10-Q 1 a02-015ambcx20180630x10q.htm 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
| OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2018

¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
| OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 1-10777

Ambac Financial Group, Inc.
(Exact name of Registrant as specified in its charter)

Delaware |  | 13-3621676
(State of incorporation) |  | (I.R.S. employer identification no.)
One State Street Plaza, New York, New York |  | 10004
(Address of principal executive offices) |  | (Zip code)

212-658-7470
(Registrant's telephone number, including area code)

Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company or an emerging growth company. See definition of “large accelerated filer”, “accelerated filer”, “smaller reporting company” and "emerging growth company" in Rule 12b-2 of the Exchange Act): (Check one):

Large accelerated filer | x | Accelerated filer | ¨ | Non-accelerated filer | ¨ | Smaller reporting company | ¨ | Emerging growth company | ¨

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes x No ¨
As of August 6, 2018, 45,332,214 shares of common stock, par value $0.01 per share, of the Registrant were outstanding.

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
TABLE OF CONTENTS

|  | Page
PART I. | FINANCIAL INFORMATION |  |
Item 1. | Unaudited Consolidated Financial Statements of Ambac Financial Group, Inc. and Subsidiaries |  |
| Consolidated Balance Sheets (Unaudited) | 1 |
| Consolidated Statements of Total Comprehensive Income (Loss) (Unaudited) | 2 |
| Consolidated Statements of Stockholders' Equity (Unaudited) | 3 |
| Consolidated Statements of Cash Flows (Unaudited) | 4 |
| Notes to Unaudited Consolidated Financial Statements | 5 |
Item 2. | Management's Discussion and Analysis of Financial Condition and Results of Operations | 53 |
| Cautionary Statement Pursuant To The Private Securities Litigation Reform Act Of 1995 | 54 |
| Executive Summary | 55 |
| Critical Accounting Policies and Estimates | 57 |
| Financial Guarantees in Force | 57 |
| Results of Operations | 62 |
| Liquidity and Capital Resources | 68 |
| Balance Sheet | 69 |
| Variable Interest Entities | 76 |
| Accounting Standards | 76 |
| Ambac Assurance Statutory Basis Financial Results | 76 |
| Ambac Assurance UK Limited Financial Results Under UK Accounting Principles | 77 |
| Non-GAAP Financial Measures | 77 |
Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 80 |
Item 4. | Controls and Procedures | 80 |
PART II. | OTHER INFORMATION |  |
Item 1. | Legal Proceedings | 80 |
Item 1A. | Risk Factors | 80 |
Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 82 |
Item 3. | Defaults Upon Senior Securities |  |
Item 6. | Exhibits | 84 |
SIGNATURES | 84 |

PART I. FINANCIAL INFORMATION
Item 1. Unaudited Financial Statements of Ambac Financial Group, Inc. and Subsidiaries
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Consolidated Balance Sheets

| June 30, |  | December 31,
(Dollars in thousands, except share data) (June 30, 2018 (Unaudited)) | 2018 |  | 2017
Assets: |  |  |
Investments: |  |  |
Fixed income securities, at fair value (amortized cost of $3,355,223 and $4,614,623) | $ | 3,514,927 |  |  | $ | 4,652,172 |
Fixed income securities pledged as collateral, at fair value (amortized cost of $84,641 and $99,719) | 84,641 |  |  | 99,719 |
Short-term investments, at fair value (amortized cost of $393,516 and $557,476) | 393,447 |  |  | 557,270 |
Other investments (includes $356,899 and $396,689 at fair value) | 394,396 |  |  | 431,630 |
Total investments | 4,387,411 |  |  | 5,740,791 |
Cash and cash equivalents | 44,398 |  |  | 623,703 |
Receivable for securities | 82,513 |  |  | 11,177 |
Investment income due and accrued | 12,157 |  |  | 16,532 |
Premium receivables | 553,958 |  |  | 586,312 |
Reinsurance recoverable on paid and unpaid losses | 39,071 |  |  | 40,997 |
Deferred ceded premium | 47,886 |  |  | 52,195 |
Subrogation recoverable | 1,876,188 |  |  | 631,213 |
Loans | 10,007 |  |  | 10,358 |
Derivative assets | 56,510 |  |  | 73,199 |
Current taxes | 34,619 |  |  | 11,803 |
Insurance intangible asset | 786,208 |  |  | 846,973 |
Other assets | 33,631 |  |  | 46,614 |
Variable interest entity assets: |  |  |
Fixed income securities, at fair value | 2,756,924 |  |  | 2,914,145 |
Restricted cash | 1,052 |  |  | 978 |
Loans, at fair value | 10,751,199 |  |  | 11,529,384 |
Derivative assets | 60,403 |  |  | 54,877 |
Other assets | 1,088 |  |  | 1,123 |
Total assets | $ | 21,535,223 |  |  | $ | 23,192,374 |
Liabilities and Stockholders’ Equity: |  |  |
Liabilities: |  |  |
Unearned premiums | $ | 721,689 |  |  | $ | 783,155 |
Loss and loss expense reserves | 2,057,334 |  |  | 4,745,015 |
Ceded premiums payable | 35,594 |  |  | 37,876 |
Deferred taxes | 32,781 |  |  | 33,659 |
Long-term debt | 2,796,389 |  |  | 991,696 |
Accrued interest payable | 237,558 |  |  | 436,984 |
Derivative liabilities | 67,648 |  |  | 82,782 |
Other liabilities | 58,191 |  |  | 67,583 |
Payable for securities purchased | 16,556 |  |  | 1,932 |
Variable interest entity liabilities: |  |  |
Accrued interest payable | 550 |  |  | 589 |
Long-term debt, at fair value | 11,454,746 |  |  | 12,160,544 |
Derivative liabilities | 1,992,227 |  |  | 2,205,264 |
Other liabilities | 39 |  |  | 37 |
Total liabilities | 19,471,302 |  |  | 21,547,116 |
Commitments and contingencies (See Note 12) |  |  |
Stockholders’ equity: |  |  |
Preferred stock, par value $0.01 per share; 20,000,000 shares authorized shares; issued and outstanding shares—none | — |  |  | — |
Common stock, par value $0.01 per share; 130,000,000 shares authorized; issued and outstanding shares: 45,365,170 and 45,275,982 | 454 |  |  | 453 |
Additional paid-in capital | 208,328 |  |  | 199,560 |
Accumulated other comprehensive income (loss) | 45,854 |  |  | (52,239 | )
Retained earnings | 1,545,702 |  |  | 1,233,845 |
Treasury stock, shares at cost: 32,956 and 24,816 | (527 | ) |  | (471 | )
Total Ambac Financial Group, Inc. stockholders’ equity | 1,799,811 |  |  | 1,381,148 |
Noncontrolling interest | 264,110 |  |  | 264,110 |
Total stockholders’ equity | 2,063,921 |  |  | 1,645,258 |
Total liabilities and stockholders’ equity | $ | 21,535,223 |  |  | $ | 23,192,374 |

See accompanying Notes to Unaudited Consolidated Financial Statements
| Ambac Financial Group, Inc. 1 2018 Second Quarter FORM 10-Q |

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Total Comprehensive Income (Loss) (Unaudited)

|  | Three Months Ended June 30, |  | Six Months Ended June 30,
(Dollars in thousands, except share data) |  | 2018 |  | 2017 |  | 2018 |  | 2017
Revenues: |  |  |  |  |  |  |  |
Net premiums earned |  | $ | 25,836 |  |  | $ | 43,152 |  |  | $ | 56,719 |  |  | 90,765 |
Net investment income: |  |  |  |  |  |  |  |
Securities available-for-sale and short-term |  | 61,742 |  |  | 80,943 |  |  | 172,293 |  |  | 154,093 |
Other investments |  | 4,920 |  |  | 4,217 |  |  | 4,609 |  |  | 12,626 |
Total net investment income |  | 66,662 |  |  | 85,160 |  |  | 176,902 |  |  | 166,719 |
Other-than-temporary impairment losses: |  |  |  |  |  |  |  |
Total other-than-temporary impairment losses |  | (1,010 | ) |  | (1,763 | ) |  | (1,351 | ) |  | (22,917 | )
Portion of other-than-temporary impairment recognized in other comprehensive income |  | (4 | ) |  | — |  |  | 38 |  |  | 17,212 |
Net other-than-temporary impairment losses recognized in earnings |  | (1,014 | ) |  | (1,763 | ) |  | (1,313 | ) |  | (5,705 | )
Net realized investment gains (losses) |  | 47,148 |  |  | 4,180 |  |  | 52,010 |  |  | (716 | )
Change in fair value of credit derivatives: |  |  |  |  |  |  |  |
Realized gains and other settlements |  | 91 |  |  | 1,134 |  |  | 197 |  |  | 1,333 |
Unrealized gains (losses) |  | (308 | ) |  | 5,490 |  |  | (760 | ) |  | 6,343 |
Net change in fair value of credit derivatives |  | (217 | ) |  | 6,624 |  |  | (563 | ) |  | 7,676 |
Net gains (losses) on interest rate derivatives |  | 9,149 |  |  | 34,068 |  |  | 34,686 |  |  | 32,554 |
Net realized gains (losses) on extinguishment of debt |  | 6 |  |  | 2,179 |  |  | 3,121 |  |  | 4,920 |
Other income (expense) |  | 2,491 |  |  | 720 |  |  | 1,982 |  |  | 778 |
Income (loss) on variable interest entities |  | 577 |  |  | (1,219 | ) |  | 1,151 |  |  | 2,482 |
Total revenues |  | 150,638 |  |  | 173,101 |  |  | 324,695 |  |  | 299,473 |
Expenses: |  |  |  |  |  |  |  |
Losses and loss expenses (benefit) |  | 32,579 |  |  | 66,100 |  |  | (214,816 | ) |  | 201,111 |
Insurance intangible amortization |  | 23,242 |  |  | 33,471 |  |  | 51,878 |  |  | 70,996 |
Operating expenses |  | 26,063 |  |  | 31,304 |  |  | 62,497 |  |  | 59,428 |
Interest expense |  | 62,446 |  |  | 28,234 |  |  | 110,519 |  |  | 59,806 |
Total expenses |  | 144,330 |  |  | 159,109 |  |  | 10,078 |  |  | 391,341 |
Pre-tax income (loss) |  | 6,308 |  |  | 13,992 |  |  | 314,617 |  |  | (91,868 | )
Provision for income taxes |  | 1,995 |  |  | 6,882 |  |  | 4,600 |  |  | 26,463 |
Net income (loss) attributable to common stockholders |  | $ | 4,313 |  |  | $ | 7,110 |  |  | $ | 310,017 |  |  | $ | (118,331 | )
Other comprehensive income (loss), after tax: |  |  |  |  |  |  |  |
Net income (loss) attributable to common stockholders |  | $ | 4,313 |  |  | $ | 7,110 |  |  | $ | 310,017 |  |  | $ | (118,331 | )
Unrealized gains (losses) on securities, net of income tax provision (benefit) of $1,122, $0, $(586) and $0 |  | 575 |  |  | 12,649 |  |  | 122,879 |  |  | 33,984 |
Gains (losses) on foreign currency translation, net of income tax provision (benefit) of $0, $0, $0 and $0 |  | (52,989 | ) |  | 29,292 |  |  | (20,933 | ) |  | 41,885 |
Credit risk changes of fair value option liabilities, net of income tax provision (benefit) of $(188), $0, $42 and $0 |  | (906 | ) |  | — |  |  | 208 |  |  | — |
Changes to postretirement benefit, net of income tax provision (benefit) of $0, $0, $0 and $0 |  | (302 | ) |  | (338 | ) |  | (1,161 | ) |  | 1,949 |
Total other comprehensive income (loss), net of income tax |  | (53,622 | ) |  | 41,603 |  |  | 100,993 |  |  | 77,818 |
Total comprehensive income (loss) attributable to common stockholders |  | $ | (49,309 | ) |  | $ | 48,713 |  |  | $ | 411,010 |  |  | $ | (40,513 | )
Net income (loss) per share attributable to common stockholders: |  |  |  |  |  |  |  |
Basic |  | $ | 0.09 |  |  | $ | 0.16 |  |  | $ | 6.80 |  |  | $ | (2.61 | )
Diluted |  | $ | 0.09 |  |  | $ | 0.16 |  |  | $ | 6.73 |  |  | $ | (2.61 | )

See accompanying Notes to Unaudited Consolidated Financial Statements
| Ambac Financial Group, Inc. 2 2018 Second Quarter FORM 10-Q |

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Stockholders’ Equity (Unaudited)

|  |  | Ambac Financial Group, Inc. |  |
(Dollars in thousands) | Total |  | Retained Earnings |  | Accumulated Other Comprehensive Income (Loss) |  | Preferred Stock |  | Common Stock |  | Additional Paid-in Capital |  | Common Stock Held in Treasury, at Cost |  | Noncontrolling Interest
Balance at January 1, 2018 | $ | 1,645,258 |  |  | $ | 1,233,845 |  |  | $ | (52,239 | ) |  | $ | — |  |  | $ | 453 |  |  | $ | 199,560 |  |  | $ | (471 | ) |  | $ | 264,110 |
Total comprehensive income | 411,010 |  |  | 310,017 |  |  | 100,993 |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Adjustment to initially apply ASU 2016-01 | — |  |  | 2,900 |  |  | (2,900 | ) |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Stock-based compensation | 8,765 |  |  | — |  |  | — |  |  | — |  |  | — |  |  | 8,765 |  |  | — |  |  | — |
Cost of shares (acquired) issued under equity plan | (1,116 | ) |  | (1,060 | ) |  | — |  |  | — |  |  | — |  |  | — |  |  | (56 | ) |  | — |
Issuance of common stock | 1 |  |  | — |  |  | — |  |  | — |  |  | 1 |  |  | — |  |  | — |  |  | — |
Warrants exercised | 3 |  |  | — |  |  | — |  |  | — |  |  | — |  |  | 3 |  |  | — |  |  | — |
Balance at June 30, 2018 | $ | 2,063,921 |  |  | $ | 1,545,702 |  |  | $ | 45,854 |  |  | $ | — |  |  | $ | 454 |  |  | $ | 208,328 |  |  | $ | (527 | ) |  | $ | 264,110 |
Balance at January 1, 2017 | $ | 1,978,024 |  |  | $ | 1,557,681 |  |  | $ | (38,990 | ) |  | $ | — |  |  | $ | 452 |  |  | $ | 195,267 |  |  | $ | (496 | ) |  | $ | 264,110 |
Total comprehensive income | (40,513 | ) |  | (118,331 | ) |  | 77,818 |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Adjustment to initially apply ASU 2016-09 | (137 | ) |  | (137 | ) |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Stock-based compensation | 2,385 |  |  | — |  |  | — |  |  | — |  |  | — |  |  | 2,385 |  |  | — |  |  | — |
Cost of shares (acquired) issued under equity plan | (1,547 | ) |  | (1,572 | ) |  | — |  |  | — |  |  | — |  |  | — |  |  | 25 |  |  | — |
Issuance of common stock | 1 |  |  | — |  |  | — |  |  | — |  |  | 1 |  |  | — |  |  | — |  |  | — |
Balance at June 30, 2017 | $ | 1,938,213 |  |  | $ | 1,437,641 |  |  | $ | 38,828 |  |  | $ | — |  |  | $ | 453 |  |  | $ | 197,652 |  |  | $ | (471 | ) |  | $ | 264,110 |

See accompanying Notes to Unaudited Consolidated Financial Statements
| Ambac Financial Group, Inc. 3 2018 Second Quarter FORM 10-Q |

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows (Unaudited)

|  | Six Months Ended June 30,
(Dollars in thousands) |  | 2018 |  | 2017
Cash flows from operating activities: |  |  |  |
Net income (loss) attributable to common stockholders |  | $ | 310,017 |  |  | $ | (118,331 | )
Adjustments to reconcile net income to net cash used in operating activities: |  |  |  |
Depreciation and amortization |  | 363 |  |  | 533 |
Amortization of bond premium and discount |  | (102,602 | ) |  | (83,180 | )
Share-based compensation |  | 8,765 |  |  | 2,385 |
Deferred income taxes |  | (880 | ) |  | 146 |
Current income taxes |  | (23,564 | ) |  | 12,283 |
Unearned premiums, net |  | (57,310 | ) |  | (63,820 | )
Losses and loss expenses, net |  | (1,435,042 | ) |  | 206,693 |
Ceded premiums payable |  | (2,282 | ) |  | (2,865 | )
Investment income due and accrued |  | 4,433 |  |  | 1,755 |
Premium receivables |  | 32,432 |  |  | 8,378 |
Accrued interest payable |  | (89,633 | ) |  | 6,576 |
Amortization of insurance intangible assets |  | 51,878 |  |  | 70,996 |
Net mark-to-market (gains) losses |  | 760 |  |  | (6,343 | )
Net realized investment gains |  | (52,010 | ) |  | 716 |
Other-than-temporary impairment charges |  | 1,313 |  |  | 5,705 |
(Gain) loss on extinguishment of debt |  | (3,121 | ) |  | (4,920 | )
Variable interest entity activities |  | (1,151 | ) |  | (2,482 | )
Derivative assets and liabilities |  | (120 | ) |  | (211,149 | )
Other, net |  | 46,166 |  |  | 11,455 |
Net cash used in operating activities |  | (1,311,588 | ) |  | (165,469 | )
Cash flows from investing activities: |  |  |  |
Proceeds from sales of bonds |  | 623,495 |  |  | 885,507 |
Proceeds from matured bonds |  | 214,066 |  |  | 390,309 |
Purchases of bonds |  | (163,917 | ) |  | (986,364 | )
Proceeds from sales of other invested assets |  | 51,402 |  |  | 177,805 |
Purchases of other invested assets |  | (18,862 | ) |  | (161,375 | )
Change in short-term investments |  | 164,860 |  |  | (73,092 | )
Loans, net |  | — |  |  | (5,965 | )
Change in cash collateral receivable |  | 781 |  |  | 73,174 |
Proceeds from paydowns of consolidated VIE assets |  | 137,983 |  |  | 120,142 |
Other, net |  | 5,543 |  |  | (4,534 | )
Net cash provided by investing activities |  | 1,015,351 |  |  | 415,607 |
Cash flows from financing activities: |  |  |  |
Net proceeds from issuance of Tier 2 notes |  | 240,000 |  |  | — |
Proceeds from sales of Senior Surplus Notes |  | 4,571 |  |  | — |
Paydowns of Ambac Note |  | (113,457 | ) |  | — |
Paydowns of a secured borrowing |  | (73,993 | ) |  | (16,929 | )
Payments for investment agreement draws |  | — |  |  | (82,358 | )
Payments for extinguishment of long-term debt |  | (191,258 | ) |  | (69,499 | )
Payments for debt issuance costs |  | (9,221 | ) |  | — |
Tax payments related to shares withheld for share-based compensation plans |  | (1,116 | ) |  | (1,268 | )
Proceeds from warrant exercises |  | 3 |  |  | — |
Payments of consolidated VIE liabilities |  | (137,984 | ) |  | (115,534 | )
Net cash used in financing activities |  | (282,455 | ) |  | (285,588 | )
Effect of foreign exchange on cash, cash equivalents and restricted cash |  | (539 | ) |  | (1,195 | )
Net cash flow |  | (579,231 | ) |  | (36,645 | )
Cash, cash equivalents, and restricted cash at beginning of period |  | 624,681 |  |  | 95,898 |
Cash, cash equivalents, and restricted cash at end of period |  | $ | 45,450 |  |  | $ | 59,253 |

See accompanying Notes to Unaudited Consolidated Financial Statements
| Ambac Financial Group, Inc. 4 2018 Second Quarter FORM 10-Q |

Table of Contents
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
1. BACKGROUND AND BUSINESS DESCRIPTION
Ambac Financial Group, Inc. (“Ambac” or the “Company”), headquartered in New York City, is a financial services holding company incorporated in the state of Delaware on April 29, 1991.
Ambac provides financial guarantee insurance policies through its principal operating subsidiary, Ambac Assurance Corporation (“Ambac Assurance" or "AAC") and its wholly owned subsidiary, Ambac Assurance UK Limited (“Ambac UK”). Insurance policies issued by Ambac Assurance and Ambac UK generally guarantee payment when due of the principal and interest on the obligations guaranteed. Ambac also has another wholly-owned subsidiary, Everspan Financial Guarantee Corp. (“Everspan”), which has been in runoff since its acquisition in 1997. The deterioration of Ambac Assurance’s financial condition resulting from losses in its insured portfolio since 2007 has prevented Ambac Assurance and Ambac UK from being able to write new business. The inability to write new business has and will continue to negatively impact Ambac’s future operations and financial results. Ambac Assurance’s ability to pay dividends and, as a result, Ambac’s liquidity, have been significantly restricted by the deterioration of Ambac Assurance’s financial condition and by the terms of the Settlement Agreement, dated as of June 7, 2010, as amended (the "Settlement Agreement"), by and among Ambac Assurance, Ambac Credit Products LLC (“ACP”), Ambac and certain counterparties to credit default swaps with ACP that were guaranteed by Ambac Assurance. Ambac Assurance is also restricted in its ability to pay dividends pursuant to regulatory restrictions, the Stipulation and Order (as described in Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017) and the terms of its Auction Market Preferred Shares ("AMPS"). It is highly unlikely that Ambac Assurance will be able to make dividend payments to Ambac for the foreseeable future.
Ambac also provides other financial products through subsidiaries of Ambac Assurance. These products include interest rate swaps, funding conduits, and investment agreements (until the first quarter of 2017) that were provided principally to clients that were also provided financial guarantee policies. These financial products have been in active run-off since 2007.
Management reviews financial information, allocates resources and measures financial performance on a consolidated basis. As a result, the Company has a single reportable segment.
In February 2018, Ambac achieved one of its key strategic priorities, the exit from rehabilitation of the Segregated Account. Having accomplished this milestone, Ambac continues to pursue and prioritize its remaining key strategic priorities, namely:

• | Active runoff of Ambac Assurance and its subsidiaries through transaction terminations, policy commutations, settlements and restructurings, with a focus on our watch list credits and known and potential future adversely classified credits, that we believe will improve our risk profile, and maximizing the risk-adjusted return on invested assets;

• | Ongoing rationalization of Ambac's and its subsidiaries' capital and liability structures;

• | Loss recovery through active litigation management and exercise of contractual and legal rights;

• | Ongoing review of organizational effectiveness and efficiency of the operating platform; and

• | Evaluation of opportunities in certain business sectors that meet acceptable criteria that will generate long-term stockholder value with attractive risk-adjusted returns.

With respect to our new business strategy, we have identified certain business sectors, adjacent to Ambac's core business, in which future opportunities will be evaluated. The evaluation will be conducted through a measured and disciplined approach to identify opportunities that are synergistic to Ambac, match Ambac's core competencies, are rapidly scalable or available through mergers and acquisitions and that may allow for the utilization of Ambac's net operating loss carry-forwards. Although we are exploring new business opportunities, no assurance can be given that we will be able to execute or obtain the financial and other resources that may be required to finance the acquisition or development of any new businesses or assets. The execution of Ambac’s objective to increase the value of its investment in Ambac Assurance is subject to the rights of OCI (as defined below) under the Stipulation and Order, which requires OCI to approve certain actions taken by or in respect of Ambac Assurance, as well as the restrictions in the Settlement Agreement. Opportunities for remediating losses on poorly performing insured transactions also depend on market conditions, including the perception of Ambac Assurance’s and its subsidiaries' creditworthiness, the structure of the underlying risk and associated policy as well as other counterparty specific factors. Decisions by OCI could impair Ambac’s ability to execute certain of its strategies. Ambac Assurance's ability to commute policies or purchase certain investments may also be limited by available liquidity. Due to these factors, as well as uncertainties relating to the ability of Ambac Assurance to deliver value to Ambac, the value of our securities remains speculative.
The Segregated Account
In March 2010, Ambac Assurance established a Segregated Account pursuant to Wisc. Stat. §611.24 (2) (the “Segregated Account”) to segregate certain segments of Ambac Assurance’s liabilities, and the Office of the Commissioner of Insurance for the State of Wisconsin (“OCI” (which
| Ambac Financial Group, Inc. 5 2018 Second Quarter FORM 10-Q |

Table of Contents
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
term shall be understood to refer to such office as regulator of Ambac Assurance and to refer to the Commissioner of Insurance for the State of Wisconsin as rehabilitator of the Segregated Account (the “Rehabilitator”), as the context requires)) commenced rehabilitation proceedings in the Dane County, Wisconsin Circuit Court (the “Rehabilitation Court”) with respect to the Segregated Account (the “Segregated Account Rehabilitation Proceedings”) in order to permit OCI to facilitate an orderly run-off and/or settlement of the liabilities allocated to the Segregated Account pursuant to the provisions of the Wisconsin Insurers Rehabilitation and Liquidation Act. On October 8, 2010, OCI filed a plan of rehabilitation for the Segregated Account (the “Segregated Account Rehabilitation Plan”) in the Rehabilitation Court, which was confirmed by the Rehabilitation Court on January 24, 2011. On June 11, 2014, the Rehabilitation Court approved amendments to the Segregated Account Rehabilitation Plan and the Segregated Account Rehabilitation Plan, as amended, became effective on June 12, 2014. Policy obligations not allocated to the Segregated Account remained in the General Account of Ambac Assurance, and such policies in the General Account were not subject to and, therefore, were not directly impacted by the Segregated Account Rehabilitation Plan.
On February 12, 2018, Ambac successfully concluded the rehabilitation of the Segregated Account pursuant to an amendment of the Segregated Account Rehabilitation Plan (the "Second Amended Plan of Rehabilitation"). The conclusion of the rehabilitation followed the successful completion of Ambac's surplus note exchange offers and consent solicitation, which, together with the satisfaction of all conditions precedent to the effectiveness of the Second Amended Plan of Rehabilitation, including the discharge of all unpaid policy claims of the Segregated Account, including accretion amounts thereon ("Deferred Amounts"), completed the restructuring transactions (the "Rehabilitation Exit Transactions") announced on July 19, 2017, as more fully described in Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.
In exchange for an effective consideration package of 40% cash, 41% Secured Notes (as defined below) and 12.5% General Account Surplus Notes (as defined below), paid in respect of outstanding Deferred Amounts and General Account Surplus Notes. Ambac Assurance received the following benefits as a result of the completion of the Rehabilitation Exit Transactions:

• | Satisfaction and discharge of all outstanding Deferred Amounts (including accretion) of the Segregated Account, totaling $3,856,992;

• | Cancellation of $552,320 in principal amount outstanding, plus accrued and unpaid interest of $257,200 thereon, of AAC's 5.1% surplus notes due 2020 (the "General Account Surplus Notes"); and

• | An effective discount of 6.5% on Deferred Amounts (applied first against accretion) and the outstanding amount of principal and accrued and unpaid interest on tendered General Account Surplus Notes.

Ambac received $0.91 in principal amount of Secured Notes for each $1.00 of Deferred Amounts that it held, and provided a $0.09 discount in full satisfaction and discharge of its Deferred Amount claims. Ambac did not participate in the voluntary surplus note exchange offers.
A newly formed special purpose entity Ambac LSNI, LLC ("Ambac LSNI") issued $2,154,332 of new secured notes (the “Secured Notes”), secured by all assets of the special purpose entity, which include a note issued by Ambac Assurance to the special purpose entity (the "Ambac Note"), which is secured by a pledge of Ambac Assurance’s right, title and interest in up to the first $1,400,000 of proceeds (net of reinsurance) from certain litigations in which Ambac Assurance seeks redress for breaches of representations and warranties and/or fraud related to residential mortgage-backed securitizations (the “RMBS Litigations”). In addition, the Ambac Note is secured by cash and securities having a market value of $255,628 as of June 30, 2018. Ambac Assurance also pledged for the benefit of the holders of Secured Notes (other than Ambac Assurance) the proceeds of the Secured Notes held by Ambac Assurance from time to time, and issued a financial guaranty insurance policy to a trustee for the benefit of holders of Secured Notes irrevocably guarantying all principal and interest payments in respect of the Secured Notes as and when such payments become due and owing.
Prior to the Rehabilitation Exit Transactions, Ambac and Ambac Assurance owned securities that were insured by Ambac Assurance and allocated to the Segregated Account. As a result of the Rehabilitation Exit Transactions, Ambac and Ambac Assurance received $124,881 and $643,583, respectively, of par amount of Secured Notes issued by Ambac LSNI. Such secured notes are reported in Investments in the Consolidated Balance Sheets at their fair value.
Ambac Assurance also received $240,000 in cash proceeds from the issuance of notes secured by recoveries from RMBS Litigations in excess of $1,600,000 ("Tier 2 Notes").
Receipt of Requisite Consents for Bank Settlement Agreement Waiver and Amendment
Ambac received sufficient consents from holders of General Account Surplus Notes for a waiver and amendment (the "BSA Waiver and Amendment") of the Settlement Agreement. Among other provisions, the BSA Waiver and Amendment includes amendments to the Settlement Agreement that (i) eliminate the requirement for Ambac Assurance to have "unaffiliated qualified directors" on its Board of Directors; (ii) eliminate the prohibition on new business activities; (iii) modify the restrictions on the incurrence of indebtedness and other material obligations; (iv) modify the restrictions on liens securing permitted indebtedness; (v) modify restrictions applicable to junior surplus notes; and (vi) modify restrictions on mergers or similar transactions.
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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
Regulatory Approval of the Rehabilitation Exit Transactions, including a partial interest payment on Surplus Notes
OCI provided all approvals necessary to consummate the Rehabilitation Exit Transactions, to give effect to the BSA Waiver and Amendment, and to make a $13,501 pro-rata interest payment, representing approximately six months of interest, on the outstanding principal and accrued and unpaid interest of General Account Surplus Notes that remained outstanding (of which $2,618 was received by Ambac for surplus notes that it owns that are considered extinguished for accounting purposes) after the closing of the Rehabilitation Exit Transactions on February 12, 2018.
For more information about the Segregated Account rehabilitation and the Rehabilitation Exit Transactions and related matters, please refer to Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.
Final Decree and Order
On June 22, 2018, the Rehabilitation Court entered the Final Decree and Order discharging the Rehabilitator and the Special Deputy Commissioner for the Segregated Account and formally closing the case that was commenced by OCI in the Rehabilitation Court in 2010.
August 2018 AMPS Exchange
At June 30, 2018, Ambac Assurance had 26,411 shares of issued and outstanding AMPS with a liquidation preference of $660,275 (reported as noncontrolling interest of $264,110 on Ambac's balance sheet).
On July 3, 2018, Ambac and Ambac Assurance commenced an offer to exchange (the “AMPS Exchange”) all of Ambac Assurance’s outstanding AMPS for General Account Surplus Notes and, from Ambac, cash and warrants to purchase Ambac's common stock. Concurrently with the AMPS Exchange, Ambac Assurance solicited proxies (each a “Proxy” and together the “Proxies”) from the holders of the AMPS to vote in favor of a resolution to be passed at a special meeting (“Special Meeting”) of Ambac Assurance’s shareholders (the “Proxy Solicitation”). The General Account Surplus Notes offered in the AMPS Exchange have the same terms as other outstanding surplus notes of Ambac Assurance (other than junior surplus notes). The offering period for the AMPS Exchange expired on August 1, 2018 and the transaction closed on August 3, 2018 (the "Settlement Date").
In exchange for each $25 of liquidation preference (i.e., per share), AMPS, holders received from Ambac Assurance, General Account Surplus Notes with a total outstanding amount (including accrued and unpaid interest thereon through on June 22, 2018 (the "Signing Date")) equal to $13.875 (the “Repurchase”). AMPS holders who tendered on or before July 17, 2018, representing 22,096 of the AMPS, also received from Ambac $0.500 in cash and 37.3076 warrants (rounded down to the nearest whole warrant) to purchase an equivalent number of shares of common stock of Ambac at an exercise price of $16.67 per share (the “AFG Purchase” and, together with the Repurchase, the “Purchases”).
As a result of the completion of the Purchases, Ambac:

1. | Repurchased 84.4% or 22,296 AMPS with an aggregate liquidation preference of $557,400, including $34,650 in aggregate liquidation preference in the AFG Purchase;

2. | Captured a nominal discount of approximately $227,000 (a discount of approximately $252,000 on a fair market value basis) on $557,400 of the total outstanding liquidation preference of AMPS; and

3. | Issued, in aggregate, $212,740 in current principal amount of surplus notes with accrued interest thereon of $96,617, issued 824,307 warrants and paid $11,048 in cash.

Prior to the Purchases, the AMPS were reported on the balance sheet within non-controlling interests and were carried at their fair value at the date Ambac emerged from bankruptcy, which is lower than the fair value of the total consideration provided to the AMPS holders in the Purchases. The difference between the fair value of consideration provided to AMPS holders and the carrying amount of the AMPS will be reflected as a reduction to Net income attributable to common stockholders in the third quarter of 2018 for approximately $83,000. The noncontrolling interest balance that will be reported on the balance sheet after the AMPS Exchange will be $41,150.
Concurrently with the offering of the AMPS Exchange, Ambac Assurance launched the Proxy Solicitation to approve (i) for the holders of AMPS only, the Purchases and (ii) an amendment to Ambac Assurance’s Restated Articles of Incorporation to delete Section 7(c) of the Fifth Article, which provided for the purported right of holders of AMPS to elect Ambac Assurance directors in certain circumstances (the “Charter Amendment” and together with the Purchases, the “Transactions”). The affirmative vote of the holders of at least two-thirds in aggregate liquidation preference of AMPS was required for the Purchases and the Charter Amendment to be operative. Additionally, the affirmative vote of at least two-thirds of the outstanding shares of Ambac Assurance common stock entitled to vote at the Special Meeting was required for the Charter Amendment to be operative. The Special Meeting was held on July 18, 2018, at which the Transactions were duly approved. The Charter Amendment became effective on the Settlement Date.
Certain holders of AMPS agreed to support the Transactions and signed and became parties to a Preferred Stock Repurchase and Support Agreement, dated as of June 22, 2018 (the “Preferred Stock Repurchase and Support Agreement”), by and among certain holders of AMPS party thereto (each, a “Supporting Holder” and together, the “Supporting Holders”), Ambac and Ambac Assurance. The Supporting Holders, who
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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
represented approximately 89% in liquidation preference of outstanding AMPS as of the Signing Date, agreed under the Preferred Stock Repurchase and Support Agreement to vote in favor of the Transactions and also committed to tender at least 80% of the aggregate liquidation preference of outstanding AMPS.
2. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES
The Company has disclosed its significant accounting policies in Note 2. Basis of Presentation and Significant Accounting Policies in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. The following significant accounting policies provide an update to those included in the Company’s Annual Report on Form 10-K.
Basis of Presentation
The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP") for interim financial reporting and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and disclosures required by GAAP for annual periods. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2017. The accompanying consolidated financial statements have not been audited by an independent registered public accounting firm in accordance with the standards of the Public Company Accounting Oversight Board (U.S.), but in the opinion of management such financial statements include all adjustments necessary for the fair presentation of the Company’s consolidated financial position and results of operations. All intercompany balances and transactions have been eliminated. The results of operations for the three and six months ended June 30, 2018 may not be indicative of the results that may be expected for the year ending December 31, 2018. The December 31, 2017 consolidated balance sheet was derived from audited financial statements.
The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. As additional information becomes available or actual amounts become determinable, the recorded estimates are revised and reflected in operating results.
Foreign Currency:
Financial statement accounts expressed in foreign currencies are translated into U.S. dollars in accordance with the Foreign Currency Matters Topic of the ASC. The functional currencies of Ambac's subsidiaries are the local currencies of the country where the respective subsidiaries are based, which are also the primary operating environments in which the subsidiaries operate.
Foreign currency translation: Functional currency assets and liabilities of Ambac’s foreign subsidiaries are translated into U.S. dollars using exchange rates in effect at the balance sheet dates and the related translation adjustments, net of deferred taxes, are included as a component of Accumulated Other Comprehensive Income in Stockholders' Equity. Functional currency operating results of foreign subsidiaries are translated using average exchange rates.
Foreign currency transactions: The impact of non-functional currency transactions and the remeasurement of non-functional currency assets and liabilities into the respective subsidiaries' functional currency (collectively "foreign currency transactions gains/(losses)") are $(3,591) and $14,786 for the six months ended June 30, 2018 and 2017, of which $(6,359) and $17,622 relate to the remeasurement of loss reserves, classified in Loss and loss expenses, respectively. Foreign currency transactions gains/(losses) are primarily the result of remeasuring Ambac UK's assets and liabilities denominated in currencies other than its functional currency, primarily the U.S. dollar and the Euro.
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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
Supplemental Disclosure of Cash Flow Information

|  | Six Months Ended June 30,
|  | 2018 |  | 2017
Cash paid during the period for: |  |  |  |
Income taxes |  | $ | 26,910 |  |  | $ | 16,012 |
Interest on long-term debt and investment agreements |  | 157,896 |  |  | 37,471 |
Non-cash financing activities: |  |  |  |
Decrease in long-term debt as a result of an exchange for investment securities |  | $ | — |  |  | $ | 55,426 |
Rehabilitation exit transaction discharge of all Deferred Amounts and cancellation of certain General Account Surplus Notes |  | 1,918,561 |  |  | — |
Reconciliation of cash, cash equivalents, and restricted cash reported within the Consolidated Balance Sheets to the Consolidated Statements of Cash Flows: |  |  |  |
Cash and cash equivalents |  | $ | 44,398 |  |  | $ | 54,238 |
Restricted cash |  | 1,052 |  |  | 5,015 |
Total cash, cash equivalents, and restricted cash shown on the Consolidated Statements of Cash Flows |  | $ | 45,450 |  |  | $ | 59,253 |

In addition to the non-cash financing activities disclosed in the above table, the Rehabilitation Exit Transactions involved the exchange of cash and non-cash consideration for the discharge of all Deferred Amounts and cancellation of certain General Account Surplus Notes. Refer to Note 1. Background and Business Description of this Form 10-Q and Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 for further details of the Rehabilitation Exit Transactions.
Reclassifications:
Reclassifications have been made to prior years' amounts to conform to the current year's presentation. Such reclassifications are primarily the result of certain new standards discussed in the Recently Adopted Accounting Standards section below.
Recently Adopted Accounting Standards:
Effective January 1, 2018, Ambac adopted the following accounting standards:
Stock Compensation--Scope of Modification Accounting
In May 2017, the FASB issued ASU 2017-09, Compensation-Stock Compensation (Topic 718) - Scope of Modification Accounting. The ASU provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting. Entities will apply the modification accounting guidance if the value, vesting conditions or classification of the award changes. The current disclosure requirements in Topic 718 apply regardless of whether an entity is required to apply modification accounting under the amendments in this ASU. The adoption of this ASU did not have an impact on Ambac's financial statements.
Net Periodic Pension and Postretirement Costs
In March 2017, the FASB issued ASU 2017-07, Compensation-Retirement Benefits (Topic 715) - Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. The objective of the ASU is to increase transparency in the reporting of net pension cost and net postretirement cost (collectively "net benefit cost"). The ASU requires that the service cost component of net benefit cost be reported on the same line item as other compensation costs arising from services rendered by employees. It further requires that the other components of net benefit costs (i.e. interest costs, amortization of prior service cost, etc.) be presented separately from the service cost component and outside the subtotal of income from operations, if one is presented. Prior to adoption of this ASU, Ambac reported all postretirement costs in Operating expenses on the Consolidated Statements of Total Comprehensive Income (Loss). Adoption of this ASU resulted in a reclassification of other non-service related costs from Operating expenses to Other income (expense) of $253 and $397 for the three and six months ended June 30, 2017.
Restricted Cash
In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230) - Restricted Cash. Prior to the effective date of this ASU, GAAP did not include specific guidance on the cash flow classification and presentation of changes in restricted cash and restricted cash flow equivalents other than limited guidance for non-for-profit entities. This ASU is intended to resolve diversity in practice in the classification of changes in restricted cash and restricted cash flow equivalents on the statement of cash flows. The ASU requires that restricted cash and restricted cash equivalents be included with cash and cash equivalents when reconciling the beginning and ending period amounts on the statement of cash flows, along with certain disclosures. Adoption of this ASU resulted in the inclusion of restricted cash activity related to consolidated VIEs on the Consolidated Statements of Cash Flows for all periods presented. Also refer to the Supplemental Disclosure of Cash Flow Information
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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
section above for the reconciliation of cash, cash equivalents, and restricted cash reported on the Consolidated Statement of Position that sum to the total of the same such amounts on the Consolidated Statements of Cash Flows.
Income Taxes
In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740) - Intra-Entity Transfers of Assets Other Than Inventory. Prior to the effective date of this ASU, GAAP prohibited the recognition of current and deferred income taxes for intercompany transfers of assets until the asset had been sold to an outside party. The ASU requires companies to recognize the income tax effects of intercompany sales and transfers of assets other than inventory, as income tax expense (or benefit) in the period in which the transfer occurs. The adoption of this ASU did not have an impact on Ambac's financial statements.
Classification of Certain Cash Receipts and Cash Payments
In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230) - Classification of Certain Cash Receipts and Cash Payments. The ASU resolves diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. Transactions addressed in the ASU that are potentially relevant to Ambac include the following:

• | Debt prepayment or debt extinguishment costs - such payments will be classified as a financing cash outflow.

• | Settlement of zero-coupon debt or other debt with coupon rates that are insignificant in relation to the effective interest rate of the borrowing - the portion of the cash payment attributable to accreted interest will be classified as an operating cash outflow and the portion attributable to the principal will be classified as a financing cash outflow.

• | Distributions from equity-method investees - an entity will elect one of the two following approaches. Under the "cumulative earnings approach": i) distributions received up to the amount of cumulative earnings recognized will be treated as returns on investments and classified as cash inflows from operating activities and ii) distributions received in excess of earnings recognized will be treated as returns of investments and classified as cash inflows from investing activities. Under the "nature of the distribution" approach, distributions received will be classified based on the nature of the activity that generated the distribution (i.e. classified as a return on investment or return of investment), when such information is available to the investor.

• | Beneficial interests in securitization transactions - any beneficial interests obtained in financial assets transferred to an unconsolidated securitization entity will be disclosed as a non-cash investing activity. Subsequent cash receipts from the beneficial interests in previously transferred trade receivables will be classified as cash inflows from investing activities.

After further evaluating the potentially relevant items, we determined the adoption of this ASU did not have an impact on Ambac's financial statements.
Recognition and Measurement of Financial Assets and Liabilities
In January 2016, the FASB issued ASC 2016-01, Financial Instruments - Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities. The ASU makes the following targeted changes for financial assets and liabilities: i) requires equity investments with readily determinable fair values to be measured at fair value with changes recognized in net income; ii) simplifies the impairment assessment of equity securities without readily determinable fair values using a qualitative approach; iii) eliminates disclosure of the method and significant assumptions used to fair value instruments measured at amortized cost on the balance sheet; iv) requires the use of the exit price notion when measuring the fair value of instruments for disclosure purposes; v) for financial liabilities where the fair value option has been elected, requires the portion of the fair value change related to instrument-specific credit risk, to be separately reported in other comprehensive income; vi) requires the separate presentation of financial assets and liabilities by measurement category and form of financial asset (liability) on the balance sheet or accompanying notes; and vii) clarifies that the evaluation of a valuation allowance on a deferred tax asset related to available-for-sale securities should be performed in combination with the entity's other deferred tax assets.
With respect to item (v) above, Ambac has elected the fair value option for all VIE financial liabilities. For these VIE liabilities this ASU has resulted in a cumulative-effect reclassification of $2,900, net of deferred tax of $590, between Retained earnings and Accumulated other comprehensive income, with no net change to Total stockholders' equity as of January 1, 2018. For the six months ended June 30, 2018 and going forward, the instrument-specific credit risk of fair value changes in VIE liabilities has been and will be reported in Accumulated other comprehensive income in accordance with this ASU, with all other fair value changes continuing to be reported through net income. There was no material impact on Ambac's financial statements for the other provisions of this ASU.
Revenue recognition
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606) that amends the accounting guidance for recognizing revenue for contracts with customers to transfer goods and contracts for the transfer of non-financial assets unless those contracts are within the scope of other accounting standards. As this ASU does not apply to insurance contracts and most financial instruments, management determined there was no impact on Ambac's financial statements.
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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
Future Application of Accounting Standards:
Equity-linked instruments with down round features
In July 2017, the FASB issued ASU 2017-11, Earnings Per Share (Topic 260) and Derivatives and Hedging (Topic 815) - Accounting for Certain Financial Instruments with Down Round Features. Equity-linked instruments, such as warrants and convertible instruments may contain down round features that result in the strike price being reduced on the basis of the pricing of future equity offerings. Under the ASU, a down round feature will no longer require a freestanding equity-linked instrument (or embedded conversion option) to be classified as a liability that is remeasured at fair value through the income statement (i.e. marked-to-market). However, other features of the equity-linked instrument (or embedded conversion option) must still be evaluated to determine whether liability or equity classification is appropriate. Equity classified instruments are not marked-to-market. For earnings per share ("EPS") reporting, the ASU requires companies to recognize the effect of the down round feature only when it is triggered by treating it as a dividend and as a reduction of income available to common stockholders in basic EPS. The amendments in this ASU are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. Early adoption is permitted, including adoption in any interim period. Ambac will adopt this ASU on January 1, 2019. The adoption of this ASU is not expected to have a consequential impact on Ambac's financial statements.
Premium Amortization on Callable Debt Securities
In March 2017, the FASB issued ASU 2017-08, Receivables-Nonrefundable Fees and Other Costs (Subtopic 310-20) - Premium Amortization on Purchased Callable Debt Securities. The ASU shortens the amortization period for the premium on callable debt securities to the earliest call date. Under current GAAP, a reporting entity generally amortizes the premium as a yield adjustment over the contractual life (i.e. maturity) of the debt security and if that debt security is called, the entity would record a loss equal to the unamortized premium. The ASU does not change the accounting for callable debt securities held at a discount, which will continue to be amortized to maturity. ASU 2017-08 is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years, with early adoption permitted. The ASU must be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. Ambac will adopt this ASU on January 1, 2019 and we are evaluating its impact on Ambac's financial statements.
Measurement of Credit Losses on Financial Instruments
In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326) - Measurement of Credit Losses on Financial Instruments. This ASU significantly affects how reporting entities will measure credit losses for financial assets that are not accounted for at fair value through net income, which include loans, debt securities, trade receivables, net investments in leases, and certain off-balance sheet credit exposures. For financial assets measured at amortized cost, the ASU replaces the "incurred loss" model, which generally delayed recognition of the full amount of credit losses until the loss was probable of occurring, with an "expected loss" model, which reflects an entity's current estimate of all expected credit losses. Expected credit losses for amortized cost assets will be recorded as a valuation allowance, with subsequent increases or decreases in the allowance reflected in the income statement each period. For available-for-sale debt securities, credit losses under the ASU will be measured similarly to current GAAP. However, under the ASU, credit losses for available-for-sale securities will be recorded as a valuation allowance (similar to the amortized cost assets approach described above), rather than as a direct write-down of the security as is required under current GAAP. As a result, improvements to estimated credit losses for available-for-sale debt securities will be recognized immediately in the income statement rather than as interest income over time. The ASU is effective for annual periods beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted as of the fiscal year beginning after December 15, 2018. Ambac has not determined whether it will early adopt this ASU and we are currently evaluating its impact on Ambac's financial statements. The significant implementation matters to be addressed include identifying the inventory of financial assets that will be affected by this standard, identifying new data requirements and data sources for implementing the expected loss model for those instruments not already using this model and identifying and documenting accounting process changes, including related controls.
Leases
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The main difference between current U.S. GAAP and this ASU is the recognition of lease assets and lease liabilities for those leases classified as operating leases. For operating leases, a lessee is required to: 1) recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the balance sheet, 2) recognize a single lease cost, calculated so that the cost is allocated over the lease term generally on a straight-line basis and 3) classify all cash payment within operating activities in the statement of cash flows. The ASU is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The transition guidance requires lessees to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach which include a number of optional practical expedients. We will adopt ASU 2015-02 on January 1, 2019. We are evaluating the impact of this ASU, including the transitional practical expedients, on Ambac's financial statements. We believe Ambac's office leases will be the most significantly impacted by this ASU. We have identified the preliminary inventory of leases that will be affected by this standard. Other significant implementation matters to be addressed are identifying and documenting accounting process changes, including related controls.
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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
3. VARIABLE INTEREST ENTITIES
A mbac, with its subsidiaries, has engaged in transactions with variable interest entities ("VIEs,") in various capacities.

• | Ambac most commonly provides financial guarantees, including credit derivative contracts, for various debt obligations issued by special purpose entities, including VIEs ("FG VIEs");

• | Ambac sponsors special purpose entities that issued notes to investors for various purposes;

• | Ambac monetized its ownership of the junior surplus note issued to it by the Segregated Account by depositing the junior surplus note into a newly formed VIE trust in exchange for cash and an owner trust certificate, which represents Ambac's right to residual cash flows from the junior surplus note; and

• | Ambac is an investor in collateralized loan obligations, mortgage-backed and other asset-backed securities issued by VIEs and its ownership interest is generally insignificant to the VIE and/or Ambac does not have rights that direct the activities that are most significant to such VIE.

FG VIEs:
Ambac’s subsidiaries provide financial guarantees in respect of assets held or debt obligations of VIEs. Ambac’s primary variable interest exists through this financial guarantee insurance or credit derivative contract. The transaction structures provide certain financial protection to Ambac. Generally, upon deterioration in the performance of a transaction or upon an event of default as specified in the transaction legal documents, Ambac will obtain certain loss remediation rights. These rights may enable Ambac to direct the activities of the entity that most significantly impact the entity’s economic performance.
We determined that Ambac’s subsidiaries generally have the obligation to absorb a FG VIE's expected losses given that they have issued financial guarantees supporting certain liabilities (and in some cases certain assets). As further described below, we consolidated certain FG VIEs because: (i) we determined, for certain transactions that experienced the aforementioned performance deterioration, that Ambac’s subsidiaries had the power, through voting rights or similar rights, to direct the activities that most significantly impact the VIE’s economic performance because certain triggers had been breached in these transactions resulting in Ambac's subsidiaries' ability to exercise certain loss remediation activities or (ii) due to the passive nature of the VIEs’ activities, Ambac’s subsidiaries’ contingent loss remediation rights upon a breach of certain triggers in the future is considered to be the power to direct the activities that most significantly impact the VIEs’ economic performance. With respect to existing VIEs involving Ambac financial guarantees, Ambac is generally required to consolidate a VIE in the period that applicable triggers result in Ambac having control over the VIE’s most significant economic activities. FG VIEs which are consolidated include recourse liabilities and, in some cases, may include non-recourse liabilities. FG VIEs' liabilities that are insured by the Company are with recourse, because the Company guarantees the payment of principal and interest to the extent there is a shortfall in the FG VIEs' assets. FG VIEs' liabilities that are not insured by the Company are without recourse, because the payment of principal and interest of these liabilities is wholly dependent on the performance of the FG VIEs' assets. The Company’s exposure to consolidated FG VIEs is limited to the financial guarantees issued for recourse liabilities and any additional variable interests held by Ambac.
In connection with the exit from rehabilitation of the Segregated Account, as further described in Note 1. Background and Business Description and in Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, Ambac evaluated the consolidation of certain VIEs. Under the Stipulation and Order, the OCI retained the authority requiring Ambac Assurance to obtain their approval with respect to the exercise of certain control rights in connection with policies that had previously been allocated to the Segregated Account. Accordingly, Ambac did not consolidate any additional VIEs as a result of the Segregated Account's exit from rehabilitation. A VIE is deconsolidated in the period that Ambac no longer has such control, which could occur in connection with the execution of remediation activities on the transaction or amortization of insured exposure, either of which may reduce the degree of Ambac’s control over a VIE. Assets and liabilities of FG VIEs that are consolidated are reported within Variable interest entity assets or Variable interest entity liabilities on the Consolidated Balance Sheets. Ambac has elected the fair value option for all FG VIE financial assets and financial liabilities which are consolidated. The total fair value changes in the financial assets of such FG VIEs are reported within Income (loss) on variable interest entities in the Consolidated Statements of Total Comprehensive Income (Loss). Prior to January 1, 2018, the total fair value changes in the financial liabilities of such FG VIEs were also reported within Income (loss) on variable interest entities. As further described in Note 2. Basis of Presentation and Significant Accounting Policies, effective January 1, 2018, Ambac adopted ASU 2016-01. Under this ASU, for financial liabilities where fair value option has been elected, the portion of the total change in fair value caused by changes in the instrument-specific credit risk is presented separately in OCI.
Upon initial consolidation of a FG VIE, we recognize a gain or loss in earnings for the difference between: (i) the fair value of the consideration paid, the fair value of any non-controlling interests and the reported amount of any previously held interests and (ii) the net amount, as measured on a fair value basis, of the assets and liabilities consolidated. Upon deconsolidation of a FG VIE, we recognize a gain or loss for the difference between: (i) the fair value of any consideration received, the fair value of any retained non-controlling investment in the VIE and the carrying amount of any non-controlling interest in the VIE and (ii) the carrying amount of the VIE’s assets and liabilities. Gains or losses from consolidation and deconsolidation that are reported in earnings are reported within Income (loss) on variable interest entities on the Consolidated Statements of Total Comprehensive Income (Loss).
| Ambac Financial Group, Inc. 12 2018 Second Quarter FORM 10-Q |

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
The impact of consolidating such FG VIEs on Ambac’s balance sheet is the elimination of transactions between the consolidated FG VIEs and Ambac’s operating subsidiaries and the inclusion of the FG VIE’s third party assets and liabilities. For a financial guarantee insurance policy issued to a consolidated VIE, Ambac does not reflect the financial guarantee insurance policy in accordance with the related insurance accounting rules under the Financial Services – Insurance Topic of the ASC. Consequently, upon consolidation, Ambac eliminates the insurance assets and liabilities associated with the policy from the Consolidated Balance Sheets. Such insurance assets and liabilities may include premium receivables, reinsurance recoverable, deferred ceded premium, subrogation recoverable, unearned premiums, loss and loss expense reserves, ceded premiums payable and insurance intangible assets. For investment securities owned by Ambac that are debt instruments issued by the VIE, the investment securities balance is eliminated upon consolidation.
As of June 30, 2018 consolidated FG VIE assets and liabilities relating to 11 consolidated entities were $13,570,666 and $13,447,562, respectively. As of December 31, 2017, consolidated FG VIE assets and liabilities relating to 11 consolidated entities were $14,500,507 and $14,366,434, respectively. As of both June 30, 2018 and December 31, 2017, eight and three consolidated FG VIEs related to transactions insured by Ambac UK and Ambac Assurance, respectively. As of June 30, 2018, FG VIE assets and liabilities of $13,274,042 and $13,151,223 and as of December 31, 2017, FG VIE assets and liabilities of $14,160,152 and $14,026,704 related to transactions guaranteed by Ambac UK. The remaining balance of consolidated FG VIE assets and liabilities are related to transactions guaranteed by Ambac Assurance. Ambac is not primarily liable for, and generally does not guarantee all of the debt obligations issued by the VIEs. Ambac would only be required to make payments on the VIE debt obligations in the event that the issuer of such debt obligations defaults on any principal or interest due and such obligation is guaranteed by Ambac. Additionally, Ambac’s general creditors, other than those specific policy holders which own the VIE debt obligations, do not have rights with regard to the assets of the VIEs. Ambac evaluates the net income effects and earnings per share effects to determine attributions between Ambac and non-controlling interests as a result of consolidating a VIE. Ambac has determined that the net income and earnings per share effect of consolidated FG VIEs are attributable to Ambac’s interests through financial guarantee premium and loss payments with the VIE.
Below is a schedule detailing the change in fair value of the various financial instruments within the consolidated FG VIEs, along with gains (losses) from consolidating and deconsolidating FG VIEs that together comprise Income (loss) on variable interest entities for the affected periods:

|  | Three Months Ended June 30, |  | Six Months Ended June 30,
|  | 2018 |  | 2017 |  | 2018 |  | 2017
Income (loss) on changes related to: |  |  |  |  |  |  |  |
Net change in fair value of VIE assets and liabilities |  | $ | (450 | ) |  | $ | (1,219 | ) |  | $ | 1,468 |  |  | $ | 2,482 |
Less: Credit risk changes of fair value liabilities |  | 1,027 |  |  | — |  |  | (317 | ) |  | — |
Consolidation / Deconsolidation |  | — |  |  | — |  |  | — |  |  | — |
Income (loss) on Variable Interest Entities |  | $ | 577 |  |  | $ | (1,219 | ) |  | $ | 1,151 |  |  | $ | 2,482 |

Ambac consolidated zero and deconsolidated zero VIEs for the three and six months ended June 30, 2018 and 2017.
The table below provides the fair value of fixed income securities, by asset-type, held by consolidated VIEs as of June 30, 2018 and December 31, 2017:

| June 30, 2018 |  | December 31, 2017
Investments: |  |  |
Corporate obligations | $ | 2,756,924 |  |  | $ | 2,914,145 |
Total variable interest entity assets: fixed income securities | $ | 2,756,924 |  |  | $ | 2,914,145 |

The following table provides supplemental information about the loans held as assets and long-term debt associated with the VIEs for which the fair value option has been elected as of June 30, 2018 and December 31, 2017:

| Estimated Fair Value |  | Unpaid Principal Balance
June 30, 2018: |  |  |
Loans | $ | 10,751,199 |  |  | $ | 7,905,992 |
Long-term debt | 11,454,746 |  |  | 9,095,639 |
December 31, 2017: |  |  |
Loans | $ | 11,529,384 |  |  | $ | 8,168,651 |
Long-term debt | 12,160,544 |  |  | 9,387,884 |

| Ambac Financial Group, Inc. 13 2018 Second Quarter FORM 10-Q |

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
Ambac Sponsored VIEs:
A subsidiary of Ambac transferred financial assets to a VIE. The business purpose of this entity was to provide certain financial guarantee clients with funding for their debt obligations. This VIE was established as a separate legal entity, demonstrably distinct from Ambac and that Ambac, its affiliates or its agents could not unilaterally dissolve. The permitted activities of this entity are contractually limited to purchasing assets from Ambac, issuing medium-term notes (“MTNs”) to fund such purchases, executing derivative hedges and obtaining financial guarantee policies with respect to indebtedness incurred. Ambac does not consolidate this entity because Ambac Assurance’s policies issued to this entity were previously allocated to the Segregated Account and, as discussed above, the exercise of related control rights in such policies remain subject to OCI approval under the Stipulation and Order. Ambac elected to account for its equity interest in this entity at fair value under the fair value option in accordance with the Financial Instruments Topic of the ASC. We believe that the fair value of the investment in this entity provides for greater transparency for recording profit or loss as compared to the equity method under the Investments – Equity Method and Joint Ventures Topic of the ASC. Refer to Note 7. Fair Value Measurements for further information on the valuation technique and inputs used to measure the fair value of Ambac’s equity interest in this entity. At June 30, 2018 and December 31, 2017 the fair value of this entity was $5,255 and $5,979, respectively, and is reported within Other assets on the Consolidated Balance Sheets.

• | Total principal amount of debt outstanding was $410,760 and $420,600 at June 30, 2018 and December 31, 2017, respectively. In each case, Ambac sold assets to this entity. The assets are composed of utility obligations with a weighted average rating of BBB+ at June 30, 2018 and weighted average life of 2.6 years. The purchase by this entity of financial assets was financed through the issuance of MTNs, which are cross-collateralized by the purchased assets. The MTNs have the same expected weighted average life as the purchased assets. Derivative contracts (interest rate swaps) are used within the entity for economic hedging purposes only. Derivative positions were established at the time MTNs were issued to purchase financial assets. As of June 30, 2018 Ambac Assurance had financial guarantee insurance policies issued for all assets, MTNs and derivative contracts owned and outstanding by the entity.

• | Insurance premiums paid to Ambac Assurance by this entity are earned in a manner consistent with other insurance policies, over the risk period. Additionally, any losses incurred on such insurance policies are included in Ambac’s Consolidated Statements of Total Comprehensive Income (Loss). Under the terms of an Administrative Agency Agreement, Ambac provides certain administrative duties, primarily col lecting amounts du e on the obligations and making interest payments on the MTNs.

In July 2015, Ambac Assurance entered into a secured borrowing transaction (the "Secured Borrowing") whereby it sold 17 Ambac insured residential mortgage-backed securities (the "Securities") and all rights associated therewith as of May 31, 2015, to a Delaware statutory trust (the "Trust") in exchange for an equity certificate in the Trust, all financial guarantee claim payments associated with the Securities and cash of $146,000 (prior to expenses associated with the transaction). Although the Securities were legally sold to the Trust, the Securities remain in Invested assets on the Consolidated Balance Sheets. Refer to Note 8. Investments for further discussion of the restrictions on the invested assets. At the same time, a second Delaware statutory trust (the "Issuer"), issued $146,000 of debt securities and used the proceeds, together with an equity certificate of the Issuer, to purchase from the Trust a certificate secured by and entitling the Issuer to all principal and interest payments (other than financial guarantee claim payments) on the Securities. Interest on the debt securities is payable monthly at an annual rate of one month LIBOR + 2.8%. Both the Trust and the Issuer were consolidated VIEs because Ambac Assurance was involved in their design and holds a significant amount of the beneficial interests issued by the VIEs and guaranteed the assets held by the VIEs. On June 22, 2018, Ambac Assurance exercised its right to terminate this structure though its right to sell a sufficient quantity of Securities to redeem the remaining outstanding Notes of the Issuer at par plus accrued interest. Accordingly, proceeds from the sale of Securities were used to redeem the outstanding Notes. VIE debt outstanding to third parties under this secured borrowing transaction had a carrying value of $0 and $73,993 as of June 30, 2018 and December 31, 2017, respectively, and is reported in Long-Term Debt on the Consolidated Balance Sheets.
Variable Interests in Non-Consolidated VIEs
On August 28, 2014, Ambac monetized its ownership of the junior surplus note issued to it by the Segregated Account by depositing the junior surplus note into a newly formed VIE trust in exchange for cash and an owner trust certificate, which represents Ambac's right to residual cash flows from the junior surplus note. Ambac does not consolidate the VIE. Ambac reports this interest in the VIE as an equity investment within Other investments on the Consolidated Balance Sheets with associated results from operations included within Net investment income: Other investments on the Consolidated Statements of Total Comprehensive Income (Loss). The equity investment had a carrying value of $37,497 and $34,941 as of June 30, 2018 and December 31, 2017, respectively.
On February 12, 2018, Ambac formed a VIE, Ambac LSNI, to issue Secured Notes in connection with the Rehabilitation Exit Transactions. Prior to the Rehabilitation Exit Transactions, Ambac and Ambac Assurance owned securities that were insured by Ambac Assurance and allocated to the Segregated Account. As a result of the Rehabilitation Exit Transactions, Ambac Assurance and Ambac received $643,583 and $124,881, respectively, of par amount of Secured Notes issued by Ambac LSNI. Ambac does not consolidate the VIE and reports its holdings of Secured Notes as Fixed Income Securities in the Consolidated Balance Sheets. The carrying values of Secured Notes held by Ambac Assurance and Ambac as of June 30, 2018 were $621,849 and $120,233, respectively. In addition, unsettled amounts from the June 30, 2018 interest payment and partial principal redemption of the Secured Notes owned by Ambac Assurance and Ambac were $50,878 and$9,837, respectively, and are included in Receivable for securities on the Consolidated Balance Sheet as of June 30, 2018.
| Ambac Financial Group, Inc. 14 2018 Second Quarter FORM 10-Q |

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
The following table displays the carrying amount of the assets, liabilities and maximum exposure to loss of Ambac’s variable interests in non-consolidated VIEs resulting from financial guarantee and derivative contracts by major underlying asset classes, as of June 30, 2018 and December 31, 2017:

| Carrying Value of Assets and Liabilities
| Maximum Exposure To Loss (1) |  | Insurance Assets (2) |  | Insurance Liabilities (3) |  | Net Derivative Assets (Liabilities) (4)
June 30, 2018: |  |  |  |  |  |  |
Global structured finance: |  |  |  |  |  |  |
Collateralized debt obligations | $ | 26,882 |  |  | $ | 108 |  |  | $ | 1 |  |  | $ | (8 | )
Mortgage-backed—residential (5) | 7,355,039 |  |  | 1,862,269 |  |  | 598,722 |  |  | — |
Other consumer asset-backed | 2,144,354 |  |  | 21,150 |  |  | 326,476 |  |  | — |
Other commercial asset-backed | 893,643 |  |  | 25,768 |  |  | 23,508 |  |  | — |
Other | 2,191,571 |  |  | 57,438 |  |  | 304,820 |  |  | 7,498 |
Total global structured finance | 12,611,489 |  |  | 1,966,733 |  |  | 1,253,527 |  |  | 7,490 |
Global public finance | 24,895,558 |  |  | 332,151 |  |  | 363,598 |  |  | (1,318 | )
Total | $ | 37,507,047 |  |  | $ | 2,298,884 |  |  | $ | 1,617,125 |  |  | $ | 6,172 |
December 31, 2017: |  |  |  |  |  |  |
Global structured finance: |  |  |  |  |  |  |
Collateralized debt obligations | $ | 35,555 |  |  | $ | 169 |  |  | $ | 1 |  |  | $ | (15 | )
Mortgage-backed—residential | 12,766,685 |  |  | 619,848 |  |  | 3,218,356 |  |  | — |
Other consumer asset-backed | 2,266,610 |  |  | 23,405 |  |  | 328,732 |  |  | — |
Other commercial asset-backed | 987,797 |  |  | 30,413 |  |  | 35,976 |  |  | — |
Other | 2,513,304 |  |  | 60,086 |  |  | 306,457 |  |  | 10,311 |
Total global structured finance | 18,569,951 |  |  | 733,921 |  |  | 3,889,522 |  |  | 10,296 |
Global public finance | 25,629,816 |  |  | 335,347 |  |  | 371,056 |  |  | (551 | )
Total | $ | 44,199,767 |  |  | $ | 1,069,268 |  |  | $ | 4,260,578 |  |  | $ | 9,745 |

(1) | Maximum exposure to loss represents the maximum future payments of principal and interest on insured obligations and derivative contracts plus Deferred Amounts and accrued and unpaid interest thereon. On February 12, 2018, all Deferred Amounts and interest accrued on Deferred Amounts were settled in connection with the Rehabilitation Exit Transactions. Ambac’s maximum exposure to loss does not include the benefit of any financial instruments (such as reinsurance or hedge contracts) that Ambac may utilize to mitigate the risks associated with these variable interests.

(2) | Insurance assets represent the amount recorded in “Premium receivables” and “Subrogation recoverable” for financial guarantee contracts on Ambac’s Consolidated Balance Sheets.

(3) | Insurance liabilities represent the amount recorded in “Loss and loss expense reserves” and “Unearned premiums” for financial guarantee contracts on Ambac’s Consolidated Balance Sheets.

(4) | Net derivative assets (liabilities) represent the fair value recognized on credit derivative contracts and interest rate swaps on Ambac’s Consolidated Balance Sheets.

(5) | On February 12, 2018, Deferred Amounts and Interest Accrued on Deferred Amounts in the amount of $3,000,158 and $856,834, respectively were settled. This settlement impacted both insurance assets and insurance liabilities in the table above.

| Ambac Financial Group, Inc. 15 2018 Second Quarter FORM 10-Q |

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
4. COMPREHENSIVE INCOME
The following tables detail the changes in the balances of each component of accumulated other comprehensive income for the affected periods:

|  | Unrealized Gains (Losses) on Available for Sale Securities (1) |  | Amortization of Postretirement Benefit (1) |  | Gain (Loss) on Foreign Currency Translation (1) |  | Credit Risk Changes of Fair Value Option Liabilities (1) (2) |  | Total
Three Months Ended June 30, 2018: |  |  |  |  |  |  |  |  |  |
Beginning Balance |  | $ | 153,059 |  |  | $ | 9,781 |  |  | $ | (61,578 | ) |  | $ | (1,786 | ) |  | $ | 99,476 |
Other comprehensive income (loss) before reclassifications |  | 46,709 |  |  | — |  |  | (52,989 | ) |  | — |  |  | (6,280 | )
Amounts reclassified from accumulated other comprehensive income (loss) |  | (46,134 | ) |  | (302 | ) |  | — |  |  | (906 | ) |  | (47,342 | )
Net current period other comprehensive income (loss) |  | 575 |  |  | (302 | ) |  | (52,989 | ) |  | (906 | ) |  | (53,622 | )
Balance at June 30, 2018 |  | $ | 153,634 |  |  | $ | 9,479 |  |  | $ | (114,567 | ) |  | $ | (2,692 | ) |  | $ | 45,854 |
Three Months Ended June 30, 2017: |  |  |  |  |  |  |  |  |  |
Beginning Balance |  | $ | 140,198 |  |  | $ | 11,654 |  |  | $ | (154,627 | ) |  | $ | — |  |  | $ | (2,775 | )
Other comprehensive income (loss) before reclassifications |  | 15,070 |  |  | — |  |  | 29,292 |  |  | — |  |  | 44,362 |
Amounts reclassified from accumulated other comprehensive income (loss) |  | (2,421 | ) |  | (338 | ) |  | — |  |  | — |  |  | (2,759 | )
Net current period other comprehensive income (loss) |  | 12,649 |  |  | (338 | ) |  | 29,292 |  |  | — |  |  | 41,603 |
Balance at June 30, 2017 |  | $ | 152,847 |  |  | $ | 11,316 |  |  | $ | (125,335 | ) |  | $ | — |  |  | $ | 38,828 |
Six Months Ended June 30, 2018: |  |  |  |  |  |  |  |  |  |
Beginning Balance |  | $ | 30,755 |  |  | $ | 10,640 |  |  | $ | (93,634 | ) |  | $ | — |  |  | $ | (52,239 | )
Adjustment to opening balance, net of taxes (3) |  | — |  |  | — |  |  | — |  |  | (2,900 | ) |  | (2,900 | )
Adjusted balance, beginning of period |  | 30,755 |  |  | 10,640 |  |  | (93,634 | ) |  | (2,900 | ) |  | (55,139 | )
Other comprehensive income (loss) before reclassifications |  | 173,576 |  |  | (556 | ) |  | (20,933 | ) |  | — |  |  | 152,087 |
Amounts reclassified from accumulated other comprehensive income (loss) |  | (50,697 | ) |  | (605 | ) |  | — |  |  | 208 |  |  | (51,094 | )
Net current period other comprehensive income (loss) |  | 122,879 |  |  | (1,161 | ) |  | (20,933 | ) |  | 208 |  |  | 100,993 |
Balance at June 30, 2018 |  | $ | 153,634 |  |  | $ | 9,479 |  |  | $ | (114,567 | ) |  | $ | (2,692 | ) |  | $ | 45,854 |
Six Months Ended June 30, 2017: |  |  |  |  |  |  |  |  |  |
Beginning Balance |  | $ | 118,863 |  |  | $ | 9,367 |  |  | $ | (167,220 | ) |  | $ | — |  |  | $ | (38,990 | )
Other comprehensive income (loss) before reclassifications |  | 27,570 |  |  | 2,625 |  |  | 41,885 |  |  | — |  |  | 72,080 |
Amounts reclassified from accumulated other comprehensive income (loss) |  | 6,414 |  |  | (676 | ) |  | — |  |  | — |  |  | 5,738 |
Net current period other comprehensive income (loss) |  | 33,984 |  |  | 1,949 |  |  | 41,885 |  |  | — |  |  | 77,818 |
Balance at June 30, 2017 |  | $ | 152,847 |  |  | $ | 11,316 |  |  | $ | (125,335 | ) |  | $ | — |  |  | $ | 38,828 |

(1) | All amounts are net of tax and noncontrolling interest. Amounts in parentheses indicate reductions to Accumulated Other Comprehensive Income.

(2) | Represents the changes in fair value attributable to instrument-specific credit risk of liabilities for which the fair value option is elected.

(3) | Beginning in 2018, Credit risk changes of fair value option liabilities are reflected as a component of Accumulated Other Comprehensive Income pursuant to the adoption of ASU 2016-01. See Note 2 to the Consolidated Financial Statements included in this Form 10-Q for further information regarding this change.

| Ambac Financial Group, Inc. 16 2018 Second Quarter FORM 10-Q |

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
The following table details the significant amounts reclassified from each component of accumulated other comprehensive income, shown in the above rollforward tables, for the affected periods:

Details about Accumulated Other Comprehensive Income Components |  | Amount Reclassified from Accumulated Other Comprehensive Income (1) |  | Affected Line Item in the Consolidated Statement of Total Comprehensive Income (Loss)
| Three Months Ended June 30, |
| 2018 |  | 2017 |
Unrealized Gains (Losses) on Available-for-Sale Securities |  |  |  |  |  |
|  | $ | (47,256 | ) |  | $ | (2,421 | ) |  | Net realized investment gains (losses) and other-than-temporary impairment losses
|  | 1,122 |  |  | — |  |  | Provision for income taxes
|  | $ | (46,134 | ) |  | $ | (2,421 | ) |  | Net of tax and noncontrolling interest
Amortization of Postretirement Benefit |  |  |  |  |  |
Prior service cost |  | $ | (241 | ) |  | $ | (241 | ) |  | Other income (2)
Actuarial (losses) |  | (61 | ) |  | (97 | ) |  | Other income (2)
|  | (302 | ) |  | (338 | ) |  | Total before tax
|  | — |  |  | — |  |  | Provision for income taxes
|  | (302 | ) |  | (338 | ) |  | Net of tax and noncontrolling interest
Credit risk changes of fair value option liabilities |  |  |  |  |  |
|  | $ | (1,094 | ) |  | $ | — |  |  | Credit Risk Changes of Fair Value Option Liabilities
|  | 188 |  |  | — |  |  | Provision for income taxes
|  | $ | (906 | ) |  | $ | — |  |  | Net of tax and noncontrolling interest
Total reclassifications for the period |  | $ | (47,342 | ) |  | $ | (2,759 | ) |  | Net of tax and noncontrolling interest
Details about Accumulated Other Comprehensive Income Components |  | Amount Reclassified from Accumulated Other Comprehensive Income (1) |  | Affected Line Item in the Consolidated Statement of Total Comprehensive Income (Loss)
| Six Months Ended June 30, |
| 2018 |  | 2017 |
Unrealized Gains (Losses) on Available-for-Sale Securities |  |  |  |  |  |
|  | $ | (50,111 | ) |  | $ | 6,414 |  |  | Net realized investment (losses) gains and other-than-temporary impairment losses
|  | (586 | ) |  | — |  |  | Tax (expense) benefit
|  | $ | (50,697 | ) |  | $ | 6,414 |  |  | Net of tax and noncontrolling interest
Amortization of Postretirement Benefit |  |  |  |  |  |
Prior service cost |  | $ | (482 | ) |  | $ | (482 | ) |  | Other income (2)
Actuarial gains |  | (123 | ) |  | (194 | ) |  | Other income (2)
|  | (605 | ) |  | (676 | ) |  | Total before tax
|  | — |  |  | — |  |  | Tax (expense) benefit
|  | $ | (605 | ) |  | $ | (676 | ) |  | Net of tax and noncontrolling interest
Credit risk changes of fair value option liabilities |  |  |  |  |  |
|  | $ | 250 |  |  | $ | — |  |  | Credit Risk Changes of Fair Value Option Liabilities
|  | (42 | ) |  | — |  |  | Provision for income taxes
|  | $ | 208 |  |  | $ | — |  |  | Net of tax and noncontrolling interest
Total reclassifications for the period |  | $ | (51,094 | ) |  | $ | 5,738 |  |  | Net of tax and noncontrolling interest

(1) | Amounts in parentheses indicate reductions to Accumulated Other Comprehensive Income with corresponding increases to the affected line items in the Consolidated Statement of Total Comprehensive Income.

(2) | These accumulated other comprehensive income components are included in the computation of net periodic benefit cost.

| Ambac Financial Group, Inc. 17 2018 Second Quarter FORM 10-Q |

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
5. NET INCOME PER SHARE
As of June 30, 2018, 45,332,214 shares of Ambac's common stock (par value $0.01) and warrants entitling holders to acquire up to 4,053,476 shares of new common stock at an exercise price of $16.67 per share were issued and outstanding. For the six months ended June 30, 2018 and 2017, 194 and 0 warrants were exercised, respectively, resulting in an issuance of 194 and 0 shares of common stock, respectively.
On June 30, 2015, the Board of Directors of Ambac authorized the establishment of a warrant repurchase program that permits the repurchase of up to $10,000 of warrants. On November 3, 2016, the Board of Directors of Ambac authorized a $10,000 increase to the warrant repurchase program. For the six months ended June 30, 2018, Ambac did not repurchase any warrants. As of June 30, 2018, Ambac had repurchased 985,331 warrants at a total cost of $8,092, (average cost of $8.21 per warrant). The remaining aggregate authorization at June 30, 2018 was $11,939. In connection with the AMPS Exchange, Ambac issued 824,307 of the repurchased warrants on August 3, 2018. Refer to Note 1. Background and Business Description for further discussion of the AMPS Exchange.
Basic net income per share is computed by dividing net income attributable to common stockholders by the weighted-average number of common shares outstanding and vested restricted stock units. Diluted net income per share is computed by dividing net income attributable to common stockholders by the weighted-average number of common shares used for basic earnings per share plus all potential dilutive common shares outstanding during the period. All potential dilutive common shares outstanding consider common stock deliverable pursuant to warrants issued under Ambac's Chapter 11 Reorganization Plan, vested and unvested options, unvested restricted stock units and performance stock units granted under employee and director compensation plans.
The following table provides a reconciliation of the common shares used for basic net income per share to the diluted shares used for diluted net income per share:

|  | Three Months Ended June 30, |  | Six Months Ended June 30,
|  | 2018 |  | 2017 |  | 2018 |  | 2017
Basic weighted average shares outstanding |  | 45,683,058 |  |  | 45,369,213 |  |  | 45,577,656 |  |  | 45,330,946 |
Effect of potential dilutive shares (1): |  |  |  |  |  |  |  |
Warrants |  | 392,772 |  |  | 250,289 |  |  | 196,386 |  |  | — |
Restricted stock units |  | 70,498 |  |  | 27,609 |  |  | 54,720 |  |  | — |
Performance stock units (2) |  | 326,047 |  |  | 126,398 |  |  | 268,885 |  |  | — |
Diluted weighted average shares outstanding |  | 46,472,375 |  |  | 45,773,509 |  |  | 46,097,647 |  |  | 45,330,946 |
Anti-dilutive shares excluded from the above reconciliation: |  |  |  |  |  |  |  |
Stock options |  | 126,667 |  |  | 126,667 |  |  | 126,667 |  |  | 126,667 |
Warrants |  | — |  |  | — |  |  | — |  |  | 4,053,670 |
Restricted stock units |  | — |  |  | — |  |  | 5,362 |  |  | 68,654 |
Performance stock units (2) |  | — |  |  | 151,527 |  |  | — |  |  | 342,092 |

(1) | For the six months ended June 30, 2017, Ambac had a net loss and accordingly excluded all potentially dilutive securities from the determination of diluted loss per share as their impact was anti-dilutive.

(2) | Performance stock units that are dilutive are reflected based on the performance metrics through the balance sheet date. Performance stock units that are anti-dilutive are reflected at their target issuance amounts. Vesting of these units is contingent upon meeting certain performance metrics. Although a portion of these performance metrics have been achieved as of the respective period end, it is possible that awards may no longer meet the metric at the end of the performance period.

6. FINANCIAL GUARANTEE INSURANCE CONTRACTS
Amounts presented in this Note relate only to Ambac’s non-derivative insurance business for insurance policies issued to beneficiaries, including VIEs, for which we do not consolidate the VIE.
Net Premiums Earned:
Gross premiums are received either upfront or in installments. 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 assets underlying the insured obligation are homogenous pools 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 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 June 30, 2018 and December 31, 2017, was 2.7% and 2.5%, respectively, and the weighted average period of future premiums used to estimate the premium receivable at June 30, 2018 and December 31, 2017, was 8.9 years and 9.8 years, respectively.
| Ambac Financial Group, Inc. 18 2018 Second Quarter FORM 10-Q |

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
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. 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.
In evaluating the credit quality of the premium receivables, management evaluates the obligor's ability to pay. For structured finance transactions, this evaluation will include a review of the priority for the payment of financial guarantee premiums to Ambac, as required by bond indentures, in the transaction's waterfall structure. The financial guarantee premium is generally senior in the waterfall. Uncollectable premiums are determined on a policy basis and utilize a combination of historical premium collection data in addition to cash flow analysis to determine if an impairment in the related policy's premium receivables exist. At June 30, 2018 and December 31, 2017, $9,329 and $9,331 respectively, of premium receivables were deemed uncollectable. As of June 30, 2018 and December 31, 2017, approximately 21% and 22% of the premium receivables, net of uncollectable receivables, related to transactions with non-investment grade internal ratings, mainly of structured finance transactions, which comprised 14% and 16% of the total premium receivables at June 30, 2018 and December 31, 2017, respectively. Past due premiums on policies insuring non-investment grade obligations amounted to less than $500 at June 30, 2018.
Below is the gross premium receivable roll-forward for the affected periods:

|  | Six Months Ended June 30,
|  | 2018 |  | 2017
Beginning premium receivable |  | $ | 586,312 |  |  | $ | 661,337 |
Premium receipts |  | (29,822 | ) |  | (33,953 | )
Adjustments for changes in expected and contractual cash flows |  | (5,066 | ) |  | 4,285 |
Accretion of premium receivable discount |  | 7,627 |  |  | 8,379 |
Changes to uncollectable premiums |  | (11 | ) |  | (151 | )
Other adjustments (including foreign exchange) |  | (5,082 | ) |  | 13,279 |
Ending premium receivable (1) |  | $ | 553,958 |  |  | $ | 653,176 |

(1) | Gross premium receivable includes premiums to be received in foreign denominated currencies most notably in British Pounds and Euros. At June 30, 2018 and 2017, premium receivables include British Pounds of $151,316 (£114,729) and $192,983 (£148,277), respectively, and Euros of $33,114 (€28,380) and $35,814 (€31,361), respectively.

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.
When a bond issue insured by Ambac Assurance has been retired early, typically due to an issuer call, any remaining UPR is recognized at that time to the extent the financial guarantee contract is legally extinguished, causing accelerated premium revenue. 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. Ambac’s accelerated premium revenue for retired obligations for the three and six months ended June 30, 2018 was $6,103 and $15,495, respectively, and for the three and six months ended June 30, 2017 was $13,190 and $29,470, respectively. Certain obligations insured by Ambac have been legally defeased whereby government securities are purchased by the issuer with the proceeds of a new bond issuance, or less frequently with other funds of the issuer, and held in escrow. The principal and interest received from the escrowed securities are then used to retire the Ambac-insured obligations at a future date either to their maturity date (a refunding) or a specified call date (a pre-refunding). Ambac has evaluated the provisions in policies issued on these obligations and determined those insurance policies have not been legally extinguished. For policies with refunding securities, premium revenue recognition is not impacted as the escrowed maturity date is the same as the previous legal maturity date. For policies with pre-refunding securities, the maturity date of the pre-refunded security has been shortened from its previous legal maturity. Although premium revenue recognition has not been accelerated in the period of the pre-refunding, it results in an increase in the rate at which the policy's remaining UPR is to be recognized.
The effect of reinsurance on premiums written and earned for the respective periods was as follows:

| Three Months Ended June 30, |  | Six Months Ended June 30,
| 2018 |  | 2017 |  | 2018 |  | 2017
| Written |  | Earned |  | Written |  | Earned |  | Written |  | Earned |  | Written |  | Earned
Direct | $ | (611 | ) |  | $ | 27,339 |  |  | $ | 6,928 |  |  | $ | 47,235 |  |  | $ | 3,650 |  |  | $ | 59,947 |  |  | $ | 12,512 |  |  | $ | 99,300 |
Assumed | — |  |  | 19 |  |  | — |  |  | 20 |  |  | — |  |  | 39 |  |  | — |  |  | 41 |
Ceded | (224 | ) |  | 1,522 |  |  | 238 |  |  | 4,103 |  |  | (1,043 | ) |  | 3,267 |  |  | (1,577 | ) |  | 8,576 |
Net premiums | $ | (387 | ) |  | $ | 25,836 |  |  | $ | 6,690 |  |  | $ | 43,152 |  |  | $ | 4,693 |  |  | $ | 56,719 |  |  | $ | 14,089 |  |  | $ | 90,765 |

| Ambac Financial Group, Inc. 19 2018 Second Quarter FORM 10-Q |

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
The following table summarizes net premiums earned by location of risk for the respective periods:

|  | Three Months Ended June 30, |  | Six Months Ended June 30,
|  | 2018 |  | 2017 |  | 2018 |  | 2017
United States |  | $ | 19,752 |  |  | $ | 36,006 |  |  | $ | 44,469 |  |  | $ | 76,627 |
United Kingdom |  | 4,958 |  |  | 5,558 |  |  | 9,815 |  |  | 10,821 |
Other international |  | 1,126 |  |  | 1,588 |  |  | 2,435 |  |  | 3,317 |
Total |  | $ | 25,836 |  |  | $ | 43,152 |  |  | $ | 56,719 |  |  | $ | 90,765 |

The table below summarizes the future gross undiscounted premiums to be collected and future premiums earned, net of reinsurance at June 30, 2018:

| Future Premiums to be Collected (1) |  | Future Premiums to be Earned Net of Reinsurance (1)
Three months ended: |  |  |
September 30, 2018 | $ | 14,870 |  |  | $ | 15,557 |
December 31, 2018 | 11,906 |  |  | 15,396 |
Twelve months ended: |  |  |
December 31, 2019 | 53,357 |  |  | 58,623 |
December 31, 2020 | 50,663 |  |  | 54,829 |
December 31, 2021 | 44,623 |  |  | 50,054 |
December 31, 2022 | 42,702 |  |  | 46,732 |
Five years ended: |  |  |
December 31, 2027 | 190,365 |  |  | 190,800 |
December 31, 2032 | 149,700 |  |  | 128,304 |
December 31, 2037 | 84,272 |  |  | 71,289 |
December 31, 2042 | 30,773 |  |  | 24,543 |
December 31, 2047 | 14,357 |  |  | 12,732 |
December 31, 2052 | 3,621 |  |  | 4,647 |
December 31, 2057 | 95 |  |  | 297 |
Total | $ | 691,304 |  |  | $ | 673,803 |

(1) | Future premiums to be collected are undiscounted and are used to derive the discounted premium receivable asset recorded on Ambac's balance sheet. Future premiums to be earned, net of reinsurance relate to the unearned premiums liability and deferred ceded premium asset 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 further described in Note 2. Basis of Presentation and Significant Accounting Policies in the Notes to Consolidated Financial Statements included in Ambac's Annual Report on Form 10-K for the year ended December 31, 2017. This results in a different premium receivable balance than if expected lives were considered. If installment paying policies are retired or prepay early, premiums reflected in the premium receivable asset and amounts reported in the above table for such policies may not be collected. Future premiums to be earned also considers the use of contractual lives for many bond types which do not have homogeneous pools of underlying collateral, which may result in different unearned premium than if expected lives were considered. If those bonds types are retired early, premium earnings may be negative in the period of call or refinancing.

Loss and Loss Expense Reserves:
The loss and loss expense reserve (“loss reserve”) policy for financial guarantee insurance relates only to Ambac’s non-derivative insurance business for insurance policies issued to beneficiaries, including VIEs, for which we do not consolidate the VIE. Losses and loss expenses are based upon estimates of the ultimate aggregate losses inherent in the non-derivative financial guarantee portfolio as of the reporting date. A loss reserve is recorded on the balance sheet on a policy-by-policy basis. Loss reserve components of an insurance policy include unpaid claims and the present value ("PV") of expected net cash flows required to be paid under an insurance contract, further described below:

• | Unpaid claims represent the sum of (i) claims presented and not yet paid for policies allocated to the Segregated Account, including Deferred Amounts and (ii) accrued interest on Deferred Amounts as required by the amended Segregated Account Rehabilitation Plan that became effective on June 12, 2014. As a result of the Rehabilitation Exit Transactions, as of February 12, 2018, all unpaid claims for policies allocated to the Segregated Account were fully satisfied and discharged.

• | The PV of expected net cash flows represents the PV of expected cash outflows less the PV of expected cash inflows. The PV of expected net cash flows are impacted by: (i) expected future claims to be paid under an insurance contract, including the impact of potential settlement

| Ambac Financial Group, Inc. 20 2018 Second Quarter FORM 10-Q |

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
outcomes upon future installment premiums, (ii) expected recoveries from contractual breaches of RMBS representations and warranties ("R&W") by transaction sponsors, (iii) excess spread within the underlying transaction's cash flow structure, and (iv) other subrogation recoveries, including expected receipts from third parties within the underlying transaction's cash flow structure. Ambac’s approach to resolving disputes involving contractual breaches by transaction sponsors or other third parties has included negotiations and/or pursuing litigation. Ambac does not include potential recoveries attributed solely to fraudulent inducement claims in our estimate of subrogation recoveries, since any remedies under such claims would be non-contractual.
Net cash outflow policies represent contracts where the sum of unpaid claims plus the PV of expected cash outflows are greater than the PV of expected cash inflows. For such policies, a “Loss and loss expense reserves” liability is recorded for the sum of: (i) unpaid claims plus (ii) the excess of the PV of expected net cash outflows over the unearned premium revenue. Net cash inflow policies represent contracts where losses have been paid, but not yet recovered, such that the PV of expected cash inflows are greater than the sum of unpaid claims plus the PV of expected cash outflows. For such policies, a “Subrogation recoverable” asset is recorded for the difference between (i) the PV of expected net cash inflows and (ii) unpaid claims.
The approaches used to estimate expected future claims and expected future recoveries considers the likelihood of all possible outcomes. The evaluation process for determining expected losses is subject to material estimates and judgments based on our assumptions regarding the probability of default by the issuer of the insured security, probability of settlement outcomes (which may include commutation settlements, refinancing and/or other settlements), expected severity of credits for each insurance contract and the timing of expected events including default, commutation and recovery. Ambac’s loss reserves are based on management’s on-going review of the financial guarantee credit portfolio. Below are the components of the Loss and loss expense reserves liability and the Subrogation recoverable asset at June 30, 2018 and December 31, 2017:

| Unpaid Claims |  | Present Value of Expected Net Cash Flows |  |  |  |
Balance Sheet Line Item | Claims |  | Accrued Interest |  | Claims and Loss Expenses |  | Recoveries |  | Unearned Premium Revenue |  | Gross Loss and Loss Expense Reserves
June 30, 2018: |  |  |  |  |  |  |  |  |  |  |
Loss and loss expense reserves | $ | — |  |  | $ | — |  |  | $ | 2,484,967 |  |  | $ | (306,232 | ) |  | $ | (121,401 | ) |  | $ | 2,057,334 |
Subrogation recoverable | — |  |  | — |  |  | 264,850 |  |  | (2,141,038 | ) |  | — |  |  | (1,876,188 | )
Totals | $ | — |  |  | $ | — |  |  | $ | 2,749,817 |  |  | $ | (2,447,270 | ) |  | $ | (121,401 | ) |  | $ | 181,146 |
December 31, 2017: |  |  |  |  |  |  |  |  |  |  |
Loss and loss expense reserves | $ | 2,411,632 |  |  | $ | 667,988 |  |  | $ | 2,855,010 |  |  | $ | (1,054,113 | ) |  | $ | (135,502 | ) |  | $ | 4,745,015 |
Subrogation recoverable | 615,391 |  |  | 171,755 |  |  | 102,171 |  |  | (1,520,530 | ) |  | — |  |  | (631,213 | )
Totals | $ | 3,027,023 |  |  | $ | 839,743 |  |  | $ | 2,957,181 |  |  | $ | (2,574,643 | ) |  | $ | (135,502 | ) |  | $ | 4,113,802 |

Below is the loss and loss expense reserve roll-forward, net of subrogation recoverable and reinsurance, for the affected periods:

| Six Months Ended June 30,
| 2018 |  | 2017
Beginning gross loss and loss expense reserves | $ | 4,113,802 |  |  | $ | 3,696,038 |
Reinsurance recoverable | 40,658 |  |  | 30,767 |
Beginning balance of net loss and loss expense reserves | 4,073,144 |  |  | 3,665,271 |
Losses and loss expenses (benefit): |  |  |
Current year | 996 |  |  | 5,137 |
Prior years | (215,812 | ) |  | 195,974 |
Total (1) (2) (3) | (214,816 | ) |  | 201,111 |
Loss and loss expenses paid (recovered): |  |  |
Current year | 105 |  |  | 153 |
Prior years (3) | 3,708,992 |  |  | 7,607 |
Total | 3,709,097 |  |  | 7,760 |
Foreign exchange effect | (6,378 | ) |  | 17,622 |
Ending net loss and loss expense reserves | 142,853 |  |  | 3,876,244 |
Reinsurance recoverable (4) | 38,293 |  |  | 47,034 |
Ending gross loss and loss expense reserves (5) | $ | 181,146 |  |  | $ | 3,923,278 |

| Ambac Financial Group, Inc. 21 2018 Second Quarter FORM 10-Q |

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)

(1) | Total losses and loss expenses (benefit) includes $870 and $(16,469) for the six months ended June 30, 2018 and 2017, respectively, related to ceded reinsurance.

(2) | Ambac records the impact of estimated recoveries related to securitized loans in RMBS transactions that breached certain R&Ws within losses and loss expenses (benefit). The losses and loss expense (benefit) incurred associated with changes in estimated representation and warranties for the six months ended June 30, 2018 and 2017 was $17,602 and $22,175, respectively.

(3) | On February 12, 2018, Deferred Amounts and Interest Accrued on Deferred Amounts in the amount of $3,000,158 and $856,834, respectively were settled in connection with the Rehabilitation Exit Transactions. 2018 includes a $288,204 loss and loss expense benefit on these settled Deferred Amounts.

(4) | Represents reinsurance recoverable on future loss and loss expenses. Additionally, the Balance Sheet line "Reinsurance recoverable on paid and unpaid losses" includes reinsurance recoverables (payables) of $778 and $(568) as of June 30, 2018 and 2017, respectively, related to previously presented loss and loss expenses and subrogation.

(5) | Includes Euro denominated gross loss and loss expense reserves of $15,084 (€12,927) and $20,212 (€17,699) at June 30, 2018 and 2017, respectively.

For 2018, the net positive development in prior years was primarily a result of the discount recorded on the Rehabilitation Exit Transactions partially offset by negative development in the Public Finance and RMBS portfolio and interest accrued on Deferred Amounts prior to the Rehabilitation Exit Transactions.
For 2017, the net adverse development was primarily the result of negative development in certain public finance transactions, including Puerto Rico, and interest accrued on Deferred Amounts partially offset by positive development in certain Ambac UK transactions.
The tables below summarize information related to policies currently included in Ambac’s loss and loss expense reserves or subrogation recoverable at June 30, 2018 and December 31, 2017. Gross par exposures include capital appreciation bonds which are reported at the par amount at the time of issuance of the insurance policy as opposed to the current accreted value of the bond. The weighted average risk-free rate used to discount loss reserves at June 30, 2018 and December 31, 2017 was 2.9% and 2.5%, respectively.

Surveillance Categories as of June 30, 2018
| I |  | IA |  | II |  | III |  | IV |  | V |  | Total
Number of policies | 29 |  |  | 26 |  |  | 13 |  |  | 19 |  |  | 149 |  |  | 4 |  |  | 240 |
Remaining weighted-average contract period (in years) (1) | 10 |  |  | 22 |  |  | 9 |  |  | 23 |  |  | 13 |  |  | 4 |  |  | 16 |
Gross insured contractual payments outstanding: |  |  |  |  |  |  |  |  |  |  |  |  |
Principal | $ | 968,349 |  |  | $ | 571,525 |  |  | $ | 583,420 |  |  | $ | 1,925,546 |  |  | $ | 5,902,142 |  |  | $ | 43,972 |  |  | $ | 9,994,954 |
Interest | 523,712 |  |  | 578,171 |  |  | 228,073 |  |  | 7,175,101 |  |  | 2,284,742 |  |  | 15,231 |  |  | 10,805,030 |
Total | $ | 1,492,061 |  |  | $ | 1,149,696 |  |  | $ | 811,493 |  |  | $ | 9,100,647 |  |  | $ | 8,186,884 |  |  | $ | 59,203 |  |  | $ | 20,799,984 |
Gross undiscounted claim liability | $ | 4,231 |  |  | $ | 56,137 |  |  | $ | 48,815 |  |  | $ | 1,399,682 |  |  | $ | 2,474,435 |  |  | $ | 59,171 |  |  | $ | 4,042,471 |
Discount, gross claim liability | (534 | ) |  | (14,068 | ) |  | (6,569 | ) |  | (660,579 | ) |  | (680,162 | ) |  | (5,095 | ) |  | (1,367,007 | )
Gross claim liability before all subrogation and before reinsurance | 3,697 |  |  | 42,069 |  |  | 42,246 |  |  | 739,103 |  |  | 1,794,273 |  |  | 54,076 |  |  | 2,675,464 |
Less: |  |  |  |  |  |  |  |  |  |  |  |  |
Gross RMBS subrogation (2) | — |  |  | — |  |  | — |  |  | — |  |  | (1,851,859 | ) |  | — |  |  | (1,851,859 | )
Discount, RMBS subrogation | — |  |  | — |  |  | — |  |  | — |  |  | 35,474 |  |  | — |  |  | 35,474 |
Discounted RMBS subrogation, before reinsurance | — |  |  | — |  |  | — |  |  | — |  |  | (1,816,385 | ) |  | — |  |  | (1,816,385 | )
Less: |  |  |  |  |  |  |  |  |  |  |  |  |
Gross other subrogation (3) | — |  |  | (8,855 | ) |  | — |  |  | (45,560 | ) |  | (645,275 | ) |  | (13,095 | ) |  | (712,785 | )
Discount, other subrogation | — |  |  | 5,982 |  |  | — |  |  | 7,328 |  |  | 64,553 |  |  | 4,037 |  |  | 81,900 |
Discounted other subrogation, before reinsurance | — |  |  | (2,873 | ) |  | — |  |  | (38,232 | ) |  | (580,722 | ) |  | (9,058 | ) |  | (630,885 | )
Gross claim liability, net of all subrogation and discounts, before reinsurance | 3,697 |  |  | 39,196 |  |  | 42,246 |  |  | 700,871 |  |  | (602,834 | ) |  | 45,018 |  |  | 228,194 |
Less: Unearned premium revenue | (1,425 | ) |  | (9,951 | ) |  | (8,700 | ) |  | (43,963 | ) |  | (57,120 | ) |  | (242 | ) |  | (121,401 | )
Plus: Loss expense reserves | 2,778 |  |  | 1,419 |  |  | 1,116 |  |  | 8,823 |  |  | 60,217 |  |  | — |  |  | 74,353 |
Gross loss and loss expense reserves | $ | 5,050 |  |  | $ | 30,664 |  |  | $ | 34,662 |  |  | $ | 665,731 |  |  | $ | (599,737 | ) |  | $ | 44,776 |  |  | $ | 181,146 |
Reinsurance recoverable reported on Balance Sheet (4) | $ | 237 |  |  | $ | 4,404 |  |  | $ | 8,414 |  |  | $ | 38,028 |  |  | $ | (12,012 | ) |  | $ | — |  |  | $ | 39,071 |

(1) | Remaining weighted-average contract period is weighted based on projected gross claims over the lives of the respective policies.

| Ambac Financial Group, Inc. 22 2018 Second Quarter FORM 10-Q |

Table of Contents
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)

(2) | RMBS subrogation represents Ambac’s estimate of subrogation recoveries from RMBS transaction sponsors for representation and warranty ("R&W") breaches.

(3) | Other subrogation represents subrogation related to excess spread and other contractual cash flows on public finance and structured finance transactions, including RMBS.

(4) | Reinsurance recoverable reported on the Balance Sheet includes reinsurance recoverables of $38,293 related to future loss and loss expenses and $778 related to presented loss and loss expenses and subrogation.

Surveillance Categories as of December 31, 2017
| I |  | IA |  | II |  | III |  | IV |  | V |  | Total
Number of policies | 26 |  |  | 20 |  |  | 26 |  |  | 22 |  |  | 179 |  |  | 4 |  |  | 277 |
Remaining weighted-average contract period (in years) (1) | 10 |  |  | 23 |  |  | 10 |  |  | 24 |  |  | 13 |  |  | 4 |  |  | 17 |
Gross insured contractual payments outstanding: |  |  |  |  |  |  |  |  |  |  |  |  |
Principal | $ | 1,046,267 |  |  | $ | 531,190 |  |  | $ | 1,199,909 |  |  | $ | 1,998,861 |  |  | $ | 6,862,281 |  |  | $ | 48,562 |  |  | $ | 11,687,070 |
Interest | 531,657 |  |  | 584,098 |  |  | 413,045 |  |  | 7,182,715 |  |  | 2,469,765 |  |  | 16,332 |  |  | 11,197,612 |
Total | $ | 1,577,924 |  |  | $ | 1,115,288 |  |  | $ | 1,612,954 |  |  | $ | 9,181,576 |  |  | $ | 9,332,046 |  |  | $ | 64,894 |  |  | $ | 22,884,682 |
Gross undiscounted claim liability (2) | $ | 4,434 |  |  | $ | 56,659 |  |  | $ | 77,289 |  |  | $ | 1,412,976 |  |  | $ | 6,409,340 |  |  | $ | 64,863 |  |  | $ | 8,025,561 |
Discount, gross claim liability | (465 | ) |  | (13,095 | ) |  | (12,250 | ) |  | (643,897 | ) |  | (616,559 | ) |  | (4,739 | ) |  | (1,291,005 | )
Gross claim liability before all subrogation and before reinsurance | 3,969 |  |  | 43,564 |  |  | 65,039 |  |  | 769,079 |  |  | 5,792,781 |  |  | 60,124 |  |  | 6,734,556 |
Less: |  |  |  |  |  |  |  |  |  |  |  |  |
Gross RMBS subrogation (3) | — |  |  | — |  |  | — |  |  | — |  |  | (1,857,502 | ) |  | — |  |  | (1,857,502 | )
Discount, RMBS subrogation | — |  |  | — |  |  | — |  |  | — |  |  | 23,115 |  |  | — |  |  | 23,115 |
Discounted RMBS subrogation, before reinsurance | — |  |  | — |  |  | — |  |  | — |  |  | (1,834,387 | ) |  | — |  |  | (1,834,387 | )
Less: |  |  |  |  |  |  |  |  |  |  |  |  |
Gross other subrogation (4) | — |  |  | (7,990 | ) |  | (9,371 | ) |  | (53,070 | ) |  | (743,456 | ) |  | (13,191 | ) |  | (827,078 | )
Discount, other subrogation | — |  |  | 5,169 |  |  | 2,550 |  |  | 8,349 |  |  | 67,045 |  |  | 3,709 |  |  | 86,822 |
Discounted other subrogation, before reinsurance | — |  |  | (2,821 | ) |  | (6,821 | ) |  | (44,721 | ) |  | (676,411 | ) |  | (9,482 | ) |  | (740,256 | )
Gross claim liability, net of all subrogation and discounts, before reinsurance | 3,969 |  |  | 40,743 |  |  | 58,218 |  |  | 724,358 |  |  | 3,281,983 |  |  | 50,642 |  |  | 4,159,913 |
Less: Unearned premium revenue | (2,126 | ) |  | (9,990 | ) |  | (12,238 | ) |  | (46,086 | ) |  | (64,786 | ) |  | (276 | ) |  | (135,502 | )
Plus: Loss expense reserves | 16,116 |  |  | 3,242 |  |  | 665 |  |  | 13,331 |  |  | 56,037 |  |  | — |  |  | 89,391 |
Gross loss and loss expense reserves | $ | 17,959 |  |  | $ | 33,995 |  |  | $ | 46,645 |  |  | $ | 691,603 |  |  | $ | 3,273,234 |  |  | $ | 50,366 |  |  | $ | 4,113,802 |
Reinsurance recoverable reported on Balance Sheet (5) | $ | 202 |  |  | $ | 4,894 |  |  | $ | 9,424 |  |  | $ | 38,465 |  |  | $ | (11,988 | ) |  | $ | — |  |  | $ | 40,997 |

(1) | Remaining weighted-average contract period is weighted based on projected gross claims over the lives of the respective policies.

(2) | Gross undiscounted claim liability includes unpaid claims, including accrued interest on Deferred Amounts, on policies allocated to the Segregated Account and Ambac's estimate of expected future claims.

(3) | RMBS subrogation represents Ambac’s estimate of subrogation recoveries from RMBS transaction sponsors for R&W breaches.

(4) | Other subrogation represents subrogation related to excess spread and other contractual cash flows on public finance and structured finance transactions, including RMBS.

(5) | Reinsurance recoverable reported on Balance Sheet includes reinsurance recoverables of $40,658 related to future loss and loss expenses and $339 related to presented loss and loss expenses and subrogation.

Puerto Rico:
Ambac has exposure to the Commonwealth of Puerto Rico (the "Commonwealth") and its instrumentalities across several different issuing entities. Each has its own credit risk profile attributable to discrete revenue sources, direct general obligation pledges and general obligation guarantees. The Commonwealth of Puerto Rico and certain of its instrumentalities have defaulted and may continue to default on debt service payments, including payments owed on bonds insured by Ambac Assurance. Ambac Assurance may be required to make significant amounts of policy payments over the next several years, the recoverability of which is subject to great uncertainty, which may lead to material permanent losses. Our exposure to Puerto Rico is impacted by the amount of monies available for debt service, which is in turn affected by a number of factors including demographic trends, economic growth, tax policy and revenues, impact of reforms, fiscal plans, government actions, budgetary
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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
performance and flexibility, weather events, litigation outcomes, as well as federal funding of Commonwealth needs. In the near term, the financial and economic outlook for Puerto Rico is dependent upon a still fragile infrastructure, heightening its vulnerability to a weather event. Even as the Commonwealth entered the 2018 hurricane season, the Puerto Rico government continued to deal with the lasting effects of Hurricane Maria, which made landfall on September 20, 2017, as well as Hurricane Irma, which passed just north of the island on September 6, 2017. The longer term recovery of the Commonwealth economy and its essential infrastructure will likely be dependent on, amongst other factors, the management, usage and efficacy of federal resources. To that end, the Bipartisan Budget Act of 2018 (signed into law on February 9, 2018) requires Governor Rossello - in coordination with the FEMA administrator, the U.S. Treasury Secretary, the U.S. Energy Secretary and other federal agencies with responsibilities under the National Disaster Recovery Framework - to submit a report within six months to U.S. Congress outlining the Commonwealth’s 12- and 24-month economic and disaster recovery plan. Following the report’s submission, which occurred on August 8, 2018, the Governor and FEMA will release a public report every six months on progress toward goals outlined in the recovery plan. Transparency and accountability regarding Governor Rossello's recovery plan, amongst other aforementioned factors, will be important to ultimate creditor outcomes.
However, substantial uncertainty exists with respect to the ultimate outcome for creditors in Puerto Rico due to legislation enacted by the Commonwealth and the federal government, including PROMESA, as well as actions taken in reliance on such laws, including Title III filings. Ambac Assurance is involved in multiple litigations relating to such actions and other issues and may not be successful in pursuing claims or protecting its interests. As a result of litigation or other aspects of the restructuring processes, the difference among the credits insured by Ambac Assurance may not be respected. Ambac Assurance is also participating in a mediation process with respect to potential debt restructurings. With respect to its COFINA exposure, significant progress toward a negotiated resolution of the COFINA Title III proceeding has been made, but no assurance can be given that a Plan of Adjustment acceptable to Ambac Assurance will be agreed to or approved by the court overseeing COFINA’s Title III restructuring. Mediation may not be otherwise productive or may not resolve Ambac Assurance's claims in a manner that avoids significant losses. It is possible that certain restructuring process solutions, together with associated legislation, budgetary, and/or public policy proposals could be adopted and could significantly or further impair our exposures.
While our reserving scenarios reflect a wide range of possible outcomes, reflecting the significant uncertainty regarding future developments and outcomes, given our exposure to Puerto Rico and the economic, fiscal, legal and political uncertainties associated therewith as well as the uncertainties emanating from the damage caused by hurricanes Maria and Irma, our loss reserves may ultimately prove to be insufficient to cover our losses, potentially by a material amount, and may be subject to material volatility.
Ambac has considered these developments and other factors in evaluating its Puerto Rico loss reserves. During the six months ended June 30, 2018, Ambac had incurred losses associated with its Domestic Public Finance insured portfolio of $32,795, which was impacted by the continued uncertainty and volatility of the situation in Puerto Rico, partially offset by an increase in loss reserve discount rates. While management believes its reserves are adequate to cover losses in its Public Finance insured portfolio, there can be no assurance that Ambac may not incur additional losses in the future, particularly given the developing economic, political, and legal circumstances in Puerto Rico. Such additional losses may have a material adverse effect on Ambac’s results of operations and financial condition. For public finance credits, including Puerto Rico, as well as other issuers, for which Ambac has an estimate of expected loss at June 30, 2018, the possible increase in loss reserves under stress or other adverse conditions and circumstances was estimated to be approximately $1,270,000. However, there can be no assurance that losses may not exceed such amount.
Representation and Warranty Recoveries:
Ambac records estimated subrogation recoveries for breaches of R&Ws by sponsors of certain RMBS transactions. For a discussion of the approach utilized to estimate R&W subrogation recoveries, see Note 2. Basis of Presentation and Significant Accounting Policies in the Notes to Consolidated Financial Statements included Part II, Item 8 in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. R&W subrogation may include estimates of potential sponsor settlements which have not been subject to a sampling approach. However, such estimates are not material to Ambac’s financial results and therefore are included in the below table.
Ambac has recorded R&W subrogation recoveries of $1,816,385 ($1,789,134 net of reinsurance) and $1,834,387 ($1,806,736 net of reinsurance) at June 30, 2018 and December 31, 2017, respectively. The balance of R&W subrogation recoveries and the related loss reserves at June 30, 2018 and December 31, 2017, are as follows:

|  | Gross Loss Reserves Before Subrogation Recoveries (1) |  | Subrogation Recoveries (2)(3) |  | Gross Loss Reserves After Subrogation Recoveries
At June 30, 2018 |  | $ | 158,324 |  |  | $ | (1,816,385 | ) |  | $ | (1,658,061 | )
At December 31, 2017 |  | $ | 1,366,483 |  |  | $ | (1,834,387 | ) |  | $ | (467,904 | )

(1) | Amount represents gross loss reserves for policies that have established a representation and warranty subrogation recovery. December 31, 2017 includes unpaid RMBS claims (including accrued interest thereon) on policies allocated to the Segregated Account, such balances have been settled via the Rehabilitation Exit Transactions.

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)

(2) | The amount of recorded subrogation recoveries related to each securitization is limited to ever-to-date paid and unpaid losses plus the present value of expected future cash flows for each policy. To the extent losses have been paid but not yet fully recovered, the recorded amount of R&W subrogation recoveries may exceed the sum of the unpaid claims and the present value of expected cash out flows 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 the sum of unpaid claims and the present value of expected cash flows, the net cash outflow for these policies is recorded as a “Loss and loss expense reserves” liability.

(3) | The sponsor’s repurchase obligation may differ depending on the terms of the particular transaction and the status of the specific loan, such as whether it is performing or has been liquidated or charged off.

Below is the rollforward of R&W subrogation for the affected periods:

| Six Months Ended June 30,
| 2018 |  | 2017
Discounted R&W subrogation (gross of reinsurance) at beginning of period | $ | 1,834,387 |  |  | $ | 1,907,035 |
Changes recognized during the period: |  |  |
All other changes (1) | (18,002 | ) |  | (22,579 | )
Discounted R&W subrogation (gross of reinsurance) at end of period | $ | 1,816,385 |  |  | $ | 1,884,456 |

(1) | All other changes which may impact R&W subrogation recoveries include changes in actual or projected collateral performance, changes in the creditworthiness of a sponsor and/or the projected timing of recoveries. All other changes may also include estimates of potential sponsor settlements that may not have been subject to a sampling approach. Those that have not been subject to a sampling approach are not material to Ambac’s financial results and therefore are included in this table.

Our ability to realize R&W 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, intervention by OCI, which could impede our ability to take actions required to realize such recoveries, and uncertainty inherent in the assumptions used in estimating such recoveries. Failure to realize R&W subrogation recoveries for any reason or the realization of R&W subrogation recoveries materially below the amount recorded on Ambac's consolidated balance sheet would have a material adverse effect on our results of operations and financial condition and may result in adverse consequences such as impairing the ability of Ambac Assurance to honor its financial obligations; the initiation of rehabilitation proceedings against Ambac Assurance; decreased likelihood of Ambac Assurance delivering value to Ambac, through dividends or otherwise; and a significant drop in the value of securities issued or insured by Ambac or Ambac Assurance.
Insurance intangible asset:
The insurance intangible amortization expense is included in insurance intangible amortization on the Consolidated Statements of Total Comprehensive Income (Loss). For the three and six months ended June 30, 2018, the insurance intangible amortization expense was $23,242 and $51,878, respectively and for the three and six months ended June 30, 2017, the insurance intangible amortization expense was $33,471 and $70,996, respectively. As of June 30, 2018 and December 31, 2017, the gross carrying value of the insurance intangible asset was $1,568,403 and $1,581,156, respectively. Accumulated amortization of the insurance intangible asset was $782,195 and $734,183, as of June 30, 2018 and December 31, 2017, respectively, resulting in a net insurance intangible asset of $786,208 and $846,973, respectively.
The estimated future amortization expense for the net insurance intangible asset is as follows:

|  | 2018 |  | 2019 |  | 2020 |  | 2021 |  | 2022 |  | Thereafter
Amortization expense (1) |  | $ | 35,309 |  |  | $ | 66,024 |  |  | $ | 61,165 |  |  | $ | 55,771 |  |  | $ | 51,920 |  |  | $ | 516,019 |

(1) | Future amortization considers the use of contractual lives for many bond types which do not have homogeneous pools of underlying collateral. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay certain obligations. If those bonds types are retired early, amortization expense may differ in the period of call or refinancing.

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
7. FAIR VALUE MEASUREMENTS
The Fair Value Measurement Topic of the ASC establishes a framework for measuring fair value and disclosures about fair value measurements.
Fair Value Hierarchy:
The Fair Value Measurement Topic of the ASC specifies a fair value hierarchy based on whether the inputs to valuation techniques used to measure fair value are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect Company-based assumptions. The fair value hierarchy prioritizes model inputs into three broad levels as follows:

l | Level 1 |  | Quoted prices for identical instruments in active markets. Assets and liabilities classified as Level 1 include US Treasury and other foreign government obligations traded in highly liquid and transparent markets, exchange traded futures contracts, variable rate demand obligations and money market funds.
l | Level 2 |  | Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets. Assets and liabilities classified as Level 2 generally include investments in fixed income securities representing municipal, asset-backed and corporate obligations, certain interest rate swap contracts and most long-term debt of variable interest entities consolidated under the Consolidation Topic of the ASC.
l | Level 3 |  | Model derived valuations in which one or more significant inputs or significant value drivers are unobservable. This hierarchy requires the use of observable market data when available. Assets and liabilities classified as Level 3 include credit derivative contracts, certain uncollateralized interest rate swap contracts, equity interests in Ambac sponsored special purpose entities and certain investments in fixed income securities. Additionally, Level 3 assets and liabilities generally include loan receivables, and certain long-term debt of variable interest entities consolidated under the Consolidation Topic of the ASC.

The following table sets forth the carrying amount and fair value of Ambac’s financial assets and liabilities as of June 30, 2018 and December 31, 2017, including the level within the fair value hierarchy at which fair value measurements are categorized. As required by the Fair Value Measurement Topic of the ASC, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.
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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)

|  | Carrying Amount |  | Total Fair Value |  | Fair Value Measurements Categorized as:
June 30, 2018: |  | Level 1 |  | Level 2 |  | Level 3
Financial assets: |  |  |  |  |  |  |  |  |  |
Fixed income securities: |  |  |  |  |  |  |  |  |  |
Municipal obligations |  | $ | 899,122 |  |  | $ | 899,122 |  |  | $ | — |  |  | $ | 899,122 |  |  | $ | — |
Corporate obligations |  | 1,350,787 |  |  | 1,350,787 |  |  | 450 |  |  | 1,350,337 |  |  | — |
Foreign obligations |  | 25,442 |  |  | 25,442 |  |  | 24,346 |  |  | 1,096 |  |  | — |
U.S. government obligations |  | 82,413 |  |  | 82,413 |  |  | 82,413 |  |  | — |  |  | — |
Residential mortgage-backed securities |  | 512,309 |  |  | 512,309 |  |  | — |  |  | 512,309 |  |  | — |
Collateralized debt obligations |  | 65,457 |  |  | 65,457 |  |  | — |  |  | 65,457 |  |  | — |
Other asset-backed securities |  | 579,397 |  |  | 579,397 |  |  | — |  |  | 510,595 |  |  | 68,802 |
Fixed income securities, pledged as collateral: |  |  |  |  |  |  |  |  |  |
U.S. government obligations |  | 84,641 |  |  | 84,641 |  |  | 84,641 |  |  | — |  |  | — |
Short term investments |  | 393,447 |  |  | 393,447 |  |  | 314,070 |  |  | 79,377 |  |  | — |
Other investments (1) |  | 394,396 |  |  | 378,471 |  |  | 59,834 |  |  | — |  |  | 21,571 |
Cash and cash equivalents |  | 44,398 |  |  | 44,398 |  |  | 23,993 |  |  | 20,405 |  |  | — |
Loans |  | 10,007 |  |  | 12,039 |  |  | — |  |  | — |  |  | 12,039 |
Derivative assets: |  |  |  |  |  |  |  |  |  |
Interest rate swaps—asset position |  | 56,147 |  |  | 56,147 |  |  | — |  |  | 9,208 |  |  | 46,939 |
Interest rate swaps—liability position |  | (161 | ) |  | (161 | ) |  | — |  |  | (161 | ) |  | — |
Futures contracts |  | 524 |  |  | 524 |  |  | 524 |  |  | — |  |  | — |
Other assets |  | 5,255 |  |  | 5,255 |  |  | — |  |  | — |  |  | 5,255 |
Variable interest entity assets: |  |  |  |  |  |  |  |  |  |
Fixed income securities: Corporate obligations |  | 2,756,924 |  |  | 2,756,924 |  |  | — |  |  | — |  |  | 2,756,924 |
Restricted cash |  | 1,052 |  |  | 1,052 |  |  | 1,052 |  |  | — |  |  | — |
Loans |  | 10,751,199 |  |  | 10,751,199 |  |  | — |  |  | — |  |  | 10,751,199 |
Derivative assets: Currency swaps-asset position |  | 60,403 |  |  | 60,403 |  |  | — |  |  | 60,403 |  |  | — |
Total financial assets |  | $ | 17,988,518 |  |  | $ | 17,974,625 |  |  | $ | 506,682 |  |  | $ | 3,508,148 |  |  | $ | 13,662,729 |
Financial liabilities: |  |  |  |  |  |  |  |  |  |
Long term debt, including accrued interest |  | $ | 3,033,947 |  |  | $ | 3,147,361 |  |  | $ | — |  |  | $ | 2,733,359 |  |  | $ | 414,002 |
Derivative liabilities: |  |  |  |  |  |  |  |  |  |
Credit derivatives |  | 1,326 |  |  | 1,326 |  |  | — |  |  | — |  |  | 1,326 |
Interest rate swaps—asset position |  | — |  |  | — |  |  | — |  |  |  |  |  | — |
Interest rate swaps—liability position |  | 66,322 |  |  | 66,322 |  |  | — |  |  | 66,322 |  |  | — |
Liabilities for net financial guarantees written (2) |  | (463,146 | ) |  | 1,022,545 |  |  | — |  |  | — |  |  | 1,022,545 |
Variable interest entity liabilities: |  |  |  |  |  |  |  |  |  |
Long-term debt |  | 11,454,746 |  |  | 11,454,746 |  |  | — |  |  | 8,937,108 |  |  | 2,517,638 |
Derivative liabilities: Interest rate swaps—liability position |  | 1,992,227 |  |  | 1,992,227 |  |  | — |  |  | 1,992,227 |  |  | — |
Total financial liabilities |  | $ | 16,085,422 |  |  | $ | 17,684,527 |  |  | $ | — |  |  | $ | 13,729,016 |  |  | $ | 3,955,511 |

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)

|  | Carrying Amount |  | Total Fair Value |  | Fair Value Measurements Categorized as:
December 31, 2017: |  | Level 1 |  | Level 2 |  | Level 3
Financial assets: |  |  |  |  |  |  |  |  |  |
Fixed income securities: |  |  |  |  |  |  |  |  |  |
Municipal obligations |  | $ | 779,834 |  |  | $ | 779,834 |  |  | $ | — |  |  | $ | 779,834 |  |  | $ | — |
Corporate obligations |  | 860,075 |  |  | 860,075 |  |  | 450 |  |  | 859,625 |  |  | — |
Foreign obligations |  | 26,543 |  |  | 26,543 |  |  | 25,615 |  |  | 928 |  |  | — |
U.S. government obligations |  | 85,408 |  |  | 85,408 |  |  | 85,408 |  |  | — |  |  | — |
Residential mortgage-backed securities |  | 2,251,333 |  |  | 2,251,333 |  |  | — |  |  | 1,515,316 |  |  | 736,017 |
Collateralized debt obligations |  | 51,037 |  |  | 51,037 |  |  | — |  |  | 51,037 |  |  | — |
Other asset-backed securities |  | 597,942 |  |  | 597,942 |  |  | — |  |  | 525,402 |  |  | 72,540 |
Fixed income securities, pledged as collateral: |  |  |  |  |  |  |  |  |  |
U.S. government obligations |  | 99,719 |  |  | 99,719 |  |  | 99,719 |  |  | — |  |  | — |
Short term investments |  | 557,270 |  |  | 557,270 |  |  | 389,299 |  |  | 167,971 |  |  | — |
Other investments (1) |  | 431,630 |  |  | 413,977 |  |  | 56,498 |  |  | 29,750 |  |  | 17,288 |
Cash and cash equivalents |  | 623,703 |  |  | 623,703 |  |  | 615,073 |  |  | 8,630 |  |  | — |
Loans |  | 10,358 |  |  | 10,284 |  |  | — |  |  | — |  |  | 10,284 |
Derivative assets: |  |  |  |  |  |  |  |  |  |
Interest rate swaps—asset position |  | 73,199 |  |  | 73,199 |  |  | — |  |  | 11,825 |  |  | 61,374 |
Other assets |  | 5,979 |  |  | 5,979 |  |  | — |  |  | — |  |  | 5,979 |
Variable interest entity assets: |  |  |  |  |  |  |  |  |  |
Fixed income securities: Corporate obligations |  | 2,914,145 |  |  | 2,914,145 |  |  | — |  |  | — |  |  | 2,914,145 |
Restricted cash |  | 978 |  |  | 978 |  |  | 978 |  |  | — |  |  | — |
Loans |  | 11,529,384 |  |  | 11,529,384 |  |  | — |  |  | — |  |  | 11,529,384 |
Derivative assets: Currency swaps—asset position |  | 54,877 |  |  | 54,877 |  |  | — |  |  | 54,877 |  |  | — |
Total financial assets |  | $ | 20,853,695 |  |  | $ | 20,835,968 |  |  | $ | 1,173,321 |  |  | $ | 4,005,195 |  |  | $ | 15,347,011 |
Financial liabilities: |  |  |  |  |  |  |  |  |  |
Long term debt, including accrued interest |  | $ | 1,428,680 |  |  | $ | 1,369,499 |  |  | $ | — |  |  | $ | 1,046,511 |  |  | $ | 322,988 |
Derivative liabilities: |  |  |  |  |  |  |  |  |  |
Credit derivatives |  | 566 |  |  | 566 |  |  | — |  |  | — |  |  | 566 |
Interest rate swaps—asset position |  | (627 | ) |  | (627 | ) |  | — |  |  | (627 | ) |  | — |
Interest rate swaps—liability position |  | 81,495 |  |  | 81,495 |  |  | — |  |  | 81,495 |  |  | — |
Futures contracts |  | 1,348 |  |  | 1,348 |  |  | 1,348 |  |  | — |  |  | — |
Liabilities for net financial guarantees written (2) |  | 3,435,438 |  |  | 4,842,402 |  |  | — |  |  | — |  |  | 4,842,402 |
Variable interest entity liabilities: |  |  |  |  |  |  |  |  |  |
Long-term debt |  | 12,160,544 |  |  | 12,160,544 |  |  | — |  |  | 9,402,856 |  |  | 2,757,688 |
Derivative liabilities: Interest rate swaps—liability position |  | 2,205,264 |  |  | 2,205,264 |  |  | — |  |  | 2,205,264 |  |  | — |
Total financial liabilities |  | $ | 19,312,708 |  |  | $ | 20,660,491 |  |  | $ | 1,348 |  |  | $ | 12,735,499 |  |  | $ | 7,923,644 |

(1) | Excluded from the fair value measurement categories in the table above are investment funds of $297,066 and $310,441 as of June 30, 2018 and December 31, 2017, respectively, which are measured using NAV per share as a practical expedient.

(2) | The carrying value of net financial guarantees written includes the following balance sheet items: Premium receivables; Reinsurance recoverable on paid and unpaid losses; Deferred ceded premium; Subrogation recoverable; Insurance intangible asset; Unearned premiums; Loss and loss expense reserves; Ceded premiums payable, premiums taxes payable and other deferred fees recorded in Other liabilities.

Determination of Fair Value:
When available, Ambac uses quoted active market prices specific to the financial instrument to determine fair value, and classifies such items within Level 1. The determination of fair value for financial instruments categorized in Level 2 or 3 involves significant judgment due to the complexity of factors contributing to the valuation. Third-party sources from which we obtain independent market quotes also use assumptions, judgments and estimates in determining financial instrument values and different third parties may use different methodologies or provide different values for financial instruments. In addition, the use of internal valuation models may require assumptions about hypothetical or inactive markets. As a result of these factors, the actual trade value of a financial instrument in the market, or exit value of a financial instrument position by Ambac, may be significantly different from its recorded fair value.
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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
Ambac’s financial instruments carried at fair value are mainly comprised of investments in fixed income securities, equity interests in pooled investment funds, derivative instruments, variable interest entity assets and liabilities and interests in Ambac sponsored special purpose entities. Valuation of financial instruments is performed by Ambac’s finance group using methods approved by senior financial management with consultation from risk management and portfolio managers as appropriate. Preliminary valuation results are discussed with portfolio managers quarterly to assess consistency with market transactions and trends as applicable. Market transactions such as trades or negotiated settlements of similar positions, if any, are reviewed to validate fair value model results. However many of the financial instruments valued using significant unobservable inputs have very little or no observable market activity. Methods and significant inputs and assumptions used to determine fair values across portfolios are reviewed quarterly by senior financial management. Other valuation control procedures specific to particular portfolios are described further below.
We reflect Ambac’s own creditworthiness in the fair value of financial liabilities by including a credit valuation adjustment (“CVA”) in the determination of fair value. A decline (increase) in Ambac’s creditworthiness as perceived by market participants will generally result in a higher (lower) CVA, thereby lowering (increasing) the fair value of Ambac’s financial liabilities as reported.
Fixed Income Securities:
The fair values of fixed income investment securities are based primarily on market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. Because many fixed income securities do not trade on a daily basis, pricing sources apply available market information through processes such as matrix pricing to calculate fair value. Such prices generally consider a variety of factors, including recent trades of the same and similar securities. In those cases, the items are classified within Level 2. For those fixed income investments where quotes were not available or cannot be reasonably corroborated, fair values are based on internal valuation models. Key inputs to the internal valuation models generally include maturity date, coupon and yield curves for asset-type and credit rating characteristics that closely match those characteristics of the specific investment securities being valued. Items valued using valuation models are classified according to the lowest level input or value driver that is significant to the valuation. Thus, an item may be classified in Level 3 even though there may be significant inputs that are readily observable. Longer (shorter) expected maturities or higher (lower) yields used in the valuation model will, in isolation, result in decreases (increases) in fair value. Generally, lower credit ratings or longer expected maturities will be accompanied by higher yields used to value a security. At June 30, 2018, approximately 4%, 94% and 2% of the fixed income investment portfolio (excluding variable interest entity investments) was valued using dealer quotes, alternative pricing sources with reasonable levels of price transparency and internal valuation models, respectively. At December 31, 2017, approximately 6%, 79% and 15% of the fixed income investment portfolio (excluding variable interest entity investments) was valued using dealer quotes, alternative pricing sources with reasonable levels of price transparency and internal valuation models, respectively. At December 31, 2017, among the investments valued using internal valuation models were Ambac insured securities for which projected cash flows consisted solely of Deferred Amounts and interest thereon. These securities were internally valued based upon the valuation of Ambac Assurance's surplus notes and comprised 13% of the portfolio at December 31, 2017.
Ambac performs various review and validation procedures to quoted and modeled prices for fixed income securities, including price variance analyses, missing and static price reviews, overall valuation analysis by senior traders and finance managers and reviews associated with our ongoing impairment analysis. Unusual prices identified through these procedures will be evaluated further against alternative third party quotes (if available) and/or internally modeled prices, and the pricing source values will be challenged as necessary. Price challenges generally result in the use of the pricing source’s quote as originally provided or as revised by the source following their internal diligence process. A price challenge may result in a determination by either the pricing source or Ambac management that the pricing source cannot provide a reasonable value for a security or cannot adequately support a quote, in which case Ambac would resort to using either other quotes or internal models. Results of price challenges are reviewed by senior traders and finance managers.
Information about the valuation inputs for fixed income securities classified as Level 3 is included below:
Residential mortgage-backed securities: A portion of these securities were guaranteed under policies that were subject to the Segregated Account Rehabilitation Plan and had projected future cash flows consisting solely of Deferred Amounts under such policies including interest thereon. As described in Note 1. Background and Business Description, upon consummation of the Rehabilitation Exit Transactions on February 12, 2018, all Deferred Amounts have been settled. The fair value of such securities classified as Level 3 was $0 and $709,950 at June 30, 2018 and December 31, 2017, respectively. Fair value was calculated based on the valuation of Ambac Assurance surplus notes which, under the terms of the Segregated Account Rehabilitation Plan, were to be redeemed in proportion with the payment of Deferred Amounts on or about the dates when such payments were to be made.
The remaining portion of Level 3 residential mortgage-backed securities as of December 31, 2017 is an Ambac-insured re-REMIC containing distressed mortgage-backed securities as collateral. This security was transfered from Level 3 to Level 2 during the second quarter of 2018. The fair value of this security was $26,067 as of December 31, 2017. Fair value was calculated using a discounted cash flow approach with expected future cash flows discounted using a yield consistent with the security type and rating. Significant inputs for the valuations at December 31, 2017 were as follows:
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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)

December 31, 2017 |  |
a. Coupon rate: | 2.05% |  |  |
b. Average Life: | 0.65 years |  |  |
c. Yield: | 10.00% |  |  |

Other asset-backed securities: These securities are a subordinated tranche of a resecuritization collateralized by Ambac-insured military housing bonds. The fair value of such securities classified as Level 3 was $68,802 and $72,540 at June 30, 2018 and December 31, 2017, respectively. Fair value was calculated using a discounted cash flow approach with expected future cash flows discounted using a yield consistent with the security type and rating. Significant inputs for the valuation at June 30, 2018 and December 31, 2017 include the following weighted averages:

June 30, 2018: |  | December 31, 2017:
a. Coupon rate: | 5.97% |  | a. Coupon rate: | 5.97%
b. Average Life: | 16.65 years |  | b. Maturity: | 17.02 years
c. Yield: | 12.75% |  | c. Yield: | 12.00%

Other Investments:
Other investments primarily relate to investments in pooled investment funds. The fair value of pooled investment funds is determined using dealer quotes or alternative pricing sources when such investments have readily determinable fair values. When fair value is not readily determinable, pooled investment funds are valued using the net asset value (“NAV”) per share as a practical expedient as permitted under the Fair Value Measurement Topic of the ASC. Refer to Note 8. Investments for additional information about such investments in pooled funds that are reported at fair value using NAV as a practical expedient.
Other investments also includes Ambac's equity interest in a non-consolidated VIE, which is carried under the equity method. Valuation of this equity interest is internally calculated using a discounted cash flow approach and is classified as Level 3.
Derivative Instruments:
Ambac’s derivative instruments primarily comprise interest rate and credit default swaps and exchange traded futures contracts. Fair value is determined based upon market quotes from independent sources, when available. When independent quotes are not available, fair value is determined using valuation models. These valuation models require market-driven inputs, including contractual terms, credit spreads and ratings on underlying referenced obligations, yield curves and tax-exempt interest ratios. The valuation of certain interest rate as well as all credit derivative contracts also require the use of data inputs and assumptions that are determined by management and are not readily observable in the market. Under the Fair Value Measurement Topic of the ASC, Ambac is required to consider its own credit risk when measuring the fair value of derivatives. Additional factors considered in estimating the amount of any Ambac CVA on such contracts include collateral posting provisions, right of set-off with the counterparty, the period of time remaining on the derivative and the pricing of recent terminations.
As described further below, the selection of a model to value a derivative depends on the contractual terms of, and specific risks inherent in the instrument as well as the availability of pricing information in the market.
Derivatives that are less complex may be valued primarily by reference to interest rates and yield curves that are observable and regularly quoted, such as interest rate swaps, for which we generally utilize vendor-developed models. These models provide the net present value of the derivatives based on contractual terms and observable market data. Downgrades of Ambac Assurance, as guarantor of the derivatives, have increased collateral requirements and triggered termination provisions in certain interest rate swaps. Termination activity since the initial rating downgrades of Ambac Assurance provided additional information about the replacement and/or exit value of certain derivatives, which has been incorporated into the fair value of these derivatives as appropriate. Generally, the need for counterparty (or Ambac) CVAs is mitigated by the existence of collateral posting agreements under which adequate collateral has been posted. Derivative contracts entered into with financial guarantee customers are not subject to collateral posting agreements. Counterparty credit risk related to such customer derivative assets is included in our fair value adjustments.
For derivatives that do not trade, or trade in less liquid markets such as credit derivatives, an internal model is generally used because such instruments tend to be unique, contain complex or heavily modified and negotiated terms and pricing information is not readily available in the market. Derivative fair value models and the related assumptions are continuously re-evaluated by management and enhanced, as appropriate, based on improvements in modeling techniques. Ambac has not made any significant changes to its modeling techniques or related model inputs for the periods presented.
Credit Derivatives (“CDS”):
Fair value of Ambac’s CDS is determined using internal valuation models and represents the hypothetical transfer cost of the contract calculated as the difference between the net present value of the projected fees receivable under the CDS and our estimate of the fees a financial guarantor
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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
of comparable credit quality would charge to provide the same protection at the balance sheet date. Financial guarantee contracts, including CDS, are typically priced to capture some portion of the spread that would be observed in the capital markets for the underlying (insured) obligation. Because of this relationship and in the absence of severe credit deterioration, changes in the fair value of our credit default swaps will generally be less than changes in the fair value of the underlying reference obligations.
Key variables used in the valuation of our credit derivatives include the balance of unpaid notional, expected term, fair values of the underlying reference obligations, reference obligation credit ratings and the CVA applied against Ambac Assurance liabilities by market participants. Notional balances, expected remaining term and reference obligation credit ratings are monitored and determined by Ambac’s portfolio risk management group. Fair values of the underlying reference obligations are obtained from broker quotes when available or are estimated internally using the same methodologies used to value Ambac’s fixed income securities in its investment portfolio.
Ambac reflects changes in reference obligation credit ratings within the fair value of its CDS contracts by changing the percentage of the obligation's market spread (over LIBOR) that would be captured as a CDS fee at the valuation date. We adjust this percentage (“relative change ratio”) in our valuations based on internal rating changes such that the resulting fair value liability of the CDS contract, excluding the effect of Ambac's own credit risk, will increase up to the full amount of the unrealized loss on the reference obligation as the credit rating declines. Ambac incorporates its own credit risk into the valuation of its CDS liabilities by applying a CVA to the calculations described above. The Ambac CVA represents the difference between the present value of the hypothetical fees discounted at LIBOR compared to discount rates that incorporate Ambac credit risk.
Information about the above described model inputs used to determine the fair value of credit derivatives, including the CVA as a percentage of the gross mark-to-market liability before considering Ambac credit risk (“CVA percentage”), as of June 30, 2018 and December 31, 2017 is summarized below:

| June 30, 2018 |  | December 31, 2017
Number of CDS transactions |  | 2 |  |  | 2 |
Notional outstanding |  | $ | 311,237 |  |  | $ | 325,890 |
Weighted average reference obligation price |  | 98.1 |  |  | 99.3 |
Weighted average life (WAL) in years |  | 6.1 |  |  | 6.5 |
Weighted average credit rating |  | A |  |  | A |
Weighted average relative change ratio |  | 23.4 | % |  | 23.6 | %
CVA percentage |  | 8.06 | % |  | 9.64 | %
Fair value of derivative liabilities |  | $ | 1,326 |  |  | $ | 566 |

The maximum potential amount of future payments under Ambac’s credit derivative contracts is generally the gross notional outstanding amount included in the above table plus future interest payments by the derivative reference obligations. Since Ambac’s credit derivatives typically reference obligations of or assets held by special purpose entities that meet the definition of a VIE, the amount of maximum potential future payments for credit derivatives is included in the table in Note 3. Variable Interest Entities.
Changes in fair value are recorded in “Net change in fair value of credit derivatives” on the Consolidated Statements of Total Comprehensive Income (Loss). Although CDS contracts are accounted for at fair value, they are surveilled similar to non-derivative financial guarantee contracts. As with financial guarantee insurance policies, Ambac’s Risk Management group tracks credit migration of CDS contracts’ reference obligations from period to period. Credits are assigned risk classifications by the Risk Management group. As of June 30, 2018, there are no CDS contracts on Ambac’s adversely classified credit listing.
Significant unobservable inputs for credit derivatives include WAL, internal credit rating, relative change ratio and CVA percentage. A longer (shorter) WAL, lower (higher) reference obligation credit rating, higher (lower) relative change ratio or lower (higher) CVA, in isolation, would result in an increase (decrease) in the fair value liability measurement. A change in an internal credit rating of a reference obligation in our model will generally result in a directionally opposite change in the relative change ratio. Also, a shorter (longer) WAL will generally correspond with a lower (higher) CVA percentage.
Financial Guarantees:
Fair value of net financial guarantees written represents our estimate of the cost to Ambac to completely transfer its insurance obligation to another market participant of comparable credit worthiness. In theory, this amount should be the same amount that another market participant of comparable credit worthiness would hypothetically charge in the market place, on a present value basis, to provide the same protection as of the balance sheet date. This fair value estimate of financial guarantees is presented on a net basis and includes direct and assumed contracts written, net of ceded reinsurance contracts.
The fair value estimate of financial guarantees is computed by utilizing cash flows calculated at the policy level. For direct and assumed contracts, net cash flows for each policy includes future: (i) installment premium receipts, (ii) gross claim payments, (iii) subrogation receipts, and, (iv) at
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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
December 31, 2017, unpaid claims on claims presented and not yet paid for policies allocated to the Segregated Account, including Deferred Amounts and interest thereon. The timing of future claim payments of the Segregated Account was at the sole discretion of the Rehabilitator until the Segregated Account rehabilitation was concluded on February 12, 2018. For ceded reinsurance contracts, net cash flows for each policy includes future: (i) installment ceded premium payments, (ii) ceding commission receipts, (iii) ceded claim receipts, and (iv) ceded subrogation payments. For each assumed,or ceded reinsurance contract, the respective undiscounted cash flow components are aggregated to determine if we are in a net asset or net liability position. U.S. GAAP requires that the nonperformance risk of a financial liability be included in the estimation of fair value, which includes considering Ambac Assurance’s own credit risk. Accordingly, for each contract in a net liability position, we estimate the fair value using internally developed discount rates and market pricing that incorporate Ambac’s own credit risk and subsequently apply a profit margin. This profit margin represents what another market participant would require to assume the financial guarantee contracts. A profit margin was developed based on discussions with the third-party institutions with valuation expertise and discussions with industry participants. The discount rates used for contracts in a net liability position are derived from the rates implicit in the fair value of surplus notes and guaranteed securities with future cash flows that are highly dependent upon Ambac financial guarantee payments. For each contract in a net asset position, we estimate the fair value using a discount rate that is commensurate with a hypothetical buyer’s cost of capital.
This methodology is based on management’s expectations of how a market participant would estimate net cash flows. We are aware of a number of factors that may cause such fair or exit value to differ, perhaps materially. For example, (i) since no financial guarantor with Ambac Assurance’s credit quality is writing or otherwise obtaining financial guarantee business (e.g. reinsurance or novation of policies from other insurers) we do not have access to observable pricing data points and (ii) at December 31, 2017, certain segments of Ambac's financial guarantees were allocated to the Segregated Account and timing of the payments of such liabilities were at the sole discretion of the Rehabilitator.
Long-term Debt:
Long-term debt includes Ambac Assurance senior surplus notes and junior surplus notes, notes outstanding to third parties arising from Ambac Assurance's Secured Borrowing transaction (redeemed in June 2018) and the Ambac Note and Tier 2 Notes issued in connection with the Rehabilitation Exit Transactions. The fair values of senior surplus notes, the Secured Borrowing notes, the Ambac Note and Tier 2 Notes are classified as Level 2. The fair value of junior surplus notes are classified as Level 3.
Other Financial Assets and Liabilities:
The fair values of Loans and Ambac’s equity interest in Ambac sponsored VIEs (included in Other assets) are estimated based upon internal valuation models and are classified as Level 3.
Variable Interest Entity Assets and Liabilities:
The financial assets and liabilities of VIEs consolidated under the Consolidation Topic of the ASC consist primarily of fixed income securities, loans, derivative and debt instruments and are generally carried at fair value. These consolidated VIEs are securitization entities which have liabilities and/or assets guaranteed by Ambac Assurance. The fair values of VIE debt instruments are determined using the same methodologies used to value Ambac’s fixed income securities in its investment portfolio as described above. VIE debt fair value is based on market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. Such quotes are considered Level 2 and generally consider a variety of factors, including recent trades of the same and similar securities. For those VIE debt instruments where quotes were not available, the debt instrument fair values are considered Level 3 and are based on internal discounted cash flow models. Comparable to the sensitivities of investments in fixed income securities described above, longer (shorter) expected maturities or higher (lower) yields used in the valuation model will, in isolation, result in decreases (increases) in fair value liability measurement for VIE debt. VIE debt instruments considered Level 3 include fixed rate, floating rate and zero coupon notes secured by various asset types, primarily European ABS. Information about the valuation inputs for the various VIE debt categories classified as Level 3 is as follows:
European ABS transactions: The fair value of such obligations classified as Level 3 was $2,517,638 and $2,757,688 at June 30, 2018 and December 31, 2017, respectively. Fair values were calculated by using a discounted cash flow approach. The discount rates used were based on the rates implied from the third party quoted values for comparable notes from the same securitization entity. Significant inputs for the valuation at June 30, 2018 and December 31, 2017 include the following weighted averages:

June 30, 2018: |  | December 31, 2017:
a. Coupon rate: | 0.36% |  | a. Coupon rate: | 0.40%
b. Maturity: | 14.80 years |  | b. Maturity: | 15.28 years
c. Yield: | 5.84% |  | c. Yield: | 4.82%

VIE derivative asset and liability fair values are determined using valuation models. When specific derivative contractual terms are available and may be valued primarily by reference to interest rates, foreign exchange rates and yield curves that are observable and regularly quoted, the derivatives are valued using vendor-developed models. Other derivatives within the VIEs that include significant unobservable valuation inputs are valued using internally developed models. VIE derivative fair value balances at June 30, 2018 and December 31, 2017 were developed using vendor-developed models and do not use significant unobservable inputs.
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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
The fair value of VIE assets are obtained from market quotes when available. Typically VIE asset fair values are not readily available from market quotes and are estimated internally. The consolidated VIEs are securitization entities in which net cash flows from assets and derivatives (after adjusting for financial guarantor cash flows and other expenses) will be paid out to note holders or equity interests. Our valuation of VIE assets (fixed income securities or loans), therefore, are derived from the fair value of notes and derivatives, as described above, adjusted for the fair value of cash flows from Ambac’s financial guarantee. The fair value of financial guarantee cash flows include: (i) estimated future premiums discounted at a rate consistent with that implicit in the fair value of the VIE’s liabilities and (ii) internal estimates of future loss payments by Ambac discounted at a rate that includes Ambac’s own credit risk. Estimated future premium payments to be paid by the VIEs were discounted at a weighted average rate of 3.4% and 3.1% at June 30, 2018 and December 31, 2017, respectively. The value of future loss payments to be paid by Ambac to the VIEs was adjusted to include an Ambac CVA appropriate for the term of expected Ambac claim payments.
Additional Fair Value Information for Financial Assets and Liabilities Accounted for at Fair Value:
The following tables present the changes in the Level 3 fair value category for the periods presented in 2018 and 2017. Ambac classifies financial instruments in Level 3 of the fair value hierarchy when there is reliance on at least one significant unobservable input to the valuation model. In addition to these unobservable inputs, the valuation models for Level 3 financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly. Thus, the gains and losses presented below include changes in the fair value related to both observable and unobservable inputs.

Level 3 - Financial Assets and Liabilities Accounted for at Fair Value |  |  |  |  |  |  |  |
|  |  |  |  |  |  |  | VIE Assets and Liabilities |  |
|  | Investments |  | Other Assets |  | Derivatives |  | Investments |  | Loans |  | Long-term Debt |  | Total
Three Months Ended June 30, 2018: |  |  |  |  |  |  |  |  |  |  |  |  |  |
Balance, beginning of period |  | $ | 77,630 |  |  | $ | 5,621 |  |  | $ | 49,908 |  |  | $ | 2,955,763 |  |  | $ | 11,558,331 |  |  | $ | (2,696,516 | ) |  | $ | 11,950,737 |
Total gains/(losses) realized and unrealized: |  |  |  |  |  |  |  |  |  |  |  |  |  |
Included in earnings |  | 282 |  |  | (366 | ) |  | (2,682 | ) |  | (4,137 | ) |  | 27,466 |  |  | 17,228 |  |  | 37,791 |
Included in other comprehensive income |  | (3,514 | ) |  | — |  |  | — |  |  | (177,107 | ) |  | (672,595 | ) |  | 161,650 |  |  | (691,566 | )
Purchases |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Sales |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Settlements |  | (287 | ) |  | — |  |  | (1,613 | ) |  | (17,595 | ) |  | (162,003 | ) |  | — |  |  | (181,498 | )
Transfers out of Level 3 |  | (5,309 | ) |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | (5,309 | )
Balance, end of period |  | $ | 68,802 |  |  | $ | 5,255 |  |  | $ | 45,613 |  |  | $ | 2,756,924 |  |  | $ | 10,751,199 |  |  | $ | (2,517,638 | ) |  | $ | 11,110,155 |
The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date |  | $ | — |  |  | $ | (366 | ) |  | $ | (2,773 | ) |  | $ | (4,137 | ) |  | $ | 27,466 |  |  | $ | 17,228 |  |  | $ | 37,418 |
Three Months Ended June 30, 2017: |  |  |  |  |  |  |  |  |  |  |  |  |  |
Balance, beginning of period |  | $ | 721,624 |  |  | $ | 7,039 |  |  | $ | (102,588 | ) |  | $ | 2,663,719 |  |  | $ | 11,015,305 |  |  | $ | (2,716,642 | ) |  | $ | 11,588,457 |
Total gains/(losses) realized and unrealized: |  |  |  |  |  |  |  |  |  |  |  |  |  |
Included in earnings |  | 16,479 |  |  | (348 | ) |  | 54,115 |  |  | (26,259 | ) |  | 32,198 |  |  | 14,100 |  |  | 90,285 |
Included in other comprehensive income |  | 10,812 |  |  | — |  |  | — |  |  | 100,783 |  |  | 402,842 |  |  | (102,138 | ) |  | 412,299 |
Purchases |  | 25,930 |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | 25,930 |
Sales |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Settlements |  | (9,163 | ) |  | — |  |  | 101,202 |  |  | (15,927 | ) |  | (149,047 | ) |  | 462 |  |  | (72,473 | )
Balance, end of period |  | $ | 765,682 |  |  | $ | 6,691 |  |  | $ | 52,729 |  |  | $ | 2,722,316 |  |  | $ | 11,301,298 |  |  | $ | (2,804,218 | ) |  | $ | 12,044,498 |
The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date |  | $ | — |  |  | $ | (348 | ) |  | $ | 4,240 |  |  | $ | (26,259 | ) |  | $ | 32,198 |  |  | $ | 14,100 |  |  | $ | 23,931 |

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)

Level 3 - Financial Assets and Liabilities Accounted for at Fair Value |  |  |  |  |  |  |  |
|  |  |  |  |  |  |  | VIE Assets and Liabilities |  |
|  | Investments |  | Other Assets |  | Derivatives |  | Investments |  | Loans |  | Long-term Debt |  | Total
Six Months Ended June 30, 2018: |  |  |  |  |  |  |  |  |  |  |  |  |  |
Balance, beginning of period |  | $ | 808,557 |  |  | $ | 5,979 |  |  | $ | 60,808 |  |  | $ | 2,914,145 |  |  | $ | 11,529,384 |  |  | $ | (2,757,688 | ) |  | $ | 12,561,185 |
Total gains/(losses) realized and unrealized: |  |  |  |  |  |  |  |  |  |  |  |  |  |
Included in earnings |  | 35,466 |  |  | (724 | ) |  | (12,057 | ) |  | (73,163 | ) |  | (175,122 | ) |  | 177,213 |  |  | (48,387 | )
Included in other comprehensive income |  | (56,022 | ) |  | — |  |  | — |  |  | (66,463 | ) |  | (248,703 | ) |  | 57,773 |  |  | (313,415 | )
Purchases |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Sales |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Settlements |  | (713,890 | ) |  | — |  |  | (3,138 | ) |  | (17,595 | ) |  | (354,360 | ) |  | 5,064 |  |  | (1,083,919 | )
Transfers out of Level 3 |  | (5,309 | ) |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | (5,309 | )
Balance, end of period |  | $ | 68,802 |  |  | $ | 5,255 |  |  | $ | 45,613 |  |  | $ | 2,756,924 |  |  | $ | 10,751,199 |  |  | $ | (2,517,638 | ) |  | $ | 11,110,155 |
The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date |  | $ | — |  |  | $ | (724 | ) |  | $ | (12,254 | ) |  | $ | (73,163 | ) |  | $ | (175,122 | ) |  | $ | 177,213 |  |  | $ | (84,050 | )
Six Months Ended June 30, 2017: |  |  |  |  |  |  |  |  |  |  |  |  |  |
Balance, beginning of period |  | $ | 762,703 |  |  | $ | 7,382 |  |  | $ | (100,282 | ) |  | $ | 2,622,566 |  |  | $ | 10,658,963 |  |  | $ | (2,582,220 | ) |  | $ | 11,369,112 |
Total gains/(losses) realized and unrealized: |  |  |  |  |  |  |  |  |  |  |  |  |  |
Included in earnings |  | 26,298 |  |  | (691 | ) |  | 51,298 |  |  | (31,454 | ) |  | 378,390 |  |  | (80,307 | ) |  | 343,534 |
Included in other comprehensive income |  | 17,097 |  |  | — |  |  | — |  |  | 147,131 |  |  | 586,391 |  |  | (148,394 | ) |  | 602,225 |
Purchases |  | 35,781 |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | 35,781 |
Sales |  | (79,319 | ) |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | (79,319 | )
Settlements |  | (18,956 | ) |  | — |  |  | 101,713 |  |  | (15,927 | ) |  | (322,446 | ) |  | 6,703 |  |  | (248,913 | )
Transfers in Level 3 |  | 22,078 |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | 22,078 |
Balance, end of period |  | $ | 765,682 |  |  | $ | 6,691 |  |  | $ | 52,729 |  |  | $ | 2,722,316 |  |  | $ | 11,301,298 |  |  | $ | (2,804,218 | ) |  | $ | 12,044,498 |
The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date |  | $ | — |  |  | $ | (691 | ) |  | $ | 3,914 |  |  | $ | (31,454 | ) |  | $ | 378,390 |  |  | $ | (80,307 | ) |  | $ | 269,852 |

The tables below provide roll-forward information by class of investments and derivatives measured using significant unobservable inputs.

Level 3 - Investments by Class: |  |  |  |  |  |  |  |  |  |  |  |
|  | Three Months Ended June 30, 2018 |  | Three Months Ended June 30, 2017
|  | Other Asset Backed Securities |  | Non-Agency RMBS |  | Total Investments |  | Other Asset Backed Securities |  | Non-Agency RMBS |  | Total Investments
Balance, beginning of period |  | $ | 72,321 |  |  | $ | 5,309 |  |  | $ | 77,630 |  |  | $ | 65,807 |  |  | $ | 655,817 |  |  | $ | 721,624 |
Total gains/(losses) realized and unrealized: |  |  |  |  |  |  |  |  |  |  |  |
Included in earnings |  | 282 |  |  | — |  |  | 282 |  |  | 356 |  |  | 16,123 |  |  | 16,479 |
Included in other comprehensive income |  | (3,514 | ) |  | — |  |  | (3,514 | ) |  | (555 | ) |  | 11,367 |  |  | 10,812 |
Purchases |  | — |  |  | — |  |  | — |  |  | — |  |  | 25,930 |  |  | 25,930 |
Sales |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Settlements |  | (287 | ) |  | — |  |  | (287 | ) |  | (242 | ) |  | (8,921 | ) |  | (9,163 | )
Transfers out of Level 3 |  | — |  |  | (5,309 | ) |  | (5,309 | ) |  | — |  |  | — |  |  | — |
Balance, end of period |  | $ | 68,802 |  |  | $ | — |  |  | $ | 68,802 |  |  | $ | 65,366 |  |  | $ | 700,316 |  |  | $ | 765,682 |
The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date |  | $ | — |  |  | $ | — |  |  | $ | — |  |  | $ | — |  |  | $ | — |  |  | $ | — |

| Ambac Financial Group, Inc. 34 2018 Second Quarter FORM 10-Q |

Table of Contents
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)

Level 3 - Investments by Class: |  |  |  |  |  |  |  |  |  |  |  |
|  | Six Months Ended June 30, 2018 |  | Six Months Ended June 30, 2017
|  | Other Asset Backed Securities |  | Non-Agency RMBS |  | Total Investments |  | Other Asset Backed Securities |  | Non-Agency RMBS |  | Total Investments
Balance, beginning of period |  | $ | 72,540 |  |  | $ | 736,017 |  |  | $ | 808,557 |  |  | $ | 65,990 |  |  | $ | 696,713 |  |  | $ | 762,703 |
Total gains/(losses) realized and unrealized: |  |  |  |  |  |  |  |  |  |  |  |
Included in earnings |  | 739 |  |  | 34,727 |  |  | 35,466 |  |  | 709 |  |  | 25,589 |  |  | 26,298 |
Included in other comprehensive income |  | (3,884 | ) |  | (52,138 | ) |  | (56,022 | ) |  | (834 | ) |  | 17,931 |  |  | 17,097 |
Purchases |  | — |  |  | — |  |  | — |  |  | — |  |  | 35,781 |  |  | 35,781 |
Sales |  | — |  |  | — |  |  | — |  |  | — |  |  | (79,319 | ) |  | (79,319 | )
Settlements |  | (593 | ) |  | (713,297 | ) |  | (713,890 | ) |  | (499 | ) |  | (18,457 | ) |  | (18,956 | )
Transfers into Level 3 |  | — |  |  | — |  |  | — |  |  | — |  |  | 22,078 |  |  | 22,078 |
Transfers out of Level 3 |  | — |  |  | (5,309 | ) |  | (5,309 | ) |  | — |  |  | — |  |  | — |
Balance, end of period |  | 68,802 |  |  | — |  |  | 68,802 |  |  | 65,366 |  |  | 700,316 |  |  | 765,682 |
The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date |  | $ | — |  |  | $ | — |  |  | $ | — |  |  | $ | — |  |  | $ | — |  |  | $ | — |

Level 3 - Derivatives by Class: |  |  |  |
|  | Three Months Ended June 30, 2018 |  | Three Months Ended June 30, 2017
|  | Interest Rate Swaps |  | Credit Derivatives |  | Total Derivatives |  | Interest Rate Swaps |  | Credit Derivatives |  | Total Derivatives
Balance, beginning of period |  | $ | 50,926 |  |  | $ | (1,018 | ) |  | $ | 49,908 |  |  | $ | (88,092 | ) |  | $ | (14,496 | ) |  | $ | (102,588 | )
Total gains/(losses) realized and unrealized: |  |  |  |  |  |  |  |  |  |  |  |
Included in earnings |  | (2,465 | ) |  | (217 | ) |  | (2,682 | ) |  | 47,491 |  |  | 6,624 |  |  | 54,115 |
Included in other comprehensive income |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Purchases |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Sales |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Settlements |  | (1,522 | ) |  | (91 | ) |  | (1,613 | ) |  | 102,336 |  |  | (1,134 | ) |  | 101,202 |
Balance, end of period |  | $ | 46,939 |  |  | $ | (1,326 | ) |  | $ | 45,613 |  |  | $ | 61,735 |  |  | $ | (9,006 | ) |  | $ | 52,729 |
The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date |  | $ | (2,465 | ) |  | $ | (308 | ) |  | $ | (2,773 | ) |  | $ | 4,049 |  |  | $ | 191 |  |  | $ | 4,240 |

Level 3 - Derivatives by Class: |  |  |  |
|  | Six Months Ended June 30, 2018 |  | Six Months Ended June 30, 2017
|  | Interest Rate Swaps |  | Credit Derivatives |  | Total Derivatives |  | Interest Rate Swaps |  | Credit Derivatives |  | Total Derivatives
Balance, beginning of period |  | $ | 61,374 |  |  | $ | (566 | ) |  | $ | 60,808 |  |  | $ | (84,933 | ) |  | $ | (15,349 | ) |  | $ | (100,282 | )
Total gains/(losses) realized and unrealized: |  |  |  |  |  |  |  |  |  |  |  |
Included in earnings |  | (11,494 | ) |  | (563 | ) |  | (12,057 | ) |  | 43,622 |  |  | 7,676 |  |  | 51,298 |
Included in other comprehensive income |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Purchases |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Sales |  | — |  |  | — |  |  | — |  |  | — |  |  | — |  |  | — |
Settlements |  | (2,941 | ) |  | (197 | ) |  | (3,138 | ) |  | 103,046 |  |  | (1,333 | ) |  | 101,713 |
Balance, end of period |  | $ | 46,939 |  |  | $ | (1,326 | ) |  | $ | 45,613 |  |  | $ | 61,735 |  |  | $ | (9,006 | ) |  | $ | 52,729 |
The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date |  | $ | (11,494 | ) |  | $ | (760 | ) |  | $ | (12,254 | ) |  | $ | 3,863 |  |  | $ | 51 |  |  | $ | 3,914 |

| Ambac Financial Group, Inc. 35 2018 Second Quarter FORM 10-Q |

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
Invested assets and VIE long-term debt are transferred into Level 3 when internal valuation models that include significant unobservable inputs are used to estimate fair value. All such securities that have internally modeled fair values have been classified as Level 3. Non-agency RMBS securities transferred from Level 2 into Level 3 in 2017, and out of Level 3 into Level 2 in 2018, consist of an Ambac-insured re-REMIC collateralized by distressed mortgage-backed securities.
Derivative instruments are transferred into Level 3 when the use of unobservable inputs becomes significant to the overall valuation. There were no transfers of derivative instruments into or out of Level 3 in the periods disclosed.
There were no transfers between Level 1 and Level 2 for the periods presented. All transfers between fair value hierarchy Levels 1, 2, and 3 are recognized at the beginning of each accounting period.
Gains and losses (realized and unrealized) relating to Level 3 assets and liabilities included in earnings for the affected periods are reported as follows:

|  | Net Investment Income |  | Realized Gains or (Losses) and Other Settlements on Credit Derivative Contracts |  | Unrealized Gains or (Losses) on Credit Derivative Contracts |  | Derivative Products Revenues (Interest Rate Swaps) |  | Income (Loss) on Variable Interest Entities |  | Other Income or (Loss)
Three Months Ended June 30, 2018: |  |  |  |  |  |  |  |  |  |  |  |
Total gains or losses included in earnings for the period |  | $ | 282 |  |  | $ | 91 |  |  | $ | (308 | ) |  | $ | (2,465 | ) |  | $ | 40,557 |  |  | $ | (366 | )
Changes in unrealized gains or losses relating to the assets and liabilities still held at the reporting date |  | — |  |  | — |  |  | (308 | ) |  | (2,465 | ) |  | 40,557 |  |  | (366 | )
Three Months Ended June 30, 2017: |  |  |  |  |  |  |  |  |  |  |  |
Total gains or losses included in earnings for the period |  | $ | 16,479 |  |  | $ | 1,134 |  |  | $ | 5,490 |  |  | $ | 47,491 |  |  | $ | 20,039 |  |  | $ | (348 | )
Changes in unrealized gains or losses relating to the assets and liabilities still held at the reporting date |  | — |  |  | — |  |  | 191 |  |  | 4,049 |  |  | 20,039 |  |  | (348 | )
Six Months Ended June 30, 2018: |  |  |  |  |  |  |  |  |  |  |  |
Total gains or losses included in earnings for the period |  | $ | 35,466 |  |  | $ | 197 |  |  | $ | (760 | ) |  | $ | (11,494 | ) |  | $ | (71,072 | ) |  | $ | (724 | )
Changes in unrealized gains or losses relating to the assets and liabilities still held at the reporting date |  | — |  |  | — |  |  | (760 | ) |  | (11,494 | ) |  | (71,072 | ) |  | (724 | )
Six Months Ended June 30, 2017: |  |  |  |  |  |  |  |  |  |  |  |
Total gains or losses included in earnings for the period |  | $ | 26,298 |  |  | $ | 1,333 |  |  | $ | 6,343 |  |  | $ | 43,622 |  |  | $ | 266,629 |  |  | $ | (691 | )
Changes in unrealized gains or losses relating to the assets and liabilities still held at the reporting date |  | — |  |  | — |  |  | 51 |  |  | 3,863 |  |  | 266,629 |  |  | (691 | )

| Ambac Financial Group, Inc. 36 2018 Second Quarter FORM 10-Q |

Table of Contents
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
8. INVESTMENTS
Ambac’s non-VIE invested assets are primarily comprised of fixed income securities classified as available-for-sale and equity interests in pooled investment funds. Such equity interests in the form of common stock or in-substance common stock are classified as trading securities and are reported within Other investments on the Consolidated Balance Sheets. Other investments also include Ambac's debt (at December 31, 2017 only) and equity interests in an unconsolidated trust created in connection with its sale of Segregated Account junior surplus notes on August 28, 2014.
Fixed Income Securities:
The amortized cost and estimated fair value of available-for-sale investments, excluding VIE investments, at June 30, 2018 and December 31, 2017 were as follows:

|  | Amortized Cost |  | Gross Unrealized Gains |  | Gross Unrealized Losses |  | Estimated Fair Value |  | Non-credit Other-than temporary Impairments (1)
June 30, 2018: |  |  |  |  |  |  |  |  |  |
Fixed income securities: |  |  |  |  |  |  |  |  |  |
Municipal obligations |  | $ | 862,256 |  |  | $ | 38,667 |  |  | $ | 1,801 |  |  | $ | 899,122 |  |  | $ | — |
Corporate obligations (2) |  | 1,354,633 |  |  | 15,508 |  |  | 19,354 |  |  | 1,350,787 |  |  | — |
Foreign obligations |  | 25,347 |  |  | 269 |  |  | 174 |  |  | 25,442 |  |  | — |
U.S. government obligations |  | 83,579 |  |  | 629 |  |  | 1,795 |  |  | 82,413 |  |  |  |
Residential mortgage-backed securities |  | 460,252 |  |  | 59,441 |  |  | 7,384 |  |  | 512,309 |  |  | 7,306 |
Collateralized debt obligations |  | 65,255 |  |  | 202 |  |  | — |  |  | 65,457 |  |  | — |
Other asset-backed securities |  | 503,901 |  |  | 79,686 |  |  | 4,190 |  |  | 579,397 |  |  | — |
|  | 3,355,223 |  |  | 194,402 |  |  | 34,698 |  |  | 3,514,927 |  |  | 7,306 |
Short-term |  | 393,516 |  |  | 6 |  |  | 75 |  |  | 393,447 |  |  | — |
|  | 3,748,739 |  |  | 194,408 |  |  | 34,773 |  |  | 3,908,374 |  |  | 7,306 |
Fixed income securities pledged as collateral: |  |  |  |  |  |  |  |  |  |
U.S. government obligations |  | 84,641 |  |  | — |  |  | — |  |  | 84,641 |  |  | — |
Total collateralized investments |  | 84,641 |  |  | — |  |  | — |  |  | 84,641 |  |  | — |
Total available-for-sale investments |  | $ | 3,833,380 |  |  | $ | 194,408 |  |  | $ | 34,773 |  |  | $ | 3,993,015 |  |  | $ | 7,306 |
December 31, 2017: |  |  |  |  |  |  |  |  |  |
Fixed income securities: |  |  |  |  |  |  |  |  |  |
Municipal obligations |  | $ | 845,778 |  |  | $ | 3,456 |  |  | $ | 69,400 |  |  | $ | 779,834 |  |  | $ | — |
Corporate obligations |  | 858,774 |  |  | 6,772 |  |  | 5,471 |  |  | 860,075 |  |  | — |
Foreign obligations |  | 26,245 |  |  | 409 |  |  | 111 |  |  | 26,543 |  |  | — |
U.S. government obligations |  | 86,900 |  |  | 261 |  |  | 1,753 |  |  | 85,408 |  |  | — |
Residential mortgage-backed securities |  | 2,214,512 |  |  | 67,303 |  |  | 30,482 |  |  | 2,251,333 |  |  | 23,832 |
Collateralized debt obligations |  | 50,754 |  |  | 283 |  |  | — |  |  | 51,037 |  |  | — |
Other asset-backed securities |  | 531,660 |  |  | 66,899 |  |  | 617 |  |  | 597,942 |  |  | — |
|  | 4,614,623 |  |  | 145,383 |  |  | 107,834 |  |  | 4,652,172 |  |  | 23,832 |
Short-term |  | 557,476 |  |  | 3 |  |  | 209 |  |  | 557,270 |  |  | — |
|  | 5,172,099 |  |  | 145,386 |  |  | 108,043 |  |  | 5,209,442 |  |  | 23,832 |
Fixed income securities pledged as collateral: |  |  |  |  |  |  |  |  |  |
U.S. government obligations |  | 99,719 |  |  | — |  |  | — |  |  | 99,719 |  |  | — |
Total collateralized investments |  | 99,719 |  |  | — |  |  | — |  |  | 99,719 |  |  | — |
Total available-for-sale investments |  | $ | 5,271,818 |  |  | $ | 145,386 |  |  | $ | 108,043 |  |  | $ | 5,309,161 |  |  | $ | 23,832 |

(1) | Represents the amount of non-credit other-than-temporary impairment losses remaining in accumulated other comprehensive income on securities that also had a credit impairment. These losses are included in gross unrealized losses as of June 30, 2018 and December 31, 2017.

(2) | Includes Ambac's holdings of the secured notes issued by Ambac LSNI in connection with the Rehabilitation Exit Transactions.

| Ambac Financial Group, Inc. 37 2018 Second Quarter FORM 10-Q |

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
The amortized cost and estimated fair value of available-for-sale investments, excluding VIE investments, at June 30, 2018, by contractual maturity, were as follows:

|  | Amortized Cost |  | Estimated Fair Value
Due in one year or less |  | $ | 528,764 |  |  | $ | 528,756 |
Due after one year through five years |  | 1,178,233 |  |  | 1,182,221 |
Due after five years through ten years |  | 292,286 |  |  | 285,711 |
Due after ten years |  | 804,689 |  |  | 839,164 |
|  | 2,803,972 |  |  | 2,835,852 |
Residential mortgage-backed securities |  | 460,252 |  |  | 512,309 |
Collateralized debt obligations |  | 65,255 |  |  | 65,457 |
Other asset-backed securities |  | 503,901 |  |  | 579,397 |
Total |  | $ | 3,833,380 |  |  | $ | 3,993,015 |

Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay certain obligations with or without call or prepayment penalties.
Unrealized Losses on Fixed Income Securities:
The following table shows gross unrealized losses and fair values of Ambac’s available-for-sale investments, excluding VIE investments, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, at June 30, 2018 and December 31, 2017:

|  | Less Than 12 Months |  | 12 Months or More |  | Total
|  | Fair Value |  | Gross Unrealized Loss |  | Fair Value |  | Gross Unrealized Loss |  | Fair Value |  | Gross Unrealized Loss
June 30, 2018: |  |  |  |  |  |  |  |  |  |  |  |
Fixed income securities: |  |  |  |  |  |  |  |  |  |  |  |
Municipal obligations |  | $ | 34,650 |  |  | $ | 244 |  |  | $ | 29,761 |  |  | $ | 1,557 |  |  | $ | 64,411 |  |  | $ | 1,801 |
Corporate obligations |  | 433,313 |  |  | 14,673 |  |  | 75,649 |  |  | 4,681 |  |  | 508,962 |  |  | 19,354 |
Foreign obligations |  | 13,201 |  |  | 134 |  |  | 1,631 |  |  | 40 |  |  | 14,832 |  |  | 174 |
U.S. government obligations |  | 65,033 |  |  | 1,714 |  |  | 3,914 |  |  | 81 |  |  | 68,947 |  |  | 1,795 |
Residential mortgage-backed securities |  | 7,107 |  |  | 394 |  |  | 76,481 |  |  | 6,990 |  |  | 83,588 |  |  | 7,384 |
Other asset-backed securities |  | 17,759 |  |  | 70 |  |  | 77,994 |  |  | 4,120 |  |  | 95,753 |  |  | 4,190 |
|  | 571,063 |  |  | 17,229 |  |  | 265,430 |  |  | 17,469 |  |  | 836,493 |  |  | 34,698 |
Short-term |  | 71,044 |  |  | 75 |  |  | — |  |  | — |  |  | 71,044 |  |  | 75 |
Total temporarily impaired securities |  | $ | 642,107 |  |  | $ | 17,304 |  |  | $ | 265,430 |  |  | $ | 17,469 |  |  | $ | 907,537 |  |  | $ | 34,773 |

| Ambac Financial Group, Inc. 38 2018 Second Quarter FORM 10-Q |

Table of Contents
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)

|  | Less Than 12 Months |  | 12 Months or More |  | Total
|  | Fair Value |  | Gross Unrealized Loss |  | Fair Value |  | Gross Unrealized Loss |  | Fair Value |  | Gross Unrealized Loss
December 31, 2017: |  |  |  |  |  |  |  |  |  |  |  |
Fixed income securities: |  |  |  |  |  |  |  |  |  |  |  |
Municipal obligations |  | $ | 667,335 |  |  | $ | 68,578 |  |  | $ | 32,525 |  |  | $ | 822 |  |  | $ | 699,860 |  |  | $ | 69,400 |
Corporate obligations |  | 292,028 |  |  | 3,377 |  |  | 87,272 |  |  | 2,094 |  |  | 379,300 |  |  | 5,471 |
Foreign obligations |  | 8,122 |  |  | 81 |  |  | 1,700 |  |  | 30 |  |  | 9,822 |  |  | 111 |
U.S. government obligations |  | 74,188 |  |  | 1,653 |  |  | 5,525 |  |  | 100 |  |  | 79,713 |  |  | 1,753 |
Residential mortgage-backed securities |  | 668,524 |  |  | 12,524 |  |  | 418,617 |  |  | 17,958 |  |  | 1,087,141 |  |  | 30,482 |
Other asset-backed securities |  | 26,655 |  |  | 58 |  |  | 88,023 |  |  | 559 |  |  | 114,678 |  |  | 617 |
|  | 1,736,852 |  |  | 86,271 |  |  | 633,662 |  |  | 21,563 |  |  | 2,370,514 |  |  | 107,834 |
Short-term |  | 251,926 |  |  | 209 |  |  | — |  |  | — |  |  | 251,926 |  |  | 209 |
Total temporarily impaired securities |  | $ | 1,988,778 |  |  | $ | 86,480 |  |  | $ | 633,662 |  |  | $ | 21,563 |  |  | $ | 2,622,440 |  |  | $ | 108,043 |

Management has determined that the unrealized losses reflected in the tables above are temporary in nature as of June 30, 2018 and December 31, 2017 based upon (i) no unexpected principal and interest payment defaults on these securities; (ii) analysis of the creditworthiness of the issuer and financial guarantor, as applicable, and analysis of projected defaults on the underlying collateral; (iii) management has no intent to sell these investments in debt securities; and (iv) it is not more likely than not that Ambac will be required to sell these debt securities before the anticipated recovery of its amortized cost basis. The assessment under (iv) is based on a comparison of future available liquidity from the investment portfolio against the projected net cash outflow from operating activities and debt service. For purposes of this assessment, available liquidity from the investment portfolio is comprised of the fair value of securities for which management has asserted its intent to sell, the fair value of other securities that are available for sale and in an unrealized gain position, trading securities plus the scheduled maturities and interest payments from the remaining securities in the portfolio. To the extent that securities that management intends to sell are in an unrealized loss position, they would have already been considered other-than-temporarily impaired with the amortized cost written down to fair value. Because the above-described assessment indicates that future available liquidity exceeds projected net cash outflow, it is not more likely than not that we would be required to sell securities in an unrealized loss position before the recovery of their amortized cost basis. In the liquidity assessment described above, principal payments on securities pledged as collateral are not considered to be available for other liquidity needs until the collateralized positions are projected to be settled.
As of June 30, 2018, for securities that have indications of possible other-than-temporary impairment but which management does not intend to sell and will not more likely than not be required to sell, management compared the present value of cash flows expected to be collected to the amortized cost basis of the securities to assess whether the amortized cost will be recovered. Cash flows were discounted at the effective interest rate implicit in the security at the date of acquisition (or Fresh Start Reporting Date of April 30, 2013 for securities purchased prior to that date) or for debt securities that are beneficial interests in securitized financial assets, at a rate equal to the current yield used to accrete the beneficial interest. For floating rate securities, future cash flows and the discount rate used were both adjusted to reflect changes in the index rate applicable to each security as of the evaluation date. Of the securities that were in a gross unrealized loss position at June 30, 2018, $176,712 of the total fair value and $12,293 of the unrealized loss related to below investment grade and non-rated securities. Of the securities that were in a gross unrealized loss position at December 31, 2017, $1,855,694 of the total fair value and $100,503 of the unrealized loss related to below investment grade and non-rated securities. Most of the securities in a gross unrealized loss position that are below investment grade or non-rated are guaranteed by, or are funded with collateral that is guaranteed by Ambac Assurance. Ambac’s assessment about whether a decline in value is other-than-temporary reflects management’s current judgment regarding facts and circumstances specific to a security and the factors noted above. If that judgment changes, Ambac may ultimately record a charge for other-than-temporary impairment in future periods.
Corporate obligations
The gross unrealized losses on corporate obligations as of June 30, 2018 are primarily the result of the increase in interest rates since purchase (or the Fresh Start Reporting Date of April 30, 2013 if owned as of that date). These securities are primarily fixed-rate securities with an investment grade credit rating. Management believes that the timely receipt of all principal and interest on these positions is probable.
Realized Gains and Losses and Other-Than-Temporary Impairments:
The following table details amounts included in net realized gains (losses) and other-than-temporary impairments included in earnings for the affected periods:
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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)

|  | Three Months Ended June 30, |  | Six Months Ended June 30,
|  | 2018 |  | 2017 |  | 2018 |  | 2017
Gross realized gains on securities |  | $ | 41,974 |  |  | $ | 8,286 |  |  | $ | 53,028 |  |  | $ | 10,944 |
Gross realized losses on securities |  | (1,641 | ) |  | (1,757 | ) |  | (3,029 | ) |  | (11,228 | )
Net foreign exchange (losses) gains |  | 6,815 |  |  | (2,349 | ) |  | 2,011 |  |  | (432 | )
Net realized gains (losses) |  | $ | 47,148 |  |  | $ | 4,180 |  |  | $ | 52,010 |  |  | $ | (716 | )
Net other-than-temporary impairments (1) |  | $ | (1,014 | ) |  | $ | (1,763 | ) |  | $ | (1,313 | ) |  | $ | (5,705 | )

(1) | Other-than-temporary impairments exclude impairment amounts recorded in other comprehensive income under ASC Paragraph 320-10-65-1, which comprise non-credit related amounts on securities that are credit impaired but which management does not intend to sell and it is not more likely than not that Ambac will be required to sell before recovery of the amortized cost basis.

During the Segregated Account Rehabilitation Proceedings, changes in the estimated timing of claim payments resulted in adverse changes in projected cash flows on certain impaired Ambac insured securities. Such changes in estimated claim payments on Ambac insured securities contributed to net other-than-temporary impairments for the three and six months ended June 30, 2017, presented in the table above.
Future changes in our estimated liquidity needs could result in a determination that Ambac no longer has the ability to hold securities that are in an unrealized loss position, which could also result in additional other-than-temporary impairment charges.
The following table presents a roll-forward of Ambac’s cumulative credit losses on debt securities held as of June 30, 2018 and 2017 for which a portion of an other-than-temporary impairment was recognized in other comprehensive income:

|  | Six Months Ended June 30,
|  | 2018 |  | 2017
Balance, beginning of period |  | $ | 67,085 |  |  | $ | 52,070 |
Additions for credit impairments recognized on: |  |  |  |
Securities not previously impaired |  | 226 |  |  | 307 |
Securities previously impaired |  | 98 |  |  | 1,985 |
Reductions for credit impairments previously recognized on: |  |  |  |
Securities that matured or were sold during the period |  | (28,677 | ) |  | — |
Balance, end of period |  | $ | 38,732 |  |  | $ | 54,362 |

Counterparty Collateral, Deposits with Regulators and Other Restrictions:
Ambac routinely pledges and receives collateral related to certain transactions. Cash and securities held directly in Ambac’s investment portfolio with a fair value of $105,701 and $120,645 at June 30, 2018 and December 31, 2017, respectively, were pledged to derivative counterparties. Ambac’s derivative counterparties have the right to re-pledge the investment securities and as such, these pledged securities are separately classified on the Consolidated Balance Sheets as “Fixed income securities pledged as collateral, at fair value”. There was no cash or securities received from other counterparties that were re-pledged by Ambac.
Securities carried at $5,912 and $5,974 at June 30, 2018 and December 31, 2017, respectively, were deposited by Ambac Assurance and Everspan with governmental authorities or designated custodian banks as required by laws affecting insurance companies.
Securities with fair value of $0 and $346,212 at June 30, 2018 and December 31, 2017, respectively, were held by a bankruptcy remote trust to collateralize and fund repayment of debt issued through a Secured Borrowing transaction that was terminated on June 22, 2018. These assets were held and the secured debt is issued by entities that qualified as VIEs and were consolidated in Ambac’s unaudited consolidated financial statements. Refer to Note 3. Variable Interest Entities for further details of the Secured Borrowing transaction.
As further discussed in Note 1. Background and Business Description, Ambac LSNI, an unconsolidated VIE, issued Secured Notes in connection with the Rehabilitation Exit Transactions of February 12, 2018. Securities with a fair value of $255,628 at June 30, 2018 were pledged as collateral and as sources of funding to repay the Secured Notes. The securities may not be transferred or repledged by Ambac LSNI. Collateral may be sold to fund redemptions of the Secured Notes. Ambac Assurance also pledged for the benefit of the holders of Secured Notes (other than Ambac Assurance) the proceeds of the Secured Notes held by Ambac Assurance. Unsettled proceeds in the amount of $50,878 from the June 30, 2018 interest payment and partial redemption of Secured Notes held by Ambac Assurance were included in Receivable for securities on the Consolidated Balance Sheet at June 30, 2018. Such amount was received in July 2018. Ambac LSNI qualifies as a VIE that is not consolidated in Ambac's unaudited consolidated financial statements.
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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
Guaranteed Securities:
Ambac’s fixed income portfolio includes securities covered by guarantees issued by Ambac Assurance and other financial guarantors (“insured securities”). The published rating agency ratings on these securities reflect the higher of the financial strength rating of the financial guarantor or the rating of the underlying issuer. Rating agencies do not always publish separate underlying ratings (those ratings excluding the insurance by the financial guarantor). In the event these underlying ratings are not available from the rating agencies, Ambac will assign an internal rating. The following table represents the fair value, including the value of the financial guarantee, and weighted-average underlying rating, excluding the financial guarantee, of the insured securities at June 30, 2018 and December 31, 2017, respectively:

|  | Municipal Obligations |  | Corporate Obligations (3) |  | Mortgage and Asset- backed Securities |  | Total |  | Weighted Average Underlying Rating (1)
June 30, 2018: |  |  |  |  |  |  |  |  |  |
Ambac Assurance Corporation (2) |  | $ | 831,333 |  |  | $ | 773,401 |  |  | $ | 979,134 |  |  | $ | 2,583,868 |  |  | BB-
National Public Finance Guarantee Corporation |  | 18,193 |  |  | — |  |  | — |  |  | 18,193 |  |  | BBB-
Assured Guaranty Municipal Corporation |  | 5,998 |  |  | — |  |  | — |  |  | 5,998 |  |  | BBB+
Total |  | $ | 855,524 |  |  | $ | 773,401 |  |  | $ | 979,134 |  |  | $ | 2,608,059 |  |  | BB-
December 31, 2017: |  |  |  |  |  |  |  |  |  |
Ambac Assurance Corporation (2) |  | $ | 706,715 |  |  | $ | 32,660 |  |  | $ | 2,702,887 |  |  | $ | 3,442,262 |  |  | CC
National Public Finance Guarantee Corporation |  | 20,733 |  |  | — |  |  | — |  |  | 20,733 |  |  | BBB-
Assured Guaranty Municipal Corporation |  | 5,998 |  |  | — |  |  | — |  |  | 5,998 |  |  | BBB+
Total |  | $ | 733,446 |  |  | $ | 32,660 |  |  | $ | 2,702,887 |  |  | $ | 3,468,993 |  |  | CC

(1) | Ratings are based on the lower of Standard & Poor’s or Moody’s rating. If unavailable, Ambac’s internal rating is used.

(2) | Includes corporate obligations and asset-backed securities with a fair value of $172,531 and $170,280 at June 30, 2018 and December 31, 2017, respectively, insured by Ambac UK.

(3) | 2018 includes Ambac's holdings of the secured notes issued by Ambac LSNI in connection with the Rehabilitation Exit Transactions. These secured notes are insured by Ambac Assurance.

Equity Interests:
Ambac's investment portfolio includes equity interests in various pooled investment funds, which are classified as trading. The fair value and additional information about such investments in pooled funds, by investment type, is summarized in the table below. Except as noted in the table, fair value reported is determined using NAV per share as a practical expedient. There are no unfunded commitments applicable to any of these investments for the periods disclosed.

|  | Fair Value |  |  |  |
Class of Funds |  | June 30, 2018 |  | December 31, 2017 |  | Redemption Frequency |  | Redemption Notice Period
Real estate properties (1) |  | $ | 33,297 |  |  | $ | 33,154 |  |  | quarterly |  | 10 business days
Diversified hedge fund strategies (2) |  | 31,417 |  |  | 53,054 |  |  | semi-monthly |  | 15 - 30 days
Interest rate products (3) (7) |  | 145,981 |  |  | 136,603 |  |  | daily, weekly or monthly |  | 0 - 30 days
Illiquid investments (4) |  | 67,214 |  |  | 67,787 |  |  | quarterly |  | 180 days
Insurance-linked investments (5) |  | 22,023 |  |  | 22,666 |  |  | quarterly |  | 90-120 days
Equity market investments (6) (7) |  | 56,967 |  |  | 53,675 |  |  | daily |  | 0 days
Total equity investments in pooled funds |  | $ | 356,899 |  |  | $ | 366,939 |  |  |  |  |

(1) | Investments consist of UK property to generate income and capital growth.

(2) | Investments seek diversified exposure to hedge fund core strategies to produce high risk-adjusted returns, with low long-term correlation to traditional markets and with targeted volatility levels. Funds may have the right to defer redemptions under certain circumstances.

(3) | This class of funds includes investments in a range of instruments including leveraged loans, CLOs, asset-backed securities and floating rate notes to generate income and capital appreciation. Funds with less frequent redemption periods limit redemptions to as little as 15% per period. Funds with a same day redemption notice period are redeemable only weekly, while funds that may be redeemed any business day have notice periods of 15-30 days.

(4) | This class seeks to obtain high long-term total return through investments with low liquidity and defined term, resulting in expected capital distributions to subscribers between 2020 and 2023. Redemptions were restricted prior to the expiration of the investment lock-up period in May 2018.

(5) | This class aims to provide returns from the insurance and reinsurance markets through investments in catastrophe bonds, life insurance and other insurance linked investments. Redemption periods are quarterly, subject to 90-day notice for January/July redemption dates and 120-day notice for April/October redemption dates with redemptions greater than 3.5% during the first five years following share issuance subject to redemption fees.

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)

(6) | Investments represent a diversified exposure to global equity market returns through holdings of various regional market index funds.

(7) | Interest rate products include $2,866 at June 30, 2018 and $2,823 at December 31, 2017 and equity market investments include $56,967 at June 30, 2018 and $53,675 at December 31, 2017 that have readily determinable fair values priced through pricing vendors.

Ambac also holds interests in an unconsolidated trust created in connection with the 2014 sale of Segregated Account junior surplus notes. The investment in its debt securities were accounted for as trading and the equity interest is accounted for under the equity method.
Investment Income:
Net investment income was comprised of the following for the affected periods:

|  | Three Months Ended June 30, |  | Six Months Ended June 30,
|  | 2018 |  | 2017 |  | 2018 |  | 2017
Fixed income securities |  | $ | 60,499 |  |  | $ | 81,751 |  |  | $ | 169,848 |  |  | $ | 155,820 |
Short-term investments |  | 2,438 |  |  | 1,151 |  |  | 5,278 |  |  | 2,140 |
Loans |  | 179 |  |  | 85 |  |  | 367 |  |  | 174 |
Investment expense |  | (1,374 | ) |  | (2,044 | ) |  | (3,200 | ) |  | (4,041 | )
Securities available-for-sale and short-term |  | 61,742 |  |  | 80,943 |  |  | 172,293 |  |  | 154,093 |
Other investments |  | 4,920 |  |  | 4,217 |  |  | 4,609 |  |  | 12,626 |
Total net investment income |  | $ | 66,662 |  |  | $ | 85,160 |  |  | $ | 176,902 |  |  | $ | 166,719 |

Net investment income from Other investments primarily represents changes in fair value on securities classified as trading or under the fair value option plus income from Ambac's interests in an unconsolidated trust created in connection with its sale of Segregated Account junior surplus notes. The portion of net unrealized gains (losses) related to trading securities still held at the end of each period is as follows:

|  | Three Months Ended June 30, |  | Six Months Ended June 30,
|  | 2018 |  | 2017 |  | 2018 |  | 2017
Net gains (losses) recognized during the period on trading securities |  | $ | 3,632 |  |  | $ | 3,000 |  |  | $ | 2,053 |  |  | $ | 10,211 |
Less: net gains (losses) recognized during the reporting period on trading securities sold during the period |  | 344 |  |  | 2,070 |  |  | 1,325 |  |  | 3,698 |
Unrealized gains (losses) recognized during the reporting period on trading securities still held at the reporting date |  | $ | 3,288 |  |  | $ | 930 |  |  | $ | 728 |  |  | $ | 6,513 |

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
9. DERIVATIVE INSTRUMENTS
The following tables summarize the gross fair values of individual derivative instruments and the impact of legal rights of offset as reported in the Consolidated Balance Sheets as of June 30, 2018 and December 31, 2017:

| Gross Amounts of Recognized Assets / Liabilities |  | Gross Amounts Offset in the Consolidated Balance Sheet |  | Net Amounts of Assets/ Liabilities Presented in the Consolidated Balance Sheet |  | Gross Amount of Collateral Received / Pledged Not Offset in the Consolidated Balance Sheet |  | Net Amount
June 30, 2018: |  |  |  |  |  |  |  |  |
Derivative Assets: |  |  |  |  |  |  |  |  |
Interest rate swaps | $ | 56,147 |  |  | $ | 161 |  |  | $ | 55,986 |  |  | $ | — |  |  | $ | 55,986 |
Futures contracts | 524 |  |  | — |  |  | 524 |  |  | — |  |  | 524 |
Total non-VIE derivative assets | $ | 56,671 |  |  | $ | 161 |  |  | $ | 56,510 |  |  | $ | — |  |  | $ | 56,510 |
Derivative Liabilities: |  |  |  |  |  |  |  |  |
Credit derivatives | $ | 1,326 |  |  | $ | — |  |  | $ | 1,326 |  |  | $ | — |  |  | $ | 1,326 |
Interest rate swaps | 66,483 |  |  | 161 |  |  | 66,322 |  |  | 65,563 |  |  | 759 |
Total non-VIE derivative liabilities | $ | 67,809 |  |  | $ | 161 |  |  | $ | 67,648 |  |  | $ | 65,563 |  |  | $ | 2,085 |
Variable Interest Entities Derivative Assets: |  |  |  |  |  |  |  |  |
Currency swaps | $ | 60,403 |  |  | $ | — |  |  | $ | 60,403 |  |  | $ | — |  |  | $ | 60,403 |
Total VIE derivative assets | $ | 60,403 |  |  | $ | — |  |  | $ | 60,403 |  |  | $ | — |  |  | $ | 60,403 |
Variable Interest Entities Derivative Liabilities: |  |  |  |  |  |  |  |  |
Interest rate swaps | $ | 1,992,227 |  |  | $ | — |  |  | $ | 1,992,227 |  |  | $ | — |  |  | $ | 1,992,227 |
Total VIE derivative liabilities | $ | 1,992,227 |  |  | $ | — |  |  | $ | 1,992,227 |  |  | $ | — |  |  | $ | 1,992,227 |
December 31, 2017: |  |  |  |  |  |  |  |  |
Derivative Assets: |  |  |  |  |  |  |  |  |
Interest rate swaps | $ | 73,826 |  |  | $ | 627 |  |  | $ | 73,199 |  |  | $ | — |  |  | $ | 73,199 |
Total non-VIE derivative assets | $ | 73,826 |  |  | $ | 627 |  |  | $ | 73,199 |  |  | $ | — |  |  | $ | 73,199 |
Derivative Liabilities: |  |  |  |  |  |  |  |  |
Credit derivatives | $ | 566 |  |  | $ | — |  |  | $ | 566 |  |  | $ | — |  |  | $ | 566 |
Interest rate swaps | 81,495 |  |  | 627 |  |  | 80,868 |  |  | 79,912 |  |  | 956 |
Futures contracts | 1,348 |  |  | — |  |  | 1,348 |  |  | 1,348 |  |  | — |
Total non-VIE derivative liabilities | $ | 83,409 |  |  | $ | 627 |  |  | $ | 82,782 |  |  | $ | 81,260 |  |  | $ | 1,522 |
Variable Interest Entities Derivative Assets: |  |  |  |  |  |  |  |  |
Currency swaps | $ | 54,877 |  |  | $ | — |  |  | $ | 54,877 |  |  | $ | — |  |  | $ | 54,877 |
Total VIE derivative assets | $ | 54,877 |  |  | $ | — |  |  | $ | 54,877 |  |  | $ | — |  |  | $ | 54,877 |
Variable Interest Entities Derivative Liabilities: |  |  |  |  |  |  |  |  |
Interest rate swaps | $ | 2,205,264 |  |  | $ | — |  |  | $ | 2,205,264 |  |  | $ | — |  |  | $ | 2,205,264 |
Total VIE derivative liabilities | $ | 2,205,264 |  |  | $ | — |  |  | $ | 2,205,264 |  |  | $ | — |  |  | $ | 2,205,264 |

Amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral are not offset against fair value amounts recognized for derivative instruments on the Consolidated Balance Sheets. The amounts representing the right to reclaim cash collateral and posted margin, recorded in “Other assets” were $21,060 and $20,926 as of June 30, 2018 and December 31, 2017, respectively. There were no amounts held representing an obligation to return cash collateral as of June 30, 2018 and December 31, 2017.
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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
The following tables summarize the location and amount of gains and losses of derivative contracts in the Consolidated Statements of Total Comprehensive Income (Loss) for the three and six months ended June 30, 2018 and 2017:

| Location of Gain or (Loss) Recognized in Consolidated Statements of Total Comprehensive Income (Loss) |  | Amount of Gain or (Loss) Recognized in Consolidated Statement of Total Comprehensive Income (Loss)
|  | Three Months Ended June 30, |  | Six Months Ended June 30,
|  | 2018 |  | 2017 |  | 2018 |  | 2017
Non-VIEs: |  |  |  |  |  |  |  |  |  |  |
Credit derivatives | Net change in fair value of credit derivatives |  | $ | (217 | ) |  | $ | 6,624 |  |  | $ | (563 | ) |  | $ | 7,676 |
Non-VIE derivatives: |  |  |  |  |  |  |  |  |  |  |
Interest rate swaps | Net gains (losses) on interest rate derivatives |  | 1,620 |  |  | 37,141 |  |  | 6,163 |  |  | 37,249 |
Futures contracts | Net gains (losses) on interest rate derivatives |  | 7,529 |  |  | (3,073 | ) |  | 28,523 |  |  | (4,695 | )
Total Non-VIE derivatives |  |  |  |  | 9,149 |  |  | 34,068 |  |  | 34,686 |  |  | 32,554 |
Variable Interest Entities: |  |  |  |  |  |  |  |  |  |  |
Currency swaps | Income (loss) on variable interest entities |  | 14,143 |  |  | (9,951 | ) |  | 5,526 |  |  | (14,899 | )
Interest rate swaps | Income (loss) on variable interest entities |  | 163,229 |  |  | 34 |  |  | 213,038 |  |  | 14,530 |
Total Variable Interest Entities |  |  | 177,372 |  |  | (9,917 | ) |  | 218,564 |  |  | (369 | )
Total derivative contracts |  |  | $ | 186,304 |  |  | $ | 30,775 |  |  | $ | 252,687 |  |  | $ | 39,861 |

Credit Derivatives:
Credit derivatives, which are privately negotiated contracts, provide the counterparty with credit protection against the occurrence of a specific event such as a payment default or bankruptcy relating to an underlying obligation. Upon a credit event, Ambac is required to make payments equal to the difference between the scheduled debt service payment and the actual payment made by the issuer. Credit derivatives issued are insured by Ambac Assurance. None of the outstanding credit derivative transactions at June 30, 2018 include ratings based collateral-posting triggers or otherwise require Ambac to post collateral regardless of Ambac’s ratings or the size of the mark to market exposure to Ambac.
The portfolio of our credit derivatives were written on a “pay-as-you-go” basis. Similar to an insurance policy execution, pay-as-you-go provides that Ambac pays interest shortfalls on the referenced transaction as they are incurred on each scheduled payment date, but only pays principal shortfalls upon the earlier of (i) the date on which the assets designated to fund the referenced obligation have been disposed of and (ii) the legal final maturity date of the referenced obligation.
Ambac maintains internal credit ratings on its guaranteed obligations, including credit derivative contracts, solely to indicate management’s view of the underlying credit quality of the guaranteed obligations. Independent rating agencies may have assigned different ratings on the credits in Ambac’s portfolio than Ambac’s internal ratings. The following table summarizes the gross principal notional outstanding for CDS contracts, by Ambac rating as of June 30, 2018 and December 31, 2017:

Ambac Rating |  | June 30, 2018 |  | December 31, 2017
AAA |  | $ | — |  |  | $ | — |
AA |  | 165,387 |  |  | 175,765 |
A |  | — |  |  | — |
BBB (1) |  | 145,850 |  |  | 150,125 |
Below investment grade (2) |  | — |  |  | — |
Total |  | $ | 311,237 |  |  | $ | 325,890 |

(1) | BBB internal ratings reflect bonds which are of medium grade credit quality with adequate capacity to pay interest and repay principal. Certain protective elements and margins may weaken under adverse economic conditions and changing circumstances. These bonds are more likely than higher rated bonds to exhibit unreliable protection levels over all cycles.

(2) | Below investment grade internal ratings reflect bonds which are of speculative grade credit quality with the adequacy of future margin levels for payment of interest and repayment of principal potentially adversely affected by major ongoing uncertainties or exposure to adverse conditions.

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
Interest Rate Derivatives:
Ambac, through its subsidiary Ambac Financial Services (“AFS”), provided interest rate swaps to states, municipalities and their authorities, asset-backed issuers and other entities in connection with their financings. Additionally, AFS uses interest rate derivatives as an economic hedge against the effects of rising interest rates elsewhere in the Company, including on Ambac’s financial guarantee exposures. As of June 30, 2018 and December 31, 2017 the notional amounts of AFS’s derivatives are as follows:

|  | Notional
Type of derivative |  | June 30, 2018 |  | December 31, 2017
Interest rate swaps—receive-fixed/pay-variable |  | $ | 375,951 |  |  | $ | 379,497 |
Interest rate swaps—pay-fixed/receive-variable |  | 1,463,331 |  |  | 1,428,264 |
US Treasury futures contracts—short |  | 1,805,000 |  |  | 1,655,000 |

Derivatives of Consolidated Variable Interest Entities
Certain VIEs consolidated under the Consolidation Topic of the ASC entered into derivative contracts to meet specified purposes within the securitization structure. The notional for VIE derivatives outstanding as of June 30, 2018 and December 31, 2017 are as follows:

|  | Notional
Type of VIE derivative |  | June 30, 2018 |  | December 31, 2017
Interest rate swaps—receive-fixed/pay-variable |  | $ | 1,447,493 |  |  | $ | 1,483,491 |
Interest rate swaps—pay-fixed/receive-variable |  | 2,396,479 |  |  | 2,479,244 |
Currency swaps |  | 371,038 |  |  | 394,541 |
Credit derivatives |  | 11,152 |  |  | 12,100 |

Contingent Features in Derivatives Related to Ambac Credit Risk
Ambac’s over-the-counter interest rate swaps are centrally cleared when eligible. Certain interest rate swaps remain with professional swap-dealer counterparties and certain front-end counterparties. These non-cleared swaps are generally executed under standardized derivative documents including collateral support and master netting agreements. Under these agreements, Ambac is required to post collateral in the event net unrealized losses exceed predetermined threshold levels. Additionally, given that Ambac Assurance is no longer rated by an independent rating agency, counterparties have the right to terminate the swap positions.
As of June 30, 2018 and December 31, 2017, the net liability fair value of derivative instruments with contingent features linked to Ambac’s own credit risk was $65,563 and $79,912, respectively, related to which Ambac had posted cash and securities as collateral with a fair value of $95,291 and $111,391, respectively. All such ratings-based contingent features have been triggered as requiring maximum collateral levels to be posted by Ambac while preserving counterparties’ rights to terminate the contracts. Assuming all such contracts terminated on June 30, 2018, settlement of collateral balances and net derivative liabilities would result in a net receipt of cash and/or securities by Ambac. If counterparties elect to exercise their right to terminate, the actual termination payment amounts will be determined in accordance with derivative contract terms, which may result in amounts that differ from market values as reported in Ambac’s financial statements.
10. LONG-TERM DEBT
The carrying value of long-term debt was as follows:

|  | June 30, 2018 |  | December 31, 2017
Ambac Assurance: |  |  |  |
5.1% surplus notes due 2020 |  | $ | 268,313 |  |  | $ | 668,667 |
5.1% junior surplus notes due 2020 |  | 249,428 |  |  | 249,036 |
Ambac Note |  | 2,038,912 |  |  | — |
Tier 2 Notes |  | 239,736 |  |  | — |
Secured borrowing |  | — |  |  | 73,993 |
Ambac Assurance long-term debt |  | $ | 2,796,389 |  |  | $ | 991,696 |
Variable Interest Entities long-term debt |  | $ | 11,454,746 |  |  | $ | 12,160,544 |

| Ambac Financial Group, Inc. 45 2018 Second Quarter FORM 10-Q |

Surplus Notes
Ambac Assurance surplus notes, with a par amount of $295,871 and $754,811 at June 30, 2018 and December 31, 2017, respectively, are reported in long-term debt on the Consolidated Balance Sheet and have a scheduled maturity of June 7, 2020. On February 12, 2018, the Rehabilitation Exit Transactions were consummated, resulting in a $463,624 reduction of consolidated surplus note par outstanding. Surplus notes outstanding are recorded at their fair value at the date of issuance. The discount on surplus notes is accreted into income using the effective interest method based on projected cash flows at the date of issuance. The weighted average imputed interest rate on surplus notes outstanding as of June 30, 2018 is 10.4%. All payments of principal and interest on these surplus notes are subject to the prior approval of the OCI. Annually from 2011 through 2018, OCI issued its disapproval of the requests of Ambac Assurance to pay the full interest on outstanding surplus notes on the annual scheduled interest payment date of June 7th. If the OCI does not approve the payment of interest on these surplus notes, such interest will accrue and compound annually until paid. In connection with the Rehabilitation Exit Transactions, Ambac Assurance made a one-time current interest payment on remaining surplus notes (other than junior surplus notes) of $13,501, of which $2,618 was received by Ambac for surplus notes that it owns and that are considered extinguished for accounting purposes.
In connection with the AMPS Exchange, Ambac Assurance issued surplus notes with a par amount of $212,740 on August 3, 2018. Refer to Note 1. Background and Business Description for further discussion of the AMPS Exchange.
Junior Surplus Notes
The junior surplus notes, with a par value of $368,418 and $370,237 at June 30, 2018 and December 31, 2017, respectively, are reported in long-term debt on the Consolidated Balance Sheets and have a scheduled maturity of June 7, 2020, subject to the following restrictions. Pursuant to the Second Amended Plan of Rehabilitation, Ambac Assurance became the obligor under the junior surplus notes (previously issued by the Segregated Account) as of February 12, 2018. Principal and interest payments on these junior surplus notes cannot be made until all Ambac Assurance surplus notes (other than junior surplus notes) are paid in full and after all of Ambac Assurance's future and existing senior indebtedness, policy and other priority claims have been paid in full. All payments of principal and interest on these junior surplus notes are subject to the prior approval of the OCI. If the OCI does not approve the payment of interest on the junior surplus notes, such interest will accrue and compound annually until paid. No such approval has been sought or obtained to pay interest on junior surplus notes since their issuance.

• | Par value at June 30, 2018 and December 31, 2017 includes $18,418 and $20,237, respectively, of junior surplus notes issued in connection with a settlement agreement (the “OSS Settlement Agreement”) entered into among Ambac, Ambac Assurance, the Segregated Account and One State Street, LLC (“OSS”) with respect to the termination of Ambac’s office lease with OSS. Part of these junior surplus notes ($3,436 current par value at June 30, 2018) are reducing periodically as rent payments under the replacement lease (beginning in January 2016) are made by Ambac Assurance. Par value of these junior surplus notes was reduced by $1,819 and $1,926 during the six months ended June 30, 2018 and 2017, respectively, as rent payments were made by Ambac Assurance. These junior surplus notes were recorded at their fair value at the date of issuance. The discount on these notes are currently being accreted into income using the effective interest method at an imputed interest rate of 19.5%.

• | Par value at June 30, 2018 and December 31, 2017 includes $350,000 face amount of a junior surplus note originally issued to Ambac pursuant to Ambac's Chapter 11 Reorganization Plan in accordance with the Mediation Agreement dated September 21, 2011 among Ambac, Ambac Assurance, the Segregated Account, the Rehabilitator, the OCI and the Official Committee of Unsecured Creditors of Ambac, and that Ambac sold to a Trust on August 28, 2014. This junior surplus note was recorded at a discount to par based on its fair value on August 28, 2014. Ambac is accreting the discount on this junior surplus note into earnings using the effective interest method, based on an imputed interest rate of 8.4% .

Ambac Note
The Ambac Note, issued in connection with the Rehabilitation Exit Transactions on February 12, 2018, as more fully described in Note 1. Background and Business Description, with a par value of $2,040,894 at June 30, 2018, is reported in long-term debt on the Consolidated Balance Sheets and have a legal maturity of February 12, 2023. Interest on the Ambac Note is payable quarterly (on the last day of each quarter beginning with June 30, 2018) at an annual rate of 3-month U.S. Dollar LIBOR + 5.00%, subject to a 1.00% LIBOR floor. On June 30, 2018, $113,457 par value of the Ambac Note was redeemed. The maturity date for the Ambac Note is the earlier of (x) February 12, 2023, and (y) if the Secured Notes are then outstanding, the date that is five business days prior to the date for which OCI has approved the repayment of the outstanding principal amount of the surplus notes (other than junior surplus notes) issued by Ambac Assurance. Promptly, and in any event within four business days after the receipt (whether directly or indirectly) of any representation and warranty subrogation recoveries, Ambac Assurance shall (i) apply an amount (the “Mandatory Redemption Amount”) equal to the lesser of (a) the amount of such representation and warranty subrogation recoveries and (b) all outstanding principal and accrued and unpaid interest on the Ambac Note to redeem the Ambac Note, in whole or in part, as applicable; provided, that any non-cash representation and warranty subrogation recoveries shall be deemed to be received upon the receipt of the applicable appraisal.
The portion of the Ambac Note issued in connection with the exchange of surplus notes ("Ambac Note A") was accounted for as a debt modification since the creditors before and after the exchange remained the same and the change in terms was not considered substantial. A substantial change is considered to be a change in cash flows of equal to or greater than 10%, and because the change in cash flows was less than 10%, debt modification accounting is appropriate. Under debt modification accounting, Ambac Note A was recorded at a discount to par based on the carrying value of the surplus notes less the cash consideration paid. Furthermore, no gain or loss was recorded on the surplus
| Ambac Financial Group, Inc. 46 2018 Second Quarter FORM 10-Q |

note exchange and a new effective interest rate was established based on the cash flows of Ambac Note A. Any consideration paid directly related to the issuance of Ambac Note A was expensed as incurred. The portion of the Ambac Note issued in connection with the exchange of Deferred Amounts ("Ambac Note B") was recorded at fair value. The Deferred Amount exchange was accounted for as an extinguishment of the Deferred Amounts with the gain reflected as a benefit to loss and loss expenses. Any consideration paid directly related to the issuance of Ambac Note B was capitalized and amortized as part of the effective yield calculation. The aggregate discount on the entire Ambac Note (portions A and B) is being accreted into earnings using the effective interest method, based on an imputed interest rate of 7.6%.
Tier 2 Notes
The Tier 2 Notes, issued in connection with the Rehabilitation Exit Transactions on February 12, 2018, with a par value of $247,936 (including paid-in-kind interest of $7,936) at June 30, 2018, are reported in long-term debt on the Consolidated Balance Sheets and have a legal maturity of February 12, 2055. Interest on the Tier 2 Notes is at an annual rate of 8.50%. Interest payments will not be made in cash on interest payment dates and shall be paid-in-kind and compounded on the last day of each calendar quarter, unless (i) funds are available to make such payments in cash as a result of receiving recoveries in respect of the representation and warranty subrogation recoveries in excess of $1,600,000 or (ii) interest is paid in cash on surplus notes (other than in connection with the Rehabilitation Exit Transactions). The Tier 2 Notes may not be redeemed or repaid prior to December 17, 2020 unless Ambac Assurance pays a make-whole premium. Thereafter, the Tier 2 Notes may be redeemed, in whole or in part, at the option of Ambac Assurance, at a price equal to 100% of the aggregate principal amount redeemed, plus accrued and unpaid interest, if any. The Tier 2 Notes were recorded at a discount to par as any consideration paid that was directly related to the issuance of the Tier 2 Notes was capitalized and is part of the effective yield calculation. Ambac is accreting the discount on the Tier 2 Notes into earnings using the effective interest method, based on an imputed interest rate of 9.9%.
Secured Borrowing
The Secured Borrowing, with a par value of $0 and $73,993 at June 30, 2018 and December 31, 2017, respectively, is reported in long-term debt on the Consolidated Balance Sheets and had a legal maturity of July 25, 2047. Interest on the Secured Borrowing was payable monthly at an annual rate of one month U.S. Dollar LIBOR + 2.8%. On June 22, 2018, the Secured Borrowing was fully redeemed. Refer to Note 3. Variable Interest Entities for further discussion on the Secured Borrowing transaction.
Variable Interest Entities, Long-term Debt
The variable interest entity notes were issued by consolidated VIEs. Ambac is the primary beneficiary of the VIEs as a result of providing financial guarantees on certain of the the variable interest obligations. Consequently, Ambac has consolidated these variable interest entity notes and all other assets and liabilities of the VIEs. Ambac is not primarily liable for the debt obligations of these entities. Ambac would only be required to make payments on these debt obligations in the event that the issuer defaults on any principal or interest due and to the extent such obligations are guaranteed by Ambac. The total unpaid principal amount of outstanding long-term debt associated with VIEs consolidated as a result of the financial guarantee provided by Ambac was $9,095,639 and $9,387,884 as of June 30, 2018 and December 31, 2017, respectively. The range of final maturity dates of the outstanding long-term debt associated with these VIEs is November 2018 to December 2047 as of June 30, 2018 and 2017. As of June 30, 2018 and December 31, 2017, the interest rates on these VIEs’ long-term debt ranged from 1.07% to 8.35% and from 0.96% to 8.35%, respectively. Final maturities of VIE long-term debt for each of the five years following June 30, 2018 are as follows: 2019-$152,889; 2020-$263,780; 2021-$130,239; 2022-$0; 2023-$0.
11. INCOME TAXES
Ambac files a consolidated Federal income tax return with its subsidiaries. Ambac and its subsidiaries also file separate or combined income tax returns in various states, local and foreign jurisdictions. The following are the major jurisdictions in which Ambac and its subsidiaries operate and the earliest tax years subject to examination:

Jurisdiction | Tax Year
United States | 2010
New York State | 2013
New York City | 2013
United Kingdom | 2015
Italy | 2013

As of June 30, 2018 Ambac had U.S. federal ordinary net loss carryforwards totaling approximately $3,451,870, which, if not utilized, will begin expiring in 2029, and will fully expire in 2032.
| Ambac Financial Group, Inc. 47 2018 Second Quarter FORM 10-Q |

Table of Contents
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
The tax effects of temporary differences that give rise to significant portions of the deferred tax liabilities and deferred tax assets at June 30, 2018 and December 31, 2017 are presented below:

| June 30, 2018 |  | December 31, 2017
Deferred tax liabilities: |  |  |
Insurance intangible | $ | 165,104 |  |  | $ | 177,864 |
Debentures | — |  |  | 28,387 |
Unearned premiums and credit fees | 50,733 |  |  | 51,485 |
Variable interest entities | 20,819 |  |  | 22,817 |
Investments | 34,920 |  |  | 28,798 |
Other | 10,248 |  |  | 9,402 |
Total deferred tax liabilities | 281,824 |  |  | 318,753 |
Deferred tax assets: |  |  |
Net operating loss and capital carryforward | 724,893 |  |  | 775,917 |
Loss reserves | 253,282 |  |  | 264,624 |
Debentures | 29,577 |  |  | — |
Compensation | 7,731 |  |  | 5,585 |
Other | 1,819 |  |  | 2,140 |
Subtotal deferred tax assets | 1,017,302 |  |  | 1,048,266 |
Valuation allowance | 768,259 |  |  | 763,172 |
Total deferred tax assets | 249,043 |  |  | 285,094 |
Net deferred tax (liability) | $ | (32,781 | ) |  | $ | (33,659 | )

In accordance with the Income Tax Topic of the ASC, a valuation allowance is recognized if, based on the weight of available evidence, it is more-likely-than-not that some, or all, of the deferred tax asset will not be realized. As a result of the risks and uncertainties associated with future operating results, management believes it is more likely than not that the Company will not generate sufficient U.S. federal, state and/or local taxable income to recover the deferred tax operating assets and therefore maintains a full valuation allowance.
In accordance with SEC issued guidance (SAB 118), which provides a one-year measurement period for companies to finalize the accounting for the impact of the TCJA, Ambac continues to record the income tax effect of provisions related to the TCJA's repatriation of Ambac UK's earnings and profits and limitation's on executive compensation as estimates.
U.S. and foreign components of pre-tax income were as follows:

| Three Months Ended June 30, |  | Six Months Ended June 30,
| 2018 |  | 2017 |  | 2018 |  | 2017
U.S. | $ | 13,104 |  |  | $ | (25,177 | ) |  | $ | 310,846 |  |  | $ | (217,050 | )
Foreign | (6,796 | ) |  | 39,169 |  |  | 3,771 |  |  | 125,182 |
Total | $ | 6,308 |  |  | $ | 13,992 |  |  | $ | 314,617 |  |  | $ | (91,868 | )

The components of the provision for income taxes were as follows:

| Three Months Ended June 30, |  | Six Months Ended June 30,
| 2018 |  | 2017 |  | 2018 |  | 2017
Current taxes |  |  |  |  |  |  |
U. S. federal | $ | — |  |  | $ | 617 |  |  | $ | — |  |  | $ | 617 |
U.S. state and local | 645 |  |  | (320 | ) |  | 1,682 |  |  | — |
Foreign | 2,544 |  |  | 6,585 |  |  | 2,505 |  |  | 25,846 |
Current taxes | 3,189 |  |  | 6,882 |  |  | 4,187 |  |  | 26,463 |
Deferred taxes |  |  |  |  |  |  |
Foreign | (1,194 | ) |  | — |  |  | 413 |  |  | — |
Deferred taxes | (1,194 | ) |  | — |  |  | 413 |  |  | — |
Provision for income taxes | $ | 1,995 |  |  | $ | 6,882 |  |  | $ | 4,600 |  |  | $ | 26,463 |

| Ambac Financial Group, Inc. 48 2018 Second Quarter FORM 10-Q |

Table of Contents
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
NOL Usage
Pursuant to the intercompany tax sharing agreement, to the extent Ambac Assurance generates taxable income after September 30, 2011, which is offset with "Allocated NOLs" of $3,650,000, it is obligated to make payments (“Tolling Payments”), subject to certain credits, to Ambac in accordance with the following NOL usage table, where the “Applicable Percentage” is applied to the aggregate amount of federal income tax liability that would have been paid if the Allocated NOLs were not available. Pursuant to the Closing Agreement between Ambac and the Internal Revenue Service ("IRS"), the IRS will receive 12.5% of Tier C and 17.5% of Tier D payments, if made.
NOL Usage Table

NOL Usage Tier | Allocated NOLs |  | Applicable Percentage
A | The first | $479,000 |  | 15%
B | The next | $1,057,000 | after Tier A | 40%
C | The next | $1,057,000 | after Tier B | 10%
D | The next | $1,057,000 | after Tier C | 15%

As a result of positive taxable income at Ambac Assurance in 2017, Ambac has accrued approximately $30,496 in tax tolling payments. In May 2018, Ambac executed a waiver under the intercompany tax sharing agreement pursuant to which Ambac Assurance was relieved of the requirement to make this payment by June 1, 2018. Ambac has also agreed to continue to defer the tolling payment for the use of net operating losses by Ambac Assurance until such time as OCI consents to the payment.
For the six months ended June 30, 2018, Ambac Assurance generated $229,001 of taxable income, utilizing the remaining $168,205 balance of the $1,057,000 allocated Tier B NOL, and resulting in additional accrued Tolling Payments, net of applicable credits, of $14,129, which, assuming Ambac Assurance's cumulative full year 2018 taxable income does not fall below $168,205, will be paid to Ambac in 2019. Ambac Assurance must generate $238,095 of taxable income to offset the $5,000 Tier C credit. As of June 30, 2018, Ambac Assurance will need to generate additional taxable income of $177,299 to offset the remaining balance of the $5,000 Tier C credit, at which point additional cumulative income will begin to accrue additional tolling payments to Ambac until all the of $3,650,000 Allocated Ambac Assurance NOLs have been utilized, expire, or otherwise become unavailable.
As of June 30, 2018, the remaining balance of the $3,451,870 NOL allocated to Ambac Assurance was $2,053,204. As of June 30, 2018 Ambac's NOL was $1,398,666.
12. COMMITMENTS AND CONTINGENCIES
The following commitments and contingencies provide an update of those discussed in Note 18: Commitments and Contingencies in the Notes to Consolidated Financial Statements included Part II, Item 8 in the Company’s Annual Report on Form 10-K for the year ended December 2017, and should be read in conjunction with the complete descriptions provided in the aforementioned Form 10-K.
The Segregated Account and Wisconsin Rehabilitation Proceeding
On September 25, 2017, the Rehabilitator filed in the Rehabilitation Court a Motion to Further Amend The Plan of Rehabilitation Confirmed on January 24, 2011 To Facilitate An Exit from Rehabilitation. The evidentiary Confirmation Hearing was held on January 4, 2018, and continued on January 22, 2017. On January 22, 2018, the Rehabilitation Court entered an order (the "Confirmation Order") granting the Rehabilitator’s motion and confirming the Second Amended Plan of Rehabilitation, which became effective on February 12, 2018. Pursuant to the Confirmation Order, the Rehabilitation Court also ruled that, contrary to allegations made by certain parties to certain military housing litigations (the "MHPI Projects"), the Rehabilitation Court did not previously enter any order that could form the predicate for a claim of “Ambac Default” and confirmed Section 6.13 of the Second Amended Plan of Rehabilitation which, among other things, provided that any such default is deemed not to have existed or to be cured.
On February 7, 2018, the Rehabilitator filed a motion with the Rehabilitation Court requesting injunctive relief against the MHPI Projects that would, among other things, enjoin the MHPI Projects from taking further actions or making further arguments, in any court or otherwise, in contravention of the Confirmation Order, the findings contained in the Confirmation Order or the provisions of the Second Amended Plan of Rehabilitation. On the same day, the Rehabilitation Court issued an order granting the Rehabilitator's February 7th motion (the “February 7 Order”).
On February 26, 2018, the MHPI Projects filed a Notice of Motion and Motion for Reconsideration as well as a Notice of Motion and Motion for Expedited Hearing in the Rehabilitation Court, requesting reconsideration of the February 7 Order on an expedited basis (the “February 26 Motion”). Briefing on the motions was completed on April 5, 2018, and a hearing was scheduled for May 10, 2018.
On March 2, 2018, the MHPI Projects noticed their appeal from the Confirmation Order and the February 7 Order. On March 6, 2018, the MHPI Projects filed in the Rehabilitation Court a Notice of Motion and Motion for Stay Pending Appeal. On March 9, 2018, the MHPI Projects filed in the Wisconsin Court of Appeals a Motion for Ex Parte Relief Pending Appeal and Relief Pending Appeal. After accelerated briefing, the Court
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Table of Contents
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
of Appeals granted the MHPI Projects’ Motion for Relief Pending Appeal on March 13, 2018 and stayed enforcement of the February 7 Order and enforcement of Articles 6.8 and 6.13 of the Second Amended Plan of Rehabilitation, including but not limited to the extent that those Articles affect arguments that the MHPI Projects may make in any court (the “March 13 Order”).
On May 4, 2018, the Rehabilitator filed in the Rehabilitation Court a Motion to Dissolve the Injunction dated February 7, 2018 and Amend Confirmation Order (the “May 4 Motion”) and a Motion for Final Decree and Order Discharging the Rehabilitator. In the May 4 Motion, the Rehabilitator requested the Rehabilitation Court to dissolve the injunction put in place under the February 7 Order and to amend the Confirmation Order, and thereby amend Section 6.13 of the Second Amended Plan of Rehabilitation, to limit the application of Section 6.13 to defaults or alleged defaults related to policies formerly allocated to the Segregated Account. The Rehabilitator also requested in the May 4, 2018 filings that the Rehabilitation Court remove the May 10, 2018 hearing from its calendar and enter a final decree and order closing the case. On May 10, 2018, the Rehabilitation Court set a briefing schedule with respect to the motions filed by OCI on May 4, 2018 and set a hearing on the motions for June 7, 2018. Upon stipulation of the parties, the hearing was adjourned.
On June 21, 2018, Ambac Assurance and the MHPI Projects entered into a settlement agreement whereby the parties agreed, among other things, that the February 7 Order could be dissolved, the February 26 Motion and the May 4 Motion would each be withdrawn, and the parties would petition the Wisconsin Court of Appeals to vacate the March 13 Order and dismiss the appeal of the MHPI Projects. On June 22, 2018, the Rehabilitation Court entered an order to dissolve the February 7 Order, grant the withdrawal of the February 26 Motion and the May 4 Motion, and close the case. On June 25, 2018, the Rehabilitator, Ambac Assurance and the MHPI Projects filed with the Wisconsin Court of Appeals a Stipulation and Joint Motion to Vacate the March 13 Order. On July 3, 2018, the Wisconsin Court of Appeals vacated the March 13 Order and on July 6, 2018, the Court of Appeals dismissed the appeal of the MHPI Projects.
Litigation Against Ambac
Ambac Assurance has been defending several lawsuits in which borrowers brought declaratory judgment actions claiming, among other things, that Ambac Assurance’s claims for specific performance related to the construction and development of housing at various military bases to replace or cash-fund a debt-service-reserve surety bond, as required under the applicable loan documents (see Litigation Filed By Ambac), are time-barred or are barred by the doctrine of laches, that Ambac lacks standing on the basis that there has been an “Ambac Default,” and that Ambac is not entitled to specific performance pursuant to the terms of the loan documents. The parties to the cases described below have reached a settlement resolving all litigation between and among them (except for the RICO action described below). In connection with the settlement of these cases, related cases brought by Ambac Assurance seeking specific performance related to the construction and development of housing at various military bases to replace or cash-fund a debt-service-reserve surety bond, and the litigation involving the MHPI Projects in Wisconsin relating to orders issued by the Rehabilitation Court with respect to the conclusion of the rehabilitation of the Segregated Account of Ambac Assurance, Ambac Assurance has paid the military housing project companies for their costs and other amounts. Such settlement resulted in a net loss for Ambac of approximately $20,413 for the second quarter of 2018.

• | Meade Communities LLC v. Ambac Assurance Corporation (Circuit Court, Anne Arundel County, Maryland, Case No. C-02-CV-15-003745). On January 22, 2018, the court granted Meade's motion for summary judgment finding that Ambac Assurance lacked standing on the basis that there had been an "Ambac Default" by virtue of certain orders of the Rehabilitation Court. On January 26, 2018, Ambac Assurance filed a Motion to Alter or Amend Judgment with the Maryland Court arguing that the Rehabilitation Court's January 22 Confirmation Order constituted grounds for altering the judgment to award summary judgment on the "Ambac Default" issue for Ambac Assurance. On February 7, 2018, the Rehabilitation Court entered a further order enjoining Meade from continuing to argue that an Ambac Default occurred by virtue of the Rehabilitation Court's prior orders and requiring Meade to file that order with the Maryland Court. On February 8, 2018, Meade complied and filed the January 22nd and February 7th Rehabilitation Court orders with the Maryland court. On February 12, 2018, the Maryland Court granted Ambac Assurance's motion to stay enforcement of the Court's January 22nd amended order concerning "Ambac Default" and granting Meade an extension until March 14, 2018 to oppose Ambac Assurance's Motion to Alter or Amend Judgment. On March 14, 2018, Meade filed its opposition brief. On May 10, 2018, the Maryland Court denied Ambac Assurance’s January 26, 2018 Motion to Alter or Amend Judgement and lifted the February 12, 2018 stay order. Ambac Assurance filed a notice of appeal on May 16, 2018 and, concurrently therewith, filed a Motion to Set Supersedeas Bond Amount pending the appeal. Plaintiff opposed such motion on May 31, 2018 and the court denied Ambac Assurance’s motion on June 15, 2018. Pursuant to an agreement to settle the case, Ambac agreed to dismiss its appeals and on July 9, 2018, the parties filed a consent motion to vacate the Circuit Court's prior orders, which is pending.

• | Monterey Bay Military Housing LLC and Monterey Bay Land LLC v. Ambac Assurance Corporation (Superior Court, Monterey County, California, Case No. 15CV000599). On June 19, 2017, the court issued a preliminary order that partially granted Monterey Bay's motion for summary judgment and ruled that the California statute of limitations had run on Ambac Assurance's claim for specific performance, subject to Ambac Assurance’s defense of equitable tolling. The court also partially granted Ambac Assurance's motion for summary judgment on certain of Monterey Bay’s declaratory judgment claims. On June 23, 2017, Ambac Assurance withdrew its defense of equitable tolling. The parties agreed that the court’s summary judgment ruling on the statute of limitations was sufficient to end the case at the trial court level and submitted final orders to the court for approval. The court signed the final orders on July 13, 2017. On September 14, 2017, Ambac Assurance filed a notice of appeal. On April 19, 2018, the court entered an order awarding plaintiffs an amount representing a portion of their fees and costs incurred. On May 1, 2018, Ambac Assurance filed a notice of appeal. Pursuant to an agreement to settle the case, Ambac Assurance filed a motion to dismiss its appeal, which was granted on July 3, 2018.

| Ambac Financial Group, Inc. 50 2018 Second Quarter FORM 10-Q |

Table of Contents
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
Monterey Bay Military Housing, LLC, et al. v. Ambac Assurance Corporation, et al. (United States District Court, Northern District of California, San Jose Division, Case No. 17-cv-04992-BLF, filed August 28, 2017). On November 13, 2017, Ambac Assurance and the other defendants filed motions to dismiss the amended complaint asserting, among other claims, civil claims based on the Racketeer Influenced and Corrupt Organizations Act (“RICO”), which Plaintiffs opposed. Oral argument was held on April 12, 2018. On July 17, 2018, the court granted Ambac Assurance’s and the other defendants’ motion to dismiss without prejudice.
It is not reasonably possible to predict whether additional suits will be filed or whether additional inquiries or requests for information will be made, and it is also not possible to predict the outcome of litigation, inquiries or requests for information. It is possible that there could be unfavorable outcomes in these or other proceedings. Legal accruals for litigation against Ambac which are probable and reasonably estimable, and management's estimated range of loss for such matters, are not material to the operating results or financial position of the Company. For the litigation matters Ambac is defending that do not meet the “probable and reasonably estimable” accrual threshold and where no loss estimates have been provided above, management is unable to make a meaningful estimate of the amount or range of loss that could result from unfavorable outcomes. Under some circumstances, adverse results in any such proceedings could be material to our business, operations, financial position, profitability or cash flows. The Company believes that it has substantial defenses to the claims above and, to the extent that these actions proceed, the Company intends to defend itself vigorously; however, the Company is not able to predict the outcomes of these actions.
Litigation Filed or Joined by Ambac
In the ordinary course of their businesses, certain of Ambac’s subsidiaries assert claims in legal proceedings against third parties to recover losses already paid and/or mitigate future losses. The amounts recovered and/or losses avoided which may result from these proceedings is uncertain, although recoveries and/or losses avoided in any one or more of these proceedings during any quarter or fiscal year could be material to Ambac’s results of operations in that quarter or fiscal year.
Nat’l Collegiate Master Student Loan Trust v. Pa. Higher Education Assistance Agency (PHEAA) (Delaware Court of Chancery, C.A. No. 12111-VCS, filed March 21, 2016). On January 12, 2018, Plaintiffs filed a motion for injunctive or declaratory relief requiring Wilmington Trust Company, as Owner Trustee, and GSS Data Services, Inc., as Administrator, to resume processing for payment bills submitted by lawyers purporting to act on the Trusts’ behalf. Oppositions to Plaintiffs’ motion were filed by Ambac and others on March 1, 2018. Plaintiffs filed a reply brief in further support of their motion on March 16, 2018. At a hearing on April 3, 2018, the court denied Plaintiffs’ motion without prejudice. The court later entered an order memorializing its oral ruling on April 16, 2018. The court also granted Ambac’s motion to intervene on April 10, 2018 and Ambac filed its complaint in intervention on April 16, 2018. On June 15, 2018, the Owner Trustee filed a stipulation and proposed order addressing the selection of a Successor Owner Trustee. Among other provisions, the stipulation calls for the appointment of a Special Master to adjudicate disputes regarding “Owner Instructions,” and raises the annual expense caps that apply to the Owner Trustee and Indenture Trustee. The stipulation was negotiated and agreed to by the Owner Trustee, the Indenture Trustee, the Administrator, Ambac Assurance, and various noteholders. Plaintiffs withdrew from the negotiations and have not expressed a position regarding the stipulation. The Owner Trustee has proposed that the court schedule a hearing to consider any objections to the stipulation submitted by noteholders. The court has scheduled the hearing for September 21, 2018.
Peaje Investments LLC v. Puerto Rico Highways and Transportation Authority, et al. (United States District Court, District of Puerto Rico, No. 1:17-ap-00151, filed May 31, 2017). On June 15, 2017, Ambac Assurance moved to intervene in an adversary proceeding brought by Peaje Investments (Peaje), a holder of 1968 Bonds issued by PRHTA, against PRHTA. On May 31, 2017, Peaje filed a complaint seeking relief with respect to its ownership of the 1968 Bonds, including a declaration that the toll road revenues pledged to the 1968 Bonds are “special revenues” under Section 922 of the Bankruptcy Code, an injunction preventing the diversion of toll revenues to the Commonwealth and ordering the application of the toll revenues to the 1968 Bonds, and various declarations and injunctions related thereto. Peaje also filed a motion for a temporary restraining order and preliminary injunction on the same day, seeking to enjoin PRHTA from diverting the toll revenues to the Commonwealth. A hearing on the motion for a temporary restraining order was held on June 5, 2017, at which time Peaje withdrew the motion for a temporary restraining order. In its motion to intervene, Ambac Assurance argued that issues in this case will have a significant impact on Ambac Assurance’s own interests with respect to PRHTA bonds. On July 21, 2017, the court denied Ambac Assurance's motion to intervene. On September 8, 2017, the court denied Peaje’s motion for a preliminary injunction, finding that Peaje had not demonstrated either (i) a likelihood of success on the merits of its underlying claim that the 1968 bonds are secured by a statutory lien, or (ii) that it would be irreparably harmed in the absence of a preliminary injunction. Peaje has appealed this denial of the preliminary injunction to the U.S. Court of Appeals for the First Circuit; the First Circuit held argument on the appeal on June 5, 2018, but has not yet ruled on the appeal. On October 10, 2017, Peaje filed an amended complaint; Defendants filed answers to the amended complaint on November 17, 2017.
Ambac Assurance Corporation v. Puerto Rico, et al. (United States District Court, District of Puerto Rico, No. 1:17-ap-00159, filed June 8, 2017). On July 28, 2017, Defendants moved to dismiss Ambac Assurance’s complaint; briefing on the motion to dismiss concluded on October 31, 2017, and oral argument on the motion was held on November 21, 2017. On February 27, 2018, the court granted Defendants’ motion to dismiss. As to certain of the claims, the court found that it lacks subject matter jurisdiction (i) to the extent the claims seek to invalidate the certification of the FEGP and prohibit certain actions under PROMESA due to alleged non-compliance with PROMESA requirements that are predicates to certification of the FEGP, or (ii) to the extent Ambac Assurance sought a determination of its lien rights over the PRHTA reserve accounts. As to other claims, the court found that Ambac Assurance had failed to state a claim upon which the court could grant relief, including that (i) as to constitutional issues, Ambac Assurance had failed to plead facts sufficient to allow the court to draw a reasonable inference that the Moratorium Legislation, Moratorium Orders, and Fiscal Plan Compliance Act were “unreasonable or unnecessary to effectuate an important government
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Table of Contents
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
purpose” and had failed to allege plausibly that the FEGP is an exercise of Commonwealth legislative power, (ii) Ambac Assurance had failed to plead facts sufficient to show that the Moratorium Legislation and Moratorium Orders prohibited the payment of principal and interest or purported to bind creditors to any reduction of the outstanding obligations and therefore would have been preempted by PROMESA under PROMESA Section 303(1), and Ambac Assurance failed to plead plausible, ripe claims that the Moratorium Orders are unlawful under PROMESA section 303(3), (iii) the automatic stay is currently in effect and renders unavailable any cause of action pursuant to Section 407 of PROMESA, including claims by PRHTA bondholders that PRHTA should be compensated for any pledged special revenues transferred away from it in violation of applicable law, (iv) the court is not required or empowered under PROMESA or the Bankruptcy Code to order the payment of pledged special revenues to the PRHTA bondholders, and (v) Ambac Assurance had failed to plead facts sufficient to show that the PRHTA reserve accounts are the property of the bondholders. Finally, the court held that PROMESA section 305 prevented it from ordering any relief on Ambac’s claim that the PRHTA reserve accounts are held in trust for bondholders. On March 9, 2018, Ambac Assurance filed a notice of appeal to the First Circuit. On June 18, 2018, Ambac Assurance submitted its opening brief to the First Circuit.
Official Committee of Unsecured Creditors v. Whyte (United States District Court, District of Puerto Rico, No. 1:17-ap-00257, filed September 8, 2017). Motions for summary judgment were filed on February 21, 2018; a hearing on the summary judgment motions was held on April 10, 2018. On February 26, 2018, the COFINA Agent moved to certify questions of law to the Supreme Court of Puerto Rico regarding COFINA’s constitutionality under the Puerto Rico Constitution. On April 3, 2018, Ambac Assurance filed an opposition to the motion to certify and, in the alternative, a cross-motion to certify alternative questions to the Supreme Court of Puerto Rico. Briefing on the motion to certify concluded on April 18, 2018; a hearing on the motion to certify was held on May 9, 2018. On May 24, 2018, the court denied the motion to certify questions of law to the Supreme Court of Puerto Rico. On June 5, 2018, the Commonwealth Agent and COFINA Agent filed a joint motion asking the court to hold its decision on the summary judgment motions in abeyance for 60 days on account of an agreement in principle between the Agents to settle the Commonwealth-COFINA dispute. The court granted this motion on June 11, 2018, stating that it will not issue a decision on summary judgment in this matter any earlier than August 4, 2018.
Ambac Assurance filed various lawsuits seeking specific performance of obligations of borrowers on loans related to the construction and development of housing at various military bases to replace or cash-fund a debt-service-reserve surety bond provided by Ambac Assurance, as required under the applicable loan documents. The parties to these cases have reached a settlement resolving all claims and counterclaims between and among them with respect to the debt-service-reserve surety bonds and related issues (other than the aforementioned RICO action), which have resulted in agreed dismissals of the following cases with prejudice:

• | Ambac Assurance Corporation v. Riley Communities, LLC (District Court, Shawnee County Kansas, No. 2016-CV-00026,filed September 29, 2017). The parties filed a joint motion stipulating to the dismissal of the matter with prejudice, which was granted by the Court on July 6, 2018.

• | Ambac Assurance Corporation v. Fort Leavenworth Frontier Heritage Communities, II, LLC (U.S. District Court, District of Kansas, Index No. 15-CV-9596, filed November 19, 2015). The parties filed a joint motion stipulating to the dismissal of the matter with prejudice, which was granted by the Court on July 6, 2018.

• | Ambac Assurance Corporation v. Carlisle/ Picatinny Family Housing Limited Partnership (Court of Common Pleas, Cumberland County, Pennsylvania, No. 2015-6348, filed January 11, 2016). The parties filed a Joint Praecipe to Settle and Discontinue, which ended the matter effective July 3, 2018.

• | Ambac Assurance Corporation v. Fort Lee Commonwealth Communities, LLC (Circuit Court, Roanoke City, Virginia, No. CL16000072-00). The parties filed a joint motion stipulating to the dismissal of the matter with prejudice, which was granted by the Court on July 9, 2018.

• | Ambac Assurance Corporation v. Fort Bliss/White Sands Missile Range Housing LP (District Court, El Paso County, Texas, Cause No. 2016DCV0094, filed January 8, 2016). The parties filed an agreed motion to dismiss all claims between and among the parties with prejudice, which was granted by the Court on July 5, 2018.

In connection with Ambac Assurance’s efforts to seek redress for breaches of representations and warranties and fraud related to the information provided by both the underwriters and the sponsors of various residential mortgage-backed securities transactions and for failure to comply with the obligation by the sponsors to repurchase ineligible loans, Ambac Assurance has filed various lawsuits, including the following:

• | Ambac Assurance Corporation and The Segregated Account of Ambac Assurance Corporation v. Countrywide Securities Corp., Countrywide Financial Corp. (a.k.a. Bank of America Home Loans) and Bank of America Corp. (Supreme Court of the State of New York, County of New York, Case No. 651612/2010, filed on September 28, 2010). On May 1, 2015, Ambac Assurance filed motions for partial summary judgment, which defendants opposed. Defendants also each filed motions for summary judgment, which Ambac Assurance opposed. On October 27, 2015, the court issued a decision dated October 22, 2015 granting in part and denying in part the parties’ respective summary judgment motions regarding Ambac Assurance’s claims against Countrywide (primary-liability claims), and issued a second decision granting Ambac Assurance’s partial motion for summary judgment and denying Bank of America’s motion for summary judgment regarding Ambac Assurance’s secondary-liability claims against Bank of America. Ambac Assurance and Countrywide filed notices of appeal of the October 22, 2015 decision relating to primary liability and Bank of America filed a notice of appeal of the October 27, 2015 decision relating

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Table of Contents
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(Dollar Amounts in Thousands, Except Share Amounts)
to its secondary-liability to the New York Appellate Division, First Department. On May 16, 2017, the First Department issued rulings in both appeals, reversing a number of rulings that the trial court had made and affirming other rulings. On June 15, 2017, Ambac Assurance filed a motion with the First Department for leave to appeal certain rulings in the May 16, 2017 decision to the Court of Appeals, which Countrywide opposed. On July 25, 2017 the First Department granted Ambac Assurance’s motion. The Court of Appeals heard oral argument on June 6, 2018. On June 27, 2018, the Court of Appeals denied Ambac Assurance’s appeal and affirmed the rulings of the First Department. Trial is currently scheduled to commence on February 25, 2019, and a hearing on certain pre-trial motions scheduled to be filed in August is currently scheduled for September 27, 2018.

• | The Segregated Account of Ambac Assurance Corporation and Ambac Assurance Corporation v. Countrywide Home Loans, Inc. (Wisconsin Circuit Court for Dane County, Case No 14 CV 3511, filed on December 30, 2014). On June 23, 2016, the Wisconsin Court of Appeals reversed the trial court’s prior dismissal of the complaint, and on October 11, 2016, the Wisconsin Supreme Court granted Countrywide’s petition for review of the June 23 decision by the Wisconsin Court of Appeals. The Wisconsin Supreme Court appeal was argued on February 28, 2017. On June 30, 2017, the Wisconsin Supreme Court reversed the decision of the Wisconsin Court of Appeals and remanded the case to the Wisconsin Court of Appeals for further proceedings. On December 14, 2017, the Wisconsin Court of Appeals affirmed the trial court’s July 2, 2015 decision dismissing the case for lack of personal jurisdiction. On January 16, 2018, Ambac Assurance filed a petition with the Supreme Court of Wisconsin for review of the December 14, 2017 decision. On January 30, 2018, Countrywide opposed the petition. On March 13, 2018, the Wisconsin Supreme Court denied Ambac Assurance’s petition for review, ending the Wisconsin Action. In the 2015 New York Action, on September 20, 2016, the New York Court granted Ambac Assurance’s motion to stay, holding Countrywide’s motion to dismiss the complaint in abeyance pending resolution of the Wisconsin Action. On March 30, 2018, the court vacated its stay of the 2015 New York Action, and the parties submitted supplemental letter briefs on April 11, 2018 addressing newly-issued authority relevant to Countrywide’s pending motion to dismiss, which was restored to the calendar.

• | Ambac Assurance Corporation and The Segregated Account of Ambac Assurance Corporation v. U.S. Bank National Association (United States District Court, Southern District of New York, Docket No. 17-cv-00446 (SHS), filed January 20, 2017, (the “2017 S.D.N.Y. Action”)); Ambac Assurance Corporation v. U.S. Bank National Association (United States District Court, Southern District of New York, Docket No. 18-cv-5182 (LGS), filed June 8, 2018 (the “2018 S.D.N.Y. Action”)); In the matter of HarborView Mortgage Loan Trust 2005-10 (Minnesota state court, Docket No. 27-TR-CV-17-32 (the “Minnesota Action”)). These three actions relate to U.S. Bank National Association’s (“U.S. Bank) proposed settlement of claims related to the Harborview Mortgage Loan Trust, Series 2005-10. On December 6, 2017, in the 2017 S.D.N.Y. Action, the court granted U.S. Bank’s motion for reconsideration and granted U.S. Bank’s motion to dismiss, and on January 18, 2018, the court issued an opinion memorializing the reasons for its decision. Ambac did not appeal that decision, and judgment was entered on March 5, 2018. On March 6, 2017, U.S. Bank filed the Minnesota Action, a trust instruction proceeding in Minnesota state court concerning the proposed settlement. On April 5, 2017, Ambac Assurance filed a motion to dismiss the Minnesota Action. On June 12, 2017, U.S. Bank filed an amended petition in the Minnesota Action, and on July 7, 2017 Ambac Assurance filed a renewed motion to dismiss, which U.S. Bank opposed. On November 13, 2017, the court denied the motion to dismiss the proceeding. On February 7, 2018, Ambac Assurance appealed this dismissal and U.S Bank opposed the appeal. Oral argument was held on June 7, 2018. Additionally, certain certificateholders have objected or otherwise responded to the petition filed by U.S. Bank. On June 1, 2018, U.S. Bank moved for leave to file a Second Amended Petition seeking approval of its acceptance of a second offer to settle the separate litigation being prosecuted by U.S. Bank, as Trustee. Ambac Assurance opposed that motion. A hearing on that motion was held on July 11, 2018. No decision has been issued.

• | On June 8, 2018, Ambac Assurance filed the 2018 S.D.N.Y. Action asserting claims arising out of U.S. Bank’s acceptance of the second settlement offer and treatment of trust recoveries. Ambac asserts claims for declaratory judgment, breach of contract, and breach of fiduciary duty. On July 20, 2018, U.S. Bank filed a pre-motion letter indicating that it intends to file a motion to dismiss the complaint. Ambac filed a responsive letter on August 2, 2018, and a pre-motion conference and initial pretrial conference is scheduled for August 14, 2018.

• | Ambac Assurance Corporation v. U.S. Bank National Association (United States District Court, Southern District of New York, Docket No. 17-cv-02614, filed April 11, 2017). On September 15, 2017, U.S. Bank filed a motion to dismiss, which Ambac Assurance opposed on October 13, 2017. Oral argument on that motion was held on November 17, 2017. On March 12, 2018, Ambac Assurance filed an Amended Complaint removing the Segregated Account as a plaintiff. As a result, defendant agreed to withdraw certain arguments in support of its motion to dismiss. On June 29, 2018, the Court granted in part and denied in part U.S. Bank’s motion to dismiss. The Court dismissed the breach of fiduciary duty claim in part as duplicative of the breach of contract claim; dismissed the breach of contract claim as untimely only to the extent that it was premised on U.S. Bank's obligation to certify that mortgage documents were properly delivered to the Trusts; dismissed the Streit Act claims; and otherwise denied the motion to dismiss. Discovery is ongoing.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Following this summary is a discussion addressing the consolidated results of operations and financial condition of Ambac Financial Group, Inc. (“Ambac” or “the Company”) for the periods indicated. This discussion should be read in conjunction with Ambac’s Annual Report on Form 10-K for the year ended December 31, 2017, the CAUTIONARY STATEMENT
PURSUANT TO THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 below and Risk Factors set forth in Part II, Item 1A of this Form 10-Q.
This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) contains certain
| Ambac Financial Group, Inc. 53 2018 Second Quarter FORM 10-Q |

financial measures, in particular the presentation of Adjusted Earnings and Adjusted Book Value, which are not presented in accordance with U.S. generally accepted accounting principles (“GAAP”). We are presenting these non-GAAP financial measures because they provide greater transparency and enhanced visibility into the underlying drivers of our business. We do not intend for these non-GAAP financial measures to be a substitute for any GAAP financial measures and they may differ from similar reporting provided by other companies. Readers of this Form 10-Q should use these non-GAAP financial measures only in conjunction with the comparable GAAP financial measures. Adjusted Earnings and Adjusted Book Value are non-GAAP financial measures that adjust for the impact of certain non-recurring or non-economic GAAP accounting requirements and include the addition of certain items that the Company has or expects to realize in the future, but that are not reported under GAAP. We provide reconciliations to the most directly comparable GAAP measures; Adjusted Earnings to Net income attributable to common stockholders and Adjusted Book Value to Total Ambac Financial Group, Inc. stockholders’ equity.
CAUTIONARY STATEMENT PURSUANT TO THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Management has included in Parts I and II of this Quarterly Report on Form 10-Q, including this MD&A, statements that may constitute “forward-looking statements” within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Words such as “estimate,” “project,” “plan,” “believe,” “anticipate,” “intend,” “planned,” “potential” and similar expressions, or future or conditional verbs such as “will,” “should,” “would,” “could,” and “may,” or the negative of those expressions or verbs, identify forward-looking statements. We caution readers that these statements are not guarantees of future performance. Forward-looking statements are not historical facts but instead represent only our beliefs regarding future events, which may by their nature be inherently uncertain and some of which may be outside our control. These statements may relate to plans and objectives with respect to the future, among other things which may change. We are alerting you to the possibility that our actual results may differ, possibly materially, from the expected objectives or anticipated results that may be suggested, expressed or implied by these forward-looking statements. Important factors that could cause our results to differ, possibly materially, from those indicated in the forward-looking statements include, among others, those discussed under “Risk Factors” in Part I, Item 1A of the 2017 Annual Report on Form 10-K and in Part II, Item 1A of this quarterly Report on Form 10-Q.
Any or all of management’s forward-looking statements here or in other publications may turn out to be incorrect and are based on management’s current belief or opinions. Ambac’s actual results may vary materially, and there are no guarantees about the performance of Ambac’s securities. Among events, risks, uncertainties or factors that could cause actual results to differ materially are: (1) the highly speculative nature of Ambac’s common stock and volatility in the price of Ambac’s common stock; (2) uncertainty concerning the Company’s ability to achieve value for holders of its securities, whether from Ambac Assurance Corporation ("Ambac Assurance") or from transactions or opportunities apart from Ambac Assurance; (3) adverse effects on
Ambac’s share price resulting from future offerings of debt or equity securities that rank senior to Ambac’s common stock; (4) potential of rehabilitation proceedings against Ambac Assurance; (5) dilution of current shareholder value or adverse effects on Ambac’s share price resulting from the issuance of additional shares of common stock; (6) inadequacy of reserves established for losses and loss expenses and possibility that changes in loss reserves may result in further volatility of earnings or financial results; (7) decisions made by Ambac Assurance's primary insurance regulator for the benefit of policyholders that may result in material adverse consequences for holders of the Company’s securities or holders of securities issued or insured by Ambac Assurance; (8) increased fiscal stress experienced by issuers of public finance obligations or an increased incidence of Chapter 9 filings or other restructuring proceedings by public finance issuers; (9) failure to recover claims paid on Puerto Rico exposures or incurrence of losses in amounts higher than expected; (10) the Company’s inability to realize the expected recoveries included in its financial statements; (11) changes in Ambac Assurance’s estimated representation and warranty recoveries or loss reserves over time; (12) insufficiency or unavailability of collateral to pay secured obligations; (13) credit risk throughout the Company’s business, including but not limited to credit risk related to residential mortgage-backed securities, student loan and other asset securitizations, public finance obligations and exposures to reinsurers; (14) credit risks related to large single risks, risk concentrations and correlated risks; (15) concentration and essentiality risk in connection with Military Housing insured debt; (16) the risk that the Company’s risk management policies and practices do not anticipate certain risks and/or the magnitude of potential for loss; (17) risks associated with adverse selection as the Company’s insured portfolio runs off; (18) adverse effects on operating results or the Company’s financial position resulting from measures taken to reduce risks in its insured portfolio; (19) intercompany disputes or disputes with Ambac Assurance's primary insurance regulator; (20) our inability to mitigate or remediate losses, commute or reduce insured exposures or achieve recoveries or investment objectives, or the failure of any transaction intended to accomplish one or more of these objectives to deliver anticipated results; (21) the Company’s substantial indebtedness could adversely affect its financial condition and operating flexibility; (22) the Company may not be able to obtain financing or raise capital on acceptable terms or at all due to its substantial indebtedness and financial condition; (23) the Company may not be able to generate the significant amount of cash needed to service its debt and financial obligations, and may not be able to refinance its indebtedness; (24) restrictive covenants in agreements and instruments may impair the Company’s ability to pursue or achieve its business strategies; (25) loss of control rights in transactions for which we provide insurance due to a finding that Ambac Assurance has defaulted, whether due to the Segregated Account rehabilitation proceedings or otherwise; (26) the Company’s results of operation may be adversely affected by events or circumstances that result in the accelerated amortization of the Company’s insurance intangible asset; (27) adverse tax consequences or other costs resulting from the Segregated Account rehabilitation plan, or from the characterization of the Company’s surplus notes or other obligations as equity; (28) risks attendant to the change in composition of securities in the Company’s investment portfolio; (29) changes in tax law; (30) changes in prevailing interest rates; (31) changes on inter-bank lending rate reporting practices or the method pursuant to which LIBOR rates
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are determined; (32) factors that may influence the amount of installment premiums paid to the Company, including the Segregated Account rehabilitation proceedings; (33) default by one or more of Ambac Assurance's portfolio investments, insured issuers or counterparties; (34) market risks impacting assets in the Company’s investment portfolio or the value of our assets posted as collateral in respect of interest rate swap transactions; (35) risks relating to determinations of amounts of impairments taken on investments; (36) the risk of litigation and regulatory inquiries or investigations, and the risk of adverse outcomes in connection therewith, which could have a material adverse effect on the Company’s business, operations, financial position, profitability or cash flows; (37) actions of stakeholders whose interests are not aligned with broader interests of the Company's stockholders; (38) the Company’s inability to realize value from Ambac UK or other subsidiaries of Ambac Assurance; (39) system security risks; (40) market spreads and pricing on interest rate derivative insured or issued by the Company; (41) the risk of volatility in income and earnings, including volatility due to the application of fair value accounting; (42) changes in accounting principles or practices that may impact the Company’s reported financial results; (43) legislative and regulatory developments, including intervention by regulatory authorities; (44) the economic impact of “Brexit” may have an adverse effect on the Company’s insured international portfolio and the value of its foreign investments, both of which primarily reside with its subsidiary Ambac UK; (45) operational risks, including with respect to internal processes, risk and investment models, systems and employees, and failures in services or products provided by third parties; (46) the Company’s financial position that may prompt departures of key employees and may impact the Company’s ability to attract qualified executives and employees; (47) implementation of new tax legislation signed into law on December 22, 2017 (commonly known as the “Tax Cuts and Jobs Act”) may have unexpected consequences for the Company and the value of its securities, particularly its common shares; (48) implementation of the Tax Cuts and Jobs Act may negatively impact the economic recovery of Puerto Rico, which could result in higher loss severities or an extended moratorium on debt service owed on Ambac Assurance-insured bonds of Puerto Rico and its instrumentalities; (49) implementation of the Tax Cuts and Jobs Act could have a negative impact on municipal issuers of Ambac-insured bonds; (50) fluctuations in foreign currency exchange rates could adversely impact the insured portfolio in the event of loss reserves or claim payments denominated in a currency other than US dollars and the value of non-US dollar denominated securities in our investment portfolio; and (51) other risks and uncertainties that have not been identified at this time.
EXECUTIVE SUMMARY
Company Overview:
See Note 1. Background and Business Description to the Consolidated Financial Statements, included in Part I, Item 1 in this Form 10-Q and Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 for a description of the Company and our key strategic priorities to achieve our primary goal to maximize stockholder value.
Ambac Assurance and Subsidiaries:
A key strategy for Ambac is to increase the value of its investment in Ambac Assurance by actively managing its assets and liabilities. Asset management primarily entails maximizing the risk adjusted return on non-VIE invested assets and managing liquidity to help ensure resources are available to meet operational and strategic cash needs. These strategic cash needs include activities associated with Ambac's liability management and loss mitigation programs.
Asset Management:
Investment portfolios are subject to internal investment guidelines, as well as limits on types and quality of investments imposed by applicable insurance laws and regulations. As part of its investment strategy, and in accordance with the aforementioned guidelines, Ambac Assurance and Ambac Assurance UK Limited ("Ambac UK"), a subsidiary of Ambac Assurance, purchase distressed Ambac-insured securities based on their relative risk/reward characteristics. The investment portfolios of Ambac Assurance and Ambac UK also hold fixed income securities and funds that include a variety of other assets including, but not limited to, corporate bonds, asset backed and mortgage backed securities, municipal bonds, high yield bonds, leveraged loans, equities, real estate, insurance-linked securities and hedge funds. Refer to Note 8. Investments to the Consolidated Financial Statements, included in Part I, Item 1 in this Form 10-Q for further details of fixed income investments by asset class.
During the three and six months ended June 30, 2018, Ambac (inclusive of its subsidiaries) did not acquire a significant amount of distressed Ambac-insured securities. As a result of the Rehabilitation Exit Transactions (as defined in Note 1. Background and Business Description), Ambac discharged all Deferred Amount (as defined in Note 1. Background and Business Description) obligations for an effective consideration package comprised of cash, new Secured Notes (as defined in Note 1. Background and Business Description) and certain existing surplus notes, including those held by Ambac, and accordingly Ambac's ownership of Ambac-insured RMBS declined significantly. Furthermore, Ambac has sold certain Ambac-insured RMBS securities during 2018 in connection with re-balancing the investment portfolio. At June 30, 2018, Ambac owned $506 million of Ambac-insured RMBS and approximately 29% of outstanding PRIFA and 58% of outstanding COFINA Ambac-insured bonds. Subject to applicable internal and regulatory guidelines and other constraints, Ambac will continue to opportunistically purchase Ambac-insured securities.
Liability and Insured Exposure Management:
Ambac Assurance's Risk Management Group focuses on the analysis, implementation and execution of commutations, risk reduction or defeasance and loss recovery strategies. Analysts evaluate the estimated timing and severity of projected policy claims as well as the potential impact of loss mitigation or remediation strategies in order to target and prioritize policies, or portions thereof, for commutation, refinancing, restructuring or other risk reduction or defeasance strategies. For targeted policies, analysts will engage with bondholders, issuers and other economic stakeholders to negotiate, structure and execute such strategies. During 2018, Ambac's successes included:

• | Working closely with servicers and owners of Master Servicing Rights to exercise clean-up calls on 11 RMBS

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transactions, resulting in a benefit in losses and loss expenses of $10 million and reducing adversely classified net par exposure by $284 million;

• | Proactively working with issuers to expedite refundings of Ambac-insured bonds. During the first half of 2018. Ambac negotiated with counterparties that resulted in the termination of several international RMBS transactions on £182 million of net par exposure.

• | Working with issuers and investors of Ambac-insured debt to commute $133 million of net par exposure, including $33 million of adversely classified net par exposure.

• | In July 2018, (i) facilitating the refinancing of an Ambac UK insured debt, reducing adversely classified net par exposure by $36 million and (ii) executing a commutation of a student loan exposure, reducing adversely classified net par exposure by $127 million. These risk reductions are not expected to have a significant impact on total comprehensive income in the third quarter of 2018.

The following table provides a comparison of total and adversely classified credits ("ACC") net par outstanding in the insured portfolio at June 30, 2018 and December 31, 2017. Net par exposures within the U.S. public finance market includes capital appreciation bonds which are reported at the par amount at the time of issuance of the insurance policy as opposed to the current accreted value of the bonds.

($ in billions) | June 30, 2018 |  | December 31, 2017 |  | Variance
Total | $ | 56.5 |  |  | $ | 62.7 |  |  | $ | (6.2 | ) |  | (10 | )%
ACC | 11.8 |  |  | 14.1 |  |  | (2.3 | ) |  | (16 | )%

The overall reduction in total net par outstanding resulted from scheduled maturities, amortizations, refundings, refinancings and calls, including reductions as a result of the activities of Ambac and its subsidiaries as noted above.
The decrease in adversely classified credit exposures is primarily due to (i) paydowns or calls by issuers, mostly related to residential mortgage-backed securities and (ii) the improved credit profile of certain residential mortgage-backed securities and their upgrade from the adversely classified credit listing.
Although our insured portfolio has generally performed satisfactorily in 2018, we continue to experience stress in certain insured exposures, particularly within our approximately $2 billion of exposure to Puerto Rico consisting of several different issuing entities (all below investment grade). Each issuing entity has its own credit risk profile attributable to discreet revenue sources, direct general obligation pledges and general obligation guarantees. Refer to Part 1, Item 1 in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, for additional information regarding the different issuing entities that encompass Ambac's exposures to Puerto Rico.
During 2018, Ambac repaid the remaining December 31, 2017 balance of the Secured Borrowing (as defined and described in Note 3. Variable Interest Entities) of $74 million and made a partial paydown of the Ambac Note (as defined in Note 1. Background and Business Description) by $113 million.
Ambac:
As of June 30, 2018 total cash and investments of Ambac were $395 million, which include the following:

• | Cash, corporate securities and shor t-term securities of $270 million, (includi ng $120 million of the secured notes issued by Ambac LSNI (as defined in Note 1. Background and Business Description) in connection with the Rehabilitation Exit Transactions)

• | Ambac Assurance surplus notes with a fair value of $87 million, which are eliminated in consolidation

• | Residual equity interest in the Corolla Trust that was created in 2014 to monetize Ambac's ownership interest in junior surplus notes issued by the Segregated Account. Ambac carries this interest using the equity method with a current value of $37 million at June 30, 2018. Refer to Note 3. Special Purpose Entities, Including Variable Interest Entities to the Consolidated Financial Statements included in Part II, Item 8 in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 for more information on the Corolla Trust.

As a result of positive taxable income at Ambac Assurance in 2017, Ambac has accrued approximately $30 million in tax tolling payments. In May 2018, Ambac executed a waiver under the intercompany tax sharing agreement pursuant to which Ambac Assurance was relieved of the requirement to make this payment by June 1, 2018. Ambac has also agreed to continue to defer the tolling payment for the use of net operating losses by Ambac Assurance until such time as OCI (as defined in Note 1. Background and Business Description) consents to the payment.
For the six months ended June 30, 2018, Ambac recognized taxable income and accordingly has accrued $14 million of tolling payments. There are no assurances that Ambac Assurance will be able to generate taxable income for the full year of 2018 and therefore make future tolling payments to Ambac, including the accrued amount.
Financial Statement Impact of Foreign Currency:
The impact of foreign currency as reported in Ambac's Consolidated Statement of Total Comprehensive Income for the six months ended June 30, 2018 included the following:

($ in millions) |  |
Net income (1) |  | $ | (4 | )
Gain (loss) on foreign currency translation |  | (21 | )
Unrealized (losses) on non-functional currency available-for-sale securities |  | 6 |
Impact on total comprehensive income (loss) |  | $ | (19 | )

(1) | A portion of Ambac UK's, and to a lesser extent Ambac Assurance's, assets and liabilities are denominated in currencies other than its functional currency and accordingly, we recognized net foreign currency transaction gains/(losses) as a result of changes to foreign currency rates through our Consolidated Statement of Total Comprehensive Income (Loss). Refer to Note 2. Basis of Presentation and Significant Accounting Policies to the Consolidated Financial Statements included in Part I, Item 1 in this Form 10-Q for further details on transaction gains and losses.

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Future changes to currency rates may adversely affect our financial results. Refer to Part II, Item 7A in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, and Part I, Item 3 "Quantitative and Qualitative Disclosures in this Form 10-Q about Market Risk" for further information on the impact of future currency rate changes on Ambac's financial instruments.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Ambac’s Consolidated Financial Statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”), which require the use of material estimates and assumptions. For a discussion of Ambac’s critical accounting policies and estimates, see “Critical Accounting Policies and Estimates” in Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Ambac’s Annual Report on Form 10-K for the year ended December 31, 2017.
FINANCIAL GUARANTEES IN FORCE
Financial guarantee products were sold in three principal markets: U.S. public finance, U.S. structured finance and international finance. The following table provides a breakdown of guaranteed net par outstanding by market at June 30, 2018 and December 31, 2017. Net par exposures within the U.S. public finance market include capital appreciation bonds which are reported at the par amount at the time of issuance of the insurance policy as opposed to the current accreted value of the bonds. Guaranteed net par outstanding includes the exposures of policies insuring variable interest entities (“VIEs”) consolidated in accordance with the Consolidation Topic of the ASC, Consolidation. Guaranteed net par outstanding excludes the exposures of policies that insure bonds which have been refunded or pre-refunded:

($ in millions) | June 30, 2018 |  | December 31, 2017
Public Finance (1) (2) | $ | 28,909 |  |  | $ | 32,088 |
Structured Finance | 11,840 |  |  | 13,816 |
International Finance | 15,720 |  |  | 16,812 |
Total net par outstanding | $ | 56,469 |  |  | $ | 62,716 |

(1) | Includes $5,795 and $5,829 of Military Housing net par outstanding at June 30, 2018 and December 31, 2017, respectively.

(2) | Includes $1,968 and $1,968 of Puerto Rico net par outstanding at June 30, 2018 and December 31, 2017, respectively. Components of Puerto Rico net par outstanding includes capital appreciation bonds which are reported at the par amount at the time of issuance of the related insurance policy as opposed to the current accreted value of the bonds.

Total net par outstanding decreased $6,247 million from December 31, 2017.

• | Reductions in public finance net par outstanding included $2,393 million from calls of insured exposures, $314 million from refundings and pre-refundings of insured exposures and $472 million from scheduled paydown activity.

• | Reductions in structured finance net par primarily were due to RMBS commutations and paydowns of $1,168 million and investor-owned utilities calls and paydowns of $636 million.

• | Decreases in international finance were primarily due to the impact of foreign exchange rates of $393 million primarily related to changes in the British Pound, policy runoff including prepayments of investor-owned utility, sovereign/sub-sovereign and mortgage-backed securities.

Although insured net par outstanding has decreased during 2018, the size of the portfolio is significantly greater than the assets of Ambac. Accordingly, financial stress in the insured portfolio could have a material adverse effect on Ambac's financial condition and results of operations.
Exposure Currency
The table below shows the distribution by currency of Ambac Assurance’s insured exposure as of June 30, 2018:

Currency (Amounts in millions) |  | Net Par Amount Outstanding in Base Currency |  | Net Par Amount Outstanding in U.S. Dollars
U.S. Dollars |  | $ | 41,500 |  |  | $ | 41,500 |
British Pounds |  | £ | 9,576 |  |  | 12,629 |
Euros |  | € | 1,660 |  |  | 1,937 |
Australian Dollars |  | A$ | 545 |  |  | 403 |
Total |  |  |  | $ | 56,469 |

Ambac discloses its exposures by currency to help interested parties understand its insured book of business. These insured exposures do not represent the cash outflows that may result from such insurance policies.
Puerto Rico
For a full discussion of Ambac’s exposure to the Commonwealth of Puerto Rico and its instrumentalities across several different issuing entities, see in Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Guarantees in Force" included in Ambac’s Annual Report on Form 10-K for the year ended December 31, 2017.
Fiscal Plans
On June 29, 2018, the Financial Oversight and Management Board for Puerto Rico ("Oversight Board") certified revised versions of the Fiscal Plans for the Commonwealth of Puerto Rico, the Puerto Rico Highways and Transportation Authority ("PRHTA") and other Commonwealth instrumentalities. Among other revisions, the Fiscal Plan for the Commonwealth of Puerto Rico projects a cumulative 30-year surplus post-measures and structural reforms of $14 billion, which is a 65% reduction from the $36 billion surplus projected in the Commonwealth Fiscal Plan certified on May 30, 2018. The new surplus projection is based on less optimistic economic projections, which result in large part from the Commonwealth Legislature’s failure to enact the repeal of Law 80 and make Puerto Rico an at-will labor jurisdiction.
On August 1, 2018, the Oversight Board sent a letter to Governor Rossello stating that the Oversight Board intends to certify revised new Fiscal Plans for the Commonwealth of Puerto Rico, PRHTA and other Puerto Rico instrumentalities. The changes to the revised new Fiscal Plan for the Commonwealth would incorporate material new information including full fiscal year 2018 actual financial performance data and revised federal disaster spending estimates, as well as correct a demographic forecasting error that contributed
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to a cumulative 30-year budget surplus overestimation of approximately $4 billion in the Fiscal Plan for the Commonwealth certified on June 29, 2018. Fiscal Plans for PRHTA and other Puerto Rico instrumentalities are also being revised to incorporate appropriate adjustments. The Oversight Board outlined a certification timetable for various instrumentality Fiscal Plans with September 21, 2018 being the date by which the Oversight Board expects to deliver a compliance certification for the Fiscal Plans for the Commonwealth of Puerto Rico and PRHTA.
At this time, there is a lack of transparency regarding the data and assumptions that are going to be used to develop the revised new Fiscal Plans for the Commonwealth of Puerto Rico, PRHTA and other Puerto Rico instrumentalities. As a result, it is difficult to assess the possible impacts these changes may have on creditor outcomes or Ambac's financial condition, including liquidity, loss reserves and capital resources. No assurances can be given that Ambac's financial profile will not suffer a materially negative impact as an ultimate result of these changes.
Federal Aid
In the wake of Hurricanes Irma and Maria, the federal government has appropriated significant disaster recovery funds for Puerto Rico via three emergency supplemental spending bills. In addition to providing resources on the ground through FEMA’s Disaster Relief Fund (DRF), the U.S. Congress appropriated an additional $89.4 billion earlier this year to assist communities devastated by Irma, Maria, Harvey as well as wildfires in the western US. A significant portion of these funds will directly benefit Puerto Rico.
One portion of these funds is the U.S. Department of Housing and Urban Development’s Community Development Block Grant - Disaster Recovery (CDBG-DR) program, which has allocated over $18 billion to Puerto Rico for recovery and mitigation. In addition, various federal government agencies continue to allocate money for recovery efforts in Puerto Rico using money appropriated by the Bipartisan Budget Act of 2018. This includes $2.5 billion for 13 U.S. Army Corps of Engineers flood control projects in and around Puerto Rico, which was announced by Puerto Rico’s Resident Commissioner González on July 6, 2018.
The Commonwealth of Puerto Rico continues to benefit from this and other federal government programs for infrastructure improvement initiatives. On June 13, 2018, the Federal Communications Commission (FCC) established the Uniendo, a Puerto Rico Fund to rebuild, improve and expand voice and broadband networks in Puerto Rico. Through the Uniendo, the FCC will make available up to $750 million of funding to carriers in Puerto Rico, including an immediate infusion of $51.2 million for restoration efforts in 2018.
While all of these federal funds are expected to support economic recovery and growth in Puerto Rico, there can be no assurances as to the certainty, timing or magnitude of benefits to creditor outcomes related to disaster aid and subsequent economic growth, if any.
On July 19, 2018, U.S. Treasury Secretary Mnuchin met with Governor Rosselló and other administration officials, after which the Governor announced a final agreement between the federal government and commonwealth government regarding Community Disaster Loan financing. While details regarding final loan terms are not known by Ambac, what is known is the federal
government has agreed to extend a credit line to the Government of Puerto Rico up to a maximum amount of $2.2 billion until March 31, 2020 to be used to meet any future liquidity emergency as determined by the Government of Puerto Rico. However, in order to access the credit line, the fund balance in the Treasury Single Account needs to be less than $1.1 billion. It was reported that the loan agreement is subject to ratification by the Commonwealth Legislature, the Oversight Board, and the Title III court once it becomes necessary to access the funds.
Commonwealth Liquidity
As of June 30, 2018, the balances of bank accounts for various Puerto Rico government entities and instrumentalities totaled $9.35 billion. However, it has been previously reported by the Puerto Rico Fiscal Agency and Financial Authority ("FAFAA") that much of this balance had restricted uses or was tied up in ongoing litigation. Consequently, this purported lack of access to a portion of these funds could exacerbate existing liquidity constraints of the Commonwealth and its instrumentalities for certain essential and non-essential services and further strain timelines and potential severities for creditors, including Ambac.
The Oversight Board had announced on February 9, 2018 it retained Duff & Phelps, LLC to conduct an independent forensics analysis of the Commonwealth of Puerto Rico's government bank accounts. The progress of that analysis and any related findings have not been made public.
As of July 13, 2018, the Treasury Single Account cash position, as reported by the Puerto Rico Treasury Department, was $2.99 billion and above the $1.1 billion threshold to access Community Disaster Loan financing.
June 5 Agreement in Principle
The Commonwealth agent and the COFINA agent, who were appointed to advance the Commonwealth-COFINA dispute toward resolution, announced in a joint court filing on June 5, 2018 that they had reached an agreement in principle on settlement terms. In the filing, they asked Judge Swain to hold the court’s decision on the motions for summary judgment in the litigation in abeyance for 60 days, until August 4, 2018 (which Judge Swain granted on June 11, 2018). The Commonwealth agent and the COFINA agent also disclosed the terms of the proposed settlement, which contemplate COFINA and the Commonwealth agreeing to share the statutory pledged sales tax base amount, or PSTBA. Under the proposed settlement, COFINA would receive approximately 53.65% of the yearly scheduled PSTBA, and the Commonwealth would receive 46.35% of that amount along with any residual of the 5.5% sales and use tax and the additional 4.5% sales and use tax surcharge. COFINA would also receive 100% of the cash held in trust at Bank of New York Mellon, which is currently the subject of an ongoing interpleader action. At this time, it is unclear what the impact of the Agreement in Principle would be on the Puerto Rico-related exposures Ambac insures.
On August 2, 2018, the Commonwealth agent and the COFINA agent filed a joint motion requesting an extension of the abeyance period from August 4, 2018 to September 13, 2018 (which Judge Swain granted on August 3, 2018). The motion noted that substantial progress has been made toward the finalization of a settlement agreement and the satisfaction of the conditions precedent thereto. The Commonwealth agent and the COFINA
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agent have been working to incorporate the terms of the Agreement in Principle into a formal settlement agreement, although the settlement agreement is not yet complete. Discussions are ongoing between the Commonwealth agent and the COFINA agent and other parties in interest in order to satisfy various conditions precedent to such settlement agreement, although the Commonwealth agent and the COFINA agent could not disclose any details of those discussions due to the mediation privilege. The motion acknowledged there are several other issues that may require further negotiation and discussion, which may impact the timing, process, and execution of a settlement agreement. The Commonwealth agent and the COFINA agent reaffirmed their support in principle, committed to working in good faith to try to reach a settlement agreement, but requested an extension of the abeyance period to complete the settlement agreement prior to the abeyance period expiration date.
No assurances can be given that consensual resolutions will be achieved with respect to the Commonwealth’s or COFINA’s obligations or those of any other Puerto Rico instrumentality, or that any consensual resolutions will not be severe and cause Ambac to experience losses materially exceeding current reserves.
Mediation
On June 29, 2018, the COFINA Senior Bondholders Coalition publicly disclosed the details of debt restructuring negotiations that took place between COFINA Senior and Subordinate bondholder groups about proposed distribution of cash and new COFINA bonds that could be made under a hypothetical COFINA plan of adjustment. As per the public statement, no agreement was reached. Since that time, significant progress toward a negotiated resolution of the COFINA Title III proceeding has been made, but no assurance can be given that a Plan of Adjustment acceptable to Ambac Assurance will be agreed to or approved by the court overseeing COFINA’s Title III restructuring.
On July 31, 2018, the Oversight Board published its second Annual Report to the President, Congress, and the Governor and the Legislature of Puerto Rico. The report stated, with respect to Title III, numerous mediation sessions and other negotiations took place with creditors this past fiscal year. The report noted that the Oversight Board leads negotiations for entities in Title III (such as
the Commonwealth and COFINA) and also that negotiations over the Commonwealth-COFINA agreement in principle are ongoing in connection with the Oversight Board’s development of the COFINA Title III Plan of Adjustment.
No assurances can be given that negotiations will be successfully concluded, that COFINA parties will reach a definitive agreement, that any transaction will be approved and completed, or that any transaction or Plan of Adjustment will not have an adverse impact on Ambac's financial conditions or results.
Summary
While management believes its reserves are adequate to cover losses in its Public Finance insured portfolio, there can be no assurance that Ambac may not incur additional losses in the future, particularly given the developing economic, political, and legal circumstances in Puerto Rico. Such additional losses may have a material adverse effect on Ambac’s results of operations and financial condition.
Ambac Post-Title III Litigation Update
Ambac Assurance is party to ten litigations related to its Puerto Rico exposures. Six of these litigations are stayed under Title III of PROMESA, and one has been stayed by order of the United States District Court for the District of Puerto Rico pending resolution of an interpleader action related to COFINA funds (to which interpleader action Ambac is also a party). Two of the three active litigations are proceeding as adversary proceedings under the Title III process before the United States District Court for the District of Puerto Rico; the remaining active litigation is on appeal before the United States Court of Appeals for the First Circuit. Accordingly, Ambac is unable to predict when and how the issues raised in those cases will be resolved. If Ambac Assurance is unsuccessful with any of these challenges, Ambac’s financial condition, including liquidity, loss reserves and capital resources may suffer a material negative impact.
Refer to Note 12. Commitments and Contingencies to the Consolidated Financial Statements for further information about Ambac's litigation relating to Puerto Rico.
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Exposure Concentrations within each Market
The table below shows Ambac’s ten largest U.S. public finance exposures, by repayment source, as a percentage of total financial guarantee net par outstanding at June 30, 2018:

($ in millions) |  | Bond Type |  | Ambac Ratings(1) |  | Net Par Outstanding |  | % of Total Net Par Outstanding
New Jersey Transportation Trust Fund Authority - Transportation System |  | Lease and Tax-backed Revenue |  | BBB+ |  | $ | 1,639 |  |  | 2.9 | %
Puerto Rico Sales Tax Financing Corporation - Senior Sales Tax Revenue (COFINA) |  | Lease and Tax-backed Revenue |  | BIG |  | 805 |  |  | 1.4 | %
Massachusetts Commonwealth - GO |  | General Obligation |  | AA |  | 802 |  |  | 1.4 | %
Mets Queens Baseball Stadium Project, NY, Lease Revenue |  | Stadium |  | BBB |  | 557 |  |  | 1.0 | %
Hickam Community Housing LLC |  | Housing Revenue |  | BBB |  | 471 |  |  | 0.8 | %
Puerto Rico Infrastructure Financing Authority, Special Tax Revenue |  | Lease and Tax-backed Revenue |  | BIG |  | 438 |  |  | 0.8 | %
Puerto Rico Highways & Transportation Authority, Transportation Revenue |  | Lease and Tax-backed Revenue |  | BIG |  | 433 |  |  | 0.8 | %
Bragg Communities, LLC |  | Housing Revenue |  | A- |  | 426 |  |  | 0.8 | %
New Jersey Economic Development Authority - School Facilities Construction |  | Lease and Tax-backed Revenue |  | BBB+ |  | 400 |  |  | 0.7 | %
Chicago, IL - GO |  | General Obligation |  | BBB- |  | 360 |  |  | 0.6 | %
Total |  |  |  |  |  | $ | 6,331 |  |  | 11.2 | %

(1) | Internal credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance. Ambac Assurance credit ratings are subject to revision at any time and do not constitute investment advice. “BIG” denotes credits deemed below investment grade.

Net par related to the top ten U.S. public finance exposures reduced $95 million from December 31, 2017. Changes in these exposure amounts will occur due to scheduled paydowns, calls and refundings executed during the period. During 2018 there was no change in the listing of exposures included within the top ten U.S. public finance exposures.
The table below shows Ambac’s ten largest structured finance transactions, as a percentage of total financial guarantee net par outstanding at June 30, 2018:

($ in millions) |  | Bond Type |  | Ambac Rating(1) |  | Net Par Outstanding |  | % of Total Net Par Outstanding
Ballantyne Re Plc (2) |  | Structured Insurance |  | BIG |  | $ | 900 |  |  | 1.6 | %
Progress Energy Carolinas, Inc. |  | Investor Owned Utility |  | A- |  | 558 |  |  | 1.0 | %
Wachovia Asset Securitization Issuance II, LLC 2007-HE2 |  | Mortgage Backed Securities |  | BBB |  | 504 |  |  | 0.9 | %
Timberlake Financial, LLC |  | Structured Insurance |  | BBB |  | 493 |  |  | 0.9 | %
Wachovia Asset Securitization Issuance II, LLC 2007-HE1 |  | Mortgage Backed Securities |  | BBB |  | 351 |  |  | 0.6 | %
Consolidated Edison Company of New York |  | Investor Owned Utility |  | A |  | 347 |  |  | 0.6 | %
Niagara Mohawk Power Corporation |  | Investor Owned Utility |  | A |  | 257 |  |  | 0.5 | %
Option One Mortgage Loan Trust 2007-FXD1 |  | Mortgage Backed Securities |  | BIG |  | 251 |  |  | 0.4 | %
The National Collegiate Student Loan Trust 2007-4 |  | Student Loan |  | BIG |  | 224 |  |  | 0.4 | %
Impac CMB Trust Series 2005-7 |  | Mortgage Backed Securities |  | BIG |  | 219 |  |  | 0.4 | %
Total |  |  |  |  |  | $ | 4,104 |  |  | 7.3 | %

(1) | Internal credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance, and for Ambac UK related transactions, based on the view of Ambac UK. Ambac Assurance and Ambac UK credit ratings are subject to revision at any time and do not constitute investment advice. “BIG” denotes credits deemed below investment grade.

(2) | Insurance policy issued by Ambac UK.

Net par related to the top ten U.S. structured finance exposures reduced $226 million from December 31, 2017. The primary change in top U.S. structured finance exposures primarily relates to commutations and paydowns of RMBS during the six months ended June 30, 2018 in addition to prepayments on two investor owned utilities. During 2018, due to calls, CenterPoint Energy Inc. and Duke Energy Ohio, Inc. were removed from the top 10 largest U.S. structured finance exposures offset by the addition of The National Collegiate Student Loan Trust 2007-4 and Impac CMB Trust Series 2005-7.
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The table below shows our ten largest international finance transactions as a percentage of total financial guarantee net par outstanding at June 30, 2018. Except where noted, all international finance transactions included in the table below are insured by Ambac UK:

($ in millions) |  | Country-Bond Type |  | Ambac Rating(1) |  | Net Par Outstanding |  | % of Total Net Par Outstanding
Mitchells & Butlers Finance plc-UK Pub Securitisation |  | UK-Asset Securitizations |  | A+ |  | $ | 1,410 |  |  | 2.5 | %
National Grid Electricity Transmission |  | UK-Utility |  | A- |  | 1,117 |  |  | 2.0 | %
Capital Hospitals plc (2) |  | UK-Infrastructure |  | A- |  | 902 |  |  | 1.6 | %
Aspire Defence Finance plc |  | UK-Infrastructure |  | BBB+ |  | 895 |  |  | 1.6 | %
Anglian Water |  | UK-Utility |  | A- |  | 787 |  |  | 1.4 | %
Posillipo Finance II S.r.l |  | Italy-Sub-Sovereign |  | BBB- |  | 781 |  |  | 1.4 | %
Ostregion Investmentgesellschaft NR 1 SA (2) |  | Austria-Infrastructure |  | BIG |  | 736 |  |  | 1.3 | %
National Grid Gas |  | UK-Utility |  | A- |  | 727 |  |  | 1.3 | %
Telereal Securitisation plc |  | UK-Asset Securitizations |  | AA |  | 723 |  |  | 1.3 | %
RMPA Services plc |  | UK-Infrastructure |  | BBB+ |  | 598 |  |  | 1.1 | %
Total |  |  |  |  |  | $ | 8,676 |  |  | 15.4 | %

(1) | Internal credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance, and for Ambac UK related transactions, based on the view of Ambac UK. Ambac Assurance and Ambac UK credit ratings are subject to revision at any time and do not constitute investment advice. “BIG” denotes credits deemed below investment grade.

(2) | Ambac Assurance has issued an insurance policy for this transaction that will only pay in the event that Ambac UK does not pay under its insurance policy.

Net par related to the top ten international finance exposures reduced $283 million from December 31, 2017. International exposures are impacted by changes in foreign exchange rates, certain indexation rates and scheduled and unscheduled paydowns. As of June 30, 2018, there was no change in the listing of exposures included within the top ten international exposures.
The concentration of net par amongst the top categories noted above (as a percentage of net par outstanding) has increased since December 31, 2017. Given that Ambac has not written any new insurance policies since 2008, the risk exists that the insured portfolio becomes increasingly concentrated to large and/or below investment grade exposures.
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Ratings Distribution
The following tables provide a rating distribution of net par outstanding based upon internal Ambac credit ratings(1) and a distribution by bond type of Ambac's below investment grade net par exposures at June 30, 2018 and December 31, 2017. Below investment grade is defined as those exposures with an Ambac internal credit rating below BBB-:
Note: AAA is less than 1% in both periods.

(1) | Internal credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance, and for Ambac UK related transactions, based on the view of Ambac UK. Ambac Assurance and Ambac UK credit ratings are subject to revision at any time and do not constitute investment advice.

|  | Net Par Outstanding
Summary of Below Investment Grade Exposure ($ in millions) |  | June 30, 2018 |  | December 31, 2017
Public Finance: |  |  |  |
Lease and tax-backed (1) |  | $ | 2,101 |  |  | $ | 2,144 |
General obligation (1) |  | 464 |  |  | 491 |
Transportation |  | 378 |  |  | 397 |
Housing (2) |  | 316 |  |  | 317 |
Health care |  | 2 |  |  | 24 |
Other |  | 184 |  |  | 189 |
Total Public Finance |  | 3,445 |  |  | 3,562 |
Structured Finance: |  |  |  |
Residential mortgage-backed and home equity—first lien |  | 3,285 |  |  | 3,947 |
Residential mortgage-backed and home equity—second lien |  | 1,466 |  |  | 2,803 |
Structured Insurance |  | 900 |  |  | 900 |
Student loans |  | 883 |  |  | 922 |
Mortgage-backed and home equity—other |  | 149 |  |  | 166 |
Other |  | — |  |  | 9 |
Total Structured Finance |  | 6,683 |  |  | 8,747 |
International Finance: |  |  |  |
Other |  | 1,107 |  |  | 1,200 |
Total International Finance |  | 1,107 |  |  | 1,200 |
Total |  | $ | 11,235 |  |  | $ | 13,509 |

(1) | Lease and tax-backed revenue includes $1,802 of Puerto Rico net par at June 30, 2018 and December 31, 2017. General obligation includes $166 of Puerto Rico net par at June 30, 2018 and December 31, 2017. Components of Puerto Rico net par outstanding includes capital appreciation bonds which are reported at the par amount at the time of issuance of the related insurance policy as opposed to the current accreted value of the bonds.

(2) | Relates to military housing net par.

The decrease in below investment grade exposures is primarily due to (i) the commutation or upgrade of certain residential mortgage-backed transactions and (ii) paydowns or calls by issuers, mostly related to residential mortgage-backed securities. Despite the decrease in below investment grade exposures, such exposures could increase as a relative proportion of the guarantee portfolio given that stressed borrowers generally have less ability to prepay or refinance their debt. Accordingly, due to these and other factors, it is not unreasonable to expect the proportion of below investment grade exposure in the guarantee portfolio to increase in the future.
RESULTS OF OPERATIONS
Net income in the second quarter of 2018 was $4 million compared to net income of $7 million in the second quarter of 2017. The second quarter 2018 net income as compared to the second quarter 2017 was primarily driven by (i) higher interest expense, (ii) lower net premiums earned, (iii) lower investment income, and (iv) lower gains from interest rate derivatives, partially offset by (i) higher net realized investment gains, (ii) lower losses and loss expenses incurred, (iii) lower insurance intangible amortization, and (iv) lower operating expenses.
| Ambac Financial Group, Inc. 62 2018 Second Quarter FORM 10-Q |

Net income for the six months ended June 30, 2018 was $310 million compared to a net loss of $118 million for the six months ended June 30, 2017. The increase was primarily driven by (i) a losses and loss expenses benefit as compared to losses and loss expenses in the six months ended June 30, 2017, (ii) higher net investment income, (iii) higher net realized investment gains, and (iv) lower insurance intangible amortization, partially offset by (i) higher interest expense and (ii) lower net premiums earned.
A summary of our financial results is shown below:

|  | Three Months Ended June 30, |  | Six Months Ended June 30,
($ in millions) |  | 2018 |  | 2017 |  | 2018 |  | 2017
Revenues: |  |  |  |  |  |  |  |
Net premiums earned |  | $ | 26 |  |  | $ | 43 |  |  | $ | 57 |  |  | $ | 91 |
Net investment income |  | 67 |  |  | 85 |  |  | 177 |  |  | 167 |
Net other-than-temporary impairment losses |  | (1 | ) |  | (2 | ) |  | (1 | ) |  | (6 | )
Net realized investment gains (losses) |  | 47 |  |  | 4 |  |  | 52 |  |  | (1 | )
Net gains (losses) on interest rate derivatives |  | 9 |  |  | 34 |  |  | 35 |  |  | 33 |
Net realized gains (losses) on extinguishment of debt |  | — |  |  | 2 |  |  | 3 |  |  | 5 |
Income (loss) on variable interest entities |  | 1 |  |  | (1 | ) |  | 1 |  |  | 2 |
Expenses: |  |  |  |  |  |  |  |
Losses and loss expenses (benefit) |  | 33 |  |  | 66 |  |  | (215 | ) |  | 201 |
Insurance intangible amortization |  | 23 |  |  | 33 |  |  | 52 |  |  | 71 |
Operating expenses |  | 26 |  |  | 31 |  |  | 62 |  |  | 59 |
Interest expense |  | 62 |  |  | 28 |  |  | 111 |  |  | 60 |
Provision for income taxes |  | 2 |  |  | 7 |  |  | 5 |  |  | 26 |
Net income (loss) (attributable to common stockholders) |  | $ | 4 |  |  | $ | 7 |  |  | $ | 310 |  |  | $ | (118 | )

The following paragraphs describe the consolidated results of operations of Ambac and its subsidiaries for the three and six months ended June 30, 2018 and 2017, respectively.
Rehabilitation Exit Transactions. On February 12, 2018, Ambac Assurance executed the following Rehabilitation Exit Transactions (as more fully discussed in Note 1. Background and Business Description to the Consolidated Financial Statements, included in Part I, Item 1 in this Form 10-Q and in Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017):

• | the Second Amended Plan of Rehabilitation became effective and a series of transactions were consummated which provided holders of beneficial interests in Deferred Amounts (other than Ambac, but including Ambac Assurance) a total effective consideration package, in full satisfaction and

discharge of each $1.00 of Deferred Amounts (including accretion), of (i) $0.40 in cash, (ii) $0.41 in principal amount of new Secured Notes and (iii) $0.125 currently outstanding surplus notes (from certain holders of surplus notes). Such consideration package provided a discount of $0.065 (set first against accretion of Deferred Amounts). Ambac received $0.91 in principal amount of Secured Notes for each $1.00 of Deferred Amounts (including accretion) that it held, and provided a $0.09 discount in full satisfaction and discharge of its Deferred Amount claims. This transaction is being accounted for as an extinguishment of Deferred Amounts and the discount of approximately $288.2 million from the settlement was reflected as a benefit to loss and loss expenses in the Consolidated Statements of Comprehensive Income (Loss) in the quarter ended March 31, 2018. In connection with these transactions, Ambac Assurance received $196.3 million of principal and accrued and unpaid interest on general account surplus notes. Ambac Assurance recognized a gain on the extinguishment of these surplus notes of $3.1 million.

• | Exchanges were consummated, pursuant to which holders of surplus notes received the same effective package as holders of beneficial interests in Deferred Amounts, including the discount of $0.065 of each $1.00 of principal amount and accrued and unpaid interest on the surplus notes tendered. These exchanges resulted in Ambac Assurance's cancellation of $809.5 million of principal and accrued and unpaid interest of general account surplus notes. These exchanges were accounted for as a debt modification since the creditors before and after the discount remain the same and the change in the terms were not considered substantial. A substantial change is considered to be a change in cash flows of equal to or greater than 10% as a result of the modification of terms. As the change in cash flows is less than 10%, debt modification accounting is appropriate. Under debt modification accounting, no gain or loss is recorded, and a new effective interest rate is established based on the cash flows of the Ambac Note, which secures the Secured Notes issued. Additionally, any consideration paid that is directly related to the issuance of the Ambac Note is capitalized and amortized as part of the effective yield calculation.

• | Ambac Assurance issued $240.0 million of new debt secured by certain of Ambac Assurance’s rights to representation and warranty subrogation recoveries above $1.6 billion ("Tier 2 Notes"). The proceeds received from this issuance were used to fund the cash portion of the consideration paid pursuant to the Second Amended Plan of Rehabilitation and exchanges noted above. Refer to Note 10. Long-term Debt to the Consolidated Financial Statements, included in Part I, Item 1 in this Form 10-Q for further information regarding Ambac's debt obligations.

• | Ambac incurred operating expenses for the six months ended June 30, 2018, including for AAC and OCI financial advisors, of approximately $15.5 million.

In order to execute these transactions, Ambac established a special purpose entity, Ambac LSNI, LLC, for the sole purpose of the issuance of $2,154 million of Secured Notes, of which Ambac Assurance received $644 million and Ambac received $125 million. Ambac does not consolidate Ambac LSNI, LLC;
| Ambac Financial Group, Inc. 63 2018 Second Quarter FORM 10-Q |

therefore, the full amount of the debt is included in long term debt and Secured Notes held by Ambac and Ambac Assurance are included in invested assets on the consolidated balance sheet.
Net Premiums Earned. Net premiums earned primarily represent the amortization into income of insurance premiums. We present accelerated premiums, which result from calls and other accelerations of insured obligations separate from normal net premiums earned. When an insured bond has been retired, any remaining unearned premium revenue ("UPR") is recognized at that time to the extent the financial guarantee contract is legally extinguished, causing accelerated premium revenue. 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.
Net premiums earned decreased $17 million and $34 million for the three and six months ended June 30, 2018, respectively, compared to the same periods in the prior year. Normal net premiums earned and accelerated premiums are reconciled to total net premiums earned in the table below. The following table provides a breakdown of net premiums earned by market:

|  | Three Months Ended June 30, |  | Six Months Ended June 30,
($ in millions) |  | 2018 |  | 2017 |  | 2018 |  | 2017
Normal Premium Earned: |  |  |  |  |  |  |  |
Public finance |  | $ | 10 |  |  | $ | 18 |  |  | $ | 20 |  |  | $ | 36 |
Structured finance |  | 4 |  |  | 5 |  |  | 9 |  |  | 11 |
International finance |  | 6 |  |  | 7 |  |  | 12 |  |  | 14 |
Total normal premiums earned |  | 20 |  |  | 30 |  |  | 41 |  |  | 61 |
Accelerated Earnings: |  |  |  |  |  |  |  |
Public finance |  | 5 |  |  | 13 |  |  | 14 |  |  | 29 |
Structured Finance |  | 1 |  |  | — |  |  | 1 |  |  | — |
International finance |  | — |  |  | — |  |  | — |  |  | — |
Accelerated earnings |  | 6 |  |  | 13 |  |  | 16 |  |  | 30 |
Total net premiums earned |  | $ | 26 |  |  | $ | 43 |  |  | $ | 57 |  |  | $ | 91 |

The decrease in normal premiums earned in the three and six months ended June 30, 2018 is primarily attributable to the continued runoff of the portfolio. Terminations and accelerations, including those which occurred in prior periods, result in lower normal premiums earned in current and future periods. Normal premiums are also impacted by the earnings of pre-refunded insured securities within Public Finance. Since the maturity date of pre-refunded securities is shortened (to a specified call date from its previous legal maturity), normal premiums earned will increase over the remaining period of the related policy as the existing unearned premiums will be earned in the period between the pre-refunding date and the specified call date. Structured Finance normal premiums earned were impacted by continued runoff of the portfolio, particularly within the RMBS sector. International Finance normal premiums earned were reduced in the three and six months ended June 30, 2018 as compared to the three and six months ended June 30, 2017 as a result of continued runoff of the
portfolio, in particular a certain asset backed policy terminated in 2017 resulting in a reduction of premiums earned.
The decrease in public finance accelerated earnings in the three and six months ended June 30, 2018 is primarily attributed to the decreased call volume of municipal bonds.
Net Investment Income. Net investment income decreased $19 million and increased $10 million for the three and six months ended June 30, 2018 compared to the same periods in the prior year. The decrease for the three months ended June 30, 2018 is due primarily to the reduced size of the investment portfolio, including lower income on Ambac-insured RMBS, partially offset by higher income on other Ambac-insured securities. The balance of Ambac-insured RMBS in the portfolio has been reduced in connection with the Rehabilitation Exit Transactions and subsequent sales. Income from other Ambac-insured securities increased due to higher holdings of Puerto Rico bonds.
The increase in net investment income for the six month period is due to higher income on Ambac-insured bonds other than RMBS and Secured Notes received, partially offset by lower income on Ambac-insured RMBS and other fixed income securities resulting from the Rehabilitation Exit Transactions. Income from trading securities was $2 million for the six months ended June 30, 2018 compared to $10 million for the six months ended June 30, 2017.
Net Other-Than-Temporary Impairment Losses. Net other-than-temporary impairment losses recorded in earnings include only credit related impairment amounts to the extent management does not intend to sell and it is not more likely than not that the Company will be required to sell before recovery of the amortized cost basis. Non-credit related impairment amounts are recorded in other comprehensive income. Alternatively, non-credit related impairment is reported through earnings as part of net other-than-temporary impairment losses if management intends to sell securities or it is more likely than not that the Company will be required to sell before recovery of amortized cost less any current period credit impairment.
Net other-than-temporary impairments for the three and six month periods ended June 30, 2018 and 2017 included credit related impairments on certain securities and also included some losses due to management's intent to sell securities.
Net Realized Investment Gains (Losses). The following table provides a breakdown of net realized gains (losses) for the periods presented:

|  | Three Months Ended June 30, |  | Six Months Ended June 30,
($ in millions) |  | 2018 |  | 2017 |  | 2018 |  | 2017
Net (losses) on securities sold or called |  | $ | 40 |  |  | $ | 7 |  |  | $ | 50 |  |  | $ | — |
Net foreign exchange gains (losses) |  | 7 |  |  | (2 | ) |  | 2 |  |  | — |
Total net realized gains (losses) |  | $ | 47 |  |  | $ | 4 |  |  | $ | 52 |  |  | $ | (1 | )

Net realized gains on securities sold for the three and six months ended June 30, 2018 were primarily from sales of Ambac-insured RMBS.
| Ambac Financial Group, Inc. 64 2018 Second Quarter FORM 10-Q |

Change in Fair Value of Credit Derivatives. The loss from change in fair value of credit derivatives for both the three and six months ended June 30, 2018 was less than a million dollars, as compared to the gains of $7 million and $8 million for the three and six months ended June 30, 2017. The loss for the three and six months ended June 30, 2018 was primarily due to a decline on reference obligation pricing on certain transaction within the portfolio. The gains for the three and six months ended June 30, 2017 were primarily due to the termination of a credit derivative.
Realized gains and other settlements on credit derivative contracts represent premiums received and accrued on such contracts. Declining realized gains reflect the continued runoff of the portfolio.
Net Gain (Loss) on Interest Rate Derivatives. The interest rate derivatives portfolio is positioned to benefit from rising rates as a partial economic hedge against interest rate exposure in the financial guarantee portfolio. Results in Net gain (loss) on interest rate derivatives generally reflect mark-to-market gains (losses) in the portfolio caused by increases (declines) in forward interest rates during the periods, the carrying cost of the portfolio and the impact of the Ambac CVA and counterparty credit adjustments as discussed below.
Net gain (loss) on interest rate derivatives for the three and six months ended June 30, 2018 were $9 million and $35 million, respectively, compared to $34 million and $33 million for the three and six months ended June 30, 2017, respectively. The net gains for the three and six months ended June 30, 2018 reflect increases in interest rates and carrying costs that were higher than the comparable periods in 2017. The net gains for the three and six months ended June 30, 2017 were primarily driven by the commutation of interest rate swaps with a structured finance vehicle counterparty, partially offset by the impact of declining forward interest rates and carrying costs. Excluding gains on the terminated swaps, the net losses on interest rate derivatives for the three and six months ended June 30, 2017 were $9 million and $10 million.
Net Realized Gains (Losses) on Extinguishment of Debt. Net realized gains on extinguishment of debt was less than a million dollars and $3 million for the three and six months ended June 30, 2018, respectively, compared to gains of $2 million and $5 million for the three and six months ended June 30, 2017, respectively. The gains for the three and six months ended June 30, 2018 related to surplus notes received by Ambac Assurance in settlement of Deferred Amounts held in its investment portfolio under the Rehabilitation Exit Transactions. The gains for the three and six months ended June 30, 2017 included gains from the settlements of repurchased surplus notes below their carrying values and gains from the settlements of certain residual obligations related to previously called surplus notes.
Income (loss) on Variable Interest Entities. Included within Income (loss) on variable interest entities are income statement amounts relating to VIEs consolidated under the Consolidation Topic of the ASC as a result of Ambac's variable interest arising from financial guarantees written by Ambac's subsidiaries, including gains or losses attributable to consolidating or deconsolidating VIEs during the periods reported. Generally, the Company’s consolidated VIEs are entities for which Ambac has provided financial guarantees on all of or a portion of its assets or
liabilities. In consolidation, assets and liabilities of the VIEs are reported at fair value and the related insurance assets and liabilities are eliminated. However, the amount of VIE net assets (liabilities) that remain in consolidation generally result from the net positive (negative) present value of projected cash flows from (to) the VIEs which are attributable to Ambac’s insurance subsidiaries in the form of financial guarantee insurance premiums, fees and losses. In the case of VIEs with net negative projected cash flows, the net liability is generally to be funded by Ambac’s insurance subsidiaries through insurance claim payments. Differences between the net carrying value of the insurance accounts under the Financial Services—Insurance Topic of the ASC and the carrying value of the consolidated VIE’s net assets or liabilities are recorded through income at the time of consolidation or deconsolidation.
Income (loss) on variable interest entities was $1 million and $1 million for the three and six months ended June 30, 2018, compared to income (loss) of $(1) million and $2 million for the three and six months ended June 30, 2017. Income on variable interest entities for the three and six months ended June 30, 2018 included gains on discount accretion on VIEs net assets. Loss on variable interest entities for the three months ended June 30, 2017 included lower net asset values on certain VIEs reflecting higher estimated fair values on Ambac-insured long-term debt. Income on variable interest entities for the six months ended June 30, 2017 included higher net asset values on most VIEs reflecting lower market interest rates.
Losses and Loss Expenses. Losses and loss expenses are based upon estimates of the aggregate losses inherent in the non-derivative financial guarantee portfolio for insurance policies issued to beneficiaries, including unconsolidated VIEs. Losses and loss expenses included interest on Deferred Amounts pursuant to the Segregated Account Rehabilitation Plan that were discharged on February 12, 2018.
Ambac records as a component of its loss reserve estimate subrogation recoveries related to securitized loans in RMBS transactions with respect to which Ambac Assurance is pursuing claims for breaches of representations and warranties. Ambac does not include potential recoveries attributed solely to fraudulent inducement claims in our litigations in our estimate of subrogation recoveries. Generally, the sponsor of an RMBS transaction provided representations and warranties with respect to the securitized loans, including representations with respect to the loan characteristics, the absence of borrower fraud in the underlying loan pools or other misconduct in the origination process and attesting to the compliance of loans with the prevailing underwriting policies. Ambac has recorded representation and warranty subrogation recoveries, net of reinsurance, of approximately $1.789 billion and $1.807 billion at June 30, 2018 and December 31, 2017, respectively. Refer to Note 2. Basis of Presentation and Significant Accounting Policies to the Consolidated Financial Statements included in Part II, Item 8 in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 for more information regarding the estimation process for R&W subrogation recoveries.
The following provides details, by bond type, for losses and loss expenses (benefit) incurred for the periods presented:
| Ambac Financial Group, Inc. 65 2018 Second Quarter FORM 10-Q |

|  | Three Months Ended June 30, |  | Six Months Ended June 30,
($ in millions) |  | 2018 |  | 2017 |  | 2018 |  | 2017
RMBS (1) |  | $ | (26 | ) |  | $ | (16 | ) |  | $ | 20 |  |  | $ | (25 | )
Domestic Public Finance |  | 44 |  |  | 52 |  |  | 33 |  |  | 222 |
Student Loans |  | (4 | ) |  | 20 |  |  | (1 | ) |  | 23 |
Ambac UK |  | 24 |  |  | (35 | ) |  | 9 |  |  | (108 | )
All other credits |  | (5 | ) |  | — |  |  | (8 | ) |  | 2 |
Interest on Deferred Amounts |  | — |  |  | 44 |  |  | 21 |  |  | 88 |
Discount on Rehabilitation Exit Transactions |  | — |  |  | — |  |  | (288 | ) |  | — |
Totals (2) |  | $ | 33 |  |  | $ | 66 |  |  | $ | (215 | ) |  | $ | 201 |

(1) | The losses and loss expense (benefit) associated with changes in estimated representation and warranties was $17 and $18 for the three and six months ended June 30, 2018, respectively, and $8 and $22 for the three and six months ended June 30, 2017, respectively.

(2) | Includes loss expenses incurred of $40 and $47 for the three and six months ended June 30, 2018, respectively and $16 and $34 for the three and six months ended June 30, 2017, respectively.

Losses and loss expenses (benefit) for the three and six months ended June 30, 2018 were driven by the following:

• | Higher projected losses in domestic public finance largely driven by Military Housing loss expenses incurred and additions to Puerto Rico loss reserves;

• | A portion of Ambac UK's loss reserves are denominated in currencies other than their functional currency of British Pounds resulting in incurred losses (gains) when the British Pound depreciates (appreciates). Ambac recognized $17 and $6 million in foreign exchange losses for the three and six months ended June 30, 2018;

• | For the three months ended June 30, 2018, their was positive RMBS development as a result of clean up calls on transactions and favorable credit developments. The three and six months ended June 30, 2018 were adversely impacted by the impact of higher interest rates on excess spread;

• | Discount achieved pursuant to the Rehabilitation Exit Transactions for the six months ended June 30, 2018, partially offset by interest on Deferred Amounts through the Rehabilitation Exit Transactions date.

Losses and loss expenses (benefit) for the three and six months ended June 30, 2017 were driven by the following:

• | Higher projected losses in domestic public finance largely driven by negative development on Puerto Rico policies for the three and six months ended June 30, 2017. In addition, the three months ended June 30, 2017 saw negative development in the Military Housing sector;

• | Interest on deferred amounts; partially offset by

• | Lower projected losses in the Ambac UK portfolio for the three and six months ended June 30, 2017 from activities executed by the Ballantyne trust that indirectly reduced future expected claims on the Ambac insured notes. Lower projected losses for the six months ended June 30, 2017 in the Ambac UK portfolio is primarily due to the confidential settlement of litigation brought by Ambac UK in the name of

Ballantyne against JP Morgan Investment Management. Ambac recognized $12 million and $18 million in foreign exchange gains for the three and six months ended June 30, 2017, respectively.
The following table provides details of net claims recorded, net of reinsurance for the affected periods:

|  | Three Months Ended June 30, |  | Six Months Ended June 30,
($ in millions) |  | 2018 |  | 2017 |  | 2018 |  | 2017
Claims recorded (1) (2) |  | $ | 61 |  |  | $ | 49 |  |  | $ | 118 |  |  | $ | 110 |
Subrogation received (3) |  | (36 | ) |  | (53 | ) |  | (75 | ) |  | (118 | )
Net Claims Recorded |  | $ | 26 |  |  | $ | (4 | ) |  | $ | 43 |  |  | $ | (8 | )

(1) | Claims recorded include (i) claims paid, including commutation payments and (ii) changes in claims not yet paid for policies allocated to the Segregated Account, including Deferred Amounts and changes in unpresented claims. Item (ii) includes permitted policy claims for policies allocated to the Segregated Account that were presented and approved by the Rehabilitator of the Segregated Account, but not paid through to the balance sheet date in accordance with the amended Segregated Account Rehabilitation Plan and associated rules and guidelines. Claims recorded exclude interest accrued on Deferred Amounts. On February 12, 2018, the rehabilitation of the Segregated Account was concluded and all Deferred Amounts, including accrued interest, were settled. Subsequent to the Rehabilitation Exit Transactions, claims are paid in full.

(2) | Claims recorded includes claims paid on Puerto Rico policies of less than a $1 and $28 for the three and six months ended June 30, 2018, respectively, and $0 and $14 for three and six months ended June 30, 2017, respectively.

(3) | Subrogation received declined due to the continuous runoff of the RMBS insured portfolio and the impact of higher interest rates on excess spread.

Operating Expenses. Operating expenses consist of gross operating expenses plus reinsurance commissions. The following table provides details of operating expenses for the periods presented:

|  | Three Months Ended June 30, |  | Six Months Ended June 30,
($ in millions) |  | 2018 |  | 2017 |  | 2018 |  | 2017
Compensation |  | $ | 14 |  |  | $ | 12 |  |  | $ | 30 |  |  | $ | 25 |
Non-compensation |  | 12 |  |  | 19 |  |  | 32 |  |  | 34 |
Gross operating expenses |  | 26 |  |  | 31 |  |  | 62 |  |  | 59 |
Reinsurance commissions, net |  | — |  |  | — |  |  | — |  |  | — |
Total operating expenses |  | $ | 26 |  |  | $ | 31 |  |  | $ | 62 |  |  | $ | 59 |

Gross operating expense for the three months ended June 30, 2018 were $26 million, a decrease of $5 million from the three months ended June 30, 2017. The decrease was due to the following:

• | Higher compensation costs primarily due to performance based awards granted of $2.4 million related to the Rehabilitation Exit Transactions and a $1.5 million increase of long term incentive compensation costs. These costs were driven by an improvement in performance metrics as well as new awards issued. These increases were partially offset by

| Ambac Financial Group, Inc. 66 2018 Second Quarter FORM 10-Q |

lower salaries as a result of reduced headcount since the second quarter of 2017.

• | Lower non-compensation costs primarily due to $9.6 million of lower legal, consulting and advisory fees in connection with the exit from rehabilitation of the Segregated Account, of which $0.9 million relates to advisory services provided for the benefit of OCI, partially offset by $2.5 million of costs associated with the August 2018 AMPS Exchange. Refer to Note 1. Background and Business Description for a discussion of the August 2018 AMPS Exchange.

Gross operating expenses for the six months ended June 30, 2018 were $62 million, an increase of $3 million from the six months ended June 30, 2017. The increase was due to the following:

• | Higher compensation costs primarily due to (i) $2.5 million increase of long term incentive compensation costs driven by an improvement in performance factors in addition to new awards issued; (ii) $2.4 million of awards granted related to the Rehabilitation Exit Transactions; (iii) $1.5 million increase in equity granted in lieu of a cash bonus due to a higher number of employees receiving equity as portion of their annual bonus, (iv) $0.9 million related to the settlement of a previously granted performance restricted stock unit award issued to the former CEO that vested upon the Segregated Account's exit from rehabilitation. These costs were partially offset by lower salaries of $2.1 million as a result of reduced headcount since the second quarter of 2017.

• | Lower non-compensation costs primarily due to (i) $3.7 million of lower legal, consulting and advisory fees in connection with the exit from rehabilitation of the Segregated Account and (ii) a reduction in litigation contingencies of $1.5 million. These lower fees were partially offset by $2.5 million of costs associated with the August 2018 AMPS Exchange and higher incremental OCI Advisors consulting and legal fees of $1.2 million.

With the conclusion of the Segregated Account rehabilitation, the duties of the Wisconsin Insurance Commissioner as rehabilitator of the Segregated Account have been discharged. Legal and consulting services provided for the benefit of OCI amounted to $1.3 million and $5.8 million during the three and six months ended June 30, 2018, respectively, compared to $2.3 million and $4.6 million for the three and six months ended June 30, 2017. Subsequent to the Segregated Account's exit from rehabilitation, advisory services for the benefit of OCI will continue, but at a reduced level.
Interest Expense. Interest expense includes accrued interest on Secured Borrowing notes, the Ambac Note, Tier 2 Notes, and surplus notes issued by Ambac Assurance. Additionally, interest expense includes discount accretion on all debt (excluding the Secured Borrowing) as their carrying value is at a discount to par.
The following table provides details by type of obligation for the periods presented:

|  | Three Months Ended June 30, |  | Six Months Ended June 30,
($ in millions) |  | 2018 |  | 2017 |  | 2018 |  | 2017
Surplus notes |  | $ | 15 |  |  | $ | 27 |  |  | $ | 36 |  |  | $ | 58 |
Ambac note |  | 40 |  |  | — |  |  | 63 |  |  | — |
Tier 2 notes |  | 6 |  |  | — |  |  | 10 |  |  | — |
Secured borrowing |  | 1 |  |  | 1 |  |  | 2 |  |  | 2 |
Total interest expense |  | $ | 62 |  |  | $ | 28 |  |  | $ | 111 |  |  | $ | 60 |

The increase in interest expense for the three and six months ended June 30, 2018 compared to the three and six months ended June 30, 2017 primarily results from the issuance of the Ambac Note and Tier 2 Notes in connection with the Rehabilitation Exit Transactions, partially offset by reduced debt balances resulting from surplus notes cancelled and the amortization and redemption of the Secured Borrowing notes outstanding. On June 22, 2018, the Secured Borrowing was fully redeemed. Refer to Note 10. Long-term Debt to the Unaudited Consolidated Financial Statements included in Part I, Item 1 in this Form 10-Q for further information on the Ambac Note and Tier 2 Notes.
Surplus note principal and interest payments require the approval of OCI. Except for a one-time payment of approximately six months of interest on the surplus notes (other than junior surplus notes) outstanding immediately after the Rehabilitation Exit Transactions, annually from 2011 through 2018, OCI issued its disapproval of the requests of Ambac Assurance to pay the full interest on outstanding surplus notes issued by Ambac on the annual scheduled interest payment date of June 7th. Ambac Assurance has not requested to pay interest on any junior surplus notes since their issuance. The interest on the outstanding surplus notes and junior surplus notes were accrued for and Ambac is accruing interest on the interest amounts following each scheduled interest payment date. Total accrued and unpaid interest for surplus notes and junior surplus notes outstanding to third parties were $135 million and $110 million, respectively, at June 30, 2018.
Provision for Income Taxes. The provision for income taxes for the three and six months ended June 30, 2018, was $2 million and $5 million, a decrease of $5 million and $22 million compared to the provision for income taxes reported for three and six months ended June 30, 2017. The change for the three months ended June 30, 2018 compared to the prior year quarter was attributable to reduced foreign income tax on lower income in Ambac UK. The change for the six months ended June 30, 2018 when compared to the prior year was driven primarily by foreign taxes related to the Ballantyne litigation settlement which occurred in the first quarter of 2017.
| Ambac Financial Group, Inc. 67 2018 Second Quarter FORM 10-Q |

LIQUIDITY AND CAPITAL RESOURCES
Ambac Financial Group, Inc. Liquidity. Ambac’s liquidity is dependent on its cash and liquid investments of $270 million, (including $120 million of Secured Notes issued by Ambac LSNI) as of June 30, 2018 and expense sharing and other arrangements with Ambac Assurance. Ambac also has investments of $87 million in surplus notes issued by Ambac Assurance and $37 million in Corolla Trust (as described more fully in Note 1. Background and Business Description to the Consolidated Financial Statements included in Part II, Item 8 in the Company's Annual Report on Form 10-K for the year ended December 31, 2017). Securities issued or insured by Ambac Assurance are generally less liquid that investment grade and other traded investments.
Pursuant to the amended and restated tax sharing agreement among Ambac, Ambac Assurance and certain affiliates (the "Amended TSA"), Ambac Assurance is required to make payments ("tolling payments") to Ambac with respect to the utilization of net operating loss carry-forwards (“NOLs”). Ambac has accrued $30 million of tolling payments based on NOLs used by Ambac Assurance in 2017. In May 2018, Ambac executed a waiver under the intercompany tax sharing agreement pursuant to which Ambac Assurance was relieved of the requirement to make this payment by June 1, 2018. Ambac has also agreed to continue to defer the tolling payment for the use of net operating losses by Ambac Assurance until such time as OCI consents to the payment.
For the six months ended June 30, 2018, Ambac Assurance utilized post determination date NOLs of $229 million for which it has accrued a tolling payment liability of $14 million which, assuming Ambac Assurance's cumulative full year 2018 taxable income does not fall below $168 million, is expected to be paid to Ambac in 2019. Under an inter-company cost allocation agreement, Ambac is also reimbursed for certain operating costs and expenses, but subject to a $4 million per year cap and only if approved by OCI.
It is highly unlikely that Ambac Assurance will be able to make dividend payments to Ambac for the foreseeable future and therefore cash and investments, payments under the intercompany cost allocation agreement, if any, and future tolling payments, if any, will be Ambac’s principal source of liquidity in the near term. Refer to Part I, Item 1, “Insurance Regulatory Matters — Dividend Restrictions, Including Contractual Restrictions” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, and Note 8. Insurance Regulatory Restrictions to the Consolidated Financial Statements included in Part II, Item 8, in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, for more information on dividend payment restrictions.
The principal use of liquidity is the payment of operating expenses, including costs to explore opportunities to grow and diversify Ambac, and the making of investments including securities issued or insured by Ambac Assurance. Contingencies could cause material liquidity strains.
Ambac Assurance Liquidity. Ambac Assurance’s liquidity is dependent on the balance of liquid investments and, over time, the net impact of sources and uses of funds. The principal sources of Ambac Assurance’s liquidity are gross installment premiums on insurance policies, principal and interest payments from investments, sales of investments, proceeds from repayment of affiliate loans, recoveries on claim payments, including from litigation, and reinsurance recoveries. Termination of installment
premium policies on an accelerated basis may adversely impact Ambac Assurance’s liquidity.
The principal uses of Ambac Assurance’s liquidity are the payment of operating expenses, claims, commutation and related expense payments on insurance policies, ceded reinsurance premiums, principal and interest payments on the Ambac Note and Secured Borrowing (which was fully repaid in June 2018), surplus note principal and interest payments, Tier 2 Note payments, additional loans to affiliates and tolling payments due to Ambac under the Amended TSA. Interest and principal payments on surplus notes are subject to the approval of OCI, which has full discretion over payments regardless of the liquidity position of Ambac Assurance. Any such payment on surplus notes would require either payment or collateralization of a portion of the Tier 2 Notes under the terms of the Tier 2 Note indenture. See Note 10. Long-term Debt to the Consolidated Financial Statements, included in Part I, Item 1 in this Form 10-Q for further discussion of the payment terms and conditions on the Tier 2 Notes.
Ambac Assurance manages its liquidity risk by maintaining comprehensive analyses of projected cash flows and maintaining specified levels of cash and short-term investments at all times.
Ambac Assurance is limited in its ability to pay dividends pursuant to the terms of its Auction Market Preferred Shares (“AMPS”), which state that dividends may not be paid on the common stock of Ambac Assurance unless all accrued and unpaid dividends on the AMPS for the then current dividend period have been paid, provided that dividends on the common stock may be made at all times for the purpose of, and only in such amounts as are necessary for enabling Ambac (i) to service its indebtedness for borrowed money as such payments become due or (ii) to pay its operating expenses. If dividends are paid on the common stock for such purposes, dividends on the AMPS become cumulative until the date that all accumulated and unpaid dividends have been paid on the AMPS. Refer to Note 1. Background and Business Description for a discussion of the August 2018 AMPS Exchange that reduced the liquidation preference of the AMPS from $660.3 million at June 30, 2018 to $102.9 million as of August 1, 2018. Ambac Assurance has not paid dividends on the AMPS since 2010. Refer to Part I, Item 1, “Insurance Regulatory Matters - Dividend Restrictions, Including Contractual Restrictions” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, and Note 8. Insurance Regulatory Restrictions to the Consolidated Financial Statements included in Part II, Item 8, in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, for more information on dividend payment restrictions.
Our ability to realize representation and warranty 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, intervention by the OCI, which could impede our ability to take actions required to realize such recoveries, and uncertainty inherent in the assumptions used in estimating such recoveries. 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 materially.
Ambac Financial Services ("AFS") Liquidity. AFS provides interest rate swaps to states, municipalities and their authorities, asset-backed issuers and other entities in connection with their financings. Additionally, AFS uses interest rate derivatives as an economic hedge against the effects of rising interest rates elsewhere in the Company, including on Ambac’s financial guarantee
| Ambac Financial Group, Inc. 68 2018 Second Quarter FORM 10-Q |

exposures. The principal uses of liquidity by AFS are payments on intercompany loans, payments under derivative contracts (primarily interest rate swaps and US Treasury futures), collateral posting and operating expenses. Management believes that AFS’ short and long-term liquidity needs can be funded from intercompany loans from Ambac Assurance and receipts from derivative contracts since AFS borrows cash and securities from Ambac Assurance to meet liquidity needs when such borrowing is determined to be most economically beneficial to Ambac Assurance. Intercompany loans are made under established lending agreements with defined borrowing limits that have received non-disapproval from OCI.
Cash Flow Statement Discussion. The following table summarizes the net cash flows for the periods presented.

| Six Months Ended June 30,
($ in million) | 2018 |  | 2017
Cash provided by (used in): |  |  |
Operating activities | $ | (1,312 | ) |  | $ | (165 | )
Investing activities | 1,015 |  |  | 416 |
Financing activities | (282 | ) |  | (286 | )
Foreign exchange impact on cash and cash equivalents | (1 | ) |  | (1 | )
Net cash flow | $ | (579 | ) |  | $ | (37 | )

Operating activities
The following represents the significant cash activities during the six months ended June 30, 2018 and 2017:

• | The cash outflow from the Rehabilitation Exit Transactions to third parties was $1,353.5 million of which $1,162.3 million is included in operating activities and $191.2 is included in financing activities as it relates to payments for surplus note principal. See Note 1. Background and Business Description to the Consolidated Financial Statements, included in Part I, Item 1 in this Form 10-Q and Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 for details regarding the Rehabilitation Exit Transactions.

• | Payment of interest on long-term debt of $158 million, including $100 million on surplus notes made in connection with the Rehabilitation Exit Transactions, $56 million on the Ambac Note and $2 million on the secured borrowing which has been fully repaid as of June 30, 2018.

• | Net loss and loss expenses paid, including commutation payments, during the six months ended June 30, 2018 and 2017 are detailed below:

| Six Months Ended June 30,
($ in million) | 2018 |  | 2017
Net loss and loss expenses paid (recovered):
Net losses paid (1) | $ | 153 |  |  | $ | 105 |
Net subrogation received | (75 | ) |  | (118 | )
Net loss expenses paid | 62 |  |  | 21 |
Net cash flow | $ | 140 |  |  | $ | 8 |

(1) | Net losses paid includes claims paid on Puerto Rico policies of $28 and $14 million for the six months ended June 30, 2018 and 2017, respectively.

Future operating cash flows will primarily be impacted by the level of premium collections, investment coupon receipts and claim and expense payments. In July 2018, Ambac Assurance paid claims of $134 million (gross of reinsurance) on Puerto Rico policies.
Financing Activities
Financing activities for the six months ended June 30, 2018 include proceeds from the issuance of Tier 2 Notes of $240 million, paydowns of Ambac Note of $113 million, repayments of the Secured Borrowing of $74 million, payments for the extinguishment of surplus notes of $191 million (in connection with the Rehabilitation Exit Transactions) and paydowns of VIE debt obligations of $138 million.
Financing activities for the six months ended June 30, 2017 include repayments of a secured borrowing of $17 million, payment for investment agreements of $82 million, payments for the extinguishment of surplus notes of $69 million and paydowns of VIE debt obligations of $116 million.
Credit Ratings and Collateral.
Ambac Financial Services, LLC (“AFS”) provides interest rate swaps to states, municipalities and their authorities, asset-backed issuers and other entities in connection with their financings. AFS hedges its interest rate risk, as well as a portion of the interest rate risk in the financial guarantee portfolio, with standardized derivative contracts, including financial futures contracts, which contain collateral or margin requirements. Under these hedge agreements, AFS is required to post collateral or margin to its counterparties and futures commission merchants to cover unrealized losses. In addition, AFS is required to post collateral or margin in excess of the amounts needed to cover unrealized losses. All AFS derivative contracts containing ratings-based downgrade triggers that could result in collateral or margin posting or a termination have been triggered. If terminations were to occur, AFS would be required to make termination payments, but would also receive a return of collateral or margin in the form of cash, U.S. Treasury or U.S. government agency obligations with market values equal to or in excess of market values of the swaps and futures contracts. In most cases, AFS will look to re-establish hedge positions that are terminated early. This may result in additional collateral or margin obligations. The amount of additional collateral or margin posted on derivatives contracts will depend on several variables including the degree to which counterparties exercise their termination rights and the terms on which hedges can be replaced. All collateral and margin obligations are currently met. Collateral and margin posted by AFS totaled a net amount of $106 million (cash and securities collateral of $21 million and $85 million, respectively), including independent amounts, under these contracts at June 30, 2018.
Ambac Credit Products (“ACP”) is not required to post collateral under any of its outstanding credit derivative contracts.
BALANCE SHEET
Total assets decreased by approximately $1,657 million from December 31, 2017 to $21,535 million at June 30, 2018, primarily due to the net impact of the Rehabilitation Exit Transactions as discussed below. Other significant changes during the six months ended June 30, 2018 were lower VIE assets as a result of currency changes (weakening of the British Pound), lower intangible assets
| Ambac Financial Group, Inc. 69 2018 Second Quarter FORM 10-Q |

as a result of amortization, partially offset by gains from positive market value performance on invested assets.
Total liabilities decreased by approximately $2,076 million from December 31, 2017 to $19,471 million as of June 30, 2018, primarily as a result of the Rehabilitation Exit Transactions as discussed below. Other significant changes during the six months ended June 30, 2018 were lower VIE liabilities as a result of currency changes, lower unearned premiums from the runoff of the insured portfolio, the full redemption of the Secured Borrowing transaction on June 22, 2018 and partial paydowns on the Ambac Note, partially offset by higher accrued interest payable on surplus notes and new debt.
As of June 30, 2018 total stockholders’ equity was $2,064 million, compared with total stockholders’ equity of $1,645 million at December 31, 2017. This increase was primarily driven by Total Comprehensive Income during the period. Total Comprehensive Income during 2018 was driven by net income, unrealized gains on investment securities, partially offset by translation losses related to Ambac's foreign subsidiaries.
Rehabilitation Exit Transactions. As more fully discussed in Note 1. Background and Business Description to the Consolidated Financial Statements, included in Part I, Item 1 in this Form 10-Q and Note 1. Background and Business Description in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, and Results of Operations in this Management's Discussion and Analysis, on February 12, 2018, Ambac and Ambac Assurance executed the Rehabilitation Exit Transactions that impacted the following balance sheet accounts:

• | Invested assets and cash were reduced by cash outflow of $1,354 million and settlement of Ambac-insured RMBS securities held in the investment portfolio of $1,455 million, partially offset by the receipt of $768 million par amount of the Secured Notes and proceeds from the issuance of Tier 2 notes of $240 million.

• | Loss Reserves and Subrogation Recoverable were reduced and increased, respectively, as a result of the settlement of unpaid claims of the Segregated Account, which were approximately $3,867 million (including $840 million of accrued interest) at December 31, 2017. Loss Reserves included $3,080 million of unpaid claims at December 31, 2017. Subrogation Recoverable was net of $787 million of unpaid claims at December 31, 2017. Following the settlement of Deferred Amounts, Loss Reserves decreased $2,555 million and Subrogation Recoverable increased $1,312 million. As a result of the settlement of unpaid claims, certain policies which were previously in a liability position have transitioned to an asset position with a recoverable of $525 million at December 31, 2017.

• | Long-term debt has been increased by the Ambac Note issued to Ambac LSNI with a carrying value of approximately $2,039 million and the issuance of Tier 2 Notes with a carrying value of approximately $240 million, partially offset by the consolidated reduction of surplus notes principal with a carrying value of approximately $413 million. Refer to Note 10. Long-term Debt t o the Consolidated Financial Statements,

included in Part I, Item 1 in this Form 10-Q for further information regarding Ambac's debt obligations.
Investment Portfolio. Ambac Assurance’s and Everspan's non-VIE investment objective is to achieve the highest risk-adjusted after-tax return on a diversified portfolio of primarily fixed income investments while employing asset/liability management practices to satisfy operating and strategic liquidity needs. Ambac Assurance’s investment portfolio is subject to internal investment guidelines and is subject to limits on types and quality of investments imposed by the insurance laws and regulations of the jurisdictions in which it is licensed, primarily the States of Wisconsin and New York. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits. Within these guidelines, Ambac Assurance opportunistically purchases Ambac Assurance insured securities given their relative risk/reward characteristics. Ambac Assurance’s investment policies are subject to oversight by OCI pursuant to the Settlement Agreement and the Stipulation and Order. The Board of Directors of Ambac Assurance approves any changes to Ambac Assurance's investment policy.
Ambac UK’s non-VIE investment policy is designed with the primary objective of ensuring that Ambac UK is able to meet its financial obligations as they fall due, in particular with respect to policyholder claims. Ambac UK’s investment portfolio is primarily fixed income investments and diversified holdings of pooled investment funds. The portfolio is subject to internal investment guidelines and may be subject to limits on types and quality of investments imposed by the PRA as regulator of Ambac UK. Ambac UK’s investment policy sets forth minimum credit rating requirements and concentration limits, among other restrictions. The Board of Directors of Ambac UK approves any changes or exceptions to Ambac UK’s investment policy.
Ambac Financial Group, Inc.'s non-VIE investment portfolio's primary objective is to preserve capital and liquidity for strategic uses while maximizing income, including investments in securities issued by or guaranteed by Ambac Assurance.
The following table summarizes the composition of Ambac’s investment portfolio, excluding VIE investments, at carrying value at June 30, 2018 and December 31, 2017:

($ in millions) |  | June 30, 2018 |  | December 31, 2017
Fixed income securities |  | $ | 3,515 |  |  | $ | 4,652 |
Short-term |  | 393 |  |  | 557 |
Other investments |  | 394 |  |  | 432 |
Fixed income securities pledged as collateral |  | 85 |  |  | 100 |
Total investments (1) |  | $ | 4,387 |  |  | $ | 5,741 |

(1) | Includes investments denominated in non-US dollar currencies with a fair value of £193 ($254) and €38 ($44) as of June 30, 2018 and £210 ($284) and €41 ($49) as of December 31, 2017.

| Ambac Financial Group, Inc. 70 2018 Second Quarter FORM 10-Q |

The following table represents the fair value of mortgage and asset-backed securities at June 30, 2018 and December 31, 2017 by classification:

($ in millions) |  | June 30, 2018 |  | December 31, 2017
Residential mortgage-backed securities: |  |  |  |
RMBS—First-lien—Alt-A |  | 202 |  |  | 1,029 |
RMBS—Second Lien |  | $ | 191 |  |  | $ | 840 |
RMBS—First Lien—Sub Prime |  | 120 |  |  | 382 |
Total residential mortgage-backed securities |  | 512 |  |  | 2,251 |
Other asset-backed securities |  |  |  |
Military Housing |  | 235 |  |  | 243 |
Student Loans |  | 166 |  |  | 152 |
Structured Insurance |  | 141 |  |  | 138 |
Auto |  | 24 |  |  | 32 |
Credit Cards |  | 13 |  |  | 33 |
Total other asset-backed securities |  | 579 |  |  | 598 |
Total (1) |  | $ | 1,092 |  |  | $ | 2,849 |

(1) | Includes investments guaranteed by Ambac Assurance and Ambac UK for both periods presented. Refer to Note 8. Investments to the Unaudited Consolidated Financial Statements included in P art I, Item 1 in this Fo rm 10-Q for further details of Ambac insured securities held in the investment portfolio.

The weighted average rating, which is based on the lower of Standard & Poor’s or Moody’s ratings, of the mortgage and asset-backed securities is CC and CCC- as of June 30, 2018, and C and CCC as of December 31, 2017, respectively. The ratings on insured securities reflect the higher of the financial strength rating of the financial guarantor or the rating of the underlying issuer. Rating agencies do not always publish separate underlying ratings (those ratings excluding the insurance by the financial guarantor). In the event these underlying ratings are not available from the rating agencies, Ambac will assign an internal rating.
The following charts provide the ratings (1) distribution of the fixed income investment portfolio based on fair value at June 30, 2018 and December 31, 2017:

(1) | Ratings are based on the lower of Moody’s or S&P ratings. If ratings are unavailable from Moody's or S&P, Fitch ratings are used. If guaranteed, rating represents the higher of the underlying or guarantor’s financial strength rating.

(2) | Below investment grade and not rated bonds insured by Ambac represent 63% and 64% of the 2018 and 2017 combined fixed income portfolio, respectively.

The changes in ratings during the six months ended June 30, 2018 were the result of the Rehabilitation Exit Transactions with significant reductions in BIG Ambac-insured RMBS bonds partially offset by the receipt of the Secured Note issued from Ambac LSNI, which is not rated.
Refer to Note 8. Investments to the Unaudited Financial Statements included in Part 1, Item 1 in this Form 10-Q for information about Ambac's consolidated non-VIE investment portfolio.
Premium Receivables. Ambac either received premium upfront at time of issuance of the insurance policy or in installments over the policy term. For installment premium transactions, a premium
| Ambac Financial Group, Inc. 71 2018 Second Quarter FORM 10-Q |

receivable asset is established equal to the (i) 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 premiums to be collected over the expected life of the transaction. Ambac's premium receivables decreased to $554 million at June 30, 2018 from $586 million at December 31, 2017. As further discussed in Note 6. Financial Guarantee Insurance Contracts, the decrease is due to premium receipts, adjustments for changes in expected and contractual cash flows, and the impact of currency exchange rates on non-US denominated future premiums, partially offset by accretion of premium receivable discount.
Premium receivables by payment currency were as follows:

Currency (Amounts in millions) |  | Premium Receivable in Payment Currency |  | Premium Receivable in U.S. Dollars
U.S. Dollars |  | $ | 369 |  |  | $ | 369 |
British Pounds |  | £ | 115 |  |  | 151 |
Euros |  | € | 28 |  |  | 33 |
Australian Dollars |  | A$ | 1 |  |  | 1 |
Total |  |  |  | $ | 554 |

Reinsurance Recoverable on Paid and Unpaid Losses. Ambac Assurance has reinsurance in place pursuant to surplus share treaty and facultative agreements. To minimize its exposure to losses from reinsurers, Ambac Assurance (i) monitors the financial condition of its reinsurers; (ii) is entitled to receive collateral from its reinsurance counterparties under certain reinsurance contracts; and (iii) has certain cancellation rights that can be exercised by Ambac Assurance in the event of rating agency downgrades of a reinsurer (among other events and circumstances). Ambac Assurance benefited from letters of credit and collateral amounting to approximately $114.5 million from its reinsurers at June 30,
2018. These collateral amounts are in excess of Ambac’s reinsurance recoverable on paid and unpaid losses for the related reinsurer. As of June 30, 2018 and December 31, 2017, reinsurance recoverable on paid and unpaid losses were $39 million and $41 million, respectively.
Insurance Intangible Asset. At the Fresh Start Reporting Date, an insurance intangible asset was recorded which represented the difference between the fair value and aggregate carrying value of the financial guarantee insurance and reinsurance assets and liabilities. As of June 30, 2018 and December 31, 2017, the net insurance intangible asset was $786 million and $847 million, respectively. Other than through amortization, variance in the insurance intangible asset is solely from translation gains (losses) from the consolidation of Ambac's foreign subsidiary (Ambac UK).
Derivative Liabilities. The interest rate derivative portfolio is positioned to benefit from rising rates as a partial economic hedge against interest rate exposure in the financial guarantee portfolio. Derivative liabilities decreased from $83 million at December 31, 2017 to $68 million as of June 30, 2018. The decrease resulted primarily from higher interest rates during the six months ended June 30, 2018.
Loss and Loss Expense Reserves and Subrogation Recoverable. Loss and loss expense reserves are based upon estimates of the ultimate aggregate losses inherent in the non-derivative portfolio for insurance policies issued to beneficiaries, including unconsolidated VIEs. For periods prior to February 12, 2018, loss and loss expense reserves included the unpaid portion of interest accrued on Deferred Amounts established pursuant to the Segregated Account Rehabilitation Plan. The loss and loss expense reserves, net of subrogation recoverables and before reinsurance as of June 30, 2018 and December 31, 2017 were $181 million and $4,114 million, respectively.
Loss and loss expense reserves are included in the Consolidated Balance Sheets as follows:

|  | Unpaid Claims |  | Present Value of Expected Net Cash Flows |  | Unearned Premium Revenue |  | Gross Loss and Loss Expense Reserves (2)
($ in millions) Balance Sheet Line Item |  | Claims |  | Accrued Interest |  | Claims and Loss Expenses |  | Recoveries (1) |  |
June 30, 2018: |  |  |  |  |  |  |  |  |  |  |  |
Loss and loss expense reserves |  | $ | — |  |  | $ | — |  |  | $ | 2,484 |  |  | $ | (306 | ) |  | $ | (121 | ) |  | $ | 2,057 |
Subrogation recoverable |  | — |  |  | — |  |  | 265 |  |  | (2,141 | ) |  | — |  |  | (1,876 | )
Totals |  | $ | — |  |  | $ | — |  |  | $ | 2,749 |  |  | $ | (2,447 | ) |  | $ | (121 | ) |  | $ | 181 |
December 31, 2017: |  |  |  |  |  |  |  |  |  |  |  |
Loss and loss expense reserves |  | $ | 2,412 |  |  | $ | 668 |  |  | $ | 2,855 |  |  | $ | (1,054 | ) |  | $ | (136 | ) |  | $ | 4,745 |
Subrogation recoverable |  | 615 |  |  | 172 |  |  | 102 |  |  | (1,520 | ) |  | — |  |  | (631 | )
Totals |  | $ | 3,027 |  |  | $ | 840 |  |  | $ | 2,957 |  |  | $ | (2,574 | ) |  | $ | (136 | ) |  | $ | 4,114 |

(1) | Present value of future recoveries include R&W subrogation recoveries of $1,816 and $1,834 at June 30, 2018 and December 31, 2017, respectively.

(2) | Includes Euro denominated gross loss and loss expense reserves. US dollar equivalents of such reserves were $15 (€13) and $21 (€18) at June 30, 2018 and December 31, 2017, respectively.

The evaluation process for determining the level of reserves is subject to certain estimates and judgments. Please refer to the "Critical Accounting Policies and Estimates" and “Results of
Operations” sections of Management’s Discussion and Analysis of Financial Condition and Results of Operations in addition to Basis of Presentation and Significant Accounting Policies and Loss
| Ambac Financial Group, Inc. 72 2018 Second Quarter FORM 10-Q |

Reserves sections included in Note 2. Basis of Presentation and Significant Accounting Policies and Note 6. Financial Guarantee Insurance Contracts, respectively of the Consolidated Financial Statements included in Part II, Item 8 in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 for further information on loss and loss expenses.
Ambac has exposure to various bond types issued in the debt capital markets. Our experience has shown that, for the majority of bond types, we have not experienced significant claims. The bond types that have experienced significant claims, including through commutations, are residential mortgage-backed securities (“RMBS”) and student loan securities. These two bond types represen t 87% of our ever-to-date insurance claims recorded with RMBS comprising 81%. Although historically RMBS and student loan securities have been the largest source of claim activity there are reserves on Public Finance and Ambac UK credits that may result in significant claim payments in the future. The table below indicates gross par outstanding and the components of gross loss and loss expense reserves related to policies in Ambac’s gross loss and loss expense reserves at June 30, 2018 and December 31, 2017:

|  | Gross Par Outstanding (1)(2) |  | Unpaid Claims |  | Present Value of Expected Net Cash Flows |  | Unearned Premium Revenue |  | Gross Loss and Loss Expense Reserves (1)(3)
($ in millions) |  |  | Claims |  | Accrued Interest |  | Claims and Loss Expenses |  | Recoveries |  |
June 30, 2018: |  |  |  |  |  |  |  |  |  |  |  |  |  |
RMBS |  | $ | 4,145 |  |  | $ | — |  |  | $ | — |  |  | $ | 777 |  |  | $ | (2,027 | ) |  | $ | (14 | ) |  | $ | (1,264 | )
Domestic Public Finance |  | 3,749 |  |  | — |  |  | — |  |  | 1,222 |  |  | (377 | ) |  | (72 | ) |  | 773 |
Student Loans |  | 689 |  |  | — |  |  | — |  |  | 356 |  |  | (36 | ) |  | (11 | ) |  | 309 |
Ambac UK |  | 936 |  |  | — |  |  | — |  |  | 305 |  |  | (7 | ) |  | (18 | ) |  | 280 |
Other credits |  | 476 |  |  | — |  |  | — |  |  | 15 |  |  | — |  |  | (6 | ) |  | 9 |
Loss expenses |  | — |  |  | — |  |  | — |  |  | 74 |  |  | — |  |  | — |  |  | 74 |
Totals |  | $ | 9,995 |  |  | $ | — |  |  | $ | — |  |  | $ | 2,749 |  |  | $ | (2,447 | ) |  | $ | (121 | ) |  | $ | 181 |
December 31, 2017: |  |  |  |  |  |  |  |  |  |  |  |  |  |
RMBS |  | $ | 5,243 |  |  | $ | 3,014 |  |  | $ | 837 |  |  | $ | 888 |  |  | $ | (2,120 | ) |  | $ | (21 | ) |  | $ | 2,598 |
Domestic Public Finance |  | 4,265 |  |  | 13 |  |  | 3 |  |  | 1,278 |  |  | (403 | ) |  | (75 | ) |  | 816 |
Student Loans |  | 701 |  |  | — |  |  | — |  |  | 361 |  |  | (40 | ) |  | (13 | ) |  | 308 |
Ambac UK |  | 941 |  |  | — |  |  | — |  |  | 315 |  |  | (11 | ) |  | (18 | ) |  | 286 |
All other credits |  | 537 |  |  | — |  |  | — |  |  | 26 |  |  | — |  |  | (9 | ) |  | 17 |
Loss expenses |  | — |  |  | — |  |  | — |  |  | 89 |  |  | — |  |  | — |  |  | 89 |
Totals |  | $ | 11,687 |  |  | $ | 3,027 |  |  | $ | 840 |  |  | $ | 2,957 |  |  | $ | (2,574 | ) |  | $ | (136 | ) |  | $ | 4,114 |

(1) | Ceded par outstanding on policies with loss reserves and ceded loss and loss expense reserves are $518 and $38, respectively, at June 30, 2018 and $590 and $41, respectively at December 31, 2017. Ceded loss and loss expense reserves are included in Reinsurance recoverable on paid and unpaid losses.

(2) | Gross Par Outstanding includes capital appreciation bonds, which are reported at the par amount at the time of issuance of the insurance policy as opposed to the current accreted value of the bond.

(3) | Loss reserves are included in the balance sheet as Loss and loss expense reserves or Subrogation recoverable dependent on if a policy is in a net liability or net recoverable position.

RMBS
Ambac has exposure to the U.S. mortgage market primarily through direct financial guarantees of RMBS, including transactions collateralized by first and second liens.
We established a representation and warranty subrogation recovery as further discussed in Note 6. Financial Guarantee Insurance Contracts to the Unaudited Consolidated Financial Statements included in Part I, Item 1 in this Form 10-Q. Our ability to realize RMBS representation and warranty 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, intervention by the OCI, which could impede our ability to take actions required to realize such recoveries and uncertainty inherent in the assumptions used in estimating such recoveries.
The table below distinguishes between RMBS credits for which we have not established a representation and warranty subrogation recovery and those for which we have, providing in both cases the gross par outstanding, gross loss reserves before representation and warranty subrogation recoveries and gross loss reserves net of representation and warranty subrogation recoveries for all RMBS exposures for which Ambac established reserves at June 30, 2018 and December 31, 2017:
| Ambac Financial Group, Inc. 73 2018 Second Quarter FORM 10-Q |

($ in millions) |  | Gross Par Outstanding |  | Gross Loss Reserves Before Representation and Warranty Subrogation Recoveries |  | Representation and Warranty Subrogation Recoveries |  | Gross Loss Reserves Net of Representation and Warranty Subrogation Recoveries
June 30, 2018: |  |  |  |  |  |  |  |
Second-lien |  | $ | 804 |  |  | $ | 256 |  |  | $ | — |  |  | $ | 256 |
First-lien Mid-prime |  | 1,620 |  |  | 75 |  |  | — |  |  | 75 |
First-lien Sub-prime |  | 389 |  |  | 56 |  |  | — |  |  | 56 |
Other |  | 114 |  |  | 7 |  |  | — |  |  | 7 |
Total Credits Without Subrogation |  | 2,927 |  |  | 394 |  |  | — |  |  | 394 |
Second-lien |  | 486 |  |  | 1 |  |  | (1,260 | ) |  | (1,259 | )
First-lien Mid-prime |  | 51 |  |  | 7 |  |  | (80 | ) |  | (73 | )
First-lien Sub-prime |  | 681 |  |  | 150 |  |  | (476 | ) |  | (326 | )
Total Credits With Subrogation |  | 1,218 |  |  | 158 |  |  | (1,816 | ) |  | (1,658 | )
Total |  | $ | 4,145 |  |  | $ | 552 |  |  | $ | (1,816 | ) |  | $ | (1,264 | )
December 31, 2017: |  |  |  |  |  |  |  |
Second-lien |  | $ | 1,065 |  |  | $ | 735 |  |  | $ | — |  |  | $ | 735 |
First-lien-Mid-prime |  | 1,849 |  |  | 1,997 |  |  | — |  |  | 1,997 |
First-lien-Sub-prime |  | 667 |  |  | 190 |  |  | — |  |  | 190 |
Other |  | 137 |  |  | 144 |  |  | — |  |  | 144 |
Total Credits Without Subrogation |  | 3,718 |  |  | 3,066 |  |  | — |  |  | 3,066 |
Second-lien |  | 735 |  |  | 719 |  |  | (1,272 | ) |  | (553 | )
First-lien Mid-prime |  | 59 |  |  | 104 |  |  | (79 | ) |  | 25 |
First-lien Sub-prime |  | 731 |  |  | 543 |  |  | (483 | ) |  | 60 |
Total Credits With Subrogation |  | 1,525 |  |  | 1,366 |  |  | (1,834 | ) |  | (468 | )
Total |  | $ | 5,243 |  |  | $ | 4,432 |  |  | $ | (1,834 | ) |  | $ | 2,598 |

Public Finance
Ambac’s U.S. public finance portfolio consists predominantly of municipal bonds such as general and revenue obligations and lease and tax-backed obligations of state and local government entities; however, the portfolio also comprises a wide array of non-municipal types of bonds, including financings for not-for-profit entities and transactions with public and private elements, which generally finance infrastructure, housing and other public purpose
facilities and interests. The decline in public finance gross loss reserves at June 30, 2018 as compared to December 31, 2017 was primarily related to the payment of claims, partially offset by the continued uncertainty and volatility of the situation in Puerto Rico. To tal public finance gross loss reserves and related gross par outstanding on Ambac insured obligations by bond type were as follows:

|  | June 30, 2018 |  | December 31, 2017
Issuer Type ($ in millions) |  | Gross Par Outstanding (1) |  | Gross Loss Reserves |  | Gross Par Outstanding (1) |  | Gross Loss Reserves
Lease and tax-backed |  | $ | 2,138 |  |  | $ | 634 |  |  | $ | 2,201 |  |  | $ | 650 |
General obligation |  | 970 |  |  | 54 |  |  | 1,053 |  |  | 60 |
Transportation revenue |  | 93 |  |  | 45 |  |  | 495 |  |  | 64 |
Housing |  | 447 |  |  | 29 |  |  | 449 |  |  | 31 |
Other |  | 101 |  |  | 11 |  |  | 67 |  |  | 11 |
Total |  | $ | 3,749 |  |  | $ | 773 |  |  | $ | 4,265 |  |  | $ | 816 |

(1) | Gross Par Outstanding includes capital appreciation bonds, which are reported at the par amount at the time of issuance of the insurance policy as opposed to the current accreted value of the bond.

Variability of Expected Losses and Recoveries
Ambac’s management believes that the estimated future loss component of loss reserves are adequate to cover future claims
presented, but there can be no assurance that the ultimate liability will not be higher than such estimates.
It is possible that our estimated future losses for insurance policies discussed above could be understated, or that our estimated future
| Ambac Financial Group, Inc. 74 2018 Second Quarter FORM 10-Q |

recoveries could be overstated. We have attempted to identify possible cash flows related to losses and recoveries using more stressful assumptions than the probability-weighted outcome recorded. The possible net cash flows consider the highest stress scenario that was utilized in the development of our probability-weighted expected loss at June 30, 2018 and assumes an inability to execute any commutation transactions with issuers and/or investors. Such stress scenarios are developed based on management’s view about all possible outcomes relating to losses and recoveries. In arriving at such view, management makes considerable judgments about the possibility of various future events. Although we do not believe it is possible to have stressed outcomes in all cases, it is possible we could have stress case outcomes in some or even many cases. See “Risk Factors” in Part I, Item 1A of the Company's 2017 Annual Report on Form 10-K and in Part II, Item 1A of this quarterly Report on Form 10-Q, as well as the following descriptions of "RMBS Variability," "Public Finance Variability," "Student Loan Variability," and "Other Credits, including Ambac UK, Variability," for further discussion of the risks relating to future losses and recoveries that could result in more highly stressed outcomes. The occurrence of these stressed outcomes individually or collectively would have a material adverse effect on our results of operations and financial condition and may result in materially adverse consequence for the Company, including (without limitation) impairing the ability of Ambac Assurance to honor its financial obligations; the initiation of rehabilitation proceedings against Ambac Assurance; decreased likelihood of Ambac Assurance delivering value to Ambac, through dividends or otherwise; and a significant drop in the value of securities issued or insured by Ambac or Ambac Assurance.
RMBS Variability:
Changes to assumptions that could make our reserves under-estimated include an increase in interest rates, deterioration in housing prices, poor servicing, the effect of a weakened economy characterized by growing unemployment and wage pressures, and/or illiquidity of the mortgage market. We utilize a model to project losses in our RMBS exposures and changes to reserves, either upward or downward, are not unlikely if we used a different model or methodology to project losses. Additionally, our R&W actual subrogation recoveries could be significantly lower than our estimate of $1,816 million as of June 30, 2018 if the sponsors of these transactions: (i) fail to honor their obligations to repurchase the mortgage loans, (ii) successfully dispute our breach findings, (iii) no longer have the financial means to fully satisfy their obligations under the transaction documents, or (iv) our pursuit of recoveries is otherwise unsuccessful. Failure to realize R&W subrogation recoveries for any reason or the realization of R&W subrogation recoveries materially below the amount recorded on Ambac's consolidated balance sheet would have a material adverse effect on our results of operations and financial condition.
In the case of both first and second-lien exposures, the possible stress case assumes a lower housing price appreciation projection, which in turn drives higher defaults and severities. Using this approach, the possible increase in loss reserves for RMBS credits for which we have an estimate of expected loss at June 30, 2018 could be approximately $30 million. Combined with the absence of any R&W subrogation recoveries, a possible increase in loss reserves for RMBS could be approximately $1.8 billion. Additionally, loss payments are sensitive to changes in interest rates, increasing as interest rates rise. For example an increase in
interest rates of 0.50% could increase our estimate of expected losses by approximately $35 million. There can be no assurance that losses may not exceed such amounts.
Public Finance Variability:
It is possible our loss reserves for public finance credits may be under-estimated if issuers are faced with prolonged exposure to adverse political, economic, fiscal or socioeconomic events or trends.
Our experience with the city of Detroit in its bankruptcy proceeding was not favorable and renders future outcomes with other public finance issuers even more difficult to predict and may increase the risk that we may suffer losses that could be sizable. We agreed to settlements regarding our insured Detroit general obligation bonds that provide better treatment of our exposures than the city planned to include in its plan of adjustment, but nevertheless required us to incur a loss for a significant portion of our exposure. An additional troubling precedent in the Detroit case, as well as other municipal bankruptcies, is the preferential treatment of certain creditor classes, especially the public pensions. The cost of pensions and the need to address frequently sizable unfunded or underfunded pensions is often a key driver of stress for many municipalities and their related authorities, including entities to whom we have significant exposure, such as Chicago, its school district, the State of New Jersey and many others. Less severe treatment of pension obligations in bankruptcy may lead to worse outcomes for traditional debt creditors. In addition, cities may be more inclined to use bankruptcy to resolve their financial stresses if they believe preferred outcomes for various creditor groups can be achieved.
We expect municipal bankruptcies and defaults to continue to be challenging to project given the unique political, economic, fiscal, governance and public policy differences among municipalities as well as the complexity, long duration and relative infrequency of the cases themselves in forums with a scarcity of legal precedent.
Another potentially adverse development that could cause the loss reserves on our public finance credits to be underestimated is deterioration in the municipal bond market, resulting from reduced or limited access to alternative forms of credit (such as bank loans) or other exogenous factors, such as the Tax Cuts and Jobs Act that was signed into law on December 22, 2017, which could potentially reduce municipal investor appetite for tax-exempt municipal bonds by corporate investors and over the longer term could potentially put additional pressure on issuers in states with high state and local taxes. These factors could deprive issuers access to funding at a level necessary to avoid defaulting on their obligations. While our loss reserves consider our judgment regarding issuers’ financial flexibility to adapt to adverse markets, they may not adequately capture sudden, unexpected or protracted uncertainty that adversely affects market conditions.
Our exposures to the Commonwealth of Puerto Rico are under stress arising from the Commonwealth’s poor financial condition, weak economy, loss of capital markets access and the severe damage caused by hurricanes Irma and Maria. These factors, taken together with the payment moratorium on debt payments of the Commonwealth and its instrumentalities, ongoing Puerto Rico Oversight, Management, and Economic Stability Act ("PROMESA") Title III proceedings, and certain other provisions
| Ambac Financial Group, Inc. 75 2018 Second Quarter FORM 10-Q |

under PROMESA, the potential for a restructuring of debt insured by Ambac Assurance, either with or without its consent, and the possibility of protracted litigation as a result of which its rights may be materially impaired, may cause losses to exceed current reserves in a material manner. See "Financial Guarantees in Force" section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in Part II, Item 7 in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 for further details on the legal, economic and fiscal developments that have impacted or may impact Ambac Assurance’s insured Puerto Rico bonds. In this Form 10-Q, refer to "Financial Guarantees in Force" in Part I, Item 2 in Management's Discussion and Analysis of Financial Condition and Results of Operation and Note 12. Commitments and Contingencies to the Consolidated Financial Statements for further updates related to Puerto Rico.
Material additional losses caused by the above-described factors would have a material adverse effect on our results of operations and financial condition. For public finance credits, including Puerto Rico as well as other issuers, for which we have an estimate of expected loss at June 30, 2018, the possible increase in loss reserves could be approximately $1.3 billion. However, there can be no assurance that losses may not exceed such amount.
Student Loan Variability:
Changes to assumptions that could make our reserves under-estimated include, but are not limited to, increases in interest rates, default rates and loss severities on the collateral due to economic or other factors. Such factors may include lower recoveries on defaulted loans or additional losses on collateral or trust assets, including as a result of any enforcement actions of the Consumer Finance Protection Bureau. For student loan credits for which we have an estimate of expected loss at June 30, 2018, the possible increase in loss reserves could be approximately $95 million. Additionally, an increase in interest rates of 0.50% could increase our estimate of expected losses by approximately $30 million. However, there can be no assurance that losses may not exceed such amounts. Material additional losses caused by the above-described factors would have a material adverse effect on our results of operations and financial condition.
Other Credits, including Ambac UK, Variability:
It is possible our loss reserves on other types of credits, including those insured by Ambac UK, may be under-estimated because of various risks that vary widely, including the risk that we may not be able to recover or mitigate losses through our remediation processes. For all other credits, including Ambac UK, for which we have an estimate of expected loss, the sum of all the highest stress case loss scenarios is approximately $195 million greater than the loss reserves at June 30, 2018. However, there can be no assurance that losses may not exceed such amount. Material additional losses caused by the above-described factors would have a material adverse effect on our results of operations and financial condition.
Long-term Debt. Long-term debt consists of senior and junior surplus notes issued by Ambac Assurance, the Ambac Note and Tier 2 notes issued in connection with the Rehabilitation Exit Transactions and the Secured Borrowing obligation. The carrying value of each of these as of June 30, 2018 and December 31, 2017 is below:

($ in millions) |  | June 30, 2018 |  | December 31, 2017
Surplus notes |  | $ | 517 |  |  | $ | 918 |
Ambac note |  | 2,039 |  |  | — |
Tier 2 notes |  | 240 |  |  | — |
Secured borrowing |  | — |  |  | 74 |
Total Long-term Debt |  | $ | 2,796 |  |  | $ | 992 |

The increase in long-term debt from December 31, 2017 is due to the issuance of new debt in connection with the Rehabilitation Exit Transactions. The increase in new debt was partially offset by the redemption of a portion of the senior surplus notes in connection with the Rehabilitation Exit Transactions, the repayment of the Secured Borrowing and the June 2018 redemption of $113 million of the Ambac Note.
VARIABLE INTEREST ENTITIES
Please refer to Note 3. Variable Interest Entities to the Unaudited Consolidated Financial Statements included in Part I, Item 1 in this Form 10-Q and Note 2. Basis of Presentation and Significant Accounting Policies and Note 3. Special Purpose Entities, Including Variable Interest Entities to the Consolidated Financial Statements, included in Part II, Item 8 in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, for information regarding special purpose and variable interest entities.
ACCOUNTING STANDARDS
Please refer to Note 2. Basis of Presentation and Significant Accounting Policies to the Unaudited Consolidated Financial Statements, included in Part I, Item 1 in this Form 10-Q, for a discussion of the impact of recent accounting pronouncements on Ambac’s financial condition and results of operations.
AMBAC ASSURANCE STATUTORY BASIS FINANCIAL RESULTS
Ambac Assurance and Everspan's statutory financial statements are prepared on the basis of accounting practices prescribed or permitted by the OCI. OCI recognizes only statutory accounting practices prescribed or permitted by the State of Wisconsin (“SAP”) for determining and reporting the financial condition and results of operations of an insurance company for determining its solvency under Wisconsin Insurance Law. The National Association of Insurance Commissioners (“NAIC”) Accounting Practices and Procedures manual (“NAIC SAP”) has been adopted as a component of prescribed practices by the State of Wisconsin. For further information, see "Ambac Assurance Statutory Basis Financial Results," in Part II, Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations," and Note 8. Insurance Regulatory Restrictions to the Consolidated Financial Statements included in Part II, Item 8 in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.
In connection with the exit of the Segregated Account from rehabilitation and the merger of the Segregated Account into Ambac Assurance, Ambac Assurance requested and received permission from OCI of a permitted practice to restate its
| Ambac Financial Group, Inc. 76 2018 Second Quarter FORM 10-Q |

unassigned funds (surplus) balance, as of January 1, 2018, to $100 million with an offsetting reduction to gross paid-in and contributed surplus such that total surplus remained unchanged.
Ambac Assurance’s statutory policyholder surplus and qualified statutory capital (defined as the sum of policyholders surplus and mandatory contingency reserves) were $1,282 million and $1,758 million at June 30, 2018, respectively, as compared to $700 million and $1,156 million at December 31, 2017, respectively. The drivers to the net increase were:

• | Statutory net income of $175 million. Statutory net income was positively impacted by the Second Amended Plan of Rehabilitation whereby Ambac Assurance settled its unpaid claims at a discount of approximately $288 million which was recognized as a reduction to losses incurred, partially offset by the loss on extinguishment of surplus notes received of $43.0 million and the one-time interest payment on surplus notes (other than junior surplus notes) of $14 million.

• | In connection with the Second Amended Plan of Rehabilitation, the par amount of Ambac Assurance's remaining surplus notes of $361 million was reclassified from liabilities to a component of policyholders surplus.

• | An increase of $65 million from increases in the fair value of investment securities that are recorded at the lower of amortized cost or fair value. This increase primarily resulted from fair value increases of Ambac-insured Puerto Rico bonds owned.

The execution of Surplus Note exchanges were accounted for as a debt modification since the creditors before and after the discount remain the same and the change in the terms were not considered substantial. Under debt modification accounting, no gain or loss is recorded at transaction execution and a new effective interest rate is established based on the cash flows of the new Ambac Note.
Ambac Assurance’s statutory policyholder surplus includes $368 million of junior surplus notes. The junior surplus notes, the remaining surplus notes, the Ambac Note, the Tier 2 Notes and the preferred stock issued by Ambac Assurance, are obligations that have claims on the resources of Ambac Assurance which impact Ambac's ability to realize residual value from its equity in Ambac Assurance.
Ambac Assurance statutory surplus is sensitive to multiple factors, including: (i) loss reserve development, (ii) approval by OCI of payments on surplus notes, including junior surplus notes, (iii) ongoing interest costs associated with the Ambac Note and Tier 2 Notes, including changes to interest rates as the Ambac Note is a floating rate obligation, (iv) deterioration in the financial position of Ambac Assurance subsidiaries that have their obligations guaranteed by Ambac Assurance, (v) first time payment defaults of insured obligations, which increase statutory loss reserves, (vi) commutations of insurance policies or credit derivative contracts at amounts that differ from the amount of liabilities recorded, (vii) reinsurance contract terminations at amounts that differ from net assets recorded, (viii) changes to the fair value of investments carried at fair value, (ix) settlements of representation and warranty breach claims at amounts that differ from amounts recorded, including failures to collect such amounts or receive recoveries sufficient to pay or redeem the Ambac Note and Tier 2 Notes, (x)
realized gains and losses, including losses arising from other than temporary impairments of investment securities, and (xi) future changes to prescribed practices by the OCI.
AMBAC UK FINANCIAL RESULTS UNDER UK ACCOUNTING PRINCIPLES
Ambac UK is required to prepare financial statements under FRS 102 "The Financial Reporting Standard applicable in the UK and Republic of Ireland." Ambac UK’s shareholder funds under UK GAAP were £274 million at June 30, 2018 as compared to £266 million at December 31, 2017. The increase in shareholders’ funds was primarily due to the receipt of premiums and investment return on fixed income and other investments together with unrealized foreign exchange gains on investments denominated in currencies other than Ambac UK's functional currency (British Pounds), offset by an increase in loss provisions. At June 30, 2018, the carrying value of cash and investments was £459 million, a decrease from £460 million at December 31, 2017. The decrease in cash and investments is due to sales of fund investments at the end of the quarter where the proceeds were not received until July (£14 million), offset by the continued receipt of premiums, net investment income and unrealized foreign exchange gains as noted above.
Ambac UK is also required to prepare financial information in accordance with the Solvency II Directive. The basis of preparation of this information is significantly different from both US GAAP and UK GAAP. The calculation of available and eligible capital resources, regulatory capital requirements and regulatory capital deficits under Solvency II at March 31, 2018 represents the most recent available data for these items. The calculation of capital resources, regulatory capital requirements and regulatory capital deficit of Ambac UK as at June 30, 2018 will be finalized on August 11, 2018 and will be published on Ambac's website shortly thereafter.
Available capital resources under Solvency II were a surplus of £64 million at March 31, 2018 of which £35 million were eligible to meet solvency capital requirements. The eligible capital resources at March 31, 2018 were in comparison to regulatory capital requirements of £336 million. Ambac UK is therefore deficient in terms of compliance with applicable regulatory capital requirements by £301 million at March 31, 2018. The regulators are aware of the deficiency in capital resources as compared to capital requirements and dialogue between Ambac UK management and its regulators remains ongoing with respect to options for addressing the shortcoming, although such options remain few.
NON-GAAP FINANCIAL MEASURES
In addition to reporting the Company’s quarterly financial results in accordance with GAAP, the Company reports two non-GAAP financial measures: Adjusted Earnings and Adjusted Book Value. The most directly comparable GAAP measures are net income attributable to common stockholders for Adjusted earnings and Total Ambac Financial Group, Inc. stockholders’ equity for Adjusted Book value. A non-GAAP financial measure is a numerical measure of financial performance or financial position that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable measure calculated
| Ambac Financial Group, Inc. 77 2018 Second Quarter FORM 10-Q |

and presented in accordance with GAAP. We are presenting these non-GAAP financial measures because they provide greater transparency and enhanced visibility into the underlying drivers of our business. Adjusted Earnings and Adjusted Book Value are not substitutes for the Company’s GAAP reporting, should not be viewed in isolation and may differ from similar reporting provided by other companies, which may define non-GAAP measures differently.
Ambac has a significant U.S. tax net operating loss (“NOL”) that is offset by a full valuation allowance in the GAAP consolidated financial statements. As a result of this and other considerations, we utilized a 0% effective tax rate for non-GAAP adjustments; which is subject to change.
The following paragraphs define each non-GAAP financial measure and describe why it is useful. A reconciliation of the non-GAAP financial measure and the most directly comparable GAAP financial measure is also presented below.
Adjusted Earnings (Loss). Adjusted Earnings (Loss) is defined as net income (loss) attributable to common stockholders, as reported under GAAP, adjusted on an after-tax basis for the following:

• | Non-credit impairment fair value (gain) loss on credit derivatives: Elimination of the non-credit impairment fair value gains (losses) on credit derivatives, which is the amount in excess of the present value of the expected estimated credit losses. Such fair value adjustments are affected by, and in part fluctuate with, changes in market factors such as interest rates and credit spreads, including the market’s perception of Ambac’s credit risk (“Ambac CVA”), and are not expected to

result in an economic gain or loss. These adjustments allow for all financial guarantee contracts to be accounted for consistent with the Financial Services – Insurance Topic of ASC, whether or not they are subject to derivative accounting rules.

• | Insurance intangible amortization: Elimination of the amortization of the financial guarantee insurance intangible asset that arose as a result of Ambac’s emergence from bankruptcy and the implementation of Fresh Start reporting. This adjustment ensures that all financial guarantee contracts are accounted for consistent with the provisions of the Financial Services – Insurance Topic of the ASC.

• | Foreign exchange (gains) losses: Elimination of the foreign exchange gains (losses) on the re-measurement of assets, liabilities and transactions in non-functional currencies. This adjustment eliminates the foreign exchange gains (losses) on all assets, liabilities and transactions in non-functional currencies, which enables users of our financial statements to better view the business results without the impact of fluctuations in foreign currency exchange rates, particularly as assets held in non-functional currencies have grown, and facilitates period-to-period comparisons of Ambac's operating performance.

• | Fair value (gain) loss on interest rate derivative from Ambac CVA: Elimination of the gains (losses) relating to Ambac’s CVA on interest rate derivative contracts. Similar to credit derivatives, fair values include the market’s perception of Ambac’s credit risk and this adjustment only allows for such gain or loss when realized

The following table reconciles net income attributable to common stockholders to the non-GAAP measure, Adjusted Earnings on a dollar amount and per diluted share basis, for all periods presented:

| Three Months Ended June 30,
| 2018 |  | 2017
($ in millions, except share data) | $ Amount |  | Per Diluted Share |  | $ Amount |  | Per Diluted Share
Net income (loss) attributable to common stockholders | $ | 4 |  |  | $ | 0.09 |  |  | $ | 7 |  |  | $ | 0.16 |
Adjustments: |  |  |  |  |  |  |
Non-credit impairment fair value (gain) loss on credit derivatives | — |  |  | 0.01 |  |  | (5 | ) |  | (0.10 | )
Insurance intangible amortization | 23 |  |  | 0.50 |  |  | 33 |  |  | 0.73 |
Foreign exchange (gains) losses | 9 |  |  | 0.18 |  |  | (8 | ) |  | (0.19 | )
Fair value (gain) loss on interest rate derivatives from Ambac CVA | — |  |  | — |  |  | 43 |  |  | 0.94 |
Adjusted earnings (loss) | $ | 36 |  |  | $ | 0.78 |  |  | $ | 70 |  |  | $ | 1.54 |
| Six Months Ended June 30,
| 2018 |  | 2017
($ in millions, except share data) | $ Amount |  | Per Diluted Share |  | $ Amount |  | Per Diluted Share
Net income (loss) attributable to common stockholders | $ | 310 |  |  | $ | 6.73 |  |  | $ | (118 | ) |  | $ | (2.61 | )
Adjustments: |  |  |  |  |  |  |
Non-credit impairment fair value (gain) loss on credit derivatives | 1 |  |  | 0.02 |  |  | (3 | ) |  | (0.06 | )
Insurance intangible amortization | 52 |  |  | 1.13 |  |  | 71 |  |  | 1.57 |
Foreign exchange (gain) loss | 4 |  |  | 0.07 |  |  | (16 | ) |  | (0.34 | )
Fair value (gain) loss on derivative products from Ambac CVA | — |  |  | — |  |  | 45 |  |  | 0.99 |
Adjusted earnings (loss) | $ | 366 |  |  | $ | 7.95 |  |  | $ | (21 | ) |  | $ | (0.45 | )

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Net income (loss) effects of financial guarantee VIE consolidation: VIEs that were consolidated as a result of financial guarantees provided by Ambac are accounted for on a fair value basis. Included within Net income (loss) attributable to common stockholders of these consolidated VIEs was $1 million and $2 million for the six months ended June 30, 2018 and 2017, respectively. Had these financial guarantee VIEs been accounted for under the provisions of the Financial Services - Insurance Topic of the ASC, included within Net income (loss) would have been $8 million and $6 million for the six months ended June 30, 2018 and 2017, respectively. The difference between these different accounting bases (including per share amounts) was $6 million ($0.14 per diluted share) and $3 million ($0.07 per diluted share), for the six months ended June 30, 2018 and 2017, respectively. This is supplemental information only and is not a component of Adjusted Earnings.
Adjusted Book Value. Adjusted Book Value is defined as Total Ambac Financial Group, Inc. stockholders’ equity as reported under GAAP, adjusted for after-tax impact of the following:

• | Non-credit impairment fair value losses on credit derivatives: Elimination of the non-credit impairment fair value loss on credit derivatives, which is the amount in excess of the present value of the expected estimated economic credit loss. GAAP fair values are affected by, and in part fluctuate with, changes in market factors such as interest rates, credit spreads, including Ambac’s CVA that are not expected to result in an economic gain or loss. These adjustments allow for all financial guarantee contracts to be accounted for within Adjusted Book Value consistent with the provisions of the Financial Services—Insurance Topic of the ASC, whether or not they are subject to derivative accounting rules.

• | Insurance intangible asset: Elimination of the financial guarantee insurance intangible asset that arose as a result of

Ambac’s emergence from bankruptcy and the implementation of Fresh Start reporting. This adjustment ensures that all financial guarantee contracts are accounted for within Adjusted Book Value consistent with the provisions of the Financial Services—Insurance Topic of the ASC.

• | Ambac CVA on interest rate derivative liabilities: Elimination of the gain relating to Ambac’s CVA on interest rate derivative contracts. Similar to credit derivatives, fair values include the market’s perception of Ambac’s credit risk and this adjustment only allows for such gain when realized.

• | Net unearned premiums and fees in excess of expected losses: Addition of the value of the unearned premium revenue ("UPR") on financial guarantee contracts, in excess of expected losses, net of reinsurance. This non-GAAP adjustment presents the economics of UPR and expected losses for financial guarantee contracts on a consistent basis. In accordance with GAAP, stockholders’ equity reflects a reduction for expected losses only to the extent they exceed UPR. However, when expected losses are less than UPR for a financial guarantee contract, neither expected losses nor UPR have an impact on stockholders’ equity. This non-GAAP adjustment adds UPR in excess of expected losses, net of reinsurance, to stockholders’ equity for financial guarantee contracts where expected losses are less than UPR.

• | Net unrealized investment (gains) losses in Accumulated Other Comprehensive Income: Elimination of the unrealized gains and losses on the Company’s investments that are recorded as a component of accumulated other comprehensive income (“AOCI”). The AOCI component of the fair value adjustment on the investment portfolio may differ from realized gains and losses ultimately recognized by the Company based on the Company’s investment strategy. This adjustment only allows for such gains and losses in Adjusted Book Value when realized.

The following table reconciles Total Ambac Financial Group, Inc. stockholders’ equity to the non-GAAP measure Adjusted Book Value on a dollar amount and per share basis, for all periods presented:

| June 30, 2018 |  | December 31, 2017
($ in millions, except share data) | $ Amount |  | Per Share |  | $ Amount |  | Per Share
Total Ambac Financial Group, Inc. stockholders’ equity | $ | 1,800 |  |  | $ | 39.70 |  |  | $ | 1,381 |  |  | $ | 30.52 |
Adjustments: |  |  |  |  |  |  |
Non-credit impairment fair value losses on credit derivatives | 1 |  |  | 0.03 |  |  | 1 |  |  | 0.01 |
Insurance intangible asset | (786 | ) |  | (17.34 | ) |  | (847 | ) |  | (18.71 | )
Net unearned premiums and fees in excess of expected losses | 537 |  |  | 11.84 |  |  | 597 |  |  | 13.20 |
Net unrealized investment (gains) losses in Accumulated Other Comprehensive Income | (154 | ) |  | (3.39 | ) |  | (31 | ) |  | (0.68 | )
Adjusted book value | $ | 1,398 |  |  | $ | 30.84 |  |  | $ | 1,101 |  |  | $ | 24.34 |

Stockholders' equity effects of financial guarantee VIE consolidation: VIEs that were consolidated as a result of financial guarantees provided by Ambac are accounted for on a fair value basis. The impact on Total Ambac Financial Group, Inc. stockholders' equity of these consolidated VIEs was $123 million and $134 million at June 30, 2018 and December 31, 2017, respectively. Had these financial guarantee VIEs been accounted for under the provisions of the Financial Services Insurance Topic of the ASC, included within stockholders' equity would have been $164 million and $179 million at June 30, 2018 and December 31, 2017, respectively. The net difference between these different
accounting bases (including per share amounts) was $41 million ($0.90 per share) and $45 million ($0.99 per share) at June 30, 2018 and December 31, 2017, respectively. This is supplemental information only and is not a component of Adjusted Book Value.
Factors that impact changes to Adjusted Book Value include many of the same factors that impact Adjusted Earnings, including the majority of revenues and expenses, but generally exclude components of premium earnings since they are embedded in prior period's Adjusted Book Value through the net unearned premiums and fees in excess of expected losses adjustment. Net unearned
| Ambac Financial Group, Inc. 79 2018 Second Quarter FORM 10-Q |

premiums and fees in excess of expected losses will affect Adjusted Book Value for (i) changes to future premium assumptions (e.g. expected term, interest rates, foreign currency rates, time passage) and (ii) changes to expected losses for policies which do not exceed their related unearned premiums. The Adjusted Book Value increase from December 31, 2017 to June 30, 2018 was primarily driven by Adjusted earnings.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk represents the potential for losses that may result from changes in the value of a financial instrument as a result of changes in market conditions. The primary market risks that would impact the value of Ambac’s financial instruments are interest rate risk, credit spread risk and foreign currency risk. As a result of the Rehabilitation Exit Transactions, as of June 30, 2018 Ambac's investment portfolio is lower and long-term debt has increased which has changed our exposure to interest rate risk compared to the sensitivities disclosed in our Annual Report on Form 10-K for the year ended December 31, 2017.
Interest Rate Risk:
Financial instruments for which fair value may be affected by changes in interest rates consist primarily of fixed income investment securities, long-term debt and interest rate derivatives.
Fixed income investment securities that are guaranteed by Ambac have interest rate risk characteristics that behave inversely to those associated with future financial guarantee claim payments. Accordingly, such securities are excluded from the interest rate sensitivity table below. Changes in fair value resulting from changes in interest rates are driven primarily by the impact of interest rate shifts on the investment portfolio (which produce net fair value losses as rates increase) and long-term debt and the interest rate derivatives portfolio (which produce net fair value gains as rates increase). Interest rate increases would also have a negative economic impact on expected future claim payments within the financial guarantee portfolio, primarily related to RMBS and student loan credits. Ambac performs scenario testing to measure the potential for losses in volatile markets. These scenario tests include parallel and non-parallel shifts in the benchmark interest rate curve.
The interest rate derivatives portfolio is managed as a partial economic hedge against the effects of rising interest rates elsewhere in the Company, including on Ambac's financial guarantee exposures (the "macro-hedge"). The interest rate sensitivity of the interest rate derivatives portfolio attributable to the macro-hedge position would produce mark-to-market gains or losses of approximately $0.9 million for a 1 basis point parallel shift in USD benchmark interest rates up or down at June 30, 2018.
The following table summarizes the estimated change in fair value (based primarily on the valuation methodology discussed in Note 7. Fair Value Measurements to the Consolidated Financial Statements included in Part I, Item 1 in this Form 10-Q) on these financial instruments, assuming immediate changes in interest rates at specified levels at June 30, 2018:

|  | Change in Interest Rates
($ in millions) |  | 300 basis point rise |  | 200 basis point rise |  | 100 basis point rise |  | Base scenario |  | 100 basis point decline(1) |  | 200 basis point decline(1)
Estimated change in net fair value |  | $ | 292 |  |  | $ | 196 |  |  | $ | 99 |  |  | $ | — |  |  | $ | (103 | ) |  | $ | (216 | )
Estimated net fair value |  | (517 | ) |  | (613 | ) |  | (710 | ) |  | (809 | ) |  | (912 | ) |  | (1,025 | )

(1) | Incorporates an interest rate floor of 0%.

Due to the low interest rate environment as of June 30, 2018, stress scenarios involving interest rate declines greater than 200 basis points are not meaningful to Ambac's portfolios.
Item 4. Controls and Procedures.
In connection with the preparation of this second quarter Form 10-Q, an evaluation was carried out by Ambac’s management, with the participation of Ambac’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of Ambac’s disclosure controls and procedures (as defined in rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (Exchange Act)) as of the end of the period covered by this Quarterly Report on Form 10-Q. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives. Based on its evaluation, Ambac’s Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2018, Ambac’s disclosure controls and procedures were effective.
There were no changes in the Company’s internal control over financial reporting that occurred during the quarter ended June 30, 2018 that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Please refer to Note 12. Commitments and Contingencies of the Unaudited Consolidated Financial Statements located in Part I, Item 1 in this Form 10-Q and Note 18. Commitments and Contingencies in Part II, Item 8 in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 for a discussion on legal proceedings against Ambac and its subsidiaries.
Item 1A. Risk Factors
You should carefully consider the risk factors set forth in the “Risk Factors” section, Item 1A to Part I in our Annual Report on Form 10-K for the year ended December 31, 2017, which are hereby incorporated by reference. These important factors may cause our actual results to differ materially from those indicated by our forward-looking statements, including those contained in this report. Please also see the section entitled “Cautionary Statement Pursuant to the Private Securities Litigation Reform Act of 1995” in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of this quarterly report on Form 10-Q. There have been no material changes to the
| Ambac Financial Group, Inc. 80 2018 Second Quarter FORM 10-Q |

risk factors we have disclosed in the “Risk Factors” section of our aforementioned Annual Report on Form 10-K, other than as described below.
Risks Related to Ambac Common Shares
The issuance of additional shares of Ambac, including the shares of Ambac common stock underlying the warrants delivered pursuant to the AMPS Exchange, may dilute current shareholder value or have adverse effects on the market price of Ambac’s common stock.
If Ambac raises capital through the issuance of additional shares of common stock, whether for select business transactions, general corporate purposes, or in exchange for other securities (including the warrants delivered pursuant to the AMPS Exchange), the value of current stockholders’ interests may be diluted as Ambac is not required to offer any such shares to existing stockholders on a preemptive basis.
Ambac cannot predict the effect, if any, of future sales of its common stock, or the availability of shares for future sales, on the market price of its common stock. Sales of substantial amounts of common stock or the perception that such sales could occur may adversely affect the prevailing market price for its common stock.
Risks Related to Indebtedness
Our ability to generate the significant amount of cash needed to service our debt and financial obligations and our ability to refinance all or a portion of our indebtedness or obtain additional financing depends on many factors beyond our control.
Ambac Assurance is highly leveraged and has greater indebtedness outstanding following consummation of the AMPS Exchange. Ambac Assurance’s ability to make payments on and refinance its debt, including surplus notes (which continue to accrete), and other financial obligations and to fund its operations will depend on its ability to generate substantial operating cash flow and on the performance of the insured portfolio. After giving effect to the AMPS Exchange, Ambac Assurance had $740.1 million principal balance of surplus notes (other than junior surplus notes) outstanding plus $368 million principal balance of junior surplus notes outstanding. Ambac Assurance’s cash flow generation will depend on receipt of premiums, investment returns, earnings from subsidiaries and potential litigation recoveries offset by policyholder claims, commutation payments and operating expenses, which will be subject to prevailing economic conditions and to financial, business and other factors, many of which are beyond our control and many of which are event-driven.
Ambac Assurance has incurred, and may in the future incur, additional indebtedness that is senior to its surplus notes. For example, in February 2018, Ambac Assurance issued Tier 2 Notes and the Ambac Note. As of June 30, 2018, approximately $2,288.9 million of our indebtedness was senior to our surplus notes. The Tier 2 Notes and the Ambac Note are secured by potential litigation recoveries, the receipt of which is highly uncertain. Failure to achieve litigation recoveries in an amount sufficient to repay the Tier 2 Notes and the Ambac Note would materially weaken Ambac Assurance’s ability to service its indebtedness.
If Ambac Assurance cannot pay its policyholders’ claims or service its debt, it will have to take actions such as selling assets, restructuring or refinancing its debt or seeking additional capital. Any of these remedies may not, if necessary, be effected on
commercially reasonable terms, or at all. Because of these and other factors beyond our control, Ambac Assurance may be unable to pay the principal, interest or other amounts on its indebtedness when due or ever.
Risks Related to Capital, Liquidity and Markets
AMPS that were not exchanged and cancelled in the AMPS Exchange may be acquired, redeemed or repaid on terms that may be viewed as more, or less, favorable than the terms of the applicable consideration offered in the AMPS Exchange.
Ambac or Ambac Assurance may acquire, redeem or repay AMPS that were not exchanged and cancelled in the AMPS Exchange through open market purchases, privately negotiated transactions, other tender or exchange offers, redemptions under the AMPS, or such other means as Ambac or Ambac Assurance (as the case may be) deems appropriate, subject to the restrictions in its governing documents, the restrictive covenants in its contracts and any applicable regulatory restrictions. Any such transactions will occur upon the terms and at the prices as Ambac or Ambac Assurance (as the case may be) may determine in its sole discretion, which may be more or less favorable than the terms of the AMPS Exchange, and in any case could be for cash or other consideration. Ambac or Ambac Assurance may choose to pursue any or none of these alternatives, or combinations thereof, in the future.
For a period of 180 days following the settlement date for the AMPS Exchange, the Supporting Holders have the right to receive additional consideration equal to the difference between the consideration paid to AMPS holders who tendered their AMPS in the AMPS Exchange before July 17, 2018 and any additional consideration paid to other holders of AMPS if Ambac or Ambac Assurance (as the case may be) were to repurchase or redeem AMPS held by other holders. Eligible holders who are not Supporting Holders but participate in the AMPS Exchange are not entitled to receive any future consideration for their AMPS. Any repurchase of AMPS in the future could require us to pay significantly greater consideration.
Risks Related to Taxation
The surplus notes received in the AMPS Exchange may not be fungible for U.S. federal income tax purposes with the other surplus notes that are currently outstanding.
The surplus notes received in the AMPS Exchange have a different issue price for U.S. federal income tax purposes than the surplus notes that are currently outstanding and, therefore, are expected to accrue original issue discount (“OID”) in an amount that differs from the amounts of OID accruing on the other surplus notes that are currently outstanding. Therefore, the surplus notes received in the AMPS Exchange may not be fungible with the other outstanding surplus notes for U.S. federal income tax purposes. Because the surplus notes received in the AMPS Exchange have the same CUSIP number as the other surplus notes that are currently outstanding, the surplus notes received in the AMPS Exchange will not be readily distinguishable from the other outstanding surplus notes. This could create uncertainty in the market and could adversely affect the liquidity and/or trading values of the surplus notes.
Risks Related to International Business
Uncertainty regarding the economic impact of “Brexit” may have an adverse effect on Ambac’s insured international portfolio and
| Ambac Financial Group, Inc. 81 2018 Second Quarter FORM 10-Q |

the value of its foreign investments, both of which primarily reside with its subsidiary Ambac UK.
In a non-binding referendum on the United Kingdom’s (“UK”) membership in the European Union (“EU”) in June 2016, a majority of those who voted approved the UK’s withdrawal from the EU. As a result of the referendum, in March 2017 the UK government gave the EU formal notification of its intent to leave with the expectation of formal withdrawal two years later on 29 March 2019. Also, in March 2017 the UK began initial (or phase one) negotiations with the EU regarding the terms of its departure (“Brexit”). On December 8, 2017 the EU and UK jointly announced, as set out in the Joint Report and Commission Communication (“Joint Report”), that “sufficient progress” in phase one of the separation negotiations between the parties had been made to permit Brexit negotiations to move on to a more detailed phase two beginning in January 2018.
The Joint Report is “a summary of the negotiations toward the legally binding withdrawal agreement” and is not itself legally binding but rather is a position paper setting out current agreement between the EU and the UK Government in three priority areas (citizens’ rights, the financial settlement and the Irish border). It also notes progress on other separation issues that have not yet been settled. Further details of the negotiations are provided in the House of Commons Briefing Paper Number 8183, 18 December 2017.
While phase two Brexit separation discussions commenced in January 2018, these discussions will not include details of future, post-Brexit, trade relations. What is envisaged in the Joint Report next is “an agreement as early as possible in 2018 on transitional arrangements”. An outcome to those transitional arrangement discussions has not yet emerged. A further, separate, mandate for negotiations on a future post-transition trade framework was anticipated to begin by summer 2018 however that has been delayed as a result of the lack of progress on transitional arrangement negotiations. In any event it is envisaged negotiations on the future trade framework would be concluded during the actual transitional phase, and would be influenced by the nature of the transitional arrangements agreed between the parties.
In the event no transitional arrangements or new agreements are put into place for insurers, Brexit will mean that the activities in the EEA of UK passporting insurers will become unlawful on March 29, 2019 (“no-deal Brexit”). They will lose their legal
authorization to serve clients who benefit from policies issued by a UK incorporated insurers under freedom of services passporting rights (and thereby may be unable to legally collect premiums or pay claims) and if they have branches in EEA Member States they may be legally obliged to capitalize them as a so-called third country branch from an institution outside the EEA or close them down and no longer be legally represented in those jurisdictions.
In light of the materiality of the insurance sector to the UK economy and taking into account the significant amount of insurance business undertaken by EEA based insurers in the UK (which will be similarly affected) it is reasonable to assume transition arrangements will be put in place leading to insurers being able to continue to service EU policies beyond March 29, 2019 for at least a transition period and likely to their natural run-off in relation to policies written prior to March 29, 2019. However, at this stage there is no certainty that such a transition agreement can be reached between the EU and the UK Government, indeed the UK financial regulatory authority is actively encouraging regulated firms to put into place contingency plans in light of no-deal Brexit risk, as are the EU and EU member states’ financial regulatory bodies.
Ambac UK has a branch in Italy, with one material policy remaining issued from the branch. The branch is not capitalized separately from Ambac UK. In the event of a no-deal Brexit the future nature and status of the branch is unclear. Ambac UK is in dialogue with the PRA over this matter in terms of contingency planning however there have been no clear determinations made to date.
Ambac UK has seven policies (including the one from the branch) in the EU written under current passporting rights the aggregate par value of which as at June 30, 2018 is $2.5 billion and as noted Ambac UK’s ability to service these contracts beyond March 29, 2019 is currently unclear unless and until legally binding Brexit transition agreements are put into place. During July 2018 one of these policies terminated early such that currently Ambac UK now has six policies outstanding (including the one from the branch) with aggregate par outstanding of $2.4 billion.
In addition to the direct impact on insurers cited above, general uncertainty and the perceptions as to the ultimate impact of Brexit may adversely affect business activity, political stability and economic conditions in the UK, the Eurozone, and the EU.

Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds

(a) | Unregistered Sales of Equ ity Securities

None.

(b) | Purchases of Equity Securities By the Issuer and Affiliated Purchasers

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There following table summarized Ambac's activity of share purchases during the second quarter of 2018. When restricted stock unit awards issued by Ambac vest or settle, they become taxable compensation to employees. For certain awards, shared may be withheld to cover the employee's portion of withholding taxes. In the second quarter of 2018, Ambac purchased shares from employees that settled restricted stock units to meet employee tax withholdings.

|  | Total Shares Purchased (1) |  | Average Price Paid Per Share |  | Total Number of Shares Purchased as Part of Publicly Announced Plan (1) |  | Maximum Number of Shares That may Yet be Purchased Under the Plan
April 2018 |  | — |  |  | $ | — |  |  | — |  |  | — |
May 2018 |  | 4,763 |  |  | 19.14 |  |  | — |  |  | — |
June 2018 |  | — |  |  | — |  |  | — |  |  | — |
Second Quarter 2018 |  | 4,763 |  |  | $ | 19.14 |  |  | — |  |  | — |

(1) | There were no other repurchases of equity securities made during the three months ended June 30, 2018. Ambac does not have a stock repurchase program.

Warrants
On June 30, 2015, the Board of Directors of Ambac authorized the establishment of a warrant repurchase program that permits the repurchase of up to $10 million of warrants. On November 3, 2016, the Board of Directors of Ambac authorized a $10 million increase to the warrant repurchase program. As of June 30, 2018, Ambac had repurchased 985,331 warrants totaling $8.1 million leaving 4,053,476 warrants outstanding with an exercise price of $16.67 per share and expiration of April 30, 2023. The remaining aggregate authorization at June 30, 2018 is $11.9 million.
On August 3, 2018, Ambac and Ambac Assurance completed an exchange (the “AMPS Exchange”) of Ambac Assurance’s outstanding Auction Market Preferred Shares (“AMPS”) for Ambac Assurance’s 5.1% senior surplus notes . AMPS holders who tendered at or prior to 5:00 p.m. on July 17, 2018, received from Ambac cash and 37.3076 warrants (rounded down to the nearest whole warrant) to purchase an equivalent number of shares of Ambac common stock at an exercise price of $16.67 per share. In connection with the AMPS Exchange, Ambac paid $11.048 million in cash, issued 824,307 warrants, and received 1,386 AMPS. Ambac did not receive any cash proceeds from the issuance of the warrants.
The AMPS Exchange Offer was made in reliance on the exemption provided by Section 4(a)(2) of the Securities Act of 1933, as
amended (the “Act”), and only to holders of AMPS who were either (x) institutional “accredited investors” within the meaning of subsection (1), (2), (3) or (7) of Rule 501(a) under the Act, (y) a “qualified institutional buyer” within the meaning of Rule 144A of the Act, or (z) a non-U.S. person within the meaning of Rule 902 of the Act.
Each warrant represents the right to purchase one share of Ambac common stock. The warrants are exercisable for cash at any time on or prior to April 30, 2023 at an exercise price of $16.67 per share. The warrants also have a cashless exercise provision. Refer to Note 1. Background and Business Description to the Consolidated Financial Statements included in Part I, Item 1 in this Form 10-Q for further discussion of the AMPS Exchange.

Item 3. | Defaults Upon Senior Securities — No matters require disclosure.

Item 5. | Other Information

The information included in Item 2 “Unregistered Sales of Equity Securities and Use of Proceeds” is hereby incorporated by reference.
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Item 6. | Exhibits

Exhibit Number |  | Description
10.1 |  | Preferred Stock Repurchase and Support Agreement dated as of June 22, 2018, by and among Ambac Assurance Corporation (“AAC”), Ambac Financial Group, Inc. and the holders of one or more series of the AAC’s outstanding Auction Market Preferred Shares (filed as Exhibit 10.1 to Ambac Financial Group, Inc.’s Current Report on Form 8-K, filed on June 25, 2018 and incorporated herein by reference).
12.1+ |  | Computation of Ratio of Earnings to Fixed Charges.
31.1+ |  | Certification of Chief Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) Promulgated under the Securities Exchange Act of 1934, as amended.
31.2+ |  | Certification of Chief Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) Promulgated under the Securities Exchange Act of 1934, as amended.
32.1++ |  | Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS |  | XBRL Instance Document.
101.SCH |  | XBRL Taxonomy Extension Schema Document.
101.CAL |  | XBRL Taxonomy Extension Calculation Linkbase Document.
101.LAB |  | XBRL Taxonomy Extension Label Linkbase Document.
101.PRE |  | XBRL Taxonomy Extension Presentation Linkbase Document.
101.DEF |  | XBRL Taxonomy Extension Definition Linkbase Document.
|  | + Filed herewith. ++ Furnished herewith.

SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

|  | AMBAC FINANCIAL GROUP, INC.
Dated: | August 8, 2018 | By: | /S/ DAVID TRICK
|  | Name: | David Trick
|  | Title: | Chief Financial Officer and Treasurer (Duly Authorized Officer and Principal Financial Officer)

| Ambac Financial Group, Inc. 84 2018 Second Quarter FORM 10-Q |