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Item 7A. Quantitative and Qualitative Disclosures About Market Risk

2021-03-01 compared with 2020-03-02 · 87 added, 69 removed, 12 unchanged (93% of the section changed)

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.

Below we discuss each of these risks and the specific types of financial instruments impacted.

Senior managers are responsible for developing and applying methods to measure risk.

Market risk represents the potential for loss due to adverse changes in the fair value of financial instruments, as a result of changes in market rates and prices, such as interest rates (inclusive of credit spreads), foreign currency exchange rates and other relevant market rate or price changes.

Market risk is, in part, a function of the markets in which the underlying assets are traded.

The Company’s market risk sensitive financial instruments are primarily entered into for purposes other than trading.

As discussed further below, the Company’s primary market risk exposures include those from changes in interest rates, foreign currency exchange rates and equity values of limited partnership and other alternative investments.

• The primary market risks for fixed maturity investment securities are interest rate risk and exchange rate risk.

Ambac’s fixed maturity investment portfolio includes securities denominated both in U.S.

dollars and foreign currencies, which are sensitive to changes in interest rates and foreign currency exchange rates.

Our fixed maturity investments are classified as available for sale, with the effect of market movements recognized immediately through Other comprehensive income, or through Net income when securities are sold or when an impairment charge is recorded.

• Ambac also invests in limited partnerships and other alternative investments, primarily consisting of diversified pooled investment funds, which are reported as Other investments.

These funds are subject to equity value changes driven primarily by changes to their respective net asset value (“NAV”).

Ambac’s share of the changes of the equity value of the funds is reported through Net income.

For additional information about Ambac’s investments, see Note 11.

Investments to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K.

• The interest rate derivatives portfolio is managed as a partial hedge against the effects of rising interest rates elsewhere in the Company, including on Ambac's financial guarantee exposures.

Changes in fair value of interest rate derivatives are recognized immediately through Net income.

For additional information about Ambac’s interest rate derivatives, see Note 12.

Derivative Instruments to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K.

• Although our long-term debt obligations are reported at amortized cost and not adjusted for fair value changes, changes in interest rates could have a material impact on their fair value, though with no direct impact on our consolidated financial statements.

For additional information about Ambac’s debt obligations, see Note 13.

Long-Term Debt to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K.

Fixed maturity investment securities that are distressed Ambac-insured bonds have market risk characteristics that behave inversely to those associated with future financial guarantee claim payments.

Accordingly, such securities are excluded from the market risk sensitivity measures below.

Financial instruments of VIEs that are consolidated as a result of Ambac financial guarantees are also excluded from Ambac's measures of market risk.

Ambac’s exposure to such consolidated VIEs is generally limited to financial guarantees outstanding on the VIEs’ liabilities or assets.

Variable Interest Entities to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further information about VIEs consolidated as a result of Ambac’s financial guarantees.

Ambac utilizes various systems, models and sensitivity scenarios to monitor and manage market risk.

These models include estimates, made by management, which utilize current and historical market information.

The valuation results from these models could differ materially from amounts that would actually be realized in the market.

Financial instruments of VIEs that are consolidated as a result of Ambac's financial guarantees are excluded from the market risk measures below.

This market information is considered in management’s judgments about adverse sensitivity

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62 2020 FORM 10-K |

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scenarios that are reasonably possible to occur in the near-term.

The impact of these scenarios do not consider the possible simultaneous movement in other market rates or prices, actions of management or other factors that could lessen or worsen actual results.

For these reasons, the valuation results from these models could differ materially from amounts actually realized in the market.

The Company’s market risk exposures have changed over the course of 2020 primarily as a result of re-positioning of our investment and derivative portfolios.

Prior year-end quantitative market risk sensitivity disclosures below have been updated to conform with the current presentation.

Market Risk Sensitivities

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 se curities 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).

Financial instruments for which fair value may be affected by changes in interest rates consist primarily of fixed maturity investment securities, long-term debt and interest rate derivatives.

Increases to interest rates would result in declines in the fair value of our fixed maturity investment portfolio.

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 policies.

Conversely, interest rate increases would generally result in fair value gains on interest rate derivatives and lower the fair value of our debt obligations.

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 an 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 $0.4 million for a 1 basis point parallel shift in USD benchmark interest rates up or down at December 31, 2019 .

The following table summarizes the estimated change in fair value (based primarily on the valuation methodology discussed in Note 9.

Fair Value Measurements to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K) on these financial instruments, assuming immediate changes in interest rates at specified levels at December 31, 2019 :

($ in millions)

Estimated Change in Net Fair Value

Estimated Net Fair Value

300 Basis Point Rise

200 Basis Point Rise

100 Basis Point Rise

Base Scenario

100 Basis Point Decline (1)

200 Basis Point Decline (1)

Incorporates an interest rate floor of 0%

Due to the low interest rate environment as of December 31, 2019 , stress scenarios involving interest rate declines greater than 200 basis points are not meaningful to Ambac's portfolios.

Interest rate increases would also have a negative economic impact on expected future claim payments within the financial guarantee portfolio, most notably for RMBS and student loan policies.

An increase in interest rates of 0.50% could increase our estimate of expected losses for RMBS and student loans by approximately $45 million and $20 million, respectively.

| Ambac Financial Group, Inc.

59 2019 FORM 10-K |

Credit Spread Risk

Financial instruments that may be adversely affected by changes in credit spreads include Ambac’s outstanding credit derivative contracts, certain interest rate derivatives and investment assets.

Changes in spreads are generally caused by changes in the market’s perception of the credit quality of the underlying obligor.

Market liquidity and prevailing risk premiums demanded by market participants are also reflected in spreads and impact valuations.

The following table summarizes the estimated change in fair values on Ambac’s net derivative liabilities assuming immediate parallel shifts in reference obligation credit spreads related to written credit derivatives and counterparty credit spreads related to uncollateralized interest rate derivatives at December 31, 2019 .

It is more likely that actual changes in credit spreads will vary by obligor:

We also monitor our interest rates exposure through periodic reviews of projected cash flows and durations of our asset and liability positions.

The following table summarizes the estimated change in fair value of our fixed maturity investment portfolio of a hypothetical immediate increase in interest rates of 100 basis points across the yield curve as of December 31, 2020 and 2019:

($ in millions)

Estimated Change in Net Fair Value

Estimated Net Fair Value

250 Basis Point Widening

50 Basis Point Widening

Base Scenario

50 basis Point Narrowing

250 basis Point Narrowing

Also included in the fair value of derivatives is the effect of Ambac’s creditworthiness, which reflects market perception of Ambac’s ability to meet its obligations.

Generally, the need for an Ambac credit valuation adjustment is mitigated by the existence of collateral posting agreements under which adequate collateral has been posted.

Derivative contracts entered into with credit exposure to financial guarantee customers are not typically subject to collateral posting agreements.

As a result of runoff of uncollateralized interest rate and credit default swap liabilities, Ambac’s credit valuation adjustment included in the determination of fair value has resulted in $0.1 million reduction to derivative liabilities as of December 31, 2019 .

An increase in Ambac credit spreads as much as 250 basis points would result in less than a $1 million impact to the fair value of derivatives at December 31, 2019 .

Refer to Note 9.

Fair Value Measurements to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further information on measurement of the credit valuation adjustment.

Ambac’s fixed income investment portfolio contains securities with different sensitivities to and volatility of credit spreads.

Fixed income securities that are guaranteed by Ambac and were purchased in Ambac's investment portfolio have credit spread risk characteristics that behave inversely to those associated with future financial guarantee claim payments.

Accordingly such securities are excluded from the company's spread sensitivity measures.

The following table summarizes the estimated change in fair values of Ambac’s fixed income investment portfolio assuming immediate shifts in credit spreads across all holdings other than Ambac guaranteed securities at December 31, 2019 .

It is more likely that actual changes in credit spreads will vary by security:

December 31, 2020 2019

Fair value of fixed maturity investment (1)

$ 2,329 $ 2,343

Pre-tax impact of 100 basis point increase in interest rates

Decrease in dollars $ (69) $ (65)

As a percent of fair value 3 % 3 %

(1) Excludes investments in distressed Ambac-insured securities and securities held by VIEs consolidated as a result of Ambac’s financial guarantees

The following table presents the impact on the fair value of our long-term debt obligations and interest rate derivatives of a hypothetical immediate decrease in interest rates of 100 basis points across the yield curve as of December 31, 2020 and 2019:

($ in millions)

Estimated Change in Net Fair Value

Estimated Net Fair Value

250 Basis Point Widening

50 Basis Point Widening

Base Scenario

50 Basis Point Narrowing

250 Basis Point Narrowing

December 31, 2020 2019

Fair value of long-term debt including accrued interest (1)

$ (3,071) $ (3,274)

Pre-tax impact of 100 basis point decrease in interest rates

Increase in dollars $ (58) $ (33)

As a percent of fair value 2 % 1 %

Fair value of interest rate derivative net assets (liabilities) (1)

$ (21) $ (15)

Pre-tax impact of 100 basis point decrease in interest rates

Pre-tax loss from change in fair value in dollars $ (8) $ (36)

(1) Excludes long-term debt and derivative instruments of VIEs consolidated as a result of Ambac’s financial guarantees

Foreign Currency Risk

Ambac has financial instruments denominated in currencies other than the U.S.

dollar, primarily pounds sterling and euros.

These financial instruments are primarily invested assets of Ambac UK.

The following table summarizes the estimated net change in fair value of these financial instruments assuming immediate shifts in spot foreign exchange rates to U.S.

dollars as of December 31, 2019 .

Ambac has fixed maturity investments and investments in pooled funds denominated in currencies other than the U.S.

dollar, primarily British pounds sterling and euros.

These financial instruments are primarily invested assets of Ambac UK and are held in consideration of non-U.S.

dollar exposure in the financial guarantee insurance portfolio and operations of Ambac UK.

The adverse fair value impact of a stronger U.S.

dollar relative to other currencies on investment holdings would be directionally offset by the economic benefits to non-U.S.

dollar financial guarantees and other risk exposures.

The following table summarizes the estimated decrease in fair value of these financial instruments assuming immediate 20% strengthening of the U.S.

dollar relative to the foreign currencies as of December 31, 2020 and 2019:

($ in millions)

Estimated change in fair value

Change in Foreign Exchange Rates Against U.S.

December 31, 2020 2019

Fair value of investments denominated in currencies other than the U.S.

Pre-tax impact of 20% strengthening of the U.S.

dollar $ (91) $ (69)

(1) Excludes investments in distressed Ambac-insured securities and securities held by VIEs consolidated as a result of Ambac’s financial guarantees

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63 2020 FORM 10-K |

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Equity Sensitivity

Ambac’s investment portfolio includes equity and partnership interests in pooled funds with diverse asset holdings and strategies.

The table below summarizes the decrease in fair value of Ambac’s pooled fund investments that would occur assuming an immediate and uniform 10% decline in NAV of the funds.

The selection of a 10% fair value stress is made only as an illustration of the hypothetical impact of adverse market movements on Ambac’s investments with equity value sensitivity.

Actual market shocks could have materially different aggregate results and would likely not have a uniform impact on all funds given the diversity of the funds’ holdings and strategies.

($ in millions)

December 31, 2020 2019

Fair value of investments in pooled funds $ 544 $ 432

Pre-tax impact of 10% decline in NAV of the funds $ (54) $ (43)

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What changed 10-K

Item 7A. Quantitative and Qualitative Disclosures About Market Risk