3. 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 exposure 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 March 31, 2012 and December 31, 2011 was 2.7% and 2.6%, respectively, and the weighted average period of future premiums used to estimate the premium receivable at March 31, 2012, and December 31, 2011 was 10.2 years and 10.0 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 and consumer auto loans. 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 claims moratorium. In evaluating the credit quality of the premiums receivable, management evaluates i.) the internal ratings of the transactions underlying the premiums receivable, and, as applicable, ii.) expected future premium collections for transactions for which loss reserves have been recognized. As of March 31, 2012, and December 31, 2011 approximately 44% and 43% of the premiums receivable related to transactions with non-investment grade internal ratings, comprised mainly of non-investment grade MBS and student loan transactions, which comprised 12% and 11%, respectively, of the total premiums receivable at March 31, 2012, and December 31, 2011. For the three months ended March 31, 2012, $4,417 of premium receivables relating to a non-investment obligation were deemed uncollectible and written off. At March 31, 2012, past due premiums on policies insuring non-investment grade obligations that were not written off amounted to less than $200.

For both upfront and installment premium policies, premium revenues are earned over the life of the financial guarantee contract in proportion to the insured principal amount outstanding at each reporting date (referred to as the level-yield method). For installment paying policies, the premium receivable discount, equating to the difference between the undiscounted future installment premiums and the present value of future installment premiums, is accreted as premiums earned in proportion to the premium receivable balance at each reporting date. Because the premium receivable discount and UPR are being accreted into income using different rates, the total premiums earned as a percentage of insured principal is higher in the earlier years and lower in the later years for an installment premium transaction as compared to an upfront premium transaction. Below is the premium receivable roll-forward for the periods ended March 31, 2012, and December 31, 2011:


	March 31, 2012			December 31, 2011
Beginning premium receivable	$	2,028,479			2,422,596
Premium payments received		(40,130	)		(190,823	)
Adjustments for changes in expected life of homogeneous pools and actual changes to contractual cash flows		(102,074	)		(240,547	)
Accretion of premium receivable discount		13,892			62,841
Consolidation of certain VIEs		—			(104,736	)
Deconsolidation of certain VIEs		—			87,978
Other adjustments (including foreign exchange)		17,369			(8,830	)

Ending premium receivable	$	1,917,536		$	2,028,479

Similar to gross premiums, premiums ceded to reinsurers are paid either upfront or in installments. For premiums paid upfront, a deferred ceded premium asset is established which is initially recorded as the cash amount paid. For installment premiums, a ceded installment premiums payable liability and offsetting deferred ceded premium asset are initially established in an amount equal to: i) the present value of future contractual premiums due or, ii) if the underlying insured obligation is a homogenous pool of assets which are contractually prepayable, the present value of expected premiums to be paid over the life of the transaction. An appropriate risk-free rate corresponding to the weighted average life of each policy and exposure currency is used to discount the future premiums contractually due or expected to be collected. Premiums ceded to reinsurers reduce the amount of premiums earned by Ambac from its financial guarantee insurance policies. For both up-front and installment premiums, ceded premiums written are primarily recognized in earnings in proportion to and at the same time as the related gross premium revenue is recognized. For premiums paid to reinsurers on an installment basis, Ambac records the present value of future ceding commissions as an offset to ceded premiums payable, using the same assumptions noted above for installment premiums. The ceding commission revenue associated with the ceding premiums payable is deferred (as an offset to deferred acquisition cost) and recognized in income in proportion to ceded premiums.

The table below summarizes the future gross undiscounted premiums expected to be collected, and future expected premiums earned, net of reinsurance at March 31, 2012:


	Future premiums expected to be collected⁽¹⁾		Future expected premiums to be earned, net of reinsurance⁽¹⁾
Three months ended:
June 30, 2012	$	39,030	$	66,143
September 30, 2012		39,697		64,293
December 31, 2012		40,787		62,183

Twelve months ended:
December 31, 2013		149,704		230,902
December 31, 2014		149,695		212,834
December 31, 2015		144,199		201,025
December 31, 2016		138,824		190,565

Five years ended:
December 31, 2021		623,209		801,266
December 31, 2026		504,110		577,648
December 31, 2031		374,718		382,984
December 31, 2036		218,400		208,191
December 31, 2041		72,015		64,386
December 31, 2046		21,871		19,572
December 31, 2051		5,335		6,248
December 31, 2056		242		686

Total	$	2,521,836	$	3,088,926

(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 as a result of rate step-ups or other early retirement provision incentives for the issuer, premiums reflected in the premium receivable asset and amounts reported in the above table for such policies may not be collected in the future.

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 insurance policy is legally extinguished. 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. Accelerated premium revenue for retired obligations for three months ended March 31, 2012 and 2011 was $15,790 and ($70), respectively. The table below shows premiums written on a gross and net basis for the three month periods ended March 31, 2012 and 2011:


	Three Months Ended March 31,
	2012			2011
Revenues:
Financial Guarantee:
Gross premiums written	$	(92,594	)	($	160,211	)
Ceded premiums written		16,854			9,218

Net premiums written⁽¹⁾	$	(75,740	)	($	150,993	)

(1)

Premiums written represent the change in the present value of future installment premiums. Such changes will not have an immediate impact on earned premium but will be earned over the life of the transaction using the level yield method discussed above. Factors that generate written premium are prepayments of the insured obligation, premium rate changes for policies that have variable premium structures, discount rate changes and early termination of an insured obligation.