Ambac Financial Group, Inc. — Second-Quarter 2018 Form 10-Q
Reporting period: Three and six months ended June 30, 2018. The supplied filing is for Ambac Financial Group, Inc., not Octave Specialty Group Inc. Financial statements are unaudited and prepared under U.S. GAAP.
Business context
Ambac is a financial-services holding company whose principal subsidiaries provide financial guarantee insurance and related financial products. The insurance portfolio has been in runoff since 2007, and the company has not written new insurance business since 2008. Key activities include liability runoff, commutations and restructurings, investment management, litigation-based loss recovery, and capital-structure rationalization.
On February 12, 2018, Ambac completed the exit of the Segregated Account from rehabilitation. The transactions discharged approximately $3.857 billion of Deferred Amounts, cancelled certain surplus notes, issued secured and Tier 2 notes, and materially changed the company’s assets, liabilities, liquidity and earnings profile.
Key financial metrics
| Metric | Three months ended June 30 | Six months ended June 30 |
|---|---|---|
| Net premiums earned | $25.8 million vs. $43.2 million | $56.7 million vs. $90.8 million |
| Net investment income | $66.7 million vs. $85.2 million | $176.9 million vs. $166.7 million |
| Total revenues | $150.6 million vs. $173.1 million | $324.7 million vs. $299.5 million |
| Losses and loss expenses | $32.6 million vs. $66.1 million | Benefit of $214.8 million vs. expense of $201.1 million |
| Interest expense | $62.4 million vs. $28.2 million | $110.5 million vs. $59.8 million |
| Net income attributable to common stockholders | $4.3 million, or $0.09 diluted EPS, vs. $7.1 million, or $0.16 | $310.0 million, or $6.73 diluted EPS, vs. $(118.3) million, or $(2.61) |
| Total comprehensive income attributable to common stockholders | $(49.3) million vs. $48.7 million | $411.0 million vs. $(40.5) million |
The six-month net income benefit was primarily driven by the rehabilitation-exit transactions, including a $288.2 million benefit recognized in loss and loss expenses, higher investment income and realized investment gains. The quarter remained profitable but was affected by lower premiums and investment income and substantially higher interest expense.
Balance sheet, liquidity and debt
- Total assets were $21.535 billion at June 30, 2018, down from $23.192 billion at December 31, 2017.
- Total liabilities were $19.471 billion, down from $21.547 billion. Total stockholders’ equity increased to $2.064 billion from $1.645 billion.
- Cash and cash equivalents were $44.4 million, compared with $623.7 million at year-end. Cash, cash equivalents and restricted cash totaled $45.5 million.
- Non-VIE investments were $4.387 billion, including $3.515 billion of fixed-income securities, $393.4 million of short-term investments and $394.4 million of other investments.
- Consolidated long-term debt was $2.796 billion, up from $991.7 million. The increase primarily reflected the $2.039 billion Ambac Note and $239.7 million of Tier 2 Notes issued in connection with the rehabilitation exit, partly offset by surplus-note reductions and repayment of the $74.0 million secured borrowing.
- Six-month operating cash flow was $(1.312) billion, investing cash flow was $1.015 billion, financing cash flow was $(282.5) million, and net cash flow was $(579.2) million. The operating outflow included approximately $1.162 billion related to rehabilitation-exit payments.
- Ambac’s standalone liquidity consisted principally of approximately $270 million of cash and liquid investments, including $120 million of secured notes, plus investments in Ambac Assurance surplus notes and the Corolla Trust.
Material changes versus prior comparable periods
- The runoff portfolio reduced net premiums earned by $17.3 million in the quarter and $34.0 million year to date.
- Loss and loss expenses improved substantially year to date, primarily because of the $288.2 million rehabilitation-exit discount benefit and settlement of Deferred Amounts. The quarter still included $32.6 million of losses and expenses.
- Interest expense increased by $34.2 million in the quarter and $50.7 million year to date because of the new Ambac Note and Tier 2 Notes.
- Net realized investment gains increased to $47.1 million in the quarter and $52.0 million year to date, compared with $4.2 million and a $0.7 million loss, respectively, in the prior periods.
- Total insured net par exposure declined to $56.5 billion from $62.7 billion, while adversely classified credits declined to approximately $11.8 billion from $14.1 billion.
- Loss and loss expense reserves, net of subrogation recoverables and before reinsurance, declined to $181 million from $4.114 billion, largely because of the rehabilitation-exit settlement. The company recorded $1.876 billion of subrogation recoverable, including $1.816 billion of estimated representation-and-warranty recoveries.
Outlook, risks and unusual items
Management continues to prioritize active runoff, risk reduction, litigation recoveries, investment returns, capital and liability management, and evaluation of adjacent business opportunities. No quantitative earnings guidance was provided.
- Puerto Rico: Ambac had approximately $1.968 billion of Puerto Rico net par exposure. PROMESA Title III proceedings, fiscal-plan changes, litigation, political and economic conditions, and hurricane-related recovery uncertainty could produce losses materially above current reserves.
- Reserve and recovery uncertainty: Management estimated potential adverse reserve increases of approximately $1.27 billion for public-finance credits, approximately $30 million for RMBS expected-loss credits excluding recovery failure, approximately $95 million for student loans, and approximately $195 million for other credits including Ambac UK. Failure to realize the $1.816 billion of recorded gross representation-and-warranty recoveries could materially affect liquidity and capital.
- Regulatory constraints: Ambac Assurance dividend payments and surplus-note principal and interest payments require regulatory approval. Dividend payments to Ambac are considered highly unlikely for the foreseeable future.
- Ambac UK: At March 31, 2018, the latest available Solvency II information showed a £301 million regulatory capital deficiency. Management was in discussions with regulators, and available options were described as limited.
- AMPS Exchange: After quarter-end, on August 3, 2018, Ambac exchanged 84.4% of outstanding AMPS for surplus notes, cash and warrants. The transaction reduced the AMPS liquidation preference by approximately $557.4 million and was expected to reduce third-quarter net income attributable to common stockholders by approximately $83 million.
- Litigation: A military-housing settlement produced an approximately $20.4 million second-quarter loss. Significant Puerto Rico, RMBS, U.S. Bank and other litigation remained unresolved.
- Market risk: The company remains exposed to interest rates, credit spreads, foreign currency, collateral requirements and fair-value volatility. A 100-basis-point increase in interest rates was estimated to increase net fair value by approximately $99 million, while a 100-basis-point decline was estimated to reduce it by approximately $103 million.
Most important facts for investors to verify
- Confirm the issuer identity: the filing text is for Ambac Financial Group, Inc., despite the request metadata naming Octave Specialty Group Inc.
- Reconcile the reported six-month $310.0 million net income with the $288.2 million rehabilitation-exit benefit and other nonrecurring gains.
- Assess the liquidity impact of the $579.2 million six-month cash decline, the company’s low standalone cash balance and restricted access to subsidiary dividends.
- Evaluate the collectability and timing of the $1.816 billion representation-and-warranty recovery asset and the related litigation outcomes.
- Review Puerto Rico exposure, reserve sensitivity and the potential for losses exceeding the company’s approximately $1.27 billion public-finance stress estimate.
- Verify the terms and accounting impact of the August 3, 2018 AMPS Exchange, including the expected approximately $83 million third-quarter charge and warrant dilution.
- Monitor Ambac UK’s regulatory capital deficiency, Ambac Assurance regulatory payment restrictions, debt-service obligations and refinancing capacity.