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Financial Guarantee Insurance Contracts

9 Months Ended

Sep. 30, 2018

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 September 30, 2018 and December 31, 2017, was 2.8% and 2.5%, respectively, and the weighted average period of future premiums used to estimate the premium receivable at September 30, 2018 and December 31, 2017, was 8.7 years and 9.8 years, respectively.

Insured obligations consisting of homogeneous pools for which Ambac uses expected future premiums to estimate the premium receivable and UPR include residential mortgage-backed securities. 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 September 30, 2018 and December 31, 2017, $8,027 and $9,331 respectively, of premium receivables were deemed uncollectable. As of September 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. Past due premiums on policies insuring non-investment grade obligations amounted to approximately $1,500 at September 30, 2018, of which approximately $1,100 was received in October 2018.

Below is the gross premium receivable roll-forward for the affected periods:



	Nine Months Ended September 30,
	2018			2017
Beginning premium receivable	$	586,312		$	661,337
Premium receipts	(42,660		)	(66,141		)
Adjustments for changes in expected and contractual cash flows ⁽¹⁾	(34,088		)	(24,407		)
Accretion of premium receivable discount	11,211			12,326
Changes to uncollectable premiums	2,473			(103		)
Other adjustments (including foreign exchange)	(6,051		)	18,745
Ending premium receivable⁽²⁾	$	517,197		$	601,757


(1)	Adjustments for changes in expected and contractual cash flows primarily due to reductions in insured exposure as a result of early policy terminations and unscheduled principal paydowns.


(2)	Premium receivable includes premiums to be received in foreign denominated currencies most notably in British Pounds and Euros. At September 30, 2018 and 2017, premium receivables include British Pounds of $136,925 (£104,988) and $153,964 (£114,847), respectively, and Euros of $32,613 (€28,085) and $36,815 (€31,154), 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 nine months ended September 30, 2018 was $6,751 and $22,246, respectively, and for the three and nine months ended September 30, 2017 was $26,178 and $55,648, 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 September 30,										Nine Months Ended September 30,
	2018					2017					2018					2017
	Written			Earned		Written			Earned		Written			Earned		Written			Earned
Direct	$	(22,954	)	$	27,559	$	(24,696	)	$	57,282	$	(19,304	)	$	87,506	$	(12,184	)	$	156,582
Assumed	—			20		—			20		—			59		—			61
Ceded	(789		)	1,939		(385		)	4,313		(1,832		)	5,206		(1,962		)	12,889
Net premiums	$	(22,165	)	$	25,640	$	(24,311	)	$	52,989	$	(17,472	)	$	82,359	$	(10,222	)	$	143,754

The following table summarizes net premiums earned by location of risk for the respective periods:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
United States	$	19,539	$	31,929	$	64,009	$	108,556
United Kingdom	4,523		17,273		14,337		28,094
Other international	1,578		3,787		4,013		7,104
Total	$	25,640	$	52,989	$	82,359	$	143,754

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



	Future Premiums to be Collected ⁽¹⁾		Future Premiums to be Earned Net of Reinsurance ⁽¹⁾
Three months ended:
December 31, 2018	$	14,031	$	14,672
Twelve months ended:
December 31, 2019	52,211		55,831
December 31, 2020	49,314		52,205
December 31, 2021	42,999		47,630
December 31, 2022	41,004		44,441
Five years ended:
December 31, 2027	181,091		180,584
December 31, 2032	140,309		120,582
December 31, 2037	79,454		67,135
December 31, 2042	28,784		23,960
December 31, 2047	13,631		12,632
December 31, 2052	3,621		4,647
December 31, 2057	91		297
Total	$	646,540	$	624,616

(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 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 September 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
September 30, 2018:
Loss and loss expense reserves	$	—	$	—	$	2,278,763	$	(305,024	)	$	(105,255	)	$	1,868,484
Subrogation recoverable	—		—		182,865		(2,081,476		)	—			(1,898,611		)
Totals	$	—	$	—	$	2,461,628	$	(2,386,500	)	$	(105,255	)	$	(30,127	)

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:



	Nine Months Ended September 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	976			5,328
Prior years	(182,291		)	405,589
Total ^{(1) (2) (3)}	(181,315		)	410,917
Loss and loss expenses paid (recovered):
Current year	143			330
Prior years ⁽³⁾	3,937,561			148,082
Total	3,937,704			148,412
Foreign exchange effect	(9,578		)	26,556
Ending net loss and loss expense reserves	(55,453		)	3,954,332
Reinsurance recoverable ⁽⁴⁾	25,326			46,023
Ending gross loss and loss expense reserves⁽⁵⁾	$	(30,127	)	$	4,000,355


(1)	Total losses and loss expenses (benefit) includes $(123) and $(21,189) for the nine months ended September 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 nine months ended September 30, 2018 and 2017 was $56,928 and $62,451, 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 $185 and $(47) as of September 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 $2,475 (€2,131) and $21,142 (€17,891) at September 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 portfolios 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 September 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 September 30, 2018 and December 31, 2017 was 3.1% and 2.5%, respectively.



Surveillance Categories as of September 30, 2018
	I			IA			II			III			IV			V			Total
Number of policies	33			25			11			18			148			3			238
Remaining weighted-average contract period (in years) ⁽¹⁾	9			22			7			22			13			3			16
Gross insured contractual payments outstanding:
Principal	$	1,058,679		$	535,358		$	356,714		$	1,744,554		$	5,609,816		$	43,926		$	9,349,047
Interest	493,847			558,077			151,446			6,980,654			2,209,528			15,229			10,408,781
Total	$	1,552,526		$	1,093,435		$	508,160		$	8,725,208		$	7,819,344		$	59,155		$	19,757,828
Gross undiscounted claim liability	$	4,130		$	55,554		$	37,858		$	1,101,833		$	2,359,788		$	59,123		$	3,618,286
Discount, gross claim liability	(552		)	(14,667		)	(3,450		)	(513,413		)	(724,685		)	(5,110		)	(1,261,877		)
Gross claim liability before all subrogation and before reinsurance	3,578			40,887			34,408			588,420			1,635,103			54,013			2,356,409
Less:
Gross RMBS subrogation⁽²⁾	—			—			—			—			(1,814,915		)	—			(1,814,915		)
Discount, RMBS subrogation	—			—			—			—			38,667			—			38,667
Discounted RMBS subrogation, before reinsurance	—			—			—			—			(1,776,248		)	—			(1,776,248		)
Less:
Gross other subrogation⁽³⁾	—			(9,585		)	(23		)	(123,326		)	(597,581		)	(13,003		)	(743,518		)
Discount, other subrogation	—			6,716			—			59,749			62,645			4,156			133,266
Discounted other subrogation, before reinsurance	—			(2,869		)	(23		)	(63,577		)	(534,936		)	(8,847		)	(610,252		)
Gross claim liability, net of all subrogation and discounts, before reinsurance	3,578			38,018			34,385			524,843			(676,081		)	45,166			(30,091		)
Less: Unearned premium revenue	(1,302		)	(9,656		)	(1,688		)	(36,993		)	(55,391		)	(225		)	(105,255		)
Plus: Loss expense reserves	2,117			3,240			2,256			12,101			85,505			—			105,219
Gross loss and loss expense reserves	$	4,393		$	31,602		$	34,953		$	499,951		$	(645,967	)	$	44,941		$	(30,127	)
Reinsurance recoverable reported on Balance Sheet ⁽⁴⁾	$	275		$	4,279		$	8,736		$	27,837		$	(15,616	)	$	—		$	25,511


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


(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 $25,326 related to future loss and loss expenses and $185 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 or 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 a material increase in permanent losses causing a material adverse impact on our results of operations and financial condition. 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 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 additional weather events. 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.

Also important to Puerto Rico's economic growth, government reform and creditor outcomes is the revised fiscal plan for the Commonwealth of Puerto Rico ("Revised Commonwealth Fiscal Plan"), certified by the Financial Oversight and Management Board for Puerto Rico ("Oversight

Board") on October 23, 2018. The Revised Commonwealth Fiscal Plan outlines a series of reforms, projects the fiscal and economic impact of those reforms, and provides forecasts of resulting budgetary surpluses over a fiscal year series. However, as was the case with prior Commonwealth Fiscal Plans, the Revised Commonwealth Fiscal Plan lacks a high degree of transparency regarding the underlying data, assumptions and rationales supporting those assumptions, making reconciliation and due diligence difficult. As a result, it is difficult to predict the long-term capacity and willingness of the Puerto Rico government and its instrumentalities to pay debt service on bonded debt and how their debt burden and financial flexibility might affect Ambac Assurance's claim potential, risk profile and long-term financial strength.

Substantial uncertainty exists with respect to the ultimate outcome for creditors in Puerto Rico, such as Ambac Assurance, due to, amongst other matters, legislation enacted by the Commonwealth and the federal government, including PROMESA, as well as actions taken pursuant to 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. On October 19, 2018, the Oversight Board filed the COFINA Plan of Adjustment and Disclosure Statement as part of the COFINA Title III case. No assurance can be given that the filed COFINA Plan of Adjustment and Disclosure Statement or an amended COFINA Plan of Adjustment and Disclosure Statement acceptable to Ambac will be approved by the court. At this time, it is unclear what the impact of the COFINA restructuring will be on the non-COFINA Puerto Rico-related exposures Ambac Assurance insures.

Ambac Assurance is also participating in a mediation process with respect to potential debt restructurings. Mediation may not be 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 causing losses that could have a material adverse impact on our results of operations and financial condition.

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 nine months ended September 30, 2018, Ambac had incurred losses associated with its Domestic Public Finance insured portfolio of $41,939, which was primarily 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 September 30, 2018, the possible increase in loss reserves under stress or other adverse conditions and circumstances was estimated to be approximately $1,190,000. This possible increase in loss reserves under stress or other adverse conditions is significant and if we were to experience such incremental losses, our stockholders’ equity as of September 30, 2018 would decrease from $1,798,809 to $608,809.

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. 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 $1,776,248 ($1,749,808 net of reinsurance) and $1,834,387 ($1,806,736 net of reinsurance) at September 30, 2018 and December 31, 2017, respectively. The balance of R&W subrogation recoveries and the related loss reserves at September 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 September 30, 2018	$	131,245	$	(1,776,248	)	$	(1,645,003	)

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.

(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:



	Nine Months Ended September 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:
Impact of sponsor actions	—			—
All other changes ⁽¹⁾	(58,139		)	(62,919		)
Discounted R&W subrogation (gross of reinsurance) at end of period	$	1,776,248		$	1,844,116

(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, changes in discount rates 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 nine months ended September 30, 2018, the insurance intangible amortization expense was $26,421 and $78,299, respectively and for the three and nine months ended September 30, 2017, the insurance intangible amortization expense was $45,690 and $116,686, respectively. As of September 30, 2018 and December 31, 2017, the gross carrying value of the insurance intangible asset was $1,562,753 and $1,581,156, respectively. Accumulated amortization of the insurance intangible asset was $807,019 and $734,183, as of September 30, 2018 and December 31, 2017, respectively, resulting in a net insurance intangible asset of $755,734 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⁾	$	17,243	$	65,216	$	60,350	$	54,975	$	51,132	$	506,818

(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.