FINANCIAL GUARANTEE INSURANCE CONTRACTS

Amounts presented in this Note relate only to Ambac’s non-derivative insurance business for insurance policies issued to beneficiaries, including VIEs, for which we do not consolidate the VIE.

Net Premiums Earned:

Gross premiums are received either upfront (typical of public finance obligations) or in installments (typical of structured finance obligations). For premiums received upfront, an unearned premium revenue (“UPR”) liability is established, which is initially recorded as the cash amount received. For installment premium transactions, a premium receivable asset and offsetting UPR liability is initially established in an amount equal to: (i) the present value of future contractual premiums due (the “contractual” method) or (ii) if the underlying insured obligation is a homogenous pool of assets which are contractually prepayable, the present value of premiums to be collected over the expected life of the transaction (the “expected” method). An appropriate risk-free rate corresponding to the weighted average life of each policy and currency is used to discount the future premiums contractually due or expected to be collected. For example, U.S. dollar exposures are discounted using U.S. Treasury rates while exposures denominated in a foreign currency are discounted using the appropriate risk-free rate for the respective currency. The weighted average risk-free rate at March 31, 2015 and December 31, 2014, was 2.5% and 2.7%, respectively, and the weighted average period of future premiums used to estimate the premium receivable at March 31, 2015 and December 31, 2014, was 9.6 years and 10.1 years, respectively.

Insured obligations consisting of homogeneous pools for which Ambac uses expected future premiums to estimate the premium receivable and UPR include residential mortgage-backed securities. As prepayment assumptions change for homogenous pool transactions, or if there is an actual prepayment for a “contractual” method installment transaction, the related premium receivable and UPR are adjusted in equal and offsetting amounts with no immediate effect on earnings using new premium cash flows and the then current risk-free rate.

Generally, the priority for the payment of financial guarantee premiums to Ambac, as required by the bond indentures of the insured obligations, is very senior in the waterfall. Additionally, in connection with the allocation of certain liabilities to the Segregated Account, trustees and other parties are required under the Segregated Account Rehabilitation Plan and related court orders to continue to pay installment premiums, notwithstanding the Segregated Account Rehabilitation Proceedings. In evaluating the credit quality of the premium receivables, management evaluates the transaction waterfall structures and the internal ratings of the transactions underlying the premium receivables. Uncollectable premiums are determined on a policy basis and utilize a combination of historical premium collection data in addition to cash flow analysis to determine if an impairment in the related policy's premium receivables exist. As of March 31, 2015 and December 31, 2014, approximately 32% and 32% of the premium receivables related to transactions with non-investment grade internal ratings, comprised mainly of non-investment grade RMBS and student loan transactions, which comprised 7% and 7%, of the total premium receivables at March 31, 2015 and 7% and 8%, of the total premium receivables at December 31, 2014, respectively. At March 31, 2015 and December 31, 2014, $17,082 and $17,780 respectively, of premium receivables were deemed uncollectable. Past due premiums on policies insuring non-investment grade obligations amounted to less than $500 at March 31, 2015.

Below is the gross premium receivable roll-forward (direct and assumed contracts) for the affected periods:



	Three Months Ended March 31,
	2015			2014
Beginning premium receivable	$	1,000,607		$	1,453,021
Premium receipts	(27,453		)	(33,128		)
Adjustments for changes in expected and contractual cash flows	(5,918		)	(15,062		)
Accretion of premium receivable discount	6,282			10,370
Uncollectable premiums	698			(1,074		)
Other adjustments (including foreign exchange)	(22,217		)	3,987
Ending premium receivable	$	951,999		$	1,418,114

Similar to gross premiums, premiums ceded to reinsurers are paid either upfront or in installments. Premiums ceded to reinsurers reduce the amount of premiums earned by Ambac from its financial guarantee insurance policies.

When a bond issue insured by Ambac Assurance has been retired, including those retirements due to refundings or calls, any remaining UPR is recognized at that time to the extent the financial guarantee contract is legally extinguished, causing accelerated premium revenue. For installment premium paying transactions, the recognition of any remaining UPR is offset by the reduction of the related premium receivable to zero (as it will not be collected as a result of the retirement), which may cause negative accelerated premium revenue. Ambac’s accelerated premium revenue for retired obligations for the three months ended March 31, 2015 and 2014 was $22,852 and $25,114, respectively. Certain obligations insured by Ambac have been legally defeased whereby government securities are purchased by the issuer with the proceeds of a new bond issuance, or less frequently with other funds of the issuer, and held in escrow (a pre-refunding). The principal and interest received from the escrowed securities are then used to retire the Ambac-insured obligations at a future date either to their maturity date or a specified call date. Ambac has evaluated the provisions in certain financial guarantee insurance policies issued on legally defeased obligations and determined those insurance policies have not been legally extinguished and, therefore, premium revenue recognition has not been accelerated.

The effect of reinsurance on premiums written and earned was as follows:



	Three months ended March 31, 2015				Three months ended March 31, 2014
	Written		Earned		Written			Earned
Direct	$	1,062	$	71,649	$	(5,766	)	$	86,183
Assumed	—		22		—			68
Ceded	365		5,953		456			3,704
Net premiums	$	697	$	65,718	$	(6,222	)	$	82,547

The table below summarizes the future gross undiscounted premiums to be collected and future premiums earned, net of reinsurance at March 31, 2015:



	Future premiums to be collected ⁽¹⁾		Future premiums to be earned net of reinsurance ⁽¹⁾
Three months ended:
June 30, 2015	$	22,082	$	38,127
September 30, 2015	22,103		35,798
December 31, 2015	21,686		33,635
Twelve months ended:
December 31, 2016	83,054		123,206
December 31, 2017	76,968		110,175
December 31, 2018	72,261		101,113
December 31, 2019	68,564		94,047
Five years ended:
December 31, 2024	304,049		385,547
December 31, 2029	254,696		272,177
December 31, 2034	179,393		169,638
December 31, 2039	65,595		67,126
December 31, 2044	25,189		23,328
December 31, 2049	9,831		9,824
December 31, 2054	1,244		2,183
December 31, 2059	5		3
Total	$	1,206,720	$	1,465,927

(1)

Future premiums to be collected is undiscounted and relates to the discounted premium receivable asset recorded on Ambac's balance sheet. Future premiums to be earned, net of reinsurance relate to the unearned premium liability and deferred ceded premium asset recorded on Ambac’s balance sheet. The use of contractual lives for many bond types which do not have homogeneous pools of underlying collateral is required in the calculation of the premium receivable, as described in Note 2. Basis of Presentation and Significant Accounting Principles in the Notes to Consolidated Financial Statements included in Ambac's Annual Report on Form 10-K for the year ended December 31, 2014. This results in a different premium receivable balance than if expected lives were considered. If installment paying policies are retired or prepay early, premiums reflected in the premium receivable asset and amounts reported in the above table for such policies may not be collected in the future. Future premiums to be earned also considers the use of contractual lives for many bond types which do not have homogeneous pools of underlying collateral, which results in higher unearned premium than if expected lives were considered. If those bonds types are retired early, premium earnings may be negative in the period of call or refinancing.

Loss and Loss Expense Reserves:

Below are the components of the Loss and loss expense reserves liability and the Subrogation recoverable asset at March 31, 2015 and December 31, 2014:



	Unpaid Claims				Present Value of Expected Net Cash Flows
Balance Sheet Line Item	Claims		Accrued Interest		Claims and Loss Expenses		Recoveries			Unearned Premium Revenue			Gross Loss and Loss Expense Reserves
March 31, 2015:
Loss and loss expense reserves	$	2,158,007	$	265,708	$	3,579,957	$	(1,268,916	)	$	(258,765	)	$	4,475,991
Subrogation recoverable	774,960		103,429		175,415		(2,037,933		)	—			(984,129		)
Totals	$	2,932,967	$	369,137	$	3,755,372	$	(3,306,849	)	$	(258,765	)	$	3,491,862

December 31, 2014:
Loss and loss expense reserves	$	2,172,041	$	234,802	$	3,792,133	$	(1,205,621	)	$	(241,348	)	$	4,752,007
Subrogation recoverable	772,948		94,425		197,751		(2,018,398		)	—			(953,274		)
Totals	$	2,944,989	$	329,227	$	3,989,884	$	(3,224,019	)	$	(241,348	)	$	3,798,733

Below is the loss and loss expense reserve roll-forward, net of subrogation recoverable and reinsurance, for the affected periods:



	Three Months Ended March 31,
	2015			2014
Beginning gross loss and loss expense reserves	$	3,798,733		$	5,470,234
Less reinsurance on loss and loss expense reserves	100,355			122,357
Beginning balance of net loss and loss expense reserves	$	3,698,378		$	5,347,877
Changes in the loss and loss expense reserves due to:
Current year:
Establishment of new loss and loss expense reserves, gross of RMBS subrogation and net of reinsurance	1			151
Total current year	1			151
Prior years:
Change in previously established loss and loss expense reserves, gross of RMBS subrogation and net of reinsurance	(132,639		)	(117,692		)
Claim and loss expense (payments) recoveries, net of subrogation and reinsurance	(104,202		)	(9,375		)
(Increase) decrease in previously established RMBS subrogation recoveries, net of reinsurance	(44,195		)	(18,331		)
Total prior years	(281,036		)	(145,398		)
Net change in net loss and loss expense reserves	(281,035		)	(145,247		)
Ending net loss and loss expense reserves	$	3,417,343		$	5,202,630
Add reinsurance on loss and loss expense reserves ⁽¹⁾	74,519			111,303
Ending gross loss and loss expense reserves	$	3,491,862		$	5,313,933


(1)	Reinsurance recoverable reported on the Balance Sheet also includes reinsurance recoverables of previously presented loss and loss expenses of $4,789 and $139 as of March 31, 2015 and 2014, respectively.

The positive development in loss and loss expense reserves established in prior years for the three months ended March 31, 2015 was primarily due to improved performance and lower interest rates in the RMBS portfolio and the impact of commutations and lower interest rates in the student loan portfolio. The positive development in loss and loss expense reserves established in prior years for the three months ended March 31, 2014 was primarily due to improved performance of the RMBS portfolio and higher commutation probabilities for student loan exposures.

The net change in net loss and loss expense reserves are included in losses and loss expenses in the Consolidated Statement of Total Comprehensive Income. Reinsurance recoveries of losses included in losses and loss expenses in the Consolidated Statements of Total Comprehensive Income (Loss) were an expense of $20,601 and $10,559 for the three months ended March 31, 2015 and 2014, respectively.

The tables below summarize information related to policies currently included in Ambac’s loss and loss expense reserves or subrogation recoverable at March 31, 2015 and December 31, 2014. Net par exposures include capital appreciation bonds which are reported at the par amount at the time of issuance of the insurance policy. The weighted average risk-free rate used to discount loss reserves at March 31, 2015 and December 31, 2014 was 2.1% and 2.3%, respectively.



Surveillance Categories as of March 31, 2015
	I/SL			IA			II			III			IV			V			Total
Number of policies	34			21			43			66			163			3			330
Remaining weighted-average contract period (in years)	7			16			17			21			13			6			15
Gross insured contractual payments outstanding:
Principal	$	910,033		$	399,516		$	4,186,210		$	3,550,121		$	9,376,691		$	59,712		$	18,482,283
Interest	339,721			159,138			8,484,779			2,286,780			1,928,647			19,651			13,218,716
Total	$	1,249,754		$	558,654		$	12,670,989		$	5,836,901		$	11,305,338		$	79,363		$	31,700,999
Gross undiscounted claim liability ⁽¹⁾	$	12,901		$	6,344		$	239,113		$	1,596,918		$	6,297,440		$	79,357		$	8,232,073
Discount, gross claim liability	(644		)	(605		)	(18,502		)	(521,225		)	(712,562		)	(6,592		)	(1,260,130		)
Gross claim liability before all subrogation and before reinsurance	$	12,257		$	5,739		$	220,611		$	1,075,693		$	5,584,878		$	72,765		$	6,971,943
Less:
Gross RMBS subrogation⁽²⁾	—			—			—			—			(2,579,450		)	—			(2,579,450		)
Discount, RMBS subrogation	—			—			—			—			11,097			—			11,097
Discounted RMBS subrogation, before reinsurance	—			—			—			—			(2,568,353		)	—			(2,568,353		)
Less:
Gross other subrogation⁽³⁾	—			—			(12,388		)	(142,548		)	(646,741		)	(13,356		)	(815,033		)
Discount, other subrogation	—			—			3,474			35,608			33,795			3,660			76,537
Discounted other subrogation, before reinsurance	—			—			(8,914		)	(106,940		)	(612,946		)	(9,696		)	(738,496		)
Gross claim liability, net of all subrogation and discounts, before reinsurance	$	12,257		$	5,739		$	211,697		$	968,753		$	2,403,579		$	63,069		$	3,665,094
Less: Unearned premium revenue	(8,812		)	(2,175		)	(107,836		)	(76,061		)	(63,368		)	(513		)	(258,765		)
Plus: Loss expense reserves	—			16			2,185			7,465			75,825			42			85,533
Gross loss and loss expense reserves	$	3,445		$	3,580		$	106,046		$	900,157		$	2,416,036		$	62,598		$	3,491,862
Reinsurance recoverable reported on Balance Sheet ⁽⁴⁾	$	1		$	910		$	2,331		$	85,082		$	(9,016	)	$	—		$	79,308


(1)	Gross undiscounted claim liability includes unpaid claims, including accrued interest on Deferred Amounts, on policies allocated to the Segregated Account and Ambac's estimate of expected future claims.


(2)	RMBS subrogation represents Ambac’s probability-weighted estimate of subrogation recoveries from RMBS transaction sponsors for representation and warranty ("R&W") breaches.


(3)	Other subrogation primarily represents subrogation related to excess spread or other contractual cash flows on public finance and structured finance transactions, including RMBS.


(4)	Reinsurance recoverable reported on Balance Sheet includes reinsurance recoverables of $74,519 related to future loss and loss expenses and $4,789 related to previously presented loss and loss expenses.



Surveillance Categories as of December 31, 2014
	I/SL			IA			II			III			IV			V			Total
Number of policies	36			26			33			69			160			1			325
Remaining weighted-average contract period (in years)	8			12			15			21			12			6			16
Gross insured contractual payments outstanding:
Principal	$	1,026,513		$	519,291		$	3,091,744		$	3,792,559		$	9,892,760		$	47		$	18,322,914
Interest	418,746			212,296			1,878,770			2,765,537			1,979,627			19			7,254,995
Total	$	1,445,259		$	731,587		$	4,970,514		$	6,558,096		$	11,872,387		$	66		$	25,577,909
Gross undiscounted claim liability ⁽¹⁾	$	16,360		$	11,525		$	155,488		$	2,040,402		$	6,456,139		$	60		$	8,679,974
Discount, gross claim liability	(1,147		)	(937		)	(16,438		)	(716,812		)	(774,611		)	(3		)	(1,509,948		)
Gross claim liability before all subrogation and before reinsurance	$	15,213		$	10,588		$	139,050		$	1,323,590		$	5,681,528		$	57		$	7,170,026
Less:
Gross RMBS subrogation ⁽²⁾	—			—			—			—			(2,541,219		)	—			(2,541,219		)
Discount, RMBS subrogation	—			—			—			—			17,679			—			17,679
Discounted RMBS subrogation, before reinsurance	—			—			—			—			(2,523,540		)	—			(2,523,540		)
Less:
Gross other subrogation ⁽³⁾	—			—			(18,034		)	(127,143		)	(647,110		)	—			(792,287		)
Discount, other subrogation	—			—			6,069			36,779			48,960			—			91,808
Discounted other subrogation, before reinsurance	—			—			(11,965		)	(90,364		)	(598,150		)	—			(700,479		)
Gross claim liability, net of all subrogation and discounts, before reinsurance	$	15,213		$	10,588		$	127,085		$	1,233,226		$	2,559,838		$	57		$	3,946,007
Less: Unearned premium revenue	(10,945		)	(3,432		)	(73,749		)	(88,332		)	(64,890		)	—			(241,348		)
Plus: Loss expense reserves	3			1,303			1,968			6,470			84,330			—			94,074
Gross loss and loss expense reserves	$	4,271		$	8,459		$	55,304		$	1,151,364		$	2,579,278		$	57		$	3,798,733
Reinsurance recoverable reported on Balance Sheet⁽⁴⁾	$	73		$	890		$	1,355		$	110,957		$	(13,437	)	$	—		$	99,838


(1)	Gross undiscounted claim liability includes unpaid claims, including accrued interest on Deferred Amounts, on policies allocated to the Segregated Account and Ambac's estimate of expected future claims.


(2)	RMBS subrogation represents Ambac’s probability-weighted estimate of subrogation recoveries from RMBS transaction sponsors for representation and warranty ("R&W") breaches.


(3)	Other subrogation primarily represents subrogation related to excess spread or other contractual cash flows on public finance and structured finance transactions, including RMBS.


(4)	Reinsurance recoverable reported on Balance Sheet includes reinsurance recoverables of $100,355 related to future loss and loss expenses and $(517) related to previously presented loss and loss expenses.

Ambac records estimated subrogation recoveries for breaches of representations and warranties (R&W) by sponsors of certain RMBS transactions. Prior to the June 30, 2014 reporting period, Ambac utilized the Adverse and Random Sample approaches to estimate R&W subrogation recoveries for certain RMBS transactions. For a discussion of these subrogation recovery approaches, see Note 2. Basis Of Presentation And Significant Accounting Policies in the Notes to Consolidated Financial Statements included Part II, Item 8 in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014. Beginning with the June 30, 2014 reporting period, as a result of gaining further access to loan files, the Random Sample approach has been utilized for all transactions which were previously evaluated using the Adverse Sample approach.

Ambac has recorded RMBS subrogation recoveries of $2,568,353, ($2,540,710 net of reinsurance) and $2,523,540, ($2,496,515 net of reinsurance) at March 31, 2015 and December 31, 2014, respectively. The balance of RMBS subrogation recoveries and the related claim liabilities, by estimation approach, at March 31, 2015 and December 31, 2014, are as follows:



Approach	Gross loss reserves before subrogation recoveries ⁽¹⁾		Subrogation recoveries ⁽²⁾⁽³⁾			Gross loss reserves after subrogation recoveries
March 31, 2015:
Random samples ⁽⁴⁾	$	1,899,087	$	(2,568,353	)	$	(669,266	)

December 31, 2014:
Random samples ⁽⁴⁾	$	1,897,426	$	(2,523,540	)	$	(626,114	)


(1)	Includes unpaid RMBS claims, including accrued interest on Deferred Amounts, on policies allocated to the Segregated Account.

(2)

The amount of recorded subrogation recoveries related to each securitization is limited to ever-to-date paid and unpaid losses plus the present value of expected cash flows for each policy. To the extent losses have been paid but not yet fully recovered, the recorded amount of RMBS subrogation recoveries may exceed the sum of the unpaid claims and the present value of expected cash flows for a given policy. The net cash inflow for these policies is recorded as a “Subrogation recoverable” asset. For those transactions where the subrogation recovery is less than the sum of unpaid claims and the present value of expected cash flows, the net cash outflow for these policies is recorded as a “Loss and loss expense reserves” liability.

(3)

The sponsor’s repurchase obligation may differ depending on the terms of the particular transaction and the status of the specific loan, such as whether it is performing or has been liquidated or charged off. The estimated subrogation recovery for these transactions is based primarily on loan level data provided through trustee reports received in the normal course of our surveillance activities or provided by the sponsor. While this data may not include all the components of the sponsor’s contractual repurchase obligation we believe it is the best information available to estimate the subrogation recovery.


(4)	From time to time R&W subrogation may include estimates of potential sponsor settlements that are currently in negotiation, but have not been subject to a sampling approach. However, such estimates are not material to Ambac’s financial results and therefore are included in the Random Sample section of this table.

Below is the rollforward of RMBS subrogation, by estimation approach, for the affected periods:



	Random sample		Adverse sample			Total
Discounted RMBS subrogation (gross of reinsurance) at January 1, 2015	$	2,523,540	$	—		$	2,523,540
Changes recognized in 2015:
Changes in estimation approach	—		—			—
Impact of sponsor actions ⁽¹⁾	—		—			—
All other changes ⁽²⁾	44,813		—			44,813
Discounted RMBS subrogation (gross of reinsurance) at March 31, 2015	$	2,568,353	$	—		$	2,568,353

Discounted RMBS subrogation (gross of reinsurance) at January 1, 2014	$	953,825	$	1,252,773		$	2,206,598
Changes recognized in 2014:
Changes in estimation approach	—		—			—
Impact of sponsor actions ⁽¹⁾	—		—			—
All other changes ⁽²⁾	51,789		(34,092		)	17,697
Discounted RMBS subrogation (gross of reinsurance) at March 31, 2014	$	1,005,614	$	1,218,681		$	2,224,295


(1)	Sponsor actions include loan repurchases, direct payments to Ambac and other contributions.

(2)

All other changes which may impact RMBS subrogation recoveries include changes in actual or projected collateral performance, changes in the creditworthiness of a sponsor, and/or the projected timing of recoveries. All other changes may also include estimates of potential sponsor settlements that are currently in negotiation but have not been subject to a sampling approach. However, such estimates are not material to Ambac’s financial results and therefore are included in the Random Sample column of this table.

Insurance intangible asset:

The insurance intangible amortization expense is included in insurance intangible amortization on the Consolidated Statements of Total Comprehensive Income (Loss). For the three months ended March 31, 2015 and 2014, the insurance intangible amortization expense was $37,432 and $31,714, respectively. As of March 31, 2015 and December 31, 2014, the gross carrying value of the insurance intangible asset was $1,631,068 and $1,660,125, respectively. Accumulated amortization of the insurance intangible asset was $283,773 and $249,205, as of March 31, 2015 and December 31, 2014, respectively, resulting in a net insurance intangible asset of $1,347,295 and $1,410,920, respectively.

The estimated future amortization expense for the net insurance intangible asset is as follows:



	2015		2016		2017		2018		2019		Thereafter
Amortization expense	$	90,801	$	107,443	$	97,726	$	90,095	$	83,380	$	877,850