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) December 16, 1996
RESIDENTIAL FUNDING MORTGAGE SECURITIES II, INC. (as depositor under an
Amended
and Restated Trust Agreement, dated as of December 1, 1996, and pursuant to
which an Indenture was entered into, providing for, inter alia, the issuance of
Home Equity Loan-Backed Term Notes, Series 1996-RHS4)
Residential Funding Mortgage Securities II, Inc.
(Exact name of registrant as specified in its charter)
DELAWARE 33-80419 41-1808858
(State or Other Jurisdiction (Commission (I.R.S. Employer
of Incorporation) File Number) Identification No.)
8400 Normandale Lake Blvd.
Suite 600
Minneapolis, Minnesota 55437
(Address of Principal (Zip Code)
Executive Offices)
Registrant's telephone number, including area code, is (612) 832-7000
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Item 7. Financial Statements, Pro Forma Financial Information and Exhibits.
(a) Not applicable
(b) Not applicable
(c) Exhibits:
Item 601(a) of
Regulation S-K
Exhibit No. Exhibit No. Description
1 23.5 Accountants' Consent
2 99 Financial Statements of
AMBAC Indemnity Corporation
("AMBAC")
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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.
RESIDENTIAL FUNDING MORTGAGE
SECURITIES II, INC.
By: /s/Diane S. Wold
Name: Diane S. Wold
Title: Vice President
Dated: December 16, 1996
[NY01:245524.1] 16069-00382 12/16/96 2:58pm
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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.
RESIDENTIAL FUNDING MORTGAGE
SECURITIES II, INC.
By: /s/Diane S. Wold
Name: Diane S. Wold
Title: Vice President
Dated: December 16, 1996
[NY01:245524.1] 16069-00382 12/16/96 2:58pm
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EXHIBIT INDEX
Exhibit No. Description Page
1 Consent of KPMG Peat Marwick L.L.P. 5
2 Financial Statements of AMBAC 7
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EXHIBIT 1
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INDEPENDENT AUDITORS' CONSENT
The Board of Directors
AMBAC Indemnity Corporation:
We consent to the use of our report dated January 31, 1996 on the
consolidated financial statements of AMBAC Indemnity Corporation as of December
31, 1995 and 1994, and for each of the years in the three year period ended
December 31, 1995 included in the Form 8-K of Residential Funding Mortgage
Securities II, Inc., dated December 16, 1996, and to the reference to our firm
under the heading "Experts" in the Prospectus Supplement of Residential Funding
Mortgage Securities II, Inc. dated December 16, 1996.
Our report refers to accounting changes adopted by AMBAC Indemnity
Corporation in 1993, which include the Financial Accounting Standards Board's
Statements of Financial Accounting Standards No. 109, "Accounting for Income
Taxes," No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," No. 106, "Employers' Accounting for Postretirement Benefits Other
Than Pensions," and No. 112, "Employers' Accounting for Postemployment
Benefits."
KPMG PEAT MARWICK LLP
New York, New York
December 16, 1996
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EXHIBIT 2
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AMBAC INDEMNITY CORPORATION AND SUBSIDIARIES (a wholly owned
subsidiary of AMBAC Inc.)
Consolidated Financial Statements
December 31, 1995 and 1994
(With Independent Auditors' Report Thereon)
Independent Auditors' Report
The Board of Directors
AMBAC Indemnity Corporation:
We have audited the accompanying consolidated balance sheets of AMBAC
Indemnity Corporation and subsidiaries (a wholly owned subsidiary of AMBAC Inc.)
as of December 31, 1995 and 1994, 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, 1995. These consolidated financial
statements are the responsibility of AMBAC Indemnity 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
Indemnity Corporation and subsidiaries as of December 31, 1995 and 1994, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 1995 in conformity with generally accepted
accounting principles.
As discussed in Note 2 to the consolidated financial statements, AMBAC
Indemnity Corporation has adopted the provisions of the Financial Accounting
Standards Board's Statements of Financial Accounting Standards No. 109,
"Accounting for Income Taxes," No. 115, "Accounting for Certain Investments in
Debt and Equity Securities," No. 106, "Employers' Accounting for Postretirement
Benefits Other Than Pensions" and No. 112, "Employers' Accounting for
Postemployment Benefits," in 1993.
KPMG Peat Marwick LLP
New York, New York
January 31, 1996
<PAGE>
AMBAC Indemnity Corporation and Subsidiaries
Consolidated Balance Sheets
(Dollars In Thousands Except Share Data)
December 31,
-------------------------
1995 1994
---------- ----------
Assets
Investments:
Bonds held in available-for-sale account, at fair value
(amortized cost of $2,090,101 in 1995 and $1,865,350
in 1994)............................................ $2,224,528 $1,795,958
Short-term investments, at cost (approximates fair
value).............................................. 163,953 85,202
---------- ----------
Total investments................................... 2,388,481 1,881,160
Cash..................................................... 6,912 2,117
Securities purchased under agreements to resell.......... 4,120 8,011
Receivable for securities................................ 8,136 21,508
Investment income due and accrued........................ 38,319 34,902
Investment in affiliate.................................. 25,827 24,976
Deferred acquisition costs............................... 82,620 71,774
Deferred income taxes.................................... -- 1,778
Current income taxes..................................... 2,171 10,544
Prepaid reinsurance...................................... 153,372 139,855
Other assets............................................. 48,472 41,677
---------- ----------
Total assets........................................ $2,758,430 $2,238,302
========== ==========
Liabilities and Stockholder's Equity
Liabilities:
Unearned premiums...................................... $ 906,136 $ 839,775
Losses and loss adjustment expenses.................... 65,996 65,662
Ceded reinsurance balances payable..................... 14,654 908
Deferred income taxes.................................. 85,008 --
Accounts payable and other liabilities................. 43,625 43,519
Payable for securities................................. 86,304 26,696
---------- ----------
Total liabilities................................... 1,201,723 976,560
---------- ----------
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, 1995 and 1994.. 82,000 82,000
Additional paid-in capital............................. 481,059 444,258
Unrealized gains (losses) on investments, net of tax... 87,112 (46,087)
Retained earnings...................................... 906,536 781,571
---------- ----------
Total stockholder's equity.......................... 1,556,707 1,261,742
---------- ----------
Total liabilities and stockholder's equity..........$2,758,430 $2,238,302
========== ==========
See accompanying Notes to Consolidated Financial Statements.
1
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AMBAC Indemnity Corporation and Subsidiaries
Consolidated Statements of Operations
(Dollars In Thousands)
Years Ended December 31,
----------------------------------
1995 1994 1993
-------- -------- --------
Revenues:
Gross premiums written................. $195,033 $192,598 $321,490
Ceded premiums written................. (28,606) 2,815 (35,810)
-------- -------- --------
Net premiums written................ 166,427 195,413 285,680
Increase in unearned premiums, net..... (52,844) (76,077) (132,862)
-------- -------- --------
Net premiums earned................. 113,583 119,336 152,818
Net investment income.................. 131,496 119,737 104,609
Net realized gains (losses)............ 177 (13,386) 30,145
Other income........................... 6,777 6,887 1,516
-------- -------- --------
Total revenues...................... 252,033 232,574 289,088
-------- -------- --------
Expenses:
Losses and loss adjustment expenses.... 3,377 2,593 (1,849)
Underwriting and operating expenses.... 38,722 35,946 34,746
Interest expense....................... 1,590 1,428 163
-------- -------- --------
Total expenses...................... 43,689 39,967 33,060
-------- -------- --------
Income before income taxes.......... 208,344 192,607 256,028
-------- -------- --------
Income tax expense:
Current taxes.......................... 29,085 26,286 66,386
Deferred taxes......................... 14,461 16,277 4,090
-------- -------- --------
Total income taxes.................. 43,546 42,563 70,476
-------- -------- --------
Income before cumulative effect of
changes in accounting principles..... 164,798 150,044 185,552
Cumulative effect of changes in
accounting principles............... -- -- (98)
-------- -------- --------
Net income.......................... $164,798 $150,044 $185,454
========= ========= =========
See accompanying Notes to Consolidated Financial Statements.
2
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AMBAC Indemnity Corporation and Subsidiaries
Consolidated Statements of Stockholder's Equity
(Dollars In Thousands)
Years Ended December 31,
---------------------------------
1995 1994 1993
--------- --------- --------
Preferred Stock:
Balance at January 1 and December 31........$ -- $ -- $ --
========== ========== =========
Common Stock:
Balance at January 1 and December 31........$ 82,000 $ 82,000 $ 82,000
========== ========== =========
Additional Paid-in Capital:
Balance at January 1........................$ 444,258 $ 444,143 $397,570
Capital contributions....................... 35,000 -- 40,000
Cumulative effect of changes in
accounting principles..................... -- -- 4,708
Other paid-in capital....................... 1,801 115 1,865
--------- --------- --------
Balance at December 31......................$ 481,059 $ 444,258 $444,143
========== ========== =========
Unrealized Gains (Losses) on Investments,
Net of Tax:
Balance at January 1........................$ (46,087) $ 68,091 $ 5,285
Unrealized gain from change in accounting
principle................................ -- -- 63,568
Change in unrealized gain (loss)............ 133,199 (114,178) (762)
--------- --------- --------
Balance at December 31......................$ 87,112 ($ 46,087) $ 68,091
========== ========== =========
Retained Earnings:
Balance at January 1........................$ 781,571 $ 667,527 $515,073
Net income.................................. 164,798 150,044 185,454
Dividends declared-common stock............. (40,000) (36,000) (33,000)
Other....................................... 167 -- --
--------- --------- --------
Balance at December 31......................$ 906,536 $ 781,571 $667,527
========== ========== =========
See accompanying Notes to Consolidated Financial Statements.
3
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AMBAC Indemnity Corporation and Subsidiaries
Consolidated Statements of Cash Flows
(Dollars In Thousands)
Years Ended December 31,
-------------------------------------------
1995 1994 1993
----------- ----------- -----------
Cash flows from operating activities:
Net income.............................$ 164,798 $ 150,044 $ 185,454
Adjustments to reconcile net income to
net cash provided by operating
activities:
Depreciation and amortization.......... 1,605 1,106 1,080
Amortization of bond premium and
discount............................ (831) (1,097) (507)
Current income taxes payable........... 8,373 (6,069) (20,844)
Deferred income taxes payable.......... 14,462 16,277 (2,463)
Deferred acquisition costs............. (10,846) (20,757) (7,059)
Unearned premiums...................... 52,844 76,077 132,862
Losses and loss adjustment expenses.... 334 1,625 (718)
Ceded reinsurance balances payable..... 13,746 (2,963) (5,147)
(Gain) loss on sales of investments.... (177) 13,386 (30,145)
Proceeds from sales of bonds in trading
account............................. -- -- 2,091,143
Proceeds from maturities of bonds in
trading account..................... -- -- 34,409
Purchases of bonds for trading account. -- -- (2,181,198)
Accounts payable and other liabilities. 106 20,497 9,591
Other, net............................. (11,273) 7,179 (1,622)
----------- ----------- -----------
Net cash provided by operating
activities....................... 233,141 255,305 204,836
----------- ----------- -----------
Cash flows from investing activities:
Proceeds from sales of bonds at
amortized cost...................... 1,882,485 1,305,011 18,912
Proceeds from maturities of bonds at
amortized cost...................... 163,031 39,126 60,131
Purchases of bonds at amortized cost... (2,192,824) (1,559,982) (258,832)
Investment in preferred stock of
affiliate........................... -- -- (3,000)
Change in short-term investments....... (78,751) 9,005 (25,252)
Securities purchased under agreements
to resell............................. 3,891 (8,011) --
Other, net............................. (1,178) (3,786) (2,370)
----------- ----------- -----------
Net cash used in investing
activities....................... (223,346) (218,637) (210,411)
----------- ----------- -----------
Cash flows from financing activities:
Dividends paid......................... (40,000) (36,000) (33,000)
Capital contribution................... 35,000 -- 40,000
----------- ----------- -----------
Net cash (used in) provided by
financing activities............. (5,000) (36,000) 7,000
----------- ----------- -----------
Net cash flow....................... 4,795 668 1,425
Cash at beginning of year................ 2,117 1,449 24
----------- ----------- -----------
Cash at December 31......................$ 6,912 $ 2,117 $ 1,449
=========== =========== ===========
Supplemental disclosure of cash flow information: Cash paid during the year for:
Income taxes................. $ 19,500 $ 32,153 $ 86,781
=========== =========== ===========
See accompanying Notes to Consolidated Financial Statements.
4
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AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Dollar Amounts in Thousands)
1 BACKGROUND
AMBAC Indemnity Corporation ("AMBAC Indemnity") is a leading insurer of
municipal and structured finance obligations. Financial guarantee insurance
underwritten by AMBAC Indemnity 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 Indemnity's consent. As of December 31, 1995, AMBAC
Indemnity's net insurance in force (principal and interest) was $199,078,000.
AMBAC Indemnity is a wholly owned subsidiary of AMBAC Inc. (NYSE: ABK), a
holding company that provides financial guarantee insurance and financial
services to both public and private clients through its subsidiaries.
As of December 31, 1995, AMBAC Indemnity owned approximately 26.5% of the
outstanding common stock of an affiliate, HCIA Inc. (NASDAQ: HCIA) ("HCIA"), a
leading health care information content company. AMBAC Inc. owns approximately
19.9% of the outstanding common stock of HCIA. Prior to 1995, AMBAC Inc. and
AMBAC Indemnity combined owned approximately 96% of HCIA. During 1995, HCIA
offered approximately 3.5 million shares of its common stock for sale in two
separate public offerings. In addition, in conjunction with the second public
offering by HCIA, AMBAC Inc. sold approximately 1.1 million shares of HCIA
common stock. As a result of these public offerings, as of December 31, 1995,
AMBAC Indemnity and AMBAC Inc. combined owned 46.4% of the common stock of HCIA.
AMBAC Indemnity, as the sole limited partner, owns a limited partnership
interest representing 90% of the total partnership interests of AMBAC Financial
Services, Limited Partnership ("AFS"), a limited partnership which provides
interest rate swaps primarily to states, municipalities and municipal
authorities. The sole general partner of AFS, AMBAC Financial Services Holdings,
Inc., a wholly owned subsidiary of AMBAC Inc., owns a general partnership
interest representing 10% of the total partnership interest in AFS.
AMBAC Indemnity has one wholly owned subsidiary, American Municipal Bond
Holding Company ("AMBH"), which is a holding company for certain real estate
interests.
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 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 Indemnity and its subsidiaries are as
described below:
CONSOLIDATION:
The consolidated financial statements include the accounts of AMBAC
Indemnity, AFS and AMBH (sometimes collectively referred to as "AMBAC
Indemnity"). All significant intercompany balances have been eliminated.
5
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AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements -- (Continued)
(Dollar Amounts in Thousands)
INVESTMENTS:
AMBAC Indemnity's investment portfolio is accounted for on a trade-date
basis and consists entirely of investments in debt securities which are
considered available-for-sale and are carried at fair value. Fair value is based
on quotes obtained by AMBAC Indemnity from independent market sources.
Short-term investments are carried at cost, which approximates their 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 term of the securities. Premiums and discounts on
mortgage-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.
Effective December 31, 1993, AMBAC Indemnity adopted Statement of Financial
Accounting Standards No. 115, "Accounting for Certain Investments in Debt and
Equity Securities" ("Statement 115"). Pursuant to Statement 115, AMBAC Indemnity
has designated all investments as "available-for-sale" and reports them at fair
value. Unrealized gains and losses are excluded from earnings and reported as a
separate component of stockholder's equity, net of tax. The cumulative effect of
adopting Statement 115 as of December 31, 1993 was to increase AMBAC Indemnity's
stockholder's equity by $63,568, net of tax. The adoption of Statement 115 had
no effect on earnings.
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. AMBAC Indemnity 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.
When an AMBAC Indemnity-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 Indemnity is considered to have been eliminated.
6
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AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements -- (Continued)
(Dollar Amounts 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 reserves. The development of
the ACR is based upon estimates of the ultimate aggregate losses inherent in the
obligations insured and reflects the net result of contributions related to the
portion of earnings required to cover those losses, less reductions of ACR no
longer deemed necessary by management. 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 Indemnity'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 $10,183, $9,348
and $12,120 for 1995, 1994 and 1993, respectively. Deferred acquisition costs,
net of such amortization, amounted to $10,845, $20,757 and $7,059 for 1995, 1994
and 1993, 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
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 using the straight-line method.
INTEREST RATE CONTRACTS:
Interest Rate Contracts Held for Purposes Other Than Trading:
AMBAC Indemnity uses interest rate contracts for hedging purposes as part
of its overall interest rate risk management. Gains and losses on interest rate
futures and options contracts that qualify as accounting hedges of existing
assets or liabilities are included in the carrying amounts and amortized over
the remaining lives of the assets and liabilities as an adjustment to interest
income. When the hedged asset is sold, the unamortized gain or loss on the
related hedge is recognized in income. Gains and losses on interest rate
contracts that do not qualify as accounting hedges are recognized in current
period income.
AMBAC Indemnity accounts for its interest rate futures contracts in
accordance with the provisions of Statement of Financial Accounting Standards
No. 80, "Accounting For Futures Contracts" ("Statement 80"). Statement 80
permits hedge accounting for interest rate futures contracts when the item to be
hedged exposes the Company to price or interest rate risk, and the futures
contract effectively reduces that exposure and is designated as a hedge.
Interest rate futures contracts held for purposes other than trading are used
primarily to hedge interest sensitive assets, and are designated at inception as
a hedge to specific assets.
7
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AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements -- (Continued)
(Dollar Amounts in Thousands)
Interest rate swaps that are linked with existing liabilities are accounted
for like a hedge of those liabilities, using the accrual method as an adjustment
to interest expense. Interest rate swaps that are linked with existing assets
classified as available-for-sale are accounted for like hedges of those assets,
using the accrual method as an adjustment to interest income, with unrealized
gains and losses included in stockholder's equity, net of tax.
Interest Rate Contracts Held for Trading Purposes:
AMBAC Indemnity, in connection with its market making activities as a
provider of interest rate swaps, primarily to states, municipalities, municipal
authorities and other entities in connection with their financings, uses
interest rate contracts which are classified as held for trading purposes.
Interest rate 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 that reflects credit
considerations, on-going 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:
AMBAC Inc., as common parent, files a consolidated Federal income tax
return with its subsidiaries. Effective January 1, 1993, AMBAC Indemnity adopted
Statement of Financial Accounting Standards No. 109, "Accounting for Income
Taxes" ("Statement 109"). Under Statement 109, 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 cumulative effect of this change in accounting for income taxes
resulted in an increase to net income for 1993 of $1,162 and an increase to
additional paid-in capital of $4,708. The adjustment to additional paid-in
capital reflects Statement 109 adjustments for prior business combinations.
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 at their par value prior to the original due date of
AMBAC Inc.'s consolidated Federal tax return and held in an amount equal to the
tax benefit attributable to such deductions. The amounts deducted must be
included in taxable income when the contingency reserve is released, at which
time AMBAC Indemnity may redeem the tax and loss bonds to satisfy the additional
tax liability. The purchases of tax and loss bonds are recorded as payments of
Federal income taxes and are not reflected in AMBAC Indemnity's current tax
provision.
POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS:
AMBAC 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. AMBAC Indemnity 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.
8
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AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements -- (Continued)
(Dollar Amounts in Thousands)
Effective January 1, 1993, AMBAC Indemnity adopted Statement of Financial
Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits
Other Than Pensions" ("Statement 106"). Statement 106 requires that the expected
cost of postretirement benefits, other than pensions, be charged to expense
during the period that the employee renders service. AMBAC Indemnity elected to
recognize the transition obligation immediately and recorded a charge of $465,
after reduction of $240 for income tax benefits, as a cumulative effect of a
change in accounting principle as of the date of adoption.
Effective January 1, 1993, AMBAC Indemnity adopted Statement of Financial
Accounting Standards No. 112, "Employers' Accounting for Postemployment
Benefits" ("Statement 112"), which, similar to Statement 106, requires accrual
of a liability representing the cost of certain benefits earned by employees
over their employment period. Statement 112 applies to vested benefits provided
to former or inactive employees, their beneficiaries and covered dependents,
after employment but before retirement. In adopting Statement 112, AMBAC
Indemnity recorded a charge of $801, after reduction for income tax benefits of
$429, as a cumulative effect of a change in accounting principle as of the date
of adoption.
STOCK COMPENSATION PLANS:
In 1991, AMBAC Inc. adopted the AMBAC Inc. 1991 Stock Incentive Plan. Under
this plan awards are granted to eligible employees of AMBAC Indemnity in the
form of incentive stock options or other stock-based awards. In October 1995,
the Financial Accounting Standards Board issued Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation"
("Statement 123") which must be adopted no later than 1996. Statement 123
applies to all stock-based employee compensation plans (except employee stock
ownership plans) in which an employer grants shares of its stock or other equity
instruments to employees. Statement 123 permits a company to choose either the
fair value based method of accounting as defined in the statement or the
intrinsic value based method of accounting as prescribed by APB Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25") for its stock-based
compensation plans. Companies electing the accounting requirements under APB 25
must also make pro forma disclosures of net income and earnings per share as if
the fair value based method of accounting had been applied. AMBAC Indemnity
currently accounts for its plans under APB 25 and intends to continue to do so
after adopting Statement 123 in 1996. The adoption of Statement 123 is expected
to have no effect on AMBAC Indemnity's results of operations.
RECLASSIFICATIONS:
Certain reclassifications have been made to prior years' amounts to conform
to the current year's presentation.
9
<PAGE>
AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements -- (Continued)
(Dollar Amounts in Thousands)
3 INVESTMENTS
The amortized cost and estimated fair value of investments in debt
securities at December 31, 1995 and 1994 were as follows:
Gross Gross
Amortized Unrealized Unrealized Estimated
Cost Gains Losses Fair Value
-------------------- ---------- ----------
1995
Municipal obligations.................$1,558,754 $ 98,090 $ 2,428 $1,654,416
Corporate securities.................. 261,492 30,785 3,263 289,014
U.S. Government obligations........... 214,224 8,796 621 222,399
Mortgage-backed securities (including
GNMA)............................... 55,631 3,362 294 58,699
Other................................. 163,953 -- -- 163,953
-------------------- ---------- ----------
$2,254,054 $ 141,033 $ 6,606 $2,388,481
========= ======== ======== =========
Gross Gross
Amortized Unrealized Unrealized Estimated
Cost Gains Losses Fair Value
-------------------- ---------- ----------
1994
Municipal obligations.................$1,505,501 $ 23,009 $ 80,935 $1,447,575
Corporate securities.................. 228,992 2,336 11,501 219,827
U.S. Government obligations........... 61,906 311 1,797 60,420
Mortgage-backed securities (including
GNMA)............................... 70,251 1,325 2,140 69,436
Other................................. 83,902 -- -- 83,902
-------------------- ---------- ----------
$1,950,552 $ 26,981 $ 96,373 $1,881,160
========= ======== ======== =========
The amortized cost and estimated fair value of debt securities at December
31, 1995, by contractual maturity, were as follows:
Amortized Estimated
Cost Fair Value
---------- ----------
1995
Due in one year or less................. $ 223,069 $ 223,949
Due after one year through five years... 168,417 181,772
Due after five years through ten years.. 302,601 315,385
Due after ten years..................... 1,504,336 1,608,676
---------- ----------
2,198,423 2,329,782
Mortgage-backed securities.............. 55,631 58,699
---------- ----------
$2,254,054 $2,388,481
========= =========
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.
10
<PAGE>
AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements -- (Continued)
(Dollar Amounts in Thousands)
Net investment income comprised the following:
1995 1994 1993
-------- -------- --------
Bonds.........................$127,865 $118,685 $102,020
Short-term investments........ 6,116 3,512 4,278
-------- -------- --------
Total investment income..... 133,981 122,197 106,298
Investment expense............ (2,485) (2,460) (1,689)
-------- -------- --------
Net investment income.......$131,496 $119,737 $104,609
======== ======== ========
Gross realized gains were $27,786, $26,514 and $42,217 for 1995, 1994 and
1993, respectively, and gross realized losses were $27,609, $39,900 and $12,072
for 1995, 1994 and 1993, respectively.
As of December 31, 1995, AMBAC Indemnity did not have any investment
concentrated in any single repayment source (excluding obligations of the U.S.
Government and its agencies) with a fair value greater than 2.0% of its
stockholder's equity.
As of December 31, 1995 and 1994, AMBAC Indemnity held securities subject
to agreements to resell for $4,120 and $8,011, respectively. Such securities
were held as collateral by AMBAC Indemnity. The agreements had terms of less
than 30 days.
As of December 31, 1995 and 1994, investment securities with a fair value
of $4,583 and $3,948, respectively, were pledged to futures brokers for required
margin.
4 REINSURANCE
In the ordinary course of business, AMBAC Indemnity 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:
Year Ended December 31,
-----------------------------------------------------------------
1995 1994 1993
----------------- --------------------- ---------------------
Written Earned Written Earned Written Earned
-------- -------- -------- -------- -------- --------
Direct........$192,277 $127,322 $188,057 $136,632 $321,179 $181,320
Assumed....... 2,756 1,349 4,541 1,325 311 311
Ceded......... (28,606) (15,088) 2,815 (18,621) (35,810) (28,813)
-------- -------- -------- -------- -------- --------
Net premiums..$166,427 $113,583 $195,413 $119,336 $285,680 $152,818
======== ======== ======== ======== ======== ========
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 Indemnity under the existing
reinsurance agreements, AMBAC Indemnity would be liable for such defaulted
amounts. To minimize its exposure to significant losses from reinsurer
insolvencies, AMBAC Indemnity evaluates the financial condition of its
reinsurers and monitors concentrations of credit risk. There were no reinsurance
receivables as of December 31, 1995 and 1994. As of December 31, 1995, prepaid
reinsurance of approximately $48,120 was associated with a single reinsurer. As
of December 31, 1995, AMBAC Indemnity held letters of credit and collateral
amounting to approximately $90,643 from its reinsurers to cover liabilities
ceded under the aforementioned reinsurance contracts.
AMBAC Indemnity terminated reinsurance contracts, resulting in return
premiums to AMBAC Indemnity of $18,141, $30,482 and $36,461 of which $15,700,
$25,891 and $31,010 were recorded as an
11
<PAGE>
AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements -- (Continued)
(Dollar Amounts in Thousands)
increase to the unearned premium reserve in 1995, 1994 and 1993, respectively,
with the remainder recognized as revenue.
5 LOSSES AND LOSS ADJUSTMENT EXPENSES
AMBAC Indemnity's liability for losses and loss adjustment expenses
includes case basis loss reserves and the ACR. Following is a summary of the
activity in the case basis loss and active credit reserve accounts and the
components of the liability for losses and loss adjustment expenses:
1995 1994 1993
------- ------- --------
Case basis loss reserves:
Balance at January 1.................. $38,892 $35,155 $ 28,321
------- ------- --------
Incurred related to:
Current year........................ 750 8,073 6,630
Prior years......................... 2,650 (3,368) (926)
------- ------- --------
Total incurred................... 3,400 4,705 5,704
------- ------- --------
Paid related to:
Current year........................ 150 275 315
Prior years......................... 2,893 693 (1,445)
------- ------- --------
Total paid....................... 3,043 968 (1,130)
------- ------- --------
Balance at December 31................ 39,249 38,892 35,155
------- ------- --------
Active credit reserve:
Balance at January 1.................. 26,770 28,882 36,434
Net provision for losses.............. 4,097 4,422 6,709
ACR transfers to case reserves........ (4,120) (6,534) (14,261)
------- ------- --------
Balance at December 31................ 26,747 26,770 28,882
------- ------- --------
Total............................ $65,996 $65,662 $ 64,037
======= ======= =========
The terms "current year" and "prior years" in the foregoing table refer to
the year in which case basis loss reserves were established.
12
<PAGE>
AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements -- (Continued)
(Dollar Amounts in Thousands)
6 COMMITMENTS AND CONTINGENCIES
AMBAC Indemnity is responsible for leases on the rental of office space,
principally in New York City. The lease agreements which expire periodically
through September 2014, 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:
Year Amount
- --------------- --------
1996........................................................... $ 3,042
1997........................................................... 3,073
1998........................................................... 3,359
1999........................................................... 3,650
2000........................................................... 3,650
All later years................................................ 53,880
-------
$70,654
=======
Rent expense for the aforementioned leases amounted to $2,924, $2,719 and
$2,778 for the years ended December 31, 1995, 1994 and 1993, respectively.
7 INSURANCE REGULATORY RESTRICTIONS
AMBAC Indemnity is subject to insurance regulatory requirements of the
States of Wisconsin, New York and the other jurisdictions in which it is
licensed to conduct business.
AMBAC Indemnity'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 Indemnity paid dividends of $40,000,
$36,000 and $33,000 on its common stock in 1995, 1994 and 1993, respectively.
Based upon these restrictions, at December 31, 1995, the maximum amount that
will be available during 1996 for payment of dividends by AMBAC Indemnity
without prior approval is approximately $86,000.
However, as discussed in Note 15, AMBAC Indemnity, upon consummation of the
proposed PRIDES offering will deliver to AMBAC Inc. (in the form of an
extraordinary dividend) its 2,378,672 shares of HCIA common stock, at fair
value. The Wisconsin Commissioner has approved such dividend. The fair value of
such dividend will be determined based on the price per share of HCIA common
stock used to price the PRIDES. As a result, any dividends paid by AMBAC
Indemnity to AMBAC Inc. for the twelve months following the extraordinary
dividend will require pre-approval from the Wisconsin Commissioner. The
Wisconsin Commissioner has stated to AMBAC Indemnity management that it does not
foresee any reason such pre-approval would not be given.
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
13
<PAGE>
AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements -- (Continued)
(Dollar Amounts in Thousands)
municipal bonds, the insured average annual debt service for a single risk, net
of reinsurance and collateral, may not exceed 10% of the sum of the 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 the insurer's policyholders' surplus and
contingency reserves. 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 $862,976 and $781,772 at December 31,
1995 and 1994, respectively. Qualified statutory capital (statutory surplus plus
contingency reserve) was $1,358,769 and $1,218,204 at December 31, 1995 and
1994, respectively. Statutory net income was $142,541, $116,238 and $166,157 for
1995, 1994 and 1993, 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.
8 INCOME TAXES
The total effect of income taxes on income and stockholder's equity for the
years ended December 31, 1995 and 1994 was as follows:
1995 1994
-------- --------
Total income taxes charged to income.................. $ 43,546 $ 42,563
-------- --------
Income taxes charged (credited) to stockholder's equity:
Unrealized gain (loss) on bonds..................... 71,722 (61,480)
Unrealized gain on investment in affiliate.......... 602 --
Other............................................... (682) (116)
-------- --------
Total charged (credited) to stockholder's
equity................................... 71,642 (61,596)
-------- --------
Total effect of income taxes.......................... $115,188 $(19,033)
======== ========
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:
1995 % 1994 % 1993 %
----- ----- -------- ---- -------- ----
Computed expected tax at
statutory rate....... $ 72,920 35.0% $ 67,412 35.0% $ 89,610 35.0%
Increases (reductions) in expected tax resulting from:
Tax-exempt interest.... (28,274) (13.6) (26,336) (13.7) (21,043) (8.2)
Adjustment to deferred tax
assets and liabilities
for enacted changes in
tax laws and rates.. -- -- -- -- 754 0.3
Other, net............. (1,100) (0.5) 1,487 0.8 1,155 0.4
------- ----- ------- ---- ------- ----
Income tax expense on income from
continuing operations. $ 43,546 20.9% $ 42,563 22.1% $ 70,476 27.5%
======= ===== ======= ==== ======= ====
14
<PAGE>
AMBAC Indemnity 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,
1995 and 1994 are presented below:
1995 1994
-------- -------
Deferred tax liabilities:
Unrealized gains on bonds............................ $ 46,906 $ --
Deferred acquisition costs........................... 28,917 25,121
Unearned premiums.................................... 22,079 14,522
Unrealized gain on investment in affiliate........... 602 --
Investments.......................................... 2,911 796
Other................................................ 1,996 1,613
------- -------
Total deferred tax liabilities.............. 103,411 42,052
------- -------
Deferred tax assets:
Unrealized loss on bonds............................. -- 24,816
Loss reserves........................................ 9,631 9,733
Insurance in force................................... 2,870 3,205
Compensation......................................... 2,418 2,812
Other................................................ 3,484 3,264
------- -------
Sub-total deferred tax assets............... 18,403 43,830
Valuation allowance.................................. -- --
------- -------
Total deferred tax assets................... 18,403 43,830
------- -------
Net deferred tax (liabilities) assets....... $(85,008) $ 1,778
======= =======
AMBAC Indemnity believes that no valuation allowance is necessary in
connection with the deferred tax assets.
9 EMPLOYEE BENEFITS
Pensions:
AMBAC Inc. has a defined benefit pension plan covering substantially all
employees of AMBAC Indemnity and AFS. The benefits are based on years of service
and the employee's compensation during the last five years of employment. AMBAC
Indemnity'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 AMBAC Inc.
as of December 31, 1995 and 1994.
15
<PAGE>
AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements -- (Continued)
(Dollar Amounts in Thousands)
Actuarial present value of the benefit obligations:
1995 1994
------- -------
Accumulated benefit obligation, including vested benefits of
$6,049 and $4,300, respectively.............................$(6,788) $(5,000)
======= =======
Projected benefit obligation for service rendered to date..... (7,800) (5,500)
Plan assets at fair value, primarily listed stocks, commingled
funds and fixed income securities........................... 7,054 4,898
------- -------
Unfunded projected benefit.................................... (746) (602)
Unrecognized prior service cost............................... (1,784) (1,950)
Unrecognized net loss......................................... 1,906 1,412
Unrecognized net transition asset............................. (12) (15)
------- -------
Pension liability -- entire plan..............................$ (636) $(1,155)
======= =======
Net pension costs for 1995, 1994 and 1993 included the following
components:
1995 1994 1993
------- ----- -----
Service cost...................................$ 541 $ 558 $ 447
Interest cost on expected benefit obligation... 456 386 297
Actual return on plan assets................... (1,333) 30 (390)
Net amortization and deferral.................. 760 (547) (149)
------- ----- -----
Net periodic pension cost......................$ 424 $ 427 $ 205
======= ===== =====
The weighted-average discount rate used in the determination of the
actuarial present value for the projected benefit obligation was 7.25% and 8.0%
for 1995 and 1994, respectively. The expected long-term rate of return on assets
was 9.25% for both 1995 and 1994. The rate of increase in future compensation
levels used in determining the actuarial present value of the projected benefit
obligation was 5.0% in both 1995 and 1994.
Substantially all employees of AMBAC Indemnity and AFS are covered by a
defined contribution plan (the "Savings Incentive Plan") for which contributions
and costs are determined as 6% of each covered 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 Indemnity was $1,435, $1,292 and $1,243 in 1995, 1994 and 1993,
respectively.
Annual Incentive Plan:
AMBAC Indemnity has an annual incentive plan which provides for awards to
key officers and employees based upon predetermined criteria. The cost of the
plan to AMBAC Indemnity for the years ended December 31, 1995, 1994 and 1993 was
$7,669, $8,531 and $6,165, respectively.
Postretirement Health Care and Other Benefits:
AMBAC Indemnity provides certain medical and life insurance benefits for
retired employees and eligible dependents. All plans are contributory. None of
the plans is currently funded.
16
<PAGE>
AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements -- (Continued)
(Dollar Amounts in Thousands)
Postretirement benefits expense was $168, $176 and $500 in 1995, 1994 and
1993, respectively. The unfunded accumulated postretirement benefit obligation
was $1,309 and the accrued postretirement liability was $1,368 as of December
31, 1995.
The assumed weighted average health care cost trend rates range from 13.5%
in 1995, decreasing ratably to 5.5% in 2001, 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, 1995 by $174 and the 1995 benefit expense by $28. The
weighted average discount rate used to measure the accumulated postretirement
benefit obligation and 1995 expense was 7.25%.
10 INSURANCE IN FORCE
The par amount of bonds insured by AMBAC Indemnity, net of reinsurance, was
$110,997,000 and $93,305,000 at December 31, 1995 and 1994, respectively. As of
December 31, 1995, AMBAC Indemnity's insured portfolio was diversified by type
of insured bond as shown in the following table:
Net Par Amount
Outstanding
--------------------
(Dollars in Millions) As of December 31 1995 1994
-------- -------
Municipal finance:
General obligation........................... $ 30,546 $26,674
Utility revenue.............................. 21,053 19,597
Tax-backed revenue........................... 18,780 16,279
Health care revenue.......................... 12,553 10,922
Transportation revenue....................... 6,293 5,397
Investor Owned Utilities..................... 4,497 3,500
Higher education............................. 3,973 3,447
Student loan................................. 3,769 2,709
Housing revenue.............................. 3,577 2,567
Other........................................ 483 403
-------- -------
Total Municipal finance................... 105,524 91,495
-------- -------
Structured finance:
Domestic..................................... 3,238 902
International................................ 2,235 908
-------- -------
Total Structured finance.................. 5,473 1,810
-------- -------
$110,997 $93,305
========= =======
As of December 31, 1995, California was the state with the highest
aggregate net par amount inforce, accounting for 14.3% of the total, and the
highest single insured risk represented 0.6% of aggregate net par amount
insured. AMBAC Indemnity's direct insurance in force (principal and interest)
was $235,118,000 and $205,810,000, at December 31, 1995 and 1994, respectively.
Net insurance in force (after giving effect to reinsurance) was $199,078,000 and
$171,678,000 as of December 31, 1995 and 1994, respectively.
17
<PAGE>
AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements -- (Continued)
(Dollar Amounts in Thousands)
11 FINANCIAL INSTRUMENTS HELD FOR PURPOSES OTHER THAN TRADING
Financial instruments with off-balance-sheet risk:
In the normal course of business, AMBAC Indemnity becomes a party to
various financial transactions to reduce its exposure to fluctuations in
interest rates. These financial instruments include an interest rate swap
agreement and exchange traded interest rate futures contracts. The notional
amounts of AMBAC Indemnity's off-balance-sheet financial instruments which are
held for purposes other than trading were as follows:
As of December 31,
--------------------
1995 1994
------- --------
Interest rate futures contracts................ $44,500 $164,200
Interest rate swap............................. 20,000 20,000
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.
Interest rate futures contracts are sold to hedge interest rate risk
inherent in fixed rate investment securities. At December 31, 1995, interest
rate futures contracts with an outstanding notional amount of $44,500 were
designated as hedges of fixed rate investment securities.
The interest rate swap held for purposes other than trading is used to
manage interest rate risk by synthetically changing the nature of certain
floating rate investments.
Fair values of financial instruments held for purposes other than trading:
The following fair value amounts were determined by AMBAC Indemnity 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 necessarily require considerable judgment by management. Accordingly, the
estimates presented are not necessarily indicative of the amount AMBAC Indemnity
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 bonds 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.
Investment in affiliate: As of December 31, 1995, the fair value of AMBAC
Indemnity's investment in HCIA is based on the quoted market price of HCIA
common stock. As of December 31, 1994, the fair value of AMBAC Indemnity's
investment in HCIA was assumed to equal carrying value.
Interest rate contracts: Fair values of off-balance-sheet interest rate
contracts (futures and swap) are based on quoted market and dealer prices,
current settlement values, or pricing models.
18
<PAGE>
AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements -- (Continued)
(Dollar Amounts in Thousands)
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 AMBAC
Indemnity are determined based on the outstanding exposure at the time the
premiums are due. The fair value of AMBAC Indemnity'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
Indemnity's liability under these policies. The carrying amount and estimated
fair value of these financial instruments are presented below:
As of December 31,
---------------------------------------------------
1995 1994
----------------------- -----------------------
Carrying Estimated Carrying Estimated
(Dollars in Millions) Amount Fair Value Amount Fair Value
-------- ---------- -------- ----------
Financial assets:
Investments.................. $2,225 $2,225 $1,796 $1,796
Short-term investments....... 164 164 85 85
Securities purchased under
agreements to resell....... 4 4 8 8
Investment in affiliate...... 26 111 25 25
Cash......................... 7 7 2 2
Unrecognized financial
instruments:
Interest rate swap........... -- -- -- (1)
Interest rate futures
contracts.... -- -- --
Liability for net
financial guarantees
Direct..................... -- 655 -- 609
Net of reinsurance......... -- 543 -- 507
Net installment premiums... -- 80 -- 51
12 FINANCIAL INSTRUMENTS HELD FOR TRADING PURPOSES
AMBAC Indemnity, through its affiliate AFS, is a provider of interest rate
swaps to states, municipalities, municipal authorities and other entities,
including its affiliate, AMBAC Capital Management, Inc. ("ACMI"), in connection
with their financings. AMBAC Indemnity manages its interest rate swap business
with the goal of being market neutral to changes in overall interest rates,
while retaining "basis risk", the relationship between changes in floating rate
tax-exempt and floating rate taxable interest rates. If actual or projected
floating rate tax-exempt interest rates rise in relation to floating rate
taxable rates, AMBAC Indemnity will experience an unrealized mark-to-market
loss. Conversely, if actual or projected floating rate tax-exempt interest rates
decline in relation to floating rate taxable interest rates, AMBAC Indemnity
will experience an unrealized mark-to-market gain.
19
<PAGE>
AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements -- (Continued)
(Dollar Amounts in Thousands)
In the ordinary course of business, AMBAC Indemnity manages a variety of
risks -- principally credit, market, 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.
Credit risk relates to the ability of counterparties to perform according
to the terms of their contractual commitments. Various procedures and controls
are in place to monitor the credit risk of interest rate swaps. These include
the initial credit approval process, the establishment of credit limits,
management approvals and a process that ensures the continuous monitoring of
credit exposure.
Market risk relates to the impact of price changes on future earnings. This
risk is a consequence of AMBAC Indemnity's market-making activities in the
municipal interest rate swap market. The principal market risk is basis risk,
the relationship between changes in floating rate tax-exempt and floating rate
taxable interest rates. Since the third quarter of 1995, all municipal interest
rate swaps transacted contain provisions which are designed to protect AMBAC
Indemnity 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.
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. AMBAC Indemnity has developed a value at risk methodology to estimate
potential losses over a specified holding period and based on certain
probabilistic assessments. AMBAC Indemnity 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 year ended December 31, 1995, AMBAC Indemnity's
value at risk averaged approximately $1,358, calculated at a ninety-nine percent
confidence level. Since no single measure can capture all dimensions of market
risk, AMBAC Indemnity bolsters its value at risk methodology by performing daily
analyses of parallel and nonparallel 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 interest rate swap agreements and
in futures contracts used to hedge those agreements. AMBAC Indemnity 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.
Operational risk relates to the potential for loss caused by a breakdown in
information, communication and settlement systems. AMBAC Indemnity mitigates
operational risk by maintaining a comprehensive system of internal controls.
This includes the establishment of systems and procedures to monitor
transactions and positions, documentation and confirmation of transactions,
ensuring compliance with regulations and periodic reviews by auditors.
Legal risk relates to the uncertainty of the enforceability, through legal
or judicial processes, of the obligations of AMBAC Indemnity's counterparties,
including contractual provisions intended to reduce credit exposure by providing
for the offsetting or netting of mutual obligations. AMBAC Indemnity seeks to
remove or minimize such uncertainties through continuous consultation with
internal and external legal advisers to analyze and understand the nature of
legal risk, to improve documentation and to strengthen transaction structure.
20
<PAGE>
AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements -- (Continued)
(Dollar Amounts in Thousands)
The following table summarizes information about AMBAC Indemnity's
financial instruments held for trading purposes as of December 31, 1995 and
1994:
Net Net Average Net Fair Value
Carrying Estimated ----------------------- Notional
Amount Fair Value Assets Liabilities Amount
-------- ---------- ------- ----------- ----------
1995:
Interest rate
swaps........... $5,207 $5,207 $17,714 $16,667 $2,152,400
Interest rate
futures
contracts....... -- -- -- -- 569,800
1994:
Interest rate
swaps........... $1,681 $1,681 $ 4,441 $ 3,560 $ 771,900
Interest rate
futures
contracts....... -- -- -- -- 443,000
The aggregate amount of net trading income recognized from interest rate
financial instruments held for trading purposes was $2,602 and $3,051 for 1995
and 1994, respectively. Average net fair values were calculated based on average
daily net fair values. For 1994, average net fair values began from the
commencement of operations in September 1994.
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 Inc. and AMBAC Indemnity maintain a three-year revolving credit
facility with two major international banks, as co-agents, for $100,000. As of
December 31, 1995, no amounts were outstanding under this credit facility, which
expires in July 1998. This facility amended a one-year revolving credit facility
for $75,000. As of December 31, 1994, no amounts were outstanding under this
credit facility.
AMBAC Indemnity has an agreement with another major international bank, as
agent, for a $300,000 credit facility, expiring in 2002. This facility is a
seven-year stand-by irrevocable limited recourse line of credit, which was
increased from $225,000 to $300,000 and extended for an additional year in
December 1995. The line will provide liquidity to AMBAC Indemnity 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, 1995 and
1994, no amounts were outstanding under this line.
14 RELATED PARTY TRANSACTIONS
During 1995 and 1994, AMBAC Indemnity guaranteed the timely payment of
principal and interest on obligations under municipal investment contracts and
municipal investment repurchase agreements issued by its affiliate, ACMI. As of
December 31, 1995 and 1994, the aggregate amount of municipal investment
contracts and municipal investment repurchase contracts insured was $2,240,959
and $2,042,230, respectively, including accrued interest. These insurance
policies are collateralized by ACMI's investment securities, accrued interest,
securities purchased under agreements to resell and cash and cash equivalents,
which as of December 31, 1995 and 1994 had a fair value of $2,299,687 and
$1,964,830, respectively, in the aggregate.
21
<PAGE>
AMBAC Indemnity Corporation and Subsidiaries
Notes to Consolidated Financial Statements -- (Continued)
(Dollar Amounts in Thousands)
During 1995 and 1994, AMBAC Indemnity recorded gross premiums written of $1,707
and $2,692, and net premiums earned of $1,764 and $1,872, respectively, related
to these contracts.
During 1995 and 1994, several interest rate swap transactions were executed
between AFS and ACMI. As of December 31, 1995 and 1994, these contracts had an
outstanding notional amount of approximately $359,000 and $478,000,
respectively. As of December 31, 1995 and 1994, AFS recorded a positive fair
value of $6,539 and a negative fair value of $5,492, respectively, related to
these transactions.
15 SUBSEQUENT EVENTS
On January 19, 1996, AMBAC Inc. filed with the Securities and Exchange
Commission a registration statement related to a proposed offering of 3,781,369
PRIDES(SM) (Provisionally Redeemable Income Debt Exchangeable for Stock). The
PRIDES, which constitute senior debt of AMBAC Inc., will mature in 2001 and will
be mandatorily exchanged at maturity into shares of HCIA common stock (or, at
AMBAC Inc.'s option, cash with an equal value) determined in accordance with an
exchange rate formula. AMBAC Inc. may redeem the PRIDES, in whole or in part,
after three years. AMBAC Inc. has also granted the underwriters an option to
purchase up to 378,136 PRIDES to cover any over-allotments.
AMBAC Indemnity, upon consummation of the PRIDES offering, will deliver to
AMBAC Inc. (in the form of an extraordinary dividend) its 2,378,672 shares of
HCIA common stock, at fair value. The fair value of such dividend will be
determined based on the price per share of HCIA common stock used to price the
PRIDES.
22
[NY01:218802.1] 16069-00370 09/18/96 12:19pm
<PAGE>
EXHIBIT 99.2
AMBAC Indemnity Corporation and Subsidiaries
Consolidated Unaudited Financial Statements
as of June 30, 1996 and December 31, 1995
and for the six months ended June 30, 1996 and 1995
<PAGE>
AMBAC Indemnity Corporation and Subsidiaries
Consolidated Balance Sheets
June 30, 1996 and December 31, 1995
(Dollars in Thousands Except Share Data)
June 30, 1996 December 31, 1995
------------- -----------------
(unaudited)
Assets
- ------
Investments:
Bonds held in available for sale account,
at fair value (amortized cost of
$2,162,449 in 1996 and $2,090,101 in 1995) $2,214,817 $2,224,528
Short-term investments, at cost
(approximates fair value) 133,629 163,953
---------- ----------
Total investments 2,348,446 2,388,481
Cash 3,888 6,912
Securities purchased under agreements to resell 3,992 4,120
Receivable for securities 64,288 8,136
Investment income due and accrued 40,207 38,319
Investment in affiliate - 25,827
Deferred acquisition costs 88,107 82,620
Current income taxes - 2,171
Prepaid reinsurance 162,166 153,372
Other assets 54,378 48,472
---------- ----------
Total assets $2,765,472 $2,758,430
========== ==========
Liabilities and Stockholder's Equity
Liabilities:
Unearned premiums $936,870 $906,136
Losses and loss adjustment expenses 59,429 65,996
Ceded reinsurance balances payable 6,765 14,654
Deferred income taxes 57,190 85,008
Current income taxes 3,116 -
Accounts payable and other liabilities 47,035 43,625
Payable for securities 112,413 86,304
---------- ----------
Total liabilities 1,222,818 1,201,723
---------- ----------
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 June 30, 1996 and December 31, 1995 82,000 82,000
Additional paid-in capital 514,305 481,059
Unrealized gains (losses) on investments,
net of tax 34,039 87,112
Retained earnings 912,310 906,536
---------- ----------
Total stockholder's equity 1,542,654 1,556,707
---------- ----------
Total liabilities and stockholder's equity $2,765,472 $2,758,430
========== ==========
See accompanying Notes to Consolidated Financial Statements.
<PAGE>
AMBAC Indemnity Corporation and Subsidiaries
Consolidated Statements of Operations
(Unaudited)
For The Periods Ended June 30, 1996 and 1995
(Dollars in Thousands)
Three Months Ended Six Months Ended
June 30, June 30,
------------------- --------------------
1996 1995 1996 1995
------- ------- -------- -------
Revenues:
Gross premiums written $58,768 $36,893 $110,060 $77,465
Ceded premiums written (9,836) 6,514 (19,448) 3,055
------- ------- -------- -------
Net premiums written 48,932 43,407 90,612 80,520
Increase in unearned premiums (8,870) (15,126) (21,940) (27,563)
------- ------- -------- -------
Net premiums earned 40,062 28,281 68,672 52,957
Net investment income 35,584 32,419 70,489 64,293
Net realized gains (losses) 67,580 (2,202) 69,936 (6,876)
Other income 4,753 (393) 10,805 1,985
------- ------- -------- -------
Total revenues 147,979 58,105 219,902 112,359
------- ------- -------- -------
Expenses:
Losses and loss adjustment expenses 1,700 341 2,510 1,369
Underwriting and operating expenses 11,583 9,916 21,666 19,246
Interest expense 514 306 1,028 637
------- ------- -------- -------
Total expenses 13,797 10,563 25,204 21,252
------- ------- -------- -------
Income before income taxes 134,182 47,542 194,698 91,107
------- ------- -------- -------
Income tax expense:
Current taxes 38,665 6,696 52,313 13,543
Deferred taxes 806 2,458 760 3,666
------- ------- -------- -------
Total income taxes 39,471 9,154 53,073 17,209
------- ------- -------- -------
Net income 94,711 38,388 141,625 73,898
======= ======= ======== =======
See accompanying Notes to Consolidated Unaudited Financial Statements
<PAGE>
AMBAC Indemnity Corporation and Subsidiaries
Consolidated Statements of Cash Flows
(Unaudited)
For The Periods Ended June 30, 1996 and 1995
(Dollars in Thousands)
Six Months Ended
June 30,
-----------------------
1996 1995
-------- -----------
Cash Flows from operating activities:
Net income $141,625 $73,898
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 950 678
Amortization of bond premium and discount (811) (440)
Current income taxes payable 5,287 574
Deferred income taxes payable 760 3,666
Deferred acquisition costs (5,487) (9,366)
Unearned premiums 21,940 27,563
Losses and loss adjustment expenses (6,567) 45
Ceded reinsurance balances payable (7,889) (422)
(Gain) loss on sales of investments (69,936) 6,876
Other, net (8,685) (6,538)
-------- -----------
Net cash provided by operating activities 71,187 96,534
-------- -----------
Cash flows from investing activities:
Proceeds from sales of bonds at amortized cost 742,407 837,619
Proceeds from maturities of bonds at amortized cost 43,165 70,281
Purchases of bonds at amortized cost (901,331) (1,001,767)
Change in short-term investments 30,324 19,183
Proceeds from sale of affiliate 115,865 -
Securities purchased under agreements to resell 128 (392)
Other, net (1,404) (223)
-------- -----------
Net cash provided by (used in) investing activities 29,154 (75,299)
-------- -----------
Cash flows from financing activities:
Dividends paid (135,865) (20,000)
Capital contribution 32,500 -
-------- -----------
Net cash used in financing activities (103,365) (20,000)
-------- -----------
Net cash flow (3,024) 1,235
Cash at beginning of year 6,912 2,117
-------- -----------
Cash at June 30 $3,888 $3,352
======== ===========
Supplemental disclosure of cash flow information: Cash paid during the year for:
Income taxes $13,300 $12,700
======== ===========
See accompanying Notes to Consolidated Financial Statements.
<PAGE>
AMBAC INDEMNITY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS
(1) BASIS OF PRESENTATION
AMBAC Indemnity Corporation ("AMBAC Indemnity") is a leading insurer of
municipal and structured finance obligations. Financial guarantee insurance
underwritten by AMBAC Indemnity guarantees payment when due of the principal of
and interest on the obligation insured. In the case of a default on the insured
obligation, payments under the insurance policy may not be accelerated by the
policyholder without AMBAC Indemnity's consent. As of June 30, 1996, AMBAC
Indemnity's net insurance in force (principal and interest) was $209.3 billion.
AMBAC Indemnity is a wholly-owned subsidiary of AMBAC Inc., which is a holding
company that provides through its affiliates financial guarantee insurance and
financial services to both public and private clients.
AMBAC Indemnity has one wholly-owned subsidiary, American Municipal Bond
Holding Company ("AMBH"), which is a holding company for certain real estate
interests.
On May 6, 1996, AMBAC Inc. sold its 4,159,505 shares of common stock of its
affiliate, HCIA Inc. (NASDAQ:HCIA) ("HCIA") in a secondary public offering.
Prior to consummation of the secondary public offering, AMBAC Indemnity
delivered to AMBAC Inc. (in the form of an extraordinary dividend) its 2,378,672
shares of HCIA common stock, at fair value. The fair value of the HCIA shares
was $115.9 million, based on the offering price per share of HCIA common stock
in the secondary public offering. The carrying value of AMBAC Indemnity's HCIA
shares was $26.2 million, and the resulting gain to AMBAC Indemnity from the
disposition of the shares was $89.7 million. As a result of the secondary public
offering, neither AMBAC Indemnity, nor AMBAC Inc. owned any shares of HCIA.
AMBAC Indemnity, as the sole limited partner, owns 90% of the total
partnership interests of AMBAC Financial Services, Limited Partnership ("AFS"),
a limited partnership which provides interest rate swaps primarily to states,
municipalities and municipal authorities. The sole general partner of AFS, AMBAC
Financial Services Holdings, Inc., a wholly-owned subsidiary of AMBAC Inc., owns
a general partnership interest representing 10% of the total partnership
interest in AFS.
AMBAC Indemnity's consolidated unaudited interim financial statements have
been prepared on the basis of generally accepted accounting principles and, in
the opinion of management, reflect all adjustments necessary for a fair
presentation of the Company's financial condition, results of operations and
cash flows for the periods presented. The results of operations for the six
months ended June 30, 1996 may not be indicative of the results that may be
expected for the full year ending December 31, 1996. These financial statements
and notes should be read in conjunction with the financial statements and notes
included in the audited consolidated financial statements of AMBAC Indemnity
Corporation and its subsidiaries as of December 31, 1995 and 1994, and for each
of the years in the three-year period ended December 31, 1995.
<PAGE>
AMBAC INDEMNITY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (CONTINUED)
(2) INCOME TAXES
The tax provisions in the accompanying financial statements reflect
effective tax rates differing from prevailing federal corporate income tax
rates, primarily as a result of tax-exempt interest income.
