Item 1A. Risk Factors
Item 1A. Risk Factors ($ in millions)
Capitalized terms used but not defined in this section shall have the meanings ascribed thereto in Part I, Item 1 in this Form 10-K or in Note 1. Background and Business Description to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K unless otherwise indicated.
Our risk factors are organized in the following sections
Page
Risks Related to AFG Common Shares 12
Risks Related to FG Insured Portfolio Losses 13
Risks Related to Capital, Liquidity and Markets 16
Risks Related to Financial and Credit Markets 20
Risks Related to the Company's Business 21
Risks Related to Taxation 26
Risks Related to Strategic Plan 26
Risks Related to AFG Common Shares
Investments in AFG's common stock are highly speculative and the price per share of AFG's common stock may be subject to a high degree of volatility, including significant price declines.
Ambac's legacy financial guarantee business is in run-off and faces significant risks and uncertainties described elsewhere in Part I, Item 1A. Risk Factors. In addition, Ambac's Specialty Property & Casualty Program Insurance and Managing General Agency / Underwriting businesses are new and relatively small and therefore are also subject to uncertainties described elsewhere in Part I, Item 1A. Risk Factors. Although AFG's common stock is listed on the New York Stock Exchange ("NYSE"), there can be no assurance as to the liquidity of the trading market or the price at which such shares can be sold. The price of the shares may decline substantially in response to
a number of events or circumstances, including but not limited to:
• adverse developments in our financial condition or results of operations;
• actual or perceived adverse developments with regards to AAC's residential mortgage-backed securities ("RMBS") litigations;
• changes in the actual or perceived risk within our FG insured portfolio, particularly with regards to concentrations of credit risk, such as in Puerto Rico;
• changes to regulatory status;
• changes in investors’ or analysts’ valuation measures for our stock;
• market perceptions of our success, or lack thereof, in pursuing and implementing our Specialty Property & Casualty Program Insurance and Managing General Agency / Underwriting businesses and our new business strategy more generally;
• the impact or perceived impact of any acquisition, disposition or other strategic transaction, including entry into a new line of business, on the value or long-term prospects of the Company; and
• results and actions of other participants in our industries.
In addition, the price of AFG's shares may be affected by the additional risks described below, including risks associated with AAC’s ability to deliver value to AFG. Investments in AFG's common stock should be considered highly speculative and may be subject to a high degree of volatility.
AFG may not be able to realize value from AAC; risk remains that AAC could be subject to rehabilitation proceedings.
The value of AFG's common stock is partially dependent upon realizing residual value and/or receiving dividends from AAC; the receipt of payments to be made by AAC pursuant to the intercompany expense sharing and cost allocation agreement (the "Cost Allocation Agreement"); the receipt of payments on investments made in surplus notes issued by AAC; and the receipt of payments on other investments. There can be no assurance that AFG will be able to realize residual value and/or receive dividends from AAC, which is in run-off. AFG's ability to realize residual value and/or receive dividends from AAC will depend upon, amongst other considerations, AAC's ability to satisfy all of its obligations that are senior to AFG's equity interests, including obligations to policyholders, holders of its indebtedness (including surplus notes, the Sitka AAC Note and the Tier 2 Notes) and holders of its preferred stock. AAC's ability to satisfy all of its obligations that are senior to AFG's equity depends on a number of considerations, including its ability to achieve recoveries, particularly from litigations concerning insured RMBS; mitigate losses from its insured portfolio, which is subject to significant risks and uncertainties, including as a result of varying potential perceptions of the value of AAC’s guarantees and securities; realize material value from its investment in Ambac UK; and repay its indebtedness in a timely manner such that accruing interest costs are manageable.
Increased loss development in the FG insured portfolio or significant losses or other events resulting from litigation,
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particularly the failure to achieve sufficient recoveries from existing litigations concerning insured RMBS, or the inability of AAC to pay its debts or other obligations may prompt OCI to determine that it is in the best interests of policyholders to initiate rehabilitation proceedings with respect to AAC or to issue supervisory orders that impose restrictions on AAC, either preemptively or in response to any such event or circumstance.
If OCI were to decide to initiate rehabilitation proceedings with respect to AAC, adverse consequences may result, including, without limitation and absent enforceable protective injunctive relief, the assertion of damages by counterparties, the acceleration of losses based on early termination triggers, and the loss of control rights in insured transactions. Any such consequences may reduce or eliminate any residual value of AAC for AFG. For example, if AAC were to lose control rights, its ability to mitigate loss severities and realize remediation recoveries will be compromised, and actual ultimate losses in the insured portfolio could exceed current loss reserves. Additionally, the rehabilitator would assume control of all of AAC’s assets and management of AAC. In exercising control, the rehabilitator would act solely for the benefit of policyholders, which may result in material adverse consequences for our security holders. Similar risks would arise if Ambac UK were to become subject to a proceeding to protect the interests of its policyholders, in which case AAC's ability to realize value from Ambac UK (and consequently AFG's ability to realize value from AAC) would diminish. If OCI were to issue supervisory orders imposing restrictions on AAC, AAC's ability to satisfy its obligations to policyholders or creditors, or its ability to deliver value to AFG, may be significantly constrained.
Due to the above considerations, as well as applicable legal and contractual restrictions described elsewhere herein, it is highly unlikely that AAC will be able to pay AFG any dividends for the foreseeable future. Furthermore, the payments to be made to AFG under the intercompany Cost Allocation Agreement are subject to, in certain instances, OCI approval, making the amount and timing of such payments uncertain.
Risks Related to FG Insured Portfolio Losses
Loss reserves for the FG business may not be adequate to cover potential losses, and changes in loss reserves may result in further volatility of net income and comprehensive income.
Loss reserves are established when management has observed credit deterioration in its insured credits. Loss reserves established with respect to our non-derivative FG insurance policies issued to beneficiaries, including VIEs for which we do not consolidate the VIE, are based upon estimates and judgments by management, including estimates and judgments with respect to the probability of default; the severity of loss upon default; management’s ability to execute policy commutations, restructurings and other loss mitigation strategies; and estimated remediation recoveries for, among other things, breaches by RMBS issuers of representations and warranties. The objective of establishing loss reserve estimates is not to, and our loss reserves do not, reflect the worst possible outcomes. While our reserving scenarios reflect a wide range of possible outcomes (on a probability weighted basis), reflecting
the significant uncertainty regarding future developments and outcomes, our loss reserves may change materially based on future developments. As a result of inherent uncertainties in the estimates and judgments made to determine loss reserves, there can be no assurance that either the actual losses in our financial guarantee insurance portfolio will not exceed such reserves or that our reserves will not materially change over time as circumstances, our assumptions, or our models change.
Catastrophic public health or environmental events, like the COVID-19 pandemic or those associated with hurricanes, earthquakes, wildfires and droughts, that result in material disruption of economic activity, loss of human life or significant property damage, can have a materially negative impact on the financial performance of issuers of public finance, structured finance, investor owned utility, privatized military housing and other obligations insured by AAC. Such stresses could result in liquidity claims and/or permanent losses on obligations of those obligations.
The COVID-19 pandemic caused economic and financial disruptions that adversely affected, and may continue to adversely affect, our business and results of operations. In particular, Ambac insures the obligations of a number of issuers that have been, or may in the future be, substantially affected by the prolonged economic effects of COVID-19, such as municipalities and securitizations, including those backed by consumer loans such as mortgages or student loans. As described more fully in Management's Discussion and Analysis of Financial Condition and Results of Operations, municipalities and their authorities, agencies and instrumentalities, especially those dependent on narrow revenue streams flowing from particular economic activities, such as the collection of hotel occupancy taxes, have suffered, and may to continue to suffer, from depressed revenues due to the lingering negative economic impact brought about by the COVID-19 pandemic in certain parts of the economy. Furthermore, securitizations dependent on cash flows from payments on mortgage loans have experienced, and may continue to experience, shortfalls in receipts due to borrower nonpayments. Notably, in response to the COVID-19 pandemic, the U.S. Federal government and State governments and their agencies adopted policies or guidelines to provide emergency relief to consumers, such as limiting debt collection efforts, encouraging or requiring extensions, modifications or forbearance with respect to certain loans and fees, and establishing foreclosure and eviction moratoriums. Most of these policies or guidelines have since expired, but as a result of the impact of delays in mortgage foreclosures and of potential forbearance-related mortgage loan modifications AAC may experience higher losses in its insured portfolio of RMBS securities. See Part II, Item 7 of this Form 10-K, Management's Discussion and Analysis of Financial Condition and Results of Operations, Executive Summary, Financial Guarantees in Force, Liquidity and Capital Resources and Balance Sheet for further detail.
AAC also insures the obligations of a number of issuers that have been, or may in the future be, substantially affected by environmental or other public health events, including flooding, hurricanes, earthquakes, wildfires and drought. In addition, certain catastrophic environmental events, notably wildfires, can
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result in significant potential liabilities for issuers such as investor-owned utilities, that increase bankruptcy risk and the potential default on obligations of the issuer insured by AAC.
The ultimate impact of a catastrophic public health event like COVID-19 or a catastrophic environmental event on issuers and their obligations, and the economy in general, is by its very nature uncertain, and will be determined by a number of factors including, but not limited to, the depth and duration of a particular crisis; the extent to which affected consumers, businesses, municipal entities and other debtors or sources of revenues recover from depressed economic circumstances, and the timelines for such recoveries; the level and efficacy of government intervention or support for municipal entities, consumers, businesses and the financial markets via emergency relief measures; the availability of insurance; the availability of cost-effective financing; management of public health crisis remediation efforts; the effectiveness of other public or private crisis management efforts, mitigation measures or support; and certain socio-economic variables, such as unemployment levels. Consequently, if issuers affected by such catastrophic events do not have sufficient resources or financial flexibility, receive adequate measures of support or realize the appropriate level of economic recovery, their ultimate ability to service the debt insured by Ambac could be materially impaired and Ambac could suffer material permanent losses and therefore may have an adverse effect on our results of operations and financial condition.
AAC insures obligations of the Commonwealth of Puerto Rico, including certain of its authorities and public corporations that are or were subject to Title III or Title VI proceedings under the Puerto Rico Oversight, Management and Stability Act ("PROMESA"). AAC has made, and will continue to be required to make significant amounts of policy payments over the next several years, which will lead to material permanent losses. The recoverability of these policy payments is subject to uncertainty as well as variability in terms of the value of portions of the plan consideration to be made available under the various PROMESA plans of adjustment and qualifying modifications for the obligations AAC insures. While we believe our reserves are adequate to cover losses on Puerto Rico insured bonds, there can be no assurance that AAC may not incur additional losses in the future. Such losses may have a material adverse effect on Ambac's results of operation and financial condition.
AAC has exposure to the Commonwealth of Puerto Rico (the "Commonwealth"), including its authorities and public corporations. Each has its own credit risk profile attributable to, as applicable, discrete revenue sources, direct general obligation pledges and/or general obligation guarantees. AAC had approximately $1,054 of net par exposure to the Commonwealth and these instrumentalities as of December 31, 2021. Components of the overall Puerto Rico net par outstanding include capital appreciation bonds that 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. The outstanding net insured amount including accretion on capital
appreciation bonds is approximately $1,280 as of December 31, 2021. Total net insured lifetime debt service (net par and interest) to the Commonwealth of Puerto Rico and its instrumentalities was approximately $2,423 as of December 31, 2021.
As of July 27, 2021, AAC had signed on to (i) the PRIFA Related Plan Support Agreement (“PRIFA PSA”), dated as of July 27, 2021, by and among the Federal Oversight and Management Board for Puerto Rico, as representative of the Commonwealth of Puerto Rico (the “Oversight Board”), AAC, Financial Guaranty Insurance Company (“FGIC”), and certain holders of bonds issued by PRIFA, (ii) the PRHTA/CCDA Related Plan Support Agreement (“PRHTA/CCDA PSA”), dated as of May 5, 2021, by and among the Oversight Board, as representative of the Commonwealth of Puerto Rico and Puerto Rico Highways and Transportation Authority (“PRHTA”), and certain creditors of the Commonwealth and PRHTA, and (iii) the Amended and Restated Plan Support Agreement ("Amended and Restated GO / PBA PSA"), dated as of July 12, 2021, by and among the Oversight Board, as representative of the Commonwealth of Puerto Rico, Puerto Rico Public Buildings Authority (“PBA”) and the Employee Retirement System of the Government of the Commonwealth of Puerto Rico, and certain other creditors of the Commonwealth and PBA. As of the October 18, 2021 voting deadline, AAC had voted to support the amended Commonwealth Plan of Adjustment and as of the November 3, 2021 voting deadline, AAC voted to support the Title VI Qualifying Modifications for both PRIFA and CCDA (the "PRIFA QM" and "CCDA QM", respectively). On January 18, 2022, Judge Laura Taylor Swain, U.S. District Court for the District of Puerto Rico, confirmed a modified version of the Eighth Amended Title III Joint Plan of Adjustment of the Commonwealth of Puerto Rico ("Eighth Amended POA"). On January 22, 2022, Judge Swain approved the PRIFA QM and the CCDA QM.
While the Eighth Amended POA, the PRIFA QM, and CCDA QM are expected to become effective on or before March 15, 2022, they remain subject to appeal. On January 28, 2022, Federación de Maestros de Puerto Rico, Inc., Grupo Magisterial Educadores(as) por la Democracia, Unidad, Cambio, Militancia y Organización Sindical, Inc., and Unión Nacional de Educadores y Trabajadores de la Educación, Inc. (collectively, the"Teachers' Unions") filed a notice of appeal of the Court's order confirming the Eighth Amended POA. A number of credit unions (the "Credit Unions") filed their notice of appeal on the same day. On February 1, 2022, the Teachers' Union moved for a stay of the confirmation order while the appeal is pending. On February 3, 2022, Suiza Dairy Corp. filed its notice of appeal of the Court's order confirming the Eighth Amended POA. On February 4, 2022, Asociación Puertorriqueña de la Judicatura, Inc. ("APJ") filed a notice of appeal of the confirmation order, as well as a motion for a stay of the same pending appeal. The Credit Unions filed their motion for a stay pending appeal on February 4, 2022. Briefing in connection with the motions for a stay pending appeal was complete as of February 17, 2022. The Court has taken the motions on submission. Because the effective dates of the PRIFA QM and CCDA QM are conditioned on the occurrence of the effective date of the Eighth Amended POA, a stay pending the appeal of the Eighth Amended POA would delay the effective dates for each of the Eighth Amended POA, PRIFA QM, and CCDA QM.
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The Plan of Adjustment for the PRHTA ("PRHTA POA") is expected to be filed prior to March 31, 2022, with a confirmation hearing expected to follow later in 2022.
As a result of the developments described in this Risk Factor and elsewhere in this Annual Report on Form 10-K (see Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Guarantees in Force, and Note 6. Financial Guarantees in Force to the Consolidated Financial Statements included in Part II, Item 8 in this Annual Report on Form 10-K), the Commonwealth and certain of its instrumentalities are continuing to default on debt service payments, including payments owed on bonds insured by AAC. AAC has made, and will continue to be required to make, significant amounts of policy payments over the next several years which will lead to material permanent losses. The recoverability of these policy payments is subject to uncertainty as well as variability as it relates, in particular, to the realizable value of the contingent value instrument ("CVI") portions of the plan consideration to be made available under the recently-confirmed Commonwealth Plan of Adjustment, PRIFA QM, and CCDA QM, and the proposed PRHTA POA.
The outcome of the pending appeal of order confirming the Eighth Amended POA remains uncertain at this time and no assurances can be given that the PRHTA POA will be confirmed or that material changes will not be made to the PRHTA POA prior to confirmation. Additionally, it is possible that certain restructuring process solutions, together with associated legislation, budgetary, and/or public policy proposals could be adopted that significantly further impair our exposures or impact the value of the creditor consideration, including the new GO and PRHTA bonds and CVI, contemplated by the Commonwealth Plan of Adjustment, the CCDA QM, the PRIFA QM, and the PRHTA POA. Furthermore, it is also possible that economic or demographic outcomes may be as, or worse than, forecasted in the Commonwealth Fiscal Plan, which could result in performance-dependent sources of recovery like the CVI to produce no value or less value than expected based on current circumstances and assumptions. Given the potential variability of the CVI together with the aforementioned uncertainties and risks related to the consideration to be made available under various plans of adjustment and qualifying modifications as well as to the risk related to the confirmation of the PRHTA POA, there can be no assurance that AAC will not experience losses materially exceeding current reserves whereby AAC's financial condition would be materially adversely affected.
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, 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. Changes to our loss reserves may have a material adverse impact on AAC’s results of operations and financial condition.
AAC is subject to credit risk and other risks in its insured portfolio, including related to RMBS and securities backed by student loans, Public Finance obligations, and International obligations. We are also
subject to risks associated with adverse selection as our insured portfolio runs off.
Performance of our insured FG transactions, including (but not limited to) RMBS transactions and those involving securities backed by student loans, can be adversely affected by general economic conditions, such as recession, unemployment levels, underemployment, home prices that decline or do not increase in the patterns assumed in our models, increasing foreclosure rates and unavailability of consumer credit, mortgage product attributes, such as interest rate adjustments and balloon payment obligations, borrower and/or originator fraud or misrepresentations, mortgage and student loan servicer performance or underperformance and financial difficulty, such as risks related to whether the servicer may be required to delay the remittance of any cash collections held by it or received by it after the time it becomes subject to bankruptcy or insolvency proceedings.
While further deterioration in the performance of consumer assets, including mortgage-related assets and student loans, may occur, the timing, extent and duration of any future deterioration of the credit markets is unknown, as is the impact on potential claim payments and ultimate losses on the securities within our insured FG portfolio. In addition, there can be no assurance that any governmental or private sector initiatives designed to address such credit deterioration in the markets will be successful or inure to the benefit of the transactions we insure. For example, any initiative which permits the discharge of student loan debt in bankruptcy may adversely affect our portfolio. Similarly, servicer settlements with governmental authorities regarding foreclosure or servicing irregularities are generally designed to protect borrowers and may increase losses on securities we insure. In particular, the student loan industry and, specifically, trusts with securities insured by AAC have been subject to heightened Consumer Finance Protection Bureau ("CFPB") scrutiny and enforcement action over servicing and collections practices and potential chain of title issues and, consequently, any settlements, orders or penalties resulting from CFPB actions, or any failure on the part of servicers or other parties asserting claims against delinquent borrowers to establish title to the loans, could lead to increased losses on securities we insure.
In addition, there can be no assurance that AAC would be successful, or that it would not be delayed, in enforcing the subordination provisions, credit enhancements or other contractual provisions of RMBS or any other security that AAC insures.
Some issuers in AAC's Public Finance insured portfolio are experiencing fiscal stress that could result in increased losses on those obligations or increased liquidity claims, including losses or claims resulting from payment defaults, Chapter 9 bankruptcy or other restructuring proceedings or loss of market access. Issuers of public finance obligations insured by AAC have reported, or may report, budget shortfalls, significantly underfunded pensions or other fiscal stresses that imperil their ability to pay debt service or will require them to significantly raise taxes and/or cut spending in order to satisfy their obligations. Furthermore, over time, the consequences of poor public policy decisions by state and local governments or increases in tax burdens can impact demographic trends, such as
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out-migration from one state or municipality to another, that may negatively impact the creditworthiness of related issuers. Some issuers of obligations insured by AAC have declared payment moratoriums, defaulted or filed for bankruptcy or similar debt adjustment proceedings, raising concerns about their ultimate ability or willingness to service the debt insured by AAC and AAC's ability to recover claims paid in the future. If the issuers of the obligations in the public finance portfolio are unable to raise taxes, cut spending, or receive federal or state assistance, or if such issuers default or file for bankruptcy under Chapter 9 or for similar relief under other laws that allow for the adjustment of debts, AAC may experience liquidity claims and/or ultimate losses on those obligations, which could adversely affect the Company's business, financial condition and results of operations. Issuers in Chapter 9 or similar proceedings may obtain judicial rulings and orders that impair creditors' rights or their ability to collect on amounts owed. In certain cases, judicial decisions may be contrary to AAC's expectations or understanding of the law or its rights thereunder, which may lead to worse outcomes in Chapter 9 or similar proceedings than anticipated at the outset.
As the runoff of the insured portfolio continues, the proportion of exposures we rate as below investment grade relative to the aggregate insured portfolio is likely to increase, leaving the portfolio increasingly concentrated in higher risk exposures. This risk may result in greater volatility or have adverse effects on the Company's results from operations and on our financial condition.
We may not be able to effectively reduce FG insured exposures. Measures taken to reduce such risks may have an adverse effect on the Company's operating results or financial position.
In pursuing the objective of improving our financial position, we are seeking to terminate, commute, reinsure or otherwise reduce FG insured exposures. De-risking transactions may not be feasible or economically viable. We cannot provide any assurance that any such transaction will be consummated in the future, or if it is, as to the timing, terms or conditions of any such transaction. Even if we consummate one or more of such transactions, doing so may ultimately prove to be unsuccessful in creating value for any or all of our stakeholders and may negatively impact our operating results or financial position.
Our credit risk management policies and practices may not adequately identify significant risks.
As described in Part I, Item 1, “Risk Management” in this Form 10-K, we have established risk management policies and practices which seek to mitigate our exposure to credit risk in our insured portfolio. Ongoing surveillance of credit risks in our insured portfolio is an important component of our risk management process. These policies and practices in the past have not insulated us from risks that were unforeseen and which had unanticipated loss severity, and such policies and practices may not do so in the future. There can be no assurance that these policies and practices will be adequate to avoid future losses. If we are not able to identify significant risks, we may not be able to timely mitigate such risks, thereby increasing the amount of losses to which we are exposed. An inability to identify significant risks could also result in the failure to establish loss reserves that are sufficient in relation to such risks.
We use analytical models and tools to assist our projection of performance of our insured FG obligations and our investment portfolio but actual results could differ materially from the model and tool outputs and related analyses.
We rely on internally and externally developed complex financial models, including default models related to RMBS and a waterfall tool provided by a nationally recognized vendor for RMBS and student loan exposures, to project performance of our insured FG obligations and similar securities in our investment portfolio. These models and tools assume various conditions, probability scenarios, facts and circumstances, and there can be no assurance that such models or tools accurately predict or measure the quantum of losses, loss reserves and timing of losses. Differences in the models and tools that we employ, uncertainties or flaws in these financial models and tools, or faulty assumptions inherent in these financial models and tools or those determined by management could lead to material changes in projected outcomes, and could include increased losses, loss reserves and/or credit impairments on the investment portfolio. Moreover, estimates of transaction performance depend in part on the interpretation of contracts and other bases of our legal rights. Such interpretations may prove to be incorrect or different interpretations may be employed by bond trustees and other transaction participants and, ultimately courts, which could lead to increased losses, loss reserves and/or investment impairments.
Political developments may materially adversely affect our insured portfolio.
Our insured exposures and our results of operations can be materially affected by political developments at the federal, state and/or local government levels. Government shutdowns, trade disputes, political turnover, judicial decisions, adverse changes in federal funding, or poor public policy decision making could disrupt the national and local economies where we have insured exposures. In addition, we are exposed to correlation risk as a result of the possibility that multiple credits may concurrently and/or consecutively experience losses or increased stress as a result of any such event or series of events.
Risks Related to Capital, Liquidity and Markets
Our inability to realize the expected recoveries included in our financial statements could adversely impact our liquidity, financial condition and results of operations and the value of our securities, including the Sitka Senior Secured Notes and Tier 2 Notes.
AAC is pursuing claims in litigation with respect to certain RMBS transactions that it insured. These claims are based on, among other things, representations with respect to the characteristics of the securitized loans, the absence of borrower misrepresentations in the underlying loan pools or other misconduct in the origination process, the compliance of loans with the prevailing underwriting policies, and compliance of the RMBS transaction counterparties with policies and procedures related to loan origination and securitization. In such cases, where contract claims are being pursued, the sponsor of the transaction is obligated to repurchase, cure or substitute
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collateral for any loan that breaches the representations and warranties, subject to the terms and conditions of the applicable contracts. However, generally the sponsors have not honored those obligations and have vigorously defended claims brought against them.
As of December 31, 2021, we have estimated RMBS R&W subrogation recoveries of $1,704 (net of reinsurance) included in our financial statements. These estimated recoveries are based on the contractual claims brought in the aforementioned litigations and represent a probability-weighted estimate of amounts we expect to recover under various possible scenarios. The estimated recoveries we have recorded do not represent the best or the worst possible outcomes with respect to any particular transaction or group of transactions.
There can be no assurance that AAC will be successful in prosecuting its claims in the RMBS litigations. The outcome of any litigation, including the RMBS litigations, is inherently unpredictable, including because of risks intrinsic in the adversarial nature of litigation. Motions made to the court, rulings and appeals - in the cases being prosecuted by AAC or in other relevant cases - could delay or otherwise impact any recovery by AAC. Moreover, rulings that may be adverse to AAC (in any of its RMBS litigations, as well as in other RMBS cases in which it is not a party, including an unrelated RMBS case with an appeal argued on February 8, 2022 at the New York Court of Appeals (decision pending) involving issues relevant to AAC’s breach of contract claims, which could affect one of the bases supporting the inclusion of all breaching loans in AAC's breach-of-contract cases) could adversely affect AAC’s ability to pursue its claims, or the amount or timing of any recovery, or negatively alter settlement dynamics with RMBS litigation defendants.
Due to the foregoing factors, any litigation award or settlement may be for an amount less than the amount necessary (even when combined with other pledged collateral) to pay the Sitka Senior Secured Notes or the Tier 2 Notes, which could have a material adverse effect on our financial condition or results of operations. Such an award or settlement would also impair AAC’s ability to repay its outstanding surplus notes, on a timely basis or at all. In the event that AAC is unable to satisfy its obligations with respect to the Sitka Senior Secured Notes or the Tier 2 Notes, holders will have the right to foreclose on any available collateral and to sue AAC for failure to make required payments; however, there can be no assurance that the sale of collateral will produce proceeds in an amount sufficient to pay any or all amounts due on the Sitka Senior Secured Notes or the Tier 2 Notes, as the case may be, or that holders will be successful in any litigation seeking payments from AAC.
Even if AAC were to recover the estimated RMBS R&W subrogation recoveries of $1,704 (net of reinsurance) included in our financial statements and pay off or cause to be paid off the Sitka Senior Secured Notes and the Tier 2 Notes, AAC may still be unable to deliver value to AFG, through dividends or otherwise. In such a scenario, AAC may not have sufficient capital and surplus, or may not be permitted by OCI, to pay off its surplus notes or a substantial portion of them, whether immediately following the resolution of the RMBS litigations or within a reasonable timeframe thereafter. If the surplus notes or a substantial portion of them were to remain outstanding for a
significant period of time after the resolution of the RMBS litigations, AAC's obligation to pay interest on the surplus notes would continue to grow, which would diminish AAC's financial flexibility and reduce the likelihood that AAC will be able to pay dividends or otherwise bring value to AFG.
Additionally, while AAC may pursue settlement negotiations, there can be no assurance that any settlement negotiations will materialize or that any settlement agreement can be reached on terms acceptable to AAC, or at all. Depending on the length of time required to resolve these litigations, either through settlement or at trial, AAC could incur greater litigation expenses than currently projected. If a case is brought to trial, AAC’s ultimate recovery would be subject to the additional risks inherent in any trial, including adverse findings or determinations by the trier of fact or the court, which could materially adversely impact the value of our securities, including the Sitka Senior Secured Notes and the Tier 2 Notes.
Any litigation award is subject to risks of recovery, including that a defendant is unable to pay a judgment that AAC may obtain in litigation. In some instances, AAC also has claims against a parent or an acquirer of the counterparty. However, AAC may not be successful in enforcing its claims against any successor entity.
The RMBS litigations could also be adversely affected if AAC does not have sufficient resources to actively prosecute its claims or becomes subject to rehabilitation, liquidation, conservation or dissolution, or otherwise impaired by actions of OCI.
Our ability to realize the estimated RMBS R&W subrogation recoveries included in our financial statements and the timing of the recoveries, if any, is subject to significant uncertainty, including the risks described above and uncertainties inherent in the assumptions used in estimating such recoveries. The amount of these subrogation recoveries is significant and if we were unable to recover all such amounts, our stockholders’ equity as of December 31, 2021, would decrease from $1,098 to $(606).
We expect to recover material amounts of claims payments through remediation measures, including the litigation described above, as well as through cash flows in the securitization structures of transactions that AAC insures. Realization of such expected recoveries is subject to various risks and uncertainties, including the rights and defenses of other parties with interests that conflict with AAC’s interests, the performance of the collateral and assets backing the obligations that AAC insures, and the performance of servicers involved in securitizations in which AAC participates as insurer. Additionally, our ability to realize recoveries in insured transactions may be impaired if the continuing orders of the Rehabilitation Court are not effective.
Adverse developments with respect to any of the factors described above may cause our recoveries to fall below expectations, which could have a material adverse effect on our financial condition, including our capital and liquidity, and may result in adverse consequences such as impairing the ability of AAC to honor its financial obligations, particularly its outstanding debt and preferred stock obligations; the initiation of rehabilitation proceedings against AAC; eliminating or reducing the possibility of AAC delivering value to AFG, through
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dividends or otherwise; diminished business prospects due to third party concerns about our ability to recover losses; and a significant drop in the value of securities issued or insured by AFG or AAC, including the Sitka Senior Secured Notes and the Tier 2 Notes.
Ambac’s estimate of RMBS litigation recoveries is subject to significant uncertainty and changes to the estimate could adversely impact its liquidity, financial condition and results of operations.
For Ambac’s RMBS cases for which it records an RMBS R&W subrogation recovery in its financial statements, Ambac has obtained loan files from the relevant original pool and has conducted loan file re-underwriting to derive a breach rate that is extrapolated to estimate the damages Ambac expects to recover. Ambac does not estimate an RMBS R&W subrogation recovery for litigations where its sole claim is for fraudulent inducement. Nor does Ambac include potential recoveries attributable to pre-judgment interest in the estimate of subrogation recoveries.
The amount estimated for purposes of Ambac’s RMBS R&W subrogation recovery and the amount Ambac may ultimately receive is subject to significant uncertainty, as described in the immediately preceding risk factor. Ambac’s findings and assumptions regarding collateral performance and Ambac’s expectations with respect to the outcome of the RMBS litigations and related timing have a significant impact on Ambac’s estimated RMBS R&W subrogation recovery. If these findings, assumptions or estimates prove to be incorrect or otherwise do not support our claims, actual recoveries could differ materially from those estimated. Although Ambac believes that its methodology for estimating recoveries is appropriate, the methodologies Ambac uses to estimate expected collateral losses and specific transaction performance may not be similar to methodologies used by Ambac’s competitors, counterparties or other market participants. The determination of expected RMBS R&W subrogation recoveries is an inherently subjective and complex process involving numerous estimates and assumptions and judgments by management, using both internal and external data sources to derive a specific transaction's cash flows. Ambac reevaluates its estimated R&W recoveries on a quarterly basis in connection with the preparation of its financial statements. See “Critical Accounting Policies and Estimates” in Part II, Item 7, Note 2. Basis of Presentation and Significant Accounting Policies and Note 7. Insurance Contracts to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K for the fiscal year ended December 31, 2021. As a result of any reevaluation, the estimated amount of Ambac’s R&W recovery may be adjusted downward due to, among other things, changes in law or developments in RMBS litigation cases that impact our estimated recoveries, changes in management's view of such estimated recoveries or timing of receipt thereof and/or changes in the loss reserves related to such recoveries, and any adjustment may be material. A reduction in estimated R&W recoveries may result in material changes in Ambac’s financial condition, including its capital and liquidity. Management makes no representation that the estimated R&W recoveries will not be reduced in the future, possibly materially, including in the near term. As a result of the foregoing factors, Ambac’s current estimates may not reflect Ambac’s ultimate recovery, and management makes no representation that the actual amounts
recovered, if any, will not differ materially from those estimated. The failure of Ambac’s actual recoveries to meet or exceed its current estimates could result in a material adverse effect on Ambac’s financial condition, including its capital and liquidity.
AAC's ability to generate the significant amount of cash needed to service its debt and financial obligations and its ability to refinance all or a portion of its indebtedness or obtain additional financing depends on many factors beyond our control.
AAC is highly leveraged. AAC’s ability to make payments on and/or refinance its debt and to fund its operations will depend on its ability to generate substantial operating cash flow and on the performance of the FG insured portfolio. AAC’s cash flow generation will depend on receipt of premiums, investment returns, receipts from subsidiaries and expected litigation recoveries, offset by policyholder claims, commutation payments, reinsurance premiums, operating and loss adjustment expenses, and interest expense, 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. There is substantial risk that AAC may not have the financial resources necessary to pay its debts in full and on time due to risks associated with its cash flow, expected litigation recoveries and insured portfolio, as discussed elsewhere in these Risk Factors.
As of December 31, 2021, AAC had approximately $1,508 of indebtedness outstanding (the Tier 2 Notes and the Sitka AAC Note) that are senior to its surplus notes. AAC had $853 principal balance of surplus notes outstanding as of December 31, 2021. The Tier 2 Notes and the Sitka AAC Note are secured by potential litigation recoveries (and in the case of the Sitka AAC Note, other assets), the receipt of which is highly uncertain. Failure to achieve litigation recoveries in an amount sufficient to repay the Tier 2 Notes and the Sitka AAC Note would materially weaken AAC’s ability to service its indebtedness.
If AAC 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. The value of assets to be sold, including collateral for the Sitka AAC Note and the Tier 2 Notes in the event of liquidation, will depend on market and economic conditions, the availability of buyers, the requirements and conditions of local law, including regulatory restrictions, and other factors that may result in AAC or a party enforcing rights against AAC to be unable to receive proceeds sufficient to discharge debts or other obligations. Furthermore, the ability of creditors or claimants to realize upon any assets, including collateral, may also be subject to bankruptcy and insolvency law limitations or similar limitations applicable in insurance company rehabilitation or liquidation proceedings. Because of these and other factors beyond our control, AAC may be unable to pay or discharge the principal, interest or other amounts on its indebtedness when due or ever, which may precipitate defaults, rehabilitation proceedings, increased supervision by OCI, enforcement actions by creditors, policyholders and/or other claimants, and other actions by or against AAC or AFG that may
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further impair AAC's creditworthiness and value or the creditworthiness and value of AFG.
AAC has substantial indebtedness, which could adversely affect our financial condition, operational flexibility and our ability to obtain financing in the future.
AAC's substantial indebtedness could have significant consequences for our financial condition and operational flexibility. For example, it could:
• increase our vulnerability to general adverse economic, competitive and industry conditions;
• limit our ability to obtain additional financing in the future for working capital, capital expenditures, payment of policyholder claims, debt service requirements, acquisitions, general corporate purposes or other purposes on satisfactory terms or at all;
• require AAC to dedicate a substantial portion of its cash flow from operations to the payment of indebtedness, thereby reducing the funds available for operations and to fund the execution of key strategies;
• limit or restrict AFG from making strategic acquisitions or cause us to make non-strategic divestitures;
• limit AAC's ability or increase the costs to refinance indebtedness or repay such indebtedness due to ongoing interest accretion;
• limit our ability to attract and retain key employees; and
• limit our ability to enter into hedging transactions by reducing the number of counterparties with whom we can enter into such transactions, as well as the volume of those transactions.
Despite current indebtedness levels, we may incur additional debt. While restrictive covenants in certain of our contracts may limit the amount of additional indebtedness AAC may incur, we may obtain waivers of those restrictions and incur additional indebtedness in the future. In addition, if Ambac incurred indebtedness, its ability to make scheduled payments on, or refinance, any such indebtedness may depend on the ability of our subsidiaries to make distributions or pay dividends, which in turn will depend on their future operating performance and contractual, legal and regulatory restrictions on the payment of distributions or dividends to which they may be subject. There can be no assurance that any such dividends or distributions would be made. This could further exacerbate the risks associated with AAC's substantial leverage.
Revenues and cash flow would be adversely impacted by a decline in realization of installment premiums.
A significant percentage of our FG premium revenue is attributable to installment premiums. The amount of installment premiums we actually realize could be reduced in the future due to factors such as early termination of insurance contracts, accelerated prepayments of underlying obligations or insufficiency of cash flows (by the premium paying entity). Such reductions would result in lower revenues.
The composition of the securities in our investment portfolio exposes us to greater risk than before we invested in alternative assets.
Each of AAC and Ambac UK maintains a portion of its investment portfolio in below investment grade securities, equities and/or alternative assets, such as hedge funds, with the objective to increase risk-adjusted portfolio returns. Investments in below investment grade securities, equities and alternative assets could expose AAC and/or Ambac UK to greater earnings volatility, increased losses and decreased liquidity in the investment portfolio.
We may have future capital needs and may not be able to obtain third-party financing or raise additional third-party capital on acceptable terms, or at all.
An inability to obtain third-party debt financing or raise additional third-party capital, when required by us or when business conditions warrant, could have a material adverse effect on our business, financial condition and results of operations. Our financial condition, the risks described elsewhere in Part I, Item 1A of this Form 10-K for the fiscal year ended December 31, 2021, as well as other factors, may constrain our financing abilities. Our ability to secure third-party financing will depend upon our future operating performance, regulatory conditions, the availability of credit generally, economic conditions and financial, business and other factors, many of which are beyond our control. The market conditions and the macroeconomic conditions that affect our business could have a material adverse effect on our ability to secure third-party financing on favorable terms, if at all.
If third-party financing is not available when needed, or is available on unfavorable terms, we may be unable to take advantage of business opportunities, respond to competitive pressures or effectively and efficiently manage our balance sheet, any of which could have a material adverse effect on our business, financial condition and results of operations.
The determination of the amount of credit impairments taken on our investments is highly subjective and could materially impact our results of operations or financial position.
The determination of the amount of credit impairments on our investments varies by investment type and is based upon our periodic evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available. Management updates its evaluations regularly and reflects changes in impairments as such evaluations are revised. There can be no assurance that management has accurately assessed the level of impairments taken in our financial statements. Furthermore, additional impairments may need to be taken in the future and historical trends may not be indicative of future impairments. We use financial models and tools to project impairments. Differences and flaws in these models and tools, and/or faulty assumptions inherent in these models and tools and those determined by management, could lead to increased impairments.
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Risks Related to the Financial and Credit Markets
Changes in prevailing interest rate levels and market conditions could adversely impact our business results and prospects.
Increases in prevailing interest rate levels can adversely affect the value of our investment portfolio and, therefore, our financial strength. In the event that investments must be sold in order to pay claims, to pay debt obligations, to meet collateral posting requirements or to meet other liquidity needs, such investments would likely be sold at discounted prices. Additionally, increasing interest rates would have an adverse impact on AAC's insured portfolio. For example, increasing interest rates could result in higher claim payments in respect of defaulted obligations that bear floating rates of interest. Higher interest rates can also lead to increased credit stress on consumer asset-backed transactions (as the securitized assets supporting a portion of these exposures are floating rate consumer obligations), slower prepayment speeds and resulting “extension risk” relative to such consumer asset-backed transactions in our insured and investment portfolios, and decreased refinancing activity.
Decreasing interest rates could result in early terminations of FG insurance policies in respect of which AAC and Ambac UK are paid on an installment basis and do not receive a termination premium, thus reducing premium earned for these transactions. Decreases in prevailing interest rates may also limit growth of, or reduce, investment income and may adversely impact interest rate swap values.
Our investment portfolio may also be adversely affected by credit rating downgrades, ABS and RMBS prepayment speeds, foreign exchange movements, spread volatility, and credit losses.
We are subject to credit risk throughout our FG businesses, including large single risks, risk concentrations, correlated risks and reinsurance counterparty credit risk.
We are exposed to the risk that issuers of debt which AAC and Ambac UK have insured, issuers of debt which we hold in our investment portfolios, reinsurers and other contract counterparties of AAC and Ambac UK (including derivative counterparties) may default in their financial obligations, whether as the result of insolvency, lack of liquidity, operational failure, fraud or other reasons. These credit risks could cause increased losses and loss reserves, and/or estimates of credit impairments and mark-to-market losses, in amongst other places, our investment portfolios which materially adversely impact our results of operations and financial strength. Such credit risks may be in the form of large single risk exposures to particular issuers, reinsurers, counterparties or sectors; losses caused by catastrophic events (including public health crises, terrorist acts and natural disasters); losses in respect of different, but correlated, credit exposures; or other forms of credit risk.
The amount of interest payable on the Sitka Senior Secured Notes is set once per quarter based on the three-month LIBOR rate (or an Alternative Reference Rate as applicable) on the applicable interest determination date, which rate may fluctuate substantially; increases in interest rates will increase the cost of servicing our debt reducing our profitability and our ability to service our debt.
The Sitka Senior Secured Notes will bear interest at floating rates that could rise significantly, increasing AAC’s interest expense and reducing its cash flow and profitability. Each one percentage point increase in interest rates above the 75 basis point LIBOR (or Alternative Reference Rate as applicable) floor would result in a $12 increase in the annual cash interest payments due on the Sitka Senior Secured Notes. If AAC’s interest expense increases significantly, whether due to changes in LIBOR (or Alternative Reference Rate as applicable) or increased borrowing costs if it refinances its current indebtedness, AAC may not be able to make payments with respect to the Sitka Senior Secured Notes or its other indebtedness.
Uncertainties regarding the expected discontinuance of the London Inter-Bank Offered Rate or any other interest rate benchmark could have adverse consequences.
In 2017, the U.K. Financial Conduct Authority (“FCA”), which regulates the London Interbank Offered Rate ("LIBOR"), announced that it will no longer persuade or compel banks to submit rates for the calculation of LIBOR after 2021. On November 30, 2020, the ICE Benchmark Administration and the FCA announced that most tenors of USD LIBOR are expected to be published only through June 2023. However, Non-USD LIBOR, certain less common tenors of USD-LIBOR and certain other indices which are utilized as benchmarks ceased to be published at the end of 2021. In October 2021 noteholders of obligations insured by Ambac UK consented to the replacement of GBP LIBOR references with compounded SONIA plus a credit adjustment spread effective on the first interest payment date in 2022. AAC and Ambac UK therefore no longer insure any obligations linked to Non-USD LIBOR. AAC and/or Ambac UK insure securities, own assets, are party to certain derivative contracts and have issued debt and other obligations that reference USD LIBOR.
In 2021, New York State passed legislation addressing the cessation of U.S. Dollar (“USD”) LIBOR and specified a recommended benchmark replacement based on the Secured Overnight Financing Rate (“SOFR”) for certain legacy transactions. Similar federal legislation is pending and has already been passed by the House of Representatives. The Alternative Rates Committee, the Federal Reserve Board and several industry associations and groups have expressed support for the New York law and are encouraging Federal legislation. While Ambac believes the New York LIBOR law and pending federal legislation are generally positive steps, there remains significant uncertainty about whether the federal legislation will be enacted and how such laws will be interpreted or challenged as well as about other aspects of the discontinuance of LIBOR, including the impact of the Federal legislation, if passed.
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While regulators and market participants continue to promote the creation and functioning of post-LIBOR indices (SOFR in particular), the impact of the discontinuance and replacement of LIBOR is uncertain. It is not currently possible to know with certainty what rate or rates may become accepted alternatives to LIBOR, or what the effect of any such changes in views and alternatives may have on the financial markets for LIBOR-linked financial instruments for the periods preceding and following LIBOR's cessation. Differences in contractual provisions of certain legacy assets and liabilities and other factors may cause the consequences of the discontinuance of LIBOR to vary by instrument. While enacted and pending legislation is intended to address issues with respect to legacy LIBOR-linked assets and liabilities, it is unclear whether they will completely address the issues associated with legacy transactions.
Nevertheless, the value of our assets, derivatives and liabilities; costs to operate our business; and the losses associated with our insured portfolio may be affected in a way that may ultimately materially adversely impact Ambac’s results of operations and financial condition. In addition, Ambac may experience adverse tax and accounting impacts, system and model disruption, and increased liquidity demands in connection with the transition away from LIBOR that may have adverse operational consequences resulting in further adverse impacts on Ambac’s results of operations and financial condition. Ambac continues to actively monitor developments surrounding the transition from LIBOR-based indices and evaluate the potential impact. In addition to reviewing several hundred transactions involving various LIBOR-based indices, Ambac has made, and is in the process of making, adjustments to its reporting and analytical infrastructures to facilitate the transition from LIBOR.
Risks Related to the Company's Business
Everspan may not be successful in executing its business plans or may experience greater than expected insurance underwriting losses and/or reinsurance counterparty losses, which could result in losses material to Everspan's capital position, a downgrade of its AM Best rating and a loss of its franchise value. Such events could have a material adverse impact on the value of AFG's shares.
Everspan is in the nascent stage of the specialty insurance program business. Its business plans entails establishing programs with managing general agents ("MGAs") and managing general underwriters ("MGUs") over time. The success of these programs is dependent upon the quality of business sourced by the MGAs and MGUs, the quality of underwriting oversight of the MGAs and MGUs by Everspan, the quality and creditworthiness of reinsurance obtained with respect to the risks underwritten by Everspan, loss experience over time, premium levels, competition and other factors, some of which are outside Everspan's control. Should Everspan fail in executing its business plans or experience greater than expected losses due to shortcomings in the management of programs, Everspan's underwriting of risks, the performance of reinsurers or other factors, Everspan may suffer losses that are material to its capital position, a downgrade in its AM Best rating and/or a
loss of its franchise value. Any such outcomes could have a material adverse impact on the value of AFG's shares.
Failure of Everspan's Program Partners or Xchange to properly market, underwrite or administer policies could adversely affect us.
The marketing, underwriting, claims administration and administration of policies in our Specialty Property & Casualty Program Insurance and Managing General Agency/Underwriting businesses have been contracted to Everspan's program partners and our owned MGU, Xchange. Any failure by them to properly handle these functions could result in liability to us. Even though Everspan's program partners may be required to compensate us for any such liability, there are risks that such compensation may be insufficient or entirely unavailable if, for example, the relevant program partner becomes insolvent or is otherwise unable to pay us. Any such failures could result in monetary losses, create regulatory issues or harm our reputation, which could materially and adversely affect our business, financial condition and results of operations.
A downgrade in the AM Best financial strength ratings of our specialty program property and casualty insurance company subsidiaries may negatively affect our business.
Our specialty program property and casualty insurance company subsidiaries are evaluated for overall financial strength by AM Best to receive financial strength ratings ("FSRs"), which are an important factor in establishing the competitive position of insurance companies. These FSRs reflect AM Best’s opinion of our specialty program property and casualty insurance company subsidiaries’ financial strength, operating performance, strategic position and ability to meet obligations to policyholders, and are not evaluations directed to investors. Our specialty program property and casualty insurance company subsidiaries’ FSRs are subject to periodic review, and the criteria used in the rating methodologies are subject to change. All of our insurance company subsidiaries of Everspan currently writing business are rated "A-" (Excellent). A downgrade in Everspan's FSR could lead to Everspan's program partners moving business to other insurance companies, which would adversely affect our business, financial condition and results of operations.
If in our Specialty Program Property and Casualty Insurance business we are unable to accurately underwrite risks and charge competitive yet profitable rates to our clients and policyholders, our business, financial condition and results of operations may be adversely affected.
In general, the premiums for our specialty program property and casualty insurance policies are established at the time a policy is issued and, therefore, before all of our underlying costs are known. Like other property and casualty insurance companies, Everspan relies on estimates and assumptions in setting its premium rates. Establishing adequate premium rates is necessary, together with investment income, to generate sufficient revenue to offset losses, loss adjustment expenses and other general and administrative expenses in order to earn a profit. If Everspan does not accurately assess the risks that it assumes, it may not charge adequate premiums to cover its
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losses and expenses, which would adversely affect our results of operations and our profitability. Alternatively, Everspan could set its premiums too high, which could reduce its competitiveness and lead to lower policyholder retention, resulting in lower revenues. Pricing is a highly complex exercise involving the acquisition and analysis of historical loss data and the projection of future trends, loss costs and expenses, and inflation trends, among other factors, for each of Everspan's products in multiple risk tiers and many different markets. Everspan seeks to implement its pricing accurately in accordance with its assumptions. Everspan's ability to undertake these efforts successfully and, as a result, to accurately price its policies, is subject to a number of risks and uncertainties, including insufficient or unreliable data; incorrect or incomplete analysis of available data; uncertainties generally inherent in estimates and assumptions; failure to implement appropriate actuarial projections and ratings formulas or other pricing methodologies; regulatory constraints on rate increases; failure to accurately estimate investment yields and the duration of liabilities for losses and loss adjustment expenses; and unanticipated court decisions, legislation or regulatory action.
If Everspan is unable to obtain reinsurance coverage at reasonable prices or on terms that adequately protect it, we may be required to bear increased risks or reduce the level of our underwriting commitments.
Our specialty program property and casualty insurance company subsidiaries purchase reinsurance as part of our overall risk management strategy. While reinsurance does not discharge our insurance subsidiaries from their obligations to pay claims for losses insured under their insurance policies, it does make the reinsurer liable to them for the reinsured portion of the risk. As part of our strategy for our specialty program property and casualty business, we reinsure underwriting risk to third-party reinsurers. At the inception of a new program, Everspan acts as an issuing carrier and reinsures a majority of such risk to third parties. Everspan may be unable to maintain its current reinsurance arrangements or to obtain other reinsurance in adequate amounts and at favorable rates, particularly if reinsurers become unwilling or unable to support our specialty program property and casualty business in the future. Additionally, market conditions beyond our control may impact the availability and cost of reinsurance and could have an adverse effect on our business, financial condition and results of operations. A decline in the availability of reinsurance may increase the cost of reinsurance and materially and adversely affect our business prospects. Everspan may, at certain times, be forced to incur additional costs for reinsurance or may be unable to obtain sufficient reinsurance on acceptable terms. In the latter case, Everspan would have to accept an increase in exposure to risk, reduce the amount of business written by it or seek alternatives in line with Everspan's risk limits, all of which could adversely affect our business, financial condition and results of operations.
Everspan is subject to reinsurance counterparty credit risk. Its reinsurers may not pay on losses in a timely fashion, or at all.
Everspan purchases reinsurance to transfer part of the risk it has assumed to reinsurance companies in exchange for part of the premium Everspan receives in connection with the risk.
Although reinsurance makes reinsurers liable to Everspan for the risk transferred or ceded to the reinsurer, it does not relieve Everspan of its liability to policyholders. Accordingly, Everspan is exposed to credit risk with respect to its reinsurers, especially to the extent reinsurance receivables are not sufficiently secured by collateral or do not benefit from other credit enhancements. Everspan also bears the risk that a reinsurer may be unwilling to pay amounts it has recorded as reinsurance recoverable for any reason, including that the terms of the reinsurance contract do not reflect the intent of the parties of the contract or there is a disagreement between the parties as to their intent; the terms of the contract cannot be legally enforced; the terms of the contract are interpreted by a court or arbitration panel differently than intended by Everspan; the reinsurance transaction performs differently than Everspan anticipated due to a flawed design of the reinsurance structure, terms or conditions; or changes in law and regulation, or in the interpretation of laws and regulations, affects a reinsurance transaction.
The insolvency of one or more of Everspan's reinsurers, or their inability or unwillingness to make timely payments if and when required under the terms of reinsurance contracts, could adversely affect our business, financial condition and results of operations.
Our ability to grow our Specialty Program Property and Casualty Insurance Business will depend in part on the addition of new Program Partners, and our inability to effectively onboard such new Program Partners could have an adverse effect on our business, financial condition and results of operations.
Our ability to grow our specialty program property and casualty insurance business will depend in part on the addition of new program partners. If Everspan does not effectively onboard new program partners, including assisting such program partners to quickly resolve any post-onboarding matters and provide effective ongoing support, Everspan's ability to add new program partners and its relationships with its existing program partners could be adversely affected. Additionally, Everspan's reputation with potential new customers could be damaged if it fails to meet the requirements of its customers as a result of its failure to effectively onboard new program partners. Such reputational damage could make it more difficult for Everspan to attract new and retain existing program partners, which could have an adverse effect on our business, financial condition and results of operations.
We compete with a large number of companies in the property and casualty insurance industry for underwriting premium.
We compete with a large number of companies in the property and casualty insurance industry for underwriting premium. During periods of intense competition for premium, in particular, our specialty program property and casualty insurance and managing general agency / underwriting businesses may be challenged to maintain competitiveness with other companies that may seek to write policies without the same regard for risk and profitability targeted by our specialty program property and casualty insurance and managing general agency / underwriting businesses. During these times, it may be difficult for Everspan or our MGAs and MGUs to grow or
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maintain premium volume without lowering underwriting standards, sacrificing income, or both.
In addition, our specialty program property and casualty insurance and managing general agency / underwriting businesses face competition from a wide range of specialty insurance companies, underwriting agencies and intermediaries, as well as diversified financial services companies that are significantly larger than our specialty program property and casualty insurance and managing general agency/underwriting businesses are and that have significantly greater financial, marketing, management and other resources. Some of these competitors also have greater market recognition than we do. The greater resources or market presence that these competitors possess may enable them to avoid or defray particular costs, employ greater pricing flexibility, have a higher tolerance for risk or loss, or exploit other advantages that may make it more difficult for us to compete. We may incur increased costs in competing for underwriting revenues in this environment. If we are unable to compete effectively in the markets in which our specialty program property and casualty insurance and managing general agency/underwriting businesses operate or expand into, our underwriting revenues may decline, as well as overall business results.
System security risks, data protection breaches and cyber-attacks could adversely affect our business and results of operations.
We rely on our information technology systems for many enterprise-critical functions and a prolonged failure or interruption of these systems for any reason could cause significant disruption to our operations and have a material adverse effect on our business, financial condition and operating results. Our information technology and application systems may be vulnerable to threats from computer viruses, natural disasters, unauthorized access, cyber-attack and other similar disruptions. Computer hackers may be able to penetrate our network’s system security and misappropriate or compromise confidential information, create system disruptions or cause shutdowns. In addition to our own confidential information, we sometimes receive and are required to protect confidential information obtained from third parties and personally identifiable information of individuals. To the extent any disruption or security breach results in a loss or damage to our data, or inappropriate disclosure of our confidential information or that of others, or personally identifiable information of individuals, it could cause significant financial losses that are either not, or not fully, insured against, cause damage to our reputation, affect our relationships with third parties, lead to claims against us, result in regulatory action, or otherwise have a material adverse effect on our business or results of operations. In addition, we may be required to incur significant costs to mitigate the damage caused by any security breach, or to protect against future damage. Moreover, although we have incident response, disaster recovery and business continuity plans in place, we may not be able to adequately execute these plans in a timely fashion in the event of a disruption to our information technology and application systems.
We may be adversely affected by failures in services or products provided by third parties.
We outsource and may further outsource certain technology and business process functions, and rely upon third-party vendors for other essential services and information, such as the provision of data used in setting loss reserves. If we do not effectively develop, implement and monitor our vendor relationships, if third party providers do not perform as anticipated, if we experience technological or other problems with a transition, or if vendor relationships relevant to our business process functions are terminated, we may not realize expected productivity improvements or cost efficiencies and may experience operational difficulties, increased costs and a loss of business . A material failure by an external service or information provider or a material defect in the products, services or information provided thereby could adversely affect our financial condition and results of operations. Our outsourcing of certain technology and business process functions to third parties may expose us to increased risk related to data security, service disruptions or the effectiveness of our control system. These risks could increase as vendors increasingly offer cloud-based software services rather than software services which can be run within our data centers or as we choose to move additional functions to the cloud.
Our inability to attract and retain qualified executives, senior managers and other employees or the loss of any of these personnel could negatively impact our business.
Our ability to execute on our business strategies depends on the retention and recruitment of qualified executives and other professionals. We rely substantially upon the services of our current executive and senior management teams. In addition to these officers, we rely on key staff with insurance, underwriting, business development, credit, risk mitigation, structured finance, investment, accounting, finance, legal, technology and other technical and specialized skills. As a result of AAC’s financial situation, there is a higher risk that executive officers and other key staff will leave the Company and replacements may not be motivated to join the Company. The loss of the services of members of our executive or senior management teams or our inability to hire and retain other talented personnel could delay or prevent us from succeeding in executing our strategies, which could further negatively impact our business.
We are subject to the risk of litigation and regulatory inquiries or investigations, and the outcome of proceedings we are or may become involved in could have a material adverse effect on our business, operations, financial position, profitability or cash flows.
AAC is defending or otherwise involved in various lawsuits relating to its FG business. In addition, the Company from time to time receives various regulatory inquiries and requests for information, and its insurance company subsidiaries are subject to examination by regulatory authorities. Please see Note 19. Commitments and Contingencies to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for information on these various proceedings.
It is not possible to predict the extent to which whether additional suits involving AFG, AAC or one or more other subsidiaries will be filed or the extent to which additional
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regulatory inquiries or requests for information will be made, and it is also not possible to predict the outcome of litigation, inquiries, requests for information or examination. It is possible that there could be unfavorable outcomes in these or other proceedings. Management is unable to make a meaningful estimate of the amount or range of loss that could result from unfavorable outcomes or of the expenses that will be incurred in connection with such lawsuits or regulatory matters. Under some circumstances, adverse results in any such proceedings and/or the incurring of significant litigation or other expenses could be material to our business, operations, financial position, profitability or cash flows.
Our business could be negatively affected by actions of stakeholders whose interests may not be aligned with the broader interests of our stockholders.
Ambac could be negatively affected as a result of actions by stakeholders whose interests may not be aligned with the broader interests of our stockholders, and responding to any such actions could be costly and time-consuming, disrupt operations and divert the attention of management and employees. Such activities could interfere with our ability to execute on our strategic plans.
The Settlement Agreement, Stipulation and Order and Indenture for the Tier 2 Notes contain restrictive covenants that may impair AAC's ability to pursue its business strategies.
Pursuant to the terms of the Settlement Agreement, Stipulation and Order and indenture for the Tier 2 Notes, AAC must seek prior approval by OCI of certain corporate actions. The Settlement Agreement, Stipulation and Order and indenture for the Tier 2 Notes also include covenants which restrict the operations of AAC which, (i) in the case of the Settlement Agreement, remain in force until the surplus notes that were issued pursuant to the Settlement Agreement have been redeemed, repurchased or repaid in full, (ii) in the case of the Stipulation and Order, remain in place until the OCI decides to relax such restrictions, and (iii) in the case of the indenture for the Tier 2 Notes, remain in force until the Tier 2 Notes have been redeemed, repurchased or repaid in full. Certain of these restrictions may be waived with the approval of holders of the applicable debt securities and/or OCI. If we are unable to obtain the required consents under the Settlement Agreement, the Stipulation and Order and/or the indenture for the Tier 2 Notes, AAC may not be able to execute its planned business strategies.
OCI has certain enforcement rights with respect to the Settlement Agreement and Stipulation and Order. Disputes may arise over the interpretation of such agreements, the exercise or purported exercise of rights thereunder, or the performance of or failure or purported failure to perform obligations thereunder. Any such dispute could have material adverse effects on AAC, and the Company more broadly, whether through litigation, administrative proceedings, supervisory orders, failure to execute transactions sought by management, interference with corporate strategies, objectives or prerogatives, inefficient decision-making or execution, forced realignment of resources, increased costs, distractions to management, strained working relationships or otherwise. Such effects would also increase the
risk that OCI would seek to initiate rehabilitation proceedings or issue supervisory orders against AAC.
Actions of the PRA and FCA could reduce the value of Ambac UK realizable by AAC, which would adversely affect our securityholders.
Ambac’s international business is operated by Ambac UK, which is regulated by the Prudential Regulation Authority (“PRA”) for prudential purposes and the Financial Conduct Authority (“FCA”) for conduct purposes. The terms of Ambac UK’s regulatory authority are now restricted and Ambac UK is in run-off. Among other things, Ambac UK may not write any new business, and, with respect to any entity within the Ambac group of affiliates, commute, vary or terminate any existing financial guaranty policy, transfer certain assets, or pay dividends, without the prior approval of the PRA and FCA. The PRA and FCA act generally in the interests of Ambac UK policyholders and will not take into account the interests of AAC or the securityholders of Ambac when considering whether to provide any such approval. Accordingly, determinations made by the PRA and FCA, in their capacity as Ambac UK’s regulators, could potentially result in adverse consequences for our securityholders and also reduce the value realizable by AAC for Ambac UK.
Regulatory uncertainty in relation to Ambac UK’s capital position could adversely affect the value of Ambac UK and affect our securityholders.
Under applicable regulatory capital rules (“Solvency II”) Ambac UK was deficient in terms of capital until September 30, 2021, but as at December 31, 2021 expects to meet the capital requirements under these rules. Ambac UK's regulators are aware of the deficiency which previously existed, and dialogue between Ambac UK and its regulators remains ongoing with respect to options for strengthening the capital position further whilst Ambac UK remains in run-off.
Until Ambac UK has been able to strengthen its capital position, through the natural run-off of the insurance portfolio or otherwise, there remains a risk that market movements impacting its investments or adverse credit developments impacting loss reserving requirements within its insured portfolio could result in the capital position becoming deficient once again.
The PRA supervisory statement SS7/15 “Supervision of firms in difficulty or run-off” notes that “there are many circumstances in which a run-off strategy is in the best interests of policyholders” and notes that the PRA will review such firms and that they “may be permitted to continue activities necessary to carry out existing contracts in a manner, and for so long as, the PRA considers necessary in order to afford an appropriate degree of protection to policyholders”. If Ambac UK were to return to a capital deficit position then its run-off would become subject to the PRA taking no action in relation to that capital deficit and related Solvency II requirements. Alternative courses of action open to the PRA could adversely impact the anticipated run-off trajectory of Ambac UK and impact its value.
| Ambac Financial Group, Inc. 24 2021 FORM 10-K |
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Impairment of the intangible and goodwill assets, which resulted from the acquisition of Xchange, could adversely affect our results of operations.
In connection with Ambac’s acquisition of 80% of the membership interests of Xchange, Ambac recorded the fair value of identifiable intangible assets (primarily related to distribution relationships) and goodwill. The intangible assets will be amortized over their remaining useful lives. The Company will test intangible assets for impairment if certain events occur or circumstances change indicating that the carrying amount of the intangible asset may not be recoverable. Goodwill will be tested for impairment annually or whenever events occur or circumstances change that may indicate impairment. Intangible asset and goodwill impairments are driven by a variety of factors, which could include, among other things, declining future cash flows of the acquired business as addressed in other risk factors related to the Managing General Underwriting Business. Any intangible asset or goodwill impairment could adversely affect the Company's operating results and financial condition.
Xchange derives a significant portion of its commission revenues from a limited number of insurance companies, the loss of any of which could result in lower commissions or loss of business production.
For the year ended December 31, 2021, a majority of Xchange’s total commissions was derived from insurance policies underwritten by a limited number of insurance companies. Should one or more of these insurance companies terminate its arrangements with Xchange or otherwise decrease the number of insurance policies underwritten for it, Xchange may lose significant commission revenues or lose significant business production while it seeks other insurance companies to underwrite the business.
Xchange’s business, results of operation, financial condition and liquidity may be materially adversely affected by certain potential claims, regulatory actions or proceedings.
Xchange is subject to various potential claims, regulatory actions and other proceedings, including those relating to alleged errors and omissions in connection with the placement or servicing of insurance and/or the provision of services in the ordinary course of business, of which we cannot, and likely will not be able to, predict the outcome with certainty. Because Xchange often assists customers with matters involving substantial amounts of money, including the placement of insurance and the handling of related claims that customers may assert, errors and omissions, claims against it may arise alleging potential liability for all or part of the amounts in question. Also, the failure of an insurer with whom Xchange places business could result in errors and omissions claims against it by its customers, which could adversely affect Ambac’s results of operations and financial condition. Claimants may seek large damage awards, and these claims may involve potentially significant legal costs and damages. In addition, regardless of monetary costs, these matters could have a material adverse effect on Xchange's reputation and cause harm to its carrier, customer or employee relationships, or divert personnel and management resources.
Xchange’s current market share may decrease because of disintermediation within the insurance industry, including increased competition from insurance companies, technology companies and the financial services industry, as well as the shift away from traditional insurance markets.
The MGU business is highly competitive and Xchange actively competes with numerous firms for customers and insurance companies, many of which have relationships with insurance companies or have a significant presence in niche insurance markets that may give them an advantage. Other competitive concerns may include pricing, the entrance of technology companies into the MGU business and the direct-to-consumer insurance carriers that don't utilize third party agents and brokers as production sources. Additionally, the insurance industry may experience consolidation, and Xchange therefore may experience increased competition from insurance companies and the financial services industry, as a growing number of larger financial institutions increasingly, and aggressively, offer a wider variety of financial services, including MGU services. While Xchange collaborates and competes in these segments on a fee-for-service basis, we cannot be certain that such alternative markets will provide the same level of insurance coverage or profitability as traditional insurance markets.
Changes in law or in the functioning of the healthcare market could significantly impair Xchange’s business and therefore negatively impact Ambac’s financial condition and results of operation.
Adoption of a single payer healthcare system or a public health insurance option would likely adversely impact the entire healthcare industry. While Xchange has historically demonstrated an ability to adjust its products to major changes in the healthcare industry, given its focus on Accident and Health products, Xchange would likely be adversely impacted by such a material change in the U.S. healthcare system particularly if private health insurance is eliminated, materially limited, or is rendered noncompetitive. Material adverse developments to Xchange's business would have a negative impact on Ambac's financial condition and results of operations which could be material.
Xchange’s business and results of operation and financial condition may be adversely affected by conditions that result in reduced insurer capacity.
Xchange’s results of operations depend on the continued capacity of insurance carriers to underwrite risk and provide coverage, which depends in turn on those insurance companies’ ability to procure reinsurance. Capacity among insurance carriers and reinsurers for Xchange's products may diminish because of Xchange's performance or due to factors outside Xchange's control. For example, capacity could be reduced by insurance companies failing or withdrawing from writing certain coverages that Xchange offers to its customers. To the extent that reinsurance becomes less widely available or significantly more expensive, Xchange may not be able to procure the amount or types of coverage that its customers desire and the coverage Xchange is able to procure for its customers may be more expensive or limited.
| Ambac Financial Group, Inc. 25 2021 FORM 10-K |
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Variations in Xchange’s commissions that result from the timing of policy renewals and the net effect of new and lost business production may have unexpected effects on our results of operation.
Xchange’s commission income can vary quarterly or annually due to the timing of policy renewals and the net effect of new and lost business production. Xchange does not control the factors that cause these variations. Specifically, customers’ demand for insurance products can influence the timing of renewals, new business and lost business (which includes policies that are not renewed), and cancellations. Quarterly and annual fluctuations in revenues based upon increases and decreases associated with the timing of new business, policy renewals and payments from insurance companies may adversely affect our financial condition, results of operations and cash flows. Profit-sharing contingent commissions are paid by insurance companies based upon the profitability of the business placed with such companies. In the past these commissions have accounted for a significant amount of Xchange’s total commissions and fees. Due to, among other things, the inherent uncertainty of loss in Xchange’s industry and changes in underwriting criteria by insurance companies, there will be a level of uncertainty related to the payment of profit-sharing contingent commissions.
Risks Related to Taxation
Certain surplus notes or other obligations of AAC may be characterized as equity of AAC and as a result, AAC may no longer be a member of the U.S. federal income tax consolidated group of which AFG is the common parent.
It is possible that certain surplus notes or other obligations of AAC may be characterized as equity of AAC for U.S. federal income tax purposes. If such surplus notes or other obligations are characterized as equity of AAC that is taken into account for tax affiliation purposes and it is determined that such “equity” represented more than twenty percent of the total value of the stock of AAC, AAC may no longer be characterized as an includable corporation that is affiliated with AFG. As a result, AAC would no longer be characterized as a member of the U.S. federal income tax consolidated group of which AFG is the common parent (the “Ambac Consolidated Group”) and AAC would be required to file a separate consolidated tax return as the common parent of a new U.S. federal income tax consolidated group including AAC as the new common parent and AAC’s affiliated subsidiaries (the “AAC Consolidated Tax Group”).
To the extent AAC is no longer a member of the Ambac Consolidated Group, AAC’s net operating loss carry-forwards ("NOLs") (and certain other available tax attributes of AAC and the other members of the AAC Consolidated Tax Group) may no longer be available for use by the AAC Consolidated Tax Group or any of the remaining members of the AAC Consolidated Tax Group to reduce the U.S. federal income tax liabilities of the AAC Consolidated Tax Group. AFG, AAC and their affiliates entered into a tax sharing agreement that would require AFG to make certain tax elections that could mitigate the loss of NOLs and other tax attributes resulting from a deconsolidation of AAC from the Ambac Consolidated Group.
However, in the event of a deconsolidation, certain other benefits resulting from U.S. federal income tax consolidation may no longer be available to the Ambac Consolidated Group, including certain favorable rules relating to transactions occurring between members of the Ambac Consolidated Group and members of the AAC Consolidated Tax Group. A deconsolidation of AAC from the Ambac Consolidated Group could have a material adverse impact on our results of operations and financial condition.
If surplus notes or other obligations are characterized as equity of AAC, the AAC NOLs (and certain other tax attributes or tax benefits of the Ambac Consolidated Group) may be subject to limitation under Section 382 of the Tax Code.
It is possible that certain surplus notes or other obligations may be characterized as equity of AAC for U.S. federal income tax purposes. Such characterization could result in an “ownership change” of AAC for purposes of Section 382 of the Tax Code. If such an ownership change were to occur, the value and amount of the AAC NOLs would be substantially impaired, increasing the U.S. federal income tax liability of AAC and materially reducing the value of AAC’s stock owned by AFG and the potential for future dividend payments from AAC to AFG.
Deductions with respect to interest accruing on certain surplus notes may be eliminated or deferred until payment.
To the extent certain surplus notes are characterized as equity for U.S. federal income tax purposes, accrued interest will not be deductible by AAC. In addition, even if such surplus notes are characterized as debt for U.S. federal income tax purposes, the deduction of interest accruing on such surplus notes may be deferred until paid or eliminated in part depending upon (i) the terms of any deferral and payment provisions provided in such surplus notes, (ii) whether such surplus notes have “significant original issue discount,” and (iii) the yield to maturity of surplus notes. To the extent deductions with respect to interest are eliminated or deferred, the U.S. federal income tax of AAC or the members of the AAC Consolidated Tax Group as the case may be, could be increased reducing the amount of cash available to pay its obligations and, therefore, the value of AAC’s stock owned by AFG and the potential for future dividend payments from AAC to AFG.
Risks Related to Strategic Plan
Ambac is planning to further develop and expand the Specialty Property and Casualty Program Insurance business and the Managing General Agency/Underwriting business; however, such plans may not be realized, or if realized, may not create value and may negatively impact our financial results.
The value of AFG's common stock depends in part upon the ability of Ambac to generate earnings apart from AAC. Ambac is planning to further develop and expand the Specialty Property and Casualty Program Insurance Business and the Managing General Agency/Underwriting business. Such plans may involve additional acquisitions of assets or existing businesses and the development of businesses through new or existing subsidiaries.
| Ambac Financial Group, Inc. 26 2021 FORM 10-K |
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It is not possible at this time to fully predict the future prospects or other characteristics of such businesses. While we expect to conduct business, financial and legal due diligence in connection with the evaluation of any future business or acquisition opportunities, there can be no assurance our due diligence investigations will identify every matter that could have a material adverse effect on us. Efforts to pursue certain business opportunities may be unsuccessful or require significant financial or other resources, which could have a negative impact on our operating results and financial condition. To effect our growth strategy, we must be able to meet our capital needs, expand our systems and our internal controls effectively, allocate our human resources optimally, identify and hire qualified employees and effectively integrate any acquisitions we make in our effort to achieve growth. No assurances can be given that Ambac will successfully execute its plans for new business, generate any earnings or value from new businesses or be able to successfully integrate any such business into our current operating structure. The failure to manage our growth effectively could have a material adverse effect on our business, financial condition and results of operations.
Moreover, Ambac’s ability to enter into new businesses may be constrained, given the financial condition of AAC, counterparty or rating agency concerns about AAC's ability to mitigate insured portfolio losses or recover losses in litigation, the difficulty of leveraging or monetizing Ambac’s other assets, and the uncertainty of Ambac's ability to raise capital. Due to these factors, as well as those relating to AAC as described in this Item 1A. Risk Factors, the value of our securities is speculative.
Should changes in Ambac’s circumstances or financial condition or in the political, economic and/or legal environment occur, there can be no assurance that all or any part of our strategy and/or initiatives will not be abandoned or amended to take account of such changes. Any such adjustment or abandonment may have an material adverse effect on our securities.
Item 1B. Unresolved Staff Comments — No matters require disclosure.