7. FINANCIAL GUARANTEE INSURANCE CONTRACTS

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

Net Premiums Earned:

Gross premiums are received either upfront (typical of public finance obligations) or in installments (typical of structured finance obligations). For premiums received upfront, an unearned premium revenue (“UPR”) liability is established, which is initially recorded as the cash amount received. For installment premium transactions, a premium receivable asset and offsetting UPR liability is initially established in an amount equal to: (i) the present value of future contractual premiums due (the “contractual” method) or, (ii) if the underlying insured obligation is a homogenous pool of assets which are contractually prepayable, the present value of premiums to be collected over the expected life of the transaction (the “expected” method). An appropriate risk-free rate corresponding to the weighted average life of each policy and currency is used to discount the future premiums contractually due or expected to be collected. For example, U.S. dollar exposures are discounted using U.S. Treasury rates while exposures denominated in a foreign currency are discounted using the appropriate risk-free rate for the respective currency. The weighted average risk-free rate at September 30, 2013 and December 31, 2012, was 2.9% and 2.6%, respectively, and the weighted average period of future premiums used to estimate the premium receivable at September 30, 2013 and December 31, 2012, was 10.1 years and 9.6 years, respectively.

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

Generally, the priority for the payment of financial guarantee premiums to Ambac, as required by the bond indentures of the insured obligations, is very senior in the waterfall. Additionally, in connection with the allocation of certain liabilities to the Segregated Account, trustees are required under the Segregated Account Rehabilitation Plan and related court orders to continue to pay installment premiums, notwithstanding the Segregated Account Rehabilitation Proceedings. In evaluating the credit quality of the premium receivables, management evaluates the transaction waterfall structures and the internal ratings of the transactions underlying the premium receivables. As of September 30, 2013 and December 31, 2012, approximately 45% of the premium receivables related to transactions with non-investment grade internal ratings, comprised mainly of non-investment grade RMBS, student loan transactions and a certain asset-backed transaction, which comprised 7%, 7%, and 16% of the total premium receivables at September 30, 2013 and 7%, 9% and 15% of the total premium receivables at December 31, 2012, respectively. At September 30, 2013 and December 31, 2012, $14,800 and $118,961, respectively, of premium receivables were deemed uncollectable. The transaction that had an uncollectable premium receivable at December 31, 2012 was consolidated on April 30, 2013. Past due premiums on policies insuring non-investment grade obligations amounted to less than $500 at September 30, 2013.

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


	Successor Ambac			Predecessor Ambac
	Period from May 1 through September 30, 2013			Period from January 1 through April 30, 2013			Period from January 1 through December 31, 2012
Beginning premium receivable	$	1,531,631		$	1,620,621		$	2,028,479
Premium payments received		(49,940	)		(48,296	)		(155,626	)
Adjustments for changes in expected life of homogeneous pools and actual changes to contractual cash flows		(70,900	)		(28,237	)		(299,906	)
Accretion of premium receivable discount		17,232			14,740			50,407
Uncollectible premiums		(14,800	)		(634	)		(28,031	)
Other adjustments (including foreign exchange)		22,787			(26,563	)		25,298

Ending premium receivable	$	1,436,010		$	1,531,631		$	1,620,621

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

When a bond issue insured by Ambac Assurance has been retired, including those retirements due to refundings or calls, any remaining UPR is recognized at that time to the extent the financial guarantee contract is legally extinguished, causing accelerated premium revenue. For installment premium paying transactions, we offset the recognition of any remaining UPR by the reduction of the related premium receivable to zero (as it will not be collected as a result of the retirement), which may cause negative accelerated premium revenue. Successor Ambac’s accelerated premium revenue for retired obligations for the three and five months ended September 30, 2013 was $19,698 and $32,747, respectively. Predecessor Ambac’s accelerated premium revenue for retired obligations for the four months ended April 30, 2013 and the three and nine months ended September 30, 2012, respectively were $36,433, $34,381 and $86,037. Certain obligations insured by Ambac have been legally defeased whereby government securities are purchased by the issuer with the proceeds of a new bond issuance, or less frequently with other funds of the issuer, and held in escrow (a pre-refunding). The principal and interest received from the escrowed securities are then used to retire the Ambac-insured obligations at a future date either to their maturity date or a specified call date. Ambac has evaluated the provisions in certain financial guarantee insurance policies issued on legally defeased obligations and determined those insurance policies have not been legally extinguished and, therefore, premium revenue recognition has not been accelerated.

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


	Successor Ambac					Predecessor Ambac
	Three months ended September 30, 2013					Three Months Ended September 30, 2012
	Written			Earned		Written			Earned
Direct	($	34,380	)	$	73,997	($	55,310	)	$	117,864
Assumed		—			24		—			25
Ceded		(4,017	)		3,072		(2,082	)		4,815

Net premiums	($	30,363	)	$	70,949	($	53,228	)	$	113,074


	Successor Ambac					Predecessor Ambac
	Five Months Ended September 30, 2013					Four Months Ended April 30, 2013					Nine Months Ended September 30, 2012
	Written			Earned		Written			Earned		Written			Earned
Direct	($	68,461	)	$	136,029	($	14,125	)	$	138,468	($	175,777	)	$	323,658
Assumed		—			40		—			32		—			118
Ceded		(7,055	)		7,081		(1,098	)		8,500		(18,055	)		12,710

Net premiums	($	61,406	)	$	128,988	($	13,027	)	$	130,000	($	157,722	)	$	311,066

The table below summarizes the future gross undiscounted premiums expected to be collected, and future expected premiums earned, net of reinsurance by Successor Ambac at September 30, 2013:


	Future premiums expected to be collected ⁽¹⁾		Future expected premiums to be earned, net of reinsurance ⁽¹⁾
Three months ended:
December 31, 2013	$	33,020	$	51,560

Twelve months ended:
December 31, 2014		125,309		186,459
December 31, 2015		125,159		167,106
December 31, 2016		118,632		154,135
December 31, 2017		112,526		143,323

Five years ended:
December 31, 2022		497,121		591,581
December 31, 2027		392,615		414,028
December 31, 2032		277,704		257,483
December 31, 2037		131,553		124,457
December 31, 2042		48,449		42,002
December 31, 2047		14,564		14,429
December 31, 2052		3,639		4,692
December 31, 2057		92		296

Total	$	1,880,383	$	2,151,551

(1)

The future premiums expected to be collected and future premiums expected to be earned, net of reinsurance disclosed in the above table relate to the discounted premium receivable asset and unearned premium liability recorded on Ambac’s balance sheet. The use of contractual lives for many bond types which do not have homogeneous pools of underlying collateral is required in the calculation of the premium receivable as described above, which results in a higher premium receivable balance than if expected lives were considered. If installment paying policies are retired early premiums reflected in the premium receivable asset and amounts reported in the above table for such policies may not be collected in the future.

Loss and Loss Expense Reserves:

A loss reserve is recorded on the balance sheet on a policy-by-policy basis for the excess of: (a) the present value of expected net cash flows required to be paid under an insurance contract, over (b) the UPR for that contract. Below is the loss reserve roll-forward, net of subrogation recoverable and reinsurance, for the affected periods:


	Successor Ambac			Predecessor Ambac
	Period from May 1 through September 30, 2013			Period from January 1 through April 30, 2013			Period from January 1 through December 31, 2012
Beginning balance of loss and loss expense reserves, net of subrogation recoverable and reinsurance	$	5,434,517		$	5,974,731		$	6,230,780

Changes in the loss and loss expense reserves due to:
Current year:
Establishment of new loss and loss expense reserves, gross of RMBS subrogation and net of reinsurance		47,838			2,748			464,058
Claim and loss expense payments, net of subrogation and reinsurance		(163	)		(58	)		(20,765	)
Establishment of RMBS subrogation recoveries, net of reinsurance		(315	)		(159	)		—

Total current year		47,360			2,531			443,293


Prior years:
Change in previously established loss and loss expense reserves, gross of RMBS subrogation and net of reinsurance		(322,165	)		(52,642	)		72,700
Claim and loss (payments) recoveries, net of subrogation and reinsurance		(2,376	)		20,902			(944,860	)
Change in previously established RMBS subrogation recoveries, net of reinsurance		119,294			(12,596	)		172,818

Total prior years		(205,247	)		(44,336	)		(699,342	)

Net change in loss and loss expense reserves		(157,887	)		(41,805	)		(256,049	)
Net consolidation of certain VIE’s		—			(498,409	)		—

Ending loss and loss expense reserves, net of subrogation recoverable and reinsurance	$	5,276,630		$	5,434,517		$	5,974,731

The positive development in loss reserves established in prior years for the five months ended September 30, 2013, was primarily due to improved performance of the student loan and RMBS portfolios.

The adverse development in loss reserves established in prior years for the year ended December 31, 2012 was primarily due to projected deterioration of collateral supporting structured finance policies, including RMBS and student loan exposures, which resulted in greater expected ultimate losses and lower expected subrogation recoveries related to representation and warranty breaches on insured RMBS securitizations.

The net change in net loss and loss expense reserves are included in losses and loss expenses in the Consolidated Statement of Total Comprehensive Income. Loss expense reserves are established for surveillance, legal and other mitigation expenses associated with adversely classified credits. Total net loss expense reserves, included in the above table, were $125,341 and $136,790 at September 30, 2013 and December 31, 2012, respectively. For Successor Ambac, reinsurance recoveries of losses included in losses and loss expenses in the Consolidated Statements of Total Comprehensive Income were ($17,418) and ($12,355) for the three and five months ended September 30, 2013, respectively. For Predecessor Ambac, reinsurance recoveries of losses included in losses and loss expenses in the Consolidated Statements of Total Comprehensive Income were $3,889 for the four months ended April 30, 2013, and $5,502 and $27,354 for the three months and nine months ended September 30, 2012, respectively.

The tables below summarize information related to policies currently included in Ambac’s loss reserves or subrogation recoverable at September 30, 2013 and December 31, 2012. The weighted average risk-free rate used to discount loss reserves at September 30, 2013 and December 31, 2012 was 2.9% and 1.6%, respectively.

Successor Ambac – Surveillance Categories (at September 30, 2013)


	I/SL			IA			II			III			IV			V			Total
Number of policies		18			43			27			76			144			1			309
Remaining weighted-average contract period (in years)		13			16			19			18			10			6			13
Gross insured contractual payments outstanding:
Principal	$	849,629		$	2,185,961		$	2,112,936		$	5,676,583		$	11,491,293		$	47		$	22,316,449
Interest		531,290			1,736,991			653,033			2,360,215			2,406,091			18			7,687,638

Total	$	1,380,919		$	3,922,952		$	2,765,969		$	8,036,798		$	13,897,384		$	65		$	30,004,087

Gross undiscounted claim liability	$	8,053		$	82,907		$	112,807		$	2,857,566		$	8,072,462		$	65		$	11,133,860
Discount, gross claim liability		(1,157	)		(8,757	)		(19,038	)		(1,143,340	)		(1,068,635	)		(4	)		(2,240,931	)

Gross claim liability before all subrogation and before reinsurance	$	6,896		$	74,150		$	93,769		$	1,714,226		$	7,003,827		$	61		$	8,892,929

Less:
Gross RMBS subrogation⁽¹⁾		—			—			—			(5,139	)		(2,366,105	)		—			(2,371,244	)
Discount, RMBS subrogation		—			—			—			14			9,374			—			9,388

Discounted RMBS subrogation, before reinsurance		—			—			—			(5,125	)		(2,356,731	)		—			(2,361,856	)

Less:
Gross other subrogation⁽²⁾		—			—			(17,834	)		(106,799	)		(717,871	)		—			(842,504	)
Discount, other subrogation		—			—			7,868			30,060			38,522			—			76,450

Discounted other subrogation, before reinsurance		—			—			(9,966	)		(76,739	)		(679,349	)		—			(766,054	)

Gross claim liability, net of all subrogation and discounts, before reinsurance	$	6,896		$	74,150		$	83,803		$	1,632,362		$	3,967,747		$	61		$	5,765,019

Less: Unearned premium reserves		(4,306	)		(43,904	)		(61,877	)		(282,949	)		(98,255	)		—			(491,291	)
Plus: Loss adjustment expenses reserves		—			86			1,778			2,469			121,994			—			126,327

Claim liability reported on Balance Sheet, before reinsurance⁽³⁾	$	2,590		$	30,332		$	23,704		$	1,351,882		$	3,991,486		$	61		$	5,400,055

Reinsurance recoverable reported on Balance Sheet	$	182		$	2,699		$	2,742		$	118,493		$	13,284		$	—		$	137,400

(1)	RMBS subrogation represents Ambac’s estimate of subrogation recoveries from RMBS transaction sponsors for representation and warranty breaches.

(2)	Other subrogation represents subrogation, including subrogation from RMBS transactions, other than subrogation as defined in (1) above.

(3)	Claim liability reported on the Balance Sheet, before reinsurance is included in the Consolidated Balance Sheets as follows:


Losses and loss expense reserve (net of potential subrogation recoveries of $1,971,883)	$	5,884,660
Subrogation recoverable (includes gross potential recovery of $1,156,027)		(484,605	)

	$	5,400,055

Predecessor Ambac – Surveillance Categories (at December 31, 2012)


	I/SL			IA			II			III			IV			V			Total
Number of policies		14			12			28			114			147			1			316
Remaining weighted-average contract period (in years)		15			21			18			20			8			6			13
Gross insured contractual payments outstanding:
Principal	$	311,157		$	786,998		$	1,245,793		$	9,161,747		$	12,554,628		$	47		$	24,060,370
Interest		166,276			715,129			379,237			4,905,775			3,076,746			20			9,243,183

Total	$	477,433		$	1,502,127		$	1,625,030		$	14,067,522		$	15,631,374		$	67		$	33,303,553

Gross undiscounted claim liability	$	2,135		$	40,898		$	49,521		$	4,051,076		$	7,976,765		$	67		$	12,120,462
Discount, gross claim liability		(219	)		(3,532	)		(3,247	)		(1,342,910	)		(788,720	)		(3	)		(2,138,631	)

Gross claim liability before all subrogation and before reinsurance	$	1,916		$	37,366		$	46,274		$	2,708,166		$	7,188,045		$	64		$	9,981,831

Less:
Gross RMBS subrogation⁽¹⁾		—			—			—			(16,170	)		(2,544,993	)		—			(2,561,163	)
Discount, RMBS subrogation		—			—			—			312			37,626			—			37,938

Discounted RMBS subrogation, before reinsurance		—			—			—			(15,858	)		(2,507,367	)		—			(2,523,225	)

Less:
Gross other subrogation⁽²⁾		—			—			—			(141,012	)		(766,717	)		—			(907,729	)
Discount, other subrogation		—			—			—			21,238			15,711			—			36,949

Discounted other subrogation, before reinsurance		—			—			—			(119,774	)		(751,006	)		—			(870,780	)

Gross claim liability, net of all subrogation and discounts, before reinsurance	$	1,916		$	37,366		$	46,274		$	2,572,534		$	3,929,672		$	64		$	6,587,826

Less: Unearned premium reserves		(1,179	)		(21,626	)		(17,120	)		(450,247	)		(113,622	)		—			(603,794	)
Plus: Loss adjustment expenses reserves	$	—		$	—		$	—		$	—		$	138,108		$	—		$	138,108

Claim liability reported on Balance Sheet, before reinsurance⁽³⁾	$	737		$	15,740		$	29,154		$	2,122,287		$	3,954,158		$	64		$	6,122,140

Reinsurance recoverable reported on Balance Sheet	$	—		$	1,078		$	7,085		$	128,333		$	22,590		$	—		$	159,086

(1)	RMBS subrogation represents Ambac’s estimate of subrogation recoveries from RMBS transaction sponsors for representation and warranty breaches.

(2)	Other subrogation represents subrogation, including subrogation from RMBS transactions, other than subrogation as defined in (1) above.

(3)	Claim liability reported on the Balance Sheet, before reinsurance is included in the Consolidated Balance Sheets as follows:


Losses and loss expense reserve (net of potential subrogation recoveries of $2,611,430)	$	6,619,486
Subrogation recoverable (includes gross potential recovery of $782,575)		(497,346	)

	$	6,122,140

Losses and loss expense reserves ceded to reinsurers at September 30, 2013 and December 31, 2012 were $123,425 and $147,409, respectively. Amounts were included in reinsurance recoverable on paid and unpaid losses on the Consolidated Balance Sheets.

Ambac records estimated subrogation recoveries for breaches of representations and warranties by sponsors of certain RMBS transactions utilizing an Adverse and Random Sample approach. Ambac has recorded RMBS subrogation recoveries of $2,361,856 ($2,336,676 net of reinsurance) and $2,523,225 ($2,497,233 net of reinsurance) at September 30, 2013 and December 31, 2012, respectively. The balance of RMBS subrogation recoveries and the related claim liabilities, by estimation approach, at September 30, 2013 and December 31, 2012, are as follows:


	Successor Ambac – September 30, 2013
Approach	Count		Gross loss reserve before subrogation recoveries		Subrogation recoveries^{(1) (2)}			Gross loss reserve after subrogation recoveries
Adverse samples		27	$	2,235,026	$	(1,404,088	)	$	830,938
Random samples		21		1,096,081		(957,768	)		138,313

Totals		48	$	3,331,107	$	(2,361,856	)	$	969,251


	Predecessor Ambac – December 31, 2012
Approach	Count		Gross loss reserve before subrogation recoveries		Subrogation recoveries ^{(1) (2)}			Gross loss reserve after subrogation recoveries
Adverse samples		27	$	2,331,878	$	(1,442,817	)	$	889,061
Random samples		22		1,231,466		(1,080,408	)		151,058

Totals		49	$	3,563,344	$	(2,523,225	)	$	1,040,119

(1)

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

(2)

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

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


	Random sample			Number of transactions			Adverse sample			Number of transactions			Total
Successor Ambac:
Discounted RMBS subrogation (gross of reinsurance) at May 1, 2013	$	1,004,252			20		$	1,478,666			29			2,482,918

Changes recognized through September 30, 2013:
Additional transactions reviewed		2,426			1			—			n/a			2,426
Additional adverse sample loans reviewed		—			n/a			—			n/a			—
Impact of sponsor actions ⁽¹⁾		—			n/a			—			n/a			—
All other changes ⁽²⁾		(48,910	)		n/a			(74,578	)		(2	)		(123,488	)

Discounted RMBS subrogation (gross of reinsurance) at September 30, 2013	$	957,768			21		$	1,404,088			27		$	2,361,856


Predecessor Ambac
Discounted RMBS subrogation (gross of reinsurance) at December 31, 2012	$	1,080,408			22		$	1,442,817			27		$	2,523,225

Changes recognized through April 30, 2013:
Additional transactions reviewed		—			n/a			—			n/a			—
Additional adverse sample loans reviewed		—			n/a			—			n/a			—
Impact of sponsor actions ⁽¹⁾		(54,195	)		n/a			—			n/a			(54,195	)
All other changes ⁽²⁾		(21,961	)		(2	)		35,849			2			13,888

Discounted RMBS subrogation (gross of reinsurance) at April 30, 2013	$	1,004,252			20		$	1,478,666			29		$	2,482,918


	Random sample			Number of transactions		Adverse sample			Number of transactions			Total
Predecessor Ambac:
Rollforward:
Discounted RMBS subrogation (gross of reinsurance) at January 1, 2012	$	1,262,794			16	$	1,457,472			30		$	2,720,266

Changes recognized in 2012: Additional transactions reviewed		54,467			6		(35,486	)		(1	)		18,981
Additional adverse sample loans reviewed		—			n/a		—			—			—
Adverse loans repurchased by the sponsor		—			n/a		35			—			35
All other changes ⁽¹⁾		(236,853	)		n/a		20,796			(2	)		(216,057	)

Discounted RMBS subrogation (gross of reinsurance) at December 31, 2012	$	1,080,408			22	$	1,442,817			27		$	2,523,225

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

(2)

Other changes which may impact RMBS subrogation recoveries include changes in actual or projected collateral performance, changes in the creditworthiness of a sponsor, and/or the projected timing of recoveries. For the five months ended September 30, 2013, Successor Ambac added 1 transaction to the Random Sample subrogation population and removed 2 transactions from the Adverse Sample subrogation population; however, the impacts on RMBS subrogation disclosed in the Random Sample column relate to that, as well as other transactions. For the four months ended April 30, 2013, Predecessor Ambac transferred 2 transactions from the Random Sample population to the Adverse Sample population; however, the impacts on RMBS subrogation disclosed in the Adverse Sample column relate to those, as well as other transactions.

Insurance intangible asset:

At the Fresh Start Reporting Date, an insurance intangible asset was recorded which represented the difference between the fair value and aggregate carrying value of the insurance and reinsurance assets and liabilities. The insurance intangible asset is amortized using the level yield method based on par exposure of the related financial guarantee insurance or reinsurance contracts. The weighted-average amortization period at Fresh Start Reporting Date was 9.4 years.

The insurance intangible amortization expense for the five months ended September 30, 2013 was $62,425, and is included in insurance intangible amortization on the Consolidated Statements of Total Comprehensive Income. As of September 30, 2013, the insurance intangible asset of $1,620,952 is net of accumulated amortization of $63,006.

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


2013	$	36,308
2014		130,324
2015		116,926
2016		107,120
2017		99,300
Thereafter		1,130,974