<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 24, 1999
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 10004
New York, New York (Zip code)
(Address of principal executive offices)
(212) 668-0340
(Registrant's telephone number, including area code)
Page 1 of 27 Pages
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Index to Exhibits on Page 4
<PAGE>
Item 5. Other Events
On March 24, 1999, financial statements for Ambac Assurance Corporation, the
Registrant's wholly-owned subsidiary, for the year ended December 31, 1998
became available.
Item 7. Financial Statements and Exhibits
(c) Exhibits.
Exhibit Number Item
-------------- ----
99.05 Ambac Assurance Corporation consolidated
financial statements as of December 31, 1998 and
1997 and for the three years ended December 31,
1998.
Page 2 of 27
<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 24, 1999 By: /s/Frank J. Bivona
------------------
Frank J. Bivona
Executive Vice President, and
Chief Financial Officer
Page 3 of 27
<PAGE>
INDEX TO EXHIBITS
-----------------
Exhibit
- -------
Number Description of Exhibit
- ------ ----------------------
99.05 Ambac Assurance Corporation consolidated financial statements as
of December 31, 1998 and 1997 and for the three years ended
December 31, 1998.
Page 4 of 27
<PAGE>
EXHIBIT 99.05
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
(a wholly-owned subsidiary of Ambac Financial Group, Inc.)
Consolidated Financial Statements
December 31, 1998 and 1997
<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, 1998 and 1997, 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, 1998. 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, 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
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, 1998 and 1997
(Dollars in Thousands Except Share Data)
See accompanying Notes to Consolidated Financial Statements.
<TABLE>
<CAPTION>
1998 1997
-------------- -------------
ASSETS
<S> <C> <C>
Investments:
Fixed income securities, at fair value
(amortized cost of $3,097,289 in 1998 and $2,696,603 in 1997)............. $3,310,047 $2,878,083
Short-term investments, at cost (approximates fair value)..................... 93,912 116,905
-------------- --------------
Total investments......................................................... 3,403,959 2,994,988
Cash............................................................................. 4,895 8,004
Securities purchased under agreements to resell.................................. 5,449 2,484
Receivable for securities sold................................................... 12,132 24,018
Investment income due and accrued................................................ 54,088 49,987
Deferred acquisition costs....................................................... 120,619 105,996
Receivable from brokers and dealers.............................................. -- 183,041
Reinsurance recoverable.......................................................... 3,638 4,219
Prepaid reinsurance.............................................................. 199,920 183,492
Other assets..................................................................... 212,475 90,785
-------------- --------------
Total assets.............................................................. $4,017,175 $3,647,014
============== ==============
LIABILITIES AND STOCKHOLDER'S EQUITY
Liabilities:
Unearned premiums............................................................. $1,303,203 $1,184,537
Losses and loss adjustment expenses........................................... 115,794 103,345
Ceded reinsurance balances payable............................................ 6,576 9,258
Deferred income taxes......................................................... 144,565 122,554
Current income taxes.......................................................... 19,984 19,714
Accounts payable and other liabilities........................................ 226,950 111,624
Payable for securities purchased.............................................. 33,758 195,388
-------------- --------------
Total liabilities......................................................... 1,850,830 1,746,420
-------------- --------------
Stockholder's equity:
Preferred stock, par value $1,000 per share; authorized
shares -- 285,000; issued and outstanding shares -- none.................. -- --
Common stock, par value $2.50 per share; authorized shares
-- 40,000,000; issued and outstanding shares -- 32,800,000
at December 31, 1998 and December 31, 1997................................ 82,000 82,000
Additional paid-in capital.................................................... 541,021 521,153
Accumulated other comprehensive income........................................ 138,651 118,119
Retained earnings............................................................. 1,404,673 1,179,322
-------------- --------------
Total stockholder's equity................................................ 2,166,345 1,900,594
-------------- --------------
Total liabilities and stockholder's equity................................ $4,017,175 $3,647,014
============== ==============
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations
(Dollars in Thousands)
<TABLE>
<CAPTION>
Years Ended December 31,
---------------------------------------------------
1998 1997 1996
-------------- -------------- -------------
<S> <C> <C> <C>
Revenues:
Gross premiums written............................................ $ 366,791 $ 289,383 $249,761
Ceded premiums written............................................ (49,563) (32,452) (37,793)
-------------- -------------- -------------
Net premiums written........................................... 317,228 256,931 211,968
Increase in unearned premiums, net................................ (102,205) (101,263) (73,671)
-------------- -------------- -------------
Net premiums earned............................................ 215,023 155,668 138,297
Net investment income............................................. 186,259 160,088 145,302
Net realized (losses) gains....................................... (12,346) 18,798 69,149
Other income...................................................... 25,399 16,661 16,418
-------------- -------------- -------------
Total revenues................................................. 414,335 351,215 369,166
-------------- -------------- -------------
Expenses:
Losses and loss adjustment expenses............................... 6,000 2,854 3,778
Underwriting and operating expenses............................... 51,000 46,769 42,459
Interest expense.................................................. 3,039 2,293 2,073
-------------- -------------- -------------
Total expenses................................................. 60,039 51,916 48,310
-------------- -------------- -------------
Income before income taxes..................................... 354,296 299,299 320,856
-------------- -------------- -------------
Income tax expense:
Current taxes..................................................... 71,395 55,492 68,322
Deferred taxes.................................................... 9,550 11,702 11,298
-------------- -------------- -------------
Total income taxes............................................. 80,945 67,194 79,620
-------------- -------------- -------------
Net Income..................................................... $ 273,351 $ 232,105 $241,236
============== ============== =============
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Consolidated Statements of Stockholder's Equity
(Dollars In Thousands)
<TABLE>
<CAPTION>
Years Ended December 31,
-------------------------------------------------------------------------------
1998 1997 1996
-------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Retained Earnings:
Balance at January 1 $1,179,322 $ 991,815 $ 906,536
Net income 273,351 $273,351 232,105 $232,105 241,236 $241,236
---------- ---------- ----------
Dividends declared
common stock (48,000) (44,000) (155,865)
Other -- (598) (92)
---------- ------------ ------------
Balance at December 31 $1,404,673 $1,179,322 $ 991,815
---------- ------------ ------------
Accumulated Other
Comprehensive Income:
Balance at January 1 $ 118,119 $ 65,822 $ 87,112
Unrealized gains (losses) on
securities, ( $31,278,
$80,241, and ($32,754),
pre-tax, in 1998, 1997
and 1996, respectively) (1) 20,331 52,140 (21,290)
Foreign currency gain 201 157 --
---------- ---------- ----------
Other comprehensive income 20,532 20,532 52,297 52,297 (21,290) (21,290)
---------- ---------- ---------- ---------- ---------- ----------
Total comprehensive income $293,883 $284,402 $219,946
========== ========== ==========
Balance at December 31 $ 138,651 $ 118,119 $ 65,822
---------- ---------- ----------
Common Stock:
Balance at January 1 and
December 31 $ 82,000 $ 82,000 $ 82,000
---------- ---------- ----------
Additional Paid-in Capital:
Balance at January 1 $ 521,153 $ 515,684 $ 481,059
Capital contribution 9,000 1,475 32,500
Exercise of stock options 10,868 3,994 2,125
---------- ---------- ----------
Balance at December 31 $ 541,021 $ 521,153 $ 515,684
---------- ---------- ----------
Total Stockholder's Equity at
December 31 $2,166,345 $1,900,594 $1,655,321
========== ========== ==========
</TABLE>
<TABLE>
<CAPTION>
(1) Disclosure of reclassification amount: 1998 1997 1996
---------------------------------------------
<S> <C> <C> <C>
Unrealized holding gains (losses) arising during period $22,758 $63,182 $(34,636)
Less: reclassification adjustment for net gains (losses) included in net income 2,427 11,042 (13,346)
---------------------------------------------
Net unrealized gains (losses) on securities $20,331 $52,140 $(21,290)
=============================================
</TABLE>
See accompanying Notes to Consolidated Financial Ststements.
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Dollars in Thousands)
<TABLE>
<CAPTION>
Years Ended December 31,
-------------------------------------------------------
1998 1997 1996
--------------- --------------- ---------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income...................................................... $ 273,351 $ 232,105 $ 241,236
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization................................... 1,877 1,689 1,711
Amortization of bond premium and discount....................... (1,733) (1,084) (1,902)
Current income taxes............................................ 270 18,240 11,145
Deferred income taxes........................................... 11,064 11,702 11,299
Deferred acquisition costs...................................... (14,623) (11,784) (11,592)
Unearned premiums............................................... 102,238 101,257 73,671
Losses and loss adjustment expenses............................. 13,030 408 (5,776)
Ceded reinsurance balances payable.............................. (2,682) 1,303 (7,216)
Loss (gain) on sales of investments............................. 12,346 (18,798) (69,149)
Other, net...................................................... (25,241) 12,315 (11,309)
--------------- --------------- ---------------
Net cash provided by operating activities.................... 369,897 347,353 232,118
--------------- --------------- ---------------
Cash flows from investing activities:
Proceeds from sales of bonds at amortized cost.................. 1,127,196 1,346,231 1,555,372
Proceeds from maturities of bonds at amortized cost............. 126,822 115,476 86,292
Purchases of bonds at amortized cost............................ (1,616,863) (1,623,486) (1,938,677)
Change in short-term investments................................ 22,993 (25,585) 72,633
Securities purchased under agreements to resell................. (2,965) 1,885 (249)
Purchase of affiliate........................................... -- (120,006) --
Other, net...................................................... (1,472) (236) (1,876)
--------------- --------------- ---------------
Net cash used in investing activities........................ (344,289) (305,721) (226,505)
--------------- --------------- ---------------
Cash flows from financing activities:
Dividends paid.................................................. (48,000) (44,000) (40,000)
Capital contribution............................................ 9,000 -- 32,500
Short term financing from affiliates............................ 10,283 5,347 --
--------------- --------------- ---------------
Net cash used in financing activities........................ (28,717) (38,653) (7,500)
--------------- --------------- ---------------
Net cash flow................................................ (3,109) 2,979 (1,887)
Cash at January 1................................................. 8,004 5,025 6,912
--------------- --------------- ---------------
Cash at December 31............................................... $ 4,895 $ 8,004 $ 5,025
=============== =============== ===============
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Income taxes................................................. $ 64,618 $ 42,100 $ 54,504
=============== =============== ===============
Interest expense on intercompany line of credit.............. $ 783 $ 15 --
=============== =============== ===============
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Dollars in Thousands)
1 BACKGROUND
Ambac Assurance Corporation ("Ambac Assurance") is a leading insurer of
municipal and structured finance obligations. Ambac Assurance has earned
triple-A ratings, the highest ratings available from Moody's Investors Service,
Inc., Standard & Poor's Rating Group, Fitch IBCA, Inc., and Japan Rating and
Investment Information, Inc. 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 monetary 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, 1998, Ambac Assurance's
net insurance-in-force (principal and interest) was $317,688,000. Ambac
Assurance is a wholly owned subsidiary of Ambac Financial Group, Inc. ("AFGI"),
a holding company whose subsidiaries provide financial guarantee insurance and
financial services to clients in both the public and private sectors around the
world.
In December 1997, Ambac Assurance acquired Construction Loan Insurance
Corporation ("CLIC"). 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, did not write any new business in 1998. 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.
Ambac Assurance serves clients primarily in international markets through
its wholly-owned subsidiary Ambac Assurance UK Limited (formerly known as Ambac
Insurance UK Limited) and through an arrangement with MBIA Insurance Company
("MBIA") to participate in MBIA.AMBAC International, an unincorporated joint
venture (the "Joint Venture") formed in 1995. The joint venture was formed with
the goal of bringing the combined 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 and each company has the opportunity to reinsure up to 50% of
international business written.
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. ("AFSLP"), a limited partnership which provides interest rate
swaps primarily to states, municipalities and their authorities. The sole
general partner of AFSLP, Ambac Financial Services Holdings, Inc., a wholly
owned subsidiary of AFGI, owns a general partnership interest representing 10%
of the total partnership interest in AFSLP.
During 1996, in conjunction with the sale of AFGI's and Ambac Assurance's
combined holdings in an affiliate, HCIA Inc. ("HCIA") common stock, Ambac
Assurance delivered to AFGI (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 on the disposition of the stock.
2 SIGNIFICANT ACCOUNTING POLICIES
The accompanying consolidated financial statements have been prepared on
the basis of U.S. Generally Accepted Accounting Principles ("GAAP"). The
preparation of consolidated 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 consolidated financial statements and the
reported revenues and expenses during the reporting period.
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(Dollar Amounts in Thousands)
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 accompanying 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 component of
"Accumulated Other Comprehensive Income" in 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 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
sales 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 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 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.
2
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(Dollars in Thousands)
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 monetary
default. When losses occur (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. 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:
1998 1997
----------------------------
Net loss and loss adjustment expense reserves:
Case basis (*) $ 33,916 $50,860
ACR 78,240 48,266
----------------------------
Total $112,156 $99,126
----------------------------
(*) After netting reinsurance recoverable amounting to $3,638 and $4,219 in
1998 and 1997, respectively.
Paid losses, net of salvage received were ($7,030), $2,474 and $9,554 in
1998, 1997 and 1996, respectively.
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.
3
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(Dollar Amounts in Thousands)
DERIVATIVE CONTRACTS:
Derivative Contracts Held for Trading Purposes:
The Company, through its affiliate AFSLP, a provider of interest rate swaps
to states, municipalities and their authorities, and other entities in
connection with their financings, uses derivative contracts that 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. Interest rate swaps are recorded on the balance sheet on a gross basis,
and are included in other assets and accounts payable and other liabilites;
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 AFGI'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.
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 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 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. Purchases of tax and loss bonds are recorded as payments of Federal
income taxes.
POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS:
AFGI, 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.
4
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(Dollar Amounts in Thousands)
STOCK COMPENSATION PLANS:
The Company participates in AFGI's 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. Other than the tax benefits derived from
this plan, pursuant to the tax sharing agreement, no other recognition is given
by the Company.
ACCOUNTING STANDARDS:
During 1998, the Company adopted the following new standards: FAS Statement
130, "Reporting Comprehensive Income" ("FAS 130"); 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 stockholder's 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 Stockholder's Equity. 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 8. 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 does not expect the
impact of FAS 133 to have a material affect 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.
5
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(Dollar Amounts in Thousands)
3 INVESTMENTS
The amortized cost, gross unrealized gains and losses, and estimated fair
value of investments in fixed income securities and short-term investments at
December 31, 1998 and 1997 were as follows:
<TABLE>
<CAPTION>
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------------- ----------------- ---------------- ---------------
1998
<S> <C> <C> <C> <C>
Municipal obligations.......................... $2,592,649 $168,481 $3,912 $2,757,218
Corporate obligations.......................... 275,416 36,292 289 311,419
U.S. Government obligations.................... 130,383 9,203 -- 139,586
Mortgage- and asset-backed securities
(includes U.S. Government Agency Obligations). 98,841 3,000 17 101,824
Other.......................................... 93,912 -- -- 93,912
--------------- ----------------- ---------------- ---------------
$3,191,201 $216,976 $4,218 $3,403,959
=============== ================= ================ ===============
</TABLE>
<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
=============== ================= ================ ===============
</TABLE>
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:
<TABLE>
<CAPTION>
Amortized Estimated
Cost Fair Value
-------------------- --------------------
1998
<S> <C> <C>
Due in one year or less........................................ $ 130,536 $ 131,022
Due after one year through five years.......................... 165,846 174,260
Due after five years through ten years......................... 310,670 330,484
Due after ten years............................................ 2,485,308 2,666,369
-------------------- --------------------
3,092,360 3,302,135
Mortgage- and asset-backed securities (includes U.S.
Government Agency Obligations)................................ 98,841 101,824
-------------------- --------------------
$3,191,201 $3,403,959
==================== ====================
</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.
6
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(Dollar Amounts in Thousands)
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 of the Company comprised the following:
<TABLE>
<CAPTION>
1998 1997 1996
------------------- ------------------- -------------------
<S> <C> <C> <C>
Fixed income securities............................ $181,437 $155,810 $139,410
Short-term investments............................. 8,208 6,885 8,360
------------------- ------------------- -------------------
Total investment income......................... 189,645 162,695 147,770
Investment expense................................. (3,386) (2,607) (2,468)
------------------- ------------------- -------------------
Net investment income........................... $186,259 $160,088 $145,302
=================== =================== ===================
</TABLE>
The Company had gross realized gains of $17,186, $26,950 and $108,916 for
1998, 1997 and 1996, respectively, and gross realized losses of $29,532, $8,152
and $39,767 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 $19,047, $3,593 and $0 for 1998, 1997 and
1996, respectively.
As of December 31, 1998 and 1997, the Company held securities subject to
agreements to resell for $5,449 and $2,484, respectively. Such securities were
held as collateral by the Company. The agreements had terms of less than 30
days.
4 REINSURANCE
In the ordinary course of business, the Company 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,
-------------------------------------------------------------------------------------------------------------
1998 1997 1996
--------------------------------- --------------------------------- ---------------------------------
Written Earned Written Earned Written Earned
-------------- -------------- -------------- -------------- -------------- --------------
<S> <C> <C> <C> <C> <C> <C>
Direct......... $339,432 $240,791 $281,034 $177,677 $243,097 $157,551
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... $317,228 $215,023 $256,931 $155,668 $211,968 $138,297
============== ============== ============== ============== ============== ==============
</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 the Company under the existing
reinsurance agreements, the Company would be liable for such defaulted amounts.
To minimize its exposure to significant losses from reinsurer insolvencies, the
Company 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,
7
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(Dollar Amounts in Thousands)
prepaid reinsurance of approximately $159,361 was associated with the Company's
three largest reinsurers. As of December 31, 1998, the Company held letters of
credit and collateral amounting to approximately $198,957 from its reinsurers to
cover liabilities ceded under the aforementioned reinsurance contracts.
Premiums written assumed from MBIA under the Joint Venture were $18,715,
$8,009 and $4,674 in 1998, 1997 and 1996, respectively. Premiums written ceded
to MBIA were $15,505, $8,874 and $6,532 in 1998, 1997 and 1996, respectively.
5 COMMITMENTS AND CONTINGENCIES
The Company is responsible for leases on the rental of office space,
principally 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:
Amount
----------------
1999................................................... $ 6,116
2000................................................... 6,272
2001................................................... 5,489
2002................................................... 5,411
2003................................................... 5,417
All later years........................................ 87,526
----------------
$116,231
================
Rent expense for the aforementioned leases amounted to $5,097, $4,210 and
$3,286 for the years ended December 31, 1998, 1997 and 1996, respectively.
Total rentals to be received under future sublease agreements are estimated at
$2,235.
6 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 $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 Ambac Financial
Group, Inc.'s remaining holdings in HCIA
8
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(Dollar Amounts in Thousands)
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, 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 was
$271,808, $198,615 and $222,810 for 1998, 1997 and 1996, respectively. Statutory
capital and surplus differs from stockholder's equity determined under GAAP
principally due to statutory accounting rules that treat loss reserves, premiums
earned, policy acquisition costs, and deferred income taxes differently.
7 INCOME TAXES
The total effect of income taxes on income and stockholder's equity for the
years ended December 31, 1998 and 1997 was as follows:
<TABLE>
<CAPTION>
1998 1997
------------- -------------
<S> <C> <C>
Total income taxes charged to income............... $ 80,945 $67,194
------------- -------------
Income taxes charged to stockholder's equity:
Unrealized gain on bonds......................... 10,947 28,043
Exercise of stock options........................ (10,868) (3,995)
------------- -------------
Total charged to stockholder's equity......... 79 24,048
------------- -------------
Total effect of income taxes....................... $ 81,024 $91,242
============= =============
</TABLE>
9
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(Dollar Amounts in Thousands)
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>
1998 % 1997 % 1996 %
-------------- ------------- -------------- ------------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C>
Computed expected tax at
statutory rate........... $124,004 35.0% $104,755 35.0% $112,300 35.0%
Increases (reductions) in
expected tax resulting from:
Tax-exempt interest....... (38,821) (10.9) (35,458) (11.8) (30,655) (9.6)
Other, net................ (4,238) (1.2) (2,103) (0.7) (2,025) (0.6)
-------------- ------------- -------------- ------------- ------------- -------------
Income tax expense........ $ 80,945 22.9% $ 67,194 22.5% $ 79,620 24.8%
============== ============= ============== ============= ============= =============
</TABLE>
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:
<TABLE>
<CAPTION>
1998 1997
------------- --------------
<S> <C> <C>
Deferred tax liabilities:
Contingency reserve................................ $119,150 $111,160
Unrealized gains on bonds.......................... 74,465 63,518
Deferred acquisition costs......................... 42,583 38,030
Unearned premiums.................................. 36,572 35,591
Other.............................................. 1,248 2,225
------------- --------------
Total deferred tax liabilities..................... 274,018 250,524
------------- --------------
Deferred tax assets:
Tax and loss bonds................................. 88,471 87,951
Loss reserves...................................... 27,918 17,231
Alternative minimum tax credit carryforward........ 1,838 10,049
Amortization and depreciation...................... 2,778 6,556
Compensation....................................... 4,066 3,924
Other.............................................. 4,382 2,259
------------- --------------
Sub-total deferred tax assets...................... 129,453 127,970
Valuation allowance................................ -- --
------------- --------------
Total deferred tax assets.......................... 129,453 127,970
------------- --------------
Net deferred tax liabilities....................... $144,565 $122,554
============= ==============
</TABLE>
The Company believes that no valuation allowance is necessary in connection
with the deferred tax assets.
10
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(Dollar Amounts in Thousands)
8 EMPLOYEE BENEFITS
Pensions:
AFGI 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. AFGI'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 AFGI's beginning and ending
projected benefit obligation, beginning and ending balances of the fair value of
plan assets, and the funded status of AFGI's plan as of December 31, 1998 and
1997:
<TABLE>
<CAPTION>
1998 1997
---------------- --------------------
<S> <C> <C>
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 0
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........................................ 0 138
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)
================ ====================
</TABLE>
AFGI's net pension costs for the years ended December 31, 1998, 1997 and
1996 included the following components:
<TABLE>
<CAPTION>
1998 1997 1996
---------------- ------------------- --------------
<S> <C> <C> <C>
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
=================== =================== ==============
</TABLE>
11
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(Dollar Amounts in Thousands)
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 AFGI 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 made by eligible employees to the plan. The total cost of the
Savings Incentive Plan to Ambac Assurance was $1,299, $1,417 and $1,494 in 1998,
1997 and 1996, respectively.
Annual Incentive Program:
AFGI 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, 1998, 1997 and 1996 amounted to
$13,877, $10,392 and $8,882, 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 $275, $242 and $200 in 1998, 1997 and
1996, respectively. The unfunded accumulated postretirement benefit obligation
was $3,121 and the 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%.
9 INSURANCE IN FORCE
The par amount of bonds insured, for non-affiliates, was $227,198,000 and
$191,592,000 at December 31, 1998 and 1997, respectively. The par amount of
bonds insured, for non-affiliates, 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:
12
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(Dollar Amounts in Thousands)
<TABLE>
<CAPTION>
Net Par Amount Outstanding
----------------------------------------------
(Dollars in Millions) 1998 1997
--------------------- ---------------------
<S> <C> <C>
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
===================== =====================
</TABLE>
As of December 31, 1998 and 1997, the international insured portfolio is
shown in the following table by location of risk:
<TABLE>
<CAPTION>
Net Par Amount Outstanding
----------------------------------------------------
(Dollars in Millions) 1998 1997
----------------------- -----------------------
<S> <C> <C>
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
----------------------- -----------------------
$8,485 $5,550
======================= =======================
</TABLE>
(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
13
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(Dollar Amounts in Thousands)
percent. The highest single insured risk represented less than 1% of aggregate
net par amount insured. 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.
10 FINANCIAL INSTRUMENTS HELD FOR PURPOSES OTHER THAN TRADING
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.
Securities purchased under agreements to resell: The fair value of
securities purchased under agreements to resell is assumed to approximate
carrying value.
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 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.
14
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(Dollar Amounts in Thousands)
The carrying amount and estimated fair value of financial instruments are
presented below:
<TABLE>
<CAPTION>
As of December 31,
---------------------------------------------------------------------------------
1998 1997
--------------------------------------- --------------------------------------
(Dollars in Millions) Carrying Estimated Fair Carrying Amount Estimated Fair
Amount Value Value
----------------- ----------------- ----------------- -----------------
<S> <C> <C> <C> <C>
Financial assets:
Investments........................... $3,310 $3,310 $2,878 $2,878
Short-term investments................ 94 94 117 117
Cash.................................. 5 5 8 8
Securities purchased under agreements
to resell............................ 5 5 2 2
Liability for financial guarantees
written:
Gross............................... 1,303 912 1,185 855
Net of reinsurance.................. 1,103 772 1,002 722
Net installment premiums............ -- 216 -- 153
</TABLE>
11 FINANCIAL INSTRUMENTS HELD FOR TRADING PURPOSES
The Company, through its affiliate 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.
The following table summarizes information about the Company's financial
instruments held for trading purposes as of December 31, 1998 and 1997:
<TABLE>
<CAPTION>
Net Estimated Fair Value Average Net Fair Value
---------------------------------- ------------------------------------
Notional
Assets Liabilities Assets Liabilities Amount
-------------- --------------- --------------- ---------------- -----------------
<S> <C> <C> <C> <C> <C>
1998:
Derivative financial
instruments:
Interest rate swaps.......... $203,021 $163,140 $134,394 $103,739 $5,857,170
Futures contracts............ -- -- -- -- 706,700
Other financial instruments... -- -- 183,682 181,698 --
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 --
</TABLE>
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 $825, $8,560 and
$10,799 for 1998, 1997 and 1996, respectively. Other financial instruments held
for
15
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(Dollar Amounts in Thousands)
trading purposes consist 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 for 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.
12 LINES OF CREDIT
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
international banks, structured to be comparable to a credit facility from
AAA/Aaa-rated 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, such 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 credit facility.
13 RELATED PARTY TRANSACTIONS
During 1998 and 1997, 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, 1998 and
1997, the aggregate amount of investment agreements and investment repurchase
agreements insured was $5,331,820 and $3,856,786, 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, 1998 and 1997, had a
fair value of $5,387,493 and $3,936,718, respectively, in the aggregate. During
1998 and 1997, Ambac Assurance recorded gross premiums written of $5,598 and
$3,220, and net premiums earned of $2,156 and $1,668, respectively, related to
these agreements.
During 1998 and 1997, several interest rate swap transactions were executed
between AFSLP and its affiliates (other than Ambac Assurance). As of December
31, 1998 and 1997, these contracts had an outstanding notional amount of
approximately $499,720 and $826,970, respectively. As of December 31, 1998 and
1997, AFSLP recorded a positive fair value of $4,571 and $5,579, respectively,
related to these transactions.
AFSLP has a $25 million line of credit with AFGI. The line is available
through August 1, 1999. The purpose of this line is to fund short-term
liquidity needs of AFSLP's operations. Interest on borrowings is payable at
rates which vary according to the terms. Outstanding borrowings under the line
were $15,630 and $5,347 as of December 31, 1998 and 1997, respectively.
14 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
16
<PAGE>
AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(Dollar Amounts in Thousands)
("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.
In connection with this initiative, the Company embarked on a three phase
process. Phase I is an inventory analysis and impact assessment. Inventory
included: (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. All three of the above
phases are complete with aggregate expenditures of approximately $750.
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 the Company's 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.
With respect to the Company's internal operations, although 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 although the Company does not expect significant
disruptions among vendors, EDI partners, issuers and financial institutions, the
Company is currently developing appropriate contingency plans.
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