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 September 30, 2012 and December 31, 2011 was 2.6% and 2.6%, respectively, and the weighted average period of future premiums used to estimate the premium receivable at September 30, 2012 and December 31, 2011 was 10.5 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 consist of 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, which governs the payments of cash in the transaction. Additionally, in connection with the allocation of certain liabilities to the Segregated Account, trustees are required by order of the Rehabilitation Court to continue to pay installment premiums in full when due, regardless of the amount and timing of claims payments and existence of the Segregated Account Rehabilitation Proceedings. 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 September 30, 2012 and December 31, 2011 approximately 43% of the premiums receivable related to transactions with non-investment grade internal ratings were due from MBS and student loan transactions, which comprised 9% and 11%, and 12% and 11%, of the total premiums receivable at September 30, 2012 and December 31, 2011, respectively. As of September 30, 2012 and December 31, 2011, $106,714 and $90,930 of premium receivables relating to a non-investment obligation were deemed uncollectible, respectively. For the nine months ended September 30, 2012, the premium receivable related to this obligation deemed uncollectible and written off was $15,784. As of September 30, 2012, past due premiums on policies insuring non-investment grade obligations that were not written off amounted to less than $500.

Below is the premium receivable roll-forward for the nine month and twelve month periods ended September 30, 2012 and December 31, 2011, respectively:


	September 30, 2012			December 31, 2011
Beginning premium receivable	$	2,028,479		$	2,422,596
Premium payments received		(115,336	)		(190,823	)
Adjustments for changes in expected life of homogeneous pools and actual changes to contractual cash flows		(198,811	)		(240,547	)
Accretion of premium receivable discount		38,801			62,841
Consolidation of certain VIEs		—			(104,736	)
Deconsolidation of certain VIEs		—			87,978
Other adjustments (including foreign exchange)		2,697			(8,830	)

Ending premium receivable	$	1,755,830		$	2,028,479

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.

The table below summarizes the future gross undiscounted premiums expected to be collected, and future expected premiums earned, net of reinsurance at September 30, 2012:


	Future premiums to be collected⁽¹⁾		Future expected premiums to be earned, net of reinsurance⁽¹⁾
Three months ended:
December 31, 2012	$	38,490	$	62,992

Twelve months ended:
December 31, 2013		138,330		226,879
December 31, 2014		141,878		204,041
December 31, 2015		136,275		190,320
December 31, 2016		130,297		179,438

Five years ended:
December 31, 2021		578,474		750,984
December 31, 2026		462,155		539,033
December 31, 2031		340,300		357,079
December 31, 2036		199,914		195,106
December 31, 2041		69,794		62,902
December 31, 2046		21,420		19,306
December 31, 2051		5,325		6,236
December 31, 2056		242		686

Total	$	2,262,894	$	2,795,002

(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 the three and nine months ended September 30, 2012 was $34,381 and $86,037, respectively. Accelerated premium revenue for the three and nine months ended September 30, 2011 was $18,835 and $30,096, respectively. The table below shows premiums written on a gross and net basis for the three and nine month periods ended September 30, 2012 and 2011:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Revenues:
Financial Guarantee:
Gross premiums written	($	55,310	)	$	242,573		($	175,777	)	($	125,712	)
Ceded premiums written		2,082			(2,047	)		18,055			18,742

Net premiums written	($	53,228	)	$	240,526		($	157,722	)	($	106,970	)

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 discount rate changes, and early terminations of insured obligations.