ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2018
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number: 1-10777
AMBAC FINANCIAL GROUP INC
(Exact name of Registrant as specified in its charter)
(State of incorporation)
(I.R.S. employer identification no.)
One State Street Plaza, New York, New York
(Address of principal executive offices)
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III in this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See definition of “large accelerated filer”, “accelerated filer”, “smaller reporting company”and"emerging growth company" in Rule 12b-2 of the Exchange Act): (Check one):
Large accelerated filer
Smaller reporting company
Emerging growth company
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x
Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13, or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes x No ¨
The aggregate market value of voting stock held by non-affiliates of the Registrant as of the close of business on June 30, 2018 was $899,844,448. As of February 25, 2019, there were 45,341,834 shares of Common Stock, par value $0.01 per share, were outstanding.
Documents Incorporated By Reference
Portions of the Registrant’s proxy statement for its 2019 annual meeting of stockholders are incorporated by reference in this Form 10-K in response to Part III Items 10, 11, 12, 13, and 14.
CAUTIONARY STATEMENT PURSUANT TO THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
In this Annual Report, we have included statements that may constitute “forward-looking statements” within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Words such as “estimate,” “project,” “plan,” “believe,” “anticipate,” “intend,” “planned,” “potential” and similar expressions, or future or conditional verbs such as “will,” “should,” “would,” “could,” and “may,” or the negative of those expressions or verbs, identify forward-looking statements. We caution readers that these statements are not guarantees of future performance. Forward-looking statements are not historical facts but instead represent only our beliefs regarding future events, which may by their nature be inherently uncertain and some of which may be outside our control. These statements may relate to plans and objectives with respect to the future, among other things which may change. We are alerting you to the possibility that our actual results may differ, possibly materially, from the expected objectives or anticipated results that may be suggested, expressed or implied by these forward-looking statements. Important factors that could cause our results to differ, possibly materially, from those indicated in the forward-looking statements include, among others, those discussed under “Risk Factors” in Part I, Item 1A of this Annual Report on Form 10-K.
Any or all of management’s forward-looking statements here or in other publications may turn out to be incorrect and are based on management’s current belief or opinions. Ambac’s actual results may vary materially, and there are no guarantees about the performance of Ambac’s securities. Among events, risks, uncertainties or factors that could cause actual results to differ materially are: (1) the highly speculative nature of Ambac’s common stock and volatility in the price of Ambac’s common stock; (2) uncertainty concerning the Company’s ability to achieve value for holders of its securities, whether from Ambac Assurance Corporation ("Ambac Assurance") or from transactions or opportunities apart from Ambac Assurance; (3) changes in Ambac Assurance’s estimated representation and warranty recoveries or loss reserves over time; (4) failure to recover claims paid on Puerto Rico exposures or incurrence of losses in amounts higher than expected; (5) adverse effects on Ambac’s share price resulting from future offerings of debt or equity securities that rank senior to Ambac’s common stock; (6) potential of rehabilitation proceedings against Ambac Assurance; (7) dilution of current shareholder value or adverse effects on Ambac’s share price resulting from the issuance of additional shares of common stock; (8) inadequacy of reserves established for losses and loss expenses and possibility that changes in loss reserves may result in further volatility of earnings or financial results; (9) increased fiscal stress experienced by issuers of public finance obligations or an increased incidence of Chapter 9 filings or other restructuring proceedings by public finance issuers; (10) the Company's inability to realize the expected recoveries included in its financial statements; (11) insufficiency or unavailability of collateral to pay secured obligations; (12) credit risk throughout the Company’s business, including but not limited to credit risk related to residential mortgage-backed securities, student loan and other asset securitizations, public finance obligations (including obligations of the Commonwealth of Puerto Rico and its instrumentalities and agencies as well as obligations relating to privatized military housing projects) and exposures to
reinsurers; (13) credit risks related to large single risks, risk concentrations and correlated risks; (14) the risk that the Company’s risk management policies and practices do not anticipate certain risks and/or the magnitude of potential for loss; (15) risks associated with adverse selection as the Company’s insured portfolio runs off; (16) adverse effects on operating results or the Company’s financial position resulting from measures taken to reduce risks in its insured portfolio; (17) disagreements or disputes with Ambac Assurance's primary insurance regulator; (18) our inability to mitigate or remediate losses, commute or reduce insured exposures or achieve recoveries or investment objectives, or the failure of any transaction intended to accomplish one or more of these objectives to deliver anticipated results; (19) the Company’s substantial indebtedness could adversely affect its financial condition and operating flexibility; (20) the Company may not be able to obtain financing or raise capital on acceptable terms or at all due to its substantial indebtedness and financial condition; (21) the Company may not be able to generate the significant amount of cash needed to service its debt and financial obligations, and may not be able to refinance its indebtedness; (22) restrictive covenants in agreements and instruments may impair the Company’s ability to pursue or achieve its business strategies; (23) loss of control rights in transactions for which we provide insurance due to a finding that Ambac Assurance has defaulted; (24) the Company’s results of operation may be adversely affected by events or circumstances that result in the accelerated amortization of the Company’s insurance intangible asset; (25) adverse tax consequences or other costs resulting from the characterization of the Company’s surplus notes or other obligations as equity; (26) risks attendant to the change in composition of securities in the Company’s investment portfolio; (27) changes in tax law; (28) changes in prevailing interest rates; (29) changes on inter-bank lending rate reporting practices or the method pursuant to which LIBOR rates are determined; (30) factors that may influence the amount of installment premiums paid to the Company; (31) default by one or more of Ambac Assurance's portfolio investments, insured issuers or counterparties; (32) market risks impacting assets in the Company’s investment portfolio or the value of our assets posted as collateral in respect of interest rate swap transactions; (33) risks relating to determinations of amounts of impairments taken on investments; (34) the risk of litigation and regulatory inquiries or investigations, and the risk of adverse outcomes in connection therewith, which could have a material adverse effect on the Company’s business, operations, financial position, profitability or cash flows; (35) actions of stakeholders whose interests are not aligned with broader interests of the Company's stockholders; (36) the Company’s inability to realize value from Ambac UK or other subsidiaries of Ambac Assurance; (37) system security risks; (38) market spreads and pricing on interest rate derivatives insured or issued by the Company; (39) the risk of volatility in income and earnings, including volatility due to the application of fair value accounting; (40) changes in accounting principles or practices that may impact the Company’s reported financial results; (41) legislative and regulatory developments, including intervention by regulatory authorities; (42) the economic impact of “Brexit”; (43) operational risks, including with respect to internal processes, risk and investment models, systems and employees, and failures in services or products provided by third parties; (44) the Company’s financial position that may prompt departures of key employees and may impact the Company’s ability to attract qualified executives and employees; (45) fluctuations in foreign currency
exchange rates could adversely impact the insured portfolio in the event of loss reserves or claim payments denominated in a currency other than US dollars and the value of non-US dollar denominated securities in our investment portfolio; and (46) other risks and uncertainties that have not been identified at this time.
Item 1. Business
Ambac Financial Group, Inc. (“Ambac,” "AFG" or the “Company”), headquartered in New York City, is a financial services holding company incorporated in the State of Delaware on April 29, 1991. On May 1, 2013, Ambac emerged from Chapter 11 bankruptcy protection when the Second Modified Fifth Amended Plan of Reorganization became effective. Upon emergence Ambac had no outstanding debt at the holding company and significant net operating loss carry-forwards, of which $3.5 billion remain at December 31, 2018.
Management reviews financial information, allocates resources and measures financial performance on a consolidated basis. As a result, the Company has a single reportable segment.
Financial Guarantee Insurance:
Ambac’s provides financial guarantee policies through its principal operating subsidiary, Ambac Assurance Corporation ("Ambac Assurance" or "AAC") and its wholly owned subsidiary Ambac Assurance UK Limited (“Ambac UK”), both of which have been in runoff since 2008. Ambac has another wholly-owned subsidiary, Everspan Financial Guarantee Corp. (“Everspan”), which has been in runoff since its acquisition in 1997. Insurance policies issued provide an unconditional and irrevocable guarantee which protects the holder of a debt obligation against non-payment when due of the principal and interest on the obligations guaranteed. Pursuant to such guarantees, Ambac Assurance and its subsidiaries make payments if the obligor responsible for making payments fails to do so when scheduled. Revenues from financial guarantees consist of: (i) premiums earned from insurance contracts, net of reinsurance, whether received upfront or on an installment basis and (ii) amendment and consent fees. Expenses from financial guarantees consist of: (i) loss and commutation payments; (ii) loss-related expenses, including those relating to the remediation of problem credits; and (iii) insurance intangible amortization.
Ambac Assurance and its subsidiaries have been working toward reducing uncertainties within their insured portfolios through active monitoring of key exposures such as municipal entities with stressed financial conditions (including Puerto Rico) and asset-backed securities (including residential mortgage-backed securities ("RMBS") and student loan-backed securities). Additionally, Ambac Assurance and its subsidiaries are actively prosecuting legal claims (including RMBS related lawsuits), managing the regulatory frameworks applicable to the insurance entities, seeking to optimize capital allocation in a challenging environment that includes long duration obligations, and attempting to retain key employees.
The deterioration of the financial condition of Ambac Assurance and Ambac UK beginning in 2007 has prevented these companies from being able to write new business. An inability to write new
business has and will continue to negatively impact Ambac’s future operations and financial results. Ambac Assurance’s ability to pay dividends and, as a result, Ambac’s liquidity, have been significantly restricted by the deterioration of Ambac Assurance’s financial condition and by regulatory, legal and contractual restrictions. It is highly unlikely that Ambac Assurance will be able to make dividend payments to Ambac for the foreseeable future. Refer to "Dividend Restrictions, Including Contractual Restrictions" below and Note 8. Insurance Regulatory Restrictions to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K, for more information on dividend payment restrictions.
Interest rate derivative transactions are executed through Ambac Financial Services (“AFS”), a wholly-owned subsidiary of Ambac Assurance. The primary activity of AFS is to economically hedge interest rate risk in the financial guarantee and investment portfolios. Accordingly, interest rate derivatives are positioned to benefit from rising rates. Under agreements governing interest rate derivative positions, AFS generally must post collateral or margin in excess of the market value of the swaps and futures contracts. In addition, most of AFS’s counterparties currently possess the right to terminate their transactions with AFS, and in the event of a rehabilitation of Ambac Assurance some of AFS’s swaps could automatically terminate. A sudden termination of AFS’s derivatives, whether voluntarily or automatically, could result in losses. AFS has borrowed cash and securities from Ambac Assurance to help support its collateral and margin posting requirements, previous termination payments and other cash needs.
Credit derivative contracts were executed through Ambac Credit Products LLC (“ACP”), a wholly owned subsidiary of Ambac Assurance, for which fees are collected over the contract term. Credit derivative contract terms are substantially similar to financial guarantee insurance. Credit derivatives also permit certain counterparties to assert mark-to-market termination claims under certain conditions; however, the assertion of such mark-to-market claims based on the Segregated Account Rehabilitation Proceedings (as defined below) and related circumstances has been enjoined by the Second Amended Plan of Rehabilitation (as defined below) and orders of the Rehabilitation Court (as defined below). See discussion of “Ambac Assurance Liquidity” in Part II, Item 7 included in this Form 10-K for further information.
Ambac derives derivative revenues from (i) changes in the fair value of the derivatives portfolio resulting from interest rate or credit changes and (ii) the value of future contract terminations or settlements which may differ from the carrying value of the those contracts.
Credit risks relating to interest rate derivative positions primarily relate to the default of a counterparty. Ambac's interest rate derivatives generally consist of centrally cleared swaps, US treasury futures and some over-the-counter ("OTC") swaps with financial guarantee customers or bank counterparties. Counterparty default exposure is mitigated through the use of industry standard collateral posting agreements or margin posting requirements. Cleared swaps, futures and OTC derivatives with bank counterparties require margin or collateral to be posted up to or in excess of the market value of the interest rate derivatives.
Interest rate derivative contracts entered into with financial guarantee customers are not subject to collateral posting agreements. Credit risk associated with customer derivatives, including credit derivatives, is managed through the risk management processes described in the Risk Management Group section below. In some cases, interest rate derivatives between Ambac and financial guarantee customers are placed through a third party financial intermediary and similarly do not require collateral posting.
Ambac manages a variety of market risks inherent in its businesses, including 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. See “Quantitative and Qualitative Disclosures About Market Risk” included in Part II, Item 7A in this Form 10-K for further information.
In February 2018, Ambac achieved one of its key strategic objectives: the exit from rehabilitation of Ambac Assurance’s Segregated Account (as defined below). Having accomplished this milestone, Ambac continues to pursue and prioritize its remaining key strategic priorities, namely:
Active runoff of Ambac Assurance and its subsidiaries through transaction terminations, policy commutations, reinsurance, settlements and restructurings, with a focus on our watch list credits and known and potential future adversely classified credits, that we believe will improve our risk profile, and maximizing the risk-adjusted return on invested assets;
Ongoing rationalization of Ambac's and its subsidiaries' capital and liability structures;
Loss recovery through active litigation management and exercise of contractual and legal rights;
Ongoing review of the effectiveness and efficiency of Ambac's operating platform; and
Evaluation of opportunities in certain business sectors that meet acceptable criteria that will generate long-term stockholder value with attractive risk-adjusted returns.
With respect to our new business strategy, we have identified certain business sectors adjacent to Ambac's core business in which future opportunities will be evaluated. We have been evaluating strategic opportunities in credit, insurance, asset management and other financial services that we believe would be synergistic to Ambac and would leverage our core competencies. We will continue to be measured and disciplined in our approach as we pursue opportunities to deploy our capital with the goal of creating sustainable long-term shareholder value. Although we are exploring new business opportunities for Ambac, no assurance can be given that we will be able to identify or execute a suitable transaction and/or obtain the financial and other resources that may be required to finance the acquisition or development of any new businesses or assets. Due to these factors, as well as uncertainties relating to the ability of Ambac Assurance to deliver value to Ambac, the value of our securities remains speculative.
The execution of Ambac’s strategy to increase the value of its investment in Ambac Assurance is subject to the restrictions set forth in the Settlement Agreement, dated as of June 7, 2010 (the "Settlement Agreement"), by and among Ambac Assurance, ACP, Ambac and certain counterparties to credit default swaps with ACP that were guaranteed by Ambac Assurance, as well as the Stipulation and Order (as defined in Note 1. Background and Business Description to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K) and in the indenture for the Tier 2 Notes (as defined in Note 1. Background and Business Description to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K), each of which requires OCI (as defined below) and, under certain circumstances, holders of the debt instruments benefiting from such restrictions, to approve certain actions taken by or in respect of Ambac Assurance. In exercising its approval rights, OCI will act for the benefit of policyholders, and will not take into account the interests of Ambac. See Note 1. Background and Business Description to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further information.
Opportunities for remediating losses on poorly performing insured transactions also depend on market conditions, including the perception of Ambac Assurance’s creditworthiness, the structure of the underlying risk and associated policy as well as other counterparty specific factors. Ambac Assurance's ability to commute policies or purchase certain investments may also be limited by available liquidity.
In March 2010, Ambac Assurance established a segregated account pursuant to Wisconsin Stat. §611.24(2) (the “Segregated Account”) to segregate certain segments of Ambac Assurance’s liabilities. The Office of the Commissioner of Insurance for the State of Wisconsin (“OCI” (which term shall be understood to refer to such office as regulator of Ambac Assurance and Everspan and to refer to the Commissioner of Insurance for the State of Wisconsin as rehabilitator of the Segregated Account (the “Rehabilitator”), as the context requires)) commenced rehabilitation proceedings in the Wisconsin Circuit Court for Dane County (the “Rehabilitation Court”) with respect to the Segregated Account (the “Segregated Account Rehabilitation Proceedings”) in order to permit OCI to facilitate an orderly run-off and/or settlement of the liabilities allocated to the Segregated Account pursuant to the provisions of the Wisconsin Insurers Rehabilitation and Liquidation Act. Ambac Assurance, itself, did not enter rehabilitation proceedings.
On October 8, 2010, OCI filed a plan of rehabilitation for the Segregated Account (the "Segregated Account Rehabilitation Plan") in the Rehabilitation Court. The Rehabilitation Court confirmed the Segregated Account Rehabilitation Plan on January 24, 2011. On June 11, 2014, the Rehabilitation Court approved amendments to the Segregated Account Rehabilitation Plan and the Segregated Account Rehabilitation Plan, as amended, became effective on June 12, 2014.
On September 25, 2017 the Rehabilitator filed a motion in the Rehabilitation Court seeking entry of an order approving an amendment to the Segregated Account Rehabilitation Plan (the "Second Amended Plan of Rehabilitation"). Following the conclusion of a Confirmation Hearing on January 22, 2018, the Rehabilitation Court entered an order granting the Rehabilitator's
motion and confirming the Second Amended Plan of Rehabilitation. On February 12, 2018 (the "Effective Date"), the Second Amended Plan of Rehabilitation became effective. Consequently, the rehabilitation of the Segregated Account was concluded. Refer to Note 1. Background and Business Description to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K, for more information on the Segregated Account and the Segregated Account Rehabilitation Proceedings.
Enterprise Risk Management
The Company's policies and procedures relating to risk assessment and risk management are overseen by its Board of Directors. The Board of Directors take an enterprise-wide approach to risk management oversight that is designed to support the Company's business plans at a reasonable level of risk. A fundamental part of risk assessment and risk management is not only understanding the risks the Company faces and what steps management is taking to manage those risks, but also understanding what level of risk is appropriate for the Company. The Board of Directors periodically reviews the Company's business plan, factoring risk management into account. It also approves the Company's risk appetite statements, which articulate the Company's tolerance for certain risks and describes the general types of risk that the Company accepts, within certain parameters, or attempts to avoid.
While the Board of Directors has the ultimate oversight responsibility for the risk management process, various committees of the Board also have responsibilities related to risk assessment and risk management, and management has responsibility for managing the risks to which the Company is exposed and reporting on such matters to the Board of Directors and applicable Board committees.
The Audit Committee oversees the management of risks associated with the integrity of Ambac’s financial statements and its compliance with legal and regulatory requirements. In addition, the Audit Committee discusses policies with respect to risk assessment and risk management, including major financial risk exposures and the steps management has taken to monitor and control such exposures. The Audit Committee reviews with management, internal auditors and external auditors Ambac's accounting policies, Ambac's system of internal controls over financial reporting and the quality and appropriateness of disclosure and content in the financial statements and other external financial communications.
The Compensation Committee oversees the management of risk primarily associated with our ability to attract, motivate and retain quality talent (particularly executive talent) compensation structures that might lead to undue risk taking, and disclosure of our executive compensation philosophies, strategies and activities.
The Governance and Nominating Committee oversees the management of risk primarily associated with Ambac’s ability to attract and retain quality directors, Ambac’s corporate governance programs and practices and our compliance therewith. Additionally, the Governance and Nominating Committee oversees the processes for evaluation of the performance of the Board of Directors and its committees each year and considers risk management effectiveness as part of its evaluation. The Governance and Nominating Committee also performs oversight of the
business ethics and compliance program, and reviews compliance with Ambac’s Code of Business Conduct.
The Strategy and Risk Policy Committee oversees the management of risk and risk appetite primarily with respect to strategic plans and initiatives, oversight of Ambac’s capital structure, financing and treasury matters and oversight of management's process for the identification, evaluation and mitigation of Ambac’s financial and commercial-related risks.
The full Board of Directors also receive quarterly updates from Board committees, and the Board provides guidance to individual committee activities as appropriate.
In order to assist the Board of Directors in overseeing Ambac’s risk management, Ambac uses enterprise risk management, a company-wide process that involves the Board of Directors, management and other personnel in an integrated effort to identify, assess and manage a broad range of risks (e.g., credit, financial, legal, liquidity, market, model, operational, regulatory and strategic), that may affect the Company’s ability to execute on its corporate strategy and fulfill its business objectives. The Enterprise Risk Committee (“ERC”), which is a management committee, is comprised of senior level management responsible for assisting in the management of the Company’s risks on an individual and aggregate basis. The ERC produces the relevant risk management information for senior management, the Board of Directors and applicable Board committees.
Ambac management has established other committees to assist in managing the risks embedded in the enterprise. These committees will meet monthly or as needed on an ad hoc basis.
The Asset Liability Management Committee's (“ALCO”) objective is to foster an enterprise wide culture and approach to liquidity management, asset management, asset valuation and hedging. Members of ALCO include the Chief Executive Officer, Chief Financial Officer and senior managers from investment management and the Risk Management Group.
The Risk Committee's objective is to establish an interdisciplinary team of professionals from different parts of the company to provide oversight of the key risk remediation issues impacting Ambac. The purview of the committee is to review and approve risk remediation activities for the financial guarantee insured portfolio as well as review changes to Ambac Assurance's adversely classified, survey and watch list credits (as defined in Note 2. Basis of Presentation and Significant Accounting Policies). Additionally, the Risk Committee will provide oversight and review new risk remediation structures or approaches in connection with risk remediation plans or anticipated transactions. This committee was established in the fourth quarter of 2017. Previously, most risk remediation activities were approved by ALCO. Members of the Risk Committee include the Chief Executive Officer, Head of Risk Management, Chief Financial Officer and senior managers from throughout risk, corporate services, operations, investment management, legal and finance.
The Disclosure Committee's objective is to assist the CEO and CFO in their responsibilities to design, establish, maintain and evaluate the effectiveness of disclosure controls and procedures.
Our Internet address is www.ambac.com. We make available free of charge, through the investor relations section of our web site, annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and any amendments to those reports, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as well as proxy statements, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the U.S. Securities and Exchange Commission. Our Investor Relations Department can be contacted at Ambac Financial Group, Inc., One State Street Plaza, New York, New York 10004, Attn: Investor Relations, telephone: 212-208-3222 email: email@example.com. The reference to our website address does not constitute inclusion or incorporation by reference of the information contained on our website in this Form 10-K or other filings with the SEC, and the information contained on our website is not part of this document.
RISK MANAGEMENT GROUP
Financial guarantee insurance was sold in three principal markets: U.S. public finance, U.S. structured finance and international finance. Ambac’s financial guarantee insurance policies and credit derivative contracts expose the Company to the direct credit risk of the assets and/or obligor supporting the guaranteed obligation. In addition, insured transactions expose Ambac to indirect risks that may increase our overall risk, such as credit risk separate from, but correlated with, our direct credit risk, market, model, economic, natural disaster and mortality or other non-credit type risks. Please refer to Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Guarantees in Force” section below for details on the financial guarantee insured portfolio.
The Risk Management Group is primarily responsible for the development, implementation and oversight of loss mitigation strategies, surveillance and remediation of the insured financial guarantee portfolio (including through the pursuit of recoveries in respect of paid claims and commutations of policies). Our ability to execute certain risk management activities may be limited by the restrictions set forth in the Settlement Agreement, the Stipulation and Order and the indenture for the Tier 2 Notes. See Note 1. Background and Business Description to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further information.
Ambac’s Risk Management Group ("RMG") has an organizational structure designed around four primary areas of focus: Surveillance, Risk Remediation, Credit Risk Management and Loss Reserving and Analytics.
This group's focus is on the early identification of potential stress or deterioration in connection with exposures in the insured portfolio and the related credit analysis associated with these and other insured portfolio exposures. Additionally, surveillance will evaluate the impact of changes in the economic, regulatory or political environment on the insured portfolio.
Analysts in this group perform periodic credit reviews of insured exposures according to a schedule based on the risk profile of the guaranteed obligations or as necessitated by specific credit events or other macro-economic variables. Risk-adjusted surveillance
strategies have been developed for each bond type with review periods and scope of review based upon each bond type’s risk profile. The risk profile is assessed regularly in response to our own experience and judgments or external factors such as the economic environment and industry trends. Active surveillance enables analysts to track single credit migration and industry credit and performance trends.
The focus of a credit review is to assess performance, identify credit trends and recommend appropriate credit classifications, ratings and changes to a transaction or bond type’s review period and surveillance requirements. Please refer to Note 2. Basis of Presentation and Significant Accounting Policies to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further discussion of the various credit classifications utilized by Ambac. If a problem is detected, the Surveillance group will then work with the Risk Remediation group on a loss mitigation plan, as necessary.
Surveillance for collateral dependent transactions, including, but not limited to, residential mortgage-backed securities (“RMBS”), asset-backed securities (“ABS”) and student loan transactions, focuses on reviews of the underlying asset cash flows and, if applicable, the performance of servicers or collateral managers. Ambac Assurance generally receives periodic reporting of transaction performance from issuers or trustees. Surveillance analysts review these reports to monitor performance and, if necessary, seek legal advice to ensure that reporting and application of cash flows comply with transaction requirements.
This group’s focus is on risk remediation, loss mitigation and restructuring related to the insured portfolio of Ambac Assurance.
Risk remediation helps to reduce exposure to credits that have current negative developing trends, have the potential for future adverse development or are already adversely classified by, among other things, securing rights and remedies, both of which may help to mitigate losses in the event of further deterioration or event of default, or, as available, working with an issuer to refinance or retire debt.
Loss mitigation focuses on the analysis, implementation and execution of commutation and related claims reduction or defeasance strategies for policies with potential future claims. Loss mitigation prioritizes policies, or portions thereof, for commutation, refinancing or other claims reduction or defeasance strategies.
Restructuring or workout is the focused and active process of trying to minimize claims and maximize recoveries, typically following an event of default.
The emphasis on reducing risk is centered on reducing enterprise-wide exposure on a prioritized basis.
For certain adversely classified, survey list and watch list credits, Risk Remediation analysts will develop and implement a remediation or loss mitigation plan that could include actions such as working with the issuer, trustee, bond counsel, servicer and other interested parties in an attempt to remediate the problem and minimize Ambac Assurance’s exposure to potential loss. Other actions could include working with bond holders and other
economic stakeholders to negotiate, structure and execute solutions, such as commutations.
Adversely classified, survey list and watch list credits are tracked closely by Surveillance analysts together with Risk Remediation analysts as part of the Risk Remediation process and are discussed at regularly scheduled meetings with Credit Risk Management (see discussion following in “Credit Risk Management”) and the Risk Committee (see discussion following in "Risk Committee"). In some cases, Risk Remediation will engage restructuring or workout experts, attorneys and/or other consultants with appropriate expertise in the targeted loss mitigation area to assist management in examining the underlying contracts or collateral, providing industry specific advice and/or executing strategies.
In Risk Remediation, we have established cross-functional teams in key areas of focus, comprised of personnel both within the RMG and in other departments, to target proactive mitigation and remediation of losses and potential future losses associated with certain credits and sectors in the insured portfolio. Examples of such efforts include teams of professionals focused on (i) the review and enforcement of contractual representations and warranties ("R&W") supporting RMBS policies, (ii) RMBS servicing and remediation and (iii) the analysis and prioritization of policies with projected claims or the potential for future material adverse development to target and execute risk reduction, restructuring and commutation strategies. Members of these cross-functional teams will often work with external experts in the pursuit of risk reduction efforts.
For RMBS insured exposures, the team focuses on servicer oversight and transaction remediation. Analysts monitor the performance of servicers through a combination of (i) regular reviews of servicer performance; (ii) compliance certificates received from servicer management; (iii) independent rating agency information; (iv) reviews of servicer financial information; and (v) onsite servicing diligence. In addition, the team actively works with servicers and other RMBS transaction sponsors to facilitate the exercise of clean-up calls and other risk and exposure reducing transactions, sometimes with Ambac Assurance financial support.
Ambac Assurance believes that the close monitoring of servicers, including measures to better align the interests, and other loss mitigation activities, constitute credible means of minimizing risks and losses related to insured RMBS.
A team of professionals is focused on recoveries from sponsors where Ambac Assurance believes material breaches of representations and warranties occurred with respect to certain RMBS policies. The team engages with experienced consultants to perform the re-underwriting of loan files and consults with internal and external legal counsel with regard to loan putbacks as well as settlement and litigation strategies (refer to Note 2. Basis of Presentation and Significant Accounting Policies and Note 7. Financial Guarantee Insurance Contracts to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further discussion on this topic).
Credit Risk Management ("CRM")
CRM manages the decision process for all material matters that affect credit exposures within the insured portfolio. While not responsible for the credit analysis or execution of risk remediation or loss mitigation strategies, CRM provides a forum for independent
assessments, reviews and approvals and drives consistency and timeliness. The scope of credit matters under the purview of CRM includes material amendments, waivers and consents, evaluation of remediation or loss mitigation plans, credit review scheduling, credit classifications, rating designations, review of watch list or adversely classified credits, sector reviews and overall portfolio reviews.
The CRM decision process may involve a review of structural, legal, political and credit issues and also includes determining the proper level of approval, which varies based on the nature and materiality of the matter. In particular, formal plans or transactions that relate to risk remediation, loss mitigation or restructuring may also require Risk Committee approval. In addition, such plans or transactions that have material asset liquidity implications may also require ALCO approval.
In structured transactions, including certain structured public finance transactions, Ambac Assurance may be the control party as a result of insuring the transaction’s senior class or tranche of debt obligations. The control party may direct specified parties, usually the trustee, to take or not take certain actions following contractual defaults or trigger events. Control rights and the scope of direction and remedies vary considerably among our insured transactions. Because Ambac Assurance is party to and/or has certain rights in documents supporting transactions in the insured portfolio, Ambac Assurance frequently receives requests for amendments, waivers and consents (“AWCs”). Ambac Assurance’s risk management personnel review, analyze and process all requests for AWCs. As a part of the Segregated Account Rehabilitation Proceedings, the Rehabilitation Court enjoined certain actions by other parties to preserve Ambac Assurance’s control rights that could otherwise have lapsed or been compromised. Pursuant to the Second Amended Plan of Rehabilitation and orders of the Rehabilitation Court, such protections continue after the conclusion of the Segregated Account Rehabilitation Proceedings.
Watch List Credits
Credits that demonstrate the potential for long-term material adverse development, represent significant size or sector concentration, or have certain structural, credit or other complexities, but are otherwise currently performing, may be designated as a watch list credit as part of the CRM process. Watch list credits are closely monitored by the Surveillance for potential adverse development and are targets for proactive risk reduction efforts by the Risk Remediation group.
Adversely Classified Credits
Credits that are either in default or have developed problems that eventually may lead to a default are tracked closely by the appropriate Surveillance and Risk Remediation teams and discussed at meetings with CRM. Adversely classified credit meetings include members of CRM, Surveillance, Risk Remediation and legal, as necessary. As part of the review, relevant information, along with the plan for corrective actions and a reassessment of the credit’s rating and credit classification is considered. Internal and/or external counsel generally review the documents underlying any problem credit and, if applicable, an analysis is prepared outlining Ambac Assurance’s rights and potential remedies, the duties of all parties involved and recommendations for corrective actions. Ambac Assurance also meets with relevant parties to the transaction as necessary. The review schedule for adversely classified credits is tailored to the remediation plan to track and prompt timely action
and proper internal and external resourcing. A summary of developments regarding adversely classified credits and credit trends is also provided to the Risk Committee and Ambac’s and Ambac Assurance’s Board of Directors no less than quarterly.
The insured portfolio contains exposures that are correlated and/or concentrated. Risk Management's surveillance activities include identifying these types of exposures and identifying the risks that would or could trigger credit deterioration across these related exposures. When such risks materialize, an adverse credit classification may be designated across these correlated and/or concentrated exposures. This is the case with student loans and RMBS, for example, which have several correlations including those associated with consumer lending, unemployment and home prices. In the past, our not-for-profit healthcare and our leveraged lease exposures experienced periods of stress arising from their concentrated and/or correlated risks, when there were major changes to healthcare reimbursement programs, especially Medicaid, or significant weakness in consumer and business travel, in the case of the former and the latter, respectively. In the future, Ambac’s portfolio may be subject to similar credit deterioration arising from concentrated and/or correlated risks. Examples of other such risks that could impact our portfolio, and that our surveillance is designed to monitor include the impact of potential municipal bankruptcy contagion, the impact of tax reform on state and municipal bond issuers, or the impact of large scale domestic military cutbacks on our military housing portfolio or event risk such as natural disasters or other regional stresses. Most such risks cannot be predicted, and may materialize unexpectedly or develop rapidly. Although our surveillance allows us to connect the event and stress to the related exposures and assign an adverse credit classification and estimate losses across the affected credits, when necessary, we may not have adequate resources or contractual rights and remedies to mitigate loss arising from such risks.
Amendment, Waiver and Consent Review / Approval
The decision to approve or reject AWCs is based upon certain credit factors, such as the issuer’s ability to repay the bonds and the bond’s security features and structure. Members of Ambac' Surveillance group review, analyze and process all requests for AWCs. All AWCs are initially screened for materiality in the Surveillance group. Non-material AWCs require the approval of at least the Surveillance analyst and the Surveillance manager. Material AWCs are within the purview of CRM, as noted above. For material AWCs, CRM has established minimum requirements that may be modified to require more or varied approvals depending upon the matter’s complexity, size or other characteristics.
Ambac Assurance assigns internal credit ratings to individual exposures as part of the AWC process and at surveillance reviews. These internal credit ratings, which represent Ambac Assurance’s independent judgments, are based upon underlying credit parameters consistent with the exposure type.
Loss Reserving and Analytics ("LRA")
LRA manages the quarterly loss reserving process for insured portfolio credits with projected policy claims. It also supports the development, operation and/or maintenance of various analytical models used in the loss reserving process as well as in other risk management functions. LRA works with Surveillance and Risk Remediation analysts responsible for a particular credit on the development, review and implementation of loss reserve scenarios and related analysis.
INSURANCE REGULATORY MATTERS AND OTHER RESTRICTIONS
Ambac Assurance and Everspan are domiciled in the State of Wisconsin and, as such, are subject to the insurance laws and regulations of the State of Wisconsin (the “Wisconsin Insurance Laws”) and are regulated by the OCI. In addition, Ambac Assurance and Everspan are subject to the insurance laws and regulations of the other jurisdictions in which they are licensed. See Note 8. Insurance Regulatory Restrictions to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further information on regulatory restrictions.
In addition, pursuant to the terms of the Settlement Agreement, the Stipulation and Order and the indenture for the Tier 2 Notes, Ambac Assurance must seek prior approval by OCI of certain corporate actions. The Settlement Agreement, Stipulation and Order and indenture for the Tier 2 Notes include covenants which restrict the operations of Ambac Assurance. The Settlement Agreement will remain in force until the surplus notes issued thereunder have been redeemed, repurchased or repaid in full. The Stipulation and Order will remain in force for so long as OCI determines it to be necessary. The indenture for the Tier 2 Notes will remain in force until the Tier 2 Notes have been redeemed, repurchased or repaid in full. Certain of the restrictions in the Settlement Agreement and indenture for the Tier 2 Notes may be waived with the approval of the OCI and/or the requisite percentage of holders of debt securities issued thereunder.
The Prudential Regulatory Authority ("PRA") and Financial Conduct Authority ("FCA") (and their predecessor regulator the Financial Services Authority (“FSA”)) have exercised significant oversight of Ambac UK since 2008, after Ambac, Ambac Assurance and Ambac UK began experiencing financial stress. In 2009, Ambac UK’s license to write new business was curtailed by the FSA and the insurance license was limited to undertaking only run-off related activity. As such, Ambac UK is authorized to run-off its insurance portfolio in the United Kingdom, and to do the same through a branch in Milan, Italy, and a number of other EU countries. EU legislation has allowed Ambac UK to conduct business in EU states other than the United Kingdom through a “passporting” arrangement, which eliminates the necessity of additional licensing or authorization in those other EU jurisdictions. See Item 1A. Risk Factors in Part I, Item 1A and Note 8. Insurance Regulatory Restrictions to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further information on regulatory restrictions.
Regulations over change in control
Under Wisconsin law applicable to insurance holding companies, any acquisition of control of Ambac, and any other direct or indirect control of Ambac Assurance and Everspan, requires the prior approval of the OCI. “Control” is defined as the direct or indirect power to direct or cause the direction of the management and policies of a person. Any purchaser of 10% or more of the outstanding voting stock of a corporation is presumed to have acquired control of that corporation and its subsidiaries unless the OCI, upon application, determines otherwise. For purposes of this test, Ambac believes that a holder of common stock having the
right to cast 10% or more of the votes which may be cast by the holders of all shares of common stock of Ambac would be deemed to have control of Ambac Assurance and Everspan within the meaning of the Wisconsin Insurance Laws. The United Kingdom has similar requirements applicable in respect of Ambac, as the ultimate holding company of Ambac UK.
Common Stock Restrictions
Ambac’s Amended and Restated Certificate of Incorporation limits the rights of stockholders in significant ways. Article IV contains voting restrictions applicable to any person owning at least 10% of Ambac’s common stock so that such person (including any group consisting of such person and any other person with whom such person or any affiliate or associate of such person has any agreement, contract, arrangement or understanding with respect to acquiring, voting, holding or disposing of Ambac’s common stock) shall not be entitled to cast votes in excess of one vote less than 10% of the votes entitled to be cast by all common stock holders, except as otherwise approved by OCI.
Dividend Restrictions, Including Contractual Restrictions
Due to contractual and regulatory restrictions, Ambac Assurance has been unable to pay common dividends to Ambac since 2008 and will be unable to pay common dividends in 2019 without certain approvals, including the prior consent of the OCI, which is unlikely. Ambac Assurance’s ability to pay dividends is further restricted by the Settlement Agreement, the Stipulation and Order, the indenture for the Tier 2 Notes and the terms of its Auction Market Preferred Shares ("AMPS"). See Note 8. Insurance Regulatory Restrictions to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further information on dividends.
As a result of these restrictions, Ambac Assurance is not expected to pay dividends to Ambac for the foreseeable future.
While the UK insurance regulatory laws impose no statutory restrictions on an insurer’s ability to declare a dividend, the PRA’s and FCA’s capital requirements in practice act as a restriction on the payment of dividends, where a firm has a lower level of regulatory capital than its regulatory capital requirement as is the case for Ambac UK. Further, the FSA amended Ambac UK’s license in 2010 such that the PRA must specifically approve (“non-objection”) any transfer of value and/or assets from Ambac UK to Ambac Assurance or any other Ambac group company, other than in respect of certain disclosed contracts between the two parties (such as in respect of a management services agreement between Ambac Assurance and Ambac UK). As a result, Ambac UK is not expected to pay any dividends to Ambac Assurance for the foreseeable future.
Pursuant to the Settlement Agreement and the indenture for the Tier 2 Notes, Ambac Assurance may not make any “Restricted Payment” (which includes dividends from Ambac Assurance to Ambac) in excess of $5 million in the aggregate per annum, other than Restricted Payments from Ambac Assurance to Ambac in an amount up to $7.5 million per annum solely to pay operating expenses of Ambac. Concurrent with making any such Restricted Payment, a pro rata amount of Ambac Assurance's surplus notes (other than junior surplus notes) would also need to be redeemed at par. Any such payment on surplus notes would require either payment or collateralization of a proportional amount of the Tier
2 Notes (or interest thereon) in accordance with the terms of the Tier 2 Note indenture.
The Stipulation and Order requires OCI approval for the payment of any dividend or distribution on the common stock of Ambac Assurance.
Under the terms of Ambac Assurance’s AMPS, dividends may not be paid on the common stock of Ambac Assurance unless all accrued and unpaid dividends on the AMPS for the then current dividend period have been paid, provided, that dividends on the common stock may be made at all times for the purpose of, and only in such amounts as are necessary for, enabling Ambac (i) to service its indebtedness for borrowed money as such payments become due or (ii) to pay its operating expenses. If dividends are paid on the common stock as provided in the prior sentence, dividends on the AMPS become cumulative until the date that all accumulated and unpaid dividends have been paid on the AMPS.
INVESTMENTS AND INVESTMENT POLICY
As of December 31, 2018, the consolidated non-VIE investments of Ambac had an aggregate fair value of approximately $3.9 billion. Investments are managed both internally by officers of Ambac, who are experienced investment managers, and by external investment managers. All investments are made in accordance with the general objectives, policies, and guidelines for investments reviewed or overseen by Ambac's Board of Directors or the Board of Directors of the applicable subsidiary. These policies and guidelines include liquidity, credit quality, diversification and duration objectives and are periodically reviewed and revised as appropriate. Additionally, senior credit personnel monitor the portfolio on a continuous basis. Credit monitoring of the investment portfolio includes procedures on residential mortgage-backed securities consistent with those utilized to assess the risk of our insured RMBS exposures.
As of December 31, 2018, the Ambac Assurance and Everspan non-VIE investment portfolio had an aggregate fair value of approximately $2.9 billion. Ambac Assurance’s and Everspan’s investment objectives are to achieve the highest risk-adjusted after-tax return on a diversified portfolio consistent with Ambac Assurance’s and Everspan’s risk tolerance while employing active asset/liability management practices to satisfy all operating and strategic liquidity needs. In addition to internal investment policies and guidelines, Ambac Assurance’s investment portfolio is subject to limits on the types and quality of investments imposed by applicable insurance laws and regulations, which may be waived by the applicable regulatory authority in certain instances. The Board of Directors of Ambac Assurance approves any changes to Ambac Assurance's investment policy. Ambac Assurance purchases Ambac Assurance insured securities given their relative risk/reward characteristics. As described in Note 1. Background and Business Description to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K, changes to Ambac Assurance’s investment policies are subject to approval by OCI pursuant to covenants made by Ambac Assurance in the Settlement Agreement, the Stipulation and Order and the indenture for the Tier 2 Notes. Such requirements could adversely impact the performance of the investment portfolio.
As of December 31, 2018, the non-VIE Ambac UK investment portfolio had an aggregate fair value of approximately $0.7 billion.
Ambac UK’s investment policy is designed with the primary objective of ensuring that Ambac UK is able to meet its financial obligations as they fall due, in particular with respect to policy holder claims. Ambac UK purchases Ambac UK insured securities given their relative risk/reward characteristics. Ambac UK’s investment portfolio is subject to internal investment guidelines and may be subject to limits on types and quality of investments imposed by its regulator. The Board of Directors of Ambac UK approves any changes or exceptions to Ambac UK’s investment policy.
As of December 31, 2018, the non-VIE Ambac (parent company only) investment portfolio had an aggregate fair value of approximately $0.3 billion. The primary investment objective is to preserve capital for strategic uses while maximizing income. The investment portfolio is subject to internal investment guidelines. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits. Ambac invests in securities insured or issued by Ambac Assurance, including surplus notes ($0.06 billion fair value at December 31, 2018) and AMPS issued by Ambac Assurance that are eliminated in consolidation.
The following table provide certain information concerning the consolidated investments of Ambac:
($ in millions)
U.S. government obligations
Residential mortgage-backed securities
Total long-term investments
Other investments (3)
Yields are stated on a pre-tax basis, based on average amortized cost for both long and short term investments.
Includes investments guaranteed by Ambac Assurance and Ambac UK. Refer to Note 10. Investments of the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further discussion of Ambac insured securities held in the investment portfolio.
Other investments include equity interests in pooled investment funds which are classified as trading securities and Ambac's interests in an unconsolidated trust created in connection with its sale of Segregated Account junior surplus notes on August 28, 2014.
Ambac's exposure to RMBS in its investment portfolios is further discussed in Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Balance Sheet” section below for a discussion of the fair value of mortgage and asset-backed securities by classification.
As of December 31, 2018, Ambac had 102 employees in the United States and 11 employees in the UK. Ambac considers its employee relations to be satisfactory.
Item 1A. Risk Factors
References in the risk factors to “Ambac” are to Ambac Financial Group, Inc. References to “we,” “our,” “us” and “Company” are to Ambac and its subsidiaries, as the context requires. Capitalized terms used but not defined in this section shall have the meanings ascribed thereto in Part I, Item 1 in this Form 10-K or in Note 1. Background and Business Description to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K unless otherwise indicated.
Certain of the risk factors described below refer to Secured Notes and Tier 2 Notes, which were issued in February 2018 in connection with the transactions described in Note 1. Background and Business Description to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K. Our risk factors are organized in the following sections.
Investments in Ambac's common stock are highly speculative and the price per share of Ambac's common stock may be subject to a high degree of volatility, including significant price declines.
Ambac's principal business is in run-off and faces significant risks and uncertainties described elsewhere in Part I, Item 1A. Risk Factors. Although Ambac's common stock is listed on NASDAQ, there can be no assurance as to the liquidity of the trading market or the price at which such shares can be sold. The price of the shares may decline substantially in response to a number of events or circumstances, including but not limited to:
adverse developments in our financial condition or results of operations;
changes in the actual or perceived risk within our insured portfolio, particularly with regards to concentrations of credit risk, such as in Puerto Rico;
actual or perceived adverse developments with regards to Ambac Assurance's RMBS litigations;
changes to regulatory status;
changes in investors’ or analysts’ valuation measures for our stock;
market and industry perception of our success, or lack thereof, in pursuing our business strategy; and
results and actions of other participants in our industry.
In addition, the price of Ambac's shares may be affected by the additional risks described below, including risks associated with Ambac Assurance’s ability to deliver value to Ambac. Investments in Ambac's common stock should be considered highly speculative and may be subject to a high degree of volatility.
The occurrence of certain events could result in the initiation of rehabilitation proceedings against Ambac Assurance, with resulting adverse consequences to holders of our securities.
Increased loss development in the insured portfolio or significant losses or other events resulting from litigation, including the failure to achieve expected recoveries from existing litigations concerning insured residential mortgage-backed securities ("RMBS"), may prompt OCI to determine that it is in the best interests of policyholders to initiate rehabilitation proceedings with respect to Ambac Assurance, either preemptively or in response to any such event.
If, as a result of the occurrence of any such event(s), OCI decides to initiate rehabilitation proceedings with respect to Ambac Assurance, adverse consequences may result, including, without limitation and absent enforceable protective injunctive relief, the assertion of damages by counterparties (including mark-to-market claims with respect to insured transactions executed in ISDA format), the acceleration of losses based on early termination triggers, and the loss of control rights in insured transactions. Any such consequences may reduce any residual value of Ambac Assurance. Additionally, the rehabilitator would assume control of all of Ambac Assurance’s assets and management of Ambac Assurance. In exercising control, the rehabilitator would act for the benefit of policyholders, and would not take into account the interests of our securityholders. Such actions may result in material adverse consequences for our securityholders.
The issuance of additional shares of Ambac, including shares of Ambac common stock underlying issued and outstanding warrants, may dilute current shareholder value or have adverse effects on the market price of Ambac’s common stock.
If Ambac issues additional shares of common stock to raise capital, whether for select business transactions, general corporate purposes, in exchange for other securities, or in connection with the exercise of issued and outstanding warrants, the value of current stockholders’ interests may be diluted as Ambac is not required to offer any such shares to existing stockholders on a preemptive basis.
Ambac cannot predict the effect, if any, of future sales of its common stock, or the availability of shares for future sales, on the market price of its common stock. Sales of substantial amounts of common stock or the perception that such sales could occur may adversely affect the prevailing market price for its common stock.
Ambac may not be able to realize value from Ambac Assurance or generate earnings apart from Ambac Assurance.
The value of Ambac's stock is dependent upon the residual value of its main operating subsidiary, Ambac Assurance; the receipt of payments to be made by Ambac Assurance pursuant to the intercompany tax sharing agreement (the "Amended TSA") and
the intercompany expense sharing and cost allocation agreement (the "Cost Allocation Agreement"); the receipt of payments on the Owner Trust Certificate issued to Ambac by Corolla Trust (the "Owner Trust Certificate"), which was created in 2014 to monetize Ambac's ownership interest in junior surplus notes issued by the Segregated Account; the receipt of payments on investments made in securities issued or insured by Ambac Assurance; the receipt of dividends from Ambac Assurance; and the receipt of payments on other investments. There can be no assurance that Ambac will be able to realize residual value in Ambac Assurance, which is in run-off. There is a risk that Ambac Assurance will not be able to satisfy all of its obligations to policyholders, holders of its indebtedness (including surplus notes, junior surplus notes, the Ambac Note and the Tier 2 Notes) and holders of its preferred stock, even if Ambac Assurance is successful in achieving recoveries and mitigating losses. Our ability to achieve recoveries and mitigate losses is subject to significant risks and uncertainties, including as a result of varying potential perceptions of the value of Ambac Assurance’s guarantees and securities.
Due to the above considerations, as well as applicable legal and contractual restrictions described elsewhere herein, it is highly unlikely that Ambac Assurance will be able to pay Ambac any dividends for the foreseeable future. Furthermore, the payments to be made to Ambac under the Amended TSA and the intercompany Cost Allocation Agreement are subject to contingencies that are difficult to predict and, in certain instances, to OCI approval, making the amount and timing, if any, of such payments uncertain. Payments to be made under the Amended TSA, in particular, depend on the generation of future taxable income by Ambac Assurance above certain thresholds. Ambac Assurance’s ability to generate taxable income above such thresholds is uncertain. Due to these factors, there can be no assurance as to the amounts that Ambac will receive from Ambac Assurance under the Amended TSA. Moreover, the Cost Allocation Agreement provides that Ambac Assurance's reimbursement of Ambac's operating expenses after 2017 is subject to the approval of OCI and limited to $4.0 million per annum. We can provide no assurance as to whether OCI will approve such reimbursement or any portion thereof.
It is also uncertain whether and to what extent Ambac will realize value from the Owner Trust Certificate. The Owner Trust Certificate is subordinated to $299.2 million of senior secured notes issued by Corolla Trust plus interest thereon. Such notes and the Owner Trust Certificate are collateralized by and payable solely from a $350.0 million face amount junior surplus note plus interest thereon. Ambac Assurance became the obligor under the junior surplus notes on February 12, 2018 pursuant to the Second Amended Plan of Rehabilitation. No payment of interest on or principal of a junior surplus note may be made until all existing and future indebtedness of Ambac Assurance, including (but not limited to) senior ranking surplus notes, policy claims and claims having statutory priority, have been paid in full. All payments of principal and interest on junior surplus notes are subject to the prior approval of OCI. If OCI does not approve the payment of interest on junior surplus notes, such interest will accrue and compound annually until paid. Payments on the senior secured notes issued by Corolla Trust will only be made when and to the extent that Ambac Assurance makes payments on the junior surplus note held by Corolla Trust. The senior secured notes must be paid in full before any payments will be made on the Owner Trust Certificate. If Corolla Trust has failed to pay all interest and principal
outstanding on the senior secured notes within three business days of August 28, 2039, the senior secured noteholders may also take possession of and sell the junior surplus note. If such a sale were to occur, it is uncertain whether and to what extent there would be any value for the Owner Trust Certificate after satisfaction of the senior secured notes.
The value of Ambac's common stock may also depend upon the ability of Ambac to generate earnings apart from Ambac Assurance. As noted below, Ambac is selectively exploring potential business opportunities that, among other things, may permit utilization of Ambac’s net operating loss carry-forwards, but there are no assurances regarding its ability to find or execute such business opportunities or the prospects of any such opportunities.
Future offerings of debt or equity securities that rank senior or pari-passu to Ambac's common stock may adversely affect the market price of its common stock.
If Ambac decides to issue debt or additional equity securities in the future that rank senior or pari-passu to its common stock, it is likely that they will be governed by an indenture or other instrument containing covenants restricting Ambac's operating flexibility. Additionally, any convertible or exchangeable securities issued in the future may have rights, preferences and privileges more favorable than those of common stock and may result in dilution to owners of common stock. Because Ambac's decision to issue debt or equity securities in any future offering will depend on market conditions, it cannot predict or estimate the amount, timing or nature of future offerings. Holders of common stock bear the risk of future offerings reducing the market price of Ambac's common stock and diluting the value of their stock holdings in the Company.
Risks Related to Insured Portfolio Losses
Loss reserves may not be adequate to cover potential losses, and changes in loss reserves may result in further volatility of net income and comprehensive income.
Loss reserves are established when management has observed credit deterioration, in most cases, when the underlying credit is considered adversely classified. Loss reserves established with respect to our non-derivative financial guarantee insurance policies are based upon estimates and judgments by management, including estimates and judgments with respect to the probability of default, the severity of loss upon default, management’s ability to execute policy commutations and/or restructurings, and estimated remediation recoveries for, among other things, breaches by RMBS issuers of representations and warranties. The objective of establishing loss reserve estimates is not to, and our loss reserves do not, reflect the worst possible outcome. While our reserving scenarios reflect a wide range of possible outcomes (on a probability weighted basis) reflecting the significant uncertainty regarding future developments and outcomes, our loss reserves may change materially based on future developments. As a result of inherent uncertainties in the estimates and judgments made to determine loss reserves, there can be no assurance that either the actual losses in our financial guarantee insurance portfolio will not exceed such reserves or that our reserves will not increase or decrease materially over time as circumstances, our assumptions, or our models change.
Additionally, inherent in our estimates of loss severities and remediation recoveries is the assumption that Ambac Assurance or its subsidiaries, as applicable, will retain control rights in respect of our insured portfolio. However, according to the terms of relevant transaction documents, Ambac Assurance or its subsidiaries, as applicable, may lose control rights in many insured transactions if, among other things, the relevant insurer is the subject of delinquency proceedings and/or other regulatory actions. If Ambac Assurance or its subsidiaries lose control rights, their ability to mitigate loss severities and realize remediation recoveries will be compromised, and actual ultimate losses in the insured portfolio could exceed current loss reserves. The Second Amended Plan of Rehabilitation of the Segregated Account and related orders of the Rehabilitation Court seek to restrain actions adverse to Ambac Assurance based on a loss of control rights due to the rehabilitation of the Segregated Account or related events or circumstances. If the Second Amended Plan of Rehabilitation and such orders do not successfully preclude such actions, Ambac Assurance could lose its control rights with respect to certain policies.
Some issuers of public finance obligations insured by Ambac Assurance are experiencing fiscal stress that could result in increased losses on those obligations or increased liquidity claims, including losses or claims resulting from payment defaults, Chapter 9 bankruptcy or other restructuring proceedings or loss of market access.
Some issuers of public finance obligations insured by Ambac Assurance have reported, or may report, budget shortfalls, significantly underfunded pensions or other fiscal stresses that imperil their ability to pay debt service or will require them to significantly raise taxes and/or cut spending in order to satisfy their obligations. Government entities may also take other actions that may impact their own creditworthiness or the creditworthiness of related issuers. Some issuers of obligations insured by Ambac Assurance have declared a payment moratorium, defaulted or filed for bankruptcy or similar debt adjustment proceedings, raising concerns about their ultimate ability to service the debt insured by Ambac Assurance and Ambac Assurance's ability to recover claims paid in the future. If the issuers of the obligations in the public finance portfolio are unable to raise taxes, cut spending, or receive federal or state assistance, or if such issuers default or file for bankruptcy under Chapter 9 or for similar relief under other laws that allow for the adjustment of debts, Ambac Assurance may experience liquidity claims and/or ultimate losses on those obligations, which could adversely affect the Company's business, financial condition and results of operations.
Catastrophic environmental events, particularly those associated with hurricanes, earthquakes, wildfires and drought, that result in loss of human life, significant property damage, and/or material disruption of economic activity can have a material negative impact on the financial performance of issuers of public finance, investor owned utility, privatized military housing and other obligations insured by Ambac Assurance. Such stresses could result in liquidity claims or permanent losses on those obligations.
Ambac Assurance insures the obligations of a number of issuers that have been substantially affected by environmental events in 2017 and 2018, including certain municipalities in Texas as a result of flooding related to Hurricane Harvey in September 2017,
various obligations of the Commonwealth of Puerto Rico and the U.S. Virgin Islands impacted by hurricanes Irma and Maria in September and October 2017, certain California issuers affected by wildfires in 2017 and 2018, and an issuer in Florida impacted by Hurricane Michael in October 2018.
The short and long term impact of catastrophic environmental events on issuers and their obligations is by its very nature uncertain and is determined by a number of factors including, but not limited to, the level of Federal Government support via emergency disaster relief funding measures, both related to FEMA and otherwise, flood insurance, low interest loans, hazard mitigation, the level of state government support, the magnitude of commercial insurance recoveries, and the outcome of certain socio-economic variables. Consequently, if issuers affected by such catastrophic events do not receive adequate measures of support or realize the appropriate level of economic recovery, it could impact their ultimate ability to service the debt insured by Ambac Assurance and Ambac Assurance's ability to recover claims paid in the future.
In addition, certain catastrophic environmental events, notably wildfires, can result in significant potential liabilities for issuers such as investor owned utilities that increase bankruptcy risk and the potential default on obligations of the issuer, including obligations insured by Ambac Assurance. For example, Ambac Assurance insures approximately $32 million of obligations of Pacific Gas & Electric Company, which filed for bankruptcy protection on January 29, 2019, in part due to potentially significant liabilities associated with wildfires in 2017 and 2018 in its area of operations in California.
Ambac Assurance insures obligations of the Commonwealth of Puerto Rico, including certain of its authorities and public corporations that are either subject to a Title III bankruptcy protection proceeding under the Puerto Rico Oversight, Management and Stability Act ("PROMESA") or have otherwise suspended debt service payments. Ambac Assurance has made and may continue to be required to make significant amounts of policy payments over the next several years, the recoverability of which is subject to great uncertainty, which may lead to material permanent losses. While we believe our reserves are adequate to cover losses on Puerto Rico insured bonds, there can be no assurance that Ambac Assurance may not incur additional losses in the future, particularly given the developing economic, political and legal circumstances in Puerto Rico. Such losses may have a material adverse effect on Ambac Assurance's results of operation and financial condition.
Ambac Assurance has exposure to the Commonwealth of Puerto Rico (the "Commonwealth"), including its authorities and public corporations. Each has its own credit risk profile attributable to, as applicable, discrete revenue sources, direct general obligation pledges and/or general obligation guarantees. Ambac Assurance had approximately $1.9 billion of net par exposure to the Commonwealth and these instrumentalities at December 31, 2018. Components of the overall Puerto Rico net par outstanding include capital appreciation bonds that are reported at the par amount at the time of issuance of the related insurance policy as opposed to the current accreted value of the bonds. The outstanding net insured amount including accretion on capital appreciation bonds is approximately $2.6 billion at December 31, 2018. Total net insured lifetime debt service (net par and interest) to the Commonwealth
of Puerto Rico and its instrumentalities was approximately $9.3 billion at December 31, 2018.
As a result of the developments described in these Risk Factors and elsewhere in this 10-K (see Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Guarantees in Force, and Note 7. Financial Guarantee Insurance Contracts to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K), the Commonwealth of Puerto Rico and certain of its instrumentalities may continue to default on debt service payments, including payments owed on bonds insured by Ambac Assurance. Ambac Assurance has made, and may continue to be required to make, significant amounts of policy payments over the next several years, the recoverability of which is subject to great uncertainty, which may lead to material permanent losses. Our exposure to Puerto Rico is impacted by the amount of monies available for debt service, which is in turn affected by a number of factors including variability in economic growth and demographic trends, tax revenues, essential services expense as well as federal funding of Commonwealth needs.
Substantial uncertainty also exists with respect to the ultimate outcome for creditors in Puerto Rico due to legislation enacted by the Commonwealth and the United States, including PROMESA, as well as actions taken in reliance on such laws, including Title III filings. Ambac Assurance is involved in multiple litigations relating to such actions and other issues and may not be successful in pursuing claims or protecting its interests. Ambac Assurance has been participating in a mediation process with respect to potential debt restructurings. Mediation may not be productive or may not resolve Ambac Assurance's claims in a manner that avoids significant losses.
On February 15, 2019, the United States Court of Appeals for the First Circuit issued an opinion in the consolidated appeals brought by certain parties who argued that the members of the Financial Oversight and Management Board for Puerto Rico (the "Oversight Board") were appointed in violation of the U.S. Constitution’s Appointments Clause. The First Circuit ruled that the Oversight Board members (other than the ex-officio Member) must be, and were not, appointed in compliance with the Appointments Clause. The First Circuit declined to dismiss the Oversight Board’s Title III petitions and did not render ineffective any otherwise valid actions of the Oversight Board prior to the issuance of the ruling. The First Circuit stated that the ruling will not take effect for 90 days, “so as to allow the President and the Senate to validate the currently defective appointments or reconstitute the Board in accordance with the Appointments Clause." During the 90-day stay period, the Oversight Board may continue to operate as it had prior to the ruling. It is unclear how this ruling, both during the 90-day stay period and thereafter, will impact the restructuring process, mediation discussions and relevant litigation with respect to our Puerto Rico exposures. Certain parties to the litigation may petition the U.S. Supreme Court for a writ of certiorari, seeking a review of the First Circuit’s decision.
Given the numerous uncertainties existing with respect to the restructuring process and relevant litigations, no assurance can be given that ultimate debt service discounts will not be severe and cause Ambac to experience losses materially exceeding current reserves. It is possible that certain restructuring process solutions, together with associated legislation, budgetary, and/or public
policy proposals could be adopted and could significantly or further impair our exposures. In addition, there are possible final legal determinations, including failing to recognize or properly differentiate legal structures and protections applicable to such exposures, that could result in losses exceeding our current reserves by a material amount and further increases to our loss reserves. In particular, in a Title III process, should court-approved plans of adjustment for the Commonwealth, Puerto Rico Highways and Transportation Authority ("PRHTA"), or any other issuers of Ambac-insured debt that file for Title III protection contemplate discounts to debt service implied by, or even worse than, the Commonwealth’s Revised Fiscal and Economic Growth Plan ("Revised FEGP"), the Fiscal Plan Compliance Act be upheld, or Ambac receive unfavorable judgments in the litigations to which it is a party, Ambac’s financial condition could be materially adversely affected. It is also possible that economic or demographic outcomes may be as, or worse than, forecasted in the Commonwealth’s Revised FEGP or under proposals or plans promulgated by the Commonwealth or its instrumentalities in or in connection with a Title III process or otherwise. Even a negotiated restructuring to which Ambac agrees as part of a Title VI mediation or other process may involve material losses in excess of current reserves. While our reserving scenarios reflect a wide range of possible outcomes reflecting the significant uncertainty regarding future developments and outcomes, given our exposure to Puerto Rico and the economic, fiscal, legal and political uncertainties associated therewith our loss reserves may ultimately prove to be insufficient to cover our losses, potentially by a material amount, and may be subject to material volatility.
Implementation of P.L. 115-97, commonly referred to as the Tax Cuts and Jobs Act of 2017, may negatively impact the economic recovery of Puerto Rico, which could result in higher loss severities or an extended moratorium on debt service owed on Ambac Assurance-insured bonds of Puerto Rico and its instrumentalities.
The Tax Cuts and Jobs Act effectively treats Puerto Rico the same as it does any other foreign tax jurisdiction and otherwise makes it less attractive for U.S. taxpayers to move certain operations abroad by, among other things, imposing U.S. federal income tax on a current basis with respect to certain earnings of controlled foreign corporations. This may diminish the Commonwealth of Puerto Rico’s relative attractiveness as a location for foreign activity of a U.S. multinational group, including those with manufacturing facilities or other business on the island. The legislation was implemented in December 2017, at a difficult time as the Commonwealth of Puerto Rico was recovering from Hurricane Maria in October 2017, and, moreover, was amidst a multi-year financial crisis that is still ongoing. Consequently, the Tax Cuts and Jobs Act could have an adverse impact on the ongoing recovery of the Commonwealth of Puerto Rico by impeding much-needed economic growth, job growth, and revenue generation, which could potentially result in higher loss severities and/or an extended debt service moratorium for Puerto Rico creditors, including the Company.
Implementation of the Tax Cuts and Jobs Act of 2017 could have a negative impact on issuers of Ambac Assurance-insured municipal bonds.
Under the Tax Cuts and Jobs Act individuals who itemize their deductions on their Federal income tax returns will be limited to $10,000 of deductions for state and local taxes paid in a given year.
In states with high income tax rates, such as New York, Connecticut, New Jersey, Maryland, and California, there is a risk that municipal bond issuers could be impacted by lower tax revenues if there is significant out migration by residents to states or municipalities with lower tax rates. Lower tax revenues in these jurisdictions could lead to reduced financial flexibility, lower overall economic activity and increased credit risk, thereby potentially increasing risk to Ambac Assurance with respect to affected issuers with bonds insured by Ambac Assurance.
In addition, the Tax Cuts and Jobs Act reduced the maximum corporate federal income tax rate to 21% from 35%, which could reduce the demand for municipal bond investments by corporations, such as insurance companies, banks, and credit unions, which currently hold approximately 30% of all outstanding municipal bonds. The impact of reduced demand could result in higher borrowing costs for municipalities and/or reduced refinancing flexibility for issuers of municipal bonds, thereby potentially increasing risk to Ambac Assurance with respect to issuers with municipal bonds insured by Ambac Assurance.
We are subject to credit risk and other risks in our insured portfolio, including related to RMBS and securities backed by student loans. We are also subject to risks associated with adverse selection as our insured portfolio runs off. Measures taken to reduce such risks may have an adverse effect on the Company's operating results or financial position.
Performance of our insured transactions, including (but not limited to) RMBS transactions and those involving securities backed by student loans, can be adversely affected by general economic conditions, such as recession, rising unemployment rates, underemployment, home prices that decline or do not increase in the patterns assumed in our models, increasing foreclosure rates and unavailability of consumer credit, mortgage product attributes, such as interest rate adjustments and balloon payment obligations, borrower and/or originator fraud, mortgage and student loan servicer performance or underperformance and financial difficulty, such as risks related to whether the servicer may be required to delay the remittance of any cash collections held by it or received by it after the time it becomes subject to bankruptcy or insolvency proceedings.
While further deterioration in the performance of consumer assets, including mortgage-related assets and student loans, may occur, the timing, extent and duration of any future deterioration of the credit markets is unknown, as is the impact on potential claim payments and ultimate losses on the securities within our portfolio. In addition, there can be no assurance that any governmental or private sector initiatives designed to address such credit deterioration in the markets will be successful or inure to the benefit of the transactions we insure. For example, any initiative which permits the discharge of student loan debt in bankruptcy may adversely affect our portfolio. Similarly, servicer settlements with governmental authorities regarding foreclosure or servicing irregularities are generally designed to protect borrowers and may increase losses on securities we insure. In particular, the student loan industry and, specifically, trusts with securities insured by Ambac Assurance have been subject to heightened Consumer Finance Protection Bureau (CFPB) scrutiny and enforcement action over servicing and collections practices and potential chain of title issues and, consequently, any settlements, orders, consents or penalties resulting from CFPB actions, or any failure on the part
of servicers or other parties asserting claims against delinquent borrowers to establish title to the loans, could lead to increased losses on securities we insure.
In addition, there can be no assurance that Ambac Assurance would be successful, or that it would not be delayed, in enforcing the subordination provisions, credit enhancements or other contractual provisions of the RMBS that Ambac Assurance insures.
As the runoff of the insured portfolio continues, the proportion of exposures we rate as below investment grade relative to the aggregate insured portfolio is likely to continue to increase, leaving the portfolio increasingly concentrated in higher risk exposures. This risk may result in greater volatility or have adverse effects on the Company's results from operations and on our financial condition.
One of our primary goals is to create shareholder value through transaction terminations, policy commutations, reinsurance, settlements and restructurings that we believe will improve our risk profile. As we take such actions to reduce known and potential risks, such actions may negatively impact our operating results or financial position in one or more reporting periods.
Our credit risk management policies and practices may not adequately identify significant risks.
As described in Part I, Item 1, “Risk Management” in this Form 10-K, we have established risk management policies and practices which seek to mitigate our exposure to credit risk in our insured portfolio. Ongoing surveillance of credit risks in our insured portfolio is an important component of our risk management process. These policies and practices in the past have not insulated us from risks that were unforeseen and which had unanticipated loss severity, and such policies and practices may not do so in the future. There can be no assurance that these policies and practices will be adequate to avoid future losses. If we are not able to identify significant risks, we may not be able to timely remediate such risks, thereby increasing the amount of losses to which we are exposed. An inability to identify significant risks could also result in the failure to establish loss reserves that are sufficient in relation to such risks.
We use analytical models and tools to assist our projection of performance of our insured obligations and our investment portfolio but actual results could differ materially from the model and tool outputs and related analyses.
We rely on internally and externally developed complex financial models, including default models related to RMBS and a waterfall tool provided by a nationally recognized vendor for RMBS and student loan exposures, to project performance of our insured obligations and similar securities in our investment portfolio. These models and tools assume various conditions, probability scenarios, facts and circumstances, and there can be no assurance that such models or tools accurately predict or measure the quantum of losses, loss reserves and timing of losses. Differences in the models and tools that we employ, uncertainties or flaws in these financial models and tools, or faulty assumptions inherent in these financial models and tools or those determined by management could lead to material changes in projected outcomes, and could include increased losses, loss reserves and/or other than temporary investment impairments. Moreover, estimates of transaction performance depend in part on the interpretation of
contracts and other bases of our legal rights. Such interpretations may prove to be incorrect or different interpretations may be employed by bond trustees and other transaction participants and, ultimately courts, which could lead to increased losses, loss reserves and/or investment impairments.
Political developments may materially adversely affect our insured portfolio.
Our insured exposures and our results of operations can be materially affected by political developments at the federal, state and/or local government levels. Government shutdowns, trade disputes, political turnover, judicial decisions, adverse changes in federal funding, or poor public policy decision making could disrupt the national and local economies where we have insured exposures. In addition, we are exposed to correlation risk as a result of the possibility that multiple credits may concurrently and/or consecutively experience losses or increased stress as a result of any such event or series of events.
Risks Related to Indebtedness
Ambac Assurance's ability to generate the significant amount of cash needed to service its debt and financial obligations and its ability to refinance all or a portion of its indebtedness or obtain additional financing depends on many factors beyond our control.
Ambac Assurance is highly leveraged and has greater indebtedness outstanding following consummation of the Rehabilitation Exit Transactions and the AMPS Exchange. Ambac Assurance’s ability to make payments on and refinance its debt, including surplus notes (which continue to accrete based on compounding interest when interest has not been paid), and other financial obligations and to fund its operations will depend on its ability to generate substantial operating cash flow and on the performance of the insured portfolio. Ambac Assurance’s cash flow generation will depend on receipt of premiums, investment returns, earnings from subsidiaries and potential litigation recoveries offset by policyholder claims, commutation payments, operating and loss adjustment expenses, and interest expense, which will be subject to prevailing economic conditions and to financial, business and other factors, many of which are beyond our control and many of which are event-driven.
As of December 31, 2018, Ambac Assurance had approximately $2,198.9 million of indebtedness outstanding (the Tier 2 Notes and the Ambac Note) that are senior to its surplus notes. Ambac Assurance had $573.8 million principal balance of surplus notes (other than junior surplus notes) outstanding plus $366.6 million principal balance of junior surplus notes outstanding as of December 31, 2018. The Tier 2 Notes and the Ambac Note are secured by potential litigation recoveries (and in the case of the Ambac Note, other assets), the receipt of which is highly uncertain, as more fully discussed in Part I, Item 1A. Risk Factors. Failure to achieve litigation recoveries in an amount sufficient to repay the Tier 2 Notes and the Ambac Note would materially weaken Ambac Assurance’s ability to service its indebtedness.
If Ambac Assurance cannot pay its policyholders’ claims or service its debt, it will have to take actions such as selling assets, restructuring or refinancing its debt or seeking additional capital. Any of these remedies may not, if necessary, be effected on commercially reasonable terms, or at all. Because of these and
other factors beyond our control, Ambac Assurance may be unable to pay the principal, interest or other amounts on its indebtedness when due or ever.
We have substantial indebtedness, which could adversely affect our financial condition, operational flexibility and our ability to obtain financing in the future.
Our substantial indebtedness could have significant consequences for our financial condition and operational flexibility. For example, it could:
increase our vulnerability to general adverse economic, competitive and industry conditions;
limit our ability to obtain additional financing in the future for working capital, capital expenditures, payment of policyholder claims, debt service requirements, acquisitions, general corporate purposes or other purposes on satisfactory terms or at all;
require us to dedicate a substantial portion of our cash flow from operations to the payment of our indebtedness, thereby reducing the funds available to us for operations and to fund the execution of our key strategies;
limit or restrict us from making strategic acquisitions or cause us to make non-strategic divestitures;
limit our ability or increase the costs to refinance indebtedness or repay such indebtedness due to ongoing interest accretion;
limit our ability to attract and retain key employees; and
limit our ability to enter into hedging transactions by reducing the number of counterparties with whom we can enter into such transactions, as well as the volume of those transactions.
Despite current indebtedness levels, we may incur additional debt. While restrictive covenants in certain of our contracts currently provide limits on the amount of additional indebtedness Ambac Assurance may incur, we may obtain a waiver of those restrictions and incur additional indebtedness in the future. In addition, if Ambac incurred indebtedness, its ability to make scheduled payments on, or refinance, any such indebtedness may depend on the ability of our subsidiaries to make distributions or pay dividends, which in turn will depend on their future operating performance and contractual, legal and regulatory restrictions on the payment of distributions or dividends to which they may be subject. There can be no assurance that any such dividends or distributions would be made. This could further exacerbate the risks associated with our substantial leverage.
The Secured Notes and Tier 2 Notes are primarily secured by potential recoveries on Ambac Assurance’s RMBS litigations, and Ambac Assurance’s ability to obtain, and the timing of, any recovery on the RMBS litigations is subject to significant uncertainty.
The Secured Notes and Tier 2 Notes are primarily secured by Ambac Assurance’s potential recoveries in respect of RMBS litigations. Ambac Assurance's ability to obtain such recoveries and the timing of receipt of any such recoveries are subject to significant risks and uncertainty, as described below in Risks Related to Capital, Liquidity and Markets.
In addition, while a policy issued by Ambac Assurance guarantees all principal and interest payments (including mandatory prepayments) in respect of the Secured Notes as and when such
payments become due and owing, such policy may not provide adequate assurance that payments of principal and interest in respect of the Secured Notes will be available in the event that Ambac Assurance’s financial condition, including its capital and liquidity, is materially adversely affected, including as a result of the failure to recover expected damages and, as a result, Ambac Assurance is unable to satisfy its policy obligations. In the event that Ambac Assurance is unable to satisfy its obligations under the Secured Notes policy, holders of the Secured Notes will have the right to foreclose on the securities constituting collateral for the Secured Notes and to sue Ambac Assurance for failure to make payments under the Secured Notes policy; however, there can be no assurance that the sale of the securities collateral will produce proceeds in an amount sufficient to pay any or all amounts due on the Secured Notes or that holders will be successful in any litigation seeking payments pursuant to the Secured Notes policy. Furthermore, holders of Secured Notes will not obtain any control, consultation or direction rights in respect of the RMBS litigations nor will holders be able to sell the Ambac Note or the right to receive proceeds in respect of the RMBS litigations without the prior consent of Ambac Assurance.
Holders of Secured Notes and Tier 2 Notes will have no authority to make decisions in respect of the RMBS litigations, will need to rely on Ambac Assurance to pursue the RMBS litigations and may only receive limited information concerning the RMBS litigations.
All decisions concerning the conduct of the RMBS litigations, including as to strategy, settlement, pursuit and abandonment, will be made by Ambac Assurance, in consultation with its legal counsel. Holders of the Secured Notes and Tier 2 Notes will have no control over any decisions related to the RMBS litigations and will need to rely on Ambac Assurance to prosecute the underlying claims. If holders do not agree with decisions by Ambac Assurance with respect to the RMBS litigations, there is no recourse or ability to object to such decision. Additionally, Ambac Assurance’s ability to disclose potentially material details of the RMBS litigations on a regular basis may be limited by litigation strategy and the inherent nature and rules of judicial proceedings, including, among other things, proceedings and filings that are sealed by the court, matters involving attorney-client privilege and proceedings that are conducted on a confidential basis by agreement of the parties.
Ambac Assurance may receive non-cash proceeds in respect of the RMBS litigations and may need to liquidate such proceeds for less than fair market value in order to make cash payments on the Ambac Note and/or the Tier 2 Notes.
In connection with a settlement agreement or judgment, Ambac Assurance may receive non-cash proceeds or indirect proceeds, which are cash or non-cash proceeds received by others for the benefit of Ambac Assurance. Ambac Assurance, however, will be required to make payments on the Ambac Note, for the benefit of the holders of Secured Notes, and on the Tier 2 Notes, in cash. In the event that Ambac Assurance receives non-cash proceeds, Ambac Assurance may need to liquidate the non-cash proceeds if it does not have sufficient cash available to make a payment on the Ambac Note or the Tier 2 Notes on the applicable payment date. Market and economic conditions, governmental actions, the form of non-cash proceeds and other factors may cause substantial delays in the ability to liquidate any non-cash proceeds received. Ambac Assurance may not be able to liquidate any non-cash proceeds received for fair value or at all. If Ambac Assurance is
unable to liquidate non-cash proceeds at their fair value, Ambac Assurance will still be required to make payments on the Ambac Note and Tier 2 Notes and any payment made that is greater than the amount received could have a material adverse effect on Ambac Assurance’s financial condition, including its capital and liquidity. If indirect proceeds are received, Ambac Assurance will also be required to make payments on the Ambac Note, for the benefit of the holders of Secured Notes, and on the Tier 2 Notes, in cash to the extent of the fair value to Ambac Assurance of the indirect proceeds. Any payments of cash on the Ambac Note and/or the Tier 2 Notes as the result of receiving indirect proceeds may have a material adverse effect on Ambac Assurance’s financial condition, including its capital and liquidity.
There may not be sufficient collateral to pay any or all of the Secured Notes or Tier 2 Notes.
In addition to Ambac Assurance’s right to representation and warranty ("R&W") recoveries in respect of the RMBS litigations, which is inherently uncertain, the Ambac Note is also secured by securities having an estimated fair market value of approximately $210 million. However, no appraisal of the value of the securities has been made and there can be no assurances that the fair market value of these securities will not decrease significantly. The value of the collateral in the event of liquidation will depend on market and economic conditions, the availability of buyers and other factors. Consequently, liquidating the securities collateral securing the Ambac Note may not produce proceeds in an amount sufficient to pay any or all amounts due on the Secured Notes.
The estimated fair market value of the securities collateral securing the Ambac Note is subject to fluctuations based on factors that include, among others, the financial condition of participants in the financial guaranty insurance industry, the market for and availability of financial guaranty insurance, the ability to sell the collateral in an orderly sale, general economic conditions, the availability of buyers and other factors. The amount to be received upon a sale of the securities collateral would be dependent on numerous factors, including, but not limited to, the actual fair market value of the collateral at such time and the timing and the manner of the sale, and the amount Ambac Assurance receives may not equal or exceed the expected fair market value. Accordingly, there can be no assurance that the collateral can be sold in a short period of time or at all or at acceptable prices to Ambac Assurance.
In the event of rehabilitation, liquidation, conservation, dissolution or other insolvency proceeding, Ambac Assurance cannot assure holders that the proceeds from any sale or liquidation of the securities collateral will be sufficient to pay any or all of Ambac Assurance’s obligations under the Ambac Note.
In addition, in the event of any such proceeding, it is possible that the rehabilitator, trustee, or competing creditors will assert that the value of the collateral with respect to the Ambac Note or the Tier 2 Notes, including Ambac Assurance’s rights to recoveries in respect of the RMBS litigations, is less than the then-current principal amount outstanding under the Ambac Note and the Secured Notes and/or the Tier 2 Notes on the date of the rehabilitation filing. Upon a finding by the court overseeing an Ambac Assurance rehabilitation that the Ambac Note and the Secured Notes and/or the Tier 2 Notes are under-collateralized, the claims in the rehabilitation proceeding with respect to the Ambac Note, the Secured Notes or the Tier 2 Notes may be bifurcated
between a secured claim up to the value of the collateral and an unsecured claim for any deficiency. As a result, the claim of the holders of the Secured Notes or the Tier 2 Notes could be unsecured in whole or in part. The ability of the holders of the Secured Notes or Tier 2 Notes to realize upon any of the collateral securing the Ambac Note and the Secured Notes or Tier 2 Notes, as the case may be, may also be subject to bankruptcy and insolvency law limitations or similar limitations applicable in insurance company rehabilitation or liquidation proceedings.
Rights of holders of the Secured Notes in the RMBS litigations and securities collateral and rights of holders of the Tier 2 Notes in the RMBS litigations may be adversely affected by the failure to perfect security interests in such collateral, and insolvency considerations with respect to Ambac Assurance may have an adverse effect on the ability of holders of the Secured Notes and Tier 2 Notes to receive payments on the Secured Notes or Tier 2 Notes, respectively.
Applicable law provides that a security interest in certain tangible and intangible assets can only be properly perfected and its priority retained through certain actions undertaken by the secured party. There can be no assurance that the collateral agent in respect of the Secured Notes or Tier 2 Notes will have taken or will take all actions necessary to create properly perfected security interests in the proceeds from the RMBS litigations, which may result in the loss of the priority of the security interest in favor of the holders of the Secured Notes or the Tier 2 Notes, respectively, to which they would otherwise have been entitled. In particular, in the event of a rehabilitation, liquidation, conservation, dissolution or other insolvency proceeding with respect to Ambac Assurance, if the proceeds from the RMBS litigations received by Ambac Assurance are determined not to be under the control of the issuer of the Secured Notes, a receiver or a creditor of Ambac Assurance may take the position that the Secured Notes issuer’s security interest in such proceeds or a portion thereof is not perfected and therefore that such proceeds do not secure the Ambac Note. With respect to the Tier 2 Notes, in the event of a rehabilitation, liquidation, conservation, dissolution or other insolvency proceeding with respect to Ambac Assurance, if the proceeds from the RMBS litigations received by Ambac Assurance are determined not to be under the control of the collateral agent for the Tier 2 Notes, a receiver or a creditor of Ambac Assurance may take the position that such collateral agent’s security interest in such proceeds or a portion thereof is not perfected and therefore that such proceeds do not secure the Tier 2 Notes. Moreover, if the proceeds from the RMBS litigations are received after the initiation of a rehabilitation, liquidation, conservation, dissolution or other insolvency proceeding with respect to Ambac Assurance, a receiver or a creditor of Ambac Assurance may take the position that such proceeds do not secure the Ambac Note or the Tier 2 Notes. If a court were to accept either of these positions, payments under the Ambac Note or Tier 2 Notes, as applicable, may be adversely affected and the Secured Notes or Tier 2 Notes, as the case may be, may become worthless. In addition, a rehabilitation, liquidation, conservation, dissolution or other insolvency proceeding with respect to Ambac Assurance or the issuer of the Secured Notes, as applicable, could lead to delays in payments due on the Secured Notes or Tier 2 Notes.
Fraudulent transfer laws may permit a court to void the Ambac Note, and if that occurs, holders may not receive any payments on the Secured Notes.
Fraudulent transfer and conveyance statutes may apply to the issuance of the Ambac Note. Under state fraudulent transfer or conveyance laws, which may vary from state to state, the Ambac Note could be voided as a fraudulent transfer or conveyance if Ambac Assurance (a) issued the Ambac Note with the intent to hinder, delay or defraud creditors or (b) received less than reasonably equivalent value or fair consideration in return for issuing the Ambac Note and, in the case of (b) only, one of the following is also true at the time thereof:
Ambac Assurance was insolvent or rendered insolvent by reason of the issuance of the Ambac Note;
the issuance of the Ambac Note left Ambac Assurance with an unreasonably small amount of capital or assets to carry on its business; or
Ambac Assurance intended to, or believed that it would, incur debts beyond its ability to pay as they mature.
As a general matter, value is given for a transfer or an obligation if, in exchange for the transfer or obligation, property is transferred or a valid antecedent debt is satisfied.
Ambac Assurance cannot be certain as to the standards a court would use to determine whether or not Ambac Assurance was insolvent at the relevant time or, regardless of the standard that a court uses, whether the Secured Notes would be subordinated to Ambac Assurance’s other debt or policyholder claims. In general, however, a court would deem an entity insolvent if:
the sum of its debts, including contingent and unliquidated liabilities, was greater than the fair saleable value of all of its assets;
the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or
it could not pay its debts as they became due.
If a court were to find that the issuance of the Ambac Note was a fraudulent transfer or conveyance, the court could void the payment obligations under the Ambac Note or could subordinate the Ambac Note to presently existing and future indebtedness or policy obligations of Ambac Assurance, and, as a result, holders may not receive any payments on the Secured Notes.
Ambac Assurance has ongoing obligations related to surplus notes.
Subject to approval by OCI, Ambac Assurance is required to make interest and principal (to the extent due) payments in cash on surplus notes on an annual basis. Ambac Assurance will be required to continue to make such payments, as and when approved by OCI, until all of the surplus notes mature, are repaid in full or are otherwise repurchased or retired. Ambac Assurance is also obligated to make payments on junior surplus notes, subject to OCI approval, after the senior surplus notes and other indebtedness have been paid in full. Ambac Assurance may not have the ability to borrow, raise or otherwise have access to the funds necessary to pay such amounts when due.
Surplus notes may be acquired, redeemed or repaid on terms that may be viewed as more, or less, favorable than the terms of the consideration offered in the exchange offers consummated in February 2018 (the "Exchange Offers").
The Company may acquire, redeem or repay surplus notes through open market purchases, privately negotiated transactions, other tender or exchange offers, redemptions, repayment at maturity or such other means as the Company deems appropriate, subject to the restrictions in the Settlement Agreement, Stipulation and Order, indenture for the Tier 2 Notes and regulatory restrictions. Any such transactions will occur upon the terms and at the prices as the Company may determine in its sole discretion, which may be more or less favorable than the terms of the Exchange Offers, and could be for cash or other consideration. The Company may choose to pursue any or none of these alternatives, or combinations thereof, in the future.
Surplus notes are subordinated in right of payment to other claims, which could impair the right of the holders of such notes to receive interest and principal in the event of our insolvency or a similar occurrence.
Surplus notes are unsecured obligations of Ambac Assurance and are expressly subordinated in right of payment to all of Ambac Assurance’s existing and future indebtedness (other than junior surplus notes) and policy claims. The surplus notes are subject to provisions of Wisconsin insurance law, which establishes the priority of distribution of claims from the estate of an insolvent insurance company. In the event that Ambac Assurance becomes subject to rehabilitation, liquidation, conservation or dissolution, holders of Ambac Assurance’s senior indebtedness and policy claims would be afforded a higher priority of distribution than holders of the surplus notes, and accordingly would have the right to be paid in full before holders of the surplus notes would be paid. Due to the nature of Ambac Assurance’s business, the amount of such higher priority claims in any rehabilitation, liquidation, conservation or dissolution is likely to be many times greater than any free and divisible surplus and it is likely that the holders of surplus notes would not recover any payment in such circumstances. In addition, claims of holders of the surplus notes will be subordinated to certain liabilities of the Company’s subsidiaries that are guaranteed by Ambac Assurance.
Ambac Assurance has not made regular interest or principal payments on surplus notes and may be unable to repay surplus notes in full at maturity or ever.
On November 20, 2014, Ambac Assurance, with the approval of OCI, redeemed surplus notes (other than junior surplus notes) in an amount equal to 26.67% of the principal amount of the surplus notes, plus accrued interest thereon, outstanding as of July 20, 2014, or approximately $396 million owned by third parties. However, except for a one-time payment of approximately six months of interest on the surplus notes (other than junior surplus notes) outstanding immediately after the Exchange Offers, no other interest or principal payments on the surplus notes have been approved or made to date, and Ambac Assurance may not receive approval from OCI to make payments as and when scheduled. As a result, holders of surplus notes may not be paid in full at maturity or ever. If OCI does not approve regular payments on the surplus notes (other than junior surplus notes) within the next several years, the accretion of surplus notes may exceed our ability to ever repay in full the surplus notes. If Ambac Assurance becomes subject to
a rehabilitation or liquidation under the Wisconsin insurance law, prior to the repayment of surplus notes, holders of surplus notes may not receive any recoveries on their investments.
The effects of the amendments to the Settlement Agreement done in connection with the Exchange Offers could materially and adversely affect the credit risk inherent in, and significantly reduce protections afforded in, outstanding surplus notes.
Holders of outstanding surplus notes are subject to the terms of the Settlement Agreement as modified. Certain restrictive covenants and other related provisions in the Settlement Agreement, including covenants regarding mergers and consolidations and the incurrence of indebtedness, were modified or eliminated in connection with the Exchange Offers. As a result, holders of surplus notes are not entitled to the benefit of such provisions, which existed for the protection and benefit of holders of the surplus notes issued pursuant to the Settlement Agreement. The Settlement Agreement, as so amended, continues to govern the terms of all surplus notes issued thereunder that remain outstanding after the consummation of the Exchange Offers and Rehabilitation Exit Transactions. Accordingly, we may take certain actions in the future previously prohibited under the Settlement Agreement that could adversely affect the market prices of the surplus notes and otherwise increase the risks related to investments in the surplus notes.
Increases in interest rates will increase the cost of servicing our debt, could reduce our profitability, and could result in a decrease in the value of the Secured Notes.
The Secured Notes bear interest at a variable rate. As a result, increases in interest rates will increase the cost of servicing the Secured Notes and could adversely affect our profitability and cash flows. Each one percentage point increase in interest rates would result in an $19.4 million increase in the annual cash interest payments due on the Secured Notes.
Changes in inter-bank lending rate reporting practices or the method pursuant to which LIBOR rates are determined may adversely affect the value of LIBOR linked financial instruments.
Since February 1, 2014, the administration of LIBOR has been undertaken by ICE Benchmark Administration Limited (“IBA”), a subsidiary of Intercontinental Exchange Group. IBA, as the administrator of LIBOR, may make changes in methodology that could change the level of LIBOR, which in turn may adversely affect the value of financial instruments linked to LIBOR, including investment securities, swaps, and the Secured Notes. Since 2014, the IBA published multiple papers and other literature, including a “LIBOR Code of Conduct” relating to the setting of LIBOR. IBA has the power to alter, discontinue or suspend calculation or dissemination of LIBOR.
On July 27, 2017, the U.K. Financial Conduct Authority announced that it will no longer persuade or compel banks to submit rates for the calculation of LIBOR rates after 2021 (the “July 27th Announcement”). The July 27th Announcement indicates that the continuation of LIBOR on the current basis cannot and will not be guaranteed after 2021. Consequently, at this time, it is not possible to predict whether and to what extent banks will continue to provide LIBOR submissions to the administrator of LIBOR or whether any additional reforms to LIBOR may be enacted in the United Kingdom or elsewhere. Similarly, it is not possible to predict what rate or rates may become accepted alternatives to LIBOR or the
effect of any such alternatives on the value of LIBOR-linked securities. Any of the above changes or any other consequential changes to LIBOR or any alternative rate or benchmark as a result of any international, national, or other proposals for reform or other initiatives or investigations, or any further uncertainty in relation to the timing and manner of implementation of such changes, could have a material adverse effect on the value of investments in our investment portfolio, swaps we use for hedging, and the Secured Notes.
The amount of interest payable on the Secured Notes is set only once per interest period based on the three-month LIBOR rate on the applicable interest determination date, which rate may fluctuate substantially, and affect our ability to make payment on the Secured Notes.
In the past, the level of the three-month LIBOR rate has experienced significant fluctuations. Historical levels, fluctuations and trends of the three-month LIBOR rate are not necessarily indicative of future levels. Any historical upward or downward trend in the three-month LIBOR rate is not an indication that the three-month LIBOR rate is more or less likely to increase or decrease at any time during an interest period for the Secured Notes, and historical levels of the three-month LIBOR rate should not be taken as an indication of its future performance. In addition, although the actual three-month LIBOR rate on an interest payment date or at other times during an interest period may be higher than the three-month LIBOR rate on the applicable interest determination date, the only relevant date for purposes of determining the interest payable on the Secured Notes is the three-month LIBOR rate as of the respective interest determination date. Changes in the three-month LIBOR rates between interest determination dates will not affect the interest payable on the Secured Notes. As a result, changes in the three-month LIBOR rate may not result in a comparable change in the market value of the Secured Notes.
The Secured Notes will bear interest at floating rates that could rise significantly, increasing Ambac Assurance’s interest expense and reducing its cash flow. If Ambac Assurance’s interest expense increases significantly, whether due to changes in LIBOR or increased borrowing costs when its refinances its current indebtedness, Ambac Assurance may not be able to make payments with respect to the Secured Notes or its other indebtedness.
Ambac’s estimated R&W recovery may change over time, causing the perceived value of the collateral securing the Secured Notes and Tier 2 Notes to change, and any such change may be material.
Ambac reevaluates its estimated R&W recoveries on a quarterly basis in connection with the preparation of its financial statements. See “Critical Accounting Policies and Estimates” in Part II, Item 7, Note 2. Basis of Presentation and Significant Accounting Policies and Note 7. Financial Guarantee Insurance Contracts to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K for the fiscal year ended December 31, 2018. As a result of any reevaluation, the estimated amount of Ambac’s R&W recovery may be adjusted upward or downward due to, among other things, changes in management's view of such estimated recoveries and/or changes in the loss reserves related to such recoveries, and any adjustment may be material. Changes in estimated R&W recoveries may result in material changes in Ambac’s financial condition, including its capital and liquidity. In addition, any adjustment to estimated R&W recoveries may alter
the perceived value of the collateral securing the Secured Notes and Tier 2 Notes before payment on the Secured Notes or Tier 2 Notes is made in full, which may affect the value of, and trading market, if any, for, the Secured Notes or Tier 2 Notes. Management makes no representation that the estimated R&W recoveries will not change, materially or at all, including in the near term. There can be no assurance that the estimated R&W recoveries securing the Secured Notes and Tier 2 Notes will equal or exceed the principal amount of the Secured Notes and Tier 2 Notes, respectively, at all times prior to maturity.
Risks Related to Capital, Liquidity and Markets
Our inability to realize the expected recoveries included in our financial statements could adversely impact our liquidity, financial condition and results of operations and the value of our securities, including the Secured Notes and Tier 2 Notes.
Ambac Assurance is pursuing claims in litigation with respect to certain RMBS transactions that it insured. These claims are based on, among other things, representations with respect to the characteristics of the securitized loans, the absence of borrower fraud in the underlying loan pools or other misconduct in the origination process, the compliance of loans with the prevailing underwriting policies, and compliance of the RMBS transaction counterparties with policies and procedures related to loan origination and securitization. In such cases, where contract claims are being pursued, the sponsor of the transaction is contractually obligated to repurchase, cure or substitute collateral for any loan that breaches the representations and warranties. However, generally the sponsors have not honored those obligations and have vigorously defended claims brought against them.
As of December 31, 2018, we have estimated RMBS R&W subrogation recoveries of $1,744.2 million (net of reinsurance) included in our financial statements. These estimated recoveries are based on the contractual claims brought in the aforementioned litigations and represent a probability-weighted estimate of amounts we expect to recover under various possible scenarios. The estimated recoveries we have recorded do not represent the best or the worst possible outcomes with respect to any particular transaction or group of transactions.
There can be no assurance that Ambac Assurance will be successful in prosecuting its claims in the RMBS litigations. The outcome of any litigation, including the RMBS litigations, is inherently unpredictable, including because of risks intrinsic in the adversarial nature of litigation. Motions made to the court, rulings and appeals could delay or otherwise impact any recovery by Ambac Assurance. Moreover, rulings that may be adverse to Ambac Assurance (in any of its RMBS litigations, as well as in other RMBS cases in which it is not a party) could affect Ambac Assurance’s ability to pursue its claims or alter settlement dynamics with RMBS litigation defendants. For example, as described in Note 16. Commitments and Contingencies to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K, the defendants in Ambac Assurance’s case against Countrywide Securities Corp., Countrywide Financial Corp. (a.k.a. Bank of America Home Loans) and Bank of America Corp. (Supreme Court of the State of New York, County of New York, Case No. 651612/2010) are pursuing appeals of rulings issued in December 2018 on several pre-trial motions filed by defendants in August 2018 and October 2018. If the appeals were decided
adversely to Ambac Assurance, in whole or in part, our ability to recover on our claims could be materially impaired. Furthermore, the timing of the decision on the appeals may significantly prolong the timetable of any recovery. The timing of decisions by trial courts and appellate courts is uncertain, and courts may take longer than expected to issue decisions. A trial court may take longer than expected to schedule a trial in a case due to the schedule of the judge and the need or desire of the court to decide, or await the decision by an appellate court of, outstanding issues in the case.
Any litigation award or settlement may be for an amount less than the amount necessary to pay the Secured Notes or the Tier 2 Notes, which could have a material adverse effect on our financial condition or results of operations and make it more difficult for Ambac Assurance to repay the Ambac Note (and therefore make it more difficult for the issuer of the Secured Notes to repay the Secured Notes) and/or the Tier 2 Notes and/or Ambac Assurance’s outstanding surplus notes, on a timely basis or at all. Additionally, while Ambac Assurance may pursue settlement negotiations, there can be no assurance that any settlement negotiations will materialize or that any settlement agreement can be reached on terms acceptable to Ambac Assurance, or at all. Depending on the length of time required to resolve these litigations, either through settlement or at trial, Ambac Assurance could incur greater litigation expenses than currently projected. If a case is brought to trial, Ambac Assurance’s ultimate recovery would be subject to the additional risks inherent in any trial, including adverse findings or determinations by the trier of fact or the court, which could adversely impact the value of our securities, including the Secured Notes and Tier 2 Notes.
Any litigation award is subject to risks of recovery, including that the sponsor is unable pay a judgment that Ambac Assurance may obtain in litigation. In some instances, Ambac Assurance also has claims against a parent or an acquirer of the counterparty. However, Ambac Assurance may not be successful in enforcing its claims against any successor entity.
The RMBS litigations could also be adversely affected if Ambac Assurance does not have sufficient resources to actively prosecute its claims or becomes subject to rehabilitation, liquidation, conservation or dissolution, or otherwise impaired by actions of OCI.
Our ability to realize the estimated RMBS R&W subrogation recoveries included in our financial statements and the time of the recoveries, if any, is subject to significant uncertainty, including the risks described above and uncertainties inherent in the assumptions used in estimating such recoveries. The amount of these subrogation recoveries is significant and if we were unable to recover all such amounts, our stockholders’ equity as of December 31, 2018 would decrease from $1,633.1 million to $(111.1) million.
We expect to recover material amounts of claims payments through remediation measures including the litigation described above as well as through cash flows in the securitization structures of transactions that Ambac Assurance insures. Realization of such expected recoveries is subject to various risks and uncertainties, including the rights and defenses of other parties with interests that conflict with Ambac Assurance's interests, the performance of the collateral and assets backing the obligations that Ambac Assurance insures, and the performance of servicers involved in
securitizations in which Ambac Assurance participates as insurer. Additionally, our ability to realize recoveries in insured transactions may be impaired if the continuing orders of the Rehabilitation Court are not effective.
Adverse developments with respect to such variables may cause our recoveries to fall below expectations, which could have a material adverse effect on our financial condition, including our capital and liquidity, and may result in adverse consequences such as impairing the ability of Ambac Assurance to honor its financial obligations; the initiation of rehabilitation proceedings against Ambac Assurance; decreased likelihood of Ambac Assurance delivering value to Ambac, through dividends or otherwise; and a significant drop in the value of securities issued or insured by Ambac or Ambac Assurance, including the Secured Notes and Tier 2 Notes.
Ambac’s estimate of RMBS litigation recoveries is subject to significant uncertainty and changes to the estimate could adversely impact its liquidity, financial condition and results of operations.
For Ambac’s RMBS cases for which it records an RMBS R&W subrogation recovery in its financial statements, Ambac has obtained loan files from the relevant original pool and has conducted loan file reunderwriting to derive a breach rate that is extrapolated to estimate the damages Ambac expects to recover. Ambac does not estimate an RMBS R&W subrogation recovery for litigations where its sole claim is for fraudulent inducement.
The amount estimated for purposes of Ambac’s RMBS R&W subrogation recovery and the amount Ambac may ultimately receive is subject to significant uncertainty, as described in the immediately preceding risk factor. Ambac’s findings and assumptions regarding collateral performance and Ambac’s expectations with respect to the outcome of the RMBS litigations have a significant impact on Ambac’s estimated RMBS R&W subrogation recovery. If these findings, assumptions or estimates prove to be incorrect or otherwise do not support our claims, actual recoveries could differ materially from those estimated. Actual recoveries will ultimately depend on future events and there can be no assurance that our view of collateral performance or our estimated RMBS R&W subrogation recoveries will not differ from actual events. Although Ambac believes that its methodology for estimating recoveries is appropriate, the methodologies Ambac uses to estimate expected collateral losses and specific transaction performance may not be similar to methodologies used by Ambac’s competitors, counterparties or other market participants. The determination of expected RMBS R&W subrogation recoveries is an inherently subjective and complex process involving numerous estimates and assumptions and judgments by management, using both internal and external data sources to derive a specific transaction's cash flows. As a result, Ambac’s current estimates may not reflect Ambac’s ultimate recovery, and management makes no representation that the actual amounts recovered, if any, will not differ materially from those estimated. The failure of Ambac’s actual recoveries to meet or exceed its current estimates could result in a material adverse effect on Ambac’s financial condition, including its capital and liquidity.
AMPS that were not exchanged and cancelled in the AMPS Exchange may be acquired, redeemed or repaid on terms that may be viewed as more, or less, favorable than the terms of the applicable consideration offered in the AMPS Exchange.
Ambac or Ambac Assurance may acquire, redeem or repay AMPS that were not exchanged and cancelled in the AMPS Exchange through open market purchases, privately negotiated transactions, other tender or exchange offers, redemptions under the AMPS, or such other means as Ambac or Ambac Assurance (as the case may be) deems appropriate, subject to the restrictions in its governing documents, the restrictive covenants in its contracts and any applicable regulatory restrictions. Any such transactions will occur upon the terms and at the prices as Ambac or Ambac Assurance (as the case may be) may determine in its sole discretion, which may be more or less favorable than the terms of the AMPS Exchange, and in any case could be for cash or other consideration. Ambac or Ambac Assurance may choose to pursue any or none of these alternatives, or combinations thereof, in the future.
We may not be able to commute or reduce insured exposures.
In pursuing the objective of improving our financial position, we are seeking to commute or reduce insured exposures. De-risking transactions may not be feasible or economically viable. We cannot provide any assurance that any such transaction will be consummated in the future, or if it is, as to the timing, terms or conditions of any such transaction. Even if we consummate one or more of such transactions, doing so may ultimately prove to be unsuccessful in creating value for any or all of our stakeholders and may adversely affect our operating results or financial position.
Revenues and cash flow would be adversely impacted by a decline in realization of installment premiums.
Due to the installment nature of a significant percentage of its premium income, Ambac Assurance has an embedded future revenue stream. The amount of installment premiums actually realized by Ambac Assurance could be reduced in the future due to factors such as early termination of insurance contracts, accelerated prepayments of underlying obligations or insufficiency of cash flows (by the premium paying entity). Additionally, the Segregated Account rehabilitation may result in the loss of installment premium income from such insured transactions if the continuing orders of the Rehabilitation Court are not effective. Such reductions would result in lower revenues.
The composition of the securities in our investment portfolio exposes us to greater risk than before we invested in "alternative assets."
Each of Ambac Assurance and Ambac Assurance UK Limited (“Ambac UK”) maintains a portion of its investment portfolio in lower-rated securities and/or “alternative assets” in order to increase the risk-adjusted return on its portfolio. Investments in lower-rated securities and “alternative assets” could expose Ambac Assurance and/or Ambac UK to greater earnings volatility, increased losses and decreased liquidity in the investment portfolio.
We may have future capital needs and may not be able to obtain third-party financing or raise additional third-party capital on acceptable terms, or at all.
An inability to obtain third-party debt financing or raise additional third-party capital, when required by us or when business
conditions warrant, could have a material adverse effect on our business, financial condition and results of operations. The economic conditions affecting our industry, as well as other factors, may constrain our financing abilities. Our ability to secure third-party financing, if available, and to satisfy or refinance our financial obligations under indebtedness outstanding from time to time will depend upon regulatory conditions, our future operating performance, the availability of credit generally, economic conditions and financial, business and other factors, many of which are beyond our control. The market conditions and the macroeconomic conditions that affect our industry could have a material adverse effect on our ability to secure third-party financing on favorable terms, if at all.
If third-party financing is not available when needed, or is available on unfavorable terms, we may be unable to take advantage of business opportunities, respond to competitive pressures or refinance our outstanding indebtedness, any of which could have a material adverse effect on our business, financial condition and results of operations.
Ambac Assurance may in the future report a policyholders’ deficit or become insolvent.
While the Rehabilitation Exit Transactions and related transactions were designed to improve our financial condition, we will continue to be subject to risks and uncertainties that could materially affect our financial position. Therefore, even following consummation of the Rehabilitation Exit Transactions, circumstances may occur that would cause Ambac Assurance to report a policyholders’ deficit or not comply in the future with the statutory minimum policyholders’ surplus or undergo rehabilitation. In addition, Ambac Assurance may become insolvent in the future. OCI has prescribed or permitted additional accounting practices for Ambac Assurance and Everspan which are described in Note 8. Insurance Regulatory Restrictions to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K. If Ambac Assurance and Everspan are unable to utilize the permitted or prescribed practices, we may not comply with the statutory minimum policyholders’ surplus.
The determination of the amount of other-than temporary impairments taken on our investments is highly subjective and could materially impact our results of operations or financial position.
The determination of the amount of impairments on our investments varies by investment type and is based upon our periodic evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available. Management updates its evaluations regularly and reflects changes in impairments as such evaluations are revised. There can be no assurance that our management has accurately assessed the level of impairments taken in our financial statements. Furthermore, additional impairments may need to be taken in the future. Historical trends may not be indicative of future impairments. In particular, we use financial models and tools to project impairments with respect to RMBS held in our investment portfolio, including Ambac Assurance guaranteed RMBS. Differences in the models and tools we employ and/or flaws in these models and tools and/or faulty assumptions inherent in these models and tools and those determined by management, could lead
to increased impairments with respect to RMBS in our investment portfolio.
Risks Related to the Financial and Credit Markets
Changes in prevailing interest rate levels and market conditions could adversely impact our business results and prospects.
Increases in prevailing interest rate levels can adversely affect the value of our investment portfolio and, therefore, our financial strength. In the event that investments must be sold in order to pay claims, to pay debt obligations, to meet collateral posting requirements or to meet other liquidity needs, such investments would likely be sold at discounted prices. Additionally, increasing interest rates would have an adverse impact on our insured portfolio. For example, increasing interest rates could result in higher claim payments in respect of defaulted obligations that bear floating rates of interest. Higher interest rates can also lead to increased credit stress on consumer asset-backed transactions (as the securitized assets supporting a portion of these exposures are floating rate consumer obligations), slower prepayment speeds and resulting “extension risk” relative to such consumer asset-backed transactions in our insured and investment portfolios, and decreased refinancing activity.
Decreasing interest rates could result in early terminations of financial guarantee insurance policies in respect of which we are paid on an installment basis and do not receive a termination premium, thus reducing premium earned for these transactions. Decreases in prevailing interest rates may also limit growth of, or reduce, investment income and may adversely impact our interest rate swap portfolio.
Our investment portfolio may also be adversely affected by credit rating downgrades, ABS and RMBS prepayment speeds, foreign exchange movements, spread volatility, and credit losses.
We are subject to credit risk throughout our businesses, including large single risks, risk concentrations, correlated risks and reinsurance counterparty credit risk.
We are exposed to the risk that issuers of debt which we have insured (or with respect to which we have written credit derivatives), issuers of debt which we hold in our investment portfolio, reinsurers and other contract counterparties (including derivative counterparties) may default in their financial obligations, whether as the result of insolvency, lack of liquidity, operational failure, fraud or other reasons. These credit risks could cause increased losses and loss reserves, and/or estimates of credit impairments and mark-to-market losses with respect to credit derivatives in our financial guarantee business; and we could experience losses and decreases in the value of our investment portfolio and, therefore, our financial strength. Such credit risks may be in the form of large single risk exposures to particular issuers, reinsurers or counterparties; losses caused by catastrophic events (including terrorist acts and natural disasters); losses caused by increases in municipal defaults; or losses in respect of different, but correlated, credit exposures.
We are subject to the risk of litigation and regulatory inquiries or investigations, and the outcome of proceedings we are or may become involved in could have a material adverse effect on our business, operations, financial position, profitability or cash flows.
Ambac Assurance is defending various lawsuits relating to its financial guarantee business. In addition, the Company from time to time receives various regulatory inquiries and requests for information. Please see Note 16. Commitments and Contingencies to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for information on these various proceedings.
It is not possible to predict whether additional suits will be filed against Ambac, Ambac Assurance or one or more other subsidiaries or whether additional regulatory inquiries or requests for information will be made, and it is also not possible to predict the outcome of litigation, inquiries or requests for information. It is possible that there could be unfavorable outcomes in these or other proceedings. Management is unable to make a meaningful estimate of the amount or range of loss that could result from unfavorable outcomes or of the expenses that will be incurred in defending these lawsuits. Under some circumstances, adverse results in any such proceedings and/or the incurring of significant litigation expenses could be material to our business, operations, financial position, profitability or cash flows.
The Settlement Agreement, Stipulation and Order and Indenture for the Tier 2 Notes contain restrictive covenants that may impair our ability to pursue our business strategies.
Pursuant to the terms of the Settlement Agreement, Stipulation and Order and indenture for the Tier 2 Notes, Ambac Assurance must seek prior approval by OCI of certain corporate actions. The Settlement Agreement, Stipulation and Order and indenture for the Tier 2 Notes also include covenants which restrict the operations of Ambac Assurance which, (i) in the case of the Settlement Agreement, remain in force until the surplus notes that were issued pursuant to the Settlement Agreement have been redeemed, repurchased or repaid in full, (ii) in the case of the Stipulation and Order, remain in place until the OCI decides to relax such restrictions, and (iii) in the case of the indenture for the Tier 2 Notes, remain in force until the Tier 2 Notes have been redeemed, repurchased or repaid in full. Certain of these restrictions may be waived with the approval of holders of the applicable debt securities and/or OCI. If we are unable to obtain the required consents under the Settlement Agreement, the Stipulation and Order and/or the indenture for the Tier 2 Notes, we may not be able to execute our planned business strategies.
OCI has certain enforcement rights with respect to the Settlement Agreement and Stipulation and Order. Disputes may arise over the interpretation of such agreements, the exercise or purported exercise of rights thereunder, or the performance of or failure or purported failure to perform obligations thereunder. Any such dispute could have material adverse effects on the Company, whether through litigation, administrative proceedings, supervisory orders, failure to execute transactions sought by management, interference with corporate strategies, objectives or prerogatives, inefficient decision-making or execution, forced realignment of resources, increased costs, distractions to management, strained working relationships or otherwise. Such
effects would also increase the risk that OCI would seek to initiate rehabilitation proceedings against Ambac Assurance.
System security risks, data protection breaches and cyber-attacks could adversely affect our business and results of operations.
We rely on our information technology systems for many enterprise-critical functions and a prolonged failure or interruption of these systems for any reason could cause significant disruption to our operations and have a material adverse effect on our business, financial condition and operating results. Our information technology and application systems may be vulnerable to threats from computer viruses, natural disasters, unauthorized access, cyber-attack and other similar disruptions. Computer hackers may be able to penetrate our network’s system security and misappropriate or compromise confidential information, create system disruptions or cause shutdowns. In addition to our own confidential information, we sometimes receive and are required to protect confidential information from third parties. To the extent any disruption or security breach results in a loss or damage to our data, or inappropriate disclosure of our confidential information or that of others, it could cause significant financial losses that are either not, or not fully, insured against, cause damage to our reputation, affect our relationships with third parties, lead to claims against us, result in regulatory action, or otherwise have a material adverse effect on our business or results of operations. In addition, we may be required to incur significant costs to mitigate the damage caused by any security breach, or to protect against future damage. Moreover, although we have disaster recovery and business continuity plans in place, we may not be able to adequately execute these plans in a timely fashion in the event of a disruption to our information technology and application systems.
We may incur losses resulting from operational risk due to inadequate or failed internal processes, breakdown of settlement or communication systems, or from external events leading to disruption of our business. Events subject to operational risk include:
Internal Fraud - misappropriation of assets, intentional mismarking of positions
External Fraud - theft of information, third-party theft and forgery
Clients, Products, & Business Practice - improper trade, fiduciary breaches
Damage to Physical Assets
Business Disruption & System Failures - software failures, hardware failures; and
Execution, Delivery, & Process Management - data entry errors, accounting errors, failed mandatory reporting, settlement errors, and negligence.
We may be adversely affected by failures in services or products provided by third parties.
We have outsourced and may continue to outsource certain activities of our operations and business, and rely upon third-party vendors for other essential services and information, such as the provision of data used in setting loss reserves and the provision of risk management information and services. A material failure by an external service or information provider or a material defect in the products, services or information provided thereby could adversely affect our financial condition and results of operations.
Our inability to attract and retain qualified executives and employees or the loss of any of these personnel could negatively impact our business.
Our ability to execute on our business strategies depends on the retention and recruitment of qualified executives and other professionals. We rely substantially upon the services of our current executive team. In addition to these officers, we require key staff with risk mitigation, structured finance, insurance, credit, investment, accounting, finance, legal and technical skills. As a result of Ambac’s financial situation, there is a higher risk that executive officers and other key staff will leave the Company and replacements may not be motivated to join the Company. The loss of the services of members of our senior management team or our inability to hire and retain other talented personnel could delay or prevent us from succeeding in executing our strategies, which could further negatively impact our business.
Our business could be negatively affected by actions of stakeholders whose interests may not be aligned with the broader interests of our stockholders.
Ambac could be negatively affected as a result of actions by stakeholders whose interests may not be aligned with the broader interests of our stockholders, and responding to any such actions could be costly and time-consuming, disrupt operations and divert the attention of management and employees. Such activities could interfere with our ability to execute on our strategic plans.
Risks Related to International Business
Uncertainty regarding the economic impact of “Brexit” may have an adverse effect on Ambac’s insured international portfolio and the value of its foreign investments, both of which primarily reside with its subsidiary Ambac UK.
The Government of the United Kingdom (“UK”) continues to contend with inconclusively finding resolution in the UK Parliament and with the European Union (“EU”) for the terms of the UK’s departure from the EU (“Brexit”). Current Brexit discussions do not include details of future post-Brexit trade relations. Current negotiations are designed to reach agreement on transitional arrangements covering the UK’s exit from the EU, lasting only for a relatively brief period, currently mooted to endure from March 29, 2019, the anticipated date of formal UK departure from the EU, and end on December 31, 2020. Assuming a transition agreement is reached, a further, separate, negotiation on a future post-transition trade framework must then begin. It is envisaged that negotiation on the future trade framework would be concluded during the transitional phase, and would be influenced by the nature of the transitional arrangements agreed between the parties.
However there is a material risk that transitional Brexit negotiations are inconclusive so that on March 29, 2019 the UK automatically exits the EU without any transitional arrangement (a “no deal Brexit”), and also with no certain path to negotiating a future trade relationship with the EU.
Absent action by the EU or member states, in the event of a no deal Brexit the activities in the European Economic Area (“EEA”) of UK passporting insurers, including Ambac UK, will become unlawful on March 29, 2019. They will lose their legal authorization to serve clients who benefit from policies issued by UK incorporated insurers under freedom of services passporting
rights (and thereby may be unable to legally collect premiums or pay claims).
At December 31, 2018, Ambac UK’s insured portfolio included six policies in the EU written under current passporting rights, with an aggregate par value of $2.4 billion. In respect of these six policies, there is premium receivable of $61 million and loss and loss expense reserves (net of subrogation recoverable) of $271 million. Absent legally binding transitional arrangements Ambac UK may be unable to collect these premiums or pay the claims to which these premiums receivable and loss and loss expense reserves relate after March 29, 2019. Ambac UK’s ability to restructure these policies to mitigate this risk is limited. Nonpayment of claims under any of the affected policies could lead to the loss of control rights in the related transaction(s), which would expose Ambac UK to greater risk of loss. In addition, under applicable English law, a court may hold that Ambac UK has an enforceable obligation to pay claims irrespective of the EU regulatory position in law. Consequently Ambac UK could find itself in a position where it was not in receipt of premium on a relevant deal but chose to pay claims to avoid loss of control rights and/or other consequences of non-payment, notwithstanding the EU regulatory characterization in law.
Additionally, if UK insurers have branches in EEA Member States they may be legally obliged to either capitalize them, as a so-called third country branch from an institution whose home state is outside the EEA, or close them down and no longer be legally represented in those EU jurisdictions. Ambac UK has a branch in Italy, with one remaining policy issued from the branch. The branch is not capitalized separately from Ambac UK. In the event of a no-deal Brexit, the future nature and status of the branch is unclear, particularly with respect to the need for capitalization to support the one remaining branch policy. Given that Ambac UK is under capitalized in terms of applicable regulatory capital rules it will be difficult for the UK regulator to agree to assets leaving the company for this purpose.
There is a risk that absent agreement with the Italian regulator regarding the future of the branch, under law the Italian regulator could institute insolvent winding up proceedings against the branch as an unlicensed insurance business. In this scenario the one branch policy would then be terminated by operation of law notwithstanding the prejudicial outcome to policy holders. This chain of events could in turn trigger cross defaults with a consequential loss by Ambac UK of its controlling creditor rights in many or all transactions. This would greatly inhibit Ambac UK’s ability to exercise its rights in transactions generally, and in particular with respect to mitigating potential or actual loss in those transactions.
In light of no deal Brexit risk, the UK financial regulatory authority has been actively encouraging regulated firms to put into place contingency plans, as have been EU and EU member states’ financial regulatory bodies.
However on February 19, 2019, the European Insurance and Occupational Pensions Authority (“EIOPA”) made a series of recommendations to EU insurance regulators in light of Brexit. These recommendations include the recommendation that regulatory authorities apply legal frameworks that facilitate the orderly run off (without time limit) branch operations and of insurance policies issued in EEA member states by UK insurers
prior to March 30, 2019 that terminate after this date. The recommendations will require to be incorporated into EEA member states legal and regulatory frameworks in an appropriate manner to bring them into effect. We can provide no assurance as to the manner or timing of such regulatory changes.
The Company is in discussion with the PRA and other relevant regulatory authorities to enable the continued orderly run off of its policies issued in the EEA under passporting rights as well as the Italian branch operation in line with this recommendation.
In addition to the direct impact on insurers cited above, general uncertainty and the perceptions as to the ultimate impact of Brexit may adversely affect business activity, political stability, foreign exchange rates and economic conditions in the UK, the Eurozone, and the EU.
Actions of the PRA and FCA could reduce the value of Ambac UK realizable by Ambac, which would adversely affect our securityholders.
Ambac’s international business is operated by Ambac UK, which is regulated by the Prudential Regulation Authority (“PRA”) for prudential purposes and the Financial Conduct Authority (“FCA”) for conduct purposes. Under the Financial Services and Markets Act 2000 (“FSMA”), the PRA authorized Ambac UK to carry out financial guaranty insurance business in the UK and in the EU by way of the EU’s passporting regime (although this may change following Brexit), subject to the terms and conditions of the permission granted by the PRA and consented to by the FCA. However, the terms of Ambac UK’s regulatory authority are now restricted and Ambac UK is in run-off. Among other things, Ambac UK may not write any new business, and, with respect to any entity within the Ambac group of affiliates, commute, vary or terminate any existing financial guaranty policy, transfer certain assets, or pay dividends, without the prior approval of the PRA and FCA. The PRA and FCA act generally in the interests of Ambac UK policyholders and will not take into account the interests of securityholders of Ambac or Ambac Assurance when considering whether to provide any such approval. Accordingly, determinations made by the PRA and FCA, in their capacity as Ambac UK’s regulator, could potentially result in adverse consequences for our securityholders and also reduce the value realizable by Ambac for Ambac UK.
Regulatory uncertainty in relation to Ambac UK’s capital position could adversely affect the value of Ambac UK and affect our securityholders.
Under applicable regulatory capital rules (“Solvency II”) Ambac UK remains significantly deficient in terms of capital. Ambac UK does not have a remedial plan other than to build its assets over time by on-going premium collections and earned investment income, as well as attempting to accelerate the run-off of its exposures. Further, there currently is no prospect of any capital support from the Ambac group of affiliates. The PRA is aware of Ambac UK’s position and prospects. The PRA supervisory statement SS7/15 “Supervision of firms in difficulty or run-off” notes that “there are many circumstances in which a run-off strategy is in the best interests of policyholders” and notes that the PRA will review such firms and that they “may be permitted to continue activities necessary to carry out existing contracts in a manner, and for so long as, the PRA considers necessary in order to afford an appropriate degree of protection to policyholders”.
Ambac UK clearly falls into this category and therefore Ambac UK’s current run off approach remains at all times subject to the PRA continuing to take no action in relation to its capital deficit and related Solvency II requirements. Alternative courses of action open to the PRA could adversely impact the anticipated run-off trajectory of Ambac UK and impact its value.
Risks Related to Taxation
Surplus notes received in the AMPS Exchange and by holders of Deferred Amounts pursuant to the Second Amended Plan of Rehabilitation along with other debt reissued by Ambac may not be fungible for U.S. federal income tax purposes with other surplus notes and debt currently outstanding.
Surplus notes received in the AMPS Exchange and by holders of Deferred Amounts pursuant to the Second Amended Plan of Rehabilitation along with other debt reissued by Ambac (together "Reissued Debt") have different issue prices for U.S. federal income tax purposes than the originally issued outstanding surplus notes and other debt and, therefore, are expected to accrue original issue discount (“OID”) in an amount that differs from the amounts of OID accruing on the originally issued surplus notes and other debt currently outstanding, as the case may be. Therefore, Reissued Debt may not be fungible with the other outstanding surplus notes and debt, as applicable, for U.S. federal income tax purposes. Because Reissued Debt has the same CUSIP numbers as other related surplus notes and debt currently outstanding, the Reissued Debt will not be readily distinguishable from the other outstanding surplus notes and debt, as applicable. This could create uncertainty in the market and could adversely affect the liquidity and/or trading values of surplus notes and other debt.
Certain surplus notes or other obligations of Ambac Assurance may be characterized as equity of Ambac Assurance and as a result, Ambac Assurance may no longer be a member of the U.S. federal income tax consolidated group of which Ambac is the common parent.
It is possible that certain surplus notes or other obligations of Ambac Assurance may be characterized as equity of Ambac Assurance for U.S. federal income tax purposes. If such surplus notes or other obligations are characterized as equity of Ambac Assurance that is taken into account for tax affiliation purposes and it is determined that such “equity” represented more than twenty percent of the total value of the stock of Ambac Assurance, Ambac Assurance may no longer be characterized as an includable corporation that is affiliated with Ambac. As a result, Ambac Assurance would no longer be characterized as a member of the U.S. federal income tax consolidated group of which Ambac is the common parent (the “Ambac Consolidated Group”) and Ambac Assurance would be required to file a separate consolidated tax return as the common parent of a new U.S. federal income tax consolidated group including Ambac Assurance as the new common parent and Ambac Assurance’s affiliated subsidiaries (the “Ambac Assurance Consolidated Tax Group”).
To the extent Ambac Assurance is no longer a member of the Ambac Consolidated Group, Ambac Assurance’s net operating loss carry-forwards ("NOLs") (and certain other available tax attributes of Ambac Assurance and the other members of the Ambac Assurance Consolidated Tax Group) may no longer be available for use by the Ambac Assurance Consolidated Tax Group or any of the remaining members of the Ambac Assurance
Consolidated Tax Group to reduce the U.S. federal income tax liabilities of the Ambac Assurance Consolidated Tax Group. Ambac, Ambac Assurance and their affiliates entered into a tax sharing agreement that would require Ambac to make certain tax elections that could mitigate the loss of NOLs and other tax attributes resulting from a deconsolidation of Ambac Assurance from the Ambac Consolidated Group. However, in the event of a deconsolidation, certain other benefits resulting from U.S. federal income tax consolidation may no longer be available to the Ambac Consolidated Group including certain favorable rules relating to transactions occurring between members of the Ambac Consolidated Group and members of the Ambac Assurance Consolidated Tax Group.
If surplus notes or other obligations are characterized as equity of Ambac Assurance, the Ambac Assurance NOLs (and certain other tax attributes or tax benefits of the Ambac Consolidated Group) may be subject to limitation under Section 382 of the Tax Code.
It is possible that certain surplus notes or other obligations may be characterized as equity of Ambac Assurance for U.S. federal income tax purposes. Such characterization could result in an “ownership change” of Ambac Assurance for purposes of Section 382 of the Tax Code. If such an ownership change were to occur, the value and amount of the Ambac Assurance NOLs would be substantially impaired, increasing the U.S. federal income tax liability of Ambac Assurance and materially reducing the value of Ambac Assurance’s stock owned by Ambac and the potential of future cash tolling or dividend payments from Ambac Assurance to Ambac.
Deductions with respect to interest accruing on certain surplus notes may be eliminated or deferred until payment.
To the extent certain surplus notes are characterized as equity for U.S. federal income tax purposes, accrued interest will not be deductible by Ambac Assurance. In addition, even if such surplus notes are characterized as debt for U.S. federal income tax purposes, the deduction of interest accruing on such surplus notes may be deferred until paid or eliminated in part depending upon (i) the terms of any deferral and payment provisions provided in such surplus notes, (ii) whether such surplus notes have “significant original issue discount,” and (iii) the yield to maturity of surplus notes. To the extent deductions with respect to interest are eliminated or deferred, the U.S. federal income tax of the members of the Ambac Consolidated Group or the members of the Ambac Assurance Consolidated Tax Group as the case may be, could be increased reducing the amount of cash available to pay its obligations.
Risks Related to Strategic Plan
Ambac is exploring select business opportunities which may permit utilization of Ambac’s net operating loss carry-forwards; however, such business opportunities may not be consummated, or if consummated, may not create value and may negatively impact our financial results.
Ambac is exploring select business opportunities which may, amongst other things, permit utilization of its net operating loss carry-forwards. Such business opportunities may involve the acquisition of assets or existing businesses or the development of businesses through new or existing subsidiaries. It is not possible at this time to predict the future prospects or other characteristics
of any such business opportunities. Although we intend to conduct business, financial and legal due diligence in connection with the evaluation of any future business or acquisition opportunities, there can be no assurance our due diligence investigations will identify every matter that could have a material adverse effect on us. Efforts to pursue select business opportunities may be unsuccessful or require significant financial or other resources, which could have a negative impact on our financial condition. No assurance can be given that Ambac will be able to complete such business opportunities, generate any earnings or be able to successfully integrate any such business into our current operating structure.
Moreover, Ambac’s ability to enter into new businesses, including new businesses apart from Ambac Assurance, is also subject to significant doubt, given the financial condition of Ambac Assurance, the difficulty of leveraging or monetizing Ambac’s other assets, and the uncertainty of its ability to raise capital. Due to these factors, as well as those relating to Ambac Assurance as described in this Item 1A. Risk Factors, the value of our securities is speculative.
Ambac’s current strategy and initiatives have been derived from, and created as a consequence of, the company’s current financial condition and circumstances. Should changes in Ambac’s circumstances or financial condition or in the political, economic and/or legal environment occur, there can be no assurances that all or any part of such strategy and/or initiatives will not be abandoned or amended to take account of such changes. Any such adjustment or abandonment may have an adverse effect on our securities.
Unresolved Staff Comments — No matters require disclosure.
Item 2. Properties
The executive office of Ambac is located at One State Street Plaza, New York, New York 10004, which consists of 103,484 square feet of office space, under lease agreements that expire in September 2019 (77,613 square feet) and December 2029 (25,871 square feet). Ambac will relocate in the third quarter of 2019 and has entered into a sublease agreement at One World Trade Center, New York, New York 10007, which consists of 46,927 square feet that will expire January 2030. Ambac has sublet the remaining 25,871 square feet of space at One State Street Plaza through its expiration date.
Ambac leases additional space outside of New York for its data center at a secure facility under a lease agreement that expires in March 2020.
Additionally, Ambac maintains a disaster recovery site as part of its Disaster Recovery Plan, which is located approximately 100 miles from New York City under a lease that expires in September 2020. This remote warm-back-up facility is complete with user work stations, phone system, data center, internet connectivity and a power generator, capable of serving the needs of the disaster recovery team to support all business operations. The plan, facility and systems are revised and upgraded where necessary, and user tested annually to confirm their readiness.
Ambac UK maintains an office in London, England, which consists of 3,514 square feet of office space, under a lease agreement that expires in October 2020.
Refer to Notes to the Consolidated Financial Statements—Note 16. Commitments and Contingencies included in Part II, Item 8 in this Form 10-K for a discussion on legal proceedings against Ambac and its subsidiaries.
Item 4. Mine Safety Disclosures — Not applicable.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The Company's common stock is listed on NASDAQ under the symbol “AMBC.”
On February 25, 2019, there were 25 stockholders of record of Ambac’s common stock.
The Company did not pay cash dividends on its common stock during 2018 and 2017. Information concerning restrictions on the payment of dividends from Ambac's insurance subsidiaries is set forth in Item 1 above under the caption “Dividend Restrictions, Including Contractual Restrictions" and in Note 8. Insurance Regulatory Restrictions to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K.
Purchases of Equity Securities By the Issuer and Affiliated Purchasers
The following table summarizes Ambac's share purchases during the fourth quarter of 2018. When restricted stock unit awards issued by Ambac vest or settle, they become taxable compensation to employees. For certain awards, shares may be withheld to cover the employee's portion of withholding taxes. In the fourth quarter of 2018, Ambac purchased shares from employees that settled restricted stock units to meet employee tax withholdings.
Fourth Quarter 2018
Total Shares Purchased (1)
Average Price Paid Per Share
Total Number of Shares Purchased as Part of Publicly Announced Plan (1)
Maximum Number of Shares That may Yet be Purchased Under the Plan
There were no other repurchases of equity securities made during the three months ended December 31, 2018. Ambac does not have a stock repurchase program.
Each warrant represents the right to purchase one share of Ambac common stock. The warrants are exercisable for cash at any time on or prior to April 30, 2023 at an exercise price of $16.67 per share. The warrants also have a cashless exercise provision.
On June 30, 2015, the Board of Directors of Ambac authorized the establishment of a warrant repurchase program that permits the repurchase of up to $10 million of warrants. On November 3, 2016, the Board of Directors of Ambac authorized an additional $10 million to the warrant repurchase program. As of December 31, 2018, Ambac had repurchased 985,331 warrants at a cost of $8.1 million The remaining aggregate authorization at December 31, 2018 is $11.9 million.
In connection with the AMPS Exchange, Ambac issued 824,307 of the repurchased warrants on August 3, 2018, leaving 4,877,783 warrants outstanding. Refer to Note 1. Background and Business Description to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further discussion of the AMPS Exchange.
The following graph compares the performance of an investment in our common stock from the close of business on May 1, 2013, the date we emerged from bankruptcy through December 31, 2018, with the Russell 2000 Index and S&P Completion Index. The graph assumes $100 was invested on May 1, 2013 in our common Stock at the closing price of $20 per share and at the closing price for the Russell 2000 Index and S&P Completion Index. It also assumes that dividends (if any) were reinvested on the date of payment without payment of any commissions. The performance shown in the graph represents past performance and should not be considered an indication of future performance.
The following financial information for the five years ended December 31, 2018, has been derived from Ambac’s Consolidated Financial Statements. This information should be read in conjunction with the Consolidated Financial Statements and related notes located in Part II, Item 8 in this Form 10-K.
Year Ended December 31,
($ in millions, except per share data)
Total Comprehensive Income Highlights:
Gross premiums written
Net premiums earned
Net investment income (2)
Other than temporary impairment losses
Net realized investment gains
Net gains (losses) on derivative contracts
Net realized (losses) gains on extinguishment of debt (2)
Income (loss) on Variable Interest Entities ("VIEs")
Loss and loss expenses (benefit) (1) (2)
Operating expenses (2)
Interest expense (2)
Insurance intangible amortization
Pre-tax income (loss)
Net income (loss)
Net income (loss) attributable to Common Shareholders
Total comprehensive income attributable to Ambac Financial Group, Inc.
Net income (loss) per share:
Ambac records the impact of estimated recoveries related to securitized loans in RMBS transactions that breached certain representations and warranties within losses and loss expenses (benefit). The expense (benefit) associated with changes to our estimated recoveries for the years ended December 31, 2018, 2017, 2016, 2015 and 2014 were $62.5 million, $72.0 million, $(71.4) million, $(303.6) million, and $(481.7) million, respectively.
On February 12, 2018, Ambac Assurance executed the Rehabilitation Exit Transactions. These transactions directly resulted in: (i) a Loss and loss expense benefit of $288 million; (ii) operating expenses of $17 million and (iii) realized gains on extinguishment of debt of $3 million. Additionally, changes to the investment portfolio and to the composition of long-term debt arising from the transactions significantly impacted net investment income and interest expense for 2018 compared to prior years. Refer to Results of Operations included in Item 7 of this Form 10-K for a further discussion of the Rehabilitation Exit Transactions and their impact on financial results in 2018.
Ambac records as a component of its loss reserves and subrogation recoverable, estimated recoveries related to securitized loans in RMBS transactions that breached certain representations and warranties. Ambac has recorded gross estimated recoveries of $1,770.5 million, $1,834.4 million, $1,907.0 million, $2,829.6 million, and $2,523.5 million at December 31, 2018, 2017, 2016, 2015 and 2014, respectively.
Long-term debt includes surplus notes issued to third parties by Ambac Assurance, notes outstanding to third parties arising from Ambac Assurance's secured borrowing transaction and the Ambac Note and Tier 2 Notes issued in connection with the Rehabilitation Exit Transactions in 2018. In 2014, Ambac sold a $350.0 million junior surplus note issued to it by the Segregated Account to a newly formed Trust in exchange for cash of $224.3 million and a subordinated owner trust certificate issued by the Trust. Long-term debt for all years excludes the portion of long-term debt associated with variable interest entities.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) contains certain financial measures, in particular the presentation of Adjusted Earnings and Adjusted Book Value, which are not presented in accordance with accounting principles generally accepted in the United States (“GAAP”). We are presenting these non-GAAP financial measures because they provide greater transparency and enhanced visibility into the underlying drivers of our business. We do not intend for these non-GAAP financial measures to be a substitute for any GAAP financial measures and they may differ from similar reporting provided by other companies. Readers of this Form 10-K should use these non-GAAP financial measures only in conjunction with the comparable GAAP financial measures. Adjusted Earnings and Adjusted Book Value are non-GAAP financial measures that adjust for the impact of certain non-recurring or non-economic GAAP accounting requirements and include the addition of certain items that the Company has or expects to realize in the future, but that are not reported under GAAP. We provide reconciliations to the most directly comparable GAAP measures; Adjusted Earnings to Net income attributable to common stockholders and Adjusted Book Value to Total Ambac Financial Group, Inc. stockholders’ equity.
See Note 1. Background and Business Description for a description of the Company and our key strategies to achieve our primary goal to maximize shareholder value.
Ambac Assurance and Subsidiaries:
A key strategy for Ambac is to increase the value of its investment in Ambac Assurance by actively managing its assets and liabilities. Asset management primarily entails maximizing the risk adjusted return on non-VIE invested assets and managing liquidity to help ensure resources are available to meet operational and strategic
cash needs. These strategic cash needs include activities associated with Ambac's liability management and loss mitigation programs.
Investment portfolios are subject to internal investment guidelines, as well as limits on types and quality of investments imposed by applicable insurance laws and regulations. As part of its investment strategy, and in accordance with the aforementioned guidelines, Ambac Assurance and Ambac Assurance UK Limited ("Ambac UK"), purchase distressed Ambac-insured securities based on their relative risk/reward characteristics. The investment portfolios of Ambac Assurance and Ambac UK also hold fixed income securities and pooled funds that include a variety of other assets including, but not limited to, corporate bonds, asset backed and
mortgage backed securities, municipal bonds, high yield bonds, leveraged loans, equities, real estate, insurance-linked securities and hedge funds. Refer to Note 10. Investments to the Consolidated Financial Statements, included in Part II, Item 8 in this Form 10-K for further details of fixed income investments by asset class.
During the year ended December 31, 2018, Ambac (inclusive of its subsidiaries) did not acquire a significant amount of distressed Ambac-insured securities. As a result of the Rehabilitation Exit Transactions (as defined in Note 1. Background and Business Description), Ambac discharged all Deferred Amount (as defined in Note 1. Background and Business Description) obligations for an effective consideration package comprised of cash, new Secured Notes (as defined in Note 1. Background and Business Description) and certain existing surplus notes, including those held by Ambac, and accordingly Ambac's ownership of Ambac-insured RMBS declined significantly. Furthermore, Ambac sold certain Ambac-insured RMBS securities during 2018 in connection with re-balancing the investment portfolio and certain Ambac-insured student loan securities in connection with a commutation transaction. At December 31, 2018, Ambac owned $254 million of Ambac-insured RMBS and approximately 37% of outstanding Puerto Rico Infrastructure Financing Authority ("PRIFA") and 58% of outstanding Ambac-insured bonds issued by the Puerto Rico Sales Tax Financing Corporation ("COFINA"). Subject to applicable internal and regulatory guidelines and other constraints, Ambac will continue to opportunistically purchase Ambac-insured securities.
Liability and Insured Exposure Management:
Ambac Assurance's Risk Management Group ("RMG") focuses on the analysis, implementation and execution of risk reduction, remediation and loss recovery strategies for the insured portfolio. Analysts evaluate the estimated timing and severity of projected policy claims as well as the potential impact of loss mitigation or remediation measures in order to target and prioritize policies, or portions thereof, for commutation, reinsurance, refinancing, restructuring or other risk reduction or defeasance strategies. For targeted policies, analysts will engage with bondholders, issuers and other economic stakeholders to negotiate, structure and execute such strategies. During 2018, Ambac's successes included:
Working closely with servicers and owners of Master Servicing Rights to exercise clean-up calls on 11 RMBS transactions, reducing adversely classified net par exposure by $284 million;
Proactively working with issuers to expedite refundings or restructurings of Ambac-insured international bonds. During 2018, Ambac negotiated with counterparties that resulted in the termination of several international RMBS and asset-backed policies on £182 million and £548 million of net par exposure, respectively;
Working with issuers and other transaction counterparties to expedite refundings or calls across a number of Ambac domestic public finance bonds, resulting in a reduction of watch list and adversely classified net par of approximately $1.0 billion;
Working with issuers and investors of Ambac-insured debt to commute $484 million of net par exposure, including $127 million of adversely classified student loan exposures; and
Facilitating the refinancing of a defaulted Ambac UK insured debt, reducing adversely classified net par exposure by $36 million;
Sculpting the risk profile of the insured portfolio through quota share reinsurance. This included ceding approximately $138 million of structured finance exposure and the full amount of certain public finance exposures totaling $1.5 billion of performing par exposure (principal and interest of $3.4 billion), which was mostly comprised of policies on non-callable capital appreciation bonds and included $232 million par of watch list and adversely classified credits.
The following table provides a comparison of total, adversely classified credits ("ACC") and watch list net par outstanding in the insured portfolio at December 31, 2018 and 2017. Net par exposures within the U.S. public finance market includes capital appreciation bonds which are reported at the par amount at the time of issuance of the insurance policy as opposed to the current accreted value of the bonds.
($ in billions)
The overall reduction in total net par outstanding resulted from scheduled maturities, amortizations, commutations, reinsurance, refundings, refinancings and calls, including reductions as a result of the activities of Ambac and its subsidiaries as noted above.
The decreases in adversely classified credit exposures and watch list credit exposures are primarily due to (i) results of active risk reductions; (ii) paydowns or calls by issuers; and (iii) for adversely classified credits, the improved credit profile of certain residential mortgage-backed securities and their upgrade from the adversely classified credit listing.
Although our insured portfolio generally performed satisfactorily in 2018, we continue to experience stress in certain insured exposures, particularly within our approximately $1.9 billion of exposure to Puerto Rico, consisting of several different issuing entities (all below investment grade). Each issuing entity has its own credit risk profile attributable to. as applicable, discrete revenue sources, direct general obligation pledges and/or general obligation guarantees. On February 4, 2019, the COFINA Plan of Adjustment ("POA") was confirmed by the United States District Court for the District of Puerto Rico and became effective on February 12, 2019. Several parties are presently appealing the confirmation of the POA and no assurances can be given regarding the results of such appeals. The POA and certain related commutation transactions resulted in a reduction of Ambac Assurance's insured exposure to COFINA by approximately 75% or $603 million to $202 million and a reduction in overall Puerto Rico exposure to $1.3 billion from $1.9 billion at December 31, 2018. Refer to Part II, Item 7. Financial Guarantees in Force in this Annual Report on Form 10-K for additional information regarding the different issuing entities that encompass Ambac's exposures to Puerto Rico as well as the COFINA POA.
Ambac's RMG had additional successes in the first quarter of 2019 as follows:
Additional clean-up calls on two RMBS transactions on the watch list with net par outstanding at December 31, 2018 of $48 million;
Worked with the issuer of two watch list asset backed securitizations to expedite the refunding of the bonds with net par outstanding of $95 million at December 31, 2018; and
Worked with an issuer to commute, via a first quarter 2019 refunding, an adversely classified public finance transaction with net par outstanding of $350 million at December 31, 2018.
During 2018, Ambac repaid the remaining December 31, 2017 balance of the Secured Borrowing (as defined and described in Note 3. Variable Interest Entities) of $74 million and made partial paydowns of the Ambac Note (as defined in Note 1. Background and Business Description) by $214 million.
As of December 31, 2018 cash, investments and receivables of Ambac were $455 million.
($ in millions)
Cash and short-term investments
Other investments (1)
Includes corporate securities and securities insured or issued by Ambac Assurance, including surplus notes (fair value of $57 million) and AMPS issued by Ambac Assurance that are eliminated in consolidation.
Includes accruals for tolling payments from Ambac Assurance in accordance with the intercompany Tax Sharing Agreement ($44 million), investment income due and accrued and other receivables. Tolling payments are subject to review and approval by OCI as summarized below.
As a result of positive taxable income at Ambac Assurance in 2017, Ambac accrued approximately $30 million in tax tolling payments. In May 2018, Ambac executed a waiver under the intercompany Tax Sharing Agreement pursuant to which Ambac Assurance was relieved of the requirement to make this payment by June 1, 2018. Ambac also agreed to continue to defer the tolling payment for the use of net operating losses in 2017 by Ambac Assurance until such time as OCI (as defined in Note 1. Background and Business Description) consents to the payment.
For the year ended December 31, 2018, Ambac Assurance recognized taxable income and accordingly Ambac has accrued $14 million of tolling payments. Pursuant to the Stipulation and Order, Ambac's tax positions are subject to review by the OCI, which may lead to the adoption of positions that reduce the amount of tolling payments otherwise available to Ambac.
Financial Statement Impacts of Foreign Currency:
The impact of foreign currency as reported in Ambac's Consolidated Statement of Total Comprehensive Income for the year ended December 31, 2018 included the following:
($ in millions)
Net income (1)
Changes in other comprehensive income:
Gain (losses) on foreign currency translation
Unrealized gains (losses) on non-functional currency available-for-sale securities
Total changes in other comprehensive income
Impact on total comprehensive income (loss)
A portion of Ambac UK's, and to a lesser extent Ambac Assurance's, assets and liabilities are denominated in currencies other than its functional currency and accordingly, we recognized net foreign currency transaction gains/(losses) as a result of changes to foreign currency rates through our Consolidated Statement of Total Comprehensive Income (Loss). Refer to Note 2. Basis of Presentation and Significant Accounting Policies to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further details on transaction gains and losses.
Future changes to currency rates, including as a result of a no deal Brexit, may adversely affect our financial results. Refer to Part II, Item 7A "Quantitative and Qualitative Disclosures about Market Risk" for further information on the impact of future currency rate changes on Ambac's financial instruments.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Ambac's Consolidated Financial Statements have been prepared in accordance with GAAP. This section highlights accounting estimates management views as critical because they are most important to the portrayal of the Company's financial condition; and require management to make difficult and subjective judgments regarding matters that are inherently uncertain and subject to change. These estimates are evaluated on an on-going basis based on historical developments, market conditions, industry trends and other information that is reasonable under the circumstances. There can be no assurance that actual results will conform to estimates and that reported results of operations will not be materially adversely affected by the need to make future accounting adjustments to reflect changes in these estimates from time to time.
Management has identified the following critical accounting policies and estimates: (i) valuation of loss and loss expense reserves, (ii) valuation of certain financial instruments and (iii) valuation of deferred tax assets. Management has discussed each of these critical accounting policies and estimates with the Audit Committee, including the reasons why they are considered critical and how current and anticipated future events impact those determinations. Additional information about these policies can be found in Note 2. Basis of Presentation and Significant Accounting Policies to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K.
Valuation of Losses and Loss Expense Reserves (including Subrogation Recoverables):
The loss and loss expense reserves, including subrogation recoverables ("loss reserves"), discussed in this section relate only to Ambac’s non-derivative insurance policies issued to beneficiaries, including unconsolidated VIEs. Ambac's loss reserves include loss reserve components of an insurance policy, consisting of the present value ("PV") of expected net cash flows to be paid (or received) under an insurance contract and unpaid
claims. The PV of expected net cash flows represents the PV of expected cash outflows (future losses) less the PV of expected cash inflows (future recoveries) discounted at a risk-free discount rate. Unpaid claims represents claims that were not paid for policies allocated to the Segregated Account (as defined in Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in this Report on Form 10-K), including Deferred Amounts (as defined in Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in this Report on Form 10-K) and accrued interest. In 2018, all Deferred Amounts were settled via the Rehabilitation Exit Transactions (as defined in Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in this Report on Form 10-K); therefore, unpaid claims are no longer included as a component of loss reserves. Refer to Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in this Form 10-K for further information on the Rehabilitation Exit Transactions. While unpaid claims were known and therefore not a subjective estimate, expected future losses, net of expected future recoveries, are inherently uncertain. As such, the remaining discussion is limited to addressing expected future losses, net of expected future recoveries.
The evaluation process for expected future losses is subject to certain estimates and judgments regarding the probability of default by the issuer of the insured security, probability of remediation and settlement outcomes (which may include commutation, litigation settlements, refinancings and/or other settlement outcomes), probability of a restructuring outcome (which may include payment moratoriums, debt haircuts and/or subsequent recoveries) and the expected loss severity of credits for each insurance contract.
As the probability of default for an individual credit increases and/or the severity of loss given a default increases, our loss reserve for that insured obligation will also increase. Political, economic, credit or other unforeseen events could have an adverse impact on default probabilities and loss severities. The loss reserves for many transactions are derived from the issuer’s creditworthiness. For public finance issuers, loss reserves will consider not only creditworthiness but also political dynamics and economic status and prospects. The loss reserves for transactions which have no direct issuer support, such as most structured finance exposures, including RMBS and student loan exposures, are derived from the default activity and loss given default of underlying collateral supporting the transactions. In addition, many transactions have a combination of issuer/entity and collateral support. Loss reserves reflect our assessment of the transaction’s overall structure, support and expected performance. Loss reserve volatility will be a direct result of the credit performance of our insured portfolio, including the number, size, bond types and quality of credits included in our loss reserves as well as our ability to execute workout strategies and commutations. The number and severity of credits included in our loss reserves depend to a large extent on transaction specific attributes, but will generally increase during periods of economic stress and decline during periods of economic prosperity. Reinsurance contracts mitigate our loss reserve but since Ambac currently has minimal exposure ceded to reinsurers on credits with loss reserves, the existing reinsurance contracts are unlikely to have a significant effect on loss reserve volatility. Loss reserve volatility will also be materially impacted by changes in interest rates from period to period.
The table below indicates the gross par outstanding and gross loss reserves (including loss expenses) related to policies in Ambac’s loss and loss expense reserves at December 31, 2018 and 2017:
($ in millions) December 31
Gross Loss and Loss Expense
Gross Loss and Loss Expense Reserves(1)(3)(4)(5)
Domestic Public Finance
Ambac UK and Other Credits
Ceded par outstanding on policies with loss reserves and ceded loss and loss expense reserves are $540 and $23, respectively, at December 31, 2018 and $590 and $41, respectively at December 31, 2017. Ceded loss and loss expense reserves are included in Reinsurance recoverable on paid and unpaid losses.
Gross Par Outstanding includes capital appreciation bonds, which are reported at the par amount at the time of issuance of the insurance policy as opposed to the current accreted value of the bond.
Loss and Loss Expense reserves at December 31, 2018 of $(107) are included in the balance sheet in the following line items: Loss and loss expense reserves: $1,826 and Subrogation recoverable: $1,933. Loss and Loss Expense reserves at December 31, 2017 of $4,114 are included in the balance sheet in the following line items: Loss and loss expense reserves: $4,745 and Subrogation recoverable: $631.
Ambac records as a component of its loss and loss expense reserves, estimated recoveries related to securitized loans in RMBS transactions that breached certain representations and warranties. Ambac has recorded gross estimated recoveries of $1,771 and $1,834 at December 31, 2018 and 2017, respectively.
Included in Gross Loss and Loss Expense Reserves are unpaid claims of $3,867 at December 31, 2017 related to policies allocated to the Segregated Account of Ambac Assurance (as defined in Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in this Report on Form 10-K), inclusive of accrued interest payable on Deferred Amounts of $840.
See Note 2. Basis of Presentation and Significant Accounting Policies for a description of the cash flow and statistical methodologies used to develop loss reserves. Most of our reserved credits with large loss reserves utilize the cash flow method of reserving. Alternative cash flow scenarios are developed to represent the range of possible outcomes and resultant future claims payments and timing. Scenarios and probabilities of each are adjusted regularly to reflect changes in status, outlook and our analysis and views. Significant judgment is used to develop the cash flow assumptions and related probabilities, and there can be no certainty that the modeled scenarios or probabilities will not deviate materially from ultimate outcomes.
In some cases, such as RMBS and student loans, which are described more fully below, cash flow projections include the modeling of an issuer or transaction’s future revenues and expenses to determine the resources available to pay debt service on our insured obligations. In other cases, such as many public finance exposures including our Puerto Rico exposures, we do not specifically forecast resources available to pay debt service in the cash flow model itself. Rather, we consider the issuers’ overall ability and willingness to pay, including the existing fiscal, economic, legal and political framework. We then develop multiple scenarios where issuer debt service is paid, missed and/or haircut with claims paid then modeled for any recovery amount and timing. In our experience, this has been an effective approach to loss reserving these types of credits, but there is no certainty our assumptions as to scenarios or probabilities will not be subject to material changes as developments occur or that this method will be as effective in the future as it has been in the past.
In estimating loss reserves, we also incorporate scenarios which represent the potential outcome of remediation strategies. Remediation scenarios may include; (i) a potential refinancing of the transaction by the issuer; (ii) the issuer’s ability to redeem outstanding securities at a discount, thereby increasing the structure’s ability to absorb future losses; and (iii) our ability to terminate or restructure the policy in whole or in part (e.g., commutation). The remediation scenarios and the related probabilities of occurrence vary by policy depending on on-going and expected discussions and negotiations with issuers and/or investors. In addition to commutation negotiations that are underway with various counterparties in various forms, our reserve estimates may also include scenarios which incorporate our ability and/or expectation to commute additional exposure with other counterparties.
RMBS Expected Loss Estimate
Ambac insures RMBS transactions collateralized by first-lien mortgages. Ambac has also insured RMBS transactions collateralized predominantly by second-lien mortgage loans such as closed-end seconds and home equity lines of credit. A second-lien mortgage loan is a type of loan in which the borrower uses the equity in their home as collateral and the second-lien loan is subordinate to the first-lien loan outstanding on the home. Borrowers are obligated to make monthly payments on both their first and second-lien loans. If the borrower defaults on the payments due under these loans and the property is subsequently liquidated, the liquidation proceeds are first utilized to pay off the first-lien loan (as well as other costs) and any remaining funds are applied to pay off the second-lien loan. As a result of this
subordinate position to the first-lien loan, second-lien loans may carry a significantly higher severity in the event of a loss, approaching or exceeding 100%.
Ambac primarily utilizes a cash flow model (“RMBS cash flow model”) to develop estimates of projected losses for both our first and second lien transactions. First, the RMBS cash flow model projects collateral performance utilizing: (i) the transaction’s underlying loans' characteristics and status, (ii) projected home price appreciation (“HPA”) and (iii) projected interest rates. Depending in the amount of collateral information available for each transaction, we project such performance either at the loan-level or the deal-level. In the absence of specific loan-level information, the deal-level approach evaluates a loan pool as if it were a single loan, selecting certain aggregated deal-level characteristics to then perform a series of statistical analyses. The deal-level approach projects performance using a roll-rate that evaluates the possible future state of a loan based on its current status and three variables: average FICO (credit score), average current consolidated loan to value ratio (“CLTV”) and an overall quality indicator. Projected servicer-level behavior may also have an impact on transaction performance.
We source HPA projections from a market accepted vendor and interest rate projections are developed from market sources. We use three HPA projection scenarios to develop a base case as well as stress and upside cases. The highest probability is assigned to the base case, with lower probabilities to the stress and upside cases.
For the liabilities of the transaction which we insure, we generally utilize waterfall projections generated from a tool provided by a market accepted vendor. In some cases, we may utilize an alternative waterfall structure when our legal and commercial analysis of the transaction’s payment structure differs from the vendor’s waterfall structure.
We compare monthly claims submitted against the trustees’ reports, third-party provided waterfall projections and our understanding of the transactions’ structures to identify and resolve discrepancies. We also systematically review the vendor’s published waterfall revisions to further identify material discrepancies. Resolving discrepancies is challenging and may take place over an extended period of time. Moreover, transaction documents are subject to interpretation, and our interpretation or that of the vendor and as reflected in our loss reserves may prove to be incorrect and/or not consistent with trustees directing cash flows in the future.
In our experience, market performance and model characteristics change and therefore need to be updated and reflected in our models through time. As such, we conduct regular reviews of current models, alternative models and the overall approach to loss estimation.
Expected Representation and Warranty Subrogation Recoveries:
Ambac records as a component of its loss reserve estimate subrogation recoveries related to securitized loans in RMBS transactions that breached certain representations and warranties ("R&W") described herein. Generally, the sponsor of an RMBS transaction provided representations with respect to the securitized
loans, including representations with respect to the loan characteristics, the absence of borrower fraud in the underlying loan pools or other misconduct in the origination process and attesting to the compliance of loans with the prevailing underwriting policies. In such cases, the sponsor of the transaction is contractually obligated to repurchase, cure or substitute collateral for any loan that breaches the representations or warranties. Ambac does not estimate an RMBS R&W subrogation recovery for litigations where its sole claim is for fraudulent inducement, since any remedies under such claims would be non-contractual.
The RMBS R&W subrogation recovery estimate is subject to significant uncertainty, including risks inherent in litigation, collectability of such amounts from counterparties and/or their respective parents and affiliates, timing of receipt of any such recoveries, intervention by OCI, which could impede our ability to take actions required to realize such recoveries, and uncertainties inherent in the assumptions used in estimating such recoveries. Failure to realize RMBS R&W subrogation recoveries for any reason or the realization of RMBS R&W subrogation recoveries materially below the amount recorded on Ambac's consolidated balance sheet would have a material adverse effect on our results of operations and financial condition and may result in adverse consequences such as impairing the ability of Ambac Assurance to honor its financial obligations; the initiation of rehabilitation proceedings against Ambac Assurance; decreased likelihood of Ambac Assurance delivering value to Ambac, through dividends or otherwise; and a significant drop in the value of securities issued or insured by Ambac or Ambac Assurance. Refer to Note 2. Basis of Presentation and Significant Accounting Policies and Note 7. Financial Guarantee Insurance Contracts to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for more information regarding the estimation process for RMBS R&W subrogation recoveries, and to Part I, Item 1A. Risk Factors for more information about risks relating to our RMBS R&W subrogation recoveries.
Student Loan Expected Loss Estimate
The student loan portfolio consists of credits collateralized by private student loans. The calculation of loss reserves for our student loan portfolio involves evaluating numerous factors that can impact ultimate losses. The factor which contributes the greatest degree of uncertainty in ascertaining appropriate loss reserves is the long final legal maturity date of the insured bonds. Most of the student loan bonds which we insure were issued with original terms of 20 to 40 years until final maturity. Since our policy covers timely interest and ultimate principal payment, our loss projections must make assumptions for many factors covering a long time horizon. Key assumptions that will impact ultimate losses include, but are not limited to, the following: collateral performance (which is highly correlated to the economic environment), interest rates, operating risks associated with the issuer, servicers, special servicers, and administrators, investor appetite for tendering or commuting insured obligations and, as applicable, Ambac’s ability and willingness to commute policies. In addition, we consider in our student loan loss projections the potential impact, if any, of proposed or final regulatory actions or orders, including by the Consumer Financial Protection Bureau ("CFPB"), affecting our insured transactions.
In evaluating our student loan portfolio, our losses are projected using a cash flow modeling approach. In order to project collateral performance under the cash flow approach, we use a default projection tool that constructs lifetime cohort default curves based on loan and deal-level historical performance data. To determine ultimate losses on the transactions, the cohort default curves are used to extrapolate future default behavior. Additionally, a regression-based model is used to estimate recoveries on defaulted loans. This regression-based recovery forecast is grounded in deal-level performance data. The transaction losses are then incorporated into a waterfall tool to develop loss estimates for our exposures. This waterfall tool allows us to capture the impact of each transaction’s specific structure (e.g., the waterfall priority of payments, triggers, redemption priority) to generate our specific projected claims profile in various base, upside and downside scenarios.
We develop and assign probabilities to multiple cash flow scenarios based on each transaction’s unique characteristics. Probabilities assigned are based on available data related to the credit, information from contact with the issuer (if applicable), and any economic or market information that may impact the outcomes of the various scenarios being evaluated. Our base case usually projects deal performance out to maturity using expected loss assumptions. As appropriate, we also develop other cases that incorporate various upside and downside scenarios that may include changes to defaults and recoveries.
Variability of Expected Losses and Recoveries
Ambac’s management believes that loss reserves are adequate to cover future claims presented, but there can be no assurance that the ultimate liability will not be higher than such estimates.
It is possible that our estimated future losses for insurance policies discussed above could be understated, or that our estimated future recoveries could be overstated. We have attempted to identify possible cash flows related to losses and recoveries using more stressful assumptions than the probability-weighted outcome recorded. The possible net cash flows consider the highest stress scenario that was utilized in the development of our probability-weighted expected loss at December 31, 2018 and assumes an inability to execute any commutation transactions with issuers and/or investors. Such stress scenarios are developed based on management’s view about all possible outcomes relating to losses and recoveries. In arriving at such view, management makes considerable judgments about the possibility of various future events. Although we do not believe it is possible to have worst case outcomes in all cases, it is possible we could have worst case outcomes in some or even many cases. See “Risk Factors” in Part I, Item 1A of this Form 10-K for further discussion of the risks relating to future losses and recoveries that could result in more highly stressed outcomes. The occurrence of these stressed outcomes individually or collectively would have a material adverse effect on our results of operations and financial condition and may result in materially adverse consequence for the Company, including (without limitation) impairing the ability of Ambac Assurance to honor its financial obligations; the initiation of rehabilitation proceedings against Ambac Assurance; decreased likelihood of Ambac Assurance delivering value to Ambac, through dividends or otherwise; and a significant drop in the value of securities issued or insured by Ambac or Ambac Assurance.
Changes to assumptions that could make our reserves under-estimated include an increase in interest rates, deterioration in housing prices, poor servicing, the effect of a weakened economy characterized by growing unemployment and wage pressures, and/or illiquidity of the mortgage market. We utilize a model to project losses in our RMBS exposures and changes to reserves, either upward or downward, are not unlikely if we were to use a different model or methodology to project losses. We regularly assess models and methodologies and may change our approach and/or model at any time. Additionally, our RMBS R&W actual subrogation recoveries could be significantly lower than our estimate of $1,744.2 million as of December 31, 2018 if the sponsors of these transactions: (i) fail to honor their obligations to repurchase the mortgage loans, (ii) successfully dispute our breach findings, (iii) no longer have the financial means to fully satisfy their obligations under the transaction documents, or (iv) our pursuit of recoveries is otherwise unsuccessful.
In the case of both first and second-lien exposures, the possible stress case assumes a lower housing price appreciation projection, which in turn drives higher defaults and severities. Using this approach, the possible increase in loss reserves for RMBS credits for which we have an estimate of expected loss at December 31, 2018 could be approximately $30 million. Combined with the absence of any RMBS R&W subrogation recoveries, a possible increase in loss reserves for RMBS could be approximately $1.8 billion. Additionally, loss payments are sensitive to changes in interest rates, increasing as interest rates rise. For example an increase in interest rates of 0.50% could increase our estimate of expected losses by approximately $30 million. There can be no assurance that losses may not exceed such amounts.
Public Finance Variability:
It is possible our loss reserves for public finance credits may be under-estimated if issuers are faced with prolonged exposure to adverse political, economic, fiscal or socioeconomic events or trends.
Our experience with the city of Detroit in its bankruptcy proceeding was unfavorable and renders future outcomes with other public finance issuers even more difficult to predict and may increase the risk that we may suffer losses that could be sizable. We agreed to settlements regarding our insured Detroit general obligation bonds that provide better treatment of our exposures than the city planned to include in its plan of adjustment, but nevertheless required us to incur a loss for a significant portion of our exposure. An additional troubling precedent in the Detroit case, as well as other municipal bankruptcies, is the preferential treatment of certain creditor classes, especially the public pensions. The cost of pensions and the need to address frequently sizable unfunded or underfunded pensions is often a key driver of stress for many municipalities and their related authorities, including entities to whom we have significant exposure, such as Chicago, its school district, the State of New Jersey and many others. Less severe treatment of pension obligations in bankruptcy may lead to worse outcomes for traditional debt creditors. In addition, cities may be more inclined to use bankruptcy to resolve their financial stresses if they believe preferred outcomes for various creditor groups can be achieved.
We expect municipal bankruptcies and defaults to continue to be challenging to project given the unique political, economic, fiscal, governance and public policy differences among municipalities as well as the complexity, long duration and relative infrequency of the cases themselves in forums with a scarcity of legal precedent.
Another potentially adverse development that could cause the loss reserves on our public finance credits to be underestimated is deterioration in the municipal bond market, resulting from reduced or no access to alternative forms of credit (such as bank loans) or other exogenous factors, such as the Tax Cuts and Jobs Act that was signed into law on December 22, 2017, which contributed in part to the overall 21.6% decline in municipal issuance volume in 2018. The primary contributor of the Tax Cuts and Jobs Act to lower municipal volumes in 2018 was the elimination of tax-exempt advance refundings. In addition, the Tax Cuts and Jobs Act could potentially reduce municipal investor appetite for tax-exempt municipal bonds by corporate investors and over the longer term could potentially put additional pressure on issuers in states with high state and local taxes. These factors could deprive issuers access to funding at a level necessary to avoid defaulting on their obligations. While our loss reserves consider our judgment regarding issuers’ financial flexibility to adapt to adverse markets, they may not adequately capture sudden, unexpected or protracted uncertainty that adversely affects market conditions.
Our exposures to the Commonwealth of Puerto Rico are under stress arising from the Commonwealth’s poor financial condition, weak economy, limited capital markets access, political risk and aftereffects of the damage caused by hurricanes Irma and Maria. These factors, taken together with the payment moratorium on certain debt payments of the Commonwealth and its instrumentalities, ongoing Puerto Rico Oversight, Management, and Economic Stability Act ("PROMESA") Title III proceedings, and certain other provisions under PROMESA, the potential for a restructuring of debt insured by Ambac Assurance, either with or without its consent, and the possibility of protracted litigation as a result of which its rights may be materially impaired, may cause losses to exceed current reserves in a material manner.
On February 4, 2019, the COFINA Plan of Adjustment ("POA") under Title III was confirmed by the United States District Court for the District of Puerto Rico and became effective on February 12, 2019. Several parties are presently appealing the confirmation of the POA and no assurances can be given regarding the outcome of such appeals. The POA, which emerged from a consensually negotiated Plan Support Agreement executed in August 2018, resolved the COFINA Title III case and restructuring. Among other things, the POA and certain related commutation transactions resulted in a reduction of Ambac Assurance's insured exposure to COFINA by approximately 75% and provided for a nominal initial recovery amount in new COFINA bonds and cash equivalent to approximately 93% of the Petition Date (May 5, 2017) claim amount on the remaining approximately 25% non-commuted policy portion of Ambac Assurance's insured exposure to COFINA. The Ambac Assurance-insured COFINA bonds that comprise such non-commuted exposure, together with such remaining policy portion of Ambac Assurance's COFINA exposure, have been deposited into a trust, as have the non-commuted bondholders' portion of the new bonds issued by COFINA and cash paid by COFINA under the POA, in exchange for which the non-commuted Ambac-insured bondholders
received units of the trust in return representing undivided fractional interests in the trust property. Cash flows from the new COFINA bonds and cash will be passed through to unit-holders over time and will reduce amounts owed under the Ambac Assurance policy with respect to the Ambac Assurance-insured COFINA bonds. There are no assurances that future debt restructurings for other Ambac Assurance-insured Puerto Rico instrumentalities subject to Title III proceedings or otherwise will reach a similar negotiated structure and outcome; any such restructurings could therefore cause losses to exceed current reserves in a material manner.
See "Financial Guarantees in Force" below for further details on the legal, economic, fiscal, and political developments that have impacted or may impact Ambac Assurance’s insured Puerto Rico bonds.
Material additional losses caused by the above-described factors would have a material adverse effect on our results of operations and financial condition. For public finance credits, including Puerto Rico as well as other issuers, for which we have an estimate of expected loss at December 31, 2018, the possible increase in loss reserves could be approximately $1.0 billion. However, there can be no assurance that losses may not exceed such amount.
Student Loan Variability:
Changes to assumptions that could make our reserves under-estimated include, but are not limited to, increases in interest rates, default rates and loss severities on the collateral due to economic or other factors. Such factors may include lower recoveries on defaulted loans or additional losses on collateral or trust assets, including as a result of any enforcement actions of the Consumer Finance Protection Bureau. For student loan credits for which we have an estimate of expected loss at December 31, 2018, the possible increase in loss reserves could be approximately $25 million. Additionally, an increase in interest rates of 0.50% could increase our estimate of expected losses by approximately $25 million. There can be no assurance that losses may not exceed such amount.
Other Credits, including Ambac UK, Variability:
It is possible our loss reserves on other types of credits, including those insured by Ambac UK, may be under-estimated because of various risks that vary widely, including the risk that we may not be able to recover or mitigate losses through our remediation processes. For all other credits, including Ambac UK, for which we have an estimate of expected loss, the sum of all the highest stress case loss scenarios is approximately $170 million greater than the loss reserves at December 31, 2018. However, there can be no assurance that losses may not exceed such amount.
Valuation of Certain Financial Instruments:
The Fair Value Measurement Topic of the ASC requires financial instruments to be classified within a three-level fair value hierarchy. The fair value hierarchy, the financial instruments classified within each level, our valuation methods, inputs, assumptions and the review and validation procedures over quoted and modeled pricing are further detailed in Note 9. Fair Value Measurements to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K.
The level of judgment in estimating fair value is largely dependent on the amount of observable market information available to fair value a financial instrument, which is also determinative of where the financial instrument is classified in the fair value hierarchy. Level 3 instruments are valued using models which use one or more significant inputs or value drivers that are unobservable and therefore require significant judgment. Level 3 financial instruments which are material include uncollateralized interest rate swaps, investments and loan receivables of consolidated VIEs and certain VIE debt obligations. Model-derived valuations of Level 3 financial instruments incorporate estimates of the effects of Ambac's own credit risk and/or counterparty credit risk, which can be complex and judgmental. Furthermore, Level 3 loan receivables of consolidated VIEs incorporate estimates of Ambac's financial guarantee cash flows, including future premiums and losses. Such cash flow estimates require judgments regarding prepayments of VIE debt, loss probabilities and loss severities, all of which are inherently uncertain.
All models and related assumptions are continuously re-evaluated by management and enhanced, as appropriate, based on improvements in information and modeling techniques. The re-evaluation process includes a quarterly meeting of senior Finance personnel to review and approve changes to models and key assumptions.
As a result of the significant judgment for the above-described instruments, the actual trade value of the financial instrument in the market, or exit value of the financial instrument owned by Ambac, may be significantly different from its recorded fair value.
Valuation of Deferred Tax Assets:
Our provision for taxes is based on our income, statutory tax rates and tax planning opportunities available to us in the jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Significant judgment is required in determining our tax expense and in evaluating our tax positions. We review our tax positions quarterly and adjust the balances as new information becomes available. Deferred tax assets arise because of temporary differences between the financial reporting and tax bases of assets and liabilities, as well as from net operating loss ("NOL") and tax credit carry forwards. More specifically, deferred tax assets represent a future tax benefit (or receivable) that results from losses recorded under GAAP in a current period which are only deductible for tax purposes in future periods and NOL carry forwards.
The Tax Cut and Jobs Act ("TCJA") was enacted in December 2018 and introduced significant changes to the U.S. tax code effective January 1, 2018. The U.S. NOL component of the deferred tax asset expires if not utilized 20 years from when the NOL was generated. However, NOLs generated from non-insurance activity after the effective date of the TCJA are carried forward indefinitely. Valuation allowances are established to reduce deferred tax assets to an amount that “more likely than not” will be realized. On a quarterly basis, management identifies and considers all available evidence, both positive and negative, in making the determination with significant weight given to evidence that can be objectively verified. Negative evidence includes the potential for unrecognized future insurance losses; uncertainty regarding timing and magnitude of RMBS R&W litigation recoveries; no new financial guarantee business and
execution risk of any new business venture. Positive evidence includes the Segregated Account's exit from rehabilitation further described in Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in this Report on Form 10-K.
The level of deferred tax asset recognition is influenced by management’s assessment of future expected taxable income, which depends on the existence of sufficient taxable income within the carry forward periods available under the tax law. As a result of the risks and uncertainties associated with future operating results, management believes it is more likely than not that the Company will not generate sufficient taxable income to recover the U.S. deferred tax asset and therefore has a full valuation allowance. To the extent significant uncertainties such as Puerto Rico losses, RMBS R&W litigation and new business ventures are resolved, Ambac may have the ability to establish a history of making reliable estimates of future income which could ultimately result in a reduction to the deferred tax asset valuation allowance. See Note 14. Income Taxes for additional information on the Company's deferred income taxes, including the effects of the TCJA.
FINANCIAL GUARANTEES IN FORCE
The following table provides a breakdown of guaranteed net par outstanding by market sector at December 31, 2018 and 2017. Net par exposures within the U.S. public finance market include capital appreciation bonds which are reported at the par amount at the time of issuance of the insurance policy as opposed to the current accreted value of the bonds. Guaranteed net par outstanding includes the exposures of policies that insure variable interest entities (“VIEs”) consolidated by Ambac. Guaranteed net par outstanding excludes the exposures of policies that insure bonds which have been refunded or pre-refunded:
($ in millions) December 31,
Public Finance (1)(2)
Total net par outstanding
Includes $5,759 and $5,829 of Military Housing net par outstanding at December 31, 2018 and 2017, respectively.
Includes $1,880 and $1,968 of Puerto Rico net par outstanding at December 31, 2018 and 2017, respectively. Components of Puerto Rico net par outstanding includes capital appreciation bonds which are reported at the par amount at the time of issuance of the related insurance policy as opposed to the current accreted value of the bonds. As discussed below under Puerto Rico, the COFINA POA was confirmed by the United States District Court for the District of Puerto Rico on February 4, 2019 and became effective on February 12, 2019. The POA and certain related commutation transactions resulted in a reduction of Ambac Assurance's insured exposure to COFINA by approximately 75% or $603 to $202.
U.S. Public Finance Insured Portfolio
Ambac’s portfolio of U.S. public finance exposures is $23,442 million, representing 50% of Ambac’s net par outstanding as of December 31, 2018 and a 27% reduction from the amount outstanding at December 31, 2017. This reduction in exposure was due to additional reinsurance acquired, exposure runoff, and early terminations (calls, refundings and pre-refundings). While
Ambac’s U.S. public finance portfolio consists predominantly of municipal bonds such as general obligation, revenue, and lease and tax-backed obligations of state and local government entities, the portfolio also comprises a wide array of non-municipal types of bonds, including financings for not-for-profit entities and transactions with public and private elements, which generally finance infrastructure, housing and other public interests. See Note 6. Financial Guarantees in Force to the Consolidated Financial Statements, included in Part II, Item 8 in this Form 10-K for exposures by bond type.
Municipal bonds are generally supported directly or indirectly by the issuer’s taxing authority or by public sector fees and assessments which may or may not be specifically pledged. Risk factors in these transactions derive from the municipal issuer, including its fiscal management, politics, and economic position, as well as its ability and willingness to continue to pay its debt service. Municipal bankruptcies and similar proceedings, while still relatively uncommon, have occurred, exposing Ambac to the risk of liquidity claims and ultimate losses if issuers cannot successfully adjust their liabilities without impairing creditors.
Not-for-profit transactions are generally supported by the not-for-profit entities’ net revenues and may also include specific pledges, liens and/or mortgages. The entity typically serves a well-defined market and promulgates a public purpose mission. These transactions may afford Ambac contractual protections such as financial covenants and control rights in the event of issuer breaches and defaults. Risk factors in these transactions derive from the creditworthiness of the issuer, including but not limited to, its financial condition, leverage, management, business mix, competitive position, industry and socioeconomic trends, government programs and other factors. Examples of these types of transactions include not-for-profit hospitals, universities, associations and charities.
Public/private transactions are generally structured to achieve their targeted public interest objective without direct support from the public sector. Some examples of this type of financing include affordable housing, private education, privatized military housing and student housing. Protections within these financings provided to Ambac usually include the strength of the financed asset’s essentiality and public purpose and may include financial covenants, collateral and control rights. Risk factors include financial underperformance, event risk and a shift in the asset’s mission or essentiality. One example of this type of financing is U.S. military housing.
Ambac insures approximately $6 billion net par of privatized military housing debt. The debt was issued to finance the construction and/or renovation of housing units for military personnel and their families on domestic U.S. military bases. Debt service is not directly paid or guaranteed by the U.S. Government. Rather, the bonds are serviced from the cash flow generated in most cases by rental payments deposited by the military directly into lockbox accounts as part of each service personnel’s Basic Allowance for Housing (BAH). In a small number of cases rental payments also come from civilians, including retired service personnel, living on a particular base. Collateral for these transactions includes the BAH payments as well as an interest in the ground lease. Risk factors affecting these transactions include ongoing base essentiality, military deployments, the U.S.
government’s commitment to fund the BAH, marketability/attractiveness of the on-base housing units versus off-base housing, construction completion, environmental remediation, utility and other operating costs and housing management.
Ambac has exposure to the Commonwealth of Puerto Rico (the "Commonwealth") and its instrumentalities across several different issuing entities. Each has its own credit risk profile attributable to, as applicable, discrete revenue sources, direct general obligation pledges and/or general obligation guarantees.
On October 18, 2018, the Oversight Board certified the COFINA Fiscal Plan, which anticipated a resolution of the Commonwealth-COFINA dispute litigated in adversary proceeding no. 1:17-ap-00257. The COFINA Fiscal Plan reflects a sharing of the sales and use tax, which historically has provided security and debt service for COFINA bonds, between COFINA and the Commonwealth (53.65% / 46.35% of the statutory pledged sales tax base amount, respectively, with first dollars going to COFINA) and the issuance of new COFINA bonds backed by the COFINA portion of these taxes.
On October 23, 2018, the Oversight Board certified a revised fiscal plan for the Commonwealth of Puerto Rico (the “Revised Commonwealth Fiscal Plan”). Among other revisions from earlier certified fiscal plans in May and June 2018, the Revised Commonwealth Fiscal Plan projected a new cumulative 30-year surplus, post-measures and structural reforms, of approximately $19 billion, which is net of 30 years of expected debt service payments on the new COFINA bonds (as described below and totaling $32.3 billion). The new surplus projection is based on various revised assumptions including a higher amount of federal disaster relief funding, 2018 actual tax collections and budgetary performance, and updated demographic data. As per the Revised Commonwealth Fiscal Plan, budget surpluses in the near-term are driven by assumptions regarding fiscal measures and structural reforms, along with federal aid and enhanced revenue actuals. The Revised Commonwealth Fiscal Plan also shows long-term budget deficits which appear to be driven by Oversight Board and/or Commonwealth assumptions regarding healthcare costs that outpace Gross National Product ("GNP") growth, a lack of robust structural reforms, a phase out of disaster relief funding, and declining revenues from the Act 154 excise tax paid by multinationals operating in the Commonwealth.
However, as was the case with prior fiscal plans for the Commonwealth of Puerto Rico, the Revised Commonwealth Fiscal Plan lacks a high degree of transparency regarding the underlying data, assumptions and rationales supporting those assumptions, making reconciliation and due diligence difficult. As a result, it is difficult to assess the possible impacts the changes and new assumptions may have on creditor outcomes or Ambac's financial condition, including liquidity, loss reserves and capital resources.
It is also unclear if and when the Oversight Board will certify revised fiscal plans for Puerto Rico Highways and Transportation Authority ("PRHTA") and other Puerto Rico instrumentalities that have debt outstanding that is insured by Ambac Assurance. It is
unknown if and when other Puerto Rico instrumentalities, which have debt outstanding insured by Ambac Assurance, will be filed under Title III and what effect their fiscal plans may have on Ambac's financial position. No assurances can be given that Ambac's financial profile will not suffer a materially negative impact as an ultimate result of the Revised Commonwealth Fiscal Plan or any future changes to the Revised Commonwealth Fiscal Plan or fiscal plans for PRHTA or other Puerto Rico instrumentalities.
In the October 23, 2018 Revised Commonwealth Fiscal Plan, the assumption for total projected federal disaster relief aid spending from fiscal years 2018 through 2032 is $74 billion. This consists of $45.8 billion in projected FEMA Public Assistance program spending through FEMA’s Disaster Relief Fund (DRF). The Revised Commonwealth Fiscal Plan also projects $20 billion in spending from the U.S. Department of Housing and Urban Development’s Community Development Block Grant - Disaster Recovery (CDBG-DR) program, which has allocated aid funding to Puerto Rico for recovery and mitigation. In addition, the Revised Commonwealth Fiscal Plan projects $3.2 billion spending from the FEMA Individual Assistance program , which provides support to individuals and families who have sustained uncovered losses due to disasters, and $5 billion in other federal funding. In addition, the Commonwealth of Puerto Rico continues to benefit from other federal government programs for infrastructure improvement initiatives or recovery efforts.
While these federal funds are expected to support economic recovery and growth in Puerto Rico, there can be no assurances as to the certainty, timing, usage, efficacy or magnitude of benefits to creditor outcomes related to disaster aid and ensuing economic growth, if any.
See Part I, Item 1A. Risk Factors in this Form 10-K for a description of the risks to Ambac's Puerto Rico exposures due to tax reform.
The Oversight Board announced on February 9, 2018 that it retained Duff & Phelps, LLC to conduct an independent forensics analysis of the Commonwealth of Puerto Rico's government bank accounts. It has been publicly disclosed that Duff & Phelps, LLC and the Puerto Rico Fiscal Agency and Financial Advisory Authority ("FAFAA") have participated in discussions to coordinate this process. On February, 15, 2019, the Oversight Board filed a complaint in the United States District Court for the District of Puerto Rico to compel the Puerto Rico Senate to provide its bank account balances. The Oversight Board stated that the Puerto Rico Senate bank account balance is a necessary element of a forensic investigation into the liquidity of the Puerto Rico government and its instrumentalities and entities, led by Duff & Phelps, LLC. The related Oversight Board press release disclosed that except for the Puerto Rico Senate, all 163 public entities which received requests for account balance and financial information have responded and provided data, including the Puerto Rico House of Representatives and the judicial branch. The progress of the analysis by Duff & Phelps, LLC and any related findings and financial information have not yet been made public.
As of the December 31, 2018 bank account report published by FAFAA, the balances of bank accounts for various Puerto Rico government entities and instrumentalities totaled $12.1 billion. According to the report, various account balances are considered restricted for different government entities or due to Title III proceedings. However, it is unclear if these restricted designations are inaccurate or outdated since any legal analysis that may have been conducted to determine the restricted or unrestricted nature of funds in non-Treasury Single Account bank accounts has not been made publicly available. Consequently, the purported lack of access to restricted funds could limit the financial flexibility of the Commonwealth and its instrumentalities to provide essential and non-essential services. More generally, the lack of clear, consistent and complete information regarding account balances could further strain debt resolution timelines and potential severities for creditors, including Ambac.
As of February 1, 2019, the Treasury Single Account cash position, as reported by the Puerto Rico Treasury Department, was $4.2 billion and above the $1.1 billion threshold to access Community Disaster Loan financing. While details regarding final Community Disaster Loan terms are not known by Ambac, what is known is that the federal government has agreed to extend a credit line to the Commonwealth of Puerto Rico up to a maximum amount of $2.2 billion until March 31, 2020 to be used to meet any future liquidity emergency as determined by the Commonwealth of Puerto Rico. However, in order to access the credit line, the fund balance in the Treasury Single Account needs to be less than $1.1 billion.
COFINA Debt Restructuring
On October 19, 2018, following the certification of the COFINA Fiscal Plan, the Oversight Board filed the COFINA Plan of Adjustment ("POA") and Disclosure Statement as part of the COFINA Title III case. The Oversight Board also filed a Rule 9019 Motion in the Commonwealth Title III case to approve the settlement of the Commonwealth-COFINA dispute. The filing of the COFINA POA and Disclosure Statement as well as the settlement motion followed the execution of a settlement agreement between the Oversight Board and the COFINA Agent. That settlement agreement was based on the previously announced agreement in principle developed by the COFINA Agent and the Commonwealth Agent. The COFINA POA was based on the settlement agreement as well as the preliminary agreement among COFINA bondholders announced August 8, 2018 and the subsequent Plan Support Agreement and term sheet among the Oversight Board, FAFAA, COFINA, bond insurers (including Ambac Assurance), as well as certain COFINA and General Obligation creditors.
Under the COFINA POA, the Pledged Sales Tax Base Amount ("PSTBA) is split with 53.65% allocated on a first-dollars basis to COFINA through and including 2058 and 46.35% allocated to the Commonwealth. The COFINA POA contemplated exchanging all existing COFINA senior and subordinate bonds for cash as well as new COFINA current interest and capital appreciation bonds ("new COFINA bonds"). The cash and new COFINA bonds allocated to senior bondholders equaled approximately 93% (considering the new COFINA bonds at par) of such senior bondholders’ allowed claim, in the amount of the COFINA senior bond accreted value, as of, but not including, May 5, 2017 (the COFINA Title III Petition Date).
Pursuant to the COFINA POA, each holder of Ambac Assurance-insured senior COFINA bonds had the option to elect by January 11, 2019 to either (i) commute their rights in respect of the Ambac Assurance insurance policy associated with the existing senior COFINA bonds, which bonds would be discharged and Ambac Assurance policy obligations with respect thereto would be released, in exchange for new COFINA bonds, cash amounts to be paid by COFINA, plus additional cash consideration provided by Ambac Assurance equal to 5.25% of the accreted value of the Ambac Assurance-insured senior COFINA bonds as of the COFINA Petition Date or (ii) agree to deposit their Ambac Assurance-insured senior COFINA bonds into a a trust in exchange for units issued by the trust (the "COFINA Class 2 Trust"), which trust would receive the new COFINA bonds and the cash amounts to be paid by COFINA that such bondholders would have otherwise received to the extent they had elected the recovery under clause (i) above (thereby entitling the COFINA Class 2 Trust to receive debt service payments from COFINA with respect to the new COFINA bonds deposited into the trust), plus any accelerated policy payments (made solely at Ambac Assurance's own discretion) or claim payments due under the existing Ambac Assurance insurance policy for the deficiency relating to the existing senior COFINA bonds at the relevant scheduled payment dates (2047 through 2054). Any claims payable under the existing Ambac Assurance policy for the Ambac Assurance-insured senior COFINA bonds held in the trust will be reduced by all amounts distributed or deemed distributed from the trust to the holders of the trust units from the new COFINA bonds and cash as well as accelerated policy payments made by Ambac Assurance at its own discretion. Ambac makes no representation and can give no assurances that the new COFINA bonds or COFINA Class 2 Trust units, both of which are not insured by Ambac Assurance, will trade at par or any other price. Under the COFINA POA, Ambac Assurance-insured bondholders who did not affirmatively elect the trust option in clause (ii) above were deemed to have elected the commutation option described in clause (i) above. As of the January 11, 2019 election date, 74.9% of Ambac Assurance-insured senior COFINA bondholders, by measure of insured par, elected the commutation option or did not affirmatively elect to exchange their bonds for units of the COFINA Class 2 Trust.
On January 16-17, 2019, the hearings for the confirmation of the COFINA POA and the Commonwealth 9019 motion were held. On February 4, 2019, the COFINA Plan of Adjustment was confirmed and the Commonwealth 9019 motion was approved by Judge Laura Taylor Swain of the U.S. District Court for the District of Puerto Rico. On February 12, 2019, the COFINA POA went effective, concurrent with the completion of the commutation described above. Several parties are presently appealing the confirmation of the POA. As a result, Ambac Assurance's insured COFINA bond exposure decreased by $603 million net par to approximately $202 million net par (a reduction of $5.5 billion of net principal and interest to $1.8 billion of net principal and interest). Ambac Assurance's remaining policy obligation of $202 million net par is an asset of the COFINA Class 2 Trust, which holds a ratable distribution of cash and new COFINA bonds, which can be used to partially offset Ambac’s remaining insurance liability.
Several parties are presently appealing the confirmation of the POA and no assurances can be given regarding the results of such appeals. At this time, it is unclear what impact the COFINA
restructuring will have on the prospective recoveries of Ambac Assurance's other insured Puerto Rico instrumentalities.
The status, timing and subject of any current or future mediation discussions have not been officially disclosed. No assurances can be given that negotiations will be successfully concluded, that Commonwealth, Oversight Board and creditor parties will reach definitive agreements on additional debt restructurings, that any additional negotiated transaction debt restructuring, definitive agreement or Plan of Adjustment will be approved by the court and completed, or that any transaction or Plan of Adjustment will not have an adverse impact on Ambac's financial conditions or results.
On February 15, 2019, the United States Court of Appeals for the First Circuit issued an opinion in the consolidated appeals brought by certain parties who argued that the members of the Financial Oversight and Management Board for Puerto Rico (the "Oversight Board") were appointed in violation of the U.S. Constitution’s Appointments Clause. The First Circuit ruled that the Oversight Board members (other than the ex-officio Member) must be, and were not, appointed in compliance with the Appointments Clause. The First Circuit declined to dismiss the Oversight Board’s Title III petitions and did not render ineffective any otherwise valid actions of the Oversight Board prior to the issuance of the ruling. The First Circuit stated that the ruling will not take effect for 90 days, “so as to allow the President and the Senate to validate the currently defective appointments or reconstitute the Board in accordance with the Appointments Clause." During the 90-day stay period, the Oversight Board may continue to operate as it had prior to the ruling. It is unclear how this ruling will impact, whether during or after such 90-day stay period, the restructuring process, mediation discussions and relevant litigation with respect to our Puerto Rico exposures.
Ambac Post-COFINA Title III Litigation Update
Ambac Assurance is party to ten litigations related to its Puerto Rico exposures, and is currently seeking to intervene in an
eleventh. Three of these litigations are COFINA-related cases that have been, or will soon be, dismissed by operation of the COFINA Plan of Adjustment (“POA”) that was confirmed on February 4, 2019, and became effective on February 12, 2019. Several parties are presently appealing the confirmation of the POA. A fourth is another COFINA-related case that had been stayed pending resolution of an interpleader action related to COFINA funds, but which will be permitted to proceed by operation of the POA now that the interpleader action has been resolved. The two remaining active litigations are an appeal relating to the Puerto Rico Highways and Transportation Authority pending before the United States Court of Appeals for the First Circuit, and an adversary proceeding relating to the Puerto Rico Public Buildings Authority pending before the United States District Court for the District of Puerto Rico. The remainder of these litigations are stayed under Title III of PROMESA. Ambac is unable to predict when and how the issues raised in these cases (other than those already dismissed by operation of the POA) will be resolved. If Ambac Assurance is unsuccessful in any of these proceedings, Ambac’s financial condition, including liquidity, loss reserves and capital resources may suffer a material negative impact.
Refer to Note 16. Commitments and Contingencies to the Consolidated Financial Statements, included in Part II, Item 8 in this Form 10-K, for further information about Ambac's litigation relating to Puerto Rico.
Ambac has considered these developments and other factors in evaluating its Puerto Rico loss reserves. During the year ended December 31, 2018, Ambac had incurred losses associated with its Domestic Public Finance insured portfolio of $36.7 million, which was significantly impacted by the continued uncertainty and volatility of the situation in Puerto Rico. While management believes its reserves are adequate to cover losses in its Public Finance insured portfolio, there can be no assurance that Ambac may not incur additional losses in the future, particularly given the developing economic, political, and legal circumstances in Puerto Rico. Such additional losses may have a material adverse effect on Ambac’s results of operations and financial condition.
The following table shows Ambac's insured exposure to each issuer segregated by whether such debt obligation is subject to the Priority Debt Provision or "clawback." Ambac has initiated litigation challenging the application of the "clawback" announced by Governor Padilla, Puerto Rico's former governor, on December 1, 2015. A description of Ambac's legal challenge is provided in Note 16. Commitments and Contingencies in the Consolidated Financial Statements, included in Part II, Item 8 in this Form 10-K.
Internal credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance. In cases where Ambac Assurance has insured multiple tranches of an issue with varying internal ratings, or more than one obligation of an issuer with varying internal ratings, a weighted average rating is used. Ambac Assurance credit ratings are subject to revision at any time and do not constitute investment advice. BIG denotes credits deemed below investment grade.
Net Par includes capital appreciation bonds, which are reported at the par amount at the time of issuance of the insurance policy as opposed to the current accreted value of the bonds. Accretion of the capital appreciation bonds would increase the related net par by $753 at December 31, 2018.
Net Par and Interest Outstanding ("P&I") represents the total insured future debt service remaining over the lifetime of the bonds. P&I for capital appreciation bonds does not represent the accreted amount as noted in footnote (2) but rather the amount due at respective maturity dates.
In addition to ever-to-date net claims paid, Ambac made net claim payments of $25 during January 2019.
Commonly known as "clawback" provision pursuant to Section 8 of Article VI of the Constitution of the Commonwealth of Puerto Rico. Under this provision, in case the available revenues (the Spanish version uses the term “resources”) including surplus for any fiscal year are insufficient to meet the appropriations made for that year, interest on the public debt and amortization thereof shall first be paid, and other disbursements shall thereafter be made in accordance with the order of priorities established by law. These exposures are also subject to Act No. 5-2017, as amended, also known as the Financial Emergency and Fiscal Responsibility Act of 2017, which declares an emergency period that has been subsequently re-extended until June 30, 2019 from its prior December 31, 2018 deadline. Pursuant to Act 5-2017, all executive orders issued under Act No. 21-2016 (as amended, known as the Puerto Rico Emergency Moratorium and Financial Rehabilitation Act), shall continue in full force and effect until amended, rescinded or superseded.
Certain Pledged Revenues for Highways and Transportation Revenue Bonds such as Toll Revenues and Investment Earnings are not subject to the Priority Debt Provision.
Payable from and secured by proceeds from a federal excise tax imposed on all items produced in Puerto Rico and sold on the mainland of the United States. Currently, rum is the only product from Puerto Rico subject to this federal excise tax.
Net Par and Interest Outstanding excludes the effects of a 10% current interest rate on $60 net par of PR Public Building Authority ("PBA") bonds with a maturity date of July 1, 2035, resulting from the absence of a remarketing. Should a remarketing not occur before the maturity of the bonds, the Net Par and Interest Outstanding for PBA exposure would increase by $44.7.
As mentioned above, the COFINA POA was confirmed by the United States District Court for the District of Puerto Rico on February 4, 2019 and became effective on February 12, 2019. The POA and certain related commutation transactions resulted in a reduction of Ambac Assurance's insured net par exposure to COFINA by approximately 75% or $603 to $202 (net par and interest reduction of $5,525 to $1,797).
Puerto Rico Highways & Transportation Authority, Transportation Revenue
Lease and Tax-backed Revenue
Puerto Rico Infrastructure Financing Authority, Special Tax Revenue
Lease and Tax-backed Revenue
New Jersey Economic Development Authority - School Facilities Construction
Lease and Tax-backed Revenue
Massachusetts Port Authority Special Facility Revenue Bonds
Internal credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance. In cases where Ambac Assurance has insured multiple tranches of an issue with varying internal ratings, or more than one obligation of an issuer with varying internal ratings, a weighted average rating is used. Ambac Assurance credit ratings are subject to revision at any time and do not constitute investment advice. BIG denotes credits deemed below investment grade.
Net Par includes capital appreciation bonds, which are reported at the par amount at the time of issuance of the insurance policy as opposed to the current accreted value of the bonds.
As mentioned above, the COFINA POA was confirmed by the United States District Court for the District of Puerto Rico on February 4, 2019 and became effective on February 12, 2019. The POA and certain related commutation transactions resulted in a reduction of Ambac Assurance's insured net par exposure to COFINA by approximately 75% or $603 to $202.
U.S. Structured Finance Portfolio
Ambac’s portfolio of U.S. structured finance exposures is $9,947 million, representing 21% of Ambac’s net par outstanding as of December 31, 2018, and a 28% reduction from the amount outstanding at December 31, 2017. This reduction in exposure was primarily related to residential mortgage-backed securities ("RMBS") policies, which was attributable to continued prepayments and claims presented on insured RMBS bonds as well as commutations and clean-up calls, both negotiated and non-negotiated, of certain RMBS transactions with less than 10% of their original mortgage pool balances remaining. In addition, the refinancing of various investor-owned utility exposures and commutation and reinsurance of other structured finance transactions contributed to this overall reduction in U.S. structured finance exposure.
Current insured exposures include securitizations of mortgage loans, home equity loans, student loans, leases, operating assets, collateralized loan obligations (“CLO”), and other asset-backed financings, in each case where the majority of the underlying collateral risk is situated in the United States. Included within the lease securitization sector are pooled aircraft. Additionally, Ambac’s structured finance insured portfolio includes secured and unsecured debt issued by investor-owned utilities. It also includes structured insurance transactions, including transactions providing insurance on the notes of trusts that were established in connection with the reinsurance of defined blocks of life insurance and that were used to fund regulatory reserves associated with level
premium term life insurance policies (commonly referred to as Regulation XXX reserves).
See Note 6. Financial Guarantees in Force to the Consolidated Financial Statements, included in Part II, Item 8 included in this Form 10-K, for exposures by bond type as of December 31, 2018.
Structured finance securitization exposures generally entail three forms of risk: (i) asset risk, which relates to the amount and quality of the underlying assets; (ii) structural risk, which relates to the extent to which the transaction’s legal structure and credit support provide protection from loss; and (iii) servicer risk, which is the risk that poor performance at the servicer or manager level contributes to a decline in cash flow available to the transaction. Ambac Assurance seeks to mitigate and manage these risks through its risk management practices.
Securitized securities are usually designed to help protect the investors and, therefore, the guarantor from the bankruptcy or insolvency of the entity that originated the underlying assets as well as from the bankruptcy or insolvency of the servicer of those assets. The servicer of the assets is typically responsible for collecting cash payments on the underlying assets and forwarding such payments, net of servicing fees, to a trustee for the benefit of the issuer. One potential issue is whether the sale of the assets by the originator to the issuer would be upheld in the event of the bankruptcy or insolvency of the originator and whether the servicer of the assets may be permitted or stayed from remitting to investors cash collections held by it or received by it after the servicer or the
originator becomes subject to bankruptcy or insolvency proceedings. Another potential issue is whether the originator sold ineligible assets to the securitization transaction that subsequently deteriorated, and, if so, whether the originator has the willingness or financial wherewithal to meet its contractual obligations to repurchase those assets out of the transaction. Structural protection in a transaction, such as control rights that are typically held by the senior note holders, or guarantor in insured transactions, will determine the extent to which underlying asset performance can be influenced upon non-performance to improve the revenues available to cover debt service.
Ambac has exposure to the U.S. mortgage market primarily through direct financial guarantees of RMBS, including transactions that contain risks to first and second lien mortgages. Ambac's total net par exposure to RMBS at December 31, 2018 was approximately $5.5 billion ($3.2 billion, $2.1 billion, $0.2 billion are first lien, second lien and other respectively), a decrease of 24% during 2018. At December 31, 2018, 85% of RMBS net par exposure relates to securitizations issued during 2005 through 2007.
The following table presents the top five servicers by net par outstanding at December 31, 2018, for U.S. structured finance exposures:
($ in millions)
% of Total
Specialized Loan Servicing, LLC
Bank of America N.A.
Wells Fargo Bank
Ocwen Loan Servicing, LLC
Pennsylvania Higher Education Assistance Agency
The table below shows Ambac’s ten largest structured finance transactions, as a percentage of total financial guarantee net par outstanding at December 31, 2018:
($ in millions)
% of Total
Ballantyne Re Plc (2)
Timberlake Financial, LLC
Wachovia Asset Securitization Issuance II, LLC 2007-HE2
Mortgage Backed Securities
Progress Energy Carolinas, Inc.
Investor Owned Utility
Wachovia Asset Securitization Issuance II, LLC 2007-HE1
Mortgage Backed Securities
Option One Mortgage Loan Trust 2007-FXD1
Mortgage Backed Securities
Terwin Mortgage Trust Asset-Backed Certificates, Series 2006-6
Internal credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance, and for Ambac UK related transactions, based on the view of Ambac UK. In cases where Ambac Assurance or Ambac UK has insured multiple tranches of an issue with varying internal ratings, or more than one obligation of an issuer with varying internal ratings, a weighted average rating is used. Ambac Assurance and Ambac UK credit ratings are subject to revision at any time and do not constitute investment advice. BIG denotes credits deemed below investment grade.
Insurance policy issued by Ambac UK.
International Finance Insured Portfolio
Ambac’s portfolio of international finance insured exposures is $13,538 million, representing 29% of Ambac’s net par outstanding as of December 31, 2018 and a 19% reduction from the amount outstanding at December 31, 2017. This reduction in exposure was primarily the result of policy terminations within investor-owned utilities and asset-backed securities as well as a strengthening of the US dollar. Ambac’s international finance insured exposures include a wide array of obligations in the international markets, including infrastructure financings, asset-securitizations, utility
obligations, whole business securitizations (e.g., securitizations of substantially all of the operating assets of a corporation) and sub-sovereign credit. Ambac has no insured exposure related to emerging markets. See Note 6. Financial Guarantees in Force to the Consolidated Financial Statements, included in Part II, Item 8 included in this Form 10-K, for exposures by bond type as of December 31, 2018.
When underwriting transactions in the international markets, Ambac considered the specific risks related to the particular
country and region that could impact the credit of the issuer. These risks include the legal and political environment, capital markets dynamics, foreign exchange issues and the degree of governmental support. Ambac continues to assess these risks through its ongoing risk management.
Ambac UK, which is regulated in the United Kingdom (“UK”), had been Ambac Assurance’s primary vehicle for directly issuing financial guarantee policies in the UK and the European Union with $13,193 million net par outstanding in those markets at December 31, 2018, of which $900 million relates to a structured insurance US risk transaction. The portfolio of insured exposures underwritten by Ambac UK is financially supported exclusively by the assets of Ambac UK and no capital support arrangements are in place with any other Ambac affiliate.
Other European Union Exposures (“EU”)
Ambac's international net par exposures are principally in the United Kingdom ($10,965 million); however, we also have exposures with credit risk based in various other EU member states, including Austria, France, Germany and Italy ($1,564 million). Italy, with net par exposures of $811 million, in particular has experienced economic, fiscal and political strains since the 2008 global financial crisis such that the likelihood of default on an insured sub-sovereign obligation in that country is higher than when the policy was underwritten.
Ambac does not guarantee any sovereign bonds of the above EU countries.
In March 2017 the UK government gave the European Union (“EU”) formal notification of its intention to leave the EU with the expectation of formal withdrawal two years later on March 29, 2019 (“Brexit”). In November 2018 the UK Government and EU agreed upon the terms of a legal binding treaty ("Withdrawal
Agreement") setting out the terms of a transition period to apply to the UK between March 29, 2019 and December 31, 2020. The effect of the withdrawal agreement, if ratified, will be to retain the rights and obligations between the UK and the EU within this transition period.
The withdrawal agreement remains subject to ratification by the UK Parliament, EU Council and EU Parliament. If the withdrawal agreement is not ratified and no transitional arrangement is put into place, Brexit may mean that the activities in the EEA of UK passporting insurers may become unlawful on March 29, 2019. They may lose their legal authorization to serve clients who benefit from policies issued by a UK incorporated insurer under freedom of services and freedom of establishment passporting rights (and thereby maybe unable to legally collect premiums or pay claims) and if they have branches in EEA Member States they may be legally obliged to close them down and no longer be legally represented in those jurisdictions.
However on February 19, 2019, the European Insurance and Occupational Pensions Authority (“EIOPA”) made a series of recommendations to EU insurance regulators in light of Brexit. These recommendations include the recommendation that regulatory authorities apply legal frameworks that facilitate the orderly run off (without time limit) of branch operations and of insurance policies issued in EEA member states by UK insurers prior to March 30, 2019 that terminate after this date. The recommendations will require to be incorporated into EEA member states legal and regulatory frameworks in an appropriate manner to bring them into effect. If introduced as expected, these measures will retain Ambac UK's right to collect premium and pay claims on policies issued under EU passporting rights.
As of December 31, 2018 Ambac UK's insured portfolio included 6 financial guarantee obligations with a gross par outstanding of $2.4 billion issued under EU passporting rules.
The table below shows our ten largest international finance transactions as a percentage of total financial guarantee net par outstanding at December 31, 2018. Except where noted, all international finance transactions included in the table below are insured by Ambac UK: