverse changes in
market relationships, known as "value-at-risk," is a key element in managing
market risk for financial instruments held for trading purposes. The Company has
developed a value-at-risk methodology to estimate potential losses over a
specified holding period and based on certain probabilistic assessments. The
Company's methodology estimates value-at-risk using a 300 day historical "look
back" period. This means that changes in market values are simulated using
market inputs from the past 300-days. For the years ended December 31, 1998 and
1997, the Company's value-at-risk, for financial instruments considered held for
trading purposes, calculated at a ninety-nine percent confidence level, averaged
approximately $1.0 million and $0.6 million, respectively. The Company's
value-at-risk ranged from a high of $1.1 million to a low of $0.7 million in
1998, and from a high of $1.1 million to a low of $0.3 million in 1997. Since no
single measure can capture all dimensions of market risk, the Company
supplements its value-at-risk methodology by performing daily analyses of
parallel and non-parallel shifts in yield curves and stress test scenarios which
measure the potential impact of normal market conditions, which might cause
abnormal volatility swings or disruptions of market relationships.
Credit risk arises from the potential inability of issuers of bond
obligations in Ambac Assurance's insured portfolio and other counterparties to
perform on an obligation in accordance with the terms of the contract. The
Company is exposed to credit risk in various capacities including as an issuer
of a financial guarantee policy, as counterparty to financial contracts and as a
holder of investment securities. The Company has established various procedures
and controls to monitor and manage credit risk. These include the initial
credit review and approval process, minimum credit rating requirements, single
credit concentration limits and the continuous monitoring of credit exposures.
Liquidity risk relates to the possible inability to satisfy contractual
obligations when due. This risk is present in financial guarantee insurance,
investment agreements, interest rate swaps and futures contracts. Ambac
Assurance manages its liquidity risk by maintaining a comprehensive daily
analysis of projected cash flows. Additionally, Ambac Assurance maintains a
minimum level of cash and short-term investments at all times. See additional
discussion in "Liquidity and Capital Resources" section. The investment
agreement business manages liquidity risk by matching the effective duration of
its invested assets, including hedges, with the effective duration of its
investment agreement liabilities. Additionally, the Company's policy is to
maintain a minimum level of cash and short-term investments equivalent to a
specified percentage of its investment agreement liabilities outstanding. AFSLP
maintains cash and cash equivalents, closely matching the dates swap payments
are made and received, and limiting the amount of risk hedged with futures
contracts.
Operational risk relates to the potential for loss caused by a breakdown
in information, communication and settlement systems. The Company mitigates
operational risk by maintaining systems and procedures to monitor transactions
and positions, documentation and confirmation of transactions and ensuring
compliance with regulations.
Legal risk relates to the uncertainty of the enforceability, through
legal or judicial processes, of the obligations that Ambac Assurance insures or
obligations of the Company's counterparties, including contractual provisions
intended to reduce exposure by providing for the offsetting or netting of mutual
obligations. The Company seeks to remove or minimize such uncertainties through
continuous consultation with internal and external legal advisers to analyze and
understand the nature of legal risk, to improve documentation and to strengthen
transaction structure.
OTHER MATTERS
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 technology systems. The Company has also contracted with an outside
consultant to support its Y2K initiative.
In connection with this initiative, the Company embarked on a three
phase process. Phase I is an inventory analysis and impact assessment. Inventory
included:
29
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
(a) those information technology systems which were 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 are tested; (b) transactions are run through critical systems
by applying various permutations and combinations of Y2K sensitive dates; and
(c) results are reviewed independently by each business unit. In Phase III, the
extent of code repair is determined and remediated.
Phase I, the inventory analysis and impact assessment, is 100% complete.
Phase II, the testing phase, is 100% complete for all aspects of the business
except for the investment advisory and cash management services business
(Cadre). Phase II is approximately 80% complete for Cadre, and is expected to be
100% complete by March 31, 1999. Phase III, code repair, is 100% complete for
all aspects of the business except for Cadre. Code repair, if necessary for
Cadre, is targeted for completion by March 31, 1999.
The cost of identifying, testing and remediating critical systems is
estimated to be approximately $1.1 million, $0.7 million of which was 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 under way, the Company does not yet have
the information to estimate the likelihood of significant disruptions among its
suppliers.
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.
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 has requested compliance statements from
certain trustees or paying agents of its insured transactions, reviewed the
appropriate publicly available disclosures and monitored the activities of the
banking regulatory agencies for Y2K developments. Additionally, financial
institution risk relates to custodians of securities held for its own account
and the accounts of others. The procedures outlined above have been applied to
such custodians as well.
With respect to the Company's internal operations, preliminary findings
do not give any indications that these systems will be non-compliant, management
is in the process of developing contingent procedures in the event its critical
systems should fail. With respect to third parties, the Company's inquiries are
underway, and the Company does not expect significant disruptions among vendors,
EDI partners, issuers and financial institutions.
FOOTNOTES
(1) Adjusted gross premiums written, which is not promulgated under GAAP, is
used by management, equity analysts and investors to measure the financial
results of the Company. Adjusted gross premiums written, which the Company
reports as analytical data, is defined as gross up-front premiums written plus
the present value of estimated future installment premiums written in the
period. The definition of adjusted gross premiums written used by the Company
may differ from definitions of adjusted gross premiums written used by other
public holding companies of financial guarantee insurers.
The definition of adjusted gross premiums written, and all current and
historical figures, have been revised to better reflect the Company's
international joint venture arrangement with MBIA. Under the revision, all
reinsurance cessions to MBIA under the joint venture reinsurance arrangement
reduce adjusted gross premiums written. Consequently, the revised adjusted gross
premiums written recorded by the Company includes only the net retention on
business written under the joint venture arrangement.
(2) Core earnings and operating earnings are not substitutes for net income
computed in accordance with GAAP, but are important measures used by management,
equity analysts and investors to measure the financial results of the Company.
The definition of core earnings and operating earnings used by the Company may
differ from definitions of core earnings and operating earnings used by other
public holding companies of financial guarantee insurers.
(3) Adjusted book value ("ABV"), which is not promulgated under GAAP, is used by
management, equity analysts and investors as a measurement of the Company's
intrinsic value with no benefit given for ongoing business activity. Management
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.
The definition of ABV used by the Company may differ from definitions of ABV
used by other public holding companies of financial guarantee insurers. The
adjustments to book value described above will not be realized until future
periods and may differ materially from the amounts used in determining ABV.
30
REPORT ON MANAGEMENT'S RESPONSIBILITIES
The management of Ambac Financial Group, Inc. is responsible for the integrity
and objectivity of the financial statements and all other financial information
presented in this Annual Report and for assuring that such information fairly
presents the consolidated financial position and operating results of Ambac
Financial Group, Inc. The accompanying consolidated financial statements have
been prepared in conformity with generally accepted accounting principles using
management's best estimates and judgment. The financial information presented
elsewhere in this Annual Report is consistent with that in the consolidated
financial statements.
Ambac Financial Group, Inc. maintains a system of internal accounting
controls designed to provide reasonable assurance that assets are safeguarded
against loss or unauthorized use and that the financial records are reliable for
use in preparing financial statements and maintaining accountability of assets.
Qualified and professional financial personnel maintain and monitor these
internal controls on a continuous basis. The concept of reasonable assurance is
based on the recognition that the cost of a system of internal control should
not exceed the related benefits.
Ambac Financial Group, Inc.'s consolidated financial statements have
been audited by KPMG LLP, independent auditors, whose audits were made in
accordance with generally accepted auditing standards and included a review of
internal accounting controls to the extent necessary to express an opinion on
the fairness of the consolidated financial statements.
The Audit Committee of the Board of Directors, comprised solely of
outside directors, meets regularly with financial management, the independent
auditors and the internal auditors to review the work and procedures of each.
The independent auditors and the internal auditors have free access to the Audit
Committee, without the presence of management, to discuss the results of their
work and their considerations of Ambac and its subsidiaries and the quality of
Ambac Financial Group, Inc.'s financial reporting. The Board of Directors, upon
recommendation of the Audit Committee, appoints the independent auditors,
subject to stockholder approval.
/s/ Phillip B. Lassiter
PHILLIP B. LASSITER
Chairman, President and Chief Executive Officer
/s/ Frank J. Bivona
FRANK J. BIVONA
Executive Vice President and Chief Financial Officer
January 27, 1999
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders
Ambac Financial Group, Inc.
We have audited the accompanying consolidated balance sheets of Ambac Financial
Group, Inc. and subsidiaries as of December 31, 1998 and 1997, and the related
consolidated statements of operations, stockholders' equity and cash flows for
each of the years in the three-year period ended December 31, 1998. These
consolidated financial statements are the responsibility of Ambac Financial
Group, Inc.'s management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Ambac
Financial Group, Inc. and subsidiaries as of December 31, 1998 and 1997, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 1998 in conformity with generally accepted
accounting principles.
/s/ KPMG LLP
KPMG LLP
New York, New York
January 27, 1999
31
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
=============================================================================================================
(Dollars in thousands, except per share amounts) December 31, 1998 1997
- -------------------------------------------------------------------------------------------------------------
ASSETS:
Investments:
Fixed income securities, at fair value (amortized cost of $8,307,046
in 1998 and $6,525,650 in 1997) $ 8,622,282 $6,773,844
Short-term investments, at cost (approximates fair value) 119,528 136,278
Other, at cost 6,567 5,000
- -------------------------------------------------------------------------------------------------------------
Total investments 8,748,377 6,915,122
Cash 8,239 9,256
Securities purchased under agreements to resell 252,295 85,466
Receivable for investment agreements 73,142 -
Receivable for securities sold 16,233 106,246
Investment income due and accrued 125,929 78,690
Reinsurance recoverable 3,638 4,219
Prepaid reinsurance 199,920 183,492
Deferred acquisition costs 120,619 105,996
Loans 673,930 503,192
Receivable from brokers and dealers 750,000 183,041
Other assets 239,989 116,985
- -------------------------------------------------------------------------------------------------------------
Total assets $11,212,311 $8,291,705
=============================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY:
Liabilities:
Unearned premiums $1,294,214 $1,178,990
Losses and loss adjustment expenses 115,794 103,345
Ceded reinsurance balances payable 6,576 9,258
Obligations under investment and payment agreements 4,774,953 3,230,052
Obligations under investment repurchase agreements 1,181,810 1,090,912
Deferred income taxes 145,782 135,228
Current income taxes 6,949 9,016
Debentures 423,929 223,864
Accrued interest payable 89,615 46,017
Accounts payable and other liabilities 262,423 117,153
Payable to brokers and dealers 750,000 -
Payable for securities purchased 64,176 275,388
- -------------------------------------------------------------------------------------------------------------
Total liabilities 9,116,221 6,419,223
- -------------------------------------------------------------------------------------------------------------
Stockholders' equity:
Preferred stock, par value $0.01 per share; authorized shares -
4,000,000; issued and outstanding shares - none - -
Common stock, par value
$0.01 per share; authorized shares -
200,000,000 at December 31, 1998 and 100,000,000 at
December 31, 1997; issued shares - 70,680,384 at
December 31, 1998 and December 31, 1997 707 707
Additional paid-in capital 519,305 500,107
Accumulated other comprehensive income 159,313 135,223
Retained earnings 1,449,832 1,262,740
Common stock held in treasury at cost, 738,381 shares at
December 31, 1998 and 732,947 at December 31, 1997 (33,067) (26,295)
- -------------------------------------------------------------------------------------------------------------
Total stockholders' equity 2,096,090 1,872,482
- -------------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $11,212,311 $8,291,705
=============================================================================================================
See accompanying Notes to Consolidated Financial Statements
32
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
========================================================================================================
(Dollars in thousands, except per share amounts)
Years Ended December 31, 1998 1997 1996
- --------------------------------------------------------------------------------------------------------
REVENUES:
Financial Guarantee Insurance:
Gross premiums written $ 361,011 $ 286,163 $ 247,208
Ceded premiums written (49,563) (32,452) (37,793)
- --------------------------------------------------------------------------------------------------------
Net premiums written 311,448 253,711 209,415
Increase in unearned premiums (98,764) (99,711) (72,786)
- --------------------------------------------------------------------------------------------------------
Net premiums earned 212,684 154,000 136,629
Net investment income 186,190 159,709 144,941
Net realized gains (losses) 3,735 21,084 (20,531)
Other income 5,781 4,402 5,261
Financial Management Services:
Revenue 49,510 35,249 21,973
Net realized (losses) gains (17,096) (637) 393
Other:
Revenue 13,725 7,207 7,929
Net realized gains 2,507 748 156,313
- --------------------------------------------------------------------------------------------------------
Total revenues 457,036 381,762 452,908
- --------------------------------------------------------------------------------------------------------
EXPENSES:
Financial Guarantee Insurance:
Losses and loss adjustment expenses 6,000 2,854 3,778
Underwriting and operating expenses 46,720 40,672 37,182
Financial Management Services 35,540 27,993 12,040
Interest 32,761 21,346 20,925
Other 7,103 2,901 3,477
- --------------------------------------------------------------------------------------------------------
Total expenses 128,124 95,766 77,402
- --------------------------------------------------------------------------------------------------------
Income before income taxes 328,912 285,996 375,506
Provision for income taxes 74,918 62,966 99,189
- --------------------------------------------------------------------------------------------------------
Net income $ 253,994 $ 223,030 $ 276,317
========================================================================================================
Net income per share $ 3.63 $ 3.19 $ 3.95
========================================================================================================
Net income per diluted share $ 3.56 $ 3.13 $ 3.91
========================================================================================================
Weighted average number of shares outstanding 69,939,710 69,988,497 69,929,628
========================================================================================================
Weighted average number of diluted shares outstanding 71,330,053 71,227,347 70,748,470
========================================================================================================
See accompanying Notes to Consolidated Financial Statements
33
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
=======================================================================================================================
(Dollars in thousands) Years Ended December 31, 1998 1997 1996
- -----------------------------------------------------------------------------------------------------------------------
RETAINED EARNINGS:
Balance at January 1 $1,262,740 $1,072,418 $ 819,479
Net income 253,994 $253,994 223,030 $223,030 276,317 $276,317
---------- ---------- ----------
Dividends declared -
common stock (26,571) (24,165) (21,500)
Exercise of stock options (40,331) (8,543) (1,878)
----------- ----------- -----------
Balance at December 31 $1,449,832 $1,262,740 $1,072,418
----------- ----------- -----------
ACCUMULATED OTHER
COMPREHENSIVE INCOME:
Balance at January 1 $ 135,223 $ 58,911 $ 102,470
Unrealized gains (losses)
on securities, ($36,476,
$121,347,
and ($71,667),
pre-tax, in 1998, 1997
and 1996, respectively)(1) 23,889 76,155 (43,559)
Foreign currency gain 201 157 -
---------- ---------- ----------
Other comprehensive income 24,090 24,090 76,312 76,312 (43,559) (43,559)
----------- ---------- ----------- ---------- ----------- ----------
Total comprehensive income $278,084 $299,342 $232,758
========== ========== ==========
Balance at December 31 $ 159,313 135,223 $ 58,911
----------- ----------- -----------
PREFERRED STOCK:
Balance at January 1
and December 31 $ - $ - $ -
----------- ----------- -----------
COMMON STOCK:
Balance at January 1 $ 707 $ 353 $ 353
Stock split effected
as dividend - 354 -
----------- ----------- -----------
Balance at December 31 $ 707 $ 707 $ 353
----------- ----------- -----------
ADDITIONAL PAID-IN CAPITAL:
Balance at January 1 $ 500,107 $ 498,401 $ 492,495
Issuance of stock - (3,506) 3,624
Exercise of stock options 19,198 5,566 2,282
Stock split effected
as dividend - (354) -
----------- ----------- -----------
Balance at December 31 $ 519,305 $ 500,107 $ 498,401
----------- ----------- -----------
COMMON STOCK HELD IN
TREASURY AT COST:
Balance at January 1 $ (26,295) $ (15,067) $ (10,809)
Cost of shares acquired (52,738) (40,397) (31,751)
Shares issued under
equity plans 45,966 29,169 17,211
Issued to acquire subsidiary - - 10,282
----------- ----------- -----------
Balance at December 31 $ (33,067) $ (26,295) $ (15,067)
----------- ----------- -----------
TOTAL STOCKHOLDERS' EQUITY
AT DECEMBER 31 $2,096,090 $1,872,482 $1,615,016
=======================================================================================================================
(1) Disclosure of reclassification amount: 1998 1997 1996
=============================================================================================
Unrealized holding gains (losses)
arising during period $34,526 $88,744 $(56,195)
Less: reclassification adjustment
for net gains (losses)
included in net income 10,637 12,589 (12,636)
--------- -------- ---------
Net unrealized gains (losses) on securities $23,889 $76,155 $(43,559)
=============================================================================================
See accompanying Notes to Consolidated Financial Statements.
34
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
=============================================================================================================
(Dollars in thousands) Years Ended December 31, 1998 1997 1996
- -------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 253,994 $ 223,030 $ 276,317
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 2,460 1,925 1,986
Amortization of bond premium and discount (4,942) (3,257) (1,603)
Current income taxes (2,067) 9,978 1,413
Deferred income taxes (2,034) 12,015 4,497
Deferred acquisition costs (14,623) (11,784) (11,592)
Unearned premiums, net 98,796 99,706 72,786
Losses and loss adjustment expenses 13,030 408 (5,776)
Ceded reinsurance balances payable (2,682) 1,303 (7,216)
Investment income due and accrued (47,239) (9,415) (9,550)
Accrued interest payable 43,598 16,059 4,464
Loss (gain) on sales of investments and affiliates 10,854 (21,195) (136,175)
Other, net (11,488) 5,744 1,079
- -------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 337,657 324,517 190,630
- -------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sales of bonds 2,020,463 1,718,174 1,911,909
Proceeds from matured bonds 1,034,511 1,080,338 959,527
Purchases of bonds (4,746,366) (4,135,404) (3,825,803)
Change in short-term investments 16,750 (23,767) 64,178
Securities purchased under agreements to resell (166,829) 115,703 39,111
Loans (170,738) (503,192) -
Purchase of affiliate, net of cash acquired - (120,006) -
Proceeds from sale of affiliate - - 202,609
Other, net (49,478) (19,121) (9,783)
- -------------------------------------------------------------------------------------------------------------
Net cash used in investing activities (2,061,687) (1,887,275) (658,252)
- -------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Dividends paid (26,571) (24,165) (21,500)
Proceeds from issuance of investment agreements 3,628,266 2,805,256 1,696,813
Payments for investment agreement draws (2,236,348) (1,708,775) (1,197,584)
Proceeds from issuance of debentures 193,700 - -
Payment agreements 170,738 503,192 -
Purchases of treasury stock (52,738) (40,397) (31,751)
Proceeds from sale of treasury stock 45,966 29,169 17,211
- -------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 1,723,013 1,564,280 463,189
- -------------------------------------------------------------------------------------------------------------
NET CASH FLOW (1,017) 1,522 (4,433)
Cash at January 1 9,256 7,734 12,167
- -------------------------------------------------------------------------------------------------------------
Cash at December 31 $ 8,239 $ 9,256 $ 7,734
=============================================================================================================
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the year for:
Income taxes $ 66,853 $ 34,163 $ 90,649
=============================================================================================================
Interest expense on debt $ 33,056 $ 21,799 $ 21,675
=============================================================================================================
Interest expense on investment agreements $ 252,713 $ 169,875 $ 148,526
=============================================================================================================
See accompanying Notes to Consolidated Financial Statements.
35
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
1 BACKGROUND
Ambac Financial Group, Inc. ("AFGI") is a holding company whose subsidiaries
provide financial guarantee insurance and financial management services to
clients in both the public and private sectors in the United States and abroad.
AFGI'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. AFGI's Financial Management
Services segment provides investment agreements, interest rate swaps, and
investment advisory and cash management services, principally to states,
municipalities and their authorities, school districts, and hospitals and health
organizations.
2 SIGNIFICANT ACCOUNTING POLICIES
The accompanying Consolidated Financial Statements of AFGI and subsidiaries (the
"Company") have been prepared on the basis of U.S. Generally Accepted Accounting
Principles ("GAAP"). The preparation of financial statements in conformity with
GAAP requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosures of contingent assets
and liabilities 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 significant accounting policies of the Company are
described below:
CONSOLIDATION:
The consolidated financial statements include the accounts of AFGI and its
subsidiaries. All significant intercompany balances have been eliminated.
NET INCOME PER SHARE AND NET INCOME PER DILUTED SHARE: Net income per share is
based on the weighted average number of shares outstanding during the year,
retroactively adjusted to reflect a two-for-one stock split in 1997. Net income
per diluted share reflects the potential dilution that would occur if
securities, such as employee stock options, were exercised.
INVESTMENTS:
The Company's investment portfolio is accounted for on a trade-date basis and
consists primarily of investments in fixed income securities that are considered
available-for-sale and are carried at fair value. Fair value is based on quotes
obtained by the Company from independent market sources. Short-term investments
are carried at cost, which approximates fair value. Unrealized gains and losses,
net of deferred income taxes, are included as a component of "Accumulated Other
Comprehensive Income" in stockholders' equity and are computed using amortized
cost as the basis. For purposes of computing amortized cost, premiums and
discounts are accounted for using the interest method. For bonds purchased at a
price below par value, discounts are accreted over the remaining term of the
securities. For bonds purchased at a price above par value which have call
features, premiums are amortized to the most likely call dates as determined by
management. For premium bonds that do not have call features, such premiums are
amortized over the remaining terms of the securities. Premiums and discounts on
mortgage-backed and asset-backed securities are adjusted for the effects of
actual and anticipated prepayments. Realized gains and losses on the sale of
investments are determined on the basis of specific identification.
SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL:
Securities purchased under agreements to resell are collateralized financing
transactions, and are recorded at their contracted resale amounts, plus accrued
interest. The Company takes possession of the collateral underlying those
agreements and monitors its market value on a daily basis and, when necessary,
requires prompt transfer of additional collateral to reflect current market
value.
LOANS:
Loans are reported at their outstanding unpaid principal balances, net of any
deferred fees. Interest income is accrued on the unpaid principal balance.
Deferred fees are amortized to interest income over the contractual life of the
loan using the interest method or the straight-line method if not materially
different.
OBLIGATIONS UNDER INVESTMENT AND PAYMENT AGREEMENTS:
Obligations under investment and payment agreements and investment repurchase
agreements are recorded as liabilities on the Consolidated Balance Sheets at the
face value of the agreement, adjusted for draws paid and interest credited to
the account. Unsettled agreements are accrued on a trade-date basis on the
Consolidated Balance Sheets at the time of commitment. Interest expense is
computed based upon daily outstanding settled liability balances at rates and
periods specified in the agreements. Net interest income relating to investment
agreements and investment repurchase agreements is included as a component of
Financial Management Services revenue.
PREMIUM REVENUE RECOGNITION:
Premiums can be structured in two ways: (1) computed as a percentage of
principal and interest insured, typically collected in a single payment at
policy inception date, and earned pro-rata over the period of risk; and (2)
computed as a percentage of either principal or principal and interest insured,
collected periodically (i.e., monthly, quarterly or annually), and reflected in
income pro-rata over the period covered by the premium payment.
When a new or secondary market issue insured by Ambac Assurance has been
refunded or called, the remaining unearned premium (net of refunding credits, if
any) is generally earned at that time.
36
LOSSES AND LOSS ADJUSTMENT EXPENSES:
The liability for losses and loss adjustment expenses consists of the active
credit reserve ("ACR") and case basis loss and loss adjustment expense reserves.
The development of the ACR is based upon estimates of the expected annual levels
of debt service defaults resulting from credit failures on currently insured
issues that are not presently or imminently in default. When losses occur
(actual monetary defaults or defaults which are imminent on insured
obligations), case basis loss reserves are established in an amount that is
sufficient to cover the present value of the anticipated defaulted debt service
payments over the expected period of default and estimated expenses associated
with settling the claims, less estimated recoveries under salvage or subrogation
rights. During 1998, 1997 and 1996, paid losses, net of salvage received, were
($7,030), $2,474 and $9,554, respectively. All or part of case basis loss
reserves are allocated from any ACR available.
Ambac Assurance's management believes that the reserves for losses and
loss adjustment expenses are adequate to cover the ultimate net cost of claims,
but the reserves are necessarily based on estimates and there can be no
assurance that the ultimate liability will not exceed such estimates.
DEFERRED ACQUISITION COSTS:
Certain costs incurred that vary with, and are primarily related to, the
production of business have been deferred. These costs include direct and
indirect expenses related to underwriting, marketing and policy issuance, rating
agency fees and premium taxes, net of reinsurance ceding commissions. The
deferred acquisition costs are being amortized over the periods in which the
related premiums are earned, and such amortization amounted to $18,248, $14,213
and $12,553 for 1998, 1997 and 1996, respectively. Deferred acquisition costs,
net of such amortization, amounted to $14,623, $11,784 and $11,592 for 1998,
1997 and 1996, respectively.
DEPRECIATION AND AMORTIZATION:
Depreciation of furniture and fixtures and electronic data processing equipment
is provided over the estimated useful lives of the respective assets, ranging
from three to five years, using the straight-line method. Amortization of
leasehold improvements and intangibles, including certain computer software
licenses, is provided over the estimated useful lives of the respective assets,
ranging from three to 10 years, using the straight-line method.
DERIVATIVE CONTRACTS:
DERIVATIVE CONTRACTS HELD FOR PURPOSES OTHER THAN TRADING: The Company uses
derivative contracts (primarily interest rate swaps and futures contracts) for
hedging purposes as part of its overall interest rate risk management.
The Company accounts for its futures contracts in accordance with the
provisions of FAS Statement 80, "Accounting for Futures Contracts" ("FAS 80").
FAS 80 permits hedge accounting for futures contracts when the item to be hedged
exposes the Company to price or interest rate risk, and the futures contract
effectively reduces that exposure and is designated as a hedge. Futures
contracts held for purposes other than trading are used primarily to hedge
interest sensitive assets and liabilities. Futures contracts are designated at
inception as a hedge to specific assets and liabilities. Gains and losses on
futures and options contracts that qualify as accounting hedges of existing
assets or liabilities are included as a component of "Accumulated Other
Comprehensive Income" in stockholders' equity, net of deferred tax, and
amortized over the remaining lives of the assets and liabilities as an
adjustment to interest income or expense. When the hedged asset is sold, or the
hedged liability is settled, the unamortized gain or loss on the related hedge
is recognized in income.
Interest rate swaps that are linked with existing liabilities are
accounted for as a hedge of those liabilities, using the accrual method as an
adjustment to interest expense. Interest rate swaps that are linked with
existing assets classified as available for sale are accounted for as hedges of
those assets, using the accrual method as an adjustment to interest income, with
unrealized gains and losses included as a component of "Accumulated Other
Comprehensive Income" in stockholders' equity, net of deferred tax. Interest
rate risk is managed through the linkage of the interest rate swaps, which
synthetically changes the nature of the underlying asset or liability (for
example, from a fixed to floating interest rate obligation).
Gains and losses on futures contracts, purchased options or interest
rate swaps that do not qualify as accounting hedges are recognized immediately
in current period income.
DERIVATIVE CONTRACTS HELD FOR TRADING PURPOSES:
The Company, through its subsidiary Ambac Financial Services, L.P. ("AFSLP"), a
provider of interest rate swaps to states, municipalities and their authorities,
and other entities in connection with their financings, uses derivative
contracts which are classified as held for trading purposes. Derivative
contracts are recorded on trade date at fair value. Changes in fair value are
recorded as a component of Financial Management Services segment income. The
fair value of interest rate swaps is determined through the use of valuation
models. Interest rate swaps are recorded on the balance sheet on a gross basis;
assets and liabilities are netted by customer only when a legal right of set-off
exists.
INCOME TAXES:
AFGI files a consolidated federal income tax return with its subsidiaries.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in
37
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
tax rates is recognized in the period that includes the enactment date.
The Internal Revenue Code permits financial guarantee insurance
companies to deduct from taxable income, subject to certain limitations, the
amounts added to the statutory mandatory contingency reserve for municipal
obligations during the year. The deduction taken is allowed only to the extent
that U.S. Treasury noninterest-bearing tax and loss bonds are purchased at their
par value prior to the original due date of the Company's consolidated federal
tax return and held in an amount equal to the tax benefit attributable to such
deductions. The amounts deducted must be included in taxable income when the
contingency reserve is released, at which time the Company may redeem the tax
and loss bonds to satisfy the additional tax liability. The purchases of tax and
loss bonds are recorded as payments of federal income taxes.
POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS:
The Company provides various postretirement and post-employment benefits,
including pension, and health and life benefits covering substantially all
employees who meet certain age and service requirements. The Company accounts
for these benefits under the accrual method of accounting. Amounts related to
the defined benefit pension plan and postretirement health benefits are charged
based on actuarial determinations.
STOCK COMPENSATION PLANS:
In 1997, the Company adopted the Ambac 1997 Equity Plan. Under this plan, awards
are granted to eligible employees of the Company in the form of incentive stock
options or other stock-based awards. The Company accounts for its incentive
stock options and stock-based awards under FAS Statement 123, "Accounting for
Stock-Based Compensation" ("FAS 123"). FAS 123 permits a company to choose
either the fair value based method of accounting as defined in the Statement or
the intrinsic value based method of accounting as prescribed by APB Opinion No.
25, "Accounting for Stock Issued to Employees" ("APB 25"), for its stock-based
compensation plans. Companies electing the accounting requirements under APB 25
must also make pro-forma disclosures of net income, earnings per share and
earnings per diluted share as if the fair value based method of accounting had
been applied. The Company has elected to account for its plans under APB 25.
ACCOUNTING STANDARDS:
During 1998, the Company adopted the following new standards: FAS Statement 130,
"Reporting Comprehensive Income" ("FAS 130"); FAS Statement 131, "Disclosures
about Segments of an Enterprise and Related Information" ("FAS 131"); and FAS
Statement 132, "Employers' Disclosures about Pensions and Other Postretirement
Benefits" ("FAS 132").
FAS 130 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 from transactions with stockholders) and includes net income, net
unrealized capital gains or losses on available-for-sale securities and foreign
currency translation adjustments. Comprehensive income is disclosed in the
Consolidated Statement of Stockholders' Equity. FAS 131 redefines how reportable
segments are determined and requires disclosure of certain financial and
descriptive information about a company's reportable segments. Disclosures
regarding the Company's two reportable segments, Financial Guarantee Insurance
and Financial Management Services are included in Note 17. FAS 132 alters
disclosure requirements regarding pensions and other postretirement benefits in
the financial statements of employers who sponsor such benefit plans. The
revised disclosure requirements are designed to provide additional information
to assist readers in evaluating future costs related to such plans. The required
pension disclosures are included in Note 10. As each of these new standards only
requires additional disclosure information in the consolidated financial
statements, they do not affect the Company's consolidated financial position or
results of operations.
In June 1998, the Financial Accounting Standards Board issued FAS
Statement 133, "Accounting for Derivative Instruments and Hedging Activities"
("FAS 133"). FAS 133 establishes accounting and reporting standards for
derivative instruments and hedging activities. The statement requires all
derivatives to be recorded on the balance sheet at fair value and establishes
special accounting for the following three different types of hedges: (1) hedges
of changes in the fair value of assets, liabilities or firm commitments
(referred to as fair value hedges); (2) hedges of the variable cash flows of
forecasted transactions (cash flow hedges); and (3) hedges of foreign currency
exposures of net investments in foreign operations. Though the accounting
treatment and criteria for each of the three types of hedges is unique, they all
result in recognizing offsetting changes in value or cash flow of both the hedge
and the hedged item in earnings in the same period. Changes in the fair value of
derivatives that do not meet the criteria of one of these three categories of
hedges are included in earnings in the period of the change with no related
offset. FAS 133 is effective for years beginning after June 15, 1999, but
companies may adopt early. The Company will adopt FAS 133 effective January 1,
2000. Management is assessing the impact of FAS 133 on the Company's
consolidated financial position and results of operations.
RECLASSIFICATIONS:
Certain reclassifications have been made to prior years' amounts to conform to
the current year's presentation.
3 INVESTMENTS
The amortized cost and estimated fair value of investments in fixed income
securities and short-term investments at December 31, 1998 and 1997 were as
follows:
38
===========================================================================
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
- ---------------------------------------------------------------------------
1998
Municipal obligations $2,632,276 $172,960 $3,912 $2,801,324
Corporate obligations 1,335,749 103,030 3,352 1,435,427
U.S. Government
obligations 114,385 8,511 - 122,896
Mortgage- and asset-
backed securities
(includes U.S.
Government Agency
obligations) 4,224,636 41,994 3,995 4,262,635
Other 119,528 - - 119,528
- ---------------------------------------------------------------------------
Total $8,426,574 $326,495 $11,259 $8,741,810
===========================================================================
1997
Municipal obligations $2,146,137 $152,971 $ 112 $2,298,996
Corporate obligations 1,022,995 71,520 928 1,093,587
U.S. Government
obligations 136,771 2,855 28 139,598
Mortgage- and asset-
backed securities
(includes U.S.
Government Agency
obligations) 3,200,262 25,511 3,017 3,222,756
Other 155,763 91 669 155,185
- ---------------------------------------------------------------------------
Total $6,661,928 $252,948 $ 4,754 $6,910,122
===========================================================================
The amortized cost and estimated fair value of fixed income securities and
short-term investments at December 31, 1998, by contractual maturity, were as
follows:
=========================================================================
Estimated
Amortized Fair
Cost Value
- -------------------------------------------------------------------------
Due in one year or less $ 250,741 $ 252,235
Due after one year through five years 222,466 232,054
Due after five years through ten years 399,846 423,355
Due after ten years 3,328,885 3,571,531
- -------------------------------------------------------------------------
4,201,938 4,479,175
Mortgage- and asset-backed securities 4,224,636 4,262,635
- -------------------------------------------------------------------------
$8,426,574 $8,741,810
=========================================================================
Expected maturities will differ from contractual maturities because
borrowers may have the right to call or prepay obligations with or without call
or prepayment penalties.
Securities carried at $6,191 and $8,415 at December 31, 1998 and 1997,
respectively, were deposited by the Company with governmental authorities or
designated custodian banks as required by laws affecting insurance companies.
Net investment income from the Financial Guarantee Insurance segment
comprised the following:
==========================================================================
1998 1997 1996
- --------------------------------------------------------------------------
Fixed income securities $181,437 $155,810 $139,410
Short-term investments 8,139 6,506 7,999
- --------------------------------------------------------------------------
Total investment income 189,576 162,316 147,409
Investment expense (3,386) (2,607) (2,468)
- --------------------------------------------------------------------------
Net investment income $186,190 $159,709 $144,941
==========================================================================
The Financial Guarantee Insurance segment had gross realized gains of
$14,219, $25,641 and $19,236 for 1998, 1997 and 1996, respectively, and gross
realized losses of $10,484, $4,557 and $39,767 for 1998, 1997 and 1996,
respectively.
The Financial Management Services segment had gross realized gains of
$22,592, $3,766 and $3,406 for 1998, 1997 and 1996, respectively, and gross
realized losses of $39,688, $4,403 and $3,013 for 1998, 1997 and 1996,
respectively. Gross realized gains and losses includes amounts related to a
trading position, which represented a small portion of the Company's assets,
containing high quality municipal bonds hedged with treasury futures. These
gains were $2,967, $1,309 and $0 for 1998, 1997 and 1996, respectively, and
losses of $18,638, $3,578 and $0 for 1998, 1997 and 1996, respectively. Gross
realized losses also include the Company's $11,548 write-off of its investment
in Ambac Connect, Inc. in 1998.
Net investment income related to the investment agreement business
comprises gross investment income less related interest expense, and is a
component of Financial Management Services revenue. For 1998, 1997 and 1996,
gross investment income from investment agreements was $281,904, $200,337 and
$165,196, respectively, and the related interest expense was $263,586, $186,678
and $154,484, respectively.
As of December 31, 1998 and 1997, the Company held securities subject to
agreements to resell for $252,295 and $85,466, respectively. These securities
were held as collateral by the Company under agreements that had terms of less
than 30 days.
As of December 31, 1998 and 1997, the Company had pledged (or sold under
agreements to repurchase) securities purchased under agreements to resell and
investment securities to certain municipalities, with a fair value of $3,636,519
and $2,714,719, respectively, in connection with certain investment agreements
(including agreements structured as investment repurchase agreements).
During 1998, the Company entered into security borrowing agreements, the
purpose of which was to limit the Company's cost of collateralizing certain
investment agreements (including agreements structured as investment repurchase
agreements) by reducing the use of securities purchased under agreements to
resell. The security borrowing agreements allow the Company to borrow securities
with a maximum market value of $1,000,000. The borrowings are secured by
Company-owned investment securities. As of December 31, 1998, the Company had
$750,000 in outstanding securities borrowed. The borrowings and related pledged
securities are classified as "Payable to brokers and dealers" and "Receivable
from brokers and dealers," respectively, on the Consolidated Balance Sheets.
4 LOANS
In the normal course of business, the Company has extended loans to customers
participating in certain structured municipal transactions. The loans are
collateralized with cash that the customers have deposited with a payment
custodian in amounts adequate to repay the loan balance and interest thereon.
Equipment and other assets underlying the transactions serve as additional
collateral for the loans. The Company may act as the payment custodian and hold
the funds posted as collateral.
39
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
As of December 31, 1998 and 1997, the interest rates on these loans ranged from
6.25% to 8.42%.
5 REINSURANCE
In the ordinary course of business, Ambac Assurance cedes exposures under
various reinsurance contracts primarily designed to minimize losses from large
risks and to protect capital and surplus. The effect of reinsurance on premiums
written and earned was as follows:
==========================================================================
Years Ended
December 31, 1998 1997 1996
- --------------------------------------------------------------------------
Written Earned Written Earned Written Earned
- --------------------------------------------------------------------------
Direct $333,652 $238,452 $277,814 $176,009 $240,544 $155,883
Assumed 27,359 7,367 8,349 3,614 6,664 3,126
Ceded (49,563) (33,135) (32,452) (25,623) (37,793) (22,380)
- --------------------------------------------------------------------------
Net premiums $311,448 $212,684 $253,711 $154,000 $209,415 $136,629
==========================================================================
The reinsurance of risk does not relieve the ceding insurer of its
original liability to its policyholders. In the event that all or any of the
reinsurers are unable to meet their obligations to Ambac Assurance under the
existing reinsurance agreements, Ambac Assurance would be liable for such
defaulted amounts. To minimize its exposure to significant losses from reinsurer
insolvencies, Ambac Assurance evaluates the financial condition of its
reinsurers and monitors concentrations of credit risk. There were no reinsurance
recoverables on paid losses as of December 31, 1998 and 1997. As of December 31,
1998, prepaid reinsurance of approximately $159,361 was associated with Ambac
Assurance's three largest reinsurers. As of December 31, 1998, Ambac Assurance
held letters of credit and collateral amounting to approximately $198,957 from
its reinsurers to cover liabilities ceded under the aforementioned reinsurance
contracts.
Ambac Assurance and MBIA Insurance Corporation ("MBIA") formed an
unincorporated joint venture, MBIAoAMBAC International, in 1995. The joint
venture was formed with the goal of bringing the combined capital and human
resources of the two companies together to more efficiently serve the
international market. Under the joint venture arrangement, financial guarantee
policies are issued separately by each of the companies. Premiums assumed from
MBIA were $18,715, $8,009 and $4,674 in 1998, 1997 and 1996, respectively.
Premiums ceded to MBIA were $15,505, $8,874 and $6,532 in 1998, 1997 and 1996,
respectively.
6 STOCKHOLDERS' EQUITY
The Company is authorized to issue 200,000,000 shares of common stock, par value
$0.01 per share, of which 70,680,384 were issued as of December 31, 1998. The
Company is also authorized to issue 4,000,000 shares of preferred stock, $0.01
par value per share, none of which was issued and outstanding as of December 31,
1998.
Dividends declared per share amounted to $0.38, $0.345 and $0.3075 in
1998, 1997 and 1996, respectively.
The Board of Directors of the Company (the "Board") has authorized the
establishment of a stock repurchase program that permits the repurchase of up to
6,000,000 shares of the Company's common stock. As of December 31, 1998,
approximately 4,248,000 shares had been repurchased under this program for an
aggregate amount of $142,700.
STOCKHOLDER RIGHTS PLAN:
The Company adopted a Stockholder Rights Plan under which stockholders received
(after giving effect to a stock split since adoption of the Plan) one Right for
each two shares of common stock owned. Each Right entitles the registered holder
to purchase from the Company one one-hundredth of a share of Series A Junior
Participating Preferred Stock, par value $0.01 per share, at a purchase price of
$190 per share. The Rights generally detach and become exercisable when any
person or group acquires 20% or more (or announces a tender offer for 20% or
more) of the Company's common stock, at which time each Right (other than those
held by the acquiring company) will entitle the holder to receive that number of
shares of common stock of the Company with a value of two times the exercise
price of the Right. If the Company is acquired in a merger or other business
combination transaction in which the Company is not the surviving corporation or
50% or more of the Company's assets, cash flow or earning power is sold or
transferred, each Right will entitle the holder to receive that number of shares
of stock of the acquiring company having a value equal to two times the exercise
price of the Right. The Rights, which expire on January 31, 2006, are redeemable
in whole, but not in part, by action of the Board at a price of $0.01 per Right
at any time prior to their becoming exercisable.
7 COMMITMENTS AND CONTINGENCIES
The Company is responsible for leases on the rental of office space. The lease
agreements, which expire periodically through September 2019, contain provisions
for scheduled periodic rent increases and are accounted for as operating leases.
An estimate of future net minimum lease payments in each of the next five years
ending December 31, and the periods thereafter, is as follows:
===============================
Amount
- -------------------------------
1999 $ 7,067
2000 7,076
2001 6,174
2002 6,115
2003 6,091
All later years 88,369
- -------------------------------
$120,892
===============================
Rent expense for the aforementioned leases amounted to $5,537, $5,048
and $3,862 for the years ended December 31, 1998, 1997 and 1996, respectively.
Total rentals to be received under future sublease agreements is estimated at
$5,125.
8 INSURANCE REGULATORY RESTRICTIONS
Ambac Assurance is subject to insurance regulatory requirements of the States of
Wisconsin and New York,
40
and the other jurisdictions in which it is licensed to conduct business.
Ambac Assurance's ability to pay dividends is generally restricted by
law and subject to approval by the Office of the Commissioner of Insurance of
the State of Wisconsin (the "Wisconsin Commissioner"). Wisconsin insurance law
restricts the payment of dividends in any 12-month period without regulatory
approval to the lesser of (a) 10% of policyholders' surplus as of the preceding
December 31 and (b) the greater of (i) statutory net income for the calendar
year preceding the date of dividend, minus realized capital gains for that
calendar year and (ii) the aggregate of statutory net income for three calendar
years preceding the date of the dividend, minus realized capital gains for those
calendar years and minus dividends paid or credited within the first two of the
three preceding calendar years. Ambac Assurance paid cash dividends of $48,000,
$44,000 and $40,000 on its common stock in 1998, 1997 and 1996, respectively. In
addition, on April 30, 1996, Ambac Assurance, in conjunction with the sale of
the Company's remaining holdings in HCIA, Inc. ("HCIA") common stock, delivered
to the Company (in the form of an extraordinary dividend) its 2,378,672 shares
of HCIA common stock, at fair value. The Wisconsin Commissioner approved such
dividend. Based upon these restrictions, at December 31, 1998, the maximum
amount that will be available during 1999 for payment of dividends by Ambac
Assurance is approximately $116,200.
The New York Financial Guarantee Insurance Law establishes single risk
limits applicable to all obligations issued by a single entity and backed by a
single revenue source. Under the limit applicable to municipal bonds, the
insured average annual debt service for a single risk, net of reinsurance and
collateral, may not exceed 10% of qualified statutory capital, which is defined
as the sum of insurer's policyholders' surplus and contingency reserves. In
addition, insured principal of municipal bonds attributable to any single risk,
net of reinsurance and collateral, is limited to 75% of Ambac Assurance's
qualified statutory capital. Additional single risk limits, which generally are
more restrictive than the municipal bond single risk limit, are also specified
for several other categories of insured obligations.
Statutory capital and surplus was $1,162,639 and $1,006,829 at December
31, 1998 and 1997, respectively. Qualified statutory capital was $1,920,298 and
$1,655,554 at December 31, 1998 and 1997, respectively. Statutory net income for
Ambac Assurance was $271,808, $198,615 and $222,810 for 1998, 1997 and 1996,
respectively. Statutory capital and surplus differs from stockholders' equity
determined under GAAP principally due to statutory accounting rules that treat
loss reserves, premiums earned, policy acquisition costs, and deferred income
taxes differently.
9 INCOME TAXES
The Company's provision for income taxes is comprised of the following:
1998 1997 1996
======================================================================
Current taxes $72,608 $51,036 $94,392
Deferred taxes 2,310 11,930 4,797
- ----------------------------------------------------------------------
$74,918 $62,966 $99,189
======================================================================
The total effect of income taxes on income and stockholders' equity for the
years ended December 31, 1998 and 1997 was as follows:
======================================================================
1998 1997
- ----------------------------------------------------------------------
Total income taxes charged to income $ 74,918 $ 62,966
- ----------------------------------------------------------------------
Income taxes (credited) charged to stockholders' equity:
Unrealized gains on bonds 12,587 45,192
Exercise of stock options (19,144) (5,566)
- ----------------------------------------------------------------------
Total (credited) charged to stockholders' equity (6,557) 39,626
- ----------------------------------------------------------------------
Total effect of income taxes $ 68,361 $102,592
======================================================================
The tax provisions in the accompanying consolidated statements of operations
reflect effective tax rates differing from prevailing federal corporate income
tax rates. The following is a reconciliation of these differences:
============================================================================
1998 % 1997 % 1996 %
- ----------------------------------------------------------------------------
Computed expected
tax at
statutory rate $115,119 35.0% $100,099 35.0% $131,427 35.0%
Reductions in
expected tax
resulting from:
Tax-exempt
interest (38,926) (11.8) (35,682) (12.5) (30,760) (8.2)
Other, net (1,275) (0.4) (1,451) (0.5) (1,478) (0.4)
- ----------------------------------------------------------------------------
Income tax
expense $ 74,918 22.8% $ 62,966 22.0% $ 99,189 26.4%
============================================================================
The tax effects of temporary differences that give rise to significant
portions of the deferred tax liabilities and deferred tax assets at December 31,
1998 and 1997 are presented below:
========================================================================
1998 1997
- ------------------------------------------------------------------------
Deferred tax liabilities:
Contingency reserve $119,150 $115,360
Unrealized gains on bonds 87,930 75,342
Deferred acquisition costs 42,583 38,030
Unearned premiums 36,728 35,679
Investments 2,442 1,491
Other 1,189 2,026
- ------------------------------------------------------------------------
Total deferred tax liabilities 290,022 267,928
- ------------------------------------------------------------------------
Deferred tax assets:
Tax and loss bonds 88,471 87,951
Loss reserves 27,918 17,182
Alternative minimum tax carryforward 7,001 14,049
Amortization and depreciation 5,406 6,032
Compensation 12,009 4,030
Other 3,435 3,456
- ------------------------------------------------------------------------
Sub-total deferred tax assets 144,240 132,700
Valuation allowance - -
- ------------------------------------------------------------------------
Total deferred tax assets 144,240 132,700
- ------------------------------------------------------------------------
Net deferred tax liabilities $145,782 $135,228
========================================================================
The Company believes that no valuation allowance is necessary in connection
with the deferred tax assets.
41
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
10 EMPLOYEE BENEFITS
PENSIONS:
The Company has a defined benefit pension plan covering substantially all
employees of the Company. The benefits are based on years of service and the
employee's compensation during the last five years of employment. The Company's
funding policy is to contribute annually the maximum amount that can be deducted
for Federal income tax purposes. Contributions are intended to provide not only
for benefits attributed to service-to-date, but also for those expected to be
earned in the future.
The table below sets forth a reconciliation of the beginning and ending
projected benefit obligation, beginning and ending balances of the fair value of
plan assets, and the funded status of the plan as of December 31, 1998 and 1997.
========================================================================
1998 1997
- ------------------------------------------------------------------------
Change in Projected Benefit Obligation:
Projected benefit obligation at beginning of year $ 9,374 $ 8,189
Service cost 691 723
Interest cost 684 601
Amendments 116 -
Actuarial loss 1,843 114
Benefits paid (275) (253)
- ------------------------------------------------------------------------
Projected benefit obligation at end of year $12,433 $ 9,374
- ------------------------------------------------------------------------
Change in Plan Assets:
Fair value of plan assets at beginning of year $ 9,644 $ 8,153
Actual return on plan assets 1,595 1,635
Company contributions - 138
Benefits paid (275) (253)
Expenses paid (30) (29)
- ------------------------------------------------------------------------
Fair value of plan assets at end of year $10,934 $ 9,644
- ------------------------------------------------------------------------
Funded status $ (1,499) $270
Unrecognized net loss 1,118 62
Unrecognized prior service cost (1,289) (1,454)
Unrecognized net transition asset (4) (7)
- ------------------------------------------------------------------------
Pension liability included in other liabilities $ (1,674) $(1,129)
========================================================================
Net pension costs for 1998, 1997 and 1996 included the following components:
============================================================================
1998 1997 1996
- ----------------------------------------------------------------------------
Service cost $ 807 $ 723 $ 674
Interest cost on expected benefit obligation 684 601 539
Expected return on plan assets (793) (701) (613)
Amortization of unrecognized transition asset (3) (3) (3)
Amortization of prior service cost (165) (165) (165)
Recognized net actuarial loss 15 33 87
- ----------------------------------------------------------------------------
Net periodic pension cost $ 545 $ 488 $ 519
============================================================================
The discount rate used in the determination of the actuarial present
value for the projected benefit obligation was 6.50% and 7.25% for 1998 and
1997, respectively. The expected long-term rate of return on assets was 9.25%
for both 1998 and 1997. The rate of increase in future compensation levels used
in determining the actuarial present value of the projected benefit obligation
was 5.0 % and 4.8% for 1998 and 1997, respectively.
Substantially all employees of the Company are covered by a defined
contribution plan (the "Savings Incentive Plan"), for which contributions and
costs are determined as 6% of each eligible employee's base salary, plus a
matching company contribution of 50% on contributions up to 6% of base salary
made by eligible employees to the plan. The total cost of the Savings Incentive
Plan was $2,063, $1,806 and $1,680 in 1998, 1997 and 1996, respectively.
ANNUAL INCENTIVE PROGRAM:
The Company has an annual incentive program that provides for awards to key
officers and employees based upon predetermined criteria. The cost of the
program in 1998, 1997 and 1996 amounted to $16,095, $12,038 and $10,822,
respectively.
POSTRETIREMENT HEALTH CARE AND OTHER BENEFITS:
Ambac Assurance provides certain medical and life insurance benefits for retired
employees and eligible dependents. All plans are contributory. None of the plans
are currently funded.
Postretirement benefits expense was $316, $262 and $220 in 1998, 1997
and 1996, respectively. The unfunded accumulated postretirement benefit
obligation was $3,121 and the related accrued postretirement liability was
$1,956 as of December 31, 1998.
The assumed health care cost trend rates range from 8.0% in 1999,
decreasing ratably to 5.5% in 2003, and remaining at that level thereafter.
Increasing the assumed health care cost trend rate by one percentage point in
each future year would increase the accumulated postretirement benefit
obligation at December 31, 1998 by $554 and the 1998 benefit expense by $79. The
weighted average discount rate used to measure the accumulated postretirement
benefit obligation and 1998 expense was 6.50%.
11 INSURANCE IN FORCE
The par amount of bonds insured, net of reinsurance, was $198,274,000 and
$165,601,000 at December 31, 1998 and 1997, respectively. As of December 31,
1998 and 1997, the insured portfolio was diversified by type of insured bond as
shown in the following table:
42
===============================================================================
Net Par Amount Outstanding
- -------------------------------------------------------------------------------
(Dollars in millions) 1998 1997
- -------------------------------------------------------------------------------
Domestic:
Municipal finance:
General obligation $ 37,502 $ 36,324
Lease and tax-backed revenue 36,929 30,980
Utility revenue 27,014 24,913
Health care revenue 20,071 18,545
Investor-owned utilities 8,013 6,255
Transportation revenue 7,831 7,370
Higher education 7,720 6,852
Housing revenue 6,445 6,064
Student loans 4,528 3,516
Other 873 597
- -------------------------------------------------------------------------------
Total municipal finance 156,926 141,416
- -------------------------------------------------------------------------------
Structured finance:
Mortgage-backed and home equity 19,478 11,620
Commercial asset-backed 10,015 4,538
Other consumer asset-backed 2,132 1,514
Banks/financial institutions 671 524
Other 567 439
- -------------------------------------------------------------------------------
Total structured finance 32,863 18,635
- -------------------------------------------------------------------------------
Total domestic 189,789 160,051
- -------------------------------------------------------------------------------
International finance:
Commercial asset-backed 3,180 2,600
Banks/financial institutions 1,514 283
Utilities 1,073 456
Sovereign/sub-sovereign 1,027 981
Mortgage-backed and home equity 607 496
Other 1,084 734
- -------------------------------------------------------------------------------
Total international finance 8,485 5,550
- -------------------------------------------------------------------------------
$198,274 $165,601
===============================================================================
As of December 31, 1998 and 1997, the international insured portfolio is
shown in the following table by location of risk:
==============================================================================
Net Par Amount Outstanding
- ------------------------------------------------------------------------------
(Dollars in millions) 1998 1997
- ------------------------------------------------------------------------------
United Kingdom $2,289 $ 865
Australia 779 63
France 692 1,032
Japan 675 879
Italy 571 555
Internationally diversified (1) 1,621 899
Other international 1,858 1,257
- ------------------------------------------------------------------------------
Total International $8,485 $5,550
==============================================================================
(1) Internationally diversified represents insured policies with multiple
locations of risk.
Direct insurance in force (principal and interest) was $367,801,000 and
$321,104,000 at December 31, 1998 and 1997, respectively. Net insurance in force
(after giving effect to reinsurance) was $317,668,000 and $275,931,000 as of
December 31, 1998 and 1997, respectively.
12 FINANCIAL INSTRUMENTS HELD FOR PURPOSES OTHER THAN TRADING
DERIVATIVE FINANCIAL INSTRUMENTS:
In the normal course of business, the Company becomes a party to various
financial instruments to reduce its exposure to fluctuations in interest rates.
These financial instruments include interest rate swaps, exchange traded futures
contracts and purchased interest rate options. The notional amounts of these
financial instruments were as follows:
==============================================================================
As of December 31, 1998 1997
- ------------------------------------------------------------------------------
Derivative financial instruments with off-balance
sheet risk:
Interest rate futures contracts $5,836,700 $3,689,100
Interest rate swaps 590,468 712,206
Other:
Purchased interest rate options 15,000 85,500
==============================================================================
Notional principal amounts are often used to express the volume of these
transactions and do not reflect the extent to which positions may offset one
another. These amounts do not represent the much smaller amounts potentially
subject to risk.
As discussed in Note 2, interest rate futures and purchased option
contracts held for purposes other than trading are used primarily to hedge
interest rate risk inherent in the portfolio of interest-sensitive assets and
liabilities. Interest rate swaps held for purposes other than trading are used
to manage interest rate risk by synthetically changing the nature of specific
assets or liabilities.
Futures contracts are purchased to hedge interest rate risk inherent in
fixed rate liabilities. Futures contracts are sold to hedge interest rate risk
inherent in fixed rate investment securities. Interest rate option contracts are
purchased to hedge interest rate risk inherent in fixed rate assets and
liabilities. At December 31, 1998 and 1997, futures and purchased option
contracts with an outstanding notional of $360,700 and $627,000, respectively,
were designated as hedges of fixed rate liabilities. Additionally, at December
31, 1998 and 1997, futures and purchased option contracts with an outstanding
notional of $5,491,000 and $3,147,600, respectively, were designated as hedges
of fixed rate investment securities.
Interest rate swaps that require the Company to pay a fixed rate are
used primarily to hedge fixed rate investment securities. Interest rate swaps
that require the Company to receive a fixed rate are used primarily to hedge
fixed rate liabilities. The table below summarizes, for each major type of swap,
the weighted average fixed rate paid or received on the respective notional
amounts outstanding. Notional amounts are used to calculate the contractual
payments to be exchanged.
================================================================================
Pay fixed swaps: Receive fixed swaps:
Maturing Weighted Weighted Range of implied
After Notional average Notional average floating interest
December 31, amount fixed rate amount fixed rate rates
- --------------------------------------------------------------------------------
1999 $299,775 6.98% $12,922 6.46% 4.98% to 5.16%
2000 202,368 7.02% 12,271 6.46% 5.08% to 5.25%
2001 161,145 6.93% 11,602 6.46% 5.23% to 5.35%
2002 173,144 6.93% 10,913 6.46% 5.32% to 5.45%
2003 182,783 6.93% 10,205 6.46% 5.45% to 5.52%
Thereafter 53,924 7.08% 20,354 7.07%
================================================================================
The floating rate side of the Company's interest rate swaps is based on
several indices, primarily one-month, three-month and six-month LIBOR. The
floating rates shown above reflect the range of the implied forward LIBOR yield
curve for those indices, as of December 31, 1998.
43
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, except per
share amounts)
FAIR VALUES OF FINANCIAL INSTRUMENTS HELD FOR PURPOSES OTHER THAN TRADING:
Fair value amounts are determined by using independent market information when
available, and appropriate valuation methodologies when market quotes were not
available. In cases where specific market quotes are unavailable, interpreting
market data and estimating market values require considerable judgment by
management. Accordingly, the estimates presented are not necessarily indicative
of the amount the Company could realize in a current market exchange.
The following methods and assumptions were used to estimate the fair
value of each class of financial instruments for which it is practicable to
estimate that value:
INVESTMENTS: The fair values of fixed income investments are based on quoted
market prices received from a nationally recognized pricing service or dealer
quotes.
SHORT-TERM INVESTMENTS AND CASH: The fair values of short-term investments and
cash are assumed to equal amortized cost.
OTHER: The fair value of other investments, primarily preferred stock, is based
on an evaluation of the underlying company and recent transactions in such
preferred stock.
SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL: The fair value of securities
purchased under agreements to resell is assumed to approximate carrying value.
LOANS: The fair value of loans is assumed to approximate carrying value.
RECEIVABLE/PAYABLE TO BROKERS AND DEALERS: The fair value of receivable/payable
to brokers and dealers, representing securities borrowed from various
counterparties secured by Company-owned securities, are assumed to approximate
carrying value.
DEBENTURES: The fair value of the debentures is based on the quoted market
prices and dealer quotes.
OBLIGATIONS UNDER INVESTMENT, REPURCHASE AND PAYMENT AGREEMENTS (INCLUDING
ACCRUED INTEREST): The fair value of the liability for investment agreements and
repurchase agreements (including accrued interest) is estimated based upon
valuation models using rates currently offered for contracts of similar
remaining maturities. The fair value of payment agreements is assumed to
approximate carrying value.
DERIVATIVE CONTRACTS: Fair values of derivative contracts (futures, swaps and
interest rate options) are based on quoted market and dealer prices, current
settlement values, or pricing models.
LIABILITY FOR NET FINANCIAL GUARANTEES WRITTEN: The fair value of the liability
for those financial guarantees written related to new issue and secondary market
exposures is based on the estimated cost to reinsure those exposures at current
market rates, which amount consists of the current unearned premium reserve,
less an estimated ceding commission thereon.
Certain other financial guarantee insurance policies have been written
on an installment basis, where the future premiums to be received by the Company
are determined based on the outstanding exposure at the time the premiums are
due. The fair value of Ambac Assurance's liability under its installment premium
policies is measured using the present value of estimated future installment
premiums, less an estimated ceding commission. The estimate of the amounts and
timing of the future installment premiums is based on contractual premium rates,
debt service schedules and expected run-off scenarios. This measure is used as
an estimate of the cost to reinsure Ambac Assurance's liability under these
policies.
The carrying amount and estimated fair value of financial instruments
held for purposes other than trading are presented below:
================================================================================
As of December 31, 1998 1997
- --------------------------------------------------------------------------------
Estimated Estimated
Carrying Fair Carrying Fair
(Dollars in Millions) Amount Value Amount Value
- --------------------------------------------------------------------------------
Financial assets:
Fixed income securities $8,622 $8,622 $6,774 $6,774
Short-term investments 120 120 136 136
Other investments 7 7 5 5
Cash 8 8 9 9
Securities purchased under
agreements to resell 252 252 85 85
Loans 674 674 503 503
Receivable from brokers
and dealers 750 750 - -
Financial liabilities:
Debentures 424 476 224 269
Obligations under investment,
repurchase and payment
agreements (including
accrued interest) 6,046 5,959 4,367 4,405
Payable to brokers and dealers 750 750 - -
Derivative financial instruments:
Interest rate futures contracts (4) - (2) -
Interest rate swaps (22) (20) (9) (7)
Purchased interest rate
option contracts - - - -
Liability for financial
guarantees written:
Gross 1,294 906 1,179 855
Net of reinsurance 1,094 766 995 722
Net installment premiums - 216 - 153
================================================================================
13 FINANCIAL INSTRUMENTS HELD FOR TRADING PURPOSES
AFSLP is a provider of interest rate swaps to states, municipalities and their
authorities and other entities in connection with their financings. AFSLP is
subject to basis risk (the relationship between tax-exempt and taxable interest
rates). If actual or projected tax-exempt interest rates change in relation to
taxable rates, the Company will experience an unrealized mark-to-market gain or
loss. The AFSLP swap portfolio is considered held for trading purposes.
44
The following table summarizes information about the Company's financial
instruments held for trading purposes as of December 31, 1998 and 1997:
=============================================================================
Net Estimated Average Net
Fair Value Fair Value Notional
- ----------------------------------------------------------------- Amount
Assets Liabilities Assets Liabilities
- -----------------------------------------------------------------------------
1998:
Derivative
financial
instruments:
Interest rate
swaps $200,454 $163,043 $130,984 $103,414 $5,357,450
Futures
contracts - - - - 706,700
Other financial
instruments - - 183,682 181,698 -
1997:
Derivative
financial
instruments:
Interest rate
swaps $ 67,743 $ 49,265 $ 43,748 $ 33,954 $3,347,190
Futures
contracts - - - - 514,900
Other financial
instruments 183,041 181,732 160,251 159,213 -
=============================================================================
Financial instruments held for trading purposes are carried at estimated
fair value. The aggregate amount of net trading income recognized from
derivative financial instruments held for trading purposes was $705, $7,454 and
$10,579 for 1998, 1997 and 1996, respectively. Other financial instruments held
for trading purposes consists of fixed income securities held in 1997 and sold
during 1998. The aggregate amount of net trading income recognized from other
financial instruments was $2,967, $1,309 and $0 in 1998, 1997 and 1996,
respectively. Average net fair values were calculated based on average monthly
net fair values. Notional principal amounts are often used to express the volume
of these transactions and do not reflect the extent to which positions may
offset one another. These amounts do not represent the much smaller amounts
potentially subject to risk.
14 LONG-TERM DEBT AND LINES OF CREDIT
The carrying value of long-term debt was as follows:
========================================================================
As of December 31, 1998 1997
- ------------------------------------------------------------------------
9 3/8% Debentures, due 2011 $149,434 $149,389
7 1/2% Debentures, due 2023 74,495 74,475
7.08% Debentures, due 2098 200,000 -
- ------------------------------------------------------------------------
$423,929 $223,864
========================================================================
The debentures due on August 1, 2011 were issued on August 8, 1991 in
the principal amount of $150,000 and bear interest of 9 3/8%, payable on
February 1 and August 1 of each year and are non-callable.
The debentures due on May 1, 2023 were issued on May 11, 1993 in the
principal amount of $75,000 and bear interest of 7 1/2%, payable on May 1 and
November 1 of each year and are non-callable.
The debentures due on March 31, 2098 were issued on April 1, 1998 in the
principal amount of $200,000 and bear interest of 7.08%, payable on March 31,
June 30, September 30 and December 31 of each year. The debentures may not be
redeemed prior to March 31, 2003 and were sold at 100% of their principal
amount. 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 interest to the date of redemption.
AFGI and Ambac Assurance have a revolving credit facility with three
major international banks for $150,000, which expires in August 1999 and
provides a two-year term loan provision. The facility is available for general
corporate purposes, including the payment of claims. As of December 31, 1998 and
1997, no amounts were outstanding under this credit facility.
Ambac Assurance maintains third party capital support in the form of a
seven-year irrevocable limited recourse credit facility from a group of
highly-rated international banks. This credit facility provides liquidity to
Ambac Assurance in the event claims from municipal obligations in its insured
portfolio exceed specified levels. Repayment of amounts drawn under the credit
facility are limited primarily to the amount of any recoveries of losses related
to policy obligations. During 1998, total third party capital support was
increased from $500,000 to $555,000 and its expiration reset to December 2005.
As of December 31, 1998 and 1997, no amounts were outstanding under this
facility.
15 OBLIGATIONS UNDER INVESTMENT AGREEMENTS AND PAYMENT AGREEMENTS
Obligations under investment agreements, including those structured in the form
of repurchase contracts, are recorded on a trade-date basis. Certain obligations
may be called at various times prior to maturity at the option of the
counterparty. As of December 31, 1998 and 1997, the interest rates on these
agreements ranged from 4.00% to 8.14% and 4.23% to 8.14%, respectively. As of
December 31, 1998 and 1997, the average yield on these agreements was 5.70% and
5.85%, respectively. Obligations under investment agreements and investment
repurchase agreements as of December 31, 1998 and 1997 were as follows:
================================================================
As of December 31, 1998 1997
- ----------------------------------------------------------------
Settled $5,209,690 $3,817,772
Unsettled 73,142 -
- ----------------------------------------------------------------
$5,282,832 $3,817,772
================================================================
45
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
Net payments due under settled investment agreements in each of the next
five years ending December 31, and the periods thereafter, based on expected
draw dates, are as follows:
================================
Principal
Amount
- --------------------------------
1999 $2,308,820
2000 1,237,441
2001 554,655
2002 190,338
2003 29,481
All later years 888,955
- --------------------------------
$5,209,690
================================
Obligations under payment agreements represent funds received by the
Company from certain municipal customers. These funds serve as collateral for
loans extended by the Company in connection with certain structured municipal
transactions. In connection with these transactions, the Company is obligated to
make periodic agreed upon payments. As of December 31, 1998 and 1997, the
interest rates on these obligations ranged from 6.25% to 8.42%. Net
(deposits)/payments due under payment agreements in each of the next five years
ending December 31, and the periods thereafter, based on contractual payment
dates, are as follows:
================================
Principal
Amount
- --------------------------------
1999 $ (11,558)
2000 (6,971)
2001 2,840
2002 8,493
2003 16,248
All later years 664,879
- --------------------------------
$673,931
================================
16 COMMON STOCK INCENTIVES
The Ambac 1997 Equity Plan (the "Equity Plan") provides for the granting of
stock options, stock appreciation rights, restricted stock units, performance
units and other awards that are valued or determined by reference to the common
stock. Stock options awarded to employees are exercisable and expire as
specified at the time of grant. Additionally, such options generally may not
have a per share exercise price less than the fair market value of a share of
common stock on the date of grant or have a term in excess of ten years from the
date of the grant. The Company also maintains the Ambac 1997 Non-Employee
Directors Equity Plan (the "Directors Plan"), which provides awards of stock
options and restricted stock units to non-employee members of the Company's
Board of Directors. The number of options and their exercise price, and the
number of restricted stock units, awarded to each non-employee director under
the Directors Plan are determined by formula. As of December 31, 1998,
approximately 6,070,000 shares were available for future grant under the Equity
Plan and the Directors Plan. A summary of option activity is as follows:
===============================================================================
1998 1997 1996
- -------------------------------------------------------------------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
- -------------------------------------------------------------------------------
Outstanding at
beginning
of year 3,917,693 $22.15 4,248,642 $19.37 4,140,824 $18.17
Granted 969,698 $47.66 859,800 $33.59 964,150 $24.25
Exercised (1,332,729) $15.78 (898,942) $19.05 (721,724) $18.53
Forfeited (165,298) $34.46 (291,807) $24.99 (134,608) $21.87
--------- --------- ---------
Outstanding
at end
of year 3,389,364 $31.34 3,917,693 $22.15 4,248,642 $19.37
--------- --------- ---------
Exercisable 1,941,601 2,392,853 2,407,838
===============================================================================
===============================================================================
Options Outstanding Options Exercisable
- -------------------------------------------------------------------------------
Weighted
Number Average Weighted Number Weighted
Range of outstanding at Remaining Average Exercisable at Average
Exercise December 31, Contract Exercise December 31, Exercise
Prices 1998 Life Price 1998 Price
- -------------------------------------------------------------------------------
$10 to 24 1,780,468 4.7 $22.02 1,584,390 $21.74
$25 to 44 696,446 5.1 $33.56 235,482 $33.52
$45 to 61 912,450 5.6 $47.84 121,729 $53.42
--------- ---------
3,389,364 1,941,601
===============================================================================
The Company applies APB 25 and related interpretations in accounting for
its plans. Accordingly, since the fair value of the options at grant date equals
the exercise price, no compensation cost has been recognized for its fixed stock
option plan. Had compensation cost for the Company's stock-based compensation
plan been determined consistent with FAS 123, the Company's net income, earnings
per share and earnings per diluted share for the years ended December 31, 1998,
1997 and 1996, would have been reduced to the pro-forma amounts indicated below:
========================================================================
1998 1997 1996
- ------------------------------------------------------------------------
Net Income:
As reported $253,994 $223,030 $276,317
Pro-forma $248,089 $218,852 $273,528
Earnings per share:
As reported $3.63 $3.19 $3.95
Pro-forma $3.55 $3.13 $3.91
Earnings per diluted share:
As reported $3.56 $3.13 $3.91
Pro-forma $3.48 $3.07 $3.87
========================================================================
The weighted-average fair value (determined as of the date of the
grants) of options granted in 1998, 1997 and 1996 was $13.09 per share, $9.85
per share, and $6.19 per share, respectively. The fair value of each option
grant issued was estimated as of the date of the grant using the Black-Scholes
option-pricing model, with the following weighted-average assumptions used for
grants in 1998, 1997 and 1996, respectively: (i) dividend yield of 0.85%, 1.08%
and 1.24%; (ii) expected volatility of 20.5%, 19.4% and 16.5%; (iii) risk-free
interest rates of 5.5%, 6.4% and 6.2%; and (iv) expected lives of 5 years, 6
years and 5 years. The pro-forma amounts disclosed above are not likely to be
representative of the effects of reported pro-forma net income for future years
because options vest over several years and additional awards are granted each
year.
46
17 SEGMENT INFORMATION
The Company has two reportable segments, as follows: (1)Financial Guarantee
Insurance, which provides insurance of municipal and structured finance
obligations; and (2) Financial Management Services, which provides investment
agreements, interest rate swaps, and investment advisory and cash management
services. During the fourth quarter of 1998, the Company discontinued its
operations relating to electronic commerce applications for the municipal
marketplace. Balances relating to the electronic commerce business are included
in the Financial Management Services segment below. Total losses before income
taxes for the electronic commerce business was $6,946, $3,557 and $617 for the
years ended December 31, 1998, 1997 and 1996, respectively. Also included below
for both revenues and income before income taxes for the Financial Management
Services segment is a $11,548 charge representing the write-off of the
investment in Ambac Connect.
The Company's reportable segments are strategic business units that
offer different products and services. They are managed separately because each
business requires different marketing strategies, personnel skill sets and
technology.
The accounting policies of the segments are the same as those described
in Note 2, "Significant Accounting Policies." Pursuant to insurance and
indemnity agreements, Ambac Assurance guarantees the swap and investment
agreement obligations of those financial management services subsidiaries.
Intersegment revenues include the premiums earned under those agreements. Such
premiums are accounted for as if they were premiums to third parties, that is,
at current market prices.
Information provided below for "Corporate and Other" relates to AFGI
corporate activities. Revenue from unaffiliated customers of $16,232 and $7,955
consists primarily of interest income from investment securities for the years
ended December 31, 1998 and 1997, respectively. Revenue from unaffiliated
customers in 1996 of $164,242 includes a one-time gain from the sale of a
subsidiary of approximately $155,600.
The following table is a summary of the financial information by reportable
segment for the years ended December 31, 1998, 1997 and 1996:
=================================================================================================================================
Financial Financial
Guarantee Management Corporate Intersegment Total
Insurance Services and Other Eliminations Consolidated
- ----------------------------------------------------------------------------------------------------------------------------------
1998:
Revenues:
Unaffiliated customers $ 408,390 $ 32,414 $ 16,232 $ - $ 457,036
Intersegment 2,761 (2,819) 48,610 (48,552) -
- ----------------------------------------------------------------------------------------------------------------------------------
Total revenues $ 411,151 $ 29,595 $ 64,842 $ (48,552) $ 457,036
- ----------------------------------------------------------------------------------------------------------------------------------
Income before income taxes:
Unaffiliated customers $ 355,670 $ (3,126) $(23,632) $ - $ 328,912
Intersegment 2,761 (4,891) 48,610 (46,480) -
- ----------------------------------------------------------------------------------------------------------------------------------
Total income before income taxes $ 358,431 $ (8,017) $ 24,978 $ (46,480) $ 328,912
- ----------------------------------------------------------------------------------------------------------------------------------
Identifiable assets $3,825,411 $7,128,350 $258,550 $ - $11,212,311
- ----------------------------------------------------------------------------------------------------------------------------------
1997:
Revenues:
Unaffiliated customers $ 339,195 $ 34,612 $ 7,955 $ - $ 381,762
Intersegment 1,857 (194) 44,068 (45,731) -
- ----------------------------------------------------------------------------------------------------------------------------------
Total revenues $ 341,052 $ 34,418 $ 52,023 $ (45,731) $ 381,762
- ----------------------------------------------------------------------------------------------------------------------------------
Income before income taxes:
Unaffiliated customers $ 295,669 $ 6,619 $(16,292) $ - $ 285,996
Intersegment 1,736 (1,031) 44,068 (44,773) -
- ----------------------------------------------------------------------------------------------------------------------------------
Total income before income taxes $ 297,405 $ 5,588 $ 27,776 $ (44,773) $ 285,996
- ----------------------------------------------------------------------------------------------------------------------------------
Identifiable assets $3,392,333 $4,805,517 $ 93,855 $ - $8,291,705
- ----------------------------------------------------------------------------------------------------------------------------------
1996:
Revenues:
Unaffiliated customers $ 266,300 $ 22,366 $164,242 $ - $ 452,908
Intersegment 1,728 (810) 159,883 (160,801) -
- ----------------------------------------------------------------------------------------------------------------------------------
Total revenues $ 268,028 $ 21,556 $324,125 $ (160,801) $ 452,908
- ----------------------------------------------------------------------------------------------------------------------------------
Income before income taxes:
Unaffiliated customers $ 225,340 $ 10,326 $139,840 $ - $ 375,506
Intersegment 1,728 (980) 159,883 (160,631) -
- ----------------------------------------------------------------------------------------------------------------------------------
Total income before income taxes $ 227,068 $ 9,346 $299,723 $ (160,631) $ 375,506
- ----------------------------------------------------------------------------------------------------------------------------------
Identifiable assets $2,886,657 $2,861,527 $128,174 $ - $5,876,358
- ----------------------------------------------------------------------------------------------------------------------------------
47
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
The following table summarizes gross premiums written and net premiums
earned included in the financial guarantee segment, by location of risk.
==============================================================
Gross Net
Premiums Premiums
Written Earned
- --------------------------------------------------------------
1998:
United States $297,565 $198,904
United Kingdom 30,337 1,754
Australia 16,166 686
France 1,318 1,745
Japan 3,970 1,941
Italy - 974
Internationally diversified(1) 4,436 3,654
Other international 7,219 3,026
- --------------------------------------------------------------
Total $361,011 $212,684
==============================================================
1997:
United States $242,727 $145,988
United Kingdom 16,144 903
Australia - 114
France 2,911 2,048
Japan 2,349 1,175
Italy 4,731 841
Internationally diversified(1) 1,831 1,409
Other international 15,470 1,522
- --------------------------------------------------------------
Total $286,163 $154,000
==============================================================
==============================================================
Gross Net
Premiums Premiums
Written Earned
- --------------------------------------------------------------
1996:
United States $226,276 $131,638
United Kingdom 11,624 751
Australia 1,624 81
France 2,515 1,959
Japan 472 338
Italy - 617
Internationally diversified(1) 392 662
Other international 4,305 583
- --------------------------------------------------------------
Total $247,208 $136,629
==============================================================
(1) Internationally diversified represents insured policies with
multiple locations of risk.
In the United States, California was the state with the highest
aggregate net par amount in force, accounting for 11.4% of the total at December
31, 1998, and no other state accounted for more than ten percent. The highest
single insured risk represented less than 1% of aggregate net par amount
insured. All revenues of the Financial Management Services segment are from
operations in the United States.
18 QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
=================================================================================================================
First Second Third Fourth Full Year
- -----------------------------------------------------------------------------------------------------------------
1998:
Gross premiums written $77,487 $88,042 $88,731 $106,751 $361,011
Net premiums written 51,400 77,994 83,967 98,087 311,448
Net premiums earned 53,184 53,318 50,143 56,039 212,684
Net investment income 45,040 45,872 47,436 47,842 186,190
Financial management services income 12,754 12,732 13,541 10,483 49,510
Losses and loss adjustment expenses 1,577 1,423 1,500 1,500 6,000
Financial guarantee underwriting and
operating expenses 12,018 11,190 11,844 11,668 46,720
Financial management services expenses 7,443 8,603 8,237 11,257 35,540
Income before income taxes 86,197 78,513 85,199 79,003 328,912
Net income 65,658 60,796 65,382 62,158 253,994
Net income per share 0.94 0.87 0.94 0.89 3.63
Net income per diluted share $ 0.92 $ 0.85 $ 0.92 $ 0.87 $ 3.56
- -----------------------------------------------------------------------------------------------------------------
1997:
Gross premiums written $51,792 $73,740 $52,371 $108,260 $286,163
Net premiums written 46,360 66,545 45,876 94,930 253,711
Net premiums earned 37,033 36,386 35,672 44,909 154,000
Net investment income 38,447 39,258 40,109 41,895 159,709
Financial management services income 7,222 6,150 9,062 12,815 35,249
Losses and loss adjustment expenses 728 664 730 732 2,854
Financial guarantee underwriting and
operating expenses 9,092 9,732 10,173 11,675 40,672
Financial management services expenses 8,980 5,474 5,751 7,788 27,993
Income before income taxes 62,396 67,836 79,637 76,127 285,996
Net income 49,738 53,613 60,795 58,884 223,030
Net income per share(1) 0.71 0.77 0.87 0.84 3.19
Net income per diluted share $ 0.70 $ 0.75 $ 0.85 $ 0.83 $ 3.13
- -----------------------------------------------------------------------------------------------------------------
(1) Net income per share has been retroactively adjusted to reflect the
two-for-one stock split which occurred in September 1997.
48
STOCKHOLDER INFORMATION
CORPORATE HEADQUARTERS:
AMBAC FINANCIAL GROUP, INC.
One State Street Plaza
New York, New York 10004
212-668-0340
fax 212-509-9190
OTHER LOCATIONS:
CADRE FINANCIAL SERVICES,INC.
905 Marconi Avenue
Ronkonkoma, New York 11779
516-467-0200
MBIA.AMBAC INTERNATIONAL JOINT VENTURE OFFICES:
NEW YORK:
885 Third Avenue
New York, New York 10022
212-644-1300
AUSTRALIA:
Level 29, Chifley Tower
Sydney, Australia
NSW 2000
61 2 9375 2198
FRANCE:
112, Avenue Klebor
75116 Paris, France
33 153 704 343
SPAIN:
Serrano, 20-2 Dcha
28001 Madrid, Spain
34 9 1 431-6881
UK:
Hasilwood House
60 Bishopsgate
London EC2N4BE England
44 171-786-4300
TOKYO:
Shiroyama JT Mori Bldg., 16F
4-3-1 Toranomon Minato-ku
Tokyo 105 6016
8135 403 4625
ANNUAL MEETING OF STOCKHOLDERS
The Annual Meeting of Stockholders of Ambac Financial Group, Inc. will be held
on Wednesday, May 12, 1999, at 11:30 a.m. in New York City. Detailed information
about the meeting is contained in the Notice of Annual Meeting and Proxy
Statement to be sent to each stockholder of record as of March 22, 1999. The
Company estimates that it has approximately 34,000 stockholders.
FORM 10-K
A copy of the Company's 1998 Annual Report on Form 10-K for the year ended
December 31, 1998, as filed with the Securities and Exchange Commission, may be
obtained without charge by writing to: Ambac Financial Group, Inc., Attn:
Investor Relations, One State Street Plaza, New York, New York 10004
TRANSFER AGENT, REGISTRAR AND DIVIDEND PAYING AGENT
Citibank, N.A.
111 Wall Street, 5th Floor
New York, New York 10043
212-657-5997
INDEPENDENT AUDITORS
KPMG LLP
New York, New York
STOCK LISTING
Ambac Financial Group, Inc. common stock is listed on the New York Stock
Exchange under the ticker symbol ABK.
INVESTOR RELATIONS
Frank J. Bivona
Executive Vice President
and Chief Financial Officer
Brian S. Moore
Managing Director
212-208-3333
1-800-221-1854
bmoore@ambac.com
COMMON STOCK DATA
The table below shows the high and low price per share for each quarter of 1998
and 1997, as adjusted for the two-for-one common stock split, which occurred in
September 1997.
=================================================================================================================================
1998 Market Price 1997 Market Price
- ---------------------------------------------------------------------------------------------------------------------------------
Dividends Dividends
Three Months Ended High Low Close Per Share High Low Close Per Share
- ---------------------------------------------------------------------------------------------------------------------------------
March 31 $58 9/16 $44 3/8 $58 7/16 $0.0900 $37 $31 5/8 $32 1/4 $0.0825
June 30 61 53 1/2 58 1/2 0.0900 42 1/4 31 38 3/16 0.0825
September 30 65 15/16 45 9/16 48 0.1000 42 15/16 38 1/4 40 11/16 0.0900
December 31 62 3/8 40 7/8 60 3/16 0.1000 47 9/16 40 46 0.0900
=================================================================================================================================
50