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Losses And Loss Expenses | 9 Months Ended
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Sep. 30, 2011
Losses And Loss Expenses [Abstract] |
Losses And Loss Expenses | (6) Losses and Loss Expenses Ambac's financial guarantee insurance policies generally pay scheduled interest and principal if the issuer of the insured obligation fails to meet its obligation. The loss and loss expense reserve ("loss reserve") policy for financial guarantee insurance discussed in this footnote relates only to Ambac's non-derivative insurance business. The policy for derivative contracts is discussed in "Derivative Contracts" in Note 7. 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 outflows to be paid under an insurance contract (i.e., the expected loss) over (b) the UPR for that contract. To the extent (a) is less than (b), no loss reserve is recorded. Changes to the loss reserve in subsequent periods are recorded as a loss and loss expense on the income statement. Expected losses are based upon estimates of the ultimate aggregate losses inherent in the non-derivative financial guarantee portfolio as of the reporting date. The evaluation process for determining expected losses is subject to certain estimates and judgments based on our assumptions regarding the probability of default and expected severity of credits, including our active surveillance of the insured book of business and observation of deterioration in the obligor's performance and credit standing. Ambac's loss reserves are based on management's on-going review of the non-derivative financial guarantee credit portfolio. Active surveillance of the insured portfolio enables Ambac's surveillance group to track credit migration of insured obligations from period to period and update internal classifications and credit ratings for each transaction. Non-adversely classified credits are assigned a Class I or Survey List ("SL") rating while adversely classified credits are assigned a rating of Class IA through Class V. The criteria for an exposure to be assigned an adversely classified credit rating includes the deterioration of an issuer's financial condition, underperformance of the underlying collateral (for collateral dependent transactions such as mortgage-backed securitizations), poor performance by the servicer of the underlying collateral and other adverse economic events or trends. The servicer of the underlying collateral of an insured securitization transaction is a consideration in assessing credit quality because the servicer's performance can directly impact the performance of the related issue. For example, a servicer of a mortgage-backed securitization that does not remain current in its collection loss mitigation efforts could cause an increase in the delinquency and potential default of the underlying obligation. Similarly, loss severities increase when a servicer does not effectively handle loss mitigation activities such as (i) the advancing of delinquent principal and interest and of default related expenses which are deemed to be recoverable by the servicer, (ii) pursuit of loan charge-offs which maximize cash flows from the mortgage loan pool, and (iii) foreclosure and real estate owned disposition strategies and timelines. As a consequence of the Segregated Account Rehabilitation Proceedings, the Rehabilitator retains operational control and decision-making authority with respect to all matters related to the Segregated Account, including surveillance, remediation and loss mitigation. Similarly, by virtue of the contracts executed between Ambac Assurance and the Segregated Account in connection with the establishment, and subsequent rehabilitation, of the Segregated Account, the Rehabilitator retains the discretion to oversee and approve certain actions taken by Ambac Assurance in respect of assets and liabilities which remain in Ambac Assurance. As such, the following discussion of Ambac's risk management practices is qualified by reference to the Rehabilitator's exercise of its discretion to alter or eliminate any of these risk management practices. All credits are assigned risk classifications by the Surveillance Group using the following guidelines: CLASS I – "Fully Performing – Meets Ambac Criteria with Remote Probability of Claim" Credits that demonstrate adequate security and structural protection with a strong capacity to pay interest, repay principal and perform as underwritten. Factors supporting debt service payment and performance are considered unlikely to change and any such change would not have a negative impact upon the fundamental credit quality. SURVEY LIST (SL) – "Investigation of Specific Condition or Weakness Underway" Credits that require additional analysis to determine if adverse classification is warranted. These credits may lack information or demonstrate a weakness but further deterioration is not expected. CLASS IA – "Potential Problem with Risks to be Dimensioned" Credits that are fully current and monetary default or claims-payment are not anticipated. The payor's or issuer's financial condition may be deteriorating or the credits may lack adequate collateral. A structured financing may also evidence weakness in its fundamental credit quality as evidenced by its under-performance relative to its modeled projections at underwriting, issues related to the servicer's ability to perform, or questions about the structural integrity of the transaction. While these credits may still retain an investment grade rating, they usually have experienced or are vulnerable to a ratings downgrade. Further investigation is required to dimension and correct any deficiencies. A complete legal review of documents may be required. An action plan should be developed with triggers for future classification changes upward or downward. CLASS II – "Substandard Requiring Intervention" Credits whose fundamental credit quality has deteriorated to the point that timely payment of debt service may be jeopardized by adversely developing trends of a financial, economic, structural, managerial or political nature. No claim payment is currently foreseen but the probability of loss or claim payment over the life of the transaction is now existent (10% or greater probability). Class II credits may be borderline or below investment grade (BBB- to B). Prompt and sustained action must be taken to execute a comprehensive loss mitigation plan and correct deficiencies. CLASS III – "Doubtful with Clear Potential for Loss" Credits whose fundamental credit quality has deteriorated to the point that timely payment of debt service has been or will be jeopardized by adverse trends of a financial, economic, structural, managerial or political nature which, in the absence of positive change or corrective action, are likely to result in a loss. The probability of monetary default or claims paying over the life of the transaction is 50% or greater. Full exercise of all available remedial actions is required to avert or minimize losses. Class III credits will generally be rated below investment grade (B to CCC). CLASS IV – "Imminent Default or Defaulted" Monetary default or claims payment has occurred or is expected imminently. Class IV credits are generally rated D. CLASS V – "Fully Reserved" The credit has defaulted and payments have occurred. The claim payments are scheduled and known, reserves have been established to fully cover such claims, and no claim volatility is expected. The population of credits evaluated in Ambac's loss reserve process are: i) all adversely classified credits (Class IA through V) and ii) non-adversely classified credits (Class I and SL) which had an internal Ambac rating downgrade since the transaction's inception. One of two approaches is then utilized to estimate expected losses to ultimately determine if a loss reserve should be established. The first approach is a statistical expected loss approach, which considers the likelihood of all possible outcomes. The "base case" statistical expected loss is the product of: (i) the net par outstanding on the credit; (ii) internally developed historical default information (taking into consideration internal ratings and average life of an obligation); (iii) internally developed loss severities; and (iv) a discount factor. The loss severities and default information are based on rating agency information, are specific to each bond type and are established and approved by Ambac's senior risk management professionals and other senior management. For certain credit exposures, Ambac's additional monitoring and loss remediation efforts may provide information relevant to adjust this estimate of "base case" statistical expected losses. As such, loss severities used in estimating the "base case" statistical expected losses may be adjusted based on the professional judgment of the surveillance analyst monitoring the credit with the approval of senior management. Analysts may accept the "base case" statistical expected loss as the best estimate of expected loss or assign multiple probability weighted severities to determine an adjusted statistical expected loss that better reflects a given transaction's potential severity. The second approach entails the use of estimates of expected net cash outflows (future claim payments, net of potential recoveries, expected to be paid to the holder of the insured financial obligation). Ambac's surveillance group will consider the likelihood of all possible outcomes and develop cash flow scenarios. This approach can include the utilization of market accepted software tools to develop net claim payment estimates. We have utilized such tools primarily for residential mortgage-backed and student loans exposures. These tools, in conjunction with detailed data of the historical performance of the collateral pools, assist Ambac in the determination of certain assumptions, such as home price and interest rate forecasts, and default and voluntary prepayment rates, which are needed in order to estimate expected future net cash outflows associated with the credit. In this approach a probability-weighted expected loss estimate is developed based on assigning probabilities to multiple net cashflow scenarios and applying an appropriate discount factor. Probabilities assigned are based on all known data related to the credit, any contact with the issuer or investors, and any economic or market information that may impact the possibilities of the various scenarios being evaluated. For a limited number of policies, certain net cash outflow scenarios incorporate various remediation strategies. These remediation scenarios may include: 1) a potential refinancing of the transaction by the issuer; (2) the issuer's ability to redeem outstanding insured bonds at a discount, thereby increasing equity in the deal to absorb future losses; and (3) Ambac's ability to terminate the policy in whole or in part (a "commutation"). The remediation scenarios and the related probabilities of occurrence vary by transaction depending on on-going discussions and negotiations that are underway with issuers and/or investors. In addition to commutation negotiations that are underway with certain counterparties in various forms, our loss reserve estimates may include net cash outflow scenarios that incorporate our ability to commute additional exposure with other counterparties under similar terms where we deem such expectations to be reasonably possible based on historical results. For certain policies, estimated potential recoveries exceed estimated future claim payments because all or a portion of such recoveries relate to claims previously paid. The expected net cash inflows for these policies are recorded as a subrogation recoverable asset. The discount factor applied to both of the above described approaches is based on a risk-free discount rate corresponding to the remaining expected weighted-average life of the exposure and the exposure currency. The discount factor is updated for the current risk-free rate each reporting period. The weighted average risk-free rate used to discount the loss reserves at September 30, 2011 and December 31, 2010 was 1.9% and 3.0%, respectively. The tables below summarize information related to policies currently included in Ambac's loss reserves at September 30, 2011 and December 31, 2010: Surveillance Categories (at September 30, 2011)
|  | I/SL |  |  | IA |  |  | II |  |  | III |  |  | IV |  |  | V |  |  | Total |
Number of policies |  |  | 34 |  |  |  | 11 |  |  |  | 40 |  |  |  | 128 |  |  |  | 154 |  |  |  | 1 |  |  |  | 368 |
Remaining weighted-average contract period (in years) |  |  | 7 |  |  |  | 13 |  |  |  | 17 |  |  |  | 19 |  |  |  | 10 |  |  |  | 10 |  |  |  | 14 |
Gross insured contractual payments outstanding: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Principal |  |  | 819,328 |  |  |  | 257,124 |  |  |  | 2,162,057 |  |  |  | 14,568,739 |  |  |  | 14,236,146 |  |  |  | 47 |  |  |  | 32,043,441 |
Interest |  |  | 298,170 |  |  |  | 99,619 |  |  |  | 1,077,190 |  |  |  | 10,768,818 |  |  |  | 3,896,118 |  |  |  | 29 |  |  |  | 16,139,944 |
Total |  |  | 1,117,498 |  |  |  | 356,743 |  |  |  | 3,239,247 |  |  |  | 25,337,557 |  |  |  | 18,132,264 |  |  |  | 74 |  |  |  | 48,183,384 |
Gross undiscounted claim liability |  |  | 12,925 |  |  |  | 9,090 |  |  |  | 89,501 |  |  |  | 3,890,440 |  |  |  | 7,751,226 |  |  |  | 75 |  |  |  | 11,753,257 |
Discount, gross claim liability |  |  | (640 | ) |  |  | (2,415 | ) |  |  | (26,453 | ) |  |  | (1,139,896 | ) |  |  | (868,307 | ) |  |  | (20 | ) |  |  | (2,037,731 | )
Gross discounted claim liability before all subrogation and before reinsurance |  |  | 12,285 |  |  |  | 6,675 |  |  |  | 63,048 |  |  |  | 2,750,544 |  |  |  | 6,882,919 |  |  |  | 55 |  |  |  | 9,715,526 |
Less: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Gross RMBS subrogation(1) |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (158,813 | ) |  |  | (2,489,294 | ) |  |  | — |  |  |  | (2,648,107 | )
Discount, RMBS subrogation |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 5,696 |  |  |  | 44,157 |  |  |  | — |  |  |  | 49,853 |
Discounted RMBS subrogation, before reinsurance |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (153,117 | ) |  |  | (2,445,137 | ) |  |  | — |  |  |  | (2,598,254 | )
Less: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Gross other subrogation(2) |  |  | — |  |  |  | (229 | ) |  |  | (1 | ) |  |  | (119,885 | ) |  |  | (1,022,823 | ) |  |  | — |  |  |  | (1,142,938 | )
Discount, other subrogation |  |  | — |  |  |  | 78 |  |  |  | — |  |  |  | 22,504 |  |  |  | 35,212 |  |  |  | — |  |  |  | 57,794 |
Discounted other subrogation, before reinsurance |  |  | — |  |  |  | (151 | ) |  |  | (1 | ) |  |  | (97,381 | ) |  |  | (987,611 | ) |  |  | — |  |  |  | (1,085,144 | )
Gross discounted claim liability, net of all subrogation, before reinsurance |  |  | 12,285 |  |  |  | 6,524 |  |  |  | 63,047 |  |  |  | 2,500,046 |  |  |  | 3,450,171 |  |  |  | 55 |  |  |  | 6,032,128 |
Less: Unearned premium reserves |  |  | (4,071 | ) |  |  | (1,803 | ) |  |  | (24,680 | ) |  |  | (278,884 | ) |  |  | (184,736 | ) |  |  | — |  |  |  | (494,174 | )
Plus: Loss adjustment expenses reserves |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 93,728 |  |  |  | — |  |  |  | 93,728 |
Discounted claim liability reported on Balance Sheet, before reinsurance(3) |  |  | 8,214 |  |  |  | 4,721 |  |  |  | 38,367 |  |  |  | 2,221,162 |  |  |  | 3,359,163 |  |  |  | 55 |  |  |  | 5,631,682 |
Reinsurance recoverable reported on Balance Sheet |  |  | 976 |  |  |  | 18 |  |  |  | 5,718 |  |  |  | 130,057 |  |  |  | 8,932 |  |  |  | — |  |  |  | 145,701 |
(1) | RMBS subrogation represents Ambac's estimate of subrogation recoveries from RMBS transaction sponsors for representations and warranty breaches. Please see "Representation and Warranty Breaches by RMBS Transaction Sponsors" below for detailed discussion.
(2) | Other subrogation represents subrogation other than subrogation as defined in (1) above.
(3) | Claim liability reported is included in the Consolidated Balance Sheets as follows:
Loss and loss expense reserve (net of potential remediation subrogation of $1,052,295) |  | $ | 6,359,409 |
Subrogation recoverable (includes potential remediation of $1,545,959) |  |  | (714,496 | )
Other assets (within) |  |  | (13,231 | )
|  | $ | 5,631,682 |
Surveillance Categories (at December 31, 2010)
|  | I/SL |  |  | IA |  |  | II |  |  | III |  |  | IV |  |  | V |  |  | Total |
Number of policies |  |  | 24 |  |  |  | 4 |  |  |  | 34 |  |  |  | 118 |  |  |  | 127 |  |  |  | 1 |  |  |  | 308 |
Remaining weighted-average contract period (in years) |  |  | 5 |  |  |  | 9 |  |  |  | 17 |  |  |  | 19 |  |  |  | 9 |  |  |  | 10 |  |  |  | 14 |
Gross insured contractual payments outstanding: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Principal |  | $ | 1,831,525 |  |  | $ | 198,460 |  |  | $ | 2,620,973 |  |  | $ | 17,723,814 |  |  | $ | 13,766,322 |  |  | $ | 47 |  |  | $ | 36,141,141 |
Interest |  |  | 392,486 |  |  |  | 58,317 |  |  |  | 1,983,875 |  |  |  | 10,609,295 |  |  |  | 3,327,242 |  |  |  | 27 |  |  |  | 16,371,242 |
Total |  | $ | 2,224,011 |  |  | $ | 256,777 |  |  | $ | 4,604,848 |  |  | $ | 28,333,109 |  |  | $ | 17,093,564 |  |  | $ | 74 |  |  | $ | 52,512,383 |
Gross undiscounted claim liability |  | $ | 19,664 |  |  | $ | 9,952 |  |  | $ | 62,469 |  |  | $ | 4,195,891 |  |  | $ | 7,197,833 |  |  | $ | 75 |  |  | $ | 11,485,884 |
Discount, gross claim liability |  |  | (925 | ) |  |  | (4,700 | ) |  |  | 13,974 |  |  |  | (1,517,671 | ) |  |  | (1,234,704 | ) |  |  | (20 | ) |  |  | (2,744,046 | )
Gross discounted claim liability before all subrogation and before reinsurance |  | $ | 18,739 |  |  | $ | 5,252 |  |  | $ | 76,443 |  |  | $ | 2,678,220 |  |  | $ | 5,963,129 |  |  | $ | 55 |  |  | $ | 8,741,838 |
Less: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Gross RMBS subrogation(1) |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (2,514,477 | ) |  |  | — |  |  |  | (2,514,477 | )
Discount, RMBS subrogation |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 97,371 |  |  |  | — |  |  |  | 97,371 |
Discounted RMBS subrogation, before reinsurance |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (2,417,106 | ) |  |  | — |  |  |  | (2,417,106 | )
Less: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Gross other subrogation(2) |  |  | — |  |  |  | — |  |  |  | (11 | ) |  |  | (629,022 | ) |  |  | (1,033,055 | ) |  |  | — |  |  |  | (1,662,088 | )
Discount, other subrogation |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 207,811 |  |  |  | 89,166 |  |  |  | — |  |  |  | 296,977 |
Discounted other subrogation, before reinsurance |  |  | — |  |  |  | — |  |  |  | (11 | ) |  |  | (421,211 | ) |  |  | (943,889 | ) |  |  | — |  |  |  | (1,365,111 | )
Gross discounted claim liability, net of all subrogation, before reinsurance |  |  | 18,739 |  |  |  | 5,252 |  |  |  | 76,432 |  |  |  | 2,257,009 |  |  |  | 2,602,134 |  |  |  | 55 |  |  |  | 4,959,621 |
Less: Unearned premium reserves |  |  | (9,095 | ) |  |  | (3,959 | ) |  |  | (49,782 | ) |  |  | (289,408 | ) |  |  | (149,235 | ) |  |  | — |  |  |  | (501,479 | )
Plus: Loss adjustment expenses reserves |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 9,762 |  |  |  | 85,495 |  |  |  | — |  |  |  | 95,257 |
Discounted claim liability reported on Balance Sheet, before reinsurance(3) |  |  | 9,644 |  |  |  | 1,293 |  |  |  | 26,650 |  |  |  | 1,977,363 |  |  |  | 2,538,394 |  |  |  | 55 |  |  |  | 4,553,399 |
Reinsurance recoverable reported on Balance Sheet |  |  | 542 |  |  |  | 8 |  |  |  | 1,588 |  |  |  | 107,920 |  |  |  | 26,928 |  |  |  | — |  |  |  | 136,986 |
(1) | RMBS subrogation represents Ambac's estimate of subrogation recoveries from RMBS transaction sponsors for representations and warranty breaches. Please see "Representation and Warranty Breaches by RMBS Transaction Sponsors" below for detailed discussion.
(2) | Other subrogation represents subrogation other than subrogation as defined in (1) above.
(3) | Claim liability reported is included in the Consolidated Balance Sheets as follows:
Loss and loss expense reserve (net of potential remediation subrogation of $714,679) |  | $ | 5,288,655 |
Subrogation recoverable (includes potential remediation of $1,702,427) |  |  | (714,270 | )
Other assets (within) |  |  | (20,986 | )
|  | $ | 4,553,399 |
Loss expense reserves were also established for significant surveillance and mitigation expenses associated with adversely classified credits. Total loss expense reserves, net of reinsurance, were $92,169 and $93,900 at September 30, 2011 and December 31, 2010, respectively. Loss reserves ceded to reinsurers at September 30, 2011 and December 31, 2010 were $149,089 and $128,993, respectively. Amounts were included in reinsurance recoverable on paid and unpaid losses on the Consolidated Balance Sheet. Below is the loss reserve roll-forward, net of subrogation recoverable and reinsurance for the nine months ended September 30, 2011 and the year ended December 31, 2010:
|  | Nine months Ended September 30, 2011 |  |  | Year Ended December 31, 2010 |
Loss reserves at December 31, net of RMBS subrogation recoverable and reinsurance |  |  |  |  |  | $ | 3,777,321 |
Impact of adopting ASU 2009-17 |  |  |  |  |  |  | (503,887 | )
Beginning balance of net loss reserves, net of RMBS subrogation recoverable and reinsurance |  |  | 4,424,450 |  |  |  | 3,273,434 |
Changes in the loss reserves due to: |  |  |  |  |  |  |  |
Current year: |  |  |  |  |  |  |  |
Establishment of new loss reserves, gross of RMBS subrogation and net of reinsurance |  |  | 203,474 |  |  |  | 266,913 |
Claim (payments) recoveries, net of reinsurance |  |  | 4,722 |  |  |  | (874 | )
Establishment of RMBS subrogation recoveries, net of reinsurance |  |  | (215,433 | ) |  |  | (342,979 | )
Total current year |  |  | (7,237 | ) |  |  | (76,940 | )
Prior year: |  |  |  |  |  |  |  |
Change in previously established loss reserves, gross of RMBS subrogation and net of reinsurance |  |  | 1,027,863 |  |  |  | 822,848 |
Change in previously established RMBS subrogation recoveries, net of reinsurance |  |  | 36,531 |  |  |  | (26,864 | )
Claim payments, net of RMBS subrogation recoverable and reinsurance |  |  | 43,718 |  |  |  | (244,661 | )
Total prior year |  |  | 1,108,112 |  |  |  | 551,323 |
Changes in loss reserves |  |  | 1,100,875 |  |  |  | 474,383 |
Deconsolidation of certain VIEs under ASU 2009-17 |  |  | (39,345 | ) |  |  | 676,633 |
Ending loss reserves, net of subrogation recoverable and reinsurance |  | $ | 5,485,980 |  |  | $ | 4,424,450 |
Representation and Warranty Breaches by RMBS Transaction Sponsors: In an effort to better understand the unprecedented levels of delinquencies, Ambac or its counsel engaged consultants with significant mortgage underwriting experience to review the underwriting documentation for mortgage loans underlying certain insured RMBS transactions. Transactions which exhibited exceptionally poor performance were chosen for further examination of the underwriting documentation supporting the underlying loans. Factors which Ambac believes to be indicative of poor performance include (i) increased levels of early payment defaults, (ii) significant number of loan liquidations or charge-offs and resulting high levels of losses, and (iii) rapid elimination of credit protections inherent in the transactions' structures. With respect to item (ii), "loan liquidations" refers to loans for which the servicer has liquidated the related collateral and the securitization has realized losses on the loan; "charge-offs" refers to loans which have been written off as uncollectible by the servicer, thereby generating no recoveries to the securitization, and may also refer to the unrecovered balance of liquidated loans. In either case, the servicer has taken such actions to recover against the collateral, and the securitization has incurred losses to the extent such actions did not result in full repayment of the borrower's obligations. Generally, the sponsor of the transaction provided representations and warranties with respect to the securitized loans, including the loan characteristics, the absence of fraud or other misconduct in the origination process, and attesting to the compliance of loans with the prevailing underwriting policies. Per the underlying transaction documents, the sponsor of the transaction is contractually obligated to repurchase, cure or substitute collateral for any loan that breaches the representations and warranties. Subsequent to the forensic exercise of examining loan files to ascertain whether the loans conformed to the representations and warranties, we submit nonconforming loans to the sponsor for repurchase. To effect a repurchase, depending on the transaction, the sponsor is obligated to repurchase the loan at (a) for loans which have not been liquidated or charged off, either (i) the current unpaid principal balance of the loan, (ii) the current unpaid principal balance plus accrued unpaid interest, or (iii) the current unpaid principal balance plus accrued interest plus unreimbursed servicer advances/expenses and/or trustee expenses resulting from the breach of representations and warranties that trigger the repurchase, and (b) for a loan that has already been liquidated or charged-off, the amount of the realized loss (which in certain cases may exclude accrued unpaid interest). Notwithstanding the material breaches of representations and warranties, until the establishment of the Segregated Account and the associated Segregated Account Rehabilitation Proceedings, Ambac continued to pay claims submitted under the financial guarantee insurance policies related to these securitizations and will resume paying such claims in accordance with the Segregated Account Rehabilitation Plan after such plan is effective. In cases where loans are repurchased by a sponsor, the effect is typically to offset current period losses and then to increase the over-collateralization of the securitization, depending on the extent of loan repurchases and the structure of the securitization. Specifically, the repurchase price is paid by the sponsor to the securitization trust which holds the loan. The cash becomes an asset of the trust, replacing the loan that was repurchased by the sponsor. On a monthly basis the cash received related to loan repurchases by the sponsor is aggregated with cash collections from the underlying mortgages and applied in accordance with the trust indenture payment waterfall. This payment waterfall typically includes principal and interest payments to the note holders, various expenses of the trust and reimbursements to Ambac, as financial guarantor, for claim payments made in previous months. Notwithstanding the reimbursement of previous monthly claim payments, to the extent there continues to be insufficient cash in the waterfall in the current month to make scheduled principal and interest payments to the note holders, Ambac is required to make additional claim payments to cover this shortfall. Ambac's estimate of subrogation recoveries includes two components: (1) estimated dollar amounts of loans with material breaches of representations and warranties based on an extrapolation of the breach rate identified in a random sample of loans taken from the entire population of loans in a securitization ("random sample approach"); and (2) dollar amounts of actual loans with identified material breaches of representations and warranties discovered from samples of impaired loans in a securitization ("adverse sample approach"). We do not include estimates of damages in our estimate of subrogation recoveries under either approach. The amount the sponsors believe to be their liability for these breaches is not known; however, certain large financial institutions which have served as sponsors for certain transactions that Ambac has insured have disclosed that they have established reserves related to claims by financial guarantors and others for breaches of representations and warranties in RMBS transactions. The random sample approach to estimate subrogation recoveries was based on obtaining a statistically valid random sample for all the original loans in the pool, based on a protocol developed by a statistical expert. For March 31, 2011 and prior periods the following approach was used:
| • |  | A "breach rate" was computed by dividing (i) the loans identified in the sample as having breached representations and warranties by (ii) the total sample size.
| • |  | Next, the estimated repurchase obligation was determined by multiplying the breach rate by the sum of (a) realized losses resulting from loan liquidations or charge-offs to date plus (b) the current unpaid loan pool balance ("CULPB"). The CULPB includes principal only on non-charged-off and non-liquidated loans, and the realized losses include principal, interest and unreimbursed servicer advances and/or trustee expenses on charged-off and liquidated loans as determined by the relevant transaction documents. As a result, the CULPB and realized loss components, which were used in extrapolating the estimated repurchase obligation, do not precisely correspond to each sponsor's contractual repurchase obligation as defined in the transaction documents. Nonetheless, the CULPB and realized loss components are provided through trustee reports we receive in the normal course of our surveillance of these transactions and was the best information available to estimate the sponsor's repurchase obligation under the random sample approach used for March 31, 2011 and prior periods.
| • |  | Then, a realization factor (which incorporates Ambac's views about the uncertainties surrounding the litigation process and/or settlement negotiation) was applied to the estimated repurchase obligation to compute the undiscounted subrogation recovery. The realization factor was developed from a range of realization factors using Ambac's own assumptions about the likelihood of outcomes based on all the information available to it including (i) discussions with external legal counsel and their views on ultimate settlement, (ii) recent experience with loan put back negotiations where the existence of a material breach was debated and negotiated at the loan level, and (iii) the pervasiveness of the breach rates.
| • |  | Finally, a discount factor was applied to the undiscounted subrogation recovery to compute the estimated subrogation recovery.
Due to the nature of the sampling methodology used for March 31, 2011 and prior periods the subrogation recovery estimate Ambac has recorded based on the above-described random sample approach included all breached loans which Ambac believes the sponsor is contractually required to repurchase, including extrapolation to a loan pool which includes loans which have not defaulted, and, in fact, may not default in the future (i.e., performing loans). In theory, a loan that continues to perform in accordance with its terms through repayment should have little or no effect on Ambac's anticipated claim payments, regardless of whether or not the sponsor repurchases the loan. In other words, since there will be sufficient cash flows to service the notes in either situation (i.e., whether cash is received from a sponsor loan repurchase or whether cash is received from the underlying performing loan), there should be no claim payment under Ambac's insurance policy in respect of such loans. Nonetheless, Ambac may have recorded a subrogation recovery for certain performing loans because it believes the breaches of representations and warranties are so pervasive that a court would deem it impractical to have the sponsor re-underwrite every loan in a given transaction and repurchase only individual loans that have breached. Rather, Ambac believes there is precedent for the utilization of a statistical sampling and extrapolation methodology across a population to prove liability and damages where it would be impractical to make a determination on an individual loan basis. A recent court ruling in a similar suit unrelated to Ambac, but in the same jurisdiction in which Ambac has filed its litigation to date, supports the view that a sampling methodology is permissible. Ambac believes a court would likely award damages based on a reasonable methodology, such as our random sample approach, which damages would be either remitted directly to Ambac, placed in the securitization trust, or otherwise held under an arrangement for the benefit of the securitization trust; however, Ambac believes that under such an approach individual loans would not be repurchased from the trust. In either case, Ambac believes those damages would compensate Ambac for past and future claim payments. Consequently, since the sponsor is contractually obligated to repurchase those loans which breach representations and warranties regardless of whether they are current or defaulted, Ambac previously estimated its subrogation recoveries by applying the breach rate to both performing and defaulted loans. Starting with the June 30, 2011 reporting period, Ambac revised its random sample approach by replacing the CULPB with estimated future collateral pool losses in the above-described calculation. Specifically, the estimated repurchase obligation in the second step above was developed by multiplying the breach rate by the sum of (a) realized losses resulting from loan liquidations or charge-offs to date plus (b) the estimated future collateral pool losses. While we believe both the previous and current random sample approaches are statistically valid, the current approach only extrapolates against the estimated population of adverse loans. No other changes were made to the random sample approach since March 31, 2011. The adverse sample approach to estimate subrogation recoveries was based on a sample taken from those loans in the pool that were impaired, meaning loans greater than 90 days past due, charged-off, or are in foreclosure, REO or bankruptcy. The estimated subrogation recovery under this approach represents 100% of the original principal balance of those specific loans identified as having not met the underwriting criteria or otherwise breaching representations and warranties (i.e., the adverse loans), multiplied by a discount factor using the same assumptions used for the discount factor in the random sample approach. For transactions subject to the adverse sample approach, given Ambac's limitations in developing a statistically valid random sample and its belief that the subrogation estimate under this approach is inherently conservative (for reasons discussed below), Ambac did not attempt to develop probability-weighted alternative cash flow scenarios as it believes such results would not be meaningful. The three primary differences between this adverse sample approach and the random sample approach, discussed in the previous paragraphs, are as follows:
| (i) | There is no extrapolation to the sum of realized losses and estimated future losses under the adverse sample approach. At September 30, 2011, the adverse sample approach is being used for 20 transactions that are with the same sponsor, which has limited access to loan files precluding the selection of statistically valid random sample from the entire loan pool. This is in contrast to the transactions subject to the random sample approach where Ambac's access to individual loan files has not been limited and the Company, therefore, has been able to develop a statistically valid representative sample.
| (ii) | The adverse sample approach is based on the original principal balance rather than the principal balance at the time of default and liquidation or charge-off. Furthermore, it does not include other components of the sponsor's contractual repurchase obligation where the sponsor is also obligated to repay accrued interest, servicer advances and/or trustee expenses. The adverse sample approach relies on individual loan level data where all of the loan-level information pertaining to the sponsor's buyback obligation has not been provided by the sponsor, or the sponsor's buyback obligation is not easily estimable. For example, home equity lines of credit (HELOCs) are revolving loans whose principal balances may be higher or lower at the time of default and liquidation or charge-off than at the time of origination. However, given the limited information available to Ambac in estimating such principal balances at the time of liquidation or charge-off, the original principal balance was used in calculating subrogation recoveries. Another example is closed-end second lien RMBS where the interest due on a particular loan will be a function of the length of time of delinquency prior to liquidation or charge-off, and cannot be readily estimated. Incremental costs, including fees and servicer advances for such items as property taxes and maintenance, are likewise not readily estimatable.
| (iii) | Unlike the random sample approach, for the adverse sample approach Ambac did not apply a realization factor to the estimated repurchase obligation for the adverse loans related to uncertainties surrounding settlement negotiation or litigation processes given that the adverse loans selected represent only approximately 39% of the value of the impaired population of loans, only approximately 4% of the value of the original loans in the pool, and the breach rate in the sample was pervasive. In other words, because the adverse loans selected represent only a fraction of the population of impaired loans and a very small proportion of the original loans in the pools, and because the breach rates in these pools are very high, Ambac believes there is an ample population of additional impaired loans where breaches of representations and warranties exist that could potentially replace any adverse loans it already identified that might be successfully challenged in negotiations or litigation.
Ambac has updated its estimated subrogation recoveries to $2,598,254 ($2,570,242 net of reinsurance) at September 30, 2011 from $2,417,106 ($2,391,335, net of reinsurance) at December 31, 2010. The balance of subrogation recoveries and the related claim liabilities at September 30, 2011 and December 31, 2010 are as follows:
|  | September 30, 2011 |
Method |  | Count |  |  | Gross claim liability before subrogation recoveries |  |  | Subrogation recoveries(1) |  |  | Gross claim liability after subrogation recoveries |
Adverse samples |  |  | 20 | (2) |  | $ | 1,869,360 |  |  | $ | (868,648 | ) |  | $ | 1,000,712 |
Random samples |  |  | 16 | (3) |  |  | 1,189,299 |  |  |  | (1,729,606 | ) |  |  | (540,307 | )
Totals |  |  | 36 |  |  | $ | 3,058,659 |  |  | $ | (2,598,254 | ) |  | $ | 460,405 |
|  | December 31, 2010 |
Method |  | Count |  |  | Gross claim liability before subrogation recoveries |  |  | Subrogation recoveries(1) |  |  | Gross claim liability after subrogation recoveries |
Adverse samples |  |  | 15 | (2) |  | $ | 1,644,488 |  |  | $ | (719,448 | ) |  | $ | 925,040 |
Random samples |  |  | 12 | (3) |  |  | 1,010,704 |  |  |  | (1,697,658 | ) |  |  | (686,954 | )
Totals |  |  | 27 |  |  | $ | 2,655,192 |  |  | $ | (2,417,106 | ) |  | $ | 238,086 |
(1) | The amount of recorded subrogation recoveries related to each securitization is limited to ever-to-date paid losses plus the present value of projected future paid losses for each policy. To the extent significant losses have been paid but not yet recovered, the recorded amount of subrogation recoveries may exceed the projected future paid losses 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 projected future paid losses, the net cash outflow for these policies is recorded as a "Loss and loss expense reserve" liability. Of the $2,598,259 of subrogation recoveries recorded at September 30, 2011, $1,545,959 was included in "Subrogation recoverable" and $1,052,295 was included in "Loss and loss expense reserves." Of the $2,417,106 of subrogation recoveries recorded at December 31, 2010, $1,702,427 was included in "Subrogation recoverable" and $714,679 was included in "Loss and loss expense reserves."
(2) | Of these 20 (15 in 2010) transactions, 10 contractually require the sponsor to repurchase loans at the unpaid principal balance and 10 (5 in 2010) contractually require the sponsor to repurchase loans at unpaid principal plus accrued interest. However, for reasons discussed above in the description of the adverse sample approach, our estimated subrogation recovery for these transactions may not include all the components of the sponsor's contractual repurchase obligation.
(3) | Of these 16 (12 in 2010) transactions, 3 contractually require the sponsor to repurchase loans at unpaid principal plus accrued interest and 13 (9 in 2010) contractually require the sponsor to repurchase loans at unpaid principal plus accrued interest plus servicer advances/expense and/or trustee expenses. However, for reasons discussed above in the description of the random sample approach, our estimated subrogation recovery for these transactions may not include all the components of the sponsor's contractual repurchase obligation.
While the obligation by sponsors to repurchase loans with material breaches is clear, generally the sponsors have not yet honored those obligations. Ambac's approach to resolving these disputes has included negotiating with individual sponsors at the transaction level and in some cases at the individual loan level and has resulted in the repurchase of some loans. Ambac has utilized the results of the above described loan file examinations to make demands for loan repurchases from sponsors or their successors and, in certain instances, as a part of the basis for litigation. Ambac has initiated and will continue to pursue lawsuits seeking compliance with the repurchase obligations in the securitization documents. Ambac estimates that it will take approximately three years from the initiation of litigation with the sponsor to ultimate resolution. These future subrogation cash flows are discounted at a risk-free rate of 1.52%. Ambac has performed the above-mentioned, detailed examinations on a variety of second-lien and first-lien transactions that have experienced exceptionally poor performance. However, the loan file examinations and related estimated recoveries we have reviewed and recorded to date have been limited to only those transactions whose sponsors (or their successors) are subsidiaries of large financial institutions, all of which carry an investment grade rating from at least one nationally recognized rating agency. A total of seven sponsors represent the 36 transactions which have been reviewed as of September 30, 2011. While our contractual recourse is generally to the sponsor/subsidiary, rather than to the financial institutional parent, each of these financial institutions has significant financial resources and an ongoing interest in mortgage finance, and we therefore believe that the financial institution/parent would not seek to disclaim financial responsibility for these obligations if the sponsor/subsidiary is unable to honor its contractual obligations or pay a judgment that we may obtain in litigation. Additionally, in the case of successor institutions, we are not aware of any provisions that explicitly preclude or limit the successors' obligations to honor the obligations of the original sponsor. In fact, certain successor financial institutions have made significant payments to certain claimants to settle breaches of representations and warranties perpetrated by sponsors that have been acquired by such financial institutions. As a result, we did not make any significant adjustments to our estimated subrogation recoveries with respect to the credit risk of these sponsors or their successors. We believe that focusing our loan remediation efforts on large financial institutions first will provide the greatest economic benefit to Ambac. Ambac retains the right to review other RMBS transactions for representations and warranties breaches. Since a significant number of other second-lien and first-lien transactions are also experiencing poor performance, management is considering expanding the scope of this effort. Below is the rollforward of RMBS subrogation for the period December 31, 2010 through September 30, 2011:
|  | Random sample |  |  | # of deals |  |  | Adverse Sample |  |  | # of deals |
Rollforward: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Discounted RMBS subrogation (gross of reinsurance) at December 31, 2010 |  | $ | 1,697,658 |  |  |  | 12 |  |  | $ | 719,448 |  |  |  | 15 |
Changes recognized in 2011: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Additional transactions reviewed |  |  | 127,289 |  |  |  | 4 |  |  |  | 95,244 |  |  |  | 5 |
Additional adverse sample loans reviewed |  |  | — |  |  |  | n/a |  |  |  | 21,831 |  |  |  | n/a |
Loans repurchased by the sponsor |  |  | — |  |  |  | n/a |  |  |  | (11,706 | ) |  |  | n/a |
Subtotal of changes recognized in current period |  |  | 127,289 |  |  |  | n/a |  |  |  | 105,369 |  |  |  | n/a |
Changes from re-estimation of opening balance: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Change in pre-recovery loss reserves |  |  | (95,341 | ) |  |  | n/a |  |  |  | 43,831 |  |  |  | n/a |
Discounted RMBS subrogation (gross of reinsurance) at September 30, 2011 |  | $ | 1,729,606 |  |  |  | 16 |  |  | $ | 868,648 |  |  |  | 20 |
Our ability to recover the RMBS subrogation recoveries is subject to significant uncertainty, including risks inherent in litigation, collectability of such amounts from counterparties (and/or their respective parents and affiliates), timing of receipt of any such recoveries, regulatory intervention which could impede our ability to take actions required to realize such recoveries and uncertainty inherent in the assumptions used in estimating such recoveries. Our current estimate considers that we will receive subrogation recoveries of $2,648,107 in 2013, (gross of discounting and reinsurance in the amount of $49,853 and $28,012). The amount of these subrogation recoveries is significant and if we are unable to recover any amounts our future available liquidity to pay claims would be reduced and our stockholders' deficit as of September 30, 2011 would increase from $2,180,576 to $4,750,818.

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- Definition Disclosure of accounting policy for the various components of the reserve for future policy benefits and guaranteed minimum benefits, and for claims and claims adjustment expenses; the significant assumptions for estimating claims losses; causes of significant variances from prior periods (such as catastrophes, asbestos and environmental claims reserve losses); and reconciliations of beginning to ending reserve balances. + References Reference 1: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 944 -SubTopic 40 -Section 50 -Paragraph 3 -URI http://asc.fasb.org/extlink&oid=6482485&loc=d3e14764-158437 Reference 2: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 944 -SubTopic 40 -Section 50 -Paragraph 6 -URI http://asc.fasb.org/extlink&oid=6482852&loc=d3e14931-158439 Reference 3: http://www.xbrl.org/2003/role/presentationRef -Publisher SEC -Name Regulation S-X (SX) -Number 210 -Article 7 -Section 03 -Paragraph 13 Reference 4: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 944 -SubTopic 40 -Section 50 -Paragraph 1 -URI http://asc.fasb.org/extlink&oid=6482485&loc=d3e14754-158437 Reference 5: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Statement of Financial Accounting Standard (FAS) -Number 60 -Paragraph 60 -LegacyDoc This reference is SUPERSEDED by the Accounting Standards Codification effective for interim and annual periods ending after September 15, 2009. This reference is included to help users transition from the previous accounting hierarchy and will be removed from future versions of this taxonomy. Reference 6: http://www.xbrl.org/2003/role/presentationRef -Publisher AICPA -Name Statement of Position (SOP) -Number 94-5 -Paragraph 11 -LegacyDoc This reference is SUPERSEDED by the Accounting Standards Codification effective for interim and annual periods ending after September 15, 2009. This reference is included to help users transition from the previous accounting hierarchy and will be removed from future versions of this taxonomy. Reference 7: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 944 -SubTopic 210 -Section S99 -Paragraph 1 -Subparagraph (SX 210.7-03.13(a)(1),(b)) -URI http://asc.fasb.org/extlink&oid=6879938&loc=d3e572229-122910 + Details
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