AMBAC FINANCIAL GROUP, INC. The objectives of our Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") are to provide users of our consolidated financial statements with the following:
•A narrative explanation from the perspective of management of our financial condition, results of operations, cash flows, liquidity and certain other factors that may affect future results;
•Context to the unaudited consolidated financial statements; and
•Information that allows assessment of the likelihood that past performance is indicative of future performance.
The following discussion should be read in conjunction with our consolidated financial statements in Item 8 of this Report and the matters described under Part II, Item 1A Risk Factors in this Quarterly Report and under Item 1A. Risk Factors in our Annual Report on Form 10-K for the year endedDecember 31, 2021 . Refer to Item 1. Business and Note 1. Background and Business Description for a description of our business and our key strategies to achieve our primary goal to maximize shareholder value.
MD&A includes the following sections:
Page
Executive Summary 45
Critical Accounting Estimates 48
Financial Guarantees in Force 48
Results of Operations 53
Liquidity and Capital Resources 58
Balance Sheet 60
Variable Interest Entities 66
Accounting Standards 66
U.S. Insurance Statutory Basis Financial Results 66
Ambac
67
EXECUTIVE SUMMARY ($ in millions)
AFG Net Assets
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AFG has the following net assets to support the development and growth of its existing subsidiaries and future acquisitions. AFG does not have any capital commitments or other obligations to provide capital or liquidity to AAC whose financial guarantee business has been in run-off since 2008. As ofMarch 31, 2022 , net assets of AFG, excluding its equity investments in subsidiaries, were$243 . Cash and short-term investments$ 118 Other investments (1) 113 Other net assets 12 Total$ 243
(1)Includes surplus notes (fair value of
AFG's subsidiaries/businesses are divided into three segments, the key value metrics of which are summarized below along with other recent developments.
Specialty Property and Casualty Insurance Segment
The key value metrics for the
Three Months EndedMarch 31, 2022 Gross premiums written$ 24 Net premiums written 5
Earnings before interest, taxes, depreciation and amortization (2)
Pretax income (loss)$ (2) Stockholders Equity$ 115 To support expansion of the admitted insurance component of its business, onJanuary 3, 2022 , Everspan (rated 'A-' (Excellent) by AM Best) completed the acquisition of the 21st Century Companies (three carriers) from a national insurance group that has a Financial Strength Rating of "A" (Excellent) from AM Best. The 21st Century Companies collectively possess certificates of authority in thirty-nine states. All legacy liabilities remain with affiliates of the sellers through reinsurance and contractual indemnities. The 21st Century Companies will be re-named during 2022. Such acquisitions will enhance Everspan's capabilities to launch new admitted programs, develop innovative products and provide enhanced flexibility to foster strategic relationships with prospective program partners.
For additional information on the Specialty Property and Casualty Insurance Segment see the Results of Operations section below in this Management Discussion and Analysis.
Insurance Distribution Segment
The key value metrics for the Insurance Distribution segment for the three
months ended
Three Months Ended March 31, 2022 2021 Premiums placed$ 45 $ 40 Commission income$ 9 $ 7 Sub-producer commission expense (1) 5
4
Net commissions 4
3
Earnings before interest, taxes, depreciation and amortization 2
2
Pretax income (loss) $ 2 $ 2
Stockholders Equity $ 66 (1)The Consolidated Statements of Comprehensive Income presents this item within Operating Expenses.
For additional information about the Insurance Distribution Segment see the Results of Operations section below in this Management Discussion and Analysis.
Legacy Financial Guarantee Insurance Segment
The key value metrics for the
Three Months Ended March 31, 2022 Net premiums earned$ 13 Net investment income 5 Loss and loss expenses (benefit) 23 Operating expenses 21 Pretax income (loss)$ 6 Stockholders Equity$ 567
Adversely Classified Credit Net Par Outstanding
A key strategy forAmbac is to increase the value of its investment in AAC 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 withAmbac's liability management and loss mitigation programs.
Asset Management
Investment portfolios are subject to internal investment guidelines, as well as limits on the types and quality of investments imposed by insurance laws and regulations. The investment portfolios of AAC and AmbacUK hold fixed maturity securities and various pooled investment funds. Refer to Note 4. Investments to the Unaudited Consolidated Financial Statements, included in Part I, Item 1 in this Form 10-Q for further details of fixed maturity investments by asset category and pooled investment funds by investment type.
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AtMarch 31, 2022 , AAC owned$313 of distressedAmbac -insured bonds, including significant concentrations of insured RMBS bonds. As a result of thePuerto Rico restructurings discussed under "Liability and Insured Exposure Management" below, the amount ofAmbac -insuredPuerto Rico bonds held in the investment portfolio was significantly reduced during the three months endedMarch 31, 2022 . Subject to internal and regulatory guidelines, market conditions and other constraints,Ambac may continue to opportunistically purchase and sellAmbac -insured securities.
Liability and Insured Exposure Management
Ambac's Risk Management Group focuses on the implementation and execution of risk reduction, defeasance and loss recovery strategies. Analysts evaluate the estimated timing and severity of projected policy claims as well as the potential impact of loss mitigation or remediation strategies in order to target and prioritize policies, or portions thereof, for commutation, reinsurance, refinancing, restructuring or other risk reduction strategies. For targeted policies, analysts will engage with issuers, bondholders and other economic stakeholders to negotiate, structure and execute such strategies.Ambac completed risk reduction transactions consisting of refinancings and commutations of$310 of net par exposure for the three months endedMarch 31, 2022 , of which$266 related to thePuerto Rico restructuring. In the second quarter of 2022, the remainder of the PRIFA and CCDA bonds or about$317 belonging to bondholders who elected not to commute their AAC insurance policies (which were deposited into trusts) together with such policies have all been accelerated byAmbac , satisfying and eliminating all of theAmbac -insured PRIFA and CCDA bonds. Refer below to the Financial Guarantees In Force section of the Management Discussion and Analysis for Results of Operations, Financial Guarantees in Force for additional details of thePuerto Rico restructuring.Puerto Rico . The following table provides a comparison of total, adversely classified ("ACC") and watch list credit net par outstanding in the insured portfolio atMarch 31, 2022 andDecember 31, 2021 . Net par exposure within theU.S. public finance market includes capital appreciation bonds which are reported at the par amount at the time of issuance of the insurance policy as opposed to the current accreted value of the bonds. March 31, December 31, 2022 2021 Decrease Total$ 27,118 $ 28,020 $ (902) (3) % ACC 5,884 6,361 (477) (7) % Watch list 3,729 3,824 (95) (2) %
The decrease in total and ACC credit net par outstanding resulted from the active de-risking noted above, as well as scheduled maturities, amortizations, refundings and calls.
COVID-19 The COVID-19 pandemic had, and to a lesser degree, continues to have, an impact on general economic conditions; including, but not limited to, higher unemployment; volatility in the capital markets; closure or severe curtailment of the operations and,
hence, revenues, of many businesses and public and private enterprises to which we are directly or indirectly exposed.
COVID-19 and the public health responses by the US federal and state governments at the onset of the pandemic resulted in a shut down for several months of significant portions of the US economy, including areas that AAC's insured obligors rely upon to generate the revenues and cash flows necessary to service debts we insure. In theU.S. andEurope , where most ofAmbac's financial guaranty exposure is located, significant fiscal stimulus measures, monetary policy actions and other relief measures helped to moderate the negative economic impacts of COVID-19 and supported the economic recovery which began in the second half of 2020 and continues into 2022. As ofMarch 31, 2022 , there have been no defaults ofAmbac -insured obligations as a result of the COVID-19 pandemic. Given the economic uncertainties associated with the duration and effects of the COVID-19 pandemic, it is impossible to fully predict all of its long-term consequences and, as a result, it is possible that our future operating results and financial condition may be materially adversely affected by the continuance of the pandemic.
The current conflict betweenRussia andUkraine and the related sanctions and other penalties imposed by countries across the globe againstRussia are creating substantial uncertainty in the global economy. We do not have operations inRussia orUkraine or any insured exposures in those countries.Ambac's investment portfolio exposure to Russian issuers is not significant. Given our insignificant exposure, we have not experienced, and do not expect this conflict to have, a material adverse impact on our results of operations, financial condition or cash flows. However, as the conflict continues and if it were to escalate, the global economy and capital markets will be adversely impacted in ways that we cannot predict and therefore we are unable to estimate the ultimate impact that this conflict may have on our future financial condition, results of operations, and cash flows.
Financial Statement Impact of Foreign Currency:
The impact of foreign currency as reported inAmbac's Unaudited Consolidated Statement of Total Comprehensive Income for the three months endedMarch 31, 2022 , included the following: Net income (1) $ 1 Gain (loss) on foreign currency translation (net of tax) (23)
Unrealized gains (losses) on non-functional currency available-for-sale securities (net of tax)
2
Impact on total comprehensive income (loss) $ (20)
(1) A portion of Ambac UK's , and to a lesser extent AAC'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 Unaudited Consolidated
Statement of Total Comprehensive Income (Loss).
Future changes to currency rates may adversely affect our financial results.
Refer to Part II, Item 7A in the Company's Annual Report on Form 10-K for the
year ended December 31 ,
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2021, for further information on the impact of future currency rate changes on
LIBOR Sunset
Ambac continuously monitors regulatory and industry developments related to the transition from LIBOR to alternative reference rates. In 2021,New York State passed legislation addressing the cessation ofU.S. Dollar ("USD") LIBOR and specified a recommended benchmark replacement based on the Secured Overnight Financing Rate ("SOFR") for certain legacy transactions. Similar Federal legislation gained approval in March of 2022. The Alternative Reference Rates Committee, theFederal Reserve Board and several industry associations and groups have expressed support for the new law. WhileAmbac believes the LIBOR law is generally a positive step, there remains uncertainty about how it will be interpreted or challenged as well as about other aspects of the discontinuance of LIBOR. At the same time, regulatory and governmental authorities continue to promote the creation and functioning of post-LIBOR indices, SOFR in particular. See the Risk Factor entitled "Uncertainties regarding the expected discontinuance of the London Inter-Bank Offered Rate or any other interest rate benchmark could have adverse consequences" found in Part I, Item 1A ofAmbac's Annual Report on Form 10-K for the year endedDecember 31, 2021 . Also, for further background and information about management's evaluation ofAmbac's potential exposures to LIBOR transition, see "Executive Summary - LIBOR Sunset" in Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" included inAmbac's Annual Report on Form 10-K for the year endedDecember 31, 2021 .
SEC Proposed Rules on Climate Related Information
OnMarch 21, 2022 , theSecurities and Exchange Commission ("SEC") proposed rule amendments that would require public companies to include certain climate-related information in their periodic reports and registration statements, including oversight and governance, material impacts (operational and financial), risk identification and management, and Scope 1, 2 and 3 emissions (the "Proposed Rule"). For large accelerated filers, such asAmbac , the Scope 1 and 2 emissions disclosures would require attestation from a third party. These new requirements, if adopted, would at the earliest take effect in fiscal year 2023 and begin to apply toSEC filings in 2024.Ambac is reviewing the Proposed Rule and assessing related compliance obligations and other effects on our operations.
CRITICAL ACCOUNTING ESTIMATES
Ambac's Unaudited Consolidated Financial Statements have been prepared in accordance withU.S. generally accepted accounting principles ("GAAP"), which require the use of material estimates and assumptions. For a discussion ofAmbac's critical accounting policies and estimates, see "Critical Accounting Policies and Estimates" in Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" included inAmbac's Annual Report on Form 10-K for the year endedDecember 31, 2021 . FINANCIAL GUARANTEES IN FORCE ($ in millions) Financial guarantee products were sold in three principal markets:U.S. public finance,U.S. structured finance and international finance. The following table provides a breakdown of guaranteed net par outstanding by market atMarch 31, 2022 andDecember 31, 2021 . Net par exposures within theU.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 insuring variable interest entities ("VIEs") consolidated in accordance with the Consolidation Topic of the ASC. Guaranteed net par outstanding excludes the exposures of policies that insure bonds which have been refunded or pre-refunded and excludes exposure of the policies insuring the Sitka Senior Secured Notes as defined in Note 1. Background and Business Description in the Notes to the Consolidated Financial Statements included in Part II, Item 8 in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 : March 31, December 31, 2022 2021 Public Finance (1) (2)$ 11,980 $ 12,360 Structured Finance 4,688 4,904 International Finance 10,450 10,756 Total net par outstanding$ 27,118 $ 28,020
(1)Includes
(2)Includes
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The table below showsAmbac's ten largest insured exposures, by repayment source, as a percentage of total financial guarantee net par outstanding atMarch 31, 2022 : Ultimate % of Total Country-Bond Ambac Maturity Net Par Net Par Risk Name Type Ratings (1) Year Outstanding Outstanding IF AUK Capital Hospitals plc (2) UK-Infrastructure A- 2046$ 899 3.3 % IF AUK Anglian Water UK-Utility A- 2035 895 3.3 %
IF AUK Mitchells & Butlers Finance plc-
BBB 2033 852 3.1 %
Pub Securitisation
IF AUK Aspire Defence Finance plc UK-Infrastructure A- 2040 799 2.9 %
IF AUK National Grid Gas UK-Utility BBB+ 2037 783 2.9 %
IF AUK Posillipo Finance II S.r.l Italy-Sub-Sovereign BIG 2035 643 2.4 %PF AAC New Jersey Transportation Trust US-Lease and Tax-backed Revenue
BBB- 2036 623 2.3 %
Fund Authority - Transportation
System
IF AUK National Grid Electricity UK-Utility BBB+ 2036 2.0 %
Transmission 551
IF AUK RMPA Services plc UK-Infrastructure BBB+ 2038 524 1.9 %
IF AUK Catalyst Healthcare (Manchester) UK-Infrastructure BBB- 2040 522 1.9 %
Financing plc (2)
Total $ 7,091 26.0 %
PF = Public Finance, SF = Structured Finance, IF = International Finance
AAC =
(1) Internal credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view ofAmbac . In cases whereAmbac 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 credit ratings are subject to revision at any time and do not constitute investment advice. BIG denotes credits deemed below investment grade. (2) A portion of this transaction is insured by an insurance policy issued by AAC. AAC has issued policies for these transactions that will only pay in the event that AmbacUK does not pay under its insurance policies ("second to pay policies"). Net par related to the top ten exposures reduced$234 fromDecember 31, 2021 . Exposures are impacted by changes in foreign exchange rates ($189 reduction during the three months endedMarch 31, 2022 ), certain indexation rates, reinsurance transactions and scheduled and unscheduled paydowns. As a result of recent increases in inflation, such indexation exposures have increased at a faster pace than they have historically. The concentration of net par amongst the top ten (as a percentage of net par outstanding) remained unchanged at 26% atMarch 31, 2022 , andDecember 31, 2021 . Excluding the top ten exposures, the remaining insured portfolio of financial guarantees has an average net par outstanding of$32 per single risk, with insured exposures ranging up to$454 and a median net par outstanding of$5 . Given thatAmbac has not written any new financial guaranty insurance policies since 2008, the risk exists that the legacy financial guarantee insured portfolio becomes increasingly concentrated to large and/or below investment grade exposures.Puerto Rico The following table outlinesAmbac's insured net par outstanding to eachCommonwealth of Puerto Rico issuer. Each issuing entity has its own credit risk profile attributable to, as applicable, discreet revenue sources, direct general obligation pledges and general obligation guarantees. Net Par Outstanding ($ in millions) March 31, 2022 December 31, 2021PR Highways and Transportation Authority (1998 Resolution - Senior Lien Transportation Revenue) $ 394 $ 394PR Infrastructure Financing Authority (Special Tax Revenue) (1) 247 403PR Convention Center District Authority (Hotel Occupancy Tax) (2) 70 86PR Sales Tax Financing Corporation - Senior Sales Tax Revenue (COFINA) 69 73PR Highways and Transportation Authority (1968 Resolution - Highway Revenue) 4 4Commonwealth of Puerto Rico - General Obligation Bonds - 11PR Public Buildings Authority - Guaranteed by the Commonwealth of Puerto Rico - 83 Total Net Exposure to The Commonwealth of Puerto Rico and Related Entities $ 784 $ 1,054
(1) As of
(2) As of
Commonwealth Plan of Adjustment (Title III Case)
OnMarch 15, 2022 , the Eighth Amended Title III Joint Plan of Adjustment of theCommonwealth of Puerto Rico , et al. ("Eighth Amended POA") together with the Qualifying Modifications for PRIFA and CCDA ("PRIFA QM" and "CCDA QM", respectively) became effective, restructuring approximately$33,000 of debt across various Commonwealth instrumentalities,
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including obligations insured by AAC, and approximately
The Eighth Amended POA, among other things, incorporated the settlement
reflected in the PRIFA Related Plan Support Agreement ("PRIFA PSA") that was
signed on July 27, 2021 , by the Oversight Board, as representative of the
Commonwealth of Puerto Rico , AAC, FGIC, and other holders of bonds issued by
PRIFA. The Eighth Amended POA also incorporated the settlements reflected in the
PRHTA/CCDA Related Plan Support Agreement ("PRHTA/CCDA PSA") dated May 5, 2021 ,
and the Amended and Restated Plan Support Agreement with the Oversight Board, as
representative of the Commonwealth of Puerto Rico , PBA, and the Employee
Retirement System of the Government of the Commonwealth of Puerto Rico ("Amended
and Restated GO / PBA PSA") dated as of July 12, 2021 .
The plan consideration made available to creditors under these plan support agreements on the Eighth Amended POA effective date was as follows:
PRIFA Plan Consideration
PRIFA creditors receive, on account of approximately$1,929 of allowed claims arising from PRIFA bonds, consideration in the form of (i)$193.5 cash and (ii) a contingent value instrument ("CVI") premised on (a) a share of the outperformance of general fund rum tax collections relative to the certified 2021 Commonwealth Fiscal Plan's projections (the "Rum Tax CVI") and (b) an approximately 27% share, subject to a lifetime cap of about$1,302 , of the Clawback Creditors' portion of the outperformance of the Commonwealth's sales and use tax ("SUT") relative to the certified 2020 Commonwealth Fiscal Plan's projections (the "Clawback CVI").
CCDA Plan Consideration
CCDA creditors receive, on account of approximately$384 of allowed claims against the Commonwealth arising from CCDA bonds, consideration in the form of (i)$97 cash and (ii) an approximately 4% share, subject to a lifetime cap of about$217 , of the Clawback CVI.
GO/PBA Plan Consideration
GO/PBA creditors receive, on account of approximately$18,409 of allowed claims arising from various GO and PBA bonds and other loans, consideration of (i) approximately$7,074 of cash, including plan support fees, (ii) approximately$6,683 of new GO current interest bonds,$1,170 face value of new GO capital appreciation bonds and (iv) GO Bond CVI, subject to a lifetime cap of about$3,500 . The GO Bond CVI is intended to provide creditors with additional returns tied to outperformance of the SUT against the certified 2020 Commonwealth Fiscal Plan's projections.
AAC-Insured Bond Effective Date Transactions
GO / PBA
On the Eight Amended POA effective date, AAC-insured GO and PBA bondholders who elected commutation of their insurance received: 1) their respective shares of GO/PBA plan consideration available under the Eighth Amended POA, and 2) cash fromAmbac .Ambac's obligations to the bondholders under theAmbac insurance policies who elected this option were deemed to be fully satisfied. On the plan effective date, about 50% and 27% of the outstanding par of theAmbac -insured GO and PBA bonds, respectively, totaling about$28 of insured par was commuted. The AAC-insured GO and PBA bondholders who failed to elect commutation received payment, in cash, of the outstanding principal amount of the bondholders' insured bonds plus the accrued and unpaid interest thereon as of the effective date (the "Ambac Acceleration Price."). Pursuant to this option, bondholders received the Ambac Acceleration Price in full and final discharge ofAmbac's obligations under theAmbac insurance policies. As of the effective date, all the remaining outstanding AAC-insured GO and PBA bonds totaling about$94 of insured par were satisfied and eliminated via commutation or acceleration.
PRIFA / CCDA
On the Eight Amended POA effective date, AAC-insured PRIFA and CCDA bondholders who elected commutation of their insurance received: 1) their respective shares of PRIFA or CCDA plan consideration available under the Eighth Amended POA and the PRIFA QM, or CCDA QM, as applicable, and 2) cash fromAmbac .Ambac's obligations to the bondholders under theAmbac insurance policies who elected this option were deemed to be fully satisfied. The AAC-insured PRIFA and CCDA bondholders who failed to elect commutation had their bondholders' respective shares of consideration available under the Commonwealth Plan and the PRIFA QM, or CCDA QM, as applicable, deposited into a trust. On the plan effective date, about 39% and 19% of the outstanding par of theAmbac -insured PRIFA and CCDA bonds, respectively, totaling about$172 of insured par was commuted with the remainder totaling about$317 of insured par deposited into the trusts. Since the effective date, the remainder of those PRIFA and CCDA bonds belonging to bondholders who elected not to commute their AAC Insurance Policies and were deposited into trusts together with such policies have all been accelerated, satisfying and eliminating all of theAmbac -insured PRIFA and CCDA bonds.
AAC's remaining unrestructured PROMESA Puerto Rico exposure, PRHTA, is subject
to the PRHTA Plan of Adjustment ("PRHTA POA"), which was filed on May 2, 2022 . A
confirmation hearing for the PRHTA POA is expected to follow later in 2022.
PRHTA/CCDA PSA
AAC signed a joinder to the PRHTA/CCDA PSA onJuly 15, 2021 . The PRHTA/CCDA PSA, originally executed onMay 5, 2021 , provides for certain consideration for holders of bonds issued by certain Commonwealth instrumentalities, PRHTA, and CCDA on account of their claims against the Commonwealth arising from such bonds ("Clawback" claims). Under the PRHTA/CCDA PSA, PRHTA creditors will share$389 of cash proceeds, including a$264 interim distribution, payable once the PRHTA distribution condition has been met pursuant to the Eighth Amended POA. In addition, PRHTA creditors will receive an
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approximately 69% share of the Clawback CVI, subject to a lifetime nominal cap of about$3,698 , which is also payable once the PRHTA distribution condition has been met pursuant to the Eighth Amended POA. The PRHTA Clawback CVI is subject to a PRHTA-specific waterfall: holders of PRHTA '68 bonds will receive the first dollars of Clawback CVI, followed by holders of PRHTA '98 bonds. The value of the Clawback CVI is highly uncertain, given the contingent, outperformance-driven structure. Changes in our assumed values of the Clawback CVI or in the actual performance of the Clawback CVI could cause an adverse change in our reserves which could be material. As a result, a significant decrease in our assumed values of the Clawback CVI could have a material adverse impact on our results of operations and financial condition. PRHTA bondholders will also receive new PRHTA bonds or cash with a face amount of$1,245 . Of the$1,245 in new bonds or cash, approximately$646.4 will be allocated to holders of PRHTA '68 bonds and approximately$598.6 will be allocated to holders of PRHTA '98 bonds. The new PRHTA bonds or cash will be distributed to creditors upon consummation of the PRHTA POA. AAC and other PRHTA creditors will receive restriction fees and consummation costs payable at the effective date of the PRHTA POA. Puerto Rico Considerations The Eighth Amended POA and the qualifying modifications for PRIFA and CCDA became effective onMarch 15, 2022 , and on that date and since, AAC-insuredPuerto Rico exposures have been significantly reduced via commutation and acceleration. However, uncertainty remains as to our remaining exposures as to (i) the value or perceived value of the consideration provided by or on behalf of the debtors under the Eighth Amended POA, PRIFA QM, and CCDA QM; (ii) the extent to which exposure management strategies, such as commutation and acceleration, will be executed for PRHTA; (iii) the tax treatment of the consideration provided by or on behalf of the debtors under the Eighth Amended POA, PRIFA QM, and CCDA QM; (iv) whether and when the PRHTA POA will be confirmed; and (vii) other factors, including market conditions such as interest rate movements and credit spread changes on the new CVI instruments.Ambac's loss reserves may prove to be understated or overstated, possibly materially, due to favorable or unfavorable developments or results with respect to these factors. Refer to Management's Discussion and Analysis of Financial Condition and Results of Operations - Balance Sheet to the Unaudited Consolidated Financial Statements included in Part I, Item 2 in this Form 10-Q for the possible increase in loss reserves under stress or other adverse conditions. There can be no assurance that losses may not exceed such estimates.
Ambac Title III Litigation Update
AAC continues to actively participate in PRHTA's Title III proceedings.
Refer to Note 14. Commitments and Contingencies to the Consolidated Financial Statements included in Part I, Item 1 in this Form 10-Q for further information aboutAmbac's litigation relating toPuerto Rico .
Summary
Ambac has considered these developments and other factors in evaluating itsPuerto Rico loss reserves. While management believes its reserves are adequate to cover losses in its Public Finance insured portfolio, there can be no assurance thatAmbac may not incur additional losses in the future. Such additional losses may have a material adverse effect onAmbac's results of operations and financial condition. Due to uncertainty regarding numerous factors, described above, that will ultimately determine the extent ofAmbac's losses, it is also possible that favorable developments and results with respect to such factors may cause losses to be lower than current reserves, possibly materially. Exposure Currency The table below shows the distribution by currency of AAC's insured exposure as ofMarch 31, 2022 : Net Par Amount Net Par Amount Outstanding in Outstanding in Currency Base Currency U.S. Dollars U.S. Dollars$ 16,878 $ 16,878 British Pounds £ 6,6428,725 Euros € 1,1121,231 Australian Dollars A$ 380 284 Total$ 27,118
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Ratings Distribution
The following charts provide a rating distribution of net par outstanding based upon internalAmbac credit ratings(1) and a distribution by bond type ofAmbac's below investment grade ("BIG") net par exposures atMarch 31, 2022 andDecember 31, 2021 . BIG is defined as those exposures with anAmbac internal credit rating below BBB-:
[[Image Removed: ambc-20220331_g2.jpg]][[Image Removed: ambc-20220331_g3.jpg]]
Note:
(1)Internal credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view ofAmbac . In cases whereAmbac 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 credit ratings are subject to revision at any time and do not constitute investment advice.
Summary of Below Investment Grade Exposure:
Net Par Outstanding
March 31, December 31,
Bond Type 2022 2021
Public Finance:
Puerto Rico $ 784 $ 1,054
Military Housing 369 370
Other 308 317
Total Public Finance 1,461 1,741
Structured Finance:
RMBS 2,080 2,170
Student loans 293 302
Total Structured Finance 2,373 2,472
International Finance:
Sovereign/sub-sovereign 752 774
Transportation 375 389
Other 59 62
Total International Finance 1,186 1,225
Total $ 5,020 $ 5,438 The net decline in below investment grade exposures is primarily due to
de-risking activities, including the
Below investment grade exposures could increase as a relative proportion of the guarantee portfolio given that stressed borrowers generally have less ability to prepay or refinance their debt. Accordingly, due to these and other factors, it is not unreasonable to expect the proportion of below investment grade exposure in the guarantee portfolio to increase in the future.
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Results of Operations ($ in millions)Consolidated Results
A summary of our financial results is shown below:
Three Months Ended March 31, 2022 2021 Gross premiums written$ 30 $ (2) Revenues: Net premiums earned$ 15 $ 14 Net investment income 5 49
Net investment gains (losses), including impairments 10 2
Net gains (losses) on derivative contracts 57 25
Net realized gains (losses) on extinguishment of debt - 33 Commission income
9 7
Other income (expense) 2 (2)
Income (loss) on variable interest entities 22 -
Expenses:
Losses and loss expenses (benefit) 24 8 Intangible amortization 14 19 Operating expenses 34 33 Interest expense 44 50 Provision (benefit) for income taxes - 2
Net income (loss) attributable to common stockholders
•AAC has successfully implemented the restructuring of a significant portion of its remainingPuerto Rico exposures, following the occurrence of the effective dates for the Plan of Adjustment related to AAC-insured Puerto Rico General Obligation bonds ("GO") andPublic Buildings Authority ("PBA") bonds, and Qualifying Modifications forAAC-insured Puerto Rico Infrastructure Authority ("PRIFA") andConvention Center District Authority ("CCDA") bonds, all effectiveMarch 15, 2022 . As a result of these successful restructurings,Ambac recorded a gain in the amount of$198 as part of its first quarter 2022 consolidated financial results. This gain includes (i) a net benefit in losses; (ii) gain on the consolidation of newly established variable interest entities; partially offset by losses from sales and changes to the fair value of securities received in the restructuring and amortization of the insurance intangible asset. •Management recorded a reduction to AAC's estimated R&W subrogation recoveries in the amount of$224 ,$186 of which was based on AAC's evaluation of the effect on certain of AAC's R&W litigations of theNew York Court of Appeals' decision in the case entitledU.S. Bank National Association v.DLJ Mortgage Capital, Inc. relating toHome Equity Asset Trust 2007-1 ("HEAT"), a residential mortgage-backed securities trust, and the remainder of which reflects the impact of changes in discount rates and underlying insured RMBS transaction performance. The decision in HEAT is relevant to AAC's breach-of-contract cases relating to its insured RMBS transactions and may affect one of the bases upon which AAC seeks recovery with respect to a significant portion of breaching loans in AAC's RMBS cases. However, management believes there remain other alternative paths to recovery for such breaching loans. AAC's ultimate recoveries in its RMBS litigations may be materially higher or lower than its estimated subrogation recoveries based on a number of factors, including those described inAmbac's Form 10-K for the fiscal year endedDecember 31, 2021 and elsewhere in this Quarterly Report.
The following paragraphs describe the consolidated results of operations of
Gross Premiums Written. Gross premiums written increased$32 for the three months endedMarch 31, 2022 , compared to the same period in the prior year. The increase was driven by the growth in theSpecialty Property & Casualty Insurance segment of$24 .
Net Premiums Earned. Net premiums earned increased
The increase was driven by$1 of specialty property and casualty net premiums earned, partially offset by a slight reduction in legacy financial guarantee premiums earned. Net Investment Income. Net investment income primarily consists of interest and net discount accretion on fixed maturity securities classified as available-for-sale, interest and changes in fair value of fixed maturity securities classified as trading, and net gains (losses) on pooled investment funds which include changes in fair value of the funds' net assets. Fixed maturity securities include investments inAmbac -insured securities that are made opportunistically based on their risk/reward and asset-liability management characteristics. Investments in pooled investment funds and certain other investments are either classified as trading securities with changes in fair value recognized in earnings or are reported under the equity method. These funds and other investments are reported in Other investments on the Unaudited Consolidated Balance Sheets, which consists primarily of pooled fund investments in diversified asset classes. For further information about investment funds held, refer to Note 4. Investments to the Unaudited Consolidated Financial Statements, included in Part I, Item 1 in this Form 10-Q. Net investment income for the periods presented were driven by the legacy financial guarantee segment; other segments' results were not significant.
Net investment income from
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Three Months Ended
2022 2021
Securities available-for-sale:
$
7 $ 15
Securities available-for-sale and short-term other than
7 7
Other investments (includes trading securities) (9) 27
Net investment income $ 5 $ 49
Net investment income decreased
•Other investments income (loss) decreased$36 for the three months endedMarch 31, 2022 , compared to the same period in the prior year. The three months endedMarch 31, 2022 , included a loss of$9 on securities received in thePuerto Rico restructuring which are classified as trading. Pooled fund investment returns were lower for most asset classes, particularly equity and hedge funds. Hedge funds had modest positive performance in the three months endedMarch 31, 2022 , while equities experienced losses as global markets declined. Both of these fund categories reported very strong positive performance in the first quarter of 2021. Performance of other fund categories were mixed relative to the prior year period. •Net investment income fromAmbac -insured securities for the three months endedMarch 31, 2022 decreased$8 compared to the prior year period, due primarily to lower income on LSNI Secured Notes which were redeemed inJuly 2021 . Additionally, continued runoff of insured RMBS and theMarch 15, 2022 ,Puerto Rico restructuring both contributed to declines in investment income fromAmbac -insured securities.
Net Investment Gains (Losses), including Impairments. The following table provides a breakdown of net investment gains (losses) for the periods presented:
Three months ended March 31 2022 2021
Net gains (losses) on securities sold or called
3 (4)
Credit impairments (1) -
Intent / requirement to sell impairments - -
Total net realized gains (losses) $ 10 $ 2
Net gains for the three months ended March 31, 2022 , included a recovery of $9
from a class-action settlement relating to certain RMBS securities previously
held in the investment portfolio. Net gains for the three months ended March 31,
2021 , included a gain of $4 realized on the sale AFG's equity interest in the
Corolla Trust in connection with the Corolla Exchange Transaction. Other net
realized gains on securities sold or called during both periods were primarily
from sales in connection with routine portfolio management.
Credit impairments are recorded as an allowance for credit losses with changes in the allowance recorded through earnings. When
credit impairments are recorded, any non-credit related impairment amounts on the securities are recorded in other comprehensive income. If management either: (i) has the intent to sell its investment in a debt security or (ii) determines that the Company more likely than not will be required to sell the debt security before its anticipated recovery, then the amortized cost of the security is written-down to fair value with a corresponding impairment charge recognized in earnings.Net Gains (Losses) on Derivative Contracts. Net gains (losses) on derivative contracts include results from the Company's interest rate derivatives portfolio and its runoff credit derivatives portfolio. The interest rate derivatives portfolio is positioned to benefit from rising rates as a partial economic hedge against interest rate exposure in the financial guarantee insurance and investment portfolios. Net gains (losses) on interest rate derivatives generally reflect mark-to-market gains (losses) in the portfolio caused by increases (declines) in forward interest rates during the periods, the carrying cost of the portfolio, and the impact of counterparty credit adjustments as discussed below. Results from credit derivatives were not significant to the periods presented. Net gains (losses) on interest rate derivatives for the three months endedMarch 31, 2022 , were$57 compared to$25 for the three months endedMarch 31, 2021 . The net gains for both periods reflect changes in fair value from increases in forward interest rates and lower counterparty credit adjustments on certain derivative assets, partially offset by portfolio carrying costs. The higher net gain for the three months endedMarch 31, 2022 , resulted from the significant rate increases in the period combined with favorable portfolio positioning, partially offset by the impact of wider credit spreads described further below. Counterparty credit adjustments are generally applicable for uncollateralized derivative assets that may not be offset by derivative liabilities under a master netting agreement. Inclusion of counterparty credit adjustments in the valuation of interest rate derivatives resulted in gains (losses) within Net gains (losses) on derivative contracts of$2 and$9 for the three months endedMarch 31, 2022 and 2021, respectively. In addition to the impact of interest rates on the underlying derivative asset values, the changes in counterparty credit adjustments are driven by movement of credit spreads. Credit spreads widened in the three months endedMarch 31, 2022 and narrowed in the three months endedMarch 31, 2021 . Commissions Income. Commission income for the three months endedMarch 31, 2022 was$9 compared to$7 , for the three months endedMarch 31, 2021 . Commissions include both base and profit sharing commissions of the Insurance Distribution segment. The increase is primarily driven by greater premiums placed for the three months endedMarch 31, 2022 . Gross commission income has an accompanying expense, sub-producer commissions (included in Operating Expenses in the Consolidated Statements of Total Comprehensive Income (Loss), which will largely track changes in gross commission. For the three months endedMarch 31, 2022 Sub-producer commissions of$5 million were up from$4 million in three months endedMarch 31, 2021 .
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Net Realized Gains on Extinguishment of Debt. Net realized gains on extinguishment of debt was$33 for the three months endedMarch 31, 2021 , resulting from the first quarter 2021 exchanges of junior surplus notes below their carrying values. Refer to Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 for further discussion of the 2021 Surplus Notes Exchanges. Income (Loss) on Variable Interest Entities. Included within Income (loss) on variable interest entities are income statement amounts relating to FG VIEs, consolidated under the Consolidation Topic of the ASC as a result ofAmbac's variable interest arising from financial guarantees written byAmbac's subsidiaries, including gains or losses attributable to consolidating or deconsolidating FG VIEs during the periods reported. Generally, the Company's consolidated FG VIEs are entities for whichAmbac has provided financial guarantees on all of or a portion of its assets or liabilities. In consolidation, assets and liabilities of the FG VIEs are initially reported at fair value and the related insurance assets and liabilities are eliminated. However, the amount of FG VIE net assets (liabilities) that remain in consolidation generally result from the net positive (negative) projected cash flows from (to) the FG VIEs which are attributable toAmbac's insurance subsidiaries in the form of financial guarantee insurance premiums, fees and losses. In the case of FG VIEs with net negative projected cash flows, the net liability is generally to be funded byAmbac's insurance subsidiaries through insurance claim payments. Differences between the net carrying value of the insurance accounts under the Financial Services-Insurance Topic of the ASC and the carrying value of the consolidated FG VIE's net assets or liabilities are recorded through income at the time of consolidation. Additionally, terminations or other changes toAmbac's financial guarantee insurance policies that impact projected cash flows between a consolidated FG VIE andAmbac could result in gains or losses, even if such policy changes do not result in deconsolidation of the FG VIE. Income on variable interest entities was$22 for the three months endedMarch 31, 2022 , compared to income of less than a million for the three months endedMarch 31, 2021 . Results for the three months endedMarch 31, 2022 , were driven by net income of$22 related to two new trusts created in connection with thePuerto Rico restructurings inMarch 2022 , including an initial gain upon consolidation of$28 partially offset by subsequent declines in the fair value of the trusts' assets throughMarch 31, 2022 . Income on variable interest entities for the three months endedMarch 31, 2022 and 2021 both included realized gains of$1 on sales of assets from one FG VIE (theCOFINA Trust ) offset by declines in the valuation of net assets of other VIEs.
Refer to Note 9. Variable Interest Entities to the Unaudited Consolidated Financial Statements, included in Part I, Item 1 in this Form 10-Q for further information on the accounting for FG VIEs.
Losses and Loss Expenses. Loss and loss expenses increased$16 for the three months endedMarch 31, 2022 , compared to the same period in the prior year. The increase was driven by a
reduction to AAC's estimated R&W subrogation recoveries in the amount of
Intangible Amortization. Insurance intangible amortization for the three months endedMarch 31, 2022 and 2021, was$14 and 19, a decrease of$5 over the three months endedMarch 31, 2021 . The decrease was driven by run-off of the insured portfolio and de-risking activity. Other intangible amortization for the three months endedMarch 31, 2022 and 2021, was$1 and$1 , respectively. Operating Expenses. Operating expenses consist of gross operating expenses plus reinsurance commissions. The following table provides a summary of operating expenses for the periods presented: Three Months Ended March 31, 2022 2021 Compensation$ 16 $ 16 Non-compensation 18 17 Gross operating expenses 34 33 Reinsurance commissions, net (1) - Total operating expenses$ 34 $ 33
Gross operating expenses increased
The increase in operating expenses during the three months ended
•Higher compensation costs due to a net increase in staffing resulting from additions in theSpecialty Property & Casualty Insurance segment offset by lower incentive compensation expense including the timing of performance factor adjustments. •Higher non-compensation costs primarily related to sub-producers commissions as part of the Insurance Distribution segment andLegacy Financial Guarantee Insurance legal costs, partially offset by lower transaction driven consulting fees. Interest Expense. All interest expense relates to theLegacy Financial Guarantee Insurance segment and includes accrued interest on the LSNI Ambac Note, Sitka AAC Note, Tier 2 Notes, surplus notes and other debt obligations. Additionally, interest expense includes discount accretion when the debt instrument carrying value is at a discount to par. The following table provides details by type of obligation for the periods presented: Three Months Ended March 31, 2022 2021 Surplus notes (1)$ 20 $ 18 LSNI Ambac Note - 25 Sitka AAC note 17 - Tier 2 Notes 7 7 Other - - Total interest expense$ 44 $ 50
(1)Includes junior surplus notes that were acquired and retired in the first quarter of 2021.
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The decrease in interest expense for the three months endedMarch 31, 2022 , compared to the three months endedMarch 31, 2021 , was mainly driven by the impact of the Secured Note Refinancing as further described in Note 1. Background and Business Description, in the Notes to the Consolidated Financial Statements included in Part II, Item 8 in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 , partially offset by discount accretion on surplus notes reissued in 2021. Surplus note principal and interest payments require the approval of OCI. InMay 2022 , OCI declined the request of AAC to pay the principal amount of the surplus notes, plus all accrued and unpaid interest thereon, on the then next scheduled payment date ofJune 7, 2022 . As a result, the scheduled payment date for interest, and the scheduled maturity date for payment of principal of the surplus notes, shall be extended until OCI grants approval to make the payment. Interest will accrue, compounded on each anniversary of the original scheduled payment date or scheduled maturity date, on any unpaid principal or interest through the actual date of payment, at 5.1% per annum. Holders of surplus notes will have no rights to enforce the payment of the principal of, or interest on, surplus notes in the absence of OCI approval to pay such amount. The interest on the outstanding surplus notes were accrued for and AAC is accruing interest on the interest amounts following each scheduled payment date. Total accrued and unpaid interest for surplus notes outstanding to third parties were$593 atMarch 31, 2022 . Since the issuance of the surplus notes in 2010, OCI has declined to approve regular payments of interest on surplus notes, although the OCI has permitted two exceptional payments. Provision for Income Taxes. The provision for income taxes for the three months endedMarch 31, 2022 and 2021, was$0 , and$2 a decrease of$1 compared to the provision for income taxes reported for three months endedMarch 31, 2021 .
Results of Operations by Segment
Three Months Ended March 31, 2022 2021 Revenues: Net premiums earned$ 13 $ 14 Net investment income 5 49 Net investment gains (losses), including impairments 10
(2)
Net gains on derivative contracts 57
25
Net realized gains on extinguishment of debt - 33 Other 24 (2) Total 109 118 Expenses: Loss and loss expenses (benefit) 23 8 Operating expenses 21 17 Total 44 25
Earnings before interest, taxes, depreciation and amortization 65
93
Interest expense 44 50
Depreciation - -
Intangible amortization 14 19
Pretax income (loss) $ 6 $ 24
Stockholders equity $ 567 $ 727
The Legacy Financial Guarantee Insurance segment is in active runoff. This will
generally result in lower premium earnings, investment income, operating
expenses and intangible amortization. The variability in the financial results
are primarily driven by changes in loss and loss expenses and de-risking
transactions. Additionally, the segment results are impacted by changes in
interest rates (net gains on derivative contracts and interest expense as the
AAC Sitka Note is a floating rate obligation). Key variances not discussed above
in the Consolidated Results section are as follows:
Net premiums earned. Net premiums earned decreased $1 for the three months ended
March 31, 2022 , compared to the same period in the prior year. Net premiums
earned were impacted by the runoff of the financial guarantee insured portfolio,
including through transaction terminations, calls and scheduled maturities,
which reduce current and future net premiums earned and were also impacted by
the following:
•Changes to the allowance for credit losses on the premium receivable asset. The
positive impact on net premiums earned related to credit losses amounted to $1
and $4 for the for the three months ended March 31, 2022 and 2021.
•Accelerated financial guarantee premium earnings as a result of calls and other
accelerations on insured obligations largely due to de-risking activity of $4
and $0 for the for the three months ended March 31, 2022 and 2021.
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Losses and Loss Expenses. Losses and loss expenses are based upon estimates of the aggregate losses inherent in the non-derivative portfolio for insurance policies issued to beneficiaries, excluding consolidated VIEs.
Ambac records as a component of its loss reserve estimate subrogation recoveries related to securitized loans in RMBS transactions with respect to which AAC is pursuing claims for breaches of representations and warranties.Ambac does not include potential recoveries attributed solely to fraudulent inducement claims in our litigations in our estimate of subrogation recoveries. Nor doesAmbac include potential recoveries attributable to pre-judgment interest in the estimate of subrogation recoveries. Generally, the sponsor of an RMBS transaction provided representations and warranties 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.Ambac has recorded representation and warranty subrogation recoveries, net of reinsurance, of$1,480 and$1,704 atMarch 31, 2022 , andDecember 31, 2021 , respectively. Refer to Note 2. Basis of Presentation and Significant Accounting Policies to the Consolidated Financial Statements included in Part II, Item 8 in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 , for more information regarding the estimation process for R&W subrogation recoveries. The following provides details for losses and loss expenses (benefit) incurred for the periods presented: Three Months Ended March 31, 2022 2021 Structured Finance$ 213 $ (8) Domestic Public Finance (190) 9 Other 1 6 Totals (1)$ 23 $ 8
(1) Includes loss expenses incurred of
Losses and loss expenses (benefit) for the three months endedMarch 31, 2022 , were driven by a reduction to AAC's estimated R&W subrogation recoveries in the amount of$224 , partially offset by favorable loss development in domestic public finance, primarily due to thePuerto Rico restructuring. Losses and loss expenses (benefit) for the three months endedMarch 31, 2021 , were driven by higher projected losses in domestic public finance from adverse development related toPuerto Rico , partially offset by the positive impact of higher discount rates. Operating Expenses. The increase in operating expenses of$4 during the three months endedMarch 31, 2022 , as compared to the three months endedMarch 31, 2021 , is primarily due additional legal fees related to defensive litigation costs. In addition, incentive compensation expense increased due to performance factors, partially offset by lower other compensation costs resulting from a net reduction in headcount within the segment.
Three Months Ended March 31, 2022 2021 Gross premiums written$ 24 $ - Net premiums written 5 - Revenues: Premiums earned$ 1 $ - Investment income - - Net investment gains (losses), including impairments - - Other income (program fees) - - Total 2 - Expenses: Losses and loss expenses incurred 1 - Operating expenses 3 1 Other expense - - Total 4 1 Earnings before interest, taxes, depreciation and amortization (2)$ (1) Pretax income (loss)$ (2) $ (1) Loss and LAE Ratio 65.3 % NM Combined Ratio 331.9 % NM Stockholders Equity$ 115 $ 106 The Specialty Property and Casualty Insurance segment has grown significantly since underwriting its first program inMay 2021 . Ten programs have been signed as ofMarch 31, 2022 . The growth in both the number and size of these programs has contributed to the increase in gross and net premiums written, net premiums earned and net loss and loss expenses incurred. Loss and loss expenses incurred may be adversely impacted by increasing economic and social inflation, particularly within the commercial auto business. The impact of inflation on ultimate loss reserves is difficult to estimate, particularly in light of recent disruptions to the judicial system, supply chain and labor market. In addition to the impact of inflation on reserves, on a going forward basis, we may not be able to offset the impact of inflation on our loss costs with sufficient price increases. The estimation of loss reserves may also be more difficult during extreme events, such as a pandemic, or during the persistence of volatile or uncertain economic conditions, due to, amongst other reasons, unexpected changes in behavior of claimants and policyholders, including an increase in fraudulent reporting of exposures and/or losses. Due to the inherent uncertainty underlying loss reserve estimates, the final resolution of the estimated liability for loss and loss expenses will likely be higher or lower than the related loss reserves at the reporting date. In addition, our estimate of losses and loss expenses may change. These additional liabilities or increases in estimates, or a range of either, could vary significantly from period to period.
Segment pre-tax net income was impacted by the growth in operating expenses, including costs associated with the acquisition additional shell insurance companies, as we continue to ramp up Everspan's operations.
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Insurance Distribution Three Months Ended March 31, 2022 2021 Premiums placed$ 45 $ 40 Commission income$ 9 $ 7 Sub-producer commission expense (1) 5 4 Net commissions 4 3 Expenses: Other Operating expenses (1) 1 1 Net (gain) attributable to noncontrolling interest -
-
Earnings before interest, taxes, depreciation and amortization 2
2
Depreciation - -
Intangible amortization 1 1
Pretax income (loss) 2 $ 2
Stockholders Equity, net of NCI $ 66 (1) The Consolidated Statements of Comprehensive Income presents the sum of these items as Operating Expenses.
Ambac's Insurance Distribution segment currently includes Xchange Benefits, a P&C MGA specializing in accident and health products, 80% of which was acquired by AFG onDecember 31, 2020 . Xchange is compensated for its services primarily by commissions paid by insurance carriers for underwriting, structuring and/or administering polices and, in the case of ESL, managing claims under an agency agreement. Commission revenues are usually based on a percentage of the premiums placed. Xchange is also eligible to receive profit sharing contingent commissions on certain of its Affinity programs based on the underwriting results of the policies it places with the carrier, which may cause some variability in revenue and earning recognition. Xchange underwrote and placed premiums for its carriers of approximately$45 for the three months endedMarch 31, 2022 , an increase of$5 or 12% as compared to the three months endedMarch 31, 2021 . Higher premiums placed were the primary drivers to the increases in both gross and sub-producer commissions. Employer Stop Loss business underwritten by Xchange has seasonality in January and July, which result in revenue and earnings concentrations in the first and third quarters each calendar year. Employer Stop Loss is Xchange's largest business. LIQUIDITY AND CAPITAL RESOURCES ($ in millions)
Holding Company Liquidity
AFG is organized as a legal entity separate and distinct from its operating subsidiaries. AFG is a holding company with no outstanding debt. AFG's liquidity is primarily dependent on its net assets, excluding the operating subsidiaries that it owns, totaling$243 as ofMarch 31, 2022 , and secondarily on distributions and expense sharing payments from its operating subsidiaries. AFG's investments include securities directly issued by AAC (i.e. surplus notes), which are eliminated in consolidation. Securities issued by AAC and certain other of AFG's investments are generally less liquid than investment grade and highly traded investments. •Under an inter-company cost allocation agreement, AFG is reimbursed by AAC for a portion of certain operating costs and expenses and, if approved by OCI, entitled to an additional payment of up to$4 per year to cover expenses not otherwise reimbursed. The$4 reimbursement for 2021 expenses was approved by OCI and paid to AFG inApril 2022 . AFG's principal uses of liquidity are: (i) the payment of operating expenses, including costs to explore opportunities to grow and diversifyAmbac , (ii) the making of strategic investments, which may include illiquid investments and (iii) making capital investments to acquire, grow and/or capitalize new and/or existing businesses. AFG may also provide short-term financial support, primarily in the form of loans, to its operating subsidiaries to support their operating requirements. AFG supported the development of theSpecialty P&C Insurance business, and its acquisitions, by contributing$6 of capital to Everspan Indemnity in first quarter of 2022 and$92 in 2021, respectively. Xchange currently does not have any regulatory restrictions on its ability to make distributions. AFG received distributions from Xchange of$2 and $- during the three months endedMarch 31, 2022 and 2021. It is highly unlikely that AAC or Everspan will be able to make dividend payments to AFG for the foreseeable future. In the opinion of the Company's management the net assets of AFG are sufficient to meet AFG's current liquidity requirements. However, events, opportunities or circumstances could arise that may cause AFG to seek additional capital (e.g. through the issuance of debt, equity or hybrid securities or facilities).
Operating Companies' Liquidity
Insurance
The liquidity requirements of the Company's insurance subsidiaries are met primarily by funds generated from premiums; recoveries on claim payments, including RMBS representation and warranty subrogation recoveries (AAC only); reinsurance recoveries; fees; investment income and maturities and sales of investments.
•AAC's ability to realize RMBS representation and warranty subrogation recoveries is subject to significant uncertainty, including risks inherent in litigation, such as adverse rulings or decisions in our cases or in litigations to which AAC is not a party that set precedents or resolve questions of law that impact our own claims; collectability of such amounts from counterparties (and/or their respective parents and affiliates); timing of receipt of any such recoveries, including due to delays in court proceedings; intervention by the OCI, which could impede our ability to take actions required to realize such recoveries; and uncertainty inherent in the assumptions used in estimating the amount of such
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recoveries. The amount of these subrogation recoveries is material and if AAC is unable to recover any amounts or recovers materially less than its estimated recoveries, its future available liquidity to pay claims, debt service and meet other obligations would be materially adversely impacted. See Part I, Item 1A. Risk Factors in AFG's Annual Report on Form 10-K and Part II, Item 1A of this Quarterly Report for more information about risks relating to RMBS R&W subrogation recoveries. •See Note 6. Insurance Contracts to the Consolidated Financial Statements included in Part II, Item 8, in this Form 10-Q for a summary of future gross financial guarantee premiums to be collected by AAC and AmbacUK . Termination of financial guarantee policies on an accelerated basis may adversely impact AAC's liquidity. Cash provided from these sources is used primarily for claim payments and commutations, loss expenses and acquisition costs (Specialty Property & Casualty Insurance segment only), debt service on outstanding debt (AAC only), operating expenses, reinsurance payments and purchases of securities and other investments that may not be immediately converted into cash. •Interest and principal payments on surplus notes are subject to the approval of OCI, which has full discretion over payments regardless of the liquidity position of AAC. Any such payment on surplus notes would require either payment or collateralization of a portion of the Tier 2 Notes under the terms of the Tier 2 Note indenture. As discussed more fully in "Results of Operations" above in this Management's Discussion and Analysis, OCI declined AAC's request to pay the principal amount of the surplus notes, plus all accrued and unpaid interest thereon, onJune 7, 2022 . See Note 12. Long-term Debt to the Consolidated Financial Statements included in Part II, Item 8 in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 for further discussion of the payment terms and conditions of the Tier 2 Notes as well as the aggregate annual maturities of all debt outstanding. In addition to principal amounts of$2,341 as ofMarch 31, 2022 , with various maturities as described in Note 12. Long-term Debt to the Consolidated Financial Statements included in Part II, Item 8 in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 , AAC's future interest obligations include$65 , subject to changes in interest rates, annually on the Sitka AAC Note through maturity onJuly 6, 2026 ,$605 of accrued and unpaid interest that would be payable on surplus notes if approved by OCI on the next scheduled payment date ofJune 7, 2022 , and Tier 2 Note interest that may be paid-in-kind until maturity onFebruary 12, 2055 at which time$5,060 would be due. •AAC lends its wholly-owned subsidiary,Ambac Financial Services ("AFS") cash to support its operations. AFS uses interest rate derivatives (primarily interest rate swaps andUS Treasury futures) as a partial economic hedge against the effects of rising interest rates elsewhere in the legacy financial guarantee segment. AFS's derivatives also include interest rate swaps previously provided to asset-backed issuers and other entities in connection with their financings. AAC loans cash and securities to AFS as needed to fund payments under these derivative contracts, collateral posting requirements and operating expenses. Intercompany loans are governed by an established lending agreement with defined borrowing limits that has received non-disapproval from OCI. Insurance subsidiaries manage their liquidity risk by maintaining comprehensive analyses of projected cash flows and maintaining specified levels of cash and short-term investments at all times. It is the opinion of the Company's management that the insurance subsidiaries' near term liquidity needs will be adequately met from the sources described above.
Insurance Distribution:
The liquidity requirements of our MGA subsidiaries are met primarily by funds generated from commission receipts (both base and profit commissions). Base commissions are generally received monthly, whereas profit commissions are received only if the business underwritten is profitable. Cash provided from these sources is used primarily for commissions paid to sub-producers, operating expenses and distributions to AFG and other members.
Consolidated Cash Flow Statement Discussion.
The following table summarizes the net cash flows for the periods presented. Three Months Ended March 31, 2022 2021 Cash provided by (used in): Operating activities$ 9 $ (40) Investing activities 136 116 Financing activities (1) (52) (69)
Foreign exchange impact on cash and cash equivalents - - Net cash flow
$ 93 $ 6 (1) During the second quarter of 2022, AAC made$393 of payments in connection with the acceleration of the AAC-insured PRIFA and CCDA bonds that were not commuted during the first quarter of 2022 and were deposited into the respective trusts. As a result of these claim payments and associated full redemption of the trust certificates, the remaining assets of the trusts, valued at$114 atMarch 31, 2022 , were distributed to AAC. Additionally, AAC was the holder of$164 of the PRIFA trust certificates that were fully redeemed. Because these trusts are consolidated VIEs, this activity will be reflected as$221 payments of VIE liabilities in second quarter 2022 financing activities.
Operating activities
The following represents the significant cash operating activity during the
three months ended
•Debt service payments on the Sitka AAC Note were$15 for the three months endedMarch 31, 2022 . Debt service payments on the LSNI Ambac Note were$25 for the three months endedMarch 31, 2021 .
•Payments related to (i) operating expenses were
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for the three months ended
•Cash provided by (i) premiums were$28 and$12 for the three months endedMarch 31, 2022 and 2021, respectively; (ii) interest rate derivatives were$11 and$3 for the three months endedMarch 31, 2022 and 2021, respectively; (iii) investment portfolio income were$14 and$23 for the three months endedMarch 31, 2022 and 2021, respectively; and (iv) cash settlements from thePuerto Rico restructuring transactions to the consolidated trusts was$47 for the three months endedMarch 31, 2022 . •Net Legacy Financial Guarantee Insurance loss and loss expenses paid, including commutation payments, during the three months endedMarch 31, 2022 and 2021 are detailed below: Three Months Ended March 31, 2022 2021 Net loss and loss expenses paid (recovered): Net losses paid$ 213 $ 30 Net subrogation received (177) (25) Net loss expenses paid (8) 20 Net cash flow$ 28 $ 25
Future operating flows will primarily be impacted by interest payments on outstanding debt, net claim and expense payments, investment coupon receipts and premium collections.
Financing Activities
Financing activities for the three months ended
Financing activities for the three months ended
Collateral
AFS hedges a portion of the interest rate risk in theLegacy Financial Guarantee Insurance segment financial guarantee and investment portfolios, along with legacy customer interest rate swaps, with standardized derivative contracts, including financial futures contracts, which contain collateral or margin requirements. Under these hedge agreements, AFS is required to post collateral or margin to its counterparties and futures commission merchants to cover unrealized losses. In addition, AFS is required to post collateral or margin in excess of the amounts needed to cover unrealized losses. All AFS derivative contracts containing ratings-based downgrade triggers that could result in collateral or margin posting or a termination have been triggered. If terminations were to occur, AFS would be required to make termination payments but would also receive a return of collateral or margin in the form of cash orU.S. Treasury obligations with market values equal to or in excess of market values of the swaps and futures contracts. AFS may look to re-establish hedge positions that are terminated early, resulting in additional collateral or margin obligations. The amount of additional collateral or margin posted on derivatives contracts will depend on several variables including the degree to which counterparties exercise their termination rights (or agreements terminate automatically) and the terms on which hedges can be replaced. All collateral and margin obligations are currently met. Collateral and margin posted by AFS totaled a net amount of$119 (cash and securities collateral of$6 and$114 , respectively), including independent amounts, under these contracts atMarch 31, 2022 .
Ambac Credit Products ("ACP") is not required to post collateral under any of its outstanding credit derivative contracts.
BALANCE SHEET ($ in millions)
Total assets decreased by approximately $772 from December 31, 2021 , to $11,531
at March 31, 2022 , primarily due to payment of loss and loss expenses, interest
and operating expenses, lower subrogation recoverables, declines in invested
asset values, lower derivative assets caused by rising interest rates, lower
consolidated VIE assets and lower premium receivables and intangible assets from
the continued runoff of the financial guarantee insurance portfolio.
Total liabilities decreased by approximately $649 from December 31, 2021 , to
$10,538 as of March 31, 2022 , primarily due to the payment of loss and loss
expenses, lower VIE long-term debt and lower derivative liabilities caused by
rising interest rates.
As of March 31, 2022 , total stockholders' equity was $974 , compared with total
stockholders' equity of $1,098 at December 31, 2021 . This decrease was primarily
due to the changes in unrealized losses on invested assets and losses on foreign
currency translation.
Investment Portfolio
Ambac's investment portfolio is managed under established guidelines designed to
meet the investment objectives of AAC, Everspan Group , Ambac UK and AFG. Refer
to "Description of the Business - Investments and Investment Policy" located in
Part I. Item 1 of the Company's Annual Report on Form 10-K for the year ended
December 31, 2021 , for further description of Ambac's investment policies and
applicable regulations.
Refer to Note 4. Investments to the Unaudited Consolidated Financial Statements,
included in Part I, Item 1 in this Form 10-Q for information about Ambac's
consolidated investment portfolio. Ambac's investment policies and objectives do
not apply to the assets of VIEs consolidated as a result of financial guarantees
written by its insurance subsidiaries.
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The following table summarizes the composition ofAmbac's investment portfolio, excluding VIE investments, at carrying value atMarch 31, 2022 andDecember 31, 2021 : March 31, December 31, 2022 2021 Fixed maturity securities(1), (2)$ 1,383 $
1,730
Fixed maturity securities - trading 119 - Short-term(1), (2) 540 414 Other investments(2) 660 690 Fixed maturity securities pledged as collateral 114 120 Total investments (3)$ 2,815 $ 2,955
(1)
(2) Includes assets held by AFG comprising fixed maturity securities,
short-term and other investments of
(3) Includes investments denominated in non-US dollar currencies with a fair value of £339 ($445 ) and €35 ($39 ) as ofMarch 31, 2022 , and £341 ($462 ) and €38 ($43 ) as ofDecember 31, 2021 .
The following charts provide the ratings(1) distribution of the fixed maturity
investment portfolio based on fair value at
[[Image Removed: ambc-20220331_g4.jpg]]
[[Image Removed: ambc-20220331_g5.jpg]]
(1)Ratings are based on the lower of Moody's or S&P ratings. If ratings are unavailable from Moody's or S&P, Fitch ratings are used. If guaranteed, rating represents the higher of the underlying or guarantor's financial strength rating.
(2)Below investment grade and not rated bonds insured by
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Premium Receivables
Ambac's premium receivables decreased to$317 atMarch 31, 2022 , from$323 atDecember 31, 2021 . As further discussed in Note 6. Insurance Contracts, the decrease is primarily due to activities in the Legacy Financial Guarantee Insurance Segment partially offset by growth in theSpecialty P&C Insurance Segment. The Legacy Financial Guarantee Insurance Segment declines are due to premium receipts, partially offset by decreases to the allowance for credit losses and accretion of the premium receivable discount. AtMarch 31, 2022 ,Legacy Financial Guarantee Insurance and Specialty P&C premiums receivables are$308 and$9 , respectively.
Premium receivables by payment currency were as follows:
Premium Receivable in Premium Receivable in
Currency Payment Currency U.S. Dollars
U.S. Dollars $ 200 $ 200
British Pounds £ 77 101
Euros € 15 16
Total $ 317
Reinsurance Recoverable on Paid and Unpaid Losses
Ambac has reinsurance in place pursuant to surplus share treaty and facultative agreements. To minimize its exposure to losses from reinsurers,Ambac (i) monitors the financial condition of its reinsurers; (ii) is entitled to receive collateral from its reinsurance counterparties under certain reinsurance contracts; and (iii) has certain cancellation rights that can be exercised in the event of rating agency downgrades of a reinsurer (among other events and circumstances). For those reinsurance counterparties that do not currently post collateral,Ambac's reinsurers are well capitalized, highly rated, authorized capacity providers.Ambac benefited from letters of credit and collateral amounting to approximately$106 from its reinsurers atMarch 31, 2022 . Additionally, while legacy liabilities from the 21st Century Companies and PWIC acquisitions were fully ceded to certain reinsurers, Everspan also benefits from an unlimited, uncapped indemnity from the respective sellers to mitigate any residual risk to these reinsurers. As ofMarch 31, 2022 andDecember 31, 2021 , reinsurance recoverable on paid and unpaid losses were$48 and$55 , respectively. The decrease was primarily a result of favorable development in financial guarantee insured exposures largely related to thePuerto Rico restructuring.
Intangible Assets
Intangible assets includes (i) an insurance intangible asset that was established at AFG's emergence from bankruptcy (Legacy
Financial Guarantee Insurance Segment), representing the difference between the fair value and aggregate carrying value of the financial guarantee insurance and reinsurance assets and liabilities of$303 atMarch 31, 2022 , (ii) intangible assets established as part of the acquisition of Xchange (Insurance Distribution Segment) onDecember 31, 2020 of$32 atMarch 31, 2022 and (iii) indefinite-lived intangible assets established as part of the acquisitions of PWIC onOctober 1, 2021 and the 21st Century Companies onJanuary 3, 2022 (Specialty Property & Casualty Insurance segment) of$14 atMarch 31, 2022 .
As of
Derivative Assets and Liabilities
The interest rate derivative portfolio is positioned to benefit from rising rates as a partial economic hedge against interest rate exposure in the Legacy Financial Guarantee insurance and investment portfolios. Derivative assets decreased from$76 atDecember 31, 2021 , to$55 as ofMarch 31, 2022 . Derivative liabilities decreased from$95 atDecember 31, 2021 , to$76 as ofMarch 31, 2022 . The net decreases resulted primarily from higher interest rates during the three months endedMarch 31, 2022 .
Loss and Loss Expense Reserves and Subrogation Recoverable
Loss and loss expense reserves are based upon estimates of the ultimate aggregate losses inherent in the non-derivative portfolio for insurance policies issued to beneficiaries, excluding consolidated VIEs.
The evaluation process for determining the level of reserves is subject to certain estimates and judgments. Refer to the "Critical Accounting Policies and Estimates" and "Results of Operations" sections of Management's Discussion and Analysis of Financial Condition and Results of Operations, in addition to Basis of Presentation and Significant Accounting Policies and Loss Reserves sections included in Note 2. Basis of Presentation and Significant Accounting Policies and Note 7. Insurance Contracts, respectively, of the Consolidated Financial Statements included in Part II, Item 8 in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 , for further information on loss and loss expenses. The loss and loss expense reserves, net of subrogation recoverables and before reinsurance as ofMarch 31, 2022 andDecember 31, 2021 , were$(647) and$(522) , respectively. |Ambac Financial Group, Inc. 62 2022 First Quarter FORM 10-Q | --------------------------------------------------------------------------------
Loss and loss expense reserves are included in the Unaudited Consolidated Balance Sheets as follows:
Legacy Financial Guarantee
Specialty Property Present Value of Expected
and Casualty Net Cash Flows
Gross Loss Gross Loss
and Loss Claims and Unearned and Loss
Expense Loss Premium Expense
Balance Sheet Line Item Reserves Expenses Recoveries (1) Revenue Reserves
March 31, 2022 :
Loss and loss expense reserves $ 36 $ 1,168 $ (95) $ (42) $ 1,067
Subrogation recoverable - 52 (1,766) - (1,714)
Totals $ 36 $ 1,221 $ (1,861) $ (42) $ (647)
December 31, 2021:
Loss and loss expense reserves $ 32 $
1,749 $ (155)
- 88 (2,180) - (2,092)
Totals $ 32 $ 1,837 $ (2,335) $ (56) $ (522) (1)Present value of future recoveries includes R&W subrogation recoveries of
Ambac has exposure to various bond types issued in the debt capital markets. Our experience has shown that, for the majority of bond types, we have not experienced significant claims. The bond types that have experienced significant claims, including through commutations, are residential mortgage-backed securities ("RMBS"), student loan securities and public finance securities. These bond types represent 93% of our ever-to-date insurance claims recorded, with RMBS comprising 75%. AtMarch 31, 2022 ,$298 million of gross loss and loss expense reserves were consolidated into a VIE in connection with thePuerto Rico restructuring. The table below indicates gross par outstanding and the components of gross loss and loss expense reserves related to policies inAmbac's gross loss and loss expense reserves atMarch 31, 2022 andDecember 31, 2021 : : Present Value of Expected Gross Loss Net Cash Flows and Loss Gross Claims and Unearned Expense Par Loss Premium Reserves Outstanding (1) Expenses Recoveries Revenue (1)(2)March 31, 2022 : Structured Finance $ 2,293 $
782
1,914 365 (141) (20) 204
Other 1,262 34 (5) (12) 17
Loss expenses - 39 - - 39
Totals $ 5,469 $ 1,221 $ (1,861) $ (42) $ (683)
December 31, 2021 :
Structured Finance $ 2,371 $ 852 $ (2,018) $ (12) $ (1,178)
Domestic Public Finance 2,742 905 (312) (31) 562
Other 1,189 35 (5) (13) 17
Loss expenses $ - $ 45 $ - $ - $ 45
Total $ 6,302 $ 1,837 $ (2,485) $ (56) $ (554)
(1) Ceded par outstanding on policies with loss reserves and ceded loss and
loss expense reserves are $646 and $14 respectively, at March 31, 2022 , and $784
and $24 , respectively at December 31, 2021 . Recoverable ceded loss and loss
expense reserves are included in Reinsurance recoverable on paid and unpaid
losses on the balance sheet.
(2) Loss reserves are included in the balance sheet as Loss and loss expense reserves or Subrogation recoverable dependent on if a policy is in a net liability or net recoverable position.
(3) As a result of the
Variability of Expected Losses and Recoveries
Ambac's management believes that the estimated future loss component of loss reserves (present value of expected net cash flows) are adequate to cover future claims presented, but there
can be no assurance that the ultimate liability will not be higher than such estimates.
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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 atMarch 31, 2022 , 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 stressed outcomes in all cases, it is possible that we could have stress case outcomes in some or even many cases. See "Risk Factors" in Part I, Item 1A as well as the descriptions of "RMBS Variability," "Public Finance Variability," "Student Loan Variability," and "Other Credits, including AmbacUK , Variability" in Part II, Item 7 of the Company's 2021 Annual Report on Form 10-K, and Part II, Item1A "Risk Factors" of this Quarterly Report, for further discussion of the risks relating to future losses and recoveries that could result in more highly stressed outcomes, as well as the descriptions of "Structured Finance Variability," "Domestic Public Finance Variability," "Student Loan Variability," and "Other Variability" appearing below. 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 AAC to honor its financial obligations; the initiation of rehabilitation proceedings against AAC; decreased likelihood of AAC delivering value to AFG, through dividends or otherwise; and a significant drop in the value of securities issued or insured by AFG or AAC.
Structured Finance Variability
RMBS:
Changes to assumptions that could make our reserves under-estimated include an increase in interest rates, deterioration in housing prices, poor servicing, government intervention into the functioning of the mortgage market and the effect of a weakened economy characterized by growing unemployment and wage pressures. We utilize a model to project losses in our RMBS exposures and changes to reserves, either upward or downward, are not unlikely if we used a different model or methodology to project losses. 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. We established a representation and warranty subrogation recovery as further discussed in Note 6. Insurance Contracts to the Unaudited Consolidated Financial Statements included in Part I, Item 1 in this Form 10-Q. Our ability to realize RMBS representation and warranty recoveries is subject to significant uncertainty, including due to risks inherent in litigation, including adverse rulings or decisions in our cases or in litigations to which AAC is not a party that set precedents or resolve questions of law that impact our own claims; collectability of such amounts from counterparties (and/or their respective parents and affiliates); delays in realizing such recoveries, including as a result of trial delays due to court closures related to COVID-19 or other events or circumstances (such as changes in law that affect any basis on which AAC seeks recovery); intervention by the OCI, which could impede our ability to take actions required to realize such recoveries; and uncertainty inherent in the assumptions used in estimating such recoveries. For example, AAC expects the implications of the decision of theNew York Court of Appeals in the case entitledU.S. Bank National Association v.DLJ Mortgage Capital, Inc. relating toHome Equity Asset Trust 2007-1, a residential mortgage-backed securities trust, to be the subject of additional arguments, decisions and appeals in certain of its RMBS litigations as well as in unrelated cases. Actions or decisions by trial or appellate courts regarding the implications of HEAT may significantly impact the manner in which AAC presents its case, AAC's ultimate recoveries, or the timing of trials or pre-trial procedures, filings or actions. Additionally, our actual R&W subrogation recoveries could be significantly lower than our estimate of$1,480 , net of reinsurance, as ofMarch 31, 2022 , if the sponsors of these transactions: (i) fail to honor their obligations to repurchase the mortgage loans, (ii) successfully dispute our breach findings or claims for damages, (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. Failure to realize R&W subrogation recoveries for any reason or the realization of R&W subrogation recoveries materially below the amount recorded onAmbac's consolidated balance sheet would have a material adverse effect on our results of operations and financial condition.
Student Loans:
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, including the COVID-19 related economic impact. 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 by theConsumer Finance Protection Bureau .
Structured Finance Variability:
Using the approaches described above, the possible increase in loss reserves for structured finance credits for which we have an estimate of expected loss atMarch 31, 2022 , could be approximately$20 . Combined with the absence of any R&W subrogation recoveries, a possible increase in loss reserves for structured finance credits could be approximately$1,500 . A loss of this magnitude may render AAC insolvent. 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$35 . There can be no assurance that losses may not exceed such amounts. Due to the uncertainties related to the economic effects of the COVID-19 pandemic and other risks associated with structured finance credits, there can be no assurance that losses may not exceed our stress case estimates.
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Domestic Public Finance Variability:
Ambac's U.S. public finance portfolio predominantly consists of municipal bonds such as general and revenue obligations and lease and tax-backed obligations of state and local government entities; however, the portfolio also includes 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 purpose facilities and interests.
It is possible our loss reserves for public finance credits may be under-estimated if issuers are faced with prolonged exposure to adverse political, judicial, economic, fiscal or socioeconomic events or trends. Additionally, our loss reserves may be under-estimated because of the continuing effects of COVID-19 pandemic.
Our experience with the city ofDetroit's bankruptcy andCommonwealth of Puerto Rico's Title III proceedings as well as other municipal bankruptcies demonstrates 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 asChicago's school district, theState of New Jersey and many others. Less severe treatment of pension obligations in bankruptcy may lead to worse outcomes for traditional debt creditors. Variability of outcomes applies to even what are generally considered more secure municipal financings, such as dedicated sales tax revenue bonds that capture sales tax revenues for debt service ahead of any amounts being deposited into the general fund of an issuer. In the case of the Puerto Rico COFINA sales tax bonds that were part of theCommonwealth of Puerto Rico's Title III proceedings, AAC and other creditors agreed to settle at a recovery rate equal to about 93% of pre-petition amounts owed on theAmbac insured senior COFINA bonds. In the COFINA case, the senior bonds still received a reduction or "haircut" despite the existence of junior COFINA bonds, which received a recovery rate equal to about 56% of pre-petition amounts owed. In addition, municipal entities 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, legal, 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. Moreover, issuers in Chapter 9 or similar proceedings may obtain judicial rulings and orders that impair creditors' rights or their ability to collect on amounts owed. In certain cases, judicial decisions may be contrary to AAC's expectations or understanding of the law or its rights thereunder, which may lead to worse outcomes in Chapter 9 or similar proceedings than anticipated at the outset.
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 limited access to alternative forms of credit (such as bank loans) or other exogenous factors, such as changes in tax law that could reduce certain municipal investors' appetite for tax-exempt municipal bonds or put 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. Following theMarch 15, 2022 consummation of the Eighth Amended POA, the PRIFA QM and the CCDA QM, all ofAmbac's exposures to theCommonwealth of Puerto Rico across various instrumentalities with the exception of PRHTA have now been restructured. PRHTA is subject to a plan support agreement and will be subject to the PRHTA POA that was filed onMay 2, 2022 , and is expected to be confirmed later in 2022. However, uncertainty remains as to (i) the value or perceived value of the consideration provided by or on behalf of the debtors under the Eighth Amended POA, PRIFA QM, and CCDA QM; (ii) the extent to which exposure management strategies, such as commutation and acceleration, will be executed for PRHTA; (iii) the tax treatment of the consideration provided by or on behalf of the debtors under the Eighth Amended POA, PRIFA QM, and CCDA QM; (iv) whether and when the PRHTA POA will be confirmed; and (vii) other factors, including market conditions such as interest rate movements and credit spread changes on the new CVI instruments. Losses may exceed current reserves in a material manner due to favorable or unfavorable developments or results with respect to these factors. See Note 14. Commitments and Contingencies to the Consolidated Financial Statements in Part I and "Financial Guarantees in Force" section of Management's Discussion and Analysis of Financial Condition and Results of Operations included in Part II in this Form 10-Q for further updates relating toPuerto Rico . Material additional losses on our public finance credits caused by the aforementioned factors, including the possibility of a protracted recovery related to the COVID-19 crisis would have a material adverse effect on our results of operations and financial condition. For the public finance credits, includingPuerto Rico , for which we have an estimate of expected loss atMarch 31, 2022 , the possible increase in loss reserves could be approximately$220 and there can be no assurance that losses may not exceed our stress case estimates. Other Variability: It is possible our loss reserves on other types of credits, including those insured by AmbacUK , 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 AmbacUK , for which we have an estimate of expected loss, the sum of all the highest stress case loss scenarios is approximately$345 greater than the loss reserves atMarch 31, 2022 . Additionally, our loss reserves may be under-estimated as a result of the ultimate scope, duration and magnitude of the effects of COVID-19. There can be no assurance that losses may not exceed our stress case estimates.
Long-term Debt
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Long-term debt consists of surplus notes issued by AAC, the Sitka AAC Note, Tier 2 Notes issued in connection with the Rehabilitation Exit Transactions, and AmbacUK debt issued in connection with the 2019 Ballantyne commutation. All long-term debt relates to the Legacy Financial Guarantee Segment. The carrying value of each of these as ofMarch 31, 2022 andDecember 31, 2021 is below: March 31, 2022 December 31, 2021 Surplus notes$ 732 $ 729 Sitka AAC note 1,155 1,154 Tier 2 notes 340 333 Ambac UK debt 15 15 Total Long-term Debt$ 2,242 $ 2,230 The increase in long-term debt fromDecember 31, 2021 , resulted from accretion on the carrying value of surplus notes, Sitka AAC Note, and AmbacUK debt and paid-in-kind interest on Tier 2 notes. VARIABLE INTEREST ENTITIES Please refer to Note 9. Variable Interest Entities to the Unaudited Consolidated Financial Statements included in Part I, Item 1 in this Form 10-Q and Note 2. Basis of Presentation and Significant Accounting Policies and Note 11. Variable Interest Entities to the Consolidated Financial Statements, included in Part II, Item 8 in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 , for information regarding variable interest entities. ACCOUNTING STANDARDS
There are no new accounting standards applicable to
Please refer to Note 2. Basis of Presentation and Significant Accounting Policies to the Consolidated Financial Statements, included in Part II, Item 8 in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 , and in Part I, Item 1 on this Form 10-Q for a discussion of the impact of other recent accounting pronouncements onAmbac's financial condition and results of operations.U.S. INSURANCE STATUTORY BASIS FINANCIAL RESULTS ($ in million) AFG'sU.S. insurance subsidiaries prepare financial statements under accounting practices prescribed or permitted by its domiciliary state regulator ("SAP") for determining and reporting the financial condition and results of operations of an insurance company. TheNational Association of Insurance Commissioners ("NAIC") Accounting Practices and Procedures manual ("NAIC SAP") is adopted as a component of prescribed practices by each domiciliary state. For further information, see "Ambac Assurance Statutory Basis Financial Results," in Part II, Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations," and Note 8. Insurance Regulatory Restrictions to the Consolidated Financial Statements included in
Part II, Item 8 in the Company's Annual Report on Form 10-K for the year ended
Ambac Assurance Corporation AAC's statutory policyholder surplus and qualified statutory capital (defined as the sum of policyholders surplus and mandatory contingency reserves) were$805 and$1,378 atMarch 31, 2022 , respectively, as compared to$757 and$1,322 atDecember 31, 2021 , respectively. As ofMarch 31, 2022 , statutory policyholder surplus and qualified statutory capital included$853 principal balance of surplus notes outstanding and$138 liquidation preference of preferred stock outstanding. These surplus notes (in addition to related accrued interest of$644 that is not recorded under statutory basis accounting principles); preferred stock; and all other liabilities, including insurance claims, the Sitka AAC Note and the Tier 2 Notes are obligations that, individually and collectively, have claims on the resources of AAC that are senior to AFG's equity and therefore impede AFG's ability to realize residual value and/or receive dividends from AAC. The driver to the net increase in policyholder surplus is statutory net income of$61 for the three months endedMarch 31, 2022 . AAC statutory surplus and therefore AFG's ultimate ability to realize residual value and/or dividends from AAC is sensitive to multiple factors, including: (i) loss reserve development, (ii) settlements or other resolutions of representation and warranty breach claims at amounts that differ from amounts recorded, including failures to collect such amounts or receive recoveries sufficient to pay or redeem obligations of AAC, including the Sitka AAC Note and Tier 2 Notes, (iii) approval by OCI of payments on surplus notes, (iv) ongoing interest costs associated with the Sitka AAC Note and Tier 2 Notes, including changes to interest rates as the Sitka AAC Note is a floating rate obligation, (v) deterioration in the financial position of AAC subsidiaries that have their obligations guaranteed by AAC, (vi) first time payment defaults of insured obligations, which increase statutory loss reserves, (vii) commutations of insurance policies or credit derivative contracts at amounts that differ from the amount of liabilities recorded, (viii) reinsurance contract terminations at amounts that differ from net assets recorded, (ix) changes to the fair value of pooled fund and other investments carried at fair value, (x) realized gains and losses, including losses arising from other than temporary impairments of investment securities, and (xi) future changes to prescribed practices.
The significant drivers to the increase in policyholder surplus were capital contributions of$13 partially offset by the admitted asset limitation on goodwill within investment in subsidiaries, and operating expenses during the three months endedMarch 31, 2022 .
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AMBAC
AmbacUK is required to prepare financial statements under FRS 102 "The Financial Reporting Standard applicable in theUK andRepublic of Ireland ." AmbacUK's shareholder funds underUK GAAP were £449 atMarch 31, 2022 , as compared to £444 atDecember 31, 2021 . AtMarch 31, 2022 , the carrying value of cash and investments was £509, an increase from £500 atDecember 31, 2021 . The increase in shareholders' funds and cash and investments was primarily due to the continued receipt of premiums and foreign exchange gains, partially offset by investment losses, operating expenses and tax payments. AmbacUK is also required to prepare financial information in accordance with the Solvency II Directive. The basis of preparation of this information is significantly different from both US GAAP andUK GAAP. Available capital resources under Solvency II were a surplus of £250 atDecember 31, 2021 , the most recently published position, of which £240 were eligible to meet solvency capital requirements. Eligible capital resources atDecember 31, 2021 , were in comparison to regulatory capital requirements of £238. Therefore, AmbacUK had a surplus of capital resources as compared to regulatory capital requirements of £1 atDecember 31, 2021 . NON-GAAP FINANCIAL MEASURES ($ in millions) In addition to reporting the Company's quarterly financial results in accordance with GAAP, the Company currently reports three non-GAAP financial measures: EBITDA, adjusted earnings and adjusted book value. The most directly comparable GAAP measures are pre-tax net income for EBITDA, net income attributable to common stockholders for adjusted earnings andTotal Ambac Financial Group, Inc. stockholders' equity for adjusted book value. A non-GAAP financial measure is a numerical measure of financial performance or financial position that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable measure calculated and presented in accordance with GAAP. We present such non-GAAP supplemental financial information because we believe such information is of interest to the investment community that provides greater transparency and enhanced visibility into the underlying drivers of our businesses on a basis that may not be otherwise apparent on a GAAP basis. We view these non-GAAP financial measures as important indicators when assessing and evaluating our performance on a segmented and consolidated basis. These non-GAAP financial measures are not substitutes for the Company's GAAP reporting, should not be viewed in isolation and may differ from similar reporting provided by other companies, which may define non-GAAP measures differently.Ambac has a significantU.S. tax net operating loss ("NOL") that is offset by a full valuation allowance in the GAAP consolidated financial statements. As a result of this and other considerations, we utilized a 0% effective tax rate for non-GAAP adjustments for both Adjusted Earnings and Adjusted Book Value; which is subject to change.
The following paragraphs define each non-GAAP financial measure. A reconciliation of the non-GAAP financial measure and the most directly comparable GAAP financial measure is also presented below.
EBITDA. EBITDA is defined as net income before interest expense, income taxes, depreciation and amortization of intangible assets. EBITDA is also adjusted for noncontrolling interests in subsidiaries whereAmbac does not own 100%. The following table reconciles pre-tax net income (loss) to the non-GAAP measure, EBITDA on a consolidation and segment basis for all periods presented:
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