-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, O8dv5Q+BtVpM4IB4QMLPZZuk8ch1zpu0atsKuSP0dK1bb7fnKMTtkib9e2+/3t/y wBXKaBPxpXH/kvhZrIja8Q== 0000950130-98-001593.txt : 19980401 0000950130-98-001593.hdr.sgml : 19980401 ACCESSION NUMBER: 0000950130-98-001593 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 24 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980331 SROS: NYSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: AMBAC FINANCIAL GROUP INC CENTRAL INDEX KEY: 0000874501 STANDARD INDUSTRIAL CLASSIFICATION: SURETY INSURANCE [6351] IRS NUMBER: 133621676 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 001-10777 FILM NUMBER: 98580099 BUSINESS ADDRESS: STREET 1: ONE STATE ST PLZ CITY: NEW YORK STATE: NY ZIP: 10004 BUSINESS PHONE: 2126680340 MAIL ADDRESS: STREET 1: ONE STATE ST PLZ CITY: NEW YORK STATE: NY ZIP: 10004 FORMER COMPANY: FORMER CONFORMED NAME: AMBAC INC /DE/ DATE OF NAME CHANGE: 19930328 10-K405 1 FORM 10-K SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED COMMISSION FILE NUMBER December 31, 1997 1-10777 Ambac Financial Group, Inc. (Exact name of Registrant as specified in its charter) DELAWARE 13-3621676 (State of incorporation) (I.R.S. employer identification no.) ONE STATE STREET PLAZA NEW YORK, NEW YORK 10004 (Address of principal executive offices) (Zip code) (212) 668-0340 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered COMMON STOCK, $0.01 PER SHARE AND Preferred Stock Purchase Rights New York Stock Exchange, Inc. Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ___ --- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] The aggregate market value of voting stock held by non-affiliates of the Registrant as of March 15, 1998 was $3,956,113,609 (based upon the closing price of the Registrant's shares of the New York Stock Exchange on March 15, 1998, which was $56.625). For purposes of this information, the outstanding shares of Common Stock which were owned by all directors and executive officers of the Registrant were deemed to be shares of Common Stock held by affiliates. As of March 15, 1998, 70,110,811 shares of Common Stock, par value $0.01 per share, (net of 569,573 treasury shares) were outstanding. Documents Incorporated By Reference Portions of the Registrant's Annual Report to Stockholders for the year ended December 31, 1997 are incorporated by reference into Parts II and IV hereof. Portions of the Registrant's Proxy Statement dated March 31, 1998 in connection with the Annual Meeting of Stockholders to be held on May 13, 1998 are incorporated by reference into Part III hereof. TABLE OF CONTENTS
Page ---------- PART I Item 1. Business................................................................ 1 Item 2. Properties.............................................................. 29 Item 3. Legal Proceedings....................................................... 29 Item 4. Submission of Matters to a Vote of Security Holders................................................ 29 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.................................. 29 Item 6. Selected Financial Data................................................. 29 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations............................................... 30 Item 7A. Quantitative and Qualitative Disclosures About Market Risk.............. 30 Item 8. Financial Statements and Supplementary Data............................. 30 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.................................................... 30 PART III Item 10. Directors and Executive Officers of the Registrant....................................................... 30 Item 11. Executive Compensation.................................................. 30 Item 12. Security Ownership of Certain Beneficial Owners and Management........................................ 30 Item 13. Certain Relationships and Related Transactions.................................................... 31 PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K...................................... 31 SIGNATURES 36 APPENDIX A Types and Ratings of Bonds.............................................. A-1 FINANCIAL STATEMENT SCHEDULES S-1
Part I ITEM 1. BUSINESS. GENERAL Ambac Financial Group, Inc. (the "Company") headquartered in New York City, is a holding company whose affiliates provide financial guarantee insurance and financial management services to clients in both the public and private sectors in the U.S. and abroad. The Company was incorporated on April 29, 1991. The Company's principal operating subsidiary, Ambac Assurance Corporation ("Ambac Assurance"), is a leading insurer of municipal and structured finance obligations. Through its financial management services subsidiaries, the Company provides investment agreements, interest rate swaps, investment management advisory, cash management, fund administration and broker/dealer services, and electronic commerce and information management solutions, principally to states, municipalities and their authorities, school districts, and hospitals and health organizations. During the first quarter of 1997, Ambac Assurance established a new subsidiary in the United Kingdom, Ambac Insurance UK Limited ("Ambac UK"), which is authorized to conduct certain classes of general insurance business in the United Kingdom. Ambac UK is the Company's primary vehicle for the issuance of financial guarantee insurance policies in the United Kingdom and Europe. On December 18, 1997, Ambac Assurance acquired Construction Loan Insurance Corporation ("CLIC"). Ambac Assurance paid $106.0 million in cash and retired $18.4 million of CLIC debt. CLIC (renamed Connie Lee Holdings, Inc.) and its triple-A rated financial guarantee insurance subsidiary Connie Lee Insurance Company ("Connie Lee"), are now wholly owned subsidiaries of Ambac Assurance. Connie Lee, which guaranteed bonds primarily for college and hospital infrastructure projects, is not expected to write any new business. Ambac Assurance and Connie Lee have arrangements in place to assure that Connie Lee maintains a level of capital sufficient to support Connie Lee's outstanding obligations and for Connie Lee insured bonds to retain their triple-A rating. As previously reported, management expects the acquisition to have a positive impact on earnings in 1998, depending upon several factors, including interest rates and economic conditions. Ambac Assurance is primarily engaged in insuring municipal and structured finance obligations and is the successor of the oldest municipal bond insurance company, which wrote the first municipal bond insurance policy in 1971. Financial guarantee insurance written by Ambac Assurance in both the primary and secondary markets guarantees payment when due of the principal of and interest on the obligation insured. In the case of a default on the insured obligation, payments under the insurance policy may not be accelerated by the policyholder without Ambac Assurance's consent. Ambac Assurance seeks to minimize the risk inherent in its insurance portfolio by maintaining a diverse portfolio which spreads its risk across a number of criteria, including issue size, type of bond, geographic area and obligor. As of December 31, 1997, Ambac Assurance's net insurance in force (after giving effect for reinsurance) was $275.9 billion. See "Insurance in Force" below. Ambac Assurance has been assigned triple-A claims-paying ability ratings, the highest ratings of Moody's Investors Service, Inc. ("Moody's"), Standard & Poor's Ratings Group ("S&P"), Fitch IBCA, Inc., ("Fitch") and Nippon Investors Service, Inc. ("Nippon"). These ratings are an essential part of Ambac Assurance's ability to provide credit enhancement. See "Rating Agencies" below. 1 The Company's investment agreement business ("IA Business") provides triple-A investment agreements primarily to states, municipalities and their authorities. The investment agreements are rated triple-A by virtue of Ambac Assurance's insurance policies which guarantee the IA Business' performance. Investment agreements are used by municipal bond issuers to invest bond proceeds until the proceeds can be used for their intended purpose, such as financing construction. The investment agreement provides for the guaranteed return of principal invested, and for the payment of interest thereon at a guaranteed rate. See "Investment Agreement Business" below. The Company provides interest rate swaps through its subsidiary Ambac Financial Services, L.P. ("AFS") to states, municipalities and their authorities, and other entities in connection with their financings. The interest rate swaps provided by AFS are insured by triple-A rated Ambac Assurance and provide a financing alternative that can reduce a municipal issuer's overall borrowing costs. See "Ambac Financial Services, L.P. below. The Company provides investment advisory, cash management and fund administration services through its Cadre Financial Services, Inc. ("Cadre") subsidiary and broker/dealer services through its Cadre Securities, Inc. ("Cadre Securities") subsidiary, to school districts, hospitals and health organizations, and municipalities. The Company also provides electronic commerce solutions through its 61% owned subsidiary, Ambac Connect, Inc. ("ACI") to states, municipalities and their authorities. As a holding company, Ambac Financial Group, Inc. is largely dependent on dividends from Ambac Assurance, its principal operating subsidiary, to pay dividends on its capital stock, to pay principal and interest on its indebtedness, to pay its operating expenses, and to make capital investments in its subsidiaries. Such dividends from Ambac Assurance are subject to certain insurance regulatory restrictions. See "Insurance Regulatory Matters -- Wisconsin Dividend Restrictions" below and "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" in the Company's 1997 Annual Report to Stockholders. BUSINESS SEGMENTS The following paragraphs describe the business operations of Ambac Financial Group, Inc., its subsidiaries and affiliates (sometimes collectively referred to as "the Company") for the Company's two business segments: Financial Guarantee Insurance and Financial Management Services. FINANCIAL GUARANTEE INSURANCE Financial guarantee insurance of the type written by Ambac Assurance guarantees to the holder of the underlying obligation the timely payment of principal and interest on such obligation in accordance with its original payment schedule. Accordingly, in the case of an issuer default on the insured obligation, payments under the insurance policy may not be accelerated by the policyholder without Ambac Assurance's consent. Financial guarantee insurance provides a form of credit enhancement which benefits both the issuer and the investor. Issuers benefit because their securities are sold with a higher credit rating than securities of the issuer sold on an uninsured basis, resulting in interest cost savings and greater marketability. In addition, for complex financings and obligations of issuers that are not well known by investors, insured obligations receive greater 2 market acceptance than uninsured obligations. Investors benefit from greater marketability and a reduction in the risk of loss associated with an issuer's default. The Company derives financial guarantee insurance revenues from (i) premiums earned over the life of the obligations insured, (ii) net investment income, (iii) net realized gains and losses and (iv) fees. Excluding transactions with affiliates, total financial guarantee insurance revenues were $339.2 million, $266.3 million and $248.6 million in 1997, 1996 and 1995, respectively. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 18 of Notes to Consolidated Financial Statements in the Company's 1997 Annual Report to Stockholders. Financial guarantee insurance is sold in three principal markets: the United States municipal market, the United States structured finance and asset- backed market, and the international market. UNITED STATES MUNICIPAL MARKET Until 1993, Ambac Assurance was almost exclusively focused on the municipal market in the United States. The municipal market includes taxable and tax-exempt bonds, notes and other evidences of indebtedness issued by states, political subdivisions (e.g., cities, counties, towns and villages), water, sewer and other utility districts, higher educational institutions, hospitals, transportation and housing authorities and other similar authorities and agencies. Municipal obligations are supported by either the taxing authority of the issuer or the issuer's or underlying obligor's ability to collect fees or assessments for certain projects or public services. The following table sets forth the volume of new issues of long-term (longer than 12 months) municipal bonds and the volume of new issues of insured long-term municipal bonds over the period from 1988 through 1997 in the United States. NEW ISSUES OF U.S. LONG-TERM MUNICIPAL BONDS
INSURED BONDS AS PERCENTAGE TOTAL INSURED OF TOTAL Volume Volume Volume ($ in Billions) 1988........................................................ $117.3 $ 27.1 23.1 1989........................................................ 125.0 31.1 24.9 1990........................................................ 127.8 33.5 26.2 1991........................................................ 172.4 51.9 30.1 1992........................................................ 234.7 80.8 34.4 1993........................................................ 292.2 107.8 36.9 1994........................................................ 164.8 61.4 37.3 1995........................................................ 160.3 68.5 42.7 1996........................................................ 183.5 85.5 46.6 1997........................................................ 215.1 104.8 48.7 __________________
Source: Amounts in the total volume column (except for 1997) are based upon estimated data reported by The Bond Buyer's 1997 Yearbook. The 1997 volume amounts are Ambac Assurance estimates, compiled from industry sources including Securities Data Company, Inc. and The Bond Buyer. Statistics in the Insured Volume column include only the insured portion of an issue and are based upon industry sources including Securities Data Company, Inc. and The Bond Buyer. Amounts in the Total Volume and Insured Volume columns represent gross par amounts issued or insured, respectively, during such year.
The foregoing table illustrates the changes in the total volume and insured volume of new issues of municipal bonds over the past ten years. The increase in volume of municipal bond issuance during 1991, 1992 and 1993 was primarily due to increased 3 refunding activity related to a lower interest rate environment. The decrease in municipal bond issuance during 1994 and 1995 was primarily due to decreased refunding activity related to a higher interest rate environment. During 1996 and 1997, municipal bond issuance began to rise again as interest rates began to decrease. Although there have been certain monetary defaults in bond issues of substantial amounts, incidents of monetary default on municipal bonds have been infrequent in recent years. With the exception of the default by the Washington Public Power Supply System, most monetary defaults since 1981 have been related to industrial revenue bonds, nursing home bonds, housing bonds and other non- general obligation bonds. Furthermore, based upon data reported by the Association of Financial Guaranty Insurers, the percentage of insured municipal bonds experiencing monetary defaults in recent years is relatively low compared to the entire municipal market. The relatively low incidence of municipal bond defaults may be partially the result of safeguards developed over the years since the Depression of the 1930's, when a great number of municipal defaults occurred. Such safeguards include the imposition of issuer debt limits, greater supervision by state governments of local debt administration, and more thorough credit reviews by investment firms, rating agencies and institutional investors. While these safeguards address many of the causes of earlier defaults, they may be inadequate to prevent an increased level of defaults in the future caused by presently unforeseen economic and other factors. For example, 1994 and 1995 were notable years in the municipal finance industry in that certain municipal issuers realized losses in their investment portfolios as a result of the use of derivative financial instruments. These investment losses, however, did not result in a higher level of ultimate payment defaults by municipal issuers. See "Losses and Reserves" below. UNITED STATES STRUCTURED FINANCE AND ASSET-BACKED MARKET Insurance on securities in the structured finance and asset-backed market is typically issued in connection with structured financings or securitizations in which the securities being issued are secured by or payable from a specific pool of assets having an ascertainable cash flow or market value and held by a special purpose issuing entity. Such obligations include, but are not limited to: mortgage-backed securities and pools of home equity loans, credit card receivables, trade receivables or other assets. While most structured finance and asset-backed obligations are secured by or represent interest in pools of assets, monoline financial guarantors have also insured structured finance and asset-backed obligations secured by one or a few assets. In general, structured finance and asset-backed obligations are payable only from cash flow generated by a pool of assets and take the form of either "pass-through" obligations, which represent interests in the related assets, or "pay-through" obligations, which generally are debt obligations which are collateralized by the related assets. Both types of obligations also generally have the benefit of over-collateralization or one or more forms of credit enhancement to cover credit risks associated with the related assets. Structured finance and asset-backed obligations generally entail two forms of risks: asset risk, which relates to the amount and quality of asset coverage; and structural risk, which relates to the extent to which the transaction structure protects the interests of the investors, and therefore the insurer. In general, the amount and quality of asset coverage required is determined by the historical performance of the assets. The future performance of the underlying pool of assets will generally determine whether the amount of over-collateralization or other credit 4 enhancement ultimately is sufficient to protect investors, and therefore the insurer, against adverse asset performance. The ability of the servicer of the assets to properly service and collect the underlying assets often is a factor in determining future asset performance. Structural risks addressed by asset-backed transactions include bankruptcy and tax risks. Structured and asset-backed securities are usually designed to protect the investors, and therefore the insurer, from the bankruptcy or insolvency of the entity that originated the underlying assets as well as from the bankruptcy or insolvency of the servicer of those assets. (The servicer of the assets is typically responsible for collecting cash payments on the underlying assets and forwarding such payments, net of servicing fees, to the special purpose issuing entity). Related issues that often arise concern whether the sale of the assets by the originator to the issuer of the asset- backed obligations would be respected in the event of the bankruptcy or insolvency of the originator and whether the servicer of the assets may be permitted or required to delay the remittance to investors of any cash collections held by it or received by it after the time it becomes subject to bankruptcy or insolvency proceedings. Ambac Assurance addresses these risks through its credit underwriting guidelines, standards and procedures. The U.S. structured finance and asset-backed market in which Ambac Assurance provides financial guarantee insurance is broad and disparate, comprising public issues and private placements. The varied classes of assets securitized or guaranteed, and the recent rapid development of the market make estimating the size of the aggregate U.S. structured finance and asset-backed markets difficult. One of the most well developed sectors of this market is the U.S. public asset-backed market. The volume in this market in recent years is summarized in the following table. NEW ISSUES OF U.S. PUBLIC ASSET-BACKED SECURITIES
TOTAL Volume ($ in Billions) 1993................................................................................. $ 57.7 1994................................................................................. 75.5 1995................................................................................. 108.0 1996................................................................................. 151.5 1997................................................................................. 176.0 __________________
Source: Amounts are based upon estimated data reported by Asset Sales Report. INTERNATIONAL MARKET
Outside of the United States, sovereign and sub-sovereign, structured and asset-backed, utilities and other issuers are increasingly using financial guarantee insurance, particularly in markets throughout Western Europe. A number of important trends in international markets have contributed to this expansion. In the United Kingdom, Australia and elsewhere, ongoing privatization efforts have shifted the burden of funding from the government to public and private capital markets, where investors may seek the security of financial guarantee insurance. In Europe, there is growing interest in asset-backed securitization, especially through commercial paper conduits. While the principles of securitization have been increasingly applied in overseas markets, development in particular countries has varied due to the sophistication of the local capital markets and the impact of financial regulatory requirements, accounting standards and legal systems. It is anticipated that securitization will continue to expand internationally, 5 albeit at varying rates in each country. Ambac Assurance insures both asset- backed and structured transactions, sovereign and sub-sovereign debt issues, utilities, and other obligations in selected international markets. Ambac Assurance believes that the risk profile of the international business it insures is generally the same as in the U.S. However, there are some unique risks inherent in the international business, including legal and political environments, capital market dynamics, exposures to foreign exchange and transfer risk, and the degree of governmental support. Ambac Assurance monitors these risks carefully, and addresses them through its credit underwriting guidelines, standards and procedures. FINANCIAL GUARANTEE INSURANCE PUBLIC FINANCE - ORGANIZATION Public Finance is responsible for underwriting insurance and maintaining client relationships for the following types of municipal bonds: general obligation, tax-backed, transportation, leases, utilities, higher education and airports. During 1997 and 1996, Public Finance was responsible for insured gross par written of $22.5 billion and $19.0 billion, respectively. As of December 31, 1997, net par outstanding related to Public Finance was $101.5 billion. Public Finance is organized along regional lines, with a team of underwriters assigned to each of three regions of the United States; North, South and West. Management believes a regional focus promotes closer ties to issuers, financial advisors and bankers who now deal with the same team of professionals in each region, regardless of the type of obligation being insured. Within Public Finance, the management of credit decisions and criteria is centralized in the Credit Management Group. This group, in conjunction with the Public Finance Senior Credit Committee, seeks to assure that credit criteria are maintained, are appropriate and are systematically and consistently applied across the regions. The Public Finance Portfolio Risk Management Group reviews the division's insured portfolio for concentration of risk, whether in specific bond types, geographically or by size of issue. This group is also responsible for portfolio surveillance within the Public Finance Division. Analysts and others responsible for portfolio surveillance, schedule and execute regular and ad hoc reviews of credits in the book of business. Risk adjusted surveillance strategies have been developed for each bond type. Review periods and scope of review vary by bond type based upon the risk inherent in the nature of the credits. The focus of the surveillance review is to determine credit trends and recommend appropriate classification and review periods. Generally, the surveillance reviews are performed by analysts having the same experience and authority as those reviewing issues for initial underwriting. Compliance with this process is monitored by the head of Public Finance Portfolio Risk Management. Ambac Assurance assigns internal ratings to individual exposures as part of the new issue underwriting process and at surveillance reviews. These internal ratings, which represent Ambac Assurance's independent judgments, are based upon underlying credit parameters similar to those used by nationally recognized rating agencies. 6 SPECIALIZED FINANCE - ORGANIZATION Specialized Finance is responsible for underwriting insurance and maintaining client relationships for the following types of financings: structured transactions; receivable securitizations; asset-backed commercial paper conduits; home equity and mortgage-backed securities; bonds of state housing and student loan agencies, health care institutions and investor-owned utilities. Underwriters in Specialized Finance are organized into teams of experienced professionals with expertise in a specific type of security. During 1997 and 1996, Specialized Finance was responsible for insured gross par written of $23.8 billion and $17.8 billion, respectively. As of December 31, 1997, net par outstanding related to Specialized Finance was $64.1 billion. Specialized Finance is also responsible for underwriting all transactions with international exposure, primarily in Europe. During 1997 and 1996, Ambac Assurance insured gross par written in international transactions of $4.0 billion and $3.7 billion, respectively. As of December 31, 1997, net par outstanding related to international risks was $5.6 billion. Geographically, the countries receiving Ambac Assurance's primary international focus have been France, Japan and the United Kingdom. The types of international obligations insured primarily have been asset-backed securities, sovereign and sub-sovereign obligations, and special revenue and infrastructure obligations. Management has developed underwriting standards for international risks which are consistent with those applied to risks in the United States. In addition management believes that the international risks insured to date are largely similar in risk type to those insured in the United States. Ambac Assurance and MBIA Insurance Corporation ("MBIA") formed an unincorporated joint venture, MBIA/AMBAC International, to market financial guarantee insurance in Europe in September 1995. The joint venture was formed with the goal of bringing the combined capital and human resources of the two companies together to more efficiently serve the European markets. Since the inception of the joint venture, the two companies have insured a combined total par amount of approximately $12.0 billion related to international risks under the joint venture. Under the joint venture, financial guarantee policies are issued separately by each of the companies. While retaining the right to act individually, each company has the opportunity to reinsure up to 50 percent of the non-U.S. financial guarantee business written by the other company as part of the joint venture. Customer preference, licensing and market considerations determine which company insures a transaction. In January 1997, Ambac Assurance capitalized a new subsidiary in the United Kingdom, Ambac UK, which is authorized to conduct certain classes of general insurance business in the United Kingdom. Ambac UK is the Company's primary vehicle for directly issuing financial guarantee insurance policies in the United Kingdom and Europe. Ambac Assurance and Ambac UK have entered into a net worth maintenance agreement and reinsurance agreements. As is the case with Public Finance, the management of credit decisions and criteria in Specialized Finance is centralized in the Risk Management Group. This group, in conjunction with the Specialized Finance Senior Credit Committee, seeks to assure that credit criteria are appropriate and systematically applied across the division. The Risk Management Group is responsible for overseeing the surveillance process, setting and monitoring standards for quality, timing and documentation of credit reviews. Analysts responsible for portfolio surveillance schedule and execute regular and ad hoc reviews of credits in the book of business. Risk adjusted surveillance strategies have been developed for each bond type. 7 Review periods and scope of review vary by bond type based upon the risk inherent in the nature of the credits. In certain cases, portfolio surveillance may be the responsibility of the underwriting departments that originate the transactions. The focus of the surveillance review is to determine credit trends, recommend appropriate classification and set the next review date. Compliance with this process is monitored by the head of Specialized Finance Risk Management. INSURANCE WRITTEN Ambac Assurance provides financial guarantee insurance for U.S. municipal bonds, U.S. structured finance and asset-backed obligations and international obligations. Financial guarantee insurance is delivered in two markets: the new issue market and the secondary market. The new issue market includes municipal bond insurance, insurance of structured finance and asset-backed obligations, insurance of debt service reserve funds, insurance of international obligations, assumed reinsurance, and insurance of other financial obligations. The secondary market includes insurance of municipal bonds, structured finance and asset- backed obligations, bonds in mutual funds, and unit investment trusts ("UITs"). The following table indicates the gross par amount written for each of the years, 1997, 1996 and 1995 with respect to each market:
1997 1996 1995 --------------------- --------------------- --------------------- ($ In Millions) New issue market....................................... $44,726 $35,384 $23,630 Secondary market....................................... 1,571 1,434 2,339 --------------------- --------------------- --------------------- $46,297 $36,818 $25,969 ===================== ===================== =====================
New Issue Market - U. S. Municipal Ambac Assurance sells the majority of its insurance in the new issue municipal bond market. Of the $44.7 billion, $35.4 billion and $23.6 billion of new issue par exposure written in 1997, 1996 and 1995, respectively, $27.9 billion, $25.3 billion and $18.0 billion, respectively, was new issue U.S. municipal bond exposure. In the new issue U.S. municipal bond market, an issuer typically pays a single premium to Ambac Assurance at the time the policy is issued. Premiums are based on the total amount of principal and interest that will become due during the life of the bonds and on Ambac Assurance's evaluation of the inherent strength and credit quality of the issuer. Insurance premium rates take into account the risk assumed by the insurer. Critical factors in assessing risk include the credit quality of the issuer, type of issue, the repayment source, the type of security pledged, the presence of restrictive covenants and the length of maturity. Each bond issue is evaluated in accordance with, and the final premium rate is a function of, the particular factors as they relate to such issue. Charges for new issue insurance also take into account the benefits to be obtained by the issuer, as well as the cost and the projected return to Ambac Assurance. Proposed new municipal bond issues are submitted to Ambac Assurance to determine their insurability by issuers or by their investment bankers or financial advisors. Municipal bond issues are sold on either a competitive or a negotiated basis. With respect to competitive issues, an issuer will publish a notice of sale soliciting bids for the purchase of a proposed issue of municipal bonds. Various syndicates are then formed by potential bidders on the bonds. These syndicates then solicit a determination from some or all of the financial guarantee insurers whether an issue is insurable and at what premium rate and on what terms. The syndicate then determines whether to bid on the issue with insurance (and if so, 8 with which insurer) or without insurance. The issuer then generally selects the syndicate with the lowest bid. In a negotiated offering, an individual investment banker or team of investment bankers has already been selected by the issuer and that banker or team then typically solicits premium quotes and terms from the insurers. The new issue U.S. market includes insurance policies designed to satisfy debt service reserve fund requirements of municipal bond issuers. These policies insure the availability of an amount not to exceed the debt service reserve fund requirement for the issues, which in most cases is the lesser of one year's maximum principal and interest payments or approximately 10% of the original principal amount of a bond issue. Any amounts drawn under the debt service reserve fund policy must be reimbursed by the issuer within a specified time period and at a specified interest rate. New Issue Market - U.S. Structured Finance and Asset-Backed Of the $44.7 billion, $35.4 billion and $23.6 billion of new issue par exposure written in 1997, 1996 and 1995, respectively, $12.8 billion, $6.5 billion and $3.7 billion was new issue U.S. structured finance bond exposure. Premiums for U.S. structured finance and asset-backed policies are based on a percentage of either principal or principal and interest insured. The timing of the collection of structured finance and asset-backed premiums varies among individual transactions; some being collected in a single payment at policy inception date, and others being collected periodically (i.e., monthly, quarterly or annually). As of December 31, 1997 and 1996, net outstanding par exposure related to U. S. structured finance and asset-backed transactions was $18.6 billion and $8.1 billion, respectively. NEW ISSUE MARKET - INTERNATIONAL Of the $44.7 billion, $35.4 billion and $23.6 billion of new issue par exposure written in 1997, 1996 and 1995, respectively, $4.0 billion, $3.6 billion and $1.9 billion was new issue international structured finance and asset-backed bond exposure. Premiums for international policies are based on a percentage of either principal or principal and interest insured. The timing of the collection of structured finance and asset-backed premiums varies among individual transactions; some being collected in a single payment at policy inception date, and others being collected periodically (i.e., monthly, quarterly or annually). As of December 31, 1997 and 1996, net outstanding par exposure related to international transactions was $5.6 billion and $4.3 billion, respectively. SECONDARY MARKET Insurance on bonds outstanding in the secondary market is typically purchased by an institution to facilitate the sale of municipal bonds in its portfolio or inventory. The insurance generally increases the sale price of bonds (typically by an amount greater than the cost of the policy) and affords a wider secondary market and therefore greater marketability to a given issue of previously-issued bonds. As is the case with new issues, the premium is generally payable in full at the time of policy issuance. Ambac Assurance employs the same underwriting standards on secondary market issues that it does on new municipal bond issues. However, Ambac Assurance is more selective in the types of bonds it will insure in the secondary market. Secondary market insurance can be riskier for a more complex legal structure since the insurer does not have the ability to influence restrictive covenants at the time of issuance. Consequently, Ambac Assurance concentrates its secondary market insurance efforts on insurance of general obligation and utility revenue bonds, in addition to issues where Ambac Assurance has existing exposure. 9 Sponsors of UITs contact Ambac Assurance for insurance on individual bonds in a specific trust. Insurance policies on individual bonds in insured UITs are effective only as long as such bonds remain in the UIT unless an additional premium is paid to extend their effective date to the stated maturity of the bonds. Ambac Assurance insures individual bonds in insured mutual funds. Insurance policies on individual bonds in insured mutual funds are effective only as long as the individual bonds remain in the fund. Premiums on bonds included in mutual funds are collected monthly. INSURANCE IN FORCE Ambac Assurance underwrites and prices financial guarantee insurance on the assumption that the insurance will remain in force until maturity of the insured bonds. Ambac Assurance estimates that the average life (as opposed to the stated maturity) of its insurance policies on new issue par in force at December 31, 1997 was 12.8 years. The 12.8 year average life is determined by applying a weighted average calculation, using the remaining years to maturity of each insured bond, and weighting them on the basis of the remaining par insured. No assumptions are made for any prepayment of insured bonds or for any future refundings of insured issues. Municipal bonds generally have provisions that allow the issuer to prepay all or a portion of the outstanding amount prior to maturity. Ambac Assurance seeks to maintain a diversified insurance portfolio designed to spread its risk based on a variety of criteria, including (i) issue size, (ii) type of bond, (iii) geographic area and (iv) issuer. As of December 31, 1997, the total net par amount of insured bonds outstanding was $165.6 billion. This amount excludes Ambac Assurance's guarantees for the timely payment of principal and interest on obligations under investment agreements issued by the IA Business. As of December 31, 1997, the aggregate amount of investment agreements insured was $3.86 billion, including accrued interest. The insurance policies covering the IA Business are collateralized by the IA Business' investment securities, accrued interest, securities purchased under agreements to resell and cash and cash equivalents, which as of December 31, 1997, had a fair value of $3.94 billion in the aggregate. See "Financial Management Services" below. ISSUE SIZE Ambac Assurance seeks a broad coverage of the market by insuring small and large issues alike. Ambac Assurance's insured exposure as of December 31, 1997 reflects the emphasis on issues insured with an original par amount of less than $25 million, which reduces Ambac Assurance's average per-issue exposure to losses. The following table sets forth the distribution of Ambac Assurance's insured portfolio as of December 31, 1997 with respect to the original size of each insured issue: 10 ORIGINAL PAR AMOUNT PER ISSUE AS OF DECEMBER 31, 1997
% OF TOTAL NET PAR % OF TOTAL NUMBER NET PAR AMOUNT AMOUNT OUTSTANDING ORIGINAL PAR AMOUNT NUMBER OF ISSUES OF ISSUES OUTSTANDING - ------------------------------------- -------------------- -------------------- -------------------- -------------------- ($ In Millions) Less than $10 million................ 9,215 64% $ 23,698 14% $10-25 million....................... 2,004 14 24,249 15 $25-50 million....................... 911 6 24,292 15 Greater than $50 million............. 2,369 16 93,362 56 -------------------- ------------------- ------------------- -------------------- 14,499 100% $165,601 100% ==================== ==================== ==================== ====================
TYPES OF BONDS The table below shows the distribution by bond type of Ambac Assurance's insured portfolio as of December 31, 1997. As the table illustrates, approximately 37% of Ambac Assurance's net par amount outstanding at December 31, 1997, consisted of general obligation bonds and utility revenue bonds, which generally present less credit risk than other types of municipal bonds. Ambac Assurance tries to avoid insuring bond issues which entail excessive single project risk, over-capacity or customer contract disputes. For a more detailed discussion of the various types of obligations in Ambac Assurance's insured portfolio, see "Types and Ratings of Bonds" attached as Appendix A hereto. INSURED PORTFOLIO BY BOND TYPE AS OF DECEMBER 31, 1997
% of Total Net Par NET PAR AMOUNT Amount Outstanding BOND TYPE OUTSTANDING - -------------------------------------------------------------------------- ---------------------- --------------------- ($ In Millions) U.S. MUNICIPAL MARKET: General obligation...................................................... $ 36,324 22 % Lease and tax-backed revenue............................................ 30,980 19 Utility revenue......................................................... 24,913 15 Health care revenue..................................................... 18,545 11 Transportation revenue.................................................. 7,370 4 Higher education........................................................ 6,852 4 Investor-owned utilities................................................ 6,255 4 Housing revenue......................................................... 6,064 4 Student loans........................................................... 3,516 2 Other................................................................... 597 1 ---------------------- --------------- Total U.S. Municipal Market.......................................... 141,416 86 ---------------------- -------------- U.S. STRUCTURED FINANCE AND ASSET-BACKED MARKET: Mortgage-backed and home equity........................................ 11,620 7 Commercial asset-backed................................................ 4,538 3 Other consumer asset-backed............................................ 1,514 1 Banks/financial institutions........................................... 524 - Other.................................................................. 439 - Total U.S. Structured Finance and Asset-Backed Market................ 18,635 11 ---------------------- --------------- Total U.S............................................................ 160,051 97 ---------------------- --------------- INTERNATIONAL MARKET:..................................................... Commercial asset-backed............................................... 2,600 2 Sovereign/sub-sovereign............................................... 981 1 Mortgage-backed and home equity....................................... 496 - Utilities............................................................. 456 - Banks/financial institutions.......................................... 283 - Other................................................................. 734 - ---------------------- -------------- Total International Market........................................... 5,550 3 N ---------------------- -------------- Total............................................................ $165,601 100% ====================== ==============
11 The table below shows the percentage, by bond type, of new business insured by Ambac Assurance during each of the last five years. During this period, Ambac Assurance has consistently emphasized insurance of general obligation bonds, utility revenue bonds and tax-backed revenue bonds and has maintained a decreasing but substantial proportion of its insured volume in such bond types. NEW BUSINESS INSURED BY BOND TYPE (1)
Bond Type 1993 1994 1995 1996 1997 - ----------------------------------------------------------------------------------------- U.S. Municipal Market: General obligation..................... 29% 29% 23% 16% 18% Utilities (2).......................... 26 21 16 15 12 Lease and tax-backed revenue........... 21 16 16 23 17 Health care revenue.................... 13 8 8 7 8 Housing revenue........................ 2 5 5 3 3 Transportation revenue................. 3 5 5 3 2 Student loans.......................... 1 4 5 3 1 Higher education....................... 3 4 3 3 3 Other.................................. 0 1 0 0 1 ------------------------------------------------ Total Municipal Market............... 98 93 81 73 65 ------------------------------------------------- U.S. STRUCTURED FINANCE AND ASSET-BACKED MARKET: Mortgage-backed and home.............. equity............................. 0 1 8 12 18 Commercial asset-backed............... 0 0 5 4 8 Other consumer asset-backed.......... 0 0 0 0 1 Banks/financial institutions.......... 0 0 0 0 2 Other................................. 2 1 1 3 1 ------------------------------------------------ Total U.S. Structured Finance and Asset-Backed Market............................... 2 2 14 19 30 ------------------------------------------------- INTERNATIONAL MARKET: Commercial asset-backed............... 0 1 2 6 1 Sovereign/sub-sovereign............... 0 0 0 0 1 Mortgage-backed and home.............. equity............................. 0 0 0 0 1 Utilities............................. 0 0 0 0 1 Banks/financial institutions.......... 0 0 0 0 0 Other................................. 0 4 3 2 1 Total International Market...........------------------------------------------------- 0 5 5 8 5 ------------------------------------------------- Total................................ 100 % 100 % 100 % 100 % 100 % =================================================
(1) Stated as a percentage of total net par amount insured during such year. (2) Includes investor-owned utilities. Geographic Area Ambac Assurance is licensed to write business in all 50 states, the District of Columbia, the Commonwealth of Puerto Rico and Guam. As of December 31, 1997, the eight largest states, as measured by net par amount outstanding, accounted for approximately 51% of Ambac Assurance's total net par amount outstanding. The following table sets forth those states and geographic areas in which Ambac Assurance's aggregate insured exposure equaled 2% or more of its total net par amount outstanding as of December 31, 1997. 12 INSURED PORTFOLIO BY STATE AS OF DECEMBER 31, 1997
Net Par Amount % of Total Net Par Outstanding Amount Outstanding STATE/GEOGRAPHIC AREA - ------------------------------------------------------------ --------------------- --------------------- ($ In Millions) California.................................................. $ 19,593 12% New York.................................................... 13,219 8 Pennsylvania................................................ 11,988 7 Florida..................................................... 11,803 7 Texas....................................................... 8,607 5 Illinois.................................................... 7,510 5 Ohio........................................................ 6,210 4 Michigan.................................................... 5,535 3 New Jersey.................................................. 5,432 3 Massachusetts............................................... 5,142 3 Washington.................................................. 3,255 2 Indiana..................................................... 3,075 2 Other States................................................ 58,682 36 --------------------- --------------------- Total domestic......................................... 160,051 97 International............................................... 5,550 3 --------------------- --------------------- $165,601 100% ===================== =====================
Issuers Ambac Assurance has adopted underwriting and exposure management policies designed to limit the net insurance in force for any one credit. In addition, Ambac Assurance uses reinsurance to limit net exposure to any one credit. As of December 31, 1997, Ambac Assurance's net par amount outstanding for its 20 largest credits, totaling $12.1 billion, was approximately 7% of Ambac Assurance's total net par amount outstanding with no one credit representing more than 1% of Ambac Assurance's total net par amount outstanding. Ambac Assurance is also subject to certain regulatory limits and rating agency guidelines on exposure to a single credit. See "Insurance Regulatory Matters" and "Rating Agencies" below. UNDERWRITING GUIDELINES, POLICIES AND PROCEDURES Underwriting guidelines, policies and procedures have been developed by Ambac Assurance's management with the intent that Ambac Assurance insure only those obligations which, in the opinion of Ambac Assurance analysts, are of investment grade quality. There are instances where one of the major rating agencies will differ with Ambac Assurance's assessment of the investment grade nature of a particular obligation or where the underlying rating of an issuer is subsequently downgraded to below investment grade. As of December 31, 1997, Ambac Assurance's aggregate outstanding net par insured of below investment grade issues was $1,428.4 million (or 0.9% of Ambac Assurance's total net par amount outstanding of obligations insured). The underwriting process involves review of structural, legal and credit issues, including compliance with current Ambac Assurance underwriting standards. These standards are reviewed periodically by management. The rating agencies also monitor the credits underlying Ambac Assurance's insurance in force and, in most cases, advise Ambac Assurance of the credit rating each issue would receive if it were not insured by Ambac Assurance. 13 The following table sets forth Ambac Assurance's insured portfolio by rating as of December 31, 1997: INSURED PORTFOLIO BY RATING (1) AS OF DECEMBER 31, 1997
Net Par Amount % of Total Net Par Outstanding Amount Outstanding RATING - ------------------------------------------------------------ --------------------- --------------------- ($ In millions) AAA......................................................... $ 287 -% AA.......................................................... 14,720 9 A........................................................... 102,667 62 BBB......................................................... 46,499 28 BIG (2)..................................................... 1,428 1 -------------------- ---------------------- $165,601 100% ===================== =====================
(1) Ratings represent Ambac Assurance internal ratings. (2) Represents those bonds which have been categorized as "below investment grade" by Ambac Assurance. Ambac Assurance's policy is to reduce default risk associated with the obligations insured by it to the extent practicable. The decision to insure an issue is based upon the issuer's ability to repay the bonds, security features and structure, rather than upon an actuarial or statistical prediction of the likelihood that the issuer will default on the underlying debt obligation. Ambac Assurance insures only those bonds on which it expects not to incur a loss. However, Ambac Assurance's policy is to provide for loss reserves that are adequate to cover potential losses. See "Losses and Reserves" below. Underwriting criteria vary by bond type, reflecting the differences, for example, in economic and social factors, debt management, public purpose essentiality, financial management, legal and administrative factors, revenue sources and security features. All requests for insurance are reviewed by Ambac Assurance's underwriting staff, which is divided into two major underwriting divisions. The underwriting process is designed to screen each issue carefully and begins with a thorough credit analysis and written report prepared by the primary analyst assigned to the issue. The report is then reviewed within the primary analyst's underwriting group and division. The primary analyst's recommendation to qualify or reject an issue must be approved by a concurring analyst and an underwriting officer. The number of additional approvals required and the extent of an attorney's involvement in a particular credit depends on the aggregate amount of Ambac Assurance's existing or potential exposure to the credit. On large credits, where the aggregate exposure exceeds a certain pre-determined amount, the insurance decision must be approved by a credit committee comprised of senior underwriting officers and an attorney in addition to the analysts and underwriting officer mentioned above. Ambac Assurance determines premium rates on the basis of the bond type and credit strength of the bond issue, the maturity and structure of the issue, and other credit and market factors, including, but not limited to, security features, the presence or absence of a debt service reserve fund or additional credit enhancement features and the interest rate spread between insured and uninsured obligations with characteristics similar to those of the proposed bond issue. Premium rates are based upon established premium ranges, extensive consultation with the analysts responsible for the issue, and market intelligence developed from daily contact with syndicate managers and traders at investment banking firms to help form the most accurate view of the value of Ambac Assurance's insurance on each issue. 14 REMEDIAL MANAGEMENT Those issues which are either in default or have developed problems that, with the passage of time, may lead to a claim or loss are tracked closely by the appropriate surveillance team. The documents underlying any problem credit are reviewed by internal or outside counsel and an analysis is prepared outlining Ambac Assurance's rights and potential remedies, the duties of all parties involved and recommendations for corrective actions. This analysis, along with the schedule of corrective actions, is reviewed in the monthly remedial credit meetings. Ambac Assurance also meets with issuers to reach agreement upon the nature and the scope of the problem and to discuss the issuers' operating plans. In many instances, Ambac Assurance, under the terms of the documents governing the underlying obligation, has the ability, among other things, to direct that audits be performed with respect to servicer and trustee contractual responsibilities and to meet with the appropriate officials to outline Ambac Assurance's concerns and rights. When the underlying economics so indicate, Ambac Assurance may aid in a restructuring to improve the debt service coverage. LOSSES AND RESERVES Ambac Assurance's policy is to provide for loss and loss adjustment expense reserves that are adequate to cover potential losses as well as losses that may arise from insured obligations which are currently or imminently in default. The active credit reserve ("ACR") is that portion of the reserves that is based on Ambac Assurance's estimate of ultimate aggregate losses inherent in the obligations insured. As of December 31, 1997, Ambac Assurance's ACR was $48.2 million. When a default occurs or is imminent with respect to a particular insured obligation, a reserve ("case basis reserve") is established in an amount that is sufficient to cover the present value of the anticipated defaulted debt service payments over the expected period of default and the estimated expenses associated with settling the claims, less estimated recoveries under salvage or subrogation rights. In estimating the losses on defaults, Ambac Assurance makes its assessment based on the full term of the insured obligation. All or part of the case basis reserve is allocated from any ACR available for such insured obligation. Ambac Assurance's case basis reserves totaled $55.1 million at December 31, 1997. Ambac Assurance's reserve for losses and loss adjustment expenses consists of the ACR and Case Basis Reserves. The most recent three-year history of Ambac Assurance's loss reserves, and losses and loss adjustment expenses incurred and paid, is described in the table below: 15 RESERVE FOR LOSSES AND LOSS ADJUSTMENT EXPENSES (1)
YEARS ENDED DECEMBER 31, -------------------------------------------------------------------- 1997 1996 1995 ------------------ --------------------- --------------------- ($ In Thousands) Reserve for losses and loss adjustment expenses at January 1,.............................................. $ 60,613 $66,637 $66,112 Less: reinsurance recoverables.............................. 393 641 450 ------------------ --------------------- -------------------- Net reserve for losses and loss adjustment expenses at January 1,........................................... 60,220 65,996 65,662 Losses and loss adjustment expenses incurred................ 2,854 3,778 3,377 Losses and loss adjustment expenses paid.................... (2,474) (9,554) (3,043) Net balance for Connie Lee, at acquisition.................. 38,526 - - ------------------ --------------------- -------------------- Net reserve for losses and loss adjustment expenses at December 31,......................................... 99,126 60,220 65,996 Plus: reinsurance recoverables.............................. 4,219 393 641 ------------------ --------------------- -------------------- Reserve for losses and loss adjustment expenses at December 31,............................................... $103,345 $60,613 $66,637 ================== ===================== ====================
(1) All information is net of salvage. Management of Ambac Assurance believes that the reserves for losses and loss adjustment expenses are adequate to cover the ultimate net costs of claims, but the reserves are necessarily based on estimates and there can be no assurance that the ultimate liability will not exceed such estimates. See Notes 2 and 6 of Notes to Consolidated Financial Statements in the Company's 1997 Annual Report to Stockholders. COMPETITION The financial guarantee insurance business is highly competitive. Ambac Assurance's principal competitors in the market for municipal bond insurance are three other monoline insurance companies, Financial Guaranty Insurance Company ("FGIC"), MBIA and Financial Security Assurance Inc. ("FSA"). According to Ambac Assurance estimates based on industry sources, Ambac Assurance, FGIC, MBIA and FSA, in the aggregate, insured approximately 100% of all new issue municipal bonds insured during 1997, with MBIA insuring approximately 43% of such bonds, Ambac Assurance insuring approximately 24% of such bonds, FGIC insuring approximately 19% of such bonds and FSA insuring approximately 14% of such bonds. In the structured finance and asset-backed markets, Ambac Assurance's principal competitors are FGIC, MBIA and FSA. The principal competitive factors among financial guarantee insurers are (i) premium rates, (ii) conditions precedent to the issuance of a policy related to the structure and security features of a proposed bond issue, (iii) the financial strength of an insurer and (iv) the quality of service provided to issuers, investors and other clients of the issuer. With respect to each of these competitive factors, Ambac Assurance believes it is on equal footing with each of its principal competitors in the municipal bond, structured finance and asset-backed markets. Financial guarantee insurance also competes domestically and internationally with other forms of credit enhancement, including letters of credit and guarantees (for example, mortgage guarantees where pools of mortgages secure debt service payments) provided by banks and other financial institutions, some of which are governmental agencies. Letters of credit are most often issued for periods of less than 10 years, although there is no legal restriction on the issuance of letters of credit having longer terms. Thus, financial institutions and banks issuing letters of credit compete directly with Ambac Assurance to guarantee short-term notes and bonds with a maturity of less than 10 years. To the extent 16 that banks providing credit enhancement may begin to issue letters of credit with commitments of longer than 10 years, the competitive position of financial guarantee insurers, such as Ambac Assurance, could be adversely affected. Letters of credit also are frequently used to assure the liquidity of a short- term put option for a long-term bond issue. This assurance of liquidity effectively confers on such issues, for the short-term, the credit standing of the financial institution providing the facility, thereby competing with Ambac Assurance and other financial guarantee insurers in providing interest cost savings on such issues. Financial guarantee insurance and other forms of credit enhancement also compete in nearly all instances with the issuer's alternative of foregoing credit enhancement and paying a higher interest rate. If the interest savings from insurance or another form of credit enhancement do not exceed the cost of such credit enhancement, the issuer will generally choose to issue bonds without enhancement. Multiline insurance companies are not significant direct participants in the financial guarantee industry. Also, under a law enacted in 1989 in New York, multiline insurers are prohibited from writing financial guarantee insurance in New York State, except during a transitional period which, subject to certain specific conditions, expired in May 1997. Although a significant minimum amount of capital is required of a financial guarantee insurer by the rating agencies in order to obtain triple-A claims-paying ability ratings (at least $100 million), there can be no assurance that major multiline insurers or other financial institutions will not participate in financial guarantee insurance in the future, either directly or through subsidiaries. Under the New York law, a financial guarantee insurance company must have at least $75 million of paid-in capital and surplus and maintain thereafter at least $65 million of policyholders' surplus. A similar law in California imposes a $100 million minimum capital and surplus requirement, with a maintenance requirement thereafter of $75 million. REINSURANCE State insurance laws and regulations (as well as the rating agencies) impose minimum capital requirements on financial guarantee insurance companies, limiting the aggregate amount of insurance which may be written and the maximum size of any single risk exposure which may be assumed. Such companies can use reinsurance to diversify risk, increase underwriting capacity, reduce additional capital needs, stabilize shareholder returns and strengthen financial ratios. See "Insurance Regulatory Matters" below. During 1996 and in prior years, Ambac Assurance entered into pro rata reinsurance agreements with certain reinsurers which provided for a combination reinsurance program. Each agreement was divided into a quota share program and a surplus share program. Under each agreement, which was renewed on an annual basis, the reinsurer shared the interests and liabilities of Ambac Assurance under all municipal bond business (as defined below) written during the term of the agreement. Municipal bond business was defined as all new issue and secondary market insurance policies written by Ambac Assurance which were classified by Ambac Assurance as municipal bond insurance and which insured bonds satisfying the definition of municipal bonds contained in the applicable laws and regulations in the States of Wisconsin and New York. Any policy written during the term of the agreement was reinsured for the full term of the policy, even if the reinsurer did not renew its participation in Ambac Assurance's reinsurance program for subsequent years. Under the 1996 quota share program, Ambac Assurance ceded a percentage of each insured policy. The surplus share program provided a surplus layer of reinsurance in 17 excess of the quota share percentage which increased Ambac Assurance's insurance capacity. A ceding commission was withheld to defray Ambac Assurance's underwriting expenses under both the quota share program and surplus share program. Ambac Assurance has also entered into facultative reinsurance agreements with certain of the same reinsurers that are party to the agreements described above, which allow Ambac Assurance to reduce its large risks, to manage its portfolio of insurance by bond type and geographic distribution, and to provide additional capacity for frequent bond issuers. Under these agreements, portions of Ambac Assurance's interests and liabilities are ceded on an issue-by-issue basis. A ceding commission is withheld to defray Ambac Assurance's underwriting expenses. In addition, Ambac Assurance and MBIA, in conjunction with the MBIA/AMBAC joint venture described above, have entered into facultative reinsurance agreements whereupon each company may reinsure the other on risks insured in conjunction with the joint venture. Effective January 1, 1997, Ambac Assurance discontinued the quota share and surplus share reinsurance programs as described above, and has only used facultative reinsurance agreements to reduce its risks and manage its insurance portfolio. As of December 31, 1997, Ambac Assurance had retained approximately 84% of its gross insurance in force of $321.1 billion and had ceded approximately 16% to its treaty and facultative reinsurers. See Note 5 of Notes to Consolidated Financial Statements in the Company's 1997 Annual Report to Stockholders. As a primary insurer, Ambac Assurance is required to honor its obligations to its policyholders whether or not its reinsurers perform their obligations under the various reinsurance agreements with Ambac Assurance. To minimize its exposure to significant losses from reinsurer insolvencies, Ambac Assurance evaluates the financial condition of its reinsurers, prepares annual written reviews of such reinsurers and monitors for concentrations of credit risk. Ambac Assurance's current reinsurers are Aachener Ruckversicherungs, AXA Re Finance, Capital Markets Assurance Corporation (acquired by MBIA in 1998), Capital Reinsurance Company, Enhance Reinsurance Company, MBIA and Royal Reinsurance Company, Ltd.. The majority of these reinsurers have long-standing relationships with Ambac Assurance. In addition, Aachener Ruckversicherungs, AXA Re Finance and Royal Reinsurance Company, Ltd., are multiline insurance companies which are diversified by the lines of insurance they underwrite. RATING AGENCIES Moody's, S&P, Fitch and Nippon periodically review the business and financial condition of Ambac Assurance and other companies providing financial guarantee insurance. These rating agencies' reviews focus on the insurer's underwriting policies and procedures and the quality of the obligations insured. The rating agencies frequently perform assessments of the credits insured by Ambac Assurance to confirm that Ambac Assurance continues to meet the capital allocation criteria considered necessary by the particular rating agency to maintain Ambac Assurance's triple-A claims-paying ability ratings. A rating by Moody's, S&P, Fitch or Nippon, however, is not a "market rating" or a recommendation to buy, hold or sell any security. See "Underwriting Guidelines, Policies and Procedures" above. Ambac Assurance's ability to attract new business or to compete with other triple-A rated financial guarantors, and its results of operations and financial condition, would be materially adversely affected by any reduction in its ratings. 18 INSURANCE REGULATORY MATTERS GENERAL LAW Ambac Assurance is licensed to do business as an insurance company in all 50 states, the District of Columbia, the Commonwealth of Puerto Rico and Guam. It is subject to the insurance laws and regulations of the State of Wisconsin (the "Wisconsin Insurance Laws"), its state of incorporation, and the insurance laws and regulations of other states in which it is licensed to transact business. These laws and regulations, as well as the level of supervisory authority that may be exercised by the various state insurance departments, vary by jurisdiction, but generally require insurance companies to maintain minimum standards of business conduct and solvency, meet certain financial tests, file certain reports with regulatory authorities, including information concerning their capital structure, ownership and financial condition, and require prior approval of certain changes in control of domestic insurance companies and their direct and indirect parents and the payment of certain dividends and distributions. In addition, these laws and regulations require approval of certain inter-corporate transfers of assets and certain transactions between insurance companies and their direct and indirect parents and affiliates, and generally require that all such transactions have terms no less favorable than terms that would result from transactions between parties negotiating at arm's length. Ambac Assurance is required to file quarterly and annual statutory financial statements in each jurisdiction in which it is licensed, and is subject to single and aggregate risk limits and other statutory restrictions concerning the types and quality of investments and the filing and use of policy forms and premium rates. Additionally, Ambac Assurance's accounts and operations are subject to periodic examination by the Office of the Commissioner of Insurance of the State of Wisconsin (the "Wisconsin Commissioner") (the last such examination having been conducted in 1997 for the period ended December 31, 1996) and other state insurance regulatory authorities. See Note 9 of Notes to Consolidated Financial Statements in the Company's 1997 Annual Report to Stockholders. The Company believes that Ambac Assurance is in material compliance with all applicable insurance laws and regulations. INSURANCE HOLDING COMPANY LAWS Under the Wisconsin insurance holding company laws, any acquisition of control of the Company and thereby indirect control of Ambac Assurance requires the prior approval of the Wisconsin Commissioner. "Control" is defined as the direct or indirect power to direct or cause the direction of the management and policies of a person. Any purchaser of 10% or more of the outstanding voting stock of a corporation is presumed to have acquired control of that corporation and its subsidiaries unless the Wisconsin Commissioner, upon application, determines otherwise. For purposes of this 10% test, the Company believes that a holder of common stock having the right to cast 10% of the votes which may be cast by the holders of all shares of common stock of the Company would be deemed to have control of Ambac Assurance within the meaning of the Wisconsin Insurance Laws. As of December 31, 1997, no one had percentages of 10% or more of the outstanding common stock of the Company. The Wisconsin insurance holding company laws also require prior approval by the Wisconsin Commissioner of certain transactions between Ambac Assurance and companies affiliated with Ambac Assurance. 19 Wisconsin Dividend Restrictions Pursuant to the Wisconsin Insurance Laws, Ambac Assurance may declare dividends, subject to any restriction in its articles of incorporation, provided that, after giving effect to the distribution, it would not violate certain statutory equity, solvency, income and asset tests. Distributions to the shareholder (other than stock dividends) must be reported to the Wisconsin Commissioner. Extraordinary dividends must be reported prior to payment and are subject to disapproval by the Wisconsin Commissioner. An extraordinary dividend is defined as a dividend or distribution, the fair market value of which, together with all dividends from the preceding 12 months, exceeds the lesser of (a) 10% of policyholders' surplus as of the preceding December 31 or (b) the greater of (i) statutory net income for the calendar year preceding the date of the dividend or distribution, minus realized capital gains for that calendar year or (ii) the aggregate of statutory net income for the three calendar years preceding the date of the dividend or distribution, minus realized capital gains for those calendar years and minus dividends paid or credited and distributions made within the first two of the preceding three calendar years. During 1997, Ambac Assurance paid to the Company cash dividends on its common stock totaling $44.0 million. See Note 9 of Notes to Consolidated Financial Statements in the Company's 1997 Annual Report to Stockholders. NEW YORK FINANCIAL GUARANTEE INSURANCE LAW New York's comprehensive financial guarantee insurance law governs the conduct of business of all financial guarantee insurers licensed to do business in New York, including Ambac Assurance. This law requires a financial guarantee insurer to contribute to a contingency reserve an amount equal to 50% of premiums as they are earned on a statutory basis on policies written prior to July 1, 1989, and, with respect to policies written on and after July 1, 1989, it must make contributions over a period of 20 years for municipal bonds and 15 years for all other obligations until the contingency reserve for such insured obligations equals the greater of 50% of premiums written for the relevant category of insurance or a percentage of the principal guaranteed, varying from 0.55% to 2.50%, depending upon the type of obligation guaranteed. This reserve must be maintained for the periods specified above, except that withdrawals by the insurer may be permitted under specified circumstances in the event that actual loss experience exceeds certain thresholds or if the reserve accumulated is deemed excessive in relation to the insurer's outstanding insured obligations. Financial guarantee insurers are also required to maintain case basis loss and loss adjustment expense reserves and unearned premium reserves on bases established by the regulations. The New York financial guarantee insurance law establishes single risk limits applicable to all obligations issued by a single entity and backed by a single revenue source. Under the limit applicable to municipal bonds, the insured average annual debt service for a single risk, net of reinsurance and collateral, may not exceed 10% of the sum of the insurer's policyholders' surplus and contingency reserves. In addition, insured principal of municipal bonds attributable to any single risk, net of reinsurance and collateral, is limited to 75% of the insurer's policyholders' surplus and contingency reserves. Additional single risk limits, which generally are more restrictive than the municipal bond single risk limit, are also specified for several other categories of insured obligations, including structured finance obligations. 20 Aggregate risk limits are also established on the basis of aggregate net liability and policyholders' surplus requirements. "Aggregate net liability" is defined as outstanding principal and interest of guaranteed obligations insured, net of reinsurance and collateral. Under these limits, policyholders' surplus and contingency reserves must at least equal a percentage of aggregate net liability that is equal to the sum of various percentages of aggregate net liability for various categories of specified obligations. The percentage varies from 0.33% for municipal bonds to 4.00% for certain non-investment grade obligations. FINANCIAL GUARANTEE INSURANCE REGULATION IN OTHER STATES The Wisconsin Insurance Laws have regulations of municipal bond insurers similar in structure to those in effect in New York. Under the Wisconsin regulations, Ambac Assurance must establish a contingency reserve in an amount equal to 50% of net statutory earned premium on municipal bond insurance policies. This reserve must be maintained for 20 years. However, the regulations provide that compliance with contingency reserve provisions under statutes in other jurisdictions which result in greater contributions than under the Wisconsin regulations is deemed to constitute compliance with the Wisconsin regulations. The Wisconsin regulations also include certain single and aggregate risk limitations. The average annual debt service for any single issue of municipal bonds may not exceed 10% of Ambac Assurance's policyholders' surplus. In addition, Ambac Assurance's cumulative net liability, defined as one-third of one percent of the insured unpaid principal and interest covered by current municipal bond insurance policies, may not exceed its qualified statutory capital, which is defined as the sum of its capital and surplus and contingency reserve. California has a financial guarantee insurance law similar in structure and effect to the New York statute. None of the risk limits established in California's legislation with respect to business transacted by Ambac Assurance are more stringent in any material respect than the corresponding provisions in the New York financial guarantee insurance statute. California law requires a financial guarantee insurer to contribute to a contingency reserve an amount equal to 50% of premiums as they are earned on a statutory basis on policies written prior to July 1, 1989, and, with respect to policies written on and after July 1, 1989, it must make contributions over a period of 20 years for municipal bonds and 15 years for all other obligations until the contingency reserve for such insured obligations equals a percentage of principal outstanding, varying from 0.80% to 3.00%, depending upon the type of obligation guaranteed. This reserve must be maintained for the periods specified above, except that withdrawals by the insurer may be permitted under specified circumstances in the event that actual loss experience exceeds certain thresholds or if the reserve accumulated is deemed excessive in relation to the insurer's outstanding insured obligations. Ambac Assurance's reported contingency reserve is equal to the greater of the required reserve as calculated under New York and California law. In addition to the laws and regulations of New York, Wisconsin and California, Ambac Assurance is subject to laws and regulations of other states concerning the transaction of financial guarantee insurance, none of which is more stringent in any material respect than the New York financial guarantee insurance statute. Financial Management Services ----------------------------- The Company's Financial Management Services Division provides investment agreements, interest rate swaps, investment advisory and fund administration services, and 21 electronic commerce and information management solutions, principally to states, municipalities and their authorities, school districts, and hospitals and health organizations. Financial management services revenues are derived from (i) net investment income, (ii) net swap trading revenues, (iii) fund management and advisory revenues, and (iv) net realized gains and losses. Excluding transactions with affiliates, total revenues were $34.6 million, $22.4 million and $13.0 million in 1997, 1996 and 1995, respectively. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 18 of Notes to Consolidated Financial Statements in the Company's 1997 Annual Report to Stockholders. The principal competitive factors among providers of investment agreements are (i) contract rates, (ii) conditions precedent to the issuance of a policy related to the structure and security features of a proposed investment contract, (iii) the financial strength of the financial services provider, and (iv) the quality of service provided to issuers, investors and other clients of the issuer. The Company believes that the IA Business competes favorably with respect to each of these factors. The principal competitive factors among providers of interest rate swap contracts are (i) pricing of contracts, (ii) the financial strength of the financial services provider, (iii) the ability to structure a complete financial package, and (iv) the quality of service provided to issuers, investors and other clients of the issuer. The Company believes that AFS competes favorably with respect to each of these competitive factors. The principal competitive factors among providers of investment advisory and fund administration services are (i) pricing of services, (ii) investment returns, (iii) the ability to provide services tailored to customers needs, and (iv) the quality of service provided to customers. The Company believes that Cadre competes favorably with respect to each of these competitive factors. INVESTMENT AGREEMENT BUSINESS The principal purpose of the IA Business is providing investment agreements and investment repurchase agreements primarily to states, municipalities and their authorities. Investment agreements are used by municipal bond issuers to invest bond proceeds until such proceeds can be used for their intended purpose, such as financing construction. The investment agreement provides for the guaranteed return of principal invested, as well as the payment of interest thereon at a guaranteed rate and is rated triple-A by virtue of Ambac Assurance's insurance policy which guarantees the IA Business' performance. The IA Business manages its balance sheet to protect against a number of risks inherent in its business including liquidity, market (principally interest rate) and credit risk. The IA Business' asset-liability guidelines stipulate that the effective duration of the invested assets, including hedges, must be matched to the effective duration of the investment agreement liabilities. The IA Business maintains expected cash flow matching of invested assets (including hedges) to funded liabilities in order to minimize market and liquidity risk. A source of liquidity risk is the ability of some counterparties to withdraw moneys on dates other than those specified in the draw down schedule. Liquidity risk is somewhat mitigated by provisions in certain of the municipal investment contracts that limit an issuer's ability to draw on the funds and by risk management procedures that require the 22 regular reevaluation and reprojection of draw down schedules. Investments are restricted to fixed income securities with a minimum average credit quality of Aa/AA. Based upon management's projections, the IA Business maintains funds invested in cash and cash equivalents to meet short term liquidity needs. The IA Business uses derivative rate contracts in the normal course of business for hedging purposes as part of its overall interest rate risk management. Several of its derivative contracts have been entered into with its affiliate, AFS. Derivative contracts used by the IA Business include financial instruments with off-balance sheet risk such as interest rate futures contracts, interest rate swap agreements and purchased interest rate option contracts. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the financial statements. For further discussion, see Notes 2 and 13 of Notes to Consolidated Financial Statements in the Company's 1997 Annual Report to Stockholders. Interest rate futures contracts are commitments to either purchase or sell designated financial instruments at a future date for a specified price and are settled in cash. Initial margin requirements are met in cash or other financial instruments, and changes in the contract values are settled daily. Futures contracts have little credit risk since futures exchanges are the counterparties. Interest rate swap contracts are agreements where the IA Business agrees with other parties to exchange, at specified intervals, the difference between fixed-rate and floating-rate interest amounts or the difference between different interest rate indices calculated by reference to an agreed upon notional amount. The IA Business is exposed to credit risk in the event counterparties fail to perform according to the terms of the contractual commitments. The IA Business deals only with counterparties of high credit quality and as such, does not expect any counterparties to fail to meet their obligations. Credit risk is also likely to be a factor on longer term investment agreements where credit deterioration or the default of an issuer would increase the likelihood of early withdrawal of funds. The IA Business and Ambac Assurance have various procedures and controls in place to monitor the credit risk of these agreements, including the initial credit approval process and the continuous monitoring of credit exposure. The following table sets forth the net payments due under the IA Business' investment agreements in each of the next five years ending December 31, and the period thereafter, based on expected call dates: OBLIGATIONS UNDER INVESTMENT AGREEMENTS
Principal Amount (1) - -------------------------------------------------------------------------------------------------------------------------------- ($ In Thousands) 1998............................................................................................... $1,463,194 1999............................................................................................... 1,120,315 2000............................................................................................... 410,454 2001............................................................................................... 202,237 2002............................................................................................... 33,677 All later years.................................................................................... 587,895 ----------------------------- $3,817,772 =============================
(1) As of December 31, 1997, the interest rates on these agreements ranged from 4.23% to 8.14%. 23 AMBAC FINANCIAL SERVICES, L.P. AFS provides interest rate swaps primarily to states, municipalities and their authorities, and other entities in connection with their financings. In addition, AFS also provides interest rate swaps to the IA Business, an affiliate. AFS commenced operations in September 1994 and manages its business with the goal of being market neutral to changes in overall interest rates, while retaining "basis risk," the relationship between changes in floating rate tax-exempt and floating rate taxable interest rates. The interest rate swaps provided by AFS are insured by Ambac Assurance through policies which guarantee the obligations of AFS and its counterparties. AFS is a limited partnership. Ambac Assurance, the sole limited partner, owns a limited partnership interest representing 90% of the total partnership interests of AFS. Ambac Financial Services Holdings, Inc. ("AFS Holdings"), a wholly-owned subsidiary of the Company, the sole general partner, owns a general partnership interest representing 10% of the total partnership interest in AFS. Interest rate swaps are agreements to exchange with a counterparty, a stream of periodic payments calculated by reference to agreed upon interest rates, indices and notional amounts. In the ordinary course of business, AFS manages a variety of risks principally (i) credit, (ii) market, (iii) liquidity, (iv) operational, and (v) legal. These risks are identified, measured, and monitored through a variety of control mechanisms, which are in place at different levels throughout the organization. Below is a discussion of these risks: (i) Credit risk relates to the ability of counterparties to perform according to the terms of their contractual commitments. Various procedures and controls are in place to monitor the credit risk of interest rate swaps. These include the initial credit approval process, the establishment of credit limits, management approvals and a process that ensures the continuous monitoring of credit exposure. (ii) Market risk relates to the impact of price changes on future earnings. This risk is a consequence of AFS's market-making activities in the municipal interest rate swap market. The principal market risk is basis risk, the relationship between changes in floating rate tax-exempt and floating rate taxable interest rates. Since the third quarter of 1995, most interest rate swaps transacted contain provisions which are designed to protect AFS against certain forms of tax reform, thus mitigating its basis risk. An independent risk management group monitors trading risk limits and, together with senior management, is involved in the application of risk measurement methodologies. The estimation of potential losses arising from adverse changes in market relationships, known as "value-at-risk," is a key element in managing market risk. AFS has developed a value-at-risk methodology to estimate potential losses over a specified holding period and based on certain probabilistic assessments. AFS estimates value at risk utilizing historical short-term and long-term interest rate volatilities and the relationship between changes in tax-exempt and taxable interest rates calculated on a consistent daily basis. AFS's value- at-risk, calculated at a 99% confidence level, averaged approximately $1.6 million and $1.4 million in 1997 and 1996, respectively. AFS's value-at-risk ranged from a high of $2.6 million to a low of $0.9 million for 1997 and from a high of $2.6 million to a low of $1.1 million for 1996. Since no single measure can capture all dimensions of market risk, AFS supplements its value at risk methodology by performing daily analyses of parallel 24 and non-parallel shifts in yield curves and stress test scenarios which measure the potential impact of market conditions, however improbable, which might cause abnormal volatility swings or disruptions of market relationships. (iii) Liquidity risk relates to the possible inability to satisfy contractual obligations when due. This risk is present in swaps and in futures contracts used to hedge swaps. AFS manages liquidity risk by maintaining cash and cash equivalents, closely matching the dates swap payments are made and received, and limiting the amount of risk hedged by futures contracts. (iv) Operational risk relates to the potential for loss caused by a breakdown in information, communication, and settlement systems. AFS mitigates operational risk by maintaining a comprehensive system of internal controls. This includes the establishment of systems and procedures to monitor transactions and positions, documentation and confirmation of transactions, ensuring compliance with regulations. (v) Legal risk relates to the uncertainty of the enforceability, through legal or judicial processes, of the obligations of AFS's counterparties, including contractual provisions intended to reduce credit exposure by providing for the offsetting or netting of mutual obligations. AFS seeks to remove or minimize such uncertainties through continuous consultation with internal and external legal advisers, to analyze and understand the nature of legal risk, to improve documentation, and to strengthen transaction structure. For further discussion, see Notes 2 and 14 of Notes to Consolidated Financial Statements in the Company's 1997 Annual Report to Stockholders. CADRE FINANCIAL SERVICES, INC. AND CADRE SECURITIES, INC. Effective December 31, 1996, the Company completed its acquisition of certain assets, including the name, and the assumption of certain liabilities of Cadre Financial Services, Inc. ("Cadre"). Cadre is registered as an investment adviser with the Securities and Exchange Commission and with certain states that currently require such registration. As a registered adviser, Cadre is subject to regulation in certain aspects of its business, particularly with respect to advisory activities on behalf of investment companies. On June 19, 1997, Ambac Securities Inc., a wholly-owned subsidiary of the Company, completed its acquisition of certain assets, including the name, and the assumption of certain liabilities of Cadre Securities, Inc. ("Cadre Securities"). Cadre Securities is a distributor and marketing agent for various registered and unregistered money market funds and offers its clients U.S. government securities and money market instruments. Cadre Securities is registered as a broker-dealer with the Securities and Exchange Commission and with certain states that require such registration, and it is a member of the National Association of Securities Dealers, Inc. As a registered broker-dealer, Cadre Securities is subject to the net capital requirements of Rule 15c3-1 of the Securities Exchange Act of 1934, as amended, which is designed to measure the general financial condition and liquidity of a broker-dealer. In accordance with this rule, the ratio of aggregate indebtedness to net capital shall not exceed 8 to 1 for the first year of operations and 15 to 1 thereafter. At December 31, 1997, Cadre Securities had net capital of $160,790, which was $60,790 in excess of its required net capital of $100,000. The net capital ratio was 1.19 to 1. 25 Cadre provides administrative and investment advisory services to money market funds which were established to enable qualified participants, primarily school districts and municipalities, to pool available moneys for investment. At December 31, 1997, Cadre was providing investment administration services for approximately 3,000 clients with approximately $6.0 billion in assets. Marketing services are also provided through Cadre Securities to the participants of these and other registered funds. Included in the assets under administration at December 31, 1997, were approximately $2.6 billion of assets for which Cadre Securities provides marketing services. Also included in the assets under administration at December 31, 1997, were approximately $2.0 billion of assets for which Cadre provides direct investment advisory services. Other investment services are provided to fund participants including placing certificates of deposit with qualified financial institutions and purchasing commercial paper, bankers' acceptances and U.S. government securities through dealers. Fees from the money market funds for which Cadre and Cadre Securities performs services are based on percentages of the average daily net assets of such funds. Fees for placement of certificates of deposit and other fixed-rate investments on behalf of participants in funds are based on the value and time to maturity of the related investment. Fixed-rate investment fees are recorded upon placement of the instrument since, at that time, substantially all of Cadre Securities obligations have been fulfilled. INVESTMENTS AND INVESTMENT POLICY As of December 31, 1997, the consolidated investments of the Company had an aggregate fair value of $6.9 billion and an aggregate amortized cost of $6.7 billion. These investments are managed internally by officers of the Company and its subsidiaries, who are experienced investment managers. In the normal course of business, the Company uses derivative contracts for hedging purposes as part of its overall interest rate risk management. These derivative contracts include interest rate futures contracts, interest rate swap agreements and purchased interest rate option contracts. All investments, including derivative contracts, are effected in accordance with the general objectives and guidelines for investments established by each subsidiary's Board of Directors, including guidelines relating to credit quality, risk concentration and holding period. These guidelines are periodically reviewed and revised as appropriate. Pursuant to Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," the Company has designated all investments as "available-for-sale" and reports them at fair value. Unrealized gains and losses are excluded from earnings and reported as a separate component of stockholders' equity, net of tax. As of December 31, 1997, Ambac Assurance's investment portfolio had an aggregate fair value of $3.0 billion and an aggregate amortized cost of $2.8 billion. The investment policy established by the Board of Directors of Ambac Assurance for its investments is designed to achieve diversification of the portfolio and generally to preclude investments in obligations insured by Ambac Assurance. Ambac Assurance's current investment policy only permits investment in investment grade fixed-income securities, consistent with its goal to achieve the highest after-tax, long-term return. This policy takes into consideration Ambac Assurance's desire for both current income and long-term capital growth. Ambac Assurance is subject to limits on types and quality of investments imposed by the insurance laws and regulations of the States of Wisconsin and New York. In 26 compliance with these laws, Ambac Assurance's Board of Directors approves each specific investment transaction of Ambac Assurance. See "Insurance Regulatory Matters - General Law" above. As of December 31, 1997, the IA Business' investment portfolio had an aggregate fair value of $3.8 billion and an aggregate amortized cost of $3.8 billion. The investment policy established by the Board of Directors of the IA Business for its investments is designed to achieve the highest after-tax return on equity, subject to minimum average quality ratings. The IA Business also uses derivative contracts for hedging purposes as part of its overall interest rate risk management. For further discussion, see "Investment Agreement Business." The following tables set forth certain information concerning the investments of the Company: INVESTMENTS BY RATING (1) as of December 31, 1997
% OF INVESTMENT RATING PORTFOLIO - -------------------------------------------------------------------------------------------------------- ---------------------- AAA (2)................................................................................................. 70% AA...................................................................................................... 13 A....................................................................................................... 16 BBB..................................................................................................... 1 Not Rated............................................................................................... - ---------------------- 100% ======================
(1) Ratings represent S&P categories. (2) Includes U.S. Treasury and agency obligations, which comprised approximately 33% of the total investment portfolio. SUMMARY OF INVESTMENTS AS OF DECEMBER 31,
---------------------------------------------------------------------------------------------------- 1997 1996 1995 ---------------------------------------------------------------------------------------------------- WEIGHTED WEIGHTED WEIGHTED CARRYING VALUE AVERAGE YIELD CARRYING VALUE AVERAGE YIELD CARRYING VALUE AVERAGE YIELD INVESTMENT CATEGORY (1) (2) (1) (2) (1) (2) - ------------------------------------------------------------------------------------------------------------------------------ ($ In Thousands) Long-term investments: Taxable bonds................ $4,545,177 6.75% $3,116,373 6.69 $2,610,164 6.91% Tax-exempt bonds............. 2,228,667 6.20 1,971,658 6.21 1,654,740 6.17 ------------------ ---------------- Total long-term investments 6,773,844 6.55 5,088,031 6.52 4,264,904 6.59 Short-term investments (3).... 136,278 5.43 112,511 5.24 176,689 5.72 ------------------ ---------------- --------------- Total investments.......... $6,910,122 6.52% $5,200,542 6.46 $4,441,593 6.56% ================== ================ ===============
(1) Yields presented include assets held in the IA Business portfolio. Interest expense on related investment agreements was $186.7 million, $154.5 million and $127.6 million in 1997, 1996 and 1995, respectively. (2) Yields are stated on a pre-tax basis, based on average amortized cost. (3) Includes taxable and tax-exempt investments. 27 INVESTMENTS BY SECURITY TYPE AS OF DECEMBER 31,
---------------------------------------------------------------------------------------------------- 1997 1996 1995 ---------------------------------------------------------------------------------------------------- WEIGHTED WEIGHTED WEIGHTED CARRYING VALUE AVERAGE YIELD CARRYING VALUE AVERAGE YIELD CARRYING VALUE AVERAGE YIELD INVESTMENT CATEGORY (1) (2) (1) (2) (1) (2) -------------------------------------------------------------------------------------------------------------------------------- ($ In Thousands) Municipal obligations......... $2,298,996 6.20 % $1,982,911 6.21 % $1,659,903 6.17 % Corporate securities.......... 1,093,587 7.61 963,890 7.56 828,060 7.67 U.S. government obligations... 139,598 6.25 102,430 6.09 227,425 6.51 Mortgage- and asset-backed securities (includes U.S. Government Agency............ obligations) (3)............. 3,222,756 6.46 2,035,115 6.35 1,549,516 6.48 Other......................... 18,907 3.72 3,685 3.50 -- -- ------------------ --------------- ------------------- Total long-term investments 6,773,844 6.55 5,088,031 6.52 4,264,904 6.59 Short-term investments (4).... 136,278 5.43 112,511 5.24 176,689 5.72 ------------------ --------------- ------------------- Total investments.......... $6,910,122 6.52 % $5,200,542 6.46 % $4,441,593 6.56 % ================== =============== ===================
(1) Yields presented include assets held in the IA Business portfolio. Interest expense on related investment agreements was $186.7 million, $154.5 million and $127.6 million in 1997, 1996 and 1995, respectively. (2) Yields are stated on a pre-tax basis, based on average amortized cost. (3) The actual maturity dates of mortgage-backed securities are uncertain because the underlying mortgages may be paid prior to the stated maturity of such securities. This possibility of pre-payment creates the risk that the Company will be unable to replace such investments with securities of comparable yield. (4) Includes taxable and tax-exempt investments. DISTRIBUTION OF INVESTMENTS BY MATURITY AS OF DECEMBER 31, 1997
Amortized Estimated MATURITY COST FAIR VALUE - ---------------------------------------------------------------------------- ------------------- -------------------- ($ In Thousands) Due in one year or less (1)................................................. $ 171,955 $ 172,067 Due after one year through five years....................................... 309,796 316,696 Due after five years through ten years...................................... 433,363 452,362 Due after ten years......................................................... 2,546,552 2,746,241 -------------- ------------------ 3,461,666 3,687,366 Mortgage- and asset-backed securities (2)................................... 3,200,262 3,222,756 -------------- ------------------ Total investments........................................................... $6,661,928 $6,910,122 ============== ==================
(1) Includes long-term investments in the amount of $35.8 million maturing within one year. (2) The actual maturity dates of mortgage- and asset-backed securities are uncertain because the underlying mortgages may be paid prior to the stated maturity of such securities. This possibility of pre-payment creates the risk that the Company will be unable to replace such investments with securities of comparable yield. For further discussion, see Note 3 of Notes to Consolidated Financial Statements in the Company's 1997 Annual Report to Stockholders. 28 EMPLOYEES As of December 31, 1997, the Company and its subsidiaries had 340 employees. None of the employees is covered by collective bargaining agreements. The Company considers its employee relations to be satisfactory. ITEM 2. PROPERTIES. The principal executive offices of the Company are located at One State Street Plaza, New York, New York 10004. The telephone number is (212) 668-0340. Ambac Assurance maintains its principal executive offices at One State Street Plaza, New York, New York 10004, which consists of approximately 121,000 square feet of office space, under an agreement which expires on September 30, 2019. Ambac UK maintains offices in London, England. Cadre maintains its principal executive office at 905 Marconi Avenue, Ronkonkoma, New York 11779. The office building was acquired by the Company as part of the acquisition of Cadre. It consists of approximately 15,000 square feet of office space and storage. In addition, the Company owns certain interests in real estate acquired in connection with the defeasance of Ambac Assurance's policy obligations with respect to certain industrial revenue bonds. ITEM 3. LEGAL PROCEEDINGS. There are no material lawsuits pending, or to the knowledge of the Company threatened, to which the Company or any of its majority-owned subsidiaries is a party. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS. There were no matters submitted to a vote of security holders during the fourth quarter of 1997. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Information relating to the principal market on which the Company's Common Stock is tradable, the high and low sales prices per share for each full quarterly period within the two most recent fiscal years, and the frequency and amount of any cash dividends declared for the two most recent fiscal years is set forth on page 54 of the Company's 1997 Annual Report to Stockholders and such information is incorporated herein by reference. Information concerning restrictions on the payment of dividends is set forth in Item 1 above under the caption "Insurance Regulatory Matters - Wisconsin Dividend Restrictions." As of March 23, 1998, there were 94 stockholders of record of the Company's Common Stock, which is listed on the New York Stock Exchange. 29 ITEM 6. SELECTED FINANCIAL DATA. Selected financial data for the Company and its subsidiaries for each of the last five fiscal years is set forth under the caption "Financial Highlights" on page 1 of the Company's 1997 Annual Report to Stockholders. Such information is incorporated herein by reference and should be read in conjunction with the Consolidated Financial Statements and the Notes thereto contained on pages 31 to 51 of such Annual Report. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Management's Discussion and Analysis of Financial Condition and Results of Operations is set forth under the same caption on pages 23 through 29 of the Company's 1997 Annual Report to Stockholders. Such information is incorporated herein by reference and should be read in conjunction with the Consolidated Financial Statements and the Notes thereto contained on pages 31 to 51 of such Annual Report. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Quantitative and Qualitative Disclosures About Market Risk is set forth under the caption Risk Management on pages 28 and 29 of the Company's 1997 Annual Report to Stockholders. Such information is incorporated herein by reference and should be read in conjunction with the Consolidated Financial Statements and the Notes thereto contained on pages 31 to 51 of such Annual Report. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The 1997 Consolidated Financial Statements, together with the Notes thereto and the Independent Auditors' Report thereon, are set forth on pages 30 through 51 of the Company's 1997 Annual Report to Stockholders. Such information is incorporated herein by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information relating to the Company's directors and executive officers is set forth on pages 7, 11 to 12, and 27 to 28 of the Company's 1998 Proxy Statement and such information is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION. Information relating to compensation of the Company's directors and executive officers is set forth on pages 9 and 10 and on pages 13 to 21 of the Company's 1998 Proxy Statement and such information is incorporated herein by reference. 30 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information relating to security ownership of certain beneficial owners and management is set forth on pages 5 to 7 of the Company's 1998 Proxy Statement and such information is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. None. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A) DOCUMENTS FILED AS A PART OF THIS REPORT: 1. Financial Statements -------------------- The following consolidated financial statements included in the 1997 Annual Report to Stockholders are incorporated herein by reference under Part II, Item 8:
PAGE NUMBER IN ANNUAL REPORT -------------------- Independent Auditors' Report.................................. 30 Consolidated Balance Sheets as of December 31, 1997 and 1996.. 31 Consolidated Statements of Operations for each of the years ended December 31, 1997, 1996 and 1995........................ 32 Consolidated Statements of Stockholders' Equity for each of the years ended December 31, 1997, 1996 and 1995.............. 33 Consolidated Statements of Cash Flows for each of the years ended December 31, 1997, 1996 and 1995........................ 34 Notes to Consolidated Financial Statements.................... 35-51
2. Financial Statement Schedules ------------------------------------------------------------------------------------------------------------------ The financial statement schedules filed herein, which are the only schedules required to be filed, are as follows:
Independent Auditors' Report (Page S-1) Schedule I -- Summary of Investments Other Than (Page S-2) Investments in Related Parties Schedule II -- Condensed Financial Information of (Pages S-3 Registrant (Parent Company Only) to S-5) Schedule IV -- Reinsurance (Page S-6)
31 3. Exhibits -------- The following items are annexed as exhibits:
Exhibit Number Description ---------------- ----------- 3.01 Conformed Amended and Restated Certificate of Incorporation of the Company filed with the Secretary of State of the State of Delaware on July 11, 1997. (Filed as Exhibit 4.05 to the Company's Quarterly Report for the quarter ended September 30, 1997 and incorporated herein by reference.) 3.02 By-laws of the Company, as amended through January 28, 1998. 4.01 Definitive Engraved Stock Certificate representing shares of Common Stock. 4.02 Indenture, dated as of August 1, 1991, between the Company and The Chase Manhattan Bank (National Association), Trustee. (Filed as Exhibit 4.01 to the Company's Registration Statement on Form S-3 (Reg. No. 33-59290) and incorporated herein by reference.) 4.03 Rights Agreement, dated as of January 31, 1996, between Ambac Financial Group, Inc. and Citibank N.A., as Rights Agent, including all exhibits thereto. (Filed as Exhibit 1 to the Company's Registration Statement on Form 8-A dated February 27, 1996 and incorporated herein by reference.) 10.01 Second Amended and Restated Employment Agreement dated as of December 2, 1997, between the Company and Phillip B. Lassiter. 10.02 Ambac Financial Group, Inc. 1991 Stock Incentive Plan, as amended as of December 2, 1997 (Filed as Exhibit 10.02 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 and incorporated herein by reference.) 10.03* Ambac Financial Group, Inc. 1997 Equity Plan, amended as of October 28 1997. 10.04* Ambac Financial Group, Inc. 1991 Non-Employee Directors Stock Plan (Filed as Exhibit 10.09 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference.) 10.05* Ambac Financial Group, Inc. 1997 Non-Employee Directors Equity Plan. (Filed as Exhibit 10.23 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1997 and incorporated herein by reference.) 10.06* Ambac Financial Group, Inc. 1997 Executive Incentive Plan. (Filed as Exhibit 10.24 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1997 and incorporated herein by reference.)
* Management contract or compensatory plan, contract or arrangement required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K. --------- * 32
10.07* Ambac Financial Group, Inc. Deferred Compensation Plan for Outside Directors and Eligible Senior Officers, effective as of December 1, 1993 and amended as of December 30, 1994. (Filed as Exhibit 10.14 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1995 and incorporated herein by reference.) 10.08* Form of Amended and Restated Management Retention Agreement dated as of December 2, 1997. 10.09* The Ambac Financial Group, Inc. Non-Qualified Savings Incentive Plan (effective as of January 1, 1995). (Filed as Exhibit 10.16 to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 1995, and incorporated herein by reference.) 10.10* Amendment Number 1 to the Ambac Financial Group, Inc. Non-Qualified Savings Incentive Plan effective as of April 30, 1997. 10.11* Ambac Financial Group, Inc. Excess Benefits Pension Plan (Amended and Restated as of January 1, 1994) (As amended through October 25, 1995). (Filed as Exhibit 10.17 to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 1995, and incorporated herein by reference.) 10.12* Amendment Number 1 to the Ambac Financial Group, Inc. Excess Benefits Pension Plan effective as of April 30, 1997. 10.13* Employment letter between David L. Boyle and the Company. (Filed as Exhibit 10.19 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997, and incorporated herein by reference.) 10.14* Agreement and General Release between W. Dayle Nattress, the Company and AMBAC Indemnity Corporation dated April 10, 1997. (Filed as Exhibit 10.20 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997, and incorporated herein by reference.) 10.15 Supplemental Pension Agreement between the Company and Philip B. Lassiter dated April 30, 1997. (Filed as Exhibit 10.24 in the Company's Quarterly Report Form 10-Q for the quarter ended June 30, 1997, and incorporated herein by reference.) 10.16 Supplemental Pension Agreement between the Company and David L. Boyle dated April 30, 1997. (Filed as Exhibit 10.25 in the Company's Quarterly Report Form 10-Q for the quarter ended June 30, 1997, and incorporated herein by reference.) 10.17 Ambac Financial Group, Inc. Supplemental Pension Plan (Amended and Restated as of January 1, 1995) (As amended through October 25, 1995). (Filed as Exhibit 10.18 to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 1995, and incorporated herein by reference.) 10.18 Amendment Number 1 to the Ambac Financial Group, Inc. Supplemental Pension Plan effective as of April 30, 1997.
* Management contract or compensatory plan, contract or arrangement required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K. --------- 33 10.19 Lease Agreement, dated as of January 1, 1992 between South Ferry Building Company and Ambac Assurance Corporation. (Filed as Exhibit 10.36 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992 and incorporated herein by reference.) 10.20 Amendment to Lease Agreement dated August 1, 1997 between South Ferry Building Company and Ambac Assurance Corporation. 10.21 Tax Settlement Agreement, dated as of March 30, 1993, among Citicorp, Citibank, N.A., Citicorp Financial Guaranty Holdings, Inc., Ambac Financial Group, Inc., Ambac Assurance Corporation, American Municipal Bond Holding Company and Health Care Investment Analysts, Inc. (Filed as Exhibit 10.02 to the Company's Registration Statement on Form S-3 (Registration No. 33-59290) and incorporated herein by reference.) 10.22 Second Amended and Restated U.S. $100,000,000 Credit Agreement, dated as of July 21, 1995 (the "BNS Credit Agreement") among the Company and Ambac Assurance Corporation as the Borrowers, Certain Commercial Lending Institutions as the Lenders, The Bank of Nova Scotia, acting through its New York Agency, and Citibank, N.A., as the Co-Agents for the Lenders, and The Bank of Nova Scotia, acting through its New York Agency, as the Administrative Agent. (Filed as Exhibit 10.15 to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 1995 and incorporated herein by reference.) 10.23 Credit Agreement, dated December 2, 1993 (the "Deutsche Bank Credit Agreement") between Ambac Assurance Corporation and Deutsche Bank AG (New York Branch), Individually and as Agent. (Filed as Exhibit 10.09 to the Company's Report on Form 10-K for the year ended December 31, 1993 and incorporated herein by reference.) 10.24 Amendment No. 1 to the Deutsche Bank Credit Agreement, dated as of December 2, 1994 between Ambac Assurance Corporation and Deutsche Bank AG, New York Branch, Individually and as Agent. (Filed as Exhibit 10.11 to the Company's Report on Form 10-K for the year ended December 31, 1994, and incorporated herein by reference.) 10.25 Amendment No. 2 to the Deutsche Bank Credit Agreement, dated as of December 1, 1995, between Ambac Assurance Corporation and Deutsche Bank AG, New York Branch, Individually and as Agent. (Filed as Exhibit 10.15 to the Company's Report on Form 10-K for the year ended December 31, 1995, and incorporated herein by reference.) 10.26 Amendment No. 3 to the Deutsche Bank Credit Agreement, dated as of December 2, 1996, between Ambac Assurance Corporation and Deutsche Bank AG, New York Branch, Individually and as Agent. (Filed as Exhibit 10.16 to the Company's Report on Form 10-K for the year ended December 31, 1996, and incorporated herein by reference.)
34
10.27 Amendment No. 4 to the Deutsche Bank Credit Agreement, dated as of February 14, 1997, between Ambac Assurance Corporation and Deutsche Bank AG, New York Branch, Individually and as Agent. (Filed as Exhibit 10.17 to the Company's Report on Form 10-K for the year ended December 31, 1996, and incorporated herein by reference.) 10.28 Amendment No. 5 to the Deutsche Bank Credit Agreement, dated as of December 2, 1997, between Ambac Assurance Corporation and Deutsche Bank AG, New York Branch, Individually and as Agent. 10.29 Letter Agreement, dated as of August 1, 1996 between Gregory & Hoenemeyer, Inc. and AMBAC Capital Corporation. (Filed as Exhibit 10.17 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996 and incorporated herein by reference.) 12.01 Statement re computation of ratios. 13.01 Annual Report to Stockholders for the fiscal year ended December 31, 1997. (Furnished for the information of the Securities and Exchange Commission and not deemed "filed" as part of this Form 10-K except for those portions which are expressly incorporated by reference.) 21.01 List of Subsidiaries of Ambac Financial Group, Inc. 24.01 Power of Attorney from Phillip B. Lassiter. 24.02 Power of Attorney from Frank J. Bivona. 24.03 Power of Attorney from Michael A. Callen. 24.04 Power of Attorney from Renso L. Caporali. 24.05 Power of Attorney from Richard Dulude. 24.06 Power of Attorney from W. Grant Gregory. 24.07 Power of Attorney from C. Roderick O'Neil. 27.00 Financial Data Schedule. 99.01 Ambac Assurance Corporation and Subsidiaries Consolidated Financial Statements (with independent auditors' report thereon) as of December 31, 1997 and 1996.
(B) REPORTS ON FORM 8-K: There were no reports on Form 8-K filed during the fourth quarter of 1997. -------- However, on February 6, 1998, the Company filed a Current Report on Form 8-K -------- with its January 29, 1998 press release containing unaudited financial information and accompanying discussion for the three months ended December 31, 1997 and the year ended December 31, 1997. On March 27, 1998, the Company filed a Current Report on Form 8-K containing the consolidated financial statements (with independent auditors' report thereon) of Ambac Assurance Corporation and Subsidiaries as of December 31, 1997 and 1996. On March 27, 1998, the Company filed a Current Report on Form 8-K containing the consolidated financial statements (with independent auditors' report thereon) of Ambac Assurance Corporation and Subsidiaries as of December 31, 1997 and 1996. 35 SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. AMBAC FINANCIAL GROUP, INC. (Registrant) Dated: March 31, 1998 By: /s/ Frank J. Bivona Name: Frank J. Bivona Title: Executive Vice President, Chief Financial Officer and Treasurer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date - ------------------------------------------ ------------------------------------ ----------------------- Phillip B. Lassiter* Chairman, President March 31, 1998 - ------------------------------------------ and Chief Executive Officer Phillip B. Lassiter and Director (Principal Executive Officer) /s/ Frank J. Bivona Executive Vice President, March 31, 1998 - ------------------------------------------ Chief Financial Officer and Frank J. Bivona Treasurer (Principal Financial and Accounting Officer) Michael A. Callen* Director March 31, 1998 - ------------------------------------------ Michael A. Callen Renso L. Caporali* Director March 31, 1998 - ------------------------------------------ Renso L. Caporali Richard Dulude* Director March 31, 1998 - ------------------------------------------ Richard Dulude W. Grant Gregory* Director March 31, 1998 - ------------------------------------------ W. Grant Gregory C. Roderick O'Neil* Director March 31, 1998 - ------------------------------------------ C. Roderick O'Neil
- --------------------- * Frank J. Bivona, by signing his name hereto, does hereby sign this Annual Report on Form 10-K on behalf of each of the directors and officers of the Registrant after whose typed names asterisks appear pursuant to powers of attorney duly executed by such directors and officers and filed with the Securities and Exchange Commission as exhibits to this report. By: /s/ Frank J. Bivona --------------------------------- Frank J. Bivona Attorney-in-fact 36 APPENDIX A TYPES AND RATINGS OF BONDS TYPES OF BONDS INSURED - MUNICIPAL General Obligation Bonds. These bonds are supported by the general ------------------------ obligation of the issuer to pay from available funds and by a pledge of the issuer to levy property taxes sufficient in amount to provide for the full payment of the bonds. Utility Revenue Bonds. This category includes primarily revenue bonds --------------------- supported by a pledge of revenues from municipal utility systems that supply basic services to the community. In most cases the utility systems are subject to little competition, if any. These issuers typically have control over their utility rates and are required by their bond indentures to raise rates as necessary to meet certain debt service coverage requirements. This category also includes bonds secured by revenues of major power generation or regional water or sewer facilities which serve many local utilities. Tax-Backed Revenue Bonds. This category includes a wide range of issues ------------------------ secured by various municipal taxes (including sales and excise taxes), assessments and fees. Bond proceeds are typically used for local municipal purposes such as the construction of roads and municipal buildings. Health Care Revenue Bonds. This category includes both long-term issues ------------------------- for capital construction of hospitals and medium-term pool issues for hospital equipment purchase purposes. Transportation Revenue Bonds. This category includes a range of revenue ---------------------------- bonds, including revenue bonds for airports, toll roads, bridges, tunnels and parking facilities. Investor-Owned Utilities. This category includes bonds that are sold by ------------------------ electric, gas and water utilities, generally secured by a first mortgage lien on the utility's assets and are payable from the utility revenues derived from the sale of an essential service. Higher Education Bonds. This category includes both public and private ---------------------- college and university bonds issued to finance general university improvements or specific projects the payment of which is secured by the general credit of the institution, tuition or unrestricted revenues, student fees or auxiliary enterprise fees. Student Loan Bonds. These bonds include issues to finance the origination ------------------ of student loans or the purchase of student loans from eligible lenders in the state and are often insured by state guarantee agencies and reinsured by the federal government through the Department of Education. Housing Revenue Bonds. This category includes both multi-family and --------------------- single-family housing bonds which exhibit multi-tiered security structures based on the underlying mortgages, reserve funds, and various combinations of features which might include FHA or private mortgage insurance, bank letters of credit, the general obligation of the issuing housing agency and, in some cases, a state's "moral obligation" (that is, not a legally binding commitment) to make up deficiencies. A-1 TYPES OF BONDS INSURED - STRUCTURED FINANCE AND ASSET-BACKED Asset-Backed Obligations. These obligations are typically issued in ------------------------ connection with transactions in which the securities being issued are secured by or payable from a specific pool of assets, such as residential mortgages and high quality corporate trade receivables and securities, having an ascertainable cash flow or market value and held by a special purpose issuing entity. While most asset-backed obligations are secured by or represent interest in pools of assets, some of these asset-backed obligations can be secured by one or a few assets. Home Equity Security. A financial instrument whose collateral and source -------------------- of repayment consist of a pool of individual home equity loans. Such loans may have a first or second lien position, or be unsecured. Mortgage Backed Security. A financial instrument whose collateral and ------------------------ source of repayment consist of a pool of individual residential first mortgage loans. Sovereign Obligation. The financial obligation, such as a bond or note, of -------------------- a national government. Special Revenue Bond. A bond whose sole source of repayment is the -------------------- revenues derived from a specific project, such as a toll road or a mass transit system, financed with such bonds. Such bonds typically have no recourse to any other entity, government or taxing authority. Subsovereign Obligation. The financial obligation, such as a bond or note, ----------------------- of the government of a political subdivision of a country, such as a state or department. TYPES OF PROGRAMS New issue insurance. The insurance of bonds at the time of issuance by the ------------------- issuer of the bonds. Unit investment trust insurance. The insurance of individual bonds ------------------------------- deposited into a unit investment trust while such bonds remain in the unit investment trust, unless an additional premium is paid to extend the insurance coverage to the stated maturity of the bonds. Secondary market insurance. The insurance of individual bonds outstanding -------------------------- in the secondary market. Mutual fund insurance. The insurance of individual bonds in insured mutual --------------------- funds. Insurance policies on individual bonds in insured mutual funds are effective only as long as the individual bonds remain in the fund. Debt service reserve fund insurance. Insurance, by means of a debt service ----------------------------------- reserve fund surety policy, designed to satisfy debt service reserve fund requirements of municipal bond issuers. The surety policy insures the availability of an amount not to exceed the debt service reserve fund requirement for the issues, which in most cases is the lesser of (a) one year's maximum principal and interest payments and (b) approximately 10% of the original principal amount of a bond issue. Structured finance insurance. The insurance of various types of asset- ---------------------------- backed and mortgage-backed financings. A-2 RATINGS OF BONDS The following descriptions of credit ratings applicable to bonds are taken from more extensive explanations provided by Standard & Poor's Ratings Group, Moody's Investors Service, Inc., Fitch IBCA, Inc., L.P. and Nippon Investors Service, Inc. All bonds given a rating of BBB or Baa or better are considered by S&P, Moody's, Fitch, and Nippon to be investment grade. STANDARD & POOR'S RATINGS GROUP DEBT RATINGS AAA: Debt rated "AAA" has the highest rating assigned by Standard & Poor's. Capacity to pay interest and repay principal is extremely strong. AA: Debt rated "AA" has a very strong capacity to pay interest and repay principal and differs from the higher rated issues only in a small degree. A: Debt rated "A" has a strong capacity to pay interest and repay principal although it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than debt in higher rated categories. BBB: Debt rated "BBB" is regarded as having an adequate capacity to pay interest and repay principal. Whereas it normally exhibits adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal for debt in this category than in higher rated categories. BB, B, CCC, CC: Debt rated "BB", "B", "CCC" and "CC" is regarded, on balance, as predominantly speculative with respect to capacity to pay interest and repay principal in accordance with the terms of the obligation. "BB" indicates the lowest degree of speculation and "CC" the highest degree of speculation. While such debt will likely have some quality and protective characteristics, these are outweighed by large uncertainties or major risk exposures to adverse conditions. Plus (+) or Minus (-): The ratings from "AA" to "CCC" may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories. MOODY'S INVESTORS SERVICE, INC. DEBT RATINGS Aaa: Bonds which are rated "Aaa" are judged to be of the best quality. They carry the smallest degree of investment risk and are generally referred to as "gilt edge." Interest payments are protected by a large or by an exceptionally stable margin and principal is secure. While the various protective elements are likely to change, such changes as can be anticipated are most unlikely to impair the fundamentally strong position of such issues. Aa: Bonds which are rated "Aa" are judged to be of high quality by all standards. Together with the "Aaa" group they comprise what are generally known as high grade bonds. They are rated lower than the best bonds because margins of protection may not be as large as in Aaa securities or fluctuation in protective elements may be of greater amplitude or there A-3 may be other elements present which make the long-term risk appear somewhat larger than in Aaa securities. A: Bonds which are rated "A" possess many favorable investment attributes and are to be considered as upper medium grade obligations. Factors giving security to principal and interest are considered adequate, but elements may be present which suggest a susceptibility to impairment sometime in the future. Baa: Bonds which are rated "Baa" are considered to be medium grade obligations: that is, they are neither highly protected nor poorly secured. Interest payments and principal security appear adequate for the present but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Such bonds lack outstanding investment characteristics and in fact have speculative characteristics as well. Ba: Bonds which are rated "Ba" are judged to have speculative elements: their future cannot be considered as well assured. Often the protection of interest and principal payments may be very moderate, and thereby not well safeguarded during both good and bad times over the future. Uncertainty of position characterizes bonds in this class. FITCH IBCA, INC. DEBT RATINGS AAA: Debt rated "AAA" are bonds considered to be investment grade and of the highest credit quality. The obligor has an exceptionally strong ability to pay interest and repay principal, which is unlikely to be affected by reasonable foreseeable events. AA: Debt rated "AA" are bonds considered to be investment grade and of very high credit quality. The obligor's ability to pay interest and repay principal is very strong, although not quite as strong as bonds rated "AAA." A: Debt rated "A" are bonds considered to be investment grade and of high credit quality. The obligor's ability to pay interest and repay principal is considered to be strong, but may be more vulnerable to adverse changes in economic conditions and circumstances than bonds with higher ratings. BBB: Debt rated "BBB" are bonds considered to be investment grade and of satisfactory credit quality. The obligor's ability to pay interest and repay principal is considered to be adequate. Adverse changes in economic conditions and circumstances, however, are more likely to have an adverse impact on these bonds and, therefore, impair timely payment. The likelihood that the ratings of these bonds will fall below investment grade is higher than for bonds with higher ratings. BB, B, CCC, CC: Debt rated "BB", "B", "CCC" and "CC" is regarded, on balance, as predominantly speculative with respect to capacity to pay interest and repay principal in accordance with the terms of the obligation. "BB" indicates the lowest degree of speculation and "CC" the highest degree of speculation. While such debt will likely have some quality and protective characteristics, these are outweighed by large uncertainties or major risk exposures to adverse conditions. Plus (+) or Minus (-) signs are used with a rating symbol to indicate the relative position of a credit within the rating category. Plus and minus signs, however, are not used in the "AAA" category. A-4 NIPPON INVESTORS SERVICE, INC. DEBT RATINGS AAA: Debt rated "AAA" are bonds with the highest degree of certainty regarding the discharge of debt, even under adverse circumstances. AA: Debt rated "AA" are bonds with an extremely strong degree of certainty regarding the discharge of debt, even under adverse circumstances. A: Debt rated "A" are bonds with a strong degree of certainty regarding the discharge of debt, even under adverse circumstances. BBB: Debt rated "BBB" are bonds with an adequate degree of certainty regarding the discharge of debt. However, it can be affected by major adverse changes in circumstances. BB, B, CCC, CC, C: Debt rated "BB", "B", "CCC", "CC" or "C" are bonds with varying degrees of uncertainty regarding the discharge of debt. "BB" indicates the lowest degree of uncertainty and therefore the lowest probability of default, "C" the highest degree of uncertainty, and therefore the highest probability of default. Plus (+) or Minus (-) signs may be added to ratings from "AA" through "B" to indicate the relative standing within each of these categories. A-5 INDEPENDENT AUDITORS' CONSENT The Board of Directors Ambac Financial Group, Inc.: The audits referred to in our report dated January 29, 1998, included the related financial statement schedules as of December 31, 1997 and 1996 and for each of the years in the three-year period ended December 31, 1997, included in this Form 10-K. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audit. In our opinion, such financial statement schedules, when considered in relation to the basic financial statement taken as a whole, present fairly in all material respects the information set forth therein. We consent to the use of our reports incorporated by reference in the registration statement (No. 333-43695) on Form S-3, and the registration statements (Nos. 33-47970, 33-63134, 33-47971 and 33-44913) on Form S-8 of Ambac Financial Group, Inc. New York, New York March 30, 1998 S-1 AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES SCHEDULE I - SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 1997 (Dollar Amounts in Thousands)
Amount at which shown in the AMORTIZED ESTIMATED balance sheet TYPE OF INVESTMENT COST FAIR VALUE - ------------------------------------------------------------ ------------------------------------------ ------------------ U.S. Government obligations................................. $ 136,771 $ 139,598 $ 139,598 Municipal obligations....................................... 2,146,137 2,298,996 2,298,996 Mortgage- and asset-backed securities (includes U.S. Government Agency obligations)............................. 3,200,262 3,222,756 3,222,756 Corporate obligations....................................... 1,022,995 1,093,587 1,093,587 Other....................................................... 155,763 155,185 155,185 ------------------------ ------------- ---------------- Total investments...................................... $6,661,928 $6,910,122 $6,910,122 ======================== ============= ================
S-2 AMBAC FINANCIAL GROUP, INC. SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY ONLY) CONDENSED BALANCE SHEETS DECEMBER 31, 1997 AND 1996 (Dollar Amounts in Thousands Except Per Share Data)
1997 1996 ------------------------- ------------------ ASSETS Assets: Cash....................................................................... $ 8 $ 9 Investments in subsidiaries................................................ 2,002,653 1,716,328 Fixed income securities, at fair value (amortized cost of $65,772 in 1997 and $104,925 in 1996).................. 70,380 107,338 Short-term investments, at cost (approximates fair value).................. 13,592 15,722 Current income taxes receivable............................................ 4,576 3,066 Deferred income taxes receivable........................................... 2,207 -- Other assets............................................................... 9,876 5,106 --------------- ------------------------- Total assets.............................................................. $2,103,292 $1,847,569 =============== ========================= LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities: Debentures................................................................. 223,864 223,798 Accrued interest payable................................................... 6,797 6,797 Accounts payable and other liabilities..................................... 149 1,958 --------------- ------------------------- Total liabilities......................................................... 230,810 232,553 --------------- ------------------------- Stockholders' equity: Preferred stock, par value $0.01 per share; authorized shares - 4,000,000; issued and outstanding shares - none....................................... -- -- Common Stock, par value $0.01 per share; authorized shares - 100,000,000; issued shares - 70,680,384 at December 31, 1997 and 35,340,192 at December 31, 1996................................................................... 707 353 Additional paid-in capital.................................................. 500,107 498,401 Unrealized gains on investments, net of tax................................. 135,066 58,911 Retained earnings........................................................... 1,262,740 1,072,418 Cumulative translation adjustment........................................... 157 -- Common Stock held in treasury at cost, 732,947 shares at December 31, 1997 and 249,807 at December 31, 1996 (26,295) (15,067) ---------------- -------------------------- Total stockholders' equity................................................ 1,872,482 1,615,016 --------------- ------------------------- Total liabilities and stockholders' equity................................ $2,103,292 $1,847,569 =============== =========================
S-3 AMBAC FINANCIAL GROUP, INC. SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY ONLY) CONDENSED STATEMENTS OF OPERATIONS AND RETAINED EARNINGS THREE YEARS ENDED DECEMBER 31, (Dollar Amounts in Thousands)
1997 1996 1995 ---------------- --------------------- -------------- Revenues: Dividend income........................................... $ 44,000 $ 44,000 $ 40,000 Extraordinary dividend (1)................................ -- 115,865 -- Interest and other income................................. 7,047 7,589 389 Net realized gains........................................ 748 66,633 19,103 ---------------- --------------------- --------------- Total revenues........................................... 51,795 234,087 59,492 ---------------- --------------------- --------------- Expenses: Interest expense.......................................... 19,053 18,852 19,467 Operating expenses........................................ 2,826 3,477 1,531 --------------- --------------------- --------------- Total expenses........................................... 21,879 22,329 20,998 ---------------- --------------------- --------------- Income before income taxes and equity in undistributed net income of subsidiaries................................. 29,916 211,758 38,494 Federal income tax (benefit) expense........................ (5,433) 18,203 155 ---------------- --------------------- --------------- Income before equity in undistributed net income of subsidiaries............................................... 35,349 193,555 38,339 Equity in undistributed net income of subsidiaries.......... 187,681 82,762 129,256 ---------------- --------------------- --------------- Net income.................................................. 223,030 276,317 167,595 Common dividends............................................ (24,165) (21,500) (19,484) Other....................................................... (8,543) (1,878) (1,761) Retained earnings at beginning of period................... 1,072,418 819,479 673,129 ---------------------- --------------------- --------------- Retained earnings at end of period.......................... $1,262,740 $1,072,418 $819,479 ===================== ===================== ===============
(1) Represents fair value of 2,378,672 shares of HCIA common stock received from Ambac Assurance in the form of an extraordinary dividend on April 30, 1996. S-4 AMBAC FINANCIAL GROUP, INC. SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY ONLY) CONDENSED STATEMENTS OF CASH FLOWS THREE YEARS ENDED DECEMBER 31, (DOLLAR AMOUNTS IN THOUSANDS)
1997 1996 1995 ---------------- --------------------- --------------------- Cash flows from operating activities: Net income................................................ $ 223,030 $ 276,317 $ 167,595 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Equity in undistributed net income of subsidiaries............................................. (187,681) (82,762) (129,256) Extraordinary dividend(1)................................. -- (115,865) -- (Decrease) increase in accrued interest payable........... -- (28) 28 (Gain) loss on sale of investments........................ (748) (66,633) (19,103) (Decrease) increase in current income taxes payable............................................ (1,510) (10,443) 6,176 Other, net................................................ (20,715) (8,292) (941) ---------------- --------------------- --------------------- Net cash provided by (used in) operating................ activities 12,376 (7,706) 24,499 ---------------- --------------------- --------------------- Cash flows from investing activities: Proceeds from sales of bonds.............................. 39,728 17,396 -- Purchases of bonds........................................ -- (121,734) -- Proceeds from sale of affiliate........................... -- 202,609 28,502 Change in short-term investments.......................... 2,130 (4,585) 2,108 Other, net -- 13,842 -- ---------------- --------------------- --------------------- Net cash provided by investing activities................ 41,858 107,528 30,610 ---------------- --------------------- --------------------- Cash flows from financing activities: Dividends paid............................................ (24,165) (21,500) (19,484) Purchases of treasury stock............................... (40,397) (31,751) (5,913) Proceeds from sale of treasury stock...................... 29,169 17,211 6,302 Contribution to subsidiaries.............................. (18,842) (63,801) (36,001) ---------------- --------------------- --------------------- Net cash used in financing activities.................... (54,235) (99,841) (55,096) ---------------- --------------------- --------------------- Net cash flow............................................... (1) (19) 13 Cash at January 1......................................... 9 28 15 ---------------- --------------------- --------------------- Cash at December 31....................................... $ 8 $ 9 $ 28 ================ ===================== ===================== Supplemental disclosure of cash flow information: Cash paid during the year for: Income taxes............................................. $ 12,861 $ 90,197 $ 24,800 ===================== ===================== ===================== Interest expense......................................... $ 19,687 $ 19,687 $ 19,687 ===================== ===================== ===================== Cash received during the year for: Income taxes............................................. $ -- $ -- $ 8,749 ===================== ===================== =============
(1) Represents fair value of 2,378,672 shares of HCIA common stock received from Ambac Assurance in the form of an extraordinary dividend on April 30, 1996. S-5 AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES SCHEDULE IV - REINSURANCE (Dollar Amounts in Thousands Except Percentages)
ASSUMED PERCENTAGE OF CEDED TO FROM AMOUNT OTHER OTHER NET AMOUNT ASSUMED TO GROSS AMOUNT COMPANIES COMPANIES NET INSURANCE PREMIUMS WRITTEN Year ended December 31, 1995............ $190,570 $28,606 $2,756 $164,720 1.67 % Year ended December 31, 1996............ $240,544 $37,793 $6,664 $209,415 3.18 % Year ended December 31, 1997............ $277,814 $32,452 $8,349 $253,711 3.29 %
S-6 EX-3.02 2 BY-LAWS OF THE COMPANY (EXHIBIT 3.02) _________________________________ BY-LAWS OF AMBAC FINANCIAL GROUP, INC. _________________________________ Amended through January 28, 1998 TABLE OF CONTENTS Page ---- ARTICLE I OFFICES SECTION 1.01 Registered Office........................................... 1 SECTION 1.02 Other Offices............................................... 1 ARTICLE II MEETINGS OF STOCKHOLDERS SECTION 2.01 Annual Meetings............................................. 1 SECTION 2.02 Special Meetings............................................ 1 SECTION 2.03 Notice of Meetings.......................................... 1 SECTION 2.04 Waiver of Notice............................................ 2 SECTION 2.05 Adjournments................................................ 2 SECTION 2.06 Quorum...................................................... 3 SECTION 2.07 Voting...................................................... 3 SECTION 2.08 Proxies..................................................... 3 SECTION 2.09 Chairman and Secretary at Meetings.......................... 3 SECTION 2.10 Judges...................................................... 3 SECTION 2.11 List of Stockholders........................................ 3 SECTION 2.12 Notice of Stockholder Business.............................. 4 SECTION 2.13 Notice of Stockholder Nominees.............................. 4 SECTION 2.14 Stockholders' Consent in Lieu of Meeting.................... 5 ARTICLE III BOARD OF DIRECTORS SECTION 3.01 General Powers.............................................. 6 SECTION 3.02 Number and Term of Office................................... 6 SECTION 3.03 Resignation................................................. 7 SECTION 3.04 Removal..................................................... 7 SECTION 3.05 Vacancies................................................... 7 SECTION 3.06 Meetings.................................................... 7 SECTION 3.07 Committees of the Board..................................... 8 SECTION 3.08 Directors' Consent in Lieu of Meeting....................... 9 SECTION 3.09 Action by Means of Telephone or Similar Communications Equipment................................................... 9 SECTION 3.10 Compensation................................................ 9 -i- Page ---- ARTICLE IV OFFICERS SECTION 4.01 Officers..................................................... 10 SECTION 4.02 Authority and Duties......................................... 10 SECTION 4.03 Term of Office, Resignation and Removal...................... 10 SECTION 4.04 Vacancies.................................................... 10 SECTION 4.05 The Chairman................................................. 10 SECTION 4.06 The President................................................ 11 SECTION 4.07 Vice Chairmen, Vice Presidents and Managing Directors........ 11 SECTION 4.08 The Secretary................................................ 11 SECTION 4.09 Assistant Secretaries........................................ 11 SECTION 4.10 The Treasurer................................................ 12 SECTION 4.11 Assistant Treasurers......................................... 12 ARTICLE V CHECKS, DRAFTS, NOTES AND PROXIES SECTION 5.01 Checks, Drafts and Notes..................................... 12 SECTION 5.02 Execution of Proxies......................................... 12 ARTICLE VI SHARES AND TRANSFERS OF SHARES SECTION 6.01 Certificates Evidencing Shares............................... 13 SECTION 6.02 Stock Ledger................................................. 13 SECTION 6.03 Transfers of Shares.......................................... 13 SECTION 6.04 Addresses of Stockholders.................................... 13 SECTION 6.05 Lost, Destroyed and Mutilated Certificates................... 14 SECTION 6.06 Regulations.................................................. 14 SECTION 6.07 Fixing Date for Determination of Stockholders of Record...... 14 ARTICLE VII SEAL SECTION 7.01 Seal......................................................... 14 ARTICLE VIII FISCAL YEAR SECTION 8.01 Fiscal Year.................................................. 15 -ii- Page ---- ARTICLE IX INDEMNIFICATION AND INSURANCE SECTION 9.01 Indemnification.............................................. 15 SECTION 9.02 Insurance for Indemnification................................ 17 ARTICLE X AMENDMENTS SECTION 10.01 Amendments.................................................. 17 -iii- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 BY-LAWS OF AMBAC FINANCIAL GROUP, INC. (Amended through January 28, 1998) ARTICLE I OFFICES SECTION 1.01 REGISTERED OFFICE. The registered office of Ambac ----------------- Financial Group, Inc. (the "CORPORATION") in the State of Delaware shall be at the principal office of The Corporation Trust Company in the City of Wilmington, County of New Castle, and the registered agent in charge thereof shall be The Corporation Trust Company. SECTION 1.02 OTHER OFFICES. The Corporation may also have an office ------------- or offices at any other place or places within or without the State of Delaware as the Board of Directors of the Corporation (the "BOARD") may from time to time determine or the business of the Corporation may from time to time require. ARTICLE II MEETINGS OF STOCKHOLDERS SECTION 2.01 ANNUAL MEETINGS. The annual meeting of Stockholders (as --------------- defined in Section 2.03) of the Corporation for the election of directors of the Corporation ("DIRECTORS"), and for the transaction of such other business as may properly come before such meeting, shall be held at such place, date and time as shall be fixed by the Board and designated in the notice or waiver of notice of such annual meeting. SECTION 2.02 SPECIAL MEETINGS. Special meetings of Stockholders for ---------------- any purpose or purposes may be called by the Board or the Chairman of the Board of the Corporation (the "CHAIRMAN") the President of the Corporation (the "PRESIDENT") or the Secretary of the Corporation (the "SECRETARY"), to be held at such place, date and time as shall be designated in the notice or waiver of notice thereof. SECTION 2.03 NOTICE OF MEETINGS. (a) Except as otherwise provided by ------------------ law, written notice of each annual or special meeting of Stockholders stating the place, date and time of such meeting and, in the case of a special meeting, the purpose or purposes for which such meeting is to be held, shall be given personally or by first-class -1- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 mail (airmail in the case of international communications) to each recordholder of shares of common stock of the Corporation issued and outstanding ("SHARES") entitled to vote thereat, not less than 10 nor more than 90 days before the date of such meeting. If mailed, such notice shall be deemed to be given when deposited in the United States mail, postage prepaid, directed to the recordholder of Shares (a "STOCKHOLDER") at such Stockholder's address as it appears on the records of the Corporation. If, prior to the time of mailing, the Secretary shall have received from any Stockholder a written request that notices intended for such Stockholder are to be mailed to some address other than the address that appears on the records of the Corporation, notices intended for such Stockholder shall be mailed to the address designated in such request. (b) Notice of a special meeting of Stockholders may be given by the person or persons calling the meeting, or, upon the written request of such person or persons, such notice shall be given by the Secretary on behalf of such person or persons. If the person or persons calling a special meeting of Stockholders give notice thereof, such person or persons shall deliver a copy of such notice to the Secretary. Each request to the Secretary for the giving of notice of a special meeting of Stockholders shall state the purpose or purposes of such meeting. SECTION 2.04 WAIVER OF NOTICE. Notice of any annual or special ---------------- meeting of Stockholders need not be given to any Stockholder who files a written waiver of notice with the Secretary, signed by the person entitled to notice whether before or after such meeting. Neither the business to be transacted at, nor the purpose of, any meeting of Stockholders need to be specified in any written waiver of notice thereof. Attendance of a Stockholder at a meeting, in person or by proxy, shall constitute a waiver of notice of such meeting, except when such Stockholder attends a meeting for the express purpose of objecting, at the beginning of the meeting, to the transaction of any business on the grounds that the notice of such meeting was inadequate or improperly given. SECTION 2.05 ADJOURNMENTS. Whenever a meeting of Stockholders, ------------ annual or special, is adjourned to another date, time or place, notice need not be given of the adjourned meeting if the date, time and place thereof are announced at the meeting at which the adjournment is taken. If the adjournment is for more than 30 days, or if after the adjournment a new record date is fixed for the adjourned meeting, a notice of the adjourned meeting shall be given to each Stockholder entitled to vote thereat. At the adjourned meeting, any business may be transacted which might have been transacted at the original meeting. Any previously scheduled meeting of the Stockholders may be postponed, and (unless the Certificate of Incorporation of the Corporation (the "CERTIFICATE OF INCORPORATION") otherwise provides) any special meeting of the Stockholders may be canceled, by resolution of the Board upon public notice given prior to the date previously scheduled for such meeting of Stockholders. -2- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 SECTION 2.06 QUORUM. Except as otherwise provided by law or the ------ Certificate of Incorporation, the recordholders of a majority of the Shares entitled to vote thereat, present in person or by proxy, shall constitute a quorum for the transaction of business at all meetings of Stockholders, whether annual or special. If , however, such quorum shall not be present in person or by proxy at any meeting of Stockholders, the presiding officer at the meeting of the Stockholders entitled to vote thereat may adjourn the meeting from time to time in accordance with Section 2.05 hereof until a quorum shall be present in person or by proxy. SECTION 2.07 VOTING. Each Stockholder shall be entitled to one vote ------ for each Share held of record by such Stockholder. Except as otherwise provided by law or the Certificate of Incorporation, when a quorum is present at any meeting of Stockholders, the vote of the recordholders of a majority of the Shares constituting such quorum shall decide any question brought before such meeting. SECTION 2.08 PROXIES. Each Stockholder entitled to vote at a meeting ------- of Stockholders or to express, in writing, consent to or dissent from any action of Stockholders without a meeting may authorize another person or persons to act for such Stockholder by proxy. Such proxy shall be filed with the Secretary before such meeting of Stockholders or such action of Stockholders without a meeting, at such time as the Board may require. No proxy shall be voted or acted upon more than three years from its date, unless the proxy provides for a longer period. SECTION 2.09 CHAIRMAN AND SECRETARY AT MEETINGS. At any meeting of ---------------------------------- Stockholders, the Chairman, or in his absence, the President, or if neither such person is available, then a person designated by the Board, shall preside at and act as chairman of the meeting. The Secretary, or in his absence a person designated by the chairman of the meeting, shall act as secretary of the meeting. SECTION 2.10 JUDGES. The votes at each meeting of Stockholders shall ------ be supervised by not less than two judges who shall decide all questions respecting the qualification of voters, the validity of the proxies and the acceptance or rejection of votes. The judges shall be appointed by the Board but if, for any reason, there are less than two judges present and acting at any meeting, the chairman of the meeting shall appoint an additional judge or judges so that there shall always be at least two judges to act at the meeting. SECTION 2.11 LIST OF STOCKHOLDERS. A complete list of the -------------------- Stockholders entitled to vote at each meeting of Stockholders, arranged in alphabetical order, and showing the address and number of shares registered in the name of each Stockholder, shall be prepared and made available for examination during regular business hours by any Stockholder for any purpose germane to the meeting. The list shall be available for such examination for a period of not less than ten days prior to the meeting -3- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 and during the whole time of the meeting either at a place within the city where the meeting is to be held, which place shall be specified in the notice of meeting or, if not so specified, at the place where the meeting is to be held. SECTION 2.12 NOTICE OF STOCKHOLDER BUSINESS. At an annual meeting of ------------------------------ the Stockholders, only such business shall be conducted as shall have been brought before the meeting (a) by or at the direction of the Board or (b) by any Stockholder who complies with the notice procedures set forth in this Section 2.12. For business to be properly brought before an annual meeting by a Stockholder, the Stockholder must have given timely notice thereof in writing to the Secretary of the Corporation. To be timely, a Stockholder's notice must be delivered to or mailed and received at the principal executive offices of the Corporation, not less than sixty days nor more than ninety days prior to the meeting; provided, however, that in the event that less than seventy days' -------- ------- notice or prior public disclosure of the date of the meeting is given or made to the Stockholders, notice by the Stockholder to be timely must be received not later than the close of business on the 10th day following the day on which such notice of the date of the annual meeting was mailed or such public disclosure was made. A Stockholder's notice to the Secretary shall set forth as to each matter the Stockholder proposes to bring before the annual meeting (a) a brief description of the business desired to be brought before the annual meeting and the reasons for conducting such business at the annual meeting; (b) the name and address, as they appear on the Corporation's books, of the Stockholder proposing such business; (c) the class and number of shares of the Corporation which are beneficially owned by the Stockholder; and (d) any material interest of the Stockholder in such business. Notwithstanding anything in these By-laws to the contrary, no business shall be conducted at an annual meeting except in accordance with the procedures set forth in this Section 2.12. The chairman of an annual meeting shall, if the facts warrant, determine and declare to the meeting that business was not properly brought before the meeting and in accordance with the provisions of this Section 2.12, and if he should so determine, he shall so declare to the meeting and any such business not properly brought before the meeting shall not be transacted. Notwithstanding the foregoing provisions of this Section 2.12, a Stockholder seeking to have a proposal included in the Corporation's proxy statement shall comply with the requirements of Regulation 14A under the Securities Exchange Act of 1934, as amended (including, but not limited to, Rule 14a-8 or its successor provision.) SECTION 2.13 NOTICE OF STOCKHOLDER NOMINEES. Only persons who are ------------------------------ nominated in accordance with the procedures set forth in these By-laws shall be eligible for election as Directors. Nominations of persons for election to the Board may be made at a meeting of Stockholders (a) by or at the direction of the Board or (b) by any Stockholder entitled to vote for the election of Directors at the meeting who complies with the notice procedures set forth in this Section 2.13. Nominations by Stockholders shall be made pursuant to timely notice in writing to the Secretary of the Corporation. To be timely, a Stockholder's notice shall be delivered to or mailed and received at the principal executive offices of the Corporation not less than sixty days nor more than ninety -4- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 days prior to the meeting; provided, however, that in the event that less than -------- ------- seventy days' notice or prior public disclosure of the date of the meeting is given or made to Stockholders, notice by the Stockholder to be timely must be so received not later than the close of business on the 10th day following the day on which such notice of the date of the meeting was mailed or such public disclosure was made. Such Stockholder's notice shall set forth (a) as to each person whom the Stockholder proposes to nominate for election or re-election as a Director, all information relating to such person that is required to be disclosed in solicitations of proxies for election of directors, or is otherwise required, in each case pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended (including such person's written consent to being named in the proxy statement as a nominee and to serving as a Director if elected); and (b) as to the Stockholder giving the notice (i) the name and address, as they appear on the Corporation's books, of such Stockholder and (ii) the class and number of shares of the Corporation which are beneficially owned by such Stockholder. At the request of the Board any person nominated by the Board for election as a Director shall furnish to the Secretary that information required to be set forth in a Stockholder's notice of nomination which pertains to the nominee. No person shall be eligible for election as a Director unless nominated in accordance with the procedures set forth in these By-laws. The chairman of the meeting shall, if the facts warrant, determine and declare to the meeting that a nomination was not made in accordance with the procedures prescribed by these By-laws, and if he should so determine, he shall so declare to the meeting and the defective nomination shall be disregarded. SECTION 2.14 STOCKHOLDERS' CONSENT IN LIEU OF MEETING. (a) Consents ---------------------------------------- -------- to Corporate Action. Any action which is required to be or may be taken at any - ------------------- annual or special meeting of Stockholders, subject to the provisions of Subsections (b) and (c) of this Section 2.14, may be taken without a meeting, without prior notice and without a vote if consents in writing, setting forth the action so taken, shall have been signed by the holders of the outstanding Shares having not less than the minimum number of votes that would be necessary to authorize or to take such action at a meeting at which all Shares entitled to vote thereon were present and voted; provided, however, that prompt notice of -------- ------- the taking of the corporate action without a meeting and by less than unanimous written consent shall be given to those Stockholders who have not consented in writing. (b) Determination of Record Date of Action by Written Consent. The --------------------------------------------------------- record date for determining Stockholders entitled to express consent to corporate action in writing without a meeting shall be fixed by the Board. Any Stockholder of record seeking to have the Stockholders authorize or take corporate action by written consent without a meeting shall, by written notice to the Secretary, request the Board to fix a record date. Upon receipt of such a request, the Secretary shall place such request before the Board at its next regularly scheduled meeting, provided, however, that if the Stockholder -------- ------- represents in such request that he intends, and is prepared, to commence a consent solicitation as soon as is permitted by the Securities Exchange Act of 1934, as amended, and the regulations thereunder and other applicable law, the Secretary shall, as -5- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 promptly as practicable, call a special meeting of the Board, which meeting shall be held as promptly as practicable. At such regular or special meeting, the Board shall fix a record date as provided in Section 213(a) (or its successor provision) of the General Corporation Law of the State of Delaware (the "GENERAL CORPORATION LAW"). Should the Board fail to fix a record date as provided for in this Subsection (b), then the record date shall be the day on which the first written consent is expressed. (c) Procedures for Written Consent. In the event of the delivery to ------------------------------ the Corporation of a written consent or consents purporting to represent the requisite voting power to authorize or take corporate action and/or related revocations, the Secretary shall provide for safekeeping of such consents and revocations and shall, as promptly as practicable, engage nationally recognized independent judges of election for the purpose of promptly performing a ministerial review of the validity of the consents and revocations. No action by written consent and without a meeting shall be effective until such judges have completed their review, determined that the requisite number of valid and unrevoked consents has been obtained to authorize or take action specified in the consents, and certified such determination for entry in the records of the Corporation kept for the purpose of recording the proceedings of meetings of Stockholders. ARTICLE III BOARD OF DIRECTORS SECTION 3.01 GENERAL POWERS. The business and affairs of the -------------- Corporation shall be managed by the Board, which may exercise all such powers of the Corporation and do all such lawful acts and things as are not by law, the Certificate of Incorporation or these By-laws directed or required to be exercised or done by Stockholders. SECTION 3.02 NUMBER AND TERM OF OFFICE. The number of Directors ------------------------- shall be three or such greater number as shall be fixed from time to time by the Board. Directors need not be Stockholders. Directors shall be elected at the annual meeting of Stockholders, and each Director shall hold office until his successor is elected and qualified, or until his earlier death or resignation or removal in the manner hereinafter provided. SECTION 3.03 RESIGNATION. Any Director may resign at any time by ----------- giving written notice to the Board, the Chairman or the Secretary. Such resignation shall take effect at the time specified in such notice or, if the time be not specified, upon receipt thereof by the Board, the Chairman or the Secretary, as the case may be. Unless otherwise specified therein, acceptance of such resignation shall not be necessary to make it effective. -6- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 SECTION 3.04 REMOVAL. Any or all of the Directors may be removed, ------- with or without cause, at any time by vote of the recordholders of a majority of the Shares then entitled to vote at an election of Directors, or by written consent of the recordholders of Shares pursuant to Section 2.14 hereof. SECTION 3.05 VACANCIES. Vacancies occurring on the Board as a result --------- of the removal of Directors without cause may be filled only by vote of the recordholders of a majority of the Shares then entitled to vote at an election of Directors, or by written consent of such recordholders pursuant to Section 2.14 hereof. Vacancies occurring on the Board for any other reason, including, without limitation, vacancies occurring as a result of the creation of new directorships that increase the number of Directors, may be filled by such vote or written consent or by vote of the Board or by written consent of the Directors pursuant to Section 3.08 hereof. If the number of Directors then in office is less than quorum, such other vacancies may be filled by vote of a majority of the Directors then in office or by written consent of all such Directors pursuant to Section 3.08 hereof. Unless earlier removed pursuant to Section 3.04 hereof, each Director chosen in accordance with this Section 3.05 shall hold office until the next annual election of Directors by the Stockholders and until his successor shall be elected and qualified. SECTION 3.06 MEETINGS. (a) Annual Meetings. As soon as practicable -------- --------------- after each annual election of Directors by the Stockholders, the Board shall meet for the purpose of organization and the transaction of other business, unless it shall have transacted all such business by written consent pursuant to Section 3.08 hereof. (b) Stated Meetings. The Board may provide for stated meetings --------------- of the Board. (c) Other Meetings. Other meetings of the Board shall be held at -------------- such times as the Chairman, the President, the Secretary or a majority of the Board shall from time to time determine. (d) Notice of Meetings. No notice need be given of any organization ------------------ or stated meeting of the Board for which the date, hour and place have been fixed by the Board. The Secretary shall give written notice to each Director of each other organization and stated meeting and of all special meetings of the Board, which notice shall state the place, date, time and purpose of such meeting. Notice of each such meeting shall be given to each Director, if by mail, addressed to him at his residence or usual place of business, at least two days before the day on which such meeting is to be held, or shall be sent to him at such place by telecopy, telegraph, cable, or other form of recorded communication, or be delivered personally or by telephone not later than the day before the day on which such meeting is to be held. A written waiver of -7- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 notice, signed by the Director entitled to notice, whether before or after the time of the meeting referred to in such waiver, shall be deemed equivalent to notice. Neither the business to be transacted at, nor the purpose of any meeting of the Board need be specified in any written waiver of notice thereof. Attendance of a Director at a meeting of the Board shall constitute a waiver of notice of such meeting, except as provided by law. (e) Place of Meetings. The Board may hold its meetings at such place ----------------- or places within or without the State of Delaware as the Board or the Chairman may from time to time determine, or as shall be designated in the respective notices or waivers of notice of such meetings. (f) Quorum and Manner of Acting. One-third of the total number of --------------------------- Directors then in office (but in no event less than three Directors) shall be present in person at any meeting of the Board in order to constitute a quorum for the transaction of business at such meeting, and the vote of a majority of those Directors present at any such meeting at which a quorum is present shall be necessary for the passage of any resolution or act of the Board, except as otherwise expressly required by law, the Certificate of Incorporation or these By-laws. In the absence of a quorum for any such meeting, a majority of the Directors present thereat may adjourn such meeting from time to time until a quorum shall be present. (g) Organization. At each meeting of the Board, one of the following ------------ shall act as chairman of the meeting and preside, in the following order of precedence: (i) the Chairman; (ii) the President; (iii) any Director chosen by a majority of the Directors present. The Secretary or, in the case of his absence, any person (who shall be an Assistant Secretary, if an Assistant Secretary is present) whom the chairman of the meeting shall appoint shall act as secretary of such meeting and keep the minutes thereof. SECTION 3.07 COMMITTEES OF THE BOARD. The Board may designate one or ----------------------- more committees, each committee to consist of one or more Directors. The Board may designate one or more Directors as alternate members of any committee, who may replace any absent or disqualified member at any meeting of such committee. In the absence or disqualification of a member of a committee, the member or members thereof present at any meeting and not disqualified from voting, whether or not he or they constitute a quorum, may unanimously appoint another Director to act at the meeting in the place of any such absent or disqualified member. A majority of the members of any committee of the Board shall be present in person at any meeting of the committee in order to constitute a quorum for the transaction of business at such meeting, and the act of a majority of the members present at any such meeting at which a quorum is present shall be the act of the committee. In the absence of a quorum for any such meeting, a majority -8- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 of the members present thereat may adjourn such meeting from time to time until a quorum shall be present. Any committee of the Board, to the extent provided in the resolution of the Board designating such committee, shall have and may exercise all the powers and authority of the Board in the management of the business and affairs of the Corporation, and may authorize the seal of the Corporation to be affixed to all papers which may require it; provided, however, -------- ------- that no such committee shall have such power or authority in reference to the following matters: (i) approving or adopting, or recommending to the stockholders, any action or matter expressly required by the General Corporation Law to be submitted to stockholders for approval or (ii) adopting, amending or repealing these By-laws. In addition, each committee of the Board so appointed may appoint a sub-committee of the Board in furtherance of the duties delegated to it by the Board. Each committee of the Board shall keep regular minutes of its proceedings and report the same to the Board when so requested by the Board. SECTION 3.08 DIRECTORS' CONSENT IN LIEU OF MEETING. Any action ------------------------------------- required or permitted to be taken at any meeting of the Board or of any committee thereof may be taken without a meeting, without prior notice and without a vote, if a consent in writing, setting forth the action so taken, shall be signed by all the members of the Board or such committee and such consent is filed with the minutes of the proceedings of the Board or such committee. SECTION 3.09 ACTION BY MEANS OF TELEPHONE OR SIMILAR COMMUNICATIONS ------------------------------------------------------ EQUIPMENT. Any one or more members of the Board, or of any committee thereof, - --------- may participate in a meeting of the Board or such committee by means of conference telephone or similar communications equipment by means of which all persons participating in the meeting can hear each other, and participation in a meeting by such means shall constitute presence in person at such meeting. SECTION 3.10 COMPENSATION. Unless otherwise restricted by the ------------ Certificate of Incorporation, the Board may determine the compensation of Directors. In addition, as determined by the Board, Directors may be reimbursed by the Corporation for their expenses, if any, in the performance of their duties as Directors. No such compensation or reimbursement shall preclude any Director from serving the Corporation in any other capacity and receiving compensation therefor. ARTICLE IV OFFICERS SECTION 4.01 OFFICERS. The officers of the Corporation shall be the -------- Chairman, the President, the Secretary and a Treasurer and may include one or more of the following: Vice Chairmen, Vice Presidents, Managing Directors, Assistant Secretaries -9- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 and Assistant Treasurers. Any two or more offices may be held by the same person provided that the office of President and Secretary shall not be held by the same person. SECTION 4.02 AUTHORITY AND DUTIES. All officers shall have such -------------------- authority and perform such duties in the management of the Corporation as may be provided in these By-laws or, to the extent not so provided, by resolution of the Board. SECTION 4.03 TERM OF OFFICE, RESIGNATION AND REMOVAL. (a) Each --------------------------------------- officer shall be appointed by the Board and shall hold office for such term as may be determined by the Board. Each officer shall hold office until his successor has been appointed and qualified or his earlier death or resignation or removal in the manner hereinafter provided. The Board may require any officer to give security for the faithful performance of his duties. (b) Any officer may resign at any time by giving written notice to the Board, the Chairman, the President or the Secretary. Such resignation shall take effect at the time specified in such notice or, if the time be not specified, upon receipt thereof by the Board, the Chairman, the President or the Secretary, as the case may be. Unless otherwise specified therein, acceptance of such resignation shall not be necessary to make it effective. (c) All officers and agents appointed by the Board shall be subject to removal, with or without cause, at any time by the Board or by the action of the recordholders of a majority of the Shares entitled to vote thereon SECTION 4.04 VACANCIES. Any vacancy occurring in any office of the --------- Corporation, for any reason, shall be filled by action of the Board. Unless earlier removed pursuant to Section 4.03 hereof, any officer appointed by the Board to fill any such vacancy shall serve only until such time as the unexpired term of his predecessor expires unless reappointed by the Board. SECTION 4.05 THE CHAIRMAN. The Chairman shall be the chief executive ------------ officer of the Corporation and shall have general and active management and control of the business and affairs of the Corporation, subject to the control of the Board, and shall see that all orders and resolutions of the Board are carried into effect. The Chairman shall have the power to call special meetings of Stockholders, to call special meetings of the Board and, if present, to preside at all meetings of Stockholders and all meetings of the Board. The Chairman shall perform all duties incident to the office of Chairman and all such other duties as may from time to time be assigned to him by the Board or these By-laws. SECTION 4.06 THE PRESIDENT. The President shall be the chief ------------- operating officer of the Corporation and shall have general and active management and control the operations of the Corporation, subject to the control of the Board, and shall -10- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 see that all orders and resolutions of the Board are carried into effect. The President shall perform all duties incident to the office of President and all such other duties as may from time to time be assigned to him by the Board or these By-laws. SECTION 4.07 VICE CHAIRMEN, VICE PRESIDENTS AND MANAGING DIRECTORS. ----------------------------------------------------- Vice Chairmen, Vice Presidents and Managing Directors, if any, in order of their seniority or in any other order determined by the Board, shall generally assist the President and perform such other duties as the Board or the President shall prescribe, and in the absence or disability of the President, shall perform the duties and exercise the powers of the President. A Vice President may be designated as an Executive Vice President, a Senior Vice President, a First Vice President, a Vice President or an Assistant Vice President. SECTION 4.08 THE SECRETARY. The Secretary shall, to the extent ------------- practicable, attend all meetings of the Board and all meetings of Stockholders and shall record all votes and the minutes of all proceedings in a book to be kept for that purpose, and shall perform the same duties for any committee of the Board when so requested by such committee. He shall give or cause to be given notice of all meetings of Stockholders and of the Board, shall perform such other duties as may be prescribed by the Board, the Chairman or the President and shall act under the supervision of the Chairman. He shall keep in safe custody the seal of the Corporation and affix the same to any instrument that requires that the seal be affixed to it and which shall have been duly authorized for signature in the name of the Corporation and, when so affixed, the seal shall be attested by his signature or by the signature of the Treasurer of the Corporation (the "TREASURER") or an Assistant Secretary or Assistant Treasurer of the Corporation. He shall keep in safe custody the certificate books and stockholder records and such other books and records of the Corporation as the Board, the Chairman or the President may direct and shall perform all other duties incident to the office of Secretary and such other duties as from time to time may be assigned to him by the Board, the Chairman or the President. SECTION 4.09 ASSISTANT SECRETARIES. Assistant Secretaries of the --------------------- Corporation ("ASSISTANT SECRETARIES"), if any, in order of their seniority or in any other order determined by the Board, shall generally assist the Secretary and perform such other duties as the Board or the Secretary shall prescribe, and, in the absence or disability of the Secretary, shall perform the duties and exercise the powers of the Secretary. SECTION 4.10 THE TREASURER. The Treasurer shall have the care and ------------- custody of all the funds of the Corporation and shall deposit such funds in such banks or other depositories as the Board, or any officer or officers, or any officer and agent jointly, duly authorized by the Board, shall, from time to time, direct or approve. He shall disburse the funds of the Corporation under the direction of the Board and the President. He shall keep a full and accurate account of all moneys received and paid on account of the Corporation and shall render a statement of his accounts whenever the Board, the Chairman or the President shall so request. He shall perform all other necessary actions -11- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 and duties in connection with the administration of the financial affairs of the Corporation and shall generally perform all the duties usually appertaining to the office of treasurer of a corporation. When required by the Board, he shall give bonds for the faithful discharge of his duties in such sums and with such sureties as the Board shall approve. SECTION 4.11 ASSISTANT TREASURERS. Assistant Treasurers of the -------------------- Corporation ("ASSISTANT TREASURERS"), if any, in order of their seniority or in any other order determined by the Board, shall generally assist the Treasurer and perform such other duties as the Board or the Treasurer shall prescribe, and, in the absence or disability of the Treasurer, shall perform the duties and exercise the powers of the Treasurer. ARTICLE V CHECKS, DRAFTS, NOTES AND PROXIES SECTION 5.01 CHECKS, DRAFTS AND NOTES. All checks, drafts and other ------------------------ orders for the payment of money, notes and other evidences of indebtedness issued in the name of the Corporation shall be signed by such officer or officers, agent or agents of the Corporation and in such manner as shall be determined from time to time, by resolution of the Board. SECTION 5.02 EXECUTION OF PROXIES. The Chairman or the President, -------------------- or, in the absence or disability of both of them, any Vice Chairman, Vice President or Managing Director, may authorize, from time to time, the execution and issuance of proxies to vote shares of stock or other securities of other corporations held of record by the Corporation and the execution of consents to action taken or to be taken by any such corporation. All such proxies and consents, unless otherwise authorized by the Board, shall be signed in the name of the Corporation by the Chairman, the President or any Vice Chairman, Vice President or Managing Director. -12- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 ARTICLE VI SHARES AND TRANSFERS OF SHARES SECTION 6.01 CERTIFICATES EVIDENCING SHARES. Shares shall be ------------------------------ evidenced by certificates in such form or forms as shall be approved by the Board. Certificates shall be issued in consecutive order and shall be numbered in the order of their issue, and shall be signed by the Chairman, the President or any Vice Chairman, Vice President or Managing Director and by the Secretary, any Assistant Secretary, the Treasurer or any Assistant Treasurer; provided that -------- if such a certificate is manually signed by one such officer, any other signature on the certificate may be a facsimile and, if such a certificate is countersigned by a transfer agent or registrar other than the Corporation or its employee, any other signature on the certificate may be a facsimile. In the event any such officer who has signed or whose facsimile signature has been placed upon a certificate shall have ceased to hold such office or to be employed by the Corporation before such certificate is issued, such certificate may be issued by the Corporation with the same effect as if such officer had held such office on the date of issue. SECTION 6.02 STOCK LEDGER. A stock ledger in one or more ------------ counterparts shall be kept by the Corporation, in which shall be recorded the name and address of each person, firm or corporation owning the Shares evidenced by each certificate evidencing Shares issued by the Corporation, the number of Shares evidenced by each such certificate, the date of issuance thereof and, in the case of cancellation, the date of cancellation. Except as otherwise expressly required by law, the person in whose name Shares stand on the stock ledger of the Corporation shall be deemed the owner and recordholder thereof for all purposes. The Board may from time to time appoint such transfer agents or registrars as it may deem advisable and may define their powers and duties. Any such transfer agent or registrar need not be an employee of the Corporation. SECTION 6.03 TRANSFERS OF SHARES. Registration of transfers of ------------------- Shares shall be made only in the stock ledger of the Corporation upon request of the registered holder of such shares, or of his attorney thereunto authorized by power of attorney duly executed and filed with the Corporation, and upon the surrender of the certificate or certificates evidencing such Shares properly endorsed or accompanied by a stock power duly executed, together with such proof of the authenticity of signatures as the Corporation may reasonably require. SECTION 6.04 ADDRESSES OF STOCKHOLDERS. Each Stockholder shall ------------------------- designate to the Corporation an address at which notices of meetings and all other corporate notices may be served or mailed to such Stockholder, and, if any Stockholder shall fail to so designate such an address, corporate notices may be served upon such Stockholder by mail directed to the mailing address, if any, as the same appears in the stock ledger of the Corporation or at the last known mailing address of such Stockholder. -13- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 SECTION 6.05 LOST, DESTROYED AND MUTILATED CERTIFICATES. Each ------------------------------------------ recordholder of Shares shall promptly notify the Corporation of any loss, destruction or mutilation of any certificate or certificates evidencing any Share or Shares of which he is the recordholder. The Board, in its discretion, or any transfer agent thereunto duly authorized by the Board, may authorize the issue of a new certificate in place of any certificate theretofore issued and alleged to have been mutilated, lost, stolen or destroyed, upon the surrender of the mutilated certificate or, in the case of loss, theft or destruction of the certificate, upon satisfactory proof of such loss, theft or destruction, and the Board may, in its discretion, require, and its transfer agents and registrars may so require, the recordholder of the Shares evidenced by the lost, stolen or destroyed certificate or his legal representative to give the Corporation a bond sufficient to indemnify the Corporation against any claim made against it on account of the alleged loss, theft or destruction of any such certificate or the issuance of such new certificate. SECTION 6.06 REGULATIONS. The Board may make such other rules and ----------- regulations as it may deem expedient, not inconsistent with these By-laws, concerning the issue, transfer and registration of certificates evidencing Shares. SECTION 6.07 FIXING DATE FOR DETERMINATION OF STOCKHOLDERS OF RECORD. ------------------------------------------------------- In order that the Corporation may determine the Stockholders entitled to notice of or to vote at any meeting of Stockholders or any adjournment thereof, or to express consent to, or to dissent from, corporate action in writing without a meeting, or entitled to receive payment of any dividend or other distribution or allotment of any rights, or entitled to exercise any rights in respect of any change, conversion or exchange of stock, or for the purpose of any other lawful action, the Board may fix, in advance, a record date, which shall not be more than 60 nor less than 10 days before the date of such meeting, nor more than 60 days prior to any other such action. A determination of the Stockholders entitled to notice of or to vote at a meeting of Stockholders shall apply to any adjournment of such meeting; provided, however, that the Board may fix a new -------- ------- record date for the adjourned meeting. ARTICLE VII SEAL SECTION 7.01 SEAL. The Board may approve and adopt a corporate seal, ---- which shall be in the form of a circle and shall bear the full name of the Corporation, the year of its incorporation and the words "Corporate Seal Delaware". -14- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 ARTICLE VIII FISCAL YEAR SECTION 8.01 FISCAL YEAR. The fiscal year of the Corporation shall ----------- end on the thirty-first day of December of each year unless changed by resolution of the Board. ARTICLE IX INDEMNIFICATION AND INSURANCE SECTION 9.01 INDEMNIFICATION. (a) The Corporation shall indemnify --------------- any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative (other than an action by or in the right of the Corporation) by reason of the fact that he is or was a director, officer, employee or agent of the Corporation, or is or was serving at the request of the Corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, against expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by him in connection with such action, suit or proceeding if he acted in good faith and in a manner he reasonably believed to be in, or not opposed to, the best interests of the Corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe his conduct was unlawful. The termination of any action, suit or proceeding by judgment, order, settlement, conviction, or upon a plea of nolo contendere or its equivalent, shall not, of itself, create a --------------- presumption that the person did not act in good faith and in a manner which he reasonably believed to be in, or not opposed to, the best interests of the Corporation, and, with respect to any criminal action or proceeding, had reasonable cause to believe that his conduct was unlawful. (b) The Corporation shall indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action or suit by or in the right of the Corporation to procure a judgment in its favor by reason of the fact that he is or was a director, officer, employee or agent of the Corporation, or is or was serving at the request of the Corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise against expenses (including attorney's fees) actually and reasonably incurred by him in connection with the defense or settlement of such action or suit if he acted in good faith and in a manner he reasonably believed to be in, or not opposed to, the best interests of the Corporation and except that no indemnification shall be made in respect of any claim, issue or matter as to which such person shall have been adjudged to be liable to the Corporation unless and only to the extent that the Court of Chancery of the State of Delaware or the court in which such action or suit was brought shall determine upon application that, despite the adjudication of liability but in view of all the circumstances of the case, such person is -15- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 fairly and reasonably entitled to indemnity for such expenses which the Court of Chancery or such other court shall deem proper. (c) To the extent that a director, officer, employee or agent of the Corporation has been successful on the merits or otherwise in defense of any action, suit or proceeding referred to in Section 9.01(a) and (b) of these By- laws, or in defense of any claim, issue or matter therein, he shall be indemnified against expenses (including attorneys' fees) actually and reasonably incurred by him in connection therewith. (d) Any indemnification under Section 9.01(a) and (b) of these By- laws (unless ordered by a court) shall be made by the Corporation only as authorized in the specific case upon a determination that indemnification of the director, officer, employee or agent is proper in the circumstances because he has met the applicable standard of conduct set forth in Section 9.01(a) and (b) of these By-laws. Such determination shall be made (i) by the Board by a majority vote of a quorum consisting of directors who were not parties to such action, suit or proceeding, or (ii) if such a quorum is not obtainable, or, even if obtainable, a quorum of disinterested directors so directs, by independent legal counsel in a written opinion, or (iii) by the stockholders of the Corporation. (e) Expenses (including attorneys' fees) incurred by an officer or director in defending any civil, criminal, administrative or investigative action, suit or proceeding may be paid by the Corporation in advance of the final disposition of such action, suit or proceeding upon receipt of an undertaking by or on behalf of such director or officer to repay such amount if it shall ultimately be determined that he is not entitled to be indemnified by the Corporation pursuant to this Article IX. Such expenses (including attorneys' fees) incurred by other employees and agents may be so paid upon such terms and conditions, if any, as the Board deems appropriate. (f) The indemnification and advancement of expenses provided by, or granted pursuant to, other Sections of this Article IX shall not be deemed exclusive of any other rights to which those seeking indemnification or advancement of expenses may be entitled under any law, by-law, agreement, vote of stockholders or disinterested directors or otherwise, both as to action in an official capacity and as to action in another capacity while holding such office. (g) For purposes of this Article IX, references to "the Corporation" shall include, in addition to the resulting corporation, any constituent corporation (including any constituent of a constituent) absorbed in a consolidation or merger which, if its separate existence had continued, would have had power and authority to indemnify its directors, officers, employees or agents so that any person who is or was a director, officer, employee or agent of such constituent corporation, or is or was serving at the request of such constituent corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, shall stand in the same position under the provisions of this Article IX with respect to the -16- By-laws of Ambac Financial Group, Inc. Amended through January 28, 1998 resulting or surviving corporation as he would have with respect to such constituent corporation if its separate existence had continued. (h) For purposes of this Article IX, references to "other enterprises" shall include employee benefit plans, references to "fines" shall include any excise taxes assessed on a person with respect to an employee benefit plan; and references to "serving at the request of the Corporation" shall include any service as a director, officer, employee or agent of the Corporation which imposes duties on, or involves service by, such director, officer, employee or agent with respect to any employee benefit plan, its participants, or beneficiaries; and a person who acted in good faith and in a manner he reasonably believed to be in the interest of the participants and beneficiaries of an employee benefit plan shall be deemed to have acted in a manner "not opposed to the best interests of the Corporation" as referred to in this Article IX. (i) The indemnification and advancement of expenses provided by, or granted pursuant to, this Article IX shall, unless otherwise provided when authorized or ratified, continue as to a person who has ceased to be a director, officer, employee or agent and shall inure to the benefit of the heirs, executors and administrators of such a person. SECTION 9.02 INSURANCE FOR INDEMNIFICATION. The Corporation may ----------------------------- purchase and maintain insurance on behalf of any person who is or was a director, officer, employee or agent of the Corporation, or is or was serving at the request of the Corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, against any liability asserted against him and incurred by him in any such capacity, or arising out of his status as such, whether or not the Corporation would have the power to indemnify him against such liability under the provisions of Section 145 of the General Corporation Law. ARTICLE X AMENDMENTS SECTION 10.01 AMENDMENTS. Any By-law (including these By-laws) may ---------- be adopted, amended or repealed by the vote of the recordholders of a majority of the Shares then entitled to vote at an election of Directors or by written consent of Stockholders pursuant to Section 2.14 hereof, or by vote of the Board or by a written consent of Directors pursuant to Section 3.08 hereof. -17- EX-4.01 3 DEFINITIVE ENGRAVED STOCK CERTIFICATE SUEM 8-1-97 NUMBER A AMBAC SEAL American Bank Note Company (EXHIBIT 4.01) SM ETHER 1 H-51928 SHARES COMMON STOCK AMBAC FINANCIAL GROUP, INC. INCORPORATED UNDER THE LAWS OF THE STATE OF DELAWARE SEE REVERSE FOR LEGEND AND CERTAIN DEFINITIONS CUSIP 023139 10 8 THIS IS TO CERTIFY THAT IS THE OWNER OF FULLY PAID AND NON-ASSESSABLE SHARES OF THE COMMON STOCK OF AMBAC FINANCIAL GROUP, INC., transferable in person or by duly authorized attorney upon surrender of this Certificate properly endorsed. This Certificate is not valid until countersigned and registered by the Transfer Agent and Registrar. Witness the facsimile seal of the Corporation and the facsimile signatures of its duly authorized officers. Dated Countersigned and Registered: CITIBANK, N.A. Transfer Agent and Registrar By /s/Richard B. Gross /s/P. Lassiter Senior vice President Chairman of the Board and Authorized Signatory and Secretary Chief Executive Officer Richard B. Gross P. Lassiter AMBAC FINANCIAL GROUP, INC. This Certificate also evidences and entitles the holder hereof to certain Rights as set forth in the Rights Agreement between the Corporation and the Rights Agent thereunder (the "Rights Agreement"), the terms of which are hereby incorporated herein by reference and a copy of which is on file at the principal offices of the Corporation. Under certain circumstances, as set forth in the Rights Agreement, such Rights will be evidenced by separate Certificates and will no longer be evidenced by this Certificate. The Corporation will mail to the holder of this Certificate a copy of the Rights Agreement, as in effect on the date of mailing, without charge, promptly after receipt of a written request therefor. Under certain circumstances set forth in the Rights Agreement, Rights issued to, or held by, any Person who is, was or becomes an Acquiring Person or any Affiliate or Associate thereof (as such terms are defined in the Rights Agreement), whether currently held by or on behalf of such Person or by any subsequent holder, may become null and void. The Corporation will furnish without charge to any stockholder who so requests the designations, preferences and relative, participating, optional or other special rights of each class and series of stock which the Corporation is authorized to issue and the qualifications, limitations or restrictions of such preferences and/or rights. Such request may be made to the Secretary of the Corporation or to the Transfer Agent named on the face hereof. The following abbreviations, when used in the inscription on the face of this Certificate, shall be construed as though they were written out in full according to applicable laws or regulations: TEN COM -as tenants in common UNIF GIFT MIN ACT-______Custodian_______ (Cust) (Minor) TEN ENT -as tenants by the entireties JT TEN -as joint tenants with right of survivorship and not as tenants under Uniform Gifts to Minors in common Act_____________________ (State) Additional abbreviations may also be used though not in the above list. For value received,___________hereby sell, assign and transfer unto PLEASE INSERT SOCIAL SECURITY OR OTHER IDENTIFYING NUMBER OF ASSIGNEE [____________________________________] _____________________________________________________________________________ (PLEASE PRINT OR TYPEWRITE NAME AND ADDRESS, INCLUDING ZIP CODE, OF ASSIGNEE) _____________________________________________________________________________ _____________________________________________________________________________ _______________________________________________________________________shares of the capital stock represented by the within Certificate, and do hereby irrevocably constitute and appoint _____________________________________________________________________Attorney to transfer the said stock on the books of the within named Corporation with full power of substitution in the premises. Dated______________________ _____________________________________________ NOTICE: THE SIGNATURE TO THIS ASSIGNMENT MUST CORRESPOND WITH THE NAME AS WRITTEN UPON THE FACE OF THE CERTIFICATE IN EVERY PARTICULAR WITHOUT ALTERATION OR ENLARGEMENT OR ANY CHANGE WHATEVER. Signature(s) Guaranteed: ____________________________________________________ THE SIGNATURE(S) SHOULD BE GUARANTEED BY AN ELIGIBLE GUARANTOR INSTITUTION (BANKS, STOCKBROKERS, SAVINGS AND LOAN ASSOCIATIONS AND CREDIT UNIONS WITH MEM- BERSHIP IN AN APPROVED SIGNATURE GUARANTEE MEDALLION PROGRAM), PURSUANT TO S.E.C. RULE 17Ad-15. EX-10.01 4 EMPLOYMENT AGREEMENT PHILLIP B. LASSITER (EXHIBIT 10.01) SECOND AMENDED AND RESTATED EMPLOYMENT AGREEMENT SECOND AMENDED AND RESTATED EMPLOYMENT AGREEMENT dated as of July 18, 1991, as initially amended and restated in full as of December 30, 1994 and subsequently further amended and restated in full as of December 2, 1997, by and between AMBAC FINANCIAL GROUP, INC., a Delaware corporation (the "COMPANY"), and PHILLIP B. LASSITER (the "EXECUTIVE"). WHEREAS, the Company and the Executive originally entered into this Agreement as of July 18, 1991 providing for the Executive to be employed by the Company as its Chairman and Chief Executive Officer upon the terms and conditions set forth in such original agreement, the Executive's positions having subsequently been enlarged to include President of the Company; and WHEREAS, the Company and the Executive amended and restated this Agreement in its entirety as of December 30, 1994 in order to reflect certain amendments to the terms thereof; and WHEREAS, the Company and the Executive have agreed to amend this Agreement further, principally to conform to certain terms set forth in Amended and Restated Management Retention Agreements between the Company and certain of its senior officers, and to restate this Agreement in its entirety; NOW, THEREFORE, in consideration of the premises and the mutual covenants herein contained, the parties hereto hereby agree as follows (capitalized terms used herein without definition shall have the meanings ascribed to such terms in Section 12 below): 1. EMPLOYMENT AND DUTIES. (a) EFFECTIVE DATE. The effective date of this Agreement (the "EFFECTIVE DATE") was July 18, 1991, such date being the date of the consummation of the "Equity Offerings," as such term is defined in Registration Statement No. 33-40306 on Form S-1 of the Company. (b) GENERAL. The Company hereby continues the employment of the Executive, and the Executive agrees upon the terms and conditions herein set forth to continue to serve, as the Chairman, President and Chief Executive Officer of the Company. In addition, the Executive shall continue to serve as the Chairman, President and Chief Executive Second Amended and Restated Employment Agreement Page 2 of 23 Officer of Ambac Assurance Corporation, a Wisconsin corporation that is a wholly-owned subsidiary of the Company ("AMBAC ASSURANCE"). The Executive shall devote his full-time working hours and best efforts to his duties hereunder. The Company agrees to nominate the Executive for election to its Board of Directors (the "BOARD") as a member of the management slate at each annual meeting of stockholders (or if the members of the Board are divided into classes pursuant to Section 141(d) of the Delaware General Corporation Law, at each annual meeting of stockholders at which the Executive's director class comes up for election) during his employment hereunder. The Executive agrees to serve on the Board if elected. In addition, the Executive agrees to serve, if requested by the Board, as an officer or director of any subsidiary or affiliate of the Company at no additional compensation. 2. TERM OF EMPLOYMENT. The term of the Executive's employment under this Agreement (the "TERM") commenced on the Effective Date and initially continued until the second anniversary of the Effective Date. Starting with the day following the Effective Date the Term has been extended, and, continuing until the date the Executive's employment is terminated in accordance with the terms of this Agreement, the Term shall continue to be so extended, on a daily basis to continue until the second anniversary of the date of such extension, provided, however, that (i) the Company or the Executive may give the other notice that it does not wish to extend the Term beyond two years from the date of such notice, and (ii) unless the Company shall specify in writing to the contrary, the Term shall not extend past the Executive's sixty-fifth birthday. Notwithstanding the preceding sentence, upon the occurrence of a Change in Control, the Term shall be extended and shall at any time be considered to continue until the later of (x) the third anniversary of the Change in Control and (y) the date determined in accordance with the preceding sentence. Nothing in this Section 2 shall limit the right of the Company to terminate the Executive's employment hereunder on the terms and conditions set forth in Section 4. 3. COMPENSATION AND OTHER BENEFITS. Subject to the provisions of this Agreement, the Company shall pay and provide the following compensation and other benefits to the Executive during the Term as compensation for services rendered hereunder: (a) SALARY. The Executive's rate of salary (the "SALARY") was initially $410,000 and has subsequently been increased to $530,000. The Salary is payable in substantially equal installments at such intervals (not less frequently than monthly) as may be determined by the Company in accordance with its payroll practices as established from time to time. The Compensation and Organization Committee of the Board (or any successor thereto) (the "COMMITTEE") shall periodically review and may increase, but not decrease, the Executive's Salary as in effect at the time of such review. Second Amended and Restated Employment Agreement Page 3 of 23 (b) BONUS. The Executive shall participate for each calendar year in a bonus arrangement pursuant to which he shall be eligible to earn an annual bonus, based on the Company's achieving certain performance goals which the Committee shall establish. For each such year, the bonus arrangement will provide that, in the event that target performance goals are achieved, the bonus for such year shall be no less than 70% of the Executive's Salary for such year (the "TARGET BONUS") and may provide for a bonus greater or less than the Target Bonus in the event the target performance goals for such year are exceeded or are not met in full. The form of payment of the Executive's bonus (whether in cash, in awards under the Company's 1997 Equity Plan, as the same may be amended from time to time, or any successor thereto (the "EQUITY PLAN"), in a combination of cash and such awards or in some other form), and the value to be attributed to any non-cash component of the bonus, will be determined by the Committee in its discretion. (c) LONG-TERM INCENTIVE COMPENSATION. The Executive's long-term incentive compensation awards, whether under the Equity Plan or any other plan or program of the Company, shall be determined by the Committee in its discretion. (d) EXPENSES. The Company shall reimburse the Executive for reasonable travel and other business related expenses incurred by him in performance of the business of the Company. In addition, the Company shall reimburse the Executive for the annual membership fees of one golf club and one luncheon club. (e) PENSION, WELFARE AND FRINGE BENEFITS. (i) GENERAL. The Executive shall participate in each pension, welfare, life insurance, health, disability and other fringe benefit plan or program maintained by the Company for its executive officers in accordance with the terms thereof. (ii) PARTICIPATION IN RETIREMENT PLAN. The Executive participates, and shall continue to participate, in the Company's Pension Plan (the "RETIREMENT PLAN") or any successor plan thereto and has received service credit under the Retirement Plan, in accordance with the terms thereof, for periods of service with Citibank, N.A. and its affiliates for which he received credit under The Retirement Plan of Citibank, N.A. and its affiliates (the "CITIBANK PLAN"), it being understood that under the terms of such plans amounts paid under the Citibank Plan shall reduce the amounts payable from the Retirement Plan. (iii) SUPPLEMENTAL RETIREMENT BENEFITS. Provided that the Executive remains in the employ of the Company or its affiliates until at least the age at which he becomes Second Amended and Restated Employment Agreement Page 4 of 23 eligible for early retirement under the terms of the Retirement Plan (or, if earlier, until termination of his employment by reason of death or Disability, the Company will pay the Executive, commencing at the time payment of benefits under the Retirement Plan commences (or, if earlier, commencing as of the first month following termination of the executive's employment by reason of death or Disability), an annual supplemental retirement benefit (the "ASRB") determined by the formula "ASRB = X - (Y + Z)", where "X", "Y" and "Z" are defined as follows: "X" equals the annual amount that would be payable under the Retirement Plan to the Executive commencing at his retirement (or earlier termination of employment due to death or Disability) determined as though (A) the provisions of the Retirement Plan in effect on December 31, 1991 had remained in effect through such retirement or earlier termination, (B) the Executive's bonus compensation (including cash bonus and any restricted stock or stock units awarded in lieu of cash (any such stock and units to be considered to have the value attributed thereto by the Committee as provided in Section 3(b)), but excluding the value of any stock options) were taken into account in computing the benefit payable thereunder, and (C) such benefit were calculated without giving effect to the limitations provided for in Sections 401(a)(17) and 415 of the Internal Revenue Code of 1986, as amended (the "CODE"), or any successor provisions thereto. "Y" equals the aggregate annual benefits payable to the Executive under any qualified or nonqualified defined benefit retirement plan or arrangement maintained by the Company or any of its subsidiaries or affiliates. "Z" equals an annual amount that is the actuarial equivalent of the excess, if any of: (A) the aggregate amount of employer contributions that would have been contributed to the Executive's account under the Company's Savings Incentive Plan or any successor plan thereto (the "SIP") through the date of the Executive's retirement (or earlier termination of employment due to death or Disability), determined pursuant to the terms of the SIP and any such other plans or arrangements as in effect from time to time, over (B) the amount of employer contributions that would have been so contributed to the Executive's account under the SIP determined Second Amended and Restated Employment Agreement Page 5 of 23 pursuant to the terms of the SIP in effect on December 31, 1991, in each such case calculated on the assumptions: (a) that Section 401(a)(17), 402(g) and 415 of the Code did not apply and that the Executive's annual contributions would not be limited by operation of the actual deferral percentage or actual contribution percentage tests under Sections 401(k) and (m), respectively, of the Code, and (b) that the Executive had deferred 6% of his salary under the SIP, all such amounts to be credited with interest from December 31 of the year in respect of which any such contribution would have been made to the date of the Executive's retirement or other termination of employment at a rate equal to the applicable long-term federal rate compounded semiannually, such rate to be adjusted annually on the first day of each calendar year to reflect the rate then in effect. For this purpose, actuarial equivalence shall be determined using the actuarial assumptions used in the valuation of the required minimum contribution to the Retirement Plan under Section 412 of the Code for the plan year in which the Executive retires or otherwise terminates employment. The ASRB shall be determined and paid on the basis of the same payment alternative that the Executive shall have elected under the Retirement Plan. 4. TERMINATION OF EMPLOYMENT. This Section 4 sets forth the provisions that will apply generally upon a termination of the Executive's employment with the Company. Special provisions that will apply in the event of a Change in Control are set forth at Section 5 below. (a) TERMINATION FOR CAUSE; RESIGNATION WITHOUT GOOD REASON. (i) RIGHTS ON TERMINATION. If, prior to the expiration of the Term, the Executive's employment is terminated by the Company for Cause, or the Executive resigns from his employment hereunder other than for Good Reason, the Executive shall be entitled to payment of his Salary accrued through the date of such termination or resignation, plus any other accrued but unpaid benefits or compensation (including any accrued but unpaid bonus compensation in respect of a year prior to the year in which such termination or resignation Second Amended and Restated Employment Agreement Page 6 of 23 occurs), provided, however, that the Executive shall not be entitled to any bonus compensation pursuant to Section 3(b) in respect of the year in which such termination or resignation occurs. Except as may be provided under the terms of any applicable grants to the Executive under the Stock Plan or any amended or successor plan thereto, the Executive shall have no right under this Agreement or otherwise to receive any other compensation, or to participate in any other plan, arrangement or benefit, with respect to future periods after such termination or resignation of Employment. (ii) NOTICE OF TERMINATION OR RESIGNATION. Termination of the Executive's employment for Cause shall be communicated by delivery to the Executive of a copy of a resolution duly adopted by the affirmative vote of not less than a majority (or, following a Change in Control, not less than three- fourths) of the entire membership of the Board at a meeting of the Board called and held for such purpose (after reasonable notice to the Executive and reasonable opportunity for the Executive, together with the Executive's counsel, to be heard before the Board prior to such vote), finding that in the good faith opinion of the Board an event constituting Cause for termination in accordance with Section 10(a) has occurred and specifying the particulars thereof (a "NOTICE OF TERMINATION"). If the event constituting Cause for termination is of a type specified in clause (i) or clause (iii) of the definition of Cause set forth in Section 12, the Executive shall have 20 business days from the date of receipt of such Notice of Termination to effect a cure of the event described therein and, upon cure thereof by the Executive to the reasonable satisfaction of the Company, such event shall no longer constitute Cause for purposes of this Agreement. (b) TERMINATION WITHOUT CAUSE; RESIGNATION FOR GOOD REASON. (i) SEVERANCE AMOUNT. If, prior to the expiration of the Term, the Executive's employment is terminated by the Company without Cause, or the Executive resigns from his employment hereunder for Good Reason, the Company shall pay to the Executive his Salary accrued up to and including the date of such termination or resignation, plus a pro rata portion (based on the number of days elapsed prior to such termination or resignation) of the Target Bonus for the year in which such termination or resignation occurs, plus any other accrued but unpaid benefits or compensation. In addition, the Company shall pay to the Executive the Severance Amount (as hereinafter defined) over a two-year period commencing with the date of such termination or resignation (the "SEVERANCE PERIOD"). As used herein, the "SEVERANCE AMOUNT" shall mean the product of "A" times "B" where "A" equals the number of years (including any fraction thereof, based on 365 days per year) remaining in the Term as of the date of such termination or resignation, and "B" equals the sum of the Salary as in effect on the date of such termination or resignation and the Executive's Target Bonus for the year in which such termination or resignation occurs (or if Second Amended and Restated Employment Agreement Page 7 of 23 the Executive's Target Bonus has not yet been determined for such year, his Target Bonus for the immediately preceding year) (such sum, which shall be not less than 170% of such Salary, is referred to as the "REFERENCE AMOUNT"). The Severance Amount shall be payable in equal monthly installments over the Severance Period and each such installment shall be subject to regular payroll deductions. (ii) BENEFITS UNDER THE STOCK PLAN. In the event of the Executive's termination or resignation as provided in this Section 4(b), the Executive shall be fully vested in all stock options, restricted stock, restricted stock units and any other awards theretofore awarded to him under the Company's 1991 Stock Incentive Plan, as amended, the Equity Plan, or any successor thereto. (iii) OTHER BENEFITS. In the event of the Executive's termination or resignation as provided in this Section 4(b), the Executive shall also be entitled to the following benefits: (A) For purposes of calculating the Executive's benefit under the Retirement Plan, the Executive shall receive an additional two years of credited service. In addition, for all purposes under the Retirement Plan, including for purposes of benefit calculations, the Executive shall be treated as having retired from service with the Company, rather than as a "terminated vested" employee. (B) Within five business days following the Termination Date, the Company shall make a lump sum payment to the Executive equal to the amount that the Company would have contributed for the Executive's account under the SIP in respect of the two years following the Termination Date, based on (A) the formula for determining employer contributions in effect on the Termination Date and (B) the Salary (and, if such formula takes account of bonus compensation, the Target Bonus) used for purposes of determining the Reference Amount, and calculated without giving effect to the limitations provided for in Sections 401(a)(17) and 415 of the Code, or any successor provisions thereto. (C) Within five business days following the Termination Date the Executive shall receive a lump sum payment of his account balance as of the Termination Date under any nonqualified plan maintained by the Company or any of its Affiliates to provide benefits in excess of those permitted under the Code to be provided by the SIP. (It is understood that no such plan exists as of the date of this Agreement.). The Company shall remain obligated to pay to the Executive or his beneficiaries any benefits to which he or they may be entitled under any nonqualified plan maintained by Second Amended and Restated Employment Agreement Page 8 of 23 the Company or any of its Affiliates to provide benefits in excess of those permitted under the Code to be provided by the Retirement Plan (including without limitation benefits under the Company's Excess Benefit Plan and Supplemental Retirement Plan or any successors to such plans, and the ASRB provided for in Section 3(e) of this Agreement); such payments shall be made in accordance with the terms of such plans, and benefits thereunder shall take account of the two years of additional credited service provided for in clause (ii) above. (D) During the Severance Period, the Executive and his dependents, if any, shall continue to participate (at no greater expense to them than was the case for such coverage prior to his termination) in the employee benefit arrangements described in Section 3(e)(i) above, provided, however, that such benefits shall cease to the extent the Executive begins coverage under plans of a subsequent employer. (E) At the end of the Severance Period, the Executive and his family shall be entitled for the remainder of his life to retiree medical and dental benefits under the applicable plans and programs of the Company as if he retired on the last day of the Severance Period, with such benefits to commence immediately at the end of the Severance Period and with the amount of contribution by the Executive to be no greater than that of any other employee of the Company who had retired on the last day of the Severance Period (it being understood and agreed that contribution rates may be changed, and the terms of such benefits may be modified, to the extent permitted under the relevant plans, from those in effect on the date hereof). (F) During the Severance Period, the Company shall provide the Executive with appropriate individual outplacement services and financial planning at the Company's expense. (G) The Executive shall receive all amounts due to him under any compensatory plan or arrangement of the Company and not specifically addressed above, in accordance with the terms of the relevant plan or arrangement. Anything herein to the contrary notwithstanding, the Company shall have no obligation to continue to maintain during the Severance Period any plan or program solely as a result of the provisions of this Agreement. If, during the Severance Period, the Executive is precluded from participating in a plan or program by its terms or applicable law or if the Company for any reason ceases to maintain such plan or program, the Company shall provide the Executive with compensation or benefits the aggregate value of which is no less than the aggregate value of the compensation or benefits that the Executive would have received under such plan or Second Amended and Restated Employment Agreement Page 9 of 23 program had he been eligible to participate therein or had such plan or program continued to be maintained by the Company. (iv) OFFSET PROVISIONS. In the event of any termination of the Executive's employment, the Executive shall be under no obligation to seek other employment or otherwise to mitigate damages resulting from his termination of employment. Nevertheless, subject to Section 5 below, amounts owed to the Executive under Section 4(b)(i) shall be offset by the amount of cash compensation to which the Executive becomes entitled, or which is voluntarily deferred at his request, during the Severance Period, from a Third Party Employer. Promptly upon becoming engaged by a Third Party Employer, the Executive shall provide the Company with written notice of such engagement and shall set forth the terms of his compensation, including any amount of guaranteed or target bonus; within five business days of the receipt of such notice, the Company shall make a lump-sum payment to the Executive equal to the amount that remains due to the Executive under Section 4(b)(i) reduced by the amount of cash compensation to which the Executive is expected to become entitled during the Severance Period from the Third Party Employer (including any amounts which are to be voluntarily deferred at his request) based on the compensation information set forth in his notice to the Company, including therein a pro rata portion (based on the number of days remaining in the Severance Period) of any guaranteed or target bonus. The Company and the Executive shall use their good faith efforts to agree upon the offset amount, but in the event they are unable to agree, the amount proposed by the Executive, and certified by an independent certified public account selected by the Executive, shall control. (v) DEATH DURING SEVERANCE PERIOD. In the event of the Executive's death during the Severance Period, the balance of the Severance Amount will be paid to his Beneficiary in a lump sum. "BENEFICIARY" shall mean the person or persons designated by the Executive in writing to the Company to receive payment under this Agreement or, if no such person or persons are designated, the Executive's estate. (c) TERMINATION DUE TO DEATH OR DISABILITY. In the event of the Executive's Disability, the Company shall be entitled to terminate his employment. Notwithstanding anything contained in this Agreement to the contrary, if the Executive employment terminates due to death or Disability, any Salary earned by the Executive up to the date of such termination, plus a pro rata portion (based on the number of days elapsed prior to such termination or resignation) of the Target Bonus for the year in which such termination occurs, shall be paid to the Executive or his estate, as the case may be, within 30 days of such termination. All stock options, restricted stock, restricted stock units or other awards awarded to the Executive under the Stock Plan shall be fully vested as of the date of death or termination of employment due to Disability. As used in this Section 4(c), the term Second Amended and Restated Employment Agreement Page 10 of 23 "DISABILITY" shall be defined in the same manner as such term or a similar term is defined in any long-term disability policy maintained by the Company which covers the Executive and is in effect on the date of the Executive's termination of employment with the Company, provided, however, that the Executive shall not be "disabled" for purposes of this Section 4(c) unless he has a physical or mental incapacity that substantially prevents him from performing his duties hereunder, that has continued at least 180 days and that can reasonably be expected to continue indefinitely. Any dispute as to whether or not the Executive is disabled within the meaning of the preceding sentence shall be resolved by a physician reasonably satisfactory to the Executive and the Board, and the determination of such physician shall be final and binding upon both the Executive and the Company. 5. CHANGE IN CONTROL PROVISIONS. Notwithstanding anything in to the contrary in this Agreement, the provisions of this Section 5 shall apply in the event there is a Change in Control. (a) EQUITY AWARDS. Upon the occurrence of a Change in Control, the Executive shall be fully vested in all stock options, restricted stock, restricted stock units and any other awards theretofore awarded to him under the Equity Plan, or any successor thereto, on or after January 1, 1998 provided, however, that if any Person commences a tender offer for shares of the Company's common stock, par value $0.01 per share (the "COMMON STOCK"), which, if successfully completed, would result in a Change in Control, then the Executive shall be fully vested in all such stock options, restricted stock units and any other such awards, and any such awards that by their terms are to be paid or settled by the delivery of shares of Common Stock without the payment of any additional consideration by the Executive shall be so paid or settled, immediately prior to the scheduled expiration of such tender offer, and the Company shall have instituted procedures to enable the Executive, if he so desires, to tender the shares issued upon the exercise of such stock options or delivered in payment or settlement of such restricted stock units or other awards into such offer. (b) PAYMENT OF SEVERANCE AMOUNT. If the Executive's employment with the Company is terminated by the Executive for Good Reason or by the Company without Cause, in either case at any time during the period beginning with a Change in Control and ending on the third anniversary thereof, then: (i) the Reference Amount shall equal the sum of (X) the Salary in effect on the Termination Date and (Y) the higher of the Target Bonus for the year in which the Termination Date occurs (or if the Executive's Target Bonus has not yet been determined for such year, his Target Bonus for the immediately preceding year) and the Second Amended and Restated Employment Agreement Page 11 of 23 highest Bonus percentage paid or payable to the Executive at any time prior to his Termination Date times the Salary in effect on the Termination Date; and (ii) the Severance Amount shall equal two times the Reference Amount and shall be paid to the Executive by the Company in a lump sum within five business days of the Termination Date. (c) NO OBLIGATION TO MITIGATE AND NO OFFSET. As provided above in Section 4, upon termination of the Executive's employment, the Executive shall be under no obligation to seek other employment or otherwise to mitigate damages resulting from his termination of employment. In addition, notwithstanding Section 4(b)(iv) above, if such termination occurs at any time during the period beginning with a Change in Control and ending on the third anniversary thereof, there shall be no offset against amounts due to the Executive under any provision of this Agreement on account of any remuneration to which the Executive becomes entitled from any Third Party Employer or any other Person for whom the Executive subsequently provides services (as an officer, director, employee, independent contractor or otherwise), other than as provided in Section 4(b)(iii)(D) relating to continuation of benefits coverage. (d) NO REDUCTION IN RIGHTS UNDER SECTION 4. Except as otherwise provided in this Section 5, the rights and entitlements of the Executive upon termination of employment incident to or following a Change in Control shall be as provided in Section 4. In particular, nothing in this Section 5 is intended, or shall be construed, to reduce any of the rights and entitlements of the Executive set forth in Section 4. 6. CERTAIN ADDITIONAL PAYMENTS BY THE COMPANY. (a) Anything in this Agreement to the contrary notwithstanding, in the event it shall be determined that any payment or distribution by the Company to or for the benefit of the Executive (whether paid or payable or distributed or distributable pursuant to the terms of this Agreement or otherwise, but determined without regard to any additional payments required under this Section 6) (a "PAYMENT") would be subject to the excise tax imposed by the Code or any interest or penalties are incurred by the Executive with respect to such excise tax (such excise tax, together with any such interest and penalties, are hereinafter collectively referred to as the "EXCISE TAX"), then the Executive shall be entitled to receive an additional payment (a "GROSS-UP PAYMENT") in an amount such that after payment by the Executive of all taxes (including any interest or penalties imposed with respect to such taxes), including, without limitation, any income taxes (and any interest and penalties imposed with respect thereto) and Excise Tax imposed upon the Gross-Up Payment, the Executive retains an amount of the Gross-Up Payment equal to the Excise Tax imposed upon the Payments. Second Amended and Restated Employment Agreement Page 12 of 23 (b) Subject to the provisions of Section 6(c), all determinations required to be made under this Section 6, including whether and when a Gross-Up Payment is required and the amount of such Gross-Up Payment and the assumptions to be utilized in arriving at such determination, shall be made by KPMG Peat Marwick LLP or such other certified public accounting firm as may be jointly designated by the Executive and the Company (the "ACCOUNTING FIRM"), which shall provide detailed supporting calculations both to the Company and the Executive within 15 business days of the receipt of notice from the Executive that there has been a Payment, or such earlier time as is requested by the Company. All fees and expenses of the Accounting Firm shall be borne solely by the Company. Any Gross-Up Payment, as determined pursuant to this Section 6, shall be paid by the Company to the Executive within five days of the receipt of the Accounting Firm's determination. Any determination by the Accounting Firm shall be binding upon the Company and the Executive. As a result of the uncertainty in the application of Section 4999 of the Code at the time of the initial determination by the Accounting Firm hereunder, it is possible that Gross-Up Payments which will not have been made by the Company should have been made ("UNDERPAYMENT"), consistent with the calculations required to be made hereunder. In the event that the Company exhausts its remedies pursuant to Section 6(c) and the Executive thereafter is required to make a payment of any Excise Tax, the Accounting Firm shall determine the amount of the Underpayment that has occurred and any such Underpayment shall be promptly paid by the Company to or for the benefit of the Executive. (c) The Executive shall notify the Company in writing of any claim by the Internal Revenue Service that, if successful, would require the payment by the Company of the Gross-Up Payment. Such notification shall be given as soon as practicable but no later than ten business days after the Executive is informed in writing of such claim and shall apprize the Company of the nature of such claim and the date on which such claim is requested to be paid. The Executive shall not pay such claim prior to the expiration of the 30-day period following the date on which it gives such notice to the Company (or such shorter period ending on the date that any payment of taxes with respect to such claim is due). If the Company notifies the Executive in writing prior to the expiration of such period that it desires to contest such claim, the Executive shall: (i) give the Company any information reasonably requested by the Company relating to such claim, (ii) take such action in connection with contesting such claim as the Company shall reasonably request in writing from time to time, including, without limitation, accepting legal representation with respect to such claim by an attorney Second Amended and Restated Employment Agreement Page 13 of 23 reasonably selected by the Company, (iii) cooperate with the Company in good faith in order effectively to contest such claim, and (iv) permit the Company to participate in any proceedings relating to such claim; provided, however, that the Company shall bear and pay directly all costs and expenses (including additional interest and penalties) incurred in connection with such contest and shall indemnify and hold the Executive harmless, on an after-tax basis, for any Excise Tax or income tax (including interest and penalties with respect thereto) imposed as a result of such representation and payment of costs and expenses. Without limitation on the foregoing provisions of this Section 6(c), the Company shall control all proceedings taken in connection with such contest and, at its sole option, may pursue or forgo any and all administrative appeals, proceedings, hearings and conferences with the taxing authority in respect of such claim and may, at its sole option, either direct the Executive to pay the tax claimed and sue for a refund or contest the claim in any permissible manner, and the Executive agrees to prosecute such contest to a determination before any administrative tribunal, in a court of initial jurisdiction and in one or more appellate courts, as the Company shall determine; provided, however, that if the Company directs the Executive to pay such claim and sue for a refund, the Company shall advance the amount of such payment to the Executive, on an interest-free basis and shall indemnify and hold the Executive harmless, on an after-tax basis, from any Excise Tax or income tax (including interest or penalties with respect thereto) imposed with respect to such advance or with respect to any imputed income with respect to such advance; and further provided that any extension of the statute of limitations relating to payment of taxes for the taxable year of the Executive with respect to which such contested amount is claimed to be due is limited solely to such contested amount. Furthermore, the Company's control of the contest shall be limited to issues with respect to which a Gross-Up Payment would be payable hereunder and the Executive shall be entitled to settle or contest, as the case may be, any other issue raised by the Internal Revenue Service or any other taxing authority. (d) If, after the receipt by the Executive of an amount advanced by the Company pursuant to Section 6(c), the Executive becomes entitled to receive any refund with respect to such claim, the Executive shall (subject to the Company's complying with the requirements of Section 6(c)) promptly pay to the Company the amount of such refund (together with any interest paid or credited thereon after taxes applicable thereto). If, after the receipt by the Executive of an amount advanced by the Company pursuant to Section 6(c), a determination is made that the Executive shall not be entitled to any refund with respect to Second Amended and Restated Employment Agreement Page 14 of 23 such claim and the Company does not notify the Executive in writing of its intent to contest such denial of refund prior to the expiration of 30 days after such determination, then such advance shall be forgiven and shall not be required to be repaid and the amount of such advance shall offset, to the extent thereof, the amount of Gross-Up Payment required to be paid. 7. PROTECTION OF THE COMPANY'S INTERESTS. (a) CONFIDENTIAL INFORMATION. Except for actions taken in the course of his employment hereunder or as required by law, at no time shall the Executive divulge, furnish or make accessible to any person any information of a confidential or proprietary nature obtained by him while in the employ of the Company. Upon termination of his employment with the Company, the Executive shall return to the Company all such information which exists in written or other physical form and all copies thereof in his possession or under his control. (b) EXCLUSIVE SERVICES. During the Term, the Executive shall not directly or indirectly engage in competition with, or own any interest in any business which competes with, any business of the Company or any of its subsidiaries, provided, however, that the provisions of this Section 7 shall not prohibit the Executive's ownership of not more than 5% of the voting stock of any publicly held corporation, and provided, further, that the Executive's covenant under this Section 7(b) shall not apply following termination of his employment following a Change in Control. 8. REMEDIES. The Executive acknowledges that a breach of any of the covenants contained in Section 7 may result in material irreparable injury to the Company or its Affiliates for which there is no adequate remedy at law, that it will not be possible to measure damages for such injuries precisely and that, in the event of such breach or threat thereof, the Company shall be entitled, in addition to any other rights or remedies it may have, to obtain a temporary restraining order and/or a preliminary or permanent injunction enjoining or restraining the Executive from engaging in activities prohibited by Section 7. In no event, however, shall an asserted violation of the provisions of Section 7 constitute a basis for deferring or withholding any amounts otherwise payable to the Executive under this Agreement, unless the Company shall have first obtained a final decision, in an arbitration conducted in accordance with Section 11 of this Agreement, finding that the Executive has materially breached the provisions of Section 7. 9. INDEMNIFICATION. The Company will indemnify the Executive to the fullest extent permitted (including payment of expenses in advance of final disposition of a Second Amended and Restated Employment Agreement Page 15 of 23 proceeding) by the laws of the State of Delaware, as in effect at the time of the subject act or omission, or by the Certificate of Incorporation and By-Laws of the Company, as in effect at such time or on the Effective Date of this Agreement, whichever affords or afforded greatest protection to the Executive, and the Executive shall be entitled to the protection of any insurance policies the Company may elect to maintain generally for the benefit of its directors and officers (and to the extent the Company maintains such an insurance policy or policies, the Executive shall be covered by such policy or policies, in accordance with its or their terms, to the maximum extent of the coverage provided for any Company officer or director), against all costs, charges and expenses whatsoever incurred or sustained by him or his legal representatives at the time such costs, charges and expenses are incurred or sustained, in connection with any action, suit or proceeding to which he may be made a party by reason of his being or having been a director, officer or employee of the Company or any subsidiary thereof, or his serving or having served any other enterprise as a director, officer or employee at the request of the Company. 10. LIMITATION OF LIABILITY. The Company hereby represents that, as of the Effective Date, its Certificate of Incorporation and By-Laws provide the Executive with the maximum limitation on his liability permitted by the laws of the State of Delaware and the Company agrees that during the Term it will amend its Certificate of Incorporation and By-Laws, to the extent necessary, to provide the Executive the maximum limitation on his liability permitted by such laws. 11. ARBITRATION. (a) Any dispute or controversy arising under or in connection with this Agreement shall be settled exclusively by arbitration in New York, New York in accordance with the rules of the American Arbitration Association then in effect. Judgment may be entered on the arbitrator's award in any court having jurisdiction; provided, however, that the Executive shall be entitled to seek specific performance of the Executive's right to be paid until the Termination Date during the pendency of any dispute or controversy arising under or in connection with this Agreement. (b) The Company shall promptly reimburse the Executive for all legal fees and expenses incurred by the Executive in connection any claim to enforce his rights under this Agreement, except for any claim which shall have been determined, in an arbitration conducted in accordance with subsection (a) above, to have been brought by the Executive in bad faith. (c) In addition to the reimbursement provided for in subsection (b) above, Second Amended and Restated Employment Agreement Page 16 of 23 the Company shall reimburse the Executive for up to $15,000 in legal, accounting and financial expenses incurred after a Change in Control in connection with this Agreement (whether or not the Executive's employment is terminated), including without limitation in connection with financial planning and the investigation of the Executive's rights hereunder. 12. DEFINITIONS. For purposes of this Agreement, the following definitions shall apply. "AFFILIATE" includes any company or other entity or person controlling, controlled by or under common control with the Company. "CAUSE" means any of the following: (i) the willful commission by the Executive of acts that are dishonest and demonstrably and materially injurious to the Company or any of its Affiliates, monetarily or otherwise; (ii) the conviction of the Executive for a felonious act resulting in material harm to the financial condition or business reputation of the Company or any of its Affiliates; or (iii) a material breach of any of the covenants set forth in Section 5 of this Agreement. A "CHANGE IN CONTROL" shall be deemed to occur on the date on which one of the following events occurs: (i) the acquisition by any Person of beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Securities Exchange Act of 1934, as amended) of 20% or more of the Common Stock then outstanding, but shall not include any such acquisition by: (A) the Company; (B) any Subsidiary of the Company; (C) any employee benefit plan of the Company or of any Subsidiary of the Company; Second Amended and Restated Employment Agreement Page 17 of 23 (D) any Person or entity organized, appointed or established by the Company for or pursuant to the terms of any such plan; (E) any Person who as of January 31, 1996 was the beneficial owner of 15% or more of the shares of Common Stock outstanding on such date unless and until such Person, together with all affiliates and associates of such Person, becomes the beneficial owner of 25% or more of the shares of Common Stock then outstanding whereupon a Change in Control shall be deemed to have occurred; or (F) any Person who becomes the Beneficial Owner of 20% or more, or, with respect to a Person described in clause (E) above, 25% or more, of the shares of Common Stock then outstanding as a result of a reduction in the number of shares of Common Stock outstanding due to the repurchase of shares of Common Stock by the Company unless and until such Person, after becoming aware that such Person has become the beneficial owner of 20% or more, or 25% or more, as the case may be, of the then outstanding shares of Common Stock, acquires beneficial ownership of additional shares of Common Stock representing 1% or more of the shares of Common Stock then outstanding, whereupon a Change in Control shall be deemed to have occurred; or (ii) individuals who, as of January 29, 1997, constitute the Board, and subsequently elected members of the Board whose election is approved or recommended by at least a majority of such current members or their successors whose election was so approved or recommended (other than any subsequently elected members whose initial assumption of office occurs as a result of an actual or threatened election contest with respect to the election or removal of directors or other actual or threatened solicitation of proxies or consents by or on behalf of a person other than the Board), cease for any reason to constitute at least a majority of such Board; or (iii) approval by the stockholders of the Company of (A) a merger or consolidation of the Company with any other corporation, (B) the issuance of voting securities of the Company in connection with a merger or consolidation of the Company (or any Subsidiary) pursuant to applicable stock exchange requirements, or (C) sale or other disposition of all or substantially all of the assets of the Company or the acquisition of assets of another corporation (each, a "BUSINESS COMBINATION"), unless, in each case, immediately following such Second Amended and Restated Employment Agreement Page 18 of 23 Business Combination, all or substantially all of the individuals and entities who were the beneficial owners of the Common Stock outstanding immediately prior to such Business Combination beneficially own, directly or indirectly, more than 70% of the then outstanding shares of common stock and 70% of the combined voting power of the then outstanding voting securities entitled to vote generally in the election of directors, as the case may be, of the corporation resulting from such Business Combination (including, without limitation, a corporation which as a result of such transaction owns the Company or all or substantially all of the Company's assets either directly or through one or more subsidiaries) in substantially the same proportions as their ownership, immediately prior to such Business Combination, of the Common Stock. "GOOD REASON" means, without the Executive's express written consent, any of the following: (i) a substantial adverse alteration in the nature or status of the Executive's duties or responsibilities or in the Executive's title, including the Executive's ceasing to report directly to the Board, except that the appointment by the Company and/or Ambac Assurance of an individual other than the Executive as its President shall not constitute Good Reason hereunder, so long as the Executive retains the titles and responsibilities of Chairman and Chief Executive Officer; (ii) a reduction in the Salary as then in effect or failure of the Company to pay any amount owing to the Executive hereunder when due; (iii) the Company's requiring the Executive to be based at any office or location more than 25 miles outside of the city limits of New York City; (iv) the failure to obtain a satisfactory agreement from any successor of the Company to assume and agree to perform this Agreement, as contemplated in Section 9(d) hereof; (v) following a Change in Control, the failure by the Company to continue in effect any compensation plan in which the Executive participates as of the date of such Change in Control, or any substitute plans adopted after the date thereof, unless an equitable arrangement (embodied in an ongoing substitute or alternative plan) has been made with respect to such plan, or the failure by the Company to continue the Executive's participation therein on at Second Amended and Restated Employment Agreement Page 19 of 23 least as favorable a basis as that enjoyed by other similarly situated executives of the Company and its Affiliates; (vi) following a Change in Control, the failure by the Company to continue to provide the Executive with benefits at least as favorable to those enjoyed by other similarly situated executives of the Company and its Affiliates under any of the Company's pension, life insurance, medical, dental, health and accident, disability, deferred compensation or savings plans, or the taking of any action by the Company which would directly or indirectly materially reduce any of such benefits or deprive the Executive of any material fringe benefit enjoyed by the Executive. provided, however, that unless the Executive provides written notification of his intention to resign within 10 business days after the Executive has actual knowledge of the occurrence of any such event constituting Good Reason, the Executive shall be deemed to have consented thereto and such event shall no longer constitute Good Reason for purposes of this Agreement. If the Executive provides such written notice to the Company, the Company shall have 20 business days from the date of receipt of such notice to effect a cure of the event described therein and, upon cure thereof by the Company to the reasonable satisfaction of the Executive, such event shall no longer constitute Good Reason for purposes of this Agreement. Anything in this Agreement to the contrary notwithstanding, a termination by the Executive for any reason during the 30-day period immediately following the first anniversary of the occurrence of a Change in Control shall be deemed to be a termination for Good Reason for all purposes of this Agreement. "PERSON" means any individual, firm, corporation, partnership or other entity. "SUBSIDIARY" means (i) a corporation or other entity with respect to which the Company, directly or indirectly, has the power, whether through the ownership of voting securities, by contract or otherwise, to elect at least a majority of the members of such corporation's board of directors or analogous governing body, or (ii) any other corporation or other entity in which the Company, directly or indirectly, has an equity or similar interest and which the Committee designates as a Subsidiary for purposes of this Agreement. "TERMINATION DATE" means: Second Amended and Restated Employment Agreement Page 20 of 23 (i) in the case of a termination of the Executive's employment by the Company for Cause, the effective date of such termination specified in the Notice of Termination, which, if the event constituting Cause for termination is of a type specified in clause (i) or clause (iii) of the definition of Cause, shall be not less than 21 business days from receipt of the Notice of Termination by the Executive; (ii) in the case of a termination of the Executive's employment by the Company without Cause, the date specified in a written notice of termination to the Executive, such written notice to provide at least 90 days' advance written notice of termination; (iii) in the case of the Executive's resignation from employment without Good Reason, the date specified in a written notice of resignation from the Executive to the Company, such written notice provide at least 90 days' advance written notice of resignation; (iv) in the case of the Executive's resignation from employment for Good Reason, the date specified in a written notice of resignation from the Executive to the Company, provided, however, that no such written notice shall be effective unless the cure period specified in the definition of Good Reason has expired without the Company having corrected, to the reasonable satisfaction of the Executive, the event or events subject to cure; (v) in the case of termination of employment due to the Executive's death, the date of death; and (vi) in the case of termination of employment due to the Executive's Disability, the effective date of termination specified in a written notice of termination from the Company to the Executive, which effective date shall be not earlier than the last day of the 180 day period provided for in Section 4(c) above. 13. GENERAL PROVISIONS. (a) NO OTHER SEVERANCE BENEFITS. Except as specifically set forth in this Agreement, the Executive covenants and agrees that he shall not be entitled to any other form of severance benefits from the Company, including, without limitation, benefits otherwise payable under any of the Company's regular severance policies, in the event his employment Second Amended and Restated Employment Agreement Page 21 of 23 hereunder ends for any reason and, except with respect to obligations of the Company expressly provided for herein, the Executive unconditionally releases the Company and its subsidiaries and affiliates, and their respective directors, officers, employees and stockholders, or any of them, form any and all claims, liabilities or obligations under this Agreement or under any severance or termination arrangements of the Company or any of its subsidiaries or affiliates for compensation or benefits in connection with his employment or the termination thereof. (b) NOTICES. Any notice hereunder by either party to the other (including, without limitation, any notice of intention to arbitrate pursuant to Section 14) shall be given in writing by personal delivery, telex, telecopy or certified mail, return receipt requested, to the applicable address set forth below: (i) To the Company: Ambac Financial Group, Inc. One State Street Plaza New York, NY 10004 Attention: General Counsel (ii) To the Executive: Phillip B. Lassiter 16 Sutton Place Apartment 12A New York, New York 10022 or to such other person or other address as either party may specify to the other in writing. (c) LIMITED WAIVER. The waiver by the Company or the Executive of a violation of any of the provisions of this Agreement, whether express or implied, shall not operate or be construed as a waiver of any subsequent violation of any such provision. (d) ASSIGNMENT. No right, benefit or interest hereunder shall be subject to assignment, encumbrance, charge, pledge, hypothecation or set off by the Executive in respect of any claim, debt, obligation or similar process. The Company will require any successor (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of the business or assets or the Company to assume expressly and to agree to perform this Agreement in the same manner and to the same extent that the Company would be required to perform it if no such succession had taken place. (e) AMENDMENT. This Agreement may not be amended, modified or canceled except by written agreement of the Executive and the Company. Second Amended and Restated Employment Agreement Page 22 of 23 (f) SEVERABILITY. If any term or provision hereof is determined to be invalid or unenforceable in a final court or arbitration proceeding, (i) the remaining terms and provisions hereof shall be unimpaired and (ii) the invalid or unenforceable term or provision shall be deemed replaced by a term or provision that is valid and enforceable and that comes closest to expressing the intention of the invalid or unenforceable term or provision. (g) UNSECURED PROMISE. No benefit or promise hereunder shall be secured by any specific assets of the Company. Unless otherwise stated herein, the Executive shall have only the rights of an unsecured general creditor of the Company in seeking satisfaction of such benefits or promises. (h) GOVERNING LAW. This Agreement has been made in and shall be governed by and construed in accordance with the laws of the State of Delaware. (i) ENTIRE AGREEMENT. This Agreement sets forth the entire agreement and understanding of the parties hereto with respect to the matters covered hereby. (j) HEADINGS. The headings and captions of the Sections of this Agreement are included solely for convenience of reference and shall not control the meaning or interpretation of any provisions of this Agreement. (k) COUNTERPARTS. This Agreement may be executed by the parties hereto in counterparts, each of which shall be deemed an original, but all such counterparts shall together constitute one and the same document. Second Amended and Restated Employment Agreement Page 23 of 23 IN WITNESS WHEREOF, the parties have executed this Agreement effective as of the day and year first written above. AMBAC FINANCIAL GROUP, INC. By /s/ Richard B. Gross --------------------------------- Name: Richard B. Gross Title: Sen. Vice President, General Counsel and Secretary EXECUTIVE /s/ Phillip B. Lassiter ------------------------------------ Phillip B. Lassiter EX-10.3 5 1997 EQUITY PLAN (EXHIBIT 10.03) AMBAC 1997 EQUITY PLAN (AMENDED OCTOBER 28, 1997) 1. PURPOSES The purposes of the Ambac 1997 Equity Plan (the "PLAN") are to attract, retain and motivate key employees of the Company, to compensate them for their contributions to the growth and profits of the Company and to encourage ownership by them of Common Stock. 2. DEFINITIONS For purposes of the Plan, the following terms shall be defined as follows: "ADMINISTRATOR" means the individual or individuals to whom the Committee delegates authority under the Plan in accordance with Section 3(d). "AMBAC" means Ambac Financial Group, Inc., a Delaware corporation. "AWARD" means an award made pursuant to the terms of the Plan to an Eligible Individual in the form of Stock Options, Stock Appreciation Rights, Stock Awards, Restricted Stock Units, Performance Units or Other Awards. "AWARD AGREEMENT" means a written document approved in accordance with Section 3 which sets forth the terms and conditions of the Award to the Participant. An Award Agreement may be in the form of (i) an agreement between Ambac or one of its Subsidiaries which is executed by an officer on behalf of Ambac or such Subsidiary and is signed by the Participant or (ii) a certificate issued by Ambac or one of its Subsidiaries which is executed by an officer on behalf of Ambac or such Subsidiary but does not require the signature of the Participant. "BOARD" means the Board of Directors of the Company. "CODE" means the Internal Revenue Code of 1986, as amended, and the applicable rulings and regulations (including any proposed regulations) thereunder. "COMMITTEE" means the Compensation and Organization Committee of the Board, any successor committee thereto or any other committee appointed from time to time by the Board to administer the Plan. The Committee shall consist of at least two individuals and shall serve at the pleasure of the Board. "COMMON STOCK" means the Common Stock, par value $.01 per share, of the Company. "COMPANY" means Ambac and its Subsidiaries. "ELIGIBLE INDIVIDUALS" means the individuals described in Section 6 who are eligible for Awards under the Plan. "EXCHANGE ACT" means the Securities Exchange Act of 1934, as amended, and the applicable rulings and regulations thereunder. "FAIR MARKET VALUE" means, with respect to a share of Common Stock, the fair market value thereof as of the relevant date of determination, as determined in accordance with a valuation methodology approved by the Committee. In the absence of any alternative valuation methodology approved by the Committee, the Fair Market Value of a share of Common Stock shall equal the average of the highest and the lowest quoted selling price of a share of Common Stock as reported on the composite tape for 1 securities listed on the New York Stock Exchange, or such other national securities exchange as may be designated by the Committee, or, in the event that the Common Stock is not listed for trading on a national securities exchange but is quoted on an automated system, on such automated system, in any such case on the valuation date (or, if there were no sales on the valuation date, the average of the highest and the lowest quoted selling prices as reported on said composite tape or automated system for the most recent day during which a sale occurred). "INCENTIVE STOCK OPTION" means a Stock Option which is an "incentive stock option" within the meaning of Section 422 of the Code and designated by the Committee as an Incentive Stock Option in an Award Agreement. "NONQUALIFIED STOCK OPTION" means a Stock Option which is not an Incentive Stock Option. "OTHER AWARD" means any other form of award authorized under Section 13 of the Plan. "PARTICIPANT" means an Eligible Individual to whom an Award has been granted under the Plan. "PERFORMANCE UNIT" means a performance unit granted to an Eligible Individual pursuant to Section 12 hereof. "PREDECESSOR PLAN" means the AMBAC Inc. 1991 Stock Incentive Plan, as amended. "RESTORATION OPTION" means a Stock Option that is awarded upon the exercise of a Stock Option earlier awarded under the Plan or the Predecessor Plan (an "UNDERLYING OPTION") for which the exercise price is paid in whole or in party by tendering shares of Common Stock previously owned by the Participant, where such Restoration Option (i) covers a number of shares of Common Stock no greater than the number of previously owned shares tendered in payment of the exercise price of the Underlying Option plus the number of shares withheld to pay taxes arising upon such exercise, (ii) the expiration date of the Restoration Option is no later than the expiration date of the Underlying Option and (iii) the exercise price per share of the Restoration Option is no less than the Fair Market Value per share of Common Stock on the date of exercise of the Underlying Option. "RESTRICTED STOCK UNIT" means a restricted stock unit granted to an Eligible Individual pursuant to Section 11 hereof. "STOCK APPRECIATION RIGHT" means a right to receive all or some portion of the appreciation on shares of Common Stock granted to an Eligible Individual pursuant to Section 9 hereof. "STOCK AWARD" means a share of Common Stock granted to an Eligible Individual for no consideration other than the provision of services or offer for sale to an Eligible Employee at a purchase price determined by the Committee, in either case pursuant to Section 10 hereof. "STOCK OPTION" means an Award to purchase shares of Common Stock granted to an Eligible Individual pursuant to Section 8 hereof, which Award may be either an Incentive Stock Option or a Nonqualified Stock Option. "SUBSIDIARY" means (i) a corporation or other entity with respect to which Ambac, directly or indirectly, has the power, whether through the ownership of voting securities, by contract or otherwise, to elect at least a majority of the members of such corporation's board of directors or analogous governing body, or (ii) any other corporation or other entity in which Ambac, directly or indirectly, has an equity or similar interest and which the Committee designates as a Subsidiary for purposes of the Plan. 2 "SUBSTITUTE AWARD" means an Award granted upon assumption of, or in substitution for, outstanding awards previously granted by a company or other entity in connection with a corporate transaction, such as a merger, combination, consolidation or acquisition of property or stock. 3. ADMINISTRATION OF THE PLAN (a) POWER AND AUTHORITY OF THE COMMITTEE. The Plan shall be administered by the committee, which shall have full power and authority, subject to the express provisions hereof: (i) to select Participants from the Eligible Individuals; (ii) to make Awards in accordance with the Plan; (iii) to determine the number of shares of Common Stock subject to each Award or the cash amount payable in connection with an Award; (iv) to determine the terms and conditions of each Award, including, without limitation, those related to vesting, forfeiture, payment and exercisability, and the effect, if any, of a Participant's termination of employment with the Company, and including the authority to amend the terms and conditions of an Award after the granting thereof to a Participant in a manner that is not, without the consent of the Participant, prejudicial to the rights of such Participant in such Award; (v) to specify and approve the provisions of the Award Agreements delivered to Participants in connection with their Awards; (vi) to construe and interpret any Award Agreement delivered under the Plan; (vii) to prescribe, amend and rescind rules and procedures relating to the Plan; (viii) to vary the terms of Awards to take account of tax, securities law and other regulatory requirements of foreign jurisdictions; (ix) subject to the provisions of the Plan and subject to such additional limitations and restrictions as the Committee may impose, to delegate to one or more officers of the Company some or all of its authority under the Plan; (x) to employ such legal counsel, independent auditors and consultants as it deems desirable for the administration of the Plan and to rely upon any opinion or computation received therefrom; and (xi) to make all other determinations and to formulate such procedures as may be necessary or advisable for the administration of the Plan. (b) PLAN CONSTRUCTION AND INTERPRETATION. The Committee shall have full power and authority, subject to the express provisions hereof, to construe and interpret the Plan. (c) DETERMINATIONS OF COMMITTEE FINAL AND BINDING. All determinations by the Committee in carrying out and administering the Plan and in construing and interpreting the Plan shall be final, binding and conclusive for all purposes and upon all persons interested herein. (d) DELEGATION OF AUTHORITY. The Committee may, but need not, from time to tiMe delegate some or all of its authority under the Plan to an Administrator consisting of one or more members of the Committee or of one or more officers of the Company; provided, however, that the Committee may not delegate its authority (i) to make Awards to Eligible Individuals who are officers of the Company who are 3 delegated authority by the Committee hereunder, or (ii) under Sections 3(b) and 16 of the Plan. Any delegation hereunder shall be subject to the restrictions and limits that the Committee specifies at the time of such delegation or thereafter. Nothing in the Plan shall be construed as obligating the Committee to delegate authority to an Administrator, and the Committee may at any time rescind the authority delegated to an Administrator appointed hereunder or appoint a new Administrator. At all times, the Administrator appointed under this Section 3(d) shall serve in such capacity at the pleasure of the Committee. Any action undertaken by the Administrator in accordance with the Committee's delegation of authority shall have the same force and effect as if undertaken directly by the Committee, and any reference in the Plan to the Committee shall, to the extent consistent with the terms and limitations of such delegation, be deemed to include a reference to the Administrator. (e) LIABILITY OF COMMITTEE. No member of the Committee shall be liable for any action nor determination made in good faith, and the members of the Committee shall be entitled to indemnification and reimbursement in the manner provided in Ambac's Certificate of Incorporation as it may be amended from time to time. In the performance of its responsibilities with respect to the Plan, the Committee shall be entitled to rely upon information and advice furnished by the Company's officers, the Company's accountants, the Company's counsel and any other party the Committee deems necessary, and no member of the Committee shall be liable for any action taken or not taken in reliance upon any such advice. (f) ACTION BY THE BOARD. Anything in the Plan to the contrary notwithstanding, any authority or responsibility which, under the terms of the Plan, may be exercised by the Committee may alternatively be exercised by the Board. 4. EFFECTIVE DATE AND TERM The Plan shall become effective upon its adoption by the Board subject to its approval by the stockholders of Ambac. Prior to such stockholder approval, the Committee may grant Awards conditioned on stockholder approval. If such stockholder approval is not obtained at or before the first annual meeting of stockholders to occur after the adoption of the Plan by the Board (including any adjournment or adjournments thereof), the Plan and any Awards made thereunder shall terminate ab initio and be of no further force and effect. In no event shall any Awards be made under the Plan after the seventh anniversary of the date of stockholder approval. 5. SHARES OF COMMON STOCK SUBJECT TO THE PLAN (a) GENERAL. Subject to adjustment as provided in Section 15(b) hereof, the number of shares of Common Stock that may be issued pursuant to Awards under the Plan (the "SECTION 5 LIMIT") shall not exceed, in the aggregate: (I) 5,500,000 shares; plus (II) the number of shares of Common Stock that remain available for issuance under the Predecessor Plan as of the date this Plan is approved by the stockholders of the Company (increased by any shares of Common Stock subject to any award (or portion thereof) outstanding under the Predecessor Plan on such date which lapses, expires or is otherwise terminated without the issuance of such shares or is settled by the delivery of consideration other than shares). Shares issued under this Plan may be either authorized but unissued shares, treasury shares or any combination thereof. (b) RULES APPLICABLE TO DETERMINING SHARES AVAILABLE FOR ISSUANCE. For purPoses of determining the number of shares of Common Stock that remain available for issuance, the following shares shall be added back to the Section 5 Limit and again be available for Awards: 4 (x) The number of shares tendered to pay the exercise price of a Stock Option or other Award; and (y) The number of shares withheld from any Award to satisfy a Participant's tax withholding obligations or, if applicable, to pay the exercise price of a Stock Option or other Award. In addition, any shares underlying Substitute Awards shall not be counted against the Section 5 Limit and shall not be subject to Section 5(c) below. (c) SPECIAL LIMITS. Anything to the contrary in Section 5(a) above notwithstanding, but subject to Section 15(b) below, the following special limits shall apply to shares of Common Stock available for Awards under the Plan: (i) The maximum number of shares that may be issued in the form of Stock Awards, or issued upon settlement of Restricted Stock Units or Other Awards, shall equal 1,600,000 shares, of which no more than a number of shares equal to 10% of the Section 5 Limit shall be in the form of Other Awards, provided, however, that any such Stock Awards, Restricted Stock Units or Other Awards that are issued in lieu of cash compensation that otherwise would be paid to a Participant, or in satisfaction of any other obligation owed by the Company to a Participant, shall not be counted against such limitation; and (ii) The maximum number of shares of Common Stock that may be subject to Stock Options or Stock Appreciation Rights granted to any Eligible Individual in any fiscal year of the Company shall equal 400,000 shares plus any shares which were available under this Section 5(c) (ii) for Awards of Stock Options or Stock Appreciation Rights to such Eligible individual in any prior fiscal year but which were not covered by such Awards. (d) NO FURTHER AWARDS UNDER PREDECESSOR PLAN. From and after the date this Plan is approved by the stockholders of the Company, no further awards shall be made under the Predecessor Plan. 6. ELIGIBLE INDIVIDUALS Awards may be granted by the Committee to individuals ("ELIGIBLE INDIVIDUALS") who are officers or other key employees of the Company. Members of the Committee will not be eligible to receive Awards under the Plan. An individual's status as an Administrator will not affect his or her eligibility to participate in the Plan. 7. AWARDS IN GENERAL (a) TYPES OF AWARD AND AWARD AGREEMENT. Awards under the Plan may consist of Stock Options, Stock Appreciation Rights, Stock Awards, Restricted Stock Units, Performance Units or Other Awards. Any Award described in Sections 8 through 13 of the Plan may be granted singly or in combination or tandem with any other Award, as the Committee may determine. Awards may be made in combination with, in replacement of, or as alternatives to grants of rights under any other employee compensation plan of the Company, including the plan of any acquired entity, or may be granted in satisfaction of the Company's obligations under any such plan. (b) TERMS SET FORTH IN AWARD AGREEMENT. The terms and provisions of an Award shall be set forth in a written Award Agreement approved by the Committee and delivered or made available to the Participant as soon as practicable following the date of the award. The vesting, exercisability, payment and other restrictions applicable to an Award (which may include, without limitation, restrictions on transferability or provision for mandatory resale to the Company) shall be determined by the Committee and set forth in the applicable Award Agreement. Notwithstanding the foregoing, the Committee may 5 accelerate (i) the vesting or payment of any Award, (ii) the lapse of restrictions on any Award or (iii) the date on which any Stock Option, Stock Appreciation Right or other Award first becomes exercisable. (c) TERMINATION OF EMPLOYMENT AND CHANGE IN CONTROL. The Committee shall also have full authority to determine and specify in the applicable Award Agreement the effect, if any, that a Participant's termination of employment for any reason will have on the vesting, exercisability, payment or lapse of restrictions applicable to an Award. The date of a Participant's termination of employment for any reason shall be determined in the sole discretion of the Committee. Similarly, the Committee shall have full authority to determine the effect, if any, of a change in control of Ambac on the vesting, exercisability, payment or lapse of restrictions applicable to an Award, which effect may be specified in the applicable Award Agreement or determined at a subsequent time. (d) DIVIDENDS AND DIVIDEND EQUIVALENTS. The Committee may provide Participants with the right to receive dividends or payments equivalent to dividends or interest with respect to an outstanding Awards, which payments can either be paid currently or deemed to have been reinvested in shares of Common Stock, and can be made in Common Stock, cash or a combination thereof, as the Committee shall determine. 8. STOCK OPTIONS (a) TERMS OF STOCK OPTIONS GENERALLY. A Stock Option shall entitle the Participant to whom the Stock Option was granted to purchase a specified number of shares of Common Stock during a specified period at a price that is determined in accordance with Section 8(b) below. Stock Options may be either Nonqualified Stock Options or Incentive Stock Options. The Committee will fix the vesting and exercisability conditions applicable to a Stock Option, provided that no Stock Option shall vest sooner than one year from the date of grant (subject to early vesting, if so provided by the Committee, upon death, disability, termination of employment or a change in control of the Company), but provided, further, that such minimum vesting period shall not apply to any Restoration Option. (b) EXERCISE PRICE. The exercise price per share of Common Stock purchasable under a Stock Option shall be fixed by the Committee at the time of grant or, alternatively, shall be determined by a method specified by the Committee at the time of grant; provided, however, that the exercise price per share shall be no less than 100% of the Fair Market Value per share on the date of grant (or it the exercise price is not fixed on the date of grant, then on such date as the exercise price is fixed); and provided further, that, except as provided in Section 15(b) below, the exercise price per share of Common Stock applicable to a Stock Option may not be adjusted or amended, including by means of amendment, cancellation or the replacement of such Stock Option with a subsequently awarded Stock Option. Notwithstanding the foregoing, the exercise price per share of a Stock Option that is a Substitute Award may be less than the Fair Market Value per share on the date of award, provided that the excess of: (i) the aggregate Fair Market Value (as of the date such Substitute Award is granted) of the shares of Common Stock subject to the Substitute Award, over (ii) the aggregate exercise price thereof, does not exceed the excess of: (iii) the aggregate fair market value (as of the time immediately preceding the transaction giving rise to the Substitute Award, such fair market value to be determined by the Committee) of the shares of the predecessor entity that were subject to the award assumed or substituted for by the Company, over (iv) the aggregate exercise price of such shares. 6 (c) OPTION TERM. The term of each Stock Option shall be fixed by the Committee and shall not exceed ten years from the date of grant. (d) METHOD OF EXERCISE. Subject to the provisions of the applicable Award Agreement, the exercise price of a Stock Option may be paid in cash or previously owned shares or a combination thereof and, if the applicable Award Agreement so provides, in whole or in part through the withholding of shares subject to the Stock Option with a value equal to the exercise price. In accordance with the rules and procedures established by the Committee for this purpose, the Stock Option may also be exercised through a "cashless exercise" procedure approved by the Committee involving a broker or dealer approved by the Committee, that affords Participants the opportunity to sell immediately some or all of the shares underlying the exercised portion of the Stock Option in order to generate sufficient cash to pay the Stock Option exercise price and/or to satisfy withholding tax obligations related to the Stock Option. 9. STOCK APPRECIATION RIGHTS (a) GENERAL. A Stock Appreciation Right shall entitle a Participant to receive, upon satisfaction of the conditions to the payment specified in the applicable Award Agreement, an amount equal to the excess, if any, of the Fair Market Value on the exercise date of the number of shares of Common Stock for which the Stock Appreciation Right is exercised, over the exercise price for such Stock Appreciation Right specified in the applicable Award Agreement. The exercise price per share of Common Stock covered by a Stock Appreciation Right shall be fixed by the Committee at the time of grant or, alternatively, shall be determined by a method specified by the Committee at the time of grant; provided, however, that, except as provided in Section 9(b) below, the exercise price per share shall be no less than 100% of the Fair Market Value per share on the date of grant (or if the exercise price is not fixed on the date of grant, then on such date as the exercise price is fixed); and provided further, that, except as provided in Section 15(b) below, the exercise price per share of Common Stock subject to a Stock Appreciation Right may not be adjusted or amended, including by means of amendment, cancellation or the replacement of such Stock Appreciation Right with a subsequently awarded Stock Appreciation Right. Notwithstanding the foregoing, the exercise price per share of a Stock Appreciation Right that is a Substitute Award may be less than the Fair Market Value per share on the date of award, provided, that such exercise price is not less than the minimum exercise price that would be permitted for an equivalent Stock Option as determined in accordance with Section 8(b) above. At the sole discretion of the Committee, payments to a Participant upon exercise of a Stock Appreciation Right may be made in cash, in shares of Common Stock having an aggregate Fair Market Value as of the date of exercise equal to such amount, or in a combination of cash and shares having an aggregate value as of the date of exercise equal to such amount. (b) STOCK APPRECIATION RIGHTS IN TANDEM WITH STOCK OPTIONS. A Stock Appreciation Right may be granted alone or in addition to other Awards, or in tandem with a Stock Option. A Stock Appreciation Right granted in tandem with a Stock Option may be granted either at the same time as such Stock Option or subsequent thereto. If granted in tandem with a Stock Option, a Stock Appreciation Right shall cover the same number of shares of Common Stock as covered by the Stock Option (or such lesser number of shares as the Committee may determine) and shall be exercisable only at such time or times and to the extent the related Stock Option shall be exercisable, and shall have the same term and exercise price as the related Stock Option (which, in the case of a Stock Appreciation Right granted after the grant of the related Stock Option, may be less than the Fair Market Value per share on the date of grant of the tandem Stock Appreciation Right). Upon exercise of a Stock Appreciation Right granted in tandem with a Stock Option, the related Stock Option shall be canceled automatically to the extent of the number of shares covered by such exercise; conversely, if the related Stock Option is exercised as to some or all of the shares covered by the tandem grant, the tandem Stock Appreciation Right shall be canceled automatically to the extent of the number of shares covered by the Stock Option exercise. 10. STOCK AWARDS 7 (a) GENERAL. A Stock Award shall consist of one or more shares of Common Stock granted to a Participant for no consideration other than the provision of services (or, if required by applicable law in the reasonable judgment of the Company, for payment of the par value of such shares). Stock Awards shall be subject to such restrictions (if any) on transfer or other incidents of ownership for such periods of time, and shall be subject to such conditions of vesting, as the Committee may determine and as shall be set forth in the applicable Award Agreement. (b) DISTRIBUTIONS. Any shares of Common Stock or other securities of the Company received by a Participant to whom a Stock Award has been granted as a result of a stock distribution to holders of Common Stock or as a stock dividend on Common Stock shall be subject to the same terms, conditions and restrictions as such Stock Award. 11. RESTRICTED STOCK UNITS An Award of Restricted Stock Units shall consist of a grant of units, each of which represents the right of the Participant to receive one share of Common Stock, subject to the terms and conditions established by the Committee in connection with the Award and set forth in the applicable Award Agreement. Upon satisfaction of the conditions to vesting and payment specified in the applicable Award Agreement, Restricted Stock Units will be payable, at the discretion of the Committee, in Common Stock, in cash equal to the Fair Market Value of the shares subject to such Restricted Stock Units, or in a combination of Common Stock and cash. Restricted Stock Units that are granted in respect to individual or corporate performance shall vest no sooner than one year from the date of grant, and Restricted Stock Units that are granted in connection with hiring or retention arrangements between the Company and a Participant shall vest no sooner than three years from the date of grant (subject, in either case, to early vesting, if so provided by the Committee, upon death, disability, termination of employment or a change in control of the Company). 12. PERFORMANCE UNITS Performance units may be granted as fixed or variable share- or dollar- denominated units subject to such conditions of vesting and time of payment as the Committee may determine and as shall be set forth in the applicable Award Agreement relating to such Performance Units. Performance Units may be paid in Common Stock, cash or a combination of Common Stock and cash, as the Committee may determine. 13. OTHER AWARDS The Committee shall have the authority to specify the terms and provisions of other forms of equity-based or equity-related Awards not described above which the Committee determines to be consistent with the purpose of the Plan and the interests of the Company, which Awards may provide for cash payments based in whole or in part on the value or future value of Common Stock, for the acquisition or future acquisition of Common Stock, or any combination thereof. Other Awards shall also include cash payments (including the cash payment of dividend equivalents) under the Plan which may be based on one or more criteria determined by the Committee which are unrelated to the value of Common Stock and which may be granted in tandem with, or independent of, other Awards under the Plan. 14. CERTAIN RESTRICTIONS (a) TRANSFERS. Unless the Committee determines otherwise, no Award shall be transferable other than by will or by the laws of descent and distribution or pursuant to a domestic relations order; provided, however, that the Committee may, in its discretion and subject to such terms and conditions as it shall specify, permit the transfer of an Award for no consideration to a Participant's family members or to one or more trusts or partnerships established in whole or in part for the benefit of one or more of such family members (collectively, "PERMITTED TRANSFEREES"). Any Award transferred to a Permitted Transferee shall be further transferable only by will or the laws of descent and distribution or, for no consideration, to 8 another Permitted Transferee of the Participant. The Committee may in its discretion permit transfers of Awards other than those contemplated by this Section. (b) EXERCISE. During the lifetime of the Participant, a Stock Option, Stock Appreciation Right or similar-type Other Award shall be exercisable only by the Participant or by a Permitted Transferee to whom such Stock Option, Stock Appreciation Right or Other Award has been transferred in accordance with Section 14(a). 15. RECAPITALIZATION OR REORGANIZATION (a) AUTHORITY OF THE COMPANY AND STOCKHOLDERS. The existence of the Plan, the Award Agreements and the Awards granted hereunder shall not affect or restrict in any way the right or power of the Company or the stockholders of the Company to make or authorize any adjustment, recapitalization, reorganization or other change in the Company's capital structure or its business, any merger or consolidation of the Company, any issue of stock or of options, warrants or rights to purchase stock or of bonds, debentures, preferred or prior preference stocks whose rights are superior to or affect the Common Stock or the rights thereof or which are convertible into or exchangeable for Common Stock, or the dissolution or liquidation of the Company, or any sale or transfer of all or any part of its assets or business, or any other corporate act or proceeding, whether of a similar character or otherwise. (b) CHANGE IN CAPITALIZATION. Notwithstanding any provision of the Plan or any Award Agreement, the number and kind of shares authorized for issuance under Section 5(a) above, including the maximum number of shares available under the special limits provided for in Section 5(c) above, may be equitably adjusted in the sole discretion of the Committee in the event of a stock split, stock dividend, recapitalization, reorganization, merger, consolidation, extraordinary dividend, split-up, spin-off, combination, exchange of shares, warrants or rights offering to purchase Common Stock at a price substantially below Fair Market Value or other similar corporate event affecting the Common Stock in order to preserve, but not increase, the benefits or potential benefits intended to be made available under the Plan. In addition, upon the occurrence of any of the foregoing events, the number of outstanding Awards and the number and kind of shares subject to any outstanding Award and the purchase price per share, if any, under any outstanding Award may be equitably adjusted (including by payment of cash to a Participant) in the sole discretion of the Committee in order to preserve the benefits or potential benefits intended to be made available to Participants granted Awards. Such adjustments shall be made by the Committee, whose determination as to what adjustments shall be made, and the extent thereof, shall be final. Unless otherwise determined by the Committee, such adjusted Awards shall be subject to the same vesting schedule and restrictions to which the underlying Award is subject. 16. AMENDMENTS The Board or Committee may at any time and from time to time alter, amend, suspend or amend the Plan in whole or in part; provided, however, that any amendment which under the requirements of any applicable law or stock exchange rule must be approved by the stockholders of the Company shall not be effective unless and until such stockholder approval has been obtained in compliance with such law or rule; and provided further, that, except as contemplated by Section 15(b) above, the Board or Committee may not, without the approval of the Company's stockholders, increase the maximum number of shares issuable under the Plan or reduce the exercise price of a Stock Option or Stock Appreciation Right. No termination or amendment of the Plan may, without the consent of the Participant to whom an Award has been granted, adversely affect the rights of such Participant under such Award. Notwithstanding any provision herein to the contrary, the Board or Committee shall have broad authority to amend the Plan or any Award under the Plan to take into account changes in applicable tax laws, securities laws, accounting rules and other applicable state and federal laws. 17. MISCELLANEOUS 9 (a) TAX WITHHOLDING. The Company may require any individual entitled to receive a payment in respect of an Award to remit to the Company, prior to such payment, an amount sufficient to satisfy any Federal, state or local tax withholding requirements. The Company shall also have the right to deduct from all cash payments made pursuant to or in connection with any Award any Federal, state or local taxes required to be withheld with respect to such payments. In the case of an Award payable in shares of Common Stock, the Company may permit such individual to satisfy, in whole or in part, such obligation to remit taxes by directing the Company to withhold shares of Common Stock that would otherwise be received by such individual, pursuant to such rules as the Committee may establish from time to time. (b) NO RIGHT TO GRANTS OR EMPLOYMENT. No Eligible Individual or Participant shall have any claim or right to receive grants of Awards under the Plan. Nothing in the Plan or in any Award or Award Agreement shall confer upon any employee of the Company any right to continued employment with the Company or interfere in any way with the right of the Company to terminate the employment of any of its employees at any time, with or without cause. (c) OTHER COMPENSATION. Nothing in this Plan shall preclude or limit the ability of the Company to pay any compensation to a Participant under the Company's other compensation and benefit plans and programs. (d) OTHER EMPLOYEE BENEFIT PLANS. Payments received by a Participant under any Award made pursuant to the Plan shall not be included in, nor have any effect on, the determination of benefits under any other employee benefit plan or similar arrangement provided by the Company, unless otherwise specifically provided for under the terms of such plan or arrangement or by the Committee. (e) UNFUNDED PLAN. The Plan is intended to constitute an unfunded plan for incentive compensation. Prior to the payment or settlement of any Award, nothing contained herein shall give any Participant any rights that are greater than those of a general creditor of the Company. In its sole discretion, the Committee may authorize the creation of trusts or other arrangements to meet the obligations created under the Plan to deliver Common Stock or payments in lieu thereof with respect to awards hereunder. (f) SECURITIES LAW RESTRICTIONS. The Committee may require each Eligible Individual purchasing or acquiring shares of Common Stock pursuant to a Stock Option or other Award under the Plan to represent to and agree with the Company in writing that such Eligible Individual is acquiring the shares for investment and not with a view to the distribution thereof. All certificates for shares of Common Stock delivered under the Plan shall be subject to such stock-transfer orders and other restrictions as the Committee may deem advisable under the rules, regulations, and other requirements of the Securities and Exchange Commission, any exchange upon which the Common Stock is then listed, and any applicable federal or state securities law, and the Committee may cause a legend or legends to be put on any such certificates to make appropriate reference to such restrictions. No shares of Common Stock shall be issued hereunder unless the Company shall have determined that such issuance is in compliance with, or pursuant to an exemption from, all applicable federal and state securities laws. (g) COMPLIANCE WITH RULE 16B-3. Notwithstanding anything contained in the Plan or in any Award Agreement to the contrary, if the consummation of any transaction under the Plan would result in the possible imposition of liability on a Participant pursuant to Section 16(b) of the Exchange Act, the Committee shall have the right, in its sole discretion, but shall not be obligated, to defer such transaction or the effectiveness of such action to the extent necessary to avoid such liability, but in no event for a period longer than six months. (h) AWARD AGREEMENT. In the event of any conflict or inconsistency between the Plan and any Award Agreement, the Plan shall govern, and the Award Agreement shall be interpreted to minimize or eliminate any such conflict or inconsistency. (i) EXPENSES. The costs and expenses of administering the Plan shall be borne by the Company. 10 (j) APPLICATION OF FUNDS. The proceeds received from the Company from the sale of Common Stock or other securities pursuant to Awards will be used for general corporate purposes. (k) APPLICABLE LAW. Except as to matters of federal law, the Plan and all actions taken thereunder shall be governed by and construed in accordance with the laws of the State of Delaware without giving effect to conflicts of law principles. 11 EX-10.08 6 MANAGEMENT RETENTION AGREEMENT (EXHIBIT 10.08) FORM OF AMENDED AND RESTATED MANAGEMENT RETENTION AGREEMENT AMENDED AND RESTATED MANAGEMENT RETENTION AGREEMENT (this "AGREEMENT"), made as of December 30, 1994, as amended and restated as of December 2, 1997, by and between AMBAC FINANCIAL GROUP, INC., a Delaware corporation (the "COMPANY"), and the executive officer named on the signature page of this Agreement (the "EXECUTIVE"). W I T N E S S E T H: WHEREAS, the Executive is currently a valued key executive of the Company or one of its Affiliates (as defined below); and WHEREAS, the Compensation and Organization Committee (the "COMMITTEE") of the Board of Directors of the Company (the "BOARD"), recognizes that in the event of a future change in control of the Company, or any threatened change in control, uncertainty and questions could rise among management and could result in the departure or distraction of management personnel to the detriment of the Company and its stockholders; and WHEREAS, the Company considers it essential to the best interests of its stockholders to foster the continuous employment of key management personnel, such as the Executive, in the event of any actual or threatened change in control by providing for the payment of severance and other benefits in the event of the Executive's termination of employment following a change in control; NOW, THEREFORE, in consideration of the covenants and agreements herein contained, the parties hereto agree as follows: 1. EMPLOYMENT AND DUTIES The Company hereby agrees to employ the Executive in the capacity indicated on the signature page of this Agreement (or such other, superior position to which the Executive may be promoted by the Company in its discretion), and the Executive hereby accepts such employment. During the Term, as defined in Section 2 below, the Executive shall have such duties as may be assigned to the Executive from time to time by the Board or the Board's designee which are commensurate with the duties of the Executive in the capacity indicated on the signature page of this Agreement (or such other, superior position to which the Executive may be promoted by the Company in its discretion). The Executive shall devote 2 substantially all his business time, attention, skill and efforts during the Term to the faithful performance of his duties hereunder and shall not accept employment elsewhere during the Term. 2. TERM The term of the Executive's employment under this Agreement (the "TERM") shall commence on the date of any Change in Control (as defined in Section 8(i) of this Agreement) occurring after the date hereof and shall continue in effect through the third anniversary thereof. Anything in this Agreement to the contrary notwithstanding, if a Change in Control occurs and if the Executive's employment with the Company is terminated prior to the date on which the Change in Control occurs, and if it is reasonably demonstrated by the Executive that such termination of employment (i) was at the request of a third party who has taken steps reasonably calculated to effect a Change in Control or (ii) otherwise arose in connection with or anticipation of a Change in Control, then for all purposes of this Agreement the Term shall be considered to have commenced on the date immediately prior to the date of the Executive's termination of employment, rather than on the date of such Change in Control. The provisions of this Agreement shall continue in effect beyond the Term to the extent necessary to carry out the intentions of the parties hereto. 3. COMPENSATION During the Term the Executive shall be entitled to the following compensation for his services to the Company: (a) BASE SALARY. The Company shall pay, and the Executive shall accept, a base salary (the "BASE SALARY") at a rate no less than the Executive's base salary in effect immediately prior to the Change in Control, subject to increase in accordance with the immediately succeeding sentence. The Base Salary shall be reviewed at least annually by the Committee and may be increased, but not decreased, to reflect the Executive's performance and shall be increased to provide the Executive with such other increases as shall be consistent with increases in base salary awarded in the ordinary course of business to other key executives of the Company or of any Affiliate. (b) CASH BONUS. In addition to the Base Salary, the Executive shall be paid for each full or partial fiscal year of the Company during the Term, an annual cash bonus (the "BONUS") pursuant to the current bonus and incentive plans of the Company, as may be amended or supplemented by the Company during the Term; provided, however, that such annual Bonus shall in no event be less than 70% of the Base Salary payable to the Executive for the relevant fiscal year. Bonuses shall be paid in cash to the Executive no later than 30 days following the close of each fiscal year during and immediately following the Term. 3 (c) EQUITY AWARDS. Upon the occurrence of a Change in Control, the Executive shall be fully vested in all stock options, restricted stock, restricted stock units and any other awards theretofore awarded to him under the Company's 1997 Equity Plan, as amended, or any successor thereto, on or after January 1, 1998 provided, however, that if any Person (as defined in Section 8 hereof) commences a tender offer for shares of the Company's common stock, par value $0.01 per share (the "COMMON STOCK"), which, if successfully completed, would result in a Change in Control, then the Executive shall be fully vested in all such stock options, restricted stock units and any other such awards, and any such awards that by their terms are to be paid or settled by the delivery of shares of Common Stock without the payment of any additional consideration by the Executive shall be so paid or settled, immediately prior to the scheduled expiration of such tender offer, and the Company shall have instituted procedures to enable the Executive, if he so desires, to tender the shares issued upon the exercise of such stock options or delivered in payment or settlement of such restricted stock units or other awards into such offer. (d) INCENTIVE, SAVINGS AND RETIREMENT PLANS. In addition to the Base Salary and Bonuses payable pursuant to this Agreement, the Executive shall be entitled to participate in incentive, savings and retirement plans and programs, whether qualified or non-qualified, of the Company and its Affiliates applicable to other key executives (including, without limitation, the following plans of the Company and its Affiliates: the 1991 Stock Incentive Plan, the 1997 Equity Plan, the Savings Incentive Plan, the Retirement Plan, the Excess Benefits Plan, the Supplemental Retirement Plan, and the Deferred Compensation Plan for Outside Directors and Eligible Senior Officers, the Non-Qualified Savings Incentive Plan or substantially equivalent successor or substitute plans), providing an aggregate level of compensation (including target payouts, where applicable) and benefits no less favorable than in effect prior to a Change in Control. (e) WELFARE BENEFIT PLANS. The Executive and/or the Executive's family, as the case may be, shall be eligible for participation in and shall receive all benefits under each welfare benefit plan of the Company applicable to other key executives, including, without limitation, all medical, dental, disability, group life, accidental death and travel accident insurance plans and programs of the Company and its Affiliates, upon terms, and at a level of participation, no less favorable than applicable to other similarly situated executives of the Company and its Affiliates. (f) EXPENSES. The Executive shall be entitled to receive prompt reimbursement for all reasonable expenses incurred by him in the performance of his duties for the Company which shall be paid to him in accordance with the policies and procedures of the Company as in effect at any time thereafter with respect to other key executives. (g) FRINGE BENEFITS. The Executive shall be entitled to fringe benefits no less favorable than in effect prior to a Change in Control. 4 (h) OFFICE AND SUPPORT STAFF. The Executive shall be entitled to an office or offices of a size and with furnishings and other amenities, and to secretarial and other assistance, at least equal to those currently used by the Executive. (i) VACATION. The Executive shall be entitled to four weeks of paid vacation per year, or such longer period as the Company shall institute for senior executives, and paid holidays in accordance with the policies of the Company as in effect at any time. (j) APPLICATION OF SEVERANCE POLICIES AFTER THE TERM. Upon the expiration of the Term, the Executive shall become a participant in the most favorable severance policy applicable to similarly situated executives of the Company and its Affiliates (other than as agreed to as part of individual employment agreements), with all years of service with the Company and any Affiliate counted for purposes of the calculation of such severance benefits. 4. TERMINATION OF EMPLOYMENT (a) TERMINATION FOR CAUSE; RESIGNATION WITHOUT GOOD REASON. The Company may terminate the Executive's employment hereunder for Cause (as defined in Section 8(a) of this Agreement). If the Executive's employment is terminated by the Company for Cause, or by the Executive for reasons other than Good Reason (as defined in Section 8(b) of this Agreement) prior to the expiration of the Term, the Company shall be obligated to make payment of any Compensation (as defined in Section 8(h) of this Agreement) earned prior to the Date of Termination (as defined in Section 8(d) of this Agreement) but not yet paid to the Executive and any payment from any employee benefit plan described in Section 3 of this Agreement which shall be paid in accordance with such plan and the continuation of coverage under any insurance program as required under any such benefit plan or which may be required by law. The Executive shall also be entitled to the payment of any Bonus earned but not yet paid, including, without limitation, any deferred Bonus, and the pro rata amount of the guaranteed -------- minimum Bonus under Section 3(b) of this Agreement if the Date of Termination occurs before the end of any fiscal year. Except as provided above, the Company shall not be obligated to make any additional payments of Compensation or benefits specified in Section 3 of this Agreement for any periods after the Date of Termination. (b) RESIGNATION FOR GOOD REASON; TERMINATION WITHOUT CAUSE. If the Executive's employment is terminated by the Executive for Good Reason or by the Company without Cause, in either case at any time prior to the expiration of the Term, the Executive shall be entitled to the following benefits: (i) In addition to the payment of all Base Salary and any Bonus earned but not paid, or a pro rata portion of the guaranteed minimum Bonus -------- under Section 3(b) of 5 this Agreement if the Date of Termination occurs prior to the end of any fiscal year, within five business days of the Termination Date the Company shall make a lump sum payment to the Executive equal to two times the sum of: (x) his highest Base Salary, plus (y) the highest Bonus percentage paid or payable to the Executive at any time prior to his Date of Termination times his highest Base Salary (the sum of the amounts described in the foregoing clauses (x) and (y) being referred to as the "REFERENCE AMOUNT"). For purposes of calculating the Reference Amount, "BONUS" shall include cash bonus and the value on the grant date, as determined by the Committee, of any restricted stock or restricted stock units or other awards granted in lieu of cash, but excluding the value of any stock options. (ii) For purposes of calculating the Executive's benefit under the AMBAC Inc. Retirement Plan (or any successor plan) (the "RETIREMENT PLAN"), the Executive shall receive an additional two years of credited service. In addition, for all purposes under the Retirement Plan, including for purposes of benefit calculations, the Executive shall be treated as having retired from service with the Company and its Affiliates, rather than as a "terminated vested" employee. (iii) Within five business days following the Termination Date, the Company shall make a lump sum payment to the Executive equal to the amount that the Company would have contributed for the Executive's account under the AMBAC Inc. Savings Incentive Plan (or any successor plan) (the "SIP") in respect of the two years following the Termination Date, based on (A) the formula for determining employer contributions in effect on the Termination Date and (B) the Base Salary (and, if such formula takes account of bonus compensation, the Bonus) used for purposes of determining the Reference Amount, and calculated without giving effect to the limitations provided for in Sections 401(a)(17) and 415 of the Internal Revenue Code of 1986, as amended (the "CODE"), or any successor provisions thereto. (iv) Within five business days following the Termination Date the Executive shall receive a lump sum payment of his account balance as of the Date of Termination under any nonqualified plan maintained by the Company or any of its Affiliates to provide benefits in excess of those permitted under the Code to be provided by the SIP. The Company shall remain obligated to pay to the Executive or his beneficiaries any benefits to which he or they may be entitled under any nonqualified plan maintained by the Company or any of its Affiliates to provide benefits in excess of those permitted under the Code to be provided by the Retirement Plan (including without limitation benefits under the AMBAC Excess Benefit Plan and the AMBAC Supplemental 6 Retirement Plan, or any successors to such plans); such payments shall be made in accordance with the terms of such plans, and benefits thereunder shall take account of the two years of additional credited service provided for in clause (ii) above. (v) For a period of two years following the Date of Termination (the "CONTINUATION PERIOD"), the Executive and his dependents, if any, shall continue to participate (at no greater expense to them than was the case for such coverage prior to his termination) in the employee benefit arrangements described in Section 3(e) and 3(g) above, provided, however, that the benefits described in Section 3(e) shall cease to the extent the Executive begins coverage under plans of a subsequent employer. (vi) At the end of the Continuation Period, the Executive and his family shall be entitled for the remainder of his life to retiree medical and dental benefits under the applicable plans and programs of the Company as if he retired on the last day of the Continuation Period, with such benefits to commence immediately at the end of the Continuation Period and with the amount of contribution by the Executive to be no greater than that of any other employee of the Company who had retired on the last day of the Continuation Period (it being understood and agreed that contribution rates may be changed, and the terms of such benefits may be modified, to the extent permitted under the relevant plans, from those in effect on the date hereof). (vii) During the Continuation Period, the Company shall provide the Executive with appropriate individual outplacement services and financial planning at the Company's expense. (viii) To the extent not previously vested pursuant to Section 3(c) above, the Executive shall be fully vested in all stock options, restricted stock, restricted stock units and any other awards theretofore awarded to him under the Company's 1991 Stock Incentive Plan, as amended, or the Company's 1997 Equity Plan, as amended, or any successor thereto. (viii) The Executive shall receive all amounts due to him under any compensatory plan or arrangement of the Company and not specifically addressed above, in accordance with the terms of the relevant plan or arrangement. (c) DEATH BEFORE END OF TERM. If the Executive dies prior to the expiration of the Term, the Company shall be under no obligation to make additional payments of the Compensation and benefits described in Section 3 of the Agreement to the Executive's estate after the Date of Termination except, however, for any Compensation earned prior to the Date of Termination but not yet paid, including, without limitation, any deferred Bonus and the pro rata amount of the guaranteed minimum Bonus under Section 3(b) of this Agreement if the Date of Termination occurs before the end of a fiscal year, and all benefits 7 payable under the various plans described in Section 3 of this Agreement, which shall be paid in accordance with the terms of all such applicable plans. The Company shall also continue to provide any benefits to the Executive's survivors as required by law. (d) DISABILITY. In the event of the Executive's Permanent Disability (as defined in Section 8(e) of this Agreement) prior to the expiration of the Term, the Executive's employment shall terminate. In that event, the Executive shall be entitled to continue to receive payment of the Compensation and benefits described in Section 3 of the Agreement through the end of the Term, less the amount of any payment to the Executive on account of disability from any employer sponsored disability insurance plan. In addition, the Executive shall receive all benefits payable under the various plans described in Section 3 of this Agreement, which shall be paid in accordance with the terms of all such applicable plans. (e) RETIREMENT. The Executive may terminate his employment on account of Retirement (as defined in Section 8(f) of this Agreement). The Executive shall not be entitled to any further payments of Compensation or other benefits provided under Section 3 of this Agreement after the Date of Termination, other than any retirement benefit payments from any employer sponsored plan, any Compensation earned prior to the date of Retirement but not yet paid, including, without limitation, any deferred Bonus and the pro rata amount of the guaranteed minimum Bonus under Section 3(b) of this Agreement if the Date of Termination occurs before the end of a fiscal year, and all benefits payable under the various plans described in Section 3 of this Agreement, which shall be paid in accordance with the terms of all such applicable plans. (f) NOTICE OF TERMINATION REQUIRED. No termination of employment by the Executive or by the Company pursuant to this Section 4 shall be effective unless the terminating party shall have delivered a Notice of Termination (as defined in Section 8(c) of this Agreement) to the other party. (g) NATURE OF PAYMENTS. Any amounts due under this Section 4 are in the nature of severance payments, liquidated damages, or both, and are not in the nature of a penalty. 5. NO OBLIGATION TO MITIGATE Following termination of the Executive's employment, the Executive shall be under no obligation to seek other employment or otherwise to mitigate damages resulting from his termination of employment. In addition, there shall be no offset against amounts due to the Executive under any provision of this Agreement, on account of any remuneration to which the Executive becomes entitled from any Person for whom the Executive subsequently provides services (as an officer, director, employee, independent contractor or otherwise), other than as provided in Section 4(b)(v) relating to continuation of benefits coverage. 8 6. CERTAIN ADDITIONAL PAYMENTS BY THE COMPANY. (a) Anything in this Agreement to the contrary notwithstanding, in the event it shall be determined that any payment or distribution by the Company to or for the benefit of the Executive (whether paid or payable or distributed or distributable pursuant to the terms of this Agreement or otherwise, but determined without regard to any additional payments required under this Section 6) (a "PAYMENT") would be subject to the excise tax imposed by the Code or any interest or penalties are incurred by the Executive with respect to such excise tax (such excise tax, together with any such interest and penalties, are hereinafter collectively referred to as the "EXCISE TAX"), then the Executive shall be entitled to receive an additional payment (a "GROSS-UP PAYMENT") in an amount such that after payment by the Executive of all taxes (including any interest or penalties imposed with respect to such taxes), including, without limitation, any income taxes (and any interest and penalties imposed with respect thereto) and Excise Tax imposed upon the Gross-Up Payment, the Executive retains an amount of the Gross-Up Payment equal to the Excise Tax imposed upon the Payments. (b) Subject to the provisions of Section 6(c), all determinations required to be made under this Section 6, including whether and when a Gross-Up Payment is required and the amount of such Gross-Up Payment and the assumptions to be utilized in arriving at such determination, shall be made by KPMG Peat Marwick LLP or such other certified public accounting firm as may be jointly designated by the Executive and the Company (the "ACCOUNTING FIRM"), which shall provide detailed supporting calculations both to the Company and the Executive within 15 business days of the receipt of notice from the Executive that there has been a Payment, or such earlier time as is requested by the Company. All fees and expenses of the Accounting Firm shall be borne solely by the Company. Any Gross-Up Payment, as determined pursuant to this Section 6, shall be paid by the Company to the Executive within five days of the receipt of the Accounting Firm's determination. Any determination by the Accounting Firm shall be binding upon the Company and the Executive. As a result of the uncertainty in the application of Section 4999 of the Code at the time of the initial determination by the Accounting Firm hereunder, it is possible that Gross-Up Payments which will not have been made by the Company should have been made ("UNDERPAYMENT"), consistent with the calculations required to be made hereunder. In the event that the Company exhausts its remedies pursuant to Section 6(c) and the Executive thereafter is required to make a payment of any Excise Tax, the Accounting Firm shall determine the amount of the Underpayment that has occurred and any such Underpayment shall be promptly paid by the Company to or for the benefit of the Executive. (c) The Executive shall notify the Company in writing of any claim by the Internal Revenue Service that, if successful, would require the payment by the Company of the Gross-Up Payment. Such notification shall be given as soon as practicable but no later than ten business days after the Executive is informed in writing of such claim and shall apprize the 9 Company of the nature of such claim and the date on which such claim is requested to be paid. The Executive shall not pay such claim prior to the expiration of the 30-day period following the date on which it gives such notice to the Company (or such shorter period ending on the date that any payment of taxes with respect to such claim is due). If the Company notifies the Executive in writing prior to the expiration of such period that it desires to contest such claim, the Executive shall: (i) give the Company any information reasonably requested by the Company relating to such claim, (ii) take such action in connection with contesting such claim as the Company shall reasonably request in writing from time to time, including, without limitation, accepting legal representation with respect to such claim by an attorney reasonably selected by the Company, (iii) cooperate with the Company in good faith in order effectively to contest such claim, and (iv) permit the Company to participate in any proceedings relating to such claim; provided, however, that the Company shall bear and pay directly all costs and expenses (including additional interest and penalties) incurred in connection with such contest and shall indemnify and hold the Executive harmless, on an after-tax basis, for any Excise Tax or income tax (including interest and penalties with respect thereto) imposed as a result of such representation and payment of costs and expenses. Without limitation on the foregoing provisions of this Section 6(c), the Company shall control all proceedings taken in connection with such contest and, at its sole option, may pursue or forgo any and all administrative appeals, proceedings, hearings and conferences with the taxing authority in respect of such claim and may, at its sole option, either direct the Executive to pay the tax claimed and sue for a refund or contest the claim in any permissible manner, and the Executive agrees to prosecute such contest to a determination before any administrative tribunal, in a court of initial jurisdiction and in one or more appellate courts, as the Company shall determine; provided, however, that if the Company directs the Executive to pay such claim and sue for a refund, the Company shall advance the amount of such payment to the Executive, on an interest-free basis and shall indemnify and hold the Executive harmless, on an after-tax basis, from any Excise Tax or income tax (including interest or penalties with respect thereto) imposed with respect to such advance or with respect to any imputed income with respect to such advance; and further provided that any extension of the statute of limitations relating to payment of taxes for the taxable year of the Executive with respect to which such contested amount is claimed to be due is limited solely to such contested amount. Furthermore, the Company's control of the contest shall be limited to issues with respect to which a Gross-Up Payment would be payable 10 hereunder and the Executive shall be entitled to settle or contest, as the case may be, any other issue raised by the Internal Revenue Service or any other taxing authority. (d) If, after the receipt by the Executive of an amount advanced by the Company pursuant to Section 6(c), the Executive becomes entitled to receive any refund with respect to such claim, the Executive shall (subject to the Company's complying with the requirements of Section 6(c)) promptly pay to the Company the amount of such refund (together with any interest paid or credited thereon after taxes applicable thereto). If, after the receipt by the Executive of an amount advanced by the Company pursuant to Section 6(c), a determination is made that the Executive shall not be entitled to any refund with respect to such claim and the Company does not notify the Executive in writing of its intent to contest such denial of refund prior to the expiration of 30 days after such determination, then such advance shall be forgiven and shall not be required to be repaid and the amount of such advance shall offset, to the extent thereof, the amount of Gross-Up Payment required to be paid. 7. PROTECTION OF THE COMPANY'S INTERESTS (a) CONFIDENTIAL INFORMATION. Except for actions taken in the course of his employment hereunder or as required by law, at no time shall the Executive divulge, furnish or make accessible to any person any information of a confidential or proprietary nature obtained by him while in the employ of the Company. Upon termination of his employment with the Company, the Executive shall return to the Company all such information which exists in written or other physical form and all copies thereof in his possession or under his control. (b) REMEDIES. The Executive acknowledges that a breach of any of the covenants contained in this Section 7 may result in material irreparable injury to the Company or its Affiliates for which there is no adequate remedy at law, that it will not be possible to measure damages for such injuries precisely and that, in the event of such breach or threat thereof, the Company shall be entitled, in addition to any other rights or remedies it may have, to obtain a temporary restraining order and/or a preliminary or permanent injunction enjoining or restraining the Executive from engaging in activities prohibited by this Section 7. In no event, however, shall an asserted violation of the provisions of this Section 7 constitute a basis for deferring or withholding any amounts otherwise payable to the Executive under this Agreement, unless the Company shall have first obtained a final decision, in an arbitration conducted in accordance with Section 17 of this Agreement, finding that the Executive has materially breached the provisions of this Section 7. 8. DEFINITIONS As used in this Agreement, the following terms shall have the following 11 meanings: (a) CAUSE. Each of the following shall constitute "CAUSE": (i) the willful commission by the Executive of acts that are dishonest and demonstrably and materially injurious to the Company or any of its Affiliates, monetarily or otherwise; (ii) the conviction of the Executive for a felonious act resulting in material harm to the financial condition or business reputation of the Company or any of its Affiliates; or (iii) a material breach of any of the covenants set forth in Section 7 of this Agreement. Notwithstanding the foregoing, the Executive shall not be deemed to have been terminated for Cause unless there shall have been delivered to him, together with a Notice of Termination, a copy of a resolution duly adopted by the affirmative vote of not less than three-fourths (3/4ths) of the entire membership of the Board at a meeting of the Board called and held for such purpose (after reasonable notice to the Executive and an opportunity for the Executive, together with his counsel, to be heard before the Board), finding that in the good faith opinion of the Board the Executive was guilty of conduct set forth above in clause (i), (ii) or (iii) above and specifying the particulars thereof in detail. (b) GOOD REASON. For purposes of this Agreement, "GOOD REASON" shall mean, without the Executive's express written consent, any of the following: (i) a substantial adverse alteration in the nature or status of the Executive's duties or responsibilities or in the Executive's title; (ii) the failure of the Company to pay when due the Executive any Compensation or provide other benefits as specified in this Agreement or a reduction by the Company in the Executive's Compensation or benefits or a failure by the Company to increase the Executive's Compensation as required in Section 3 of this Agreement; (iii) the relocation of the office of the Executive to a location more than 25 miles from the location where the Executive is employed immediately prior to the Change in Control; (iv) the failure by the Company to continue in effect any compensation plan in which the Executive participates, including but not limited to all plans described in 12 Section 3 of this Agreement, or any substitute plans adopted after the date hereof, unless an equitable arrangement (embodied in an ongoing substitute or alternative plan) has been made with respect to such plan, or the failure by the Company to continue the Executive's participation therein on at least as favorable a basis as that enjoyed by other similarly situated executives of the Company and its Affiliates; (v) the failure by the Company to continue to provide the Executive with benefits at least as favorable to those enjoyed by other similarly situated executives of the Company and its Affiliates under any of the Company's pension, life insurance, medical, dental, health and accident, disability, deferred compensation or savings plans, or the taking of any action by the Company which would directly or indirectly materially reduce any of such benefits or deprive the Executive of any material fringe benefit enjoyed by the Executive; or (vi) the failure to obtain a satisfactory agreement from any successor of the Company to assume and agree to perform this Agreement, as contemplated in Section 9 hereof or, if the business of the Company for which the Executive's services are principally performed is sold, the purchaser of such business shall fail to agree to provide the Executive with the same or a comparable position, duties, salary and benefits as provided to the Executive by the Company hereunder. Anything in this Agreement to the contrary notwithstanding, a termination by the Executive for any reason during the 30-day period immediately following the first anniversary of the Effective Date shall be deemed to be a termination for Good Reason for all purposes of this Agreement. (c) NOTICE OF TERMINATION. For purposes of this Agreement, a "NOTICE OF TERMINATION" shall mean a written notice which shall indicate the specific termination provision in this Agreement relied upon and, in the case of a termination of the Executive's employment by the Company for Cause or by the Executive for Good Reason, shall set forth in reasonable detail the facts and circumstances claimed to provide a basis for termination of the Executive's employment under the provision so indicated. (d) DATE OF TERMINATION. "DATE OF TERMINATION" shall mean: (i) in the case of Retirement or death, the date of such event; (ii) if the Executive's employment is terminated for Permanent Disability, thirty (30) days after a Notice of Termination is given (provided that the Executive shall not have returned to the full-time performance of the Executive's duties during such thirty (30) day period); and 13 (iii) if the Executive's employment is terminated for any other reason, the date specified in the Notice of Termination (which, in the case of a termination by the Company (whether with or without Cause) shall not be less than thirty (30) days, and in the case of a resignation by the Executive (whether with or without Good Reason) shall not be less than thirty (30) nor more than sixty (60) days, from the date such Notice of Termination is given). (e) PERMANENT DISABILITY. "PERMANENT DISABILITY" shall mean a disability within the meaning of the long-term disability plan of the Company which covers the Executive immediately prior to the Change in Control. (f) RETIREMENT. "RETIREMENT" shall mean the voluntary termination of the Executive's employment by the Executive in accordance with the Retirement Plan or any other plan or the retirement policy of the Company. (g) AFFILIATE. The term "AFFILIATE" includes any company or other entity or person controlling, controlled by or under common control with the Company. (h) COMPENSATION. The term "COMPENSATION" shall mean all amounts paid or payable to the Executive pursuant to Sections 3(a), 3(b) and 3(c) of this Agreement. (i) CHANGE IN CONTROL. For purposes of this Agreement, a "CHANGE IN - CONTROL" shall be deemed to occur on the date on which one of the following events occurs: (i) the acquisition by any Person of beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Securities Exchange Act of 1934, as amended) of 20% or more of the Common Stock then outstanding, but shall not include any such acquisition by: (A) the Company; (B) any Subsidiary of the Company; (C) any employee benefit plan of the Company or of any Subsidiary of the Company; (D) any Person or entity organized, appointed or established by the Company for or pursuant to the terms of any such plan; (E) any Person who as of January 31, 1996 was the beneficial owner of 15% or more of the shares of Common Stock outstanding on such date unless and until such Person, together with all affiliates and associates of such Person, 14 becomes the beneficial owner of 25% or more of the shares of Common Stock then outstanding whereupon a Change in Control shall be deemed to have occurred; or (F) any Person who becomes the Beneficial Owner of 20% or more, or, with respect to a Person described in clause (E) above, 25% or more, of the shares of Common Stock then outstanding as a result of a reduction in the number of shares of Common Stock outstanding due to the repurchase of shares of Common Stock by the Company unless and until such Person, after becoming aware that such Person has become the beneficial owner of 20% or more, or 25% or more, as the case may be, of the then outstanding shares of Common Stock, acquires beneficial ownership of additional shares of Common Stock representing 1% or more of the shares of Common Stock then outstanding, whereupon a Change in Control shall be deemed to have occurred; or (ii) individuals who, as of January 29, 1997, constitute the Board, and subsequently elected members of the Board whose election is approved or recommended by at least a majority of such current members or their successors whose election was so approved or recommended (other than any subsequently elected members whose initial assumption of office occurs as a result of an actual or threatened election contest with respect to the election or removal of directors or other actual or threatened solicitation of proxies or consents by or on behalf of a person other than the Board), cease for any reason to constitute at least a majority of such Board; or . (iii) approval by the stockholders of the Company of (A) a merger or consolidation of the Company with any other corporation, (B) the issuance of voting securities of the Company in connection with a merger or consolidation of the Company (or any Subsidiary) pursuant to applicable stock exchange requirements, or (C) sale or other disposition of all or substantially all of the assets of the Company or the acquisition of assets of another corporation (each, a "BUSINESS COMBINATION"), unless, in each case, immediately following such Business Combination, all or substantially all of the individuals and entities who were the beneficial owners of the Common Stock outstanding immediately prior to such Business Combination beneficially own, directly or indirectly, more than 70% of the then outstanding shares of common stock and 70% of the combined voting power of the then outstanding voting securities entitled to vote generally in the election of directors, as the case may be, of the corporation resulting from such Business Combination (including, without limitation, a corporation which as a result of such transaction owns the Company or all or substantially all of the Company's assets either directly or through one or more subsidiaries) in substantially the same proportions as their ownership, immediately prior to such Business Combination, of the Common Stock. 15 As used herein, "PERSON" means any individual, firm, corporation, partnership or other entity, and "SUBSIDIARY" means (i) a corporation or other entity with respect to which the Company, directly or indirectly, has the power, whether through the ownership of voting securities, by contract or otherwise, to elect at least a majority of the members of such corporation's board of directors or analogous governing body, or (ii) any other corporation or other entity in which the Company, directly or indirectly, has an equity or similar interest and which the Committee designates as a Subsidiary for purposes of this Agreement. 9. SUCCESSORS; BINDING AGREEMENT (a) The Company will require any successor (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of the business and/or assets of the Company to expressly assume and agree to perform this Agreement in the same manner and to the same extent that the Company would be required to perform it if no such succession had taken place. Failure of the Company to obtain such assumption and agreement prior to the effectiveness of any such succession shall be a breach of this Agreement and shall entitle the Executive to compensation from the Company in the same amount and on the same terms as the Executive would be entitled hereunder if the Executive had terminated his employment for Good Reason, except that for purposes of implementing the foregoing, the date on which any such succession becomes effective shall be deemed the Date of Termination. (b) This Agreement shall inure to the benefit of and be enforceable by the Executive's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. If the Executive should die while any amount would still be payable hereunder if the Executive had continued to live, all such amounts, unless otherwise provided herein, shall be paid in accordance with the terms of this Agreement to the Executive's devisee, legatee or other designee or, if there is no such designee, to the Executive's estate. 10. INDEMNIFICATION The Company will indemnify the Executive to the fullest extent permitted (including payment of expenses in advance of final disposition of a proceeding) by the laws of the State of Delaware, as in effect at the time of the subject act or omission, or by the Certificate of Incorporation and By-Laws of the Company, as in effect at such time or on the date of this Agreement, whichever affords or afforded greatest protection to the Executive, and the Executive shall be entitled to the protection of any insurance policies the Company may elect to maintain generally for the benefit of its directors and officers (and to the extent the Company maintains such an insurance policy or policies, the Executive shall be covered by such policy or policies, in accordance with its or their terms, to the maximum extent of the coverage provided for any Company officer or director), against all costs, charges and 16 expenses whatsoever incurred or sustained by him or his legal representatives at the time such costs, charges and expenses are incurred or sustained, in connection with any action, suit or proceeding to which he may be made a party by reason of his being or having been a director, officer or employee of the Company or any subsidiary thereof, or his serving or having served any other enterprise as a director, officer or employee at the request of the Company. 11. NOTICES Any notice hereunder by either party to the other shall be given in writing by personal delivery, telex, telecopy or certified mail, return receipt requested, to the address first set forth below in the case of the Company, and to the address set forth on the signature page hereof in the case of the Executive (or, in either case, to such other address as may from time to time be designated by notice by any party hereto for such purpose): Ambac Financial Group, Inc. One State Street Plaza New York, New York 10004 Attn: Chief Executive Officer Notice shall be deemed given, if by personal delivery, on the date of such delivery or, if by telex or telecopy, on the business day following receipt of answer back or telecopy confirmation or, if by certified mail, on the date shown on the applicable return receipt. 12. AMENDMENT AND WAIVER No provision of this Agreement may be amended, modified, waived or discharged unless such amendment, modification, waiver or discharge is agreed to in writing and signed by the Executive and such officer as may be specifically designated by the Board. No waiver by either party hereto at any time of any breach by the other party hereto of, or compliance with, any condition or provision of this Agreement to be performed by such other party shall be deemed a waiver of similar or dissimilar provisions or conditions at the same or at any prior or subsequent time. 13. MERGER OF PRIOR NEGOTIATIONS (a) This Agreement sets forth all of the promises, agreements, conditions and understandings between the parties hereto respecting the subject matter hereof and supersedes all prior negotiations, conversations, discussions, correspondence, memoranda and agreements between the parties concerning such subject matter. (b) The Executive and the Company acknowledge that, except as may otherwise be provided under any other written agreement between the Executive and the 17 Company, the employment of the Executive by the Company is "at will" and that, subject to the provisions of Section 2 above, if the Executive's employment is terminated by either the Executive or the Company at any time prior to the beginning of the Term, the Executive shall have no further rights under this Agreement. From and after the commencement of the Term, this Agreement shall supersede any other agreement between the parties with respect to the subject matter hereof. 14. PARTIAL INVALIDITY If the final determination of a court of competent jurisdiction or arbitrator declares, after the expiration of the time within which judicial review (if permitted) of such determination may be perfected, that any term or provision hereof is invalid or unenforceable, (a) the remaining term and provisions hereof shall be unimpaired and (b) the invalid or unenforceable term or provision shall be deemed replaced by a term or provision that is valid and enforceable and that comes closest to expressing the intention of the invalid or unenforceable term or provision. 18 15. GOVERNING LAW This Agreement is to be governed by and interpreted in accordance with the laws of the State of New York. 16. COUNTERPARTS This Agreement may be executed in two or more counterparts, each of which shall be deemed to be an original but all of which together will constitute one and the same instrument. 17. ARBITRATION; LEGAL FEES (a) Any dispute or controversy arising under or in connection with this Agreement shall be settled exclusively by arbitration in New York, New York in accordance with the rules of the American Arbitration Association then in effect. Judgment may be entered on the arbitrator's award in any court having jurisdiction; provided, however, that the Executive shall be entitled to seek specific performance of the Executive's right to be paid until the Date of Termination during the pendency of any dispute or controversy arising under or in connection with this Agreement. (b) The Company shall promptly reimburse the Executive for all legal fees and expenses incurred by the Executive in connection any claim to enforce his rights under this Agreement, except for any claim which shall have been determined, in an arbitration conducted in accordance with subsection (a) above, to have been brought by the Executive in bad faith. (c) In addition to the reimbursement provided for in subsection (b) above, the Company shall reimburse the Executive for up to $15,000 in legal, accounting and financial expenses incurred after a Change in Control in connection with this Agreement (whether or not the Executive's employment is terminated), including without limitation in connection with financial planning and the investigation of the Executive's rights hereunder. 19 IN WITNESS WHEREOF, the parties hereto, having entered into this Agreement as of December 30, 1994, have executed this Amended and Restated Management Retention Agreement as of December 2, 1997. AMBAC FINANCIAL GROUP, INC. By: --------------------------------------- Phillip B. Lassiter Chairman, President and Chief Executive Officer EXECUTIVE ------------------------------------------ Name: Title: Address: EX-10.10 7 SAVINGS INCENTIVE PLAN (EXHIBIT 10.10) AMENDMENT NUMBER 1 TO THE AMBAC INC. NONQUALIFIED SAVINGS INCENTIVE PLAN WHEREAS, Section 12 of the AMBAC Inc. Nonqualified Savings Incentive Plan (the "PLAN") provides that the Board of Directors (the "BOARD") of AMBAC Inc. (the "COMPANY") may amend the Plan; and WHEREAS, the Board has approved an amendment to the Plan in the manner set forth below; NOW, THEREFORE, effective as of April 30, 1997, the Plan is hereby amended as follows: 1. Section 2 of the Plan is hereby amended to add after the definition of "ERISA" the following: ""Excluded Individual" means (i) any individual who is designated by the Company at the time of hire as not eligible to participate in the Plan or (ii) any individual who is treated or designated by the Company as an independent contractor, leased employee or consultant (regardless of whether such treatment or designation is subsequently upheld by a court, judicial or arbitral authority or any other governmental agency). Excluded Individuals are not eligible to participate in or receive benefits under the Plan." 2. The definition of "Participant" in Section 2 of the Plan is hereby deleted and replaced by the following: ""Participant" means an individual, other than an Excluded Individual, who has satisfied the qualification requirements of Section 3(a)." 3. The second paragraph of Section 3 is hereby amended by adding at the end thereof the following: "Furthermore, no Excluded Individual may qualify as a Participant." 4. Section 14(a) is hereby deleted and replaced by the following: "(a) The Plan shall be administered and operated by the Committee, which shall be responsible for the interpretation of the Plan and the establishment of the rules and regulations governing the administration thereof. The Committee shall have complete authority, in its sole and absolute discretion, to construe the terms of the Plan (and any related or underlying documents or policies), and to determine the eligibility for, and amount of benefits due under, the Plan to Participants. All such interpretations and determinations of the Committee shall be final and binding upon all parties and persons affected thereby." 5. Except as otherwise amended above, the Plan shall remain in full force and effect. AMBAC Inc. By: /s/ Janice Reals Ellig ------------------------- Title: Senior Vice President EX-10.12 8 EXCESS BENEFITS PENSION PLAN (EXHIBIT 10.12) AMENDMENT NUMBER 1 TO THE AMBAC INC. EXCESS BENEFITS PENSION PLAN WHEREAS, Section 12.1 of the AMBAC Inc. Excess Benefits Pension Plan (the "PLAN") provides that the Board of Directors (the "BOARD") of AMBAC Inc. (the "COMPANY") may amend the Plan; and WHEREAS, the Board has approved an amendment to the Plan in the manner set forth below; NOW, THEREFORE, effective as of April 30, 1997, the Plan is hereby amended as follows: 1. The text of Section 3.1 of the Plan is hereby deleted and is replaced by the following: "Eligibility. Any Employee who is not an Excluded Individual and ----------- who is a participant in the Pension Plan and whose retirement benefits under the Pension Plan are limited by the benefit limitation set forth in Code Section 415 shall be eligible to participate in this Excess Plan. "Excluded Individual" shall mean (i) any Employee who is -------- ---------- designated by the Company at the time of hire as not eligible to participate in the Excess Plan, (ii) any employee of AMBAC Connect Inc., a Delaware corporation, or its predecessors, (iii) any employee of Cadre Financial Services, Inc., a Delaware corporation, or its predecessors, (iv) any employee of AMBAC Securities Inc., a Delaware corporation, or its predecessors, or (v) any individual who is treated or designated by the Company as an independent contractor, leased employee or consultant (regardless of whether such treatment or designation is subsequently upheld by a court, judicial or arbitral authority or any other governmental agency). Excluded Individuals are not eligible to participate in or receive benefits under the Excess Plan." 2. The text of Section 7.2 of the Plan is hereby deleted and is replaced by the following: "Interpretation of the Excess Plan; Finality of Determination. ------------------------------------------------------------ The Plan Administrator has complete authority, in its sole and absolute discretion, to construe the terms of the Excess Plan (and any related or underlying documents or policies), and to determine the eligibility for, and amount of benefits due under, the Excess Plan to Participants. All such interpretations and determinations of the Plan Administrator shall be final and binding upon all parties and persons affected thereby." 3. Except as otherwise amended above, the Plan shall remain in full force and effect. AMBAC Inc. By: /s/ Janice Reals Ellig ------------------------- Title: Senior Vice President EX-10.18 9 SUPPLEMENTAL PENSION PLAN (EXHIBIT 10.18) AMENDMENT NUMBER 1 TO THE AMBAC INC. SUPPLEMENTAL PENSION PLAN WHEREAS, Section 12.1 of the AMBAC Inc. Supplemental Pension Plan (the "PLAN") provides that the Board of Directors (the "BOARD") of AMBAC Inc. (the "COMPANY") may amend the Plan; and WHEREAS, the Board has approved an amendment to the Plan in the manner set forth below; NOW, THEREFORE, effective as of April 30, 1997, the Plan is hereby amended as follows: 1. The text of Section 3.1 of the Plan is hereby deleted and is replaced by the following: "Eligibility. Any Employee who is not an Excluded Individual and ----------- who is a participant in the Pension Plan and whose retirement benefits under the Pension Plan are limited by the benefit limitation set forth in Code Section 401(a)(17) shall be eligible to participate in this Supplemental Plan. "Excluded Individual" shall mean (i) any -------- ---------- Employee who is designated by the Company at the time of hire as not eligible to participate in the Supplemental Plan, (ii) any employee of AMBAC Connect Inc., a Delaware corporation, or its predecessors, (iii) any employee of Cadre Financial Services, Inc., a Delaware corporation, or its predecessors, (iv) any employee of AMBAC Securities Inc., a Delaware corporation, or its predecessors, or (v) any individual who is treated or designated by the Company as an independent contractor, leased employee or consultant (regardless of whether such treatment or designation is subsequently upheld by a court, judicial or arbitral authority or any other governmental agency). Excluded Individuals are not eligible to participate in or receive benefits under the Supplemental Plan." 2. The text of Section 7.2 of the Plan is hereby deleted and is replaced by the following: "Interpretation of the Supplemental Plan; Finality of ---------------------------------------------------- Determination. The Plan Administrator has complete authority, in its ------------- sole and absolute discretion, to construe the terms of the Supplemental Plan (and any related or underlying documents or policies), and to determine the eligibility for, and amount of benefits due under, the Supplemental Plan to Participants. All such interpretations and determinations of the Plan Administrator shall be final and binding upon all parties and persons affected thereby." 3. Except as otherwise amended above, the Plan shall remain in full force and effect. AMBAC Inc. By: /s/ Janice Reals Ellig ------------------------- Title: Senior Vice President EX-10.20 10 LEASE AGREEMENT (EXHIBIT 10.20) August 1, 1997 Ambac Assurance Corporation One State Street Plaza New York, NY 10004 Attention: Mr. Bill Mitchell Dear Sirs: Reference is made to the Lease between South Ferry Building Company, Landlord, and Ambac Assurance Corporation (formerly known as AMBAC Indemnity Corporation), Tenant, dated January 1, 1992 (as amended from time to time, the "Lease"). Capitalized terms not defined herein shall have their respective meanings as set forth in the Lease. Landlord and Tenant hereby agree that the Lease be amended as follows: 1. The "Expiration Date" of the Lease as defined in Section 1.03 of the Lease is hereby changed to September 30, 2019 for the entire Premises (i.e., the existing premises and the additional premises added pursuant to this Amendment). 2. Landlord hereby leases to Tenant, and Tenant hereby hires from Landlord and adds to the Premises under the Lease, the entire nineteenth (19/th/) floor, substantially as shown cross-hatched on Exhibit A annexed hereto (the "19/th/ Floor Space") for the period commencing on May 1, 1997 and ending on the Expiration Date (or sooner termination of the Lease), pursuant to the terms, covenants, conditions and provisions of the Lease, subject to the following: (a) As of the date hereof, with respect to the 19/th/ Floor Space: (i) "Tenant's Proportionate Share" under Section 3.02(c) of the Lease shall be increased by 3.4058%; (ii) The "Operating Payment" multiplier under clause (ii) of the first sentence of the second paragraph of Section 3.01(c) of the Lease shall be increased by 24,254; (iii) For purposes of calculating Tenant's Operating Payments allocable to the 19/th/ Floor Space, the Base Wage Rate shall be the Wage Rate in effect on January 1, 1997; and Ambac Assurance Corporation August 1, 1997 page 2 (iv) For purposes of calculating Tenant's Tax Payments allocable to the 19/th/ Floor Space, the Basic Tax shall be the Taxes for the real estate tax fiscal year commencing July 1, 1997 and ending June 30, 1998, as finally determined. (v) Nothing contained in this paragraph 2(a) shall affect Tenant's Operating Payments or Tenant's Tax Payments for the existing Premises other than the 19/th/ Floor Space. (b) Landlord shall perform (i) demolition of all portions of the 19/th/ Floor Space other than the core bathrooms and other core areas on the floor and cart away all debris caused thereby, (ii) asbestos removal in compliance with all laws and requirements of any public authority having jurisdiction with respect to the same as is required for the issuance of an ACP-5 Certificate for the 19/th/ floor of the Building and (iii) fireproof the 19/th/ floor of the Building as required by laws or requirements of public authorities (all of such work to constitute, the "Landlord's 19/th/ Floor Work"). Such work shall be completed on or prior to September 15, 1997 (the "Work Completion Date"). If Landlord's 19/th/ Floor Work is not substantially complete on or before the Work Completion Date, then Landlord and Tenant agree that the failure to substantially complete Landlord's 19/th/ Floor Work on or before the Work Completion Date shall in no way affect the validity of this Agreement or the inclusion of the 19/th/ Floor Space in the Premises or the obligations of the Landlord or Tenant hereunder; provided, however, in the event Landlord shall fail to substantially complete Landlord's 19/th/ Floor Work on or before the Work Completion Date, then for each one day after the Work Completion Date that Landlord's 19/th/ Floor Work is not substantially complete, Tenant shall receive a credit equal to $1927.03 per day which credit shall be applied to Fixed Rent commencing on April 1, 1999, provided that no more than $57,810.90 of such credit shall be applied against the Fixed Rent in any month, and any excess shall be carried over to the following month. Tenant has examined the 19/th/ Floor Space and, with the exception of the Landlord's 19/th/ Floor Work, agrees to take the same "as is" and Landlord shall not be obligated to perform any other work or incur any other expense to prepare the 19/th/ Floor Space for Tenant's use and the provisions of Landlord's Work in Article 38 of the Lease shall not apply to the 19/th/ Floor Space. (c) To the extent required by applicable law, Landlord shall, in conjunction with the Tenant's initial buildout of its space, perform any work required to bring the core areas of the 19/th/ floor of the Building in compliance with the American with Disabilities Act of 1990, as amended to date. Ambac Assurance Corporation August 1, 1997 page 3 (d) Landlord shall deliver to Tenant an ACP-5 Certificate applicable to the area in which Landlord shall perform asbestos removal pursuant to paragraph 2(b) herein. Landlord shall deliver to Tenant such ACP-5 Certificate promptly after Tenant delivers to Landlord construction plans for the 19/th/ Floor Space which are sufficient to obtain such ACP-5 Certificate. (e) The provisions of Article 14 of the Lease which are applicable to Tenant's use and consumption of electricity in the 15/th/, 16/th/ and 17/th/ floors of the Building shall apply to Tenant's use and consumption of electricity in the 19/th/ Floor Space; provided (i) the $2.80 per rentable square foot "interim rate" described in Section 14.01 of the Lease shall commence on the date that Tenant commences its buildout of the 19/th/ Floor Space and (ii) Landlord shall install the meters described in Section 14.01 of the Lease with respect to the 19/th/ Floor Space within six (6) months after the completion of Landlord's 19/th/ Floor Work and in the event that Landlord fails to install such meters within such six (6) month period then the remedies available to Tenant under Section 37.03 of the Lease with respect to the installation of meters in the 18/th/ floor of the Building shall be available to Tenant with respect to the installation of meters in the 19/th/ Floor Space. 3. Sections 1.04(a) of the Lease is hereby deleted in its entirety and the following is inserted in its place: "(a) fixed rent (herein called "Fixed Rent") at the following rates during the following periods: (i) For the period commencing on the Commencement Date and ending March 14, 1994, Zero and 00/100 ($0.00) DOLLARS per annum; (ii) For the period commencing March 15, 1994 (hereinafter called the "Rent Commencement Date") and ending June 30, 1995, ONE MILLION NINE HUNDRED SIXTY-FOUR THOUSAND FIVE HUNDRED SEVENTY-FOUR and 00/100 ($1,964,574.00) DOLLARS per annum; (iii) For the period commencing on the July 1, 1995 (hereinafter called the "18/th/ Floor Rent Commencement Date") and ending December 31, 1995, TWO MILLION SIX HUNDRED NINETEEN THOUSAND FOUR HUNDRED THIRTY-TWO and 00/100 ($2,619,432.00) DOLLARS per annum; Ambac Assurance Corporation August 1, 1997 page 4 (iv) For the period commencing January 1, 1996 and ending December 31, 1996, TWO MILLION SEVEN HUNDRED SIXTY-FOUR THOUSAND NINE HUNDRED FIFTY-SIX and 00/100 ($2,764,956.00) DOLLARS per annum; (v) For the period commencing January 1, 1997 and ending December 31, 1997, TWO MILLION EIGHT HUNDRED THIRTEEN THOUSAND FOUR HUNDRED SIXTY-FOUR and 00/100 ($2,813,464.00) DOLLARS per annum; (vi) For the period commencing January 1, 1998 and ending December 31, 1998, THREE MILLION NINETY-NINE THOUSAND SIX HUNDRED SIXTY- ONE and 20/100 ($3,099,661.20) DOLLARS per annum; (vii) For the period commencing January 1, 1999 and ending March 31, 1999, THREE MILLION THREE HUNDRED NINETY THOUSAND SEVEN HUNDRED NINE and 20/100 ($3,390,709.20) DOLLARS per annum; (viii) For the period commencing April 1, 1999 and ending December 31, 2001, FOUR MILLION TWO HUNDRED THIRTY-EIGHT THOUSAND THREE HUNDRED EIGHTY-SIX and 50/100 ($4,238,386.50) DOLLARS per annum; (ix) For period commencing January 1, 2002 and ending December 31, 2008, FOUR MILLION THREE HUNDRED FIFTY-NINE THOUSAND SIX HUNDRED FIFTY-SIX DOLLARS and 50/100 ($4,359,656.50) DOLLARS per annum; (x) For the period commencing January 1, 2009 and ending on December 31, 2009, FOUR MILLION FIVE HUNDRED FORTY-ONE THOUSAND FIVE HUNDRED SIXTY-ONE DOLLARS and 50/100 ($4,541,561.50) DOLLARS per annum; (xi) For the period commencing January 1, 2010 and ending on September 30, 2014, FOUR MILLION NINE HUNDRED SIXTY-SIX THOUSAND SIX and 50/100 ($4,966,006.50) DOLLARS per annum; (xii) For the period commencing on October 1, 2014 and ending on the Expiration Date, FIVE MILLION THREE HUNDRED NINETY THOUSAND FOUR HUNDRED FIFTY-ONE and 50/100 ($5,390,451.50) DOLLARS per annum. Ambac Assurance Corporation August 1, 1997 page 5 Such Fixed Rent shall be payable commencing on the Rent Commencement Date and thereafter in equal monthly installments in advance on the first day of each and every calendar month during the term of the Lease, and" 4. Article 41 of the Lease is hereby deleted in its entirety. 5. (a) As of July 31, 1997 and thereafter throughout the term of the Lease, Landlord shall furnish, in addition to the 100 tons of condenser water to be provided pursuant to Article 15 of the Lease, 40 tons of additional condenser water from the Building tower for Tenant's use, and Tenant shall pay, as additional rent, at the same time together with the payments of the monthly rent under the Lease, the amounts set forth in this paragraph (hereinafter referred to as the "Additional Condenser Water Charges") for such 40 tons. The Additional Condenser Water Charges are twenty-five cents ($0.25) per ton per hour of the maximum permitted use (whether or not Tenant shall use such maximum) per year, which rate shall be increased on each anniversary of the July 31, 1997 to an amount equal to 105% of the Additional Condenser Water Charges payable during the immediately preceding year (without regard to any abatement or setoff which may have been in effect). Tenant shall obtain and maintain, at Tenant's sole cost and expense, all permits necessary for the operation of any air conditioning units installed in the Premises, other than those relating to the supply of condenser water by Landlord. (b) As of the date hereof, Tenant shall be entitled to an additional 6 Blocs (as such term is defined in Section 15.04(a) of the Lease) during each calendar year to occur during the term of the Lease (prorated with respect to any partial calendar year to occur during the term of the Lease). 6. (a) For the period (the "Additional Basement Term") from April 29, 1997 (the "Basement Effective Date") until October 31, 1997 (the "Basement Termination Date") Tenant shall have the right to use and occupy the portion of the basement area of the Building known as Subconcourse level no. 2 substantially as shown hatched on the floor plan annexed hereto as Exhibit B (hereinafter referred to as the "Additional Basement Space"); accordingly, effective as of the Basement Effective Date throughout the Additional Basement Term the Basement Space (as such term is used in the Lease) shall include the Additional Basement Space, and except as hereinafter expressly otherwise provided in this Amendment, all of the terms, covenants, conditions and provisions of Article 42 of the Lease shall be applicable to the Additional Basement Space from and after the Basement Effective Date, and all references in the Lease to the Basement Space shall be deemed to include the Additional Basement Space. Ambac Assurance Corporation August 1, 1997 page 6 (b) In the event Landlord's 19/th/ Floor Work is not substantially complete on or prior to the Work Completion Date then for each one day after the Work Completion Date that Landlord's 19/th/ Floor Work is not substantially complete, the Basement Termination Date as defined herein shall occur one calendar day later. (c) Effective as of the Basement Effective Date, the Fixed Rent payable pursuant to Section 42.01 of the Lease shall be increased (in addition to the amounts set forth in Section 42.01 of the Lease) with respect to the Additional Basement Space as follows: For the period commencing on the Basement Effective Date and ending on the Basement Termination Date, at the rate of TWENTY THOUSAND FOUR HUNDRED THIRTY and 00/100 ($20,430.00) DOLLARS per annum ($1,702.50 per month). (d) Tenant agrees that it shall vacate the Additional Basement Space no later than the Basement Termination Date. In addition, all other terms of the Lease relating to the termination of the Basement Space Term shall apply to the termination of the Additional Basement Term with respect to the Additional Basement Space. (e) The Basement Space Term with respect to the existing Basement Space without regard to the Additional Basement Space) shall terminate 30 days after the date that Tenant first uses the 19/th/ Floor Space for the purpose of conducting business operations or at such earlier time as Tenant gives five (5) business days notice to Landlord of its intent to vacate such Basement Space. 7. Tenant represents that it has not dealt with any brokers other than Insignia/Edward S. Gordon Company, Inc. in connection with this Amendment, and agrees to indemnify and hold harmless Landlord from and against any and all claims for brokerage commission and all costs, expenses and liabilities (including, without limitation, reasonable attorneys fees) by any person other than Insignia/Edward S. Gordon Company, Inc. in connection with this agreement. Landlord represents that it has not dealt with any brokers other than Edward S. Gordon in connection with this Amendment. 8. Landlord shall cooperate with Tenant, at Tenant's cost and expense, in connection with any application made, or proposed to be made, by Tenant seeking a refund, abatement, reduction, rebate, or incentive pursuant to Title 4 of Article 4 of the New York Real Property Tax Law, commonly referred to as the lower Manhattan tax incentive plan (the "Lower Manhattan Tax Incentive Plan") with respect to the 19/th/ Floor Space. Landlord shall not be required hereunder to take any action, other than to cooperate with Tenant as aforesaid (including the execution of application materials prepared by Tenant), in order to make any such refund, abatement, reduction, rebate Ambac Assurance Corporation August 1, 1997 page 7 or incentive available to Tenant. Tenant shall indemnify and hold Landlord harmless from and against all loss, damage, liability, reasonable cost or reasonable expense of any nature (including without limitation reasonable attorney's fees and disbursements) resulting from Landlord's cooperation with Tenant as aforesaid. Nothing contained in this paragraph, however, shall be deemed or construed to constitute any representation or warranty by Landlord that Tenant will be entitled to any refund, abatement, reduction, rebate, or incentive pursuant to the Lower Manhattan Tax Incentive Plan. 9. Notwithstanding any other provision to the contrary, in the event that Landlord receives any refund or abatement of Taxes pursuant to the Lower Manhattan Tax Incentive Plan, or any other similar tax reduction, rebate or incentive which is attributable to and passed though to a particular tenant(s) in the Building (whether related to the Premises under the Lease or otherwise and whether related to the Tenant or another tenant in the Building), (i) Tenant shall not be entitled to any payment or credit under the Lease in connection with such refund or abatement (except to the extent such abatement is for the benefit of, and required by law to be paid to, Tenant) and (ii) for purposes of computing Taxes for any Tax Year pursuant to Section 3.02 of the Lease, there shall not be deducted from Taxes all or any portion of such refund or abatement. Ambac Assurance Corporation August 1, 1997 page 8 Please confirm your agreement to this letter by executing and returning a copy of this letter to the undersigned. Sincerely, SOUTH FERRY BUILDING COMPANY, Landlord By: /s/ Zev Wolfson --------------- Name: Zev Wolfson ----------- Title: General Partner --------------- ACCEPTED AND AGREED TO: AMBAC ASSURANCE CORPORATION (formerly known as AMBAC Indemnity Corporation), Tenant By: /s/ Frank. Bivona ----------------- Name: Frank J. Bivona --------------- Title: Chief Financial Officer ----------------------- MM: adf Enclosure EX-10.28 11 AMENDMENT NO. 5 TO CREDIT AGREEMENT EXHIBIT 10.28 AMENDMENT NO. 5 TO CREDIT AGREEMENT ----------------------------------- AMENDMENT NO. 5 TO CREDIT AGREEMENT (this "Amendment") dated as of December 2, 1997 among Ambac Assurance Corporation (formerly, AMBAC Indemnity Corporation) (the "Borrower"), Landesbank Hessen-Thuringen Girozentrale, ("Helaba"), Bayerische Landesbank Girozentrale, ("BLG"), Cooperatieve Centrale Raiffeisen-Boerenleenbank B.A., "Rabobank Nederland", New York Branch ("Rabobank" and, together with Helaba and BLG, the "Banks"), and Deutsche Bank AG, New York Branch, as Agent (the "Agent"). W I T N E S S E T H : ------------------- WHEREAS, the Borrower, the Banks and the Agent have entered into a Credit Agreement, dated as of December 2, 1993 (as amended to date, the "Agreement"); and WHEREAS, the parties hereto desire to amend the Agreement as herein provided; and WHEREAS, pursuant to Section 12.12 of the Agreement, the Agreement may be amended by the written agreement of the Borrower, the Banks and the Agent; NOW, THEREFORE, in consideration of the premises and the mutual covenants herein contained, the parties hereto hereby agree as follows: 1. Defined Terms. Capitalized terms used herein and not ------------- otherwise defined herein shall have the meanings assigned to such terms in the Agreement. 2. Amendments. (a) All references in the Agreement (including ---------- in any Schedule or Exhibit thereto) to "AMBAC Indemnity Corporation" are hereby amended to "Ambac Assurance Corporation". (b) The definition of "Parent" in Section 1.01 is hereby amended in its entirety and replaced with the following: "Parent" shall mean Ambac Financial Group, Inc., a Delaware corporation. (c) The "December 2, 2003" date set forth in the first sentence of Section 3.04 is hereby amended to "December 2, 2004". (d) Schedule I is hereby deleted in its entirety and replaced with Exhibit A attached hereto. 3. No Default. The Borrower hereby represents and warrants to ---------- the Banks and the Agent that, both before and after giving effect to this Amendment, no Default or Event of Default exists. 4. Representations and Warranties. The Borrower hereby represents ------------------------------ and warrants to the Banks and the Agent that, both before and after giving effect to this Amendment, the representations and warranties contained in Section 7 of the Agreement are true and correct in all material respects on and as of the date hereof. 5. Counterparts. This Amendment may be executed simultaneously ------------ in two or more counterparts, each of which shall be deemed to be an original, and it shall not be necessary in making proof of this Amendment to produce or account for more than one such counterpart. 6. Agreement Not Otherwise Amended. Terms and provisions of ------------------------------- the Agreement not amended hereby shall continue to remain in full force and effect. From and after the date hereof, all references in the Agreement and each of the Credit Documents to the Agreement shall be deemed references to the Agreement as amended by this Amendment. 7. GOVERNING LAW. THIS AMENDMENT AND THE RIGHTS AND OBLIGATIONS OF ------------- THE PARTIES HEREUNDER SHALL BE CONSTRUED IN ACCORDANCE WITH AND GOVERNED BY THE LAWS OF THE STATE OF NEW YORK, WITHOUT REGARD TO THE CONFLICT OF LAW PROVISIONS THEREOF. IN WITNESS WHEREOF, each of the parties hereto has caused this Amendment to be executed and delivered on its behalf, all on the date first above written. AMBAC ASSURANCE CORPORATION By /s/ Frank Bivona ------------------------- Title: Senior Vice President, CFO and Treasurer LANDESBANK HESSEN-THURINGEN GIROZENTRALE -2- By /s/ Lisa S. Pent ----------------------------- Title: Senior Vice President, Manager By /s/ Peter Icreccaio III ----------------------------- Title: Assistant Vice President BAYERISCHE LANDESBANK GIROZENTRALE By /s/ Peter Obermann ----------------------------- Title: Senior Vice President By /s/ Scott Allison ----------------------------- Title: First Vice President COOPERATIEVE CENTRALE RAIFFEISEN-BOERENLEENBANK B.A.,"RABOBANK NEDERLAND", NEW YORK BRANCH By /s/ Michael de Konkoly Thege ----------------------------- Title: Managing Director By /s/ Angela R. Reilly ----------------------------- Title: Vice President DEUTSCHE BANK AG, NEW YORK BRANCH, as Agent By /s/ Louis Caltavuturo ----------------------------- Title: Vice President By /s/ Alan Krour ----------------------------- Title: Associate -3- EXHIBIT A --------- SCHEDULE I ---------- COMMITMENTS ----------- BANK COMMITMENT AMOUNT ---- ----------------- COOPERATIEVE CENTRALE RAIFFEISEN- $180,000,000 BOERENLEENBANK B.A., "RABOBANK NEDERLAND", NEW YORK BRANCH BAYERISCHE LANDESBANK GIROZENTRALE 165,000,000 LANDESBANK HESSEN-THURINGEN GIROZENTRALE 105,000,000 ----------- TOTAL $450,000,000 =========== EX-12.01 12 STATEMENT OF COMPUTATION OF RATIOS (EXHIBIT 12.01) Ambac Financial Group, Inc. Ratio of Earnings to Fixed Charges The following table contains our ratio of earnings to fixed charges for each of the periods indicated:
Years Ended December 31, ------------------------------------------------------------- 1997 1996 1995 1994 1993 ------------------------------------------------------------- Ratio of earnings to fixed charges 13.41x 17.91x 10.77x 10.14x 15.78x - --------------------------
We computed the ratio of earnings to fixed charges by dividing earnings before income taxes and extraordinary items plus fixed charges by the fixed charges. For the purpose of this ratio, fixed charges consist of interest expense incurred, capitalized interest, amortization of debt expense and one-third of rental payments under operating leases (an amount deemed representative of the appropriate interest factor). EX-13.01 13 ANNUAL REPORT TO STOCKHOLDERS FINANCIAL HIGHLIGHTS
- ------------------------------------------------------------------------------------------------------------------------------------ AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES Years Ended December 31 - ------------------------------------------------------------------------------------------------------------------------------------ STATEMENT OF OPERATIONS HIGHLIGHTS 1997 1996 1995 1994 1993 (DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS) Gross premiums written ...................................... $ 286.2 $ 247.2 $ 193.3 $ 189.9 $ 318.3 Net premiums earned ......................................... 154.0 136.6 111.8 117.5 152.0 Net investment income ....................................... 159.7 144.9 131.0 117.1 104.6 Financial management services income ........................ 35.2 22.0 13.1 15.9 8.7 Total revenues .............................................. 381.8 452.9 282.3 242.3 299.3 Losses and loss adjustment expenses ......................... 2.9 3.8 3.4 2.6 (1.8) Financial guarantee insurance underwriting and operating expenses ................................... 40.7 37.2 34.5 32.8 34.5 Financial management services expenses ...................... 28.0 12.0 7.8 6.1 2.0 Interest expense ............................................ 21.3 20.9 20.9 18.8 15.8 Net income .................................................. 223.0 276.3 167.6 141.1 179.3 Net income per share ........................................ 3.19 3.95 2.39 2.00 2.54 Net income per diluted share ................................ 3.13 3.91 2.37 1.99 2.52 - ------------------------------------------------------------------------------------------------------------------------------------ AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES As of December 31 - ------------------------------------------------------------------------------------------------------------------------------------ BALANCE SHEET HIGHLIGHTS 1997 1996 1995 1994 1993 (DOLLARS IN MILLIONS) Total investments ........................................... $ 6,915.1 $ 5,200.5 $ 4,441.6 $ 3,764.2 $ 3,132.7 Prepaid reinsurance ......................................... 183.5 168.8 153.4 139.9 161.3 Total assets ................................................ 8,249.7 5,876.4 5,309.3 4,287.0 3,807.2 Unearned premiums ........................................... 1,179.0 991.2 903.0 836.6 782.8 Losses and loss adjustment expenses ......................... 103.3 60.6 66.0 65.7 64.0 Obligations under investment agreements, investment repurchase agreements and payment agreements ............. 4,321.0 2,754.6 2,426.9 2,025.3 1,477.7 Debentures .................................................. 223.9 223.8 223.7 223.7 223.6 Total stockholders' equity .................................. 1,872.5 1,615.0 1,404.0 1,033.5 1,099.7
FIVE YEAR HIGHLIGHTS [THE FOLLOWING TABLE WAS REPRESENTED AS A BAR CHART IN THE PRINTED MATERIAL.]
1993 1994 1995 1996 1997 ---- ---- ---- ---- ---- TOTAL REVENUES ($ MILLIONS) $299.3 $242.3 $282.3 $452.9 $381.8 NET INCOME ($ MILLIONS) $179.3 $141.1 $167.6 $276.3 $223.0 NET INCOME PER DILUTED SHARE $ 2.52 $ 1.99 $ 2.37 $ 3.91 $ 3.13 RETURN ON EQUITY 18.3% 13.2% 13.8% 18.3% 12.8%
- -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - -------------------------------------------------------------------------------- GENERAL Ambac Financial Group, Inc. (the "Company") headquartered in New York City, is a holding company that provides through its affiliates financial guarantee insurance and financial management services to clients in both the public and private sectors in the U.S. and abroad. The following paragraphs describe the consolidated results of operations of Ambac Financial Group, Inc. and its subsidiaries (sometimes collectively referred to as the "Company") for 1997, 1996 and 1995, and its financial condition as of December 31, 1997 and 1996. These results are presented for the Company's two business segments: Financial Guarantee Insurance and Financial Management Services. RESULTS OF OPERATIONS CONSOLIDATED NET INCOME The Company's net income in 1997 was $223.0 million or $3.13 per diluted share, a decrease of 19% from $276.3 million or $3.91 per diluted share in 1996. This decrease was primarily the result of a net realized gain in 1996 of $155.6 million (which had a net income per diluted share effect of $1.42) from the Company's sale of its former affiliate, HCIA Inc. ("HCIA"). Excluding the effect of this one-time gain, 1997 net income increased 27% over 1996 due to higher net income in the financial guarantee insurance segment, partially offset by lower net income in the financial management services segment. The Company's net income in 1996 increased 65% from $167.6 million or $2.37 per diluted share in 1995. This increase was due to a number of factors, primarily the $155.6 million net realized gain from the Company's sale of HCIA. In 1995, the Company had recognized a realized gain of $19.1 million (which had a net income per diluted share effect of $0.17) from a partial sale of its investment in HCIA. Excluding the effects of the respective gains from the sales of HCIA stock in both 1996 and 1995, net income in 1996 increased 13% over 1995 due to higher net income in both the financial guarantee insurance and financial management services business segments. FINANCIAL GUARANTEE INSURANCE The Company provides financial guarantee insurance through its principal operating subsidiary, Ambac Assurance Corporation ("Ambac Assurance"), which is a leading insurer of municipal and structured finance obligations both in the U.S. and abroad. Gross Par Value Written. Ambac Assurance insured $46.3 billion of par value bonds during 1997, an increase of 26% from $36.8 billion in 1996. Par value written in 1996 represented an increase of 42% from $26.0 billion in 1995. Par value written in 1997 comprised $29.4 billion from the insurance of domestic municipal bond obligations, $12.9 billion from domestic structured finance obligations and $4.0 billion from international obligations, versus $26.7 billion, $6.4 billion and $3.7 billion, respectively, in 1996 and $20.3 billion, $4.0 billion and $1.7 billion, respectively, in 1995. The 1997 increase in insured domestic municipal bond obligations resulted primarily from a 19% increase in market issuance, partially offset by lower market share. The 1997 increase in insured domestic structured finance obligations was attributable to higher market share, mostly in the home equity loan and mortgage-backed sectors. The 1997 increase in insured international obligations resulted from greater acceptance of financial guarantee insurance, primarily in Europe and Japan. Gross Premiums Written. Gross premiums written in 1997 were $286.2 million, an increase of 16% from $247.2 million in 1996. This increase was primarily due to higher structured finance and international premiums written, partially offset by lower municipal finance premiums. Gross premiums written in 1996 increased 28% from $193.3 million in 1995. This increase was primarily due to higher new issue municipal finance premiums written. The following table sets forth the amounts of gross premiums written by type and percent of total: [PHOTOS] From left to right: Ambac Connect: John Harrison, Martha Rochelle; Human Resources: Gregg Bienstock; Cadre Financial Services: Will Sullivan and Tim Sullivan; Finance: Graham Nelson, Yiping Guo 23 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) - --------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------------ (DOLLARS IN MILLIONS) 1997 1996 1995 - ------------------------------------------------------------------------------------------------------------------------------------ Municipal finance policies: Up-front policies: New issue ......................................... $178.9 62% $182.9 74% $125.2 65% Secondary market .................................. 19.6 7 20.4 8 27.3 14 ------------------------------------------------------------------ Sub-total up-front ............................. 198.5 69 203.3 82 152.5 79 ------------------------------------------------------------------ Installment policies: Annual policies ................................... 10.5 4 9.2 4 7.8 4 Portfolio products ................................ 3.0 1 3.8 1 5.4 3 ------------------------------------------------------------------ Sub-total installment .......................... 13.5 5 13.0 5 13.2 7 ------------------------------------------------------------------ Total municipal finance policies ............ 212.0 74 216.3 87 165.7 86 ------------------------------------------------------------------ Structured finance policies: Up-front ............................................. 11.1 4 1.2 -- 0.5 -- Installment .......................................... 19.6 7 8.8 4 2.8 1 ------------------------------------------------------------------ Total structured finance policies .............. 30.7 11 10.0 4 3.3 1 ------------------------------------------------------------------ Total domestic written ...................... 242.7 85 226.3 91 169.0 87 International: Up-front ............................................. 37.6 13 18.0 8 23.7 12 Installment .......................................... 5.9 2 2.9 1 0.6 1 ------------------------------------------------------------------ Total international written ................. 43.5 15 20.9 9 24.3 13 ------------------------------------------------------------------ Total gross premiums written ................ $286.2 100% $247.2 100% $193.3 100% ------------------------------------------------------------------ Total up-front written .................................. $247.2 86% $222.5 90% $176.7 91% Total installment written ............................... 39.0 14 24.7 10 16.6 9 ------------------------------------------------------------------ Total gross premiums written ................ $286.2 100% $247.2 100% $193.3 100% - ------------------------------------------------------------------------------------------------------------------------------------
Adjusted Gross Premiums.(1) While the majority of Ambac Assurance's premiums written are collected up front at policy issuance, a growing portion of premiums are collected on an installment basis. Adjusted gross premiums written, which are defined as up-front premiums written plus the present value of estimated future installment premiums written in the period, were $339.6 million in 1997, up 15% from $296.4 million in 1996. The increase in 1997 was primarily due to increased structured finance and international business. Adjusted gross premiums written in 1996 increased 34% from $221.3 million in 1995. The present value of estimated future installment premiums written in 1997 was $92.4 million, an increase of 25% from $74.0 million in 1996. The present value of estimated future installment premiums written in 1996 increased 66% from $44.6 million in 1995. The aggregate net present value of estimated future installment premiums was $210.8 million, $157.7 million, and $110.0 million as of December 31, 1997, 1996, and 1995 respectively. Ceded Premiums Written. Ceded premiums written in 1997 were $32.5 million, versus $37.8 million in 1996. The 14% decrease in ceded premiums written is primarily due to the non-renewal of automatic treaty reinsurance, partially offset by higher ceded premiums for international business. In 1997, Ambac Assurance began using only facultative reinsurance to reduce its risk and manage its insurance portfolio. Ceded premiums written in 1995 were $28.6 million. Ceded premiums written in 1995 include $18.1 million in return premiums from the cancellation of reinsurance contracts. A portion of the return premiums, $15.7 million, was deferred in unearned premiums, with the remainder included in accelerated premiums earned in 1995. Excluding the return premiums in 1995, ceded premiums written in 1996 decreased by 19% compared to 1995. The decrease reflects lower premiums ceded under facultative agreements in 1996. Ceded premiums written, exclusive of return premiums, were 11%, 15%, and 24% of gross premiums written in 1997, 1996, and 1995 respectively. Net Premiums Written. Net premiums written in 1997 were $253.7 million, an increase of 21% from $209.4 million in 1996. The increase reflects higher gross premiums written and lower premiums ceded to reinsurers in 1997 compared with 1996. Net premiums written in 1996 increased 27% from $164.7 million in 1995. The increase reflects higher gross premiums written in 1996, partially offset by higher premiums ceded to reinsurers (after the effect of the 1995 return premium). 24 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) - -------------------------------------------------------------------------------- Net Premiums Earned. Net premiums earned during 1997 were $154.0 million, an increase of 13% from $136.6 million in 1996. This increase was primarily the result of higher premiums earned from the growth of the book of business during the year, partially offset by a decline in premiums earned from refundings, calls and other accelerations in 1997. Net premiums earned in 1997 included $28.0 million (net income per diluted share effect of $0.22) from refundings, calls and other accelerations of previously insured issues. Net premiums earned in 1996 included $31.3 million (net income per diluted share effect of $0.25) from refundings, calls and other accelerations. Refunding levels vary depending upon a number of conditions, primarily the relationship between current interest rates and interest rates on outstanding debt. Excluding the effect of accelerated earnings, net premiums earned in 1997 were $126.0 million, an increase of 20% from $105.3 million in 1996. Net premiums earned during 1996 increased 22% from $111.8 million in 1995. This increase was primarily the result of higher premiums earned from the growth of the book of business during the year, as well as higher premiums earned from refundings, calls and other accelerations in 1996. Net premiums earned in 1995 included $22.6 million (net income per diluted share effect of $0.18) from refundings, calls and other accelerations. Excluding the effect of accelerated earnings, net premiums earned in 1996 increased 18% from $89.2 million in 1995. Net Investment Income. Net investment income in 1997 was $159.7 million, an increase of 10% from $144.9 million in 1996. This increase was primarily attributable to the growth of the investment portfolio, partially offset by lower yields. Investments in tax-exempt securities amounted to 75% of the total market value of the portfolio as of December 31, 1997, versus 79% and 69% as of December 31, 1996 and 1995 respectively. The average pre-tax yield-to-maturity on the investment portfolio was 6.40% as of December 31, 1997 and 6.47% for both December 31, 1996 and December 31, 1995. Net investment income in 1996 increased 11% from $131.0 million in 1995. This increase was primarily attributable to the growth of the investment portfolio. Net Realized Gains (Losses). Net realized gains in 1997 were $21.1 million, compared to $20.5 million in net realized losses in 1996. The 1997 net realized gains were generated as a result of the ongoing management of the investment portfolio. The net realized losses in 1996 were realized for tax planning purposes to partially offset the realized gain from the sale of HCIA. Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses in 1997 were $2.9 million, versus $3.8 million in 1996 and $3.4 million in 1995. Losses and loss adjustment expenses are generally based upon estimates of the ultimate aggregate losses inherent in the insured portfolio. Losses and loss adjustment expenses, exclusive of salvage recognized, were $3.0 million, $5.1 million, and $4.1 million in 1997, 1996, and 1995 respectively. Underwriting and Operating Expenses. Underwriting and operating expenses were $40.7 million in 1997, an increase of 9% from $37.2 million in 1996. Underwriting and operating expenses in 1996, increased 8% from $34.5 million in 1995. Underwriting and operating expenses consist of gross underwriting and operating expenses, less the deferral to future periods of expenses and reinsurance commissions related to the acquisition of new insurance contracts, plus the amortization of previously deferred expenses and reinsurance commissions. During 1997, Ambac Assurance's gross underwriting and operating expenses were $59.2 million, an increase of 5% from $56.4 million in 1996. During 1996, Ambac Assurance's gross underwriting and operating expenses increased 11% from $50.9 million in 1995. The increase in gross underwriting and operating expenses in both 1997 and 1996 reflects the overall increased business activity in those years. Underwriting and operating expenses deferred were $32.8 million, $32.3 million, and $27.8 million in 1997, 1996, and 1995 respectively. Reinsurance commissions which related to the current period (net of deferred) were $0, $(0.6) million, and $(1.2) million in 1997, 1996, and 1995 respectively. The amortization of previously deferred expenses and reinsurance commissions was $14.2 million, $12.5 million, and $10.2 million in 1997, 1996, and 1995 respectively. FINANCIAL MANAGEMENT SERVICES Through its financial management services subsidiaries, the Company provides investment agreements, interest rate swaps, investment advisory and cash management services, and electronic commerce solutions, principally to states, municipalities and their authorities, school districts, and hospitals and health organizations. Revenues in 1997 were $34.6 million (includes $0.6 million in net realized losses), versus $22.4 million (includes $0.4 million in net realized gains) in 1996. This increase is primarily due to revenues of Cadre Financial Services, Inc. ("Cadre"), acquired at the end of 1996, and higher revenues from investment agreements, due to higher volume. Expenses in 1997 were $28.0 million, versus $12.0 million in 1996. This increase reflects expenses for Cadre, and start-up expenses for Ambac Connect, a new electronic commerce initiative. Additionally, 1997 expenses include a $3.5 million restructuring charge ($0.03 per diluted share) to consolidate certain operations in New York. Revenues in 1996 reflected a 72% increase from $13.0 million in 1995. The increase was primarily due to recoveries in 1996 of net unrealized mark-to-market losses in the portfolio of municipal interest rate swaps which had been 25 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) - -------------------------------------------------------------------------------- recognized in 1995. Also contributing to the increased revenues in 1996, was higher net interest income from investment agreements due to higher volume. Expenses in 1996 increased 54% from $7.8 million in 1995. This increase related primarily to the start up of an investment advisory business. CORPORATE ITEMS Interest Expense. Interest expense in 1997 was $21.3 million, an increase of 2% from $20.9 million in 1996. Interest expense in 1995 was $20.9 million. Other Income. Other income includes investment income of the holding company, Ambac Financial Group, Inc., and the equity in income of HCIA for 1995 and the first four months of 1996. Other income decreased to $7.2 million in 1997 from $7.9 million in 1996, primarily due to the inclusion of equity in income from HCIA in 1996. The increase in 1996 from $1.5 million in 1995 was primarily due to additional investment income generated by the proceeds from the sale of HCIA. Other Net Realized Gains. The net realized gain in 1996 resulted primarily from the sale of its remaining holdings in HCIA in a secondary public offering yielding net proceeds to the Company of $202.6 million. The sale resulted in a net realized gain of $155.6 million pre-tax, $100.6 million after-tax (net income per diluted share effect of $1.42). During 1995 the Company sold a portion of its HCIA stock in a public offering resulting in a realized gain of $19.1 million (net income per diluted share effect of $0.17). Other Expenses. Other expenses includes the operating expenses of Ambac Financial Group, Inc. Other expenses were $2.9 million in 1997, $3.5 million in 1996, and $1.5 million in 1995. Income Taxes. Income taxes for 1997 were at an effective rate of 22.0%, compared to 26.4% in 1996. The decrease in the effective rate is primarily due to the realized gain on the sale of HCIA in 1996 taxed at the statutory federal rate of 35%. Income taxes for 1995 were at an effective rate of 21.7%. SUPPLEMENTAL ANALYTICAL FINANCIAL DATA Core Earnings.(2) In 1997 core earnings were $195.8 million, an increase of 15% from $170.5 million in 1996. The increase was primarily the result of continued higher premiums earned from the growth in the insurance book of business and net investment income. In 1996 core earnings increased 17% from $145.5 million in 1995. This increase was primarily the result of continued higher premiums earned from the growth in the insurance book of business and net investment income, as well as increased net income from the financial management services segment. Core earnings, which the Company reports as analytical data, exclude the effect on consolidated net income from net realized gains and losses, net insurance premiums earned from refundings, calls and other accelerations and certain non-recurring items. Operating Earnings.(2) Operating earnings in 1997 were $211.8 million, an increase of 12% from $188.3 million in 1996. Operating earnings in 1996 increased 19% from $158.2 million in 1995. The Company defines operating earnings as net income, less the effect of net realized gains and losses and certain non-recurring items. Following is a table reconciling net income computed in accordance with Generally Accepted Accounting Principles ("GAAP") to operating earnings and core earnings for the years ended December 31, 1997, 1996 and 1995:
(DOLLARS IN MILLIONS) 1997 1996 1995 - -------------------------------------------------------------------------------- Net income .............................. $223.0 $276.3 $167.6 Net realized gains, after tax ........... (13.3) (88.0) (11.9) Non-recurring items, after tax .......... 2.1 -- 2.5 -------------------------------- Operating earnings ...................... 211.8 188.3 158.2 Premiums earned from refundings, calls and other accelerations, after tax ............................. (16.0) (17.8) (12.7) -------------------------------- Core earnings ........................ $195.8 $170.5 $145.5 - --------------------------------------------------------------------------------
LIQUIDITY AND CAPITAL RESOURCES Ambac Financial Group, Inc. Liquidity. The Company's liquidity, both on a short-term basis (for the next twelve months) and a long-term basis (beyond the next twelve months), is largely dependent upon Ambac Assurance's ability to pay dividends or make payments to the Company and external financings. Pursuant to Wisconsin insurance laws, Ambac Assurance may declare dividends, provided that, after giving effect to the distribution, it would not violate certain statutory equity, solvency and asset tests. During 1997, Ambac Assurance paid dividends of $44.0 million on its common stock to the Company. For further discussion, see Note 9 of Notes to Consolidated Financial Statements. The Company's principal uses of liquidity are for the payment of its operating expenses, interest on its debt, dividends on its shares of common stock, and capital investments in its subsidiaries. Based on the amount of dividends that Ambac Assurance expects to pay during 1998 and the income it expects to receive from its investment portfolio, the Company believes it will have sufficient liquidity to satisfy its liquidity needs over the next twelve months, including the payment of dividends on the Common Stock in accordance with its dividend policy. Beyond the next twelve months, Ambac Assurance's ability to declare and pay dividends to the Company may be influenced by a variety of factors, including adverse market changes, insurance regulatory changes and changes in general economic conditions. Consequently, although the Company believes that it will continue to have sufficient liquidity to meet its debt service and other obligations over the long term, no assurance 26 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) - -------------------------------------------------------------------------------- can be given that Ambac Assurance will be permitted to dividend amounts sufficient to pay all of the Company's operating expenses, debt service obligations and dividends on its Common Stock. The Company has an effective shelf registration covering the issuance of up to $250 million of debt securities. Ambac Assurance Liquidity. The principal uses of Ambac Assurance's liquidity are the payment of operating expenses, reinsurance premiums, income taxes, and dividends to the Company. The Company believes that Ambac Assurance's operating liquidity needs can be funded exclusively from its operating cash flow. The principal sources of Ambac Assurance's liquidity are gross premiums written, scheduled investment maturities and net investment income. The majority of premiums for Ambac Assurance's financial guarantee insurance policies are payable in full at the outset of the term of the policy, even though premiums are earned over the life of such policies for financial accounting purposes. Financial Management Services Liquidity. The principal uses of liquidity by the Company's financial management services subsidiaries are the payment of investment agreement obligations pursuant to defined terms, net obligations under interest rate swaps and related hedges, operating expenses, and income taxes. The Company believes that its financial management services liquidity needs can be funded primarily from its operating cash flow and the maturity of its invested assets. The principal sources of this segment's liquidity are proceeds from issuance of investment agreements, net investment income, maturities of securities from its investment portfolio which are invested with the objective of matching the duration of its obligations under the investment agreements, net receipts from interest rate swaps and related hedges, and fees for investment management services. The Company's investment objectives with respect to investment agreements are to achieve the highest after-tax total return, subject to a minimum average quality rating of Aa/AA on invested assets, and to maintain cash flow matching of invested assets to funded liabilities to minimize interest rate and liquidity exposure. The Company maintains a portion of its financial management services assets in short-term investments and repurchase agreements in order to meet unexpected liquidity needs. Credit Facilities. As of December 31, 1997, the Company and Ambac Assurance had a revolving credit facility with two major international banks, as co-agents, for $100.0 million, which expires in July 1998. This facility is available for general corporate purposes, including the payment of claims. As of December 31, 1997 and 1996, no amounts were outstanding under this credit facility. Ambac Assurance has an agreement with a group of AAA/Aaa-rated international banks for a $450.0 million credit facility, expiring in 2004. The terms of this facility were renegotiated in December 1997, to increase the facility from $350.0 million to $450.0 million; and to extend the expiration date from December 2, 2003 to December 2, 2004. This facility is a seven-year stand-by irrevocable limited recourse line-of-credit which will provide liquidity to Ambac Assurance in the event claims from municipal obligations exceed specified levels. Repayment of any amounts drawn under the line will be limited primarily to the amount of any recoveries of losses related to policy obligations. As of December 31, 1997 and 1996, no amounts were outstanding under this line. Connie Lee Insurance Company, which the Company acquired in 1997 and is a subsidiary of Ambac Assurance (see "Other Matters" section) has an agreement with commercial banks for a $50.0 million standby credit facility, expiring in 2003. The line will provide a source of additional claims-paying resources for insured transactions. The obligation to repay is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations including installment premiums and other collateral. As of December 31, 1997, no amounts were outstanding under this line. Stock Repurchase Program. During 1997, the Company acquired approximately 1,149,000 treasury shares for an aggregate amount of $40.4 million. Since inception of the Stock Repurchase Program the Company has acquired approximately 3,272,000 shares for an aggregate amount of $90.0 million. Adjusted Book Value.(3) Adjusted Book Value ("ABV") per share increased 17% to $36.59 at December 31, 1997 from $31.25 at December 31, 1996. The following table reconciles book value per share to ABV per share as of December 31, 1997 and 1996:
- ------------------------------------------------------------------------------- 1997 1996 - ------------------------------------------------------------------------------- Book value per share ............................. $26.77 $23.01 After-tax value of: Net unearned premium reserve .................. 9.25 7.63 Deferred acquisition costs .................... (0.99) (0.87) Present value of installment premiums ......... 1.96 1.45 Unrealized (loss) gain on investment agreements ...................... (0.40) 0.03 --------------------- Adjusted book value per share .................... $36.59 $31.25 - -------------------------------------------------------------------------------
Balance Sheet. Total assets as of December 31, 1997 were $8.25 billion, an increase of 40% over $5.88 billion at December 31, 1996. The increase was primarily due to the increased volume in investment and payment agreements, cash flow from operations and the acquisition of Connie Lee Insurance Company. Stockholders' equity as of December 31, 1997 was $1.87 billion, an increase of 16% from $1.62 billion at year-end 1996. This increase was primarily due to net income for the year and a change in unrealized gains on investments, net of tax, of $76.2 million, partially offset by dividends to shareholders. 27 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) - -------------------------------------------------------------------------------- Cash Flows. Net cash provided by operating activities was $324.5 million, $190.6 million and $231.3 million during 1997, 1996 and 1995, respectively. These cash flows were primarily provided by the financial guarantee insurance operations. Net cash provided by financing activities was $1,564.3 million, $463.2 million and $177.7 million during 1997, 1996 and 1995, respectively. This activity included $1,096.5 million, $499.2 million and $196.8 million in investment agreements issued (net of draws paid) in 1997, 1996 and 1995, respectively. The total cash provided by operating and financing activities was $1,888.8 million, $653.8 million and $409.0 million during 1997, 1996 and 1995, respectively. From these totals, $1,887.3 million, $658.2 million and $401.3 million was used in investing activities, principally purchases of investment securities during 1997, 1996 and 1995, respectively. Material Commitments. The Company has made no commitments for material capital expenditures within the next twelve months. However, management continually evaluates opportunities to expand the Company's businesses through internal development of new products as well as acquisitions. RISK MANAGEMENT In the ordinary course of business, the Company, through its affiliates, manages a variety of risks, principally market, credit, liquidity, operational, and legal. These risks are identified, measured and monitored through a variety of control mechanisms, which are in place at different levels throughout the organization. Market risk generally represents the risk of loss that may result from the potential change in the fair value of a financial instrument as a result of changes in prices and interest rates. The Company has financial instruments held for purposes other than trading and for trading purposes. The principal market risk for the Company's financial instruments held for purposes other than trading is interest rate risk. An independent risk management group is involved in setting and monitoring risk limits and the application of risk measurement methodologies. The estimation of potential losses arising from adverse changes in market conditions is a key element in managing market risk. The Company utilizes various models and stress test scenarios to monitor and manage interest rate risk. This process includes frequent analyses of both parallel and nonparallel shifts in the yield curve. These models include estimates made by management and the valuation results could differ materially from amounts that would actually be realized in the market. Financial instruments held for purposes other than trading which may be adversely affected by changes in interest rates, consist primarily of investment securities, investment agreement liabilities, debentures, and related derivative contracts (primarily interest rate swaps and futures) used for hedging purposes. The following summarizes the estimated change in fair value (based primarily on the valuation models discussed above) on the net balance of these financial instruments assuming immediate changes in interest rates at specified levels at December 31, 1997:
- ------------------------------------------------------------------------------- ESTIMATED FAIR ESTIMATED CHANGE IN VALUE OF CHANGE INTEREST RATES NET FINANCIAL IN FAIR (DOLLARS IN MILLIONS) INSTRUMENTS VALUE - ------------------------------------------------------------------------------- 300 basis point rise ........................ $2,071 $(560) 200 basis point rise ........................ 2,264 (367) 100 basis point rise ........................ 2,489 (142) Base scenario ............................... 2,631 -- 100 basis point decline ..................... 2,801 170 200 basis point decline ..................... 2,965 334 300 basis point decline ..................... 3,136 505 - -------------------------------------------------------------------------------
The Company through its affiliate Ambac Financial Services, L.P. ("AFSLP"), is a provider of interest rate swaps to states, municipalities and their authorities and other entities in connection with their financings. AFSLP manages its business with the goal of being market neutral to changes in overall interest rates, while retaining basis risk, the relationship between floating tax-exempt and floating taxable interest rates. If actual or projected floating tax-exempt interest rates change in relation to floating taxable interest rates, AFSLP will experience an unrealized mark-to-market gain or loss. The AFSLP swap portfolio is considered held for trading purposes. Market risk for financial instruments held for trading purposes relates to the impact of pricing changes on future earnings. The principal market risk is basis risk. Since late 1995, most municipal interest rate swaps transacted contain provisions which are designed to protect the Company against certain forms of tax reform, thus mitigating its basis risk. An independent risk management group monitors trading risk limits and, together with senior management, is involved in the application of risk measurement methodologies. The estimation of potential losses arising from adverse changes in market relationships, known as "value-at-risk," is a key element in managing market risk for financial instruments held for trading purposes. AFSLP has developed a value-at-risk methodology to estimate potential losses over a specified holding period and based on certain probabilistic assessments. AFSLP estimates value-at-risk utilizing historical short and long-term interest rate volatilities and the relationship between changes in tax-exempt and taxable interest rates calculated on a consistent daily basis. For the years ended December 31, 1997 and 1996, AFSLP's value-at-risk, for financial instruments considered held for trading purposes, calculated at a ninety-nine percent confidence level, averaged approximately $1.6 million and $1.4 million, respectively. AFSLP's value-at-risk ranged from a high of $2.6 million to a low of $0.9 million in 1997, and from a high of $2.6 million to a low of $1.1 million in 1996. Since no single measure can 28 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) - -------------------------------------------------------------------------------- capture all dimensions of market risk, AFSLP supplements its value-at-risk methodology by performing daily analyses of parallel and non-parallel shifts in yield curves and stress test scenarios which measure the potential impact of market conditions, however improbable, which might cause abnormal volatility swings or disruptions of market relationships. Credit risk arises from the potential inability of counterparties to perform on an obligation in accordance with the terms of the contract. The Company is exposed to credit risk in various capacities including as an issuer of a financial guarantee policy, as counterparty to financial contracts and as a holder of investment securities. The Company has established various procedures and controls to monitor and manage credit risk. These include the initial credit review and approval process, minimum credit rating requirements, single credit concentration limits, and the continuous monitoring of credit exposures. Liquidity risk relates to the possible inability to satisfy contractual obligations when due. This risk is present in financial guarantee insurance, investment agreements, interest rate swaps and futures contracts. Ambac Assurance manages its liquidity risk by maintaining a comprehensive daily analysis of projected cash flows. Additionally, Ambac Assurance maintains a minimum level of cash and short-term investments at all times. See additional discussion in "Liquidity and Capital Resources" section. The investment agreement business manages liquidity risk by matching the effective duration of its invested assets, including hedges, with the effective duration of its investment agreement liabilities. Additionally, the Company's policy is to maintain a minimum level of cash and short-term assets equivalent to a specified percentage of its investment agreement liabilities outstanding. AFSLP maintains cash and cash equivalents, closely matching the dates swap payments are made and received, and limiting the amount of risk hedged with futures contracts. Operational risk relates to the potential for loss caused by a breakdown in information, communication and settlement systems. The Company mitigates operational risk by maintaining a comprehensive system of internal controls. This includes the establishment of systems and procedures to monitor transactions and positions, documentation and confirmation of transactions and ensuring compliance with regulations. Legal risk relates to the uncertainty of the enforceability, through legal or judicial processes, of the obligations of the Company's counterparties, including contractual provisions intended to reduce exposure by providing for the offsetting or netting of mutual obligations. The Company seeks to remove or minimize such uncertainties through continuous consultation with internal and external legal advisers to analyze and understand the nature of legal risk, to improve documentation and to strengthen transaction structure. OTHER MATTERS Acquisitions. On December 18, 1997 Ambac Assurance acquired Construction Loan Insurance Corporation ("CLIC"). Ambac Assurance paid $106 million in cash and retired $18.4 million of CLIC debt. CLIC (renamed Connie Lee Holdings, Inc.) and its triple-A rated financial guarantee insurance subsidiary Connie Lee Insurance Company ("Connie Lee"), are now wholly owned subsidiaries of Ambac Assurance Corporation. Connie Lee, which guaranteed bonds issued primarily for college and hospital infrastructure projects, is not expected to write any new business. Ambac Assurance and Connie Lee have arrangements in place to assure that Connie Lee maintains a level of capital sufficient to support Connie Lee's outstanding obligations and for Connie Lee insured bonds to retain their triple-A rating. Year 2000. The Company recognizes the worldwide challenge for all systems to recognize the date change for the year 2000 and, is assessing its computer applications and business processes to provide for their continued functionality. A process of inventory, scoping and analysis, modification, testing, certification and implementation is under way. The Company expects to incur internal staff costs, as well as consulting expense related to this process. The Company does not anticipate that the related overall costs will be material. FOOTNOTES (1) Adjusted gross premiums written, which is not promulgated under GAAP, is used by management, equity analysts and investors to measure the financial results of the Company. Adjusted gross premiums written, which the Company reports as analytical data, is defined as gross up-front premiums written plus the present value of estimated future installment premiums written in the period. The definition of adjusted gross premiums written used by the Company may differ from definitions of adjusted gross premiums written used by other public holding companies of financial guarantee insurers. (2) Core earnings and operating earnings are not substitutes for net income computed in accordance with GAAP, but are important measures used by management, equity analysts and investors to measure the financial results of the Company. The definition of core earnings and operating earnings used by the Company may differ from definitions of core earnings and operating earnings used by other public holding companies of financial guarantee insurers. (3) Adjusted book value ("ABV"), which is not promulgated under GAAP, is used by management, equity analysts and investors as a measurement of the Company's intrinsic value with no benefit given for ongoing business activity. Management derives adjusted book value by beginning with stockholders' equity (book value) and adding or subtracting the after-tax value of: the net unearned premium reserve, deferred acquisition costs, the present value of estimated net future installment premiums, and the unrealized gain or loss on investment agreement liabilities. The definition of ABV used by the Company may differ from definitions of ABV used by other public holding companies of financial guarantee insurers. The adjustments to book value described above will not be realized until future periods and may differ materially from the amounts used in determining ABV. 29 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- REPORT ON MANAGEMENT'S RESPONSIBILITIES - -------------------------------------------------------------------------------- The management of Ambac Financial Group, Inc. is responsible for the integrity and objectivity of the financial statements and all other financial information presented in this Annual Report and for assuring that such information fairly presents the consolidated financial position and operating results of Ambac. The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles using management's best estimates and judgment. The financial information presented elsewhere in this Annual Report is consistent with that in the consolidated financial statements. The Company maintains a system of internal accounting controls designed to provide reasonable assurance that assets are safeguarded against loss or unauthorized use and that the financial records are reliable for use in preparing financial statements and maintaining accountability of assets. Qualified and professional financial personnel maintain and monitor these internal controls on a continuous basis. The concept of reasonable assurance is based on the recognition that the cost of a system of internal control should not exceed the related benefits. The Company's consolidated financial statements have been audited by KPMG Peat Marwick LLP, independent auditors, whose audits were made in accordance with generally accepted auditing standards and included a review of internal accounting controls to the extent necessary to express an opinion on the fairness of the consolidated financial statements. The Audit Committee of the Board of Directors, comprised solely of outside directors, meets regularly with financial management, the independent auditors and the internal auditors to review the work and procedures of each. The independent auditors and the internal auditors have free access to the Audit Committee, without the presence of management, to discuss the results of their work and their considerations of Ambac and its subsidiaries and the quality of Ambac's financial reporting. The Board of Directors, upon recommendation of the Audit Committee, appoints the independent auditors, subject to stockholder approval. /s/ P. Lassiter Phillip B. Lassiter Chairman, President and Chief Executive Officer /s/ Frank Bivona Frank J. Bivona Executive Vice President, Chief Financial Officer and Treasurer January 29, 1998 - -------------------------------------------------------------------------------- INDEPENDENT AUDITORS' REPORT - -------------------------------------------------------------------------------- To the Board of Directors and Stockholders Ambac Financial Group, Inc. We have audited the accompanying consolidated balance sheets of Ambac Financial Group, Inc. and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1997. These consolidated financial statements are the responsibility of Ambac Financial Group, Inc.'s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Ambac Financial Group, Inc. and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1997 in conformity with generally accepted accounting principles. /s/ KPMG Peat Marwick LLP KPMG Peat Marwick LLP New York, New York January 29, 1998 30 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEETS - --------------------------------------------------------------------------------
- -------------------------------------------------------------------------------------------------------------- AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES December 31, - -------------------------------------------------------------------------------------------------------------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1997 1996 - -------------------------------------------------------------------------------------------------------------- ASSETS: Investments: Fixed income securities, at fair value (amortized cost of $6,525,650 in 1997 and $4,979,017 in 1996) ............. $6,773,844 $5,088,031 Short-term investments, at cost (approximates fair value) .................... 136,278 112,511 Preferred stock, at cost ..................................................... 5,000 -- ------------------------- Total investments ......................................................... 6,915,122 5,200,542 Cash ............................................................................ 9,256 7,734 Securities purchased under agreements to resell ................................. 85,466 201,169 Receivable for investment agreements ............................................ -- 33,299 Receivable for securities sold .................................................. 106,246 18,467 Investment income due and accrued ............................................... 78,690 65,920 Reinsurance recoverable ......................................................... 4,219 393 Prepaid reinsurance ............................................................. 183,492 168,786 Deferred acquisition costs ...................................................... 105,996 94,212 Loans ........................................................................... 503,192 -- Receivable from brokers and dealers ............................................. 183,041 -- Other assets .................................................................... 75,002 85,836 ------------------------- Total assets .............................................................. $8,249,722 $5,876,358 ------------------------- LIABILITIES AND STOCKHOLDERS' EQUITY: Liabilities: Unearned premiums ............................................................ $1,178,990 $991,224 Losses and loss adjustment expenses .......................................... 103,345 60,613 Ceded reinsurance balances payable ........................................... 9,258 7,438 Obligations under investment and payment agreements .......................... 3,230,052 2,417,817 Obligations under investment repurchase agreements ........................... 1,090,912 336,773 Deferred income taxes ........................................................ 135,228 80,086 Current income taxes ......................................................... 9,016 6,538 Debentures ................................................................... 223,864 223,798 Accrued interest payable ..................................................... 46,017 29,958 Accounts payable and other liabilities ....................................... 75,170 57,689 Payable for securities purchased ............................................. 275,388 49,408 ------------------------- Total liabilities ......................................................... 6,377,240 4,261,342 ------------------------- Stockholders' equity: Preferred stock, par value $0.01 per share; authorized shares - 4,000,000; issued and outstanding shares - none ...................................... -- -- Common stock, par value $0.01 per share; authorized shares - 100,000,000; issued shares - 70,680,384 at December 31, 1997 and 35,340,192 at December 31, 1996 ...................................................... 707 353 Additional paid-in capital ................................................... 500,107 498,401 Unrealized gains on investments, net of tax .................................. 135,066 58,911 Retained earnings ............................................................ 1,262,740 1,072,418 Cumulative translation adjustment ............................................ 157 -- Common stock held in treasury at cost, 732,947 shares at December 31, 1997 and 249,807 at December 31, 1996 .............................................. (26,295) (15,067) ------------------------- Total stockholders' equity ................................................ 1,872,482 1,615,016 ------------------------- Total liabilities and stockholders' equity ................................ $8,249,722 $5,876,358 -------------------------
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. 31 - -------------------------------------------------------------------------------- --------------------------------------- CONSOLIDATED STATEMENTS OF OPERATIONS ---------------------------------------
- ---------------------------------------------------------------------------------------------------- AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES Years Ended December 31, - ---------------------------------------------------------------------------------------------------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1997 1996 1995 - ---------------------------------------------------------------------------------------------------- REVENUES: Financial Guarantee Insurance: Gross premiums written ........................... $286,163 $247,208 $193,326 Ceded premiums written ........................... (32,452) (37,793) (28,606) ------------------------------------------ Net premiums written .......................... 253,711 209,415 164,720 Increase in unearned premiums .................... (99,711) (72,786) (52,900) ------------------------------------------ Net premiums earned ........................... 154,000 136,629 111,820 Net investment income ............................ 159,709 144,941 131,049 Net realized gains (losses) ...................... 21,084 (20,531) 177 Other income ..................................... 4,402 5,261 5,580 Financial Management Services: Income ........................................... 35,249 21,973 13,126 Net realized (losses) gains ...................... (637) 393 (117) Other: Income ........................................... 7,207 7,929 1,521 Net realized gains ............................... 748 156,313 19,103 ------------------------------------------ Total revenues ................................ 381,762 452,908 282,259 ------------------------------------------ EXPENSES: Financial Guarantee Insurance: Losses and loss adjustment expenses .............. 2,854 3,778 3,377 Underwriting and operating expenses .............. 40,672 37,182 34,450 Financial Management Services ....................... 27,993 12,040 7,793 Interest ............................................ 21,346 20,925 20,934 Other ............................................... 2,901 3,477 1,531 ------------------------------------------ Total expenses ................................ 95,766 77,402 68,085 ------------------------------------------ Income before income taxes .......................... 285,996 375,506 214,174 Provision for income taxes .......................... 62,966 99,189 46,579 ------------------------------------------ Net income .................................... $223,030 $276,317 $167,595 ------------------------------------------ Net income per share ............................. $3.19 $3.95 $2.39 ------------------------------------------ Net income per diluted share ..................... $3.13 $3.91 $2.37 ------------------------------------------ Weighted average number of shares outstanding ....... 69,988,497 69,929,628 70,201,762 ------------------------------------------ Weighted average number of diluted shares outstanding 71,227,347 70,748,470 70,847,441 ------------------------------------------
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. 32 - -------------------------------------------------------------------------------- - ---------------------------------------------- CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY - ----------------------------------------------
- ------------------------------------------------------------------------------------------------- AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES Years Ended December 31, - ------------------------------------------------------------------------------------------------- (DOLLARS IN THOUSANDS) 1997 1996 1995 - ------------------------------------------------------------------------------------------------- PREFERRED STOCK: Balance at January 1 and December 31 ............. $ -- $ -- $ -- ----------------------------------------- COMMON STOCK: Balance at January 1 ............................. $ 353 $ 353 $ 353 Stock split effected as dividend ................. 354 -- -- ----------------------------------------- Balance at December 31 ........................... $ 707 $ 353 $ 353 ----------------------------------------- ADDITIONAL PAID-IN CAPITAL: Balance at January 1 ............................. $ 498,401 $ 492,495 $ 477,467 Issuance of stock ................................ (3,506) 3,624 (5) Sale of affiliate, net of tax .................... -- -- 14,356 Stock split effected as dividend ................. (354) -- -- Other ............................................ 5,566 2,282 677 ----------------------------------------- Balance at December 31 ........................... $ 500,107 $ 498,401 $ 492,495 ----------------------------------------- UNREALIZED GAINS (LOSSES) ON INVESTMENTS, NET OF TAX: Balance at January 1 ............................. $ 58,911 $ 102,470 $ (106,264) Change in unrealized gains (losses), net of tax .. 76,155 (43,559) 208,734 ----------------------------------------- Balance at December 31 ........................... $ 135,066 $ 58,911 $ 102,470 ----------------------------------------- RETAINED EARNINGS: Balance at January 1 ............................. $ 1,072,418 $ 819,479 $ 673,129 Net income ....................................... 223,030 276,317 167,595 Dividends declared - common stock ................ (24,165) (21,500) (19,484) Other ............................................ (8,543) (1,878) (1,761) ----------------------------------------- Balance at December 31 ........................... $ 1,262,740 $ 1,072,418 $ 819,479 ----------------------------------------- CUMULATIVE TRANSLATION ADJUSTMENT: Balance at January 1 ............................. $ -- $ -- $ -- Changes during year .............................. 157 -- -- ----------------------------------------- Balance at December 31 ........................... $ 157 $ -- $ -- ----------------------------------------- COMMON STOCK HELD IN TREASURY AT COST: Balance at January 1 ............................. $ (15,067) $ (10,809) $ (11,198) Cost of shares acquired during year .............. (40,397) (31,751) (5,913) Issued under equity plans ........................ 29,169 17,211 6,302 Issued to acquire subsidiary ..................... -- 10,282 -- ----------------------------------------- Balance at December 31 ........................... $ (26,295) $ (15,067) $ (10,809) ----------------------------------------- TOTAL STOCKHOLDERS' EQUITY AT DECEMBER 31 ........... $ 1,872,482 $ 1,615,016 $ 1,403,988 -----------------------------------------
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. 33 - -------------------------------------------------------------------------------- ------------------------------ CONSOLIDATED STATEMENTS OF CASH FLOWS ------------------------------
- --------------------------------------------------------------------------------------------------------------------------------- AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES Years Ended December 31, - --------------------------------------------------------------------------------------------------------------------------------- (DOLLARS IN THOUSANDS) 1997 1996 1995 CASH FLOWS FROM OPERATING ACTIVITIES: Net income ...................................................................... $ 223,030 $ 276,317 $ 167,595 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization ................................................ 1,925 1,986 4,765 Amortization of bond premium and discount .................................... (3,257) (1,603) 324 Current income taxes ......................................................... 9,978 1,413 15,713 Deferred income taxes ........................................................ 12,015 4,497 13,727 Deferred acquisition costs ................................................... (11,784) (11,592) (10,846) Unearned premiums, net ....................................................... 99,706 72,786 52,900 Losses and loss adjustment expenses .......................................... 408 (5,776) 334 Ceded reinsurance balances payable ........................................... 1,303 (7,216) 13,746 Investment income due and accrued ............................................ (9,415) (9,550) (6,465) Accrued interest payable ..................................................... 16,059 4,464 1,668 Gains on sales of investments and affiliates ................................. (21,195) (136,175) (19,222) Accounts payable and other liabilities ....................................... 4,754 13,111 (6,240) Other, net ................................................................... 990 (12,032) 3,340 ----------------------------------------- Net cash provided by operating activities ................................. 324,517 190,630 231,339 ----------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sales of bonds .................................................... 1,718,174 1,911,909 2,955,475 Proceeds from matured bonds ..................................................... 1,080,338 959,527 660,181 Purchases of bonds .............................................................. (4,135,404) (3,825,803) (3,820,086) Purchases of preferred stock .................................................... (5,000) -- -- Change in short-term investments ................................................ (23,767) 64,178 (38,714) Securities purchased under agreements to resell ................................. 115,703 39,111 (152,269) Loans ........................................................................... (503,192) -- -- Purchase of affiliate, net of cash acquired ..................................... (120,006) -- -- Proceeds from sale of affiliate ................................................. -- 202,609 28,502 Other, net ...................................................................... (14,121) (9,783) (34,380) ----------------------------------------- Net cash used in investing activities ..................................... (1,887,275) (658,252) (401,291) ----------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES: Dividends paid .................................................................. (24,165) (21,500) (19,484) Proceeds from issuance of investment agreements ................................. 2,805,256 1,696,813 1,374,856 Payments for investment agreement draws ......................................... (1,708,775) (1,197,584) (1,178,083) Payment agreements .............................................................. 503,192 -- -- Purchases of treasury stock ..................................................... (40,397) (31,751) (5,913) Proceeds from sale of treasury stock ............................................ 29,169 17,211 6,302 ----------------------------------------- Net cash provided by financing activities ................................. 1,564,280 463,189 177,678 ----------------------------------------- Net cash flow ................................................................... 1,522 (4,433) 7,726 Cash at January 1 ............................................................... 7,734 12,167 4,441 ----------------------------------------- Cash at December 31 ............................................................. $ 9,256 $ 7,734 $ 12,167 ----------------------------------------- SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the year for: Income taxes ................................................................. $ 34,163 $ 90,649 $ 25,731 ----------------------------------------- Interest expense on debt ..................................................... $ 21,799 $ 21,675 $ 21,170 ----------------------------------------- Interest expense on investment agreements .................................... $ 169,875 $ 148,526 $ 124,797 ----------------------------------------- Cash received during the year for: Income taxes ................................................................. $ -- $ -- $ 8,843 -----------------------------------------
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. 34 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- 1 BACKGROUND Ambac Financial Group, Inc. (the "Company") is a holding company whose affiliates provide financial guarantee insurance and financial management services to clients in both the public and private sectors in the U.S. and abroad. The Company's principal operating subsidiary, Ambac Assurance Corporation ("Ambac Assurance"), a leading insurer of municipal and structured finance obligations, has earned triple-A claims-paying ability ratings, the highest ratings available from Moody's Investors Service, Inc., Standard & Poor's Ratings Group, Fitch IBCA, Inc., and Nippon Investors Services, Inc. Ambac Financial Group, Inc.'s Financial Management Services segment provides investment agreements, interest rate swaps, investment advisory and cash management services, and electronic commerce solutions, principally to states, municipalities and their authorities, school districts, and hospitals and health organizations. During the first quarter of 1997, Ambac Assurance established a new subsidiary in the United Kingdom, Ambac Insurance UK Limited ("Ambac UK"), which is authorized to conduct certain classes of general insurance business in the United Kingdom. Ambac UK is the Company's primary vehicle for the issuance of financial guarantee insurance policies in the United Kingdom and Europe. On December 18, 1997, Ambac Assurance acquired Construction Loan Insurance Corporation ("CLIC") for $106,000 in cash and retired $18,400 of CLIC debt. CLIC's wholly owned subsidiary, Connie Lee Insurance Company ("Connie Lee"), a triple-A rated financial guarantee insurance company which guaranteed bonds primarily for college and hospital infrastructure projects, is not expected to write any new business. Ambac Assurance and Connie Lee have arrangements in place to assure that Connie Lee maintains a level of capital sufficient to support Connie Lee's outstanding obligations and for Connie Lee insured bonds to retain their triple-A rating. The acquisition of CLIC was accounted for using the purchase method. CLIC's results of operations subsequent to December 18, 1997 are included in the accompanying Consolidated Statements of Operations. The pro forma results of operations for the years ended December 31, 1997 and 1996, assuming CLIChad been acquired as of January 1, 1996, are as follows: 1997: revenues of $406,400; pre-tax income of $260,500; net income of $205,800; and earnings per diluted share of $2.89; 1996: revenues of $477,300; pre-tax income of $390,500; net income of $287,300; and earnings per diluted share of $4.08. 2 SIGNIFICANT ACCOUNTING POLICIES The accompanying consolidated financial statements have been prepared on the basis of generally accepted accounting principles ("GAAP"). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported revenues and expenses during the reporting period. Actual results could differ from those estimates. The significant accounting policies of the Company are as described below: CONSOLIDATION: The consolidated financial statements include the accounts of Ambac Financial Group, Inc. and its subsidiaries. All significant intercompany balances have been eliminated. NET INCOME PER SHARE AND NET INCOME PER DILUTED SHARE: Net income per share is based on the weighted average number of shares outstanding during the year, retroactively adjusted to reflect a two-for-one stock split in 1997. Net income per diluted share reflects the potential dilution that would occur if securities, such as employee stock options, were exercised. INVESTMENTS: The Company's investment portfolio is accounted for on a trade-date basis and consists primarily of investments in fixed income securities that are considered available-for-sale and are carried at fair value. Fair value is based on quotes obtained by the Company from independent market sources. Short-term investments are carried at cost, which approximates fair value. Unrealized gains and losses, net of deferred income taxes, are included as a separate component of stockholders' equity and are computed using amortized cost as the basis. For purposes of computing amortized cost, premiums and discounts are accounted for using the interest method. For bonds purchased at a price below par value, discounts are accreted over the remaining term of the securities. For bonds purchased at a price above par value which have call features, premiums are amortized to the most likely call dates as determined by management. For premium bonds which do not have call features, such premiums are amortized over the remaining terms of the securities. Premiums and discounts on mortgage- and asset-backed securities are adjusted for the effects of actual and anticipated prepayments. Realized gains and losses on the sale of investments are determined on the basis of specific identification. 35 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL: Securities purchased under agreements to resell are collateralized financing transactions, and are recorded at their contracted resale amounts, plus accrued interest. The Company takes possession of the collateral underlying those agreements and monitors its market value on a daily basis and, when necessary, requires prompt transfer of additional collateral to reflect current market value. LOANS: Loans are reported at their outstanding unpaid principal balances, net of any deferred fees. Interest income is accrued on the unpaid principal balance. Deferred fees are amortized to interest income over the contractual life of the loan using the interest method or the straight line method if not materially different. Interest and amortization income are included in financial guarantee revenue. OBLIGATIONS UNDER INVESTMENT AND PAYMENT AGREEMENTS: Obligations under investment and payment agreements and investment repurchase agreements are recorded as liabilities on the consolidated balance sheet at the face value of the agreement, adjusted for draws paid and interest credited to the account. Unsettled agreements are accrued on a trade-date basis on the consolidated balance sheet at the time of commitment. Interest expense is computed based upon daily outstanding settled liability balances at rates and periods specified in the agreements. Net interest income relating to investment agreements and investment repurchase agreements is included as a component of financial management services revenue. PREMIUM REVENUE RECOGNITION: Premiums for municipal new issue and secondary market policies are: (i) generally computed as a percentage of principal and interest insured; (ii) typically collected in a single payment at policy inception date; and (iii) are earned pro rata over the period of risk. Premiums for structured finance policies can be computed as a percentage of either principal or principal and interest insured. The timing of the collection of structured finance premiums varies among individual transactions. For policies where premiums are collected in a single payment at policy inception date, premiums are earned pro rata over the period of risk. For policies with premiums that are collected periodically (i.e., monthly, quarterly or annually), premiums are reflected in income pro rata over the period covered by the premium payment. When an Ambac Assurance insured new or secondary market issue has been refunded or called, the remaining unearned premium is generally earned at that time, as the risk to Ambac Assurance is considered to have been eliminated. LOSSES AND LOSS ADJUSTMENT EXPENSES: The liability for losses and loss adjustment expenses consists of the active credit reserve ("ACR") and case basis loss and loss adjustment expense reserves. The development of the ACR is based upon estimates of the ultimate aggregate losses inherent in the obligations insured. When losses occur (actual monetary defaults or defaults which are imminent on insured obligations), case basis loss reserves are established in an amount that is sufficient to cover the present value of the anticipated defaulted debt service payments over the expected period of default and estimated expenses associated with settling the claims, less estimated recoveries under salvage or subrogation rights. All or part of case basis loss reserves are allocated from any ACR available for such insured obligation. Ambac Assurance's management believes that the reserves for losses and loss adjustment expenses are adequate to cover the ultimate net cost of claims, but the reserves are necessarily based on estimates and there can be no assurance that the ultimate liability will not exceed such estimates. DEFERRED ACQUISITION COSTS: Certain costs incurred which vary with, and are primarily related to, the production of business have been deferred. These costs include direct and indirect expenses related to underwriting, marketing and policy issuance, rating agency fees and premium taxes, net of reinsurance ceding commissions. The deferred acquisition costs are being amortized over the periods in which the related premiums are earned, and such amortization amounted to $14,213, $12,553 and $10,183 for 1997, 1996 and 1995, respectively. Deferred acquisition costs, net of such amortization, amounted to $11,784, $11,592 and $10,846 for 1997, 1996 and 1995, respectively. DEPRECIATION AND AMORTIZATION: Depreciation of furniture and fixtures and electronic data processing equipment is provided over the estimated useful lives of the respective assets, ranging from 3 to 5 years, using the straight-line method. Amortization of leasehold improvements and intangibles, including certain computer software licenses, is provided over the estimated useful lives of the respective assets, ranging from 3 to 5 years, using the straight-line method. DERIVATIVE CONTRACTS: Derivative Contracts Held for Purposes Other Than Trading: The Company uses derivative contracts (primarily interest rate swaps and futures contracts) for hedging purposes as part of its overall interest rate risk management. 36 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- The Company accounts for its futures contracts in accordance with the provisions of Statement of Financial Accounting Standards No. 80, "Accounting for Futures Contracts" ("Statement 80"). Statement 80 permits hedge accounting for futures contracts when the item to be hedged exposes the Company to price or interest rate risk, and the futures contract effectively reduces that exposure and is designated as a hedge. Futures contracts held for purposes other than trading are used primarily to hedge interest sensitive assets and liabilities. Futures contracts are designated at inception as a hedge to specific assets and liabilities. Gains and losses on futures and options contracts that qualify as accounting hedges of existing assets or liabilities are included in the carrying amounts and amortized over the remaining lives of the assets and liabilities as an adjustment to interest income or expense. When the hedged asset is sold, or the hedged liability is settled, the unamortized gain or loss on the related hedge is recognized in income. Interest rate swaps that are linked with existing liabilities are accounted for as a hedge of those liabilities, using the accrual method as an adjustment to interest expense. Interest rate swaps that are linked with existing assets classified as available for sale are accounted for as hedges of those assets, using the accrual method as an adjustment to interest income, with unrealized gains and losses included in stockholders' equity, net of tax. Interest rate risk is managed through the linkage of the interest rate swaps, which synthetically changes the nature of the underlying asset or liability (for example, from a fixed to floating interest rate obligation). Gains and losses on futures contracts, purchased options or interest rate swaps that do not qualify as accounting hedges are recognized in current period income immediately. Derivative Contracts Held for Trading Purposes: The Company, through its affiliate Ambac Financial Services, L.P. ("AFSLP"), a provider of interest rate swaps to states, municipalities and their authorities, and other entities in connection with their financings, uses derivative contracts which are classified as held for trading purposes. Derivative contracts are recorded on trade date at fair value. Changes in fair value are recorded as a component of financial management services operating income. The fair value of interest rate swaps is determined through the use of valuation models. The portion of the interest rate swap's initial fair value that reflects credit considerations, ongoing servicing, and transaction hedging costs is recognized over the life of the interest rate swap, as an adjustment to financial management services operating income. Interest rate swaps are recorded on a gross basis; assets and liabilities are netted by customer only when a legal right of set-off exists. INCOME TAXES: The Company, as common parent, files a consolidated federal income tax return with its subsidiaries. In accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. The Internal Revenue Code permits municipal bond insurance companies to deduct from taxable income, subject to certain limitations, the amounts added to the statutory mandatory contingency reserve during the year. The deduction taken is allowed only to the extent that U.S. Treasury noninterest-bearing tax and loss bonds are purchased at their par value prior to the original due date of the Company's consolidated federal tax return and held in an amount equal to the tax benefit attributable to such deductions. The amounts deducted must be included in taxable income when the contingency reserve is released, at which time the Company may redeem the tax and loss bonds to satisfy the additional tax liability. The purchases of tax and loss bonds are recorded as payments of federal income taxes and are not reflected in the Company's current tax provision. POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS: The Company provides various postretirement and postemployment benefits, including pension, and health and life benefits covering substantially all employees who meet certain age and service requirements. The Company accounts for these benefits under the accrual method of accounting. Amounts related to the defined benefit pension plan and postretirement health benefits are charged based on actuarial determinations. STOCK COMPENSATION PLANS: In 1997, the Company adopted the Ambac 1997 Equity Plan. Under this plan awards are granted to eligible employees of the Company and its subsidiaries in the form of incentive stock options or other stock-based awards. The Company accounts for its incentive stock options and stock-based awards under Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("Statement 123"). Statement 123 permits a company to choose either the fair value based method of accounting as defined in the Statement or the intrinsic value based method of accounting as prescribed by APB Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), for its 37 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- stock-based compensation plans. Companies electing the accounting requirements under APB 25 must also make pro forma disclosures of net income and earnings per share as if the fair value based method of accounting had been applied. The Company has elected to account for its plans under APB 25. ACCOUNTING STANDARDS: In February 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("Statement 128"), which the Company implemented in 1997. Statement 128 replaces the presentation of primary and fully diluted earnings per share with "basic earnings per share" and "diluted earnings per share," respectively. All prior periods presented have been restated to reflect the new requirement. In June 1997, the FASB issued Statement 130, "Reporting Comprehensive Income," which requires enterprises to disclose comprehensive income and its components in a prominent position on the face of the financial statements. The Company will implement this statement in 1998. This statement relates to presentation of information and will have no impact on results of operations or financial condition. In June 1997, the FASB issued Statement 131, "Disclosures about Segments of an Enterprise and Related Information," which will be effective for the Company beginning January 1, 1998. Statement 131 redefines how operating segments are determined and requires disclosure of certain financial and descriptive information about a company's operating segments. This statement relates to presentation of information and will have no impact on results of operations or financial condition. RECLASSIFICATIONS: Certain reclassifications have been made to prior years' amounts to conform to the current year's presentation. 3 INVESTMENTS The amortized cost and estimated fair value of investments in fixed income securities at December 31, 1997 and 1996 were as follows:
- -------------------------------------------------------------------------------- GROSS GROSS ESTIMATED AMORTIZED UNREALIZED UNREALIZED FAIR 1997 COST GAINS LOSSES VALUE - -------------------------------------------------------------------------------- Municipal obligations ...... $2,146,137 $ 152,971 $ 112 $2,298,996 Corporate obligations ...... 1,022,995 71,520 928 1,093,587 U.S. Government obligations 136,771 2,855 28 139,598 Mortgage- and asset-backed securities (includes U.S. Government Agency obligations) ............. 3,200,262 25,511 3,017 3,222,756 Other ...................... 155,763 91 669 155,185 ------------------------------------------------- $6,661,928 $ 252,948 $ 4,754 $6,910,122 - --------------------------------------------------------------------------------
- -------------------------------------------------------------------------------- GROSS GROSS ESTIMATED AMORTIZED UNREALIZED UNREALIZED FAIR 1996 COST GAINS LOSSES VALUE - -------------------------------------------------------------------------------- Municipal obligations ...... $1,897,518 $ 87,616 $ 2,223 $1,982,911 Corporate obligations ...... 939,312 33,943 9,365 963,890 U.S. Government obligations 102,774 1,363 1,707 102,430 Mortgage- and asset-backed securities (includes U.S. Government Agency obligations) ............. 2,035,719 8,882 9,486 2,035,115 Other ...................... 116,205 -- 9 116,196 ------------------------------------------------- $5,091,528 $ 131,804 $ 22,790 $5,200,542 - --------------------------------------------------------------------------------
The amortized cost and estimated fair value of fixed income securities at December 31, 1997, by contractual maturity, were as follows:
- -------------------------------------------------------------------------------- ESTIMATED AMORTIZED FAIR 1997 COST VALUE - -------------------------------------------------------------------------------- Due in one year or less .................. $ 171,955 $ 172,067 Due after one year through five years ..................... 309,796 316,696 Due after five years through ten years ...................... 433,363 452,362 Due after ten years ...................... 2,546,552 2,746,241 - -------------------------------------------------------------------------------- 3,461,666 3,687,366 Mortgage- and asset- backed securities ...................... 3,200,262 3,222,756 - -------------------------------------------------------------------------------- $6,661,928 $6,910,122 - --------------------------------------------------------------------------------
Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities carried at $8,415 and $2,422 at December 31, 1997 and 1996 respectively, were deposited by the Company with governmental authorities or designated custodian banks as required by laws affecting insurance companies. 38 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- Net investment income from financial guarantee insurance operations comprised the following:
- ------------------------------------------------------------------------------- 1997 1996 1995 - ------------------------------------------------------------------------------- Fixed income securities ........ $ 155,810 $ 139,410 $ 127,864 Short-term investments ......... 6,506 7,999 5,670 ----------------------------------------- Total investment income ...... 162,316 147,409 133,534 Investment expense ............. (2,607) (2,468) (2,485) ----------------------------------------- Net investment income ........ $ 159,709 $ 144,941 $ 131,049 - -------------------------------------------------------------------------------
Financial guarantee insurance operations had gross realized gains of $25,641, $19,236 and $27,786 for 1997, 1996 and 1995, respectively, and gross realized losses of $4,557, $39,767 and $27,609 for 1997, 1996 and 1995, respectively. Net investment income related to investment agreements comprises gross investment income less related interest expense, and is a component of financial management services revenue. For 1997, 1996 and 1995, gross investment income from investment agreements was $200,337, $165,196 and $137,382, respectively, and the related interest expense was $186,678, $154,484 and $127,666, respectively. As of December 31, 1997 and 1996, the Company held securities subject to agreements to resell for $85,466 and $201,169, respectively. Such securities were held as collateral by the Company. The agreements had terms of less than 30 days. As of December 31, 1997 and 1996, the Company had pledged (or sold under agreements to repurchase) securities purchased under agreements to resell and investment securities to certain municipalities, with a fair value of $2,714,719 and $1,642,964, respectively, in connection with certain investment agreements (including agreements structured as investment repurchase agreements). Additionally, as of December 31, 1997 and 1996, investment securities with a fair value of $63 and $896, respectively, were pledged to futures brokers for required margin. 4 LOANS In the normal course of business, the Company has extended loans to customers participating in certain structured municipal transactions. The loans are collateralized with cash that the customers have deposited with a payment custodian in amounts adequate to repay the loan balance and interest thereon. Equipment and other assets underlying the transactions serve as additional collateral for the loans. The Company may act as the payment custodian and hold the funds posted as collateral. As of December 31, 1997, the interest rates on these loans ranged from 6.25% to 8.42%. 5 REINSURANCE In the ordinary course of business, Ambac Assurance cedes exposures under various reinsurance contracts primarily designed to minimize losses from large risks and to protect capital and surplus. The effect of reinsurance on premiums written and earned was as follows:
- ---------------------------------------------------------------------------------------- YEARS ENDED DECEMBER 31, - ---------------------------------------------------------------------------------------- 1997 1996 1995 - ---------------------------------------------------------------------------------------- WRITTEN EARNED WRITTEN EARNED WRITTEN EARNED - ---------------------------------------------------------------------------------------- Direct ..... $277,814 $176,009 $240,544 $155,883 $190,570 $125,559 Assumed .... 8,349 3,614 6,664 3,126 2,756 1,349 Ceded ...... (32,452) (25,623) (37,793) (22,380) (28,606) (15,088) ------------------------------------------------------------------------ Net premiums $253,711 $154,000 $209,415 $136,629 $164,720 $111,820 - ----------------------------------------------------------------------------------------
The reinsurance of risk does not relieve the ceding insurer of its original liability to its policyholders. In the event that all or any of the reinsurers are unable to meet their obligations to Ambac Assurance under the existing reinsurance agreements, Ambac Assurance would be liable for such defaulted amounts. To minimize its exposure to significant losses from reinsurer insolvencies, Ambac Assurance evaluates the financial condition of its reinsurers and monitors concentrations of credit risk. There were no reinsurance recoverables on paid losses as of December 31, 1997 and 1996. As of December 31, 1997, prepaid reinsurance of approximately $152,283 was associated with Ambac Assurance's three largest reinsurers. As of December 31, 1997, Ambac Assurance held letters of credit and collateral amounting to approximately $154,387 from its reinsurers to cover liabilities ceded under the aforementioned reinsurance contracts. During 1995, Ambac Assurance terminated reinsurance contracts, resulting in return premiums to Ambac Assurance of $18,141, of which $15,700 was recorded as an increase to the unearned premium reserve, with the remainder recognized as revenue. 6 LOSSES AND LOSS ADJUSTMENT EXPENSES Ambac Assurance's liability for losses and loss adjustment expenses includes case basis loss and loss adjustment expense reserves and the ACR. Following is a summary of the activity in the 39 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- case basis loss and ACR accounts and the components of the liability for losses and loss adjustment expenses:
- ------------------------------------------------------------------------------------------- 1997 1996 1995 - ------------------------------------------------------------------------------------------- Case basis loss and loss adjustment expense reserves: Balance at January 1 ................................ $22,016 $39,890 $39,342 Less reinsurance recoverables ..................... 393 641 450 ---------------------------------- Net balance at January 1 ............................ 21,623 39,249 38,892 ---------------------------------- Incurred related to: Current year ...................................... 212 1,484 750 Prior years ....................................... 1,973 (9,556) 2,650 ---------------------------------- Total incurred ................................... 2,185 (8,072) 3,400 ---------------------------------- Paid related to: Current year ...................................... 200 150 150 Prior years ....................................... 2,274 9,404 2,893 ---------------------------------- Total paid ....................................... 2,474 9,554 3,043 ---------------------------------- Net balance for Connie Lee, at acquisition .......... 29,526 -- -- ---------------------------------- Net balance at December 31 .......................... 50,860 21,623 39,249 Plus reinsurance recoverables ..................... 4,219 393 641 ---------------------------------- Balance at December 31 .............................. 55,079 22,016 39,890 ---------------------------------- Active credit reserve: Balance at January 1 ................................ 38,597 26,747 26,770 Net provision for losses ............................ 3,000 5,115 4,097 ACR transfers (to) from case reserves ............... (2,331) 6,735 (4,120) Balance for Connie Lee, at acquisition .............. 9,000 -- -- ---------------------------------- Balance at December 31 .............................. 48,266 38,597 26,747 ---------------------------------- Total ............................................ $103,345 $60,613 $66,637 - -------------------------------------------------------------------------------------------
The terms "current year" and "prior years" in the foregoing table refer to the year in which case basis loss reserves were established. 7 STOCKHOLDERS' EQUITY The Company is authorized to issue 100,000,000 shares of Common Stock, par value $0.01 per share, of which 70,680,384 were issued as of December 31, 1997. The Company is also authorized to issue 4,000,000 shares of preferred stock, $0.01 par value per share, none of which was issued and outstanding as of December 31, 1997. Dividends declared per share amounted to $0.3450, $0.3075 and $0.2775 in 1997, 1996 and 1995, respectively. The Board of Directors of the Company (the "Board") has authorized the establishment of a stock repurchase program which permits the repurchase of up to 6,000,000 shares of the Company's Common Stock. As of December 31, 1997, approximately 3,272,000 shares had been repurchased under this program for an aggregate amount of $89,968. The difference between weighted average number of shares outstanding and weighted average number of diluted shares outstanding is from employee stock options. STOCKHOLDER RIGHTS PLAN: In January 1996, the Company adopted a Stockholder Rights Plan under which stockholders received (after giving effect to a stock split since adoption of the Plan) one Right for each two shares of Common Stock owned. Each Right entitles the registered holder to purchase from the Company one one-hundredth of a share of Series A Junior Participating Preferred Stock, par value $0.01 per share, at a purchase price of $190 per share. The Rights generally detach and become exercisable when any person or group acquires 20% or more (or announces a tender offer for 20% or more) of the Company's Common Stock, at which time each Right (other than those held by the acquiring company) will entitle the holder to receive that number of shares of Common Stock of the Company with a value of two times the exercise price of the Right. If the Company is acquired in a merger or other business combination transaction in which the Company is not the surviving corporation or 50% or more of the Company's assets, cash flow or earning power is sold or transferred, each Right will entitle the holder to receive that number of shares of stock of the acquiring company having a value equal to two times the exercise price of the Right. The Rights, which expire on January 31, 2006, are redeemable in whole, but not in part, by action of the Board of Directors at a price of $0.01 per Right at any time prior to their becoming exercisable. 8 COMMITMENTS AND CONTINGENCIES The Company is responsible for leases on the rental of office space. In 1997, the Company executed an agreement for additional office space and a lease term extension at its corporate headquarters in New York City. The lease agreements, which expire periodically through September 2019, contain provisions for scheduled periodic rent increases and are accounted for as operating leases. An estimate of future net minimum lease payments in each of the next five years ending December 31, and the periods thereafter, is as follows:
- -------------------------------------------------------------------------------- AMOUNT - -------------------------------------------------------------------------------- 1998 ............................................................... $ 5,474 1999 ............................................................... 6,469 2000 ............................................................... 6,648 2001 ............................................................... 5,772 2002 ............................................................... 5,714 All later years .................................................... 91,418 -------- $121,495 - --------------------------------------------------------------------------------
Rent expense for the aforementioned leases amounted to $5,048, $3,862 and $3,461 for the years ended December 31, 1997, 1996 and 1995, respectively. 40 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- 9 INSURANCE REGULATORY RESTRICTIONS Ambac Assurance is subject to insurance regulatory requirements of the States of Wisconsin and New York, and the other jurisdictions in which it is licensed to conduct business. Ambac Assurance's ability to pay dividends is generally restricted by law and subject to approval by the Office of the Commissioner of Insurance of the State of Wisconsin (the "Wisconsin Commissioner"). Wisconsin insurance law restricts the payment of dividends in any 12-month period without regulatory approval to the lesser of (a) 10% of policyholders' surplus as of the preceding December 31 and (b) the greater of (i) statutory net income for the calendar year preceding the date of dividend, minus realized capital gains for that calendar year and (ii) the aggregate of statutory net income for three calendar years preceding the date of the dividend, minus realized capital gains for those calendar years and minus dividends paid or credited within the first two of the three preceding calendar years. Ambac Assurance paid cash dividends of $44,000, $40,000 and $40,000 on its common stock in 1997, 1996 and 1995, respectively. In addition, on April 30, 1996, Ambac Assurance, in conjunction with the sale of the Company's remaining holdings in HCIA common stock, delivered to the Company (in the form of an extraordinary dividend) its 2,378,672 shares of HCIA common stock, at fair value. The Wisconsin Commissioner approved such dividend. Based upon these restrictions, at December 31, 1997, the maximum amount that will be available during 1998 for payment of dividends by Ambac Assurance is approximately $100,700. The New York Financial Guarantee Insurance Law establishes single risk limits applicable to all obligations issued by a single entity and backed by a single revenue source. Under the limit applicable to municipal bonds, the insured average annual debt service for a single risk, net of reinsurance and collateral, may not exceed 10% of qualified statutory capital, which is defined as the sum of insurer's policyholders' surplus and contingency reserves. In addition, insured principal of municipal bonds attributable to any single risk, net of reinsurance and collateral, is limited to 75% of Ambac Assurance's qualified statutory capital. Additional single risk limits, which generally are more restrictive than the municipal bond single risk limit, are also specified for several other categories of insured obligations. Statutory capital and surplus was $1,006,829 and $899,023 at December 31, 1997 and 1996, respectively. Qualified statutory capital was $1,655,554 and $1,466,560 at December 31, 1997 and 1996, respectively. Statutory net income was $198,615, $222,810 and $142,541 for 1997, 1996 and 1995, respectively. Statutory capital and surplus differs from stockholders' equity determined under GAAP principally due to statutory accounting rules that treat loss reserves, premiums earned, policy acquisition costs, and deferred income taxes differently. 10 INCOME TAXES The Company's provision for income taxes is comprised of the following:
- -------------------------------------------------------------------------------- 1997 1996 1995 - -------------------------------------------------------------------------------- Current taxes .................. $51,036 $94,392 $33,286 Deferred taxes ................. 11,930 4,797 13,293 --------------------------------------- $62,966 $99,189 $46,579 - --------------------------------------------------------------------------------
The total effect of income taxes on income and stockholders' equity for the years ended December 31, 1997 and 1996 was as follows:
- --------------------------------------------------------------------------------- 1997 1996 Total income taxes charged to income .................. $62,966 $99,189 ---------------------- Income taxes charged (credited) to stockholders' equity: Unrealized gains (losses) on bonds ................... 45,192 (28,108) Other ................................................ (5,566) (2,282) ---------------------- Total charged (credited) to stockholders' equity .... 39,626 (30,390) ---------------------- Total effect of income taxes ........................... $102,592 $68,799 - ---------------------------------------------------------------------------------
The tax provisions in the accompanying consolidated statements of operations reflect effective tax rates differing from prevailing federal corporate income tax rates. The following is a reconciliation of these differences:
- ---------------------------------------------------------------------------------------------------------- 1997 % 1996 % 1995 % Computed expected tax at statutory rate .................. $100,099 35.0% $131,427 35.0% $74,961 35.0% Reductions in expected tax resulting from: Tax-exempt interest ...................... (35,682) (12.5) (30,760) (8.2) (28,379) (13.3) Other, net ............................... (1,451) (0.5) (1,478) (0.4) (3) -- ------------------------------------------------------------ Income tax expense ....................... $62,966 22.0% $99,189 26.4% $46,579 21.7% - ----------------------------------------------------------------------------------------------------------
41 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- The tax effects of temporary differences that give rise to significant portions of the deferred tax liabilities and deferred tax assets at December 31, 1997 and 1996 are presented below:
- -------------------------------------------------------------------------------- 1997 1996 - -------------------------------------------------------------------------------- Deferred tax liabilities: Contingency reserve ............................ $115,360 $76,805 Unrealized gains on bonds ...................... 75,342 30,150 Deferred acquisition costs ..................... 38,030 32,974 Unearned premiums .............................. 35,679 28,060 Investments .................................... 1,491 60 Other .......................................... 2,026 1,250 ----------------------- Total deferred tax liabilities ................ 267,928 169,299 ----------------------- Deferred tax assets: Tax and loss bonds ............................. 87,951 63,871 Loss reserves .................................. 17,182 13,512 Alternative minimum tax carryforward ........... 14,049 -- Amortization and depreciation .................. 6,032 4,836 Compensation ................................... 4,030 2,884 Other .......................................... 3,456 4,110 ----------------------- Sub-total deferred tax assets ................. 132,700 89,213 Valuation allowance ............................ -- -- ----------------------- Total deferred tax assets ..................... 132,700 89,213 ----------------------- Net deferred tax liabilities .................. $135,228 $80,086 - --------------------------------------------------------------------------------
The Company believes that no valuation allowance is necessary in connection with the deferred tax assets. 11 EMPLOYEE BENEFITS PENSIONS: The Company has a defined benefit pension plan covering substantially all employees of the Company and most of its subsidiaries. The benefits are based on years of service and the employee's compensation during the last five years of employment. The Company's funding policy is to contribute annually the maximum amount that can be deducted for federal income tax purposes. Contributions are intended to provide not only for benefits attributed to service-to-date but also for those expected to be earned in the future. The actuarial present value of the benefit obligations shown in the table below sets forth the plan's funded status and amounts recognized by the Company as of December 31, 1997 and 1996.
- ------------------------------------------------------------------------------- 1997 1996 - ------------------------------------------------------------------------------- Accumulated benefit obligation, including vested benefits of $7,192 and $6,282, respectively .................... $(7,956) $(6,979) --------------------- Projected benefit obligation for service rendered to date ........................... (9,374) (8,189) Plan assets at fair value, primarily listed stocks, commingled funds and fixed income securities ........................ 9,644 8,153 --------------------- Funded/unfunded projected benefit .................... 270 (36) Unrecognized prior service cost ...................... (1,454) (1,619) Unrecognized net loss ................................ 62 885 Unrecognized net transition asset .................... (7) (9) --------------------- Pension liability included in other liabilities ...... $(1,129) $(779) - -------------------------------------------------------------------------------
Net pension costs for 1997, 1996 and 1995 included the following components:
- ------------------------------------------------------------------------------- 1997 1996 1995 - ------------------------------------------------------------------------------- Service cost ......................... $723 $674 $541 Interest cost on expected benefit obligation ................. 601 539 456 Actual return on plan assets ......... (1,606) (957) (1,333) Net amortization and deferral ........ 770 263 760 ---------------------------------- Net periodic pension cost ............ $488 $519 $424 - -------------------------------------------------------------------------------
The weighted average discount rate used in the determination of the actuarial present value for the projected benefit obligation was 7.25% and 7.50% for 1997 and 1996, respectively. The expected long-term rate of return on assets was 9.25% for both 1997 and 1996. The rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation was 4.8 % and 5.0% for 1997 and 1996, respectively. Upon the acquisition of CLIC, the Company assumed the liability for its two terminated pension plans. Those plans had unfunded projected benefit obligations of approximately $800, which is included in other liabilities at December 31, 1997. Substantially all employees of the Company and its subsidiaries are covered by a defined contribution plan (the "Savings Incentive Plan"), for which contributions and costs are determined as 6% of each eligible employee's base salary, plus a matching company contribution of 50% on contributions up to 6% of base salary, subject to Internal Revenue Code limitations, made by eligible employees to the plan. The total cost of the Savings Incentive Plan was $1,806, $1,680 and $1,555 in 1997, 1996 and 1995, respectively. 42 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- ANNUAL INCENTIVE PROGRAM: The Company has an annual incentive program which provides for awards to key officers and employees based upon predetermined criteria. The cost of the program for the years ended December 31, 1997, 1996 and 1995 amounted to $12,038, $10,822 and $8,860, respectively. POSTRETIREMENT HEALTH CARE AND OTHER BENEFITS: Ambac Assurance provides certain medical and life insurance benefits for retired employees and eligible dependents. All plans are contributory. None of the plans are currently funded. Postretirement benefits expense was $262, $220 and $168 in 1997, 1996 and 1995, respectively. The unfunded accumulated postretirement benefit obligation was $2,064 and the accrued postretirement liability was $1,719 as of December 31, 1997. The assumed weighted average health care cost trend rates range from 9.0% in 1997, decreasing ratably to 6.0% in 2002, and remaining at that level thereafter. Increasing the assumed health care cost trend rate by one percentage point in each future year would increase the accumulated postretirement benefit obligation at December 31, 1997 by $172 and the 1997 benefit expense by $48. The weighted average discount rate used to measure the accumulated postretirement benefit obligation and 1997 expense was 7.25%. 12 INSURANCE IN FORCE The par amount of bonds insured, net of reinsurance, was $165,601,000 and $131,497,000 at December 31, 1997 and 1996, respectively. As of December 31, 1997 and 1996, the insured portfolio was diversified by type of insured bond as shown in the following table:
- -------------------------------------------------------------------------------- NET PAR AMOUNT OUTSTANDING - -------------------------------------------------------------------------------- (DOLLARS IN MILLIONS) 1997 1996 - -------------------------------------------------------------------------------- Municipal finance: General obligation ............................. $36,324 $31,863 Lease and tax-backed revenue ................... 30,980 25,366 Utility revenue ................................ 24,913 22,780 Health care revenue ............................ 18,545 13,521 Transportation revenue ......................... 7,370 6,891 Higher education ............................... 6,852 4,745 Investor-owned utilities ....................... 6,255 5,492 Housing revenue ................................ 6,064 4,497 Student loans .................................. 3,516 3,439 Other .......................................... 597 484 ---------------------- Total municipal finance ....................... 141,416 119,078 ---------------------- Domestic structured finance: Mortgage-backed and home equity ................ 11,620 5,263 Commercial asset-backed ........................ 4,538 1,329 Other consumer asset-backed .................... 1,514 1,126 Banks/financial institutions ................... 524 214 Other .......................................... 439 159 ---------------------- Total domestic structured finance ............. 18,635 8,091 ---------------------- Total domestic ................................ 160,051 127,169 ---------------------- International finance: Commercial asset-backed ........................ 2,600 2,530 Sovereign/sub-sovereign ........................ 981 631 Mortgage-backed and home equity ................ 496 265 Utilities ...................................... 456 131 Banks/financial institutions ................... 283 346 Other .......................................... 734 425 ---------------------- Total international finance ................... 5,550 4,328 ---------------------- $165,601 $131,497 - --------------------------------------------------------------------------------
As of December 31, 1997 and 1996, the international insured portfolio by geographic area is shown in the following table:
- -------------------------------------------------------------------------------- NET PAR AMOUNT OUTSTANDING - -------------------------------------------------------------------------------- (DOLLARS IN MILLIONS) 1997 1996 - -------------------------------------------------------------------------------- International: France ....................................... $1,032 $1,025 Japan ........................................ 879 645 United Kingdom ............................... 865 569 Italy ........................................ 555 423 Spain ........................................ 380 130 Internationally diversified .................... 899 985 Other international ............................ 940 551 ---------------------- $5,550 $4,328 - --------------------------------------------------------------------------------
43 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- As of December 31, 1997, California was the state with the highest aggregate net par amount in force, accounting for 11.8% of the total. The highest single insured risk represented less than 1% of aggregate net par amount insured. Direct insurance in force (principal and interest) was $321,104,000 and $268,870,000 at December 31, 1997 and 1996, respectively. Net insurance in force (after giving effect to reinsurance) was $275,931,000 and $227,235,000 as of December 31, 1997 and 1996, respectively. 13 FINANCIAL INSTRUMENTS HELD FOR PURPOSES OTHER THAN TRADING DERIVATIVE FINANCIAL INSTRUMENTS: In the normal course of business, the Company becomes a party to various financial instruments to reduce its exposure to fluctuations in interest rates. These financial instruments include interest rate swaps, exchange traded futures contracts and purchased interest rate options. The notional amounts of these financial instruments were as follows:
- -------------------------------------------------------------------------------- AS OF DECEMBER 31, 1997 1996 - -------------------------------------------------------------------------------- Derivative financial instruments with off balance sheet risk: Interest rate futures contracts ............ $3,689,100 $1,569,800 Interest rate swaps ........................ 712,206 689,023 Other: Purchased interest rate options ............ 85,500 32,200 - --------------------------------------------------------------------------------
Notional principal amounts are often used to express the volume of these transactions and do not reflect the extent to which positions may offset one another. These amounts do not represent the much smaller amounts potentially subject to risk. RISK MANAGEMENT: In the ordinary course of business, the Company, through its affiliates, manages a variety of risks, principally market, credit, liquidity, operational, and legal. These risks are identified, measured and monitored through a variety of control mechanisms, which are in place at different levels throughout the organization. Market risk generally represents the risk of loss that may result from the potential change in the fair value of a financial instrument as a result of changes in prices or interest rates. The principal market risk for financial instruments held for purposes other than trading is interest rate risk. An independent risk management group is involved in setting and monitoring risk limits and in the application of risk measurement methodologies. The estimation of potential losses arising from adverse changes in market conditions is a key element in managing market risk. The Company utilizes various models and stress testing to manage interest rate risk. This process includes frequent analyses of both parallel and nonparallel shifts in the yield curve. These models include estimates made by management and the valuation results could differ materially from amounts that would actually be realized in the market. Credit risk relates to the ability of counterparties to perform according to the terms of their contractual commitments. Credit risk is calculated based on the current replacement cost or fair value of the Company's financial instruments. The gross replacement cost of these financial instruments is the positive fair value of all transactions with a counterparty, excluding the effects of netting or collateral arrangements, and was approximately $3,000 and $2,000 as of December 31, 1997 and 1996, respectively. The Company executes these transactions with a diverse base of counterparties in order to minimize concentrations of credit risk. Various procedures and controls are in place to monitor the credit risk associated with investment agreements and interest rate swaps. These include the initial credit approval process, minimum credit rating requirements and the continuous monitoring of credit exposure. The Company also has credit risk associated with its investment portfolio. These risks are controlled through strict compliance with written investment policy guidelines. These investment policy guidelines include a pre-established set of criteria including minimum credit ratings, restrictions on the nature of investments, and single credit concentration limits. Liquidity risk relates to the possible inability to satisfy contractual obligations when due. This risk is present in investment agreements, interest rate swaps and futures contracts. The investment agreement business manages liquidity risk by matching the effective duration of its invested assets, including hedges, with the effective duration of its investment agreement liabilities. Additionally, the Company's policy is to maintain a minimum level of cash and short-term liquid assets equivalent to a specified percentage of its investment agreement liabilities outstanding. Operational risk relates to the potential for loss caused by a breakdown in information, communication and settlement systems. The Company mitigates operational risk by maintaining a comprehensive system of internal controls. This includes the establishment of systems and procedures to monitor transactions and positions, documentation and confirmation of transactions, and ensuring compliance with regulations. Legal risk relates to the uncertainty of the enforceability, through legal or judicial processes, of the obligations of the Company's counterparties, including contractual provisions intended to reduce credit exposure by providing for the offsetting 44 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- or netting of mutual obligations. The Company seeks to remove or minimize such uncertainties through continuous consultation with internal and external legal advisers to analyze and understand the nature of legal risk, to improve documentation and to strengthen transaction structure. As discussed in Note 2, interest rate futures and purchased option contracts held for purposes other than trading are used primarily to hedge price or interest rate risk inherent in the portfolio of interest-sensitive assets and liabilities. Interest rate swaps held for purposes other than trading are used to manage interest rate risk by synthetically changing the nature of specific assets or liabilities. Futures contracts are purchased to hedge interest rate risk inherent in fixed rate liabilities. Futures contracts are sold to hedge interest rate risk inherent in fixed rate investment securities. Interest rate option contracts are purchased to hedge interest rate risk inherent in fixed rate assets and liabilities. At December 31, 1997 and 1996, futures and purchased option contracts with an outstanding notional of $627,000 and $1,109,100, respectively, were designated as hedges of fixed rate liabilities. Additionally, at December 31, 1997 and 1996, futures and purchased option contracts with an outstanding notional of $3,147,600 and $492,900, respectively, were designated as hedges of fixed rate investment securities. Interest rate swaps which require the Company to pay a fixed rate are used primarily to hedge fixed rate investment securities. Interest rate swaps which require the Company to receive a fixed rate are used primarily to hedge fixed rate liabilities. The table below summarizes, for each major type of swap, the weighted average fixed rate paid or received on the respective notional amounts outstanding. Notional amounts are used to calculate the contractual payments to be exchanged under these contracts.
- ------------------------------------------------------------------------------------------------------------- MATURING AFTER DECEMBER 31, - ------------------------------------------------------------------------------------------------------------- THERE- 1998 1999 2000 2001 2002 AFTER - ------------------------------------------------------------------------------------------------------------- Pay fixed swaps: Notional amount .. $226,528 $299,775 $202,368 $161,145 $173,144 $58,217 Weighted-average fixed rate ...... 6.05% 6.98% 7.02% 6.93% 6.93% 7.06% Receive fixed swaps: Notional amount .. $138,556 $137,922 $137,271 $136,602 $135,913 $20,756 Weighted-average fixed rate ...... 6.45% 6.45% 6.45% 6.45% 6.45% 7.06% Range of implied floating interest rates.... 5.86% to 5.94% to 5.95% to 6.04% to 6.13% to 6.01% 6.11% 6.16% 6.22% 6.22% - -------------------------------------------------------------------------------------------------------------
The floating rate side of the Company's interest rate swaps is based on several indices, primarily one-month, three-month and six-month LIBOR. The floating rates shown above reflect the range of the implied forward LIBOR yield curve for those indices, as of December 31, 1997. FAIR VALUES OF FINANCIAL INSTRUMENTS HELD FOR PURPOSES OTHER THAN TRADING: The following fair value amounts were determined by the Company using independent market information when available, and appropriate valuation methodologies when market quotes were not available. In cases where specific market quotes are unavailable, interpreting market data and estimating market values require considerable judgment by management. Accordingly, the estimates presented are not necessarily indicative of the amount the Company could realize in a current market exchange. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Investments: The fair values of fixed income investments are based on quoted market prices or dealer quotes. Short-term investments and cash: The fair values of short-term investments and cash are assumed to equal amortized cost. Preferred stock: The fair value of preferred stock is based on an evaluation of the underlying company and recent transactions in such preferred stock. Securities purchased under agreements to resell: The fair value of securities purchased under agreements to resell is assumed to approximate carrying value. Debentures: The fair value of the debentures is based on quoted market prices and dealer quotes. Obligations under investment, repurchase and payment agreements (including accrued interest): The fair value of the liability for investment agreements and repurchase agreements (including accrued interest) is estimated based upon valuation models using rates currently offered for contracts of similar maturities. Derivative contracts: Fair values of derivative contracts (futures, swaps and interest rate options) are based on quoted market prices and dealer quotes, current settlement values, or pricing models. 45 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- Liability for net financial guarantees written: The fair value of the liability for those financial guarantees written related to new issue and secondary market exposures is based on the estimated cost to reinsure those exposures at current market rates, which amount consists of the current unearned premium reserve, less an estimated ceding commission thereon. Certain other financial guarantee insurance policies have been written on an installment basis, where the future premiums to be received by the Company are determined based on the outstanding exposure at the time the premiums are due. The fair value of Ambac Assurance's liability under its installment premium policies is measured using the present value of estimated future installment premiums, less an assumed ceding commission. The estimate of the amounts and timing of the future installment premiums is based on contractual premium rates, debt service schedules and expected run-off scenarios. This measure is used as an estimate of the cost to reinsure Ambac Assurance's liability under these policies. The carrying amount and estimated fair value of financial instruments held for purposes other then trading are presented below:
- -------------------------------------------------------------------------------------- AS OF DECEMBER 31, 1997 1996 - -------------------------------------------------------------------------------------- ESTIMATED ESTIMATED CARRYING FAIR CARRYING FAIR (DOLLARS IN MILLIONS) AMOUNT VALUE AMOUNT VALUE Financial assets: Fixed income securities ................... $6,774 $6,774 $5,088 $5,088 Short-term investments .................... 136 136 113 113 Preferred stock ........................... 5 5 -- -- Cash ...................................... 9 9 8 8 Securities purchased under agreements to resell .................... 85 85 201 201 Financial liabilities: Debentures ................................ 224 269 224 259 Obligations under investment, repurchase and payment agreements (including accrued interest) ............ 4,367 4,405 2,778 2,775 Derivative financial instruments: Interest rate futures contracts ........... (2) -- -- -- Interest rate swaps ....................... (9) (7) -- (1) Purchased interest rate option contracts ........................ -- -- -- -- Liability for financial guarantees written: Gross ................................... 1,179 855 991 719 Net of reinsurance ...................... 995 722 822 596 Net installment premiums ................ -- 153 -- 114 - -------------------------------------------------------------------------------------
14 FINANCIAL INSTRUMENTS HELD FOR TRADING PURPOSES AFSLP is a provider of interest rate swaps to states, municipalities and their authorities and other entities in connection with their financings. AFSLP manages its business with the goal of being market neutral to changes in overall interest rates, while retaining basis risk, the relationship between changes in floating tax-exempt and floating taxable interest rates. If actual or projected floating tax-exempt interest rates change in relation to floating taxable rates, the Company will experience an unrealized mark-to-market gain or loss. The AFSLP swap portfolio is considered held for trading purposes. In the ordinary course of business, AFSLP manages a variety of risks, principally market, credit, liquidity, operational, and legal. These risks are identified, measured and monitored through a variety of control mechanisms, which are in place at different levels throughout the organization. Qualitative factors relating to credit, operational and legal risks for financial instruments held for trading purposes are similar to those risks as described in Note 13. Market risk relates to the impact of price changes on future earnings. This risk is a consequence of AFSLP's market-making activities in the interest rate swap market. The principal market risk is basis risk, the relationship between changes in floating tax-exempt and floating taxable interest rates. Since late 1995, most interest rate swaps transacted contain provisions which are designed to protect AFSLP against certain forms of tax reform, thus mitigating its basis risk. An independent risk management group monitors trading risk limits and, together with senior management, is involved in the application of risk measurement methodologies. As discussed in Note 13, credit risk is calculated based on the current replacement cost or fair value of the Company's financial instruments. The gross replacement of the Company's financial instruments held for trading purposes is the positive fair value of all transactions with a counterparty, excluding the effects of netting or collateral arrangements and was approximately $66,000 and $42,000 as of December 31, 1997 and 1996, respectively. Liquidity risk relates to the possible inability to satisfy contractual obligations when due. This risk is present in swaps and in futures contracts used to hedge swaps. The Company manages liquidity risk by maintaining cash and cash equivalents, closely matching the dates swap payments are made and received, and limiting the amount of risk hedged by futures contracts. 46 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- The following table summarizes information about the Company's financial instruments held for trading purposes as of December 31, 1997 and 1996:
- -------------------------------------------------------------------------------------------------- NET ESTIMATED AVERAGE NET FAIR VALUE FAIR VALUE NOTIONAL ASSETS LIABILITIES ASSETS LIABILITIES AMOUNT - -------------------------------------------------------------------------------------------------- 1997: Derivative financial instruments: Interest rate swaps ........... $67,743 $49,265 $43,748 $33,954 $3,347,190 Futures contracts ............. -- -- -- -- 514,900 Other financial instruments ..... 183,041 181,732 160,251 159,213 -- 1996: Derivative financial instruments: Interest rate swaps ........... $42,030 $29,897 $44,241 $37,451 $2,341,660 Futures contracts ............. -- -- -- -- 484,500 Other financial instruments ..... -- -- -- -- -- - --------------------------------------------------------------------------------------------------
Financial instruments held for trading purposes are carried at estimated fair value. The aggregate amount of net trading income recognized from derivative financial instruments held for trading purposes was $7,454, $10,579 and $2,871 for 1997, 1996 and 1995, respectively. Other financial instruments held for trading purposes consist of fixed income securities. The aggregate amount of net trading income recognized from other financial instruments was $1,309 for 1997. Average net fair values were calculated based on average daily net fair values. Notional principal amounts are often used to express the volume of these transactions and do not reflect the extent to which positions may offset one another. These amounts do not represent the much smaller amounts potentially subject to risk. 15 LONG-TERM DEBT AND LINES OF CREDIT The carrying value of long-term debt was as follows:
- -------------------------------------------------------------------------------- AS OF DECEMBER 31, 1997 1996 - -------------------------------------------------------------------------------- 9 3/8% Debentures, due 2011 ................... $149,389 $149,344 7 1/2% Debentures, due 2023 ................... 74,475 74,454 ------------------------- $223,864 $223,798 - --------------------------------------------------------------------------------
The debentures due on February 1, 2011 were issued on August 8, 1991 in the principal amount of $150,000 and bear interest of 9 3/8%, payable on February 1 and August 1 of each year. The debentures are noncallable and were sold at 99.4% of their principal amount at an effective yield of 9.44%. The debentures due on November 1, 2023 were issued on May 11, 1993 in the principal amount of $75,000 and bear interest of 7 1/2%, payable on May 1 and November 1 of each year. The debentures are noncallable and were sold at 99.171% of their principal amount at an effective yield of 7.57%. The Company and Ambac Assurance maintain a three-year revolving credit facility with two major international banks, as co-agents, for $100,000. As of December 31, 1997 and 1996, no amounts were outstanding under this credit facility, which expires in July 1998. Ambac Assurance has an agreement with a group of AAA/Aaa-rated international banks for a $450,000 credit facility, expiring in 2004. This facility is a seven-year stand-by irrevocable limited recourse line of credit, which was increased from $350,000 to $450,000 and extended for an additional year in December 1997. The line will provide liquidity to Ambac Assurance in the event claims from municipal obligations exceed specified levels. Repayment of any amounts drawn under the line will be limited primarily to the amount of any recoveries of losses related to policy obligations. As of December 31, 1997 and 1996, no amounts were outstanding under this line. Connie Lee has an agreement with commercial banks for a $50,000 stand-by credit facility, expiring in 2003. The line will provide a source of additional claims-paying resources for insured transactions. The obligation to repay is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations including installment premiums and other collateral. As of December 31, 1997 and 1996, no amounts were outstanding under this line. 47 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- 16 OBLIGATIONS UNDER INVESTMENT AGREEMENTS AND PAYMENT AGREEMENTS Obligations under investment agreements, including those structured in the form of repurchase contracts, are recorded on a trade-date basis. Certain obligations may be called at various times prior to maturity at the option of the counterparty. As of December 31, 1997 and 1996, the interest rates on these agreements ranged from 4.23% to 8.14% for each year. The average yield on these agreements for the years ended December 31, 1997 and 1996, were 5.85% and 5.87%, respectively. As of December 31, 1997 and 1996, obligations under investment agreements and investment repurchase agreements were as follows:
- -------------------------------------------------------------------------------- AS OF DECEMBER 31, 1997 1996 - -------------------------------------------------------------------------------- Settled .............................. $3,817,772 $2,721,291 Unsettled ............................ -- 33,299 ------------------------------- $3,817,772 $2,754,590 - --------------------------------------------------------------------------------
Net payments due under settled investment agreements in each of the next five years ending December 31, and the periods thereafter, based on expected call dates, were as follows:
- -------------------------------------------------------------------------------- PRINCIPAL AMOUNT - -------------------------------------------------------------------------------- 1998 .............................................................. $1,463,194 1999 .............................................................. 1,120,315 2000 .............................................................. 410,454 2001 .............................................................. 202,237 2002 .............................................................. 33,677 All later years ................................................... 587,895 ---------- $3,817,772 - --------------------------------------------------------------------------------
Obligations under payment agreements represent funds received by the Company from certain municipal customers. These funds serve as collateral for loans extended by the Company in connection with certain structured municipal transactions. In connection with these transactions, the Company is obligated to make periodic agreed upon payments. As of December 31, 1997, the interest rates on these obligations ranged from 6.25% to 8.42%. Net payments due under payment agreements in each of the next five years ending December 31, and the periods thereafter, based on contractual payment dates, are as follows:
- -------------------------------------------------------------------------------- PRINCIPAL AMOUNT - -------------------------------------------------------------------------------- 1998 ................................................................ $ 8,219 1999 ................................................................ 10,157 2000 ................................................................ 10,169 2001 ................................................................ 13,323 2002 ................................................................ 11,220 All later years ..................................................... 450,104 -------- $503,192 - --------------------------------------------------------------------------------
17 COMMON STOCK INCENTIVES The Company's stock incentive plan for officers and other key employees, the Ambac 1997 Equity Plan (the "1997 Plan"), provides for the granting of stock options, stock appreciation rights, restricted stock units, performance units and other awards that are valued or determined by reference to the Common Stock. The 1997 Plan was approved by the stockholders of the Company in 1997 and replaces the 1991 Stock Incentive Plan, under which no further awards will be made. Stock options awarded to employees are exercisable and expire as specified at the time of grant and generally may not have a per share exercise price less than the fair market value of a share of Common Stock on the date of grant or a term in excess of ten years from the date of the grant. The Company also maintains the Ambac 1997 Non-Employee Directors Equity Plan ("The Directors Plan"), which provides awards of stock options and restricted stock units to non-employee members of the Company's Board of Directors. The number of options and their exercise price, and the number of restricted stock units, awarded to each non-employee director under the Directors Plan is determined by formula. As of December 31, 1997, approximately 6,500,000 shares were available for future grant under the 1997 Plan and the Directors Plan. A summary of option activity is as follows:
- ------------------------------------------------------------------------------------------------------------- 1997 1996 1995 WEIGHTED WEIGHTED WEIGHTED AVERAGE AVERAGE AVERAGE EXERCISE EXERCISE EXERCISE SHARES PRICE SHARES PRICE SHARES PRICE - ------------------------------------------------------------------------------------------------------------- Outstanding at beginning of year 4,248,642 $19.37 4,140,824 $18.17 3,400,240 $17.30 Granted ........... 859,800 $33.59 964,150 $24.25 1,023,290 $19.79 Exercised ......... (898,942) $19.05 (721,724) $18.53 (242,496) $12.39 Forfeited ......... (291,807) $24.99 (134,608) $21.87 (40,210) $20.79 --------- --------- --------- Outstanding at end of year ..... 3,917,693 $22.15 4,248,642 $19.37 4,140,824 $18.17 --------- --------- --------- Exercisable ....... 2,392,853 2,407,838 2,282,490 - -------------------------------------------------------------------------------------------------------------
- --------------------------------------------------------------------------------------- OPTIONS OUTSTANDING OPTIONS EXERCISABLE WEIGHTED WEIGHTED WEIGHTED RANGE OF NUMBER AVERAGE AVERAGE NUMBER AVERAGE EXERCISE OUTSTANDING AT REMAINING EXERCISE EXERCISABLE AT EXERCISE PRICES DECEMBER 31, 1997 CONTRACT LIFE PRICE DECEMBER 31, 1997 PRICE - --------------------------------------------------------------------------------------- $10 to 20 1,481,674 5.2 $15.02 1,265,183 $14.20 $21 to 25 1,647,479 5.4 $23.07 1,124,337 $22.54 $30 to 42 788,540 6.1 $33.60 3,333 $30.88 3,917,693 2,392,853 - ---------------------------------------------------------------------------------------
48 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- The Company applies APB 25 and related interpretations in accounting for its plans. Accordingly, since the fair value of the options at grant date equals the exercise price, no compensation cost has been recognized for its fixed stock option plan. Had compensation cost for the Company's stock-based compensation plan been determined consistent with Statement 123, the Company's net income, earnings per share and earnings per diluted share for the years ended December 31, 1997, 1996 and 1995, would have been reduced to the pro forma amounts indicated below:
- -------------------------------------------------------------------------------- 1997 1996 1995 - -------------------------------------------------------------------------------- Net Income: As reported ..................... $223,030 $276,317 $167,595 Pro forma ....................... $218,852 $273,528 $166,080 Earnings per share: As reported ..................... $3.19 $3.95 $2.39 Pro forma ....................... $3.13 $3.91 $2.37 Earnings per diluted share: As reported ..................... $3.13 $3.91 $2.37 Pro forma ....................... $3.07 $3.87 $2.34 - --------------------------------------------------------------------------------
The weighted-average fair value (determined as of the date of the grants) of options granted in 1997, 1996 and 1995 was $9.85 per share, $6.19 per share, and $6.40 per share, respectively. The fair value of each option grant issued was estimated as of the date of the grant using the Black-Scholes option-pricing model, with the following weighted-average assumptions used for grants in 1997, 1996 and 1995, respectively: dividend yield of 1.08%, 1.24% and 1.18%; expected volatility of 19.4%, 16.5% and 20.0%; risk-free interest rates of 6.4%, 6.2% and 7.2%; and expected lives of 6 years, 5 years and 6 years. The pro forma amounts disclosed above are not likely to be representative of the effects of reported pro forma net income for future years because options vest over several years and additional awards are granted each year. 18 SEGMENT INFORMATION As of December 31, 1997, the Company's products are reported in two industry segments, as follows: Financial guarantee insurance includes insurance of municipal and structured finance obligations. Financial management services includes the issuance of investment agreements, interest rate swaps, investment advisory and management services, and electronic commerce solutions, principally to states, municipalities and their authorities, school districts, and hospitals and health organizations. The following table is a summary of the operations by operating segment for the years ended December 31, 1997, 1996 and 1995: 49 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - --------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------------ FINANCIAL FINANCIAL ADJUSTMENTS GUARANTEE MANAGEMENT CORPORATE AND INSURANCE SERVICES AND OTHER ELIMINATIONS CONSOLIDATED - ------------------------------------------------------------------------------------------------------------------------------------ 1997: Revenues: Unaffiliated customers .................. $ 339,195 $ 34,612 $ 7,955 $ -- $ 381,762 Intersegment ............................ 1,857 (194) 44,068 (45,731) -- ---------------------------------------------------------------------------------- Total revenues ............................. $ 341,052 $ 34,418 $ 52,023 $ (45,731) $ 381,762 ---------------------------------------------------------------------------------- Income before income taxes: Unaffiliated customers .................. $ 295,669 $ 6,619 $ (16,292) $ -- $ 285,996 Intersegment ............................ 1,736 (1,031) 44,068 (44,773) -- ---------------------------------------------------------------------------------- Total income before income taxes ........... $ 297,405 $ 5,588 $ 27,776 $ (44,773) $ 285,996 ---------------------------------------------------------------------------------- Identifiable assets ........................ $ 3,392,333 $ 4,763,534 $ 93,855 $ -- $ 8,249,722 ---------------------------------------------------------------------------------- 1996: Revenues: Unaffiliated customers .................. $ 266,300 $ 22,366 $ 164,242 $ -- $ 452,908 Intersegment ............................ 1,728 (810) 159,883 (160,801) -- ---------------------------------------------------------------------------------- Total revenues ............................. $ 268,028 $ 21,556 $ 324,125 $ (160,801) $ 452,908 ---------------------------------------------------------------------------------- Income before income taxes: Unaffiliated customers .................. $ 225,340 $ 10,326 $ 139,840 $ -- $ 375,506 Intersegment ............................ 1,728 (980) 159,883 (160,631) -- ---------------------------------------------------------------------------------- Total income before income taxes ........... $ 227,068 $ 9,346 $ 299,723 $ (160,631) $ 375,506 ---------------------------------------------------------------------------------- Identifiable assets ........................ $ 2,886,657 $ 2,861,527 $ 128,174 $ -- $ 5,876,358 ---------------------------------------------------------------------------------- 1995: Revenues: Unaffiliated customers .................. $ 248,626 $ 13,009 $ 20,624 $ -- $ 282,259 Intersegment ............................ 1,798 (2,187) 40,292 (39,903) -- ---------------------------------------------------------------------------------- Total revenues ............................. $ 250,424 $ 10,822 $ 60,916 $ (39,903) $ 282,259 ---------------------------------------------------------------------------------- Income before income taxes: Unaffiliated customers .................. $ 210,799 $ 5,216 $ (1,841) $ -- $ 214,174 Intersegment ............................ 1,549 (2,610) 40,268 (39,207) -- ---------------------------------------------------------------------------------- Total income before income taxes ........... $ 212,348 $ 2,606 $ 38,427 $ (39,207) $ 214,174 ---------------------------------------------------------------------------------- Identifiable assets ........................ $ 2,741,426 $ 2,533,743 $ 34,110 $ -- $ 5,309,279 ----------------------------------------------------------------------------------
50 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- 19 QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
- ------------------------------------------------------------------------------------------------------------------------------------ FIRST SECOND THIRD FOURTH FULL YEAR - ------------------------------------------------------------------------------------------------------------------------------------ 1997 Gross premiums written ......................... $51,792 $73,740 $52,371 $108,260 $286,163 Net premiums written ........................... 46,360 66,545 45,876 94,930 253,711 Net premiums earned ............................ 37,033 36,386 35,672 44,909 154,000 Net investment income .......................... 38,447 39,258 40,109 41,895 159,709 Financial management services income ........... 7,222 6,150 9,062 12,815 35,249 Losses and loss adjustment expenses ............ 728 664 730 732 2,854 Financial guarantee underwriting and operating expenses .......................... 9,092 9,732 10,173 11,675 40,672 Financial management services expenses ......... 8,980 5,474 5,751 7,788 27,993 Income before income taxes ..................... 62,396 67,836 79,637 76,127 285,996 Net income ..................................... 49,738 53,613 60,795 58,884 223,030 Net income per share(1) ........................ 0.71 0.77 0.87 0.84 3.19 Net income per diluted share ................... $0.70 $0.75 $0.85 $0.83 $3.13 ------------------------------------------------------------------------ 1996 Gross premiums written ......................... $50,287 $58,115 $67,613 $71,193 $247,208 Net premiums written ........................... 40,675 48,279 57,800 62,661 209,415 Net premiums earned ............................ 28,193 39,645 33,745 35,046 136,629 Net investment income .......................... 34,827 35,498 36,887 37,729 144,941 Financial management services income ........... 7,011 5,114 4,034 5,814 21,973 Other net realized gains ....................... -- 155,613 -- 700 156,313 Losses and loss adjustment expenses ............ 810 1,700 1,301 (33) 3,778 Financial guarantee underwriting and operating expenses .......................... 8,748 10,351 8,646 9,437 37,182 Financial management services expenses ......... 2,136 2,358 3,073 4,473 12,040 Income before income taxes ..................... 57,007 197,777 54,685 66,037 375,506 Net income ..................................... 44,553 135,947 43,828 51,989 276,317 Net income per share(1) ........................ 0.64 1.95 0.63 0.74 3.95 Net income per diluted share ................... $0.63 $1.92 $0.62 $0.73 $3.91 ------------------------------------------------------------------------
(1) Net income per share has been retroactively adjusted to reflect the two-for-one stock split which occurred in September 1997. 51 - -------------------------------------------------------------------------------- ------------------------------- STOCKHOLDER INFORMATION -------------------------------
- ------------------------------------------------------------------------------------------------------------------------------------ CORPORATE OTHER LOCATIONS: ANNUAL MEETING OF TRANSFER AGENT, HEADQUARTERS AUSTRALIA: STOCKHOLDERS REGISTRAR AND DIVIDEND PAYING AGENT Ambac Financial Group, Inc. Level 29, The Chifley Tower The Annual Meeting of One State Street Plaza 2 Chiefly Square, Sydney Stockholders of Ambac Financial Citibank, N.A. New York, New York 10004 NSW 2000, Australia Group, Inc. will be held on 111 Wall Street, 5th Floor 212-668-0340 61 2 9375 2117 Wednesday, May 13, 1998, at 11:30 New York, New York 10043 fax 212-509-9190 a.m. in New York City. Detailed 212-657-5997 www.ambac.com FRANCE: information about the meeting is contained in the Notice of Annual INDEPENDENT AUDITORS CADRE FINANCIAL Citicenter Meeting and Proxy Statement to be SERVICES, INC. 19, le Parvis sent to each stockholder of KPMG Peat Marwick LLP 92073 Paris la Defense record as of March 23, 1998. The New York, New York 905 Marconi Avenue Cedex 37, France Company estimates that it has Ronkonkoma, New York 11779 330146939364 approximately 15,000 STOCK LISTING 516-467-0200 stockholders. SPAIN: Ambac Financial Group, Inc. common AMBAC CONNECT, INC. FORM 10-K stock is listed on the New York Serrano, 20-2 Dcha Stock Exchange (ticker symbol 9130 Jollyville Road, Suite 355 28001 Madrid, Spain A copy of the Company's 1997 ABK). The Company is listed in Austin, Texas 78759 3414316881 Annual Report on Form 10-K for the daily stock tables under 512-338-0091 the year ended December 31, 1997, "Ambac." UK: as filed with the Securities and MBIA-AMBAC Exchange Commission, may be INVESTOR RELATIONS INTERNATIONAL St. Helen's, One Undershaft obtained without charge by JOINT VENTURE OFFICES: London EC3A 8JL, England writing to: Ambac Financial 1-800-221-1854 44 171-444-7200 Group, Inc., Attn: Investor E-mail: info@ambac.com One State Street Plaza Relations One State Street Plaza Frank J. Bivona New York, New York 10004 New York, New York 10004 Executive Vice President, 212-668-0304 Chief Financial Officer and Treasurer 113 King Street 212-208-3236 Armonk, New York 10504 914-273-4545 Brian S. Moore Managing Director 212-208-3333
COMMON STOCK DATA The table below shows the high and low price per share for each quarter of 1997 and 1996, as adjusted for the two-for-one common stock split, which occurred in September 1997.
- ---------------------------------------------------------------------------------------------------------------------------- 1997 Market Price 1996 Market Price - ---------------------------------------------------------------------------------------------------------------------------- Dividends Dividends THREE MONTHS ENDED High Low Close Per Share High Low Close Per Share March 31 .............. $37 $31 5/8 $32 1/4 $0.0825 $24 3/4 $22 3/4 $24 1/16 $0.0750 June 30 ............... 42 1/4 31 38 3/16 0.0825 27 5/8 23 5/8 26 1/16 0.0750 September 30 .......... 42 15/16 38 1/4 40 11/16 0.0900 29 3/16 23 1/2 27 7/8 0.0750 December 31 ........... 47 9/16 40 46 0.0900 34 3/4 27 7/8 33 3/16 0.0825 ------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------
52 - -------------------------------------------------------------------------------- EX-21.01 14 LIST OF SUBSIDIARIES List of Subsidiaries of Ambac Financial Group,Inc. -------------------------------------------------- The following is a list of significant and other subsidiaries of Ambac Financial Group, Inc. The state of incorporation of each subsidiary is included in parentheses after its name. AMBAC ASSURANCE CORPORATION (Wisconsin) AMBAC CAPITAL CORPORATION (Delaware) AMBAC CAPITAL MANAGEMENT, INC. (Delaware) AMBAC INVESTMENTS, INC. (Delaware) AMBAC FINANCIAL SERVICES HOLDINGS, INC. (Delaware) AMBAC FINANCIAL SERVICES, L.P. (Delaware) EX-24.01 15 POWER OF ATTORNEY LASSITER (EXHIBIT 24.01) AMBAC FINANCIAL GROUP, INC. Power of Attorney ----------------- KNOW ALL MEN BY THESE PRESENTS that the undersigned director and officer of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of FRANK J. BIVONA and RICHARD B. GROSS, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1997, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said FORM 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 9th day of March, 1998. /s/ Phillip B. Lassiter -------------------------- Phillip B. Lassiter EX-24.02 16 POWER OF ATTORNEY BIVONA (EXHIBIT 24.02) AMBAC FINANCIAL GROUP, INC. Power of Attorney ----------------- KNOW ALL MEN BY THESE PRESENTS that the undersigned officer of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of RICHARD B. GROSS and ANNE G. GILL, as his true and lawful attorney-in- fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1997, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said FORM 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 9th day of March, 1998. /s/ Frank J. Bivona -------------------- Frank J. Bivona EX-24.03 17 POWER OF ATTORNEY CALLEN (EXHIBIT 24.03) AMBAC FINANCIAL GROUP, INC. Power of Attorney ----------------- KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of FRANK J. BIVONA and RICHARD B. GROSS, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1997, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said FORM 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 12th day of March, 1998. /s/ Michael A. Callen ---------------------- Michael A. Callen EX-24.04 18 POWER OF ATTORNEY CAPORALI (EXHIBIT 24.04) AMBAC FINANCIAL GROUP, INC. Power of Attorney ----------------- KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of FRANK J. BIVONA and RICHARD B. GROSS, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1997, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said FORM 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 5th day of March, 1998. /s/ Renso L. Caporali ---------------------- Renso L. Caporali EX-24.05 19 POWER OF ATTORNEY DULUDE (EXHIBIT 24.05) AMBAC FINANCIAL GROUP, INC. Power of Attorney ----------------- KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of FRANK J. BIVONA and RICHARD B. GROSS, as his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign the ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1997, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said FORM 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 9th day of March, 1998. /s/ Richard Dulude ------------------- Richard Dulude EX-24.06 20 POWER OF ATTORNEY GREGORY (EXHIBIT 24.06) AMBAC FINANCIAL GROUP, INC. Power of Attorney ----------------- KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of FRANK J. BIVONA and RICHARD B. GROSS, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1997, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said FORM 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 10th day of March, 1998. /s/ W. Grant Gregory --------------------- W. Grant Gregory EX-24.07 21 POWER OF ATTORNEY O'NEIL (EXHIBIT 24.07) AMBAC FINANCIAL GROUP, INC. Power of Attorney ----------------- KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of FRANK J. BIVONA and RICHARD B. GROSS, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1997, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said FORM 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this 8th day of March, 1998. /s/ C. Roderick O'Neil ---------------------- C. Roderick O'Neil EX-27 22 FINANCIAL DATA SCHEDULE
7 1,000 YEAR DEC-31-1997 JAN-01-1997 DEC-31-1997 6,773,844 0 0 5,000 0 0 6,915,122 9,256 0 105,996 8,249,722 103,345 1,178,990 0 0 223,864 0 0 707 1,871,775 8,249,722 154,000 159,709 21,195 4,402 2,854 40,672 0 285,996 62,966 223,030 0 0 0 223,030 3.19 3.13 0 0 0 0 0 0 0
EX-27.2 23 RESTATED FINANCIAL DATA SCHEDULE
7 1,000 YEAR YEAR DEC-31-1996 DEC-31-1995 JAN-01-1996 JAN-01-1995 DEC-31-1996 DEC-31-1995 5,088,031 4,264,904 0 0 0 0 0 0 0 0 0 0 5,200,542 4,441,593 7,734 12,167 0 0 94,212 82,620 5,876,358 5,309,279 60,613 65,996 991,224 903,026 0 0 0 0 223,798 223,732 0 0 0 0 353 353 1,614,663 1,403,635 5,876,358 5,309,279 136,629 111,820 144,941 131,049 136,175 19,163 5,261 5,580 3,778 3,377 37,182 34,450 0 0 375,506 214,174 99,189 46,579 276,317 167,595 0 0 0 0 0 0 276,317 167,595 3.95 2.39 3.91 2.37 0 0 0 0 0 0 0 0 0 0 0 0 0 0
EX-99.01 24 CONSOLIDATED FINANCIAL STATEMENTS Exhibit 99.01 AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF AMBAC FINANCIAL GROUP, INC.) CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1997 AND 1996 Independent Auditors' Report The Board of Directors Ambac Assurance Corporation We have audited the accompanying consolidated balance sheets of Ambac Assurance Corporation and subsidiaries (a wholly owned subsidiary of Ambac Financial Group, Inc.) as of December 31, 1997 and 1996, and the related consolidated statements of operations, stockholder's equity and cash flows for each of the years in the three-year period ended December 31, 1997. These consolidated financial statements are the responsibility of Ambac Assurance Corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Ambac Assurance Corporation and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1997 in conformity with generally accepted accounting principles. New York, New York January 29, 1998 Ambac Assurance Corporation and Subsidiaries Consolidated Balance Sheets December 31, 1997 and 1996 (Dollars in Thousands Except Share Data)
1997 1996 ------------------ ------------------- ASSETS ------ Investments: Fixed income securities, at fair value (amortized cost of $2,696,603 in 1997 and $2,323,259 in 1996) $2,878,083 $2,424,524 Short-term investments, at cost (approximates fair value) 116,905 91,320 ------------------ ------------------- Total investments 2,994,988 2,515,844 Cash 8,004 5,025 Securities purchased under agreements to resell 2,484 4,369 Receivable for securities sold 24,018 18,462 Investment income due and accrued 49,987 42,263 Deferred acquisition costs 105,996 94,212 Receivable from brokers and dealers 183,041 - Reinsurance recoverable 4,219 393 Prepaid reinsurance 183,492 168,786 Other assets 48,802 59,544 ------------------ ------------------- Total assets $3,605,031 $2,908,898 ================== =================== LIABILITIES AND STOCKHOLDER'S EQUITY ------------------------------------ Liabilities: Unearned premiums $1,184,537 $995,220 Losses and loss adjustment expenses 103,345 60,613 Ceded reinsurance balances payable 9,258 7,438 Deferred income taxes 122,554 84,842 Current income taxes 19,714 8,974 Accounts payable and other liabilities 69,641 50,244 Payable for securities purchased 195,388 46,246 ------------------ ------------------- Total liabilities 1,704,437 1,253,577 ------------------ ------------------- Stockholder's equity: Preferred stock, par value $1,000.00 per share; authorized shares - 285,000; issued and outstanding shares - none - - Common stock, par value $2.50 per share; authorized shares - 40,000,000; issued and outstanding shares - 32,800,000 at December 31, 1997 and December 31, 1996 82,000 82,000 Additional paid-in capital 521,153 515,684 Unrealized gains on investments, net of tax 117,962 65,822 Cumulative translation adjustment 157 - Retained earnings 1,179,322 991,815 ------------------ ------------------- Total stockholder's equity 1,900,594 1,655,321 ------------------ ------------------- Total liabilities and stockholder's equity $3,605,031 $2,908,898 ================== ===================
See accompanying Notes to Consolidated Unaudited Financial Statements. Ambac Assurance Corporation and Subsidiaries Consolidated Statements of Operations (Dollars in Thousands)
Years Ended December 31 ------------------------------------------------- 1997 1996 1995 ------------ ------------ ------------ Revenues: Gross premiums written $289,383 $249,761 $195,033 Ceded premiums written (32,452) (37,793) (28,606) ------------ ------------ ------------ Net premiums written 256,931 211,968 166,427 Increase in unearned premiums, net (101,263) (73,671) (52,844) ------------ ------------ ------------ Net premiums earned 155,668 138,297 113,583 Net investment income 160,088 145,302 131,496 Net realized gains 18,798 69,149 177 Other income 16,661 16,418 6,777 ------------ ------------ ------------ Total revenues 351,215 369,166 252,033 ------------ ------------ ------------ Expenses: Losses and loss adjustment expenses 2,854 3,778 3,377 Underwriting and operating expenses 46,769 42,459 38,722 Interest expense 2,293 2,073 1,590 ------------ ------------ ------------ Total expenses 51,916 48,310 43,689 ------------ ------------ ------------ Income before income taxes 299,299 320,856 208,344 ------------ ------------ ------------ Income tax expense: Current taxes 55,492 68,322 29,085 Deferred taxes 11,702 11,298 14,461 ------------ ------------ ------------ Total income taxes 67,194 79,620 43,546 ------------ ------------ ------------ Net Income $232,105 $241,236 $164,798 ============ ============ ============
See accompanying Notes to Consolidated Unaudited Financial Statements. Ambac Assurance Corporation and Subsidiaries Consolidated Statements of Stockholder's Equity (Dollars In Thousands)
Years Ended December 31, ---------------------------------------- 1997 1996 1995 ------------ ------------ ------------ Preferred Stock: Balance at January 1 and December 31 $ - $ - $ - ============ ============ ============ Common Stock: Balance at January 1 and December 31 $82,000 $82,000 $82,000 ============ ============ ============ Additional Paid-in Capital: Balance at January 1 $515,684 $481,059 $444,258 Capital contributions 1,475 32,500 35,000 Other 3,994 2,125 1,801 ------------ ------------ ------------ Balance at December 31 $521,153 $515,684 $481,059 ============ ============ ============ Unrealized Gains (Losses) on Investments, Net of Tax: Balance at January 1 $65,822 $87,112 ($46,087) Change in unrealized gain (loss) 52,140 (21,290) 133,199 ------------ ------------ ------------ Balance at December 31 $117,962 $65,822 $87,112 ============ ============ ============ Cumulative Currency Adjustment: Balance at January 1 $ - $ - $ - Changes during the year 157 - - ------------ ------------ ------------ Balance at December 31 $157 $ - $ - ============ ============ ============ Retained Earnings: Balance at January 1 $991,815 $906,536 $781,571 Net income 232,105 241,236 164,798 Dividends declared-common stock (44,000) (155,865) (40,000) Other (598) (92) 167 ------------ ------------ ------------ Balance at December 31 $1,179,322 $991,815 $906,536 ============ ============ ============ Total Stockholder's Equity at December 31 $1,900,594 $1,655,321 $1,556,707 ============ ============ ============
See accompanying Notes to Consolidated Unaudited Financial Statements. Ambac Assurance Corporation and Subsidiaries Consolidated Statements of Cash Flows (Dollars in Thousands)
Years Ended December 31, ------------------------------------------- 1997 1996 1995 ------------ ------------- ------------ Cash flows from operating activities: Net income $232,105 $241,236 $164,798 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,689 1,711 1,605 Amortization of bond premium and discount (1,084) (1,902) (831) Current income taxes 18,240 11,145 8,373 Deferred income taxes 11,702 11,299 14,462 Deferred acquisition costs (11,784) (11,592) (10,846) Unearned premiums 101,257 73,671 52,844 Losses and loss adjustment expenses 408 (5,776) 334 Ceded reinsurance balances payable 1,303 (7,216) 13,746 Gain on sales of investments (18,798) (69,149) (177) Accounts payable and other liabilities 6,670 6,619 106 Other, net 10,992 (17,928) (11,273) ------------ ------------- ------------ Net cash provided by operating activities 352,700 232,118 233,141 ------------ ------------- ------------ Cash flows from investing activities: Proceeds from sales of bonds at amortized cost 1,346,231 1,555,372 1,882,485 Proceeds from maturities of bonds at amortized cost 115,476 86,292 163,031 Purchases of bonds at amortized cost (1,623,486) (1,938,677) (2,192,824) Change in short-term investments (25,585) 72,633 (78,751) Securities purchased under agreements to resell 1,885 (249) 3,891 Purchase of affiliate (120,006) - - Other, net (236) (1,876) (1,178) ------------ ------------- ------------ Net cash used in investing activities (305,721) (226,505) (223,346) ------------ ------------- ------------ Cash flows from financing activities: Dividends paid (44,000) (40,000) (40,000) Capital contribution - 32,500 35,000 ------------ ------------- ------------ Net cash used in financing activities (44,000) (7,500) (5,000) ------------ ------------- ------------ Net cash flow 2,979 (1,887) 4,795 Cash at January 1 5,025 6,912 2,117 ------------ ------------- ------------ Cash at December 31 $8,004 $5,025 $6,912 ============ ============= ============ Supplemental disclosure of cash flow information: Cash paid during the year for: Income taxes $42,100 $54,504 $19,500 ============ ============= ============
See accompanying Notes to Consolidated Unaudited Financial Statements. AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) 1 BACKGROUND Ambac Assurance Corporation ("Ambac Assurance") is a leading insurer of municipal and structured finance obligations. Financial guarantee insurance underwritten by Ambac Assurance guarantees payment when due of the principal of and interest on the obligation insured. In the case of a default on the insured bond, payments under the insurance policy may not be accelerated by the policyholder without Ambac Assurance's consent. As of December 31, 1997, Ambac Assurance's net insurance in force (principal and interest) was $275,931,000. Ambac Assurance is a wholly owned subsidiary of Ambac Financial Group, Inc. (NYSE: ABK), a holding company that provides financial guarantee insurance and financial management services to clients in the public and private sectors in the U.S. and abroad through its subsidiaries. Ambac Assurance, as the sole limited partner, owns a limited partnership interest representing 90% of the total partnership interests of Ambac Financial Services, L.P. ("AFS"), a limited partnership which provides interest rate swaps primarily to states, municipalities and their authorities. The sole general partner of AFS, Ambac Financial Services Holdings, Inc., a wholly owned subsidiary of Ambac Financial Group, Inc., owns a general partnership interest representing 10% of the total partnership interest in AFS. On December 18, 1997, Ambac Assurance acquired Construction Loan Insurance Corporation ("CLIC") for $106,000 in cash and retired $18,400 of CLIC debt. CLIC's wholly owned subsidiary, Connie Lee Insurance Company ("Connie Lee"), a triple-A rated financial guarantee insurance company which guaranteed bonds primarily for college and hospital infrastructure projects, is not expected to write any new business. Ambac Assurance and Connie Lee have arrangements in place to assure that Connie Lee maintains a level of capital sufficient to support Connie Lee's outstanding obligations and for Connie Lee insured bonds to retain their triple-A rating. The acquisition of CLIC was accounted for using the purchase method. CLIC's results of operations subsequent to December 18, 1997 are included in the accompanying Consolidated Statements of Operations. The pro forma results of operations for the years ended December 31, 1997 and 1996, assuming CLIC had been acquired as of January 1, 1996, are as follows; 1997: revenues of $375,839; pre-tax income of $273,806 and net income of $214,894; 1996: revenues of $393,577; pre-tax income of $335,826; net income of $252,181. During the first quarter of 1997, Ambac Assurance established a new subsidiary in the United Kingdom, Ambac Insurance UK Limited ("Ambac UK"), which is authorized to conduct certain classes of general insurance business in the United Kingdom. Ambac UK is the Company's primary vehicle for the issuance of financial guarantee insurance policies in the United Kingdom and Europe. As of December 31, 1995, Ambac Assurance owned 26.5% and Ambac Financial Group, Inc. owned 19.9% of the outstanding common stock of an affiliate, HCIA Inc. ("HCIA"), a leading health care information content company. Prior to 1995, Ambac Financial Group, Inc. and Ambac Assurance, combined, owned approximately 96% of HCIA. During 1996, in conjunction with the sale of Ambac Financial Group, Inc.'s and Ambac Assurance's combined holdings in HCIA common stock, Ambac Assurance delivered to Ambac Financial Group, Inc. (in the form of an extraordinary dividend) its 2,378,672 shares of HCIA common stock. As a result, Ambac Assurance recognized a realized gain of $89,680. 2 SIGNIFICANT ACCOUNTING POLICIES The accompanying consolidated financial statements have been prepared on the basis of generally accepted accounting principles ("GAAP"). The preparation of financial statements in conformity with AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS) GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported revenues and expenses during the reporting period. Actual results could differ from those estimates. The significant accounting policies of Ambac Assurance and its subsidiaries (sometimes collectively referred to as the "Company") are as described below: CONSOLIDATION: The consolidated financial statements include the accounts of Ambac Assurance and its subsidiaries. All significant intercompany balances have been eliminated. INVESTMENTS: The Company's investment portfolio is accounted for on a trade-date basis and consists entirely of investments in fixed income securities that are considered available-for-sale and are carried at fair value. Fair value is based on quotes obtained by the Company from independent market sources. Short-term investments are carried at cost, which approximates fair value. Unrealized gains and losses, net of deferred income taxes, are included as a separate component of stockholder's equity and are computed using amortized cost as the basis. For purposes of computing amortized cost, premiums and discounts are accounted for using the interest method. For bonds purchased at a price below par value, discounts are accreted over the remaining term of the securities. For bonds purchased at a price above par value which have call features, premiums are amortized to the most likely call dates as determined by management. For premium bonds which do not have call features, such premiums are amortized over the remaining terms of the securities. Premiums and discounts on mortgage- and asset-backed securities are adjusted for the effects of actual and anticipated prepayments. Realized gains and losses on the sale of investments are determined on the basis of specific identification. SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL: Securities purchased under agreements to resell are collateralized financing transactions, and are recorded at their contracted resale amounts, plus accrued interest. The Company takes possession of the collateral underlying those agreements and monitors its market value on a daily basis and, when necessary, requires prompt transfer of additional collateral to reflect current market value. PREMIUM REVENUE RECOGNITION: Premiums for municipal new issue and secondary market policies are: (i) generally computed as a percentage of principal and interest insured; (ii) typically collected in a single payment at policy inception date; and (iii) are earned pro rata over the period of risk. Premiums for structured finance policies can be computed as a percentage of either principal or principal and interest insured. The timing of the collection of structured finance premiums varies among individual transactions. For policies where premiums are collected in a single payment at policy inception date, premiums are earned pro rata over the period of risk. For policies with premiums that are collected periodically (i.e., monthly, quarterly or annually), premiums are reflected in income pro rata over the period covered by the premium payment. 2 AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS) When an Ambac Assurance insured new or secondary market issue has been refunded or called, the remaining unearned premium is generally earned at that time, as the risk to Ambac Assurance is considered to have been eliminated. LOSSES AND LOSS ADJUSTMENT EXPENSES: The liability for losses and loss adjustment expenses consists of the active credit reserve ("ACR") and case basis loss and loss adjustment expense reserves. The development of the ACR is based upon estimates of the ultimate aggregate losses inherent in the obligations insured. When losses occur (actual monetary defaults or defaults which are imminent on insured obligations), case basis loss reserves are established in an amount that is sufficient to cover the present value of the anticipated defaulted debt service payments over the expected period of default and estimated expenses associated with settling the claims, less estimated recoveries under salvage or subrogation rights. All or part of case basis loss reserves are allocated from any ACR available for such insured obligation. Ambac Assurance's management believes that the reserves for losses and loss adjustment expenses are adequate to cover the ultimate net cost of claims, but the reserves are necessarily based on estimates and there can be no assurance that the ultimate liability will not exceed such estimates. DEFERRED ACQUISITION COSTS: Certain costs incurred which vary with, and are primarily related to, the production of business have been deferred. These costs include direct and indirect expenses related to underwriting, marketing and policy issuance, rating agency fees and premium taxes, net of reinsurance ceding commissions. The deferred acquisition costs are being amortized over the periods in which the related premiums are earned, and such amortization amounted to $14,213, $12,553 and $10,183 for 1997, 1996 and 1995, respectively. Deferred acquisition costs, net of such amortization, amounted to $11,784, $11,592 and $10,846 for 1997, 1996 and 1995, respectively. DEPRECIATION AND AMORTIZATION: Depreciation of furniture and fixtures and electronic data processing equipment is provided over the estimated useful lives of the respective assets, ranging from 3 to 5 years, using the straight-line method. Amortization of leasehold improvements and intangibles, including certain computer software licenses, is provided over the estimated useful lives of the respective assets, ranging from 3 to 5 years, using the straight-line method. DERIVATIVE CONTRACTS: DERIVATIVE CONTRACTS HELD FOR TRADING PURPOSES: The Company, through its affiliate AFS, a provider of interest rate swaps to states, municipalities and their authorities, and other entities in connection with their financings, uses derivative contracts which are classified as held for trading purposes. Derivative contracts are recorded on trade date at fair value. Changes in fair value are recorded as a component of other income. The fair value of interest rate swaps is determined through the use of valuation models. The portion of the interest rate swap's initial fair value 3 AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS) that reflects credit considerations, ongoing servicing, and transaction hedging costs is recognized over the life of the interest rate swap, as an adjustment to other income. Interest rate swaps are recorded on a gross basis; assets and liabilities are netted by customer only when a legal right of set-off exists. INCOME TAXES: Pursuant to a tax-sharing agreement, the Company is included in Ambac Financial Group, Inc.'s consolidated Federal income tax return. The tax-sharing agreement provides for the determination of tax expense or benefit based on the contribution of the Company to Ambac Financial Group, Inc.'s consolidated Federal income tax liability, computed substantially as if the Company filed a separate Federal income tax return. The tax liability due is settled quarterly, with a final settlement taking place after the filing of the consolidated Federal income tax return. The Company files its own state income tax returns. In accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. The Internal Revenue Code permits municipal bond insurance companies to deduct from taxable income, subject to certain limitations, the amounts added to the statutory mandatory contingency reserve during the year. The deduction taken is allowed only to the extent that U.S. Treasury noninterest-bearing tax and loss bonds are purchased in an amount equal to the tax benefit attributable to such deductions. The amounts deducted must be included in taxable income when the contingency reserve is released, at which time the Company will redeem the tax and loss bonds to satisfy the additional tax liability. Purchases of tax and loss bonds are recorded as payments of federal income taxes and are not reflected in the Company's current tax provision. POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS: Ambac Financial Group, Inc., through its subsidiaries, provides various postretirement and postemployment benefits, including pension, and health and life benefits covering substantially all employees who meet certain age and service requirements. The Company accounts for these benefits under the accrual method of accounting. Amounts related to the defined benefit pension plan and postretirement health benefits are charged based on actuarial determinations. ACCOUNTING STANDARDS: In June 1997, the FASB issued Statement 130, "Reporting Comprehensive Income," which requires enterprises to disclose comprehensive income and its components in a prominent position on the face of the financial statements. The Company will implement this statement in 1998. This statement relates to presentation of information and will have no impact on results of operations or financial condition. 4 AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS) In June 1997, the FASB issued Statement 131, "Disclosures about Segments of an Enterprise and Related Information," which will be effective for the Company beginning January 1, 1998. Statement 131 redefines how operating segments are determined and requires disclosure of certain financial and descriptive information about a company's operating segments. This statement relates to presentation of information and will have no impact on results of operations or financial condition. RECLASSIFICATIONS: Certain reclassifications have been made to prior years' amounts to conform to the current year's presentation. 3 INVESTMENTS The amortized cost and estimated fair value of investments in fixed income securities at December 31, 1997 and 1996 were as follows:
Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value ----------------- ----------------- ----------------- ----------------- 1997 Municipal obligations................................. $2,126,136 $149,807 $ 112 $2,275,831 Corporate obligations................................. 315,492 27,384 36 342,840 U.S. Government obligations........................... 136,771 2,854 27 139,598 Mortgage- and asset-backed securities (includes U.S. Government Agency Obligations) 98,719 2,190 2 100,907 Other................................................. 136,390 91 669 135,812 -------------- --------------- ----------------- --------------- $2,813,508 $182,326 $ 846 $2,994,988 ============== =============== ================= =============== Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value -------------- --------------- ----------------- --------------- 1996 Municipal obligations................................. $1,892,875 $ 86,984 $ 2,223 $1,977,636 Corporate obligations................................. 273,770 17,336 2,187 288,919 U.S. Government obligations........................... 102,774 1,363 1,707 102,430 Mortgage- and asset-backed securities (includes U.S. Government Agency Obligations) 50,145 2,081 373 51,853 Other................................................. 95,015 - 9 95,006 -------------- -------------- ---------------- --------------- $2,414,579 $107,764 $6,499 $2,515,844 ============== ============== ================ ===============
5 AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS) The amortized cost and estimated fair value of fixed income securities at December 31, 1997, by contractual maturity, were as follows:
Amortized Estimated Cost Fair Value ----------------------- ----------------------- 1997 Due in one year or less................................................. $ 152,582 $ 152,695 Due after one year through five years................................... 180,417 185,672 Due after five years through ten years.................................. 360,248 375,831 Due after ten years..................................................... 2,070,321 2,228,662 ----------------------- ----------------------- 2,763,568 2,942,860 Mortgage- and asset-backed securities (includes U.S. Government Agency Obligations)........................................................... 49,940 52,128 ----------------------- ----------------------- $2,813,508 $2,994,988 ======================= =======================
Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities carried at $8,415 and $2,422 at December 31, 1997 and 1996 respectively, were deposited by the Company with governmental authorities or designated custodian banks as required by laws affecting insurance companies. Net investment income from the Company comprised the following:
1997 1996 1995 ----------- -------------- -------------- Fixed income securities................................... $155,810 $139,410 $127,865 Short-term investments.................................... 6,885 8,360 6,116 ----------- ------------- ------------- Total investment income................................ 162,695 147,770 133,981 Investment expense........................................ (2,607) (2,468) (2,485) ----------- ------------- ------------- Net investment income.................................. $160,088 $145,302 $131,496 =========== ============= =============
The Company had gross realized gains of $25,641, $108,916 and $27,786 for 1997, 1996 and 1995, respectively, and gross realized losses of $6,843, $39,767 and $27,609 for 1997, 1996 and 1995, respectively. As of December 31, 1997 and 1996, the Company held securities subject to agreements to resell for $2,484 and $4,369, respectively. Such securities were held as collateral by the Company. The agreements had terms of less than 30 days. 6 AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS) 4 REINSURANCE In the ordinary course of business, Ambac Assurance cedes exposures under various reinsurance contracts primarily designed to minimize losses from large risks and to protect capital and surplus. The effect of reinsurance on premiums written and earned was as follows:
Year Ended December 31, ------------------------------------------------------------------------------------------------------------------ 1997 1996 995 ------------------------------------ ------------------------------------ ---------------------------------- Written Earned Written Earned Written Earned --------------- --------------- --------------- --------------- --------------- --------------- Direct............ $281,034 $177,677 $243,097 $157,551 $192,277 $ 127,322 Assumed........... 8,349 3,614 6,664 3,126 2,756 1,349 Ceded............. (32,452) (25,623) (37,793) (22,380) (28,606) (15,088) --------------- --------------- --------------- --------------- --------------- --------------- Net premiums...... $256,931 $155,668 $211,968 $138,297 $166,427 $ 113,583 =============== =============== =============== =============== =============== ===============
The reinsurance of risk does not relieve the ceding insurer of its original liability to its policyholders. In the event that all or any of the reinsurers are unable to meet their obligations to Ambac Assurance under the existing reinsurance agreements, Ambac Assurance would be liable for such defaulted amounts. To minimize its exposure to significant losses from reinsurer insolvencies, Ambac Assurance evaluates the financial condition of its reinsurers and monitors concentrations of credit risk. There were no reinsurance recoverables on paid losses as of December 31, 1997 and 1996. As of December 31, 1997, prepaid reinsurance of approximately $152,283 was associated with Ambac Assurance's three largest reinsurers. As of December 31, 1997, Ambac Assurance held letters of credit and collateral amounting to approximately $154,387 from its reinsurers to cover liabilities ceded under the aforementioned reinsurance contracts. During 1995, Ambac Assurance terminated reinsurance contracts, resulting in return premiums to Ambac Assurance of $18,141, of which $15,700 was recorded as an increase to the unearned premium reserve, with the remainder recognized as revenue. 7 AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS) 5 LOSSES AND LOSS ADJUSTMENT EXPENSES Ambac Assurance's liability for losses and loss adjustment expenses includes case basis loss and loss adjustment expense reserves and the ACR. Following is a summary of the activity in the case basis loss and loss adjustment expense reserve and ACR accounts and the components of the liability for losses and loss adjustment expenses:
1997 1996 1995 --------------- ---------------- --------------- C> Case basis loss and loss adjustment expense reserves: Balance at January 1................................. $ 22,016 $39,890 $ 39,342 Less reinsurance recoverables...................... 393 641 450 --------------- ---------------- --------------- Net balance at January 1............................. 21,623 39,249 38,892 --------------- ---------------- --------------- Incurred related to: Current year....................................... 212 1,484 750 Prior years........................................ 1,973 (9,556) 2,650 --------------- ---------------- --------------- Total incurred................................... 2,185 (8,072) 3,400 --------------- ---------------- --------------- Paid related to: Current year....................................... 200 150 150 Prior years........................................ 2,274 9,404 2,893 Total paid....................................... 2,474 9,554 3,043 --------------- ---------------- ---------------- Net balance for Connie Lee, at acquisition........... 29,526 - - --------------- ---------------- ---------------- Net balance at December 31........................... 50,860 21,623 39,249 Plus reinsurance recoverables...................... 4,219 393 641 Balance at December 31............................... 55,079 22,016 39,890 --------------- ---------------- ---------------- Active credit reserve: Balance at January 1................................. 38,597 26,747 26,770 Net provision for losses............................. 3,000 5,115 4,097 ACR transfers (to) from case reserves................ (2,331) 6,735 (4,120) Balance for Connie Lee, at acquisition............... 9,000 - - --------------- ---------------- ------------------ Balance at December 31............................... 48,266 38,597 26,747 --------------- ---------------- ------------------ Total............................................ $103,345 $60,613 $ 66,637 =============== ================ ==================
The terms "current year" and "prior years" in the foregoing table refer to the year in which case basis loss reserves were established. 8 AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS) 6 COMMITMENTS AND CONTINGENCIES The Company is responsible for leases on the rental of office space, principally in New York City. In 1997, the Company executed an agreement for additional office space and a lease term extension at its corporate headquarters in New York City. The lease agreements, which expire periodically through September 2019, contain provisions for scheduled periodic rent increases and are accounted for as operating leases. An estimate of future net minimum lease payments in each of the next five years ending December 31, and the periods thereafter, is as follows:
Amount ---------------- 1998.......................... $ 4,621 1999.......................... 5,634 2000.......................... 5,861 2001.......................... 5,087 2002.......................... 5,010 All later years............... 89,902 ---------------- $116,115 ================
Rent expense for the aforementioned leases amounted to $4,210, $3,286 and $2,924 for the years ended December 31, 1997, 1996 and 1995, respectively. 7 INSURANCE REGULATORY RESTRICTIONS Ambac Assurance is subject to insurance regulatory requirements of the States of Wisconsin and New York, and the other jurisdictions in which it is licensed to conduct business. Ambac Assurance's ability to pay dividends is generally restricted by law and subject to approval by the Office of the Commissioner of Insurance of the State of Wisconsin (the "Wisconsin Commissioner"). Wisconsin insurance law restricts the payment of dividends in any 12-month period without regulatory approval to the lesser of (a) 10% of policyholders' surplus as of the preceding December 31 and (b) the greater of (i) statutory net income for the calendar year preceding the date of dividend, minus realized capital gains for that calendar year and (ii) the aggregate of statutory net income for three calendar years preceding the date of the dividend, minus realized capital gains for those calendar years and minus dividends paid or credited within the first two of the three preceding calendar years. Ambac Assurance paid cash dividends of $44,000, $40,000 and $40,000 on its common stock in 1997, 1996 and 1995, respectively. In addition, on April 30, 1996, Ambac Assurance, in conjunction with the sale of the Ambac Financial Group, Inc.'s remaining holdings in HCIA common stock, delivered to Ambac Financial Group, Inc. (in the form of an extraordinary dividend) its 2,378,672 shares of HCIA common stock, at fair value. The Wisconsin Commissioner approved such dividend. Based upon these restrictions, at December 31, 1997, the maximum amount that will be available during 1998 for payment of dividends by Ambac Assurance is approximately $100,700. The New York Financial Guarantee Insurance Law establishes single risk limits applicable to all obligations issued by a single entity and backed by a single revenue source. Under the limit applicable to municipal bonds, the insured average annual debt service for a single risk, net of reinsurance and collateral, may not exceed 10% of qualified statutory capital, which is defined as the sum of insurer's policyholders' 9 AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS) surplus and contingency reserves. In addition, insured principal of municipal bonds attributable to any single risk, net of reinsurance and collateral, is limited to 75% of Ambac Assurance's qualified statutory capital. Additional single risk limits, which generally are more restrictive than the municipal bond single risk limit, are also specified for several other categories of insured obligations. Statutory capital and surplus was $1,006,829 and $899,023 at December 31, 1997 and 1996, respectively. Qualified statutory capital was $1,655,554 and $1,466,560 at December 31, 1997 and 1996, respectively. Statutory net income was $198,615, $222,810 and $142,541 for 1997, 1996 and 1995, respectively. Statutory capital and surplus differs from stockholders' equity determined under GAAP principally due to statutory accounting rules that treat loss reserves, premiums earned, policy acquisition costs, and deferred income taxes differently. 8 INCOME TAXES The total effect of income taxes on income and stockholder's equity for the years ended December 31, 1997 and 1996 was as follows:
1997 1996 ---------- --------- Total income taxes charged to income...................... $67,194 $ 79,620 ----------- --------- Income taxes charged (credited) to stockholder's equity: Unrealized gain (loss) on bonds......................... 28,043 (11,464) Other................................................... (3,995) (2,125) Total charged (credited) to stockholder's equity..... 24,048 (13,589) ----------- --------- Total effect of income taxes.............................. $91,242 $ 66,031 =========== =========
The tax provisions in the accompanying consolidated statements of operations reflect effective tax rates differing from prevailing federal corporate income tax rates. The following is a reconciliation of these differences:
1997 % 1996 % 1995 % --------- -------- ------------ --------- --------------- --------------- Computed expected tax at statutory rate.............. $104,755 35.0% $112,300 35.0% $ 72,920 35.0% Increases (reductions) in expected tax resulting from: Tax-exempt interest.......... (35,458) (11.8) (30,655) (9.6) (28,274) (13.6) Other, net................... (2,103) (0.7) (2,025) (0.6) (1,100) (0.5) --------- --------- ---------- -------- ---------- ----------- Income tax expense $ 67,194 22.5% $ 79,620 24.8% $ 43,546 20.9% ========== ======== ========= ======== ======== ============
10 AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS) The tax effects of temporary differences that give rise to significant portions of the deferred tax liabilities and deferred tax assets at December 31, 1997 and 1996 are presented below:
1997 1996 ------------- -------------- Deferred tax liabilities: Contingency reserve................................ $111,160 $ 76,805 Unrealized gains on bonds.......................... 63,518 35,443 Deferred acquisition costs......................... 38,030 32,974 Unearned premiums.................................. 35,591 27,971 Other.............................................. 2,225 1,389 ---------- ----------- Total deferred tax liabilities..................... 250,524 174,582 ---------- ----------- Deferred tax assets: Tax and loss bonds................................. 87,951 63,871 Loss reserves...................................... 17,231 13,561 Alternative minimum tax credit carryforward........ 10,049 -- Amortization and depreciation...................... 6,556 6,791 Compensation....................................... 3,924 2,721 Investments........................................ -- 1,374 Other.............................................. 2,259 1,422 ---------- -------------- Sub-total deferred tax assets...................... 127,970 89,740 Valuation allowance................................ -- -- ---------- -------------- Total deferred tax assets.......................... 127,970 89,740 ---------- -------------- Net deferred tax liabilities....................... $122,554 $ 84,842 ========== ==============
The Company believes that no valuation allowance is necessary in connection with the deferred tax assets. 9 EMPLOYEE BENEFITS PENSIONS: Ambac Financial Group, Inc. has a defined benefit pension plan covering substantially all employees of the Company and most of its subsidiaries. The benefits are based on years of service and the employee's compensation during the last five years of employment. Ambac Financial Group, Inc.'s funding policy is to contribute annually the maximum amount that can be deducted for federal income tax purposes. Contributions are intended to provide not only for benefits attributed to service-to-date but also for those expected to be earned in the future. The actuarial present value of the benefit obligations shown in the table below sets forth the plan's funded status and amounts recognized by the Ambac Financial Group, Inc. as of December 31, 1997 and 1996. 11 AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS)
1997 1996 --------------- ------------ Accumulated benefit obligation, including vested benefits of $7,192 and $6,282, respectively................... ($7,956) ($6,979) ================ ========== Projected benefit obligation for service rendered to date..... (9,374) (8,189) Plan assets at fair value, primarily listed stocks, commingled funds and fixed income securities.................. 9,644 8,153 ---------------- ---------- Funded/unfunded projected benefit............................. 270 (36) Unrecognized prior service cost............................... (1,454) (1,619) Unrecognized net loss......................................... 62 885 Unrecognized net transition asset............................. (7) (9) ---------------- ---------- Pension liability included in other liabilities............... ($1,129) ($779) ================ ==========
Net pension costs for 1997, 1996 and 1995 included the following components:
1997 1996 1995 ------------- ----------- ------------ Service cost................................................... $ 723 $ 674 $ 541 Interest cost on expected benefit obligation................... 601 539 456 Actual return on plan assets................................... (1,606) (957) (1,333) Net amortization and deferral.................................. 770 263 760 ------------- ----------- ------------ Net periodic pension cost...................................... $ 488 $ 519 $ 424 ============= =========== ============
The weighted average discount rate used in the determination of the actuarial present value for the projected benefit obligation was 7.25% and 7.50% for 1997 and 1996, respectively. The expected long-term rate of return on assets was 9.25% for both 1997 and 1996. The rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation was 4.8 % and 5.0% for 1997 and 1996, respectively. Upon the acquisition of CLIC, Ambac Financial Group, Inc. assumed the liability for its two terminated pension plans. Those plans had an unfunded projected obligation of approximately $800, which is included in other liabilities at December 31, 1997. Substantially all employees of Ambac Financial Group, Inc. and its subsidiaries are covered by a defined contribution plan (the "Savings Incentive Plan"), for which contributions and costs are determined as 6% of each eligible employee's base salary, plus a matching company contribution of 50% on contributions up to 6% of base salary, subject to Internal Revenue Code limitations, made by eligible employees to the plan. The total cost of the Savings Incentive Plan to Ambac Assurance was $1,417, $1,494 and $1,435 in 1997, 1996 and 1995, respectively. ANNUAL INCENTIVE PROGRAM: Ambac Financial Group, Inc. has an annual incentive program which provides for awards to key officers and employees based upon predetermined criteria. The cost of the program for the years ended December 31, 1997, 1996 and 1995 amounted to $9,429, $7,641 and $7,669, respectively. POSTRETIREMENT HEALTH CARE AND OTHER BENEFITS: Ambac Assurance provides certain medical and life insurance benefits for retired employees and eligible dependents. All plans are contributory. None of the plans are currently funded. 12 AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS) Postretirement benefits expense was $230, $220 and $168 in 1997, 1996 and 1995, respectively. The unfunded accumulated postretirement benefit obligation was $2,064 and the accrued postretirement liability was $1,719 as of December 31, 1997. The assumed weighted average health care cost trend rates range from 9.0% in 1997, decreasing ratably to 6.0% in 2002, and remaining at that level thereafter. Increasing the assumed health care cost trend rate by one percentage point in each future year would increase the accumulated postretirement benefit obligation at December 31, 1997 by $172 and the 1997 benefit expense by $48. The weighted average discount rate used to measure the accumulated postretirement benefit obligation and 1997 expense was 7.25%. 10 INSURANCE IN FORCE The par amount of bonds insured, for non-affiliates, net of reinsurance, was $165,601,000 and $131,497,000 at December 31, 1997 and 1996, respectively. As of December 31, 1997 and 1996, the insured portfolio was diversified by type of insured bond as shown in the following table:
Net Par Amount Outstanding ------------------------------ (Dollars in Millions) 1997 1996 ------------------------------ Municipal finance: General obligation.......................... $ 36,324 $ 31,863 Lease and tax-backed revenue................ 30,980 25,366 Utility revenue............................. 24,913 22,780 Health care revenue......................... 18,545 13,521 Transportation revenue...................... 7,370 6,891 Higher education............................ 6,852 4,745 Investor-owned utilities.................... 6,255 5,492 Housing revenue............................. 6,064 4,497 Student loans............................... 3,516 3,439 Other....................................... 597 484 ------------------------------ Total municipal finance.................. 141,416 119,078 ------------------------------ Domestic structured finance: Mortgage-backed and home equity.......... 11,620 5,263 Commercial asset-backed.................. 4,538 1,329 Other consumer asset-backed.............. 1,514 1,126 Banks/financial institutions............. 524 214 Other.................................... 439 159 ------------------------------ Total domestic structured finance........ 18,635 8,091 ------------------------------ Total domestic........................... 160,051 127,169 ------------------------------ International finance: Commercial asset-backed.................. 2,600 2,530 Sovereign/sub-sovereign.................. 981 631 Mortgage-backed and home equity.......... 496 265 Utilities................................ 456 131 Banks/financial institutions............. 283 346 Other.................................... 734 425 ------------------------------ Total international finance.............. 5,550 4,328 ------------------------------ $165,601 $131,497 ==============================
13 AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS) As of December 31, 1997 and 1996, the international insured portfolio by geographic area is shown in the following table:
Net Par Amount Outstanding ----------------------------------- (Dollars in Millions) 1997 1996 ---------------- --------------- International: France.............................. $1,032 $1,025 Japan............................... 879 645 United Kingdom...................... 865 569 Italy............................... 555 423 Spain............................... 380 130 Internationally diversified............ 899 985 Other international.................... 940 551 ---------------- --------------- $5,550 $4,328 ================ ===============
As of December 31, 1997, California was the state with the highest aggregate net par amount in force, accounting for 11.8% of the total. The highest single insured risk represented less than 1% of aggregate net par amount insured. Direct insurance in force (principal and interest) was $321,104,000 and $268,870,000 at December 31, 1997 and 1996, respectively. Net insurance in force (after giving effect to reinsurance) was $275,931,000 and $227,235,000 as of December 31, 1997 and 1996, respectively. 11 FINANCIAL INSTRUMENTS HELD FOR PURPOSES OTHER THAN TRADING Fair values of financial instruments held for purposes other than trading: The following fair value amounts were determined by the Company using independent market information when available, and appropriate valuation methodologies when market quotes were not available. In cases where specific market quotes are unavailable, interpreting market data and estimating market values require considerable judgment by management. Accordingly, the estimates presented are not necessarily indicative of the amount the Company could realize in a current market exchange. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Investments: The fair values of fixed income investments are based on quoted market prices or dealer quotes. Short-term investments and cash: The fair values of short-term investments and cash are assumed to equal amortized cost. Securities purchased under agreements to resell: The fair value of securities purchased under agreements to resell is assumed to approximate carrying value. Derivative contracts: Fair values of derivative contracts (futures, swaps and interest rate options) are based on quoted market prices and dealer quotes, current settlement values, or pricing models. Liability for net financial guarantees written: The fair value of the liability for those financial guarantees written related to new issue and secondary market exposures is based on the estimated cost to 14 AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS) reinsure those exposures at current market rates, which amount consists of the current unearned premium reserve, less an estimated ceding commission thereon. Certain other financial guarantee insurance policies have been written on an installment basis, where the future premiums to be received by the Company are determined based on the outstanding exposure at the time the premiums are due. The fair value of Ambac Assurance's liability under its installment premium policies is measured using the present value of estimated future installment premiums, less an assumed ceding commission. The estimate of the amounts and timing of the future installment premiums is based on contractual premium rates, debt service schedules and expected run-off scenarios. This measure is used as an estimate of the cost to reinsure Ambac Assurance's liability under these policies. The carrying amount and estimated fair value of these financial instruments are presented below:
As of December 31, ----------------------------------------------------------------------------------- 1997 1996 ----------------------------------------- ------------------------------------- (Dollars in Millions) Carrying Estimated Fair Carrying Amount Estimated Fair Amount Value Value ---------------- ------------------- ------------------- -------------- Financial assets: Investments................................ $2,878 $2,878 $2,425 $2,425 Short-term investments..................... 117 117 91 91 Cash....................................... 8 8 5 5 Securities purchased under agreements to resell.................................... 2 2 4 4 Liability for financial guarantees written: Gross.................................... 1,185 855 995 719 Net of reinsurance....................... 1,002 722 826 596 Net installment premiums................. -- 153 -- 114
12 FINANCIAL INSTRUMENTS HELD FOR TRADING PURPOSES The Company, through its affiliate AFS is a provider of interest rate swaps to states, municipalities and their authorities and other entities in connection with their financings. AFS manages its business with the goal of being market neutral to changes in overall interest rates, while retaining basis risk, the relationship between changes in floating tax-exempt and floating taxable interest rates. If actual or projected floating tax-exempt interest rates change in relation to floating taxable rates, the Company will experience an unrealized mark-to-market gain or loss. The AFS swap portfolio is considered held for trading purposes. In the ordinary course of business, AFS manages a variety of risks, principally market, credit, liquidity, operational, and legal. These risks are identified, measured and monitored through a variety of control mechanisms, which are in place at different levels throughout the organization. Market risk relates to the impact of price changes on future earnings. This risk is a consequence of AFS's market-making activities in the interest rate swap market. The principal market risk is basis risk, the 15 AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS) relationship between changes in floating tax-exempt and floating taxable interest rates. Since late 1995, most interest rate swaps transacted contain provisions which are designed to protect AFS against certain forms of tax reform, thus mitigating its basis risk. An independent risk management group monitors trading risk limits and, together with senior management, is involved in the application of risk measurement methodologies. Credit risk relates to the ability of counterparties to perform according to the terms of their contractual commitments. Credit risk is calculated based on the current replacement cost or fair value of the Company's financial instruments. The gross replacement of the Company's financial instruments held for trading purposes is the positive fair value of all transactions with a counterparty, excluding the effects of netting or collateral arrangements and was approximately $72,000 and $47,000 as of December 31, 1997 and 1996, respectively. The estimation of potential losses arising from adverse changes in market relationships, known as "value-at-risk," is a key element in managing market risk. The Company has developed a value-at-risk methodology to estimate potential losses over a specified holding period and based on certain probabilistic assessments. The Company estimates value-at-risk utilizing historical short and long-term interest rate volatilities and the relationship between changes in tax-exempt and taxable interest rates calculated on a consistent daily basis. For the years ended December 31, 1997 and 1996, the Company's value-at-risk, for financial instruments considered held for trading purposes, calculated at a ninety-nine percent confidence level, averaged approximately $1,600 and $1,400, respectively. The Company's value-at-risk ranged from a high of $2,600 to a low of $900 in 1997, and from a high of $2,600 to a low of $1,100 in 1996. Since no single measure can capture all dimensions of market risk, the Company supplements its value-at-risk methodology by performing daily analyses of parallel and non-parallel shifts in yield curves and stress test scenarios which measure the potential impact of market conditions, however improbable, which might cause abnormal volatility swings or disruptions of market relationships. Liquidity risk relates to the possible inability to satisfy contractual obligations when due. This risk is present in swaps and in futures contracts used to hedge swaps. The Company manages liquidity risk by maintaining cash and cash equivalents, closely matching the dates swap payments are made and received, and limiting the amount of risk hedged by futures contracts. The following table summarizes information about the Company's financial instruments held for trading purposes as of December 31, 1997 and 1996:
Net Estimated Fair Value Average Net Fair Value ---------------------------- --------------------------- Notional Assets Liabilities Assets Liabilities Amount ---------------------------- ---------------------------------------------- 1997: Derivative financial instruments: Interest rate swaps............... $ 71,505 $ 49,772 $ 47,276 $ 34,768 $4,174,160 Futures contracts................. -- -- -- -- 514,900 Other financial instruments........... 183,041 181,732 160,251 159,213 -- 1996: Derivative financial instruments: Interest rate swaps............... $ 45,990 $ 33,650 $ 48,734 $ 41,445 $2,856,600 Futures contracts................. -- -- -- -- 484,500 Other financial instruments........... -- -- -- -- --
16 AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS) Financial instruments held for trading purposes are carried at estimated fair value. The aggregate amount of net trading income recognized from derivative financial instruments held for trading purposes was $8,560, $10,799 and $2,602 for 1997, 1996 and 1995, respectively. Other financial instruments held for trading purposes consist of fixed income securities. The aggregate amount of net trading income recognized from other financial instruments was $1,309 for 1997. Average net fair values were calculated based on average daily net fair values. Notional principal amounts are often used to express the volume of these transactions and do not reflect the extent to which positions may offset one another. These amounts do not represent the much smaller amounts potentially subject to risk. 13 LINES OF CREDIT Ambac Financial Group, Inc. and Ambac Assurance maintain a three-year revolving credit facility with two major international banks, as co-agents, for $100,000. As of December 31, 1997 and 1996, no amounts were outstanding under this credit facility, which expires in July 1998. Ambac Assurance has an agreement with a group of AAA/Aaa-rated international banks for a $450,000 credit facility, expiring in 2004. This facility is a seven-year stand-by irrevocable limited recourse line of credit, which was increased from $350,000 to $450,000 and extended for an additional year in December 1997. The line will provide liquidity to Ambac Assurance in the event claims from municipal obligations exceed specified levels. Repayment of any amounts drawn under the line will be limited primarily to the amount of any recoveries of losses related to policy obligations. As of December 31, 1997 and 1996, no amounts were outstanding under this line. Connie Lee has an agreement with commercial banks for a $50,000 stand-by credit facility, expiring in 2003. The line will provide a source of additional claims-paying resources for insured transactions. The obligation to repay is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations including installment premiums and other collateral. As of December 31, 1997 and 1996, no amounts were outstanding under this line. 14 RELATED PARTY TRANSACTIONS During 1997 and 1996, Ambac Assurance guaranteed the timely payment of principal and interest on obligations under investment agreements and investment repurchase agreements issued by its affiliates. As of December 31, 1997 and 1996, the aggregate amount of investment agreements and investment repurchase agreements insured was $3,856,786 and $2,744,283, respectively, including accrued interest. These insurance policies are collateralized by investment securities, accrued interest, securities purchased under agreements to resell and cash and cash equivalents, which as of December 31, 1997 and 1996 had a fair value of $3,936,718 and $2,775,250, respectively, in the aggregate. During 1997 and 1996, Ambac Assurance recorded gross premiums written of $3,220 and $2,553, and net premiums earned of $1,668 and $1,668, respectively, related to these agreements. During 1997 and 1996, several interest rate swap transactions were executed between AFS and its affiliates (other than Ambac Assurance). As of December 31, 1997 and 1996, these contracts had an outstanding notional amount of approximately $827,000 and $515,000, respectively. As of December 31, 1997 and 1996, AFS recorded a positive fair value of $3,762 and $3,503, respectively, related to these transactions. 17 -----END PRIVACY-ENHANCED MESSAGE-----