<PAGE>
================================================================================
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 8-K
CURRENT REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Date of Report (Date of earliest event reported): March 27, 1998
AMBAC FINANCIAL GROUP, INC.
(Exact name of Registrant as specified in its charter)
Delaware 1-10777 13-3621676
(State of incorporation) (Commission file number) (I.R.S. employer
identification no.)
One State Street Plaza
New York, New York 10004
(Address of principal executive offices) (Zip Code)
(212) 668-0340
(Registrant's telephone number, including area code)
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Page 1 of 2
Index to Exhibits on Page 4
<PAGE>
ITEM 5. OTHER EVENTS
On March 27, 1998, financial statements for Ambac Assurance Corporation,
the Registrant's wholly-owned subsidiary, for the year ended December 31, 1997
became available.
ITEM 7. FINANCIAL STATEMENTS AND EXHIBITS
(c) Exhibits.
Exhibit Number Item
-------------- ----
99.06 Ambac Assurance Corporation consolidated
financial statements as of December 31, 1997 and
1996 and for the three years ended December 31,
1997.
Page 2 of 4
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Ambac Financial Group, Inc.
(Registrant)
Dated: March 27, 1998 By: /s/ Richard B. Gross
---------------------------------
Richard B. Gross
Senior Vice President,
General Counsel and Secretary
Page 3 of 4
<PAGE>
INDEX TO EXHIBITS
-----------------
Exhibit
- -------
Number DESCRIPTION OF EXHIBIT
- ------ ----------------------
99.06 Ambac Assurance Corporation consolidated financial statements as of
December 31, 1997 and 1996 and for the three years ended December 31,
1997.
Page 4 of 4
<PAGE>
Exhibit 99.06
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
(A WHOLLY OWNED SUBSIDIARY OF AMBAC FINANCIAL GROUP, INC.)
CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1997 AND 1996
<PAGE>
Independent Auditors' Report
The Board of Directors
Ambac Assurance Corporation
We have audited the accompanying consolidated balance sheets of Ambac
Assurance Corporation and subsidiaries (a wholly owned subsidiary of Ambac
Financial Group, Inc.) as of December 31, 1997 and 1996, and the related
consolidated statements of operations, stockholder's equity and cash flows for
each of the years in the three-year period ended December 31, 1997. These
consolidated financial statements are the responsibility of Ambac Assurance
Corporation'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
Assurance Corporation and subsidiaries as of December 31, 1997 and 1996, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 1997 in conformity with generally accepted
accounting principles.
New York, New York
January 29, 1998
<PAGE>
Ambac Assurance Corporation and Subsidiaries
Consolidated Balance Sheets
December 31, 1997 and 1996
(Dollars in Thousands Except Share Data)
<TABLE>
<CAPTION>
1997 1996
------------------ -------------------
<S> <C> <C>
ASSETS
------
Investments:
Fixed income securities, at fair value
(amortized cost of $2,696,603 in 1997 and $2,323,259 in 1996) $2,878,083 $2,424,524
Short-term investments, at cost (approximates fair value) 116,905 91,320
------------------ -------------------
Total investments 2,994,988 2,515,844
Cash 8,004 5,025
Securities purchased under agreements to resell 2,484 4,369
Receivable for securities sold 24,018 18,462
Investment income due and accrued 49,987 42,263
Deferred acquisition costs 105,996 94,212
Receivable from brokers and dealers 183,041 -
Reinsurance recoverable 4,219 393
Prepaid reinsurance 183,492 168,786
Other assets 48,802 59,544
------------------ -------------------
Total assets $3,605,031 $2,908,898
================== ===================
LIABILITIES AND STOCKHOLDER'S EQUITY
------------------------------------
Liabilities:
Unearned premiums $1,184,537 $995,220
Losses and loss adjustment expenses 103,345 60,613
Ceded reinsurance balances payable 9,258 7,438
Deferred income taxes 122,554 84,842
Current income taxes 19,714 8,974
Accounts payable and other liabilities 69,641 50,244
Payable for securities purchased 195,388 46,246
------------------ -------------------
Total liabilities 1,704,437 1,253,577
------------------ -------------------
Stockholder's equity:
Preferred stock, par value $1,000.00 per share; authorized
shares - 285,000; issued and outstanding shares - none - -
Common stock, par value $2.50 per share; authorized shares
- 40,000,000; issued and outstanding shares - 32,800,000
at December 31, 1997 and December 31, 1996 82,000 82,000
Additional paid-in capital 521,153 515,684
Unrealized gains on investments, net of tax 117,962 65,822
Cumulative translation adjustment 157 -
Retained earnings 1,179,322 991,815
------------------ -------------------
Total stockholder's equity 1,900,594 1,655,321
------------------ -------------------
Total liabilities and stockholder's equity $3,605,031 $2,908,898
================== ===================
</TABLE>
See accompanying Notes to Consolidated Unaudited Financial Statements.
<PAGE>
Ambac Assurance Corporation and Subsidiaries
Consolidated Statements of Operations
(Dollars in Thousands)
<TABLE>
<CAPTION>
Years Ended December 31
-------------------------------------------------
1997 1996 1995
------------ ------------ ------------
Revenues:
<S> <C> <C> <C>
Gross premiums written $289,383 $249,761 $195,033
Ceded premiums written (32,452) (37,793) (28,606)
------------ ------------ ------------
Net premiums written 256,931 211,968 166,427
Increase in unearned premiums, net (101,263) (73,671) (52,844)
------------ ------------ ------------
Net premiums earned 155,668 138,297 113,583
Net investment income 160,088 145,302 131,496
Net realized gains 18,798 69,149 177
Other income 16,661 16,418 6,777
------------ ------------ ------------
Total revenues 351,215 369,166 252,033
------------ ------------ ------------
Expenses:
Losses and loss adjustment expenses 2,854 3,778 3,377
Underwriting and operating expenses 46,769 42,459 38,722
Interest expense 2,293 2,073 1,590
------------ ------------ ------------
Total expenses 51,916 48,310 43,689
------------ ------------ ------------
Income before income taxes 299,299 320,856 208,344
------------ ------------ ------------
Income tax expense:
Current taxes 55,492 68,322 29,085
Deferred taxes 11,702 11,298 14,461
------------ ------------ ------------
Total income taxes 67,194 79,620 43,546
------------ ------------ ------------
Net Income $232,105 $241,236 $164,798
============ ============ ============
</TABLE>
See accompanying Notes to Consolidated Unaudited Financial Statements.
<PAGE>
Ambac Assurance Corporation and Subsidiaries
Consolidated Statements of Stockholder's Equity
(Dollars In Thousands)
<TABLE>
<CAPTION>
Years Ended December 31,
----------------------------------------
1997 1996 1995
------------ ------------ ------------
<S> <C> <C> <C>
Preferred Stock:
Balance at January 1 and December 31 $ - $ - $ -
============ ============ ============
Common Stock:
Balance at January 1 and December 31 $82,000 $82,000 $82,000
============ ============ ============
Additional Paid-in Capital:
Balance at January 1 $515,684 $481,059 $444,258
Capital contributions 1,475 32,500 35,000
Other 3,994 2,125 1,801
------------ ------------ ------------
Balance at December 31 $521,153 $515,684 $481,059
============ ============ ============
Unrealized Gains (Losses) on Investments, Net of Tax:
Balance at January 1 $65,822 $87,112 ($46,087)
Change in unrealized gain (loss) 52,140 (21,290) 133,199
------------ ------------ ------------
Balance at December 31 $117,962 $65,822 $87,112
============ ============ ============
Cumulative Currency Adjustment:
Balance at January 1 $ - $ - $ -
Changes during the year 157 - -
------------ ------------ ------------
Balance at December 31 $157 $ - $ -
============ ============ ============
Retained Earnings:
Balance at January 1 $991,815 $906,536 $781,571
Net income 232,105 241,236 164,798
Dividends declared-common stock (44,000) (155,865) (40,000)
Other (598) (92) 167
------------ ------------ ------------
Balance at December 31 $1,179,322 $991,815 $906,536
============ ============ ============
Total Stockholder's Equity at December 31 $1,900,594 $1,655,321 $1,556,707
============ ============ ============
</TABLE>
See accompanying Notes to Consolidated Unaudited Financial Statements.
<PAGE>
Ambac Assurance Corporation and Subsidiaries
Consolidated Statements of Cash Flows
(Dollars in Thousands)
<TABLE>
<CAPTION>
Years Ended
December 31,
-------------------------------------------
1997 1996 1995
------------ ------------- ------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income $232,105 $241,236 $164,798
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 1,689 1,711 1,605
Amortization of bond premium and discount (1,084) (1,902) (831)
Current income taxes 18,240 11,145 8,373
Deferred income taxes 11,702 11,299 14,462
Deferred acquisition costs (11,784) (11,592) (10,846)
Unearned premiums 101,257 73,671 52,844
Losses and loss adjustment expenses 408 (5,776) 334
Ceded reinsurance balances payable 1,303 (7,216) 13,746
Gain on sales of investments (18,798) (69,149) (177)
Accounts payable and other liabilities 6,670 6,619 106
Other, net 10,992 (17,928) (11,273)
------------ ------------- ------------
Net cash provided by operating activities 352,700 232,118 233,141
------------ ------------- ------------
Cash flows from investing activities:
Proceeds from sales of bonds at amortized cost 1,346,231 1,555,372 1,882,485
Proceeds from maturities of bonds at amortized cost 115,476 86,292 163,031
Purchases of bonds at amortized cost (1,623,486) (1,938,677) (2,192,824)
Change in short-term investments (25,585) 72,633 (78,751)
Securities purchased under agreements to resell 1,885 (249) 3,891
Purchase of affiliate (120,006) - -
Other, net (236) (1,876) (1,178)
------------ ------------- ------------
Net cash used in investing activities (305,721) (226,505) (223,346)
------------ ------------- ------------
Cash flows from financing activities:
Dividends paid (44,000) (40,000) (40,000)
Capital contribution - 32,500 35,000
------------ ------------- ------------
Net cash used in financing activities (44,000) (7,500) (5,000)
------------ ------------- ------------
Net cash flow 2,979 (1,887) 4,795
Cash at January 1 5,025 6,912 2,117
------------ ------------- ------------
Cash at December 31 $8,004 $5,025 $6,912
============ ============= ============
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Income taxes $42,100 $54,504 $19,500
============ ============= ============
</TABLE>
See accompanying Notes to Consolidated Unaudited Financial Statements.
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLAR AMOUNTS IN THOUSANDS)
1 BACKGROUND
Ambac Assurance Corporation ("Ambac Assurance") is a leading insurer of
municipal and structured finance obligations. Financial guarantee insurance
underwritten by Ambac Assurance guarantees payment when due of the principal of
and interest on the obligation insured. In the case of a default on the insured
bond, payments under the insurance policy may not be accelerated by the
policyholder without Ambac Assurance's consent. As of December 31, 1997, Ambac
Assurance's net insurance in force (principal and interest) was $275,931,000.
Ambac Assurance is a wholly owned subsidiary of Ambac Financial Group, Inc.
(NYSE: ABK), a holding company that provides financial guarantee insurance and
financial management services to clients in the public and private sectors in
the U.S. and abroad through its subsidiaries.
Ambac Assurance, as the sole limited partner, owns a limited partnership
interest representing 90% of the total partnership interests of Ambac Financial
Services, L.P. ("AFS"), a limited partnership which provides interest rate swaps
primarily to states, municipalities and their authorities. The sole general
partner of AFS, Ambac Financial Services Holdings, Inc., a wholly owned
subsidiary of Ambac Financial Group, Inc., owns a general partnership interest
representing 10% of the total partnership interest in AFS.
On December 18, 1997, Ambac Assurance acquired Construction Loan Insurance
Corporation ("CLIC") for $106,000 in cash and retired $18,400 of CLIC debt.
CLIC's wholly owned subsidiary, Connie Lee Insurance Company ("Connie Lee"), a
triple-A rated financial guarantee insurance company which guaranteed bonds
primarily for college and hospital infrastructure projects, is not expected to
write any new business. Ambac Assurance and Connie Lee have arrangements in
place to assure that Connie Lee maintains a level of capital sufficient to
support Connie Lee's outstanding obligations and for Connie Lee insured bonds to
retain their triple-A rating. The acquisition of CLIC was accounted for using
the purchase method. CLIC's results of operations subsequent to December 18,
1997 are included in the accompanying Consolidated Statements of Operations. The
pro forma results of operations for the years ended December 31, 1997 and 1996,
assuming CLIC had been acquired as of January 1, 1996, are as follows; 1997:
revenues of $375,839; pre-tax income of $273,806 and net income of $214,894;
1996: revenues of $393,577; pre-tax income of $335,826; net income of $252,181.
During the first quarter of 1997, Ambac Assurance established a new
subsidiary in the United Kingdom, Ambac Insurance UK Limited ("Ambac UK"), which
is authorized to conduct certain classes of general insurance business in the
United Kingdom. Ambac UK is the Company's primary vehicle for the issuance of
financial guarantee insurance policies in the United Kingdom and Europe.
As of December 31, 1995, Ambac Assurance owned 26.5% and Ambac Financial
Group, Inc. owned 19.9% of the outstanding common stock of an affiliate, HCIA
Inc. ("HCIA"), a leading health care information content company. Prior to 1995,
Ambac Financial Group, Inc. and Ambac Assurance, combined, owned approximately
96% of HCIA. During 1996, in conjunction with the sale of Ambac Financial Group,
Inc.'s and Ambac Assurance's combined holdings in HCIA common stock, Ambac
Assurance delivered to Ambac Financial Group, Inc. (in the form of an
extraordinary dividend) its 2,378,672 shares of HCIA common stock. As a result,
Ambac Assurance recognized a realized gain of $89,680.
2 SIGNIFICANT ACCOUNTING POLICIES
The accompanying consolidated financial statements have been prepared on
the basis of generally accepted accounting principles ("GAAP"). The preparation
of financial statements in conformity with
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
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 Ambac Assurance and
its subsidiaries (sometimes collectively referred to as the "Company") are as
described below:
CONSOLIDATION:
The consolidated financial statements include the accounts of Ambac
Assurance and its subsidiaries. All significant intercompany balances have been
eliminated.
INVESTMENTS:
The Company's investment portfolio is accounted for on a trade-date basis
and consists entirely 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 separate component
of stockholder's 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 which do not have call features, such premiums are amortized over the
remaining terms of the securities. Premiums and discounts on mortgage- 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.
PREMIUM REVENUE RECOGNITION:
Premiums for municipal new issue and secondary market policies are: (i)
generally computed as a percentage of principal and interest insured; (ii)
typically collected in a single payment at policy inception date; and (iii) are
earned pro rata over the period of risk. Premiums for structured finance
policies can be computed as a percentage of either principal or principal and
interest insured. The timing of the collection of structured finance premiums
varies among individual transactions. For policies where premiums are collected
in a single payment at policy inception date, premiums are earned pro rata over
the period of risk. For policies with premiums that are collected periodically
(i.e., monthly, quarterly or annually), premiums are reflected in income pro
rata over the period covered by the premium payment.
2
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
When an Ambac Assurance insured new or secondary market issue has been
refunded or called, the remaining unearned premium is generally earned at that
time, as the risk to Ambac Assurance is considered to have been eliminated.
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 ultimate
aggregate losses inherent in the obligations insured. 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. All or
part of case basis loss reserves are allocated from any ACR available for such
insured obligation.
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 which 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 $14,213, $12,553
and $10,183 for 1997, 1996 and 1995, respectively. Deferred acquisition costs,
net of such amortization, amounted to $11,784, $11,592 and $10,846 for 1997,
1996 and 1995, 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 3 to 5 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 3 to 5 years, using the straight-line method.
DERIVATIVE CONTRACTS:
DERIVATIVE CONTRACTS HELD FOR TRADING PURPOSES:
The Company, through its affiliate AFS, 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 other income.
The fair value of interest rate swaps is determined through the use of valuation
models. The portion of the interest rate swap's initial fair value
3
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
that reflects credit considerations, ongoing servicing, and transaction hedging
costs is recognized over the life of the interest rate swap, as an adjustment to
other income. Interest rate swaps are recorded on a gross basis; assets and
liabilities are netted by customer only when a legal right of set-off exists.
INCOME TAXES:
Pursuant to a tax-sharing agreement, the Company is included in Ambac
Financial Group, Inc.'s consolidated Federal income tax return. The tax-sharing
agreement provides for the determination of tax expense or benefit based on the
contribution of the Company to Ambac Financial Group, Inc.'s consolidated
Federal income tax liability, computed substantially as if the Company filed a
separate Federal income tax return. The tax liability due is settled quarterly,
with a final settlement taking place after the filing of the consolidated
Federal income tax return. The Company files its own state income tax returns.
In accordance with Statement of Financial Accounting Standards No. 109,
"Accounting for Income Taxes", 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 tax rates is
recognized in the period that includes the enactment date.
The Internal Revenue Code permits municipal bond insurance companies to
deduct from taxable income, subject to certain limitations, the amounts added to
the statutory mandatory contingency reserve during the year. The deduction taken
is allowed only to the extent that U.S. Treasury noninterest-bearing tax and
loss bonds are purchased 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 will redeem the
tax and loss bonds to satisfy the additional tax liability. Purchases of tax and
loss bonds are recorded as payments of federal income taxes and are not
reflected in the Company's current tax provision.
POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS:
Ambac Financial Group, Inc., through its subsidiaries, provides various
postretirement and postemployment 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.
ACCOUNTING STANDARDS:
In June 1997, the FASB issued Statement 130, "Reporting Comprehensive Income,"
which requires enterprises to disclose comprehensive income and its components
in a prominent position on the face of the financial statements. The Company
will implement this statement in 1998. This statement relates to presentation
of information and will have no impact on results of operations or financial
condition.
4
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
In June 1997, the FASB issued Statement 131, "Disclosures about Segments of an
Enterprise and Related Information," which will be effective for the Company
beginning January 1, 1998. Statement 131 redefines how operating segments are
determined and requires disclosure of certain financial and descriptive
information about a company's operating segments. This statement relates to
presentation of information and will have no impact on results of operations or
financial condition.
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 at December 31, 1997 and 1996 were as follows:
<TABLE>
<CAPTION>
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
----------------- ----------------- ----------------- -----------------
1997
<S> <C> <C> <C> <C>
Municipal obligations................................. $2,126,136 $149,807 $ 112 $2,275,831
Corporate obligations................................. 315,492 27,384 36 342,840
U.S. Government obligations........................... 136,771 2,854 27 139,598
Mortgage- and asset-backed securities (includes U.S.
Government Agency Obligations) 98,719 2,190 2 100,907
Other................................................. 136,390 91 669 135,812
-------------- --------------- ----------------- ---------------
$2,813,508 $182,326 $ 846 $2,994,988
============== =============== ================= ===============
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
-------------- --------------- ----------------- ---------------
1996
Municipal obligations................................. $1,892,875 $ 86,984 $ 2,223 $1,977,636
Corporate obligations................................. 273,770 17,336 2,187 288,919
U.S. Government obligations........................... 102,774 1,363 1,707 102,430
Mortgage- and asset-backed securities (includes U.S.
Government Agency Obligations) 50,145 2,081 373 51,853
Other................................................. 95,015 - 9 95,006
-------------- -------------- ---------------- ---------------
$2,414,579 $107,764 $6,499 $2,515,844
============== ============== ================ ===============
</TABLE>
5
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
The amortized cost and estimated fair value of fixed income securities at
December 31, 1997, by contractual maturity, were as follows:
<TABLE>
<CAPTION>
Amortized Estimated
Cost Fair Value
----------------------- -----------------------
1997
<S> <C> <C>
Due in one year or less................................................. $ 152,582 $ 152,695
Due after one year through five years................................... 180,417 185,672
Due after five years through ten years.................................. 360,248 375,831
Due after ten years..................................................... 2,070,321 2,228,662
----------------------- -----------------------
2,763,568 2,942,860
Mortgage- and asset-backed securities (includes U.S. Government Agency
Obligations)........................................................... 49,940 52,128
----------------------- -----------------------
$2,813,508 $2,994,988
======================= =======================
</TABLE>
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 $8,415 and $2,422 at December 31, 1997 and 1996
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 Company comprised the following:
<TABLE>
<CAPTION>
1997 1996 1995
----------- -------------- --------------
<S> <C> <C> <C>
Fixed income securities................................... $155,810 $139,410 $127,865
Short-term investments.................................... 6,885 8,360 6,116
----------- ------------- -------------
Total investment income................................ 162,695 147,770 133,981
Investment expense........................................ (2,607) (2,468) (2,485)
----------- ------------- -------------
Net investment income.................................. $160,088 $145,302 $131,496
=========== ============= =============
</TABLE>
The Company had gross realized gains of $25,641, $108,916 and $27,786 for
1997, 1996 and 1995, respectively, and gross realized losses of $6,843, $39,767
and $27,609 for 1997, 1996 and 1995, respectively.
As of December 31, 1997 and 1996, the Company held securities subject to
agreements to resell for $2,484 and $4,369, respectively. Such securities were
held as collateral by the Company. The agreements had terms of less than 30
days.
6
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
4 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:
<TABLE>
<CAPTION>
Year Ended December 31,
------------------------------------------------------------------------------------------------------------------
1997 1996 995
------------------------------------ ------------------------------------ ----------------------------------
Written Earned Written Earned Written Earned
--------------- --------------- --------------- --------------- --------------- ---------------
<S> <C> <C> <C> <C> <C> <C>
Direct............ $281,034 $177,677 $243,097 $157,551 $192,277 $ 127,322
Assumed........... 8,349 3,614 6,664 3,126 2,756 1,349
Ceded............. (32,452) (25,623) (37,793) (22,380) (28,606) (15,088)
--------------- --------------- --------------- --------------- --------------- ---------------
Net premiums...... $256,931 $155,668 $211,968 $138,297 $166,427 $ 113,583
=============== =============== =============== =============== =============== ===============
</TABLE>
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, 1997 and 1996. As of December 31,
1997, prepaid reinsurance of approximately $152,283 was associated with Ambac
Assurance's three largest reinsurers. As of December 31, 1997, Ambac Assurance
held letters of credit and collateral amounting to approximately $154,387 from
its reinsurers to cover liabilities ceded under the aforementioned reinsurance
contracts.
During 1995, Ambac Assurance terminated reinsurance contracts, resulting in
return premiums to Ambac Assurance of $18,141, of which $15,700 was recorded as
an increase to the unearned premium reserve, with the remainder recognized as
revenue.
7
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
5 LOSSES AND LOSS ADJUSTMENT EXPENSES
Ambac Assurance's liability for losses and loss adjustment expenses
includes case basis loss and loss adjustment expense reserves and the ACR.
Following is a summary of the activity in the case basis loss and loss
adjustment expense reserve and ACR accounts and the components of the liability
for losses and loss adjustment expenses:
<TABLE>
<CAPTION>
1997 1996 1995
--------------- ---------------- ---------------
<S> <C> <C> C>
Case basis loss and loss adjustment expense reserves:
Balance at January 1................................. $ 22,016 $39,890 $ 39,342
Less reinsurance recoverables...................... 393 641 450
--------------- ---------------- ---------------
Net balance at January 1............................. 21,623 39,249 38,892
--------------- ---------------- ---------------
Incurred related to:
Current year....................................... 212 1,484 750
Prior years........................................ 1,973 (9,556) 2,650
--------------- ---------------- ---------------
Total incurred................................... 2,185 (8,072) 3,400
--------------- ---------------- ---------------
Paid related to:
Current year....................................... 200 150 150
Prior years........................................ 2,274 9,404 2,893
Total paid....................................... 2,474 9,554 3,043
--------------- ---------------- ----------------
Net balance for Connie Lee, at acquisition........... 29,526 - -
--------------- ---------------- ----------------
Net balance at December 31........................... 50,860 21,623 39,249
Plus reinsurance recoverables...................... 4,219 393 641
Balance at December 31............................... 55,079 22,016 39,890
--------------- ---------------- ----------------
Active credit reserve:
Balance at January 1................................. 38,597 26,747 26,770
Net provision for losses............................. 3,000 5,115 4,097
ACR transfers (to) from case reserves................ (2,331) 6,735 (4,120)
Balance for Connie Lee, at acquisition............... 9,000 - -
--------------- ---------------- ------------------
Balance at December 31............................... 48,266 38,597 26,747
--------------- ---------------- ------------------
Total............................................ $103,345 $60,613 $ 66,637
=============== ================ ==================
</TABLE>
The terms "current year" and "prior years" in the foregoing table refer to
the year in which case basis loss reserves were established.
8
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
6 COMMITMENTS AND CONTINGENCIES
The Company is responsible for leases on the rental of office space,
principally in New York City. In 1997, the Company executed an agreement for
additional office space and a lease term extension at its corporate headquarters
in New York City. 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:
<TABLE>
<CAPTION>
Amount
----------------
<S> <C>
1998.......................... $ 4,621
1999.......................... 5,634
2000.......................... 5,861
2001.......................... 5,087
2002.......................... 5,010
All later years............... 89,902
----------------
$116,115
================
</TABLE>
Rent expense for the aforementioned leases amounted to $4,210, $3,286 and
$2,924 for the years ended December 31, 1997, 1996 and 1995, respectively.
7 INSURANCE REGULATORY RESTRICTIONS
Ambac Assurance is subject to insurance regulatory requirements of the
States of Wisconsin and New York, 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 $44,000, $40,000 and $40,000 on its
common stock in 1997, 1996 and 1995, respectively. In addition, on April 30,
1996, Ambac Assurance, in conjunction with the sale of the Ambac Financial
Group, Inc.'s remaining holdings in HCIA common stock, delivered to Ambac
Financial Group, Inc. (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, 1997, the maximum
amount that will be available during 1998 for payment of dividends by Ambac
Assurance is approximately $100,700.
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'
9
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
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 $1,006,829 and $899,023 at December 31,
1997 and 1996, respectively. Qualified statutory capital was $1,655,554 and
$1,466,560 at December 31, 1997 and 1996, respectively. Statutory net income was
$198,615, $222,810 and $142,541 for 1997, 1996 and 1995, 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.
8 INCOME TAXES
The total effect of income taxes on income and stockholder's equity for the
years ended December 31, 1997 and 1996 was as follows:
<TABLE>
<CAPTION>
1997 1996
---------- ---------
<S> <C> <C>
Total income taxes charged to income...................... $67,194 $ 79,620
----------- ---------
Income taxes charged (credited) to stockholder's equity:
Unrealized gain (loss) on bonds......................... 28,043 (11,464)
Other................................................... (3,995) (2,125)
Total charged (credited) to stockholder's equity..... 24,048 (13,589)
----------- ---------
Total effect of income taxes.............................. $91,242 $ 66,031
=========== =========
</TABLE>
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:
<TABLE>
<CAPTION>
1997 % 1996 % 1995 %
--------- -------- ------------ --------- --------------- ---------------
<S> <C> <C> <C> <C> <C> <C>
Computed expected tax at
statutory rate.............. $104,755 35.0% $112,300 35.0% $ 72,920 35.0%
Increases (reductions) in
expected tax resulting from:
Tax-exempt interest.......... (35,458) (11.8) (30,655) (9.6) (28,274) (13.6)
Other, net................... (2,103) (0.7) (2,025) (0.6) (1,100) (0.5)
--------- --------- ---------- -------- ---------- -----------
Income tax expense $ 67,194 22.5% $ 79,620 24.8% $ 43,546 20.9%
========== ======== ========= ======== ======== ============
</TABLE>
10
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
The tax effects of temporary differences that give rise to significant
portions of the deferred tax liabilities and deferred tax assets at December 31,
1997 and 1996 are presented below:
<TABLE>
<CAPTION>
1997 1996
------------- --------------
<S> <C> <C>
Deferred tax liabilities:
Contingency reserve................................ $111,160 $ 76,805
Unrealized gains on bonds.......................... 63,518 35,443
Deferred acquisition costs......................... 38,030 32,974
Unearned premiums.................................. 35,591 27,971
Other.............................................. 2,225 1,389
---------- -----------
Total deferred tax liabilities..................... 250,524 174,582
---------- -----------
Deferred tax assets:
Tax and loss bonds................................. 87,951 63,871
Loss reserves...................................... 17,231 13,561
Alternative minimum tax credit carryforward........ 10,049 --
Amortization and depreciation...................... 6,556 6,791
Compensation....................................... 3,924 2,721
Investments........................................ -- 1,374
Other.............................................. 2,259 1,422
---------- --------------
Sub-total deferred tax assets...................... 127,970 89,740
Valuation allowance................................ -- --
---------- --------------
Total deferred tax assets.......................... 127,970 89,740
---------- --------------
Net deferred tax liabilities....................... $122,554 $ 84,842
========== ==============
</TABLE>
The Company believes that no valuation allowance is necessary in connection
with the deferred tax assets.
9 EMPLOYEE BENEFITS
PENSIONS:
Ambac Financial Group, Inc. has a defined benefit pension plan covering
substantially all employees of the Company and most of its subsidiaries. The
benefits are based on years of service and the employee's compensation during
the last five years of employment. Ambac Financial Group, Inc.'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 actuarial present value of the benefit obligations shown in the table
below sets forth the plan's funded status and amounts recognized by the Ambac
Financial Group, Inc. as of December 31, 1997 and 1996.
11
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
1997 1996
--------------- ------------
<S> <C> <C>
Accumulated benefit obligation, including vested
benefits of $7,192 and $6,282, respectively................... ($7,956) ($6,979)
================ ==========
Projected benefit obligation for service rendered to date..... (9,374) (8,189)
Plan assets at fair value, primarily listed stocks,
commingled funds and fixed income securities.................. 9,644 8,153
---------------- ----------
Funded/unfunded projected benefit............................. 270 (36)
Unrecognized prior service cost............................... (1,454) (1,619)
Unrecognized net loss......................................... 62 885
Unrecognized net transition asset............................. (7) (9)
---------------- ----------
Pension liability included in other liabilities............... ($1,129) ($779)
================ ==========
</TABLE>
Net pension costs for 1997, 1996 and 1995 included the following
components:
<TABLE>
<CAPTION>
1997 1996 1995
------------- ----------- ------------
<S> <C> <C> <C>
Service cost................................................... $ 723 $ 674 $ 541
Interest cost on expected benefit obligation................... 601 539 456
Actual return on plan assets................................... (1,606) (957) (1,333)
Net amortization and deferral.................................. 770 263 760
------------- ----------- ------------
Net periodic pension cost...................................... $ 488 $ 519 $ 424
============= =========== ============
</TABLE>
The weighted average discount rate used in the determination of the
actuarial present value for the projected benefit obligation was 7.25% and 7.50%
for 1997 and 1996, respectively. The expected long-term rate of return on assets
was 9.25% for both 1997 and 1996. The rate of increase in future compensation
levels used in determining the actuarial present value of the projected benefit
obligation was 4.8 % and 5.0% for 1997 and 1996, respectively.
Upon the acquisition of CLIC, Ambac Financial Group, Inc. assumed the
liability for its two terminated pension plans. Those plans had an unfunded
projected obligation of approximately $800, which is included in other
liabilities at December 31, 1997.
Substantially all employees of Ambac Financial Group, Inc. and its
subsidiaries 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, subject to Internal Revenue Code
limitations, made by eligible employees to the plan. The total cost of the
Savings Incentive Plan to Ambac Assurance was $1,417, $1,494 and $1,435 in 1997,
1996 and 1995, respectively.
ANNUAL INCENTIVE PROGRAM:
Ambac Financial Group, Inc. has an annual incentive program which provides
for awards to key officers and employees based upon predetermined criteria. The
cost of the program for the years ended December 31, 1997, 1996 and 1995
amounted to $9,429, $7,641 and $7,669, 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.
12
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
Postretirement benefits expense was $230, $220 and $168 in 1997, 1996 and
1995, respectively. The unfunded accumulated postretirement benefit obligation
was $2,064 and the accrued postretirement liability was $1,719 as of December
31, 1997.
The assumed weighted average health care cost trend rates range from 9.0%
in 1997, decreasing ratably to 6.0% in 2002, 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, 1997 by $172 and the 1997 benefit expense by $48. The
weighted average discount rate used to measure the accumulated postretirement
benefit obligation and 1997 expense was 7.25%.
10 INSURANCE IN FORCE
The par amount of bonds insured, for non-affiliates, net of reinsurance,
was $165,601,000 and $131,497,000 at December 31, 1997 and 1996, respectively.
As of December 31, 1997 and 1996, the insured portfolio was diversified by type
of insured bond as shown in the following table:
<TABLE>
<CAPTION>
Net Par Amount Outstanding
------------------------------
(Dollars in Millions) 1997 1996
------------------------------
<S> <C> <C>
Municipal finance:
General obligation.......................... $ 36,324 $ 31,863
Lease and tax-backed revenue................ 30,980 25,366
Utility revenue............................. 24,913 22,780
Health care revenue......................... 18,545 13,521
Transportation revenue...................... 7,370 6,891
Higher education............................ 6,852 4,745
Investor-owned utilities.................... 6,255 5,492
Housing revenue............................. 6,064 4,497
Student loans............................... 3,516 3,439
Other....................................... 597 484
------------------------------
Total municipal finance.................. 141,416 119,078
------------------------------
Domestic structured finance:
Mortgage-backed and home equity.......... 11,620 5,263
Commercial asset-backed.................. 4,538 1,329
Other consumer asset-backed.............. 1,514 1,126
Banks/financial institutions............. 524 214
Other.................................... 439 159
------------------------------
Total domestic structured finance........ 18,635 8,091
------------------------------
Total domestic........................... 160,051 127,169
------------------------------
International finance:
Commercial asset-backed.................. 2,600 2,530
Sovereign/sub-sovereign.................. 981 631
Mortgage-backed and home equity.......... 496 265
Utilities................................ 456 131
Banks/financial institutions............. 283 346
Other.................................... 734 425
------------------------------
Total international finance.............. 5,550 4,328
------------------------------
$165,601 $131,497
==============================
</TABLE>
13
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
As of December 31, 1997 and 1996, the international insured portfolio by
geographic area is shown in the following table:
<TABLE>
<CAPTION>
Net Par Amount Outstanding
-----------------------------------
(Dollars in Millions) 1997 1996
---------------- ---------------
International:
<S> <C> <C>
France.............................. $1,032 $1,025
Japan............................... 879 645
United Kingdom...................... 865 569
Italy............................... 555 423
Spain............................... 380 130
Internationally diversified............ 899 985
Other international.................... 940 551
---------------- ---------------
$5,550 $4,328
================ ===============
</TABLE>
As of December 31, 1997, California was the state with the highest
aggregate net par amount in force, accounting for 11.8% of the total. The
highest single insured risk represented less than 1% of aggregate net par amount
insured. Direct insurance in force (principal and interest) was $321,104,000 and
$268,870,000 at December 31, 1997 and 1996, respectively. Net insurance in force
(after giving effect to reinsurance) was $275,931,000 and $227,235,000 as of
December 31, 1997 and 1996, respectively.
11 FINANCIAL INSTRUMENTS HELD FOR PURPOSES OTHER THAN TRADING
Fair values of financial instruments held for purposes other than trading:
The following fair value amounts were determined by the Company 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 or dealer quotes.
Short-term investments and cash: The fair values of short-term investments
and cash are assumed to equal amortized cost.
Securities purchased under agreements to resell: The fair value of
securities purchased under agreements to resell is assumed to approximate
carrying value.
Derivative contracts: Fair values of derivative contracts (futures, swaps
and interest rate options) are based on quoted market prices and dealer quotes,
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
14
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
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 assumed 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 these financial instruments
are presented below:
<TABLE>
<CAPTION>
As of December 31,
-----------------------------------------------------------------------------------
1997 1996
----------------------------------------- -------------------------------------
(Dollars in Millions) Carrying Estimated Fair Carrying Amount Estimated Fair
Amount Value Value
---------------- ------------------- ------------------- --------------
Financial assets:
<S> <C> <C> <C> <C>
Investments................................ $2,878 $2,878 $2,425 $2,425
Short-term investments..................... 117 117 91 91
Cash....................................... 8 8 5 5
Securities purchased under agreements to
resell.................................... 2 2 4 4
Liability for financial guarantees written:
Gross.................................... 1,185 855 995 719
Net of reinsurance....................... 1,002 722 826 596
Net installment premiums................. -- 153 -- 114
</TABLE>
12 FINANCIAL INSTRUMENTS HELD FOR TRADING PURPOSES
The Company, through its affiliate AFS is a provider of interest rate swaps
to states, municipalities and their authorities and other entities in connection
with their financings. AFS manages its business with the goal of being market
neutral to changes in overall interest rates, while retaining basis risk, the
relationship between changes in floating tax-exempt and floating taxable
interest rates. If actual or projected floating tax-exempt interest rates change
in relation to floating taxable rates, the Company will experience an unrealized
mark-to-market gain or loss. The AFS swap portfolio is considered held for
trading purposes.
In the ordinary course of business, AFS 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 relates to the impact of price changes on future earnings. This
risk is a consequence of AFS's market-making activities in the interest rate
swap market. The principal market risk is basis risk, the
15
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
relationship between changes in floating tax-exempt and floating taxable
interest rates. Since late 1995, most interest rate swaps transacted contain
provisions which are designed to protect AFS against certain forms of tax
reform, thus mitigating its basis risk. An independent risk management group
monitors trading risk limits and, together with senior management, is involved
in the application of risk measurement methodologies.
Credit risk relates to the ability of counterparties to perform according
to the terms of their contractual commitments. Credit risk is calculated based
on the current replacement cost or fair value of the Company's financial
instruments. The gross replacement of the Company's financial instruments held
for trading purposes is the positive fair value of all transactions with a
counterparty, excluding the effects of netting or collateral arrangements and
was approximately $72,000 and $47,000 as of December 31, 1997 and 1996,
respectively.
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. 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 estimates value-at-risk utilizing
historical short and long-term interest rate volatilities and the relationship
between changes in tax-exempt and taxable interest rates calculated on a
consistent daily basis. For the years ended December 31, 1997 and 1996, the
Company's value-at-risk, for financial instruments considered held for trading
purposes, calculated at a ninety-nine percent confidence level, averaged
approximately $1,600 and $1,400, respectively. The Company's value-at-risk
ranged from a high of $2,600 to a low of $900 in 1997, and from a high of $2,600
to a low of $1,100 in 1996. 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 market
conditions, however improbable, which might cause abnormal volatility swings or
disruptions of market relationships.
Liquidity risk relates to the possible inability to satisfy contractual
obligations when due. This risk is present in swaps and in futures contracts
used to hedge swaps. The Company manages liquidity risk by maintaining cash and
cash equivalents, closely matching the dates swap payments are made and
received, and limiting the amount of risk hedged by futures contracts.
The following table summarizes information about the Company's financial
instruments held for trading purposes as of December 31, 1997 and 1996:
<TABLE>
<CAPTION>
Net Estimated Fair Value Average Net Fair Value
---------------------------- ---------------------------
Notional
Assets Liabilities Assets Liabilities Amount
---------------------------- ----------------------------------------------
<S> <C> <C> <C> <C> <C>
1997:
Derivative financial instruments:
Interest rate swaps............... $ 71,505 $ 49,772 $ 47,276 $ 34,768 $4,174,160
Futures contracts................. -- -- -- -- 514,900
Other financial instruments........... 183,041 181,732 160,251 159,213 --
1996:
Derivative financial instruments:
Interest rate swaps............... $ 45,990 $ 33,650 $ 48,734 $ 41,445 $2,856,600
Futures contracts................. -- -- -- -- 484,500
Other financial instruments........... -- -- -- -- --
</TABLE>
16
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
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 $8,560, $10,799
and $2,602 for 1997, 1996 and 1995, respectively. Other financial instruments
held for trading purposes consist of fixed income securities. The aggregate
amount of net trading income recognized from other financial instruments was
$1,309 for 1997. Average net fair values were calculated based on average daily
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.
13 LINES OF CREDIT
Ambac Financial Group, Inc. and Ambac Assurance maintain a three-year
revolving credit facility with two major international banks, as co-agents, for
$100,000. As of December 31, 1997 and 1996, no amounts were outstanding under
this credit facility, which expires in July 1998.
Ambac Assurance has an agreement with a group of AAA/Aaa-rated
international banks for a $450,000 credit facility, expiring in 2004. This
facility is a seven-year stand-by irrevocable limited recourse line of credit,
which was increased from $350,000 to $450,000 and extended for an additional
year in December 1997. The line will provide liquidity to Ambac Assurance in the
event claims from municipal obligations exceed specified levels. Repayment of
any amounts drawn under the line will be limited primarily to the amount of any
recoveries of losses related to policy obligations. As of December 31, 1997 and
1996, no amounts were outstanding under this line.
Connie Lee has an agreement with commercial banks for a $50,000 stand-by
credit facility, expiring in 2003. The line will provide a source of additional
claims-paying resources for insured transactions. The obligation to repay is a
limited recourse obligation payable solely from, and collateralized by, a pledge
of recoveries realized on defaulted insured obligations including installment
premiums and other collateral. As of December 31, 1997 and 1996, no amounts were
outstanding under this line.
14 RELATED PARTY TRANSACTIONS
During 1997 and 1996, Ambac Assurance guaranteed the timely payment of
principal and interest on obligations under investment agreements and investment
repurchase agreements issued by its affiliates. As of December 31, 1997 and
1996, the aggregate amount of investment agreements and investment repurchase
agreements insured was $3,856,786 and $2,744,283, respectively, including
accrued interest. These insurance policies are collateralized by investment
securities, accrued interest, securities purchased under agreements to resell
and cash and cash equivalents, which as of December 31, 1997 and 1996 had a fair
value of $3,936,718 and $2,775,250, respectively, in the aggregate. During 1997
and 1996, Ambac Assurance recorded gross premiums written of $3,220 and $2,553,
and net premiums earned of $1,668 and $1,668, respectively, related to these
agreements.
During 1997 and 1996, several interest rate swap transactions were executed
between AFS and its affiliates (other than Ambac Assurance). As of December 31,
1997 and 1996, these contracts had an outstanding notional amount of
approximately $827,000 and $515,000, respectively. As of December 31, 1997 and
1996, AFS recorded a positive fair value of $3,762 and $3,503, respectively,
related to these transactions.
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