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 Part I, Item 1 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 50
Critical Accounting Estimates 53
Financial Guarantees in Force 53
Results of Operations 58
Liquidity and Capital Resources 64
Balance Sheet 67
Variable Interest Entities 72
Accounting Standards 72
U.S. Insurance Statutory Basis Financial Results 72
Ambac
73
EXECUTIVE SUMMARY ($ in millions)
AFG Net Assets
AFG has the following net assets to support the development and growth of its
existing subsidiaries, future acquisitions and capital management activities.
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 of September 30, 2022 , AFG's stand alone net assets,
excluding its equity investments in subsidiaries, were $223 .
Cash and short-term investments $ 112
Other investments (1) (2) 97
Other net assets 15
Total $ 223 (1)Includes surplus notes (fair value of
(2)Includes strategic minority investments in insurance services businesses of
From
AFG's subsidiaries/businesses are divided into three segments, the key value metrics of which are summarized below along with other recent developments.
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Specialty Property and Casualty Insurance Segment
The key value metrics for the
Three and nine months ended September 30, Three Months Nine Months Gross premiums written $ 30 $ 95 Net premiums written 6 19 Earnings before interest, taxes, depreciation and amortization (1) (5) Pretax income (loss) $ (1) $ (5) Stockholders Equity (1) $ 110
(1)Represents Ambac's stockholders equity in the
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 admitted 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. Such acquisitions enhanced 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 and
nine months ended
Three and nine months ended September 30, Three Months Nine Months Premiums placed $ 28 $ 97 Commission income $ 7 $ 22 Sub-producer commission expense (1) 4 13 Net commissions 3 9 Earnings before interest, taxes, depreciation and amortization 1 4 Pretax income (loss) $ 1 $ 3 Stockholders Equity (2) $ 64
(1)Included in Operating Expense within the Consolidated Statements of Comprehensive Income.
(2)Represents Ambac's stockholders equity in the Insurance Distribution segment, including intercompany eliminations.
OnNovember 7, 2022 ,Ambac acquired controlling interests inAll Trans Risk Solutions, LLC andCapacity Marine Corporation , adding approximately$60 of annual premiums placed to the Insurance Distribution segment, for a collective purchase price of$26 . Refer to Note 1. Background and Business Description to the Unaudited Consolidated Financial Statements, included in Part I, Item 1 in this Form 10-Q for further details on these acquisitions.
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 and nine months ended September 30, Three Months Nine Months Net premiums earned $ 7 $ 31 Net investment income 9 (9) Loss and loss expenses (benefit) (356) (347) Operating expenses 20 64 Interest expense 49 138 Pretax income (loss) $ 349$ 362 Stockholders Equity (1) $ 681
Adversely Classified Credit Net Par Outstanding
(1)Represents Ambac's stockholders equity in the
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. InOctober 2022 , AAC entered into a Settlement Agreement and Release (the "Settlement Agreement") with Bank of America Corporation and certain affiliates thereof (together, the "BOA Parties") whereby the BOA Parties paid AAC the sum of$1,840 (the "Settlement Payment") inOctober 2022 . In connection with the Settlement Payment, as required under the terms of AAC's secured debt, AAC utilized$1,431 of the Settlement Payment to redeem a majority of the principal and accrued interest of its secured debt. Following these redemptions, current principal outstanding on AAC's long-term debt consisted of$143 of Tier 2 Notes and$788 current par of surplus notes (including$67 of surplus notes held by AFG). Refer to Note 1. Background and Business Description to the Unaudited Consolidated Financial Statements, included in Part I, Item 1 in this Form 10-Q for further details of the Settlement Agreement and related impacts onAmbac's Statement of Comprehensive Income.
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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. AtSeptember 30, 2022 , AAC owned$282 of distressedAmbac -insured bonds, including significant concentrations of insured RMBS bonds, and excludingAmbac's holdings of Sitka Senior Secured Notes. 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 nine months endedSeptember 30, 2022 . AtSeptember 30, 2022 , AAC owned$87 of Sitka Senior Secured Notes withinFixed Maturity Securities in the Consolidated Balance Sheet. As further discussed in Note 1. Background and Business Description, the Sitka Senior Secured Notes were fully redeemed effective as ofOctober 29, 2022 , andAmbac will recognize an investment gain on these investments of$5 during the fourth quarter of 2022. Subject to internal and regulatory guidelines, market conditions and other constraints,Ambac may continue to opportunistically purchase or sellAmbac -insured securities, surplus notes and/or otherAmbac issued securities, and may consider opportunities to exchange securities issued or insured by it from time to time for other securities issued by it.
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$169 and$1,357 of net par exposure for the three and nine months endedSeptember 30, 2022 , of which$584 related toPuerto Rico for the nine months endedSeptember 30, 2022 . Refer below to the Financial Guarantees In Force section of the Management Discussion and Analysis for Results of Operations, Financial Guarantees in Force for additional details of thePuerto Rico restructuring.Ambac also recovered losses on insured RMBS pursuant to the Settlement Agreement with Bank of America Corporation and related entities, as discussed in Note 1. Background and Business Description to the Unaudited Consolidated Financial Statements included in this Form 10-Q. The following table provides a comparison of total, adversely classified ("ACC") and watch list credit net par outstanding in the insured portfolio atSeptember 30, 2022 andDecember 31, 2021 . Net par exposure within theU.S. public finance market includes capital appreciation bonds which are reported at the par amount at the time of issuance of the insurance policy as opposed to the current accreted value of the bonds. September 30, December 31, 2022 2021 Decrease Total$ 24,063 $ 28,020 $ (3,957) (14) % ACC 4,979 6,361 (1,382) (22) % Watch list 3,184 3,824 (640) (17) % The decrease in total and ACC credit net par outstanding resulted from active de-risking, and strengthening of the USD versus the GBP and EURO, as well as scheduled maturities, amortizations, refundings and calls.
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 meaningful. 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 may 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 nine months endedSeptember 30, 2022 , included the following: Net income (1) $ 14
Gain (loss) on foreign currency translation (net of tax), included in other comprehensive income
(136)
Foreign currency impact on unrealized gains (losses) on non-functional currency available-for-sale securities (net of tax), included in other comprehensive income
17
Impact on total comprehensive income (loss) $ (105)
(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.
Other than the foreign currency impact on unrealized gains (losses) on
available-for-sale securities, which is included in Other comprehensive income,
foreign currency transaction gains/(losses) as a result of changes to foreign
currency rates are reported through Net income in the 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 a positive step, there remains some 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 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 2024 and begin to apply toSEC filings in 2025.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,U.S. structured and international finance. The following table provides a breakdown of guaranteed net par outstanding by market atSeptember 30, 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 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 :September 30 ,December 31, 2022 2021
Public Finance (1) (2)
3,983 4,904
International Finance 8,980 10,756
Total net par outstanding
(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 atSeptember 30, 2022 : Ultimate % of Total Ambac Maturity Net Par Net Par Risk Name Country-Bond Type Ratings (1) Year Outstanding Outstanding IF AUK Anglian Water UK-Utility A- 2035$ 820 3.4 % IF AUK Capital Hospitals plc (2) UK-Infrastructure A- 2046 810 3.4 % IF AUK Mitchells & Butlers Finance UK-Asset Securitizations BBB 2033 719 3.0 % plc-UK Pub Securitisation IF AUK National Grid Gas UK-Utility BBB+ 2037 718 3.0 % IF AUK Aspire Defence Finance plc UK-Infrastructure A- 2040 670 2.8 %
PF AAC New Jersey Transportation Trust US-Lease and Tax-backed Revenue
BBB- 2036 623 2.6 %
Fund Authority
IF AUK Posillipo Finance II S.r.l Italy-Sub-Sovereign BIG 2035 556 2.3 %
IF AUK National Grid Electricity UK-Utility BBB+ 2036 500 2.1 %
Transmission
IF AUK Catalyst Healthcare (Manchester) UK-Infrastructure BBB- 2040 470 2.0 %
Financing plc (2)
PF AAC Hickam Community Housing LLC US-Housing Revenue BBB- 2052 452 1.9 %
Total $ 6,338 26.5 %
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$987 fromDecember 31, 2021 . Exposures are impacted by changes in foreign exchange rates ($1,045 reduction during the nine months endedSeptember 30, 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) was 27% atSeptember 30, 2022 , and 26% atDecember 31, 2021 . Excluding the top ten exposures, the remaining insured portfolio of financial guarantees has an average net par outstanding of$31 per single risk, with insured exposures ranging up to$450 and a median net par outstanding of$5 .
Given that
The following table outlinesAmbac's insured net par outstanding to eachCommonwealth of Puerto Rico issuer. Each issuing entity has its own credit risk profile attributable to, as applicable, discreet revenue sources, direct general obligation pledges and general obligation guarantees. Net Par Outstanding ($ in millions) September 30, 2022 December 31, 2021PR Highways and Transportation Authority (1998 Resolution - Senior Lien Transportation Revenue) $ 394 $ 394PR Sales Tax Financing Corporation - Senior Sales Tax Revenue (COFINA) 69 73PR Highways and Transportation Authority (1968 Resolution - Highway Revenue) 4 4PR Infrastructure Financing Authority (Special Tax Revenue) - 403PR Convention Center District Authority (Hotel Occupancy Tax - 86Commonwealth 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 $ 467 $ 1,054
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, including obligations insured by AAC, and approximately$50,000 in pension obligations.
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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 .
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. During the second quarter of 2022, 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 were all 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 is expected to become
effective in the fourth quarter of 2022 following a confirmation order entered
by Judge Laura Taylor Swain , U.S. District Judge for the District of Puerto Rico
on October 12, 2022 .
PRHTA/CCDA PSA
AAC signed a joinder to the PRHTA/CCDA PSA on July 15, 2021 . The PRHTA/CCDA PSA,
originally executed on May 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 shared $389 of
cash proceeds that was payable once the PRHTA distribution condition was met
pursuant to the Eighth Amended POA (the "Interim Distribution"). In addition,
PRHTA creditors received an approximately 69% share of the Clawback CVI, subject
to a lifetime nominal cap of about $3,698 , which was also paid as part of the
Interim Distribution. 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, which, following the confirmation of the plan on October 12, 2022 , is
expected to occur prior to December 31, 2022 . AAC and other PRHTA creditors will
receive restriction fees and consummation costs payable at the effective date of
the PRHTA POA.
Interim Distribution
On July 8, 2022 , following satisfaction of the PRHTA distribution condition, AAC
received its share of the Interim Distribution of cash and Clawback CVI related
to the Ambac -insured PRHTA '68 and '98 bonds in satisfaction of the Clawback
claims against the Commonwealth. The Interim Distribution to AAC totaled
approximately $19 of cash and $295 maximum notional amount of Clawback CVI. On
the PRHTA POA effective date, a portion of the cash and Clawback CVI, or the
proceeds thereof, will either be: (i) distributed to PRHTA '98 commuting
bondholders together with the new PRHTA bonds (or cash plan consideration) in
connection with the PRHTA POA and a commutation payment from AAC in full
satisfaction of in full and final discharge of Ambac's obligations under the
Ambac insurance policies or (ii) deposited into a trust, as described
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below, together with the new PRHTA bonds or cash plan consideration in connection with the PRHTA POA.
Bondholder Elections
As outlined in theJuly 2022 , Form of Election Notice for AAC-insured Bond Holders with Claims in Class 6 (the AAC Insured PRHTA 98 Senior Bonds), AAC-insured PRHTA 98 bondholders were each permitted to choose between two different treatment options for the satisfaction of their claims. The first option allowed the bondholders to elect commutation of their insurance policies (the "Ambac Insurance Policies"). Under this option, bondholders will receive: (i) their respective shares of certain consideration available under PRHTA/CCDA PSA, including the aforementioned Interim Distribution of cash and Clawback CVI fromAmbac as well as the new PRHTA bonds or cash related to the PRHTA POA and (ii) a cash commutation payment from AAC equivalent to 48% of the outstanding insured bond balance as ofJuly 1, 2022 , less any subsequent insured policy payments prior to the PRHTA plan effective date. AAC's obligations to the bondholders under the AAC Insurance Policies who elected this option will be deemed fully satisfied. Approximately 21% of PRHTA 98 bondholders, by par outstanding, elected treatment under this first option. Under the second option, the bondholders' respective shares of consideration, or the proceeds thereof, related to the Interim Distribution fromAmbac and the new PRHTA bonds or cash to be distributed under the PRHTA POA, will be deposited into a trust. Those bondholders are expected to receive scheduled payments from this trust, unless AAC elects, in its sole discretion, to pay all or a portion of the outstanding par amounts of the AAC-insured bonds in such trust. The accelerated payments will satisfy AAC's obligations under the applicable AAC Insurance Policies. Approximately 79% of PRHTA 98 bondholders, by par outstanding, elected treatment under this second option. In addition, on the PRHTA plan effective date, all AAC-insured PRHTA 68 bonds will be accelerated, satisfying AAC's obligations under the applicable AAC Insurance Policies.
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 of the consideration provided by or on behalf of the debtors under the Eight Amended POA, as it relates to the PRHTA Interim Distribution, and under the PRHTA POA; (ii) the extent to which exposure management strategies, such as commutation and acceleration, will be executed for PRHTA; and (iii) other factors, including market conditions such as interest rate movements and credit spread changes on the new CVI instruments. AAC'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.
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 ofSeptember 30, 2022 : Net Par Amount Net Par Amount Outstanding in Outstanding in Currency Base Currency U.S. Dollars U.S. Dollars$ 15,280 $ 15,280 British Pounds £ 6,8397,642 Euros € 915898 Australian Dollars A$ 380 243 Total$ 24,063
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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 atSeptember 30, 2022 andDecember 31, 2021 . BIG is defined as those exposures with anAmbac internal credit rating below BBB-:
[[Image Removed: ambc-20220930_g2.jpg]][[Image Removed: ambc-20220930_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
September 30, December 31,
Bond Type 2022 2021
Public Finance:
Puerto Rico $ 467 $ 1,054
Military Housing 367 370
Other 223 317
Total Public Finance 1,057 1,741
Structured Finance:
RMBS 1,899 2,170
Student loans 280 302
Total Structured Finance 2,179 2,472
International Finance:
Sovereign/sub-sovereign 654 774
Transportation 323 389
Other 2 62
Total International Finance 979 1,225
Total $ 4,215 $ 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 September 30, Nine Months Ended September 30,
2022 2021 2022 2021
Gross premiums written $ 16 $ (1) $ 83 $ (6)
Revenues:
Net premiums earned $ 11 $ 11 $ 39 $ 36
Net investment income 11 21 (6) 112
Net investment gains (losses),
including impairments 14 3 31 4
Net gains (losses) on derivative
contracts 37 5 124 19
Net realized gains (losses) on
extinguishment of debt - - 57 33
Commission income 7 7 22 20
Other income (expense) 1 1 5 -
Income (loss) on variable interest
entities (1) 3 14 5
Expenses:
Losses and loss expenses (benefit) (353) (55) (341) (73) Intangible amortization 6 11 34 44 Operating expenses 37 32 104 94 Interest expense 49 44 138 144 Provision (benefit) for income taxes 2 2 4 15 Net income (loss) attributable to common stockholders $ 340$ 17 $ 347$ 5
•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 included (i) a net benefit in losses and (ii) a 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 accelerated amortization of the insurance intangible asset. In the second quarter 2022, the newly created VIEs combined with changes to the fair value of securities received by AAC resulted in losses totaling$17 . •During the three and nine months endedSeptember 30, 2022 management recorded an increase to AAC's estimated R&W subrogation recoveries in the amount of$319 and$80 , respectively. The change in recorded RMBS R&W recoveries is primarily attributable to the impact of the Settlement Agreement with Bank of America Corporation and certain affiliates thereof described in Note 1. Background and Business Description to the Unaudited Consolidated Financial Statements in this Form 10-Q. AAC's ultimate recoveries in its remaining RMBS litigation 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$18 and$90 for the three and nine months endedSeptember 30, 2022 , compared to the same periods in the prior year, as shown by segment below. Three Months Ended September 30, Nine Months Ended September 30, 2022 2021 2022 2021 Legacy Financial Guaranty Insurance $ (13)$ (5) $ (12)$ (13) Specialty Property & Casualty Insurance 30 4 95 6 Total $ 16$ (1) $ 83$ (6)
Net Premiums Earned. Net premiums earned decreased$0 and increased$3 for the three and nine months endedSeptember 30, 2022 , compared to the same periods in the prior year as shown by segment below. Three Months Ended September 30, Nine Months Ended September 30, 2022 2021 2022 2021 Legacy Financial Guaranty Insurance $ 7$ 11 $ 31$ 36 Specialty Property & Casualty Insurance 4 - 8 - Total $ 11$ 11 $ 39$ 36 The reduction inLegacy Financial Guarantee Insurance segment was primarily due to run-off of the insured portfolio, de-risking activities and the impact from the strengthening of the US dollar relative to the British Pound Sterling.
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
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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
Three Months Ended September 30, Nine Months Ended September 30,
2022 2021 2022 2021
Securities available-for-sale:
Ambac-insured (including secured notes) $ 6 $ 8 $ 19 $ 37
Securities available-for-sale and
short-term other than Ambac-insured 11 7 26 22
Other investments (includes trading
securities) (7) 6 (50) 53
Net investment income (loss) $ 11 $ 21 $ (6) $ 112 Net investment income (loss) decreased
•Other investments income (loss) decreased$13 and$103 for the three and nine months endedSeptember 30, 2022 , respectively, compared to the same periods in the prior year. The three and nine months endedSeptember 30, 2022 , included losses of$1 and$22 on securities received in thePuerto Rico restructuring which are classified as trading. Pooled fund investments results decreased$12 and$81 for the three and nine months endedSeptember 30, 2022 , respectively, compared to the prior year periods. Results of most fund categories decreased for the three months endedSeptember 30, 2022 compared to third quarter 2021, with the largest declines in hedge funds, equities and real estate. The decrease for the nine months endedSeptember 30, 2022 were driven primarily by market losses in equities, hedge funds and high-yield and leveraged loan funds, all of which performed well in the comparable prior year period. Investments in pooled funds may be volatile, but are generally expected to produce higher returns than available-for-sale investments. •Net investment income fromAmbac -insured securities for the three and nine months endedSeptember 30, 2022 decreased$1 and$19 compared to the prior year periods, due primarily to different levels of secured note holdings, the impact of theMarch 15, 2022 ,Puerto Rico restructuring and continued runoff of AAC-insured RMBS. LSNI secured notes were held until redeemed inJuly 2021 . Sitka Senior Secured Notes were purchased in the second and third quarters of 2022. •Net investment income from available-for-sale and short-term securities, other thanAmbac -insured increased for the three and nine months endedSeptember 30, 2022 , compared to the same periods in the prior year due to higher portfolio yields. Net Investment Gains (Losses), including Impairments. The following table provides a breakdown of net investment gains (losses) for the periods presented: Three Months Ended September 30, Nine Months Ended September 30, 2022 2021 2022 2021 Net gains (losses) on securities sold or called $ 5 $ 1 $ 12 $ 7 Net foreign exchange gains (losses) 9 3 20 (3) Credit impairments - - - - Intent / requirement to sell impairments - - - - Net investment gains (losses), including impairments $ 14 $ 3 $ 31 $ 4 Net gains for the three and nine months endedSeptember 30, 2022 , included$4 from the distribution of residual assets of a legacy financial guarantee student loan restructuring vehicle. Net gains for the nine months endedSeptember 30, 2022 , also 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 nine months endedSeptember 30, 2021 , included a gain of$4 realized on the sale AFG's equity interest in theCorolla 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 is 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.
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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 and as ofJune 30, 2022 , all outstanding credit derivatives have matured. Net gains (losses) on interest rate derivatives for the three and nine months endedSeptember 30, 2022 , were$37 and$122 compared to$5 and$18 for the three and nine months endedSeptember 30, 2021 . The net gains in 2022 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 improved results for the three and nine months endedSeptember 30, 2022 , resulted from the significant rate increases in the periods combined with favorable portfolio positioning, and the impact of changing credit spreads in derivative assets as 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. In periods when credit spreads are stable, counterparty credit adjustments will generally have a proportionate offsetting impact to gains or losses on derivative assets, relative to fully collateralized assets. 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. Generally, narrowing (widening) of credit spreads will increase (decrease) derivative gains relative to a period of stable credit spreads. 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$6 for the three and nine months endedSeptember 30, 2022 , respectively, and$2 and$8 for the three and nine months endedSeptember 30, 2021 , respectively. The lower counterparty credit adjustments for all periods were driven primarily by lower underlying asset values. Commissions Income. Commission income for the three and nine months endedSeptember 30, 2022 was$7 and$22 compared to$7 and$20 , for the three and nine months endedSeptember 30, 2021 . Commissions include both base and profit sharing commissions of the Insurance Distribution segment. The increase was driven by greater premiums placed by Xchange Benefits. 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 and nine months endedSeptember 30, 2022 Sub-producer commissions of$4 and$13 compared to$4 and$11 in three and nine months endedSeptember 30, 2021 .
Net Realized Gains on Extinguishment of Debt. Net realized gains on
extinguishment of debt was
endedSeptember 30, 2022 , resulting from repurchases of surplus notes below their carrying values. Net realized gains on extinguishment of debt was$33 for the nine months endedSeptember 30, 2021 , resulting from the 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. AAC may continue to repurchase surplus notes and other debt in future periods. 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 (loss) on variable interest entities was$(1) and$14 for the three and nine months endedSeptember 30, 2022 , respectively, compared to$3 and$5 for the three and nine months endedSeptember 30, 2021 . Results for the three months endedSeptember 30, 2022 , related to decline in fair value of net assets on VIEs driven by higher market discount rates. Results for the nine months endedSeptember 30, 2022 , related primarily to two VIE trusts created in connection with thePuerto Rico restructurings inMarch 2022 . The nine months endedSeptember 30, 2022 included the initial$28 gain upon consolidation onMarch 15, 2022 , losses of$8 from changes to fair value of these VIEs' assets, and losses of$4 from these VIEs driven by interest costs. Results for the three months endedSeptember 30, 2021 , were due primarily to gains on higher valuation of net assets on VIEs. Results for the nine months endedSeptember 30, 2022 and 2021 included realized gains of$2 and$2 , respectively, on sales of assets, together with higher valuation of net assets on VIEs.
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Refer to Note 9. Variable Interest Entities to the Unaudited Consolidated Financial Statements, included in Part I, Item 1 in this Form 10-Q for further information on the accounting for FG VIEs.
Losses and Loss Expenses. Loss and loss expenses decreased$(298) and$(268) for the three and nine months endedSeptember 30, 2022 , compared to the same periods in the prior year. Legacy financial guarantee loss and loss expenses (benefit) were$(356) and$(347) for the three and nine months endedSeptember 30, 2022 .Specialty Property and Casualty Insurance loss and loss expenses were$3 and$5 for the three and nine months endedSeptember 30, 2022 . Legacy financial guarantee loss and loss expenses (benefit) for the three months endedSeptember 30, 2022 , were largely driven impact of the Settlement Agreement with Bank of America Corporation and certain affiliates of approximately$319 as described in Note 1. Background and Business Description to the Unaudited Consolidated Financial Statements in this Form 10-Q. Legacy financial guarantee loss and loss expenses (benefit) for the nine months endedSeptember 30, 2022 , were driven by favorable loss development in domestic public finance (primarily due to thePuerto Rico restructuring), favorable RMBS development due to the positive impact of discount rates, and the impact of the Settlement Agreement with Bank of America Corporation and certain affiliates thereof of$80 . Intangible Amortization. Insurance intangible amortization for the three and nine months endedSeptember 30, 2022 , was$5 and$32 , a decrease of$5 as compared to the the three months endedSeptember 30, 2021 and a decrease of$10 over the nine months endedSeptember 30, 2021 . The decrease was driven primarily by the size of the financial guarantee insured portfolio and timing of de-risking activity. Other intangible amortization for the three and nine months endedSeptember 30, 2022 , was$1 and$2 , respectively unchanged from the three and nine months endedSeptember 30, 2021 . 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 September 30, Nine Months Ended September 30, 2022 2021 2022 2021 Compensation $ 17$ 15 $ 49$ 45 Non-compensation 14 13 41 37 Gross operating expenses 31 28 102 93 Sub-producer Commissions 4 4 13 11 Amortization of deferred acquisition costs 3 - 7 - Reinsurance commissions, net (2) - (5) - Total operating expenses $ 37$ 32 $ 104$ 94 The increase in gross operating expenses during the three and nine months endedSeptember 30, 2022 , as compared to the three and nine months endedSeptember 30, 2021 , was due to the following: •Higher compensation costs due to a net increase in staffing resulting from additions in theSpecialty Property & Casualty Insurance and Insurance Distribution segments and higher incentive compensation expense including the impact of performance factor adjustments. •Higher non-compensation costs primarily related toLegacy Financial Guarantee Insurance segment legal defense costs;Specialty Property and Casualty Insurance segment auditing, licensing fees and equipment costs associated with growth of the business; and Insurance Distribution segment sub-producer commissions. These items were partially offset for the nine months comparative periods by first quarter 2021 advisory fees associated withLegacy Financial Guarantee Insurance debt restructuring. 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 September 30, Nine Months Ended September 30, 2022 2021 2022 2021 Surplus notes (1) $ 20$ 20 $ 61$ 57 LSNI Ambac Note - 1 - 50 Sitka AAC note 21 16 55 16 Tier 2 Notes 7 7 22 20 Other - - 1 1 Total interest expense $ 49$ 44 $ 138$ 144
(1)Includes junior surplus notes that were acquired and retired in the first quarter of 2021.
The increase in interest expense for the three months endedSeptember 30, 2022 , compared to the three months endedSeptember 30, 2021 , was mainly driven by higher rates on the Sitka AAC note. The decrease in interest expense for the nine months endedSeptember 30, 2022 , compared to the nine months endedSeptember 30, 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
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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$575 atSeptember 30, 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 endedSeptember 30, 2022 and 2021, was$2 , and$2 respectively, a decrease of$0 . The provision for income taxes reported for nine months endedSeptember 30, 2022 and 2021 was$4 and$15 , respectively, a decrease of$11 , resulting primarily from the 2021 effect on the deferred tax liability of enactment of an increase inUK tax rates from 19% to 25%.
Results of Operations by Segment
Three Months Ended September 30, Nine Months Ended September 30,
2022 2021 2022 2021
Revenues:
Net premiums earned $ 7 $ 11 $ 31 $ 36
Net investment income 9 21 (9) 111
Net investment gains (losses),
including impairments 14 3 31 -
Net gains on derivative contracts 37 5 123 19
Net realized gains on extinguishment
of debt - - 57 33
Other (1) 4 17 5
Total 67 44 250 204
Expenses:
Loss and loss expenses (benefit) (356) (55) (347) (73)
Operating expenses 20 18 64 56
Total (336) (37) (283) (17)
Earnings before interest, taxes,
depreciation and amortization (1) 403 81 533 221
Interest expense 49 44 138 144
Depreciation - - 1 1
Intangible amortization 5 10 32 42
Pretax income (loss) $ 349 $ 27 $ 362 $ 35
Stockholders equity (1) $ 681 $ 713 (1)Abbreviated as "EBITDA" in future references
(2)Represents the share of
The Legacy Financial Guarantee Insurance segment is in active runoff. This will generally result in lower premium earned, investment income, operating expenses and intangible amortization. The variability in the financial results are primarily driven by changes in loss and loss expenses resulting from, amongst other items, credit developments, interest rates and de-risking transactions. Additionally, the segment results are impacted by changes in interest rates as they impact net gains on derivative contracts and interest expense on the floating rate AAC Sitka Note. Key variances not discussed above in the Consolidated Results section are as follows: Net premiums earned. Net premiums earned decreased$4 and$5 for the three and nine months endedSeptember 30, 2022 , compared to the same period in the prior year. Net premiums earned were impacted by the organic and active runoff of the financial guarantee insured portfolio resulting in a reduction to current and future normal net premiums earned and 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$3 for the for the three and nine months endedSeptember 30, 2022 , as compared to$1 and$7 for the three and nine months endedSeptember 30, 2021 . •Accelerated financial guarantee premiums earned as a result of calls and other accelerations on insured obligations, largely due to active de-risking of the insured portfolio, of ($2 ) and$5 for the for the three and nine months endedSeptember 30, 2022 , as compared to$1 and$1 for the three and nine months endedSeptember 30, 2021 .
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. 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$1,785 and$1,704 atSeptember 30, 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.
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The following provides details for losses and loss expenses (benefit) incurred for the periods presented:
Three Months Ended September 30, Nine Months Ended September 30,
2022 2021 2022 2021
Structured Finance $ (351) $ (21) $ (150) $ (44)
Domestic Public Finance (1) (30) (194) (32)
Other (4) (4) (3) 3
Totals (1) $ (356) $ (55) $ (347) $ (73) (1) Includes loss expenses incurred of
Loss and loss expenses (benefit) for the three months endedSeptember 30, 2022 , were largely driven impact of the Settlement Agreement with Bank of America Corporation and certain affiliates of approximately$319 as described in Note 1. Background and Business Description to the Unaudited Consolidated Financial Statements in this Form 10-Q. Losses and loss expenses (benefit) for the nine months endedSeptember 30, 2022 , were driven by favorable loss development in domestic public finance (primarily due to thePuerto Rico restructuring), favorable RMBS development due to the positive impact of discount rates, and the impact of the Settlement Agreement with Bank of America Corporation and certain affiliates thereof of$80 . Losses and loss expenses (benefit) for the three and nine months endedSeptember 30, 2021 , were largely driven by favorable loss development in domestic public finance, primarily related toPuerto Rico , and structured finance, primarily related to improved credit in RMBS, partially offset by loss expenses incurred. Results for the nine months endedSeptember 30, 2021 , also reflect the positive impact of interest rates on RMBS excess spread, partially offset by the negative impact of discount rates. Operating Expenses. The increases in operating expenses of$2 and$5 during the three and nine months endedSeptember 30, 2022 , as compared to the three and nine months endedSeptember 30, 2021 , is due to additional legal fees related to defensive litigation costs and additional compensation costs from the impact of incentive compensation performance factor adjustments, partially offset by a net reduction in headcount within the segment.
Three Months Ended September 30, Nine Months Ended September 30,
2022 2021 2022 2021
Gross premiums written $ 30 $ 4 $ 95 $ 6
Net premiums written 6 1 19 1
Revenues:
Premiums earned $ 4 $ - $ 8 $ -
Investment income - - 1 1
Net investment gains (losses),
including impairments - - - -
Other income (program fees) 1 - 2 -
Total 6 - 11 1
Expenses:
Losses and loss expenses incurred 3 - 5 - Operating expenses 4 2 11 5 Total 7 2 16 5 EBITDA (1)$ (2) (5)$ (4) Pretax income (loss) $ (1)$ (2) $ (5)$ (4) Loss and LAE Ratio 65.2 % NM 65.7 % NM Combined Ratio 150.8 % NM 176.5 % NM Ambac's stockholders equity (1) $ 110 $
104
(1)Represents Ambac stockholders equity in the
The Specialty Property and Casualty Insurance segment has grown significantly since underwriting its first program inMay 2021 . Thirteen programs were authorized to issue policies as ofSeptember 30, 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 markets. In addition, 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.
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OnSeptember 28, 2022 , Hurricane Ian reached landfall resulting in significant damage primarily in the states ofFlorida andSouth Carolina . Everspan's estimate of its losses and loss expenses is minimal and to date has received one claim related to Hurricane Ian. Segment pre-tax net income was favorably impacted by the growth in earned premium and program fees relative to loss and loss expenses incurred and operating expenses for the three month period endedSeptember 30, 2022 , compared to the three month period endedSeptember 30, 2021 . Costs associated with the acquisition of additional shell insurance companies, as we continue to ramp up Everspan's operations, impacted pre-tax income for the nine months endedSeptember 30, 2022 , relative to the nine months endedSeptember 30, 2021 . Insurance Distribution Three Months Ended September 30, Nine Months Ended September 30, 2022 2021 2022 2021 Premiums placed $ 28$ 29 $ 97$ 91 Commission income $ 7$ 7 $ 22$ 20 Sub-producer commission expense (1) 4 4 13 11 Net commissions 3 3 9 9 Expenses: Other Operating expenses (1) 1 1 4 4 Net (gain) attributable to noncontrolling interest - - (1) (1) EBITDA 1 1 4 4 Depreciation - - - - Intangible amortization 1 1 1 2 Pretax income (loss) $ 1$ 1 $ 3$ 3 Ambac's stockholders equity (2) $ 64$ 64
(1) The Consolidated Statements of Comprehensive Income presents the sum of these items as Operating Expenses.
(2) Represents the share of
Ambac's Insurance Distribution segment currently includes Xchange Benefits, a P&C MGA specializing in accident and health products. 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 programs based on the underwriting results of the policies it places with the carrier, which may cause some variability in revenue and earnings.
Xchange underwrote and placed premiums for its carriers of approximately
September 30, 2022 , unchanged and up$6 or 7% as compared to the three and nine months endedSeptember 30, 2021 , respectively. Higher premiums placed and shifts in mix of business were the primary drivers to the increases in both gross and sub-producer commissions. Employer Stop Loss business underwritten by Xchange has seasonality in January and July, which result in revenue and earnings concentrations in the first and third quarters each calendar year. ESL is Xchange's largest business. Other Operating Expenses. Other operating expenses for the three and nine months endedSeptember 30, 2022 increased slightly as compared to the three and nine months endedSeptember 30, 2021 as a result of employees hired to support the ESL renewal rights acquisition that occurred onApril 29, 2022 . LIQUIDITY AND CAPITAL RESOURCES ($ 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$223 as ofSeptember 30, 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$15 of capital to Everspan Indemnity in the first nine months of 2022 and$92 in 2021, respectively.
Xchange does not have any regulatory restrictions on its ability to make distributions. AFG received distributions from Xchange of
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It is highly unlikely that AAC will be able to make dividend payments to AFG for the foreseeable future.
Everspan's ability to make future dividend payments will mostly depend on its future profitability relative to its capital needs to support growth. Everspan is not expected to pay dividends in the near term. 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).
Operating Companies' Liquidity
Insurance
Sources of liquidity for the Company's insurance subsidiaries are through 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.
•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 (Legacy Financial Guarantee segment 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 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. As further described in Note 1. Background and Business Description to the Unaudited Consolidated Financial Statements, included in Part I, Item 1 in this Form 10-Q, effective as ofOctober 29, 2022 , AAC wholly redeemed the Sitka AAC Note and partially redeemed Tier 2 Notes. Following these redemptions, current principal outstanding on AAC's long-term debt consisted of$143 of Tier 2 Notes and$788 of surplus notes (including$67 of surplus notes held by AFG and eliminated in consolidation). AAC's future interest obligations on long-term debt after giving effect to the redemptions onOctober 29, 2022 include$678 of accrued and unpaid interest that would be payable on surplus notes if approved by OCI on the next scheduled payment date ofJune 7, 2023 (including surplus notes held by AFG), and Tier 2 Note interest that may be paid-in-kind until maturity onFebruary 12, 2055 at which time$2,030 would be due. •Ambac Financial Services ("AFS") uses interest rate derivatives (primarily interest rate swaps andUS Treasury futures) as a partial economic hedge against the effects of rising interest rates elsewhere in the Legacy Financial Guarantee segment. AFS's derivatives also include interest rate swaps previously provided to asset-backed issuers and other entities in connection with their financings. AAC lends AFS cash and securities as needed to fund payments under these derivative contracts, collateral posting requirements and operating expenses. Intercompany loans are governed by an established lending agreement with defined borrowing limits that has received non-disapproval from OCI. Insurance subsidiaries manage their liquidity risk by maintaining comprehensive analyses of projected cash flows and maintaining specified levels of cash and short-term investments at all times. It is the opinion of the Company's management that the insurance subsidiaries' near term liquidity needs will be adequately met from the sources described above.
Insurance Distribution:
The liquidity requirements of our MGA subsidiaries are met primarily by funds generated from commission receipts (both base and profit commissions). Base commissions are generally received monthly, whereas profit commissions are received only if the business underwritten is profitable. Cash provided from these sources is used primarily for commissions paid to sub-producers, operating expenses and distributions to AFG and other members.
Consolidated Cash Flow Statement Discussion.
The following table summarizes the net cash flows for the periods presented.
Nine Months Ended September 30, 2022 2021 Cash provided by (used in): Operating activities$ 59 $ (136) Investing activities 435 745 Financing activities (1) (479) (623)
Foreign exchange impact on cash and cash equivalents (1) - Net cash flow
$ 14 $ (14)
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(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. The receipt of$393 from AAC plus the existing cash assets of the consolidated trusts fully redeemed the trust certificates (AAC was the holder of$164 of the PRIFA trust certificates that were fully redeemed). As a result of the AAC claim payments and associated full redemption of the trust certificates, the remaining non-cash assets of the trusts, valued at$111 , were distributed to AAC. Because these trusts are consolidated VIEs, this activity will be reflected as$274 payments of VIE liabilities in second quarter 2022 financing activities.
Operating activities
The following represents the significant cash operating activity during the nine
months ended
•Cash provided by (i) gross premiums were$100 and$29 for the nine months endedSeptember 30, 2022 and 2021, respectively; (ii) interest rate derivatives were$61 and$(5) for the nine months endedSeptember 30, 2022 and 2021, respectively; (iii) investment portfolio income were$59 and$66 for the nine months endedSeptember 30, 2022 and 2021, respectively; and (iv) cash settlements from thePuerto Rico restructuring transactions to the consolidated trusts was$47 for the nine months endedSeptember 30, 2022 . •Debt service payments on the Sitka AAC Note were$51 for the nine months endedSeptember 30, 2022 . Debt service payments on the LSNI Ambac Note and Sitka AAC Note were$51 and$14 , respectively, for the nine months endedSeptember 30, 2021 . •Payments related to (i) operating expenses were$75 and$65 for the nine months endedSeptember 30, 2022 and 2021, respectively; and (ii) reinsurance premiums paid were$43 and$20 for the nine months endedSeptember 30, 2022 and 2021, respectively •Net Legacy Financial Guarantee Insurance loss and loss expenses paid, including commutation payments, during the nine months endedSeptember 30, 2022 and 2021 are detailed below: Nine Months Ended September 30, 2022 2021 Net loss and loss expenses paid (recovered): Net losses paid$ 239 $ 95 Net subrogation received (233) (85) Net loss expenses paid 18 64 Net cash flow$ 24 $ 74
Future operating flows will primarily be impacted by net premium collections and investment coupon receipts, operating expenses, net claim and loss expense payments and interest payments on outstanding debt.
Financing Activities
Financing activities for the nine months endedSeptember 30, 2022 , included payments for extinguishment of surplus notes of$58 , share repurchases of$14 and paydowns and maturities of VIE debt obligations of$404 (including payments for the accelerations of the VIE trusts created from thePuerto Rico restructuring). Financing activities for the nine months endedSeptember 30, 2021 , include paydowns of the LSNI Ambac Note of$1,641 and paydowns and maturities of VIE debt obligations of$133 . Net cash used in financing activities was partially offset by net proceeds from issuance of Sitka AAC Note of$1,163 .
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$77 (cash and securities collateral of$8 and$69 , respectively), including independent amounts, under these contracts atSeptember 30, 2022 .
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BALANCE SHEET ($ in millions)
Total assets decreased by approximately $2,891 from December 31, 2021 , to $9,412
at September 30, 2022 , primarily due to the reduction in asset values of VIEs of
$2,352 . This decline was driven by increases in interest rates, the
strengthening of the US dollar against the British Pound Sterling and assets
used to fund VIE obligation repayments. Additional declines in total assets were
the result of (i) the payment of loss and loss expenses, interest and operating
expenses, (ii) declines in invested asset values, (iii) lower derivative assets
caused by rising interest rates, (iv) lower subrogation recoverables, (v)
repurchases of Ambac common stock and AAC surplus notes, and (vi) lower premium
receivables and intangible assets from the continued runoff of the financial
guarantee insurance portfolio, partially offset by cash and securities received
relating to the Interim Distribution from Puerto Rico HTA in connection with the
PRHTA POA.
Total liabilities decreased by approximately $2,863 from December 31, 2021 , to
$8,324 as of September 30, 2022 , primarily due to reductions in the value of
VIEs liabilities of $2,294 (consistent factors as noted above in assets).
Additional liability declines driven by (i) payments of loss and loss expenses,
(ii) repurchases of AAC surplus notes, and (iii) lower
derivative liabilities caused by rising interest rates; partially offset by the
establishment of a liability relating to the Interim Distribution received from
Puerto Rico HTA that will need to be distributed by Ambac in connection with the
PRHTA POA.
As of September 30, 2022 , total stockholders' equity was $1,071 , compared with
total stockholders' equity of $1,098 at December 31, 2021 . This decrease was
primarily due to the changes in unrealized losses on invested assets and losses
on foreign currency translation partially offset by net income for the nine
months ended September 30, 2022 .
Investment Portfolio
Ambac's investment portfolio is managed under established guidelines designed to meet the investment objectives of AAC,Everspan Group , AmbacUK and AFG. Refer to "Description of the Business - Investments and Investment Policy" located in Part I. Item 1 of the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 , for further description ofAmbac's investment policies and applicable regulations.
The following table summarizes the composition ofAmbac's investment portfolio, excluding VIE investments, at carrying value atSeptember 30, 2022 andDecember 31, 2021 : Specialty Legacy Financial Property & Guarantee Casualty Insurance Corporate & Insurance Insurance Distribution Other ConsolidatedSeptember 30, 2022 Fixed maturity securities$ 1,278 $ 94 $ - $ 12$ 1,384 Fixed maturity securities - trading 105 - - - 105 Short-term 387 27 - 109 523 Other investments 543 - - 16 559 Fixed maturity securities pledged as collateral 69 - - - 69 Total investments (1)$ 2,382 $ 121 $ -$ 137 $ 2,640 December 31, 2021 Fixed maturity securities$ 1,630 $ 72 $ - $ 28$ 1,730 Fixed maturity securities - trading - - - - - Short-term 258 32 - 124 414 Other investments 679 - - 11 690 Fixed maturity securities pledged as collateral 120 - - - 120 Total investments (1)$ 2,687 $ 104 $ -$ 164 $ 2,955 (1) Includes investments denominated in non-US dollar currencies with a fair value of £296 ($330 ) and €37 ($37 ) as ofSeptember 30, 2022 and £341 ($462 ) and €38 ($43 ) as ofDecember 31, 2021 .
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The following charts provide the ratings(1) distribution of the fixed maturity investment portfolio based on fair value atSeptember 30, 2022 andDecember 31, 2021 :
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[[Image Removed: ambc-20220930_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 byAmbac represent 22% and 32% of theSeptember 30, 2022 , andDecember 31, 2021 , combined fixed maturity portfolio, respectively. The decrease is primarily due to the impact of the settlement of insuredPuerto Rico bonds described above, under Financial Guarantees in Force - AAC-Insured Bond Effective Date Transactions.
Premium Receivables
Ambac's premium receivables decreased to$268 atSeptember 30, 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, impact of foreign currency movements and adjustments for changes in expected and contractual cash flows, partially offset by accretion of the premium receivable discount and decreases to the allowance for credit losses. AtSeptember 30, 2022 ,Legacy Financial Guarantee Insurance and Specialty P&C premiums receivables were$259 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 $ 181 $ 181
British Pounds £ 66 73
Euros € 14 14
Total $ 268
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$99 from its reinsurers atSeptember 30, 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 ofSeptember 30, 2022 andDecember 31, 2021 , reinsurance recoverable on paid and unpaid losses were$80 and$55 , respectively primarily due to growth in the Specialty P&C Insurance Segment, including an increase to reinsurance recoverables related to legacy liabilities which were$47 and$30 as ofSeptember 30, 2022 andDecember 31, 2021 , respectively.
Intangible Assets
Intangible assets primarily include (i) an insurance intangible asset that was established at AFG's emergence from bankruptcy (Legacy Financial Guarantee Insurance Segment) in 2013, representing the difference between the fair value and aggregate carrying value of the financial guarantee insurance and reinsurance assets and liabilities of$272 atSeptember 30, 2022 , (ii) intangible assets established as part of the acquisition of
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Xchange (Insurance Distribution Segment) onDecember 31, 2020 of$31 atSeptember 30, 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 atSeptember 30, 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$28 as ofSeptember 30, 2022 . Derivative liabilities decreased from$95 atDecember 31, 2021 , to$40 as ofSeptember 30, 2022 . The net decreases resulted primarily from higher interest rates during the nine months endedSeptember 30, 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 of
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
September 30, 2022 : Loss and loss expense reserves $ 75$ 1,174 $ (205)$ (34) $ 1,009 Subrogation recoverable - 37 (1,986) - (1,949) Totals $ 75$ 1,211 $ (2,192) $ (34) $ (940) December 31, 2021: Loss and loss expense reserves $ 32$ 1,749 $ (155)$ (56) $ 1,570 Subrogation recoverable - 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
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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 73%. 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 atSeptember 30, 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)September 30, 2022 : Structured Finance $ 2,073 $
670
1,657 481 (220) (19) 242
Other 1,083 22 (4) (7) 11
Loss expenses - 38 - - 38
Totals $ 4,813 $ 1,211 $ (2,192) $ (34) $ (1,015)
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 $525 and $10 respectively, at September 30, 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. 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 atSeptember 30, 2022 , and, among other things, 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," 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
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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.
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 economic impact from public health crises and/or natural or other catastrophic events. 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 atSeptember 30, 2022 , could be approximately$15 . Combined with the absence of any unsettled R&W subrogation recoveries, a possible increase in loss reserves for structured finance credits could be approximately$115 . Additionally, loss payments are sensitive to changes in interest rates, increasing as interest rates rise. For example, an increase in interest rates of 1% could increase our estimate of expected losses by approximately$25 . There can be no assurance that losses may not exceed such amounts. Due to the uncertainties related to risks associated with structured finance credits, there can be no assurance that losses may not exceed our stress case estimates.
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 local, regional or national economic impact from public health crises and/or natural or other catastrophic events. 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 the PRHTA POA that was confirmedOctober 12, 2022 , and that is expected to become effective in the fourth quarter 2022. However, uncertainty remains as to (i) the value of the consideration provided by or on behalf of the debtors under the Eighth Amended POA as it relates to the Interim Distribution of Clawback CVI to PRHTA creditors and to the new PRHTA bonds or cash under PRHTA POA; (ii) the extent to which exposure management strategies, such as commutation and acceleration, will be executed for PRHTA; and (iii) 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
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manner due to favorable or unfavorable developments or results with respect to these factors. See Note 6. Insurance Contracts and 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 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 atSeptember 30, 2022 , the possible increase in loss reserves could be approximately$145 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$285 greater than the loss reserves atSeptember 30, 2022 . There can be no assurance that losses may not exceed our stress case estimates. Long-term Debt 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 ofSeptember 30, 2022 andDecember 31, 2021 is below: September 30, 2022 December 31, 2021 Surplus notes $ 675 $ 729 Sitka AAC note 1,157 1,154 Tier 2 notes 354 333 Ambac UK debt 15 15 Total Long-term Debt$ 2,201 $ 2,230 The decrease in long-term debt fromDecember 31, 2021 , resulted from repurchases of surplus notes, partially offset by paid-in-kind interest on Tier 2 Notes, and accretion on the carrying value of Sitka AAC Note and AmbacUK debt. The Sitka AAC Note was wholly redeemed and the Tier 2 Notes were partially redeemed following the receipt of recoveries under the Settlement Agreement with Bank of America Corporation and related entities inOctober 2022 . See Note 1. Background and Business Description to the Unaudited Consolidated Financial Statements, included in Part I, Item 1 in this Form 10-Q. 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 endedDecember 31, 2021 .
AAC's statutory policyholder surplus and qualified statutory capital (defined as the sum of policyholders surplus and mandatory contingency reserves) were$870 and$1,457 atSeptember 30, 2022 , respectively, as compared to$757 and$1,322 atDecember 31, 2021 , respectively. As ofSeptember 30, 2022 , statutory policyholder surplus and qualified statutory capital included$788 principal balance of surplus notes outstanding and$138 liquidation preference of preferred stock outstanding. These surplus notes (in addition to related accrued interest of$629 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 was the statutory net income of$211 for the
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nine months endedSeptember 30, 2022 , largely driven by the statutory net income impact of the Bank of America litigation settlement gain of$183 million , partially offset by (i) repurchase of surplus notes for$58 , (ii) contingency reserve contribution of$21 , and (iii) decrease in fair value with undistributed earnings (losses) of pooled funds of$16 .The Bank of America Settlement proceeds were received inOctober 2022 . AAC's 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 remaining 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 remaining balance of the Tier 2 Notes (after the partial repayment inOctober 2022 ), (iii) approval by OCI of payments on surplus notes, (iv) ongoing interest costs associated with surplus notes and Tier 2 Notes, (v) swap gains and losses at AFS, the financial position of which is supported by certain guarantees and financing arrangement from 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, (xi) the ultimate residual value of AmbacUK , which may be impacted by numerous factors including foreign exchange rates, and (xii) future changes to prescribed practices.
The significant drivers to the increase in policyholder surplus were capital contributions of$15 partially offset by the admitted asset limitation on goodwill within investment in subsidiaries, and operating expenses during the nine months endedSeptember 30, 2022 .
AMBAC
AmbacUK is required to prepare financial statements under FRS 102 "The Financial Reporting Standard applicable in theUK andRepublic of Ireland ." AmbacUK's shareholder funds underUK GAAP were £466 atSeptember 30, 2022 , as compared to £444 atDecember 31, 2021 . AtSeptember 30, 2022 , the carrying value of cash and investments was £526, an increase from £500 atDecember 31, 2021 . The increase in shareholders' funds and cash and investments was primarily due to the continued receipt of premiums and foreign exchange gains, partially offset by investment losses, operating expenses and tax payments. AmbacUK is also required to prepare financial information in accordance with the Solvency II Directive. The basis of preparation of this information is significantly different from both US GAAP andUK GAAP. Available capital resources under Solvency II were a surplus of £287 atJune 30, 2022 , the most recently published position, of which £282 were eligible to meet solvency capital requirements. Eligible capital resources atJune 30, 2022 , were in comparison to regulatory capital requirements of £228. Therefore, AmbacUK had a surplus of capital resources as compared to regulatory capital requirements of £54 atJune 30, 2022 . NON-GAAP FINANCIAL MEASURES ($ 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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