Ambac Financial Group, Inc. — Q1 2020 Form 10-Q Summary
Filing and period: Quarterly report for the three months ended March 31, 2020, filed May 11, 2020. The supplied request identifies “OCTAVE SPECIALTY GROUP INC,” but the filing itself is for Ambac Financial Group, Inc. and its subsidiaries.
Business context
Ambac is a financial services holding company whose principal insurance subsidiaries, Ambac Assurance Corporation and Ambac Assurance UK Limited, are financial guarantee insurers in run-off. The company is focused on reducing insured exposures through commutations, restructurings, reinsurance and other remediation, managing invested assets and liquidity, pursuing recoveries, rationalizing capital and liabilities, and evaluating selective new-business opportunities.
The unaudited consolidated statements were prepared under U.S. GAAP. Results for the quarter may not be indicative of full-year 2020 results. COVID-19 materially increased uncertainty across the insured portfolio, investment portfolio and capital markets.
Key financial metrics
| Metric | Q1 2020 | Q1 2019 / Year-end 2019 |
|---|---|---|
| Net premiums earned | $10 million | $28 million |
| Net investment income (loss) | $(21) million | $55 million |
| Net realized investment gains | $8 million | $17 million |
| Net gains (losses) on derivatives | $(70) million | $(16) million |
| Losses and loss expenses | $117 million | $12 million |
| Operating expenses | $24 million | $25 million |
| Interest expense | $63 million | $68 million |
| Net loss attributable to common stockholders | $(280) million | $(43) million |
| Basic and diluted loss per share | $(6.07) | $(0.94) |
| Total assets | $12.777 billion | $13.320 billion at December 31, 2019 |
| Total liabilities | $11.716 billion | $11.783 billion at December 31, 2019 |
| Total stockholders’ equity | $1.062 billion | $1.536 billion at December 31, 2019 |
| Long-term debt | $2.760 billion | $2.822 billion at December 31, 2019 |
| Cash, cash equivalents and restricted cash | $91 million | $81 million at January 1, 2020 |
Comprehensive loss attributable to common stockholders was $470 million, including $191 million of other comprehensive loss. The principal components were $146 million of unrealized investment losses and $46 million of foreign-currency translation losses.
Cash flow from operating activities was $(87) million, cash flow from investing activities was $244 million and cash flow from financing activities was $(146) million, producing net cash flow of $10 million. Financing outflows included a $77 million paydown of the Ambac Note and $66 million of consolidated VIE debt payments.
Reported GAAP margins are not meaningful for this run-off financial guarantee business, and the filing does not provide a conventional operating-margin measure.
Material changes versus the comparable period and prior year-end
- Net loss widened to $280 million from $43 million, primarily because of investment losses, larger derivative losses, higher insurance losses, lower premium earnings and lower VIE income.
- Net investment income declined by $76 million, driven mainly by COVID-19-related fair-value losses in pooled funds and other investments, a smaller invested-asset base and lower income from Ambac-insured securities.
- Derivative losses increased by $54 million, primarily because of sharp declines in forward interest rates and a $30 million counterparty credit adjustment.
- Losses and loss expenses increased by $105 million. Domestic public finance incurred $178 million of losses, while RMBS produced an $83 million benefit, student loans incurred $14 million and Ambac UK and other credits incurred $7 million.
- Loss and loss expense reserves increased to $1.797 billion from $1.548 billion. Net loss reserves after subrogation recoverables and before reinsurance improved from $(482) million to $(395) million, reflecting higher estimated recoveries.
- Total insured net par outstanding declined 5% to $36.186 billion from $38.018 billion. Adversely classified credits increased 11% to $8.376 billion, while watch-list credits declined 19% to $5.442 billion.
- Stockholders’ equity declined $474 million, primarily because of the $470 million comprehensive loss.
- Long-term debt declined by $62 million, primarily due to the $77 million Ambac Note paydown, partly offset by debt accretion.
- AFG completed a January commutation of a public finance transaction with $171 million of prior year-end net par exposure and a February refinancing of an asset-backed leasing transaction with $86 million of prior year-end net par exposure.
Liquidity, capital and debt
- AFG reported net assets of $482 million, including $317 million of cash and short-term investments. Management expects AFG’s near-term liquidity to come primarily from cash and investments, expense-sharing payments and potential future tax-sharing payments; dividends from Ambac Assurance are considered highly unlikely for the foreseeable future.
- Ambac Assurance’s statutory policyholder surplus was $930 million at March 31, 2020, down from $1.088 billion at year-end 2019. Qualified statutory capital was $1.465 billion, down from $1.618 billion.
- OCI declined Ambac Assurance’s request to pay surplus-note principal and accrued interest on the scheduled June 7, 2020 maturity date. Payment is deferred until OCI approval, and unpaid amounts continue to accrue interest at 5.1% per annum.
- Ambac UK had a £94 million deficit against applicable Solvency II capital requirements at March 31, 2020, compared with a £30 million deficit at year-end 2019. Management continued discussions with regulators, but identified few options to address the shortfall.
- Derivative-related collateral and margin posted totaled $165 million at quarter-end. Ratings-based collateral and termination triggers had been activated on applicable contracts.
Guidance, outlook, management commentary and risks
The filing provides no formal earnings or revenue guidance. Management’s COVID-19 base case assumed a deep recession in the first half of 2020 followed by a modest recovery in the second half, but emphasized that actual results could differ materially.
- COVID-19 increased expected credit losses and reserve requirements across public finance, mortgage-backed securities, student loans and other structured finance exposures. Management stated that reserves may be understated if the pandemic is deeper or longer than assumed.
- Public finance exposures most sensitive to COVID-19 included hotels and convention centers, stadiums, airports, dedicated-tax obligations, higher education, mass transit and toll roads. Total net par exposure in these identified sectors was $2.722 billion, with $485.7 million of debt service due over the following twelve months.
- Puerto Rico remained a major risk, with $1.105 billion of net par exposure. During the quarter, Ambac incurred $178 million of domestic public finance losses, primarily related to Puerto Rico, lower discount rates and COVID-19 uncertainty.
- For public finance credits with estimated expected losses, management estimated a possible additional reserve increase of approximately $1.220 billion under stress. Such an increase would reduce stockholders’ equity from $1.062 billion to approximately negative $158 million; losses could exceed this estimate.
- Recorded RMBS representation-and-warranty subrogation recoveries were $1.764 billion gross, or approximately $1.738 billion net of reinsurance. These recoveries depend on litigation, counterparties’ ability to pay, regulatory approvals and uncertain timing.
- Management sold a material portion of certain investment classes in early April, including below-“A” corporate securities, directly owned CMBS other than certain military-housing bonds and approximately 50% of CLOs. The filing states these positions were sold at a net gain, but future investment losses remain possible.
- The company’s insured portfolio, investment valuations, derivative collateral requirements, reinsurance recoveries and litigation outcomes remain highly sensitive to interest rates, credit spreads, foreign exchange rates, market liquidity and counterparty credit quality.
- Major legal and regulatory matters include Puerto Rico restructuring and claim litigation, RMBS recovery actions, student-loan-related proceedings and disputes concerning insured revenue bonds. The filing states that potential adverse outcomes could materially affect results, liquidity and financial condition.
- Management reported that disclosure controls and procedures were effective as of March 31, 2020, with no material change in internal control over financial reporting despite remote work arrangements.
Important facts for investors to verify
- Whether COVID-19-related claims and reserve increases exceed the company’s recorded assumptions, particularly the stated $1.220 billion public-finance stress estimate.
- The ultimate treatment and recovery values for Ambac’s $1.105 billion Puerto Rico net par exposure and the progress of related restructuring litigation and plans of adjustment.
- Whether the approximately $1.738 billion of net RMBS representation-and-warranty recoveries are collectible and realized on the assumed timing.
- Ambac UK’s plan for addressing its £94 million Solvency II capital deficit and any resulting regulatory restrictions.
- The timing and approval of surplus-note payments, including the June 7, 2020 scheduled payment that OCI declined to authorize.
- Liquidity requirements arising from insurance claims, derivative collateral, debt service and possible counterparty terminations.
- The valuation and liquidity of Level 3 assets, pooled funds and other investments affected by the COVID-19 market disruption.
- Reconciliations between GAAP net loss and non-GAAP adjusted earnings, which was $(265) million, and adjusted book value, which was $1.012 billion at March 31, 2020.